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Proving a Reasonable Royalty for Trade-Secret Misappropriation

By Chip Brooker – October 22, 2012

 

As the proverbial catchall of intellectual property, trade secrets are nebulous by their very nature, protecting hazier forms of intellectual property, such as business methods; manufacturing processes and formulas; customer, supplier, and vendor information and lists; marketing information and strategies; and “know-how,” among other things. By contrast, patents, copyrights, and trademarks each protect a discrete form of intellectual property, enjoy the consistent application of federal statutory and common law, and unlike trade secrets, do not lose value when they are publicly disclosed. As a result, any attempt to calculate damages for trade-secret misappropriation comes with inherent difficulties and inconsistencies in the law from one jurisdiction to the next, despite the extensive adoption of the Uniform Trade Secrets Act.


With this background, each trade-secret-misappropriation case requires a flexible and imaginative approach to the problem of damages. Each case should be controlled by its own facts and circumstances. As a result, plaintiffs should adjust their damages theories to fit with the commercial setting of the injury, the future consequences of any misappropriation, and the nature and extent of the defendant’s use of the trade secret after misappropriation. In some cases, damages will be subject to exact measurement, either because the parties had previously agreed on a licensing rate or because an industry standard provides a clear measure. In other cases, damages will be easily calculable based on traditional damages theories, such as a plaintiff’s lost profits or a defendant’s unjust enrichment.


However, where the damages are uncertain, the plaintiff should be afforded every opportunity to prove damages once misappropriation is proven. In these cases, a plaintiff may consider pursuing a reasonable royalty for a defendant’s misappropriation, or at the very least, the plaintiff should employ a reasonable royalty measure to backstop more traditional damages theories, such as lost profits and unjust enrichment.


Reasonable Royalties for Trade Secrets Generally
In the context of damages for a reasonable royalty, trade secrets benefit greatly from the thorough development of a comparable analysis for patent infringement. Consequently, the reasonable-royalty analysis is well established in common law. Originally, courts employed the reasonable-royalty measure of damages to deal with the situation where the misappropriated trade secrets were used either to improve the defendant’s manufacturing process or as part of a larger manufactured product. This approach is consistent with comment (f) to section 45 of the Restatement of the Law of Unfair Competition, in which the American Law Institute noted that:


If the trade secret accounts for only a portion of the profits earned on the defendant’s sales, such as when the trade secret relates to a single component of a product marketable without the secret, an award to the plaintiff of defendant’s entire profit may be unjust. The royalty that the plaintiff and defendant would have agreed to for the use of the trade secret made by the defendant may be one measure of the approximate portion of the defendant’s profits attributable to the use.


In Egry Register Co. v. Standard Register Co., 23 F.2d 438 (6th Cir. 1928)—a seminal patent-infringement case utilizing a reasonable royalty— the defendant manufactured and sold cash registers that used, only in part, a device developed by the plaintiff to roll paper through the machine. However, the trial court awarded the plaintiff the total profits the defendant made on all sales of all machines using this component. On appeal, the U.S. Court of Appeals for the Sixth Circuit reversed and remanded, holding that this measure of damages was inequitable because the device was only a part of the larger product sold by the defendant.


Because it was impossible to determine what percentage of profits was attributable to the plaintiff’s component, the Sixth Circuit held that the proper measure of damages would be a reasonable royalty on the defendant’s sales, thereby creating a percentage of profits based on an approximation of the actual value of the infringed device to the defendant. The Sixth Circuit stated that “to adopt a reasonable royalty as the measure of damages is to adopt and interpret, as well as may be, the fiction that a license was to be granted at the time of beginning the infringement, and then to determine what the license price should have been.” Ultimately, in adopting a willing licensor-willing licensee standard, the court further clarified that, “in effect, the court assumes the existence ab initio of, and declares the equitable terms of, a supposititious license, and does this nunc pro tunc; it creates and applies retrospectively a compulsory license.”


Uniform Trade Secrets Act
Unlike patents, trademarks, and copyrights, whose protection is codified by federal statute and subject to the exclusive jurisdiction of federal courts, the laws of each state continue to govern trade-secret misappropriation. The Uniform Trade Secrets Act (UTSA) was initially drafted and published in 1979—and subsequently amended in 1985—in an attempt to codify and harmonize common-law principles that had developed from state to state concerning trade-secret misappropriation. Now, 47 states, the District of Columbia, and the U.S. Virgin Islands have formally enacted and adopted the UTSA in some form. Massachusetts, New York, and Texas remain the only states that have not adopted the UTSA. New York and Texas rely on their established common law alone and are guided by the Restatement (First) of Torts. Massachusetts, however, has adopted its own trade-secret statute, which represents a codification of its own common law.


Section 3(a) of the UTSA governs damages. When originally drafted in 1979, section 3(a) did not provide for the recovery of a reasonable royalty as a measure of damages for trade-secret misappropriation. Instead, initially, section 3(a) limited damages to “the actual loss caused by misappropriation” and the “unjust enrichment caused by misappropriation that is not taken into account in computing damages for actual loss.” Subsequently, in 1985, section 3(a) was amended to allow for damages as follows:


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.


Unfortunately, the UTSA has not necessarily accomplished its goal of uniformity, as the adopting states have codified various versions influenced by their own common law. Further, subsequent court opinions in each state have continued to modify and interpret the UTSA. Plus, the six-year delay in recognizing the legitimacy of a reasonable royalty as a measure of damages for trade-secret misappropriation has resulted in disparities between early adopters and later adopters of the UTSA. For example, as an early adopter of the UTSA, until recently, California would not allow a litigant to recover a reasonable royalty for trade-secret misappropriation. But see Ajaxo, Inc. v. E*Trade Financial Corp., 187 Cal. App. 4th 1295, 115 Cal. Rptr. 3d 168 (Cal. Ct. App. 2010) (allowing the recovery of a reasonable royalty where the plaintiff could not prove lost profits or unjust enrichment).


Calculating a Reasonable Royalty
As the reasonable-royalty measure of damages developed, courts often cited and quoted the Egry Register decision. Now, in practice, a reasonable royalty is usually reserved for situations when a plaintiff can prove neither lost profits nor unjust enrichment, which generally offer easier, more cost-efficient analyses. As the term is presently understood, a reasonable royalty is taken to mean more than simply a percentage of actual profits. Instead, the measure now attempts to approximate the actual value of what has been misappropriated. Because this is rarely subject to exact measurement, multiple methods have developed to determine a reasonable royalty, including (i) an established royalty, (ii) a fair-market-value approach, (iii) the Georgia-Pacific factors, (iv) an analytical approach, and (v) the 25 percent rule.


First, with regard to an established royalty, courts will refer to any other products that the plaintiff and the defendant have actually licensed in the past. With that historical context, the court will analyze the product at issue, its associated licensing agreements, and the parties’ prior licensing history to determine a range of reasonably acceptable royalty rates. Similarly, under the fair-market-value approach, where there is no prior licensing history between the parties, the court will consider the rates with which third parties in the industry have recently licensed other comparable technologies or products. Plaintiffs utilizing a fair-market-value approach must be careful to obtain credible, reliable, and relevant data and to consider only truly comparable transactions.


One of the most influential cases concerning the reasonable-royalty measure of damages is Georgia-Pacific Corp. v. United States Plywood Corp., 318 F.Supp. 1116, 1120 (S.D.N.Y. 1970). In Georgia-Pacific, a patent case whose analysis has been expanded to trade secrets, the Southern District of New York significantly expanded the willing-licensor-willing-licensee analysis. The Georgia-Pacific court noted that “[w]here a willing licensor and a willing licensee are negotiating for a royalty, the hypothetical negotiations would not occur in a vacuum of pure logic.” Instead, those negotiations would involve a “a market place confrontation of the parties”—the outcome of which would depend upon numerous factors, which include, among others, similar license agreements between the parties or in the industry, anticipated profits, the trade secret’s contribution to the product, the nature of the market, the parties’ competitive positions, and the development costs of the same or a similar trade secret.


Under Georgia-Pacific, this “hypothetical negotiation” is by its very nature speculative. Essentially, an expert is opining on what two unwilling parties would have agreed to be a fair price if they were willing to negotiate a deal. While each factor may not apply in each case, courts have indicated that an expert must at least consider every factor and make a decision to include or exclude each factor from his or her analysis. Obviously, proving as many factors as possible reduces the speculation inherent in this “hypothetical negotiation.”


Another method to calculate a reasonable royalty for trade-secret misappropriation includes an analytical approach that uses one of the following two formulas: (i) the defendant’s expected profit margin minus the industry’s profit margin or (ii) the defendant’s expected profit margin minus its normal profit margin. In these cases, courts generally base the reasonable-royalty award on the defendant’s own internal profit projections at the time misappropriation began for any product employing the trade secret. Essentially, this approach attempts to use the information upon which the defendant may have made its decision to misappropriate the trade secret. Consequently, courts have found pre-misappropriation memoranda and projections particularly relevant, which often forces the defendant into the uncomfortable position of having to undermine the reliability of its own internal and proprietary documents.


Finally, another approach commonly referred to as the 25 percent rule simply sets the royalty rate at 25– 33 percent of operating profit depending on a number of factors. Although this approach has proven useful to courts, it is regularly criticized for being overly simplistic. However, at the very least, the 25 percent rule may provide a useful starting point to any reasonable-royalty analysis.


Conclusion and Practical Application
A plaintiff’s lost profits or a defendant’s unjust enrichment should still be the first options considered when attempting to calculate damages for trade-secret misappropriation. These measures of damages are generally easier and more cost-efficient to calculate. However, with that being said, a plaintiff should not forget about or ignore its ability to recover a reasonable royalty. There are certainly factual scenarios where a reasonable royalty may maximize damages, such as where the plaintiff does not actively market its trade secret and the defendant has only recently begun profiting from its misappropriation. Further, where evidence of lost profits and unjust enrichment is weak, a plaintiff can effectively backstop its damages by pleading and proving a reasonable royalty as an alternative measure of damages. That way, should the plaintiff be unable to prove lost profits or unjust enrichment, it will not have sacrificed its ability to recover in the alternative.


Keywords: business torts litigation, remedies, trade secret, reasonable royalty


Chip Brooker is an associate with Haynes and Boone, LLP in Dallas, Texas.


 
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