March 08, 2013 Articles

Calculating Defendants' Profits

Exploring different approaches to this inexact science.

By Juli Saitz

There are a several remedies available to a successful plaintiff in a trademark infringement action. The Lanham Act, which governs trademark cases in federal court, allows a plaintiff to seek either injunctive relief or monetary relief in the form of (1) defendant's profits, (2) any damages sustained by the plaintiff, and (3) the costs of the action.

This article focuses on the calculation of the defendant's profits. On its face, this seems like a straightforward calculation—defendant's revenues less its costs. Courts have often ruled that costs with a "sufficient nexus" to the product or products at issue may be included in the calculation of profits. However, there is no accounting literature or term that defines these costs, and this leaves substantial room for judgment and disagreement between the parties and the courts. Some courts look at costs on a variable basis, the "incremental approach" in which only direct costs of production are deducted, while others adopt the "full absorption approach," which provides for an allocation of overhead on a fixed and fully loaded basis. Other courts fall somewhere in between. The different approaches to allowable cost deductions, as well as the concepts and methodologies used by experts to determine "nexus," are addressed here.

Profits in the United States
Generally speaking, profits in the United States can be defined as an entity's earnings calculated in accordance with General Accepted Accounting Principles (GAAP) by deducting all the costs of a business from its revenues. This definition encompasses what is commonly known as "net profit"—that is, what is left after the deduction of all variable and fixed expenses (including cost of goods sold, other variable operating expenses, fixed operating expenses, interest, and taxes). These categories can be broken down further and contain certain nuances that vary by company as to the fixed or variable nature of a particular expense item. The profits described herein are not what are typically referred to by the courts when discussing or awarding defendant's profits in a trademark infringement action. Surprisingly, defendant's profits, as understood by the United States courts, are not defined by GAAP. Rather, they represent various calculations of revenues less deductions as determined and allowed by a particular court.

Despite the lack of distinction as to the measure of damages, the general measures of profits and the calculation of each measure can be summarized as follows.

  • Gross profit is simply sales less the cost of goods sold. The cost of goods sold (COGS) is driven either by product purchases that are later resold, as in the case of a retailer, or the costs to manufacture products for sale to another company or end customer. Some companies include items such as shipping or freight expense required to move the product in their cost of goods sold category. COGS are purely variable (incremental) expenses in that they change in relation to sales. There is often a fixed portion of allocated manufacturing overhead contained in COGS, given the nature of cost accounting conventions.
  • Incremental profit is one step down on the income statement from gross profit. To calculate incremental profit, variable operating expenses are deducted from gross profit. Variable operating expenses are ones that move with a company's sales or production levels, and they include sales commissions, overtime, franchise fees, royalty payments, shipping, and freight expense. Some expenses can be fixed and variable in nature and can "step up" given a certain level of manufacturing or sales activity. Examples are higher utility costs after a manufacturing plant has reached a certain level of capacity or additional sales staff payroll expense after a new product launch. Many companies track what they call the "contribution margin" for a particular product or line of business. The contribution margin is essentially the same as incremental profit in that it is meant to capture expenses that are directly related to the sales or production of a product.
  • Operating profit, in addition to the variable in nature expenses discussed above, includes a company's fixed operating expenses. Fixed expenses do not change with a company's level of sales (absent certain step-up situations) and are largely general and administrative in nature, such as rent, salaries, office expense, utilities, and depreciation. The courts generally refer to such fixed expenses as overhead. Operating profit provides a picture of the company's operational performance for all product lines or services.
  • Net profit is simply operating profit less interest and taxes. This measure of profit is typically not used in the calculation of a defendant's profits, given the tax implications after an award is granted. Interest, however, may be included as an incremental income or expense item if the cash flow generated by infringing sales generated interest or if debt was incurred in financing the production and sale of infringing goods.

Profits under the Lanham Act and Case Law
The Lanham Act states, "In assessing profits, the plaintiff shall be required to prove defendant's sales only; defendant must prove all elements of cost or deduction claimed." 15 U.S.C. § 1117(a). Simply stated, a plaintiff is only required to prove the infringing sales at issue, and the burden then shifts to the defendant to provide all allowable deductions. In practice, many damage experts working on behalf of a plaintiff will also include their assessment of allowable deductions to arrive at the defendant's profit in an effort to present the court with its view of infringer's profits, should it differ from that of the defendant.

Assuming a court has decided to award infringer's profits, what measure of profit is awarded? The answer varies from court to court, rendering the calculation of infringer's profits uncertain and confusing to plaintiffs, defendants, and damage experts. Some of the cases discussed in this article are decisions from copyright infringement actions. Because the Copyright Act also allows for a recovery of profits of the infringer, courts look to such cases for guidance in trademark infringement actions.

Second Circuit. The Second Circuit has adopted the "full absorption approach." In Sheldon v. Metro-Goldwyn Pictures Corp., 106 F.2d 45 (2d Cir. 1939), aff'd, 309 U.S. 390 (1940), the court ruled that the defendants could be credited with only "such factors as they bought and paid for; the actors, the scenery, the producers, the directors and the general overhead." Id. at 54. The court further held that overhead not assisting in the production of infringing goods should not be deducted from revenues in determining profits; "that which does, should be." Id.

The "sufficient nexus" standard was discussed in Manhattan Industries v. Sweater Bee by Banff, Ltd., 885 F.2d 1 (2d Cir. 1989). In this case, the court ruled that the defendant must "prove not only that it has borne the particular cost or expense but also that the cost or expense is attributable to its unlawful sales." Although the defendant was not required to prove the relationship of overhead expenses to the production of infringing goods in "minute detail," it "still must carry its burden of demonstrating a sufficient nexus between each expense claimed and the sales of the unlawful goods." Id. at 7. Similarly, in Hamil America Inc. v. GFI, 193 F.3d 92 (2d. Cir. 1999), the appellate court disagreed with the district court's exclusion of all overhead deductions by the defendant and ruled in favor of a recalculation of profits with the stipulation that "it must demonstrate a direct and valid nexus between each claimed overhead expense category and the production of GFI Pattern No. 330 and propose a fair and acceptable formula for allocating a portion of overhead to the pattern's production." Id. at 104–7.

Fifth Circuit. The Fifth Circuit approaches the question of the deductibility of overhead expenses by taking into account the extent to which infringing sales likely increase such expenses. In Maltina Corp. v. Cawy Bottling Co., 613 F.2d 582 (5th Cir. 1980), the court noted that "a proportionate share of overhead is not deductible when the sales of an infringing product constitute only a small percentage of total sales." Id.. at 586. Notably, the infringing sales constituted just over 6 percent of total sales, which leaves a party wondering what is deemed a "small percentage" of total sales.

Seventh Circuit. The Seventh Circuit, on the other hand, favors the "incremental approach" in which fixed costs occurring in the normal course of business that do not fluctuate with the production of infringing goods are not to be deducted from profits. See Ruolo v. Russ Berrie & Co., 886 F.2d 931, 941 (7th Cir. 1989) (Defendant's expert witness "improperly deducted certain administrative expenses without demonstrating they were variable costs. Fixed costs are not deducted from the profit calculation."); Taylor v. Meirick, 712 F.2d 1112, 1121 (7th Cir. 1983) ("Costs that would be incurred anyway should not be subtracted, because by definition they cannot be avoided by curtailing the profit-making activity.").

Ninth Circuit. Similar to the Second Circuit, the Ninth Circuit has adopted a "full absorption approach." In Kamar International, Inc. v. Russ Berrie & Co., 752 F.2d 1326 (9th Cir. 1984), the defendant's controller testified that total overhead consisted of five distinct categories, two of which had no relation to the infringing goods at issue. The court ruled that overhead could still be deducted, so long as each category could be proved to have "actually contributed to the production, distribution or sales of infringing goods." Id. at 1332. The Ninth Circuit Model Civil Jury Instructions give guidance for calculating defendants' profits in trademark infringement matters: "Expenses are all [operating] [overhead] and production costs incurred in producing the gross revenue." Ninth Circuit Model Civil Jury Instructions 15.26 (2008).

Nexus Requirements
Despite the disagreement among the circuits as to the deductibility of indirect costs or overhead, one theme emerges—deductible costs should have some connection or nexus to the production and sale of the infringing products. The question left to trademark owners, infringers, and their advisors is what constitutes "sufficient nexus"? In looking at whether an expense is properly deductible, it is helpful to ask certain questions.

First, does the expense change in relation to sales? If so, the cost is variable and directly related to the infringing sales, and such costs would be deductible under either the full absorption or incremental approach.

Second, is the cost directly related to the production, sale, or both the production and sale of the infringing goods? These costs are likely to be of a semi-variable or fixed nature, for example, a national print advertisement featuring the infringing product. Such an advertisement may be part of the defendant's normal annual advertising budget, the costs of which would not change whether the infringing products were featured or not. Under the incremental approach, a deduction for these advertising costs would not be permissible. Under the full absorption approach, this expense likely would be up for discussion as an acceptable deduction, assuming the defendant could provide records to satisfy the court.

Next, is the cost indirectly related to the infringing sales? Indirect expenses or overhead items pose the most ambiguity as to their deductible nature (and need not be considered under the incremental approach). For example, are payroll expenses for employees in a retail store where infringing goods are sold properly deductible? What about warehouse rent? Expenses incurred by the accounting department related to the collection of revenue for infringing sales? Trademark owners may argue that such expenses are too far removed from the sale of infringing goods and thus should not be deducted. Further, such costs would be incurred by the infringers in the normal course of business whether producing infringing goods or not; thus, a proportional deduction of such general costs is inequitable. Defendants, on the other hand, will argue that all costs incurred in the normal course of business are necessary to generate the revenues realized by that business and to disallow proportional overhead deductions would result in a windfall to the plaintiff.

Experience and guidance from several district court decisions lead to the conclusion that the most reasoned approach is to review all expense items line by line to determine the connection, if any, to infringing sales. Inquiries of management and the compilation of supporting documentation offer more persuasive evidence of a nexus than a general allocation of overhead.

Questions to ask may include the following: Did the company added head count with the launch of the infringing products? Where are the records verifying this information? Did existing employees switch focus from non-infringing to infringing products? Did these employees maintain time sheets? What about warehouse rent—were the infringing goods stored in the company's facilities or were they shipped directly from the manufacturer to a retail outlet?

The answers to these types of questions can provide a basis for determining the connection of the claimed costs to infringing sales. However, the sufficiency of this nexus is in the hands of the court. For example, in Fendi Adele S.R.L. v. Burlington Coat Factory Warehouse Corp., 642 F. Supp. 2d 276 (S.D.N.Y. Apr. 27, 2009), the magistrate judge accepted the "full absorption method" but disallowed the deduction of "store expenses," stating that the defendant's support for such a deduction was "plainly inadequate." Id. at 292. The judge went on to elaborate that "[b]y not describing the categories it mentions beyond a one- or two-word label, Burlington makes it impossible for the court—even if we disregarded the defendant's burden of proof—to determine the nature of the linkage of the cost category to the sales of Fendi goods." Id. at 293. (The magistrate judge's Report and Recommendation was later affirmed by the court. See Fendi Adele S.R.L. v. Burlington Coat Factory Warehouse Corp., 642 F. Supp. 2d 276, 279 (S.D.N.Y. Aug. 10, 2009).)

In the recent case of Gucci America, Inc. v. Guess?, Inc., 868 F. Supp. 2d 207 (S.D.N.Y. May 21, 2012), experts on both sides proffered opinions on the defendants' profits. Both experts performed a nexus analysis, but the method offered by Gucci's expert was accepted while that of the defendants was rejected. (Another expert served on behalf of defendant Marc Fisher Footwear LLC (MFF). There was little controversy between the findings of Gucci's expert and MFF's expert, which are not discussed here.) The court noted that "[the plaintiff's expert] reached this profit figure by deducting costs that he could determine had a close nexus to the design, manufacture, and sale of products using the data available to him." Id. at 53. With respect to the defendants' expert, the court found "[the defendants' expert's] nexus analysis was cursory, and not explained in a satisfactory manner. I find that [the defendants' expert] did no real nexus analysis, but simply decided to deduct all company costs…" Id. at 54. For the purposes of full disclosure, FTI provided the expert witness damage testimony on behalf of the plaintiff in this case.

Conclusion
The measure of defendants' profits varies by jurisdiction. The calculation of such profits is an inexact science, and the inclusion or exclusion of particular overhead items is inherently subjective. However, regardless of the venue, it behooves defendants to provide documentation and a credible rationale for the inclusion of overhead items in the calculation of profits.

Keywords: litigation, intellectual property, Lanham Act, expert witness, gross profit, incremental profit, operating profit, net profit, incremental approach, full absorption approach

Juli Saitz – March 8, 2013


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