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Will crowdfunding make Intellectual Property obsolete?

Friday, August 10th, 2012

‘The problem with traditional publishing is that you do all the work and take all the risk before you find out if the audience is ready and willing to buy the book. And you have only a few days to go from “it’s new” to “it’s over.”’

(Seth Godin blogging on his Kickstarter campaign for a proposed new book).

Does the success of crowdfunding cultural goods do away with the necessity for intellectual property?

The economic argument for  intellectual property schemes is often something along these lines: it takes a great deal of time/money to make something that requires knowledge or creativity such as books or pills. In the absence of legislation anyone could copy the book or pill and undercut the creator’s investment. Knowing this a rational creator would not write or invent. In this model incentives to create are scarce. This account dismisses both Shakespeare and Salk as irrational.

That people create for reasons other than potential monetary rewards has been pointed out repeatedly but the account is inadequate for other reasons.  Some proponents of intellectual property argue that is it necessary not so much for the initial creation of an intangible good so much as for the mass production and distribution of material copies of the good.  Proponents of intellectual property are often intermediaries rather than creators, record companies, movie studios and book publishers for example. These intermediaries (have) often control(led) the distribution channels for creative goods. One reason for this control is that intermediaries spend all their time trying to control the channels while creatives are creating. Another is that some kinds of creative goods cost a lot of money to mass manufacture and distribute, LP’s or CD’s for example. The argument is that exclusive rights are necessary to ensure a return on the capital expended in mass manufacture and distribution.

Intermediaries are able to maximize their profits by spreading the payment they were required to make to the creator over the greatest number of copies of a good. If a publisher could publish just one best seller a year it could make more profit than publishing a 100 books for which there was limited demand. But best sellers have proven notoriously hard to predict. Intermediaries have to market a number of intangible goods some of which are profitable and cross subsidize others.  In this argument for intellectual property the demand for an intangible good cannot be as readily ascertained as the demand for a tangible good say a can of baked beans. Exclusive rights are useful not so much as an incentive to initial creation but to reduce the risk to capital. Intermediaries provide(d) capital for such capital intensive processes. In this model information about customer preferences is scarce. This is why Hollywood is so obsessed with making movies only from successful books, computer games and endless remakes, sequels, prequels and sharquels (the sequel that jumps the shark).

The result was a world in which intermediary control of production and distribution channels together with the limits of technology defined by what  Chris Anderson explained as ‘limited shelf space’; distribution channels offering only a narrow choice of creative goods. Digital technology and new intermediaries have increased choice, and reduced blockbusters. Digital technology is also revealing new data on customer preferences. New intermediaries have lowered the barrier to market entry. Amazon.com offers authors an opportunity to publish ebooks through Amazon, and it is the market and not Amazon that decides whether the work becomes popular. Authors are able to set their own price unlike authors who publish ebooks through traditional publishers. But Amazon still takes a substantial portion of the revenue and controls the distribution system. In this model the attention of consumers is scarce. Amazon consolidates consumer attention.

Enter crowdfunding. Here is a description of the process on the Fundable site:

Entrepreneurs with great business ideas pitch them to the Fundable community. Each fundraise has a minimum fundraising goal that it must reach in order to be funded….

“Community “backers” support the ideas by pledging capital in exchange for rewards, like a pre-order of the product.”

Goding used crowdfunding site kickstarter.com to raise money; $ 287 342 was pledged, while Godin’s goal was only $40 000. but Godin also used the kickstarter campaign to demonstrate interest in in his proposed book ‘The Icarus Deception’ to his publisher. Godin, a popular figure amongst marketers, used crowdfunding not simply for funding but in order to simultaneously create, gauge and demonstrate demand.

Musician Amanda Palmer also used kickstarter but to raise money for mixing, promotion, manufacture and distribution of an album, album art and a world tour. She obtained $1 192 793 though her goal was only $100 000.

The campaigns by Godin and Palmer share certain features including tiered support levels tied to creative rewards, the higher the pledge the more, and more elaborate, artifacts promised to the pledge maker.  Both Godin and Palmer are established creative personalities with strong brands. Neither offered to release their creations under open licences. These data give rise to some caveats that I’ll discuss in a paragraph or two. But these examples and others like them suggest are highly suggestive.

Creators are able to simultaneously aggregate demand and raise capital. It is in principle possible for a creator using no more than technology and contract law to set a price for creative work, and once that price is met to produce the work without requiring intellectual property as an incentive.

Of course crowdfunding creative production means disintermediating incumbent intermediaries. It is more economically efficient because captures two important pieces of information; what is the market demand for the good and what is the minimum (financial) incentive for the creator. It also enables the creator to raise capital directly from the purchasers of the good thus lowering the cost of capital. It also enables a far greater range and number of creative projects than was ever in the interests of intermediaries.

Even this scheme is far from perfect. Creatives may over or under price their projects. The system relies on a certain minimum reputation, Godin for instance has already had numerous books on marketing published. It would likely be more difficult for an unknown author to obtain similar levels of funding. Godin presumably is adept at marketing. Other objections are that only 25% of tech and design projects on kickstarter currently deliver on time, some proposals may be scams. Despite these issues there are already crowdfunding sights for fashion, social causes in the United States and in Britain.   Glyn Moody suggests crowdfunding to create FLOSS. Using crowd funding for resources that are open is particularly interesting since it will enable discovery of information that is distorted by the current intellectual property system; the price that is a sufficient incentive for a creative person to create something.

I expect that economists will begin to pay attention to crowdfunding because it enables market mechanisms to discover information distorted or obscured by current intellectual property production systems. I expect creative people will begin to pay attention to crowdfunding because it will give them the ability to engage more directly with the people who like their work and are willing to pay for it.

Shipping Intangibles

Thursday, March 24th, 2011

Executive Summary for Busy Entrepreneurs:
1.Reserve Bank permission for transfer of a South African patent, trademark, design or copyright is not (currently) required.
2.Payment of royalties for use of a South African patent, trademark, design or copyright is revenue expenditure not capital expenditure for income tax purposes
3. Tax deductions for royalties for use of a patent, trademark, design or copyright anywhere in the world originally created or owned by a South African taxpayer but transferred to a foreign entity are not allowed.*
4.Patents, trademark, design, copyright and even trade secrets developed together with a South African University or research council require Department of Trade and Industry permission for transfer to a foreign entity.

Justin Sanford’s new blogpost draws attention to a recent judgment that affects South African entrepreneurs intending to use their knowledge assets in other countries. The way that SARS characterized the rights to intangibles illustrates both how much legal institutions created for tangible goods struggle when dealing with knowledge, and how the metaphor of intellectual “property” leads to confusion.

The Supreme Court of Appeal is South Africa’s second highest court, and a judgment from it can only be appealed to the Constitutional Court if it raises a constitutional question. In Oilwell v Protec the Supreme Court of Appeal ruled that trademarks registered in South Africa are not “capital” within the meaning of that term in the exchange control regulations and its empowering statute. As a result, a South African entity can transfer a South African trademark to a foreign entity without requiring SA Reserve Bank permission. As a logical consequence a South African entity can transfer a South African registered patent, or the South African copyright to a foreign entity without Reserve Bank permission. How did this come to be an issue? What does this mean for entrepreneurs in South Africa?

To understand the judgment, and other legal provisions that affect cross border arrangements of intangibles its useful to re-visit some basic points. The term “intellectual property” is of recent origin, and it was intended by lawyers as a metaphoric collective term for widely different statutory schemes; patent, trademark, copyright and design. Each of these differs from the other in some significant way. Copyright, patent and design rights are intended to create incentives for innovation and creativity, while trademark is consumer protection legislation, intended to enable consumers to be sure of the origin of the goods they buy. Patent, trademark and design are registered while copyright does not require registration. All grant the rights holder the legal power to stop others from doing certain things, but none confer on the rights holder the power to do those same things.
Two patent holder that hold overlapping patents could stop each making a product. A copyright holder isn’t entitled to distribute or make copies of a video that is banned by the Film and Publications Act.

Patents, trademarks, designs and copyright are all territorial. What that means is that a patent in South Africa applies only in South Africa. For example if Intellectual Vultures Ltd has registered a patent for a back scratcher in South Africa but there is no patent registered in Lesotho then anyone in Lesotho is free to make a back scratcher of that type. If Intellectual Vultures Ltd has registered a trademark over the word “bakscratchz”in South Africa but not in Botswana then anyone in Botswana could sell stuff marked with the word “ bakscratchz” in Botswana.

The situation is a little different for copyright. When Henrietta Sutton pens her new politically correct novel entitled “Non-gender specific mutual regard for life, or at least as long as both persons consent” in Rondebosch she acquires copyright in South Africa, but also in every other country that is a party to the Berne Convention. But what she acquires is not single right, but rather a unique right in each country. In South Africa that rights lasts for her life, and then another fifty years, in the United States it persists for seventy years after she has died, and presumably lost interest in continued revenue (in the unlikely event that there is any) from her work.

The rights relating to intangibles can’t be removed from the territory of a country, any more than the title to a house could be moved from the territory in which the house is located. Of course trademarks, patents and copyrights are located “everywhere” in the Republic of South Africa and are not localised in one particular spot. They aren’t for instance fixed to offices of the Department of Trade and Industry in Tshwane. I point this out because even some “intellectual property” lawyers seem to be confused by the concept by a territorially defined right to an intangible which is neither universal nor located at specific point in space. The idea that “Intellectual Property” is a tangible “thing” somehow distinct from and underlying the statutory schemes of patent, copyright, trademark and design and not only a thing but a thing that can be shipped overseas seems to underlie at least some of the confusion evident in the Intellectual Property Rights from Publicly Financed Research Act.

In the Oilwell case, a South African company called Oilwell argued that a transfer of a trademark from it to an foreign company, Protec International Limited, was not allowed by the Foreign Exchange Regulations. The trademark was in the word ‘Protec’ and had been registered in the name of Oilwell in South Africa but later transferred to Protec International Limited. If the claim had succeeded then Oilwell would get the trademark back. The register that records the trademark holder would have had to be amended. The Foreign Exchange Regulation that Oilwell claimed invalidated the transfer states “no person shall, except with permission granted by the
Treasury and in accordance with such conditions as the Treasury may impose . . . enter into any transaction whereby capital or any right to capital is directly or indirectly exported from the Republic.” The Reserve Bank acts as the agent of the Treasury in giving or denying permission required under the regulation. The Treasury wasn’t involved in the case and so didn’t present an interpretation of the regulation in court.

The judge who gave the judgment of the Supreme Court of Appeal, Judge Harms said that the term ‘capital’ is capable of a number of different meanings depending on the context. He then discussed what ‘capital’ means in the regulation that he had to interpret. He concluded that ‘capital’ was intended in a financial sense, as money that could be invested, but not things on which money had been spent, such as land, movables or goods.

Judge Harms ruled that intellectual property is territorial and can not be exported. It is also not capital for purposes of the Foreign Exchange Regulations, and so does not require Reserve Bank permission for transfer.

This isn’t the first time in which the Supreme Court of Appeal has had to decide whether a right to a trademark is capital or not. In BP Southern Africa (Pty) Ltd v Commissioner for South African Revenue Services the court had to decide whether licensing royalties that BP South Africa paid to BP plc, a foreign company incorporated in the United Kingdom, and listed on both the LSE and NYSE were ‘capital’ expenditure.
The question the court had to decide was whether the licensing royalty for use of the BP trademarks was ‘intended to produce income’ for the purposes of Section 11 (a) of the Income Tax Act. ‘Revenue’ expenditure is not ‘capital’ expenditure. The judge giving the decision of the Supreme Court of Appeal, Judge Ponnan, concluded that the licensing royalties were paid so that BP South Africa could use the trademarks and not so that it could acquire “ownership” of the trademarks, and therefore that the amount paid was ‘revenue’ expenditure and not ‘capital’ expenditure. Based on the reasoning by the court if a South African transferred ‘ownership’ in a trademark registered in South Africa to a foreigner then the South African may be liable for capital gains tax. However if the South African merely licensed the foreigner to make use of the South African trademark then the royalties received would be income.

Royalties and license fees are regarded as gross income in the Income Tax Act (s 1 s v ‘gross income’ (g)(iii)). But even that is complicated. Its complicated by Section 23I of the Income Tax Act. The intention of Section 23I is that a South African taxpayer (which includes a local establishment of a foreign firm) may not get a tax deduction for research and development of ‘intellectual property’ and then transfer the right to earn the revenue to an entity that does not pay South African income tax. It includes expenditure in South Africa that results in South African patents, copyright, designs and trademark and also expenditure by a South African taxpayer that results in copyright, trademarks, patents and designs in other territories. Expenditure hit by the section is disallowed. It doesn’t apply to capital expenditure in terms of Section 11 (gC). A brief informative note on the section by Pitsi Rammutla is here.

Another potential barrier to foreign investment in South African start-ups are the provisions of the Intellectual Property Rights from Publicly Financed Research Act.

That Act refers to “intellectual property” anywhere in the world that is developed by a South African public university or research council with a few exceptions, not relevant to entrepreneurs. A patent, trademark, design, copyright or even trade secret developed by an entrepreneur together with a South African public university cannot be the subject of an “offshore” transaction without the approval of the National Intellectual Property Management Office, a subsidiary of the Department of Trade and Industry. “Offshore transaction” is not defined in the statute and so the prohibition is likely void for vagueness.

I wrote about some of the problems with the Act in 2009, before the Act was passed, suggesting that the problems could be resolved by suitable amendments. They were not resolved and that post remains a largely accurate guide for entrepreneurs considering working with universities or research councils.

The recent decision of the Supreme Court of Appeal in Oilgate has removed one barrier to South African entrepreneurs accessing foreign capital. However several laws still in place require careful structuring of transactions involving “intellectual property” and foreign investors. South African entrepreneurs would benefit from a systematic survey of these laws and their impact on entrepreneurs.

Update: Readers may have noticed the logical conclusion from the territoriality of patent, trademark, copyright and design rights; that they do not extend to places outside of the territory of countries with patent, trademark, copyright and design laws; the High Seas, Antarctica and countries such as Afghanistan that don’t have such laws. One consequence is that international agreements on biodiversity have not paid attention to the oceans.

* I’ve reworded point 3 of the summary for greater accuracy.