1997 Robert P. Merges.

Wilson Sonsini Professor of Law, UC Berkeley (Boalt Hall) School of Law.

1. See, e.g., Richard Allan Horning, Has Hal Signed a Contract: The Statute of Frauds in Cyberspace, 12 SANTA CLARA COMPUTER & HIGH TECH. L.J. 253, 256 (1996) ("By linking buyers and sellers electronically and eliminating paperwork, . . . transaction costs should drop dramatically.").

2. See generally OLIVER E. WILLIAMSON, THE ECONOMIC INSTITUTIONS OF CAPITALISM (1985); Howard A. Shelanski & Peter G. Klein, Empirical Research in Transaction Cost Economics: A Review and Assessment, 11 J.L. ECON. & ORG. 335 (1995).

3. THRAINN EGGERTSSON, ECONOMIC BEHAVIOR AND INSTITUTIONS 14-16 (1990).

4. See generally Mark Stefik, Shifting the Possible: How Trusted Systems and Digital Property Rights Challenge Us to Rethink Digital Publishing, 12 BERKELEY TECH. L.J. 137 (1997).

5. I do not mean to argue that encryption does not strengthen the de facto protection available to a seller of content. The point is simply that the enhancement is not complete; the content may still be subject to misuse down the line.

6. Not to zero, of course; these systems are expensive to design and implement (for instance, consider the costs of embedding self-reporting features in every piece of digital content).

7. See, e.g., J.H. Reichman & Pamela Samuelson, Intellectual Property Rights in Data?, 50 VAND. L. REV. 51, 70 (1997) (describing this view, and citing sources critical of it):

By restricting access to identifiable online subscribers, for example, and by "placing conditions on access and [using technology] to monitor . . . customer usage," the publisher can largely restore the power of the two-party contractual deal that the advent of the printing press had appeared to destroy. In effect, publishers in this position may not need copyright law at all, even if they qualify for protection.

Id. at 70 (quoting Jessica Litman, After Feist, 17 U. DAYTON L. REV. 607, 611 (1992)).

8. GRANT GILMORE, THE DEATH OF CONTRACT (1974).

9. Libertarianism was certainly no stranger to the Silicon Valley of fifteen years ago, either.

10. See Diana J.P. McKenzie, Commerce on the Net: Surfing Through Cyberspace Without Getting Wet, 14 J. MARSHALL J. COMPUTER & INFO. L. 247, 254 (1996) ("[O]n-line contracting is moving toward a system where users simply log on, point, and click-and a contract is formed.").

11. Genetic information, for example, is available by contract. Cf. Face Value: Genes and T-Shirts-Selling Information Rather Than Drugs is the Key to Making Swift Profits in Biotechnology, THE ECONOMIST, Jan. 4, 1997. Contract is the only option since fragmentary gene data is generally not patentable. See Rebecca S. Eisenberg & Robert P. Merges, Opinion Letter as to the Patentability of Certain Inventions Associated with the Identification of Partial cDNA Sequences, 23 AM INTELL. PROP. L. ASS'N Q.J. 1 (1995).

12. See, e.g., Hill v. Gateway 2000, Inc., 105 F.3d 1147 (7th Cir. 1997) (enforcing warranty included inside box containing computer bought by plaintiff); ProCD, Inc. v. Zeidenberg, 86 F.3d 1447 (7th Cir. 1996) (terms inside a box of software bind consumers who use the software after an opportunity to read the terms and to reject them by returning the product); cf. Carnival Cruise Lines, Inc. v. Shute, 499 U.S. 585 (1991) (enforcing a forum election clause that was included among three pages of terms attached to a cruise ship ticket).

13. See infra note 14.

14. See, e.g., William K. Jones, Economic Losses Caused By Construction Deficiencies: Competing Regimes of Contract and Tort, 59 U. CIN. L. REV. 1051 (1991). Indeed, William Prosser authored a widely cited article on "The Fall of the Citadel," celebrating the end of the privity requirement in products liability cases. See William L. Prosser, The Fall of the Citadel, 50 MINN. L. REV. 791 (1966). I do not include third-party beneficiary contracts in this discussion because (1) they are an anomaly even in the common law tradition, and (2) the requirement that third parties must be intentional beneficiaries of a contract amounts to a sort of quasi-privity in any event. See VERNON V. PALMER, THE PATHS TO PRIVITY: THE HISTORY OF THIRD PARTY BENEFICIARY CONTRACTS AT ENGLISH LAW (1992).

15. On the general notion that much of intellectual property law can be derived from simple notions of restitution, see Wendy J. Gordon, On Owning Information: Intellectual Property and the Restitutionary Impulse, 78 VA. L. REV. 149, 156-57 (1992).

16. See Richard E. Speidel, Warranty Theory, Economic Loss, and the Privity Requirement: Once More into the Void, 67 B.U.L. REV. 9 (1987).

17. The usual warranty case where lack of privity is ignored involves a manufacturer, a distributor, and a consumer. Traditionally, the consumer cannot sue the manufacturer for breach of warranty due to lack of privity. Numerous cases have set aside contract law's privity requirement under these circumstances. See generally Speidel, supra note 15, at 9. The rationale is straightforward: consumers are the intended beneficiary of a product warranty (distributors usually don't use the product themselves), and they expect a warranty to be binding. Ignoring privity thus comports with the expectations of the parties.

18. For example, if use restrictions affect marketability of property by unreasonably limiting the class of persons to whom the property may be transferred, such restrictions have been held invalid as unreasonable restraints upon alienation. Falls City v. Missouri Pac. R.R. Co., 453 F.2d 771 (8th Cir. 1971); Grossman v. Hill, 122 A.2d 69 (Pa. 1956), overruled in Central Delaware County Authority v. Greyhound Corp., 563 A.2d 139 (Pa.Super.Ct. 1989), rev'd, 588 A.2d 485 (Pa. 1991).

19. Richard A. Epstein, Notice and Freedom of Contract in the Law of Servitudes, 55 S. CAL. L. REV. 1353, (1982).

20. See id. at 1354, 1358 ("[U]nder a unified theory of servitudes, the only need for public regulation, either judicial or legislative, is to provide notice by recordation of the interests privately created . . . . My thesis is simple: With notice secured by recordation, freedom of contract should control."). But see Susan F. French, Toward a Modern Law of Servitudes: Reviewing the Ancient Strands, 55 S. CAL. L. REV. 1261, 1281-1304 (1982); Uriel Reichman, Toward a Unified Concept of Servitudes, 55 S. CAL. L. REV. 1177, 1186-1211 (1982).

21. This statement is a generalization. Where the creator of a work merely requires compensation when someone uses the work, and where the compensation mechanism is built into the content, additional transaction costs are minimized. Assuming the new use makes economic sense after paying the required compensation, the condition on reuse will not substantially impede the market for the work. In some cases, however, restrictions on use may not be so simple. Where, for example, the creator of a digital work attaches a condition that subsequent users must seek his or her permission before reuse is permitted, transaction costs increase, since such a restriction creates additional bargaining and negotiation costs.

22. MARGARET JANE RADIN, REINTERPRETING PROPERTY 114 (1993).

23. Id. at 115.

24. This frustration may suggest an occasion to apply a renewed fair use doctrine. See generally infra part III.

25. Actually, there is one legal principle in intellectual property law that appears to embody the policy against restraints on alienation: the so-called "first sale" rule. Under this rule, which has been codified for copyright (see 17 U.S.C 109) but not patent law, the owner of intellectual property rights may not restrict a buyer's post-sales activity along a number of dimensions, most importantly with respect to resale prices or restrictions on the class of subsequent purchasers. This is not the place for a full-scale explication of "first sale" doctrine. For present purposes it is enough to note that few "first sale" cases are concerned with market fluidity. These cases are centered primarily on extensions of rightholders' power "beyond" that conferred by the property right, and the notion that it would be unfair for rightholders to receive compensation beyond the initial transaction. Cf. Neel Chatterjee, Imperishable Intellectual Creations: The Limits of the First Sale Doctrine, 5 FORDHAM INTELL. PROP. MEDIA & ENT. L.J. 383 (1995). Both rationales are poorly articulated; the latter is especially weak. Most importantly, the rule is not particularly important, since it is easily evaded by simply characterizing a transaction as a license rather than a sale. See, e.g. Microsoft Corp. v. Harmony Computers & Elecs., Inc., 846 F. Supp. 208 (E.D.N.Y. 1994); cf. Julie E. Cohen, A Right to Read Anonymously: A Closer Look at "Copyright Management" in Cyberspace, 28 CONN. L. REV. 981, 984 n.3 (1996) ("Consistent with the planned extraction of royalties on a per-use basis, copyright owners and developers of copyright management systems refer to the initial transaction in the copyrighted work as a 'license' rather than a sale.").

26. See ROBERT P. MERGES, PATENT LAW AND POLICY (2d ed. 1997), at Chapter 11.

27. Indeed, like misuse, the law against unreasonable restraints on trade emerged before federal antitrust law and persists alongside it in a sometimes uncomfortable tandem arrangement.

28. See, e.g., Brulotte v. Thys Co., 379 U.S. 29 (1964). See also MERGES, supra note 26, at 116:

The question in the case of private patent term extensions (beyond 17 years) . . . is whether parties "external to the contract" need to be protected. In general, it would seem to depend on a number of factors: (1) the market power of the licensor; (2) the strategic significance of the patented item; (3) the identity of the licensee; and (4) the overall structure of the industry, among others.

One can imagine scenarios where these factors suggest the need for a mandatory (or immutable) rule. Consider the case where a licensor controls a key technology in an industry dominated by it and a licensee, and the two agree on a private patent term extension. Unlicensed competitors could avoid the effects of the licensor-licensee private extension simply by remaining unlicensed. This might put them to a difficult choice (at the margin)-take a license and stay alive (though burdened with royalty obligations for more than 17 years), or try to survive and prosper in the post-expiration period. NB: This analysis assumes they will not be able to invent cost-effectively around the patent for at least as long as the extended term lasts; it also assumes unrealistic discount rates, insofar as the present value of the post-expiration period is quite low whether the patent term is extended or not. In some circumstances, this might be too harsh a choice to place on licensees. See generally JEAN TIROLE, THE THEORY OF INDUSTRIAL ORGANIZATION 221 (1988) (reciting the standard Cournot model, where monopolist has incentive to contract with potential entrant, rather than co-exist as duopolists; implies possibility of using licensing as opportunity for monopoly-splitting agreement).

Note that Tirole's discussion applies whether a patent term is extended by contract or not (though presumably the longer the period of monopoly the greater the incentive to play the split-the-monopoly game). On the other hand, agreements such as those in Brulotte are arguably nothing more than extended payment plans, in which case they look much more benign. See Frank M. Caprio, The Trouble with Brulotte: The Patent Royalty Term and Patent Monopoly Extension, 1990 UTAH L. REV. 813.

29. See, e.g., Merges, supra note 26, at Chapter 1.

30. See generally Louis Kaplow, The Patent-Antitrust Intersection: A Reappraisal, 97 HARV. L. REV. 1813 (1984).

31. 376 U.S. 225 (1964).

32. 376 U.S. 234 (1964).

33. 489 U.S. 141 (1989).

34. Preemption has been located at various times in copyright and patent law in a statute (see 17 U.S.C. 301 (Supp. 1991) (copyright preemption)) and in the United States Constitution (see Bonito Boats, 489 U.S. 141).

35. See Bonito Boats, 489 U.S. 141; Sears, 376 U.S. 225; Compco, 376 U.S. 234.

36. David A. Rice, Public Goods, Private Contract, and Public Policy: Federal Preemption of Software License Prohibitions Against Reverse Engineering, 53 U. PITT. L. REV. 543 (1992).

Under United States copyright law, infringers escape liability if their activities constitute "fair use." Fair use has been described as an "equitable rule of reason, as it must be flexible in order to allow judges, on a case-by-case basis, to make individual determinations of the copyright balance." Meeropol v. Nizer, 560 F.2d 1061, 1068 (2d Cir. 1977). For a history of the fair use doctrine, see WILLIAM F. PATRY, THE FAIR USE PRIVILEGE IN COPYRIGHT LAW 6-17 (1985). Congress codified the fair use doctrine and outlined four factors for fair use. 17 U.S.C. 107 (1994). These four factors are: (1) the purpose and character of the use, including whether such use is of commercial nature or is for nonprofit educational purposes; (2) the nature of the copyrighted work; (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. See id.

37. Robert P. Merges, Intellectual Property and the Costs of Commercial Exchange: A Review Essay, 93 MICH. L. REV. 1570 (1995).

38. The term is, of course, Kessler's. See Friedrich Kessler, Contracts of Adhesion-Some Thoughts About Freedom of Contract, 43 COLUM. L. REV. 629 (1943) (defining notion of "private legislation" in context of adhesion contracts).

39. See Maureen O'Rourke, Drawing the Boundary Between Copyright and Contract: Copyright Preemption of Software License Terms, 45 DUKE L.J. 479, 557 (1995) (stating that copyright preempts contract only where the contract environment gives the seller monopoly power ).

40. The National Information Infrastructure Copyright Protection Act, S. 1284 & H.R. 2441, 104th Cong., 2d Sess. (1995) [hereinafter NIICPA], introduced in both houses of Congress in September 1995, draws on the "White Paper" issued by the Clinton Administration's Information Infrastructure Task Force. See U.S. DEP'T OF COMMERCE, INFORMATION INFRASTRUCTURE TASK FORCE, INTELLECTUAL PROPERTY AND THE NATIONAL INFORMATION INFRASTRUCTURE: THE REPORT OF THE WORKING GROUP ON INTELLECTUAL PROPERTY RIGHTS 10-12, 177-78, 230 (1995) [hereinafter WHITE PAPER]. Section 4 of the NIICPA, titled "Copyright Protection and Management Systems," would establish comprehensive protection for copyright owners' decisions regarding copyright management in cyberspace. See generally Pamela Samuelson, Intellectual Property Rights and the Global Information Economy, 39 COMM. OF THE ACM 23 (1996); Julie E. Cohen, Some Reflections On Copyright Management Systems and Laws Designed to Protect Them, 12 BERKELEY TECH. L.J. 161 (1997). Under the NIICPA, Section 1201 of the Copyright Act would prohibit the importation, manufacture, or distribution of devices or services "the primary purpose or effect of which is to avoid, bypass, remove, deactivate, or otherwise circumvent . . . any process, treatment, mechanism or system which prevents or inhibits the violation of any of the exclusive rights of the copyright owner under section 106" of the Copyright Act. Section 1202 would prohibit tampering with "copyright management information" appended to a digital work by the copyright owner.

41. Legitimate privacy concerns and the like may, however, arise in the details of particular proposed systems. One might argue in this connection that a default rule should compensate victims of informational misuse, such as those who are reported against their wishes as readers of certain information or visitors to certain sites. At a minimum, this type of rule would require that anyone who does record such information about the users of information or visitors to a site must report that fact to users and visitors, and in effect ask them to waive their right to compensation. This would have the familiar "information-forcing" effect of the Ayres-Gertner default rule model.

42. See Robert P. Merges, Contracting Into Liability Rules: Intellectual Property Rights and Collective Rights Organizations, 84 CAL. L. REV. 1293 (1996).

43. See Joseph T Janczyk, An Economic Analysis of the Land Title System for Transferring Real Property, 6 J. Leg. Stud. 213 (1977); cf. RICHARD POSNER, ECONOMIC ANALYSIS OF LAW 79 (4th ed. 1992) ("It would improve efficiency to institute a system of paper water titles analogous to the systems used to record land titles.").

44. See Margaret Jane Radin, Regulation of Computing and Information Technology: Property Evolving in Cyberspace, 15 J.L. & COM. 509 (1996).

45. Indeed, the ongoing debate over software patents-pitting purist programmers against bottom-line-oriented business types-has many earmarks of a clash of cultures.

46. The copyleft agreement, or "General Public License," is available at <http://www.gnu.ai.mit.edu/copyleft/gpl.html> (visited May 2, 1997).

47. Many other communities operate with similar norms. Consider the accepted practice in academia of marking a draft research paper with the notice "Do Not Cite or Quote Without Permission of Author." Unless such a notice creates a unilateral contract-accepted when the other party reads the paper, perhaps-it is unlikely to be enforceable. Yet breach of the informal norm is considered a serious infraction in the academic community. Informal restrictions thus have some force in many realms, and cyberspace is surely one.

48. Wendy Gordon, Fair Use as Market Failure: A Structural and Economic Analysis of the Betamax Case and its Predecessors, 82 COLUM. L. REV. 1600 (1982).

49. Id. at 1614-15.

50. See id. at 1628-30.

51. See id. at 1614-15.

52. In all fairness, a re-reading of Gordon's article makes quite clear that this was only one of her chief insights. She also commented on the appropriateness of fair use as a vehicle to favor explicitly certain uses-an altogether distinct rationale, which I take up later.

53. See generally Merges, supra note 37.

54. 60 F.3d 913 (2d Cir. 1994).

55. 60 F.3d at 930-31.

56. Princeton Univ. Press, Inc. v. Michigan Document Serv., Inc., 99 F.3d 1381, 1387 (6th Cir. 1996).

57. See Robert P. Merges, Are You Making Fun of Me? Notes on Market Failure and the Parody Defense in Copyright, 21 AM. INTELL. PROP. L. ASS'N Q.J. 305 (1993); Robert P. Merges, Intellectual Property Rights and Bargaining Breakdown: The Case of Blocking Patents, 62 TENN. L. REV. 75 (1994) (focusing on bargaining breakdown in one-shot, as opposed to repeat-play, intellectual property rights transactions).

58. For a good statement of the conventional view, see Louis Kaplow & Steven Shavell, Why the Legal System Is Less Efficient than the Income Tax in Redistributing Income, 23 J. LEGAL STUD. 667 (1994).

59. Id.; see also, e.g., Thomas J. Miceli & Kathleen Segerson, Defining Efficient Care: The Role of Income Redistribution, 24 J. LEGAL STUD. 189 (1995).

60. See Kaplow & Shavell, supra note 58, at 674-75.

61. See id. at 675.

62. That is, intellectual property rights are required to call forth the optimal amount of investment in products embodying creativity; lower levels of investment yield suboptimal levels of creativity and innovation.

63. Cf. Niva Elkin-Koren, Cyberlaw and Social Change: A Democratic Approach to Copyright Law in Cyberspace, 14 CARDOZO ARTS & ENT. L.J. 215, 283-94 (1996) (on fair use in copyright).