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April 18, 2012 Articles

The Broad Spectrum of Trade Secret Damages

The wide variety of economic facts and circumstances encountered in trade secret cases leads to the need for flexibility in the calculation of damages.

By Glenn Perdue

Compensatory damages for the infringement of intellectual property (IP) may be based on the actual damage suffered by a claimant, a reasonable royalty, the unjust enrichment of an infringer, or some form of statutory damage, depending on the type of IP being infringed. For instance, damages for the infringement of a utility patent are based on the claimant's actual damages (typically measured as lost profits) or a reasonable royalty. However, in cases of trade secret misappropriation, all forms of IP damage remedies may be available, other than statutory damages, which are only available under certain circumstances in trademark and copyright infringement matters.

Unlike patents, trademarks, and copyrights, which are disclosed and substantially governed by federal law, trade secrets are governed by state law and rely on some level of nondisclosure to maintain their status as a trade secret. Indeed, the economic value of a trade secret stems partially from its secrecy. Generally speaking, a trade secret provides economic value to its owner by providing some sort of proprietary competitive advantage.

The Uniform Trade Secrets Act
According to the Uniform Law Commission, the Uniform Trade Secrets Act (UTSA) has been enacted by 45 states, Puerto Rico, and the Virgin Islands, and adoption legislation is pending in Massachusetts and New Jersey. That leaves New York, Texas, and North Carolina as the only states that had not enacted—or were not actively attempting to enact—the UTSA at the time of this writing. Uniform Law Commission, Trade Secrets Act (accessed Dec. 16, 2011). However, even in states that have not enacted the UTSA, existing laws may, in many ways, be similar to the UTSA with respect to defining a trade secret and with respect to damage provisions. See, for instance, the North Carolina Trade Secrets Protection Act, which provides for "actual damages" or "unjust enrichment." For these reasons, the following discussion will be based primarily on the UTSA (as amended in 1985).

Section 1 of the UTSA defines a trade secret as follows:

[I]nformation, including a formula, pattern, compilation, program, device, method, technique, or process, that:

(i) derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable by proper means by, other persons who can obtain economic value from its disclosure or use, and

(ii) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.

This definition illustrates the linkages between secrecy and economic value that must be present for a trade secret to exist.

Section 2 of the UTSA addresses the issue of injunctive relief. Subsection 2(b) states:

[A]n injunction may condition future use upon payment of a reasonable royalty for no longer than the period of time for which use could have been prohibited.

UTSA § 2(b) (emphasis added).

Section 3 of the UTSA addresses the issue of damages. Subsection 3(a) states:

Damages can include both the actual loss caused by misappropriation and the unjust enrichment caused by misappropriation that is not taken into account in computing actual loss. In lieu of damages measured by any other methods, the damages caused by misappropriation may be measured by imposition of liability for a reasonable royalty for a misappropriator's unauthorized disclosure or use of a trade secret.

UTSA § 3(a) (emphasis added).

Trade secret damage recoveries based on actual loss, unjust enrichment, or a reasonable royalty are limited to the period of time during which trade secret status is deemed effective. The comments following section 3 describe that period of time as follows:

Like injunctive relief, a monetary recovery for trade secret misappropriation is appropriate only for the period in which information is entitled to protection as a trade secret, plus the additional period, if any, in which a misappropriator retains an advantage over good faith competitors because of misappropriation. Actual damage to a complainant and unjust benefit to a misappropriator are caused by misappropriation during this time alone. A claim for actual damages and net profits can be combined with a claim for injunctive relief, but, if both claims are granted, the injunctive relief ordinarily will preclude a monetary award for a period in which the injunction is effective.

UTSA § 3 cmt. (citations omitted).

Actual Loss
Consistent with the concept of recovering an "actual loss," an injured party may seek its lost profits due to the misappropriation of its trade secrets. It makes economic sense that this method of recovery is available because it is conceptually straightforward and often the most apparent means of making an injured party whole.

Damage theory related to lost profits is highly evolved in the United States, particularly in the area of IP damages. Lost profits are typically based upon the plaintiff's lost "net profits" or "incremental profits" as generally measured at the operating profit level. If lost profits resulted from lost revenues, incremental costs related to these revenues are deducted. These are generally costs that would have been incurred if the lost revenues had been realized by the plaintiff. Put another way, these are the "costs saved" by the plaintiff as a result of not generating the lost revenues. While the philosophical basis of lost profits may be straightforward, the legal and economic concepts to be considered in calculating lost profits can be esoteric and complex.

A plaintiff may experience actual damages due to lost revenues, increased costs, or both, resulting from a defendant's misappropriation. Lost revenues may result from lost sales of the protected product or service, lost sales of complementary products and services (convoyed sales), and price erosion resulting from the misappropriator's entry into the market with a competitive good or service.

While prominent, lost profits are not the only measure of actual loss a plaintiff may use to calculate trade secret damages. Courts have accepted calculations of actual loss based on the investment value of the trade secret and the loss of business value resulting from the misappropriation. See, e.g., Cardiovention, Inc. v. Medtronic, Inc., 483 F. Supp. 2d 830, 846 (D. Minn. 2007).

Of course, whether an actual loss is being claimed due to the misappropriation of a trade secret or some other wrongful conduct, a plaintiff must still show how the damages being claimed were caused by the wrongful conduct. Recovery will not be successful unless this linkage is sufficiently demonstrated. See Robert L. Dunn, Recovery of Damages for Lost Profits § 1.1 (6th ed.) (The Proximate Cause Rule).

Unjust Enrichment
Under the premise that a defendant was unjustly enriched due to misappropriation, a plaintiff may seek the defendant's wrongfully gained net profits as a remedy to the extent that such profits do not result from sales considered in the calculation of the actual loss. With sufficient support, wrongfully gained sales can also include sales of related products and services (convoyed sales).

Under federal statute, when the defendant's profits are being sought as damages in trademark and copyright infringement matters, the plaintiff is responsible for identifying revenues only, while the defendant is responsible for identifying deductions for costs and factors unrelated to the infringement. See 15 U.S.C. § 1117(a)(3) for trademark damages and 17 U.S.C. § 504(b) for copyright damages. While there is no such provision for the splitting of these calculation duties under the UTSA, certain courts have endorsed this type of approach. For instance, citing the federal Copyright Act, a Massachusetts appeals court provided the following guidance in a case in which the defendant's unjust gains were the sole source of damages being sought by the plaintiff:

Once a plaintiff demonstrates that a defendant made a profit from the sale of products produced by improper use of a trade secret, the burden shifts to the defendant to demonstrate those costs properly to be offset against its profit and the portion of its profit attributable to factors other than the trade secret.

USM Corp. v. Marson Fastener Corp., 392 Mass. 334 (Mass. App. Ct. 1984).

Speaking further to the basis for seeking a defendant's profits as an appropriate measure of trade secret damages, this opinion states, "The guiding principle is to order the wrongdoing defendant to give up all gain attributable to the misuse of the trade secret and to measure that gain as accurately as possible."

As discussed in the previous section, lost "incremental" operating profits—as derived after the deduction of incremental costs—are a broadly accepted measure of lost profits in calculating the plaintiff's actual loss. However, when calculating the defendant's gained profits, there is less consensus about the means by which deductible costs should be determined. Generally speaking, for purposes of calculating a defendant's profits, deductible costs may be based on one of the following:

Incremental Costs. Variable costs are incremental, but certain semi-variable or "step" costs may also be incremental depending on volume levels.

Direct Assistance Costs. This view of costs generally considers variable costs and overhead costs related directly to the product, product group, or business unit relevant to the analysis. Direct overhead costs may be deducted using an allocation method based on accused revenues, units, or some other measure.

Fully Allocated Costs. This approach considers costs on a fully allocated or "fully absorbed" basis. Therefore, in addition to the variable and direct overhead expenses considered under direct assistance costs, this approach may also consider indirect overhead, such as corporate office expenses, also on an allocated basis.

To summarize, variable costs, semi-variable costs, direct overhead, and indirect overhead may all be relevant cost considerations in determining the defendant's profits as a measure of its unjust enrichment.

However, the defendant's gained profits may not be the only measure of its ill-gotten gains. The economic value of trade secrets to the misappropriator at the time of misappropriation could also be an appropriate measure of the defendant's unjust enrichment. This concept is discussed more fully in the following section.

Reasonable Royalty
A reasonable royalty represents compensation for the use of IP that a willing licensor and willing licensee would have negotiated in an arm's-length setting prior to infringement or misappropriation. A plaintiff can opt to be compensated for misappropriation by imposition of a reasonable royalty "in lieu of damages measured by any other methods," as stated in subsection 3(a) of the UTSA.

In one regard, a reasonable royalty represents a form of actual loss to a plaintiff (licensor) under the premise that, had the misappropriator (licensee) negotiated a license instead of misappropriating, the plaintiff would have generated additional revenues and profits from the license. In another regard, a reasonable royalty represents the component of economic value wrongfully obtained by the misappropriator, thus also representing a form of unjust enrichment. The Fifth Circuit echoed this sentiment in discussing the determination of trade secret damages in University Computing Co. v. Lykes-Youngstown Corp.:

Because the primary concern in most cases is to measure the value to the defendant of what he actually obtained from the plaintiff, the proper measure is to calculate what the parties would have agreed to as a fair price for licensing the defendant to put the trade secret to the use the defendant intended at the time the misappropriation took place.

504 F.2d 518 (5th Cir. 1974).

In this 1974 opinion, the Fifth Circuit delineated a list of factors it considered relevant in the assessment of a reasonable royalty:

In calculating what a fair licensing price would have been had the parties agreed, the trier of fact should consider such factors as the resulting and foreseeable changes in the parties' competitive posture; the prices past purchasers or licensees may have paid; the total value of the secret to the plaintiff, including the plaintiff's development costs and the importance of the secret to the plaintiff's business; the nature and extent of the use the defendant intended for the secret; and finally whatever other unique factors in the particular case which might have affected the parties' agreement, such as the ready availability of alternative processes.

Of course, in its 1971 opinion, the court in Georgia-Pacific delineated its list of 15 factors that remain core considerations to the determination of a reasonable royalty in patent (and non-patent) cases today. See Georgia-Pacific Corp., v. United States Plywood Corp., 318 F. Supp. 1116 (S.D.N.Y. 1970) aff'd, 446 F.2d 225 (1971). In fact, the Iyer and Hansen articles discuss the CAFC's recent Uniloc decision, which spoke directly to the proper interpretation and use of certain Georgia-Pacific factors.

Other Damage Provisions
Under subsection 3(b) of the UTSA, exemplary damages of up to two times the amount of compensatory damages awarded under subsection 3(a) may be awarded "if willful and malicious misappropriation exists." In addition, the court may award reasonable attorney fees to a prevailing party under section 4 of the UTSA, based on certain conditions.

Case Examples
By their nature, trade secrets often relate to methods of production, software, and proprietary customer information.

USM Corp. v. Marson Fastener Corp., 392 Mass. 334 (Mass. App. Ct. 1984), was a 1984 Massachusetts trade secrets case involving methods and systems for manufacturing "blind rivets" that were misappropriated by Marson from USM, the trade secret owner. While the production improvement provided by the USM trade secret was characterized by Marson as "minor," the court found as follows:

The fact that use of the trade secret was the sole reason for the defendants' profitability makes it appropriate to measure USM's recovery by consideration of the defendants' profits from the manufacture and sale of blind rivets and inappropriate to consider only the value, or cost saving, to the defendants arising from the use of the trade secret.

The court thus articulated the causal relationship that it found between the defendant's use of the trade secret and resulting profits from the sale of blind rivets as its basis for concluding that Marson was unjustly enriched by the amount of these profits. The court found deductions for incremental costs used in the calculation of Marson's profits to be acceptable.

In the case of business software maintained as a trade secret, actual damages might be presented as the lost profits arising from lost sales that the trade secret owner would have captured but for the misappropriation. Or, as in USM v. Marson, the unjust profits earned by the misappropriator might be deemed an appropriate basis of recovery. However, a court might also determine that a "fair licensing price" is an appropriate remedy, as did the court in University Computing Co. v. Lykes-Youngstown Corp., 504 F.2d 518 (5th Cir. 1974), which involved the misappropriation of COBOL-based computer source code for an inventory control system developed for retailers in the late 1960s.

When contemplating a reasonable royalty, the application of a running royalty to revenues or units sold may immediately come to mind. And in a setting where, for instance, the trade secret is a method of production that can be analogized to patented methods for which royalty rate information can be readily obtained, a running royalty might be appropriate and straightforward to apply. However, in University Computing, damages were ultimately based on a lump-sum royalty that was determined to be 2.5 times the cost incurred by the trade secret owner to produce the system.

Finally, a case that provides an example of trade secret damages arising from the misappropriation of proprietary customer information is Hamilton-Ryker v. Keymon, 2010 WL 323057 (Tenn. Ct. App. Jan. 28, 2010), a recent Tennessee Court of Appeals case. After being laid off, Tammy Keymon began competing with her previous employer by working directly for Verizon Communications, Inc., the client she previously served while at Hamilton-Ryker, providing shipping-related services for telephone directories produced for Verizon. While still employed by Hamilton-Ryker, Keymon calculated that the Verizon projects generated an average net profit of 32.9 percent.

Prior to her layoff, Keymon solidified her direct contracting arrangement with Hamilton-Ryker's client. She then emailed 56 documents from her Hamilton-Ryker email account to her personal email account. These documents were determined to be trade secrets of Hamilton-Ryker and were ultimately used in Keymon's direct contracting work on the Verizon account. The emailed information included Verizon production schedules, Verizon project profit and loss analysis, Verizon mail address listings in a label-ready format, and Hamilton-Ryker invoices related to the Verizon projects.

The case reached the trial court in March 2008. By that time, Keymon had billed approximately $1.45 million to her former employer's client. Hamilton-Ryker applied the 32.9 percent profitability rate to these billings in arriving at an actual damage amount of $477,178 which was doubled by the trial court as exemplary damages. This damage award was upheld on appeal.

Unique Facts and Circumstances
In University Computing, the Fifth Circuit provided the following insight regarding trade secret damages:

Our review of the case law leads us to the conclusion that every case requires a flexible and imaginative approach to the problem of damages. We agree with the Court of Appeals for the Sixth Circuit that "each case is controlled by its own peculiar facts and circumstances," and accordingly we believe that the cases reveal that most courts adjust the measure of damages to accord with the commercial setting of the injury, the likely future consequences of the misappropriation, and the nature and extent of the use the defendant put the trade secret to after misappropriation.

504 F.2d 518 (5th Cir. 1974) (citations omitted).

The broad spectrum of economic facts and circumstances encountered in trade secret cases leads to the need for flexibility in the calculation of damages. Fortunately, state legislatures and courts have responded to this need by supporting a similarly broad spectrum of damage approaches for use by plaintiffs and their experts in the calculation of trade secret damages.

Keywords: litigation, intellectual property, trade secret damages, Uniform Trade Secrets Act, damages provisions

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