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