Six Ways to Translate a Trade Secrets Claim Into Specific Damages

The foregoing elements of potential damage reflect general approaches which will be tailored to specific facts.

By Jeff Compton
January 12, 2015
Originally published in Texas Lawyer.

Client ABC calls to complain that their salesman, Bill, left and went to work for a competitor. Now, Bill has called his best ABC customers and convinced them to come to his new employer, XYZ, which will offer the same prices for goods or services generated from the same supply chain developed and kept secret by ABC. Counsel listens and advises ABC there is a legal claim against Bill and XYZ arising from trade secret misappropriation. Let’s look at six ways to translate that claim into specific damages.

  1. Defendant XYZ’s Profits

Ideally, counsel will want to obtain all of defendant XYZ’s invoices to its customers for perhaps several years before, and then during, the damage period. From these, a schedule can be prepared showing the customers to which the defendant made sales, and specifically which goods or services were sold to each, throughout the period. This will allow identification of whether the defendant sold to these customers before the trade secret was transferred to the defendant, and more importantly, whether sales of the trade secret goods or services began only after the trade secret was transferred, and also whether additional sales of nontrade secret items were made because of those trade secret sales. This allows the determination of whether those sales would not have been made by the defendant “but for” the trade secret misappropriation and therefore represent economic losses to ABC.

Next, counsel requests an electronic copy of the defendant XYZ’s general ledger. In conjunction with the invoices, ABC can review the general ledger detail to check that the defendant XYZ’s sales it believes arose from the trade secret in fact were collected instead of being turned into credit memos or bad debts.

The electronic general ledger also makes it much more efficient to answer the many questions that arise during discovery and expert report preparation than paper printouts of individual accounts. Another benefit is the audit trail generally available in the electronic version, which can illustrate changes made to accounts prior to production.

Courts may vary as to whether the defendant must prove its costs to deduct against the sales it improperly gained. Regardless of the burden, having the electronic general ledger provides much more direct analysis of the costs which should or should not be deducted. Generally, the deductible costs are those incremental to the sales gained from the trade secret although case law may vary and at times a broader allocation of costs, even if not incremental per se, must be employed. While most costs are variable over multiple years, reasonable individuals differ often as to the amount by which the defendant’s costs increased with the sales gained from the trade secret.

The extent to which the trade secret misappropriation produced the defendant XYZ’s sales should be considered, and an appropriate allocation of XYZ’s profits to the trade secret should be made.

  1. Plaintiff ABC’s Lost Profits

Assuming ABC chooses to pursue these damages and disclose its records, it would use the same process of invoice analysis described above to identify its lost sales, based on the historical pattern of sales to the identified customers.

Next, the incremental costs associated with those lost sales will need to be determined. Here, the plaintiff ABC’s general ledger in electronic form will be the basis for determining the relationship of incremental costs to incremental sales. Note, however, that the plaintiff’s overhead costs may not have changed at all with the lost sales if Bill, in this example, was replaced immediately. In that situation, the plaintiff’s lost profits are likely the plaintiff’s lost sales less the cost of acquiring the goods or services.

  1. Defendant XYZ’s Head Start/Cost Savings

Having the benefit of the plaintiff’s proprietary knowledge may allow the defendant XYZ to come to market more quickly, and more importantly, enabled defendant XYZ to potentially obtain all its sales during this “head start” period. Measuring this head start requires two timelines, where one shows how quickly the defendant XYZ went through the steps of lining up the customers and suppliers with the trade secret, while the other estimates the time needed to do the same without the trade secret. Adding dollar estimates to each step identifies the defendant XYZ’s cost savings. These cost savings and earlier sales represent the head start advantage gained by the defendant.

The complexity of customer relationships bears upon head start as well. If detailed technical knowledge of customer requirements was developed over time and was intrinsic to sales, the recreation of such knowledge to enable the defendant’s sales would have likely taken more time without the trade secret, producing a greater head start advantage in terms of cost savings and earlier revenue receipt.

  1. Reasonable Royalty

To evaluate the market value of a trade secret, a reasonable royalty may be calculated. Using the Georgia-Pacific factors to develop a reasonable royalty requires an extensive analysis focused on the comparability of the misappropriated trade secret to available license data from ABC, XYZ and other companies and is therefore expensive to properly analyze.

  1. The Damage Period

Damages become harder to relate to a particular act as time passes because other facts enter the mix, such as changes to the market and new competitors. The defendant XYZ may claim it either could have immediately, or would have shortly, known the trade secret through legitimate means. If a multiple year damage period appears to be proper under the facts, one source advises against exceeding four or five years. Reasonably, this would not lead to four or five full years of damages but instead to a graduated decline: say, 100 percent, 80 percent, 60 percent, 40 percent, 20 percent, and then 0 percent.

  1. Damage to Reputation and Related Sales

If Bill created turmoil with customers of ABC who chose not to deal with either ABC or XYZ, then discovery may determine whether the lost customers would have remained with ABC absent Bill’s actions. If so, this reflects damage to plaintiff ABC in the form of lost reputation and moreover lost sales, even though there were no sales to XYZ. These lost sales of plaintiff ABC are not only the trade secret goods or services but also items typically sold with the trade secret goods or services.

Sometimes loss of reputation equates to loss of earning power or goodwill, again with the challenge of assessing permanent loss.

The foregoing elements of potential damage reflect general approaches which will be tailored to specific facts. The first and second are obvious alternatives, while the third through sixth may overlap. More or less extensive approaches should be considered as appropriate.