March 16, 2021 Practice Points

Tips for Leveraging the Cost Approach When Quantifying Damages in Trade Secret Litigation

This method can inform the determination of a defendant’s unjust enrichment and serve as a starting point for determining a reasonable royalty.

By Jim Pampinella and Chris Schulte

The cost approach is a method of calculating damages in trade secret litigation. This framework is based on the premise that, when negotiating intellectual property rights, rational negotiators will consider the cost of acceptable alternatives to an intellectual property license.

With respect to trade secret litigation, the cost approach can inform the determination of a defendant’s unjust enrichment. The cost approach can also serve as a starting point for determining a reasonable royalty when neither the plaintiff’s actual loss, nor the defendant’s unjust enrichment are “provable.” See, e.g., Ajaxo Inc. v. E*Trade Fin. Corp., 187 Cal. App. 4th 1295 (Cal. Ct. App. 2010); The Defend Trade Secrets Act of 2016, Pub. L. 114-153 (2016).

While both the plaintiff and defendant in trade secret litigation may point to their research and development (R&D) investments as the value of the subject trade secrets or the efforts deployed to avoid their misappropriation, this historical approach can be subject to challenge. An additional challenge for the R&D cost argument is that companies may not diligently track R&D expenditures. Moreover, it can be difficult to compartmentalize R&D efforts into discrete categories after the fact. As such, a generally accepted application of the cost approach focuses on quantifying the incremental development costs and risks that the defendant would have incurred to develop an alternative product without access to the subject trade secrets.

Courts have measured such incremental development cost by reference to the “Standard of Comparison Method,” which “contemplates the comparison of the cost of [obtaining a result] by means of the use of the trade secret with a method of accomplishing the same result which would have been open to defendant had he not appropriated the trade secret.” Int’l Indus.s, Inc. v. Warren Petroleum Corp., 248 F.2d 696 (3d Cir. 1957). The defendant’s incremental cost in the absence of the alleged misappropriation could include incremental development expenses, incremental operating expenses, and forgone profits from delayed market entry. These incremental costs can also be used as a starting point for determining a reasonable royalty, and then adjusted for factors prescribed in patent damages case law related to the “hypothetical negotiation.”

Notably, this hypothetical negotiation construct is a theoretical exercise. And this exercise can be confusing and difficult for a jury to follow, particularly in the context of analyzing damages in trade secret matters. In addition to the fact that “licensing a trade secret” is counterintuitive, given the proprietary and confidential nature of the subject matter, the invocation of the Georgia-Pacific factors may invite unnecessary subjectivity into an already complex damages construct.

Tips for using the cost approach to measure a defendant’s unjust enrichment and/or assist in the assessment of a reasonable royalty in trade secret litigation include:

  • Be mindful of alternative technologies that could satisfy customer demand. The cost of developing an acceptable alternative in the absence of the alleged wrongful conduct can serve as the basis for an unjust enrichment claim or a starting point for calculating a reasonable royalty.
  • To the extent that the defendant’s market entry and alleged wrongful sales would have been delayed in the absence of the alleged misappropriation, the profits forgone by the defendant during that longer development period could represent an incremental cost of deploying the alternative.
  • In multi-trade secret matters, consider the extent to which the value proposition and development of individual or similar trade secrets can be isolated. This may help focus fact discovery efforts and allow for modified damages calculations if one or more of the trade secrets are dropped from the case.
  • Consider the extent to which financial and employee time records can (or should) track employee time and development expenses by project, product, or feature.
  • Consider early interaction among counsel, fact witnesses, and expert (technical, marketing and economic) witnesses relevant to the cost approach analysis.  Among other benefits, this interaction can help ensure the timely production of engineering data, time records, material cost data, and other financial records necessary to analyze the cost approach and prove unjust enrichment.

Jim Pampinella is a senior managing director with Ankura Consulting Group, LLC, in San Francisco, California. Chris Schulte is a managing director with the Ankura in Ann Arbor, Michigan. Ankura is not a law firm and cannot provide legal advice.

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.

 


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