Trade Secret Valuation: Should Georgia-Pacific Be On Your Mind? (November 2018) - Jonathan D. Putnam

Page created by Daryl Ray
 
CONTINUE READING
Trade Secret Valuation: Should Georgia-Pacific Be On Your Mind? (November 2018) - Jonathan D. Putnam
Trade Secret Valuation: Should
Georgia-Pacific Be On Your Mind?
(November 2018)

Jonathan D. Putnam

 Reprinted with permission of the author.
Trade Secret Valuation: Should Georgia-Pacific Be On Your Mind?

                                                     Jonathan D. Putnam
                                                  Competition Dynamics, Inc.
                                 PLI Trade Secrets 2018: What Every IP Attorney Should Know
                                                        San Francisco
                                                      November 7, 2018

I.     INTRODUCTION ............................................................................................................................................. 2
      A. WHAT IS THE PROPERTY? .............................................................................................................................................. 2
        (1) Alternatives ..................................................................................................................................................................3
        (2) Availability ...................................................................................................................................................................4
        (3) Economic definition ..................................................................................................................................................4
      B. WHO ARE THE NEGOTIATORS? ...................................................................................................................................... 5
      C. WHAT IS THE HARM?....................................................................................................................................................... 7
      D. WHAT IS THE TERM? ....................................................................................................................................................... 8
      E. WHERE IS THE MARKET? ................................................................................................................................................ 9
      F. GEORGIA-PACIFIC VS. UNIVERSITY COMPUTING ........................................................................................................... 9
        (1) University Computing ........................................................................................................................................... 10
        (2) Summary .................................................................................................................................................................... 13
II.     SOME EMPIRICAL STRATEGIES ............................................................................................................ 13
      A.  LICENSES TO FOREIGN AFFILIATES............................................................................................................................ 13
      B.  VALUING ASSETS SUSCEPTIBLE TO UNCERTAIN, CATASTROPHIC LOSS ............................................................. 14
        (1) Long-lived assets ..................................................................................................................................................... 14
        (2) Combining shorter forecasts with terminal values.................................................................................. 16
      C. UNFAIR COMPETITION.................................................................................................................................................. 17
      D. APPORTIONMENT .......................................................................................................................................................... 19
      E. AVOIDED DEVELOPMENT COSTS ................................................................................................................................ 22
      F. CONCLUSION ................................................................................................................................................................... 24
I.     INTRODUCTION

       Businesses invest in new technological information to make money. They recoup those

investments in various ways, including through various types of intellectual property. Notably,

R&D managers as a group view trade secrecy as a more important mechanism than patents for

recouping investments in industrial processes.1

       When competitors “take” new information, litigation ensues. And since patent litigation

is by far the dominant form of IP litigation, it is natural to look to patent-related precedents for

non-patent IP damages. Of these precedents, the familiar Georgia-Pacific factors are by far the

most common. The question is: are these “factors” actually useful in a trade secret setting?

       In general, the answer is “Not without further specification.” But to understand why, it is

worth restating the role that valuation plays in the analysis of intellectual property.

       A.      WHAT IS THE PROPERTY?

       The last and most encompassing Georgia-Pacific factor (#15) is the price at which patent

rights would change hands in a hypothetical negotiation between the patentee and the infringer.

This is a patent-specific reformulation of the Supreme Court’s much more general definition of

the “fair market value” of an asset, which is:

               [T]he price at which the property would change hands between a willing
               buyer and a willing seller, neither being under any compulsion to buy or to

1
  In a classic survey, Richard Levin and colleagues surveyed 650 R&D managers, who rated
“secrecy” 4.31 on a 7-point scale for its effectiveness in recouping R&D investments in process
innovations; in contrast, “patents to prevent duplication” were rated 3.52. For product
innovations, the ratings were 3.57 and 4.33, respectively. R. C. Levin, A. K. Klevorick, R. R.
Nelson and S. Y. Winter, “Appropriating the Returns to Industrial Research and Development,”
Brookings Papers on Economic Activity 3 (1987): 783-831.

                                                  2
sell and both having reasonable knowledge of relevant facts.2

       But this formulation depends crucially on several subsidiary factual differences between

patents and trade secrets. The most important of these is that “the property” in a patent is

defined, explicitly and as a matter of law, by the patent’s claims, which are only crystallized after

examination by the patent office and any further construction by the trial court. As subject to

dispute as these terms may be, they are much less malleable than the parties’ competing

definitions of “the secret.” This matters because the fair market value of what “would have

been” traded necessarily depends on what “it” is.3

       But the differences between patents and trade secrets do not end with their definition.

Here are several others that bear on valuation:

               (1)     Alternatives

       In Grain Processing, the Federal Circuit emphasized the importance of considering an

infringer’s alternatives when valuing his use of the patent:

       only by comparing the patented invention to its next-best available alternative(s)
       … can the court discern the market value of the patent owner's exclusive right,

2
  United States v. Cartwright, 411 U.S. 546 (1973). The Court further observed that, “The
willing buyer-willing seller test of fair market value is nearly as old as the federal income, estate,
and gifts taxes themselves….”
3
  I have testified in trade secret disputes in which, as part of its complaint, the trade secret owner
claimed several dozen trade secrets, each of which was drafted in the form of a patent claim.
This formulation permitted an element-by-element comparison of the plaintiff’s claimed secrets
with the defendant’s accused process, much like a patent infringement case, as well as a
comparison of the secrets with the rights transferred in existing know-how contracts. But I have
also testified in a trade secret dispute in which, even after a trial and a finding of liability, the
exact definition of the trade secret remained in dispute, so much so that, in the midst of an
ambiguous cross-examination, I had to ask the judge how the court defined “the property” – in
order to answer a question as to its value. Needless to say, it is far better for “the property” to
have been defined, via a claim chart or otherwise, well before this point in a damages trial.

                                                  3
and therefore his expected profit or reward….4

Georgia-Pacific incorporates this general principle in factor #9: “the utility and advantages of

patent property over old modes and devices.” But patents are defined relative to “old modes and

devices” – the “prior art” – while trade secrets are not. Thus, if the definition of the trade secret

property is unclear, so must be the definition of the alternatives to it – and with that, the

valuation of the property itself.

               (2)     Availability

       Under patent law, the next-best (non-infringing) alternative must be “available on the eve

of infringement” – but is not limited to the prior art. On the other hand, the infringer cannot, by

definition, consider the patented invention an “alternative.” But a trade secret can be used after

independent discovery, so one cannot rule out the possibility that the infringer would have

discovered, and been able to use legally, the trade secret at some point after the misappropriation.

Similarly, the information could have been discovered by one or more third parties, and

published or otherwise disseminated in such a manner as to make the secret available to the

defendant. The expected length of time until such independent discovery and/or publication is

frequently (and hotly) disputed.

               (3)             Economic definition

       The alternatives to a trade secret, and their availability, are not relevant merely to the

defendant’s options. A necessary condition for the existence of a trade secret is that it “derives

independent economic value from not being generally known.”5 But if it is “only by comparing

the [property] to its next-best available alternative that the court can discern the market value of

4
  Grain Processing Corp. v. American Maize-Products Co., 185 F.3d 1341, 1353 (Fed. Cir.
1999). (emphasis supplied)
5
  Uniform Trade Secrets Act, § 1.4.

                                                 4
the [property] right,” then the plaintiff may be expected to demonstrate alternatives to it, as well

as their availability, simply to prove the existence of a bona fide trade secret.            In these

circumstances – unlike a patent case – economic testimony may be required as part of the

liability determination – and those calculations must be consistent with the calculation of

damages.

       Fortunately for trade secret owners, the facts surrounding many misappropriations

contain at least the building blocks of such testimony: intentional misappropriators tend to

“take” only those things that are worth taking. But a best practice for firms that depend heavily

on secret information – particularly industrial processes – is to document (before litigation

occurs) the process and its evolution, so that the creation of the information, as well as each

change, can be described accurately, distinguished from publicly known alternatives, and

justified on an economic basis. 6

       B.      WHO ARE THE NEGOTIATORS?

       In patent litigation, a “reasonable royalty” is the statutory floor on damages, which aim in

general to “compensate for the infringement.” “Compensation” generally requires proving loss,

typically lost profits. When the patentee cannot prove such loss (typically, because the infringer

gained from infringement, but the patentee – not being a competitor in the same market – did not

lose from it), Georgia-Pacific provides a framework for hypothesizing the bargain the parties

would have struck for the infringer’s use. This is, by definition, the case when the plaintiff is a

non-practicing entity.

6
 This step is also important before executing a non-disclosure agreement, such as with a
prospective joint-venture partner, so that the disclosing party clearly specifies what it believes its
secrets to be. Of course, the secrets themselves cannot be the subject of negotiation, so the
parties will rarely agree on their definition as a matter of contract.

                                                  5
But in trade secret litigation, an aggrieved plaintiff is usually not a non-practicing entity;

he usually does experience some kind of competitive loss; and usually does not wish to license

the misappropriated information, under any terms.           This unwillingness is not simply a

negotiating position. Rather, a fundamental property of competitive relationships is that the

profit earned by two competitors in the same market7 is never as much as the profit that one of

them would have earned if the other had not competed. The reason is that competition drives

down prices, with that gain being captured by each party’s customers, and thus unavailable to be

divided by negotiation. This means that, even if the defendant were to assign all of its profits to

the plaintiff in the negotiation, the plaintiff would still be worse off than if the defendant had

never competed. That being the case, an “unwilling” plaintiff is entirely rational: there is no

royalty that simultaneously compensates the plaintiff and permits the defendant to earn a profit –

contrary to the premise of Georgia-Pacific factor 15.8

       The legal implication is this: if compensation for loss is the goal, Georgia-Pacific cannot

achieve it – unless the plaintiff is permitted to impose a high enough royalty on the defendant so

that the plaintiff is fully compensated, and the defendant does not underprice the plaintiff.9 But

7
  If the two firms do not compete entirely in the same market – e.g., if the defendant expands
sales to customers outside the market in which the plaintiff competes – then such sales would
not, by definition, have been made by the plaintiff, so a reasonable royalty may be appropriate.
8
  “…that is, the amount which a prudent licensee … would have been willing to pay as a royalty
and yet be able to make a reasonable profit.”
9
  This is, in principle, the law:

       The infringer’s selling price can be raised if necessary to accommodate a higher
       royalty rate, and indeed, requiring the infringer to do so may be the only way to
       adequately compensate the patentee for the use of its technology. Thus, the
       district court clearly erred by ensuring the ongoing royalty rate it awarded would
       “leave some room for profit’ by Buyers at its current prices.

Douglas Dynamics, LLC v. Buyers Products Company, Fed. Cir. 2013, slip op. at 14
(emphasis). But if the infringer had charged a higher price, he would have sold fewer

                                                 6
permitting the plaintiff to “impose” a fully compensating royalty on the defendant is at least in

tension with a “willing buyer, willing seller” framework.10

       C.      WHAT IS THE HARM?

       Patent infringement violates the patentee’s exclusive right to “make, use, sell, offer for

sale or import” the patented invention. While patent rights can be infringed, they cannot be

“taken” or destroyed. But both events can and do happen to trade secrets.

       A classic example is the following: a misappropriator obtains a trade secret from its

owner, and then files for patent protection on some or all of the secret information. These acts

harm the trade secret owner in two ways: (1) the owner can be excluded from the use of his own

invention because he is not the inventor named on the patent; (2) the owner evidently could have

patented the information but did not, which implies it is more valuable to him as a secret. Thus,

when the patent application is published some or all of the value of the secret is destroyed, and

cannot be captured even if the owner of the once-secret information is successful in efforts to

have the patent assigned to him.

       As an empirical matter, the difference between the value of the information as a secret

and as a patent is usually difficult to determine. And, for the reasons previously given, it is not

something the parties can successfully “bargain” over, since the trade secret owner has lost more

infringing units, (a) the calculation of which is relatively complicated because it requires
computing the infringer’s elasticity of demand, and (b) the liability for which bases
damages on the but-for number of infringing acts, not the actual number. To the best of
my knowledge, no court has held that this is the correct basis.
10
   In the patent context, the fact that litigating parties are “unwilling,” by definition, to reach
agreement in a “hypothetical negotiation” is a well-remarked truism. (“The methodology
encompasses fantasy … because it requires a court to imagine what warring parties would have
agreed to as willing negotiators ….” Fromson v. Western Litho Plate & Supply Co., 853
F.2d 1568, 1575 (1988), overruled on other grounds by Knorr-Bremse Systeme Fuer
Nutzfahrzeuge GmbH v. Dana Corp., 383 F.3d 1337, 1343 (Fed. Cir. 2004).) Even so, this
awareness still fails to recognize the logical (and often determinable) tension between the end of
the proposed remedy (“compensation”) and the means (voluntary agreement).

                                                7
than the misappropriator has gained. And when the misappropriator’s actions impair or destroy

the secret, Georgia-Pacific usually cannot help.11

       D.      WHAT IS THE TERM?

       Patentees are usually imagined to bargain over the right to use the patented invention

during the damages period, with an injunction or other remedy covering the post-trial period.

Alternatively, courts have also awarded “life-of-patent” royalties, particularly when such a

hypothetical license is consistent with typical industry practice.          This parameter of the

hypothetical contract falls under Georgia-Pacific factor 7, “The duration of the patent and the

term of the license.” But how are the parties to bargain when a trade secret has no natural or

statutory “term”?12

       One sure source of dispute is to engage competing technical experts to opine on when the

trade secret “would have been lost.” Invariably, the plaintiff’s expert will find reasons why the

trade secret would have been maintained for many years, while the defendant’s expert will find

reasons why it would have been easy, for the defendant or anyone else, to acquire the

information through independent discovery. Of course, the (frequently) best answer – “no one

knows for sure” – is not only not very satisfying, but may prevent the trade secret owner from

11
   In a similar vein, related information is sometimes protected both by trade secrecy and by
another form of IP, such as a patent. It is rare that one can isolate the value of one from the other
in a principled fashion, since even when the information is traded (i.e. licensed), it is usually
traded as a whole. Even more fundamentally, the value of either, as a mechanism for excluding
competitors, may depend crucially on whether the other is present: just as suspenders are
unnecessary as long as one’s belt is functioning, either IP mechanism may be superfluous if the
other operates to exclude a rival. But because one often cannot know, ex ante, which mechanism
will prove to be “valid and infringed,” one often cannot assign value to one or the other, and it is
often misleading to divide the total value between them.
12
   This difficulty also afflicts the trade secret owner, since the value of a trade secret (like any
other asset) is usually calculated as the present value of a stream of benefits, the length of which
is indeterminate.

                                                 8
attaching any value at all to the trade secret, endangering the statutory requirement that the

owner “derive value” from the information while it is secret.

          E.      WHERE IS THE MARKET?

          These valuation problems are often exacerbated by cross-border disputes.         Although

Tianrui13 extended the jurisdiction of the International Trade Commission to foreign trade secret

misappropriation (unlike foreign patent infringement), one still must establish a “domestic

industry” in which the trade secret has value. Thus, foreign misappropriate of secret information

which results in the filing of a foreign patent may, through publication of the patent application,

devalue a trade secret in the U.S., but calculating the secret’s value and quantifying that harm in

the U.S. can be quite challenging. Again, Georgia-Pacific offers little guidance for how the

parties would “bargain” over the “U.S. trade secret rights” under such circumstances.

          F.      GEORGIA-PACIFIC VS. UNIVERSITY COMPUTING

          In University Computing Co. v. Lykes-Youngstown Corp.,14 the Fifth Circuit discussed

five factors for determining the outcome of a “hypothetical negotiation” in a trade secret case.

          1. the resulting and foreseeable change in the parties’ competitive posture.

          2. the prices past purchasers or licensees of the trade secrets may have paid.

          3. 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.

          4. the nature and extent of the use the defendant intended for the secret.

          5. whatever other unique factors in a particular case that might have affected the parties’

               agreement.

The University Computing factors have been adopted by courts throughout the country.

13
     Tianrui Group Co. v. U.S. International Trade Commission, 661 F.3d 1322 (Fed. Cir. 2011).
14
     504 F.2d 518 (5th Cir. 1974).

                                                     9
(1)      University Computing

       The second University Computing factor corresponds to Georgia-Pacific factor 1, which

addresses the royalties the plaintiff may have received for the property. Empirically speaking,

these factors are not analogous, however, both because trade secret owners license their secrets

much less frequently than do patent owners, and because even when secret information is

licensed the misappropriated property rarely corresponds neatly to a package of information

conveyed by contract.

       It is important not to overlook the fact that the relative dearth of information on the

licensing of trade secrets represents not just an exogenous infrequency of usable data. Rather,

this infrequency results from directly the optimizing choices made by trade secret owners: trade

secrets are licensed less often than patents precisely because licensing to others is usually less

profitable than maintaining exclusive possession of the secret. Thus, the correct inference from

the absence of licensing is usually that there is no price at which the trade secret owner would

have been willing to license.

       As I have explained, a trade secret owner’s “unwillingness to license” therefore is not

simply a matter of negotiating position or competitive preference. Licensing, at least at a price

that would be feasible for the licensee, is generally a suboptimal choice for the licensor. This

means that, by trying to solve a problem rooted in involuntary competition via voluntary

agreement, the law introduces a fundamental tension: either the trade secret owner can be made

whole (by “hypothetically negotiating” a “reasonable royalty” that leaves her indifferent to the

misappropriation); or the parties can “hypothetically negotiate” an amount that the defendant is

willing to pay and that, from the trade secret owner’s perspective, is suboptimal and therefore

non-compensatory. Naturally, economists cannot tell lawyers how to resolve this dilemma in the

                                               10
law. But then, lawyers cannot tell economists to “solve the problem” by pretending that the

dilemma does not exist.

        This tension directly implicates the first University Computing factor, which corresponds

to Georgia-Pacific factor 5 and which addresses the competitive relationship between the

parties.15 In Douglas Dynamics, the Federal Circuit stated that this tension, if it exists, should be

resolved in favor of the patentee, based on the statutory objective of “compensation,” by

hypothesizing that the infringer would have raised the price of the infringing product. But to the

best of my knowledge, there is no analogous holding for trade secret reasonable royalties, where

the parties are much more likely to be direct competitors and where the law may not tie a

reasonable royalty explicitly to “[full] compensation.”

        The second University Computing factor indirectly implicates the fourth factor: “the

nature and extent of the [generally competitive] use the defendant intended for the secret.”

Georgia-Pacific also contemplates the infringer’s “use” of the patent (factor 11), but the

differences with Georgia-Pacific can be subtle and profound. An infringer “uses” an invention

by actually making, using or selling (or offering to sell, or importing) an infringing embodiment

of the patent. Actual use is, in other words, an ex post determination based on actual commercial

activity.16   On the other hand, intended use is an ex ante determination, which may have no

commercial embodiment. If, as may be the case, the defendant’s “intended use” at the time of

misappropriation differs from the “[actual] change in the parties’ competitive posture” realized

ex post, the parties confront the insoluble argument about whether the outcome of the

15
   Arguably, the “resulting and foreseeable change in the parties’ competitive posture” invites a
more detailed analysis of both the ex ante and ex post effects of the misappropriation than the
(typically binary) question of whether or not the patentee contemplates licensing to an infringing
competitor.
16
   The infringer’s sales or profit projections may be relevant, but these generally represent a
subset of his “intent.”

                                                 11
hypothetical negotiation should be determined based on what the defendant intended to happen,

or what actually happened, following the misappropriation. This tension is also present, to some

degree, in patent law, for example in the difference between projected and realized infringing

sales. But because the use of a trade secret may involve no commercial embodiment, or the

embodiment represents a small fraction of the misappropriated information, the scope of the

“intended use” may be much broader than the actual use of a patent, and the gap between the

defendant’s intended and actual outcomes much larger. And because of this logical lacuna, when

framing the parties’ hypothetical bargaining positions the trade secret owner naturally points to

the “intended use,” while the defendant naturally points to the (ostensible) absence of any “actual

use” or “actual change in the parties’ competitive posture.”17

       Finally, the differences in the actual and intended uses of a trade secret are also reflected

in the fourth University Computing factor: “the total value of the secret to the plaintiff, including

the plaintiff’s development costs …” There is no analogue to this factor in Georgia-Pacific.

Even more importantly, this factor recognizes that, in contrast to patent infringement, the

misappropriation of a trade secret is the misappropriation of disembodied information, which

would have been costly for the defendant to develop regardless of whether it ever received any

particular commercial embodiment.18 Thus, the defendant is unjustly enriched by saving those

development costs, a remedy that is not available in patent law. But then the question becomes:

17
   Other factors, such as an intervening restraining order, may further complicate the framing of
the hypothetical negotiation and thus the inference from it.
18
   In the archetypal case, the defendant misappropriates a map showing not only where to drill
productive oil wells, but also where not to drill. In other words, the misappropriated information
encompasses mostly “negative knowledge,” in addition to the affirmative information that is the
subject of the commercial embodiment (the productive wells). The reasonable inference under
such circumstances is that the defendant “intended to avoid” the cost and time inherent in the
experimentation necessary to identify the productive locations – even if the defendant never
actually drilled a productive well.

                                                 12
when the expenses to generate the information have been made over a number of years, and

when the value of that information potentially depreciates (or appreciates), how does one

measure exactly how much the defendant saved?

       This and other empirical issues are the subject of the following section.

                 (2)   Summary

       In sum, the valuation of trade secrets via a “reasonable royalty” often does not fit neatly

into a Georgia-Pacific “framework.” In Table 1, I summarize some of the difficulties of trying to

adapt that framework to trade secrets.

       But the larger problem is that, like University Computing, Georgia-Pacific is not really a

damages “framework” at all. Instead, it is a checklist of evidence that an expert ought to

consider in the course of applying actual economic methods, to reach a reliable economic

opinion.

       Given these various conceptual and practical difficulties, I have assembled some of the

methodological techniques on which I have relied, and which have been accepted at trial, to

confront them.

II.    SOME EMPIRICAL STRATEGIES

       A.        LICENSES TO FOREIGN AFFILIATES

       Not infrequently, a trade secret owner will license its know-how for use by a foreign

subsidiary or other affiliate. This is particularly common for industrial processes in which local

manufacturing is required by law, avoids import tariffs, or is otherwise desirable from a

marketing point of view.

       The problem with such licenses is that, while they qualify as “licenses” to the “property”

under Georgia-Pacific factor 1, they are usually not arm’s-length agreements, as required by

                                               13
Cartwright, to determine fair market value.      Such licenses are useful for establishing that the

trade secret has value in the United States, if the payments made under the license are made to a

U.S. parent. But they are, at best, a floor on damages, unless the misappropriation did not affect

the prices or sales of the trade secret owner or any of its affiliates.        To determine actual

damages, one must model the effect of the illegal competition on the trade secret owner and/or

its affiliates.19

         B.         VALUING ASSETS SUSCEPTIBLE TO UNCERTAIN, CATASTROPHIC LOSS

                    (1)   Long-lived assets

         A trade secret has value as long as it is secret. It may also have value, albeit diminished,

if it is independently discovered by a competitor but not generally known. Of course, in general

no one can predict if or when such idiosyncratic events will occur.

         Fortunately, such events can be modeled statistically, with sufficient rigor that they pass

legal muster. The simplest means to accomplish this is via a hazard rate. A hazard rate is

defined as the probability of the hazard occurring at time t, given that it has not occurred by time

t – 1. Probably the most common example is human mortality:             “What is the probability of

death at age 71, given survival to age 70?” Hazard rates are studied in the context of industrial

products and processes as well, as when engineers compute the “mean time between failures,” or

the expected lifetime of a product such as a light bulb. The advantage of such methods is that

they do not assume any particular “date of death”; rather, all dates of death or loss are possible,

with some probability.

19
  It is worth noting that, under this fact pattern, a reduction in sales by a foreign affiliate will
often lead to reduced royalty payments received in the United States, thus establishing harm
within the U.S. from foreign misappropriation.

                                                 14
One can also frequently estimate the hazard rate for the (complete) loss of a trade secret.

This strategy avoids making strict assumptions about any particular date of imitation; rather, it

assigns a probability distribution to all such dates. That distribution can be defined in terms of

the secret’s “expected” lifetime, where “expected” has its mathematical meaning of a

“probability-weighted average.”

       Thus, suppose that a technical expert will testify that he expects, on average, for the trade

secret information to survive for 5 years before becoming generally known or otherwise being

“lost.” This expectation implies an annual probability of loss of 1/5, or 20%. So if the secret

survives to year 2, there is a 20% probability of loss, and an 80% probability of no loss, i.e., of

survival. If the secret survives to year 3 (80% probability), then there is again a 20% probability

of loss, which means overall a probability of (0.80)(0.20) = 0.16, or 16%, that the secret is lost in

year 3, and a probability of (0.80)(0.80) = 64% probability of survival to year 4.              These

calculations continue indefinitely.   In particular, they continue long past year 5, which is the

“expected” time of loss. Coupled with forecasts of future cash flows from the trade secret, they

can be used to compute an expected present value of those future cash flows, adjusted for the

probability of loss.

       In Table 1, I have computed a simple version of this calculation, assuming cash flows of

100 for the next 15 years. I have also assumed a 10% discount rate (which reflects the time

value of money, and general market risk), and a 20% annual hazard rate. If the cash flows were

subject only to general market risk, the present value of this 1,500 in cash would be 837. But

because there exists the risk of catastrophic loss, their present expected value is only 406.

       The advantage of this method is that it undercuts one of the main objections to the

valuation of trade secrets: the possibility of its loss, at a date not certain. A second advantage is

                                                 15
that this calculation is inherently conservative, because it assumes only the possibility of

catastrophic (complete) loss, not gradual loss through (say) imitation or obsolescence.20

        A disadvantage of this approach, however, is that reliable 15-year forecasts are usually

hard to come by, and are easily attacked as speculative. Moreover, this simple example shows

that the trade secret continues to have value after adjusting for the possibility of loss in its first 15

years, but even a 15-year forecast does not capture that additional value. Extending the forecast

out further subjects the analysis to even stronger criticisms of speculation.

                (2)     Combining shorter forecasts with terminal values

        Again fortunately, similar problems are routinely confronted by equities analysts, who

must value the profit stream of firms that are, in principle, infinitely lived. They produce these

calculations using a terminal value, which is the present value of the entire future stream of cash

flows, computed in the year following the end of the forecast period.

        The formula for a terminal value can be adapted to incorporate the use of a hazard rate, as

shown in the bottom half of Table 1.        In this case, the forecast is made for 5 years – a more

typical planning horizon frequently found in contemporaneous business records – and a terminal

value is computed for years 6 forward.          The total value of the trade secret is 413, which

indicates that, given these assumptions the additional value beyond the 15-year horizon shown in

the first example is slight. In the case of a destruction of a trade secret, for example, calculations

like this one demonstrate, using standard financial tools, the value of the loss to the plaintiff,

while accounting for the secret’s inherently uncertain lifetime.

20
  These calculations can be modified to reflect gradual loss and/or a non-constant hazard rate, if
additional precision is required or the facts require such modifications.

                                                   16
C.      UNFAIR COMPETITION

       Under the common law, trade secret misappropriation is a tort – a species of unfair

competition.    Virtually by definition, unfair competition causes harm, and harm is to be

compensated, not bargained over.       As long as an element of harm exists, and as long as the

defendant is permitted to bargain for less than the full value of that harm – for whatever reason –

the trade secret owner will remain under-compensated by the outcome of that “bargain.”

       While “the relationship between the parties” (Georgia-Pacific factor 5) is, of course, one

“factor” in the analysis, and that factor is generally recognized to increase the royalty rate that

emerges from the hypothetical bargain, there is no case (of which I am aware) holding that

proven, quantifiable harm to the plaintiff represents a floor under a “reasonable royalty” –

whether one invokes Georgia-Pacific factor 5 to find that royalty or not. But if – as I have

experienced – defendants perceive Georgia-Pacific’s bargaining framework to offer an implicit

discount to full compensation, then its use is both attractive and erroneous.21

       The most straightforward way to compute the effects of unfair competition is to model

competition itself, then to observe how the presence of unfair competition alters market

outcomes. This can be done in a variety of ways using standard economic methods, again

controlling for the complexity of supply and demand, input costs and other market variables.22

21
   In this context, it is worth noting the oft-forgotten fact that the Georgia-Pacific court itself did
not employ any of the “Georgia-Pacific factors” to reach its reasonable royalty conclusion.
Rather, the court estimated the harm to the plaintiff caused by the defendant’s infringement, even
though the plaintiff could not establish the quantum of lost profit. On appeal, that estimate was
reduced, so as to leave room for the infringer to profit, which muddied the question of whether
the controlling objective is to compensate the plaintiff or to simulate a bargain. As I have
explained, in Douglas Dynamics the Federal Circuit reiterated its position that it is legal error to
insist that the defendant earn a profit if the result fails to compensate the plaintiff.
22
   Note that such analysis requires data obtained both before and after the misappropriation
occurs, which the discovery process need not guarantee, unless counsel has the foresight to
request it.

                                                  17
In a recent case, I analyzed the price of a product made using a trade-secret process from

a number of chemical feedstocks.          The defendant entered the market without making many

sales, but the trade secret owner alleged that its customers were able to leverage the defendant’s

presence to force the trade secret owner to reduce its price. That price depended, however, on

the price of the feedstocks, so it was not immediately obvious whether the price reductions were

due to reduced input costs or to the unfair competition.

       In Figure 1, I have shown the actual price of the trade-secret-protected product, as well as

the price predicted from input costs. The “fit” is not perfect (nor should it be, given that the

“supply” side is only half of supply-and-demand). But the predictions are good enough to

establish that, once unfair competition commenced, the price was approximately 16% lower than

otherwise would have been expected.

       This approach has three advantages. First, it properly locates the analysis in actual

market competition between the parties – not in a hypothetical negotiation between them.

Second, it establishes that the trade secret has value because it prevented competition, and

quantifies that value to the plaintiff. Third, it simultaneously proves one of the important

elements of damages for the plaintiff: reduced prices on sales that the plaintiff continued to

make following misappropriation. As I have explained, Georgia-Pacific cannot yield this result,

because the defendant gained little from misappropriation, while the plaintiff lost much – there is

nothing to bargain over. In the absence of a “pie” to be divided between the parties, the

Georgia-Pacific-style hypothetical negotiation cannot effect the objective of compensation for

the misappropriation of a trade secret.

                                                  18
D.      APPORTIONMENT

       Like a patent, a trade secret may form one part of a more technologically complex device.

It may even form an “essential” part. But in recent years, the Federal Circuit has required

increasingly stringent proofs before a plaintiff can assert that the protected intellectual property

represents the “entire market value” of the product that embodies it.23

       Leaving aside the question of when apportionment is legally necessary, it is often

conceptually difficult to implement, the more so when value arises from diverse causes.

       In a trade secret case involving semiconductor manufacturing processes, the defendant

was alleged to have misappropriated information related to a number of key steps in the

manufacturing process. The plaintiff sought its lost profits, an amount in excess of $2 billion.

The defendant argued for a reasonable royalty, based on the proportional contribution of the

misappropriated steps to the overall process.

       Complicating the analysis were three sets of facts. First, advancements in semiconductor

manufacturing are characterized by a sequence of manufacturing “nodes,” typically expressed in

the width of the circuitry, such as 90 nanometers (nm). Because the objective between nodes is

to double the number of transistors per unit area, each node shrinks relative to the prior node by a

factor of approximately √2/2, or about 0.7. Thus subsequent nodes are 65 nm, 45 nm, etc. In

many cases, the change in the manufacturing “step” required to implement the new node can be

described by an obvious function of this ratio. But in some cases, much trial and error or even an

entirely new approach is required. Second, although the plaintiff claimed that it would not have
23
  A recent statement of the law relating to apportionment is found in Power Integrations, Inc. v.
Fairchild Semiconductor et al., 2016-2691, 2017-1875 (Fed. Cir. 2018). The court held that “If
the product has other valuable features that also contribute to driving consumer demand—
patented or unpatented—then the damages for patent infringement must be apportioned to reflect
only the value of the patented feature. This is so whenever the claimed feature does not define
the entirety of the commercial product.” (Slip op. at 20). The author testified on behalf of Power
Integrations.

                                                19
licensed the defendant, the record contained evidence of several licenses of its packages of

“steps” to third-party manufacturing firms. But because of the industry’s very rapid rate of

technological advance, the fees paid for these licenses varied by two orders of magnitude, and it

was difficult to determine the extent to which any one package was “comparable” to the package

of the which the misappropriated steps were a part.          Finally, the misappropriated steps

constituted only about 5% of the overall process, which comprised more than 1,000 steps.

       The analysis proceeded in two parts. First, the value of the relevant package of steps had

to be determined. Using a statistical regression model based on the plaintiff’s R&D cost at each

node, which rose steadily with the advance of technology and the miniaturization of circuitry,

and the age of each license package relative to the date the plaintiff introduced each new node, it

became possible to model with surprising accuracy the price at which the plaintiff licensed each

package of steps, despite the wide variations in price. Using the plaintiff’s R&D costs for the

node in question, and the date at which the misappropriation occurred, this model was used to

predict the fair market value of the relevant license package at the time of the misappropriation.

In other words, this price represented the “whole.” Figure 2 shows the actual and predicted

prices for the “comparable” licenses, along with the price predicted for the hypothetical package.

       The misappropriated steps constituted the “parts.” In related work, I show that if the

parts are assumed to add up to the whole, one can compute the value relative to the mean of any

individual part, assuming one knows its rank among all of the parts, based on economic research

into the distribution of individual invention values.24 Assuming that one has some kind of

ranking mechanism – in this case, technical testimony from the defendant’s expert – one can then

apportion the value of the whole to each of the misappropriated parts. For example, if an

24
  J. Putnam, “Value Shares of Technologically Complex Products,” unpublished manuscript
(2014), available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2461533.

                                                20
invention ranks in the 99th percentile among all relevant inventions, then its value is expected to

be approximately 10.2 times as great as that of the average invention. Thus if 1,000 inventions

in a “whole” were together worth $1 billion, then the average invention is worth $1 billion /

1,000 = $1 million, and the 99th percentile “part” is expected to be worth about $10.2 million.

The economic literature shows remarkable consistency in these ratios across a wide variety of

technologies, time periods and countries.

       Using this technique, we were able to show that plaintiff’s claim vastly exceeded the

price that it charged for its own technology in “comparable” transactions. This procedure is

consistent with Georgia-Pacific factor 13 (“portion of the realizable profit that should be

credited to the invention”).25

25
  In the patent context, this method of apportionment – statistical analysis to predict the value of
the whole, coupled with ranking of the parts to assign a value relative to the mean – has been
approved in court:

       Dr. Putnam considered the rate and terms on which the parties would
       license to each other based on the parties' past practices and the past
       practice of the industry…. He then used a regression analysis to
       summarize his data and determine the terms upon which AUO and LGD
       would exchange their portfolios in a cross-license …

       With AUO's aggregate claim against LGD assessed, Dr. Putnam then used a
       method described as "count, rank, and divide" to determine the portion of the
       claim attributable to the four asserted patents. This method takes into account
       Georgia-Pacific factors 9-11. Based on the value share of each patent in AUO's
       portfolio and based on the assumption that these patents are in the top 5% of
       AUO's portfolio, Dr. Putnam determined that AUO's damages for infringement of
       all four patents would total $305,399.

MEMORANDUM OPINION, July 8, 2010, LG Display Co. Ltd. v. AU Optronics Corp., 722 F.
Supp. 2d 466 (D. Del. 2010).

                                                 21
E.      AVOIDED DEVELOPMENT COSTS

       Finally, an important limitation of Georgia-Pacific is that it does not contemplate the cost

of developing the protected information as a measure of damages, while this factor is recognized

under University Computing.       While it is sometimes straightforward to sum the plaintiff’s

development costs from its general ledger, an unmodified sum does not take account of two

important conceptual issues that can have very large impacts on what the law means by “costs.”

       First, the misappropriated information is likely to have resulted from a rational search

process that often incorporates substantial elements of trial and error. The misappropriated

information thus represents a filtered version of all the information the trade secret owner

developed in the course of discovering the portion that is valuable. A map of productive oil

wells, or a clinically effective pharmaceutical ingredient, are two examples of such a search

process. It would be economic error to impute to the defendant only the cost of reproducing the

filtered information itself, and not the cost of the entire search process.

       Second, because such processes often take place over long time intervals, the economic

value of the acquired information may depreciate substantially, e.g. through obsolescence,

competition, etc. Economists study this phenomenon when constructing intangible assets or

“information stocks” from the flow of R&D expenses incurred to create those stocks.

       To illustrate this point: suppose that a firm spent $100 on R&D for 10 years to create a

trade secret, which is then misappropriated. Its “cost of development” was $1,000. But what is

the expected value of the information at time of misappropriation? In other words, if the

defendant had instead tried to acquire the misappropriated asset at fair market value, and the only

available measure of that value is the prior expenditures, what is that value?

       The answer to that question is found in Table 3. Assuming a 15% depreciation rate for

R&D (a rate frequently found and widely assumed in the economic literature), the present value

                                                  22
of the $1,000 in total past expenditures is about $535. For sales and marketing expenditures, the

depreciation rate is generally higher, as such information becomes obsolete or “stale” more

rapidly than does new technical information. Assuming a 30% annual depreciation rate, the

value of the $1,000 in past expenditures is only about $324.

       In a recent case, in which the misappropriated information encompassed both R&D and

sales and marketing, I employed past expenditures on these categories using data from the

plaintiff’s general ledger to determine the value of the intangible asset stock on the date of

misappropriation. The defendant argued that the information could have been reproduced by its

own staff for a fraction of the plaintiff’s development cost, and that in any event only recent

expenditures were relevant. But these arguments ignore the long filtering process required to

distill the fruits of the plaintiff’s past investments to their valuable essence – even though the

value of that essence today is still much less than the cost of the entire distillation process, the

value of which depreciated over time.

       Notably, the defendant also argued that, in a hypothetical negotiation, it “would not have

been willing” to pay even the depreciated value of these costs, because they substantially

exceeded the defendant’s annual income. That argument confuses the value of an intangible

asset – a fixed stock of information, like a house – with the rent generated by the asset in a single

year (a flow). When an asset is misappropriated, the costs of generating that asset (measured by

the past flow of expenditures) must be depreciated and their value capitalized at a single point in

time. They generally should not be compared to the rental price of the asset per unit of time,

unless that rental value is itself the thing over which the parties would have bargained.

                                                 23
F.      CONCLUSION

       These examples show that one can often meet the requirements of valuing a trade secret,

whether to prove its existence or to establish damages, without needlessly shoehorning the

analysis into a bargaining framework.       Such approaches have the advantage of heeding the

advice given by former Federal Circuit chief judge Randall Rader, who has argued persuasively

that Georgia-Pacific is not a method, nor even a set of factors to be added up like “balls and

strikes.”26 Seen in that light, the damages evidence can be efficiently categorized under the

Georgia-Pacific and University Computing factors, without limiting the damages method to

patent-specific (or bargaining-specific) constructs.

26

       The expert – I trust this is not you gentlemen – is sitting on the stand and he or
       she will testify: Well, there are 15 Georgia-Pacific factors and six of them favor
       us and the other nine are neutral. Well, that is an attempt to convert this laundry
       list into some kind of a methodology. However, many of those 15 factors may be
       overlapping or irrelevant to a particular case. Yet some will try to make their case
       seem more reasonable by stacking up so many Georgia-Pacific factors in their
       favor and the rest are against their opponent or neutral. And that’s not what the
       Georgia-Pacific case was ever about and it’s a flawed methodology. Those factors
       were not meant to be counted up the way you count up balls and strikes during a
       baseball game.

D. A. Haas, J. R. Bone, “View From the Federal Circuit: An Interview With Chief Judge
Randall R. Rader,” July 9, 2012, http://www.srr.com/article/view-federal-circuit-interview-chief-
judge-randall-r-rader

                                                 24
Table 1: Georgia-Pacific factors and applied to trade secret facts
Georgia-Pacific reasonable royalty                    Factor      Trade secret reasonable royalty

Bargaining over division of gains from               5, 15       Compensa6on for losses to a compe6tor
infringement                                                     (not the subject of a “bargain”)
“The inven6on” and alterna6ves are defined            9, 10       The boundaries of the secret are hard to
by claims                                                        determine, so alterna6ves are also

The patented inven6on is never “available”           9, 10       The trade secret may become available to the
to the infringer during its term                                 compe6tor by independent discovery

Maximum term defined by statute                       7           Term is indefinite and outside the trade secret
                                                                 owner’s control
Plain6ff must prove value of actual use by            11          Plain6ff must (a) prove actual value to himself, and
the infringer                                                    (b) intended use by the compe6tor
Appor6onment of infringer’s profit is a basis         13          Compe6tor’s profit is usually not great enough to
for compensa6on                                                  compensate plain6ff when the par6es compete
Appor6onment is mandatory unless EMVR                13          Unjust enrichment and lost profits may or may not
applies                                                          require appor6onment
Patents are infringed, not destroyed                 15          If trade secret is destroyed, there is usually no
                                                                 mutually acceptable bargain
Exis6ng licenses and policy establish royalty        1, 4        Usually no “policy”; exis6ng licenses usually given
                                                                 to foreign subsidiaries – not arm’s length
Uncertain remedies for foreign infringement          15          Misappropria6on in A may cause harm in B
(presump6on against extraterritoriality)                         (importa6on / price erosion / reduced royal6es)
Table 2
Calculation of trade secret value using hazard rates and terminal value

Calculations using 15-year forecast without terminal value

                                                                                                                                   15-year forecast
                                                                            2018      2019     2020      2021      2022    2023   2024 2025 2026       2027   2028   2029   2030   2031   2032              Total

            [a]   Annual profit from trade secret                            100      100       100       100       100    100    100    100    100    100    100    100    100    100    100               1500
            [b]   Discount rate                                    10%       1.00     0.91      0.83      0.75      0.68   0.62   0.56   0.51   0.47   0.42   0.39   0.35   0.32   0.29   0.26
[a] x [b] = [c]   Present value                                              100        91        83        75        68     62     56     51     47     42     39     35     32     29     26               837
            [d]   Hazard rate                                      20%       1.00     0.83      0.69      0.58      0.48   0.40   0.33   0.28   0.23   0.19   0.16   0.13   0.11   0.09   0.08
                  Present value of trade secret
[c] x [d] = [e]   adjusted for risk of loss                                  100         76       57        43        33     25    19     14     11      8      6      5      4      3      2                406

Calculations using 5-year forecast with terminal value

                                                                              5-year forecast + terminal value
                                                                                                                                                                                                 Terminal
                                                                            2018      2019     2020      2021      2022                                                                             value   Total

            [a]   Annual profit from trade secret                            100      100       100       100       100                                                                             313     813
            [b]   Discount rate                                    10%       1.00     0.91      0.83      0.75      0.68                                                                            0.68
[a] x [b] = [c]   Present value                                              100        91        83        75        68                                                                            213      630
            [d]   Hazard rate                                      20%       1.00     0.83      0.69      0.58      0.48                                                                            0.48
                  Present value of trade secret
[c] x [d] = [e]   adjusted for risk of loss                                  100         76       57        43        33                                                                             103     413

                  Notes:

                  Terminal value calculated as 100 / (r + h + rh), where r is the discount rate and h is the hazard rate
Table 3
Calculation of trade secret value using avoided development costs

                                                              2009   2010   2011   2012   2013   2014   2015   2016   2017   2018   Total

            [a]   Annual R&D expenditures                     100    100    100    100    100    100    100    100    100    100    1000
            [b]   Depreciation rate                    15%    0.23   0.27   0.32   0.38   0.44   0.52   0.61   0.72   0.85   1.00
[a] x [b] = [c]   Present value                                 23     27     32     38     44     52     61     72     85   100     535

            [a]   Annual sales and marketing expenditures     100    100    100    100    100    100    100    100    100    100    1000
            [b]   Depreciation rate                     30%   0.04   0.06   0.08   0.12   0.17   0.24   0.34   0.49   0.70   1.00
[a] x [b] = [c]   Present value                                  4      6      8     12     17     24     34     49     70   100     324
You can also read