Patents, tax shelters, and the firm.

While critics have questioned how well business method patents fit standard patent justifications, that is, regarding their ability to provide economic incentives for innovation, the special economic peculiarities of such patents have received less scrutiny. In particular, desirability of investment patents may deserve consideration in light of the efficient market hypothesis. In its strongest form, this economic theory holds that the prices in markets reflect all the available information concerning traded commodities, so that excess returns to investment are impossible. Weaker forms of this hypothesis hold that some temporary disparity between market price and actual value may be possible, allowing some excess returns to those who have access to better value information, but that the very activity of pursuing undervalued commodities will cause their prices to rise, rapidly dissipating any advantage gained from the privately-held information. In other words, the communicative nature of prices in markets rapidly, although perhaps not instantaneously, makes privately held investment information public. (21)

This hypothesis has important implications for investment strategies generally and for the policy of patenting such strategies. Investment strategies, whether patented or unpatented, are almost by definition intended to outperform the market--there is no other reason for the development of such strategies, since the recognized, understood, and simple approach of buying and holding a diverse portfolio of investment instruments would otherwise yield the optimal outcome. The efficient market hypothesis predicts that attempts to outperform an efficiently functioning market will fail. However, an investment strategy that may be exploiting some imperfection or inefficiency in the market may yield better returns than the market as a whole, at least until the information about the inefficiency leaks out, attracts other investment, and the profits from that investment anomaly are competed away. (22)

The question for investment strategies based upon anomalies, then, is how quickly they will be noticed and dissipated. If the market is sufficiently transparent, this may occur simply by observation of pricing in the marketplace. If for some reason market pricing does not reflect the desirability of the investment strategy, the information may reach the marketplace through other channels--such as gossip. Opportunism or entrepreneurship on the part of those conducting the investment transaction may also play an important role in disseminating information about the strategy. Employees familiar with the strategy may personally employ it for their own benefit or may use the information gained in the service of the firm to service their own clients, perhaps by leaving and founding their own brokerage. Indeed, competing investment firms may attempt to hire experienced personnel away from their competitors in order to get the benefit of that competitor's specialized knowledge for their own clients.

This of course presents a problem of confidentiality for those exploiting market anomalies. One strategy for containing such information leakage is to treat the investment strategy as a trade secret, prohibiting employees from discussing it with those outside the firm, from using the information for their own benefit, or from using the information in the service of a new employer. Obligations of trade secrecy arise from a number of legal sources, including a duty of loyalty to the employer in tort and prohibitions on unjust enrichment in the law of restitution. But a common source of trade secrecy obligation arises out of contract, through employment of confidentiality agreements and possibly non-competition agreements. These agreements may be used to obligate not only employees to secrecy, but also clients who will learn of the transaction, as well as business entities that may be involved in transactions under the investment system.

Such agreements are common in many industries, but may be central to preserving the profitability of investment strategies that are profitable only so long as the market does not learn of their existence. Yet confidentiality agreements are cumbersome to draft, to police, and to enforce. They are also subject to the famous "information disclosure paradox" formulated by Kenneth Arrow: the possessor of valuable information will be reluctant to disclose information unless a confidentiality agreement is in place, but the potential recipient of the information will simultaneously be reluctant to sign a disclosure agreement until he knows what information is to be disclosed. (23) Consequently, Arrow predicts that disclosures under confidentiality agreement will be impeded and often will not occur at all.

Patents present one solution to the information disclosure paradox, by occasioning exclusive rights on the publication of an enabling disclosure of the claimed invention. (24) An important factor in the calculus of patent benefits is the public benefit of disclosure. In order to obtain a patent, the applicant must disclose the claimed invention in sufficient detail that one of ordinary skill in the pertinent art could make and use the invention by following the disclosure. (25) This disclosure is published as part of the patent document, providing the benefit of the information to the public at large and allowing anyone to practice the invention after the expiration of the exclusive rights in the patented invention. In the rationale of the patent system, disclosure of the invention is the public's quid pro quo for granting the inventor exclusive rights.

But quite apart from such public benefits to disclosure is a private benefit for negotiation and licensing transactions. The publication of the invention disclosure in a patent places potential licensees or purchasers on notice as to the nature of the invention, while the exclusive rights in the invention prevent misappropriation based on the disclosure. (26) Thus, aside from any effect they may have as an incentive to investment or any benefit due to the increase in public knowledge, patents are expected to lower transaction costs between firms by avoiding the information disclosure stand-off that may occur under purely contractual disclosures.

However, the public information function of patents remains troublesome. The corpus of published patent disclosures unquestionably provides a valuable technical library to the public. But careful observers of the patent system have long been aware of a paradox in the patent disclosure rationale. (27) The exclusive rights in a patent are only valuable in comparison to the patent holder's next best alternative, which is trade secrecy. Patent protection lasts for a little less than twenty years, but trade secrecy lasts so long as the invention remains generally unknown--essentially, so long as it is not independently recreated or reverse engineered by another. A rational innovator would prefer perpetual protection to twenty years of protection, and so would presumably opt for trade secrecy if the invention can be maintained as a secret. This in turn implies that the rational innovator will opt for a patent only when the invention cannot be maintained as a secret. Or, in other words, patents only disclose information which would have become public anyway.

Where investment methods are concerned, this problem is even more troubling. On a strong theory of the efficient market, information about investment strategies will by their very implementation be communicated via the market and their benefits dissipated away by the response of other market participants. Patenting the investment strategy, however, may legally exclude other market participants from responding to the price information signaled by the behavior of the patent holder--in other words, patents may lock in inefficiencies that the market would have corrected. On this view, the patent grant not only exchanges exclusive rights for information the public would have had anyway, it also locks in a market distortion for a period of nearly two decades. And since, on a strong theory of the efficient market, investment strategies would be impossible to maintain in secrecy, the incentive of a patent never prompts disclosure of otherwise inaccessible information.

On a weaker view of the efficient market, the prospects for patent disclosure may be somewhat less bleak. Patenting will presumably still not be an attractive option for investment strategies that might remain viable and confidential indefinitely. However, it may be that the patent will prompt disclosure sooner in those cases where the investment strategy could not be maintained in secret for seventeen or eighteen years, but might have been maintained for a significant period of time less than that. Risk averse business innovators may opt for a certain seventeen or eighteen years of exclusivity over a lesser period of uncertain use, during which the strategy might be inadvertently disclosed or independently discovered by another (and, indeed, patented after independent discovery by another business innovator, in which case the earlier innovator will be excluded or end up paying patent royalties to the later discoverer). We suspect that it is in this class of investment strategies where patenting will have the greatest effect, particularly for tax investment strategies. And so it is in this class of investment strategies that we consider the effects of the shift from trade secrecy to patenting, in light of the theory of the firm.

IV. PATENTS AND THE THEORY OF THE FIRM