• David Slarskey

To be Decided: 'Avoided Costs' Theory of Liability in Trade Secret Cases

This week, in E.J. Brooks Company v. Cambridge Security Seals, the United States Court of Appeals for the Second Circuit asked the Court of Appeals for the State of New York to decide whether, under New York law, a plaintiff asserting claims for trade secret misappropriation, unfair competition, and unjust enrichment can recover damages measured by the costs the defendant avoided due to its unlawful activity.

In the more common case, a misappropriation plaintiff seeks damages in the form of its own lost profits or other losses, or disgorgement of ill-gotten gains by the defendant. Here, however, the plaintiff did not quantify its own lost profits or damages, and the defendant -- a start up in the plastic seal manufacturing business, which had misappropriated the plaintiff's manufacturing processes -- did not have sufficient information on profitability to form the basis for a recovery. Thus, the victimized plaintiff sought compensation for the value of the costs that the defendant avoided in developing its systems.

The federal court noted that there is no reliable New York state court authority as to whether a plaintiff can recover damages for costs avoided by the defendant, rather than for its own losses and damages, and that resolution of the issue poses significant public policy questions for the courts. And so it does: should the law, as a matter of policy, compensate a plaintiff for trade secret misappropriation if (i) the plaintiff does not show any losses or damages to its own business, and (ii) the defendant has not profited in a quantifiable way?

The federal court noted that the "reasonable royalty" doctrine has been adopted and applied as a theory for measuring damages in trade secrets cases, i.e., awarding the plaintiff the "hypothetically agreed value of what the defendant wrongfully obtained from the plaintiff." This relates to the cost avoidance theory, insofar as costs avoided could presumably factor into the value of the technology.

But the cost avoidance recovery requested by the plaintiff here is conceptually distinct: Plaintiff sought a recovery based on comparing the “actual costs incurred by the defendant . . . with the costs it would have incurred to produce the same products without the use and knowledge of its manufacturing process," and asked the jury to consider, among other things, whether the defendant realized savings in research and development, and whether the defendant realized any savings in operating costs--including labor expenses and increased productivity--as a result of the misappropriation. Whereas the reasonable royalty doctrine looks at the economic value of the misappropriated technology, the avoided costs doctrine looks at the costs actually avoided as a result of the misappropriation. These are different quantifications.

The court noted that the cost-avoidance theory finds support in the Restatement (Third) of Unfair Competition, but that New York courts have not clearly incorporated the Restatement into New York law (another issue that the Court of Appeals may decide to take on, as a tangent, i.e., the extent to which the Restatement should be consulted in the absence of clear authority). To the contrary, the court noted New York decisions that suggest "even when measured by reference to a defendant’s profits," damages "should correspond to a plaintiff’s losses as a means of compensation."

This is a case to watch, as an affirmative decision from the Court of Appeals would give plaintiffs another theory on which to pursue recovery in misappropriation cases--a theory that does not focus on the profitability or the economic value of the misappropriated technology, but rather the raw costs avoided. This could have significant implication, in particular, for start-up ventures (both plaintiff and defendant) who have not yet reached profitability, or not yet demonstrated the economic value of new technologies. A "costs avoided" recovery might provide a windfall recovery to a plaintiff (e.g., if the costs avoided are very high, but the product has little economic utility or profitability). But it also may provide important protections for plaintiffs who have a significant investment in early-stage product development that has not yet been proved out on the market. The Court of Appeals for the State of New York will be asked to balance these and other public policy considerations in resolving the legal issue.