In Part 1 of this series, we addressed how different conceptions of the purpose of trade secret remedies divided the New York Court of Appeals in E.J. Brooks Co. v. Cambridge Sec. Seals. To the majority, trade secret remedies should be aimed at compensating a plaintiff for its losses. Thus, a defendant's avoided costs cannot serve as a measure of damage unless they serve as a proxy for the plaintiff's actual development costs. To the dissent, trade secret remedies should be aimed at valuing the trade secret, which includes compensation for costs avoided by a defendant through misappropriation. Here, we consider another area in which differing perspectives on the fundamental goal of trade secret damages may lead to differing damages methodologies: reasonable royalty damages.

In intellectual property law, courts often use a reasonable royalty—affixing damages at a royalty rate the defendant would have paid for a license—to approximate plaintiffs' but-for position. More specifically, in patent law, reasonable royalty calculations involve two key assumptions: that the asserted patent is (1) valid and (2) infringed. The law of trade secrets often follows patent law. But should trade secret law require similar assumptions for reasonable royalty damages?

Inherent Value and Patent Reasonable Royalties

By statute, a plaintiff who proves that a defendant has infringed its valid patent is entitled to damages adequate to compensate for that infringement—at a minimum, a reasonable royalty. Because there is no statutory definition of reasonable royalty, however, courts have developed a litany of tests to evaluate the reasonableness of a royalty.

One common test comes from Georgia–Pacific Corp. v. U.S. Plywood Corp. There, the Southern District of New York created 15 factors relevant to calculating a reasonable royalty. In essence, the Georgia–Pacific factors attempt to construct a hypothetical negotiation between a willing licensor and a willing licensee. The factors are intended to reach a royalty the licensee-infringer would have been willing to pay and the licensor-patentee would have accepted. However, Georgia–Pacific does not aim to reconstruct a real-world negotiation. Instead, it attempts to construct a necessarily hypothetical negotiation where two idealized negotiators assume that the patent is valid and infringed.

The Georgia-Pacific assumptions may result in a more inflated royalty than a real-world royalty. In reality, many litigated patents are found invalid. And it is extremely difficult to anticipate whether a particular patent will survive validity challenges. Similarly, plaintiffs are not always successful at setting out an infringement case. Indeed, patentees are victorious in a mere twenty-five percent of patent suits. Mark A. Lemley, The Surprising Resilience of the Patent System, 95 Tex. L. Rev. 1, 25 (2016) (collecting empirical studies). To account for this uncertainty, a real patentee and a potential infringer negotiating ex ante might be expected to apply a discount factor to account for uncertainty and transaction costs: The plaintiff would be required to scale its extracted royalty by a ratio accounting for the probability that its patent is invalid and/or the defendant is found to not infringe.

By assuming validity and infringement, however, courts effectively remove this particular discount factor. In so doing, courts ensure that a Georgia-Pacific royalty measures the true value of a patent. Consider the following. One way to measure a plaintiff's harm is to construct a real-world royalty rate: Absent infringement, the patentee would have been able to extract a certain value from its patent; the patentee lost that real-world royalty rate as a result of a defendant's infringement. In a royalty negotiation, that real-world royalty rate would be suppressed by a discount factor relating to a possible finding of invalidity and/or non-infringement. So factors unrelated to the value of the patent—the chance that a court might find the patent invalid or not infringed—would suppress the plaintiff's actual harm. By removing this risk, i.e., by assuming validity and infringement, the Georgia-Pacific hypothetical negotiation measures the true value of the patented invention.

Inherent Value and Trade Secret Reasonable Royalty

Under most trade secret statutes, a plaintiff who proves misappropriation of a valid trade secret is entitled to compensatory damages. Occasionally, that compensatory relief is a reasonable royalty. The Uniform Trade Secrets Act, like the patent statute, explicitly states that damages caused by misappropriation may be measured by a reasonable royalty, and many states have adopted that provision. Uniform Trade Secret Act, §3(a) (1985). Because trade secret statutes do not define a reasonable royalty, however, courts are left to construct applicable tests.

As with many areas of trade secret law, courts often borrow from patent law to craft those tests. In some cases, that means conducting a Georgia–Pacific-esque hypothetical negotiation. Similar to the patent context, parties negotiating a trade secret license ex ante would apply a discount factor, taking into account that the information at issue might not be deemed a trade secret and/or that it might not be deemed misappropriated.

But no court appears to have squarely addressed whether the “valid and infringed” assumptions of patent law should be transferred into trade secret law. That is, should a reasonable royalty calculation in a trade secret context be based on an assumption that (1) the information at issue constitutes a trade secret and (2) that the trade secret was misappropriated.

Similar to the patent context, parties in a trade secret case would effectively apply a discount factor in the course of their negotiations. However, while the parties would account for the risk of invalidity or no misappropriation ex ante, these factors would not necessarily be tied to determining the value of the trade secret. Also, similar to the patent context, removing this discount factor would necessarily render the negotiation hypothetical, but would result in a royalty calculation aimed at the value of the trade secret.

Any court addressing this question will face a fundamental question similar to that addressed in E.J. Brooks: Should trade secret remedies compensate the plaintiff for their real-world harms or measure the value of the trade secret? On one hand, if courts choose to apply “valid and misappropriated” assumptions to the trade secret hypothetical negotiation, they will be measuring the value of the trade secret by removing the associated discount factor. On the other hand, if courts choose not to apply those assumptions, they will be measuring the plaintiff's real-world harm.

Differing interpretations of the fundamental goal of trade secret damages—whether damages are aimed at compensating a plaintiff or at valuing a trade secret—can have far-reaching implications for plaintiffs and defendants alike. In E.J. Brooks, that disagreement led to differing views on whether a defendant's avoided costs can measure trade secret damages. For determining a reasonable royalty, that same disagreement could divide courts over the appropriateness of assuming that a trade secret is valid and infringed for purposes of a hypothetical negotiation.

Esha Bandyopadhyay, a principal in Fish & Richardson's Silicon Valley office, has been practicing intellectual property and technology-related commercial litigation and counseling in the Bay Area for close to two decades. Kain Day is an associate in Fish & Richardson's Silicon Valley office. He maintains a broad practice, focusing on commercial, trade secret, and patent litigation matters.