The Higher-Order Effects of Treating Intellectual Property as an Investment in Free Trade Agreements

Bruce Henderson, the founder of 波士顿谘询公司 was fond of this quote from Jay Forrester, the founder of system dynamics (a field that formed the foundation of systems thinking): "While most people understand first-order effects, few deal well with second- and third-order effects. Unfortunately, virtually everything interesting in business lies in fourth-order effects and beyond."

?Henderson knew what others didn't know about the cascading consequences that follow from first-order and subsequent-order effects, studied how hard they were to predict, and came up with a brilliant way to change the business world thought about competition through strategy. He is credited to have developed the discipline of business strategy.

?The higher-order effects framework celebrated by Henderson and Forrester, when worked backwards, is called Root Cause Analysis (RCA), a problem-solving technique that is also known as the 5 Whys (asking a series of question "Why did it happen?" to find the root cause of a problem). RCA belongs to a set of tools known as mental models that help us to understand cause and effect. While the higher-order effects framework helps us to understand the cascading consequences of a decision, the RCA helps us to trace back from the problem to its origin.

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A simple illustration of the two models using the example of a car breaking down on the highway will look like this:

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Higher-order Effects Framework:

1. Starting point: The owner did not have time to take the car for regular maintenance.

2. First-order effect: The car's essential fluids (like coolant) weren't replaced, and parts (like the radiator) weren't checked or cleaned.

3. Second-order effect: Over time, the radiator became clogged, and the coolant became ineffective.

4. Third-order effect: The engine overheated due to the ineffective coolant and clogged radiator.

5. Fourth-order effect: The car breaks down on the highway.

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Root Cause Analysis (working backwards):

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1. Problem: The car breaks down on the highway.

2. Immediate Cause: The engine overheated.

3. Underlying Cause: The coolant was not replaced, and the radiator was clogged.

4. Root Cause: The owner did not have time to take the car for regular maintenance.

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Higher-Order Effects in Intellectual Property

Administering intellectual property - the business of granting or rejecting applications for proprietary rights -? is a routine sovereign function that governments around the world carry out all the time. Rejecting applications covering intellectual property rights is a function that is as critical as granting. On an average, the United States Patent and Trademark Office (USPTO) rejects more patent applications than it grants. Apart from rejecting applications, the courts may also invalidate patents after they are granted. Rejections and invalidation of intellectual property usually results in an appeal to a higher authority. But such actions can also have grave and unforeseen consequences, what in the context of what is mentioned above, higher-order effects. One of the most controversial case involved the invalidation of two Canadian patents of the pharmaceutical company, Eli Lilly, by the Canadian courts in 2010 and 2011, which resulted in Eli Lilly claiming damages of CDN $500 million (1.4 Billion Saudi Riyals) against the Government of Canada. It is a text-book case that illustrates how signing a free trade agreement without adequate safeguards can lead to higher-order effects like a billion riyal claim against a country.

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How does performing a routine government function, of administering intellectual property rights, expose a sovereign country to a claim of billions of riyals in damages? To understand this, we may have to go beyond the confines of intellectual property law and understand the nuances of the international trade law.

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What happened in the case involving Eli Lilly and the Government of Canada is illustrative of how countries entry into Free Trade Agreements (FTAs) and Bilateral Investment Treaties (BITs) that have dedicated chapters on intellectual property rights. These treaties allow private investors to make claims against sovereign nations using treaty arbitration, usually under the International Centre for Settlement of Investment Disputes (ISCID) under the World Bank.

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Applying the RCA to this situation, we can analyze the above case as follows:

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Root Cause Analysis:

1. Problem: A private investor sues a sovereign state. (Eli Lilly files a claim for CDN $500 million (1.4 Billion Saudi Riyals) against the Government of Canada.)

2. Immediate Cause: Treaty Arbitration allows private investors to sue sovereign states. (Eli Lilly uses Treaty Arbitration to file a case against Canada before the ICSID Tribunal.)

3. Underlying Cause: Free Trade Agreements have treaty arbitration mechanisms. (Chapter 11 of the North American Free Trade Agreement (NAFTA) between Canada, Mexico and the United States allowed Eli Lilly to make a claim against Canada, a NAFTA party, for breach of its investment obligations.)

4. Connected Cause: Free Trade Agreements have chapters on Intellectual Property which treats them as an investment. (The obligations under Chapter 17 of NAFTA which deals with intellectual property can be construed as investment obligations under Chapter 11.)

5. Root Cause: Intellectual property is equated to an investment. (The mechanism in Chapter 11 allowed scope for considering invalidation of intellectual property as an expropriation of investment.)

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The History of Investment Treaties

BITs are of recent origin. The first BIT between Federal Republic of Germany and Pakistan in 1959 (which explicitly defined investment to include patents and technical knowledge) hardly had the details that we today see in the modern versions. It only had state-state dispute settlement mechanism. The investor-state arbitration picked up after the conclusion of ICSID Convention in 1966. The first BIT that allowed for investor-state treaty arbitration was the one between Netherlands and Indonesia in 1968. The last three decades have seen more than 3000 such agreements.

Model BITs agreements are agreement which countries use to negotiate with their individual partner countries. We notice the entry of Intellectual Property into BITs in some of the model BITs after 2000. The US Model BITs (2004) defined investment to include every asset that an investor owns or controls, including “intellectual property right”. We see the same pattern emerging in the German Model BIT (2005) and Chinese Model BIT (2003).

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How Countries Respond to Equating IP as Investment

Given the strong history of inclusion of intellectual property as an investment in FTAs and BITs, countries have made exceptions to what amount to expropriation as a means to abate the effect of treating IP as investment. The broad definition of investment allows IP to be considered as investment in FTAs and BITs which is the very reason why we have seen dedicated IP chapters sprouting in these agreements. For instance, the 2004 US Model BIT, specifies that to qualify as an investment, it “has the characteristics of an investment, including such characteristics as the commitment of capital or other resources, the expectation of gain or profit, or the assumption of risk.”?

Rather than excluding IP from the definition of investment, countries have focussed on adding exemptions to what amounts to expropriation. Since only the matters that amount to expropriation of investment can be raised as a dispute in treaty arbitration, the exemptions to expropriation can have the effect of making the issue a non-arbitrable issue, i.e., no action can be brought on that matter in a treaty arbitration, thereby lessening the chances of an IP-related investment dispute.?

Though the 2003 Indian Model BIT defines investment as "every kind of asset ... in accordance with the national laws of the Contracting Party in whose territory the investment is made and ... includes ... intellectual property rights," it makes an exception for compulsory licenses. The India-Japan FTA, for instance, states that the expropriation provision shall not apply with respect to grant of compulsory licenses to intellectual property rights. With Korea and Malaysia, India went a step ahead and exempted the application of expropriation provision to revocation, limitation or creation of intellectual property. (See India-Korea FTA and India-Malaysia FTA.)

Incorporating exemptions to expropriation is one of the ways in which countries have resisted the push towards treating IP as an investment. NAFTA didn't have such a provision which Canada could benefit from. But nothing stops countries entering into FTAs and BITs from insisting on a more expansive set of exemptions to expropriation.

The Arabic version of this article appeared today on the website of SAIP - Saudi Authority for Intellectual Property

Link: https://www.saip.gov.sa/articles/2113/