(FORTUNE Magazine) – TWO YEARS AGO in Milan, a squad of court officers and lawyers burst into the gloomy headquarters of Montedison, Italy's chemical giant. Sweeping through the building, they ordered employees at computer workstations to step away from their keyboards, and punched in commands to test the programs on the machines. The investigators identified some $55,000 of allegedly unlicensed software, mostly copies of Lotus 1-2-3, the popular spreadsheet program. Workers were bewildered. ''They asked, 'Why are you here for this? Everybody does it!' '' recalls Roberto Cappelli, a lawyer who represents Lotus Development Corp. After a series of raids Lotus and other U.S. software makers sued Montedison and four other Italian companies for copyright infringement. The four settled out of court for undisclosed sums, but Montedison denied any wrongdoing, claiming that Lotus salesmen had expressly authorized it to make copies of the software. The suit against Montedison is still pending. The theft of intellectual property -- ideas and innovations protected by copyrights, patents, and trademarks -- is a critical problem for American industry and America itself. In 1986 the U.S. International Trade Commission estimated that American companies lose some $60 billion to piracy abroad each year. Hardest hit are the nation's most innovative, fastest-growing industries, such as computer software, pharmaceuticals, and entertainment. Says Michael Dornemann, chief executive of Bertelsmann Music Group, a U.S. arm of the German media conglomerate Bertelsmann: ''What we're seeing is an American tragedy, a terrible drain on some of the country's most precious assets.'' Governments have long argued about the protection of ideas. The U.S. and other developed nations want tough new intellectual property provisions added to the General Agreement on Tariffs and Trade (GATT). But developing countries contend that such rules would inhibit their access to innovations, without which economic progress would slow. Meanwhile, U.S. companies are increasingly taking trade justice into their own hands, especially in parts of Asia and Latin America where patent and copyright laws are weak or nonexistent. -- ENTERTAINMENT. Few U.S. industries lose more to bootleggers than the makers of movies and music. Consider films: The Motion Picture Association of America says piracy in 1989 accounted for some $1.2 billion of lost revenues. Last $ year the MPAA spent $20 million fighting film, videocassette, and cable TV bandits, and initiated nearly 6,000 raids in 59 countries. Declares President Jack Valenti: ''We continue to turn up the heat on international piracy and cast an ever wider net.'' One of Hollywood's top cops is Charles Morgan, the son of actor Harry Morgan, who played Jack Webb's sidekick in the TV series Dragnet. He is a senior vice president at MCA's Universal Studios and has led scores of raids on shops that sell bootlegged videocassettes and audiocassettes. Fluent in Spanish and Portuguese, Morgan pursues thieves on six continents, negotiating with everyone from the copycats themselves to heads of state. He employs antipiracy investigators -- typically former police officers and government agents -- who stake out illicit operators and help police make busts. In Japan and the nations of the British Commonwealth, private enforcers don't even need the local cops: They can serve court orders and confiscate pirated movies and cassettes themselves as long as the merchant offers no resistance. (Most don't.) Entertainment theft is widespread in part because it is simple and fast. At its crudest, copying a first-run film involves nothing more than sneaking a videocamera into a theater and taping the show -- such copies can often be found on the streets of any Asian or Latin American capital. VCRs can be hooked up in tandem to reproduce videotapes; some thieves use special circuitry to override copying safeguards on tapes. Pirating compact disks also requires sophisticated, high-speed equipment: Pop a CD into such a machine, and 30 seconds later 32 copies of Whitney Houston's latest album are ready for sale. As for audiocassettes, thieves have been known to churn out as many as 80,000 illegal copies a day. Companies and trade groups select a country for cleanup because of the size of its market and the extent of the piracy in it. The MPAA has concentrated on the Pacific Rim, where populations are increasingly affluent and the demand for Western entertainment is high. These Asian countries are also important because they sometimes export bootlegged goods to Africa and the Middle East. The antipiracy effort started six years ago in Japan and has since swept through Hong Kong, South Korea, and at least 20 other nations in Asia and elsewhere. The enforcers' first move is usually to invoke whatever local laws exist, imploring officials to confiscate goods, make arrests, and impose fines. To ; attract public attention and teach consumers about intellectual property rights, copycat busters sometimes resort to theatrics. Morgan cites an example: ''In Japan we stacked up 10,000 pirated cassettes and hired a steamroller to destroy them. The public saw it all on TV.'' Small-scale busts and demonstrations are rarely enough to change a national habit. When Morgan and his lieutenants tackled the Japanese market in 1985, research showed that fully 80% of the American films and videos seen there were pirated, typically by entrepreneurs linked to organized crime. Says Morgan: ''Yakuza -- the Japanese mafia -- ran the whole operation.'' For help the MPAA turned to the office of the U.S. Trade Representative, which in February 1986 made movie piracy an issue in bilateral talks. Recalls Morgan: ''We said to the Japanese, it is just not fair that you don't protect our intellectual property when you have a $60-billion-a-year trade surplus in our country.'' But seven months later the yakuza still controlled the movie market. Only when the U.S. threatened to impose tariffs on electronic products did Japanese authorities finally go into fast-forward. They closed down copying plants and warehouses, made many arrests, and boosted jail terms and fines. Result: In the past five years movie piracy in Japan has shrunk to 15% of the market, and the annual sales of authentic American videocassettes have swelled to $300 million. The turnaround in Singapore was even more dramatic. Six years ago the city- state was a den of intellectual-property thieves: Not a single record or videotape sold in its stores or on its streets was legitimate. For records, Singapore was the biggest counterfeit market in the world, worth an estimated $250 million in annual sales. It was a major exporter of contraband music to Saudi Arabia and other countries of the Mideast. At the urging of the Recording Industry Association of America (RIAA), the U.S. Trade Representative threatened to impose sanctions. Singapore officials cracked down. By 1989 bootlegging accounted for less than 5% of music sales, while revenues from legitimate recordings soared to $465 million. Explains RIAA attorney Neil Turkewitz: ''Singapore was really nervous about losing its export trade to the U.S.'' Singapore was a headache for Hollywood as well, with a market for U.S. movies of about $9 million a year. Morgan and his men could not figure out how pirates consistently managed to flood the streets with top-quality copies of first-run films the instant they were released locally. Then an investigator realized that the pirated videos had been edited to conform with Singapore's decency laws. His conclusion: The country's board of film censors was obligingly reviewing and approving bootleg tapes. A local judge ordered the practice stopped, and the thieves' share of the videotape market plunged from 100% to 10%. Pirates often have close ties with government officials. Scandal broke out in Indonesia in 1985 when counterfeit audiocassettes of Madonna's Like a Virgin and other hit albums were discovered in a diplomatic pouch bound for the consulate in New York. The tapes were samples for crooked U.S. merchants interested in importing Jakarta's wares. The samples came along with a fat catalogue listing hundreds of titles. Among its offerings: a counterfeit of the album We Are the World, which in its legitimate version was a nonprofit venture meant to raise money for famine victims in Ethiopia. The scam was revealed when a diplomat pitched the tapes in New York to Kenneth Giel, a former FBI man hired by the RIAA to pose as a record distributor. As details of Indonesian music piracy emerged, U.S. record makers were astounded by its scale. Audiocassettes, most of them fake, accounted for $13 million of the country's exports. Recalls Joel Schoenfeld, then RIAA's top lawyer and today a senior vice president of BMG: ''The government was making a profit by charging export duty on counterfeit cassettes.'' Public outcry over the theft of We Are the World and the threat of trade sanctions finally forced Indonesia to discourage its bootleggers. Illegal copies now account for less than one-fifth of record-industry sales in Indonesia. But the war on copycats there is scarcely over. The movie industry is trying to persuade the Jakarta government to stamp out a $20-million-a-year market in stolen films.

In Thailand piracy is booming. Miles of tawdry Bangkok shops are packed to the rafters with cheap copies of Janet Jackson audiocassettes, Kindergarten Cop videotapes, and pirated computer software. Says William Nix, head of the MPAA's antipiracy division: ''Illegal copies of most movies are available in Thailand ten days after they are released in the U.S.'' Record makers estimate their annual sales losses in Thailand at $50 million, and film companies put theirs at $20 million. In the past year the pirates have waged a terror campaign against investigators from U.S. companies. Death threats, daylight ; assaults, and a bombing have blunted crackdown efforts. After receiving four bullets in the mail last spring, a Thai investigator for the U.S. record industry fled the country. The RIAA sought help in Thai courts -- to no avail. Complains Morgan: ''We hired Thailand's most prestigious copyright lawyers, and prepared as if we were in court in New York. But we lost every case on outrageous technicalities.'' Between 1987 and 1990 MCA filed 14 suits against copycats and lost every one. Last November the film and music industry associations finally made a formal complaint to the U.S. Trade Representative, based on what Valenti calls Thailand's ''flagrant refusal to protect U.S. intellectual property.'' The agency is investigating the case. -- PHARMACEUTICALS. Introducing a new medicine in America typically takes 12 years and costs more than $200 million, according to the Pharmaceutical Manufacturers Association. Drug companies applying for U.S. patents must publicly disclose their formulas in the process. That makes copying the drugs and selling them abroad easy, fast, and cheap. In many developing nations, where patent laws don't even apply to drugs, copycat versions often beat the U.S. original to market. Pfizer, the $6.4- billion-a-year New York giant, recently saw that happen in Argentina and Brazil to two important new products: Unasyn, an antibiotic, and Diflucan, an antifungal medicine. Even when Pfizer got there first, pirates quickly seized market share. In 1981, for example, Feldene, its new drug for arthritis, accounted for $4 million of sales in Brazil. But by 1986 eight knockoffs grabbed more than half the market. Drug piracy isn't confined to the developing nations. Pfizer attorney Traci Medford-Rosow says the worst offender is Spain: ''Unlike Third World countries, Spain has the technology to copy our drugs. And to make matters worse, the Spanish export to much of the world that has no patent protection.'' As is true in many countries, the best defense for intellectual- property thieves in Spain is the legal system. Drug counterfeiters, says Medford-Rosow, ''just laugh when we call, and admit to using our processes. They know it will take us ten years to drag them through the courts. Even if they wind up having to pay us $50 million, they are still better off because they will make $500 million.'' Pfizer Chairman Edmund T. Pratt Jr. estimates that the company's battles to defend its patents have cost well over $100 million in the past ten years. Has the money been well spent? Pratt is philosophical: ''If we added it all up, we don't get our money back in settlements, but we do get an intangible value. Word gets around: Don't tangle with Pfizer.'' -- COMPUTER SOFTWARE. For IBM and Texas Instruments, asserting their intellectual property rights has added hundreds of millions of dollars to the bottom line. In the past decade IBM has collected huge settlements from its top Japanese rivals, Hitachi and Fujitsu, after accusing them of pirating crucial software for mainframes. Meanwhile, Texas Instruments has squeezed nearly $700 million in damages and royalties from nine Japanese and Korean firms that infringed on patents for semiconductor memory chips. Its success has changed the way many corporations view intellectual property law, says New York patent attorney Larry Scinto, whose firm has represented IBM: ''The law used to be looked at from a defensive point of view. Now it is a way to increase profits.'' The battle against international pirates is far from won, particularly for makers of easy-to-replicate personal computer software. Even though demand is strong, with markets for personal computers in Europe and Asia growing in excess of 30% per year, software makers still have to get paid in order to succeed. Says Jim Manzi, chairman of the $1.7-billion-a-year Lotus Development Corp.: ''We spend $100 million a year on creating new software. We can't just give our stuff away!'' Novell Inc., the leading maker of software that links personal computers in networks, began marketing its products overseas eight years ago. A pirate it nabbed recently was a Madrid firm that had bought one copy of Novell's $3,000 NetWare program, translated the commands into Spanish, and marketed copies of the program under a different name. Novell dragged the thief into court and won; damages have yet to be set. In 1988, Lotus, Microsoft, and four other software companies formed the Business Software Alliance to fight piracy abroad. Software makers often find themselves in the awkward position of policing their own customers. Montedison, for example, acquired its initial copies of Lotus 1-2-3 by paying the retail price of $1,000 for a floppy disk and a manual. The alleged piracy occurred when employees copied the program onto the hard disks of scores of machines. How much longer will U.S. companies have to spend millions of dollars protecting their ideas? As long as it takes international competitors to learn to respect this form of property. Says Gloria Messinger, managing director of the music publishing association ASCAP: ''People just don't want to pay for intellectual property. They think we have a racket going when we tell them they must pay for the use of others' ideas.'' Erasing that perception, through busts, diplomacy, or trade retaliation, is the only way to stop piracy -- permanently.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: THE HIGH PRICE OF PIRACY