Category: Law School

The Need for a Detailed Procedure of Judicial Review of Civil Rights Arbitration Awards after Rent-A-Center West, Inc. v. Jackson

Congrats to Nicole Farbes-Lyons of St. John’s University School of Law – winner of the National Law Review Spring Student Legal Writing Contest.  Nicole’s topic  explored several components underlying the Supreme Court’s recent Rent-A-Center decision and the subsequent need for clearer guidance per civil rights arbitration.  

Introduction

The November 17, 2010 New York Times article “Justices Are Long on Words but Short on Guidance” blasted the Supreme Court of the United States for its issuance of sweeping and politically polarized decisions, and criticized the quality of the Court’s “judicial craftsmanship” by positing that “[i]n decisions on questions great and small, the Court often provides only limited or ambiguous guidance to lower courts. And it increasingly does so at enormous length.” [1] The article continued that critics of the Court’s work “point to reasoning that fails to provide clear guidance to lower courts,” and described the Court’s recent rulings as “fuzzy” and “unwieldy.”[2]

In the past, the Supreme Court has been notably divided over issues such as abortion and the death penalty. But the “fuzziness” in many recent rulings is owed to an obvious ideological divide in the area of arbitration. Over the past decades, a significant number of controversial decisions have arisen from the considerable attention (and contention) the Supreme Court has given arbitration as it endeavors to counterbalance pro-arbitration rulings and assurances that arbitration does not erode sufficient, constitutionally proscribed judicial control.[3] However, these decisions have been largely criticized as providing, at best, a fuzzy blueprint for lower courts to design more specific rules.

Rent-A-Center v. Jackson [4] is the most controversial, ideologically split arbitration decision of the Supreme Court’s recent term. The central issue arose because Rent-A-Center requires employees to sign a two-part arbitration agreement as a condition of their employment, stipulating first that all disputes arising out of the employment relationship be settled by arbitration, and second, that an arbitrator must settle all challenges to the validity of the arbitration agreement.[5] When plaintiff Jackson, a Rent-A-Center account manager, brought a 42 USC § 1981(a) / 42 USC §§. 2000(e)(2) employment discrimination claim against the company, Rent-A-Center insisted that the claim be resolved through arbitration.[6]

Jackson argued that the arbitration agreement was unconscionable because it denied him meaningful and appropriate access to court for a satisfactory remedy in the exact way prohibited by federal statute. Rent-A-Center argued that this threshold question of whether there was a valid and fair agreement to arbitrate Jackson’s employment grievance was a matter for the arbitrator under the Federal Arbitration Act. Jackson asserted that because the unconscionability challenge went to both parts of the arbitration agreement, arbitrability of the agreement was a question for the court.

By a vote of five to four, the Supreme Court ruled in Rent-A-Center’s favor. Led by Justice Scalia, the Court held that if Jackson had solely questioned the second part of the contract – that the agreement must be arbitrated – then the challenge would have been proper before the court. But because the employee’s grounds for unconscionability applied equally to the agreement to arbitrate all employment disputes, the general question of unconscionability was no longer a “gateway issue” before the court, and was a matter for the arbitrator.[7]

Though it generated very little media attention, the majority decision in Rent-A-Center incited much sideline animosity. Critics of Rent-A-Center argued that the case is incorrectly decided and the latest, deadliest blow to consumers and employees in a trajectory of pro-arbitration rulings that are supplanting the constitutional right to court access with compulsory arbitration. Lawmakers have admonished the Court’s short-sightedness, and Senate Judiciary Committee Chairman Patrick Leahy referred to Rent-A-Center as “a blow to our nation’s civil rights laws”.[8] Throughout the blogosphere, commentators described Rent-A-Center as “audacious,” and, as Justice Stephens described in his dissent, “fantastic”.[9]

In addition to the political arguments arising from Rent-A-Center, critics also raised concerns about procedural challenges facing professional arbitrators in light of the Court’s holding. The recent case law culminating in Rent-A-Center has drawn criticism for its lack of guidance instructing either the courts or arbitrators about their respective roles within civil rights arbitration. Broad principles of arbitration and specific doctrines of the Supreme Court encourage but do not demand that the federal protections of civil rights statutes must be enforced in private arbitration. Though the Supreme Court gives assurance that courts may reject arbitral awards for “manifest disregard,” in regards to statutory protection, the courts do not agree as to whether a showing of manifest disregard is proper grounds for vacating an arbitration award.[10]

This conundrum is disturbing, and the doctrine culminating in Rent-A-Centercreates, at best, a blueprint for potential interpretations of arbitration agreements and judicial remedies for arbitrable disputes. The question left before the legal community is, then, whether the Supreme Court’s next step will be to clarify a specific process for civil rights arbitration. Until then, the courts will likely remain divided over the issue of whether, and under what circumstances, statute-created court access can be circumvented with compulsory arbitration agreements, without violating due process of law.

This paper will explore several components underlying the Rent-A-Centerdecision and the subsequent need for clearer guidance per civil rights arbitration. First, this paper will prepare the background and context of civil rights arbitration by exploring the legislative history and statutory framework of the Federal Arbitration Act (“FAA”) and the Civil Rights Acts, particularly focusing on 42 USC §1981(a) right to recovery under Title VII of the Civil Rights Act of 1964 (“Title VII”). Second, this paper will introduce problems of separability stemming from the Supreme Court’s efforts to increase the preemptive reach of the FAA under a broad definition of interstate commerce. Finally, this paper will assert potential remedies towards ameliorating the ambiguities that culminate in the Rent-A-Center decision, in light of this judicial and legislative history.

I. Background and Context of Civil Rights Arbitration

A. Statutory History of 42 USC § 1981

The civil right at issue in Rent-A-Center was Jackson’s right to protection against racial discrimination under 42 USC § 1981. During the Reconstruction Era, restrictive employment covenants were an acknowledged social evil used by former slave owners to deny freedmen any opportunity to exercise their rights to property and employment.[11] Recognizing the elements that impaired the emancipated slaves’ ability to obtain a fair trial in former Confederate states, Congress observed that, “To say that a man is a freeman and yet is not able to assert and maintain his right in a court of justice is a negation of terms.”[12]

The framers of the Civil Rights Acts had a specific legislative goal of rooting out discrimination. The Reconstruction Congress determined that the Civil Rights Acts would only have force if the statutes also created a clear mechanism of judicial enforcement, and delineated a remedy at law that would ensure all Americans the right to a fair tribunal.[13] Accordingly, this Congress created statutes providing a federal right to action as protecting against discrimination.[14]

The legislative history behind the Reconstruction Era Civil Rights Acts is not antiquated, and the Supreme Court has recognized that, “ameliorating the effects of past racial discrimination [is] a national policy objective of the highest priority.‟[15]A predominant effect of the Civil Rights Acts, particularly 42 USC § 1981(a), is that federal law prohibits discrimination in employment based on race, gender, disability, and sexual orientation. In 1991, the 102nd Congress expanded the provisions of 42 USC § 1981(a) and subsequent law to provide statutory basis for arbitration and alternative dispute resolution to “the extent available by law.”[16]

B. Statutory History of the Federal Arbitration Act

Formal arbitration practices can be dated to the Middle Ages, and many primary themes continue in modern arbitration: greater confidentiality, group amelioration, arbitrators with particularized commercial expertise, less formality than court proceedings, greater expedition, compromise, judgments that are final in merit, and the idea that, optimally, resolution of the dispute allows the parties to maintain favorable business relationships.

Despite this equitable premise, many difficulties hindered arbitration until the 20th century, such as difficulty in enforcing awards and judicial concern over jurisdictional ouster. In 1920, the New York State legislature enacted the first modern arbitration statute, which was followed in 1925 by enactment of the FAA and, subsequently, the advent of arbitrable statutes in most of the states.[17]Core principles of the New York statute were cloned in the FAA, particularly the idea that a pre-dispute agreement compelling arbitration is contractual, and therefore a litigant must assert a valid contract defense such as fraud, duress or unconscionability to prove the agreement is unenforceable.[18]Where a counter party to a pre-dispute agreement brings a case, a party can move to stay the court case by showing the agreement was arbitrable or, if there is general recalcitrance, move to compel arbitration.[19]

C. Common Criticisms of Modern Arbitration

These attributes of modern arbitration have been greatly criticized in the context of statutory arbitration, particularly in respect to Title VII claims.[20] In the legal discussions surrounding Rent-A-Center, Jackson’s supporters argued that he, and similarly situated employees, did not have a choice about whether to sign the Rent-A-Center mandatory pre-dispute arbitration agreement; Jackson had no opportunity to negotiate its terms, and the failure to sign would have precluded employment.[21] Additionally, supporters argued that Jackson should not have been expected to understand that his acceptance of the employment agreement was a waiver of his statutory right to court access.[22] Finally, supporters believed that, even in favorable arbitration circumstances, acceptance of all arbitration terms was likely to favor the employer with respect to fees, discovery, and procedures.[23] However, the Supreme Court has noted many times that these criticisms are not unique to civil rights arbitration but instead are inherent to the very nature of dispute resolution.[24]

The Court of Appeals has noted the issue of enforceability in employment contracts mandating employees’ waiver of court access with respect to all employment disputes relating to discrimination.[25] The court described an arbitrator who resolves statutory claims as a “private judge,” but noted that, unlike a judge, an arbitrator is not publicly accountable and the lack of public accountability may favor companies over individuals.[26] The court also acknowledged that confidentiality is won at the cost of binding precedent, which presents both a potential barrier to future plaintiffs’ ability to locate necessary information as well as reduced effectiveness of binding precedence.[27] The Court of Appeals also noted that the competence of an arbitrator to analyze and decide purely legal issues in connection with statutory claims might be questioned because arbitrators do not have to be legal professionals.[28] Nonetheless, the Court of Appeals dismissed all of these criticisms by stating that the Supreme Court has decided that, as a general rule, employment discrimination claims are fully subject to binding arbitration.[29]

The Supreme Court and Court of Appeals’ dismissal of these critical issues does little to assuage the valid concerns raised regarding civil rights’ arbitration.[30]Particularly in light of the legislative history substantiating 42 USC § 1981, the Court of Appeals’ deference, without meaningful underlying analysis behind its decision, is demonstrative of the enormous lack of guidance criticized by the New York Times.

II. The Preemptive Reach of the Federal Arbitration Act

A. Basic Principles of Federal Preemption in Arbitration

The FAA is something of an anomaly in the field of federal-court jurisdiction.[31]The FAA does not vest exclusive subject matter jurisdiction in the federal courts though it creates the body of federal substantive law establishing and regulating arbitration.[32] Unless there is either a federal question or complete diversity, it is up to the state courts to apply the FAA and the federal case law standards for its implementation in any cases involving interstate commerce.[33]

Some, including some Supreme Court Justices, take this to mean that the congressional intent was that the FAA should only apply in federal court as a federal remedy.[34] The disagreement between jurists of the correct application of the FAA is, at least, indicative of the lack of clarity in the congressional intention behind the Act. The FAA says that it applies to all matters involving “interstate commerce.”[35] However, interstate commerce of 1925 was a restricted concept, to the point that a business’ involvement in interstate activity did not create sufficient minimum contact to assert jurisdiction over it.[36] Therefore, it is questionable whether this statutory language should be imposed upon by a modern definition of interstate commerce.

B. Federal Preemption of the FAA and Substantive Law Under Erie

Additionally, the Supreme Court did not distinguish substantive diversity of state versus federal law until Erie v. Tompkins in 1938.[37] Under Erie, state contract law is applied to interpret the substantive meaning of the arbitration agreement.[38] Within the context of preemption – under which interstate commerce is broadly sweeping, without regard to its substantial impact – the Court has construed the FAA as broadly as the constitutional limit.[39] Under the constitutional provisions of the Supremacy Clause, the Supreme Court has held that state courts and legislatures cannot enact statutes restricting arbitration.[40]Likewise, states cannot ease the federal presumption of arbitrability.[41]

C. Restrictions to Separability

This imposition of preemption may be the most problematic because of its restrictions to common law contract defenses. In his dissent to Prima Paint Corp. v. Flood & Conklin Mfg. Co., Justice Black described the Court’s holding that the preemptive reach of the FAA compels a counter party to carry out his agreement to arbitrate even though the a court might find the agreement void because of fraud as “fantastic.”[42] Justice Black continued in his dissent that he was unconvinced that a broad preemptive application of the FAA is not a denial of a person’s rights to due process of law.[43]

Under contract law,undue influence, fraud, and unconscionability are remedies available to parties attempting to rescind a contractual clauses. Contract defenses may be ruled on separately or prior to arbitration. This makes sense because, as Justice Stevens suggested, there is no need to arbitrate an unenforceable agreement.[44] In Rent-A-Center, plaintiff Jackson presented a well-pleaded case of unconscionability, relying on the separability of contract and arbitration.[45]However, the Supreme Court’s decision in Rent-A-Center, that a defense of unconscionability should be heard by the arbitrator, entirely undermines the presumed separability of the arbitrable matter and the arbitration agreement.[46]

This ruling is unwieldy, at best. It does not make sense to compel arbitration of the validity of an arbitration agreement when a party claims to have contractual defenses to that arbitration agreement.[47] Nevertheless, the Rent-A-Centerdecision approves this conceptual change to separability. In light of the legislative intent of the FAA and Title VII, any denial of court access resulting from this faulty logic must be considered a lack of due process.[48]

III. Judicial Review of Arbitration Awards Post-Rent-A-Center

A. Lack of Guidance on Judicial Review of Civil Rights Arbitration

Jackson’s argument in Rent-A-Center was that the making of the arbitration agreement was unconscionable, and therefore required the court to make a determination of the agreement’s legality before compelling any arbitrable review of the dispute.[49] However, as illustrated in the previous sections, even those legal minds most versed in the FAA are unable to agree whether compulsory arbitration of employment discrimination suits can be forced on employees. The Court’s ruling in Rent-A-Center dramatically affects the ability of employees to challenge the enforceability of arbitration agreements, because it sends valid challenges to arbitration to the arbitrator.[50]

However, the Rent-A-Center decision provides little guidance on judicial review of contractual defenses to arbitration. The decision does not consider the obvious question that arises from its holding: in light of this decision, has the scope of review of arbitration awards changed such that the arbitrator’s determination of whether to arbitrate is a valid ground for judicial review?

The Rent-A-Center decision is premised on the assumption that an arbitrator’s ruling on unconscionability is still subject to post-award review under the FAA.[51]In fact, Justice Scalia was insistent that an arbitrator would not be able to disregard the law when determining whether an arbitration agreement is unconscionable.[52] However, the Rent-A-Center decision does not provide any guidance on the procedure of this scope of review.

B. The Doctrine of Manifest Disregard

Justice Scalia’s insistence that an arbitrator may not disregard the law hints at the doctrine of manifest disregard, and the validity of its application to the scope of review. The Supreme Court has ruled that, so long as the litigant may vindicate his or her statutory claim in the arbitral forum, the statute will continue to serve both its remedial and deterrent function.[53] However, actual judicial review of arbitration awards is strictly limited under section 10 of the FAA.[54] The award may be vacated only if the proceeding was tainted with corruption, misconduct or bias; if the arbitrator exceeded his or her authority; or if the arbitrator acted in “manifest disregard of the law.”[55]

Generally, manifest disregard means that the arbitrator knew the applicable law but purposefully chose to ignore it or refused to apply it.[56] Since the inception of the doctrine, there has been a great expansion of the arbitrator’s authority over disputes.[57] This expansion of power has been so broad that, under applicable arbitration rules, the arbitrator himself may not correct his award after release for substantive deficiencies.[58] Because judicial review of arbitration awards is rare, it seems a convincing argument that manifest disregard applies in circumstances where arbitrators have exceeded their powers.[59] However, the doctrine is also contested because the language of section 10 does not specifically refer to manifest disregard as an independent ground for vacating arbitration awards.[60]

A good deal of confusion around the extent of the arbitrator’s power and the applicability of manifest disregard is owed to the lack of guidance provided by recent Supreme Court decisions. Prior to Rent-A-Center, the Supreme Court held in Hall Street Assocs., LLC v. Mattel, Inc. that the statutory grounds for judicial review under section 10 are exclusive. This ruling indicated that manifest disregard was not valid grounds for review.[61] Shortly after the Hall Streetdecision, the court concluded, in dictum, that if an arbitration panel exceeds its powers, the courts are authorized by section 10(b) of the FAA to either direct a rehearing or review the question de novo.[62] The federal circuit courts have been diametrically opposed in their rulings, as they struggle to interpret the meaning of these conflicting Supreme Court writings.[63]

C. Post-Award Judicial Review after Rent-A-Center

Historically, courts have been reluctant to even review arbitration awards, let alone vacate or demand rehearing. However, Rent-A-Center may be an opportunity for a new post-award standard of review.

Consider the following: An arbitration panel is selected to hear an employment discrimination dispute. Though the panel members are all industry experts and well versed in employment discrimination issues, they are not lawyers. The employee asserts that not only have her Title VII rights been violated, but also that the arbitration agreement is invalid because it was fraudulently induced. In its misunderstanding of applicable contract law, the panel misinterprets the employee’s claim and decides that the arbitration agreement is enforceable. The panel proceeds with arbitration.

This example illustrates a potential conflict arising from the Supreme Court’sRent-A-Center and Hall Street decisions. Does the arbitrators’ incorrect determination manifest purposeful disregard of the law? Although section 10 of the FAA does not allow a court to set aside an award for an error of law per se, an argument could be made that, in such a case as the previous scenario, the arbitrator exceeded his or her powers under section 10(a)(4) by acting on an unfamiliar area of law. However, there is no precedent on how the court should proceed to review such a situation. As the Supreme Court continues to expand the scope of post-award judicial review, more guidance and clearer judicial intent will be required to direct both arbitrators and the courts.

Professional mediator and former Columbia University Negotiation and Conflict Resolution faculty member, Bathabile Mthombeni, vehemently agrees that the Supreme Court must put forth specific rules relating to civil rights arbitration claims. Professor Mthombeni is an enthusiastic supporter of mediation, including employment and statutory mediation. However, her wariness of compulsory arbitration has increased over the years in tandem with Supreme Court pro-arbitration rulings.

“I am very concerned about the way that Rent-A-Center was decided because of the impact this has on access to the courts – especially by people who are likely the most vulnerable,” Professor Mthombeni stated. “Do potential employees really have a choice? [In the future, will] this mean that an employee cannot file with the EEOC? And, as the dissent inRent-A-Center points out, how are the lawyers arguing these cases supposed to anticipate how thinly they must slice their arguments as to the seperability of various portions of the agreement to arbitrate?”

Professor Mthombeni’s concern about the Rent-A-Center case’s impact on employees and consumers is based in her extensive knowledge of both dispute resolution and civil rights statutes. She suggests that arbitrators should be held to the same standards of evidential and procedural rules that would pertain in court. “The framers of [42 U.S.C. § 1981(a)] did not anticipate those claims being investigated or decided in arbitration. My recollection of 1981 legislation is that it is especially articulated in order to allow individuals to act as attorneys general, recognizing the particular interest that society has in rooting out civil rights violations.

“It does not seem that arbitration is a forum that champions this end. I am at least concerned about the lack of protections afforded to litigants in arbitration – in particular… the rules of evidence and civil procedure not being strictly adhered to.”

Professor Mthombeni suggests that not only should post-judicial review standards be more defined but also that the Supreme Court should parallel its rulings with evidential and procedural rules of arbitration. “Some might argue that the rules of evidence and civil procedure are themselves flawed. But at least they are part of a commonly understood scheme that has evolved and been tested over several hundred years that puts everyone on level ground – so long as they all understand the rules.”

Conclusion

In their best light, the Supreme Court’s pro-arbitration rulings can be dense and confusing. The Court has upheld the validity of mandatory compulsory arbitration agreements that waive an employee’s right to court access as predicated by Title VII. The Court has held that this negation of the legislative intent of Title VII is still fair, so long as arbitration provides the same statutory remedy as the court system. The Supreme Court has previously held that, because arbitration agreements are separable contractually, a party may seek judicial review of defenses to the arbitration agreement.

However, the Supreme Court has now ruled in Rent-A-Center that the entire arbitration agreement, even the contractual defenses, may be removed to the arbitrator, for a determination of whether the agreement to arbitrate is valid. This ruling is not only a confusing departure, but also requires the Supreme Court to go further with an explanation of the scope of review for civil rights arbitration.

The Rent-A-Center opinion holds that judicial review of challenges to civil rights arbitration agreements is still available under the FAA, but does not address how this review should happen. Without guidance and procedure for post-award review, and without guidance of whether manifest disregard is applicable under the FAA, the criticism of the Supreme Court’s pro-arbitration rulings as “sweeping”, “politically polarized,” and “fuzzy” will likely continue.

[1]Liptak, Adam. “Justices Are Long on Words but Short on Guidance.” The New York Times Online. 17 November 2010, available athttp://www.nytimes.com/2010/11/18/us/18rulings.html?pagewanted=1&_r=1.

[2]Id.

[3]See Halligan v. Piper Jaffray, Inc., 148 F.3d 197, 200-01 (2d. Cir. 1998).

[4]Rent-A-Center, West, Inc. v. Jackson, 130 S.Ct. 2772 (2010).

[5]Id.

[6]Id.

[7]See id.

[8]Marks, Clifford M. “Supreme Court’s Arbitration Ruling Draws Liberal’s Ire.” The Wall Street Journal Blogs. 21 June 2010, available athttp://blogs.wsj.com/law/2010/06/21/supreme-courts-arbitration-ruling-draws-liberals-ire/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed:+wsj/law/feed+%28WSJ.com:+Law+Blog%29.

[9]Lithwick, Dahlia. “Justice by the Hour.” Slate.com. 26 April 2010. Accessed 10 November 2010. http://www.slate.com/id/2252001/pagenum/all/#p2.

[10]See Coffee Beanery, Ltd. v. WW, L.L.C., 300 F.3d 415 (6th. Cir. 2008) (holding that manifest disregard is an applicable standard of review). But see Citigroup Global Markets, Inc. v. Bacon, 562 F.3d 349(5th Cir. 2009) (holding that manifest disregard is not an applicable standard of review.)

[11]A common antebellum holding, reflecting Justice Taney’s decision in Dred Scott,was that freedmen did not have the right to exercise the same civil rights as white men. See e.g., Howard v. Howard, 51 N.C. 235 (1858).

[12]Cong. Globe, 39th Cong., 1st Sess. 41 (1866).  See generally Report of the Joint Committee on Reconstruction Pt. II, 240 (1866).

[13]See, e.g., Cong. Globe, 39th Cong., 1st Sess.1758 (1866) (statement of Sen. Trumbull).

[14]42 U.S.C. § 1981(a).

[15]Franks v. Bowman Transp. Co., 424 U.S. 747, 779 (1976).

[16]Pub. L. 102-166, Title I §118.  There has been consistent disagreement between the circuit courts whether this statutory language refers to the extent defined by Gilmer v. Interstate/Johnson Lane Corp., 500 U.S. 20 (holding that an agreement to arbitrate employment claims could be binding even under the ADEA), versus Alexander v. Gardner-Denver Co., 415 U.S. 36 (holding that an employee’s suit under Title VII of the Civil Rights Act of 1964 is not foreclosed by the prior submission of his claim to arbitration).

[17]N.Y. C.P.L.R. § 7501.

[18]9 U.S.C. § 1-16.

[19]9 U.S.C. § 4.

[20]Halligan v. Piper Jaffray, Inc., 148 F.3d 197, 203 (2d. Cir. 1998).

[21]Brief of Amicus Curiae Service Employees International Union, Legal Aid Society, Employment Law Center, National Employment Lawyers Association, National Employment Law Project, Women’s Employment Rights Clinic, and The Employee Rights Advocacy Institute for Law & Policy in Support of Respondent. Part I, p. 6.

[22]Id.

[23]Id.

[24]Rodriguez de Quijas v. Shearson/American Express, Inc., 490 U.S. 477, 481 (1989).

[25]Cole v. Burns Int’l Sec. Servs., 105 F.3d 1465, 1476 (D.C. Cir. 1997).

[26]Id. at 1477.

[27]Id.

[28]Id.

[29]Id. at 1478, see also Gilmer, 500 U.S. 26, 34-35.

[30]Id.

[31]Moses H. Cone Mem’l Hospital v. Mercury Constr. Corp., 460 U.S. 1, 26.

[32]Id.

[33]Id.

[34]Gilmer v. Interstate/Johnson Lane Corp., 500 U.S. 20 (J. Stevens dissenting).

[35]The Citizens Bank v. Alafabco, Inc., 539 US 52, 53 (2003).

[36]Gilmer,500 U.S. at 39-40 (J. Stevens dissenting).

[37]See Erie Railroad Co. v. Tompkins, 304 U.S. 64 (1938)

[38]Allied-Bruce Terminix Cos. v. Dobson, 513 U.S. 265, 271 (1995). “The Act’s provisions (about contract remedies) are important and often outcome determinative, and thus amount to “substantive”, not “procedural” provisions of law.”

[39]Id.

[40]Id.

[41]Prima Paint Corp. v. Flood & Conklin Mfg. Co.,388 U.S. 395, 400.

[42]Id.at 407 (J. Black dissenting).

[43]Id.

[44]Id.

[45]Id. As a matter of substantive federal law, a claim of fraud in the inducement of a contract containing an arbitration clause is for the arbitrator, but the issue of fraud in the inducement for the arbitration clause itself is a question for the court.Id.

[46]Id.

[47]130 S. Ct. at 2782 (J. Stevens dissenting).

[48]Gilmer,500 U.S. at 39-40 (J. Stevens dissenting).

[49]Brief of Amicus Curiae The American Federation of Labor and Congress of Industrial Organizations in Support of Respondent. Part I, p. 5-9.

[50]130 S. Ct. at 2782 (J. Stevens dissenting).

[51]9 U.S.C. § 10.

[52]130 S. Ct. at 2781.

[53]Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, Inc., 473 U.S. 614 (1985).

[54]Halligan v. Piper Jaffray, Inc., 148 F.3d 197, 202 (2d. Cir. 1998).

[55]Merrill Lynch v. Jaros, 70 F.3d 418, 421 (6th. Cir. 1995).

[56]Halligan, 148 F.3d at 202.

[57]The concept of manifest disregard was first used by the Supreme Court inWilko v. Swan, 346 U.S. 427 (1953).

[58]A.A.A., Rule R-46.

[59]Stolt-Nielsen S.A. v. AnimalFeeds Int’l. Corp., 548 F.3d 85, 95 (2d. Cir.

2008), rev’d on other grounds, 130 S. Ct. 1758 (2010).

[60]9 U.S.C. § 10.

[61]Hall Street Assocs., LLC v. Mattel, Inc., 552 U.S. 579, 589 (2008). “[T]he statutory text gives us no business to expand the statutory grounds [of judicial review under the FAA].” Id.

[62]Stolt-Nielsen, S.A.,130 S. Ct. at 1772.

[63]Supra note 10.

Copyright © 2011 Nicole Farbes-Lyons

Employers are Watching Your Facebook: Worker Privacy Significantly Diminished in the Digital Era

Congrats to Michael Carlin  of University of Minnesota Law School winner of the Spring 2011 National Law Review student legal writing contest winner!   Michael’s topic explores the legal basis for privacy in and out of the workplace, specifically off- duty employee monitoring in the private sector.    

  Introduction

As surveillance technology improves, employers increasingly monitor their employees, both in and out of work.  Public sector employees enjoy First and Fourth Amendment protections, but private sector employees lack these fundamental protections.  State and federal common law and statutory protections developed during the past twenty years provide a handful of remedies for private workers when employers unduly infringe upon their right to be let alone.  Nevertheless, these laws fail to provide adequate protection in light of technological advances that make employer monitoring simple, cheap, and surreptitious.   Employees, with limited exceptions, should be given greater protection of their privacy and freedom of expression both in and especially out of the workplace.

This paper explores the legal basis for privacy in and out of the workplace, specifically off- duty employee monitoring in the private sector.  Part I details this history, discusses disturbing trends in employee monitoring, and explores open legal and ethical questions stemming from the increase in employee monitoring.  Part II reviews the interests implicated by employee monitoring and suggests a balancing point to stem employer invasiveness but protect against employee malfeasance.  The current common law protections described in Part III as well as the statutory protections covered by Part IV demonstrate that, in practice most law misses the mark and leaves employees with insufficient rights against invasive monitoring.  Finally Part V proposes new federal legislation to close the gaps in employee privacy law.

I.  Social and Historical Context of Off Duty Monitoring

A.  History of Worker Monitoring

The separation between work and home life is a recent phenomenon, developed during industrialization and urbanization.[1] The typical family in preindustrial society received little privacy; “business was conducted in the house, and the house was a crowded bustling place with little opportunity for the family to retreat in isolation.”[2]  It was not until city dwellers started working predominantly in offices that the home life was thought of as separate from work life.[3]  As Justices Warren and Brandeis stated, “[t]he intensity and complexity of life, attendant upon advancing civilization, have rendered necessary some retreat from the world. . .”[4]

Today privacy is taken, albeit mistakenly, for granted.[5]  However, even in the early Twentieth Century, the concept of privacy was challenged by the desire to monitor employees in and out of the workplace.  For example, Henry Ford created a “Sociology Department . . . . responsible for ferreting out immoral and undesirable behaviour on the part of Ford employees.”[6]  Today news stories frequently describe how employees are disciplined for their off duty behavior.[7]  Underlying these stories is a private employer’s right to substantially monitor their employees.  Employers are given broad discretion, with some exceptions, to log and monitor an employee’s phone use, voicemail,[8] and much more.

B.  Recent Developments of Off Duty Monitoring

An American Management Association study found sixty six percent of employers monitor workers’ Web site connections; forty three percent review e-mail; forty percent of companies analyze the contents of outbound e-mail; forty five percent track content, keystrokes, and time spent at the keyboard; and thirty percent have fired for misuse of the internet.[9]  RFID is another tool many employers use to track the location of their employees in and out of work, although not much is known about the extent to which this is used for off-duty monitoring.[10]  Eight percent of employers now use GPS technology to track wherever their employees go.[11]

Aligo’s WorkTrack is a technology that allows employers to monitor the location of their employees over the internet using employer provided cell phones.[12]  Technologies like Aligo promise to increase productivity, efficiency, and overall cost savings.[13]  However there are serious invasion of privacy concerns. First, the product has an “on break” mode, which allows employers to know when an employee is not working.[14]  These monitoring features often do not shut off at the end of the workday, allowing the employer to monitor even off duty behavior.[15]  Aligo and similar technologies are used by large employers such as Sun Microsystems, Lucient Technologies, and Motorola.[16]

The trend in monitoring appears to be increasing.[17]  As technology becomes more accessible, monitoring becomes easier. The social networking revolution is one prime example of how, if given easy means, employers will pry into the lives of their employees.  Employers increasingly use social networks to screen job applicants,[18] “Forty-five percent of employers use social networking sites to research job candidates.”[19]  Employers now have the power “to gather enormous amounts of data about employees, often far beyond what is necessary to satisfy safety or productivity concerns.”[20]  It is very likely that without greater privacy protections, as GPS and RFID monitoring become less expensive that more employers will begin utilizing it.

C.  Unanswered Legal Questions

Underlying the employer’s power to collect data on employers is the long line of court decisions upholding an employer’s right to monitor.  The Supreme Court’s latest of decision was City of Ontario v. Quon. Although concerning public employees, and the First and Fourth Amendments, the Quon decision raised interesting policy concerns regarding the potential importance of electronic communications as essential means of for self expression.[21]  However, the court also mentioned that these devices are so easily and cheaply available that one could easily purchase a device for personal use, defeating any expectation of privacy.[22]  This decision failed to analyze the basis for which an employee has a reasonable expectation of privacy,[23] so the expectation of privacy regarding digital monitoring is still not clear.[24]

II.  Should There Be a Line Between Work and Private Life Online? If so Where Should We Draw the Line?

A.  Employer’s Perspective

First, from an employer’s perspective, monitoring of employees is within their discretion because of the nature of at-will employment.  Generally, with the exception of Montana, employment is considered at will in the U.S,[25]  meaning employees can be fired, or leave, at any time for whatever or even no reason.[26]  Employers argue that if employees do not want to be monitored they can leave.

Employers also need to protect the integrity of their business and prevent unlawful activity.  Never before has so much damage been accomplished by low level employees through mindless behavior and social media.  One example of this occurred in April 2009 when two Domino’s Pizza employees posted several videos of disgusting, and unsanitary activities in preparation of a customer’s pizza.[27]  The video went viral and was responsible for a steep decline in stock values.[28]

Employers also need to protect against the leaking of confidential data.  In February 2010 the personal information of Shell employees in dangerous parts of the work was leaked to a blogger and published.[29]  This leak posed a great threat to the lives of these individuals; Shell employees have been attacked, and kidnapped in places like Nigeria.[30]  Similarly, the risk of liability is high for leaking of trade secrets and for initial public offerings before they are public.[31]

Productivity concerns also cause many employers to monitor employees. Even minor personal internet use in the workplace can lead to millions in lost profits.[32]  Off-duty, employers can claim fewer interests in monitoring, but in a world where telecommuting is on the rise, the line between office and home is blurring and this means that an employer may need to monitor an employee while working remotely.  Additionally, employers may want to check against irresponsible drinking, and negligent driving as evidenced by traffic tickets, especially if the worker is in a driving profession.[33]

B.  Employee’s perspective

When employers monitor their workers morale can decrease substantially.[34]  Monitoring may also undermine intended purposes of increasing productivity by spurring stress related ailments such as increased illness and absenteeism.[35]  Information gleaned from social media may also be inaccurate, forgeries of facebook accounts are commonplace.  Moreover, monitoring is usually inequitable where employees are not represented by unions, “[b]ecause of the substantial interests individuals have in both employment and in privacy, invasive monitoring puts employees in a ‘catch-22’ situation, forcing them to sacrifice reasonable expectations of privacy because of their need to work.”[36]

Technological advances exacerbate the invasiveness of monitoring and allow employers to know intimate details about an employee’s life, as one commenter notes “what happens when an employer virtually observes the employee stopping during her lunch hour at Planned Parenthood and fires her based on assumptions about her position on family planning methods?”[37]  Further, technology like social networking has become such an integral part of self expression.  Although in the context of cell phones, the Supreme Court acknowledged that it may be that some forms of communication are “essential means or necessary instruments for self expression, even identification.”[38]  This is just as true of social media.[39]

Employer monitoring has already altered the online behavior of many bloggers and social networking users, “29% of employees have become more conservative online because they fear that ‘employers can use anything and everything as an excuse to fire” them in a down economy.”  Social networking and blogging merits protection because not only is it integral to self expression, it serves a socially useful purpose by keeping people connected, and sharing and breaking news in a more effective way than traditional means ever could.[40]  Although First Amendment protection does not extend to workers in the private sphere, employer monitoring can affect speech in ways that would be unconstitutional if done by a government employer.  Most Americans spend nearly a quarter of their lives at work;[41] do we want constitutional protections to extend to only three quarters of a person’s life?  Do we want to allow employers to treat their employees like sex offenders, under constant surveillance?

Most social networking users begin using in their teens; because of this many of these users have material from their youth that depicts less than mature behavior.  Young people’s past lawful, but unfortunate conduct should not harm their employment prospects later.[42]  Even those with private profiles, as discussed in Part IV may still be at risk for having their profiles hacked by employers. Without protections we allow employers to be voyeurs and produce a chilling effect to use of online communications.[43]  Finally, the right to adequate livelihood is an international human right; one should not have to waive expression rights to enjoy the right to a livelihood.[44]

C.  Other Policy Considerations Make Line Drawing Difficult.

On one hand the free flow of information should not be impeded to protect what is usually discriminated against: misconduct and unpopular speech.  We should not have to protect people from making public fools of themselves.  Nevertheless, as the lifestyle discrimination statutes and case law discussed in Part IV attest to, employers who monitor off duty scrutinize a great deal of legal and socially important behavior including political speech.

Another issue is that the internet is by definition public, and speech is not being infringed by any unconstitutional means by employers checking social media.  However, off-duty social networking use merits privacy protections because employees have a higher expectation of privacy off the clock.[45]  Although any manager could check out an employee’s Facebook, there is a difference when this action is done with the intention to dig up dirt.  This argument also fails to consider that employers may find ways to view even non public profiles.

Finally, we must also consider whether employers should be punished just because they are using information for actions socially disapproved of.  After all, there are many anti-discrimination and collective bargaining labor laws designed to prevent employers from the really harmful discrimination.  However, anti-discrimination lawsuits are not a simple means of protecting the worst forms of discrimination; they are among the most difficult cases to prove.[46]  Employers who reserve the right to monitor of social network use and GPS location off duty can relatively easily use any information they gather as pretext for more heinous action.  Finally, the low interest the employer has in off-duty behavior, and the high value of privacy in U.S. culture, tips the balance in favor of the employee.  Although when employers suspect serious misconduct that would expose the employer to liability or lost profits, they should be allowed to monitor the employee with proper notice.

III.  Common Law Protections Are Generally Not Available for Digital Off-Duty Monitoring

Private sector privacy actions are typically based in the common law tort of intrusion upon seclusion.[47]  The elements for an intrusion claim are “[1] [intentional] intru[sion], physically or otherwise, upon the solitude or seclusion of another or his private affairs or concerns . . . [and] [2] the intrusion would be highly offensive to a reasonable person.”[48] In other words, did an individual have a reasonable expectation of keeping a matter private which the employer intruded upon.  Voluntary disclosure of information is a problem for social networking users.[49]  Some jurisdictions allow for an employer to use “intrusive and even objectionable means to obtain employment-related information about an employee.[50]  Generally, invasion of privacy actions will not be available to bloggers and social network users given the public nature of these activities.[51]  However, invasion of privacy claims may be available for monitoring off-duty personal cell phones,[52] home computer use, and location via GPS.  Still, these claims will probably fail if the employer reserves the right to monitor in an employee handbook.[53]

One recent exception to waiver of a reasonable expectation of privacy via employer notice has been found if the communication is privileged.  In Stengart v. Loving Care Agency, Inc., a home care nursing professional used her employer provided laptop to communicate with her attorney via a web-based yahoo mail account.[54]  The employer collected these emails in preparation for a lawsuit the employee filed against it. Although the employer use policy stated that employees can expect to be monitored, the New Jersey Supreme Court held that the employee had a reasonable expectation of privacy in her attorney-client privileged emails even on a work computer.[55]

IV.  Current Statutory Causes of Action Provide Little Protection.

A.  ECPA Claims Against Off-Duty Monitoring Fail.

The Electronic Communications Privacy Act (ECPA) was enacted “to provide greater protection of an individual’s privacy from emerging communication technologies in the private sector.”[56]  The Act “prohibits the intentional or willful interception, accession, disclosure, or use of one’s electronic communication.”[57]  It extends the protections of the Wiretap Act to electronic communications; it allows for criminal prosecution as well as civil action.[58]  However, “[c]ase law interpreting ECPA is virtually uniform in finding that employers can monitor with or without consent, even without notice.”[59] Further, courts disagree as to whether the interception of emails stored on a centralized server are prohibited by ECPA.

All that is necessary for a party to waive their privacy is to give so called consent, which can easily be done by the employer providing a poster or notice in a policy handbook that communications will be monitored.[60]  Further, consent or notice is not required in many federal jurisdictions when equipment is used in the course of business.[61]  Because the EPCA effortlessly allows employers to skirt the statute’s requirements, off-duty monitoring suits do not succeed against employers.[62]

B.  SCA Claims Require Employers to Behave Extremely Irresponsibly.

The Stored Communications Act (SCA) prevents communications companies from turning over communications to the government, but also prohibits hacking and exceeding authorization to view information.[63]  In Konop, an employee of Hawaiian Airlines created a blog, requiring authorization and terms of use that prohibited the airline management from reading and any disclosure of the contents of the blog.[64]  Hawaiian Airlines used the usernames and passwords of other employees to access Konop’s blog.  The company then terminated Konop after reading his critical commentary of the airline’s president and labor practices. The court held that because only a website user or provider could authorize a third party’s access under SCA, summary judgment should not have been granted for this claim.[65]

Although the employee here was given a cause of action, the remedy was limited because the court decided that “for a website such as Konop’s to be ‘intercepted’ in violation of the Wiretap Act, it must be acquired during transmission, not while it is in electronic storage.”[66]  The First Circuit disagreed with this in United States v. Councilman, holding that communications in storage can be intercepted in violation of the ECPA.[67]

Another shortcoming of these statutes is that neither EPCA or SCA would not protect all instances of employer digital snooping.  The following alteration of Konops facts illustrates this.  If Hawaiian Airlines was given the Facebook login information of Konop’s Facebook friend, and used it to login and see Konop’s critical wall posts of the company; the employer would avoid liability under SCA because there is no Facebook policy prohibiting the use of another’s login information.[68]  ECPA and SCA weaknesses points to the need for stronger statutory protections in the area of employee privacy.

C. CFAA Generally Does not Apply to Employers.

The Computer Fraud and Abuse Act (CFAA) is a criminal statute that prohibits the unauthorized access of computers involved in interstate or foreign commerce.[69]   However, unless an employer hacked into an employee’s personal computer, an action would not be possible against a monitoring employer.

D. State Protections, Statutory Privacy and Lifestyle Discrimination Statutes Mostly Miss the Mark.

Though as many as ten state constitutions explicitly provide privacy protections, nine of these provisions are interpreted to require government invasion of privacy.[70]  California is exceptional in that the state constitution provides a remedy for invasion of privacy actionable against private individuals.[71]

Twenty five states protect against employee discrimination for the use of tobacco and other legal products off-duty.[72]  However, these laws would not protect against employer monitoring and adverse action based on political or other lawful expression gleaned from social network use.  Five states prohibit adverse action based on political behavior.[73] Only California, Colorado, New York, and North Dakota protect against discrimination from legal off-duty behavior in general,[74] but these statutes may be limited where an employer declares a policy that prohibits blogging about work.[75]  Limiting employee monitoring is not a popular option even when tailored narrowly; Michigan and Illinois are the only states that prevent an employer from monitoring political activity.[76]  Only eleven states have some form of RFID use restrictions, and none have GPS monitoring restrictions.

V.  “Privacy Protection in Employment Act” a Proposal to Close Privacy Gap

Congress made two attempts to pass employee privacy legislation, the broad Privacy for Consumers and Workers Act in the 1990s and the toothless Notice of Electronic Monitoring Act in 2000.[77]  Though these failed, federal legislation is necessary for several reasons. The courts are too slow and lack the technological expertise to adequately keep privacy up to date with technological changes.  Moreover, “providing protections for employees on a state-by-state basis can cause “a race to the bottom” with states purposefully providing low protections to encourage business.”[78]  To close the gaps in employee privacy law Congress should pass what some have call the “Privacy Protection in Employment Act”.[79]  This Act would generally prevent all off-duty monitoring of employees in the home, and in any secluded area. Employers would only be permitted to monitor off-duty behavior if the employer has “reasonable grounds to believe the employee is engaging in behavior that will cause a significant concrete harm to the employer.”[80]  However, the employer must carry the burden to prove reasonable grounds.  An employer also must put the employee on notice of the scope and duration of any monitoring, and provide them an opportunity to review all information collected. The Department of Labor would also monitor compliance with these provisions, and a violation of the Act would allow a civil action with an allowance for plaintiff’s attorney fees.[81]

VI.  Conclusion

Statutory and common law protections show that there should be a line between work and private life even in this age of diminishing privacy.  However, these protections are inadequate to keep up with monitoring techniques.  Although there are important interests in promoting the free flow of information and the profitability of businesses; the risk for discriminatory use of information is great.  Interests in privacy must be balanced against interests in security of employment and reflect well reasoned normative views of society.  This can be accomplished by enacting legislation like the Privacy Protection in Employment Act.

[1] Daniel J. Solove, Conceptualizing Privacy, 90 Cal. L. Rev. 1087, 1138 (2002) (documenting the history of the concept of privacy and exploring new ways to think of it).

[2]Id. (“homes were primarily devoted to work, a shop with a place in the back or above to eat and sleep.”)

[3]Edward Shils, Privacy: Its Constitution and Vicissitudes, 31 Law & Contemp. Probs. 281, 289 (1966). See also Tamara K. Hareven, The Home and the Family in Historical Perspective, 58 Soc. Res. 253, 259 (1991) (“Following the removal of the workplace from the home as a result of urbanization and industrialization, the household was recast as the family’s private retreat, and home emerged as a new concept and existence.”).

[4]Samuel D. Warren & Louis D. Brandeis, The Right to Privacy, 4 Harv. L. Rev. 193, 196 (1890).

[5]C.f. Solove, supra note 1.

[6]Donald V. Nightingale, Workplace Democracy: An Inquiry into Employee Participation in Canadian Work Organizations 9 (1982).

[7]See Stephanie Chen, CNN International, Can Facebook get you fired? Playing it safe in the social media world, http://edition.cnn.com/2010/LIVING/11/10/facebook.fired.social.media.eti… (reviewing story of woman fired for posting about her boss reprimanding her for union activity); Don Aucoin, MySpace vs. WorkPlace, Boston Globe, May 29, 2007, at D1 (describing an Olive Garden employee fired for posting MySpace pictures of herself); Hyoung Chang, Bud Man: Canned for Coors?, USA Today, May 18, 2005, http://www.usatoday.com/money/industries/food/2005-05-18-beer-man_x.htm (finding a Budwieser employee was fired for drinking a Coors in public).

[8]Jane Kirtley, Privacy Protection, Safety and Security, Intellectual Property Course Handbook Series PLI Order No. 23334 15, 119 (Practising Law Institute, 2010) (citing Fact Sheet 7: Workplace Privacy and Employee Monitoring, Privacy Rights Clearinghouse, June 30, 2010, http://www.privacyrights.org/fs/fs7-work.htm#2c) (finding exceptions in California, where in state callers must be informed of monitoring, and in the Eleventh Circuit where the employer realizes the call is personal).

[9] American Management Association, 2007 Electronic Monitoring & Surveillance Survey: Many Companies Monitoring, Recording, Videotaping and Firing Employees, Feb. 8, 2008, http:// www.amanet.org/press/amanews/ems05.htm.

[10]Although less is known, RFID presents the largest potential invasion of privacy issues; RFID can be placed in Id badges, clothing, cell phones, and just about anything without being detectible by employees. Jeremy Gruber, RFID and Workplace Policy, (last visited, Dec. 1, 2010)  http://www.workrights.org/issue_electronic/RFIDWorkplacePrivacy.html#_ft….

[11]Id.

[12]Aligo – The Mobile Enterprise Software Company, WorkTrack, http://aligo.c3design.jp/products/workTrack/ (last visited Dec. 1, 2010).

[13]Id.

[14]This feature is marketed to help reduce unnecessary billing time, but it has troublesome invasion of privacy implications.  Jill Yung, Big Brother Is Watching: How Employee Monitoring in 2004 Brought Orwell’s 1984 to Life and What the Law Should Do About It, 36 Seton Hall L. Rev. 163, 173 (2005).

[15]Id.

[16]Aligo Inc., Aligo Customers, (last visited December 1, 2010), http://aligo.c3design.jp/customers/.

[17] Friedman, Barry A. and Lisa J. Reed, Workplace Privacy: Employee Relations and Legal Implications of Monitoring Employee E-Mail Use, 19 J. Bus. Ethics 75 (2007) (describing the follies of employer use of social networks as a monitoring tool).

[18] Jenna Wortham, More Employers Use Social Networks to Check Out Applicants, New York Times, http://bits.blogs.nytimes.com/2009/08/20/more-employers-use-social-netwo… (finding an increasing trend in use of social networks to screen applicants).

[19]Career Builder, Press Release, Forty-five Percent of Employers Use Social Networking Sites to Research Job

Candidates, CareerBuilder Survey Finds, August 19, 2009, http://uncw.edu/stuaff/career/documents/employersusingsocialnetworkingsi…

[20]Frederick S. Lane III, The Naked Employee: How Technology Is Compromising Workplace Privacy 3-4 (2003).

[21] Id. (“Cell phone and text message communications are so pervasive that some persons may consider them to be essential means or necessary instruments for self-expression, even self-identification.”)

[22]Id. (“[E]mployees who need cell phones or similar devices for personal matters can purchase and pay for their own.”).

[23]City of Ontario v. Quon, 130 S.Ct. 2619, 2630 (2010).

[24]The court also did not address whether employers can monitor their employees while off duty. C.f. Gregory I. Rasin & Ariane R. Buglione, Social Networking and Blogging: Managing the Conversation, N.Y.L.J., July 27, 2009, available at http://www.law.com/jsp/nylj/PubArticleNY.jsp?id=1202432487473&slreturn=1….

[25]See, e.g., Ariana R. Levinson, Carpe Diem: Privacy Protection in Employment Act, 43 Akron L. Rev. 331, 338 (2010).

[26]See generally, James A. Sonne, Monitoring for Quality Assurance: Employer Regulation of Off-Duty Behavior,43 Ga. L. Rev. 133, 140 (2008).

[27]Paul E. Starkman, What You Need to Know about Monitoring Employees’ Off-Duty Social Networking Activity (last accessed Dec. 2, 2010), http://chiefexecutive.net/ME2/Audiences/dirmod.asp?sid=&nm=&type=Publish….

[28]Id. (receiving over a million views in two days).

[29]Id.

[30]James Herron, Shell Data Leak May Compromise Safety Of Staff –Emails, Feb. 4, 2010 http://royaldutchshellplc.com/2010/02/04/shell-data-leak-may-compromise-….

[31]See Starkman, supra note 27.

[32]See, Association of  Local  Government Auditors, Monitoring  Internet  Usage, Spring  2010, http://www.governmentauditors.org/index.php?option=com_content&view=arti… This potential loss may only get worse as the average gen-y’er spends upwards of thirty four percent of their time online doing personal tasks, as opposed to the twenty five percent found in the rest of the working population.  Burst Media, “Online At Work”, Nov. 11, 2007,http://www.burstmedia.com/pdfs/research/2007_11_01.pdf.

[33]Ronald J. Rakowski, Employee Off-Duty Conduct: Be Careful!, Sep 7, 2010, http://www.suite101.com/content/employee-off-duty-conduct-be-careful-a28….

[34]See Mia Shopis, Employee Monitoring: Is Big Brother a Bad Idea?, Dec. 9, 2003, http://searchsecurity.techtarget.com/news/interview/0,289202,sid14_gci94….

[35]Jay P. Kesan, Cyber-Working or Cyber-Shirking?: A First Principles Examination of Electronic Privacy in the Workplace, 54  Fla. L. Rev. 289, 319-20 (April 2002)

[36]S. Elizabeth Wilborn, Revisiting the Public/Private Distinction: Employee Monitoring in the Workplace, 32 Ga. L. Rev. 825, 835 (1998).

[37]Yung, supra note 14at 174.

[38] City of Ontario v. Quon, 130 S.Ct. 2619, 2630 (2010).

[39]See Peggy Orenstein, The Way We Live Now: I Tweet, Therefore I Am, August 1, 2010, available at http://www.nytimes.com/2010/08/01/magazine/01wwln-lede-t.html

[40]I use social media broadly: it includes blogs, YouTube, and any other internet based means of conveying information.

[41]See supra note 36.

[42] Leigh A. Clark & Sherry J. Roberts, Employer’s Use of Social Networking Sites: A Socially Irresponsible Practice, 95 J. Bus. Ethics 507 (2010) (exploring the ethical concerns of employer use of social networking to monitor employees and screen applicants in the private workplace).

[43] Friedman, Barry A. and Lisa J. Reed. 2007. Workplace Privacy: Employee Relations and Legal Implications of Monitoring Employee E-Mail Use, 19 J. Bus. Ethics 75.

[44]Nevertheless, the U.S. does not recognize the International Covenant on Economic, Social and Cultural Rights, or the optional protocol, which would give rise to a claim for damages for the right to work. G.A. Res. 2200A (XXI), U.N. Doc. A/6316 (Dec. 16, 1966), Dec. 16, 1966, 993 U.N.T.S. 3, entered into force Jan. 3, 1976.

[45] Compare withthe following “the use of computers in the employment context carries with it social norms that effectively diminish the employee’s reasonable expectation of privacy with regard to his use of his employer’s computers.” TBG Ins. Servs. Corp. v. Superior Court, 96 Cal. App. 4th 443, 452 (2002) (holding that an employee who used a computer designated for working at home did not have sufficient privacy interests to prevent an employer from monitoring his computer use).

[46]See generally Michael Selmi, Why are Employment Discrimination Cases So Hard to Win?, 61 La. L. Rev. 555, (2001), see also Jonah Gelbach et al.,Passive Discrimination: When Does It Make Sense To Pay Too Little?, 76 U. Chi. L. Rev. 797 (2009) (“federal antidiscrimination law inadequately addresses either intentional or unintentional passive discrimination”)

[47] Tanya E. Milligan, Virtual Performance: Employment Issues in the Electronic Age, 38 Colo. Law. 29, 34 (2009) (exploring defamation, invasion of privacy, wiretap, EPCA, and SCA causes of action as a result of employer monitoring).

[48]Restatement 2d. Torts § 652B.

[49] Robert Sprague, Fired for Blogging, 9 U. Pa. J. Lab. & Mp. L. 355, 384 (2007) (exploring legal protections bloggers may be able to assert as a result of monitoring off duty conduct).

[50] Kelly Schoening & Kelli Kleisinger, Off-Duty Privacy: How Far Can Employers Go, 37 N. Ky. L. Rev. 287, 290-292 (2010) (exploring the limits of employer peering into the private lives of employees using technology under several privacy statutes as well as common law tort claims) (citing Baggs v. Eagle-Picher Indus., Inc., 957 F.2d 268 (6th Cir. 1992)).

[51]Sprague supra note 49at 363.

[52] But see Karch v.  Baybank FSB, 794 A.2d  763  (N.H.  2002) (refusing to find a cause of action against an employer who uses information surreptitiously intercepted from a cell phone conversation by a third party to reprimand an employee).

[53]See e.g. Thygeson v. U.S. Bancorp, 2004 WL 2066746 (D. Or. 2004).

[54]990 A.2d 650 (N.J. 2010)

[55]Id. at  663-664 (“e-mails she exchanged with her attorney on her personal, password-protected, web-based e-mail account, accessed on a company laptop, would remain private.”).

[56] Michael Newman, Shane Crase, What in the World is the Electronic Communications Privacy Act? An Overview of the ECPA Hurdles in the Context of Employer Monitoring, 54 Fed. Law. 12 (2007).

[57]  18 U.S.C. §§ 2510-2520.

[58]18 U.S.C. §§2510 to 2712.  Although an employer cannot violate the wiretap act because of a deficiency in language of the statute, they could be liable under the ECPA).  Jill Yung, supra note 14at 182 n.90.

[59]Corey A. Ciocchetti, The Privacy Bailout: State Government Involvement in the Privacy Arena, 5 Entrepreneurial Bus. L.J. 597, 605 (2010).

[60]See United States v. Rittweger, 258 F. Supp. 2d 345, 354-55 (S.D.N.Y. 2003) (finding a handbook made monitoring policy clear).

[61]Arias v. Mutual Cent. Alarm Serv. Inc., 202 F.3d 553, 559 (2d Cir. 2000).

[62]Cf. Konop v. Hawaiian Airlines, Inc., 302 F.3d 868 (9th Cir. 2002) cert denied, 537 U.S. 119 (2003) (dismissing the 18 U.S.C.A. § 2511(1)(a) claim).

[63] 18 U.S.C. § 2701, et. seq.

[64]Konop 302 F.3d at 876.

[65]Id.

[66]302 F.3d 868, 878-879.

[67]See Newman supra note 56at 14 (quoting 418 F.3d 67, 79-81 (1st Cir. 2005)).

[68]See Facebook terms http://www.facebook.com/terms.php.

[69] 18 U.S.C. §1030.

[70]See, Corey A.Ciocchetti, The Privacy Bailout: State Government Involvement in the Privacy Arena, 5 Entrepreneurial Bus. L.J. 597, 620.

[71]Chico Feminist Women’s Health Ctr. v. Butte Glenn Med. Soc’y, 557 F. Supp. 1190, 1203

(E.D. Cal. 1983) (finding an action against defendants for an infringement of the state’s constitutional privacy right to prevent procreative choice interference).

[72]Corey A.Ciocchetti, The Eavesdropping Employer: A Twenty-First Century Framework For Employee Monitoring, 17 (2010)http://www.futureofprivacy.org/wp-content/uploads/2010/07/The_Eavesdropping_Employer_%20A_Twenty-First_Century_Framework.pdf

[73]Id.

[74]Id.See also e.g., Colo. Rev. Stat. § 24-34-402.5 (“[i]t shall be a discriminatory or unfair practice for an employer to terminate the employment of any employee due to that employee’s engaging in any lawful activity off the premises of the employer during nonworking hours. . .”); N.D. Cent. Code §§ 14-02.4-03 (“[i]t is a discriminatory practice for an employer to fail or refuse to hire a person; to discharge an employee; or to [otherwise discriminate with respect to] participation in lawful activity off the employer’s premises during nonworking hours . . . .”).

[75] Levinson,supra note 25at 372.

Jessica Jackson, Colorado’s Lifestyle Discrimination Statute: A Vast and Muddled Expansion of Traditional Employment Law, 67 U. Colo. L. Rev. 143 (1996).

[76]Ciocchetti, supra note 72.

[77]Levinson,supra note 25at 343.

[78]Id.

[79]Id. at 331.

[80]Id. at 402 (These would exclude activities that merely reduce office morale, and injury to reputation and would include, but are not limited to activity such as: competition with employer’s business, reduction in the employees work or that of co-workers, harassment, obscene behavior if the employee is a child’s role model, financial harm, and complaints).

[81]Id. at 411.

© Copyright 2011 Michael Carlin

Selling the Main Street Fairness Act: A Viable Solution to the Internet Sales Tax Problem

Congrats to Michael J. Payne, CPA of Arizona State University Sandra Day O’Connor College of Law   one of the winners of the 2011 Spring National Law Review Student Legal Writing Contest.  Michael’s topic addresses the tremendous struggle in the regulation of sales tax collection on interstate internet purchases.

  I.  Introduction

States have long faced issues related to collecting sales and use tax when the seller lives in another state. Initially, disputed transactions involved purchases from mail-order catalogs and telephone orders, but with the advent and explosion of the World Wide Web, states now face a tremendous struggle in the regulation of sales tax collection on interstate internet purchases.

Today, fierce debates between internet retailers, states, and consumers regarding sales taxes on internet purchases are commonplace, yet the key issues remain unresolved. Retailers purport to be exempt from state sales tax requirements when they do not have a physical presence in the state in which their customers reside; states argue sales taxes are due regardless of physical presence; and consumers just want to find the best deal when making purchases, which often means they seek out ways to avoid paying sales taxes altogether.

As a result of fast-moving technological advances and slow-moving legislative actions, a substantial gap has developed in nearly every state between sales tax revenue due and collected. A study from the University of Tennessee estimated that between 2007 and 2012, states will sustain over $52 billion in losses from uncollected taxes on e-commerce sales.1 In addition to enlarging state budget shortfalls, untaxed interstate sales create an unfair advantage to online sellers who are relieved from the onerous sales tax collection duties imposed on in-state and traditional brick-and-mortar sellers. Thus, online sellers can offer discounts on products purchased from out-of-state residents while still earning higher profits than their in-state competitors.

Two significant constitutional hurdles restrict state regulation of interstate sales taxation: the Commerce Clause and the Due Process Clause, with the former causing the majority of current problems. This article focuses primarily on resolving the Commerce Clause concerns and attempts to reconcile the interests of sellers, consumers, and states. It then proposes the adoption of a bill that was recently introduced in the House of Representatives: the Main Street Fairness Act.2

II.  Background

A.  The Mechanics of Internet Sales Taxation

A basic understanding of common Internet sales taxation is needed to grasp the ideas discussed in this article. As a general rule, purchasers of merchandise must pay a transaction tax to the state in which they reside, provided that state imposes a sales or use tax.3 When the retailer collects the tax on behalf of the consumer and remits it to the state, it is called a sales tax.When a retailer fails to collect a sales tax, the consumer is obligated to report her purchase to the state and pay an equivalent use tax. The process is simple when the seller is in the same state as the purchaser: the seller collects taxes on local sales and remits them to the state. The more complicated and increasingly more common scenario is when the seller operates from another state; this situation has been the topic of numerous cases, statutes, opinion columns, Internet blogs, and scholarly articles, including this one.

Although state taxation of internet sales is a modern issue, courts have long debated whether the Constitution’s Commerce Clause limits the ability of a state to apply its sales and use tax provisions to out-of-state retailers.4 This Part describes the most significant cases.

B.  National Bellas Hess, Inc. v. Department of Revenue of Illinois

In 1967, the Supreme Court considered whether a state could require a mail order company to collect and remit sales taxes on sales to residents of that state when that company had no physical presence in the state. In National Bellas Hess v. Department of Revenue of Illinois,5 the taxpayer was a mail order company incorporated in Delaware with its principal place of business in Missouri. It was licensed to do business only in those states. The taxpayer maintained no office or warehouse in Illinois, had no employees, agents, or salespeople there, and conducted no significant advertising there. Moreover, all contacts the company had with the residents of the state were through the mail or a common carrier. Illinois attempted to require the taxpayer to collect and remit sales and use taxes from Illinois residents who purchased the company’s goods by mail order.

The Court held that the Commerce Clause requires “some definite link, some minimum connection, between a state and the person, property, or transaction it seeks to tax.” Mail order transactions alone do not create that minimum connection. The Court reasoned “[t]he very purpose of the Commerce Clause was to ensure a national economy free from . . . unjustifiable local entanglements. Under the Constitution, this is a domain where Congress alone has the power of regulation and control.”6

C. Quill Corp. v. North Dakota

Twenty-five years after National Bellas Hess, the Court affirmed in part its prior decision when it faced a similar set of facts in Quill Corp. v. North Dakota.7 In Quill, North Dakota attempted to require the taxpayer, a Delaware corporation with no significant tangible property or employees in North Dakota, to collect and remit use taxes from sales to North Dakota customers. The taxpayer solicited business through catalogs and flyers and delivered all its merchandise by mail or common carrier from out-of-state locations. The State argued that its statute subjecting every retailer that solicits business in the state to the tax was constitutional when the retailer had “engage[d] in regular or systematic solicitation of a consumer market in th[e] state.”

The Court disagreed, recognizing two constitutional barriers to a state’s ability to force out-of-state retailers to collect and remit sales taxes: the Due Process Clause and the Commerce Clause. The Court distinguished the Due Process Clause from the Commerce Clause, explaining:

Although the “two claims are closely related,” the Clauses pose distinct limits on the taxing powers of the States. Accordingly, while a State may, consistent with the Due Process Clause, have the authority to tax a particular taxpayer, imposition of the tax may nonetheless violate the Commerce Clause. The two constitutional requirements differ fundamentally, in several ways. . . . [W]hile Congress has plenary power to regulate commerce among the States and thus may authorize state actions that burden interstate commerce, it does not similarly have the power to authorize violations of the Due Process Clause.8

The Court concluded that because Quill had purposefully directed its activities at North Dakota, it established minimum contacts with the State, and thus the Due Process Clause did not prohibit the State from imposing its use tax against Quill.

The Court next considered whether the state statute ran afoul of the Commerce Clause. It recognized Congress’ constitutional authority to “regulate Commerce with foreign Nations, and among the several States,”9 but also recognized that the “dormant” Commerce Clause10 reserves to Congress the exclusive power to regulate interstate commerce even when it has not spoken directly on a subject. The dormant Commerce Clause requires that the retailer have a “substantial nexus” with the state before the state can force the retailer to collect and remit sales taxes, which often translates into a bright line physical presence test.

The Court held that North Dakota did not have the power to impose sales taxes on Quill because Quill had no physical presence in the state. It also found that the state’s taxation would unduly burden interstate commerce, noting that “similar obligations might be imposed by the nation’s 6,000-plus taxing jurisdictions,” thus vastly increasing the complexity of sales tax compliance for interstate retailers.

D. Streamlined Sales and Use Tax Agreement

In the shadow of the Quill decision, a new and far-reaching mode of commerce arose: the World Wide Web. Many retailers no longer needed to send catalogs to solicit sales. Instead, they could simply set up websites, make them apparent to search engines, and wait for customers to come to them. The following chart illustrates the historic growth of the Internet:

Year Estimated Number of Websites Estimated Percentage of U.S. Households with Internet Access E-Commerce sales
1992 (Quill)

< 30

< 25%

n/a
2000 (SSUTA)

17,000,000

50%

$27.6 billion
2010

249,000,000

77%

$202.6 billion

The monumental growth in online sales has contributed to the two major problems currently associated with the taxation of remote sales: administrative burdens to sellers and lost revenues to states from general noncompliance. In 1999, state and local governments from twenty-six states responded to these by banding together and implementing a new sales tax system. The group’s goal was to create and implement a method to unify and simplify the collection and remittance of sales taxes across the country, an effort that culminated in the Streamlined Sales Tax Project.11

The Project works through two steps. First, states voluntarily join the Streamlined Sales Tax Agreement by adopting its provisions as state law and conforming to the tax administration procedures set for by the Agreement. Second, interstate retailers voluntarily register with the Project’s online system. Sellers only register once and are thenceforth obligated to collect and remit sales taxes to member states when they sell products to residents of those states.

The Agreement reduces the administrative burden of tax compliance by focusing on two main goals: uniformity and simplification. The Agreement promotes uniformity in multistate sales tax collection at five levels: terminology, tax bases, registration, sourcing, and reporting. It simplifies sales tax collection and reporting by focusing on four areas: limited tax rates, seller liability for incorrectly reported exemptions, simplified tax forms, and electronic tax remittances. Additionally, it provides for sales tax software that, if used, would provide immunity to users from audits and corresponding liability.

A. Congressional Efforts to Regulate Internet Sales Taxes

Although states have been very active recently in attempting to regulate sales tax collection for out-of-state retailers, the power to regulate taxation of interstate commerce ultimately lies in Congress’s hands, as established by the Commerce Clause and reiterated in Quill. Since Quill, Congress has attempted several times to pass legislation that would provide federal authorization for states to mandate sales tax collection from out-of-state retailers, thus allowing states to bypass the substantial nexus requirement imposed by Quill.12 However, each bill that has been proposed has expired without being voted on by the House or Senate.

B. Recent State Efforts to Bypass Quill’s Substantial Nexus Requirement

Dissatisfied with Congressional efforts (or lack thereof) to increase cooperation with sales tax laws, states have attempted in various ways to establish a substantial nexus between online retailers and their state and thereby satisfy the requirements of the Commerce Clause.

a.  Borders Online v. State Board of Equalization

In 2005, the California Court of Appeals held in Borders Online v. State Board of Equalization that Borders’ retail stores in the state acted as authorized representatives of the associated online store when those stores accepted refunds of personal property sold by the internet retailer, thus establishing a nexus sufficient for the imposition of sales and use taxes under the Commerce Clause.13

After Borders, remote sellers in California sought clarification on whether their particular fact situations produced sufficient nexus to subject them to California state and local taxation. Courts look at various factors to determine the level of nexus,14 and consider these factors concurrently. An increasingly relevant factor that courts have examined is the presence of a company’s affiliates in a state, or “attributional nexus.” Courts have long looked at attributional nexus as a way to satisfy the Commerce Clause requirements, although the issue has never been directly addressed by the United States Supreme Court.

b.  Amazon.com, LLC v. New York State Department of Taxation and Finance

Most recently, a New York trial court, later affirmed by the New York Appellate Division, weighed in on attributional nexus in Amazon.com, LLC v. New York State Department of Taxation and Finance.15 In 2008, New York attempted to curtail lost revenues from internet sales by amending the definition of “vendor” in its tax law, thus requiring each of Amazon’s Associates to collect sales taxes. Amazon then brought suit claiming that the Provision violated the Commerce Clause by imposing tax collection obligations on out-of-state entities that had no substantial nexus with the state. The court dismissed Amazon’s complaint for failure to state a cause of action, holding that the statute is not unconstitutional facially or as-applied. The court took a broad view of the substantial nexus requirement when it held that Amazon had created a substantial nexus with the State, even though Amazon had no offices, property, employees, or agents in the state. The court noted that physical presence “need not be substantial;” however, there must be “more than a slight presence.”

SinceAmazon, many New York retailers have terminated associations with in-state retailers and local affiliates to avoid being subject to sales tax collection. One website purports to list sellers that have removed New York affiliates after the passage of New York’s legislation, naming almost sixty remote sellers.16 The list includes some large companies such as Overstock, KB Toys, ShopNBC, CafePress, and Fingerhut. As a result, the statute may have actually hurt local retailers, the very group it was trying to protect by leveling the sales tax playing field.

c.  The Bordersand AmazonFallout

The Amazon ruling has influenced other states to pass similar legislation in attempts to collect their own “Amazon tax.” For instance, in 2009, Rhode Island passed a statute that requires online merchants generating more than $5,000 in sales through in-state affiliates to register and collect sales tax on all its taxable sales in Rhode Island.17 Like the New York law, Rhode Island’s statute requires that the seller enter an agreement with a Rhode Island resident before the seller would be subject to sales tax collection.

Following the lead of New York and Rhode Island, North Carolina passed a statute18 enacting its own Amazon tax with a $10,000 floor, explaining that the new law codifies the United States Supreme Court’s 1960 decision in Scripto v. Carson that a state “may require tax collection by a remote retailer that had contracts with ten independent contractors in the state who solicited orders for products on its own behalf.”19 North Carolina simultaneously modernized its previous terminology by replacing “mail order” with “remote sales.”20 Similar statutes were introduced in eleven other states.21

Colorado took its sales tax collection efforts a step further. In addition to enacting its own “Amazon tax,” Colorado’s H.B. 1193 (2010) would require sellers that do not collect sales taxes to send customers that purchase products online annual statements listing total purchases.22 Retailers would also send a copy of all purchases to Colorado’s Department of Revenue so that residents may be held accountable for unpaid use taxes.23 The bill would authorize Colorado’s Executive Director of the Department of Revenue to issue a subpoena to an out-of-state retailer if that retailer refuses to voluntarily furnish that information. However, this statute is the subject of a recent lawsuit brought by the Direct Marketing Association. A federal court for the District of Colorado recently granted DMA’s motion for preliminary injunction against Colorado, holding that its statute “discriminates patently against interstate commerce” and imposes undue burdens on retailers.24

Oklahoma took a different approach to regulating sales tax collection from out-of-state sellers.25 The Oklahoma law obligates certain remote sellers to post on their websites, catalogs, and invoices notice of consumers’ obligations to pay Oklahoma use tax on electronic and mail order purchases of tangible personal property.26 Oklahoma’s law has been criticized as superfluous in application to internet and mail order sellers that have physical presence in the State because current Oklahoma use tax statutes already impose the obligation on those sellers to collect use taxes. Furthermore, the law is criticized as unconstitutional when applied to out-of-state sellers that have no physical presence in the State, because Quill’s interpretation of the Commerce Clause would prohibit Oklahoma from enforcing tax collection responsibilities on a seller with no physical presence in the state.

d.    The Case for a Federal Solution

A uniform federal solution is superior to progressive state-by-state attempts to collect sales and use taxes for three reasons. First, states are tiptoeing on the edge of a river of constitutionally-protected consumer privacy matters. Second, strict enforcement of use tax laws at an individual level is hardly tenable given the historic lack of enforcement and the resulting lack of personal accountability. The proposed solutions impose real burdens on people and will discourage online purchases. Can you recall everything you have purchased online in the last year? In the last five years? You may have to if you are in a progressive sales tax collection state. It is much simpler and more intuitive for consumers to pay the tax up front as one swift transaction than to log their purchases, store the information, and file a use tax return with their payment at some later date. The increased hassles of recording each purchase could drive people back into brick-and-mortar stores, nullifying the efforts of Amazon and other remote sellers. For this reason, remote sellers should embrace the Main Street Fairness Act as a means to create certainty and consistency in the marketplace.

Finally, the trending methods of sales and use tax enforcement are completely inefficient. This is a situation in which it makes sense to take collective federal action rather than pursue state collection efforts at the individual taxpayer level. States would be forced to allocate substantial resources toward collection efforts while receiving no greater benefit than if the tax had been collected at the time of sale. With the Main Street Fairness Act, states would incur virtually no additional costs of expansion and would continue to use their existing collection methods. States are already entitled to collect these taxes whether in the form of sales or use taxes; why not utilize retailers with software and systems already in place?

The Center on Budget and Policy Priorities has argued that states’ implementation of the “Amazon law” could be an effective means to require sales tax collection from internet sellers that use affiliate programs.27 However, the Center observed, Amazon laws are only a partial solution to the broader sales tax problem. Not every internet retailer operates an affiliate program, so the Amazon law does nothing to spur collection efforts from the numerous vendors who advertise by other means. The Center concluded that a comprehensive solution will require a federal law empowering states and localities that have streamlined their sales tax collection efforts to require all large remote sellers to collect sales taxes. This would allow states to force collection on remote sellers regardless of whether the sellers have a physical presence in their customers’ states. Such a federal grant of commerce power is the precise objective of the Main Street Fairness Act of 2010.

III.  Main Street Fairness Act

The Main Street Fairness Act, sponsored by former Representative Bill Delahunt (D-MA), seeks to “promote simplification and fairness in the administration and collection of sales and use taxes.”28 It would do so by allowing states to force “remote sellers” (companies that sell products online, by mail order catalogs, cable TV shopping, telephone, etc.) to collect sales and use taxes from customers and remit them to states. States acting alone do not have the authority to require a seller with no physical presence in the state to collect taxes on sales to that state’s residents. However, Congress affirmatively possesses the authority to regulate commerce under the Commerce Clause of the Constitution of the United States and Congress may authorize state actions that burden interstate commerce. The Main Street Fairness Act would grant states explicit authority to burden interstate commerce by allowing states to mandate collection and remittance of taxes on remote sales to their residents.

Why should Congress give the Main Street Fairness Act a second glance when a form of the current bill has essentially been rejected every other year for the last seven years? This section will focus on three ways the Main Street Fairness Act would benefit interstate commerce: (1) it would provide states a tool to enforce active yet frequently disobeyed laws regarding sales and use tax reporting and payment; (2) it would level the playing field between Main Street and “e-street;” and (3) it would help to close the enormous budget gap that is growing daily as a result of the disparity between taxes due and taxes actually collected.

A. Enforce Current Laws

The Main Street Fairness Act would grant federal authority to states, thus allowing states to enforce sales and use tax laws that are currently in place but are often not obeyed. Sales or use taxes are legally due on internet sales if the item is otherwise taxable under state law. Generally, retailers collect taxes from customers on behalf of states for convenience. However, when a customer purchases a taxable item and the retailer fails to collect a sales tax, that customer is obligated to pay a use tax and file a use tax return with the state.

People often do not pay use taxes on internet purchases for two reasons. First and most commonly, the average consumer is unaware that a tax is due when she purchases a product from an online retailer such as Amazon or Overstock. In other cases, the consumer may be aware that a tax is due but fails to pay sales or use taxes because he believes the law is not enforced and he will not be caught. This is the more dangerous scenario because in knowingly failing to pay a tax that is legally due, the consumer crosses the line of intentional disregard and is more likely to violate that law again.

In an effort to both inform residents of their obligation to pay use taxes and to actually collect those taxes, many states have started to include a line on their income tax returns where taxpayers are supposed to calculate and declare unpaid taxes. For example, Michigan includes the following line on its individual income tax return: “Use Tax: Use tax due on internet, mail order or other out-of-state purchases,” then references a separate worksheet that is provided to help the taxpayer calculate use tax due.29

Some states have begun to enforce use tax compliance on an individual level, sending tax bills to consumers that had made taxable purchases but failed to pay a tax. Nebraska recently cracked down on a local March of Dimes chapter after the chapter purchased 4,000 t-shirts from an online vendor in Florida. Nebraska tracked purchases for the preceding five years and could collect an estimated $215,000 from the charity, or approximately thirteen percent of the donations. Other states are less stringent, allowing a de minimis exemption for individuals.30

Some states have attempted to enforce sales and use tax compliance by leveraging customers to act as whistleblowers when companies knowingly fail to collect those taxes.31 Under these false claim statutes, individual consumers may bring suits on behalf of the state against parties that knowingly violated sales tax laws. If successful, the whistleblower would be entitled to a portion of the state taxes collected.

While states have had some success tackling the noncompliance issue on their own through enacting Amazon laws or similar statutes, the federal government is the sole body that is constitutionally charged with regulating interstate commerce and therefore should provide states with a tool to help them enforce their laws and uniformly tax interstate commerce. If passed, the Main Street Fairness Act could effectively serve as that tool.

B.  Level the Playing Field

Perhaps the strongest policy reason for implementing a federal law to delegate Commerce power to states is the inherent unfairness that results from forcing some companies to charge their customers sales taxes while others do not have to charge any sales tax.

Two groups are hurt by current disparities in sales tax enforcement: local retailers and large companies with physical presence in many states. Small local retailers (mom and pop shops) are at a distinct disadvantage when their online competitors do not have to charge customers sales tax. Recent studies indicate that many consumers are beginning to follow a “just looking” trend whereby they test products in local stores by seeing, touching, and feeling them, then rush home to order the same products online where they can avoid paying sales taxes.32 According to one consumer behavior report, seventy-five percent of online consumers sought to purchase from merchants that did not charge sales tax and offered free shipping.33 The savings are even greater when buying in bulk, thus enticing large organizations to shift their purchasing patterns away from small local retailers to reduce costs in a bad economy.

Ironically, opponents of internet sales tax regulation argue that enforcing sales tax laws would do greater harm than good to small retailers.34 Such opponents reason that the last decade has provided an unprecedented opportunity for individuals to start small companies that leverage the Internet to grow quickly, thus spurring the economy and creating jobs.Less than one month after the Main Street Fairness Act was introduced, a group of U.S. Representatives introduced the “Supporting the Preservation of Internet Entrepreneurs and Small Businesses” resolution.35 The Preservation bill focuses on avoiding “any legislation that would grant State governments the authority to impose any new burdensome or unfair tax collecting requirements on small online businesses and entrepreneurs.” Representative Dan Lungren, sponsor of the Preservation bill, commented:

The most effective thing we can do to help our economy recover is to remove the roadblocks standing in the way of our nation’s job creators. At a time when we are trying to foster a sustained economic recovery, it doesn’t make sense to saddle entrepreneurs with tax requirements that stifle growth. The possibility of new taxes being levied on online retailers will have a negative impact on the online marketplace. We should send a clear message that Congress should not burden small businesses with unfair tax schemes.

The Preservation bill is constructed on two false premises. First, it presupposes that federal legislation granting states Congressional authority to collect sales taxes would impose a new tax. As discussed in the previous section of this article, sales and use taxes are already due in nearly every state on online purchases. A federal grant of authority would therefore not impose a new tax, but loosen the handcuffs Quill placed on states to enforce their own laws. Second, the Preservation bill is aimed at protecting small businesses and entrepreneurs. While noble in its purpose, the Preservation bill is simply unnecessary; the Main Street Fairness Act’s small seller exception would exempt from sales tax collection the very businesses the Preservation bill aspires to protect.

Another group that is damaged by the current system is large online retailers that have a physical presence in many states, such as Wal-Mart or Target. Most, if not all, online sales from these stores are subject to sales taxes because they have a physical presence in nearly every state. These companies put appropriate resources into ensuring that the taxes are properly collected and remitted. The inconsistency arises when comparing a company like Wal-Mart to a company like Amazon. Both are large companies that sell products to residents in every U.S. state and territory. However, Wal-Mart has stores in every state, while Amazon only has physical presence in a handful of states, thus creating a real disparity that needs to be addressed.

C.  Bridge the Budget Gap

It is no secret that states are struggling to find revenue sources while tax collections are down nationwide. Advocates of internet sales taxation correctly promote the Main Street Fairness Act as a way for states to raise revenue without imposing additional taxes. While allowing states to enforce sales tax collection on all of its residents’ purchases would not solve the current budget crisis, it would allow states to take a healthy step in the right direction.

IV,  Conclusion

Regardless of which political party is in the majority, the Main Street Fairness Act should be given consideration as a viable solution to the problems discussed above. Its passage would comport with the constitutional grant of authority over interstate commerce to Congress, while allowing states the freedom to choose whether to voluntarily join the Agreement. This system is ideal because states can preserve their independence by joining or leaving the Agreement at any time, while providing substantial benefits to out-of-state retailers by simplifying and unifying their reporting requirements. The Main Street Fairness Act is the bandwagon heading toward uniformity and fairness in sales tax collection. States just need to jump on.

[1] Donald Bruce, William F. Fox & LeAnn Luna, State and Local Government Sales Tax Revenue Losses from Electronic Commerce, U. Tenn. Center Bus. Econ. Res., Apr. 13, 2009, available at http://cber.utk.edu/ecomm/ecom0409.pdf.

[2] Main Street Fairness Act, H.R. 5660, 111th Cong. (2010).

[3] Five states do not currently impose a sales tax: Alaska, Delaware, Montana, New Hampshire, and Oregon. Richard Stim, Sales Tax on the Internet, http://www.nolo.com/legal-encyclopedia/sales-tax-internet-29919.html.

[4] See, e.g., Quill Corp. v. North Dakota, 504 U.S. 298 (1992), National Bella Hess, Inc. v. Department of Revenue of Ill., 386 U.S. 753 (1967), Scripto, Inc. v. Carson, 362 U.S. 207 (1960).

[5] National Bella Hess, Inc. v. Department of Revenue of Ill., 386 U.S. 753 (1967) at 756.

[6] National Bella Hess, Inc. v. Department of Revenue of Ill., 386 U.S. 753 (1967) at 758–60. (internal citations omitted).

[7] Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

[8] Quill at 305 (internal citations omitted).

[9] U.S. Const. art I, § 8, cl. 3.

[10] The dormant Commerce Clause is a judicially-created doctrine that “rests entirely on the negative implications of the Commerce Clause of Art. I, § 8, cl. 3.” See Kathleen M. Sullivan, Gerald Gunther, Constitutional Law 174 (Thomson West 2007).

[11] Streamlined Sales Tax Governing Board, Registration Frequently Asked Questions, [hereinafter FAQs], http://www.streamlinedsalestax.org/index.php?page=faq.         …

[12] Streamlined Sales and Use Tax Act, S. 1736, H.R. 3184, 108th Cong. (2003); Sales Tax Fairness and Simplification Act, S. 2152, 109th Cong. (2005); Streamlined Sales Tax Simplification Act, S. 2153, 109th Cong. (2005); Sales Tax Fairness and Simplification Act, S. 34, H.R. 3396, 110th Cong. (2007).

[13] Borders Online v. State Board of Equalization, 129 Cal.App.4th 1179, 1189–92 (Cal. App. 2005).

[14] Id. at 664–666, (listing some of the factors courts have examined in searching for substantial nexus: business ownership structure, common logos and names, common merchandise, use of private or branded credit cards, links between affiliates’ websites, credit card reward programs, gift certificates and gift cards, trademarks, goodwill, and return policies).

[15] Amazon.com, LLC v. N.Y. State Dep’t of Tax’n & Fin., 877 N.Y.S.2d 842 (N.Y. Sup. Ct. 2009).

[16] Id.; NYaffiliates.com, Merchants Removing NY Affiliates, http://www.abestweb.com/forums/showthread.php?t=105869 (last visited Nov. 29, 2010).

[17] R.I. Gen. Laws -§ 44-18-15 (2009); see also State of Rhode Island and Providence Plantations Department of Revenue, Important Notice: Definition of Sales Tax “Retailer” Amended, available at http://www.tax.state.ri.us/notice/Retailer_definition_NoticeC.pdf.

[18] N.C Gen. Stat. § 105-164.8(b)(3) (2009).

[19] North Carolina Department of Revenue, Sales Tax Law Changes, Form E-505 (8-09), Part II: Other Legislative Changes, available at http://www.dornc.com/downloads/e505_8-09.pdf.

[20] N.C Gen. Stat. § 105-164.3(33c) (2009).

[21] Jennifer Heidt White, Safe Haven No More: How Online Affiliate Marketing Programs Can Minimize New State Sales Tax Liability, 5 Shidler J. L. Com. & Tech. 21 (2009), (listing the following states as having introduced versions of the affiliate tax: Connecticut, Maryland, Minnesota, Tennessee, California, Hawaii, Mississippi, New Mexico, Vermont, Virginia, and Illinois).

[22] H.B. 10-1193, 67th Gen. Assem., 2nd Reg. Sess. (Colo. 2010), available at http://www.leg.state.co.us/clics/clics2010a/csl.nsf/fsbillcont3/B30F5741….

[23] Id.                                                       

[24] Direct Marketing Ass’n v. Huber, Order Granting Motion for Preliminary Injunction, 2011 WL 250556, Civil No. 10-cv-01546-REB-CBS, (D.Colo. 2011).

[25] 2009 OK H.B. 2359, (Feb. 1, 2010) available at http://webserver1.lsb.state.ok.us/textofmeasures/textofmeasures.aspx.

[26] Edward A. Zelinsky, The Paradoxes of Oklahoma’s Amazon Statute: Weak Duties, Expansive Coverage, Often Superfluous, Constitutionally Infirm, Cardozo Sch. L., Inst. Advanced L. Stud., Working Paper No. 315, at 17 (Oct. 2010).

[27] Michael Mazerov, Center on Budget and Policy Priorities, New York’s “Amazon Law”: An Important Tool for Collecting Taxes Owed on Internet Purchases, 1, July 23, 2009, http://www.cbpp.org/files/7-23-09sfp.pdf.

[28] H.R. 5660 at 1.

[29] 2009 Michigan Individual Income Tax Return MI-1040, line 25, available at http://www.michigan.gov/documents/taxes/MI-1040_305378_7.pdf.

[30] Minnesota, for example, exempts individuals with total purchased under $770 from paying the use tax, which is equivalent to $50 of use tax liability. Four other states have similar exemptions for individuals. See Nina Manzi, Use Tax Collection on Income Tax Returns in Other States, Research Department, Minnesota House of Representatives, *2, June 2010, available at http://www.house.leg.state.mn.us/hrd/pubs/usetax.pdf.

[31] Leslie J. Carter, Blowing the Whistle on Avoiding Use Taxes in Online Purchases, 2008 U. Chi. Legal F. 453–54 (2008).

[32] Google Retail Advertising Blog, Trend to Watch: Research & Purchase Process is Multi-Channel, (March 3, 2010), http://googleretail.blogspot.com/2010/03/trend-to-watch-research-purchas….

[33] Sara Rodriguez, Economic Climate Shifts Consumers Online, PriceGrabber.com (March 25, 2009), https://mr.pricegrabber.com/Economic_Climate_Shifts_Consumers_Online_Mar….

[34] Congressman Daniel Lungren, Lundgren Introduces Resolution to Protect Small Businesses and Entrepreneurs from New Sales Taxes, Feb. 16, 2011, http://lungren.house.gov/index.cfm?sectionid=39&sectiontree=6,39&itemid=759.

[35] H.R. 1570, 111th Cong. (2010), available at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills….

© Copyright 2011 Michael J. Payne, CPA

Standing and In Pari Delicto Issues Arising in Bankruptcy Cases

Congrats to Rui Li of the The University of Iowa College of Law -one of  winners of the Spring 2011 National Law Review Student Legal Writing Competition:   Rui’s topic addresses whether a bankruptcy trustee has standing to bring a suit on behalf of the debtor corporation against attorneys who allegedly helped that corporation’s management with the fraud.  

1.  Introduction

Corporate and managerial fraud is pervasive in today’s economic climate. When fraud leaves a company insolvent and forced to seek protection under the Bankruptcy Code, oftentimes bankruptcy trustees commence legal actions against attorneys to generate recoveries for the benefit of the debtor’s estate. A common scenario goes something like this: A company is in dire financial straits before the fraud or is created as a vehicle for the fraud. The defendant is the corporation’s attorney, who assists the corporation in the fraud. The attorney is hired to ensure the company’s compliance with existing law. The attorney does the bidding of the company’s management in pursuance of their fraud. After the company’s collapse, the bankruptcy trustee sues the attorney for fraud, aiding and abetting fraud and legal malpractice.

Drawing upon the equitable defense that bars recovery by a plaintiff bearing fault with the defendant for the alleged harm, common law principles of agency imputation, and the Constitutional requirement that a plaintiff has standing to sue, a defendant may move to dismiss the lawsuit on the grounds that the bankruptcy trustee lacks standing to sue.

This Note provides an analysis of the issue whether the bankruptcy trustee has standing to bring a suit on behalf of the debtor corporation against attorneys who allegedly helped that corporation’s management with the fraud.

2.  The In Pari Delicto Doctrine

a) Background

In pari delicto means “at equal fault.” It is a broadly recognized equitable principle and common law defense that prevents a plaintiff who has participated in wrongdoing from recovering damages resulting from the wrongdoing.[1] The policy behind this doctrine is to prevent one joint wrongdoer from suing another for damages that resulted from their shared wrongdoing.[2] Therefore, if a bankruptcy trustee brings a claim against an attorney on behalf of the corporation, and if the corporation is involved in the corporation’s wrongful conduct which serves as the basis for the claim, the in pari delicto may bar the claim.

The use of the doctrine against bankruptcy trustees emerged in the wave of corporate frauds in the last few decades. This novel application required the introduction of an important new element: agency law. Under agency principles, if the principal acted wrongfully through an agent in the scope of that agency relationship, then the wrongdoing of the agent is attributed to the principal.  Because the acts of corporate managers in the course of their employment are imputed to the corporation, and because a bankruptcy trustee “stands in the shoes” of a debtor corporation, the fraudulent acts of the debtor’s former managers will be imputed to the trustee—unless the trustee can show that management was acting entirely on its own interests and “totally abandoned” those of the corporation to break the chain of imputation.[3]

An analysis of the equitable defense in pari delicto at issue is separable from a standing analysis.[4] “Whether a party has standing to bring claims and whether a party’s claims are barred by an equitable defense are two separate questions, to be addressed on their own terms.”[5]

b)  The Second Circuit’s Approach

In Shearson Lehman Hutton Inc. v. Wagoner, 944 F.2d 114 (2d Cir. 1991), the Second Circuit adopted the controversial approach of treating in pari delicto as a question of standing rather than an affirmative defense. Specifically, the standing analysis in the Second Circuit begins with the issue of whether the trustee can demonstrate that the third party professional injured the debtor in a manner distinct from injuries suffered by the debtor’s creditors.[6] In many jurisdictions, the question of the trustee’s standing ends here.[7] In Wagoner, the Second Circuit went further and added a second inquiry that incorporates the equitable defense ofin pari delicto.[8] By combining these two issues, the Wagoner rule blends the in pari delicto question into a rule of standing.

In Wagoner, the sole stockholder, director, and president of a corporation had used the proceeds of notes to finance fraudulent stock trading.[9] After the corporation became insolvent, the trustee brought claims against the defendant, an investment bank, for breach of fiduciary duty in allowing the company’s president to engage in inappropriate transactions.[10] The court held that because the president participated in the alleged misconduct, his misconduct must be imputed to the corporation and the bankruptcy trustee. This rationale derives from the agency principle that underlies the application of in pari delicto to corporate litigants: the misconduct of managers within the scope of their employment will normally be imputed to the corporation.[11] The court ruled that the trustee lacked standing to sue the investment bank for aiding and abetting the president’s alleged unlawful activity.[12] By adopting the Wagoner rule, the Second Circuit upped the ante by making an equitable defense a threshold question of standing at the motion-to-dismiss stage, rather than an affirmative defense better resolved on summary judgment or at trial.

c)  Approaches of Other Circuits

Although the Wagoner rule still prevails in the Second Circuit, a majority of other courts have declined to follow it, including the First, Third, Fifth, Eighth, Ninth and Eleventh Circuits. These circuits have “declined to conflate the constitutional standing doctrine with the in pari delicto defense.”[13] “Even if an in pari delictodefense appears on the face of the complaint, it does not deprive the trustee of constitutional standing to assert the claim, though the defense may be fatal to the claim.”[14]

The Eighth Circuit held that in pari delicto cannot be used at the dismissal stage.[15] On a motion to dismiss, the court is generally limited to considering the allegations in the complaint, which the court assumes to be true in ruling on the motion.[16] Because in pari delicto is an affirmative defense requiring proof of facts that the defendant asserts, it is usually not an appropriate ground for early dismissal.[17] An in pari delicto defense may be successfully asserted at the pleading stage only where “the facts establishing the defense are: (1) definitively ascertainable from the complaint and other allowable sources of information, and (2) sufficient to establish the affirmative defense with certitude.”[18] Thus, the in pari delicto defense is generally premature at this stage of the litigation, and the court must deny the motion to dismiss.

The existence of a possible defense does not affect the question of standing.[19]Standing is a constitutional question, and all a plaintiff must show is that they have suffered an injury that is fairly traceable to the defendant’s conduct and that the requested relief will likely redress the alleged injury.  In this matter, the First, Third, Fifth, Eighth, and Eleventh Circuits’ approach is more convincing. Those courts hold that whether a trustee has standing to bring a claim and whether the claim is barred by the equitable defense of in pari delicto are two separate questions and that the in pari delicto defense is appropriately set forth in responsive pleadings and the subject of motions for summary judgment and trial.

3.  Standing Issues The Trustees Face 

a)  Background

The next question is whether the bankruptcy trustee fulfills the constitutional requirement of standing. Article III specifies three constitutional requirements for standing. First, the plaintiff must allege that he has suffered or will imminently suffer an injury. Second, he must allege that the injury is traceable to the defendant’s conduct. Third, the plaintiff must show that a favorable federal court decision is likely to redress the injury.[20]

A critical issue in evaluating whether a trustee or receiver has standing to sue is whether the claim belongs to the corporate debtor entity or to the individual investors of the corporate debtor. The Supreme Court held in Caplin v. Marine Midland Grace Trust Co. of New York, 406 U.S. 416, 433-34 (1972), that a bankruptcy trustee has standing to represent only the interests of the debtor corporation and does not have standing to pursue claims for damages against a third party on behalf of one creditor or a group of creditors. Although the line is not always clear between the debtor’s claims, which a trustee has statutory authority to assert, and claims of creditors, which Caplin bars the trustee from pursuing, the focus of the inquiry is on whether the trustee is seeking to redress injuries to the debtor that defendants’ alleged conduct caused.[21]

b)  The Shifting Focus of the Second Circuit

In Wagoner, the Second Circuit held that the corporation and the trustee did not have standing to bring a claim because a “claim against a third party for defrauding a corporation with the cooperation of management accrues to creditors, not to the guilty corporation.”[22] The rationale for this rule is “though a class of creditors has suffered harm, the corporation itself has not.”[23] Without cognizable injury, the trustee representing the debtor corporation failed to meet the constitutional standing requirement.

Commentators have criticized the Wagoner rule that there is no separate injury to the corporation on several grounds. First, the court’s finding that a corporation is not harmed when its assets are squandered effectively ignores the existence of the corporation during the bankruptcy process.[24] Furthermore, the Wagonercourt seems to acknowledge the trustee’s right to sue the guilty managers for damages done to the corporation. Such a construction leads to the absurd result that when management and its accomplices defraud a corporation, management can be sued on behalf of the corporation for the harm caused to the corporation, but the accomplices cannot be sued on behalf of the corporation because the corporation was not harmed.[25] Recognizing the faults of this rule, the Second Circuit recognized that there was “at least a theoretical possibility of some independent financial injury to the debtors” as a result of the defendant’s aid in the fraud.[26] Nevertheless, the court denied the plaintiff’s standing, relying on the observation that any damage suffered by the debtor was passed on to the investors, and “there was likely to be little significant injury that accrues separately to the Debtors.”[27] In other words, most of the alleged injuries in Hirsch were suffered by third parties, not by the debtors themselves. The Second Circuit shifted the focus of the Wagoner rule from lack-of-separate-injury (the first inquiry of theWagoner rule) to the in pari delicto (the second inquiry) in Breeden v. Kirkpatrick & Lockhart LLP, 336 F.3d 94 (2d Cir. 2003). In that case, the court denied the trustee standing, holding that even if there was damage to the corporation, the trustee lacked standing because of the debtor’s collaboration with the corporate insiders.[28]

c)  Approaches of Other Circuits

In Lafferty, the creditors’ committee brought an action against the debtor’s officers, directors and outside professionals, alleging that through participation in a fraudulent Ponzi scheme, the defendants wrongfully prolonged the debtor’s life and incurred debt beyond the debtor’s ability to pay, ultimately forcing the debtor into bankruptcy.[29] The Lafferty court articulated different kinds of harms to the corporation: (1) fraudulent or wrongful prolongation of an insolvent corporation’s life, (2) prolongation that causes the corporation to incur more debt and become more insolvent, and (3) diminution of corporate value had prolongation not occurred.[30] Recognizing that conduct driving a corporation deeper into debt injures not only the corporate creditors, but the corporation itself, the Third Circuit held the committee had standing to sue the outsiders on behalf of the debtor.[31]The court also noted that although the Tenth and Sixth Circuits had applied the in pari delicto doctrine to bar claims of a bankruptcy trustee, those courts assumed that the bankruptcy trustee at least has standing to bring the claim.[32]

The Eighth Circuit held that a trustee who had alleged sufficient injury traceable to the actions of the defendants had standing to sue.[33] The court held that the defendant law firm and attorneys participated in stripping the corporation’s assets and that the injury was traceable to the activities of the lawyers who engineered the transaction to the detriment of their client.[34] In addition, the Eighth Circuit noted that the Third Circuit in Lafferty and the Ninth Circuit (in Smith v. Arthur Andersen LLP 421 F.3d at 1004) rejected the argument that a cause of action for harm to an insolvent corporation belongs to the creditors rather than the corporation. The Eighth Circuit adopted the rationale of Lafferty that simply because the creditors may be the beneficiary of recovery does not transform an action into a suit by the creditors.[35]

The Ninth Circuit found that the trustee had standing to pursue breach of contracts and duties against attorneys, auditors and investment bankers where, if defendants had not concealed the financial condition of debtor, the debtor might have filed for bankruptcy sooner and additional assets might not have been spent on a failing business.[36] “This allegedly wrongful expenditure of corporate assets qualifies as an injury to the firm which is sufficient to confer standing upon the Trustee.”[37] The court stated that “We rely only on the dissipation of assets in reaching the conclusion that the debtor was harmed.”[38] “A receiver has standing to bring a suit on behalf of the debtor corporation against third parties who allegedly helped that corporation’s management harm the corporation.”[39]

To sum up, when a director or officer enlists the help of attorneys to misstate the financial health of a company, it causes significant harm to a corporation. Harms include: (1) the fraudulent and concealed accrual of debt which can lessen the value of corporate property, (2) legal and administrative costs of bankruptcy, (3) operational limitations on profitability, (4) the undermining of business relationships, and (4) failed corporate confidence.

If court were to afford standing to trustee, third parties would be deterred from negligent, reckless, or other wrongful behavior. It will provide a means for increasing attorneys’ liability for the wrongs they commit. While limitless liability for attorneys is not the solution, increasing liability will require attorneys to answer in court when they fail to detect fraud or manipulation on the part of directors and officers that a reasonable attorney would discover.

4.  Conclusion

Attorneys are equipped with the tools to prevent fraud. An attorney may always report fraud to the appropriate authority or refuse to participate in the fraud. However, attorneys may not want to jeopardize important client relationships unless the consequence of inaction makes reporting more beneficial. Given the turmoil of the financial markets since 2008, increased liability for attorneys could help alleviate corporate fraud and bolster consumer confidence in this distressed market.

For the above reasons, the bankruptcy trustee has standing to bring a suit on behalf of the debtor corporation against attorneys who allegedly helped that corporation’s management with the fraud.

 

[1] Terlecky v. Hurd (In re Dublin Sec., Inc.), 133 F.3d 377, 380 (6th Cir.1997).

[2] In re Parmalat Sec. Litig., 383 F. Supp. 2d 587, 596 (S.D.N.Y. 2005).

[3] Wight v. Bank American Corp., 219 F.3d 79, 87 (2d Cir. 2000).

[4] See generally Jeffrey Davis, Ending the Nonsense: the In Pari Delicto Doctrine Has Nothing to Do with What is Section 541 Property of the Bankruptcy Estate, 21 Emory Bankr.Dev. J. 519 (2005); Gerald L. Baldwin, In Pari Delicto Should Not Bar a Trustee’s Recovery, 23-8 Am. Bankr.Inst. J. 8 (2004); Tanvir Alam, Fraudulent Advisors Exploit Confusion in The Bankruptcy Code: How In Pari Delicto Has Been Perverted To Prevent Recovery for Innocent Creditors, 77 Am. Bank. L.J. 305 (2003); Robert T. Kugler, The Role of Imputation and In Pari Delicto in Barring Claims Against Third Parties, 1 No. 14 Andrews Bankr.Litig. Rep. 13 (2004);Making Sense of the In Pari Delicto Defense: “Who’s Zoomin’ Who?” 23 No. 11 Bankr. Law Letter 1 (Nov.2003).

[5] Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co.,267 F.3d 340, 346-47 (3d Cir.2001).

[6] Wagoner, 944 F.2d at 118.

[7] R.F. Lafferty & Co., 267 F.3d at 340.

[8] Wagoner, 944 F.2d at 118.

[9] Id. at 116.

[10] Id. at 116-17.

[11] Wight, 219 F.3d at 86.

[12] Wagoner, 944 F.2d at 120.

[13] In re Senior Cottages of America LLC, 482 F.3d 997, 1003 (8th Cir. 2007) (collecting cases).

[14] Id. at 1004.

[15] Id. at 1002.

[16] Wilchombe v. Tee Vee Toons. Inc., 555 F.3d 949, 959 (11th Cir. 2009).

[17] Knauer v. Jonathon Roberts Financial Group, Inc., 348 F.3d 230, 237 n. 6 (7th Cir. 2003).

[18] Gray v. Evercore Restructuring, LLC, 544 F.3d 320, 325 (1st Cir. 2008).

[19] Novartis Seeds, Inc. v. Monsanto Co., 190 F.3d 868, 872 (8th Cir. 1999).

[20] Allen v. Wright, 468 U.S. 737, 756-58 (1984).

[21] Smith v. Arthur Andersen, LLP, 421 F.3d 989, 1002 (9th Cir. 2005).

[22] Wagoner, 944 F.2d at 120.

[23] Id.

[24] Jeffrey Davis, Ending the Nonsense: The In Pari Delicto Doctrine Has Nothing to Do with What Is § 541 Property of the Bankruptcy Estate, 21 Emory Bankr. Dev. J. 519, 525 (2005).

[25] Id. at 527.

[26] Hirsch v. Arthur Andersen & Co., 72 F.3d 1085, 1087 (2d Cir. 1995).

[27] Id.

[28] Id. at 100.

[29] Lafferty Co., 267 F.3d at 348-49.

[30] Id.

[31] Id. at 354.

[32] Id. at 358.

[33] In re Senior Cottages Of America, LLC, 482 F.3d 997.

[34] Id.

[35] Id. at 1001.

[36] Smith v. Arthur Andersen, LLP, 421 F.3d at 1003 (9th Cir. 2005).

[37] Id.

[38] Id. at 1004.

[39] Id.

© Copyright 2011 Rui Li

 

“Innocent” Criminals: Criminal Copyright Infringement, Willfulness and Fair Use

The National Law Review would like to congratulate Charles Francis Scott of  Pace University School of Law  one of our Spring 2011 Student Legal Writing Contest Winners.  Charles’ topic is the “willfullness”  prong of criminal copyright infringement:    

I. INTRODUCTION

            On November 17, 2010, Gawker Media LLC published on its popular blog, Gawker, excerpts of Sarah Palin’s unreleased book America By Heart: Reflections on Family, Faith and Flag.[1]  In response to the release, Palin tweeted, “Isn’t that illegal?”[2]  Defending itself, Gawker mockingly wrote to Palin in a post titled Sarah Palin is Mad at Us for Leaking Pages From Her Book, telling her to “take a moment to familiarize yourself with the law.  . . . Or skip the totally boring reading and call one of your lawyers.  They’ll walk you through it” and attached pages on the copyright law’s fair use doctrine.[3]  After Gawker refused to remove the excerpts from its blog, Palin’s publisher, HarperCollins, filed suit against Gawker and obtained a preliminary injunction on November 20, 2010.[4]  By November 23, 2010, Gawker agreed to keep the material off its website for good and settled the suit with HarperCollins.[5]  Ignoring the underlying political and ideological tension between Gawker and Palin,[6] this incident highlights a very important issue: the complex and commonly misunderstood fair use doctrine. 

            The fair use doctrine has been a large source of legal uncertainty and, as a result, has led many civil copyright infringement suits to settle out of court.[7]  While it might be desirable that civil suits are settled out of court for judicial efficiency, the doctrine’s uncertainty poses a problem when fair use is used as an affirmative defense against criminal charges of copyright infringement under 17 U.S.C. § 506.[8]  In order to convict an individual of criminal infringement, the individual must have willfully infringed a copyright (1) for commercial or financial gain; (2) reproducing or distributing copies with a total retail value over $1000; or (3) making an unpublished work publicly available on a computer.[9]  The fair use doctrine states that there are certain uses, subject to a four factor balance test, where an individual can use or copy a copyrighted work without infringing.[10]  The fair use defense would then argue that either (1) the use was not infringing because it was a fair use; or (2) the individual did not willfully infringe because he or she believed the use was a fair use. 

            A problem arises when an individual believes in good faith his or her copying is a fair use but does not pass the factor test and is actually infringing.  Depending on the courts interpretation of “willfully,” this good faith, but mistaken belief, can be the difference between conviction and freedom.  As illustrated in the Gawker-Palin example, even sophisticated parties, who presumptively have personal legal counsel, misinterpret the bounds of the fair use doctrine.  If sophisticated individuals find difficulty in the nuances of the doctrine, what can be expected of the unsophisticated individual?  Since the mens rea of willfully is attached to a section 506(a) charge, barring a bad faith fair use defense, will a fair use defense always absolve a defendant?

            This article will look at the fair use doctrine as an affirmative defense against the criminal charge of copyright infringement under section 506(a) and whether it serves as a suitable defense within the statute, or whether the statute needs to be revised to avoid the problems created by the fair use doctrine.  Part II will give a brief background of section 506(a) for a charge of criminal copyright infringement and analyze the case law defining “willfulness” generally and its application to the mens rea of section 506(a).  Part III will review the fair use doctrine and the issues created when fair use is used as a defense.  Part IV will briefly examine certain policy considerations in relation to criminal copyright infringement.  Finally, this article will conclude that the fair use doctrine is too vague of a doctrine to be an effective defense and may reduce section 506(a) to a “toothless” statute.[11]  As a result, the statute should be amended by increasing the monetary criminal trigger from $1,000 to at least $25,000 and the term “willfully” needs to be defined in accordance with the majority view.

II.  § 506(a) BACKGROUND AND WILLFULNESS STANDARD

            Criminal copyright infringement is codified under 17 U.S.C. § 506(a) and the punishment guidelines is under 18 U.S.C. § 2319.[12]  Under section 506(a), criminal copyright infringement is anyone who willfully infringes a copyright (1) for commercial or financial gain; (2) reproducing or distributing copies with a total retail value over $1000; or (3) making an unpublished work publicly available on a computer if that person knew the work was intended for commercial distribution.[13]  To prove willful infringement, evidence of reproduction or distribution of a copyright work will not be sufficient.[14] The government has the burden to prove all four elements which are: (1) a valid copyright; (2) infringement of that copyright; (3) willfulness; and (4) one of the qualifying violations of section 506(a)(1)(A)-(C).[15]  The first two elements are the same that must be shown in a civil infringement case.[16]  The difference between civil and criminal infringement is the addition of the third and fourth element. 

            Unlike civil infringement, which is a strict liability offense, criminal infringement requires that the government prove the individual acted willfully.    However, the definition of “willfulness” has been left up to the courts’ interpretation since Congress failed to define it.[17]  Unfortunately, “willfulness” has long been a thorn in court’s side when used in the context of criminal law.[18]  It was not untilUnited States v. Moran[19]that the court was confronted with interpreting the vague term’s meaning under section 506(a).

            In Moran, Moran was a full-time police officer and owner of a “mom and pop” video rental store.[20]  Moran made a practice of purchasing legal videos, making a single duplicate of the original, renting the copy, and keeping the original to “insure” the video from theft or damage.[21]  Moran testified that he believed his actions were legal.[22]  He argued that “the word ‘willful’ implies the kind of specific intent . . . which is to say, a voluntary, intentional violation of a known legal duty.”[23]  The government argued that willful only meant “an intent to copy and not to infringe.”[24]  In coming to its decision, the court looked to a prior Supreme Court case dealing with the term “willfully” in a criminal statute.

            In Cheek v. United States,[25] Cheek was charged with willfully failing to file federal income taxes and willfully attempting to evade his taxes.[26]  Cheek claimed that he believed the tax code was unconstitutional and therefore believed he did not have to pay taxes.[27]  The court held that while the “general rule that ignorance of the law or a mistake of law is no defense to criminal prosecution,” an exception is made when the term “willfully” is used in complex criminal statutes.[28]  Due to the complexity of the tax code, “willfulness . . . simply means a voluntary, intentional violation of a known legal duty.”[29]  The government then has the burden to prove that the defendant knew of the duty and voluntarily and intentionally violated it.[30]  Therefore, “a good faith belief that one is not violating the law negates willfulness, whether or not the claimed belief or misunderstanding is objectively reasonable.”[31]

       Using the reasoning of Cheek, the Moran court was persuaded that “willfully” carried the same meaning under 17 U.S.C. § 506(a) and was similarly exempt from the presumption that ignorance of the law or mistake of the law is no defense.[32]  Accordingly, the court held that Moran’s lack of sophistication, in addition to the totality of the circumstances, negated the willfulness requirement.[33] However, it should be noted, the lack of willfulness does not eliminate civil liability for copyright infringement.[34]

      The holding in Moran has since become the majority view, while the minority view interprets “willfully” as only the intent to copy.[35]  These two views are drastically different; from who carries the burden of proof to the consequence facing an individual who believed his use was protected by fair use.  Unlike the clear complexity of the tax code, the fair use doctrine appears straight-forward but is deceptively complex.[36]  Faced with this complexity, the statute should be amended to define “willfully” in accordance with the majority view and create consistency throughout the courts.

      The outcomes of a fair use balancing test can be unpredictable and creates uncertainty in its application.[37]  Applying the minor’s view, “innocent” infringers face the possibility of being labeled criminals.  By adopting the majority’s definition of “willfully”, prosecution will have the burden of showing that an individual has themens rea warranting criminal punishment.  Additionally, by codifying the majority’s definition, there will be minimal disruption to current law.

III.  FAIR USE

      Section 107 of the Copyright Act allows for the use of a copyrighted work for limited purposes such as “criticism, comment, news reporting, teaching . . ., scholarship, or research.”[38]  Whether that use is eligible for the fair use defense depends on the court’s evaluation of four factors set forth in section 107.[39]These four factors are: (1) the purpose and character of the use (i.e. whether such use is of a commercial nature or for nonprofit purposes); (2) the nature of the copyright (i.e. whether the work is fact based or creative); (3) the amount and substantiality of the portion used in relation to the copyrighted work as a whole; and (4) the effect of the use upon the potential market for or value of the copyrighted work.[40]  While the courts have held that all the factors must be examined and weighed together, the fourth factor has been given the most weight.[41]

      This first factor of the fair use doctrine is usually split into two separate questions.  The first question asks whether the use is “transformative,” meaning, whether it “supersede[s] the objects’ of the original creation.”[42]  The second question asks whether the use is “commercial.”[43]  Since “transformative” and “commercial” are general terms and are susceptible to various interpretations, the first factor can be confusing.  In Sony Corp. of America v. Universal City Studios,[44]the court acknowledged that time-shifting[45] was an acceptable “private, noncommercial” transformative use “in the home”.[46]  However, when compared to BMG Music v. Gonzalez,[47]which held that Gonzalez’s music downloading on a try-before-you-buy basis was a commercial use, the line between commercial and noncommercial, especially for private, personal use, becomes hazy.  Both seem like private, noncommercial uses in the home for personal use, but Gonzalez’s actions supplant her actually purchasing music.[48]  This creates a fine distinction that the unsophisticated individual could misunderstand.  What exactly is commercial if personal use can be both commercial and noncommercial?  Is loading potentially infringing content on YouTube or a similar streaming website commercial if the user does not have a financial interest in the website?[49]

       If an individual posts a clip to his blog or YouTube of a scene from his favorite TV show, saying just that, he could believe he is protected by the fair use doctrine.  He believes the use is noncommercial because he’s not receiving any money from it and he is only using a small portion of the show.  He could believe that he’s making commentary on the piece by saying it is his favorite piece.  Finally, since he is not making any money from posting the video, he does not believe he has any effect on the copyrighted work’s market.  Within a 180 day period it is very possible that the video is viewed well over 100,000 times.  The $1000 or even the $2500 threshold under section 506(a) could easily be attained. 

     It is feasible that a court could find fair use under these facts or slightly different facts because of the variables of the balancing test.[50]  One commentator likened the fair use balancing test to “balancing a dinner plate on the pointy end of a nail.”[51]  Since each evaluation of fair use is fact specific, and all the factors vary in weight depending on those facts, the outcomes are sometimes unpredictable.  As such, the unpredictability of fair use seems to breed fertile ground for an individual to make a good faith mistake in evaluating his or her actions.

      Depending on the district an individual is in, and the interpretation of “willfulness” observed, this mistake can be the difference between walking away a free man or going away a felon.  If the court is within the majority, an individual can theoretically always negate “willfully,” absent evidence that the individual’s belief was not in good faith.  “If a person can claim ‘fair use’ and escape criminal penalties, then the law has no teeth since alleged infringers will invariably assert this defense.”[52]  Alternatively, if the court is within the minority, an individual will not be allowed a mistake defense and will only avoid conviction if the fair use analysis is successful.  These two outcomes are polar opposites; one is too lenient while the other is too severe. 

IV. POLICY CONSIDERATIONS

            Is the infringement of $1000 worth of copyrighted material worth labeling that individual a felon or criminal, even if he did not believe his actions were illegal?[53]  “Felon is a word that should be reserved for individuals committing crimes that damage a victim beyond repair through civil means.”[54] Civil remedies are more suitable in such a case. Incarceration for up to three years for the infringement of $2500 worth of copyrighted material[55] is excessive when civil remedies are available to recover those damages.  If the basis of enacting criminal laws are for “deterring future crimes, stigmatizing offenders, expressing community values, extracting retribution, reforming the offender, and so on,”[56]what are the “retributive function[s] . . . these statutes convey?”[57]  If the offender does not know his actions are illegal, the statute does not achieve these goals.  Furthermore, public opinion does not believe the punishment fits the crime in such low level infringement, as evidenced by the outcry over a Twilight fan’s arrest for taping a birthday party during a viewing of the film “New Moon.”[58]

            Additionally, the cost attributed to the enforcement and incarceration of such an offender is far too high.  Beyond the cost of prosecution, the costs of incarcerating the offender far exceeds the low infringing $2500 threshold.  Based on California’s 2008-2009 Annual Costs to Incarcerate an Inmate in Prison, the average cost per inmate per year is about $47,000.[59]  Theoretically, for a three year sentence, the government would be paying over $140,000 of taxpayer money to incarcerate a non-violent criminal for a $2500 infringement.  Additionally, the non-violent criminal would now be exposed to the dangers and violence inherent in prison.[60]

V. CONCLUSION

       While these low threshold cases with fair use issues are typically not prosecuted,[61]charges are still filed.[62]  The statute has the ability to make criminals out of people that do not know their actions are illegal or believe that they are legal.  By raising the threshold of section 506(a)(1)(B) to at least $25,000, the statute would be better able to avoid prosecution of “innocent” infringers.  The other subsections of 506 would still allow for punishment of individuals selling infringing materials for personal financial gain and individuals distributing unpublished material prior to commercial releases (i.e. leaking music albums, movies, or books).  With these two other options available, raising the threshold would not make prosecution any more difficult. 

      Finally, “willfully” needs to be defined in the statute in accordance with the majority view.  One action should not be more or less culpable depending on the circuit where it is committed.  By defining “willfully” in the statute, all circuits would be in conformity and there would be no discrepancies between courts. Furthermore, if the purpose of the criminal copyright infringement statute is to educate, prevent, and deter, the public needs to know what is and what is not criminal.  For that reason, the definition of “willfully” is necessary to educate and assist in deterring future criminal infringement.

[1]Maureen O’Conner, Sarah Palin’s New Book: Leaked Excerpts, Gawker, (Nov. 17, 2010, 1:50 PM), http://webcache.googleusercontent.com/search?q=cache:TxlEfXyJDUMJ:gawker….

[2]NY Judge Orders Gawker To Pull Palin Book Pages, Associated Press, (Nov. 20, 2010),http://www.google.com/hostednews/ap/article/ALeqM5giNUABDpwRGZATlokAAN5D….

[3]Id.

[4]Sarah Wheaton, Gawker Ordered to Remove Palin Book Excerpts, N.Y. Times, Nov. 20, 2010, 10:45 PM,http://mediadecoder.blogs.nytimes.com/2010/11/20/gawker-ordered-to-remov….

[5]Jeremy E. Peters & Julie Bosman, Palin’s Publisher and Gawker Settle Case, N.Y. Times, November 24, 2010,http://www.nytimes.com/2010/11/25/business/media/25gawker.html?src=busln.

[6]See generally Pareene, Palin: Scared of Asians?, Gawker, (Dec. 4, 2009, 1:39 PM), http://gawker.com/5419113/palin-scared-of-asians; Foster Kamer, Are Sarah and Todd Palin Getting A Divorce?, Gawker, (Aug. 1, 2009),http://gawker.com/5327957/are-sarah-and-todd-palin-getting-a-divorce; John Cook, Please Turn the Governor of Alaska’s Family Into A Television Program. Thank You., Gawker, (Mar. 12, 2009, 11:13 AM),http://gawker.com/5168742/please-turn-the-governor-of-alaskas-family-int….

[7]See generally Diane L. Kilpatrick-Lee, Criminal Copyright Law: Preventing A Clear Danger To The U.S. Economy Or Clearly Preventing The Original Purpose Of Copyright Law?, 14 U. Balt. Intell. Prop. L.J. 87 (2005); Anthony Falzone, Diddy Could Save Sampling, Slate, (Nov. 2, 2007, 7:16 AM),http://www.slate.com/toolbar.aspx?action=print&id=2177238.

[8]17 U.S.C. § 506 (2008).

[9]Id.

[10]17 U.S.C. § 107 (1992).

[11]See generally Ting Ting Wu, The New Criminal Copyright Sanctions: A Toothless Tiger?, 39 IDEA 527 (1999).

[12]18 U.S.C. § 2319 (2008).

[13]17 U.S.C. § 506(a)(1)-(2) (2008).

[14]Id.

[15]See Daniel Newman, Mangmang Cai & Rebecca Heugstenberg, Intellectual Property Crimes, 44 Am. Crim. L. Rev. 693, 717 (2007).

[16]See id. at 718.

[17]§ 506(a)(3).

[18]See Brian P. Heneghan, The Net Act, Fair Use, and Willfulness – Is Congress Making A Scarecrow of the Law?, 1 J. High Tech. L. 27, 34 (2002).  Judge Learned Hand stated that willfulness is “an awful word!  It is one of the most troublesome words that I know.  If I were to have the index purged, ‘willful’ [sic] would lead the rest in spite of its being at the end of the alphabet.” Id. at n64.

[19]757 F. Supp. 1046 (1991).

[20]Id. at 1047.

[21]Id. at 1047-48.

[22]Id. at 1048.

[23]Id.

[24]Id.

[25]498 U.S. 192 (1991).

[26]Id. at 194.

[27]Id. at 195-97.

[28]Id. at 199-200.

[29]Id. at 200.

[30]Id. at 201.

[31]United States v. Moran, 757 F. Supp. 1046, 1049 (1991).

[32]Id.

[33]Id. at 1052.

[34]Kilpatrick-Lee, supra note 7, at 106.

[35]Newman, supra note 14, at 721.

[36]Heneghan, supra note 17, at 35-36.

[37]See infra Part III.

[38]17 U.S.C. § 107 (2007).

[39]Id.

[40]Id. §§ 107(1)-(4).

[41]Campbell v. Acuff-Rose Music Inc., 510 U.S. 569, 578 (1994).

[42]Campbell, 510 U.S. at 584.

[43]17 U.S.C. § 107(1) (2007).  See also Harper & Row, Publishers, Inc. v. Nation Enters., 471 U.S. 539, 562 (1985) (“every commercial use of copyrighted material is presumptively an unfair exploitation of the monopoly privilege that belongs to the owner of the copyright”).

[44]See Sony Corp. of Am. v. Universal City Studios, 464 U.S. 417 (1984).

[45]Time shifting is the act of recording a TV show on a VHS tape for later private viewing.

[46]Id. at 442-43.

[47]430 F.3d 888 (7th Cir. 2005).

[48]Id. at 890.

[49]See generally Michael S. Sawyer, Copyright: Note: Filters, Fair use & Feedback: User-Generated Content Principles and the DMCA, 24 Berkeley Tech, L.J. 363 (2009); Edward Lee, Warming Up To User-Generated Content, 2008 U. Ill. L. Rev. 1459 (2008).

[50]See generally Jeremy Scott, “Leave Them Kids Alone” A Proposed Fair Use Defense For Noncommercial P2P Sharing of Copyrighted Music Files, 3 Fla. Int’l U. L. Rev. 235 (2007).

[51]See Eric Spiegelman, Sarah Palin and Gawker to Debate Freedom and the Constitution, The Awl, (Nov. 22, 2010), http://www.theawl.com/2010/11/sarah-palin-and-gawker-to-debate-freedom-a….

[52]Heneghan, supra note 17, at 36.

[53]17 U.S.C. § 506(a)(1)(B) (2008).

[54]Kilpatrick-Lee, supra note 7, at 117.

[55]18 U.S.C. § 2319(c)(2) (2008).

[56]Geraldine Scott Moohr, The Crime of Copyright Infringement: An Inquiry Based on Morality, Harm, and Criminal Theory, 83 B. U. L. Rev. 731, 748 (2003).

[57]Kilpatrick-Lee, supra note 7, at 118.

[58]The charges were dropped after holding the woman for two days.  SeeShanna Schwarze, ‘New Moon’ Taping May Put Woman In Prison, CNNEntertainment (Dec. 4, 2009, 6:28PM),http://www.cnn.com/2009/SHOWBIZ/Movies/12/04/new.moon.arrest/; Amanda Bell, Charges Against Accused ‘The Twilight Saga: New Moon’ ‘Pirate’ Dropped, examiner.com (Dec. 11, 2009, 4:36PM), http://www.examiner.com/twilight-in-national/charges-against-accused-the… Jacqueline D. Lipton, Coypright’s Twilight Zone: Digital Copyright Lessons From The Vampire Blogosphere, 70 Md. L. Rev. 1, 38-42 (2010).

[59]California’s Nonpartisan Fiscal and Policy Advisor, Legislative Analyst’s Office, California’s 2008-2009 Annual Costs to Incarcerate an Inmate in Prison(2009),http://www.lao.ca.gov/laoapp/laomenus/sections/crim_justice/6_cj_inmatec….

[60]See Heneghan, supra note 17, at 39-43.

[61]Computer Crime and Intellectual Property Section, U.S. Dep’t of Just., Prosecuting Intellectual Property Crimes Manuel 67-68 (2001).

[62]See supra note 57.

© 2011 Charles F. Scott

More Than Just An Algorithm: Reconciling The Necessity For Disaggregating The Business Method, With Bilski’s Abstract Test

The National Law Review would like to congratulate Andrew L. Schwartz of Hofstra Law School one of our Spring 2011 Student Legal Writing Contest Winners.  Andrew’s topic is the business method patent.  

INTRODUCTION

As the airplane’s utility spread to the public sector, the 1940’s witnessed the sky’s transformation into the new highway. Like any new frontier and innovation, there was a need for regulation and legal guidance. Fortunately, property law had covered the topic since the 18th century. Cuius est solum, eius est usque ad coelum et ad inferos, whoever owns the soil, it is theirs up to Heaven and down to Hell.[1]The Supreme Court however did not agree with such dated application.[2]The court reasoned that categorizing air travel with ground travel under current property law would be naive. The two categories possessed different interest and policy consideration. Unification of the two, under traditional property laws, would essentially defeat air travel’s value and purpose. Such application had “no place in the modern world”[3].  The court made it clear that new innovation required new regulation and new legal guidance. Instead of fitting innovation into the law, new laws are created to fit innovation.

To promote, and protect innovation, for years American inventors have relied on the system of intellectual property and the patent system. The patent system, a once humble and optimistic institution, has evolved far beyond its beginnings. When the last patent act was passed over a half a century ago, aspirations were high. The 1950’s saw an innovation boom that inspired some of the most integral foundations for modern technology.[4]  Proponents of the patent system promoted exposure and accessibility for innovation, while discouraging concealment and private use.[5] Assuming the excitement of the era, congress eagerly looked to protect “anything under the sun that is made by man”.[6] However with the eruption of financial and software innovation in recent years, one would be hard-pressed to find the 1950’s anything-and-everything sentiment in today’s patent office.

In the eyes of the patent office, financial and software innovation is commonly referred to as a business method.  Subject to 35 U.S.C §101 and classified under Class 705, a business method patent is “the generic class for apparatus and corresponding methods for performing data processing operations.”[7] Software is a set of logical instructions, intended for a computer, made to perform computations, comparisons and sequential steps in order to process and produce a desired output.[8]Financial innovation, centuries older than software, began as basic mathematical principles.[9] Contemporary financial innovation however, has grown to enormous complexities. Fashioned from a set of multifaceted mathematical algorithms, the innovations have become so advanced that it is near impossible to solve without the aid of a computer.[10] Essentially, in the law’s view, today’s financial innovation is software.[11]

The business method has conflated financial and software innovation under the association of complex algorithms. While under a legal lens software and financial algorithms are near inseparable, the makings and interests of their respective innovations are however quite different. For instance, a large internet corporation may attempt to patent an online shopping method for common consumers;[12] while a large financial firm may attempt to patent a system of asset pooling for large mutual funds.[13] From the components that build the algorithm, to the industries effected by the patents, it is difficult not to acknowledge the distinctions between the two scenarios. The current patent system however does not recognize such distinctions. In both scenarios the algorithms are to be evaluated as business method patents.

Because of the realistic distinctions between financial and software innovation, formulating a cohesive judicial policy for the business method would seem destitute. Patent litigation over the past forty years has been frustrated with judicial attempts to reconcile both financial and software innovations under the business method patent. The most recent efforts in the ongoing business method saga produced the Abstract test for patentability assessment. The Abstract test was created by the Supreme Court’s ruling Bilski v. Kappos.[14] While the test is still in its early stages of development, lower courts have been hard pressed to reconcile financial and software innovation under the business method using the Abstract test.[15]

History has produced an ambiguous interpretation of financial and software innovation that fails to fit the enthusiastic “anything under the sun” patent system of the 1950’s. It is clear that the development of financial and software innovation has outgrown the traditional business method classification. The business method has “no place in the modern world”[16] and needs categorical disaggregation among financial and software innovation. Disaggregation would not only better serve the time and principles that each innovation represents, but simplify the Abstract test while preserving its purpose.

This article will examine the necessity for the disaggregation of the business method.  The first section will evaluate the judicial history and evolution of the business method leading up to the Bilski decision. The second section will discuss the Bilski decision and the Abstract test. The third section will contemplate the current future of the Abstract tests. The last section of the article will discuss how the business method and the Abstract test can be clarified in disaggregating the business method into financial and software innovation.

I.  HISTORY: THE GUIDEPOSTS: 1972-2008

The history of contemporary algorithmic innovation began in the 1970’s when the Supreme Court twice considered business method patents. Both decisions held the innovations unpatenable.  The first decision, Gottschalk v. Benson, was decided in 1972.[17]The Supreme Court considered whether algorithmic based software for converting binary code was  patentable. In a six justice majority, the court held the method unpatenable, unless “in connection with a digital computer”, because it “would wholly pre-empt the mathematical formula and in practical effect would be a patent on the algorithm itself”.[18]The decision confirmed that algorithms, made akin to software by the court, standing alone, were unpatenable subject matter.  [19]

While algorithms alone were unpatenable, the question existed of whether bringing a physical component into the application would preclude a patentability.  Six years after Benson, the Supreme Court returned to the business method issue and addressed such question. InParker v. Flook, the Supreme Court considered whether an algorithmic based method for triggering an alarm system, used to signal irregular conditions in a catalytic conversion process, was patentable.[20]In a seven justice majority, the Court held the innovation unpatenable. Although the alarms inclusion meant the innovation wasn’t wholly algorithmically based, the majority realized the only novel element in Flook’s innovation was the algorithm itself.[21]  It would have appeared that the patent system’s hole had been filled. The courts would not be fooled by crafty lawyering and mirrors attempting to hide an algorithm amongst physical components. After Benson and Flook, it appeared software and algorithms, were to be treated like any other mathematical formula, unpatenable.

Hopes of patenting an algorithm under the business method reemerged only four years later in the Supreme Court case Diamond v. Diehr.[22]Once again an application was presented, part physical, part algorithm. The invention used the Arrhenius Equation to calculate the operation timing on a physical rubber press. As the rubber curing process stood well known in the industry, clearly the only new innovation in the patent application was the algorithm itself.[23]However, in a five justice majority, the application was deemed acceptable. Arguably marking the first time an application containing software was considered statutorily patentable. Although the rulings in Benson and Flook were not overruled by the Diehr decision, it appeared that the physical component ambiguities after Benson had not truly been resolved.

After Diehr, the patent system became a virtual wild west. Floods of “ridiculous and truly absurd” business method applicants were submitted to the patent office.[24]The era was epitomized with a 1994 application from the software titan IBM.[25]The invention set out a group algorithms loaded onto a physical readable storage device. The physical component that was able to pass muster under Benson and Flook, a floppy disk. The application’s approval gained such recognition that it was even endowed its own business method idiom, a Beauregard claim.[26]After dilution of the Flook’s unpatenable ruling, the despondent future of the business method patent herald through the financial and software communities.[27]

The circular timeline of judicial clarification surfaced once again in 1998 with the case of State Street v. Signature Financial Group.[28]The court found Signature Financial’s financial purposed algorithm, one that moved assets into mutual funds to take advantage of tax benefits, to be patentable.   The State Street holding marked two significant chapters in business method history. The first was the court’s explicit recognition of the business method patent.[29]The court found that such a category was no less patentable than any other subject matter under Section 101. State Street’s judicial endorsement of the business method patent, once again, propagated a flood of financial and software patent applications.[30]The second major significance of the State Street decision was in the court’s clarification of business method eligibility. The court held that the new test for eligibility was to be the Useful, Concrete and Tangible Result test.  Although the test could hardly be awarded a bright line denomination, it marked the first judicial canon to reconcile Benson, Flook and Diehr. However, despite the court’s best efforts, the test still granted several questionable patents approval, many lacking any hint of a physical component.[31]

II. CREATION OF THE ABSTRACT TEST: IN RE BILSKI & BILSKI V. KAPPOS

Ten years after the State Street decision, judicial clarification poignantly returned to the Federal Court of Appeals. Finding an opportunity to reevaluate its holding in State Street and its significances over the past ten years, the court, sitting en banc, adjudicated In Re Bilski.[32]The court’s holding not only rejected State Street’s Useful, Concrete and Tangible Result test that had reigned supreme for ten years, but went as far to replace it with a new test for business method eligibility. The new test, the Machine-or-Transformation test, held that a business method patent was patentable subject matter if it 1) was applied by use of a machine, or else 2) transforms an article from one thing or state to another. Was the court’s new test a judicial endorsement of the Beauregard claim, or was it carefully worded to avoid the question of patentability with an additional physical component?  It would have appeared that, once again, the courts had clarified one complication, while subsequently creating another.

The thematic clarification of business method decisions past came to one of its most pivotal moments in 2009 when the Supreme Court granted writ of certiorari for Bilski’s appeal.[33]From Silicon Valley to Wall Street, software and financial innovators alike held their breath awaiting the decision. Mounting rumors held that the court would possibly eliminate the business method patent altogether.[34]While some justices of the dissent agreed with the business method’s eradication, the majority felt otherwise.[35]Delivered by Justice Kennedy, the majority opined, that business methods are indeed patentable; Bilski’s application however was not.

Bilski had developed a hedging algorithm to eliminate volatility in consumer energy costs. Using the Monte Carlo method and historical weather data, energy prices would be hedged with weather futures to lock in a more stable and predictable energy bill. The algorithm’s complexities went far beyond any pen and paper, and the necessity for a computer was evident. Although there was an implied necessity for a physical component (a computer), the majority still found the algorithm unpatenable. The majority reasoned that Bilski’s innovation was an abstract idea. Reiterating established ‘precedent’, as if such a rule were ostensibly written and obvious already, the court reasoned that business method patents are limited by “laws of nature, physical phenomena, and abstract ideas”.[36]The Machine-or-Transformation test developed in In Re Bilski was no longer to be a determinative test in patentability, but rather a “useful and important clue” to the inclusive Abstract test.[37]  The court continued to disregard the continuance of  other tests that have marked business method history through the years, declaring that “nothing in today’s opinion should be read as endorsing the Federal Circuit’s past interpretations of § 101. See, e.g., State Street.”[38]And in one sentence ten years of State Street and its progeny were erased.

The Bilski Supreme Court failed to clarify a definition of their Abstract test, both in its criteria’s inclusions and omissions. The court rather left such task of interpretation to the lower courts in coming years, advising them on a case by case basis to return to the legal “guideposts”[39]of Benson, Flook, and Diehr. Justice Potter’s illustrious commentary rang ever present, “I can’t define it, but I know it when I see it”.[40] The business method was, once again, afflicted with yet another ambiguous interpretation.

III.  THE  CURRENT FUTURE OF THE BUSINESS METHOD

In patent applications to come, federal courts are left with the assignment of interpretation mandated by the powers above. Courts now sit in a post-Bilski era with the future of the business method patent in their discretion. While courts have taken time to acknowledge the inconclusiveness of the Bilski decision[41], others have used the opportunity to expand its meaning. In a recent decision by the Federal Court of Appeals, the eligibility of algorithms specifically was discussed.[42]Not surprisingly opting to use the ‘guidepost’ of Diehr, the court held that “algorithms and formulas, even though admittedly a significant part of the claimed combination, do not bring this invention even close to abstractness that would override the statutory categories and context”.[43]Even the most confident and charitable views of the Bilski decision and its progeny echo a notice of future complications, some which have already begun to surface. [44]

Verified by a circular history blemished with flaws, mistakes, and corrections, the current business method system’s stability is noticeably far from safe.  While financial and software innovation has slowly, over the years, conjoined in the eyes of the court under the business method, the culture and society of their respective subscribers is quickly diverging. Such policy considerations, which have all but been neglected in past business method decisions, must be recognized before history reprises itself.

In efforts of slowing the arbitrary attachment of physical components (Beauregard claims), the Supreme Court in Bilski retained the possibility that a purely intangible may gain patentability.[45]However, in a digital age, it is almost inherent that financial and software innovation will rely on a physical element, likely a computer. Even under the court’s pragmatic recognition of the times, Bilski’s Abstract test is still extremely comprehensive. Susceptible to a wide array of differing interpretations, in coming years the Abstract test is capable of rooting itself into case law far beyond its intended purpose, possibly precluding any software or financial innovation entirely. To better limit the scope to which the Abstract test reaches, its application should be tested to separate confines, software and financial innovation. The question ‘what is an abstract business method’ is extremely different than ‘what is abstract financial innovation’ and ‘what is abstract software innovation’. Because software and financial innovations are inherently different, from their components to the industries they affect, the Abstract test will take on different considerations when applied to each individually.

IV.  DISAGGREGATION: A SOLUTION

A.  FINANCIAL ABSTRACT TEST

The assertion that all mathematical formulas are made of components in existence, workings of nature that have yet to be discovered, is a naive assertion in light of contemporary financial innovation.[46]The quintessential example for the unpatentability of mathematical formulas is Einstein’s relativity formula.[47]Einstein did not invent the formula; he simply codified and arranged components of nature in an assignable formula. Mass, energy, and the speed of light all existed in nature eons before Einstein was even born. Although contemporary financial innovations are based in principles of mathematics, the components and interactions of the numbers in the algorithm can hardly be described as derivatives of nature.

Far from nature, financial innovations operate solely on man-made financial markets. The extent of financial innovation is limited to the markets and can only exclusively function on this man-made medium.[48]For example, Bilski’s use of weather futures in his algorithm would not have even been possible during the time of Diehr, Benson or Flook because weather futures existence has only been recognized on the market since 1996.[49]If the market or weather futures ceased to exist tomorrow, Einstein’s relativity formula would certainly still be comprehensible, Bilski’s algorithm would not.

Because market components and financial algorithms are not of nature, does not mean they cannot be natural relative to the market and its culture. Maintaining the ability to freely use the public utilities and its components has always been an essential consideration in patentability.[50]  This is where the Abstract test in financial innovation can differentiate itself from the Abstract test in software innovation. If a patent were to impede and dominate a natural market component from its intended purpose and use, then such patent would likely fail the Abstract test. The Supreme Court toiled with such reasoning but ultimately carried it in an unusual direction.

Bound to traditional business method policy considerations of both financial and software innovation, and unable to reflect financial market specifics, the Bilski court was forced to reason broadly. The court stated that Bilski sought to patent “the concept of hedging risk…hedging is a fundamental economic practice…allowing petitioners to patent risk hedging would pre-empt use of this approach in all fields, and would effectively grant a monopoly over an abstract idea”.[51]  Application of the court’s wide comprehensive view on any patent will ultimately render it an abstract idea. Can a machine for bending metal be unpatenable because bending is fundamental physical practice?[52]Instead of looking to whether patenting Bilski’s algorithm would have created a monopoly over a natural market strategy, the court should have looked to whether patenting Bilski’s algorithm would have created a monopoly over a natural market component. If Bilski’s algorithm positioned itself to inhibit the public use of weather futures, then the Abstract test would have denied patentability. If Bilski’s algorithm used weather futures in such a way that was useful, novel and non-obvious, while still allowing for its natural use in the market, then the Abstract test would have allowed patentability. Reducing any algorithm to its most basic functions will appear as attempts at privatization of a public utility and fail the Abstract test. Only when the court is given range to apply the Abstract test to the specifics at hand (i.e. financial innovation specifically) can it properly operate.

With such ambiguous decisions as Bilski, financial innovation in private industry has been strained. Over the past years financial innovation has given rise to high frequency, black box and the white box trading.[53]All three concepts revolve around the use of an algorithms operating millisecond market transactions, consistently adjusting to market reactions. While the extent of high frequency trading is generally unknown, the same cannot be said for its presence.[54]Uncertainties in the patent system’s protection have driven financial innovators into hiding. For fear of competitor plagiarism, private firms using algorithms are seldom to share their innovations with the world.[55]Because of a lack of protection, the utility and public benefit of some of these innovations may never be known. Consider the Black-Scholes model, the base for many contemporary algorithms, and arguably one of the most provocative financial innovations of the past century.[56]Once used as a secret investing tool, the algorithm’s utility now goes far beyond the financial sector (ironically one alternative use is in patent valuation[57]). Failing to provide a stronger outline to patentable criteria will only push innovators further into hiding, inhibiting any progress in financial innovation.

The Abstract test applied separately to financial innovation would help facilitate reassurance in the patent system. The Abstract test for financial innovation would be tried against the interests of the market and private industry. Like any public domain, the market invites innovation as long as it does not inhibit the public’s use.[58]A patent application attempting to corner off a common public utility would be abstract. In the private industry’s interest, any application that would potentially destroy the opportunity for progress would be abstract. Evaluating abstractness in financial innovation separately would suit the patent system and innovation in a way the traditional business method system could not.

B.  SOFTWARE ABSTRACT TEST

The struggle between anti-software patent movements and patent proponents has grown significantly as more and more innovations stem from the digital age.[59]While the Bilski decision has almost solidified software as patentable, the Abstract test may serve as an elementary compromise when applied to software innovation separately.

Unlike its financial counterpart, software algorithms do not operate on a public medium such as the market. Software is bound to the rules and procedures of a given programming language. Languages are constantly being created, evolving and improving. The Java language, currently the most popular programming language, was only released in 1995 with its most recent release February 15th 2011.[60]Because the medium on which software innovation operates is moving at an enormously high rate (significantly more so than financial innovation) the innovation itself must move just as fast.

Like its financial counterpart, software also has its own natural components. The Abstract test applied to software would evaluate a patent and its implications under the software culture. If the patent would preclude a natural software component, the Abstract test would reject patentability. However, because of the speed of software evolution, what is regarded as innovation today may easily be common industry practice tomorrow. As patents protection lasts for twenty years, the test for abstractness must possess a sense of foresight. An overly lenient application of the Abstract test in software innovation would inhibit further innovation in later years rather than facilitate it. Consider a software’s spell checker component. The spell checker is only forty years old, but an almost natural component in any contemporary software algorithm.[61]Patenting such component would certainly be abstract and inhibit further innovation. Only when the use of the natural component in software innovation is useful, novel and non-obvious, with a tremendous amount of creativity, can the Abstract test allow patentability.[62]Because of the fluid environment that software innovation operates in, the threshold for abstractness would be significantly lower than financial innovation. This consideration only further proves the need for disaggregation.

Unlike financial innovation, software innovation is not as easily kept secret. The public market acts as a blanket for financial innovations used by traders, with a petty possibility of reverse engineering. The private software industry however, serves no protection to software innovation as it is much more readily reversed engineered and plagiarized. [63] This puts software innovators at a disadvantage, as hiding their innovation is not even an option. Without secrecy as an alternative, the patent system must work more readily to incentivize innovation without slowing it down. On the same token because software innovations are plainly exposed, it pushes innovators to persistently improve so that they may claim the alpha position amongst competitors.

CONCLUSION

While Bilski’s Abstract test is far from definitive criteria, it is th  e hand that has been dealt. Application of the Abstract test to software and financial innovations separately alleviates a large amount of ambiguity. Disaggregating the business method and applying the Abstract test separately allows for different considerations and thresholds for each innovation.  Attention to the components and the industry of the individual innovations restores the patent system to its intended purpose, which the traditional business method has failed to do. With such differences, aggregating software and financial innovation under the business method is impractical. The traditional business method truly has “no place in the modern world”.[64]

[1]John G. Sprankling, Owning the Center of the Earth, 55 UCLA L. Rev. 979, 980 (2008).

[2]United States v. Causby, 328 U.S. 256, 261, 66 S. Ct. 1062, 1065, 90 L. Ed. 1206 (1946).

[3]Id. at 261.

[4]Inventions include: 1951- VTR Video Tape Recorder, 1954-Solar Cell, 1955-Fiber Optics, 1959-Microchip. Cavendish, Marshall, Inventors and Inventions 372-73 (2nd ed. 2007).

[5]Edward C. Walterscheid, Within the Limits of the Constitutional Grant: Constitutional Limitations on the Patent Power, 9 J. Intell. Prop. L. 291, 300 (2002).

[6]The Supreme Court held that Congress chose very expansive language in the patent statute, 35 U.S.C. §101, such that “anything under the sun that is made by man” is patentable subject matter. Diamond v. Chakrabarty, 447 U.S. 303, 100 S. Ct. 2204, 65 L. Ed. 2d 144 (1980).

[7]35 U.S.C.A. § 101 (2010).

[8]Chittenden Trust Co. v. King, 143 Vt. 271, 272, 465 A.2d 1100, 1100 (1983).

[9]The first financial patent was issued on March 19, 1799, for a method for “Detecting Counterfeit Notes.” State Street: Business Method Patents Can They Be A Boardwalk Address?, 688 PLI/Pat 455 , 471 (2002).

[10]William Krause, Sweeping the E-Commerce Patent Minefield: The Need for A Workable Business Method Exception, 24 Seattle U. L. Rev. 79, 101 (2000).

[11]Id.

[12]Amazon.com, Inc. v. Barnesandnoble.com, Inc., 73 F. Supp. 2d 1228 (W.D. Wash. 1999) vacated, 239 F.3d 1343 (Fed. Cir. 2001).

[13]State St. Bank & Trust Co. v. Signature Fin. Group, Inc, 149 F.3d 1368, 1373 (Fed. Cir. 1998) abrogated by In re Bilski, 545 F.3d 943 (Fed. Cir. 2008).

[14]Bilski v. Kappos, 130 S. Ct. 3218, 177 L. Ed. 2d 792 (2010).

[15]“our focus on our muddy, conflicting, and overly formulaic rules.” Arlington Indus., Inc. v. Bridgeport Fittings, Inc., 2010-1025, 2011 WL 179768 (Fed. Cir. Jan. 20, 2011).[16]Causby, supra note 2.

[17]Gottschalk v. Benson, 409 U.S. 63, 93 S. Ct. 253, 34 L. Ed. 2d 273 (1972).

[18]Id. at 72.

[19]Id.

[20]Parker v. Flook, 437 U.S. 584, 98 S. Ct. 2522, 57 L. Ed. 2d 451 (1978).

[21]“Respondent’s application simply provides a new and presumably better method for calculating alarm limit.” Id. at 595.

[22]Diamond v. Diehr, 450 U.S. 175, 101 S. Ct. 1048, 67 L. Ed. 2d 155 (1981).

[23]“There is no suggestion that there is anything novel in the instrumentation of the mold, in actuating a timer when the press is closed, or in automatically opening the press when the computed time expires.” Id. at 209.

[24]In re Bilski, 545 F.3d 943, 1004 (Fed. Cir. 2008) aff’d but criticized sub nom. Bilski v. Kappos, 130 S. Ct. 3218, 177 L. Ed. 2d 792 (U.S. 2010).

[25]In re Beauregard, 53 F.3d 1583 (Fed. Cir. 1995).

[26]Electronic and Software Patents: Crafting The Claims, 909 PLI/Pat 979, 909 PLI/Pat 979 , 1000 (2005).

[27]“it is clear after Flook that the board’s conclusion that patent protection is proscribed for all inventions “algorithmic in character” is overbroad and erroneous.” Application of Johnson, 589 F.2d 1070, 1075 (C.C.P.A. 1978).

[28]State St. Bank  supra note 13.

[29]Id.

[30]Stobbs, Gregory A., Business method patents 17,(2002).

[31]Amazon.com, Inc, supra note 12.

[32]In Re Bilski, supra note 24.

[33]Bilski, supra note 14.

[34]Ryan Paul, SCOTUS to hear Bilski case, may be huge for software patents,June 2, 2009, http://arstechnica.com/tech-policy/news/2009/06/scotus-to-hear-bilski-ma….

[35]Bilski, supra note 14.

[36]Id.  at 3321.

[37]Id.

[38]Id. at 3321.

[39]Id.

[40]Jacobellis v. State of Ohio, 378 U.S. 184, 196, 84 S. Ct. 1676, 1682, 12 L. Ed. 2d 793 (1964).

[41]Arlington Indus.,supra note 15.

[42]Research Corp. Technologies, Inc. v. Microsoft Corp., 627 F.3d 859, 864 (Fed. Cir. 2010).

[43]Id.

[44] “I come from the camp that anything is patentable if you put enough money behind it, but what you might just get at the end of the day is something that won’t hold up in court. Bilski is a great example that no one really understands where patent law should head or the basics of patent decisions.” Keyson, Lauren, NYTECH.org Ecamines Software and Financial Patents, Jan. 24, 2011, http://nyconvergence.com/2011/01/nytech-org-examines-software-and-financial-patents.html

[45]Bilski, supra note 14.

[46]Durham, Alan L., Patent Law Essentials: A Concise Guide¸24(2004).

[47] Diehr supra note 22.

[48]Smith, Mark B., A History Of The Global Stock Market: From Ancient Rome To Silicon Valley(2004).

[49]Jewson, Stephen, Brix, Anders, Weather Derivative Valuation: The Meteorological, Statistical, Financial And Mathematical Foundations(2005).

[50]“patents shall not remove knowledge from the public domain or restrict free access to knowledge already available to the public.” Efthimios Parasidis, A Uniform Framework for Patent Eligibility, 85 Tul. L. Rev. 323, 330 (2010).

[51]Bilski, supra note 14.

[52]U.S. Patent No. 4356716 (issued Nov.  2, 1982).

[53]Citadel Inv. Group, LLC v. Teza Technologies LLC, 398 Ill. App. 3d 724, 725, 924 N.E.2d 95, 97 (Ill. App. Ct. 2010) appeal denied, 236 Ill. 2d 551, 932 N.E.2d 1028 (2010).

[54]Jeremy Grant, ECB Warns of High Speed Trading Risks, Feb. 24, 2011, http://www.ft.com/cms/s/0/e23ddc24-4044-11e0-9140-00144feabdc0.html#axzz1EwJH4xaz.

[55]Goldman counsel asked to seal courtroom during disclosure of trading practices. United States v. Aleynikov, 737 F. Supp. 2d 173, 174 (S.D.N.Y. 2010).

[56]Geisst, Charles R,Encyclopedia Of American Business History (Vol. 2 2006).

[57]Berman, Bruce M., From ideas to assets: investing wisely in intellectual property 532 (2002).

[58]A Uniform Framework for Patent Eligibilitysupra note 48.

[59]Paul Krill, Red Hat, Google Challenge Software Patents, Feb. 3, 2011, http://www.networkworld.com/news/2011/020311-red-hat-google-challenge-software.html?hpg1=bn.

[60]TIOBE SOFTWARE, TIOBE Programming Community Index, Feb. 2011, http://www.tiobe.com/index.php/content/paperinfo/tpci/index.html.

[61]Reiffin v. Microsoft Corp., 158 F. Supp. 2d 1016, 1020 (N.D. Cal. 2001).

[62]McIntyre v. Double-A Music Corp., 179 F. Supp. 160, 161 (S.D. Cal. 1959).

[63]Davidson & Associates v. Jung, 422 F.3d 630, 639 (8th Cir. 2005)

[64]Causby, supra note 2.

© 2011, Andrew L. Schwartz

From Trips to ACTA: Establishing the Intent to Uphold Access to Medicine in the Face of Ambiguity

The National Law Review would like to congratulate Guadalupe A. Lopez  of the American University Washington College of Law  one of our Spring 2011 Student Legal Writing Contest Winners. Guadalupe writes about generic drugs and patents and the distribution of  pharmaceuticals  in developing countries:  

Introduction

The numbers speak for themselves. Each year, over 9.5 million people die due to infectious diseases for which there exists medication – most live in developing countries.i Currently, there are over 33 million people around the world living with HIV/AIDS,ii 70 percent of whom are in dire need of anti-retroviral medication but not receiving it.iii This has been attributed, in part, to the lack of affordable healthcare in developing countries, along with the high drug prices associated with monopolies provided by pharmaceutical patents.iv

Studies demonstrate that there is a significant change in the price of a drug once its patent expires, allowing its generic version to be legally manufactured and introduced into a given market.v The introduction of a generic drug often results in the reduction of prices anywhere between 22% and 88%, depending on the type of drug and the number of generic manufacturers producing it.vi In some instances, even the threat of introducing a generic drug into a market will be enough to significantly lower the price of its patented version.vii For this reason, it is in the best financial interest of pharmaceutical companies to acquire and maintain the highest levels of intellectual property rights (“IPR”) protection on their patents. In furtherance of that objective, pharmaceutical companies have actively engaged in campaigns, both domestically and around the world, aimed at preventing generic manufacturers from accessing global drug markets.viii Unfortunately, this comes at a high cost to patients who are in need of treatment and cannot afford the patented versions of these medicines. This paper will address this concern by explaining how the pursuit of high levels of IPR protection has exacerbated the inaccessibility of medication by keeping more affordable, generic drugs off the market.ix This has been largely possible due to a narrow application of the Trade Related Aspects of Intellectual Property Rights Agreement (“TRIPS Agreement”), as well as efforts to establish the highest possible levels of IPR protection, led mainly by industrialized nations.

The first section of this paper will provide an introduction to the TRIPS framework as well as a timeline of international events leading to the Doha Declaration on the TRIPS Agreement and Public Health (“Doha Declaration”). This was a declaration by all members of the TRIPS Agreement reaffirming their obligation to protect public health through the use of provisions referred to as “TRIPS flexibilities.” The second section explains that despite the Doha Declaration, certain TRIPS flexibilities have been undermined through the implementation of bilateral trade agreements with developing countries, and regulations within regional trading blocs providing vigorous protection of IPRs.x These trade agreements and regulations contain “TRIPS-Plus” provisions demanding higher levels of IPR protection than those required by the TRIPS Agreement itself.xi In essence, they have been seen as attempts to circumvent the obligations agreed to during the Doha Declaration, acknowledging that public health issues take precedent over IPRs. The third section of this paper introduces the Anti-Counterfeiting Trade Agreement (ACTA) recently negotiated by the world’s most industrialized nations, and presents the arguments raised in opposition to the accord. Many have argued that due to the special interests behind ACTA’s negotiating countries, this agreement will have a detrimental impact on developing countries, as they will be forced to adopt a framework of heightened IP standards to which they did not explicitly assent.xii The last section argues that despite the clear threats posed by ACTA, negotiating countries have expressed a clear intent to uphold access to medicine principles as asserted in the Doha Declaration. However, because many of the ACTA negotiations have been held behind closed doors, there is no record that reflects this intent outside of the public statements made by country representatives. The section proposes creating an unofficial drafting history for ACTA based on amendments made to various drafts of the text as well as public statements released by the parties. This drafting history will provide assistance when interpreting any ambiguity within ACTA that may be used to impede access to medicine or undermine any of the obligations made under the Doha Declaration.

I.  The implementation of TRIPS and the resulting need for the Doha Declaration on public health

A. The Development of the TRIPS Agreement

During the 1980s, a number of corporate actors mobilized together after realizing that they shared the common goal of increasing the protection of their intellectual property rights.xiii This alliance was comprised of trans-national corporations from a variety of sectors, among them agricultural chemical producers, software producers, entertainment providers, and brand-name pharmaceutical providers.xiv After successfully lobbying their interests at a domestic level, these actors began seeking a way to further expand the protection of their interests by pursuing higher levels of IPR protection outside the United States.xv They did so by creating a strategy to link IP with trade, two areas of law which until then, were vastly unrelated. In addition, this interest group also formed strong political ties within the U.S. and gained considerable support with the U.S. government, particularly the Office of the US Trade Representative.xvi Through transnational mobilization and aggressive lobbying of various governments, international organizations and private sectors, this coalition managed to include its newly formulated trade-based IP regime in the agenda for the GATT’s Uruguay Round of Multilateral Trade Negotiations (“Uruguay Round”) held in 1995.xvii

During the Uruguay Round, the United States persistently promoted the adoption of a new global intellectual property regime.xviii Some scholars have noted that many countries assented to the TRIPS Agreement in hopes that a multi-lateral rule based system would eliminate the US’ coercive economic policy.xix As a result, many developing countries were at a disadvantage during TRIPS Agreement negotiations due to the asymmetry in bargaining power vis-à-vis more industrialized countries. Furthermore, developing countries were at an additional disadvantage because their negotiators lacked the necessary training in the area of intellectual property essential to negotiating a new set of IP standards.xx Daniel Gervais explains that as a result, industrialized countries made very few concessions during the negotiations while developing countries were “forced to accept a package that they perhaps did not fully understand and yet, contained a set of foreign IP norms which they now had to implement.”xxi This Uruguay Round of negotiations resulted in what is known today as the Trade-Related Aspects of Intellectual Property Rights Agreement- adopted and put into force in 1994.xxii

The TRIPS Agreement was an effort to implement a global intellectual property rights regime and establish what industrialized countries believed should be the minimum levels of IPR protection required of all countries before acceding as members of the WTO.xxiii As a result, the TRIPS Agreement obligated developing nations to enforce levels of IPR protection similar to those adopted by highly industrialized nations, despite the lack of development in their own domestic IP laws.xxiv Included as part of the TRIPS Agreement were provisions requiring a 20-year term of protection for patented medication, which pharmaceutical companies argued were necessary to sustain innovation and fund research and development for future pharmaceutical products.xxv Along with these higher levels of protection, however, came huge impediments to the accessibility of essential medication in developing nations.

B.  Access to Medicine Consequences

The implementation of the TRIPS Agreement provided pharmaceutical companies with a legal and effective monopoly over their products due to the period of protection granted to their products before the introduction of any generic competitors.xxvi This meant that name-brand pharmaceutical companies were able to maintain high drug prices so long as they were still under the 20-year patent protecting their products. Within developing countries, however, this additional term of patent protection ultimately resulted in the overall reduction of affordable medicine.

This monopoly over medicines and prices proved to be devastating during the late 1990s when the HIV/AIDS epidemic was reaching its peak.xxvii It was at this point that developing countries realized the extent of the serious access to medicine implications that accompanied the adoption of the TRIPS Agreement. Developing countries, particularly South Africa, took initiatives to address the crisis by providing low-cost medication to its citizens and by issuing compulsory licenses for anti-retroviral HIV/AIDS medication.xxviii These efforts were met with fierce resistance from pharmaceutical companies and retaliation in the form of a lawsuit by the U.S. government.xxix The outcome was a wave of public outrage and widespread protests against the U.S. and pharmaceutical companies, largely led by developing countries, civil activists, and international organizations.xxx Due to mounting international pressure, the U.S. government eventually caved, withdrawing the lawsuit against South Africa as well as the trade sanctions previously implemented against it.xxxi At this point, it became clear that there was a much-needed reassessment of the objectives and interpretation of the TRIPS Agreement.

C. A Call for the Doha Declaration on the TRIPS Agreement and Public Health

In an effort to address the public health concerns resulting from the implementation of the TRIPS Agreement, the WTO introduced a “development round” in 2001 known as the Doha Declaration on the TRIPS Agreement and Public Health (“Doha Declaration”).xxxii During this round, members of the WTO unanimously recognized the need of developing countries to address serious public health issues such as HIV/AIDS, tuberculosis, malaria and other epidemics.xxxiii The Doha Declaration thus stands for the assertion that the TRIPS Agreement should not prevent any WTO member from taking measures to protect the health of its citizens. In doing so, the Declaration reaffirmed each member’s right to use the safeguards within the TRIPS Agreement without risking retaliation from other WTO members.xxxiv Specifically, the Doha Declaration reaffirmed a member’s right to parallel import medication under Article 6 of the TRIPS Agreement, and issue compulsory licenses under Article 31.xxxv

Parallel Imports

Article 6 of the TRIPS Agreement provides WTO members with the right to import patented drugs after they have been sold in other markets.xxxvi This provision essentially allows WTO members to import brand-name drugs from other countries where it is being sold at a lower retail price.xxxvii This means that once a brand-name drug is legally sold in one country, the patent holder “exhausts” his rights over the product, at which point the drug may be re-sold and exported to other countries.xxxviii This TRIPS flexibility thus provides developing countries the option to purchase medicine from foreign markets where it is being sold at a lower price than within its own domestic market. By taking advantage of this flexibility, developing countries with limited healthcare resources are able to import cheaper medicine, thereby increasing its affordability and overall access to its citizens.

Compulsory Licensing

Another safeguard reaffirmed during the Doha Declaration is a country’s right to issue compulsory licenses in cases of national emergencies, granted through Article 31 of the TRIPS Agreement.xxxix Article 31 allows a country to license the manufacturing of a generic drug while its brand-name version is still under patent without the express consent of the patent holder.xl Compulsory licenses have proven to be one of the most effective tools for providing life-saving drugs, such as anti-retroviral medication, to patients in developing countries, particularly within Africa.xli They have led to greater competition in the drug market by allowing generic drugs to compete with patented pharmaceutical products, driving down its overall cost.xlii This leads to more affordable prices for both citizens and governments providing healthcare services in the country where it is issued. The issuance of compulsory licenses have proved so effective in reducing drugs costs that even the mere threat of issuing one will often compel pharmaceutical companies to drastically reduce their prices in an effort to keep generic manufacturers off the market.xliii

The use of TRIPS flexibilities such as the two discussed above have been praised and strongly encouraged by non-profit organizations and civil society groups working to promote access to medicine in developing countries.xliv Despite the progress made, however, there is growing concern that these efforts have been undermined through pressure from bilateral and regional trade agreements, domestic legislation, and new forms of multilateral agreements such as ACTA.

II.  Circumventing the Doha Declaration Through TRIPS-Plus Agendas

The TRIPS Agreement succeeded in implementing a new global regime of heightened standards of intellectual property right protection. However, it also left room for countries to implement measures to protect the public health of its citizens through provisions known as “TRIPS flexibilities.”xlv Through TRIPS flexibilities, governments are free to address issues arising from the lack of innovation for diseases affecting their populations, coupled with high pharmaceutical prices and restrictions on availability.xlvi Despite these flexibilities though, recent free trade agreements (FTA) between developed and developing countries, particularly those with the US, have been criticized for restricting the adoption of these TRIPS flexibilities.xlvii By including “TRIPS-Plus” provisions into their FTAs, developed nations have narrowed the application of TRIPS flexibilities, thereby posing dangers to the production and availability of medicines in developing countries. More recently, regional trading blocs, such as the EU, have similarly begun to draw criticism due to the inclusion and strict enforcement of TRIPS-Plus measures within its borders.

A.  TRIPS-Plus Obligations in Free Trade Agreements

Since the Doha Declaration and the reinforcement of TRIPS flexibilities, several industrialized countries have continued to vigorously represent the commercial interest of pharmaceutical companies in trade negotiations with developing countries.xlviii By using access to their markets as a form of inducement, developed countries have been able to secure higher levels of IPR protection, known also as “TRIPS-Plus” measures, through trade agreements.xlix As reported by Oxfam International, some FTAs have contained TRIPS-Plus provisions providing for the following increased protection:

  • Expanded scope over pharmaceutical patents (covering new therapeutic uses of existing medicines and formulations);
  • Limitations on the grounds for issuing compulsory licenses to highly restrictive emergencies, government non-commercial use, and competition cases;
  • Barring parallel imports of patented medicines sold more cheaply elsewhere;
  • Extending patent monopolies for administrative delays by patent offices and drug regulatory authorities.l

In a report prepared for House Representative Henry Waxman in 2005, the Committee on Government Reform declared that “[C]ontrary to the Doha Declaration, U.S. trade negotiators have repeatedly used trade agreements to restrict the ability of developing nations to acquire medicines at affordable prices.”li Although Congress requires that the U.S. Trade Representative (“USTR”) comply with the Doha Declaration on Public Health, nearly every free trade agreement negotiated in the past decade by USTR has included TRIPS-Plus provisions significantly restricting the manufacturing of generic drugs.lii In addition, the USTR has previously announced its TRIPS-Plus agenda as well as a commitment to pursue levels of IPR protection in accordance with those of the pharmaceutical industry.liii Oxfam International asserts that this commitment to higher standards of IPR protection can be explained by the close relationship between the USTR and the pharmaceutical industry within the U.S.liv

Special 301 Watch List

One effective tool that the U.S. has used to enforce the TRIP-Plus provisions within its FTAs is the Special 301 Watch List (“Special 301”).lv The Special 301 is a report mandated by the U.S. Trade Act of 1974 through which the USTR assesses whether countries are complying with IPR standards contained in bilateral or multi-lateral agreements with the U.S.lvi If the USTR finds that a country is not in compliance with such standards, it sends a “warning” through the Special 301 Report threatening to impose trade sanctions pursuant to the U.S. Trade Act.lvii Oxfam International argues that the U.S. has used the Special 301 process to pressure countries into unilaterally implementing TRIPS-Plus provisions.lviii In addition, the Government Accountability Office has noted that while the overall number of countries listed on the Special 301 has decreased, the number of countries cited for pharmaceutical-related issues has increased.lix One example of this, sparking controversy among various members of Congress, was the placement of Thailand on the Special 301 Watch List for having issued a compulsory license for HIV/AIDS medication in 2006.lx

After this incident sparked international attention, however, Congress took it upon itself to adjust the USTR’s attitude on how it proceeded to negotiate bilateral trade agreements.lxi Since then, the USTR has made significant concessions by providing greater flexibility to provisions that at one point may have impeded access to medicine in developing countries.lxii These efforts have been reflected in amendments made to the US-Colombia and US-South Korea FTAs, making them more amenable to the adoption of TRIPS flexibilities.lxiii

B.  TRIPS-Plus Obligations in Regional Agreements:  The Case of EU Council Regulation 1383/2003

In addition to TRIPS-Plus obligations contained in FTAs, some industrialized nations have enacted far-reaching TRIPS-Plus measures as part of their domestic legislation. As noted by the International Centre for Trade and Sustainable Development (ICTSD), the European Union (EU) has been particularly active in vigorously enforcing “maximalistic” standards of IPRs within its own region.lxiv To illustrate, the EU implemented Council Regulation 1383/2003, which involves the searches, seizures, and destruction of goods suspected of infringing intellectual property rights by customs officials throughout its borders.lxv This regulation explicitly grants IP right holders the ability to prohibit the import or export of goods suspected of infringing patents, copyrights, and trademarks to and from the EU.lxvi Because this regulation is directed at all imports and exports, it has been greatly criticized by advocacy groups concerned with access to medicine due to its obstruction to the transit of pharmaceutical goods passing through EU territory.lxvii In doing so, EC 1383/2003 comes into conflict with Article V of the GATT, which establishes the principle of freedom of transit through the territory of each contracting party.lxviii The regulation also conflicts with the obligations to public health undertaken by all WTO members under the Doha Declaration.

In particular, the implementation of EC 1383/2003 has resulted in several detentions of shipments of generic medication that did not meet the heightened IP standards within the EU, but were otherwise legal in their importing and exporting countries.lxix This incident sparked widespread controversy as most of the shipments were traveling from India and destined to developing countries – such as Mexico, Brazil, Nigeria, Peru, Colombia and Ecuador – and only briefly traveling through the EU.lxx While most of the shipments were only temporarily seized, some of them were in fact destroyed for not complying with IPR standards within the EU, pursuant to EC 1383/2003.lxxi The EU defended its actions as an unfortunate result of the MEDI-FAKE initiative, which targets illegal counterfeit medicines entering the EU.lxxii Still, critics argue that these detentions, all involving generic medication, were neither incidental nor accidental, but were rather opportunistic acts of IPR holders in an effort to obstruct generic competition through false counterfeiting allegations.lxxiii Whichever may be the case, these incidents demonstrate EU officials generalized the use of the term “counterfeit,” thereby implicating other forms of IP infringements having nothing to do with counterfeiting (such as patent violations). The EU seizures have resulted in a great deal of debate over the consequences that EC 1383/2003 (and similar policy) has on freedom of transit principles and on the overall impeding effect it can have on access to medicine. This brings us to ACTA.

III.  The Anti-Counterfeiting Trade Agreement

The Anti-Counterfeiting Trade Agreement (“ACTA”) is a multilateral agreement currently being negotiated between the world’s most industrialized nations,lxxiv and aimed at combating counterfeit goods.lxxv It represents one of the most important attempts to negotiate a “North to North” agreement on issues of intellectual property rights protection after the TRIPS Agreement. For this reason, ACTA is seen by critics as an attempt to create a new template of TRIPS-plus protection outside any interference from developing countries, multilateral organizations, or civil society in general. Parties to these negotiations assert, however, that the objectives behind the implementation of ACTA are to “establish an international framework for participating governments to more effectively combat the proliferation of counterfeiting and piracy” and to “define effective procedures for enforcing existing intellectual property rights.”lxxvi

To many of its critics though, ACTA reflects a fairly clear intent to expand TRIPS standards and even remove some of its flexibilities.lxxvii In particular, ACTA has been criticized by civil society groups and developing countries for threatening the freedom of transit of generic medicines. India and China are some of ACTA’s most vocal opponents; they argue that such measures do not take into consideration the interests of developing countries or their commitments to the Doha Declaration on Public Health.lxxviii These countries also warn that ACTA would create trade restrictions for WTO members who are not negotiating parties of ACTA, yet who are still subjected to obligations beyond those required by the TRIPS Agreement.lxxix

The criticism over ACTA has not stopped there. Other institutions that have taken issue with ACTA have included the World Trade Organization and the World Intellectual Property Organization. These organizations argue that ACTA goes far beyond what was needed to combat counterfeiting and piracy, and in the process, is creating a new regime of IPR protection that will undermine multilateral institutions such as themselves by weakening their authority.lxxx

A.  Access to Medicine Threats Posed by ACTA

The most serious concern raised by access to medicine advocates is that like EC 1382/2003, ACTA will jeopardize shipments of affordable medicines in transit between developing countries, having a chilling effect on the trade of generic pharmaceuticals and on the TRIPS Agreement flexibilities.lxxxi This problem has been mostly raised with regard to proposed border measures granting customs officials the ability to restrict shipments being imported or exported from ACTA member countries. This measure has been highly criticized for essentially requiring customs officials to make highly specialized and technical determinations as to what amounts to patent infringements.lxxxii These complex adjudications, critics say, should follow after the presentation of highly specific facts related to patents, which may only be resolved by an appropriate panel or tribunal post hoc, not while the goods are in transit.lxxxiii

Under existing TRIPS provisions, border measures are to be taken only against suspected counterfeit, trademark, and copyright violations.lxxxiv Customs officials are allowed to take ex officio action against alleged infringers only after they have acquired prima facie evidence showing that an IP right has been infringed.lxxxv In addition, TRIPS requires those who requested the ex officio action to pay for any injury caused to suspected infringers as a result of a wrongful detention of goods.lxxxvi ACTA, on the other hand, permits such actions to be taken on the mere suspicion that the goods are infringing not only copyright and trademark, but also patent rights. Furthermore, ACTA indemnifies authorities from any injury caused by the wrongful detention of goods, which may last for up to a year under this new agreement.lxxxvii This creates incentives for right holders to abuse ACTA procedures and to initiate border investigations and seizures without having to prove, within any reasonable period of time, that the goods are in fact infringing. This leaves serious implications relating to the transit of shipments carrying generic medication.

In addition, provisions addressing penalties for ACTA violations vis-à-vis the penalties enforced under the TRIPS Agreement have similarly raised serious concerns.lxxxviii Under the TRIPS Agreement, any willful, commercial-scale counterfeiting is a criminal act sanctioned by national law enforcement.lxxxix In contrast, civil IP infringements under TRIPS, including violations of patent rights, consist of commercial disputes between legitimate entities and are compensable only through legal remedies.xc The reason for this distinction is that unlike counterfeiting, civil infringements of IPRs are not seen as attempts to defraud the public and are therefore not subject to the same criminal sanctions.xci While TRIPS has made it clear what types of infringements will result in criminal and civil liability, ACTA does not distinguish between the two.xcii This leaves the inference that because ACTA explicitly targets counterfeits, all infringements will be punishable as criminal violations.

Furthermore, various ACTA drafts have included provisions extending injunctions against third parties who have provided “intermediary services” that have facilitated the infringement involved.xciii While ACTA fails to define what an “intermediary party” is, those who would likely be affected under this provision include generic drug manufacturers, international shippers, and other key players involved in the international trade of medicines.xciv In turn, such injunctions could potentially “inhibit the supply and distribution systems and thereby deter generic entry, robust generic competition, and legitimate international trade of generic medicines of assured quality.”xcv Due to its failure to define “intermediary,” this provision may similarly jeopardize non-government organizations such as Medicins Sans Frontieres and UNITAID, who assist in funding the purchase of generic drugs destined for developing countries.xcvi

The unfortunate result of these ACTA provisions is that they have a potentially chilling effect on the production, trade, and ultimate distribution of generic drugs. Due to the risk of incurring not only civil, but criminal liability, many generic drug manufacturers and third-party carriers will potentially be deterred from producing and transporting medication because of the blurred distinctions between counterfeit and simple patent infringements.

B.  New IP Law-Making in the Process?

A number of scholars have argued that ACTA is an effort to seek an alternative forum that is more responsive to higher levels of IP protection.xcvii As part of this forum-shifting argument, Susan Sell notes that protectionists have previously shifted their agenda from the World Intellectual Property Organization (“WIPO”) to the World Trade Organization (through the TRIPS Agreement), to bilateral and regional trade agreements (such as those discussed above), and now to ACTA.xcviii Each time the chosen forum becomes more receptive to exceptions, likely due to pressure from civil society groups, the forum once again changes. Thus, ACTA is seen as the creation of an entirely new international institution for IP enforcement, establishing its own set of rules, standards, and methods of enforcement, notwithstanding those outlined in prior multilateral negotiations such as the TRIPS Agreement.

However, other scholars argue that ACTA is more than a mere effort aimed at shifting the forum of protection. Instead, they assert that such attempts reflect a broader notion of international IP law-making in the process.xcix This argument is based on the impact which bilateral trade agreements tend to have on a country’s position on IP standards during subsequent multilateral negotiations. These scholars argue that this is all part of a strategy to create an endless upward spiral of international IP obligations.c This movement, often referred to as the “global IP ratchet,” is only the first stage of a conscious effort on the part of IP interest groups to use bilateral agreements as vehicles to incorporate heightened IP standards into subsequent multilateral treaties, such as ACTA.ci Targeting countries on a one-on-one basis through bilateral agreements ensures that they are on-board with future stated agendas. Scholars argue that in the end, if enough of these bilateral agreements are negotiated, these higher IP standards will become the minimum standards from which future trade negotiations will proceed.cii As cited by Kimberlee Weatherall:

“Once a substantial portion of trading partners have agreed to observe the same standards as those enshrined in present U.S./EU legislation, there is no way back to a meaningful lessening of what appear as widely accepted rules, creating a spiral endlessly moving upwards.” ciii

That is to say, that all of this is not merely about shifting the forum away from the WTO, but rather, a part of an overall scheme to slowly, but certainly, increase global levels of protection for IP right holders. Weatherall suggests that bilateral agreements have ultimately served as the “stepping stones” for ACTA by setting minimum standards of IP protection among the parties involved, while creating leverage for certain countries at the negotiating table.civ As reflected by the leaked ACTA drafts, these higher levels of IP protection were, without a doubt, introduced during the various rounds of negotiation.cv

Along these lines, ACTA is seen as part of a larger “enforcement agenda” being pushed by special interest groups within highly industrialized nations. This enforcement agenda has been described as, “[A] continuous, wide-ranging effort by special-interest groups and lobbyists to secure favorable legislation and institutionalize practices that support their current business models, all under the claim of enforcing intellectual property rights.”cvi Ultimately, what emerges is “[A] web of numerous forums, regional, and bilateral agreements and unilateral institutions, all being captured to pursue a global TRIPS-plus agenda.”cvii The unfortunate consequence of this agenda is that because it caters to special interest groups, it fails to consider the disproportionate impact that these higher standards carry for developing countries lacking the resources and infrastructure to implement them. Nonetheless, many fear that such standards will soon become the norm as more and more countries continue to adopt them through efforts such as ACTA.cviii

IV.  ACTA’s Unofficial Drafting History: Establishing An Intent to Promote Access to Medicine

Despite the concerns stated above, recent leaked drafts of the text have indicated that ACTA has amended some of the measures that have been stirring controversy with access to medicine advocates.cix The two most significant of these are provisions on border measures and intermediary liability.cx According to the new draft, ACTA no longer requires countries to provide preemptive border measures for patents, meaning that if adopted, generic medicines will no longer be subject to border detentions for alleged patent violations.cxi In addition to this, ACTA parties have dropped the provision requiring intermediary liability for carriers of shipments of generic medication. The new draft reflects that the parties have made significant concessions in response to public health concerns, resulting in what some have referred to as “ACTA-Lite,” a watered down version of what ACTA was intended to be.cxii

Aside from demonstrating the tremendous impact that civil society groups can bring to the negotiating table, this move indicates that there is at least some commitment to preserve the safeguards and flexibilities established by the TRIPS Agreement. To demonstrate this commitment, many governments have released public statements ensuring that the passage of ACTA will not affect a country’s right to provide for the public health of its citizens.cxiii In a joint statement issued by the participating governments with respect to the potential obstruction to access to medication, the parties stated that, “ACTA will not hinder the cross-border transit of legitimate generic medicines,” while reaffirming that “patents will not be covered in the section on Border Measures.”cxiv

USTR officials released similar statements after certain members of Congress voiced concern over the ways in which ACTA would affect the availability of generic medicine. In a letter from Senator Ron Wyden to the USTR regarding ACTA’s impact, one of his main questions involved the ways in which ACTA would preserve the public health flexibilities under the TRIPS Agreement and the Doha Declaration.cxv In its response, the USTR stated that “ACTA is not intended to interfere with a signatory’s ability to respect its citizens’ fundamental rights and civil liberties, and will be consistent with the WTO TRIPS Agreement and will respect the Declaration on TRIPS and Public Health. (emphasis added).”cxvi From these comments, it would therefore appear that the overall purpose of ACTA is not to limit the transit, sale, or distribution of generic medicine. Nonetheless, while this intent has been reflected through a number of press releases, likely aimed at bolstering public support, there is no record of negotiation binding the parties to this intent.

The importance of legislative history within the context of multilateral negotiations is that it establishes the parties’ intent at the time of negotiation, giving the text meaning in light of potential ambiguity. However, in the case of ACTA, there is no such record of negotiations as these have been highly secretive and mostly held behind closed doors.cxvii As a result, the only evidence of the parties’ actual negotiating intent comes from inferences that have been drawn from the modifications made to several leaked versions of the agreement.cxviii This paper suggests that based on these modifications, there be an unofficial “drafting history” established, reflecting a principle of intent aimed at upholding access to medicine. This legislative history would be a compilation of the parties’ stated objectives to the press, civil society, members of Congress and Parliament, and other government officials regarding the purpose of ACTA. These statements should be analyzed with respect to the various proposals for modification made by each respective party, as reflected by the leaked versions of the agreement. Furthermore, such a drafting history will require close scrutiny of prior versions of the text in comparison with its final version (to be released in the following weeks) in order to determine whether the parties did in fact bind themselves to their publicly stated objectives. Such an analysis will also allow scholars to draw inferences from the various amendments proposed and those that were actually adopted, such as the changes to border measures discussed above. Functionally, this drafting history will serve to provide guidance to officials whenever there may be ambiguity in the text, by establishing a principle that such ambiguity shall be read in light of the parties’ intent to provide for the unrestricted transit of generic medication.

V. CONCLUSION

Due to legitimate concerns that ACTA may be creating a new institutional framework of IP standards, it is vital that parties clearly define the limits of this new agreement. As we have seen with the cases of EU detentions, there is a genuine fear that heightened IP standards may have serious restrictions on the transit and ultimate distribution of generic medication within developing countries. For this reason, there is a need to clearly and effectively communicate that parties do not intend for this to be the case with the implementation of ACTA. Through publicly released statements, leaked drafts, and new amendments made to the agreement, it appears that the parties to ACTA have made active efforts to communicate that they do not intend to impede the flow of generic medication. However, there is still a need to bind parties to this principle through a more formal manifestation of this commitment.

i Global Health Council, Impact of Infectious Diseases. Available from: http://www.globalhealth.org/infectious_diseases (citing World Health Organization, WHO Global Burden of Disease: 2004 Update).

ii World Health Organization, Global Summary of Aids Epidemic: 2009. Available from: http://www.who.int/hiv/data/2009_global_summary.png. 

iii Medicines Sans Frontiers, Running In Place: Too Many Patients Still in Urgent Need of HIV/AIDS Treatment, Briefing Document on HIV/AIDS. Available from: http://www.msfaccess.org/main/hiv-aids/introduction-to-hivaids/msf-and-hivaids.

iv See Generally, Bryan C. Mercurio, TRIPS, Patents, and Access to Life-Saving Drugs in the Developing World, Marquette Intellectual Property Law Review 211 (Summer 2004).

v Id.

vi Id.

vii Id.

viii Id.

ix Oxfam Briefing Paper, Patents versus Patients: Five Years after the Doha Declaration, Oxfam International (November 2006).

x Id.

xi Id.

xii See Generally, Andrew Rens, Collateral Damage: The Impact of ACTA and the Enforcement Agenda on the World’s Poorest People. PIJIP Research Paper No. 2010-08, Program on Information Justice and Intellectual Property (2010).

xiii Susan Sell, Trips and the Access to Medicine Campaign, Wisconsin International Law Journal 481, 484 (2001-2002).

xiv Id.

xv Id.

xvi Id. at 485.

xvii Id. at 487, 488.

xviii Id. at 489.

xix Id. (noting that the US often used access to its large domestic market as a means to force other countries to adopt and enforce stricter intellectual property policies).

xx Daniel Gervais, Intellectual Property, Trade & Development: The State of Play, Fordham Law Review 505, 507 (2005).

xxi Id. at 509.

xxii Trade Related Aspects of Intellectual Property Rights Agreement (1994), available at http://www.wto.org/english/tratop_e/trips_e/t_agm0_e.htm.

xxiii Bryan C. Mercurio, supra note 4, at 218.

xxiv Oxfam Briefing Paper, supra at note 9, at 5.

xxv Id.

xxvi Id.

xxvii Id.

xxviii Id. A compulsory license is a type of flexibility provided by the TRIPS Agreement, stating that countries may grant drug manufacturers the authorization to produce the generic version of a patented drug without the consent of the right holder in order to meet a public health emergency.

xxix Id.

xxx Bryan C. Mercurio, supra note 4, at 224.

xxxi Id.

xxxii Doha Declaration on the TRIPS Agreement and Public Health (2001), available at http://www.wto.org/english/thewto_e/minist_e/min01_e/mindecl_trips_e.htm.

xxxiii Id.

xxxiv Rahul Rajkumar, The Central American Free Trade Agreement: An End Run Around the Doha Declaration on TRIPS and Public Health, Albany Law Journal of Science and Technology 433, 441 (2005) (citing Doha Declaration).

xxxv Id.

xxxvi Agreement on the Trade Related Aspects of Intellectual Property Rights (1995).

xxxvii Rahul Rajkumar, supra note 35, at 444.

xxxviii Id.

xxxix Agreement on the Trade Related Aspects of Intellectual Property Rights (1995).

xl Oxfam Briefing Paper, supra note 9, at 9.

xli Id.

xlii Id. at 10.

xliii Id. (explaining the case in Brazil in 2005 after it threatened to issue a compulsory license, causing a 46% discount in the price of Kaletra, an anti-retroviral AIDS drug).

xliv See e.g., Medicine Sans Frontieres, available at http://www.msf.org.

xlv See Generally Bryan C. Mercurio, supra note 4.

xlvi Sisule F. Musung et al., The Use of Flexibilities in TRIPS by Developing Countries : Can They Promote Access to Medicine?, Study 4C, Commission on Intellectual Property Rights, Innovation and Public Health (August 2005).

xlvii Id.

xlviii Oxfam Briefing Paper, supra note 9, at 13.

xlix Id. (citing as an example, the US-Jordan free trade agreement).

l Id. at 15.

li Report of Committee on Government Reform, Trade Agreements and Access toMedicine Under the Bush Administration (June 2005).

lii Jorn Sonderholm, Intellectual Property Rights and the TRIPS Agreement: An Overview of Ethical Problems and Some Proposed Solutions, Policy Research Working Paper No. 5228, World Bank Development Research Group (March 2010).

liii Oxfam Briefing Paper, supra note 9, at 13. (USTR declaring an internal reorganization plan to “better support vital US innovation, including those of the pharmaceutical industry”).

liv Id. (noting that there are currently 20 pharmaceutical-industry representatives on USTR advisory committees).

lv 19 U.S.C. § 2411 (1974).

lvi Id.

lvii Oxfam Briefing Paper, supra note 9, 1t 14. (noting that this applies despite the fact that countries may be in compliance with minimum IPR standards required by the TRIPS Agreement).

lviii Id. at 17.

lix Government Accountability Office Report, supra note 60.

lx Id.

lxi Id.

lxii Id. at 41. (noting that several pending free trade agreements have been amended and made more responsive to provisions outlining TRIPS flexibilities).

lxiii Id.

lxiv Xavier Seuba, Free Trade of Pharmaceutical Products: The Limits of Intellectual Property Enforcement at the Border, International Centre for Trade and Sustainable Development, Issue Paper No. 27, 9 (2010).

lxv Council of Regulation (EC) No. 1383/2003 of 22 July 2003.

lxvi Id.

lxvii Xavier Seuba, supra note 65.

lxviii General Agreement on Tariffs and Trade (1947).

lxix Xavier Seuba, supra note 65, at 2.

lxx Id. at 5.

lxxi Id.

lxxii Id.

lxxiii Id.

lxxiv Negotiating countries include the US, the EU, Japan, Mexico, Switzerland, Australia, NZ, South Korea, Morocco, Singapore, and Canada

lxxv United States Trade Representative, ACTA Fact Sheet (March 2010), available at http://www.ustr.gov/acta-fact-sheet-march-2010.

lxxvi Id.

lxxvii ICTSD, Animated TRIPS Council Meeting Tackles Public Health, ACTA, Biodiversity, Intellectual Property Programme, Vol. 14:22 (June 16, 2010).

lxxviii Id.

lxxix ICTSD, ACTA Faces Criticism at WTO and in the United States, Bridges Weekly Trade News Digest, at 8, Vol. 14:38 (Nov. 3, 2010).

lxxx Id.

lxxxi Peter Mayberduk, ACTA and Public Health, PIJIP Research Paper No. 2010-09, Program on Information Justice and Intellectual Property (2010).

lxxxii Id. at 2.

lxxxiii Id.

lxxxiv Id. (citing Trade Related Aspects of Intellectual Property Rights Agreement (1994)).

lxxxv Id. (citing TRIPS Article 48).

lxxxvi Id.

lxxxvii Peter Mayberduk, supra note 82, at 3.

lxxxviii Id. at 5.

lxxxix Id.

xc Id. (These remedies include monetary damages, injunctions, and declaratory relief).

xci Id.

xcii Id.

xciii Anti-Counterfeiting Trade Agreement (August 2010).

xciv Brook K. Baker, ACTA: Risks of Intermediary Liability for Access to Medicine, Program on Information Justice and Intellectual Property, PIJIP Research Paper No. 2010-01.

xcv Id.

xcvi Id.

xcvii See Generally, Peter K. Yu, Six Secret (and Now Open) Fears of ACTA (June 14, 2010). SMU Law Review, Vol. 64, 2011.

xcviii Susan K. Sell, The Global IP Upward Ratched, Anti-Counterfeiting and Piracy Enforcement Efforts: The State of Play, IQsensato Occasional Papers No. 1 (June 2008) (stating that, “As soon as one venue becomes less responsive to a high protectionist agenda, IP protectionists shift to another In search of a more hospitable venue.”). 

xcix Kimberlee Weatherall, ACTA as a New Knd of International IP Law-Making, PIJIP Paper No. 2010-12, Program on Information Justice and Intellectual Property (2010).

c Id.

ci Id. at 6. (noting that several of the countries participating in ACTA negotiations are parties to a U.S. free trade agreement (either active or pending Congressional approval) and that the negotiating position of these countries has been influenced by their respective FTA with the US).

cii Id.

ciii Id. at 9.

civ Id. at 6.

cv Anti-Counterfeiting Trade Agreement (August 2010).

cvi Peter Mayberduk, supra note 82 (arguing that the key players behind this agenda are multinational tobacco, pharmaceutical, film and record companies, noting that these are the primary lobbying bodies behind the advancement of ACTA).

cvii Andrew Rens, supra note 12.

cviii Id.

cix ICTSD, Watered-down ACTA Approaching Conclusion, Bridges Weekly Trade News Digest, Vol. 14:30 (September 8, 2010)

cx Anti-Counterfeiting Trade Agreement (October 2010).

cxi Id.

cxii ICTSD, Watered-down ACTA Approaching Conclusion, supra note 110.

cxiii ICTSD, Officials Seek to Ease Fears of Privacy Violations under ACTA, Bridges Weekly Trade News Digest, Vol. 14: 25 (July 7th 2010).

cxiv Id.

cxv Letter from Ron Wyden to USTR, January 6, 2010, available at http://www.ustr.gov/webfm_send/1701.

cxvi Response from USTR to letter from Senator Ron Wyden, January 28, 2010, available at http://www.ustr.gov/webfm_send/1700.

cxvii See generally, Over 75 Law Profs Call for Halt of ACTA, available at http://www.wcl.american.edu/pijip/go/blog-post/academic-sign-on-letter-to-obama-on-acta (accessed November 22, 2010).

cxviii See generally, ACTA- Text and Leaked Documents, PIJIP Database, available at https://sites.google.com/site/iipenforcement/acta (accessed November 22, 2010).

Guadalupe Lopez Copyright © 2011

Antitrust, Intellectual Property Rights, and the Online Music Industry: An Antitrust Analysis of Apple’s Combination of Services and Products

The National Law Review would like to congratulate Rui Li of the The University of Iowa College of Law one of our Spring 2011 Student Legal Writing Contest Winners.  Rui’s topic is An Antitrust Analysis of Apple’s Combination of Services and Products:       

I.  INTRODUCTION

For many music consumers, the ideal medium for music is digital. It offers many advantages over CDs, including easier distribution, decreased physical size, greater choice in the medium of sound reproduction, and the ability to include digital data such as artistic information and graphic artwork.i Online music stores offer more variety than consumers would get in a brick-and-mortar store, including reviews, recommendations, and other interactive features which increase the choices for consumers.ii The advantages of digital music, coupled with the efficiency of online purchasing, have helped online music stores such as Apple’s iTunes Store become the most prevalent form of commercial music distribution.iii However, online music piracy has been harming the music industry via lost CD sales even before commercial distribution of music over the Internet became prevalent. As online music firms attempt to tackle online music piracy, both antitrust enforcement agencies and private plaintiffs have raised concerns. Some of the solutions implemented by online music firms appear to promote competition by protecting intellectual property rights. However, others require closer scrutiny because some actions taken to protect these intellectual property rights have been, at times, abusive.

The tactics used by Apple to combat digital piracy have drawn legal scrutiny from a number of sources in recent years. In June 2006, the antitrust enforcement agencies of Norway, Sweden and Denmark filed a complaint against Apple regarding the restrictions it placed on iTunes audio downloads, an action that was later joined by Germany and France.iv On December 31, 2007, a group of plaintiffs brought an antitrust lawsuit against Apple in the United States District Court for the Northern District Court of California, charging Apple with maintaining an illegal monopoly on the digital music market.v On December 28, 2008, the court granted plaintiffs’ motion for class certification against Apple.vi On May 25, 2010, the New York Times reported that the United States Department of Justice was examining Apple’s tactics in the market for digital music.vii In light of this scrutiny, in 2009 Apple stopped selling music downloads with its proprietary digital rights management (“DRM”) restrictions, a technology that prevented audio downloads purchased through the iTunes Store from playing on portable media players other than Apple’s iPod.viii Given the dominant position of iTunes in online music distribution, the effect of Apple’s decision to remove DRM restrictions on the online music industry and the fight against online music piracy remains to be seen.ix

Apple’s digital music business has important ramifications for antitrust law that this Note explores. Part II of this Note examines Apple’s digital music business practices with particular emphasis on the manner in which Apple combines products and services. Part III engages in an antitrust analysis of four possible causes of action against Apple’s business conduct with an eye toward the market structure of the digital music industry. The Note concludes that Apple’s combination of products and services is procompetitive, and, in addition, offers a promising solution to digital music piracy.

II.  IPOD, ITUNES AND ITUNES STORE

In 2001, Apple introduced the iTunes music software application to help music consumers organize, browse, and play digital media. In 2003, Apple launched the iTunes Store which, in April 2008, became the number one music vendor in the United States.x On February 24, 2010, the Store had its 10 billionth song download and a music catalog of over 12 million songs.xi iTunes Store now accounts for seventy percent of the worldwide digital music download retail market.xii

Until January 2009, Apple restricted iTunes Store and iTunes Software to work only with its own portable media player, the iPod, a product that currently claims 70 percent of the portable media player market.xiii Apple restricted the iPod so it could only play files embedded with Apple’s own DRM downloads called “FairPlay”, and no one else’s. Likewise, files downloaded from the iTunes Store could only be played on an iPod. Apple maintained this closed system through regular updates and the threat of legal action. Most notably, in 2005, Apple forced RealNetworks to abandon its “Harmony” technology through software updates and the threat of patent infringement lawsuit.xiv Harmony allowed music downloads purchased through RealNetworks direct playback on iPod.

III.  ANTITRUST ANALYSIS WITH AN EYE TOWARD THE MARKET STRUCTURE OF THE MUSIC INDUSTRY

As a precursor to an analysis of Apple’s conduct from an antitrust perspective, an inquiry must be made into the market structure of the music industry.

A.  The Equilibrium Between Major Labels, Online Music Vendors, and Customers

The music market is highly concentrated, dominated by a small number of large firms (hereinafter “Major Labels”: Sony Music Entertainment, Universal Music Group, Warner Music Group, and EMI Music Group). Major Labels’ collective catalogs comprise about 85 percent of the distribution rights in the music industry.xv Each of these firms has exclusive control of a large and fungible catalog of intellectual property. In the past, Major Labels have taken advantage of their dominant position to extend market power into downstream distribution channels.xvi These practices have at times drawn the attention of antitrust enforcement agencies. In 2000, the Major Labels settled the Federal Trade Commission’s charge of restraining competition in the music market.xvii

The significant economies of scale achieved through the grouping of thousands of authors’ and composers’ copyrighted music products operate as a barrier for other firms to enter the music licensing market. This concentrated market structure lays the groundwork for a tacitly collusive environment in which Major Labels can achieve collusive results in the online music market through the non-collusive exercise of their power in the licensing market. Under this tacitly collusive structure, they may be able to reach a consensus about how to develop the online music market without explicitly agreeing with each other. If one of the Major Labels sets a high and relatively profitable licensing price, the rest of the Major Labels may follow the practice of the price-setting firm even though they do not formally communicate with each other.

The appearance of online music vendors poses a threat to this shared dominant market position. Scholars estimate that Major Labels would lose thirty to forty percent of their profit margins if online music vendors could freely compete with Major Labels.xviii To protect their advantage, it is in the Major Labels’ best interest to either deny market entry to online music vendors or bring them into the fold in an advantageous manner. Fortunately for the Major Labels, this is not much of a challenge because the barriers to entry are high and the products are fungible.xix In addition, copyright laws have given Major Labels influence over online music vendors.xx Major Labels can potentially use licensing practices to create prohibitive barriers to entry or to contractually bind online music vendors to the pricing structure of the CD market.xxi Because of this market structure, online music vendors stand little chance of success competing with the traditional distribution networks established by the Major Labels over the decades.xxii

A major, common priority of Major Labels is to gain control of the digital music distribution market. To achieve this goal, in descending order of preference, Major Labels have the potential strategies of: 1) attempting to terminate online music piracy through vigorous infringement suits or other form of antipiracy enforcement measures, 2) extracting shared monopoly profits from online sales at a rate higher than or equal to that from CD sales, or 3) expanding volume of online sales at lower profit levels by licensing online music at reasonable rates.xxiii An examination of the economic theories explaining the behaviors of oligopolies lends support to the prediction of strategies laid out above.xxiv The part that follows will compare the actual practices of Major labels to the behaviors predicted above.

Strategy No.1: Terminating online music piracy through vigorous infringement suits or other form of antipiracy enforcement measures. In 2003, the Recording Industry Association of America (RIAA), the representative of Major Labels, began attacking online music piracy by filing mass infringement suits. However, this approach, besides being expensive and time consuming, backfired.xxv It not only failed to win public sympathy for the music industry but also demonized the plaintiffs, the Recording Industry Association of America and the copyright holders they represented.xxvi In light of this, the RIAA announced in December 2008 that it was ending its mass infringement suits and attempting to cooperate with Internet Service Providers whereby Internet Service Providers will suspend or terminate Internet users’ service after repeated RIAA notices of alleged piracy.xxvii

Strategy No.2: Extracting shared monopoly profits from online sales at a rate higher than or equal to that from CD sales. In 2001, Major Labels pooled their catalogs into two non-overlapping online music vendors, MusicNet and Pressplay.xxviii They refused to license music for less than two dollars per song, and, in some cases, as much as three and a half dollars.xxix In addition, the music downloads are not transferable to CDs. In 2002, the Major Labels licensed Listen.com for a price of 99 cents per song, roughly the equivalent to the price of a CD.xxx Still, most of that music could not be burned to a CD.xxxi In March 2001, U.S. Department of Justice opened an investigation into alleged collusion in the online market.xxxii However, the DOJ later dropped the investigation in 2003 because “major labels licensed their music to a broader array of third-party music services that compete on price and features” and that unrelated firm Roxio’s acquisition of Pressplay diminished the possibility of collusion.xxxiii

Strategy No.3: Expanding volume of online sales at lower profit levels by licensing online music at reasonable rates. By the end of 2002, the Major Labels had licensed their catalogs to all major online music vendors which charged a nine to ten dollars per month subscription fee, plus 99 cents per burnable download.xxxiv

During this period Apple launched iTunes Store with a market model combining iTunes Store, iTunes Software, and iPod. The combination proved to be a huge success. Apple was thus able to dispense with subscription fees.xxxv In 2008, Apple became the number one music vendor.xxxvi The entrance of a radically efficient product model, the iTunes-iPod combination, coupled with the shared interest of Apple and Major Labels in eliminating online music piracy, promoted competition, lowered costs, improved services, and increased overall economic efficiency in the music industry.

The evolution of the online music market showed that even though Major Labels’ preference of options may partially be explained as legitimate attempts to eliminate online music piracy, they still had every incentive to thwart the development of the online music market despite the fact that customers preferred music downloads. Major Labels thought the rising of the online music market and the new business models for delivering music would deprive them of their control over the market. But when they realized they were not able to stop the development of online music distribution, they attempted to control the pace and the manner of development of online music.xxxvii

Apple’s business model combines pricing, ease of use, and technical prohibition in a way that significantly decreases the incentives for customers to choose pirated music. However, it remains to be seen whether the appearance of powerful market participant such as Apple will eventually create a more competitive environment, bring down the costs of online music, and terminate online music piracy. Therefore, the courts and the antitrust enforcement agencies should understand the equilibrium between the music industry’s interest in controlling mechanisms of distribution, the threat of online music piracy, online music vendors’ interest in lowering licensing costs, and the consumers’ interest in innovative and effective access to music. The courts could consider refraining from imposing direct legal action against online music vendors such as Apple. History has shown that time and market forces often provide equilibrium in balancing interests, whether the new technology is a player piano, a copier, a tape recorder, a video recorder, a personal computer, or a MP3 player.

B.  The Alleged “Tying Arrangement” of iPod, iTunes Music Store, And iTunes Software

“Tying” occurs when a seller insists that the buyer take a second, or “tied”, product as a condition of obtaining the seller’s initial “tying” product.xxxviii Tying arrangements can be condemned either as contracts in restraint of trade under section 1 of the Sherman Act, or else under the more explicit provisions of section 3 of the Clayton Act.xxxix

Prior to January 2009, Apple had created something that resembles a tying arrangement by using its FairPlay technology to require owners of iPods to purchase digital music from the iTunes Store (users could still use music ripped from CDs or downloaded from unauthorized websites).

Tying is illegal per se when the defendant ties two separate products and has market power in the tying product.xl The “leverage” theory articulated by Justice Brandeis in Caprice was the only theory articulated by the Supreme Court supporting the per se approach. The theory understood tying arrangements as inherently anticompetitive because it permitted a monopoly firm to “leverage” its market power to a product market in which it lacked market power, increasing its monopoly profits.xli The leverage theory has largely been discredited by economists who argue that when the second product is imposed as a cost of using the first monopoly product, the monopolists are not necessarily better off because the elevated price of the tied product reduces the consumers’ willingness to pay for the tying product. It is now widely accepted most tying arrangements are procompetitive and efficient.xlii While the “leverage” theory of tying has been largely debunked, the market foreclosure theory continues to have relevance. It is now understood that tying arrangements are anticompetitive only in the rare cases that tying denies rivals access to markets.xliii However, economists have argued that this “access denial” or “entry barrier” theory is only marginally more plausible than the “leverage” theory.xliv

Courts have followed the lead of economists and become skeptical of antitrust claims based on tying theories. In the Microsoft case, the D.C. Circuit Court held that integration in the software industry involving computer operating systems promised significant efficiencies and that even relatively low-tech ties typically produce significant efficiencies by enabling firms to control the quality of collateral products.xlv The D.C. Circuit Court further concluded that the rule of reason should be applied to the Windows and Internet Explorer tie because a per se rule could act as an irrational restraint on efficiency and innovation, which often consists in combining features or functions that previously were separate.xlvi The court recognized the difficulty in distinguishing anticompetitive forced package sales from those that are efficient and effective. This is exactly the reason why a “rule of reason” analysis should be applied to all tying arrangements, the court explained.

In a “rule of reason” analysis, an antitrust enforcer proceeds by asking first whether the tying arrangement unreasonably excludes rivals.xlvii If the products are widely available separately, then there is no market foreclosure because widespread availability of alternatives indicates that no rival is foreclosed by the tie.xlviii Applying this analysis to the subject of this Note, Apple’s online music business, it is clear that alternatives to iTunes Music Store and iPod are widely available. Alternatives to iTunes Music Store include: RealNetworks, Wal-Mart, Amazon, Napster and Yahoo. In the portable media player market, alternatives to the iPod include: Microsoft, Sony, Creative, and SanDisk. Therefore, no rival is foreclosed by the tying from a properly defined market.

Courts should not substitute their own product designs for those generated by the market. Nevertheless, courts are often asked to determine whether a tying bundle is unreasonably anticompetitive. iTunes Music Store, the dominant online music vendor, needs to combat online music piracy and perform additional functions besides distributing music in order to develop the online music market. iTunes Music Store now offers customer support, a platform for customer reviews, Podcasts subscriptions, music and audio book previews, and iTunes U online service at no extra cost. A price-cutting online music vendor or online music piracy service might take advantage of the fact that Apple cannot charge separately for these services. The other vendors might charge a lower markup and refuse to provide essential services such as combating online music piracy and developing the online music market, knowing that the consumer will keep enjoying the free services provided by iTunes Store. Undoubtedly, iTunes Store cannot survive by only supplying uncompensated services that benefit other dealers. One strategy Apple can employ to minimize free riding is to tie iTunes and iPod to ensure a healthy supply of consumers who have subscribed to either iPod or iTunes.

While all these practices are readily defended as procompetitive, the defense is unnecessary in the first place when there is no injury to competition. The purchasers of iPod and iTunes bundle simply want a smaller product than the one that Apple is offering. But that desire does not harm competition. Apple’s bundle is simply the equivalent of the land developer who refuses to subdivide before selling. It is not the purpose of antitrust law to regulate the size of the products that Apple chooses to sell.

C.  Refusal To License FairPlay Patent

Apple used its FairPlay digital rights management system to require owners of iPods to purchase digital music from iTunes Store. Apple refused to license its patented FairPlay technology to other portable media player manufacturers such as Microsoft and declined to support alternative digital rights management systems such as RealNetworks’ Harmony technology that circumvented Apple’s FairPlay system. Generally, the owner of an intellectual property right does not have a duty to deal with a competitor, even if the owner refusing to deal is a monopolist, as long as there are valid business reasons for refusing to deal. In CUS, L.L.C. v. Xerox Corp., the Federal Circuit held that a “patent holder may enforce the statutory right to exclude others free from liability under the antitrust laws” in the “absence of an indication of illegal tying, fraud in the Patent and Trademark Office, or sham litigation.”xlix In addition, the patent statute contains no compulsory licensing provisions and even stipulates that there is no patent “misuse” when a patentee refuses to license its patent to competitors.l The provisions of 35 U.S.C. § 271 provide that “No patent owner shall be denied relief or deemed guilty of misuse or illegal extension of the patent right by reason of his having refused to license or use any rights to the patent.”li Although in Image Technical Services, Inc. v. Eastman Kodak Co.lii, the Ninth Circuit Court of Appeals affirmed a finding of antitrust violation where Kodak refused to sell patented products to competitors, it is now widely accepted that the Ninth Circuit Court of Appeals made a significant error. In that case, Kodak refused to license its patented parts to firms that wanted to compete with Kodak in the repair of Kodak photocopiers.liii The court determined that Kodak was unlawfully creating a second monopoly in service by refusing to sell the patented parts.liv The court based its decision on the theory that under the patent laws, a patent may legally create a monopoly in only one market.lv Kodak reflects an erroneous understanding of the nature and functions of a patent. Rather than market rights, patent claims create exclusive rights in technologies.lvi A compulsory licensing of intellectual property rights is only justified where a monopolist’s refusal to license is profitable only because it tends to extend or preserve a monopoly.lvii Apple’s refusal to license its FairPlay technology to any other online music vendor and MP3 manufacturer would easily pass this test because licensing FairPlay to a rival such as Microsoft or RealNetworks would deprive Apple of both online music and iPod sales and that is always an adequate business justification. A compulsory licensing of Apple’s FairPlay technology to competitors would effectively turn Apple into a public utility and places the court in the undesirable position of price regulator.

D.  Patent Misuse

Patent misuse refers to improper acts committed by a patent or other intellectual property rights holder.lviii In 1952 and again in 1988 Congress amended the Patent Act to bring the concept of misuse more closely in line with antitrust principles.lix Congress intended to put a stop to the expansionist applications of patent misuse doctrine to reach practices which were not anticompetitive under any definition.lx For example, in Brulotte v. Thys Co., 379 U.S. 29 (1964), the Supreme Court condemned a contract under the patent misuse doctrine demanding royalty payments after the patent expired, even though there was no showing of anticompetitive practices.lxi In response to the Court’s application of the patent misuse doctrine to reach practices which are irrelevant to the concerns of antitrust law, Congress limited the use of the doctrine by providing that a patent owner is not guilty of patent misuse if it refuses to license, requires licensees to purchase goods that would work effectively only with the patent, or ties different products in the absence of showing of market power in the primary product.lxii Therefore, whether Apple’s use of FairPlay technology is a patent misuse may not have independent relevance when Congress limited its scope to antitrust violations. Thus, there is no need to make an independent inquiry as to whether Apple’s use of FairPlay technology is a patent misuse.

E.  Product Design: Strategic Creation of Incompatibility

Apple engaged in strategic creation of incompatibility by designing an exclusive combination or system of iPod, iTunes Software, and iTunes Store. Generally speaking, antitrust courts are not competent to second-guess decisions about product design.lxiii In most circumstances, the conduct that creates excessive incompatibility is also self-deterring.lxiv The market provides strong discipline for firms that produce innovations that customers reject. This suggests that truly anticompetitive product redesigns are uncommon.lxv Therefore, Apple’s regular updates to iTunes Software and iPod, which add new features as well as maintain the closed system of iPod, iTunes software, and iTunes Store are presumably procompetitive. However, Microsoft showed that a product redesign is anticompetitive if the firm has very substantial market power and the redesign is sufficient to exclude complementary products from the market.lxvi Moreover, the firm must intend the injury caused by the selection of a particular technology.lxvii In addition, the injury must greatly outweigh the benefits that the redesign produces for consumers.lxviii As explained in Part B, Apple’s redesign serves the purpose of its unique product model. It provides consumers through various updates with new features such as visual music, podcasts, playback capacities, and seamless management of music. Unlike the case in Microsoft, there is integrative benefit from combining the iTunes and iPod.

IV.  CONCLUSION

Apple’s business practices of combining services and products have raised antitrust concerns. This Note analyzed Apple’s practices with an eye toward the realities of the music market. For courts and antitrust enforcement agencies to continue to serve as competition and innovation facilitators, they need to fully understand what the structure and the landscape of the music market are and how the entrance of a new and aggressive business model such as Apple’s exclusive system alters the competitive landscape of the music market. The most serious impact of a court’s finding of antitrust violation is not the large damages awarded to the plaintiffs. Rather, it is the loss of healthy competition and the innovative and effective access to copyrighted materials. An antitrust analysis of the possible causes of action against Apple shows that Apple’s conduct may not have harmed competition after all. If balancing is required to determine whether certain restraint is anticompetitive or not, antitrust should stand aside, trusting that the market rather than the government will strike the right balance.

i Brendan M. Schulman, The Song Heard ‘Round the world’: The Copyright Implications of MP3s and the Future of Digital Music, 12 HARV. J.L. & Tech. 589, 626-27 (1999).

ii Press Release, NDP Group, Amazon Ties Wal-Mart as Second-Ranked U.S. Music Retailer, Behind Industry-Leader iTunes, May 26, 2010, available at http://www.npd.com/press/releases/press_100526.html.

iii Press Release, Apple, Inc., iTunes Store Top Music Retailer in the U.S., Apr. 3, 2008, available at http://www.apple.com/pr/library/2008/04/03itunes.html.

iv Thomas Crampton, Apple Faces Fresh Legal Attacks in Europe, New York Times, June 6, 2006, available at http://www.nytimes.com/2006/06/09/technology/08cnd-apple.html.

v In re Apple iPod iTunes Antitrust Litig., C05-00037 JW, 2009 WL 249234 (N.D. Cal. Jan. 15, 2009).

vi Id.

vii Brad Stone, Apple Is Said To Face Inquiry About Online Music, New York Times (May 25, 2010), available at http://www.businessweek.com/news/2010-05-26/justice-department-said-to-s….

viii Press Release, Apple, Inc., Changes Coming To The iTunes Store (Jan. 6, 2009), available at http://www.apple.com/pr/libarary/2009/01/06itunes.html.

ix See NDP Group Press Release, supra note 2.

x See Apple Press Release, supra note 3.

xi Press Release, Apple, Inc., iTunes Store Tops 10 Billion Songs Sold (Feb. 25, 2010), available at http://www.apple.com/pr/library/2010/02/25itunes.html.

xii See NDP Group Press Release, supra note 2.

xiii Jessica Hodgson, Leap Year Trips Zune in Black Eye for Microsoft, WALL ST. J. (Jan. 2, 2009), at A9, available at http://online.wsj.com/article/SB123074469238845927.html.

xiv Real Reveals Real Apple Legal Threat, MACWORLD(Aug. 10, 2005), available at http://www.macworld.co.uk/news/index.cfm?Rss&NewsID =12310.

xv In re Time Warner et al., F.T.C. File No.971-0070 (2000) (Statement of Chairman Robert Pitofsky and Commissioners Shelia F. Anthony, Mozelle W. Thompson, Orson Swindle, and Thomas B. Leary), available at http://www.ftc.gov/opa/2000/05/cdpres.shtm.

xvi Greg Kot, Are We Finally Buying It?: New Model Will Change the Way Musicians Approach Craft, Chicago Tribune, May 11, 2003, § 7, at 1.

xvii See FTC Press Release, supra note 15.

xviii Matthew Fagin et al., Beyond Napster: Using Antitrust Law to Advance and Enhance Online Music Distribution, 8 B.U. J. Sci. & Tech. L. 451, 457 (2002).

xix Anthony Maul, Are the Major Labels Sandbagging Online Music? An Antitrust Analysis of Strategic Licensing Practices, 7 N.Y.U. J. Legis. & Pub. Pol’y 365, 373-75 (2004).

xx Id.

xxi Id.

xxii Id.

xxiii Id. at 373-74.

xxiv Herbert Hovenkamp et al., Antitrust Law, Policy and Procedure: Cases, Materials, Problems 290-96 (6th ed., 2009).

xxv Sarah McBride & Ethan Smith, Music Industry to Abandon Mass Suits, WALL ST. J. (Dec. 19, 2008), available at http://online.wsj.com/article/SB122966038836021137.html.

xxvi Id.

xxvii Id.

xxviii See Maul, supra note 19.

xxix Id.

xxx Id.

xxxi Id.

xxxii Id.

xxxiii Statement by Assistant Attorney General R. Hewitt Pate, Regarding the Closing of the Digital Music Investigation, (Dec. 23, 2003) available at http://www.usdoj.gov/atr/public/press_releases/2003/201946.htm.

xxxiv See Maul, supra note 19.

xxxv Id.

xxxvi See NDP Group Press Release, supra note 2.

xxxvii See Maul, supra note 19.

xxxviii N. Pac. Ry. Co. v. United States, 356 U.S. 1, 5-6 (1958).

xxxix Id.

xl Id.

xli Cabrice Corp. v. American Patents Development Corp., 283 U.S. 27, 31-32 (1931).

xlii Herbert Hovenkamp, The Antitrust Enterprise: Principle and Execution 261 (1st ed., 2005).

xliii Id. at 263.

xliv Id.

xlv United States v. Microsoft Corp., 253 F.3d 34, 84-90 (D.C. Cir.), cert. denied, 534 U.S. 952 (2001).

xlvi Id.

xlvii Hovenkamp, supra note 42, at 265.

xlviii Id.

xlix CSU, L.L.C. v. Xerox Corp., 203 F.3d 1322, 1328 (Fed. Cir. 2000).

l Hovenkamp, supra note 42, at 265.

li 35 U.S.C § 271(d).

lii Eastman Kodak Co. v. Image Technical Servs., 125 F.3d 1195, 1196 (9th Cir. 1997), cert. denied, 523 U.S. 1094 (1998).

liii Id.

liv Id. at 1218-1219.

lv Id.

lvi Hovenkamp, supra note 42, at 269.

lvii Id. at 270.

lviii Id. at 272.

lix 35 U.S.C. § 271(d).

lx Hovenkamp, supra note 42, at 274.

lxi Brulotte v. Thys Co., 379 U.S. 29 (1964).

lxii 35 U.S.C. § 271(d).

lxiii Hovenkamp, supra note 4, at 274.

lxiv Id. at 275.

lxv Id.

lxvi See Microsoft, supra note 45.

lxvii Hovenkamp, supra note 42, at 276.

lxviii Id.

© Copyright 2011 Rui Li  

H.R. 848, The Performance Rights Act: The Recording Industry’s Saving Grace?

The National Law Review is proud to announce that Nyasha Shani Foy of  New York Law School   is one of our Student Legal Writing Contest Winners for March of 2011.  Nyasha’s article explains House Bill 848, the ‘Performance Rights Act,’ which proposes to expand copyright protection for sound recordings and require broadcast radio stations to pay performers for the use of their sound recordings. 

In February 2009, Representative John Conyer, Jr. (D-MI) introduced H.R. 848, the ‘Performance Rights Act,’ to Congress. This legislation proposes to expand copyright protection for sound recordings and require broadcast radio stations to pay performers for the use of their sound recordings. If passed, H.R. 848 would provide another source of revenue for copyright holders, musicians, and performers. This paper will analyze the major provisions in H.R. 848 and its potential effects on the broadcast radio and recorded music industries. 

State of the Music Recording Industry: Who Is To Blame?

The recorded music industry is in a state of emergency. The RIAA reports that record sales have steadily decreased for the past ten years.[i] The sale of physical records, has declined by approximately sixty (60) percent from 1999 to 2008.[ii] CD sales decreased nearly twenty-two (22) percent from 2008 to 2009 alone.[iii]

Industry analysts contend that this decline is directly linked to new music technology and the rise in piracy.[iv] Technology has enabled listeners to hear music without buying it and has shifted consumers away from the purchasing behavior that historically supported the recording industry.[v] The Internet, piracy, and the ability to acquire music-on demand has created a culture where listeners believe that music should be free.[vi] According to theInternational Federation of the Phonographic Industry (IFPI), a membership organization representing the worldwide recording industry,there are 29.8 million frequent users of file-sharing services in the top five EU markets alone.[vii]

Industry analysts also attribute changing consumer-purchasing habits to the decline in sales. Consumers have shifted from physical to digital sales. In 2009, more than one quarter of domestic record companies’ revenues came from digital channels.[viii] The a-la-carte download model, pioneered by iTunes, remains the largest revenue source in the online sector, with more than 100 million accounts across 23 countries.[ix] Recent reports suggest that while these downloads do generate revenue for the recording industry, the move to digital sales has not completely offset the revenues lost to piracy.[x]

The recording industry has struggled with identifying effective solutions that will offset the declining sales. The courts have provided assistance, as evidenced by the recent injunction on LimeWire.[xi] Similarly, Congress is doing their part to ensure the health of this industry going forward. In February 2009, Representative John Conyer, Jr. (D-MI) introduced H.R. 848, commonly known as the Performance Rights Act,[xii] which offers to provide another revenue stream for the recording industry.

Performance Right Act

The primary purpose of H.R. 848 is to “provide parity in radio performance rights under title 17, United States Code.”[xiii] Under current law, broadcast radio (analog, non-subscription AM and FM radio) is exempt from paying a performance license fee for sound recordings. The proposed billwould require broadcast radio stations to pay performance fees to copyright holders and would bring terrestrial radio into line with its digital counterparts.[xiv] The following provides a brief overview of the major provisions of H.R. 848:

H.R. 848 Section 2: Establishing Equitable Treatment for Terrestrial, Cable, Satellite, and Internet Services:

This section amends §§106 and 114 of the Title 17 and provides for:

  • A performance right applicable to radio transmissions generally and inclusion of terrestrial broadcasts in existing statutory license;
  • Reasonable rates and terms of royalty payments for transmissions; and
  • Procedures for determining reasonable terms and rates of royalty payments for a new type of service on which sound recordings are performed or those that will become operational.

H.R. 848 Section 3: Treatment for Minority, Female, Religious, Rural, Small, Noncommercial, Public Educational, and Community Stations and Certain Uses

Amends §114(f)(1) and provides for the following:

  • Each individual terrestrial broadcast station that has gross revenues in any calendar year of:
  • Less than $100,000 may elect to pay its over the air non-subscription broadcast transmission a royalty fee of $500 per year;
  • At least $100,000 but less than $500,000 may elect to pay for its over-the-air non-subscription broadcast transmission a royalty fee of $2,500 per year; and
  • $500,000, but less than $1,250,000 may elect to pay for its over-the-air non-subscription broadcast transmissions a royalty fee of $5,000 per year.
  • Each individual terrestrial broadcast station that had total gross revenues during the 4 full calendar quarters immediately preceding the date of enactment of the Performance Rights Act of:
  • Less than $5,000,000 shall not be required to pay a royalty during the three years immediately following the date of enactment of the Performing Rights Act; and
  • $5,000,000 or more shall not be required to pay during the one year immediately following the enactment of the Performance Rights Act.
  • Each public broadcasting entity as defined in §118(f) and has gross receipts in any calendar year of:
  • Less than $100,000 may elect to pay for its over-the-air non-subscription broadcast transmission a royalty fee of $500 per year; and
  • $100,000 or more may elect to pay for its over-the-air non-subscription broadcast transmission a royalty fee of $1,000 per year.

Section 4: Availability of Per Program License

Amends § 114(f)(1)(b) by providing a per program license option for terrestrial broadcast that make limited feature uses of sound recordings.

Section 5: No Harmful Effects on Songwriters

Amends § 114(i) and provides that:

  • License fees for public performance of sound recordings under § 106(6) shall not be cited, taken into account or used in any administrative, judicial or governmental forum or proceeding, to set or adjust the license fees payable to copyright owners of music works for the purpose of reducing or adversely affecting such license fees;
  • Nothing in this Act or the amendments made by the Act shall adversely affect the public performance rights of or royalties payable to songwriters or copyright owners of musical works; and
  • Notwithstanding the grant of a license under §106(6) to perform work publicly, a licensee of that sound recording may not publicly perform such sound recording unless a license has been granted for the public performance.

Section 6: Payment of Royalties

Amends § 114(g) and provides that:

  • Featured artists who perform on a sound recording will be entitled to payments from the copyright owner in accordance with the terms of the artist’s contract.
  • Copyright owners will be required to deposit 1% of the receipts from the license with the American Federation of Musicians and American Federation of Television and Radio Artists Intellectual Property Rights Distribution Fund for non-featured performers who have performed on sound recordings.
  • The Fund will be distributed as follows: 50% to non-featured musicians (whether or not members of American Federation of Musicians) and 50% to non-featured vocalists (whether or not members of American Federation of Television and Radio Artists); the fund may deduct reasonable costs related to making such distributions.
  • Amounts that are not paid by the date specified in such clause shall be subject to interest at the rate of 6% per annum for each day of nonpayment.
  • Sound recording copyright owner will be required to include with deposits, “subject to consent, if necessary,” the following information: identity of the artist; International Standard Recording Code; title of the sound recording; number of times the recording was transmitted; and total amount of receipts collected from that service.
  • To the extent that the license extends to a station’s non-subscription broadcast otherwise licensable under a statutory license, the station shall pay to the agent designated to distribute statutory license receipts 50% of the total royalties that the station is required to pay for such transmissions and payments shall be the sole payments to which featured and non-featured artists are entitled by virtue of such transmissions under the direct license with that station.

Section 7: No effect on Local Communities:

Adds an additional section to §114(f), which ensures that the payment of royalties will not affect the public interest obligations of a broadcaster to its local community.

Section 8: Preservation of Diversity

Amends §114(f) of Title 17 and requires that the Copyright Royalty Board, in making their determinations or adjustments to the rates and terms of royalty payments, consider “religious, minority-owned, female-owned, and noncommercial broadcasters;” “non-music programming;” and “religious, minority-owned, or female-owned royalty recipients”

The GAO Report on H.R. 848 and its Effects

Congress asked the United States Government Accountability Office (GAO) to analyze the potential effects of H.R. 848. The GAO reviewed 1) the current economic challenges facing the recording and broadcast radio industries; 2) the benefits both industries receive from their current relationship; 3) the potential effects of the proposed act on the broadcast radio industry; and 4) the potential effects of the proposed act on the recording industry.[xv]The GAO released two reports: a draft report in February 2010[xvi] and a final report in August 2010.[xvii]

The GAO reports that the broadcast radio and recording industries have maintained a mutually beneficial relationship. The broadcast radio industry benefits from using sound recordings to attract listeners, which in turn generates advertising revenue.[xviii] The recording industrybenefits from receiving airplay. Stakeholders from both industries agree that broadcast radio airplay facilitates the discovery of new music; increases exposure and raises awareness of sound recordings; and promotes music sales.[xix] However, the GAO found no consistent pattern between broadcast radio airplay and the cumulative number of digital single sales.

The GAO indicates that H.R. 848 would result in an overall gain for record companies, musicians, and performers.[xx]Several factors would influence potential revenues including: the individual or organizational role in the creation of a sound recording,the amount of airplay a sound recording receives, andtotal royalty payments paid by the broadcast radio industry.[xxi]Using a 2.35 percent royalty rate[xxii], the GAO estimated that fifty-six (56) percent of performers would receive $100 or less per year, and fewer than six (6) percent of performers would receive $10,000 or more per year in royalties from airplay in the Top 10 markets.[xxiii]

H.R. 848 has many supporters. To date, nearly 50 representatives in the House have signed their names in support. The bill is also backed by the United States Department of Commerce, which “has long endorsed amending the U.S. copyright law to provide for an exclusive right in the public performance of sound recordings.” The Department believes that this proposed legislation will “provid[e] fair compensation to America’s performers and record companies through a broad public performance right in sound recordings;” “provide a level playing field for all broadcasters to compete in the current environment;” and “provid[e] incentives for America’s performing artists and recording companies.”[xxiv] President Barack Obama also supports the bill.[xxv]

Proponents argue that adopting H.R. 848 would correct an imbalance in the current system. As Cameron Kerry, General Counsel for the Department of Commerce has pointed out, the United States is the only major industrialized country to have an exemption for over-the-air radio.[xxvi]Foreign musicians and performers receive a performance royalty when their music is broadcast on the radio.[xxvii] Many American artists are unable to collect the public performance money due from  foreign countries because of the lack of reciprocal protection under U.S. copyright law.[xxviii] As a result, substantial royalties for the public performance of U.S. sound recordings abroad are either not collected or not distributed to American performers and record companies. The U.S. Copyright Office estimated the amount of international performance royalties due in 2007 to be about $70 million dollars.[xxix] Adopting H.R. 848 would both protect our American copyrights in the international market by putting us on equal footing with our international counterparts, and add value to our American copyrights by providing a multi-million dollar annual revenue stream for copyright holders. Record industry stakeholders have suggested that the additional revenue could lead to more investment in the creation of music. Additional revenue for artists and musicians, especially session performers, would allow these groups to remain working in the music industry.[xxx]         

Not surprisingly the National Association of Broadcasters (NAB), a trade association representing radio and television broadcasters,does not support H.R. 848. They argue that this “new performance tax” would financially cripple local radio stations, stifle new artists trying to break into the recording business, and harm the listening public who rely on local radio.[xxxi] Others more see the bill as “an attempt by the record labels to get their own bailout courtesy of radio stations.”[xxxii] Opponents argue that H.R. 848 offers a zero-sum equation as a solution: the recording industry gains, while the broadcast industry loses.[xxxiii] Clearly, this result would be counterproductive to the overall system. Opponents of H.R. 848 also suggest that the new “tax” will largely benefit foreign record companies such as Universal (France), Sony (Japan), and EMI (UK).[xxxiv]

Broadcast radio industry stakeholders argue that they already provide revenue to copyright owners by purchasing licenses that allow radio stations to broadcast music. The cost for this license varies by station, however, the GAO estimates the industry pays approximately 3 percent of its annual revenues to the performance rights organizations (PROs) and SoundExchange.[xxxv] Adopting this legislation would add additional financial costs, in the form of royalty payments for the use of sound recordings,[xxxvi] and administrative costs, in complying with the reporting requirements.[xxxvii] The total additional annual costs to the industry could range from $258 million to $1.3 billion.[xxxviii]

The main concern regarding the adoption of H.R. 848 is that an additional license fee might cause some radio stations to shut down.[xxxix] A limited or narrow play-list would accordingly decrease the number of potential licenses the radio station would need to acquire and would ease the work needed to fulfill the reporting requirement. However, a narrow play-list could potentially alienate listeners by decreasing the variety of music offered, which could lead to fewer listeners and decreased advertising dollars. The GAO reports that the broadcast radio industry is already experiencing an 8 percent decline in advertising revenue from its peak of $18.1 billion.[xl] However, if a station uses a large music library, then the reporting would become more tedious. This result could likely lead to an increase in staffing costs and license fees, but could also likely ensure a broader listening audience and attract potential advertisers.[xli] A radio station would also have the option of switching to a non-music format or ceasing operation altogether to reduce the license fees, however, these options would not benefit the broadcast radio industry.[xlii]

The GAO offered both the draft and final report to Federal Communication Commission (FCC) and the U.S. Copyright Office for comments. The CopyrightOffice generally supports the proposed legislation. Speaking on behalf of the Copyright Office, Marybeth Peters, former Registrar of Copyrights, mentioned that the Office has established a long history of recommending extension of full performance rights to sound recordings, including recently voicing support for the Performance RightsAct in Congressionalhearings.[xliii] The FCC critiqued the GAO’s analysis on the effects of the broadcast radio industry.[xliv]

Another significant critique of H.R. 848 is that the legislation is short-cited in its scope in that it targets an increasingly less-influential industry. While broadcast radio remains the most common place to discover new music, this reliance has decreased with younger audiences, who increasingly rely on the Internet to learn about new music. A recent Arbitron research study reports that 52% of 12-34 year olds turn to Internet to learn about new music first.[xlv]The presence of other promotional outlets, such as music blog sites, puts a strain on an already complex relationship between the recording and broadcast industries.[xlvi] Although requiring performance fees for radio may create parity within our own laws and on an international scale, it is likely not the most effective means to achieve the overall goal of monetizing the recording industry. Using the underlying premise of monetizing uses of copyrighted material, Congress may be better suited to consider focusing on other businesses and industries that are tangentially related to the recording industry. For example, the IFPI reports that there has been last a sharp rise in non-peer-to-peer piracy, such as downloading from hosting sites, mobile piracy, stream ripping, instant message sharing, and downloading from forums and blogs.[xlvii] Urban music creators, in particular with its mixtape culture, often usurp radio’s ability to attract new listeners and break new music by releasing their new music thru music blogs. Instead of working to shut down these illegal music channels, Congress should draft legislation that monetizes these consumer habits. Perhaps, if music blogs, or the hosting sites that they use to share copyrighted works, were taxed in a similar fashion to what H.R. 848 proposes (however which greatly reduced fees), then the proposed legislation would have a greater effect.

Conclusion:

 While H.R. 848 may not provide the “perfect” solution, this legislation does demonstrate Congress’ dedication and commitment to intellectual property issues. Regardless of the outcome, this will remain to be an important piece of legislation for all intellectual property practitioners.

[i]See RIAA, 2008 Consumer Profile, http://76.74.24.142/CA052A55-9910-2DAC-925F-27663DCFFFF3.pdf(last visited Dec. 26, 2010).

[ii]See GAO, Preliminary Observations on the Potential Effects of the Proposed Performance Rights Act on the Recording and Broadcast Radio Industries, GAO-10-428R (Washington, D.C.: Feb. 26, 2010) at 7. Available at http://www.gao.gov/new.items/d10428r.pdf.

[iii]See, RIAA, 2009 Year-End Shipment Statistics, http://76.74.24.142/A200B8A7-6BBF-EF15-3038-582014919F78.pdf (last visited Dec. 30, 2010).

[iv]See Growing Threat From Illegal Web Downloads,December 18, 2009, http://www.bpi.co.uk/press-area/news-amp3b-press-release/article/growing…); IFPI Digital Music Report 2010, January 21, 2010, http://www.ifpi.org/content/library/DMR2010.pdf at 6 (last visited Dec. 28, 2010).

[v]GAO-10-428R at 8.

[vi]SeeGAO-10-428R at 7; IFPI Digital Music Report 2010 at 23 (“We live in a world where 1€ is considered extravagant for a music download, but a couple of euro is considered reasonable for a Starbucks coffee.”).

[vii]IFPI Digital Music Report 2010 at18.

[viii]See IFPI Digital Music Report 2010 at 3.

[ix]SeeIFPI Digital Music Report 2010 at 4.

[x]Eric Pfanner, Music Industry Counts the Cost of Piracy, N.Y. Times, January 21, 2010. Available at http://www.nytimes.com/2010/01/22/business/global/22music.html (last visited Dec. 29, 2010).

[xi]See http://www.scribd.com/doc/40191948/Injunction-Lw; The Song Is Over, Portfolio, Oct. 27, 2010, http://www.portfolio.com/views/blogs/daily-brief/2010/10/27/judge-kimba-wood-orders-limewire-to-shutdown(last visited December 29, 2010).

[xii]The Senate has also proposed a similar bill, S. 379, 111th Cong. (2009), sponsored by Senator Patrick Leahy. This bill can be found at: http://thomas.loc.gov/cgi-bin/query/z?c111:S.379. While the House and Senate bills differ in detail, both bills include a statutory royalty with a tiered structure.

[xiii]H.R. 848, 111th Cong. (2009). Full text of this bill can be found at: http://thomas.loc.gov/cgi-bin/query/z?c111:H.R.848.

[xiv]The Digital Performance Right in Sound Recordings Act of 1995 (17 U.S.C. §§ 106, 114-115; Pub. L. No. 104-39, 109 Stat. 336)created an exclusive public performance right for copyright owners of sound recordings for certain performances made by satellite and cable digital subscription services, but exempted broadcast radio. http://en.wikipedia.org/wiki/Digital_Performance_Right_in_Sound_Recordin….

[xv]See GAO-10-428R at 2.

[xvi]See GAO-10-428R (Washington, D.C.: Feb. 26, 2010).

[xvii]See GAO, The Proposed Performance Rights Act Would Result in Additional Costs for Broadcast Radio  Stations and Additional Revenue for Record Companies, Musicians, and Performers, GAO-10-826, (Washington, D.C.: Aug 4, 2010). Available at http://www.gao.gov/new.items/d10826.pdf.  

[xviii]See GAO-10-826 at 12.

[xix]Id.at 12-15.

[xx]SeeGAO-10-428R at 4.

[xxi]SeeGAO-10-826 at 27-28.

[xxii]SeeGAO-10-826 at 4. (The GOA used royalty rates considered in previous rate-setting decisions—2.35, 7.25, and 13 percent).

[xxiii]SeeGAO-10-826 at 28-29; Id.at 2, fn. 4.(“While the proposed statutory license requires direct payment to musicians and performers, agreements between record companies and artists could take into consideration this additional source of revenue. Record companies and others in the recording industry have signed a Memorandum of Understanding agreeing that those signing the memorandum will not attempt to recover any performance royalties from the musicians or performers.”).

[xxiv]Available at http://www.scribd.com/doc/29299229/Commerce-Department-Letter-on-Perform… (last visited on Dec. 27, 2010).

[xxv]See Nate Anderson, Obama admin: time to make radio pay for its music, http://arstechnica.com/tech-policy/news/2010/04/obama-admin-make-radio-p… (last visited Dec. 28, 2010).

[xxvi]Id.; Fair or Not “The Performance Rights Act” will affect more than Artists’ Royalties, Oct. 24, 2010, http://musicindustryreport.org/?p=27721 (last visited Dec. 27, 2010)(Currently, China, Iran, and North Korea are the only foreign countries that do not provide a fair performance right on radio.).

[xxvii]See GAO-10-428R at 14.

[xxviii]Available at http://www.scribd.com/doc/29299229/Commerce-Department-Letter-on-Performance-Rights-Act(last visited on Dec. 27, 2010).

[xxix]See GAO-10-826 at30. The GAO report, however, did not factor into its calculations royalties that may due to foreign artist, which could negative the overall sum collected domestically.

[xxx]GAO-10-428R at 15.

[xxxi]Anderson, Obama admin: time to make radio pay for its music http://arstechnica.com/tech-policy/news/2010/04/obama-admin-make-radio-p…. (last visited Dec. 27, 2010).

[xxxii]Mike Masnick, How The Recording Industry Changes Its Own Story, Jun 16, 2009,http://www.techdirt.com/articles/20090614/2223175228.shtml (last visited Dec. 28, 2010); Masnick, Bailing Out The RIAA?, May 14, 2009,http://www.techdirt.com/articles/20090514/0218574881.shtml (last visited Dec. 29, 2010).

[xxxiii] Matthew Lasar, Performance Rights Act might shut down some radio stations

http://arstechnica.com/tech-policy/news/2010/06/gao-report-performance-r… (last visited Dec. 29, 2010).

[xxxiv]Anderson, Obama admin: time to make radio pay for its music http://arstechnica.com/tech-policy/news/2010/04/obama-admin-make-radio-p…. (last visited Dec. 27, 2010).

[xxxv]GAO-10-826 at 14; Donald Passman, All You Need To Know About The Music Industry, Seventh Edition, Free Press (New York 2009) at 234-236.

[xxxvi]See H.R. 848 Section 3: Treatment for Minority, Female, Religious, Rural, Small, Noncommercial, Public Educational, and Community Stations and Certain Uses.

[xxxvii]See Section 6: Payment of Royalties.

[xxxviii]GAO-10-826.

[xxxix]Lasar, Performance Rights Act might shut down some radio stations

http://arstechnica.com/tech-policy/news/2010/06/gao-report-performance-r…. (last visited Dec. 29, 2010).

[xl]GAO-10-826 at 8.

[xli]Amos Biegun, Fair Or Not, The Performance Rights Act Will Affect More Than Artists’ Royalties, Oct. 24, 2010, http://www.musicdish.com/mag/?id=12773 (last visited Dec. 27, 2010).

[xlii]GAO-10-428R at 12.

[xliii]Comments From The Copyright Office On GAO-10-428R (GAO-10-707SP), an E-supplement to GAO-10-428R, April 16, 2010. Available at http://www.rbr.com/radio/24888.html (last visited Dec. 30, 2010).

[xliv]GAO, The Proposed Performance Rights Act Would Result in Additional Costs for Broadcast Radio  Stations and Additional Revenue for Record Companies, Musicians, and Performers, GAO-10-826,  Appendix V: Comments from the Federal Communications Commission, page 56-57 (July 21, 2010).

[xlv]The Infinite Dial 2010: Digital Platforms and the Future of Radio at 15-16.  Available at

http://www.arbitron.com/downloads/infinite_dial_presentation_2010_reva.pdf (last visited Dec. 29, 2010).

[xlvi]GAO-10-826 at 11-20.

[xlvii]IFPI Digital Music Report 2010 at 19. 

© Copyright 2011 Nyasha S. Foy

Notions of the Transformative in Law and the Visual Arts

The National Law Review is proud to announce that Aimée Scala of Brooklyn Law School  is one of our Student Legal Writing Contest Winners for March of 2011.  Aimee’s article focuses on what constitutes a “transformative” work for purposes of fair use under copyright law. 

In January 2011, artist Shepard Fairey and the Associated Press reached a settlement out of court regarding Fairey’s ubiquitous Hope poster (now in the collection of the National Portrait Gallery in Washington, D.C.), created and used during Barack Obama’s presidential campaign. Fairey’s image was based on a photograph of Obama, then an Illinois senator, taken by photographer Manny Garcia for the Associated Press. The A.P. accused him of copyright infringement because of the substantial similarity between the two images. In response, Fairey brought suit seeking a declaration that his use of the photograph was not infringement, but instead a fair use of the copyrighted image, a statutory exception to the exclusive grants given to authors and creators under federal copyright law. Because the parties settled their dispute, the merits of Fairey’s fair use claim were not addressed. Some commentators, however, have argued that the case would have turned primarily on whether Fairey’s use of the photograph was “transformative.” Though this case made headlines, another fair use case, one whose holding has far-reaching implications for artists and others that rely on the doctrine, fell largely under the radar of popular media.

The case of Gaylord v. United Statesi addressed and refined some of the blurry borders surrounding the fair use doctrine, particularly what constitutes a “transformative” work for purposes of fair use. Because the judicial determination of whether use of a copyrighted work in another work is “fair” requires balancing both law and fact, predicting the outcome in a specific set of circumstances is difficult, if not outright impossible. Indeed, the fair use doctrine has been described as “the most troublesome in the whole law of copyright.”ii Accordingly, artists who incorporate copyrighted material into their works often don’t know until a suit arises whether their use will be labeled infringement or protected artistic expression. The uncertainty surrounding the doctrine necessarily increases the risk of using any copyrighted material and artists are beginning to express concern. In Gaylord, the Center for Internet & Society filed an amicus brief on behalf of the Warhol Foundation, the Warhol Museum, Barbara Kruger, Thomas Lawson, Jonathan Monk, Allan Ruppersberg, and eleven law professors urging the court to affirm the lower court’s finding of fair use and reject the standard for “transformative” that it subsequently adopted.

The case involved the Korean War Memorial in Washington DC, in particular a sculpture by artist Frank Gaylord known as The Column, consisting of nineteen stainless steel statues of foot soldiers in staggered formation. Dedicated in 1995, the Memorial was commissioned and funded by the United States and constructed by Cooper-Leckey Architects. Shortly thereafter, amateur photographer and military officer John Alli photographed the monument as a retirement gift for his father, a Korean War veteran. Alli took hundreds of photographs of the sculpture using different angles, lighting, shutter speeds, varying both the time of the year and time of day. The photograph he ultimately chose for his father, which he titled Real Life, captured the monument at dawn during a snowstorm

Alli explained at trial that the he felt the subdued early morning light and falling snow evoked a surreal sensation, drawing the viewer into the photograph and communicating the harsh, freezing conditions soldiers in the Korean conflict were forced to endure. Before Alli began selling prints of his photograph, he reached out to Cooper-Leckey for permission. Though Cooper-Leckey granted a license in exchange for royalties, Gaylord sued him in 2006. Alli settled the dispute by agreeing to give Gaylord 10% of any net sales.

 The photograph was selected in 2002 by the United States Postal Service for use on a stamp to commemorate the Korean War. The Postal Service contacted Alli for the image, and he sold it to them for $1500. Alli suggested that the Postal Service contact both Cooper-Leckey and Gaylord for permission, but they did not contact anyone about licensing. They altered Real Life so as to make it monochromatic and grey, and sold the stamps until 2005 when they decided to retire it.

 In 2006 Gaylord sued the United States for copyright infringement in Federal Claims Court. The court found the United States’ use of the copyrighted material in the stamp qualified as fair use, and Gaylord appealed. The Court of Appeals for the Federal Circuit reversed and remanded the case for an assessment of damages.

 The decision largely turned on whether the Postal Service’s use of the copyrighted sculpture in the stamp was “transformative.” Fair use is determined by balancing four non-exclusive factors that are weighed together with an eye towards the fundamental purposes of copyright.iii The first factor, the purpose and character of the use,iv asks, among other things, whether the second work is “transformative.”vIf it is indeed found to be a transformation of the copyrighted material, the factor will weigh in favor of a finding of fair use.

By ultimately concluding that the Postal Service’s use of Alli’s image of The Column was not fair use, the Court of Appeals narrowed what constitutes a transformative work in the fair use context. The court explained that the use was not transformative because “the stamp did not use The Column as part of a commentary or criticism.”vi This understanding of the meaning of “transformative” poses severe limits on what may now be considered fair use of copyrighted materials. Unlike the Court of Appeals for the Second Circuit in Blanch v. Koonswhich explained that a subsequent work could use copyrighted works as “raw materials” to further creative or communicative objectives and still be considered transformative,vii the Federal Circuit—by narrowing transformative to include only comment or criticism of the copyrighted work—dismisses wholesale a broad range of established artistic practices and ignores the constitutional mandate that grounds U.S. copyright law, namely that exclusive intellectual property rights be granted to authors and inventors for limited times “to promote the progress of science and the useful arts.”viii The intent behind the intellectual property clause is to benefit society and encourage a flourishing of artistic practice by creating incentives. The holding of Gaylord may strangle creative energy and stifle previously protected artistic expression with the ominous threat of legal repercussions while rejecting important and established artistic practices

The idea that by changing context one can radically change the meaning of an object is a well-established notion in modern and contemporary art. Indeed, one landmark work that aptly illustrates the point is Marcel Duchamp’s 1917 workFountain. Probably his most famous readymade, replicas of Fountain (the original was lost) are housed in museum collections the world over. Fountain consists only of a found object the artist installed with no changes apart from his scrawling of “R. Mutt” onto the side. As Duchamp biographer and art critic Calvin Tomkins notes, “it does not take much stretching of the imagination to see in the upside-down urinal’s gently flowing curves the veiled head of a classic Renaissance madonna or a seated Buddha or, perhaps more to the point, one of Brâncuşi’s polished erotic forms.”ix Once the object was placed in an art exhibition, it ceased to be a functional item and was transformed into an object of beauty.

Further, appropriation art, a movement that gained popular ground in the late 1970s, makes broad uses of found images (or photographs of them). Sometimes incorporating images wholesale with little or no alteration, this type of practice again emphasizes that changing the context of an image, from being seen on a billboard to the wall of a gallery, is transformative because the image becomes a work of art. Artist Richard Prince’s work Spiritual America, 1983, appropriated a photograph of a young Brooke Shields, originally the work of commercial photographer Gary Gross, while the work’s title is borrowed from a 1923 photograph by Alfred Stieglitz. The subject of a retrospective at the Guggenheim Museum in 2007, Richard Prince’s influence on art history is undisputed. Unfortunately, because this work and others like it do not explicitly comment on or criticize the incorporated copyrighted material, they could very well be considered infringing under the standard the Federal Circuit has adopted.

Renowned jurist Oliver Wendell Holmes Jr. once stated that:

“[i]t would be a dangerous undertaking for persons trained only to the law to constitute themselves final judges of the worth of pictorial illustrations.”x

Though oft-quoted, his candid and self-aware remark seems to have lost its footing within contemporary copyright jurisprudence. As the boundaries of the copyright “monopoly” continuously expand like a snowball rolling down a mountain, a broad conception of fair use becomes increasingly important to promoting artistic expression. Our contemporary jurists should take heed of Holmes’s remarks as well as consider the constitutional principles on which copyright law is grounded—not exclusively to protect authors and creators, but instead to provide an incentive for individuals to make creative works for the benefit the public.

 This delicate balance requires an interpretation of fair use that allows artists to feel free to “quote” from other works, and it requires judges to acknowledge that perhaps it is the place of art historians, viewers, or artists themselves, to determine whether the intent behind work is transformative. Indeed, art history has long recognized that changing the context of a work changes its meaning: something largely worthless, once altered to become an art object, becomes invaluable. Though no explicit comment or criticism is made about the original work, a new work is created whose transformative nature has been acknowledged by art historians for almost a century. Courts must recognize that people draw creative inspiration from the world around them to make new works that benefit our society, and that world includes other people’s creative endeavors.

i 595 F.3d 1364 (Fed. Cir. 2010).

ii Dellar v. Samuel Goldwyn, Inc., 104 F.2d 661,662 (2nd Cir. 1939).

iii Campbell v. Acuff-Rose Music, Inc., 510 U.S. 569, 577-78 (1994).

iv 17 U.S.C. § 107 (1) (2006).

v Campbell 510 U.S. at 578-79.

vi Gaylord 595 F.3d at 1373 (Fed. Cir. 2010).

vii Blanch v. Koons 467 F.3d 244, 253 (2nd Cir. 2006) (internal quotation marks and citations omitted).

viii U.S. Const., Art. I, § 8, cl. 8.

ix Calvin Tompkins, Duchamp: A Biography (New York: Henry Holt, 1998). 186

x Bleistein v. Donaldson Lithographing Co. 188 U.S. 239, 251 (1903).

Aimée Scala © Copyright 2011