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Posted: May 21, 2018

Court Of Appeals Rejects “Avoided Costs” As Proper Measure Of Damages For Misappropriation Of Trade Secrets

On May 3, 2018, the Court of Appeals issued an opinion, E.J. Brooks Co. v Cambridge Sec. Seals, 2018 NY Slip Op 03171, answering a question certified by the Second Circuit, namely whether a plaintiff can recover its competitor’s avoided costs as damages in a trade secrets action, whether as misappropriation, unfair competition, or unjust enrichment. A divided court answered in the negative.

Judge Feinman, writing for the majority, first noted that, in an action for unfair competition by misappropriation,

Damages must correspond to the amount which the plaintiff would have made except for the defendant’s wrong, not the profits or revenues actually received or earned by the defendant . . . . Under the ‘misappropriation theory’ of unfair competition, a party is liable if they unfairly exploit the skill, expenditures and labors of a competitor. The essence of the misappropriation theory is not just that the defendant has reaped where it has not sown, but that it has done so in an unethical way and thereby unfairly neutralized a commercial advantage that the plaintiff achieved through honest labor. Damages, therefore, must be measured by the loss of the plaintiff’s commercial advantage, which may not correspond to what the defendant has wrongfully gained . . . . the principle that a plaintiff’s losses may be measured practically and flexibly does not remove the requirement that damages be measured by the plaintiff’s actual losses.

To be sure, courts may award a defendant’s unjust gains as a proxy for compensatory damages in an unfair competition case . . . . but even in those cases it must first be shown that there is some approximate relation of correspondence, a causal relation not wholly unsubstantial and imaginary, between the gains of the aggressor and those diverted from his or her victim. Without evidence of that correspondence, there is no presumption of law or of fact that what a defendant has gained will competently measure what the plaintiff has lost.

The majority then held that nearly identical considerations applied to damages in trade secrets misappropriation action:

We agree that damages in trade secret actions must be measured by the losses incurred by the plaintiff, and that damages may not be based on the infringer’s avoided development costs. Authorities embracing the avoided cost method of damages almost universally consider them a measure of the defendant’s unjust gains, rather than the plaintiff’s losses. This calculation of damages, however, does not consider the effect of the misappropriation on the plaintiff. Because this figure is tied to the defendant’s gains rather than the plaintiff’s losses, it is not a permissible measure of damages.

It is true that, in trade secret cases, ‘loss’ is broadly defined and must account for the fact that trade secrets inherently derive their value from their confidentiality. The plaintiff’s injury in trade secret misappropriation cases includes the loss of competitive advantage over others by virtue of its exclusive access to the secret. Where disclosure of a trade secret has destroyed that competitive edge, the plaintiff’s costs of developing the product may be the best evidence of the (now-depleted) value that the plaintiff placed on the secret. However, it is neither automatically nor presumptively the case that the costs avoided by the defendant will be an adequate approximation of the plaintiff’s investment losses, any more than it can be presumed that the defendant’s sales would approximate those of the plaintiff.

Finally, the majority noted that a claim for unjust enrichment requires defendant to have profited at the plaintiffs expense, and development costs that defendant would have had to pay to third parties “do not constitute funds held by the defendant at the expense of the plaintiff” because the plaintiff had no pre-existing right to those funds.

In summary, therefore, the majority held that, although a defendant’s avoided costs could be used as a measure of unjust enrichment or trade secret misappropriation damages, the plaintiff must show that there is an “approximate relation of correspondence, a causal relation not wholly unsubstantial and imaginary” between its losses and the defendant’s avoided costs; availability of avoided costs as a measure of damages may not simply be presumed.

Judge Wilson, writing for the three dissenters, first stated the general point that:

Avoided costs are widely recognized as an available measure of damages in trade secret cases . . . . In both unfair competition actions and unjust enrichment actions, avoided-cost damages deprive the wrongdoer of its gain. As a policy matter, avoided-cost damages would often undercompensate plaintiffs, because no rational economic actor would spend $X to recover profits of merely $X. However, the calculation of avoided-cost damages is generally much simpler than, and less subject to challenge than, lost-profit damages, which makes them an attractive alternative for plaintiffs who are willing to forego a potentially larger recovery in favor of a smaller, more certain one. I do not suggest that avoided-cost damages will always be the best measure of damages. Rather, it is one of several measures of damages, subject to election by the plaintiff, challenge by the defendant, and acceptance by the trier of fact. Trade secret cases in particular require a flexible and imaginative approach to the problem of damages. Such flexibility and imagination have been, and should remain, a hallmark of our jurisprudence.

On the specific question of trade secrets damages, the dissent argued that

The majority claims that damages in trade secret actions must be measured by the losses incurred by the plaintiff. By ‘losses incurred by the plaintiff,’ the majority means ‘plaintiff’s lost profits,’ or perhaps ‘plaintiff’s development costs.’ That narrow interpretation flouts the above basic principles and fails to engage meaningfully with the unique nature of trade secrets, as well as the differences between profits and development costs. In a trade secret case, the plaintiff’s loss is the loss in value of the trade secret; that loss can be measured in several ways, but all correspond to the plaintiff’s loss, even though they may differ in amount . . . . Of course, plaintiffs will often want to prove lost profits as a measurement of damages, but that may be difficult or impossible to do, because factors exogenous to the theft (e.g., changes in demand, changes in costs, other competition, leak of the trade secret by the defendant to others) make the estimation of lost profits difficult or unreliable . . . . But a plaintiff’s costs of development or the costs a defendant avoided by stealing the secret are also appropriate measures, because those are reasonably related to the value of the trade secret. It is of no moment that they may not be the same dollar number as a lost-profits analysis might show: as anyone who has ever retained an expert to determine lost profits knows, no two experts are likely to arrive at the same figure. Again, the law does not require such exactitude in recompensing a wrong.

As to unfair competition, the dissent argued that the cases cited by the majority were inapt, only standing for the proposition

that defendants should be allowed to challenge the amount of damages claimed; for example, by showing that the defendant could have developed the same or an equivalent method through cheaper, legitimate means (thus challenging the claimed value of the secret) or that plaintiff retained some value in the secret that should be deducted from the claimed damage amount (e.g., when a court issues an injunction after defendant has made substantial sales). Those cases provide no basis whatsoever to announce that, as a matter of New York law, a plaintiff may never ‘recover damages that are measured by the costs the defendant avoided due to its unlawful activity.’ Rather, the answer to the second question asked by the Second Circuit must be yes — as one acceptable measure of damages for unfair competition, a plaintiff may sometimes recover defendant’s avoided costs as damages for its lost trade secret, because such avoided costs can be a reasonable approximation of the injury to the plaintiff, subject, of course, to evidentiary challenge by the defendant and acceptance by the trier of fact.

The dissent also pointed out that “common-law unfair competition is an action in equity and not one at law” where damages can be based upon the wrongdoer’s ill-gotten gains, and that “in an action for unfair competition, equity will treat the wrongdoer as a trustee for the plaintiff so far as the former has realized profits from its acts. Inability to prove damages would not preclude plaintiffs from recovering, on an accounting, profits realized from sales unlawfully made, together with interest thereon from the time of the commencement of the action.”

Finally, on unjust enrichment, the dissent argued that the majority had answered the wrong question, i.e. “whether TydenBrooks can state a claim for unjust enrichment at all. We lack the power to decide that question, which the federal district court has already decided.” The dissent also argued that the majority had improperly relied upon cases holding that an unjust enrichment action may not be brought if it is duplicative of a breach of contract claim, a point not applicable either to the general question posed by the Second Circuit or to the specific dispute that gave rise to it. As to the proper measure of damages, “it is not a necessary element of a cause of action for unjust enrichment to show that plaintiff suffered a loss corresponding to the gain received by the defendant. [Defendant] was unjustly enriched by stealing to avoid development costs, which injured [Defendant]. It would be against equity to allow the defendant to retain the value it received.”

As the dissent says, this opinion obscures more than it clarifies—subsequent decisions will be required to explain (a) the quantum of proof required to prove that the defendant’s avoided costs appropriately corresponds to the plaintiffs’ actual loss, and (b) how the majority’s holdings will affect—or not—the equitable rule that a defendant’s ill-gotten gains can be a proper measure of damages, regardless of whether they correlate to plaintiff’s actual losses.

The law protects intellectual property in a number of ways, but that protection is not unlimited; indeed, as this decision shows. We frequently litigate intellectual property claims, including trademark, copyright and trade secret claims. Contact Schlam Stone & Dolan of counsel attorney Niall D. O’Murchadha at nomurchadha@schlamstone.com if you or a client have questions about whether you have, or face, a claim for theft or infringement of intellectual property.

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