James Boyle: What’s the secret?

Of all the critical forms of intellectual property, trade secrets are perhaps the least understood. The best way to understand trade secrets is to place them into opposition with patents. To acquire patent rights in any invention, the intrepid inventor has to run an impressive gauntlet of obstacles. He must make a new and useful invention that represents a nonobvious advance over the prior state of the art. And he must disclose to the world how best to practice his invention. His prize is a limited monopoly that prevents even an independent inventor from practicing the invention. His Achilles heel is that the patent protection lasts for a limited time, usually 20 years from the date of filing.

Trade secrets present different trade-offs. Creating rights in trade secrets requires its owner to take only minimal steps that fall short of the requirements of a patentable invention. But the payoffs are different: the trade secret may be kept in perpetuity, and it may be sold outright to third parties or licensed to others who are bound by contract to keep it secret. Yet unlike patents, trade secrets, as a matter of black letter law, offer no protection against either independent invention or reverse engineering.

Commonly, the two paths to defeating trade secret protection are treated with equal dignity. The two methods, however, have vastly different social consequences. In principle, no one can sensibly challenge the independent reinvention of a trade secret. The second party who by hook or crook duplicates that trade secret has not taken a free ride on the talents of others. If the initial holder of a trade secret could block all imitators, then he would have far stronger property rights than the patent holder who must contribute much to the public domain x to secure his private rights. Competition between rival firms is soundly encouraged by duplicate trade secrets.

With reverse engineering, however, the duplicator of the trade secret does free ride off the initial creator. His short cut for imitation is an impediment to creating that trade secret in the first place. The argument here tracks that for other areas where common property because one person has to bear all the cost of benefits shared by others. We enjoy the ex post efficiency of the wider dissemination of a useful trade secret. But simultaneously we suffer from the reduced probability that anyone will invest in the trade secret in the first place.

This argument is widely accepting in trade secret licensing. The gains from sharing trade secrets are protected by the strong enforcement of all confidentiality agreements. These gains would be lost if the trade secret licensee could disregard the terms and conditions of the license, as by disclosing or sharing the trade secret with third persons outside the scope of the initial license. Both the US and EU accept this line of argument.

The key question of policy therefore is this. What steps by contract may the holder of a trade secret take to prevent reverse engineering by trade secret licenses or purchasers of products that rely on trade secrets? The law on this question is hopelessly divided, but here is one cautious vote for enforcing these contracts not only against the original licensee or purchaser but also against any third person who seeks to reverse engineer with notice of the contract restriction.

The defence of this position rests again on the trade-off between ex ante and ex post efficiency. The rule that allows wider dissemination of a transferred trade secret has two negative consequences. First, it reduces the likelihood that the trade secret will be discovered. Second, it reduces the likelihood that, once discovered, it will be licensed, or licensed in the most efficient form for licensee use. Rather than make a product that is easy to use, the holder of the trade secret will go an extra step to redesign the product in ways that give false clues as to its internal structure. Or he may just refuse to issue certain risky licenses in the first place.

To see how the issue evolves, consider the business decision of the holder of a trade secret that can license or sell its product to two class of users, one which will seek to reverse engineer the product and the other which will not. Enforcing a contract against reverse engineering allows (if enforcement is reliable) the two parties to license the trade secret license or buy protected product at the same price. But once that clause is rendered illegal, the trade secret owner will work overtime to segregate their market into two classes. None of these questions ever arise with respect to independent invention. As the stakes get higher more holders of trade secrets will try to limit reverse engineering.

I see no good reason to block their efforts. Reverse engineering should not be treated like independent invention.

Richard A. Epstein is the James Parker Hall Distinguished Service Professor of Law at the University of Chicago, and the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution.


James Boyle: What’s the secret?

Richard Epstein’s column on trade secrets has me puzzled. He is right about the difference between trade secrets and patents, though he keeps one crucial point …well, secret. Trade secret protection is indeed perpetual, and does not require disclosure of the invention. He is right too, that trade secrets can be used to cover innovations that would not be novel enough to get a patent.

But what is to stop the inventors of innovations that would be worthy of patent from turning to the trade secret system instead? If that practice became widespread it would be a disaster. Indeed one of the most important reasons for the patent system in the first place is to provide a socially superior answer to trade secrets – one that requires disclosure and eventually ends. Imagine a scheme where drugs, lasers, computer technology and advances in biological sciences were all potentially controlled in perpetuity by those who held trade secrets on them.

The reason this dystopia does not come about, or does not come about more often, is that trade secret protection is deliberately made vulnerable to the two methods of working around the secret that Epstein mentions: Reverse engineering and independent invention.

Epstein has no problem with the latter. What about the former? Once your product is released to the general market I can legally reverse engineer it. Knowing that they will be vulnerable to such reverse engineering, firms that have made big innovations use patent protection. This is exactly what we want. The ability of others to “free ride” is a feature, not a bug.

What about those that have made little innovations which would not qualify for a patent. They use trade secrecy, trademark, name recognition and being first to market to capture profits from their innovation. It takes time for me to reverse engineer, time to get my product to market, and during that time consumers may get used to the first entrant as being the real provider of adhesive bandages or sugary cola drinks or what have you.

And if not? Well, too bad. There are lots of pressures to innovate in a competitive economy but the biggest one is, if you do not do it your competitor will do it to you. That “incentive” is out there to prompt the next wave of innovation. Epstein seems to assume that, if the trade secret is vulnerable, society will not get the innovation, but this is not necessarily true at all.

Now in some limited circumstances, we allow firms to contract out of the reverse engineering privilege. I want to go into business with you to produce cars and make you sign a non-disclosure agreement that you will not reveal my clever methods of making the wheels more cheaply. That seems fine. Epstein (and a few others) want this exception to swallow the rule. What if I could make that contract binding on anyone? The purchaser of the car. The person that person sells to…and so on down the line. Suddenly a negotiated contract has become very much like a property rule. Anyone with a trade secret could impose such a term.

Why would they not? Why would they not slap on a sticker “giving notice of” the contractual restriction on the product? At that point, we have effectively abolished the reverse engineering privilege. Trade secret suddenly looks a whole lot more attractive. Perhaps more attractive than patent. But that would be a dreadful result. It would dramatically expand the scope of a state backed monopoly in ways that seem inevitable to hurt consumers in terms of pricing, but also to slow down the pace of innovation itself.

After all, innovation thrives on the pressures to have technology disclosed that our current system sets up – whether by reverse engineering or by the pressure to patent, disclose and eventually release into the public domain. If I were going to tinker with that system, with the danger we move back to a set of perpetual monopolistic guild trade secrets, I’d want a stronger argument than Epstein has yet provided.

The writer is professor of law at Duke Law School, a board member of Creative Commons and the co-founder of the Center for the Study of the Public Domain

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