Make the Rules or Your Rivals Will Hardback - 2004

Excerpt

The Strategist's Dream

Controlling Competition

Without the rule of law, including the rights of property and the enforceability of contracts, the growth miracle of capitalism, indeed capitalism itself, might not have been possible.
--William J. Baumol, The Free-Market Innovation Machine (2001)

Every measure that strengthens the power of the law . . . seems unavoidably to broaden the license offered to those who [use it] to accumulate wealth.
--William J. Baumol, Entrepreneurship, Management, and the Structure of Payoffs (1993)

It was not an auspicious start for a new business. The year was 1903, and a brash, forty-year-old entrepreneur named Henry Ford was launching his third attempt at entering the automobile business. He had a radical idea: to use assembly-line technology to design and market a reliable, cheap car for the masses. But now, a mere five weeks after opening the doors of the Ford Motor Co., he faced disaster--a lawsuit for patent infringement brought against him by the most powerful, well-heeled firms in the auto business.

Automobiles in 1903 were hand-tooled, customized playthings for the rich, and the leading car firms were determined to keep it that way. Fearing an influx of destructive competition from the hundreds of mechanics who were trying their hand at making cars, the most powerful manufacturers had organized themselves into an association and acquired a key, strategic property right: a pioneer patent covering all gasoline-powered cars using internal combustion engines. The so-called Selden Patent, awarded to a lawyer named George Selden based on an application he filed in 1879, described a "road engine" that had never been built.

Selden was not much of an inventor, but he was a skilled manipulator of the patent system. Under the Patent Office procedures of that era, applications remained secret until the day a patent was issued. And there was no limit on how long an application could remain pending. Selden's strategy was to delay receiving his patent long enough for the car business to turn into a genuine industry capable of supporting him with a rich stream of patent royalties. Instead of inventing a car, he had invented a "stealth" legal weapon that would remain cloaked until he thought the time was right. He nurtured his application for sixteen years, updating and amending it to incorporate new developments in automobile technology. Then he pounced.

In 1895, the Patent Office issued patent number 549,160 for a "safe, simple, and cheap road-locomotive" using a "liquid-hydrocarbon engine." The novelty of Selden's claim was not his design for the car itself but, rather, for the combination of the basic car design with a gasoline-powered, internal combustion engine. Selden's patent referenced one such engine invented by an Englishman named George Bailey Brayton. Once issued, the patent was good for seventeen years, until 1912, unless a court ruled it invalid.

At first, most professionals in the car business scoffed at Selden's patent. "Let him try to enforce it," they said. "Then he can talk to us about royalties." But Selden got a break. Some of the larger car manufacturers saw the Selden Patent as a way to bring order to their unruly industry. They acquired the patent in 1900, organized the Association of Licensed Automobile Manufacturers, and began writing a new set of rules for doing business. Anyone who wanted to sell an automobile in the United States, including foreign importers, would have to come to them.

Their strategy was simple. First, the association enrolled all the most important firms, giving them an equity stake in the Selden Patent. Then it built a large legal war chest to back its program of patent litigation attacking the rest of the industry. It selected the weakest manufacturers first, bullying them into settlements. A patent case could cost a manufacturer tens or even hundreds of thousands of dollars. Few had those resources. When the association called, the prudent business decision was to pay its modest royalty demands. Within a very short time, the Selden Patent controlled the market.

But when the leaders of the association called on Henry Ford, they had more than royalties on their minds. These men did not like Ford's idea of designing a cheap, mass-produced car. Nor did they want another competitor in the crowded Detroit market where Ford had set up his plant. They decided to exercise their strategic control over the industry by eliminating Ford's role in it. When he asked for a license, they refused him. The meeting between the two sides was short.

"Selden can take his patent and go to hell with it," one of Ford's men roared after the association's president refused Ford a license.

"You men are foolish," the association's president replied. "The Selden crowd can put you out of business--and will."

Ford's response was terse: "Let them try it."

The association promptly obliged, filing a patent-infringement case in its favored court--New York--to stop Ford's unlicensed sales. Ford had profits of only $36,000 in 1903, and the costs of defending a patent suit--especially one in faraway New York--would greatly exceed that amount. The association was certain Ford would surrender.

But instead of backing down, Ford called the association's bluff, hired a lawyer for $40 per day, and placed a magazine ad announcing that he would contest the validity of the Selden Patent. The association raised the stakes, launching a costly legal war of attrition to drive Ford out of business before a trial. Patent cases in 1903 moved at a glacial pace through the litigation process. The association told its attorneys to make sure every legal step was followed to the letter. The only silver lining for Ford was that he remained in business; the Selden gang was unwilling to put its patent to a preliminary test, so it had not asked for an injunction to halt Ford's production while the case inched toward trial.

At first, Ford was hard-pressed to fund his defense. But other unlicensed manufacturers rallied to his side. More important, his business model proved more than a match for the association's legal strategy. When Ford Motor brought out the Model N in 1906, it became the highest-volume manufacturer in the car market. The introduction of the bestselling Model T in 1908 secured Ford's place as the industry leader. By this time, the case was a focal point of attention, pitting the old guard against the new.

Then disaster struck. In 1909, after reviewing more than ten thousand pages of testimony and documentation, the trial judge surprised everyone involved in the case by upholding the Selden Patent and ordering Henry Ford and his allies to pay millions of dollars in back royalties. William Durant's General Motors Co., another new manufacturer of the day, folded its hand at this point, settling with the association for more than $1 million. And the association began filing lawsuits against Ford Motor customers for purchasing "unlicensed" automobiles. Everyone in the car business wondered: Would Henry Ford quit?

He fought on, purchasing litigation insurance for his customers and filing a legal appeal. Meanwhile, the case became a national news story, and the press took Ford's side, depicting him as fighting for the cause of free enterprise. The Detroit Free Press, for example, editorialized that Ford deserved "to win the applause of all men with red blood; for this world dearly loves the fighting man, and needs him, too, if we are to go forward."

In 1911, after spending eight years in court and an estimated $500,000 in legal fees, Ford finally won the victory he had been so determined to achieve. A federal appeals court overturned the trial judge's ruling, holding that the Selden Patent covered only those gas-powered cars that used the Brayton engine. Ford and every other genuine automotive pioneer, meanwhile, had long ago decided to use a more efficient "Otto-type" engine unknown to Selden.

The association, with only one year left to run on its patent, surrendered and dissolved. The war was over. And at its conclusion, Henry Ford had become much more than a "car man"--he was an authentic American folk hero, a determined entrepreneur who had taken on the moneymen and their high-paid lawyers and beaten them at their own game.

One might be tempted to think that Henry Ford's legal troubles were unique, the product of a now-outdated patent system and the ethic of the robber barons. Nearly a hundred years later, however, and a world away in terms of technology, another young entrepreneur faced off against another association representing the incumbents of a well-established industry. The year was 1999, and a nineteen-year-old student named Shawn Fanning, working alone in his dorm room at Northeastern University, was about to get his first taste of legal strategy in business.

Like Ford, Fanning had devised something new that promised to make life cheaper for consumers: a software technology that allowed music lovers to use the Internet to swap digital music files stored on their personal computers. His college friends loved it because they could swap songs for free. So did tens of millions of Web-savvy music fans. Fanning gave his software and website a catchy trademark--"Napster"--and stopped going to class to see what sort of business model he could devise for his invention. It was not long before a group of high-tech venture capitalists were calling the shots at Napster.

Napster had great technology, but it faced a serious legal problem: It needed copyright licenses from the music industry in order to set up a legitimate business selling songs on the Internet. And the industry was terrified that Napster would destroy the traditional retail market for CD sales. It refused to negotiate licenses.

With millions of new users logging onto Napster every week, the Recording Industry Association of America--representing all the major music labels--sued Napster for copyright violations, asking a federal court in California for millions in damages and an injunction to shut the site down. Fanning and his pinstriped financial backers gamely mounted a defense, spinning out a David-versus-Goliath story for the media. They argued that Napster itself copied nothing--it merely allowed its users to do so. Napster was, they said, an online version of a VCR. In an especially interesting move, one of Napster's opponents, German media giant Bertelsmann (owner of the BMG recording label), contacted Napster and signed an agreement to provide it with $18 million in further funding, thus effectively becoming both a defendant and a plaintiff in the same case. The music industry was running scared, unsure which way the law or the market was moving.

The Ford and Napster cases were separated by a century, yet the parallels between them are striking. Both involved industries preoccupied with keeping prices high and resisting new technologies. Both featured entrepreneurs who had developed new, cheaper models for doing business. And in each case a dominant industry association unwilling to negotiate intellectual-property licenses filed a bet-the-company lawsuit against the innovator, sparking intense media coverage.

But here the similarities stop.

Henry Ford's strategy involved calling the bluff of a cartel holding a weak legal hand. His problem was mustering the resources to push the case to a final judgment. Shawn Fanning, by contrast, confronted ironclad property rights. He and his backers were hoping that their clever legal argument would combine with negative publicity to bring the Recording Industry Association of America to the bargaining table. Fanning was the one who was bluffing in his case. And the industry did not go for it.

The music makers won a quick legal victory, obtaining a preliminary injunction to shut Napster down while the case proceeded to trial. The judge ruled that Napster's analogy to the VCR was flawed. Napster's website provided users with much more than a way to copy music so they could listen to it at a later time. Napster was, in essence, a burglar's key, opening the archive to almost every song ever recorded. More important, Napster's website served as a central clearinghouse for its users' songs, facilitating their illegal copying. Napster therefore directly contributed to massive copyright violations. The judge ordered the website shut down permanently and awarded damages in the millions. Game over.

Unlike Ford Motor Co., Napster would not have the chance to experiment with its new technology and perfect its business model. And unlike Henry Ford, Shawn Fanning would not go down in history as one of America's great entrepreneurs. Only twenty-two years old when his firm filed for bankruptcy, Fanning moved on to other projects, including bit parts in Hollywood films and a role in an MTV movie based on his life.

But there were others in the online music world with the business determination that Fanning lacked. Napster's burst of fame had revealed gaping holes in the music industry's traditional business model. In the wake of the lawsuit, Napster-like music services cropped up around the globe, forcing industry leaders to confront enormous technical, legal, and regulatory challenges. Even Napster itself revived. A company called Roxio, Inc., bought the Napster trademark in the bankruptcy proceeding, and launched a new, entirely legal Napster Internet subscription music service.

The recording-industry association was soon back in court, suing students (some as young as twelve years old) for sharing music files and demanding that telephone companies reveal the names of customers who might be using telephone modems to download songs. Courts, meanwhile, began to hold that the next generation of music-sharing programs was legal under copyright law. These programs required no central websites for song storage and reference. They simply made it possible for one user to copy files residing on another person's computer. Like a photocopying machine, peer-to-peer technology was capable of many perfectly legal uses, and courts were reluctant to ban it. The industry returned to Congress seeking to overturn these decisions.

Ford would have shaken his head at all this frenzied legal activity. You might stop a company, he would have said, but you can't stop a technology--especially a technology that serves consumer interests. Just as his mass-produced car opened the way for the modern automobile industry, Napster had demonstrated that the old retail model for music distribution would be difficult to sustain in the Digital Age.

The race for new profit models, and the legal definitions to sustain them, was on.