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 ................................................................................................................................................................... 24I. 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.
2sell 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.
3and 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.
4the [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.
5But 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
6permitting 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).
7than 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.
8attaching 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
10law. 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.”
11hypothetical 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.
12when 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
13Cartwright, 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.
14One 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
15that 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.
16C. 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.
17In 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.
18D. 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.
19licensed 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.
20invention 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).
21E. 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
22of 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.
23F. 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
24Table 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 rateTable 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 324You can also read
