Saturday, March 29, 2014

Business Structures for Innovation

Guest Blogger

Dan L. Burk  

For the conference on Innovation Law Beyond IP at Yale Law School

Transaction cost analysis is a standard tool used across corporate, securities, bankruptcy, and related areas of business law to understand how firms respond to particular market conditions.  The fundamental premise of such analysis is that markets are costly mechanisms for organizing economic production.  In some instances managerial direction will be cheaper than market negotiation, in which case the business will develop an internal capacity to produce the necessary input.  The decision whether to make an input or buy it in the market will be determined by which option presents lower transaction costs.

This perspective implies that firms will integrate some activities, growing to a size dictated by market transaction costs, and assuming a structure that will lower their internal transaction costs.  Applicable legal regimes are an important factor determining both the transaction costs facing firms and the structures that they can adopt in response to such costs.  Laws governing the form of business association, and those governing employee relations may dictate or limit the strategies that firms can adopt in order to manage such costs.

An important consideration in the provision of production inputs is the ability of a firm to appropriate the value of investments in innovation.  Valuable information is a particular problem in this regard, as Kenneth Arrow observed long ago: once the information is disclosed to a business partner, or even to an employee, it becomes impossible to retrieve and difficult to control.  The partner or employee may quickly become a former partner or employee, departing with the disclosed information.

Firms may of course use contracts in an attempt to prevent such strategic behavior, specifying contract terms that allocate the risk of defection by employees or partner firms.  However, contracts are inevitably incomplete, and cannot specify the resolution of all possible contingencies.  Such conditional loopholes, together with the difficulty and expense of enforcing the contract in cases of breach, leaves firms vulnerable to hold-up and strategic behavior.  Integration eliminates the need for outsourcing contracts, but exacerbates the problem of employee misappropriation.

             Certain structural strategies may ameliorate this hazard as well.  For example, the firm may use the offer of stock options as an incentive to retain employees with valuable human capital who might otherwise move to a competing firm or strike out on their own.  Options with delayed vestiture provide an incentive for the employee to remain with the firm. But more importantly, stock will tend to align the incentives with the employee with those of the firm; the better the firm performs, the more valuable its stock.  Employees with a vested interest in the firm’s stock will be more inclined to work toward the success of the firm.

            Thus, firms will utilize structural and organizational arrangements to appropriate the value of innovations and such arrangements will be governed by a mixture of corporate, securities, employment, and labor law.  A number of commentators have also suggested that intellectual property rights may improve, or at least alter, the transaction cost landscape facing firms.  For example, patents may lower transaction costs by guarding against Arrow’s predictions for information disclosure; information may be disclosed in a negotiation, safeguarded by a strong exclusive right, lowering the costs of hold-up and defection.  Trade secrecy can similarly guard against employee misappropriation of the firm’s intellectual assets.  Market negotiations thus become less costly, leading to more outsourcing, and to smaller, more entrepreneurial firms.

However, the provision of intellectual property may be a mixed blessing, as exclusive rights will lower transaction costs only to a point, and only under particular conditions.  Beyond that point, intellectual property rights may actually raise transaction costs, leading to inefficient firm growth.  For example, multiple or overlapping patent rights may produce an anti-commons that makes it difficult for firms to secure freedom to operate.  Adding intellectual property to the transaction cost picture thus complicates the choices facing firms, and may push them toward either integration or outsourcing, depending on the circumstance.

            Thus, adding intellectual property rights into the mix creates a complex transactional landscape that may induce firms to vertically integrate or downsize, depending on the situation.  But a poorly investigated or appreciated effect of adding intellectual property into the transaction cost mixture is its potential effect on competing firms.  Studies to date have focused largely on the response of rights holders to altered transaction costs.  However, it is becoming clear that, at least in certain instances, the presence of intellectual property rights in the marketplace will prompt competitors, who may be potential infringers, to adopt defensive business structures.

For example, Langinier and Marcoul have developed a formal model suggesting that formation of networks of suppliers may be deterred due to patent law’s contributory infringement rule. The implications of this model for transaction cost analysis are striking.  In particular, one social cost of the contributory infringement rule may be to prevent potential infringers from outsourcing some production functions – pushing them instead toward inefficient integration and development of internal capacity.

Similarly, the current patent jurisprudence on divided infringement creates a negative space, outside the current patent system, that militates in favor of particular business structures for competitors.  Infringement of a method patent requires that a single entity, or multiple actors under the control of a single entity, perform each step of the method stated in the patent claims.  This opens the possibility that competitors of a patent holder may outsource particular steps in an otherwise infringing industrial process, pushing a competing firm away from vertical integration.  But the question of indirect liability in this situation, as explored by Langinier and Marcoul, remains unsettled.  The Akamai case currently before the Supreme Court will likely clarify the indirect infringement question, and the outcome will determine whether competitors of method patent holders are pushed toward outsourcing or integration in order to avoid infringement.

Dan L. Burk is Chancellor’s Professor of Law at the University of California, Irvine.  He can be reached at dburk at law dot uci dot edu.

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