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December 14, 2021 Practice Points

Accounting of Defendant’s Profits Under the Defend Trade Secrets Act

This Practice Point focuses on accounting considerations relevant to unjust enrichment damages.

By Kevin Arst

Several measures of monetary relief are potentially available for trade secret misappropriation under the Defend Trade Secrets Act, 18 U.S.C. § 1836(b)(3)(B), including (1) damages for actual loss, (2) damages for any unjust enrichment, or (3) a reasonable royalty. This Practice Point focuses on accounting considerations relevant to unjust enrichment damages. Exemplary discovery requests are also provided below to assist counsel in requesting accounting records that may be helpful in establishing unjust enrichment damages.

Unjust enrichment damages in trade secret misappropriation disputes traditionally seek the disgorgement of profits realized by the defendant on sales made under the trade secret. From an accounting perspective, profits can be calculated by deducting expenses from revenue. However, as illustrated in the exemplary income statement below, several different measures of profits can be calculated depending on the nature of deducted expenses:

Revenue $1,000,000
Cost of Goods Sold
($300,000)
Gross Profit
$700,000
Incremental Operating Expenses
($100,000)
Incremental Profit $600,000
Other Operating Expenses
($400,000)
Operating Profit $200,000
Interest and Tax Expenses
($50,000)
Net Profit
$150,000

Revenue represents the dollar amount of sales generated by the business on the sale of its products or services. Cost of Goods Sold is typically comprised of the direct materials, direct labor, and manufacturing overhead that is directly attributable to the production of goods or services from which the business realized revenue in the accounting period. Gross Profit can be calculated as Revenues less Cost of Goods Sold. Below the Gross Profit line, the company may incur other Incremental Operating Expenses that are directly attributable to the sale of its products or services. For example, sales commissions may represent incremental operating expenses that would be expected to increase as revenues increase. Incremental Profit can be calculated as Gross Profit less Incremental Operating Expenses. Below the Incremental Profit line, the company may incur Other Operating Expenses that are not directly attributable to the sale of a specific product or service, but rather relate to general corporate expenses like rent and management salaries. Operating Profit can be calculated as Incremental Profit less Other Operating Expenses. Below Operating Profit, the company may incur Interest and Tax Expenses, the deduction of which yields Net Profit.

As described in Restatement 3d of Unfair Competition, section 45, the plaintiff typically bears the burden of establishing the revenue realized by the defendant under the misappropriated trade secrets. The defendant has the burden of establishing any expenses to be deducted against the accused revenue in the determination of its profits.

From a practical standpoint, it is comparatively easier for the plaintiff to meet its burden than the defendant. Indeed, the disgorgement of profits is an equitable measure of relief, and courts frequently exercise discretion about the nature and amount of expenses that are properly deductible. That said, courts generally allow the deduction of at least direct costs and incremental expenses incurred by the defendant that are attributable to the sale of articles made under the misappropriated trade secrets. In parallel, courts have, at times, declined to deduct general administrative and overhead expenses absent a showing by the defendant of the portion of such expenses that increased due to the production and sale of products subject to the accounting. See, e.g., USM Corp. v. Marson Fastener Corp., 392 Mass. 334, 467 N.E.2d 1271 (1984)).

Accordingly, the determination of the defendant’s deductible expenses and resultant profits is a fact-intensive exercise, and disputes can arise about the nature, the causality, and ultimately the deductibility of expenses claimed by the defendant. Counsel representing clients seeking or subject to profit disgorgement damages may wish to consider requesting the production of detailed accounting records to facilitate an investigation into the defendant’s profits, as follows:

  • Profit and loss statements, schedules, workpapers, reports, and any other documents which identify the direct and indirect costs associated with the defendant’s manufacture, sale, and distribution of products made or services provided under the alleged misappropriated trade secrets.
  • Documents relating to accounting methods relied upon by the defendant in generating financial statements.
  • Documents that detail, discuss, describe, or relate to all overhead accounts used by the defendant to collect costs, their allocation rates, and their allocation bases.
  • Documents that analyze or study fixed or variable expenses for any manufacturing, selling, or distribution of the defendant’s products or services.

Kevin Arst is a senior managing director with Ankura Consulting Group, LLC, in Ann Arbor, Michigan.

Ankura is the Litigation Advisory Services Sponsor of the ABA Litigation Section. This article should not be construed as an endorsement by the ABA or ABA Entities. The views expressed herein are those of the author and not necessarily the views of Ankura Consulting Group, LLC, its management, its subsidiaries, its affiliates, or its other professionals. Ankura is not a law firm and cannot provide legal advice.

 

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