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Intellectual property damages
出处:法律顾问网·涉外www.flguwen.com     时间:2010-12-17 16:10:00

INTELLECTUAL
PROPERTY DAMAGES


Guidelines and Analysis

Mark A. Glick
Lara A. Reymann
Richard Hoffman

 

John Wiley & Sons, Inc.



INTELLECTUAL
PROPERTY DAMAGES



INTELLECTUAL
PROPERTY DAMAGES


Guidelines and Analysis

Mark A. Glick
Lara A. Reymann
Richard Hoffman

 

John Wiley & Sons, Inc.



This book is printed on acid-free paper. ∞

Copyright . 2003 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey

Published simultaneously in Canada

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in
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except as permitted under Section 107 or 108 of the 1976 United States Copyright Act,
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Requests to the Publisher for permission should be addressed to the Permissions Department,
John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-7486008,
e-mail: [email protected]

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best
efforts in preparing this book, they make no representations or warranties with respect to the
accuracy or completeness of the contents of this book and specifically disclaim any implied
warranties of merchantability of fitness for a particular purpose. No warranty may be created
or extended by sales representatives or written sales materials. The advice and strategies contained
herein may not be suitable for your situation. You should consult with a professional
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other commercial damages, including but not limited to special, incidental, consequential, or
other damages.

For general information on our other products and services, or technical support, please
contact our Customer Care Department within the United States at 800-762-2974, outside
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Wiley also publishes its books in a variety of electronic formats. Some content that appears in
print may not be available in electronic books.

Library of Congress Cataloging-in-Publication Data

Glick, Mark A.

Intellectual property damages : guidelines and analysis / Mark A. Glick,
Lara A. Reymann, Richard R. Hoffman.

p. cm.
Includes index.
ISBN 0-471-23719-1 (cloth : acid-free paper)

1. Intellectual property—United States. 2. Actions and
defenses—United States.
II. Hoffman, Richard R.
KF2983 .G58 2003
346.7304′8—dc21
3. Damages—United States.
III. Title.
I. Reymann, Lara A.
2002014438
Printed in the United States of America
109876543 21


ABOUT THE AUTHORS

Mark A. Glick has a Ph.D. in economics and a J.D. in law. He is a professor of
economics at the University of Utah Department of Economics, where he teaches
law and economics and industrial organization. He also serves as Of Counsel with
the law firm Parsons Behle & Latimer, where he practices in the areas of intellectual
property and antitrust. He is a graduate of UCLA, The New School for
Social Research, and Columbia University.

Lara A. Reymann is a member of the Litigation Department at Parsons Behle &
Latimer, where she practices intellectual property law. Ms. Reymann graduated
cum laude from Dartmouth College with a B.A. in government and a minor in
philosophy. She received her J.D. with honors from the University of Chicago
Law School, where she worked in the Mandel Legal Aid Clinic for several
years.

Richard Hoffman is a director at LECG with over 12 years of experience in accounting
and consulting. He is a CPA and is Accredited in Business Valuations. Rick
worked at international accounting firms for approximately 10 years before joining
LECG in 2000. He also has been an adjunct professor at the University of Utah.


Acknowledgments


T
T
he authors acknowledge the contribution of several colleagues, academics,
experts, and lawyers. The IP/Antitrust group at Parsons Behle & Latimer provided
valuable input into the chapters on litigation and the patent and antitrust interface.
In particular, Raymond Etcheverry, David Mangum, and Kevin Speirs have been
mentors and helped the authors appreciate the importance of damages in intellectual
property cases. Also, several patent lawyers and specialists in trademark and copyright
law reviewed and commented on the substantive chapters on IP law, in-cluding
Margaret McGann, Bill Evans, and Vanessa Pierce. Moreover, we are indebted to individuals
outside our respective firms who reviewed chapters within their substantive
specialties and provided vital insights. These individuals include Dr. Duncan Cameron,
economist with LECG’s Los Angeles office; Dr. Mike Lemmon, finance professor at
the University of Utah; and Steve Stauffer of PricewaterhouseCoopers. Ted Tatos,
Dianna Gibson, Roger Smith, and Laura McNichols also assisted in the development
and revision of the book. The authors also express appreciation to Robert
Goldscheider for his valuable help and thoughtful introduction. Any mistakes or errors
are our own.

Finally, the authors thank their respective spouses, without whose extreme tolerance
and support there would be no book.


Contents


Preface xv
Introduction by Robert Goldscheider xvii

PART ONE: LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS
OF INTELLECTUAL PROPERTY DAMAGES 1

CHAPTER 1—THE LITIGATION PROCESS 3

Structure of the Court System 3
The Complaint 6
The Answer 8
Attorneys’ Meeting and Protective Orders 8
Discovery 10
Expert Disclosures 14
Expert Reports 16
Expert Depositions 16
Motion Practice 17
Trial 18
Court Opinions 19
Litigation Versus Alternative Dispute Resolution 19
Summary 22

CHAPTER 2—DAMAGE PRINCIPLES AND DAUBERT 27

Daubert Issues 27
Making Sense of Daubert 29
Damage Analysis in General in Light of the
Substantive Case Law on Damages 34
Summary 40

CHAPTER 3—INTRODUCTION TO THE ECONOMICS OF
INTELLECTUAL PROPERTY DAMAGE CALCULATIONS 43

A Brief Review of Basic Economics 43
The Industrial Organization Foundations of Intellectual Property Damages 46
The Direct Approach: Econometrics 54
The Law and Economics of Bargaining 61
The Economics of Intellectual Property 62
Summary 69

ix


CONTENTS

CHAPTER 4—INTRODUCTION TO ACCOUNTING PRINCIPLES
IN INTELLECTUAL PROPERTY DAMAGES 73

Introduction to Financial Statements 73
Cash Basis 74
The Accrual Method 76
The Financial Statements 77
The Income Statement—Also Called a “Profit/Loss Statement” 77
Balance Sheet 79
Cash Flow Statement 83
The Role of Standards in Financial Statements 83
The Accounting Cycle 85
All Financial Statements Are Not Created Equal 91
Audited Financials 92
Significant Dates Identified in the Report 92
Different Audit Opinions 93
Management Representation Letter 94
Summary of Proposed Adjustments 95
Adjusted Trial Balance 95
Debt Covenant Compliance 95
Financial Statement Trend Analysis 96
Detail of Accounts 97
Summary 99

CHAPTER 5—FINANCIAL PRINCIPLES USED IN
INTELLECTUAL PROPERTY DAMAGES 101

Preliminary Issues 101
Valuation Approaches 104
The Market Approach 113
The Cost Approach 118
Summary 119

PART TWO: PATENT INFRINGEMENT DAMAGES 121

CHAPTER 6—INTRODUCTION TO PATENT LAW 123

A Brief History 123
Description of a Patent 124
The Subject Matter of Utility Patents 125
The Standards of Patentability 127
Patent Infringement 132
Summary 135


CONTENTS

CHAPTER 7—HOW TO CALCULATE PATENT DAMAGES 139

The Patent Statute 139
The Choice Between Lost Profits and Reasonable Royalties 140
Lost Profits 141
The Calculation of Incremental Profits 147
The Damage Period 148
Price Erosion 148
The Entire Market Rule 150
Reasonable Royalty 151
Summary 160

CHAPTER 8—INTRODUCTION TO THE ANTITRUST LAWS 169

The Historical Foundations of the Antitrust Laws 169
The Goals of the Antitrust Laws 175
Antitrust Claims Under Section 1 of the Sherman Act 177
Antitrust Claims Under Section 2 of the Sherman Act 193
Antitrust Claims Under the Clayton Act 195
Summary 195

CHAPTER 9—THE INTELLECTUAL PROPERTY–
ANTITRUST INTERFACE 207


Background 207
Overlap of Patent and Antitrust Principles 209
Antitrust Law and Specific Patent Practices 210
Summary 215

PART THREE: COPYRIGHT, TRADEMARK, AND
TRADE SECRET DAMAGES 219

CHAPTER 10—INTRODUCTION TO COPYRIGHT LAW 221

A Brief History of Copyright Law 221
Standards for Copyright Protection 222
Subject Matter of Copyrights 227
Publication 235
Copyright Formalities 236
Ownership 236
Copyright Holder’s Rights 237
Infringement 238
Copyright in the Digital Age 240
Fair Use Defense 241
Summary 243


CONTENTS

CHAPTER 11—INTRODUCTION TO TRADEMARK LAW
AND TRADE SECRET LAW 253

Brief History of Trademark Protection 253
Types of Marks 254
Primary Classifications of Trademarks 256
Trade Dress 261
Priority 263
Infringement 264
Trademarks and Domain Name Disputes 270
Dilution and Reverse Confusion 275
Summary of Trademark Law 280
Introduction to Trade Secret Law 281
What Is a Trade Secret? 281
Factors Indicative of Trade Secrets 283
Typical Protectable Trade Secrets 286
Information Not Protected as a Trade Secret
and Treatment of Confidential Information 286
Misappropriation of Trade Secrets 287
Summary of Trade Secret Law 288

CHAPTER 12—MISUSE OF COPYRIGHTS, TRADEMARKS,
AND TRADE SECRETS 297


Copyright Misuse 297
Defenses to Copyright Misuse 301
Trademark Misuse 304
Trade Secret Misuse 308
Summary 309

CHAPTER 13—HOW TO CALCULATE COPYRIGHT,
TRADEMARK, AND TRADE SECRET DAMAGES 315


Copyright Damages 315
Trademark Damages 328
Trade Secret Damages 334

CHAPTER 14—THE NUTS AND BOLTS OF INTELLECTUAL
PROPERTY DAMAGE CALCULATION 349

The Process of Determining Whether the Proper Damages Consist
of a Reasonable Royalty, Lost Profits, or a Combination of Both 349
Calculating Lost Profits 353
Calculation of a Reasonable Royalty 361
Summary 367


CONTENTS

PART FOUR: APPENDICES 369
A Sample Requests for Production of Documents and Interrogatories 371
B Sample Expert Report of John Smith 377
C Antitrust Guidelines for the Licensing of Intellectual Property 385
D Sample Patent 417
E United States Code (U.S.C.) Title 35—Patents 427
F Copyright Act of 1976 435
G Trademark Act of 1946 (“Lanham Act”), as Amended 449
H Uniform Trade Secrets Act with 1985 Amendments 459
I Restatement of the Law, 3rd, Unfair Competition 463

Index 469


Preface


T
T
his book arises from the authors’ collective experience acting as damage experts
and managing damage experts in intellectual property (IP) cases. In case after case
we have observed that the damage portion of IP litigation is treated as a neglected
stepchild. This failure to prioritize construction of a damage theory is curious since so
much rides on each side’s evaluation of damages, both for settlement purposes and for
trial preparation. Since it is so typical to allocate insufficient resources and inadequate
attention to damages, lawyers know little about how to effectively use their own experts
and undermine opposing experts, and the experts themselves do not possess the necessary
background in IP to be effective. This uneducated state precludes informed analysis
of IP litigation, including the decision of whether to litigate at all, what possible
outcomes to anticipate, and what terms or financial compensation might constitute a
reasonable settlement.

Over the years the authors have sought to fill this vacuum, first within their (two
authors) own law firm and then more generally. We have taught IP damages classes
for the National Association of Valuation Analysts, given presentations to numerous
law firms, and instructed economists at the University of Utah in the law and economics
program where Mark Glick is a professor. This book represents our attempt to systematize
the general knowledge that experts and lawyers need to have in order to be effective
in evaluating, presenting, and opposing damage claims in IP cases.

There are several implicit themes that run throughout this text. It may be useful to
recognize these themes at the outset to establish a context for the following chapters.
Initially, we are not concerned at all with issues such as how to answer questions in a
deposition. An informed, honest expert will have little problem with learning basic
litigation skills. Of greater moment for any expert is a firm grasp of the necessary substantive
knowledge. The deficiencies experts often display are, in part, a consequence
of the departmentalization of most business schools in the United States. For example,
there is not one question concerning calculating future sales on the CPA exam, and standard
accounting programs do not offer any courses that prepare their majors for litigation
support. However, there is a vast industry of accountants in the litigation support
area, and lawyers typically uncritically rely on these experts for their damages cases.
In contrast, economists are trained in microeconomics and econometrics (statistics
applied to economics), a skill set remarkably compatible with judicial precedent on
damages. Yet nothing in an economics Ph.D. program will prepare an economist to
effectively guide attorneys in the discovery process, or understand the structure of the
books and records of the company, or even how to apply their economic training in
the specific IP context. Financial economists are yet another breed. Finance programs

xv



xvi PREFACE


teach valuation principles, discounting, and risk analysis (i.e., all of the mechanics of
the damage calculation). But none of these skills will have any value in litigation unless
the attorneys provide the right information, effectively relate to the expert the judicial
requirements for the analysis, and manage and combine the right skill sets for each case
situation. In short, our experience is that success in an intellectual property damage
case requires experts with complementary skills, combined with attorney instruction
and management.

In the chapters that follow, we hope to provide experts and lawyers with what they
need to know about intellectual property law and intellectual property litigation in order
to be effective in their roles. Some chapters will be more relevant for some than others.
For example, Chapters 1 and 2 on litigation and Daubert cover material many attorneys
are likely to be familiar with, while nonlawyer experts are less likely to have been
exposed to these topics. Experts, on the other hand, may consider skipping some of
the chapters on economics, finance, and accounting, while lawyers should read those
chapters carefully in order to understand what information and evidence their experts
will require in order to be effective. Attorneys also may be more interested in the factors
that determine potential damages than in the equations necessary for the actual
calculations. In short, the chapters will vary in their direct applicability to the roles
of experts and attorneys in an intellectual property damage case. However, gaining an
increased understanding of the skills and knowledge that each team member will bring
to the table can only benefit the entire litigation enterprise. Finally, because this book
cannot substitute for formal training and experience, we provide suggestions for additional
reading so that any specific topic can be studied in greater depth.


Introduction


I
I
t is a pleasure and an honor for me to write some introductory remarks about this
book, which deals with the fruits of innovation and which is, itself, innovative.
As an active practitioner for over 40 years in the law and business based on intellectual
property, and someone who believes that professionals should make scholarly contributions
to their chosen specialties, I am able to appreciate this excellent collaborative
effort. In my opinion, this is an important new source of insights and information about
this dynamic subject.

This has been an ambitious project with a broader focus than most works in this
area. It contains the most complete and lively analysis about damages from patent
infringements. In addition, it is the only book I know that contains parallel analysis of
the key issues in assessing damages for the misuse of copyrights, trademarks, and trade
secrets. Inasmuch as the majority of technology-related business today involves the
employment of many, if not all, of these intellectual property rights, this multifaceted
commentary is very pertinent.

The authors do not address these core issues in a vacuum. They provide a succinct
and well-written historical background about intellectual property and the arenas in
which disputes are litigated and resolved. They also discuss the antitrust laws and their
interface with intellectual property. Furthermore, their methodology combines theoretical—
sometimes rising to philosophical—discussions of many relevant matters,
together with “nuts and bolts” solutions and vivid examples.

Because of his background as a university professor of economics as well as a litigating
lawyer, Mark Glick has the qualifications to discuss current legal and economic
issues in combination, taking into account his firsthand practical experience. Accounting
skills to help determine lost profits and reasonable royalties are invariably necessary in
these disputes. It was therefore astute that Richard Hoffman, an able CPA who specializes
in these matters, has been included in the team of authors. Mark and Richard frequently
collaborate successfully on matters of this sort. Their integrated inputs are much appreciated.
Lara Reymann, who combines youth, enthusiasm, thoroughness, and high intelligence,
has also played a continually catalytic role in this project.

Since this book covers legal, business, and accounting matters, it should be appreciated
by a wide audience. I believe senior corporate executives, IP litigating attorneys,
whether or not they are patent lawyers, and students should all be able to gain considerable
knowledge from exposure to this work product. Other members of the bar and
bench will also find useful material herein.

xvii



INTRODUCTION

This book is well organized and capable of being read through by someone new to
intellectual property who is motivated to get more than a superficial grasp of IP. The
book can also be effectively employed as a reference and research tool.

Without wanting to sound avuncular, I believe that Mark, Rick and Lara have
succeeded in creating a fine addition to the literature in their chosen field. I therefore
hope that these three ambitious people will not relax their grip on the “controls” of the
“vehicle” they have worked so hard to research, write, and edit. I look forward to regular
updates of their scholarship in the future.

Robert Goldscheider
East Hampton, New York
July 2002


Part One


Legal, Economic,
and Financial
Foundations
of Intellectual
Property Damages



1


The Litigation Process


Although litigators will be familiar with much of the content of this chapter, nonlawyers
often have only a vague understanding of the legal process involved in enforcing intellectual
property (IP) rights. Economists, accountants, and financial economists who
wish to increase their value as members of an IP litigation team should understand the
general structure and chronology of the litigation process to anticipate how they will be
involved at each stage. An expert who understands the overall theory of the case, as well
as the means of developing and presenting that theory at various stages of litigation,
exponentially increases his or her value to the litigation team. A basic knowledge of the
litigation process is therefore integral to an expert’s ability to contribute effectively
throughout litigation.

Intellectual property litigation involves teams of individuals with various areas of
expertise. A typical IP case might require attorneys, economists, accountants, experts in
the relevant field (e.g., computer science), and the necessary support staff. The more
that each participant understands about his or her role and the expected contributions
of the other team members, the more effective each participant will be during litigation.
Commonly, there will be an overlap between the individual roles, and team members
should be ready to question and supplement each others’ theories as the case progresses.

STRUCTURE OF THE COURT SYSTEM

Litigation can take place either in state court or in federal court. Intellectual property
cases (with the exception of trade secret cases) typically occur in federal court, primarily
because patents, copyrights, and, to a large extent, trademarks are governed by federal
statutes. Since there is no federal trade secret statute, trade secret law varies from
state to state and is litigated in both federal court and state court. The litigation process
in federal court is governed by the Federal Rules of Civil Procedure (FRCP). This

3



LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

means that the admissibility and form of depositions and live testimony are determined
under the FRCP and the Federal Rules of Evidence (FRE). Each state has its own rules
of civil procedure and evidence that govern actions filed in state court. Typically, these
state rules are similar (but not identical) to their federal counterparts.

Federal litigation begins at the district court level, often referred to as the trial courts.
District courts can hear both criminal and civil cases. There are 93 federal judicial districts
in the United States; each state has at least 1 federal district court, and the states
that tend to have more federal litigation have several districts. For example, New York
has 4 federal districts. Moreover, each district may have multiple judges. The bench
for the Southern District of New York, one of the busiest districts in the country, has
25 judges. In contrast, the bench for the District of Wyoming has 3 judges.

State court structures are less uniform. State trial courts are known by various names,
depending on the particular state. Many states refer to their trial courts as district courts,
while other states have titled their lowest level of courts superior courts (California) or
even supreme courts (New York). Generally, state trial courts are organized along
county lines, with the number of courts varying according to the population and litigation
needs of the relevant geographic area.

If either party decides to appeal a final judgment from the trial court, the litigation proceeds
to the appellate courts. Unlike trial courts, which almost always consist of a single
judge and possibly a jury, appellate courts are made up of a panel of judges and never
involve a jury. The federal appellate courts are divided into 13 circuits, 10 sequentially
numbered circuit courts, plus the circuit court for the District of Columbia; each circuit
handles the appeals for a geographic region of the country. For example, the Court of
Appeals for the Tenth Circuit (referred to simply as the Tenth Circuit) hears appeals
from federal district courts in Utah, Wyoming, Colorado, New Mexico, Kansas, and
Oklahoma. A circuit court typically will have a panel of three judges decide a case,
although the entire court may hear the appeal for particularly significant cases. When all
of the circuit judges hear a case, the resulting decision is referred to as an en banc ruling.

Patent appeals are handled by a specialized federal appeal court known as the United
States Court of Appeals for the Federal Circuit, or simply the Federal Circuit. In 1909,
the Court of Customs and Patent Appeals was created to handle certain customs and
patent matters. The Court of Customs and Patent Appeals was abolished in 1982 and
was completely replaced by the Federal Circuit. According to federal statute, the
Federal Circuit is the exclusive court of appeals for patent decisions from district
courts.1 Federal district court opinions in patent cases are appealed directly to the
Federal Circuit, bypassing the normally assigned circuit court for that region. Opinions
issued by the Federal Circuit are binding on all federal district courts, regardless of
where they are located. Additionally, the Federal Circuit has exclusive jurisdiction
of appeals from decisions of the Patent and Trademark Office (PTO) Board of Patent
Appeals and Interferences relating to patent applications and interferences.2 For example,
the Federal Circuit can hear appeals from the PTO Board’s rejection of certain


THE LITIGATION PROCESS

claims. The Federal Circuit’s decisions can be reviewed only by the United States
Supreme Court.

The Federal Circuit (and the Court of Customs and Patent Appeals before it) was created
because of a perceived need for patent disputes to be heard on appeal by judges
well versed in the technical aspects of patent law. By providing a single forum for
appeals of patent matters, the Federal Circuit strives to achieve uniformity in the exposition
and application of substantive patent law. Although patent appeals are heard only
by the Federal Circuit, the Federal Circuit’s appellate review is not limited to patent
issues. In fact, many nonpatent issues are heard on appeal by the Federal Circuit, primarily
when such issues are present as a separate question within a patent case.3

Like all appellate courts, the Federal Circuit is not bound by the trial court’s reasoning
in evaluating the judgment being appealed.4 A flaw in the trial court’s reasoning is
insufficient grounds for reversal when the court ultimately reached the correct result.5
Generally, appellate courts will not second-guess the trial court’s determinations on
issues exclusively within the trial court’s discretion, such as evaluations of witness credibility.
6 A trial court’s determination that one expert’s testimony and analysis is more
credible than that of the opposing expert is a matter within the discretion of the trial
court.7 The Federal Circuit repeatedly emphasizes in its opinions that it reviews decisions,
not phrases in an opinion, expressions, passing comments, or mere dicta (statements
within an opinion that are not relied on in the court’s findings). A difference in
opinion as to the correct philosophical approach is not critical unless it has resulted
in an improper result. However, if the analysis reflected in an opinion is so hopelessly
flawed that the true basis for the judgment cannot be determined, or if it appears to have
a clearly erroneous factual basis, then the lower court’s opinion may be reversed.8

The Federal Circuit’s review of PTO Board decisions is based on the record testimony
and evidence presented to the PTO. If the PTO Board’s decision affirmed a
patent examiner’s rejection of an application generally, without identifying or reviewing
a particular ground on which the examiner relied, that ground is assumed to be
affirmed. Accordingly, the Federal Circuit will consider such a ground in its review.

All appellate courts have the authority to affirm, modify, or vacate a trial court’s decision.
Moreover, if the appellate court determines that additional action must be taken,
the appellate court may remand the case to the trial court with specific directions or
guidelines as to the necessary findings or calculations that must be done. A remand
returns the case to the lower court’s jurisdiction. Because a remand involves an additional
commitment of judicial resources at the trial court level, it is not a decision that
is taken lightly by appellate courts. Ordinarily, where a trial court errs in applying a
legal standard (such as a stricter burden of proof than is warranted), the appellate court
may remand to permit reconsideration under the proper standard. However, if the record
before the appellate court indicates that there is no question as to what the result would
be on remand, the appellate court can simply correct the error and issue a final decision
itself. In contrast, if the lower court must make additional findings of fact to support the


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

decision, remand is appropriate. For example, if a district court determines that attorneys’
fees are not appropriate, but the appellate court concludes that the prevailing party
should be awarded attorneys’ fees, a remand probably is necessary for the trial court to
determine the proper amount of attorneys’ fees. In general, a remand is required if the
information necessary for the appellate court’s decision is not apparent from or contained
in the record.

Appeals from the state trial courts progress to the appellate courts, or courts of
appeal. Some states only have one level of appellate review—typically the state
supreme court. However, at least one-third of the states now have two levels of appellate
review, that is, an intermediate appellate court that hears appeals from the trial
courts and a higher court that selectively hears appeals from intermediate court decisions.
The initial appeal is called an appeal “as of right,” while an appeal to the higher
court generally is a “discretionary” right to judicial review.

The culmination of the federal and state appeals process is the United States Supreme
Court. The United States Supreme Court has discretion to review certain appeals from
both the highest level of state courts and the federal appellate courts. If the Court
decides to hear an appeal, it is said to have “granted cert.,” a shorthand reference for the
decision to review a lower court’s decision. There are nine justices on the United States
Supreme Court, and all of them hear each appeal (unlike the panels that hear appeals
on the circuit court level). Most cases never reach the United States Supreme Court, due
in part to the low odds of the Court deciding to hear an appeal. The odds of the Court
granting “cert.” on a particular case hover around 1 in 10.9 This does not take into
account the external factors that affect the number of cases submitted to the Court for
review, such as limited resources to fund the expense of protracted litigation, mootness
of particular issues after the length of time it would take to reach the highest court, and
sheer frustration with the litigation process.

THE COMPLAINT

An IP lawsuit, like any other litigation, begins with the filing of a complaint. The party
who files the complaint with the court is known as the plaintiff, while the party against
whom the complaint is filed is the defendant. There may be multiple defendants and/or
multiple plaintiffs in any particular case.

In some instances, multiple plaintiffs may desire to join their claims together in what
is known as a “class action.” A “class” of plaintiffs must satisfy four primary legal
requirements before they can be certified by a trial court to proceed as a single action:

(1) numerosity (there must be a substantial number of class members, too many to deal
with by simply joining them as additional plaintiffs); (2) commonality (common questions
of law or fact must exist and, in some types of class actions, predominate over any

THE LITIGATION PROCESS

questions affecting only individual class members); (3) typicality (the class representative,
i.e., the plaintiff present in the courtroom whose identity is known, must be part of
the class and must possess the same interest and suffer the same injury as the class
members); and (4) representativeness (the parties present must adequately represent the
interests of absent class members who may be bound by the judgment reached therein).
Additionally, the plaintiffs must satisfy the court that the class is adequately defined,
that is, the class must be defined clearly enough that the court and the parties understand
who would fall within the class, even if the exact identities and number of persons
within the class are not yet known. Class actions are more common in tort cases, such
as litigation over a defective product that may have injured a class of persons including
all purchasers of that product, than in IP cases. The reason is simple—seldom will there
be an entire class of individuals, known and unknown, with an ownership interest in a
particular piece of IP.

The complaint must detail the facts of the case sufficient to “plead” every element of
each alleged cause of action. It is not necessary for the complaint to contain every factual
detail known to the plaintiff. The courts require only that the plaintiff provide sufficient
detail to put the defendant on notice as to the basis for the claims against him or
her. The United States Supreme Court, in the seminal case Conley v. Gibson, held that
a complaint only needs to include a short plain statement of the claim, sufficient to show
that the plaintiff is entitled to relief.10 The statement is sufficient if it “give[s] the defendant
fair notice of what the plaintiff’s claim is and the grounds upon which it rests.”11
This standard for pleadings is known as notice pleading. Accordingly, a complaint
may sketch the basis of the wrongful act in fairly broad terms, because the plaintiff
likely has not yet had the opportunity to obtain all of the relevant factual details from
the defendant. For example, a typical complaint alleging patent infringement might
identify the patent being infringed and the defendant’s product or process that is
accused of infringing that patent, but it may refrain from detailing the other particulars
of the infringement. Notice pleading allows a plaintiff the flexibility to develop a
theory of the case as he or she learns more facts about the defendant’s use of the infringing
technology or design.

Generally, a complaint must state the causes of action and then “pray” for some item
of relief from the court. For example, the elements of a negligence tort, like a car accident,
are negligence (not meeting a standard of care), causation, and damages. A complaint
alleging negligence probably would detail what happened in the accident, the facts
allegedly establishing the defendant’s negligence (e.g., the defendant failed a sobriety test
at the scene of the accident), how the defendant’s negligence caused the plaintiff to break
a leg, and what amount of money will be required to compensate the plaintiff for the
damage. Some complaints opt to leave the amount of damages unspecified, simply
asking for an award of damages “in an amount to be determined at trial.” Detailing the
amount of damages sought is not necessary to satisfy the requirements of notice pleading.


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

THE ANSWER


After being served with the complaint, the defendant must either answer or move for
dismissal of the case, typically within 20 days. In an answer, the defendant will admit
or deny, in summary fashion, each fact alleged in the complaint. The answer is also
the defendant’s first opportunity to articulate the defenses and counterclaims12 that he
or she wishes to raise in the litigation. Everyone on the litigation team should read the
answer, as the admissions may significantly narrow the issues presented for litigation.
Taken together, the admissions and denials frame the issues that will be fought over in
discovery, in motions, and ultimately at trial.

In lieu of an answer, a defendant may choose to file a motion to dismiss the case.
However, at this stage, motions to dismiss face a very high standard, as the court must
assume that each allegation pled in the complaint is true. However, the defendant may
ask the court to dismiss the complaint for failing to meet certain requirements necessary
for the suit to proceed, such as if the plaintiff has filed the complaint in the wrong court
(resulting in lack of jurisdiction) or failed to state a claim for which relief can be
granted.13 For example, a plaintiff alleging negligence would fail to state a claim if the
plaintiff failed to provide any facts or allegations that he or she was injured by the defendant.
In that case, one of the essential elements of a negligence claim (causation) would
be missing and the trial court could not allow the case to proceed. Like answers, motions
to dismiss are almost exclusively the attorney’s responsibility to draft—expert analysis
is universally unnecessary for judicial evaluation at this point.

ATTORNEYS’ MEETING AND PROTECTIVE ORDERS

Rule 26 of the FRCP requires the parties’ attorneys to meet and develop a discovery
plan.14 This meeting must occur at least 14 days before a scheduling conference is held
with the judge. The discovery plan will set cutoff dates for document requests, expert
reports, interrogatories, and depositions.15 Rule 26 also requires each party to provide
the opposing party with initial disclosures concerning their witnesses, relevant documents,
and damages. Finally, Federal Rule of Civil Procedure 26(a)(2) sets forth what
must be contained in your expert report. This section of the rules should be required
reading for any expert.

The attorneys’ meeting may also be the first time that the parties discuss drafting a
stipulated protective order to govern discovery. Particularly in IP litigation, the documents
likely to be produced during discovery may contain highly sensitive information
concerning research and development, confidential technology, marketing plans, and
customer lists. Given the likelihood that such documents will be relevant to the ongoing
litigation, the parties often agree to produce documents subject to certain restrictions
on their use by the other side. Under Federal Rule of Civil Procedure 26(c)(7), confi



THE LITIGATION PROCESS

dential commercial information warrants special protection. A protective order does not
eliminate the requirement that the information be relevant or that the request for documents
must not be overly broad and burdensome. However, a stipulated protective order
does provide some security for sensitive documents without requiring the parties to seek
judicial rulings on each particular document.

Commonly, a stipulated protective order will permit any producing party to designate
information that is “believed to be subject to protection under Federal Rule of Civil
Procedure 26(c)(7)” as confidential and limit disclosure of all documents so designated.
For example, many protective orders provide that documents stamped “confidential”
may be shown only to counsel and expert witnesses, but not to anyone in-house at the
competing business, possibly including the attorney’s client. Some protective orders
contain degrees of protection, such as “confidential” and “confidential—attorneys’ eyes
only,” where the latter designation may be shown only to an even narrower class of individuals.
Protective orders also may limit the use of the disclosed information to the litigation
at hand and require the destruction or return of such information after the
conclusion of the lawsuit. In order to have a fallback position, attorneys frequently
include in the protective order provisions regarding “inadvertent disclosure” (i.e.,
production of information without the appropriate designation, which nevertheless
should be treated as confidential). Commonly, this provision simply allows an attorney
to remedy the situation if it is addressed within a certain period after the error is
discovered by retrieving the documents or retroactively designating them as confidential.
Because the particulars may vary, attorneys may agree to exchange drafts of
a proposed protective order, tailored to the facts of the case, until they can stipulate
to a mutually agreeable form for the order.

If the parties do not stipulate to a protective order, either party may still ask the court
to grant a protective order at some point in the litigation. The party seeking a protective
order must establish that the information sought is confidential and that the disclosure
of that information has the potential to harm the party or the party’s business.16 The
party opposing the protective order must then show that the disclosure of such information
is neither necessary nor relevant to the case.17 For example, the Federal Circuit
has held that an infringer’s sales information is relevant because it tends to show commercial
success, which may support patentability.18 However, the party opposing such
discovery (or a nonparty objecting to a subpoena) may argue that sales information is
neither relevant nor necessary to the case.19 Alternatively, the resisting party may seek
to delay their disclosure of such information until liability first has been established.20

The Supreme Court has considered and approved the use of protective orders to control
discovery in civil litigation. Early cases have indicated that the restrictions on the
use of information produced subject to protective orders might conflict with the rights
of free speech protected under the First Amendment.21 However, in Seattle Times Co. v.
Rhinehart, the Supreme Court clarified the interaction of those principles and indicated
its support for judicial regulation of the discovery process.


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Seattle Times Co. v. Rhinehart22

This United States Supreme Court case addressed whether parties to civil litigation
have a First Amendment right to disseminate, in advance of trial, information
gained through the pretrial discovery process. Rhinehart was the spiritual leader of
the Aquarian Foundation, an organization whose beliefs included the ability to
communicate with the dead through a medium, primarily Rhinehart. The Seattle
Times published a series of articles about the Aquarian Foundation that became the
basis for litigation between the parties. Rhinehart alleged defamation and invasion
of privacy. During the litigation, the Seattle Times sought lists of donors and members
of the foundation and certain financial information about the foundation.

The trial court granted a protective order forbidding the use of the financial and
membership information obtained through discovery for any purpose except
preparation for trial. The Seattle Times appealed, and ultimately the Supreme
Court affirmed the lower court’s decision. The Supreme Court cited the “significant
potential for abuse” of pretrial discovery by litigants as a substantial government
interest unrelated to the suppression of speech, and therefore a legitimate justification
for protective orders issued by trial courts.

In short, when a protective order is entered on a showing of “good cause” as
required by Federal Rule of Civil Procedure 26(c), is limited to the context of pretrial
civil discovery, and “does not restrict the dissemination of the information if
gained from other sources,” it will not be struck down under the First Amendment.

If the parties reach an agreement, the protective order will be submitted to the court
with the signatures of both parties to create an enforceable agreement should the parties
later disagree about the treatment of certain information. One can imagine how important
this would be in a trade secret case. Experts typically are asked to sign the agreement
before obtaining access to confidential information. It is vital that an expert
understand the conditions attached to his or her access, use, and retention of information
that falls under the protective order. Attorneys and experts should take great care to
see that they comply with the terms of the protective order, specifically the process for
designating information “confidential” and the appropriate use of such designated information
received from the other side.

DISCOVERY

The confidentiality agreement is a prelude to discovery. Typically, discovery begins
with document requests and interrogatories (written questions). Document requests
ask the other side to produce copies of relevant information in any form. Interrogatories



THE LITIGATION PROCESS

ask the other side to provide written answers to certain questions about their arguments
in the case, their account of certain events, and the possible witnesses that they may use
at trial. In general, a party has 30 days to respond or object to a discovery request. The
FRCP defines the scope of discovery as follows:

Federal Rule of Civil Procedure 26(b)(1)

Parties may obtain discovery regarding any matter, not privileged, that is relevant
to the claim or defense of any party, including the existence, description, nature,
custody, condition, and location of any books, documents or other tangible things
and the identity and location of persons having knowledge of any discoverable
matter. For good cause, the court may order discovery of any matter relevant to
the subject matter involved in the action. Relevant information need not be admissible
at the trial if the discovery appears reasonably calculated to lead to the discovery
of admissible evidence.

Clearly, the scope of discovery is intended to be broad, with the understanding that not
everything discoverable may ultimately be admissible at trial. Written discovery is an
area where expert input is critical in an IP case. A sample discovery request is included
in Appendix B.

Experts can play a critical role in helping the attorney ask for the right documents
and ask the right questions to establish the damage case. A common mistake made by
attorneys is underutilizing their experts during the discovery process. Not only can
experts assist with framing discovery requests, but the experts also should begin fleshing
out their damages theories as early as possible while there is still time to develop
and revise the theories based on the information that comes to light. Each scheduling
order will contain a deadline for concluding fact discovery; after that cutoff, attorneys
and experts will be unable to request additional information from the other side.

Several objections are available to the party who does not wish to produce responsive
documents. Generally, the responding party will identify several general objections
(such as “vague and ambiguous,” “overly broad,” and “irrelevant”) and then nevertheless
offer to produce the responsive documents “subject to and without waiving the
foregoi,ng objections.” However, there also are grounds on which a party might refuse
to produce anything at all. These objections include:

1.
The discovery request is unreasonably duplicative.
2.
The discovery sought is available from some other source that is more convenient,
less burdensome, or less expensive.
3.
The party seeking the discovery is better situated to obtain the information sought.

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

4.
The burden or expense of the proposed discovery outweighs its likely benefit,
taking into account the needs of the case, the amount in controversy, the parties’
resources, the importance of the issues at stake, and the importance of the
proposed discovery in resolving the issues in the litigation.
5.
The material sought is privileged (usually because it consists of communications
between an attorney and a client, or because it represents the “work product”
of the attorney, i.e., part of the attorney’s preparation for litigation).23
If a party claims privilege as the grounds for withholding certain information, it must
produce a “privilege log” describing each document withheld (without revealing the
contents) and identifying the reason for the assertion of privilege.24 Generally, the document
descriptions will include the date of the document, the author of the document,
and sometimes the length of the document.

Privilege generally is claimed most frequently for two types of information: attorney–
client communications and work product. Both of these privileges are the subject of
many treatises, articles, and legal opinions. The following section merely provides a
brief overview of the basis for asserting the privileges.

Attorney–Client Privilege

The attorney–client privilege generally applies to and protects communications between
a client and an attorney made for the purpose of furnishing or obtaining professional
legal advice.25 The purpose of the attorney–client privilege is to encourage full and frank
communication between attorneys and their clients by ensuring that such communications
will be held in confidence.26 Accordingly, the attorney–client privilege belongs to
the client, not the attorney, and only the client may disclose the communications.27

The communication may be oral or written, but it must be made with a reasonable
expectation of privacy. For example, if the client yells something to counsel across a
room full of people, the privilege has been waived as to that communication. Moreover,
the attorney–client privilege attaches only to the contents of the communication itself,
not the underlying facts. This means that a client cannot claim privilege over certain
facts sought to be discovered by the other side simply because the client also communicated
those facts to the attorney.28 The communication itself is protected even if the
information may be discovered through other sources.29 Finally, acts that are simply
observed by the attorney, and not directly conveyed by the client, are not necessarily
privileged. In evaluating that issue, the courts examine whether what the lawyer observed
(e.g., the client’s attitude or actions) could be deemed confidential in nature.30

Work Product Privilege

The work product privilege applies to those documents and tangible things “prepared in
anticipation of litigation or for trial” by a party or that party’s representative, including
the party’s “attorney, consultant, surety, indemnitor, insurer or agent.”31 The party seek



THE LITIGATION PROCESS

ing discovery as to those materials must show that the party has “substantial need of the
materials in the preparation of the party’s case and that the party is unable without
undue hardship to obtain the substantial equivalent of the materials by other means.”32
Even if the court finds that those requirements have been met, the court must still, where
feasible, redact certain information or otherwise “protect against disclosure of the mental
impressions, conclusions, opinions, or legal theories of an attorney or other legal representative
of a party concerning the litigation.”33 Accordingly, in ordering discovery of
work product, the court may redact such information.

The FRCP makes clear that documents indicating a party’s legal strategy, assessment
of the strength of various claims, or other preparation for trial are core work product
and generally will be outside the bounds of discovery.34 The more the materials reflect
the attorney’s mental processes and nature or direction of the investigation, the greater
the burden will be on the requesting party to show good cause for disclosure.35 Just as
with attorney–client privilege, work product protection does not prevent the underlying
information from being discovered; it only precludes production of particular materials
absent a showing of substantial need and inability to obtain that information without
undue hardship. For example, the notes taken by an attorney during or after his interview
of a particular witness may qualify as work product. However, the other party is
entitled to interview that witness and may even be able to require the first attorney to
disclose the identity of that witness.36 Moreover, should that witness become ill and
unable to communicate, the other party could argue that the facts warrant disclosure of
the attorney’s notes to avoid undue hardship on him or her based on the practical
unavailability of the information possessed by that witness. In such case, the court
could require a factual summary, redacted of all mental impressions and legal strategy,
to be turned over to the opposing party.

Electronic Discovery

An important area of discovery that recently is receiving new interest from courts and
attorneys is the discovery of electronically stored information.37 Although the definition
of a “document” under the FRCP has included a reference to electronic data since 1970,
it is only recently that litigators have begun aggressively pursuing the full extent of the
electronic data available in most companies. The volume of data available in electronic
form is staggering. In 1998, 3.4 trillion e-mail messages were sent worldwide, including
approximately 343 billion in the United States.38 Currently, approximately 93 percent
of the world’s information is being generated and stored in digital form, while only
7 percent is stored in other media such as paper and film.39 This means that the attorney
(or expert) who ignores the relevant electronic information that potentially exists in
a case is missing the lion’s share of the evidence.

Moreover, attorneys should not be content with paper versions or “hard copies,” of
the electronic files. Electronic documents have embedded information known as “meta



LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

data,” information that is attached to the file and can conclusively resolve conflicting
testimony concerning such issues as the date that a file was created and the author of
that file. For example, a date in a printed document may reflect simply the date that
it was printed rather than the date the document was created. Additionally, electronic
versions of documents may indicate the last date that the document was edited, the
last person to edit it, and possibly even the changes made. None of these factors is
apparent from the printout of the same document.

Not only do electronic documents offer more information, but also they often are
easier to review for relevant information. For instance, a collection of electronic documents
can be combined within a database enabling efficient data analysis. Attorneys,
experts, and their assistants can explore electronic data through text searches rather than
being forced to peruse thousands of pages for a minimal return. Electronic databases,
depending on their particular format, can be searched using key words or phrases,
Boolean requests, fuzzy logic, proximity, and thesaurus-based search methods to extract
relevant information.

Depositions

Discovery also involves taking and defending depositions. Each side will seek to take
the deposition of the witnesses identified by the other party as being their primary witnesses
on certain topics. A deposition involves oral questions asked by an attorney of a
witness who is sworn in as if he or she were giving testimony at trial. The witness’s testimony
will be recorded by a court reporter and will provide valuable insight into the
witness’s likely testimony at trial. In fact, deposition testimony may come back to haunt
the sloppy witness who alters his or her testimony at trial; attorneys will be prepared to
present the earlier testimony as impeachment of the expert’s credibility where it conflicts
or contrasts with the most recent evolution of the expert’s opinion. Expert depositions
are always important, but the expert’s contribution need not be limited to his or
her actual testimony at deposition. Experts can assist in creating a strategy for questioning
the opposing experts and may even attend the depositions to suggest follow-up
questions of which the attorney may not be aware.

EXPERT DISCLOSURES

During discovery, in addition to helping frame the discovery requests made of the
opposing party, expert witnesses must disclose certain information about themselves
and the information that they have reviewed in reaching their opinions. The FRCP
requires all testifying experts to disclose “a complete statement of all opinions to be
expressed and the basis and reasons therefore; [and] the data or other information considered
by the witness in forming the opinions.”40 Some federal courts have interpreted
these requirements quite broadly.


THE LITIGATION PROCESS

In re Pioneer Hi-Bred Int’l, Inc.41

In Pioneer Hi-Bred, the Federal Circuit held that documents and information disclosed
to a testifying expert are subject to mandatory disclosure “whether or not
the expert relies upon the documents and information in preparing his report.”
The court noted that “fundamental fairness requires disclosure of all information
supplied to a testifying expert in connection with his testimony,” including documents
and information that might be classified as privileged. The court emphasized
that the 1993 amendments to the rule were meant to eliminate the argument
that information disclosed to testifying experts could be withheld from discovery
on the basis of work product or attorney–client privilege.

Johnson v. Gmeinder42

In Johnson, the court held that simply reading or reviewing materials before or in
connection with formulating expert opinions would be deemed “consideration” of
the information for purposes of mandatory disclosures. In this case, the expert testified
at the hearing that he had merely read, but not “considered” certain materials
in preparing for his expert report. The court rejected that argument, holding
that mandatory disclosures would even include information that the expert had
evaluated, but then rejected as a basis for his ultimate conclusions.

The requesting party has a right to the contents of a testifying expert’s communications
with counsel, including the attorney’s mental impressions and legal theories,
because such communications could influence the expert’s substantive consideration of
the issues as well as the form of the expert’s opinions. Moreover, a recurring theme in
cases addressing this issue is that the judge has a right “to know who is testifying” (i.e.,
how much of the opinion originated with the expert and how much was spoon-fed by
counsel). Accordingly, attorneys and experts should be aware that all information
reviewed by a testifying expert may be the subject of mandatory disclosures, specific
discovery requests, and lines of questioning at the expert’s deposition.43

Furthermore, mandatory disclosures may require the production of draft versions of
the expert’s report. Draft reports that are exchanged between an expert and an attorney
and contain written comments or notes arguably are additional materials considered
by the expert in reaching his or her opinion.44 Trigon Ins. Co. v. United States took an
extremely strict approach to this requirement and stands as a warning for both counsel
and experts.


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Trigon Ins. Co. v. United States45

In Trigon, the documents in question were drafts of expert reports that were not
“solely the product of the expert’s own thoughts and work.” The court found that
parties were required to retain and produce draft reports sent to and from the
experts. The plaintiff had only requested the draft reports informally (apparently at
least once by letter), but the court found that a formal discovery request was not necessary
to trigger the obligation to retain copies of the drafts. Since the defendant had
failed to retain copies of the draft reports, the court found that the plaintiff was entitled
to recover attorneys’ fees and costs related to the issue and an adverse inference
against the expert’s testimony at trial. This adverse inference is an extremely severe
sanction, as it would substantially undermine the expert’s credibility to a jury or the
court. The court considered precluding the expert from testifying at all, but decided
to allow the testimony only because a forensic inspection of the defendant’s computers
had recovered some portion of the missing documents. The defendant also
was required to pay for the cost of the forensic inspection.

The court did not address whether retention and disclosure would be required where
the testifying experts worked alone (which were not the facts presented by the case),
but that distinction may be meaningless in any practical sense given the frequent
occurrence of experts and attorneys working closely together on the expert report.

EXPERT REPORTS

The scheduling order will contain due dates for expert reports. Typically, the plaintiff’s
expert report is due first, followed a month or so later by the defendant’s expert report.
Sometimes initial reports from both sides are due simultaneously, followed by rebuttal
reports. Many different schedules can exist. An expert should have copies of all the
pleadings and the scheduling order prior to preparing and serving his report. Much can
be said about how to structure and write an effective expert report, but that topic is
beyond the scope of this book. A sample expert report is included in Appendix B as an
example of a format and organizational structure that the authors have found particularly
effective in litigation.

EXPERT DEPOSITIONS

Sometime after the expert reports are filed, the experts on both sides usually will be
deposed.46 Testimony given at a deposition is made under oath, subject to the penalties
of perjury. Depositions are always recorded, usually by a stenographer, although videotaping
a deposition is gaining popularity. Support among litigators for videotaping dep



THE LITIGATION PROCESS

ositions has been driven in part by experienced experts who have attempted to evade
clear and honest answers to questions. Videotaping makes evasive tactics in a deposition
difficult.

In a deposition, the person being deposed (the deponent) is asked questions by an
attorney and given an opportunity to answer. At times, the attorneys present may object
either to the form of a question or to the subject matter to which the question pertains.
The deponent should always pause briefly before answering in order to give counsel
the opportunity to object, then listen carefully to the particular objection being made
because the objection may provide a clue as to the goal of the questioning attorney.
After an objection has been made, an expert should resume testifying only after counsel
instructs the expert to continue. Under certain narrow circumstances, an expert may
be instructed by the attorney not to answer. Under the FRCP, an attorney may instruct
the deponent not to answer only: (1) where the question seeks privileged information;
(2) where the question (or probable answer) violates a court-directed limitation on
evidence; or (3) where it becomes apparent that the deposition is being conducted “in bad
faith or in such a manner as unreasonably to annoy, embarrass or oppress.”47

Experts are deposed primarily for three reasons: (1) to gain a more complete understanding
of the expert’s opinions and likely testimony at trial than is possible from the
expert report, (2) to confront the expert with potential oversights and weaknesses in his
opinion or qualifications that may undermine his reliability as an expert, and (3) to test
the expert’s commitment to certain opinions. Experts can be confronted with their deposition
testimony when they are on the witness stand, so it is very important for the deposition
to go well.

As an expert, there is very little real art to being deposed. The expert’s best defense
is to know the case, know the topic of inquiry, and formulate opinions that are defensible
and not exaggerated. Substantive knowledge about IP law and damages theories can
expose the goals of the questioning attorney, as well as the purpose of certain questions
and how an expert’s statements can affect the outcome of the litigation. The Additional
Reading section at the end of this chapter identifies additional materials that provide
more detailed discussions of deposition tactics and procedures.

MOTION PRACTICE

After expert depositions, the parties may file motions to limit the issues for which trial
is necessary and restrict the evidence that will be heard at trial. These motions generally
take the form of either motions for summary judgment or motions in limine.48

In essence, a motion for summary judgment means that the judge can determine the
outcome of the case because discovery has revealed either that the issues in dispute are
purely legal (judges decide law, whereas juries decide facts) or that the evidence is so
one-sided that no reasonable juror could find in favor of a particular party on an essential
element of a claim. A party moving for summary judgment must establish that there


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

are no disputes as to “genuine issues of material fact.”49 Moreover, the court will construe
the pleadings and factual record strictly against the party moving for summary
judgment, essentially giving the opposing party the benefit of the doubt where there is
a basis for such doubt.50 In short, a party seeking summary judgment faces a very high
evidentiary standard. In light of this significant burden, parties often move for partial
summary judgment. A motion for partial summary judgment asks the court to rule on a
limited issue that will further the efficient resolution of the case (sometimes by increasing
pressure to settle), although it does not aim to decide the case completely. For example,
a plaintiff in a patent infringement case might find it strategically wise to file for
partial summary judgment solely on the issue of infringement or validity. Neither one
of those issues resolves the question of damages or ends the case, but it might effectively
limit the amount of time and resources required for trial.

“Motion in limine” simply means a motion “to exclude” certain evidence or testimony.
Since the parties will have deposed each other’s primary witnesses and exchanged
witness and exhibit lists before trial, each side should have a reasonable idea of
what to anticipate hearing at trial. A party may move to exclude evidence that he or she
anticipates the other side will use at trial because that evidence is irrelevant to the
issues that will be tried or because the evidence is more prejudicial than probative of
the issues.51 The FRE broadly defines “relevance” as “evidence having any tendency to
make the existence of any fact that is of consequence to the determination of the action
more probable or less probable than it would be without the evidence.”52 Even if the
court is satisfied that the evidence is relevant, the evidence may still be excluded for a
host of reasons, including “if its probative value is substantially outweighed by the danger
of unfair prejudice, confusion of the issues, or misleading the jury, or by considerations
of undue delay, waste of time, or needless presentation of cumulative evidence.”53
Additionally, a party may object to the admission of testimony that will consist of nothing
more than hearsay evidence.54 Basically, any of the rules of evidence could provide
the basis for a motion in limine, although relevance and lack of adequate probative value
are two of the most common grounds for moving to exclude certain evidence from trial.

Experts often play an important role during motion practice by helping the lawyers
formulate the theories of the case. In the context of motions for summary judgment,
experts often provide affidavits on issues that are submitted as supporting attachments
to the motion for summary judgment or legal memorandum opposing summary judgment.
Additionally, an expert or portions of the expert’s testimony may be the subject
of a motion in limine. Motions in limine regarding experts are commonly referred to as
“Daubert motions” and they are discussed in detail in Chapter 2.

TRIAL

If a plaintiff’s case survives summary judgment, then the dispute will be decided at trial.
The trial is a complicated process in which the expert plays a small but important role.
Although this book does not include a discussion of how to testify at trial, the funda



THE LITIGATION PROCESS

mentals of knowledge, preparation, and accuracy are just as critical at trial as during
deposition. When possible, an expert should be present during the trial to hear the testimonies
of fact witnesses prior to giving his or her own testimony. An expert generally
is not subject to the exclusionary rule that can bar fact witnesses other than the corporate
representative from the courtroom prior to giving their testimony.

COURT OPINIONS

Courts may issue rulings, or opinions, at several points during litigation. Rulings may
address the admissibility of evidence, the propriety of certain discovery tactics, the relevance
of certain issues, and the use of expert testimony. A court may issue various
orders to govern the conduct of the parties in a particular case. Published court opinions
(as opposed to merely oral rulings) also can have weight in unrelated litigation.
An opinion from a higher court (e.g., a circuit court that hears appeals from the particular
district court at issue) is described as “binding precedent.” Binding precedent
must be followed by all lower courts. However, not all circuit court opinions are binding
on all lower courts. For instance, an opinion issued from a higher court that is not
in the same circuit as the district court might be persuasive but is not binding on the
lower court’s decision. The closer the factual parallel between cases, the more likely a
court might be to find another judge’s opinion instructive, even if it comes from a different
jurisdiction. Of course, United States Supreme Court opinions are binding on all
courts.

Commonly, judicial interpretation of statutes and existing law offers better guidance for
lawyers and experts in litigation than the statutes themselves. Different jurisdictions may
interpret the same statute in different and possibly conflicting ways. The outcome of any
particular litigation may depend on the attitude of courts in the relevant jurisdiction, rather
than on some absolute answer that would apply regardless of location. Where certain
issues have not yet been addressed in a specific jurisdiction (as is commonly the case in
less populated areas), the opinions of other courts from around the country can serve both
as predictors of potential outcomes in litigation and as support for particular arguments.

A final judgment in the case can become the basis for an appeal. Until a final judgment
has been entered, other rulings by the court generally cannot be appealed. Some
intermediate decisions may significantly impact the case, but if the litigation were interrupted
for appeals of every ruling, litigation would be even more protracted and resolution
even harder to obtain.

LITIGATION VERSUS ALTERNATIVE DISPUTE RESOLUTION

After the decision to take action, often the first choice that must be made is whether to
litigate in court or pursue one of the alternative means of dispute resolution. Litigation
in court is what people typically think of when they imagine suing or being sued, and
the process has been discussed in detail. However, alternative dispute resolution (or


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

ADR) has been increasing steadily in popularity as an alternative, or sometimes a precursor,
to traditional litigation.

Alternative dispute resolution may be particularly appropriate in the context of IP litigation,
given the typical expenditures of time and resources on the litigation process.
Recent statistics indicate that 76 percent of patent suits settle, but not before each side
has incurred over $1 million in legal fees and indirect legal expenses.55 Moreover, litigating
a patent case through the trial stage costs each side an average of approximately
$2 million in legal fees and related expenses, and the average costs have been increasing
about 15 percent per year over the last five years.56 The theoretical advantages of
ADR include speed, economy, expertise of the decision maker, privacy, greater informality,
convenience related to selecting the time and place of the proceedings, and finality
without recourse to appeal.

However, extremely complex IP cases may benefit from the formal procedures
used in federal court rather than the simplified, potentially less sophisticated approaches
of ADR. Intellectual property cases typically require significant investigation and
exchange of information, perhaps best accomplished through the formal discovery procedures
used in federal courts. Similarly, the parties often will not move toward settlement
until the issues have been narrowed and both parties have been assured that they
have all relevant information. By the time both parties have conducted the necessary
factual investigation, hired and prepared expert witnesses, and identified the linchpin
issues, they may have already invested sufficient resources to void any cost savings
through ADR.

Alternative dispute resolution consists primarily of mediation and arbitration.
Essentially, mediation consists of settlement discussions facilitated by the perspective
of a neutral third party (often someone with experience as a judge or expertise in the
relevant area). Mediation is a meeting of the parties before a mutually selected mediator
who attempts to mediate the differences between the parties and facilitate settlement.
The mediation can last as long as the parties believe that it is serving a useful
purpose, but it generally does not last more than a couple days. The mediator generally
will listen to both sides’ presentations of their arguments, and then may separate
the parties and speak to each side about the perceived strengths and weaknesses in their
arguments. The mediator can present various settlement options to the opposing sides
and discuss the merits of the proposals with each side. A mediator’s goal is to enable
the parties to find a mutually satisfactory resolution to their dispute, given the facts and
the law. Although the mediator’s opinions and findings can sway one or both of the
parties toward a settlement, the parties typically agree that the findings of the mediator
will not be binding, so mediation does not preclude seeking a resolution in court or
through binding arbitration.

Arbitration, on the other hand, is conducted very much like courtroom litigation, and
the arbitrator’s decision, like a judge’s ruling, generally is binding and final for the parties.
57 Generally, the arbitration process moves faster than traditional litigation and can


THE LITIGATION PROCESS

save the parties significant amounts in fees and costs. Moreover, the ability to select
your arbitrator, in effect tailoring him or her to the nature of your case, proffers an
advantage over the random assignment of judges in the federal and state court systems.
Both forms of ADR involve attorneys, witnesses, and rules of evidence. However, the
technical rules governing the admissibility of evidence often are modified, either
through mutual stipulation of the parties beforehand or because the ADR is conducted
under the rules of a particular organization, such as the American Arbitration Association
(AAA). Generally, at a hearing, the arbitrator will receive all relevant evidence
without applying strict rules of evidence. Both parties have the option of being represented
by counsel and to present their cases in a manner possibly very similar to the
organization and structure of a court case. After the hearing, the arbitrator will have a
certain amount of time within which to render his or her final decision. The length of
time that an arbitrator has to issue a decision can be predetermined by the organization’s
rules or by an agreement between the parties. For example, under the AAA rules, the
arbitrator renders a final decision within 30 days of the hearing’s conclusion. This timing
can be in marked contrast to the lengthy time lines of many federal courts.

By law, even “final” or “binding” decisions of an arbitrator may be appealed to a
court in limited circumstances. However, courts have adopted a standard of review (in
other words, the standard to which they will hold the other forum, in this case the arbitrator)
that virtually guarantees that such appeals will be unsuccessful unless the decision
was truly arbitrary or capricious. An arbitration decision, unlike a judicial ruling,
is not subject to reversal by the courts based on the argument that it was legally erroneous.
Under section 10 of the Federal Arbitration Act (FAA),58 the arbitrator’s decision
may be set aside by a court only for such reasons as bias or corruption of the
arbitrator, misconduct by the arbitrator, or action in excess of his or her power.59
Clearly, the courts have an interest in decreasing their own caseload by encouraging
dispute resolution outside the courtroom. If every ADR decision could be essentially
reheard on appeal, the lack of finality would discourage potential litigants from pursuing
that form of dispute resolution. Therefore, the courts will only address the merits of
an arbitrated case where it appears that the arbitrator’s actions were nearly inexcusable.

The courts may, however, at the request of one of the parties, intervene before the
arbitration begins. Courts may stay the arbitration, order that the arbitration proceed, or
stay related judicial proceedings in favor of arbitration. The arbitration process generally
begins with a written “demand for arbitration” or other form of notice sent by one
party to the other alerting them of their intention to arbitrate certain issues. The recipient
of such a demand may ignore the letter and bring suit in court. The party seeking
arbitration may then apply for a stay of the judicial proceedings in favor of arbitration.60
If the party seeking arbitration can satisfy a court that the issue involved in the lawsuit
is covered by a valid and binding arbitration agreement between the parties (frequently
found in the contract at the heart of the dispute), then the court must stay the lawsuit.61
Similarly, the party seeking arbitration may ask a court for an order “directing that such


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

arbitration proceed in the manner provided for” in the parties’ arbitration agreement if
the other party simply refuses to participate in the arbitration, without bringing an independent
suit.62 To issue such an order, the court must determine the existence of a valid
arbitration agreement. Finally, the party who wishes to avoid arbitration may seek a
court order staying the arbitration pending a judicial determination of whether a valid
agreement to arbitrate exists. The federal courts are limited to these forms of injunctive
relief related to arbitration; they will not intervene merely to address evidentiary issues
or other intermediate issues within the arbitration.

SUMMARY

Chapter 1 explained the basic structure of the U.S. court system and generally outlined
the essential chronology of litigation. This background information should provide a
helpful context for participants in the litigation process. By understanding the various
stages of litigation and anticipating your role in those stages, you can be better prepared
and more capable of contributing valuable input to the development of an IP damages
theory. Early involvement and comprehension of the standards that will be applied to
your theory will improve both your work product and the work product of other team
members who could benefit from your perspective.

ENDNOTES

[1]
See 28 U.S.C. § 1295(a)(4)(C).
[2]
See 28 U.S.C. § 1295(a)(4)(A).
[3] In fact, the Federal Circuit’s application of its own law to issues outside the patent area
has sparked some controversy. See Ronald Katz and Adam Safer, Should One Patent
Court Be Making Antitrust Law for the Whole Country, 69 Antitrust L. J. 687 (2002).
[4]
See, e.g., Forsley v. Principi, 284 F.3d 1355 (Fed. Cir. 2002) (stating that appellate courts
must apply the correct law, even if not presented by the parties or considered by the
lower court (citing Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 99 (1991))).
[5]
See, e.g., Glaxo, Inc. v. Torpharm, Inc., 153 F.3d 1366, 1370 (Fed. Cir. 1998) (“We must
reverse a summary judgment if any errors of law were made, unless an independent legal
ground exists in the record upon which we can affirm.” (citations omitted)).
[6]
See, e.g., Molins PLC, v. Textron, Inc., 48 F.3d 1172, 1181 (Fed. Cir. 1995) (“We accord
deference to the fact finder’s assessment of a witness’s credibility and character.”);
DeSarno v. Dep’t of Commerce, 761 F.2d 657, 661 (Fed. Cir. 1985) (“It is not our function
to second-guess the credibility determinations of the presiding official, which were
based on the demeanor of the witnesses during the hearing.”).
[7]
See, e.g., Gould v. Quigg, 822 F.2d 1074, 1077–78 (Fed. Cir. 1987) (affirming trial court’s
resolution of conflicting expert testimony based on credibility assessments).

THE LITIGATION PROCESS

[8]
See, e.g., Smiths Indus. Med. Sys., Inc. v. Vital Signs, Inc., 183 F.3d 1347, 1354–55 (Fed.
Cir. 1999) (reversing trial court’s legal determination of obviousness based on the court’s
erroneous claim construction and flawed analysis of the differences between the claimed
invention and the prior art).
[9] The Supreme Court may review any decision of a court of appeals, including the Federal
Circuit, by granting a discretionary “writ of certiorari.” Unlike the Supreme Court’s jurisdiction
in appeals from state court decisions, which is limited to questions of federal law,
the Court may decide any legal question, whether state or federal, in cases appealed from
lower federal courts. However, the Court generally limits itself to reviewing important
questions of federal law.
[10]
Conley v. Gibson, 355 U.S. 41 (1957).
[11]
Id. at 47.
[12] Counterclaims are simply the affirmative claims that a defendant raises against the plaintiff.
In other words, where the defendant believes that not only is she without blame, but
also that in fact the plaintiff has harmed her, she can raise a counterclaim seeking damages
or some other remedy.
[13]
See Fed. R. Civ. P. 12.
[14]
See Fed R. Civ. P. 26.
[15]
Id.
[16]
See, e.g., American Standard Inc. v. Pfizer, Inc., 828 F.2d 734, 741 (Fed. Cir. 1987).
[17]
Id.
[18]
In re: Huang, 100 F.3d 135, 139–40 (Fed. Cir. 1996) (noting that sales information may
be relevant to commercial success, although such information alone is not dispositive).
[19]
See, e.g., Micro Motion, Inc. v . Kane Steel Co., Inc., 894 F.2d 1313, 1326 (Fed. Cir. 1990)
(holding sales information from a nonparty to be irrelevant).
[20]
Fed. R. Civ. P. 26(d).
[21]
See In re Halkin, 598 F.2d 176 (D.C. Cir. 1979) (overturning a protective order because the
“inherent value of speech in terms of its capacity for informing the public does not turn on
how or where the information was acquired”), overruled by Seattle Times Co. v. Rhinehart,
467 U.S. 20, 32 & n. 18 (1984). At issue in Halkin were copies of documents relating to
Operation Chaos, the CIA’s program with regard to antiwar activities during the Vietnam
War. The plaintiffs intended to release several of them at a press conference. It may be that
the inherent appeal of society’s interest in government information about private citizens
protesting an unpopular war played a role in this decision, where financial documents
about a company offer less intuitive value as a First Amendment argument.
[22]
Seattle Times Co. v. Rhinehart, 467 U.S. 20, 32–37 (1984).
[23]
See Fed. R. Civ. P. 26(b)(2).
[24]
See Fed. R. Civ. P. 26(b)(5).
[25]
See, e.g., American Standard, Inc. v. Pfizer, 828 F.2d 734, 744–45 (Fed. Cir. 1987).
[26]
Id.
[27]
Id.; see also 8 I. Wigmore, Evidence, § 2321 (McNaughton, rev. ed., 1961).

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

[28]
See, e.g., In re Grand Jury Subpoena Duces Tecum (Rich), 731 F.2d 1032, 1037 (2d Cir.
1984) (finding that attorney–client privilege protects communications, not underlying
information); J.P. Foley & Co., Inc. v. Vanderbilt, 65 F.R.D. 523, 526 (S.D.N.Y. 1974)
(noting that privilege pertains solely to substance of communications, it does not “preclude
inquiry into the subject matter of communications”).
[29]
See, e.g., United States v. O’Malley, 786 F.2d 786, 794 (7th Cir. 1986) (rejecting argument
that witness’s communications to counsel were not privileged because he had given the
same information to the FBI).
[30]
In re Grand Jury Proceedings, 791 F.2d 663, 665 (8th Cir. 1986) (requiring attorney to
authenticate certain signatures and photographs allegedly of the client who was being
investigated by a grand jury because appearance and handwriting generally are not confidential
communications as others could observe them as well); United States v. Weger, 709
F.2d 1151, 1154–56 (7th Cir. 1983) (affirming lower court’s admission of letter to counsel
purely for the purpose of comparing the typeset with that of another letter typed on the
defendant’s typewriter); In re Walsh, 623 F.2d 489, 494 (7th Cir.), cert. denied, 449 U.S.
994 (1980) (finding that privilege does not apply to attorney’s observations about client’s
physical appearance, demeanor, and dress).
[31]
Fed. R. Civ. P. 26(b)(3).
[32]
Id.
[33]
Id.
[34]
See Hickman v. Taylor, 329 U.S. 495 (1947) (finding that work product includes “interviews,
statements, memoranda, correspondence [and] briefs” of lawyers and indicating a strong
reluctance to force an attorney to become a witness); Ford v. Philips Elec. Instruments Co.,
82 F.R.D. 359, 360 (E.D. Pa. 1979) (lawyer’s discussion with a third-party witness concerning
the lawyer’s evaluation of the case were not discoverable at the witness’s deposition); In
re Grand Jury Proceedings (Duffy), 473 F.2d 840, 848 (8th Cir. 1973) (holding that lawyer’s
recollection of conversations with a witness were privileged as work product); Harper & Row
Publishers, Inc. v. Decker, 423 F.2d 487, 492 (7th Cir. 1970), aff’d 400 U.S. 348 (1971) (holding
that law firm’s memoranda of interviews with witnesses were protected).
[35]
Harper & Row Publishers, Inc. v. Decker, 423 F.2d 487, 492 (7th Cir. 1970), aff’d, 400
U.S. 348 (1971).
[36]
See United States v. Int’l Business Mach. Corp., 79 F.R.D. 378, 380 (S.D.N.Y. 1978) (noting
that Supreme Court has never indicated that opposing counsel “could not subsequently
inquire of the witnesses themselves what they said at the interview); Lauritzen v.
Atlantic Greyhound Corp., 8 F.R.D. 237, 238 (E.D. Tenn. 1948), aff’d, 182 F.2d 540 (6th
Cir. 1950) (requiring defendants to produce lists of witnesses to a bus accident, despite
objection that such lists were work product); United States v. Exxon Corp., 87 F.R.D. 624,
638 (D.D.C. 1980) (finding that work product protection does not preclude answering
questions as to whether protected documents even exist). But see In re Grand Jury
Impanelled Oct. 18, 1979 (Malfitano), 744 F.2d 1464, 1467 (11th Cir. 1984) (holding that
a list of potential witnesses interviewed by the attorney was work product because it
revealed the litigation strategy, although disclosure could be made upon a relatively low
showing of need and hardship).
[37]
See generally Kenneth J. Withers, Computer-Based Discovery in Federal Civil Litigation,
Fed. Cts. L. Rev. (Oct. 2000).

THE LITIGATION PROCESS

[38]
See Kenneth J. Withers, The Real Cost of Virtual Discovery, Federal Discovery News
(February 2001).
[39]
Id.
[40]
Fed. R. Civ. P. 26(a)(2)(B) (emphasis added). These disclosures must be made at least 90
days before the trial date or upon the date directed by the court or stipulated to by the parties.
See Fed. R. Civ. P. 26(a)(2)(C).
[41]
238 F.3d 1370 (Fed. Cir. 2001); see also Aniero Concrete Co. v. New York City School
Constr. Auth., 94 Civ. 9111, 2002 U.S. Dist. LEXIS 2892 (S.D.N.Y. Feb. 22, 2002) (concluding
that the majority of courts agree that reliance by the expert on the information is
not necessary for the information to be subject to mandatory disclosure).
[42]
191 F.R.D. 638, 641 (D. Kan. 2000).
[43] For more judicial treatment of the privilege argument in the context of expert disclosures,
see B.C.F. Oil Ref., Inc. v. Consol. Edison Co., 171 F.R.D. 57, 66 (S.D.N.Y. 1997) (disclosures
must include attorney opinions given to the expert); W.R. Grace & Co. v. Zotos
Int’l, Inc., No. 98-CV-838S(F), 2000 U.S. Dist. LEXIS 18096 (W.D.N.Y. Nov. 2, 2000)
(availability of cross-examination at trial is not an adequate substitute for pretrial disclosures
of information considered).
[44]
See W.R. Grace, 2000 U.S. Dist. LEXIS 18096 (finding that drafts of expert report faxed
to counsel must be disclosed).
[45]
204 F.R.D. 277 (E.D. Va. 2001).
[46]
See Fed. R. Civ. P. 26(b)(4).
[47]
Fed. R. Civ. P. 30(d).
[48]
See Fed. R. Civ. P. 56; Fed. R. Evid. 401–403.
[49]
See Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 250–51 (1986) (mandating summary
judgment if a party fails to establish the existence of an element essential to that party’s
claim and on which it bears the burden of proof).
[50]
See, e.g., Suntinger, Inc. v. Scientific Research Funding Group, 189 F.3d 1327, 1334 (Fed.
Cir. 1999) (viewing evidence in a light most favorable to the nonmovant and drawing all
reasonable inferences in its favor).
[51]
See Fed. R. Civ. P. 401, 402, 403.
[52]
Fed. R. Civ. P. 401.
[53]
Fed. R. Civ. P. 403.
[54]
See generally Fed. R. Evid. 801, 802, 803.
[55]
Robert Goldscheider, ADR Focused on Licensing and Intellectual Property, working
paper; 5 Eckstorm’s Licensing in Foreign and Domestic Operations: The Forms and
Substance of Licensing § 21:2 (April 2002).
[56]
See id.
[57] The binding nature of the arbitration or mediation, like many procedural aspects of ADR,
is subject to the stipulation of the parties, either in a pre-existing contract or through an
agreement reached subsequent to the conflict. However, most parties believe that any efficiency
advantages of arbitration are lost if the parties can simply pursue the case in court
once arbitration has concluded. Therefore, arbitration clauses in contracts typically

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

require the arbitration to take place within a certain time frame and for the parties to
accept the arbitrator’s decision as final.

[58] See 9 U.S.C.A. §§ 1–14 (1999).
[59] See 9 U.S.C.A. § 10(a) (1999).
[60] See FAA, 9 U.S.C.A. § 3 (1999); Uniform Arbitration Act § 2(d).
[61] See FAA, 9 U.S.C.A. § 3.
[62] See FAA, 9 U.S.C.A. § 4; Uniform Arbitration Act § 2(a).
ADDITIONAL READING

Walter D. Alley, Electronic Discovery Tools for Litigators, LJN Legal Tech Newsletter


(Oct. 2001).
Steven Babitsky and James J. Mangraviti, Jr., How to Excel During Depositions: Techniques
for Experts That Work, SEAK, Inc. (1999).


Margaret Berger, Evidentiary Framework, Reference Manual on Scientific Evidence 37
(1994).
Morgan Chu, Discovery of Experts, 8 Litigation 13 (Winter 1982).
Theodore C. Hirt, Expert Reports, 22 Litigation 46 (Summer 1996).


William Iscle, Under Oath: Tips for Testifying, LRP Pub. (1995).
Steven Lubet, Expert Testimony: A Guide for Expert Witnesses and the Lawyers Who
Examine Them, NITA (1998).


Joan A. Lukey and Elizabeth A. Rowe, Electronic Discovery: An Overview, www.abanet.org/
litigation/home.html.


David Malone and Paul Zwier, Effective Expert Testimony, NITA (2000).
Marc Rabinoff and Stephen Holmes, The Forensic Expert’s Guide to Litigation: The Anatomy
of a Lawsuit, LRP Pub. (1996).


Mark D. Robins, Computers and the Discovery of Evidence—A New Dimension to Civil
Procedure, 17 J. Marshall J. Computer Info. L. 411 (Winter 1999).


Michael Sacks, A Guide for Testifying and Consulting Experts, LRP Pub. (1995).
Kenneth J. Withers, The Real Cost of Virtual Discovery, Federal Discovery News (Feb.
2001).


Kenneth J. Withers, Computer-Based Discovery in Federal Civil Litigation, Federal
Courts Law Review (Oct. 2000).



2


Damage Principles and Daubert


The plight of the expert in an intellectual property (IP) case brings to mind the statement
by English author Samuel Butler, “Life is the art of drawing sufficient conclusions
from insufficient premises.” Although Butler’s assessment may not have held up under
the standards applicable to a testifying expert’s opinions, the fact is that a case seldom
presents complete documentation or an opportunity for perfect knowledge of all relevant
facts. Moreover, experts often are privy to only a portion of the evidence and are
instructed to operate under a certain set of factual and/or legal assumptions. In essence,
both attorneys and experts are seeking to draw “sufficient conclusions” from the hand
they are dealt. The manner in which they do so is the subject of great debate, both between
opposing parties in litigation and in the judiciary’s continuing attempt to derive
a single set of standards that would apply equally to all expert testimony and provide a
fail-safe measure of reliability. The authors believe that this attempt has been only partially
successful and that the applicable rules are still evolving. Nonetheless, attorneys
and experts must be aware of and play by the present rules set out by the courts. This
chapter explains the current standards for admissibility of expert opinions.

DAUBERT ISSUES

Federal Rules o,f Evidence 702 and 703 govern expert testimony. The traditional standard
for admissibility of expert testimony under Rule 702 was whether the testimony
would assist the triers of fact, rather than confuse or mislead them. Rule 703 sets forth
the standard for admissibility of the underlying data relied on by the expert in formulating
his or her opinion. Rules 702 and 703 were recently revised and the new text
became effective on December 1, 2000. The revisions are intended to codify and clarify
the standards that have evolved under a line of Supreme Court cases that set forth
guidelines for judging when expert testimony is reliable. This line of cases is known as

27



LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

the Daubert trilogy, and the committee notes that accompany the revised rules reaffirm
the trilogy’s continued importance.1 The three cases in the Daubert trilogy are
described in the boxes below.

Daubert v. Merrell Dow Pharmaceuticals, Inc.2

In Daubert, the Supreme Court stated that the judge must act as a gatekeeper to
determine in advance of trial whether expert testimony is reliable. The judge must
exclude unreliable testimony from consideration by the court or the jury. The Court
adopted a four-factor test: (1) is the expert opinion testable, (2) has the methodology
been subject to peer review, (3) is there a known error rate for the method, and

(4) is the method generally accepted in the scientific community? These four
criteria became the foundation for judicial evaluations of expert testimony.
General Electric Co. v. Joiner3

In Joiner, the Supreme Court resolved a disagreement among the circuits concerning
the standard for reviewing a district court’s exclusion of expert testimony. The
Court held that a stringent standard of “abuse of discretion” should be applied, giving
district court judges significant leeway in decisions concerning the admissibility
of expert testimony. Discretionary decisions are extremely difficult to overturn
on appeal. The effect of this decision was to encourage district court judges to perform
their role as a gatekeeper, rather than simply admitting everything and letting
disputes about the evidence go merely to weight rather than admissibility.

Kumho Tire, Ltd. v. Carmichael4

In Kumho Tire, the Supreme Court expressly expanded the Daubert inquiry to all
experts. Before Kumho Tire, it was unclear whether Daubert applied to experts other
than scientists. Kumho Tire applied the gatekeeping analysis to any expert, whether
the expert’s field of expertise was chemistry, accounting, economics, or drywall
repair. The Court also explained that the district court should have flexibility in
the application of the Daubert factors to the facts of the case and the expert at issue. The
flexibility of a case-by-case analysis was a natural extension of Joiner granting the district
courts discretion in the decision to admit or exclude expert testimony.


DAMAGE PRINCIPLES AND DAUBERT

All experts in IP cases must be careful not to run afoul of the Daubert principles, or
they risk having their opinions, reports, and testimony excluded. The Daubert trilogy
anticipates removing an expert from litigation entirely, not merely questioning the
weight or credibility that should be given to the expert’s opinions.

MAKING SENSE OF DAUBERT

The Supreme Court’s concern in Daubert was to establish the trial court judge as a gatekeeper
to keep “junk science” out of the courtroom. The danger of “junk science” is that
an unsophisticated jury could be persuaded by a well-polished expert or a person with
impressive credentials and could base a jury verdict on evidence that is not truly competent.
Essentially, the Supreme Court in Daubert desired to eliminate from the courtroom
“systems of knowledge” that have a fundamental nature different from “scientific knowledge.”
Of course, scientific knowledge is not limited to chemistry, physics, biology, and
the other fields one might consider to be traditional sciences. Scientific knowledge simply
refers to one particular means of establishing knowledge. For example, scientific
knowledge is knowledge that is acquired through the scientific method, whether the
information itself pertains to traditional fields of science, economics, or architecture.

The four Daubert factors that the Supreme Court introduced to differentiate science
from nonscience are (1) testability, (2) peer review, (3) error rates, and (4) acceptance
by the scientific community.5 These guidelines were supposed to aid the trial court
in separating scientific systems of knowledge from other types of knowledge. The
assumption of the Court was that scientific systems of knowledge were inherently more
reliable and thus preferable to other means of establishing knowledge. In our view, the
Daubert factors are not adequate for the task, particularly after the Court’s expansion
of the criteria to cover social science in its opinion in Kumho Tire. Instead, the drafters of
the amendment to Federal Rule of Evidence 702 properly expanded the inquiry by
adding other traditional judicial guidelines relevant to social science and damage
experts in particular. These factors are discussed in subsequent sections.

It is useful to first illustrate the logical underpinnings of several systems of knowledge
and then determine whether the Daubert factors alone are useful in distinguishing
between the systems of knowledge or identifying which types of knowledge are reliable.
One important differentiating characteristic of systems of knowledge pertains to
how each system connects unobservable core concepts to observable or empirical
events. We will refer to the unobservable conceptual theory as the “theoretical” level
and the empirical world (i.e., the phenomena we experience through our physical
senses) as the “observable” level. Exhibit 2-1 depicts two types of knowledge that the
Daubert opinion aimed at filtering out of a case during the pretrial period.6

In religious thought, the power of the analysis resides at the theoretical level alone.
There is no connecting relationship between observable reality and explanatory concepts.
The concepts originate elsewhere (e.g., in sacred texts or proclamations of religious
leaders). The litigation equivalent of religious thought is the expert who bases his


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Theoretical Analysis
x
y
y
x
Observational Knowledge
ReligionMysticism
EXHIBIT 2-1 Theoretical and Observational Knowledge

or her conclusions on theory that cannot be challenged by resorting to observation in the
discovery process or through independent analysis. In contrast, what is labeled mysticism
in Exhibit 2-1 involves pure abstraction from observation without the development
of a system of theoretical concepts that offers an explanation for association of
events and a consistency with other theories. The analogy in litigation is the expert
whose opinion is based purely on his “20 years of experience.”

One can view the Daubert opinion as an effort to eliminate religious and mystical
systems of thought as possible bases for a jury’s verdict in complicated litigation
situations. The weakness of the Daubert four-factor approach is that it is both under-
inclusive and overinclusive. In Daubert, the Court explicitly referred to Carl Hempel, an
extreme advocate of the empiricist view of science. Hempel, along with other logical
empiricists such as Karl Popper and Rudolph Carnap, narrowly defined the scientific
inquiry as encompassing solely a set of what Hempel called “deductive nomological”
explanations. The empiricist approach to accumulating scientific knowledge involves
the use of deductive logic to move from premises based on empirical generalization to
an observational conclusion, such as an explanation of a recurring event that enables a
prediction of its recurrence. Such observational predictions are testable, and testing can
directly verify or falsify the prediction. Using the same illustrative approach as adopted
in Exhibit 2-1, Exhibit 2-2 depicts the “empiricist” approach to science.

The “testability” prong of the Daubert approach is a core feature of the empiricist
critique. Unfortunately, most philosophers of science believe it goes too far and throws
the baby out with the bathwater. As many scientists will admit, there is “no exact way

Empirical Knowledge

Observational Knowledge x y
Theoretical Analysis

EXHIBIT 2-2 The “Empiricist” Approach to Science


DAMAGE PRINCIPLES AND DAUBERT

to define anything outside pure mathematics and logic, and even there some basic terms
have extremely shaggy edges.7 For example, under certain conditions, such as high
speeds, Newton’s laws no longer apply. Yet such observations typically result in modifications
and a theory of broader scope (in Newton’s case the theory of relativity), not
complete rejection of the underlying theory because it failed an empirical test. Results
of experiments inconsistent with atomic theory have led to postulation of new particles,
not rejection of the entire atomic theory. Dark matter is the result of observational
anomalies in astronomy, not theoretical rejection. Causation itself is surprisingly vague;
the modern liability expert defines cause by what courts think they can control, resulting
in something that has “little to do with scientific fact and much to do with society,
culture, and legal will. Much like the law itself, one is told.”8

Although the testability prong of Daubert does appear to accomplish the task of eliminating
religious types of thought from the courtroom, the test still is both overinclusive
and underinclusive. It is overinclusive because the testability prong alone would not
exclude mysticism, the expert whose opinion is based on “experience” but not grounded
in particulars. It is underinclusive because scientific theory, particularly in such social
sciences as economics and finance, cannot strictly meet the empiricist criteria. Exhibit
2-3 illustrates the complicated nature of scientific theory.

In science, a complex interaction exists between the observational and the theoretical.
Theories are modified in response to testing. Testing often cannot reach core concepts
of a theory, but is instead performed on a theory’s implications.

The Daubert line of cases does not provide a philosophical justification for the
assumption that the empiricist approach produces inherently more reliable conclusions
than other theories of knowledge. There seems to be a logical disconnect between testability
and reliability; the mere ability to test a conclusion by reference to observable
phenomena does not necessarily ensure that the resulting opinions will be more reliable
than those opinions based on the more complex (and common) merger of theoretical
and observable knowledge. As set forth in Exhibit 2-3, the scientific approach itself is
a process involving comparison of theory and observable phenomena, with the two
being interdependent elements of the overall scientific conclusion. For example, econometricians
are extremely wary of what they call “data mining.” Data mining involves

Observational Knowledge
a bTheoretical Analysis
x y
EXHIBIT 2-3 Scientific Theory


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

simply discovering the relationships between variables and then telling a story about
these relationships ex post facto. This is an example of empiricism, even though the
results are testable. In contrast, the scientific approach is to conceptually develop theoretical
relationships, test these relationships, and adjust the theory when testing reveals
flawed assumptions.

Damage experts in litigation rely on social science, specifically the fields of accounting,
economics, and finance, for their opinions. Unlike natural science, social science
is based on a body of core nonobservable concepts that are articulated into theories
amenable to empirical verification. The core conceptual aspects of social science are not
falsifiable by empirical testing. Although this is true of the natural sciences as well, it is
true to a lesser extent, a fact that appears to be readily accepted by courts. The conceptual
aspects of many natural sciences can be expressed in sets of equations that make
them more, albeit not completely, subject to refutation. In economics, by contrast, there
is no unifying set of equations, but instead a variety of the basic principles linked to
models. The models themselves are testable, but empirical falsification of a model
does not invalidate basic principles, because these principles are only loosely related
to the models, mediated by layers of specific assumptions. For example, economics
and finance are grounded in assumptions about human preferences that allow for the
existence of a “utility function.” A utility function can then be used to establish other
concepts such as “demand” in economics or “risk aversion” in finance. These latter concepts
are testable, but their utility foundations are not. To the extent that Daubert
requires testability of basic theory, social science cannot clear the hurdle. Yet this certainly
is not the result desired by the Daubert Court, particularly in light of Kumho Tire.

Another ambiguity in Daubert arises over how to apply the testability factor. Is testability
applied to the theory, the expert’s model, or is the expert’s model applied to the
facts of the case? The judicial answers to these questions are not clear or consistent.
Moreover, use of the word methodology is not helpful. All of these levels or any subset
thereof could be included in the term methodology.

Leaving aside the issue of the error rate, which again relates to testability, the Daubert
factors pertaining to peer review and acceptance in the scientific community are helpful
methods of ferreting out scientific thought from nonscientific knowledge within the
natural sciences. Scientists appear to know science when they see it. Thomas Kuhn, in his
book The Structure of Scientific Revolutions, is a dissenter in this regard, but today
his relativist view is held by only a minority. Kuhn contended that acceptance by the
community of scientists was what made a theory survive, not its ability to generate
knowledge. Kuhn himself revised his radical view in a postscript, and few scientists hold
such a skeptical view of science. Nonetheless, academics are well aware that peer review
and professional acceptance are not foolproof criteria for good science, and Kuhn’s criticism
contains a kernel of truth, especially in the social sciences. For example, no one
can argue persuasively that economic theory evolves solely through a series of falsifications.
Instead, social science is closely tied to events outside of its discipline. In the eco



DAMAGE PRINCIPLES AND DAUBERT

nomics profession, the Great Depression gave rise to Keynesianism and the inflation of
the 1970s led to monetarism. Moreover, there are numerous examples of prominent theories
that fail to yield empirically verifiable results yet survive and thrive in the social
sciences. In finance, the capital asset pricing theory (CAPM) is an example. Although
several prominent papers empirically have raised doubts about CAPM, it remains the
leading theory of asset pricing in finance.9 Accordingly, while reliance on peer review in
the social sciences is important, if taken to extreme, it merely delegates issues of admissibility
to a small group of journal referees (with possible political biases).

The Kumho Tire case and the commentary to Rule 702 provide a marked shift away
from the Daubert factors to a much more workable basis for the Court’s gatekeeper
function. In Kumho Tire, the Supreme Court clarified that all expert testimony is admissible
only if it is both relevant and reliable.10 The criteria of reliability and relevance
avoid the pitfalls of the strict four-factor Daubert approach and allow a plaintiff or
defendant to challenge the viability of an opposing theory on scientific grounds in the
specific context of the case in which it is being proffered. By “relevant,” the Court
meant that the expert opinion must “fit” the facts of the case and “aid the trier of fact.”11
An expert cannot simply ferret out facts from the record that are consistent with his or
her opinion and ignore others. Nor will “canned” analysis be acceptable under Rule

702. As an example, in Concord Boat Corp. v. Brunswick,12 the Eighth Circuit overturned
a $44 million verdict on the grounds that the expert opinion should not have been
admitted under Daubert. In part, the court concluded that the expert’s opinion lacked
relevance because the expert did not “segregate any lawful acts and unrelated market
events . . . in order to enable the jury to assign damages only for illegal actions taken
by [the defendant].”13 Disaggregation is connected to relevance because without dis-
aggregating damages, an expert opinion does not “aid the trier of fact.” Following
Concord Boat (which is in accord with a series of Ninth Circuit cases), experts are required
on relevance grounds to segregate damages by each alleged cause. One lump-sum
number for the amount of damages allegedly caused by a variety of conduct (potentially
both legal and illegal acts) likely will not pass the relevance prong of Rule 702.
Rule 702 also requires that an expert opinion be reliable. Reliability is a difficult
concept that combines the four Daubert factors with traditional concerns about speculation,
lack of mitigation, and logical consistency of a damage analysis. The 2000
commentary to Rule 702 is very helpful in elucidating several factors that could be
considered in a reliability analysis. We quote from the commentary at length:

Courts both before and after Daubert have found other factors relevant in determining
whether expert testimony is sufficiently reliable to be considered by the trier of fact. These
factors include:

(1) Whether experts are “proposing to testify about matters growing naturally and directly
out of research they have conducted independent of the litigation, or whether they have
developed their opinions expressly for purposes of testifying.” Daubert v. Merrell Dow
Pharmaceuticals, Inc., 43 F.3d 1311, 1317 (9th Cir. 1995).

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

(2) Whether the expert has unjustifiably extrapolated from an accepted premise to an
unfounded conclusion. See General Elec. Co. v. Joiner, 522 U.S. 136, 146 (1997) (noting
that in some cases a trial court “may conclude that there is simply too great an analytical
gap between the data and the opinion proffered).
(3) Whether the expert has adequately accounted for obvious alternative explanations. See
Claar v. Burlington N.R.R., 29 F.3d 499 (9th Cir. 1994) (testimony excluded where the
expert failed to consider other obvious causes for the plaintiff’s condition). Compare
Ambrosini v. Labarraque, 101 F.3d 129 (D.C. Cir. 1996) (the possibility of some uneliminated
causes presents a question of weight, so long as the most obvious causes have been
considered and reasonably ruled out by the expert).
(4) Whether the expert “is being as careful as he would be in his regular professional work
outside his paid litigation consulting.” Sheehan v. Daily Racing Form, Inc., 104 F.3d 940,
942 (7th Cir. 1997). See Kumho Tire Co. v. Carmichael, 119 S. Ct. 1167, 1176 (1999)
(Daubert requires the trial court to assure itself that the expert “employs in the courtroom
the same level of intellectual rigor that characterizes the practice of an expert in the relevant
field”).
(5) Whether the field of expertise claimed by the expert is known to reach reliable results for
the type of opinion the expert would give. See Kumho Tire Co. v. Carmichael, 119 S. Ct.
1167, 1175 (1999) (Daubert’s general acceptance factor does not “help show that an
expert’s testimony is reliable where the discipline itself lacks reliability, as, for example,
do theories grounded in any so-called generally accepted principles of astrology or necromancy.”);
Moore v. Ashland Chemical, Inc., 151 F.3d 269 (5th Cir. 1998) (en banc) (clinical
doctor was properly precluded from testifying to the toxicological cause of the
plaintiff’s respiratory problem, where the opinion was not sufficiently grounded in
scientific methodology); Sterling v. Velsicol Chem., Corp., 855 F.2d 1188 (6th Cir. 1988)
(rejecting testimony based on “clinical ecology” as unfounded and unreliable).
All of these factors remain relevant to the determination of the reliability of expert testimony
under the Rule as amended.14

In sum, the standards for admissibility of expert testimony have become more stringent.
The Supreme Court’s opinions in the Daubert trilogy marked a good first step
toward the development of guidelines for admissibility, but in the long run the current
guidelines will not be workable. However, the revisions to Rule 702 have made the
inquiry more realistic and flexible. Both lawyers and experts must understand and meet
the standards for admissibility as these standards continue to evolve.

DAMAGE ANALYSIS IN GENERAL IN LIGHT
OF THE SUBSTANTIVE CASE LAW ON DAMAGES


An expert can be excluded under a Daubert inquiry or because of a more traditional failure
to satisfy the proper case law standards for computing damages. The core principle
of compensatory damages requires awarding the smallest monetary amount required to
put the plaintiff in the pecuniary position he or she would have been in had the alleged
“bad act” not occurred. In order to comport with this basic standard, the expert must


DAMAGE PRINCIPLES AND DAUBERT

have a good grasp of the plaintiff’s actual economic situation. The expert must then construct
the hypothetical “but for” world, that is, the hypothetical situation that the plaintiff
would have been in had the defendant’s bad conduct not happened.

Compensation

=

“But For” World

“Actual” World

The case law puts specific limits on how experts can construct the “but for” world,
and violation of these limitations expose the expert’s analysis to a possible Daubert
challenge on reliability grounds. Being familiar with some of the judicial ground rules
for damages calculations can be as important as having a working knowledge of the
economic or financial basics necessary to reach a reliable conclusion. The most carefully
constructed damage theory may become worthless if it does not comply with the
following judicial principles.

The “But For” World Is Restricted to Constructions Based on
Information Known with “Reasonable Certainty”

Regardless of the expert’s intuition or the plaintiff’s judgment about the “but for” world,
the expert is limited to record evidence, or other evidence conforming to Rule 703, that
is known with “reasonable certainty.” For example, an expert cannot speculate about
future growth rates without a sound basis in past performance, industry growth rates,
or comparable business growth rates. A plaintiff’s confidence that sales were about
to increase ten-fold will not be adequate foundation for projecting lost profits. Absent
use of information known with reasonable certainty, the damage analysis is speculative
and subject to dismissal.

Bigelow v. RKO Productions15

Bigelow involved a suit for treble damages under the Sherman Antitrust Act by an
independent movie theater against distributors of films and their affiliated theaters.
The jury found that there had been an unlawful conspiracy among the distributors
and their affiliated theaters to leave the independent exhibitor with
nothing but second-run films. The jury awarded damages based on the discriminatory
operation of the release system and the resulting decrease in the independent
theaters’ ticket sales. The Supreme Court held that it is proper for a jury
to infer that the plaintiffs had been damaged based on certain circumstantial
facts, including the defendants’ wrongful acts, the tendency of the wrongful
acts to injure plaintiff’s business, and evidence of a decline in profits. The Court

(continues)


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Bigelow v. RKO Productions (continued)

recognized that the bad acts themselves had made it impossible to ascertain precisely
what profits would have been in the but-for world, but found that the jury
could make a “just and reasonable estimate of the damage based on relevant
data . . . [including] probable and inferential as well as . . . direct and positive
proof.”

The Court stated that a jury verdict cannot be based on “speculation or guesswork,”
but that comparison of plaintiff’s receipts before and after the unlawful
acts afforded an adequate basis for the jury’s computation of the damages.

The “But For” World Must Have Been Foreseeable by the Parties

Courts limit the “but for” world to situations that either were foreseen by the parties
in the lawsuit or would have been generally foreseeable at the time of the contract or
the tort. Subsequent exotic or remote circumstances, even if known with reasonable certainty,
cannot be used in constructing the “but for” world.

Hadley v. Baxendale16

Although Hadley v. Baxendale is a case from the English courts in the nineteenth
century, it established a principle of damage calculation, the foreseeability
requirement, that remains extremely important today. In Hadley, the owners of
a flour mill sent a broken shaft to the defendant—a nineteenth century equivalent
of a FedEx office—to be shipped for repairs. Due to some errors on the defendant’s
part, the shipment of the shaft was significantly delayed. The mill owner
sued the shipper, seeking the lost profits that he incurred from shutting down his
mill while waiting for the replacement part. The court held that damages should
be restricted to foreseeable damages, i.e., those damages that the parties might
reasonably anticipate at the time that they made the contract. In this case, the court
found that the shipper could not have reasonably foreseen that a delay in shipping
the part would force the miller to cease all business during the interim.

“[I]t is obvious that, in the great multitude of cases of millers sending off broken
shafts to third persons by a carrier under ordinary circumstances, such consequences
would not, in all probability, have occurred.... It follows, therefore, that
the loss of profits here cannot reasonably be considered such a consequence of the
breach of contract as could have been fairly and reasonably contemplated by both
parties when they made this contact.”


DAMAGE PRINCIPLES AND DAUBERT

The “But For” World Must Be Constructed Using
the “Least Cost Avoidance Principle”

When the expert constructs the “but for” world, he or she must construct it by taking
into account how the plaintiff could have adjusted or did adjust to the changed circumstances.
Optimizing behavior should be assumed on the part of the injured party.
For example, in a case involving the failure to lend money, the “but for” world should
assume that the plaintiff can borrow money at a higher rate from another source. The
expert cannot skip to the assumption of devastating losses unless it can be demonstrated
that no other lender was reasonably available. In short, irrational failures to mitigate and
minimize damages will be held against the injured party when it comes time to calculate
the appropriate remedy.

Only the “Bad Acts” of the Defendant Can Be Subtracted
in Constructing the “But For” World

The defendant is responsible for only his or her bad acts. A bad act is a violation of the
law, such as a breach of a contract or an infringement of a valid patent. The expert must
construct the “but for” world by assuming that the defendant did not behave in the manner
that caused the violation, but that all other factors remained constant. For example,
an expert cannot construct the “but for” world under the assumption that if the defendant
had not breached the contract he or she also would have entered and performed on a
second contract. In addition, the “but for” world must acknowledge shortcomings in the
profit structure of the plaintiff that cannot be attributed to the bad act of the defendant.

Risk and Reward Must be Matched

Because the violation virtually always occurs at a time earlier than the date of the damage
analysis, the difficulty lies in determining how to measure the stream of benefits
that would have occurred in the “but for” world after the date of the violation. This is
an issue of significant controversy. It is clear that when a plaintiff is awarded damages,
he or she is relieved of the risk of the receipt of the benefit stream. Hence, it is inappropriate
to construct a “but for” world in which the plaintiff is compensated for risk
that was reduced by the actions of the defendant. For example, suppose a business contracts
to provide a particular asset (possibly a type of technology) to another business.
The asset is never provided, and as a result, the purchaser loses a potentially valuable
opportunity because of the absence of the asset. Sometime later, when liability issues
are no longer in dispute, the expert is asked to calculate the damages resulting from the
breach of the contractual promise to provide the asset several years earlier. Two important
issues must be addressed. First, what would have been the plaintiff’s position at the
time of the bad act had the bad act not occurred (i.e., what was the value of the opportunity)?
Second, how should the passage of time between when the wrong occurred and


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

the resolution of the case be treated? A large body of economic literature addresses these
issues.17 The answers to both of these questions, in the authors’ view, require the use of
the real option theory.18

Unrealistic Reliance on Market Imperfections Should Be Avoided

To the extent that damages depend on significant market imperfections, such damages
must be factually justified. In the absence of facts to the contrary, courts require that
competitive responses in the “but for” world be taken into account. For example, it cannot
be assumed that a firm in a competitive market would receive substantial economic
rents for long periods without encouraging entry by other participants. Moreover, if the
expert assumes that positive net present value opportunities exist in the “but for” world,
this assumption must be justified in light of the available facts. As a last example, strong
factual justifications must be present before damages can exceed a company’s market
cap or total value.

Courts have excluded from evidence damage analyses that fail to account for competitive
responses. For example, the Ninth Circuit in Murphy Tugboat Co. v. Crowley19
stated as follows:

The expert witness’s testimony as to Murphy’s expected share in the large vessel and flat tow
market segment depended upon an assumption that Red Stack would not cut its prices in reaction,
even to a loss of over one-quarter of its prior share of . . . the market.... A reasonable
jury could not, however, indulge in the assumption that a competitor would follow a course
of behavior other than that which it believed would maximize its profits.... In a hypothetical
economic construction, such as the one underlying Murphy’s theory on lost past profits, economic
rationality must be assumed for all competitors, absent the strongest evidence of
chronic irrationality. Otherwise, it will be impossible to keep chronic speculation in check.

Other cases have reached similar conclusions.20

Where Possible, Damages Must Be Constructed Cause by Cause (Disaggregation)

A failure to disaggregate damages by the various causes at work can be fatal to an expert
opinion. Experts must link, or segregate, their claimed damages according to the identified
causal factors. Where an expert asserts an assortment of separate business practices
or a variety of conduct as the proximate cause of the claimed damages, the expert
also must particularize their damage proof to the fullest extent possible. In other words,
specific damages must be attributed to particular causes.

The impetus for requiring disaggregation wherever possible is the scenario in which
a finder of fact (either the judge or the jury) determines that only some of the challenged
acts were illegal and holds that the remainder of the alleged conduct was lawful.
Without particularized chains of cause and effect, the trier of fact is left with no rational
basis for determining the amount by which to reduce the plaintiff’s damages. Yet, if the


DAMAGE PRINCIPLES AND DAUBERT

damages are not reduced by some amount, they likely are insufficiently tied to the
challenged conduct and fail to account for the effect of legitimate market competition.
Courts want neither to give a windfall to plaintiffs damaged by legal conduct nor to
force a defendant to “compensate” for more than the damages proximately caused by
their illegal acts.

MCI Communications Corp. v. AT&T21

In MCI, the court held that plaintiff’s damage theory failed because it did “not
establish any variation on the outcome depending on which acts of AT&T were
held to be legal and which illegal.” At trial, the jury found that some of AT&T’s
conduct constituted legitimate competition. However, the jury was left without a
means to adjust the amount of damages to reflect lawful competition, other than
purely “guessing” at the appropriate reduction. Leaving the jury in such a position
does not “assist the trier of fact” as required by Federal Rule of Evidence 702, and
therefore the damage theory could not be admissible.

Damages Should Be Discounted to Account for Risk and the Time Value of Money

In some cases, an award of monetary damages should be adjusted to reflect the economic
consequences of the alleged bad act. The actual calculations required to discount
economic damages are discussed in Chapters 5 and 14. However, it is important for the
attorney to understand when such a calculation is necessary or appropriate. Essentially,
damages can be discounted for two reasons: First, where the plaintiff did not bear the
risk related to the profits or opportunity lost as a result of a defendant’s bad act; and
second, where the damages resulting from the bad act are long-lasting.

The theory behind discounting damages in the first scenario is that one component
of lost profits is a return for bearing risk. Where a plaintiff lost the opportunity to earn
profits, he did not bear risk and should not receive a return as if he had borne the risk.
Accordingly, lost profits can be discounted at a rate that includes a risk premium. This
rationale might apply where a defendant is accused of breaching a commercial contract
and that breach prevented the plaintiff from doing business.

The second reason to discount involves the time value of money. In accordance with
well-established economic principles, long-lasting damages should be discounted to
take into account the declining value of money over time. Damages can be long-lasting,
either because they stem from a single wrongful act that had significant consequences
or because they stem from a series of wrongful acts, each of which directly damaged
the plaintiff for a short period. With the first type of bad act, the defendant may have
destroyed an asset that would have yielded a stream of profits for many years. The damages
would last as long as the stream of profits would have lasted, but they would need


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

to be discounted each year back to the time of the wrongful act. Similarly, if the defendant’s
wrongful act resulted in delaying the plaintiff’s opportunity to make profits,
the lost profits attributable to the delay would be discounted for each period of delay.
For example, a stream of lost profits resulting from one year’s delay would be discounted
back to the year when the wrongful act began to inflict damages; a stream of
additional lost profits resulting from an 18-month delay also would be discounted back
to the time of the bad act.

In determining the need to discount the damage award, the duration of the damages
themselves is more important than the duration of the alleged wrongful act or acts. In
essence, courts determine whether a particular set of damages is long-lasting by evaluating
whether and how quickly the plaintiff’s stream of profits could be restored by the
cessation of the bad act.

These basic principles of damages apply in the context of each of the specific areas
of IP law that we discuss in Chapters 6, 7, 10, 11, and 13. It is important to consider the
basic tenets when evaluating your options for damage calculations. Some means of calculating
damages may offer potentially greater recovery than others, but they would be
harder to construct in a manner that coheres with the judicial rules for admissible damage
theories previously discussed. Keep these basic principles of damage calculations
in mind when evaluating the remedies available in particular areas of IP.

SUMMARY

This chapter examined the judicial standards that expert testimony must satisfy to be
admissible for any purpose in court. Specifically, this chapter analyzed the means of
establishing (or attacking) an expert’s opinions as both reliable and relevant under the
Daubert trilogy and the FRE. Additionally, the chapter introduced some general principles
that apply to all damage theories and outlined their particular application in IP litigation.
The information in this chapter provides a basic foundation for discussions of
any potential damage theory and the evidence that will be necessary to support it.

ENDNOTES

[1]
See Fed. R. Evid. 702 Advisory Committee Notes, 2000 Amendments.
[2]
Daubert v. Merrell Dow Pharms., Inc., 509 U.S. 579 (1993).
[3]
General Elec. Co. v. Joiner, 522 U.S. 136 (1997).
[4]
Kumho Tire, Ltd. v. Carmichael, 526 U.S. 137 (1999).
[5]
See Daubert, 509 U.S. at 593–94.
[6]
See generally David Willer and Judith Willer, Systematic Empiricism: Critique of a Pseudoscience,
Englewood Cliffs, N.J.: Prentice-Hall (1973).
[7]
Martin Gardner, Science: Good, Bad and Bogus, Buffalo, NY: Prometheus Books
(1989), xii.

DAMAGE PRINCIPLES AND DAUBERT

[8]
Peter W. Huber, Galileo’s Revenge: Junk Science in the Courtroom, New York: Basic
Books (1989), at 215–16.
[9]
See Richard Roll, A Critique of the Asset Pricing Theory’s Tests, J. Fin. Econ. 4 (1977);
Eugene Fama and Kenneth French, The Cross-Section of Expected Stock Returns, J. Fin.
427 (1992).
[10] See Kumho Tire, 526 U.S. at 150–51.
[11] See id.
[12] 207 F.3d 1039 (8th Cir. 2000).
[13] Id. at 1055.
[14] Fed. R. Evid. 702 Advisory Committee Notes, 2000 Amendments.
[15] Bigelow v. RKO Prods., 327 U.S. 251 (1946).
[16] Hadley v. Baxendale, 9 Ex. 341, 354, 156 Eng. Rep. 145, 151 (1854).
[17] Franklin Fisher and R. Craig Romaine, Janis Joplin’s Yearbook and the Theory of Damages,
5 J. Acct., Aud. Fin. 145 (1990). See, e.g., William Tye, Stephen Kabor, and A. Lawrence
Kolbe, How to Value a Lost Opportunity from Market Foreclosure, 12 Res. L. Econ. 83 (1995);
Konrad Bonsack, Damages Assessment, Janis Joplin’s Yearbook, and the Pie-Powder
Court, 13 Geo. Mason U.L. Rev. 1 (1990); Tyler Bowles and W. Chris Lewis, Unsettled
Issues in Measuring Lost Profits, 9 J. Legal Econ. 19 (2000); James Patell, Roman Weil, and
Mark Wolfsen, Accumulating Damages in Litigation: The Roles of Uncertainty and Interest
Rates, 11 J. of Legal Studies 341 (1982); R. F. Lanzillotti and A.K. Esquibel, Measuring
Damages in Commercial Litigation: Present Value of Lost Opportunities, S.J. Acct., Aud.
Fin. 125 (1990); Kenneth Kolaski and Mark Kuga, Measuring Commercial Damages
Via Lost Profits or Loss or Business: Are These Measures Redundant or Distinguishable?
18 J.L. Com. 1 (1998); John D. Taurman and Jeffrey C. Bodington, Measuring Damage to
a Firm’s Profitability: Ex Ante or Ex Post, 37 Antitrust Bull. 57 (1992); Andrew Simmonds,
Indirect Causation: A Reminder from the Biblical Goring Ox Rule for Fraud on the Market
Securities Litigation, 88 Ky. L.J. 641 (1999–2000); Janet Kiholm Smith, Reference Guide
on the Estimation of Economic Losses: The Economic Approach to Evaluating Damage
Awards, 36 Jurimetrics J. 217 (1996); Robert Fuhrman, A Discussion of Technical Problems
with EPA’s Ben Model, 1 Envtl. Law 561 (1995).
[18] This issue is beyond the scope of this book, but the authors plan to address it in some
detail in the first supplement to this book.
[19] 658 F.2d 1256, 1262 (9th Cir. 1981) cert. denied, 455 U.S. 1018 (1982).
[20] See, e.g. Park v. El Paso Bd. of Realtors, 764 F.2d 1053 (5th Cir. 1985), cert. denied, 474
U.S. 1102 (1986); Coleman Motor Co. v. Chrysler Corp., 525 F.2d 1338 (3rd Cir. 1975).
[21] 708 F.2d 1081, 1163 (7th Cir. 1982).
ADDITIONAL READING

Margaret A. Berger, Procedural Paradigms for Applying the Daubert Test, 78 Minnesota
Law Review 1345 (June 1994).

Judge Harvey Brown, Eight Gates for Expert Witnesses, 36 Houston Law Review 743
(Fall 1999).


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

David L. Faigman et al., How Good Is Good Enough? Expert Evidence Under Daubert
and Kumho, 50 Case Western Reserve Law Review 645 (2000).

Shubha Ghosh, Fragmenting Knowledge, Misconstruing Rule 702: How Lower Courts
Have Resolved the Problem of Technical and Other Specialized Knowledge in Daubert v.
Merrell Dow Pharmaceuticals, Inc., 1 Journal of Intellectual Property 1 (Spring 1999).

Robert J. Goodwin, The Hidden Significance of Kumho Tire Co. v. Carmichael: A Compass
for Problems of Definition and Procedure Created by Daubert v. Merrell Dow Pharmaceuticals,
Inc., 52 Baylor Law Review 603 (2000).

Michael H. Graham, The Expert Witness Predicament: Determining “Reliable” Under
the Gatekeeping Test of Daubert, Kumho, and Proposed Amended Rule 702 of the Federal
Rules of Evidence, 54 University of Miami Law Review 317 (2000).

D. Bruce Johnsen, Daubert, The Scientific Method, and Economic Expert Testimony,
9 Kansas Journal of Law & Public Policy 149 (1999).
Joseph A. Kuiper, The Courts, Daubert, and Willingness-to-Pay: The Doubtful Future of
Hedonic Damages Testimony Under the Federal Rules of Evidence, University of Illinois
Law Review 1197 (1996).

Mark Lewis and Mark Kitrick, Kumho Tire v. Carmichael: Blowout From the Over-
inflation of Daubert v. Merrell Dow Pharmaceuticals, 31 University of Toledo Law
Review 79 (Fall 1999).

Robert F. Reilly, Implications of Recent Daubert-Related Decisions on Valuation Expert
Testimony, 18 American Bankruptcy Institute Journal 28 (June 1999).

Nicholas Targ and Elise Feldman, Courting Science: Expert Testimony After Daubert and
Carmichael, 13 Natural Resources & Environment 507 (Spring 1999).

Jeanne Wiggins, Kumho Tire Co. v. Carmichael: Daubert’s Gatekeeping Method Expanded
to Apply to All Expert Testimony, 51 Mercer Law Review 1325 (2000).

David Willer and Judith Willer, Systematic Empiricism: Critique of a Pseudoscience,
Englewood Cliffs, N.J.: Prentice-Hall (1973).


3


Introduction to the Economics
of Intellectual Property
Damage Calculations


Intellectual property (IP) damage analysis is significantly informed by the disciplines of
industrial organization economics, law and economics, accounting, and the financial
principles of valuation. Chapters 3, 4, and 5 address these topics. In particular, the legal
framework for calculating damages in IP cases is remarkably amenable to economic
and financial principles. Chapter 3 begins by developing the basic economics used in IP
damage analysis. Chapters 4 and 5 address accounting and valuation principles.

A BRIEF REVIEW OF BASIC ECONOMICS

Assumptions are simply inescapable, in both economic and legal matters. “Economists
make assumptions for the obvious reason that the world, viewed economically, is too
complicated to understand without abstraction. . . . The art of economics is picking
assumptions to better understand certain features of it, without inevitably causing those
features to be unimportant ones.”1 If one were to summarize the foundations of microeconomics
in the tersest fashion, one might focus on three assertions: (1) consumers
maximize utility, (2) firms maximize profit, and (3) the market seeks equilibrium. The
first assumption, that consumers maximize utility, is called consumer rationality, and
it leads to the concept of the demand curve. The demand curve is simply a summary of
the amounts of a product that consumers as a whole will be willing to purchase at different
prices. In contrast, the supply curve describes how much output firms will produce
as their output prices increase. This follows from the second assumption because
firms produce the quantity of output that maximizes profit. Finally, market equilibrium
is the point at which neither producers nor consumers have incentives to change prices
or output. Clearly, microeconomic behavior is more complicated in the real world. The
method used in economics is to first assume perfect markets and in that context model
economic outcomes. Then, after studying perfect markets, assumptions are weakened

43



LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

and the impact of market imperfections are studied. The latter process has resulted in
much of the useful economic theory for IP damage analysis.

Demand

Demand is essentially a multivariate relationship that depends not only on the price of
the commodity in question, but also on the prices of other goods that may be substitutes
or complements, the subjective tastes and preference of the individual consumers, their
incomes, and a host of other variables. The demand function relates the quantity that
consumers demand to these determining factors. A sample demand function can be
expressed as:

Q = FP 1,,P2IT

( , )

where
P1 is the price of the commodity concerned
P2 is the price of another commodity (constant)
I is the income of the consumer (constant)
T is the tastes and preferences of the consumer (constant)


When a demand function is plotted, as in Exhibit 3-1, it displays a negative slope
implying that lower quantities are demanded at high prices and vice versa.

Supply

The supply function is also a multivariate function that depends on factors such as the
market price of the commodity at issue; the prices of the labor, capital, and raw materials;
the level of technology; the taxation or subsidy policy of the government; and so


P1

Price

P2


Demand (D)

Q1 Q2


Quantity

EXHIBIT 3-1 Demand Function


ECONOMICS OF IP DAMAGE CALCULATIONS

on. The supply curve illustrates how the quantity produced changes with the prices of
the commodity in question. In general, producers will be willing to produce more when
their ,output prices are higher because it increases their profits. Higher profits from the
sale of one particular product encourage the firm to increase the output of this product,
as opposed to other products or engaging in other activities. The supply curve is positively
sloped, as shown in Exhibit 3-2. A simple supply function can be denoted as:

( KLRG)

Q = GP 1,,, ,

where
P1 is the price of the commodity concerned
K is the amount of capital employed
L is the amount of labor employed
R is the amount of raw materials employed
G represents government taxes or subsidies


Market Equilibrium

Given a supply and a demand function, it becomes relatively simple to determine the
level of output that would be steady state position for producers and consumers alike.
Superimposing the two curves determines the equilibrium level of output and price Q*
and P* (see Exhibit 3-3).

At price P*, the producers are willing to supply Q* amount of the commodity;
likewise; the consumers are willing to pay P* for the same amount of the commodity,
making P* the equilibrium price and Q* the equilibrium quantity. At P* and Q*, there
is no incentive to change position. In contrast, at any P > P*, there will be more supply


Supply (S)

P1

Price

P2

Q2 Q1


Quantity

EXHIBIT 3-2 Supply Curve


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES


Q*


Supply (S)

Price

P*

Demand (D)

Quantity

EXHIBIT 3-3 Market Equilibrium

than demand. This will cause inventories to build up, and firms will lower prices to
sell their excess stock. Likewise, at P < P*, demand will exceed supply, and firms will
bid up prices to achieve higher profits. As a result, only at P*, Q* is there no incentive
to change price and output. We call this pair the equilibrium price and output. We now
turn (or abruptly jump) from the very basic microeconomic model to more specialized
analyses that are useful in IP damage cases. The reader who is not well versed in economics
should be aware that we now intend to skip several layers of basic concepts to
go directly to the operational economic principles useful for our topics.

THE INDUSTRIAL ORGANIZATION FOUNDATIONS
OF INTELLECTUAL PROPERTY DAMAGES


Competent analysis of damages requires a working knowledge of industrial organization.
Industrial organization is a branch of applied microeconomics that addresses such
issues as the relationship between market structure, prices and output, market power,
defining the relevant market, imperfect competition, and innovation. Numerous economics
textbooks are available that set forth the basic concepts in this area. This chapter
first focuses on a limited number of specific concepts that are critical for conducting
damage analysis in an IP case.

The fundamental question in IP damage analysis is what would the “market” look
like “but for” the infringement of a patent, copyright, trademark, or trade secret. Therefore,
an important issue for analyses of lost profits, reasonable royalties, and the causation
of infringer profits relates to how consumers react to the absence of the infringer’s
product or service in the market. Consumer reaction can be studied directly through
econometric techniques when adequate data are available or more typically through
inferences based on market analysis.


ECONOMICS OF IP DAMAGE CALCULATIONS

In this section, we focus on building the economic apparatus for market analysis.
Economists have developed two exemplifying paradigm market structures used as a
starting point by students of economics: perfect competition and monopoly. Readers
who are unfamiliar with these basic economic tools are referred to the Additional
Reading at the end of the chapter. Exhibit 3-4 illustrates both paradigm types of market
structures.

Under perfect competition, each firm sets prices equal to marginal cost. This is evident
in Exhibit 3-4, where Pc equals MC. This means that the firm achieves average
profitability (sometimes referred to as the opportunity cost of capital because it is
no more than the profits that could be achieved by the next most productive use of the
capital). The conditions that support perfect competition are extreme and exacting.
Formally, these conditions would be: (1) no differences among products; (2) infinitely
many, infinitely small firms; (3) no barriers to entry; and (4) perfect consumer and producer
information.

At the other extreme, in the absence of competition, a firm will set its price at the
monopoly price. The monopoly price is always higher than the competitive price and
occurs where marginal cost equals marginal revenue. Considering the difference between
the monopoly model and the competitive model provides some flavor for how
economics can be useful in calculating differences between an actual world and a “but
for” world in, for example, a patent infringement case. Assume that a market consists
of only two firms, the patent owner and the infringer. In competition, under fairly general
assumptions, the patent owner would set price at Pc and obtain sales of Qc. However,
if the infringer did not exist, the patent owner would set price at PM and sell QM.
The lost profits arising from the difference between the actual world and the “but for”
world in this simple case is the area B. Real-world situations are much more complex
than this simple case. Nonetheless, if the economist has sufficient information, the equilibrium
prices and quantities in the “but for” world can be calculated.

PM

PC

C
B A
DMR
MC
EXHIBIT 3-4 Paradigm Market Structures



LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

In most situations, markets in which infringement occur consist of more than two
competitive products. In these more typical situations, economists employ more complex
oligopoly models to study the impact of hypothetical market changes arising from
the removal of an infringing product from the market.

Models of competition and monopoly exhibit an important relationship between market
power and elasticity of demand. Elasticity is the economist’s measure of the responsiveness
of output, or degree of consumer switching, to changes in price. Elasticity is a
ratio of percentage changes, and therefore is unitless, so that its measure is not affected
by the units of measure for prices or quantities. More formally:

ΔQ
Q ΔQP dQP

Elasticity = = ×=×

ΔP ΔPQ dPQ
P

The inverse slope of the demand curve is dQ/dP. The additional term P/Q indicates
that elasticity typically changes at each point on the demand curve. As a firm raises
its price, elasticity generally increases because other competing products appear more
competitive to consumers. As a result, it would be incorrect to simplistically infer a lack
of market power from the observation that consumers freely substitute between a variety
of products.2

A monopolist who maximizes profit will raise its price until it faces sufficient restraints
from substitute products to make further increases unprofitable. The monopolist
maximizes profits by balancing the greater profit margin on all sales that results
from raising its price against the potential lost sales due to consumers defecting to competing
products because of the high price (this is precisely what elasticity measures).
The firm can achieve its optimal profit maximizing price by setting its marginal revenue
(the revenue it receives for an additional unit) equal to its marginal cost (the variable
cost of producing the additional unit of output).

The marginal revenue that a firm receives can be written in terms of elasticity:

dPQ ) dQ

(
dP

MR = =(P) +(Q)

dQ dQdQ

Algebraic manipulation of the right-hand side of the above equation yields:

. Q dP .

= P
1 +

..
P dQ..
1

..

= P
1 .

. e.


ECONOMICS OF IP DAMAGE CALCULATIONS

where “e” is the elasticity measure. When the firm attempts to set price optimally to maximize
its profits, it will set marginal cost equal to marginal revenue:

1

..

MC = MR = P1 .

. e.

Manipulating this equation leads to the following important relationship.3

PMC 1

.

=

Pe

Accordingly, as the equation above demonstrates, there is a very strong general relationship
between the optimal markup over cost (market power) and the inverse of the
elasticity of demand facing the firm.

The economic concept of relevant market attempts to link the concepts of market
power and market share. Market power is defined as the ability to profitably raise price
above competitive levels (i.e., above marginal cost). Courts in antitrust cases have for
several decades equated “monopoly” with large market shares. Indeed, to measure market
share it is necessary to define the relevant market in which market share is measured.
The necessity of defining the relevant market in turn begs the question of the
theoretical basis for equating market share and market power. Two oligopoly models
provide a direct link between market power and market share that does not depend on
the existence of overt collusion. The theoretical establishment of this link provides the
basis for defining the relevant market in a coherent fashion.

The two oligopoly models linking market share and market power are the dominant
firm/fringe model and the Cournot model. For purposes of defining the relevant market,
economists have focused largely on the Cournot model, and the Cournot model can be
justified by its computational simplicity, a strong correspondence with the “Nash” equilibrium
concept for noncooperative strategic interaction, and accepted intuition about
concentrated market structures.4 The Cournot model assumes that several large firms
are involved in competitive rivalry and that little or no new entry exists. Each firm
reacts to the output of its rivals, but under the simplifying assumption that each firm
assumes that its own output change will not impact rivals’ reactions. These assumptions
result in a set of reactions between rivals that culminate in an equilibrium point that is
an example of a “Nash equilibrium.”

To show the relationship between market share and market power in the Cournot
model, assume that n firms in an industry are engaged in Cournot rivalry. Each firm
seeks to maximize its own profits, πi,where profits are defined as the difference between
revenue and costs. Revenue, in turn, is equal to the market price multiplied by
firm i’s output, and the cost also depends on the output of firm i:

= P(Q) q. C(q)

πi iii


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Maximizing profits requires that the first derivative of the profit function is set equal to zero:


dπi . dP .

= O = P + qi .. ..
. MCi

dqi dQ

Manipulating this result leads to the following:

.. qi .. dP .. Q..

MC = P1 .

i ..

. .. Q .. .. dQ.. . P ..

This can be rewritten as:

P

MC = P . Si

E

This expression leads to the result that we seek:

PMC S

.

= i

Pe

where Si is the quantity market share of firm i. The Cournot assumptions therefore lead
to a straightforward relationship between market power and market share parameterized
by the inverse of the market elasticity.

To operationalize this relationship requires a definition of the relevant market that
allows for comparability of market share based on measures of market power across
industries. The 1992 Horizontal Merger Guidelines Definition promulgated by the
Department of Justice and the Federal Trade Commission (the Guidelines) does precisely
this by defining the relevant market in a manner that forces the analyst to select
a market that leads to a common market elasticity among industries5:

e2
e1
P  MC
P
Si


ECONOMICS OF IP DAMAGE CALCULATIONS

Put differently, the market definition test forces the analyst to choose a single market
elasticity, such as e2, for example, to facilitate cross-market comparisons of market power.
With this background in mind, we now turn to the Guidelines’ market test that incorporates
an economically grounded method for selecting competing products for inclusion
or exclusion in the relevant market. This will be a critical decision point in any lost profits
analysis in an infringement case.

Relevant Markets

A rigorous and operational yet accessible approach to market definition appears in
the 1994 Federal Trade Commission and Department of Justice Horizontal Merger
Guidelines.

The stated purpose of the Guidelines is to identify economic dangers posed by mergers
that may “create or enhance ‘market power’ or... facilitate its exercise.”6 “Market
power” is defined as the ability to profitably raise price above competitive levels.7 That
“market power” could result either from an increased unilateral ability to raise price or
from an industry structure more conducive to collusive activities. It has long been recognized
that market power is constrained by the ability of customers to switch away
from a price increase by buying different products, or the same products from more distant
suppliers (demand substitution), or by buying from additional sellers attracted by
the increased price (supply substitution). The Guidelines set out an integrated multistep
procedure designed to analyze these issues.

As the first step in the analytical process designed to determine when market power
may be created or enhanced by a proposed merger, the Guidelines call for defining the
relevant markets. According to the guidelines, a market:

is defined as a product or group of products and a geographic area in which it is sold such that
a hypothetical, profit-maximizing firm, not subject to price regulations, that was the only present
and future seller of those products in that area would impose a small but significant and
nontransitory increase in price above prevailing or likely future levels.8

That is, the relevant market has both a geographic component and a product component.
If, in a given geographic area, a sole provider of a particular product could profitably
raise its price a “small but significant” amount (e.g., 5 percent), then that product is a relevant
market for that geographic area.

The Narrowest Market Concept. The procedure set forth in the Guidelines is as
follows: starting with a particular product of one of the merging firms, the analyst asks
whether a hypothetical monopolist would find it profitable to increase prices of that
product above the current levels by approximately 5 percent.9 If the answer is yes,
that product is deemed a relevant market for further consideration.10 If the answer is
no, the product, in and of itself, is deemed too narrow to constitute a relevant market,


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

and the set of products is broadened to include the next-best set of substitutes and the
process is repeated. The analyst inquires whether a sole provider of both the product
and the next-best set of substitutes could profitably increase price by 5 percent. If
the answer is yes, that set of products is deemed a relevant market. If the answer is no, the
next-best set of substitutes is again added and the process is repeated.11 Thus, a relevant
product market is the smallest set of products for which a hypothetical monopolist
would find it profitable to increase prices by 5 percent. The analysis continues until
markets are delineated around each of the products of each of the merging firms. The
two sets of product markets are then compared to determine whether the two merging
firms are participants in any of the same product markets. If they are, the merger is
deemed “horizontal,” and analysis of any potential anticompetitive effects resulting
from the merger continues.

Geographic markets are defined in an analogous manner. Beginning with the location
of each merging firm, the analyst asks whether a sole provider of the relevant
product could raise its price by 5 percent. If not, the geographic area is expanded to
include the next-best substitute for production and the analysis is repeated.12 This
process continues until the test is satisfied. For any given merger, there can be multiple
relevant product and geographic markets, each addressing a different possible exercise
of market power.

Supply-Side Substitution. The Guidelines’ mechanism for dealing with potential
supply-side responses to an exercise of market power is also noteworthy. In defining the
relevant product market, the Guidelines focus directly on demand-side substitution—
the reaction of the consumer to an increase in price. Supply-side substitution responses
to attempted exercises of market power—supplier reactions to price increases—are considered
in separate sections of the Guidelines dealing with the identification of firms in
the relevant market and the likelihood of new entry.13 This is accomplished by including
among the participants in the defined market not only those firms presently producing
products in the relevant market but also those firms that are “uncommitted
entrants.”14 Uncommitted entrants are firms that, in response to a 5 percent price
increase and without the expenditure of significant sunk costs, would likely supply the
relevant product within one year. The likelihood, timeliness, and sufficiency of longer-
term supply responses (i.e., within two years) are addressed in the entry section of the
Guidelines. This longer-term supply response is also considered because, as recognized
in the Guidelines:

A merger is not likely to create or enhance market power or to facilitate its exercise, if entry
into the marketplace is so easy that market participants, after the merger, either collectively or
unilaterally could not profitably maintain a price increase above premerger levels. Such entry
likely will deter an anticompetitive merger in its incipiency, or deter or counteract the competitive
effects of concern.15


ECONOMICS OF IP DAMAGE CALCULATIONS

Calculation of Market Shares. Once the firms that participate in the relevant markets
have been identified, each firm’s market share is calculated. Market shares typically are
calculated as each firm’s share of total sales or current capacity in the market. Capacity
measures are recommended when goods are homogeneous. Sales are appropriate when
products are subject to some differentiation by product characteristics, brand name, or
other features.

The merger guidelines approach operationalizes results from the industrial organization
literature that allow the economist to make inferences about consumer behavior
where an infringer is to be removed from the market. For example, in such a case, one
plausible assumption is that the infringer’s sales would be distributed according to market
share. It is critical when such an approach is used that the boundaries of the relevant
market and the market shares in the market be determined properly.

Information Used to Implement the Merger Guidelines Market Test. The market test
requires an assessment of consumer reaction to a small but significant increase in price
of one or more products. Indirect information about such reactions typically are available
from the party’s documents and third-party sources. The Merger Guidelines themselves
refer to four categories of information:

1.
evidence that buyers have shifted or have considered shifting purchases between
products in response to relative changes in price or other competitive
variables;
2.
evidence that sellers base business decisions on the prospect of buyer substitution
between products in response to relative changes in price or other competitive
variables;
3.
the influence of downstream competition faced by buyers in their output markets;
and
4.
the timing and costs of switching products.16
In addition, other relevant information would include:

5.
the parties’ pricing documents describing how prices are set;
6.
the parties’ views of their competitors and the market;
7.
third-party views of the market;
8.
vendor’s views of the market;
9.
information concerning how the parties position their products in their advertising.
One important weakness of a market share approach to lost profits is that each
product is treated in a binary “in or out” of the market fashion. Most markets consist of


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

differentiated products, where some products are closer substitutes than others. Such
differentiation can be inferred from the same types of information described above. To
the degree that products are differentiated, close substitutes to the infringer’s product
likely would receive more sales that its market share if the infringer were eliminated;
more distant substitutes would receive fewer sales. It is appropriate to gather as much
information on product differentiation as possible even when adopting the market share
approach to determine whether adjustments to market share are in order.

THE DIRECT APPROACH: ECONOMETRICS

When detailed data are available, market analysis can be performed directly by using
econometrics to estimate a demand function. Empirically, a market demand function is
generally estimated using techniques associated with regression analysis. Regression
analysis, in its most common form, is referred to in the statistical vernacular as ordinary
least squares (OLS), because operationally, regression minimizes the squares of the
differences between the actual value and the “fitted” value of the variable that is being
studied (the dependent variable). Regression analysis is a statistical method used to
relate changes in a dependent variable Y to changes in other variables, known as independent,
or explanatory, variables. Ordinary least squares sometimes can be useful in
extrapolating trends or testing the significance of market structure changes (e.g., the
presence of an infringing product).

In IP damage analysis, we frequently are concerned with estimating demand and
elasticity of demand for market analysis. However, estimating demand functions
requires econometric techniques and considerations that are significantly more sophisticated
than OLS. In the case of a demand function (see preceding), the quantity
demanded is estimated as a function of several variables, usually the following (we now
switch notation slightly to remain consistent with econometrics textbooks):

Qx = f (Px, I, Py )

where
Qx = quantity demanded of good X
P x = price of good X
I = income of consumers
P y = vector of prices of related goods


Once we have a functional form of the model, the particular econometric technique
that is appropriate for the model specified must be chosen. Unfortunately, the expert
often has little or no a priori knowledge of the true functional form of the demand function.
Consequently, the researcher must rely on experience, previous literature on the


ECONOMICS OF IP DAMAGE CALCULATIONS

subject, market analyses, and attempts to use “flexible” specifications. Often, the results
of regression analysis using a particular functional form specification will signal a misspecification
problem. For example, lack of statistical significance in all or a majority
of explanatory variables, poor fit, or incorrect signs (e.g., negative signs on prices of
well-established substitute goods) may indicate a problem with the functional form of
the model. When this happens, the expert should estimate several models with various
functional forms to arrive at a satisfactory solution. A good place to start is to examine
the data using simple descriptive statistics. Although such data sometimes are regarded
by theoreticians as operationally problematic, some data analysis is standard practice,
because theory alone often cannot cull market inconsistencies that may be illuminated
only by analysis of the actual data. Naturally, care must be taken in applying such techniques
to ensure robustness of the results and to avoid violations of the basic assumptions
underlying regression analysis.17

In practice, the simplest demand function to specify and estimate is the linear
demand function. In this case, the term linear refers to linearity in the coefficients. The
variables themselves are free to take any functional form (e.g., quadratic, natural log,
inverse, etc.) specified by the researcher. Such a function would be represented as:

Q= α+βP +γI +Σ λ P +ε

xx yy

where α, β, γ, and λ, are unknown parameters to be estimated and εis a stochastic error
term. Estimating a regression model can be accomplished using any readily available
commercial statistical analysis software such as SAS., Stata, E-Views, and so on, and
even MS Excel. Statistical significance of these coefficient estimates is then performed
using t-tests.18

Determining own-price, income, and cross-price elasticities is one important by-
product of estimating a demand function. Own-price elasticity is defined as the percentage
increase in demand of good X associated with a given percentage increase in
the price of good X. Income elasticity is the percentage increase in the demand for
commodity X associated with a given percentage increase in consumer income. Cross-
price elasticity is the percentage increase in the demand for commodity X associated
with a given percentage increase in the price of a related commodity. Elasticities can be
easily calculated from the demand model specification as:

E= .(ΔQ/ΔP) ×P /Q(own-price elasticity)

x xxxx

=(I/Q) ×γ (income elasticity)

Eix
E =(P/Q) ×λ (cross-price elasticity)19

xyyy y

Obviously, one problem associated with the linear demand model is that the elasticities
are variable. That is, as described earlier, the elasticities are not constant across the
demand curve, but instead vary along the demand curve. A more commonly used and


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

more flexible specification is a nonlinear demand function, which has constant elasticity
along the demand curve:

βIγΠP γ

Q= αP

xx y

Although this model is nonlinear in the coefficients, simple algebraic manipulation
yields a linear model that can be estimated using linear techniques. Taking the natural
log of both sides of the equation, one obtains:

log Q= log α+βlogP+γlogI +λlog(ΣP) +log ε

x xyy

This model yields a constant elasticity estimate along the demand curve.

Unfortunately, the estimation of a market demand function is not resolved once an
appropriate functional form is chosen. The more serious empirical problem of simultaneity
arises with such market demand functions. As in many significant economic
models, a simultaneous relationship exists between the supply and demand variables in
the model. To illustrate the problem, consider the linear model equation previously
shown. We hypothesized that the price of good X influences its demand, but we also
know that the quantity demanded of a good also influences its price. The question that
naturally arises is: Which comes first? Does demand influence price first, or does price
influence demand? The answer to this question is that both variables influence each
other at the same time. That is, they are simultaneously determined, or in the parlance
of econometrics, they are endogenous. Given the simultaneous relationship that
defines them, endogenous variables must be modeled using systems of interdependent
equations. Each endogenous variable is a function of other endogenous variables
and exogenous variables (i.e., variables that are not simultaneously determined). To
examine how feedback loops work within the entire model, the entire system must be
considered together, rather than each equation separately. Consider, for example, the following
system:

Q= α+βP +γI +ΣλP +ε

xx yy 1

P= φ+.Q+δS +ΣηP +ε

x xx yy 2

where the variables are the same as defined previously, and Sx is a vector of supply-side
effects, such as production costs. Note that in the first equation, the dependent variable
is quantity, while price is included as an independent variable. In the second equation,
price is explained as a function of quantity and a series of other exogenous variables.

Two-Stage Least Squares

The above demand system generates additional empirical concerns. The OLS method
discussed previously can no longer be applied to such systems. Ordinary least squares


ECONOMICS OF IP DAMAGE CALCULATIONS

regressions are predicated on the assumptions of the Gauss–Markov theorem, which
states that, if its assumptions are satisfied, the OLS coefficients are the best linear unbiased
estimates (BLUE) of the true population parameters. The above Equations violate
one of these assumptions, that orthogonality must exist between the stochastic error
term and the independent variables cannot be correlated with one another. That is, the
error term and the independent variables must be uncorrelated. The reason for this
assumption is that, if the error term is correlated with any independent variable in the
model, the OLS coefficients will incorrectly attribute some of the effect of the error
term to the independent variable(s) with which it is correlated. As a result, the OLS
coefficients will not be unbiased (centered on the true value) and the BLUE property of
Gauss–Markov will not apply. This phenomenon is commonly known as simultaneity
equation bias. Unfortunately, this is precisely the problem that affects equations that are
simultaneous in nature, such as the demand function. To see how this works, consider
an increase in the error term ε1 in the first equation above. If ε1 increases, it will cause
an increase in Qx. If Qx increases, it will cause an increase in Px in the second equation.
But, if Px increases in the second equation, it will in turn effect an increase in Qx in the
first equation. Thus, the error term in the first equation is correlated with Px in the same
equation, generating biased coefficients and therefore violating the Gauss–Markov
assumptions.

Although OLS is no longer an appropriate tool to estimate such simultaneous equation
models, a variety of statistical tools have been developed that solve this problem.
Most tools can be classified according to two principal methodologies: the generalized
method of moments (GMM) and the method of maximum likelihood (ML). Each of
these methods consists of a series of techniques that can be applied to systems of equations,
and numerous econometrics textbooks describe how to employ the methods.

In practice, the most popular tool for dealing with simultaneous equation systems
falls under the GMM methodology and is an instrumental variable technique known as
two-stage least squares (2SLS or TSLS).20 For the purposes of this discussion, 2SLS is
used as the tool of choice.21

Two-stage least squares attempts to find a variable that is both uncorrelated with the
error term and highly correlated with the dependent variable. Considering Equations
described previously, 2SLS would substitute for Px an instrumental variable that meets
both of these conditions. Although such a variable may seem difficult to find, 2SLS
provides a systematic method to accomplish the task. The steps are as follows:

1.
Identify the demand and supply functions. The parameters of a demand system
can be estimated only if the system is “identified.” Identification refers to the
ability to algebraically recover unique values of the parameters in question. In
practice, identification requires a sufficient number of exogenous variables
in each equation of the system. The reader is referred to the econometrics texts
in the Additional Reading section for the appropriate tests for identification.

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

2.
Generate reduced-form equations. Reduced-form equations express each endogenous
variable as a function of the error term, exogenous variables, and possibly
lagged endogenous variables. In this case, separate equations would be
generated for Qx and P x .
3.
Perform OLS on the reduced-form equations. An OLS equation is estimated
for each endogenous variable that was included in the right-hand side of the
system of equations as a function of the exogenous variables in the system. In
our demand function example, a separate reduced-form regression would be
run for Qx and P x .
4.
Substitute predicted values in the model and run OLS. Each equation estimated
in Step 3 will generate predicted values for Qx and P x that are orthogonal to the
error terms. These predicted values now become instrumental variables and
are substituted for the original endogenous variables. In the equations estimated
in Step 4, predicted values would be generated for Qx and P x . These in
turn would be used to reestimate the original system of equations.
Although 2SLS provides a solution for the endogeneity problem, it is by no means a
complete cure. The effects of 2SLS are essentially that the t-tests are more reliable and
the coefficient estimates are consistent and asymptotically unbiased in large samples.
However, 2SLS estimates are still biased, particularly in small samples, and great care
should be taken when drawing any statistical inferences in situations where the sample
size used to estimate the system of equations is small.

The Almost Ideal Demand System (AIDS) Model

As mentioned previously, economic researchers have explored a variety of models to
estimate own-price and cross-price elasticities in order to examine the effects of mergers.
These techniques can be used for market analysis in IP damage cases. Linear, log-
linear (constant-elasticity), and logit models are three useful techniques. Each of these
approaches has a set of idiosyncratic characteristics that differentiate them according
to the criteria sought by the expert: computational tractability, operational flexibility,
ability to explain the data at hand, and intuitive appeal.

The AIDS model, originally proposed by Denton and Muellbauer (1980),22 has
gained a level of acceptance and popularity due to certain desirable characteristics and
is useful in IP cases for its simplicity. The AIDS model specifies the share of a brand in
a given market as a function of the prices of the other competing brands in the market.
For example, the market share of Pepsi-Cola would be modeled as a function of the
price of Coca-Cola, Mountain Dew, and other branded soda products. The model is sensitive
to the market definitions assumed. The expert must be careful because omitting
relevant variables, such as other products, can have a serious impact on the results.

The AIDS model specification for an n-good system is:


ECONOMICS OF IP DAMAGE CALCULATIONS

Si =αi +Σ
n
β ln p +λ ln(XP

ij i / )
j = 1

where
αi = constant term in the ith equation
Si = the market share of the ith brand


= coefficients for the jth brand in the ith equation

βijpj = the price vector for the jth brand
λi = the parameter associated with the aggregate expenditure terms
X = industry (aggregate) expenditure
P = price index

In practice, the aggregate expenditure term can be omitted, leaving the equation as:

n
Si =αi + Σβij ln pj
i = 1

Omitting this term requires the assumption of homotheticity, meaning that changes in
the aggregate expenditure are hypothesized to have no influence on the size of the market
shares themselves. More specifically, a change in industry expenditure is presumed
to filter down to each brand in direct proportion to its market share, such that, while the
quantities purchased of a particular brand may change, its individual market share will
remain unaffected. In merger analysis, the constant terms fall out of the equation as
well, because the metrics of interest are the market share changes created by the merger.
The AIDS model also requires that all market shares sum to 1. This is commonly

n

referred to as the “adding up” property of the AIDS model. Since Σ Si = 1, the N equations

i = 1

can be reduced to N . 1, with prices expressed relative to the “numeraire” product in the
omitted equation, because the last equation can be completely determined by subtracting
the N . 1 market shares from 1. The “adding up” property holds for any set of price
changes, which in turn implies that:

n
Σβij = 0 for any j
i = 1

That is, the own price coefficients βij (where i = j) and cross-price coefficients βij
(where i ≠ j) for any good j equal zero. This is known as the assumption of homogeneity
implied by economic theory. That is, equal proportional changes in the prices of
individual brands have no impact on their market share. Thus, in a market where homogeneity
exists, a marketwide 5 percent price increase would leave the individual market
shares of the brands operating in that market unaffected because relative prices would


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

be unchanged. Another assumption of economic theory that is easily implemented
within the AIDS model is symmetry (i.e., that β= β). That is, the effect of a change

ij ji

in brand j’s price should influence brand i’s market share by the same amount that a
change in brand i’s price will influence brand j’s market share. It is important at this
point not to confuse the βcoefficients with the elasticities. The elasticities are computed
from the βcoefficients, as will be shown subsequently, but for now it is important to
understand that these terms are not synonymous.

An attractive feature of the AIDS model is that the assumptions of homogeneity and
symmetry can be directly tested within the model. Consider a hypothetical market with
four brands. The AIDS model would specify the following equations, based on the
assumptions described:

S1 = βln(p1) +βln(p2) +βln(p3) +βln(p4)

11 121314

S2 = βln(p1) +βln(p2) +βln(p3) +βln(p4)

21 22 23 24

= βln(p1) +βln(p2) +βln(p3) +βln(p4)

S331 32 33 34
= βln(p1) +βln(p2) +βln(p3) +βln(p4)

S441 42 43 44

In this system, the βij (where i = j) indicate the effect of a change in an individuals
brand’s price on its market share. These coefficients are expected to be negative,
because an increase in a brand’s own price would be expected to decrease its market
share, all other things being equal. The cross-price coefficients βij (where i ≠j) indicate
the effects of changes in other brands’ prices on an individual brand’s market share.
Conversely, these signs would be expected to be positive in the case of substitutes,
because an increase in the price of competing brands would make a rival brand more
attractive to consumers, thereby increasing its market share. In the model estimation, it
is relatively straightforward to test the homogeneity and symmetry assumptions using a
likelihood ratio test (LRT). Most statistical software packages, such as SAS., perform
such tests.

The system described reveals a complication of the AIDS model. In the four-brand
market example, the model must estimate 16 parameters. Consider now a market with
100 brands. The model would then be required to estimate 10,000 parameters. That is,
for n goods, the model estimates n2 parameters: n own-price coefficients and n(n .1)
cross-price coefficients. As n is increased, the computational tractability of the approach
becomes an issue of concern, because a very large number of observations would be
needed to ensure that the model retains sufficient degrees of freedom for estimation.23
Furthermore, the more parameters estimated, the greater the probability of obtaining
imprecise measurements of the coefficients or algebraic signs on the coefficients that
are inconsistent with economic theory. Several methods of alleviating this problem can
be used, among them is reducing the number of parameters estimated by specifying a
model produced by a multilevel decision process.24


ECONOMICS OF IP DAMAGE CALCULATIONS

The estimated coefficients of an AIDS model are not elasticities, and we now turn to
converting these coefficients to elasticities. The equation for the elasticities is:

ε = ((βij +λi(Sj .λj ln (X/P)) ÷ Si) . δij

where δij = 1 when i = j and 0 otherwise and the rest of the variables are as defined
previously.

The AIDS model has been used extensively in demand analysis, especially in merger
simulation. Other econometric models exist, as mentioned previously, and often the
choice of the model depends on the issue addressed by the researcher. For example, in
the fields of transportation and environmental economics, the random utility model
(RUM) developed by Daniel McFadden, whose work on the subject earned him the
Nobel Prize in economics, has been widely used to estimate demand for modes of transport
or recreation sites. Operational familiarity with several models is a valuable advantage
to the researcher, as multiple arrows in the quiver can be used to address a wider
array of economic issues.

This section does not contain a full discussion of econometrics. It is meant instead
to alert experts and lawyers dealing with IP damages that economists have developed
powerful statistical tools that can be drawn on in cases in which high-quality data are
available.

THE LAW AND ECONOMICS OF BARGAINING

The economics of bargaining and the principles of game theory are foundational principles
in the analysis of reasonable royalties. This is another topic we do not address,
but again, we alert the expert to the existence of relevant literature. Courts have imposed
the legal fiction that a reasonable royalty is the outcome of a hypothetical negotiation
between the parties at the onset of infringement. The outcomes of negotiations are the
focus of the economics of cooperative game theory.

In a cooperative game, both parties understand that exchange is mutually beneficial;
that is, both parties benefit from cooperating with each other. Suppose Mark owns a car
that he values at $1,000 and Rick values the same car at $2,000. Moving the resource
(in this case the car) from Mark to Rick creates $1,000 of “surplus.” The buyer will
never pay more than the value he places on the resource (typically determined by
the next-best substitute) and the seller will never accept less than his current value of the
resource (typically determined by the next-best employment of the resource). The difference
between these two limits is called the “bargaining range.”

The parties typically will bargain over the transaction price within the bargaining
range. The final price will determine how the surplus is distributed. As long as the game


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

remains cooperative, economics has little to say on how the final negotiation ends,
except that it will remain within the bargaining range. The final transaction price within
the bargaining range depends on the art of bargaining and the parties’ skill and ability
at negotiating.25

THE ECONOMICS OF INTELLECTUAL PROPERTY

Patents

Economists have written extensively about the economics of patents. The originating
assumption for economists is that ideas differ from physical property in several important
respects. First, ideas are what economists call a public good. As Thomas Jefferson
wrote, “He who receives an idea from me, receives instructions himself without lessening
mine; as he who lights his taper at mine, receives light without darkening me.” In
contrast to physical property, where establishing property rights arguably increases the
public welfare by creating incentives to maintain and efficiently use the property, diffusion
of ideas among the members of society produces the greatest public benefit.

Second, it generally is the case that it is less costly to copy an idea than to develop
the idea in the first instance. Think of reverse engineering a product or, more dramatically,
downloading digital music or software files. This means that it frequently will be
remarkably difficult to exclude others from using an idea.

Establishing property rights to IP is a way to provide a reward in exchange for developing
new ideas. By allowing a patent owner to exclude others from using an idea, a
patent owner can earn profits by exclusively selling products that incorporate the idea
or by licensing the use of the idea to others. Thus, IP rights, such as patents, allow a
return to innovation notwithstanding the ease of copying ideas.

There is a basic conflict between the benefits of diffusion of ideas and the incentives
to create new ideas. Although the greatest public benefit would result from making
ideas freely available to the public, this would provide little or no incentive to innovate
because the private returns to innovation would be much less than the public benefit.
Conversely, granting property rights to ideas provides incentives to develop new ideas,
but limits the benefits from diffusion. The important public policy issues regarding
patents involve a balancing of benefits from increased innovation against costs of interfering
with the free use of ideas.

The patent system grants an exclusive right to exclude others from using an idea without
permission for a specified period of time (now 20 years). After the patent has expired,
the idea can be used by anybody. This represents a trade-off between providing incentives
to develop technologies and promoting diffusion of ideas that are developed. In
addition, since it is not necessary to provide rewards for all innovations, patent protection
is limited to ideas that have utility, are previously unknown, and are nonobvious.


ECONOMICS OF IP DAMAGE CALCULATIONS

The fundamental point of IP rights is to create incentives for research and development
(R&D). Studies by economists have established that technological progress is surprisingly
critical to economic welfare. Economic welfare, for economists, thus can be
increased two ways. First, “dynamic efficiency” refers to the increase in consumer welfare
from innovation in new cost-reducing processes and new products. Second, “static
efficiency” refers to the increased benefit that consumers obtain from lower prices
and increased output. Until publication of the seminal papers by Robert Solow and
Edward Dennison,26 economists focused largely on static efficiency concerns. Solow
and Dennison showed that approximately 68 to 81 percent of the growth in U.S. output
has been a result of technological advance as opposed to increased labor and capital.
This was a significant result that caused renewed interest among economists in the issue
of innovation and its causes.

According to economists, the primary problem faced, by potential innovators is that
technical changes, in the form of new products and processes, are largely “public
goods.” This means, unlike with other forms of property, inventors and authors cannot
prevent others from appropriating or using their inventions without the intervention
of the legal system. For example, you can prevent others from using your car by locking
it in your garage. You cannot prevent someone from copying software you have invented
after sale without copyright protection. Mansfield, for example, studied the cost
of imitating or copying inventions compared to the innovator’s original costs. He found
that an imitator’s costs are approximately 65 percent of the innovator’s costs. Moreover,
imitation can occur quickly. Mansfield found that information about most R&D efforts
are in the hands of rivals within 12 to 18 months of their invention, and the imitation of
a new invention can occur within months.27

As a result, absent some legal protection for innovation, the incentives for investment
in new technology would be severely dampened because inventors and authors would
be unable to capture any of the economic benefits of their inventions.

Market Structure and Innovation. Economists have debated whether firms with
market power or competitive firms will engage in more innovating activities. A
number of models have been developed that indicate that the incentive to innovate
is stronger under competition than under monopoly. These results are straightforward
and easy to understand. The incentive for the monopoly firm to innovate is the additional
profit gained from the innovation. The monopolist is already making profits in
the preinnovation stage. Therefore, in the postinnovation stage, the additional profits
are due to the cost savings themselves on the monopoly output. In contrast, the competitive
firm begins from a situation of no economic profits. The innovation potentially
provides the competitive firm with lower costs or greater market power. Thus, the
additional profits from innovation are likely to be higher to the competitive firm than
to the monopolist.


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

In contrast, Joseph Schumpeter28 contended that innovation is likely to be larger for
firms with market power than for competitive firms. This is because firms with large
profits will have a greater ability to release free cash flow for use in R&D activities.
Moreover, R&D activities may be subject to significant economies of scale. In this case,
large firms will also be much more efficient at innovating.

The empirical evidence addressing this controversy is mixed. Some studies have
found that spending on R&D and number of patents is positively related to firm size or
concentration. Other studies have found more innovation among competitive firms.
Several empirical studies have found an inverted U-shaped relationship between market
concentration and spending on R&D activities. This result, although criticized by
several other studies, suggests that R&D spending is discouraged by either too much
or too little competition. Still other studies question the relationship between R&D and
innovation and the relationship between R&D and economic growth.

Dynamic Versus Static Efficiency. An issue that lies at the heart of the interplay
between the IP laws and the antitrust laws is the apparent trade-off between incentives
for dynamic efficiency and incentives for static efficiency.

The Trade-Off. Ultimately, the goal of the IP laws can be viewed as maximizing the
difference between the total social benefit from innovation less the total social cost of
innovation. The benefit from innovation consists of lower cost processes and new or
better products. The costs are twofold. First, expenditure on innovation consumes
resources that could be put to other uses. Second, to the extent that the IP laws grant
exclusive rights, static efficiency is reduced because consumers pay higher prices, and
the market has less output. In addition, stringent IP laws can reduce incentives for follow-
on improvement inventions.

Optimal Patent Life. Nordhaus was one of the first economists to formally address
this trade-off.29 Nordhaus considered the issue of the optimal patent life, the one variable
impacting the dynamic efficiency–static efficiency trade-off that Congress can control.
Nordhaus attempted to find the optimal patent life by comparing the size of the lost
consumer surplus due to the monopoly (the deadweight loss), the impact of its deferral
measured by the discount rate, and the increasing R&D costs stimulated by the greater
monopoly profits against the increasing amount of cost reduction (and hence profit and
consumer surplus stimulated by the longer patent life). He found that, as the amount of
induced cost reduction from innovation from longer patent life increases, society must
wait longer to appropriate the full benefits of the innovation. At the same time, monopoly
profits in the future are discounted more heavily, resulting in less innovation. The
optimal length of the patent thus depends on several factors, including: (1) the elasticity
of demand (the greater the demand elasticity, the greater the cost to society from the
patent monopoly); (2) how easy it is to achieve the cost reduction (when bid cost


ECONOMICS OF IP DAMAGE CALCULATIONS

reductions are easily obtained, society is less willing to sacrifice consumer surplus to obtain
them); (3) the impact of the patent length on inventiveness; and (4) the discount rate.

The following equation relates these factors:

NSB(t) = [(CSm +πm) ∫e.rs ds +CSc ∫e.rs ds] P(N) .M(N)

where
CSm is consumer surplus with the patent
πm is the patentor’s profits
CSc is the competitive consumer surplus absent the patent
P(N) is the probability of an invention based on expenditure of N firms
M(N) is the cost of R&D by N firms

Economists believe that it is likely that the optimal patent length will differ by industry.
For example, in less competitive markets, short patents may be best because deadweight
loss can be large, whereas the opposite is true in more competitive markets.
Because of the difficulty of obtaining the required information and the costs of non-
uniformity in the patent system, policy has dictated an across-the-board 20-year patent
length in most of the world.

Optimal Patent Breadth. Unfortunately, little work has addressed the issue of optimal
patent breadth. The breadth of patent protection is a key variable in creating incentives
for the size and type of future innovations. Unlike patent length, the interpretation of
the breadth of a patent claim is a matter of law determined by the federal courts. To understand
the trade-off inherent in determining the breadth of a patent claim, consider two
patents with the following independent claims:

PATENT 1 PATENT 2


Element A Element A
Element B Element B
Element C Element C
Element D

Patent 1 might be considered a basic research patent. Patent 2 is an improvement
patent. Anyone practicing an invention that is covered by claims A, B, C, and D would
be obligated to pay a royalty to the owner of patent 2 for the combination of elements
A, B, C, and D, and to the owner of patent 1 for elements A, B, and C. As a result, the
incentive to produce improvement or second-generation patents is dampened to the extent
that patent 2 “reads on” patent 1. However, if the claims of patent 1 are interpreted
narrowly, patent 2 is less likely to read on its claims and the incentives for follow-on
research is increased, albeit at the expense of the incentive for basic research.


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

This problem may be solved privately through joint ventures and patent pools or
cooperative research. However, such collaboration among competitors can raise other
antitrust concerns.

The Economics of Copyrights

The economic literature on copyright protection has essentially focused on two issues.
The first issue is whether copyright protection is really necessary to create sufficient
incentives for authors. The second issue is an attempt to explain how copyright law has
evolved by considering the trade-off between incentives for current increased production
in artistic work and future increases in artistic work plus reductions in static output
from the copyright monopoly.

Supreme Court Justice Stephen Breyer’s article “The Uneasy Case for Copyright: A
Study of Copyright in Books, Photocopies and Computer Programs” is a leading article
that addresses the first issue. Justice Breyer contends that the case for copyright protection
generally may not be as strong as conventional wisdom suggests. This is because
market forces may be sufficient to create the necessary incentives for current investment
by authors. If this is the case, the disincentives copyright protection creates for future
expression and reductions in static efficiency could offset the social gains. Justice
Breyer considers several market mechanisms that create incentives for authors. Among
these incentives are the fact that there is a cost to copying, copying takes time, and the
result may be a poor substitute. In such cases, the author’s profits may not be significantly
diluted by the copier. Moreover, in the case of textbooks, authors receive several
external benefits, such as prestige, tenure, and higher salaries, which may alone create
sufficient incentives for scholarly works. In addition, Justice Breyer suggests that
potential textbook and software buyers could enter into executory contracts that could
ensure an adequate return to the author.

Landes and Posner30 have attempted the more comprehensive exercise of trying to
interpret copyright law as optimally balancing two competing interests. On one side
of the ledger are the incentives for the first generation of authors to create expressive
works. On the other side of the balance are the difficulty copyright protection poses for
future generations of authors who have less public domain art to build on, as well as the
static efficiency costs (proxied by Landes and Posner using an output variable) from
precluding consumers from purchasing less expensive unauthorized copies. After a
formal presentation of the trade-off, Landes and Posner attempt to draw out several
implications of their analysis:

. The rule that independent recreation is not actionable is explained by the fact
that it would be too costly to search the prior art (as done after a patent application)
because the copyrighted literature is too vast.

ECONOMICS OF IP DAMAGE CALCULATIONS

. Ideas are not protected because taking ideas out of the public domain would
increase the costs of future authors (who would have to develop the idea and the
expression) compared to the benefit of the output of first-generation authors.
. The rationale for giving authors a copyright on their derivative work is not to
create more profits on the original work. Landes and Posner contend that derivative
works typically are not close substitutes for original works (like a movie
based on a book). Instead, they argue that the rights in the derivative work (like
a translation) create incentives to create more derivative works. The right should
be given to the original author to prevent delay in original publication until the
derivative work is created. The derivative work’s author (who is not the original
author) also has a known person to go to for a license reducing transactions costs,
and where no copyright exists on the original work, the derivative work’s author
can obtain protection.
. The case for fair use is based on transaction costs. Authors benefit by the publicity
received from reviews, quotations, and parody. Works of art are often
“experience goods” requiring “free samples.” Without fair use rules, each such
quotation would require a costly licensing negotiation that might discourage its
publication.
. Tying the copyright duration to the death of the author makes tracing easier
because all of an author’s works lose protection at the same time.
The Economics of Trademarks

Economists view the analysis of trademarks as a branch of the economics of information.
The development of economic thought concerning information can be traced to Stigler’s
pioneering work on the economics of information.31 Stigler recognized that information
about the price and quality characteristics of goods and services is a scarce resource.
Information is demanded by consumers as an input to market decisions, and real resources
must be expended to obtain such information. The necessary expenditure on such information
is called “search costs.” The purpose of a trademark is to reduce consumer search costs.

To perform this function, a trademark or a brand name must be exclusive. That is, the
consumer must be confident that the name “McDonald’s” applies only to a set of fast-
food restaurants with particular characteristics that the consumer has sampled in the past.

Moreover, exclusive trademarks encourage investment in quality and implicit warranties
by producers. A firm has an important stake in how consumers judge their brand
and will invest resources in ensuring that consumers associate their brand with a high-
quality product. Furthermore, firms recognize that high-quality products can be sold at
higher prices. To the extent that a trademark is not exclusive or is inconsistent or
ambiguous, the return on investment in brand quality is diluted and firms will have a
weaker incentive to invest in quality and consistency.


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

There is a growing consensus among economists that strong brands lower search
costs and do not create market power (like a patent or a copyright does). Trademark law
appears to recognize this benefit and has evolved in the direction of protecting trademarks
to the extent that they do not distort consumer information (deceptive marks) or
impede competition by monopolizing the availability of similar marks for competitors
(the ban on generic or descriptive marks without secondary meaning).32

The Economics of Trade Secrets

Very little has been written about the economics of trade secrets. One exception is the
paper by Friedman, Landes, and Posner.33 In that paper, the authors address two questions.
First, why is a choice between patent and trade secret allowed? Second, why does
trade secret law not protect against accidental disclosure or reverse engineering?

The Choice Between Patent Law and Trade Secret Law. The answer to the first quesiton,
according to Friedman, Landes, and Posner, is that inventors choose trade secret
protection when they believe that the secret is worth less than the patent process costs
(typically in the range of $10,000 to for a U.S. patent), the invention might lack the
required novelty for patentability, or the secret is so valuable (like Coca-Cola’s formula)
that patent protection is insufficient in duration. The trade secret alternative may
also have social benefits because it discourages excessive effort in a race to the patent
office.

Why Does Trade Secret Law Only Prevent Improper Misappropriation? There is no
“finders keepers” rule with other types of personal property unless the property is
abandoned. Friedman, Landes, and Posner suggest that the answer is that the level of
protection is reciprocal. Every producer of business information is also a consumer
of its competitors’ information. The law strikes a balance by prohibiting only the most
costly means of information retrieval. If innocent appropriation were illegal, like
reverse engineering or public searches of data, then too much would have to be
expended by companies seeking to conduct business but avoid lawsuits for inadvertent
discoveries of others’ trade secrets. Moreover, a firm would have no way of
knowing whether it came across a trade secret. Refusal to enforce agreements not to
disclose trade secrets, however, would cause the trade secret holders to take unduly expensive
precautions.

The case for reverse engineering is more difficult. Friedman, Landes, and Posner
argue that it would be too difficult to distinguish independent research from reverse
engineering if reverse engineering were illegal.

In sum, economists not only have developed tools in many contexts that can be used
in IP damage analysis, but also, to a more limited extent, they have directly attempted
to explain IP law itself using economic precepts.


ECONOMICS OF IP DAMAGE CALCULATIONS

SUMMARY


This chapter focused on the basic economic tools needed for calculation of IP damages.
One such tool that is critical is an understanding of how to define the relevant product
market. When sufficient data are available, econometrics can be a helpful tool for
obtaining the inputs to an IP damage analysis. This chapter further addressed how economists
think about and understand IP. This latter discussion can help both lawyers and
experts to structure their thinking about an IP case at its initial stages.

ENDNOTES

[1] A. Mitchell Polinsky, An Introduction to Law and Economics, 2nd ed., New York: Aspen
Publishers (1989), 2, 4.
[2] Inferring lack of market power solely from evidence of substitution is known as the “cellophane
trap.”
[3] The algebra is:
MC = P . P ....→ PMC . = P
e e

[4] For a justification of the Cournot output and conjectural variation assumptions, see Carl
Shapiro, “Theories of Oligopoly Behavior,” Handbook of Industrial Organization, Vol. I,
Schalensee and Willig, eds., Amsterdam: North Holland (1990), 329–414.
[5] The Guidelines represent an attempt to bring merger analysis under section 7 of the
Clayton Act more in line with modern economic thinking. The Guidelines were authored
in large part by economists employed at the antitrust enforcement agencies. See Gregory
J. Werden, Market Delineation and the Justice Department’s Merger Guidelines, Duke
L.J. 514 (1983).
[6] See Guidelines § 0.1.
[7] Id.
[8] Id. § 2.0.
[9] In fact, the Guidelines use the term “small but significant and nontransitory” increase in
price. We use 5 percent as a shorthand.
[10] See Guidelines § 1.11.
[11] Id.
[12] Id. § 1.21.
[13] Id. §§ 1.3 and 3.0.
[14] Id. § 1.32.
[15] Id. § 3.0.
[16] Merger Guidelines § 1.11.
[17] For a more rigorous discussion of such methods and their statistical implications,
the expert is referred to W. H. Greene, Econometric Analysis, Englewood Cliffs, N.J.:
Prentice-Hall (1999).

LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

[18]
T-tests are based on the assumption of asymptotic normality. In small samples, t-tests may
be unreliable and should not be relied on as prima facie evidence of statistical significance.
[19] Cross-price elasticities can thus be estimated for each good in the vector Py .
[20] Although some texts paraphrase two-stage least squares as TSLS, the reader should be
aware of three-stage least squares, whose existence may cause some confusion when
using the TSLS acronym.
[21] An alternative called limited information maximum likelihood (LIML) is not discussed
here, but the reader is referred to W. H. Greene, Econometric Analysis (Upper Saddle
River, N.J.: Prentice-Hall (1999)) for a rigorous discussion of the subject as well as a more
in-depth treatment of 2SLS.
[22]
See A. Deaton and J. Muellbauer, An Almost Ideal Demand System, Am. Econ. Rev. 70 (1981).
[23] Note that imposing constraints on the parameters, such as the homogeneity and symmetry
properties implied by economic theory, and eliminating one equation by virtue of the
“adding up” property, reduces the number of parameters to be estimated. The ease of imposing
these parameter-saving constraints is another desirable feature of the AIDS formulation.
[24]
See Daniel L. Rubinfeld, Market Definition with Differentiated Products: The Post/Nabisco
Cereal Merger, 68 Antitrust Law J. 163, 173–176 (2000), for a discussion of this approach.
[25] Economists can say much more about the outcome of noncooperative negotiation. In
these situations, game theory concepts apply. See Robert Gibbons, Game Theory for
Applied Economists, Princeton, N.J.: Princeton University Press (1992).
[26]
Robert M. Solow, Technical Charge and the Aggregate Production Function, 39 Rev.
Econ Stat. 312 (1957); Edward Dennison, Accounting for United States Economic
Growth: 1929–1969, Washington, D.C.: Brooking Institution (1974).
[27] Edwin Mansfield et al., The Production and Application of New Industrial Technology,
New York: W. W. Norton (1977).
[28] Joseph Schumpeter, The Theory of Economic Development, Cambridge: Harvard University
Press (1934).
[29]
William Nordhaus, An Economic Theory of Technological Change, 59 Am. Econ. Rev. 18
(1969).
[30]
W. Landes and R. Posner, An Economic Analysis of Copyright Law, 18 J. Legal Studies
3LS (1989).
[31]
George S. Stigler, The Economics of Information, 69 J. Pol. Econ. 213 (1961).
[32]
W. Landes and R. Posner, The Economics of Trademark Law, 78 Trademark Rep. 267
(1988), develop the analysis of the various aspects of trademark law based on the economics
of information.
[33] Friedman, W. Landes, and R. Posner, Some Economics of Trade Secret Law, 5 Journal of
Economic Perspectives 61 (1991).
ADDITIONAL READING

Roger L. Beck, The Prospect Theory of the Patent System and Unproductive Competition,
5 Research in Law & Economics 193 (1983).


ECONOMICS OF IP DAMAGE CALCULATIONS

Stanley M. Besen and Leo J. Raskind, An Introduction to the Law and Economics of
Intellectual Property, 5 Journal of Economic Perspectives 3 (Winter 1991).

Richard Gilbert and Carl Shapiro, Optimal Patent Length and Breadth, 21 RAND Journal
of Economics 106 (Spring 1990).

Paul Klemperer, How Broad Should the Scope of Patent Protection Be? 21 RAND Journal
of Economics 113 (Spring 1990).

Janusz A. Ordover, A Patent System for Both Diffusion and Exclusion, 5 Journal of
Economic Perspectives 43 (Winter 1991).

Suzanne Scotchmer, Standing on the Shoulders of Giants: Cumulative Research and the
Patent Law, 5 Journal of Economic Perspectives 29 (Winter 1991).

David L. Kaserman and John W. Mayo, Government and Business: The Economics of
Antitrust and Regulation, The Dryden Press (1995).

Luis M.B. Cabral, Introduction to Industrial Organization, Cambridge: The MIT Press
(2000).

Mark Seidenfeld, Microeconomic Predicates to Law and Economics, Anderson Publishing
Co. (1996).

Stephen Martin, Industrial Economics: Economic Analysis and Public Policy, 2nd ed.,
New York: Macmillan Publishing Company (1994).

Jeffrey L. Harrison, Law and Economics: In a Nutshell, New York: West Publishing Co.
(1995).

Nicholas Mercuro and Steven G. Medema, Economics and the Law: From Posner to Post-
Modernism, Princeton, N.J.: Princeton University Press (1997).

A. Mitchell Polinsky, An Introduction to Law and Economics, 2nd ed., Boston: Little,
Brown (1989).
Eric A. Posner, general editor, Chicago Lectures in Law and Economics, New York:
Foundation Press (2000).


Werner Z. Hirsch, Law and Economics: An Introductory Analysis, 3rd ed., San Diego:

Academic Press (1999).
Robin Paul Malloy, Law and Economics: A Comparative Approach to Theory and
Practice, New York: West Publishing Co. (1990).


Richard A. Posner, Economic Analysis of Law, 4th ed., Boston: Little, Brown (1992).


Robert Cooter and Thomas Ulen, Law and Economics, 3rd ed., Menlo Park: AddisonWesley-
Longman (2000).
Don E. Waldman and Elizabeth J. Jensen, Industrial Organization: Theory and Practice,


2nd ed., Boston: Addison-Wesley-Longman (2001).
William F. Shughart II, The Organization of Industry, Chicago: Richard D. Irwin (1990).
Stephen Martin, Advanced Industrial Economics, Oxford: Blackwell Publishers (1993).



LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance,
Boston: Houghton Mifflin (1990).
W. Kip Viscusi, John M. Vernon, and Joseph E. Harrington, Jr., Economics of Regulation
and Antitrust, 3rd ed. Cambridge: The MIT Press (2000).
Dennis W. Carlton and Jeffrey M. Perloff, Modern Industrial Organization, 3rd ed., Menlo
Park: Addison-Wesley-Longman (2000).

Lynne Pepall, Daniel J. Richards, and George Norman, Industrial Organization: Contemporary
Theory and Practice, Cincinnati: South-Western College Publishing (1999).

Fred S. McChesney, Economic Inputs, Legal Outputs: The Role of Economists in Modern
Antitrust, New York: John Wiley & Sons (1996, 1998).

Richard Schmalensee and Robert D. Willig, Handbook of Industrial Organization, Vol. I,
Amsterdam: Elsevier Science Publishing Company (1989).

Jan Kmenta, Elements of Econometrics, Ann Arbor: University of Michigan Press (1997).

W. H. Greene, Econometric Analysis, Upper Saddle River, N.J., Prentice-Hall (1999).
G. S. Maddala, Introduction to Econometrics, New York: Macmillan (1992).
George C. Judge, R. Carter Hill, William E. Griffiths, Helmut Lütkepohl, and Tsoung-
Chao Lee, Introduction to the Theory and Practice of Econometrics, New York: John
Wiley & Sons (1988).

A. H. Studenmund, Using Econometrics: A Practical Guide, 4th ed., Boston: AddisonWesley-
Longman (2001).

4


Introduction to
Accounting Principles in
Intellectual Property Damages


In addition to economics, competent intellectual property (IP) analysis requires an
understanding of both the IP owner’s and the infringer’s books and records. A background
in accounting principles is required to accurately identify the financial information
necessary for translating abstract economic theories into factually supported
positions. Moreover, an understanding of the accounting system is needed for efficient
and effective document discovery. While this book does not try to teach a complete
accounting course, this chapter provides an overview that we believe will help the
reader identify the most important records.

INTRODUCTION TO FINANCIAL STATEMENTS

Understanding the financial statements of the relevant companies in a case is critical to
calculating damages. In most cases, the financial records of both parties must be scrutinized.
A lost profits analysis, for example, requires an analysis of the plaintiff’s financial
statements (financials) to determine the profitability of the infringed technology.
Any “unjust enrichment” or “reasonable royalty” calculation also requires an understanding
of the defendant’s financials. The documents sought through discovery will
vary depending on the theory of damages. All too often, attorneys simply will ask the
other side for the same documents that have been requested from their own client.
Such overly simplistic thinking is likely to leave damage experts at a disadvantage.
Furthermore, ineffective discovery can result in additional legal fees as subsequent
requests are necessary to capture the information that should have been included in the
initial set of discovery requests. Finally, because recent trends in the federal rules and
most state rules favor limiting the total number of document requests allowed to each
party, it is increasingly necessary for document requests to be efficient and gather the
necessary information on the first try, where possible.

73



LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Accordingly, the purpose of this chapter is to sufficiently educate those with very
little accounting knowledge to enable them to conduct effective discovery requests and
to understand useful accounting techniques generally. Be aware that because the particular
accounting data may vary greatly (even for businesses within the same industry),
the formal assistance of an accountant is likely to be necessary, or at least very
helpful, in completing discovery. The best financial discovery often is performed over
at least two document requests. The first request usually should be relatively small,
focusing on macro-type documents (e.g., tax returns, balance sheets, business plans,
private placement memoranda, etc.). This request most often is made with a relatively
large range of dates in mind, such as tax returns for the last five years. The purpose of
the request is to obtain sufficient information about the opposing party to ensure that
a second request is on point and will result in the best available useful evidence. The
second document request generally is aimed at the most detailed data regarding
the heart of the litigation. For example, a second request might ask for customer lists,
invoices, account details, sales by product number, and so on. Ideally, the second
request will provide the type of information that will allow the damage expert to use
company-related documents rather than industry estimates in performing the analysis.
Again, the actual documents requested will change from case to case, as will the ability
to narrow the requests at an early stage.

Perhaps the biggest factor affecting this two-step discovery process is the method
of accounting used by the company. There are two primary methods of accounting:

(1) cash basis and (2) accrual basis. As discussed in the following section, the practitioner
can make some assumptions about the opponents’ accounting methodology
based on generalizations that empirically function as good indicators. For example,
the tax return of a business contains a box that is checked by the filer to indicate
which method of accounting the taxpayer used. Thus, if you already have your opponent’s
tax return, you can definitively determine the methodology prior to using up
any of your document requests. As a general rule, companies that are either large or
publicly held use the accrual method. Small or private companies tend to operate on
a cash basis.
CASH BASIS

The cash basis of accounting is employed by many small businesses in the United
States. For example, many sole proprietors, multilevel marketers, and businesses
operated as a second job use the cash method of accounting. The cash basis of
accounting is similar to the way most individuals maintain their own checking
account. On the day that a company pays a bill (or cuts a check), they record it. On
the day the company actually deposits revenue, they record it. Cash accounting
ignores checks and bills that have not yet arrived, even if the company knows that they


ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

are coming. The cash basis approach even ignores bills that have arrived but have not
been paid, as well as checks that have been received but not deposited. This system of
accounting is regarded as less sophisticated than the accrual method (discussed in the
next section). The cash method is similar to an ostrich with its head in the sand,
because cash basis companies act as if a bill that has not arrived does not exist. Thus,
accounting records maintained on the cash basis of accounting are much less likely to
accurately reflect the entire business situation than if the accrual method had been
used. It is impossible to anticipate whether a cash basis company is in better or worse
financial condition than is indicated by its financial statements than if the company
used the accrual basis of accounting.

A simple example illustrates the difficulties associated in the cash basis methodology.
Imagine that you are evaluating two businesses that are both using the cash basis
of accounting. Assume that the date is December 31 and you are trying to determine
which business is in better condition as of that date. The first company is a construction
firm that has worked since last January 1 on a $5 million construction project. The company
completed construction on December 29. During the last year (over the life of the
project), the company paid out $4.5 million in expenses related to the project. The contract
called for the company to be paid the final 20 percent of the $5 million within
30 days after completion of the project. The company received partial payments of $4
million during the year.

The second business is a construction company that also has worked since last
January 1 on a $5 million construction project. This company is not yet finished with
the project. In fact, the company expects to spend $500,000 in January to complete the
project. This is in addition to the $4.6 million the company has already spent since
it began working on the project. This company did manage to negotiate a better contract
than the first company negotiated, as the second company has already received all of
the $5 million.

Which company is in better financial condition? The first company is more financially
sound. After all, the company spent a total of $4.5 million to complete the work,
netting a $500,000 profit. The second company was paid $5 million on a project that
will ultimately cost $5.1 million ($4.6 million + $500,000), resulting in a net loss of
$100,000. However, the financial statements for the two firms might lead you to the
opposite conclusion. For the year ending December 31, the first company will report
only the $4 million of revenue it received and the $5 million worth of expenses it has
already paid. Thus, the company showed a net loss of $1 million. In contrast, the second
company reported the $5 million of revenue it received and the $4.6 million of
expenses it paid. Thus, the second company showed a net gain of $400,000.

As this example illustrates, the practitioner cannot predict whether a company’s use
of the cash basis method of accounting will overstate or understate the company’s financial
position. Neither can the practitioner assume that the financial condition is in fact
misstated. However, when a firm uses the cash basis of accounting, the practitioner can


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

assume that he or she likely will need to spend time making sure he or she knows about
revenues earned but not yet deposited and expenses incurred but not yet paid. The discovery
requests should take this into account.

THE ACCRUAL METHOD

If the cash method is like an ostrich with its head in the sand, seeing neither approaching
danger nor friends, the accrual method can be compared to Chicken Little’s pessimistic
outlook—“the sky is falling.” The accrual method attempts to include all
conceivable expenses while recognizing only the most conservative estimate of revenues.
The theory behind the accrual method is based largely on the “matching principle.”
Accountants attempt to match revenues with the expenses incurred in generating
those revenues, regardless of when the expenses are actually paid. An example illustrates
the thought process. Imagine that a company engaged in oil and gas development
plans to produce oil over the next five years. At the end of the five years, the company
expects to pay $500,000 to repair the land to make it conform to environmental laws.
Under the accrual method, the company would record $100,000 of environmental remediation
expenses in each of the next five years. This treatment matches the expense with
the revenue, even though the actual remediation payments will not be made until after
the development, some five years from now.

The accrual method is the more commonly used method among large companies. In
practice, many companies use the cash basis throughout the year until the last month of
the reporting cycle. At that point, they make the accounting entries necessary to conform
to the accrual method of accounting. Thus, the expert could receive two statements
for the same company that are not prepared on a consistent basis. An indication of such
a situation is an inventory balance that does not change throughout the year or a balance
sheet that is void of accounts payable. When faced with such a situation, the damage
expert must inquire into the “accounting cycle” to identify information that is fairly
compared to the data in hand. The accounting cycle is discussed in more detail later in
this chapter.

A significant advantage of analyzing a business that uses the accrual method is that
there is a high likelihood that all expenses are identified. However, a disadvantage of
the accrual method is that it is easy to overstate a company’s incremental costs. As
discussed in detail in Chapter 14, “incremental costs” are one of the primary tools
used in preparing a damage analysis. This can be illustrated using the same oil and gas
company described previously. Assume that the company is infringing protected technology
that allows the company to get oil out of the ground for less money than it is
able to without the technology. Further assume that the technology at issue does not
affect the expected remediation costs. The expert must remove the remediation
expense from his or her analysis to avoid overstating incremental expenses. In sum,
when analyzing a cash basis firm, the practitioner must make sure that relevant


ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

expenses are not left out of the analysis. Conversely, when analyzing a firm that uses
the accrual method, the expert must be certain not to include expenses that should be
left out of the analysis.

THE FINANCIAL STATEMENTS

The first document request usually is more general in nature and broader in scope than
subsequent document requests. The first request typically asks for the high-level financial
statements for a period of time before the alleged infringement (often 3 to 5 years)
through the date of the request. When accountants use the term financial statements,
they typically are referring to a set of documents consisting of (1) income statement,

(2) balance sheet, and (3) statement of cash flows. Each of the three types of documents
is designed to serve a distinct purpose, and each can be useful for different aspects of
the IP damage analysis.
THE INCOME STATEMENT—ALSO CALLED A
“PROFIT/LOSS STATEMENT”

The income statement is called a “period” document because it relates to a specific
period of time. Most companies prepare monthly, quarterly, and annual income statements.
It is most common for the income statement to have a “Year to Date” column as
well as a column that is for the same period of time during the previous year. Exhibit
4-1 is an example of an income statement for the hypothetical company ABC, Inc.

The income statement is the most useful document for determining the incremental
margin on additional products sold. The incremental margin is the appropriate profit
stream to use when determining a lost profit damage calculation. To obtain the incremental
profit margin, one must begin with the income statement. The income statement
lists the revenues and the expenses of the business. Revenues from the company’s operating
activities are listed at the top. Frequently, the revenues are “net,” meaning net of
returns. For example, in the sample income statement (Exhibit 4-1), “Net product sales”
is listed. This amount is “net” of customer returns. In most cases, the difference between
gross revenues (before returns) and net revenues (after returns) is insignificant.
However, for certain industries, such as in the health care industry, the difference can
be quite large. This is intuitive because hospitals typically charge much more than the
insurance companies pay, which results in the large difference. For companies that are
in an industry that usually does not have such a large difference, the presence of significant
returns can be evidence of poor manufacturing quality.

Next, the cost of goods sold (COGS) is listed on the income statement. The COGS
typically includes direct costs incurred in making the sale. For instance, COGS includes
the material and the labor costs needed to make a widget. Of course, the applicable costs
change from industry to industry. For instance, in a law firm, the COGS is the cost of


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

the attorneys’ labor. In contrast, an automated widget manufacturer may not include any
labor costs in its COGS. The COGS is nearly always incremental and represents the typical
starting point for the determination of the total incremental costs.

Next, the income statement typically lists the company’s operating expenses.
Operating expenses are necessary to conduct the business’s operations. Typically, the
operating expenses include some costs that are incremental and some that are not. By
using a combination of statistical analysis and intuition, the practitioner can estimate the
portion of operating expenses that are incremental. In other words, if the plaintiff had
made the lost sale, they would have incurred the incremental costs.

The operating expenses commonly are followed on the income statement by the business’s
selling general and administrative (SG&A) expenses. Frequently, a portion of the
selling costs are incremental (e.g., commissions, etc.). Conversely, general and administrative
expenses consist of items such as the CEO’s salary and usually are not incremental.

Generally, the remaining listed income or expenses are ignored as irrelevant to a
damage calculation. These recorded but irrelevant items may include gains or losses
from discontinued operations, other income/expense, and extraordinary income and
expenses at the very bottom of the income statement. It is very rare that such amounts
would be applicable to a damage analysis.

Years Ended December 31,
2000 1999
REVENUES
Net product sales
Research grants
Total revenues
$ 5,930
198
$ 6,128
$ 6,292

$ 6,292
COST OF GOODS SOLD
Profit from sales
4,530
$ 1,598
5,250
$ 1,042
OPERATING COSTS AND EXPENSES
Selling, general, and administrative
Research and development
Total operating costs and expenses
Loss from operations
$ 4,068
10,398
$14,466
($12,868)
$ 5,320
14,669
$19,989
($18,947)
OTHER INCOME (EXPENSE)
Interest income
Interest expense
Other income
$ 2,941
(762)

$ 901
(221)

Total other income (expense) $ 2,179 $ 680
Net and other comprehensive loss ($10,689) ($18,267)
Basic and diluted net loss per share ($0.49) ($0.82)
Shares used in calculation of basic
and diluted net loss per share 21,801 15,842
EXHIBIT 4-1 Income Statement for ABC, Inc.


ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

BALANCE SHEET


The balance sheet represents a “snapshot” of a company’s assets, liabilities, and equity
as of a particular day. Although the specific items listed on the balance sheet differ from
company to company, certain aspects are always the same; assets are always listed first,
followed by liabilities, and finally equity. Within the assets, those that are most easily
and quickly converted to cash are listed first. The amounts on the balance sheet are
called “book value” and generally represent the amount spent on acquiring the account.
Exhibit 4-2 represents a sample balance sheet for ABC, Inc.

December 31,
2000 1999


ASSETS
Current assets:
Cash and cash equivalents $ 14,153

$ 881
Short-term debt securities held to maturity
and time deposits, partially restricted 109,089

20,630
Receivables 1,526

316
Note receivable from related party 278

278
Other current assets 502

547
Total Current Assets $125,548

$22,652

Property and equipment $ 9,961

$ 9,562
Accumulated depreciation $ (8,938)

$ (8,452)
Net Fixed Assets $ 1,023

$ 1,110

Debt issuance costs 108

127
Long-term debt securities held to maturity $ 12,343

TOTAL ASSETS $139,022

$23,889

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities $ 1,082

$ 993
Accounts Payable 1,663

1,167
Accrued Liabilities 256

214
Total Current Liabilities $ 3,001

$ 2,374

Convertible notes payable $ 10,958

$10,215
Deferred revenue 130

25

Stockholders’ equity

Common stock, .001 par value, 50,000,000 shares

authorized: issued and outstanding 27,352,000

shares in 2000 and 17,503,000 shares in 1999 27

17
Additional paid-in capital 226,465

102,128
Accumulated deficit (101,559)

(90,870)

Total Stockholders’ Equity $124,933

$11,275

TOTAL LIABILITIES AND
STOCKHOLDERS’ EQUITY $139,022

$23,889

EXHIBIT 4-2 Sample Balance Sheet for ABC, Inc.


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Assets

The entry titled “Total Current Assets” ($125,548 for ABC) represents the assets that the
company expects to use over the next 12 months. The most common current assets are
cash, accounts receivable, inventory, and prepaid assets. Often, the fair market value of
current assets is very similar to their book value. An asset is considered “current” if it
is likely to be used during the next year.

Fixed assets (here $1,023 for property, plant, and equipment) usually are listed
next. Fixed assets consist of assets that are expected to remain in use for more than
one year. Typical fixed assets include buildings, vehicles, property, and equipment.
Additionally, purchased patents and goodwill are fixed assets. In fact, only purchased
IP is listed. Internally developed IP, whether it be a patented process or copyrighted
software code, is not typically reflected anywhere on the balance sheet. The fixed
assets, including the IP, are recorded at their cost and depreciated over their useful life
during subsequent periods.

Accumulated depreciation is a line item under fixed assets that reduces the book
value of the fixed assets to reflect the wear and tear on the asset. The accumulated
depreciation account is a negative amount within the fixed asset section of the balance
sheet. At the bottom of the fixed asset section is a line item titled “Net Fixed Assets.”
The net fixed assets represent the cost of the assets “net” of depreciation. As each year
passes, the fixed asset balance remains the same, the accumulated depreciation increases,
and the net fixed assets decrease.

For instance, assume that a company buys a building for $600,000. Further assume that
the company expects the building to be used for 30 years. The balance sheet will include
a line item under fixed assets titled “Building” with a corresponding amount of $600,000.
Each year $20,000 ($600,000 ÷ 30 years = $20,000/year) will be added to the accumulated
depreciation account. Thus, in the first year the account balances are as follows:

Building $600,000
Accumulated depreciation ($ 20,000)
Net fixed assets $580,000


The second year would show account balances as follows:

Building $600,000
Accumulated depreciation ($ 40,000)
Net fixed assets $560,000


This process would be repeated until the 30th year when the accounts would be:

Building $600,000
Accumula,ted depreciation ($600,000)
Net fixed assets $ 0



ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

Of course, real businesses typically have more than one fixed asset (i.e., buildings,
delivery trucks, equipment, purchased patents, etc.). However, they usually have only
one accumulated depreciation account. Thus, a more typical fixed asset account looks

like the following:
Trucks $ 120,000
Equipment 80,000
Building 600,000
Patents 500,000
Accumulated depreciation ( 300,000)
Net fixed assets $1,000,000

As opposed to current assets, there rarely is a close relationship between the book
value of fixed assets and the fair market value of the fixed assets. The explanation for
this observation is easy to understand. Recall the previous example. Over a 30-year
period, it is likely that the fair market value of the building increases. Yet, after 30 years,
the balance sheet shows net fixed assets of zero. It is precisely for this reason that the
book value of assets is rarely used to value a business.

Liabilities

The liabilities of a company represent debts incurred to partially finance the purchase
of the assets. Like the assets, liabilities are classified as either current (due within one
year) ($3,001 for ABC) or long-term (due on a date later than one year from the balance
sheet date) (for ABC, $10,958 plus $130 ($11,088 total)). Some of the borrowed
amounts are via formal loans, whereas other borrowings are through more “informal”
means. Generally, the formal loans are part of long-term liabilities, whereas the informal
loans are part of the current liabilities. The formal loans typically are made to the
company by banks via a note. The balance sheet typically lists the interest rate of the note
and often the date on which it must be repaid to the bank. Informal loans consist of
accrued expenses, accounts payable, and so on. These types of borrowings usually are
interest-free and for a very short term. As can be surmised from the preceding explanation,
the liabilities section of the balance sheet usually is very straightforward and easy
to understand. There are, however, a couple of relevant exceptions.

Deferred Revenue. Deferred revenue is a liability ($130 for ABC) that indicates that
the company has received cash that it has not yet earned. This is not an uncommon
occurrence. For example, assume that the construction company described previously
had received 25 percent of the contract price as a down payment. The down payment
would be recorded as deferred revenue until the construction company completed 25
percent of the work (at which point it would be revenue or sales). The deferred revenue


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

account may be relevant to IP damage calculations. It is particularly relevant in disputes
involving software companies. Many times, software companies receive cash before
they deliver the software according to their contract. Since the proper accounting for
such revenue is a complex portion of accounting rules, many companies that are not
audited classify the amount as revenue when in fact it is deferred revenue. The result is
that the company looks as if it has higher sales (revenue) than it actually does. It also
appears to have less debt than it actually owes (because the deferred revenue is actually
a debt).

Deferred Tax Liability. Deferred tax liability results from legally deferring taxes.
It arises as a result of a taxpayer taking advantage of the tax laws. Companies legally
may use one method of accounting for tax treatment and another accounting method
for their own financial reporting. The different methods may allow the company to
pay less in taxes, resulting in a tax savings to the company. The tax savings are considered
a liability, as the savings are only temporary and ultimately must be paid to
the taxing authority. For instance, assume that a company depreciates $100,000 of
equipment over a 10-year period ($10,000 per year). Further assume that the tax laws
allow the company to depreciate the equipment over five years ($20,000 per year).
In the first year, the tax return will show $10,000 less profit than the company’s
income statement shows. As a consequence, the taxes paid by the company will be
smaller than if the company had paid taxes on the income in its income statement
(because the profits are less). The savings are booked as a deferred tax liability. The
company ultimately will pay the difference in taxes. Most valuation experts ignore
this “liability.”

Equity

The equity section is perhaps the most confusing portion of the balance sheet. The
equity section is not related to the fair market value of a company. The equity on the balance
sheet is referring to book equity, which is simply the difference between the
total assets and the total liabilities. This amount often is much less than fair value.
Perhaps the easiest way to gain a general understanding of the equity section of a balance
sheet is to describe how it evolves over a company’s lifetime. Imagine that a company
is formed and has 100 shares with a par value of one dollar. Further assume that
the company sells the shares to the original investors for $10 each for a total of $1,000.
The equity section begins with such transactions. The first line item in the example
reflects $100 for common stock. The amount is calculated as the par value times the
number of shares ($1 × 100). The next line item is “paid-in capital.” The paid-in capital
amount is calculated as the difference between the original purchase price and the
par value times the number of shares [(10 . 1) × 100 = 900].


ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

Assume next that the company generated $200 of net income during the year and
paid shareholders dividends of $100. The equity section would have increased by a total
of $100. This amount reflects the increase from the net income ($200) less the amount
paid out as dividends ($100). This discussion is intended to provide a very high level
review of the equity section. It usually is not necessary to deal with the equity section
during an IP analysis. Even if it were necessary to determine the true “equity” in a firm,
the practitioner would use valuation techniques to calculate the value rather than use the
equity section of the balance sheet.

CASH FLOW STATEMENT

The primary purpose of the cash flow statement is to provide information about a company’s
inflows and outflows of cash. This information can help project the future net
cash flows of the company. Cash flows are derived through three types of business
activities: cash flows from (used in) operating activities, cash flows from (used in)
investing activities, and cash flows from (used in) financing activities. Additionally, the
cash flow statement reports the effect of foreign exchange rates on the company as well
as the increase or decrease in cash during the period and the noncash investing and
financing activities. There are two formats in which cash flow information may be displayed:
the direct method and the indirect method. Both methods compute and present
the information pertaining to the investing and financing activities, but they differ in the
approach used to calculate net cash flows from operating activities. More important,
both methods result in providing the user with the same valuable information (e.g.,
where the cash went or came from).

An example of the indirect method for ABC, Inc. is shown in Exhibit 4-3.

For more detailed analysis on particular financial statements, it may be necessary to
read accounting literature. As there is an enormous amount of it, the following section
is intended to help the reader determine the best source of information.

THE ROLE OF STANDARDS IN FINANCIAL STATEMENTS

Over the years, the accounting profession has developed a structure of accounting
practice standards to address the comparability of financial statements. The chief body
of practice standards is a set of generally accepted accounting principles (GAAP),
which is intended both to guide and to govern the preparation of financial statements.
“Generally accepted” means either that an authoritative accounting rule-making body
has established a principle of reporting or a principle has achieved general acceptance
through practice and universal application.

Several major organizations are involved in the development of financial accounting
standards in the United States. These organizations are:


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

. Securities and Exchange Commission (SEC)—the government body that regulates
public companies
. American Institute of Certified Public Accountants (AICPA)—the entity that
regulates and licenses accountants
. Financial Accounting Standards Board (FASB)—an organization that creates
accounting policy (referred to as GAAP)
. Governmental Accounting Standards Board (GASB)—the body that governs
governmental accounting
The SEC was created by the federal government in the 1930s as a direct result of the
1929 stock market crash, which was blamed partially on inadequate financial disclosure.
The SEC is an independent regulatory agency of government. Companies issuing
publicly traded stock or listed on stock exchanges are required to file annual audited
reports with the SEC, and the SEC is charged with the responsibility of establishing the
accounting practices and policies that the companies under its jurisdiction must follow.
Initially, the SEC relied on the AICPA to create and enforce accounting standards.
In response, the AICPA created the Committee on Accounting Procedure (CAP) in
the 1930s to set reporting requirements. The CAP was replaced by the Accounting
Principles Board (APB), which was then replaced by the FASB in the early 1970s. The
upshot of all these bureaucratic transitions is that the FASB is the major operating
organization of the standard-setting structure.

Years ended December 31,
2000 1999 1998


CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss ($10,689) ($13,017) ($ 8,104)
Adjustments to reconcile net loss to


net cash used in operating activities:
Depreciation and amortization 486 546 604
Amortization of premiums and discounts on investments (15) (725) (819)
Amortization of debt issuance costs 19 — —
Noncash interest expense on convertible notes payable 743 221 —
Stock compensation expense 59 760 124
(Gain)/loss on disposal of property and equipment 74 (128)
Changes in assets and liabilities:
(Increase) decrease in receivables (1,210) (65) 38
(Increase) decrease in other current assets 45 (136) (71)
Increase in accounts payable, accrued — — —
Liabilities and accrued vacation 627 848 413
Increase in deferred rent 105 25
Decrease in deferred revenue

(4,656)

Net cash used in operating activities ($ 9,830) ($11,469) ($12,599)

EXHIBIT 4-3 Indirect Method for ABC, Inc.


ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

THE ACCOUNTING CYCLE


As discussed at the beginning of this chapter, the second, more detailed discovery
request aims at obtaining very specific information necessary to make the most objective
damage analysis possible. To make a pointed second request, it is important to
understand the accounting cycle. The accounting cycle consists of the procedures that
firms use to record transactions and ultimately prepare the financial statements. In other
words, the accounting cycle contains the raw information that is summarized by the
financial statements. Exhibit 4-4 illustrates the steps in the accounting cycle.

Each step in the accounting cycle contributes to the ultimate goal—-the generation
of the financial statements. Accordingly, understanding the nature of the steps involved
in the accounting cycle prepares the damage expert or attorney to go beyond the financial
statements and address the underlying data with more precision.

Step 1: Identification and Measurement of
Transactions or Events to Be Recorded

In the first step of the accounting cycle, events that change a firm’s resources or obligations
should be identified and relevant data about those events should be gathered. These

Years ended December 31,
2000 1999 1998


CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of investments held to maturity
and time deposits ($238,848) ($30,812) ($39,462)
Proceeds from maturity of investments held

to maturity 127,852 27,903 47,355
Proceeds from sale of investments held to maturity 10,209
Purchase of property and equipment (399) (246) (857)
Proceeds from sale of property and equipment 209
Loan to related party — (125) —

Net cash provided by (used in) investing activities ($101,186)

($ 3,280)

$ 7,245

CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of common stock $121,727


$ 5,146

$ 3,921
Net proceeds from issuance of convertible
notes payable —

9,873


Capital contribution 2,561

Net cash provided by financing activities $124,288 $15,019 $ 3,921
Increase (decrease) in cash and cash equivalents 13,272 270 (1,433)
And cash equivalents at beginning of period 881 611 2,044
And cash equivalents at end of period 14,153 881 611

EXHIBIT 4-3 (continued)


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

types of events fall into two categories: (1) internal events that occur within the entity
and do not involve external parties; and (2) external events that involve either interactions
with a third party or environmental events that are beyond the control of the
enterprise. Examples of internal events include the use of inventory for production and
the recognition of depreciation and amortization of fixed assets. External events include
losses caused by an earthquake or fire and changes in the price of a product bought or
sold by the enterprise. All such events are referred to as transactions and often are accompanied
by a “source document,” which is important to the initial recording of transactions
in a journal. A source document is the most detailed form of accounting record that
exists. For instance, invoices, sales slips, check copies, bank slips, and contracts are all
source documents. Other events, such as the accrual of interest, are not signaled by a new
source document. For example, the source document for the accrual of interest typically
is the original loan document. The objective of a firm’s accountant is to accumulate and
record as many events as possible that affect the financial position of the enterprise.

As an example of when the first step of the accounting cycle may be important to the
discovery process, imagine a case in which the plaintiff alleges that the defendant
misappropriated the plaintiff’s trade secret, a secret formula for making incredibly tasty
barbecue sauce. The source documents (in this case, invoices) could be used to show that
the defendant had never purchased the secret ingredients for the sauce prior to the time
of the alleged theft, but began buying the ingredients shortly thereafter. Accordingly,
the source documents reflecting the external event commonly known as buying supplies
could be used as evidence supporting the plaintiff’s theory of misappropriation.

Step 2: Journalize Transactions and Events

The next step in this process measures and records the economic effect of the transactions.
In other words, it reflects when an accountant actually wrote something down.
The transactions are categorized and collected in “accounts.” The seven major types of

Step 1 Identification and Measurement of Transactions or Events to Be
Recorded
Step 2 Journalize Transactions and Events
Step 3 Posting from Journals to the Ledger
Step 4 Trial Balance Preparation
Step 5 Journalize and Post Adjusting Journal Entries
Step 6 Adjusted Trial Balance
Step 7 Financial Statement Preparation

EXHIBIT 4-4 Accounting Cycle Steps


ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

accounts are assets, liabilities, owners’ equity, revenue, expenses, gains, and losses.
Transactions are recorded via “journal entries” that are kept in chronological order.
Journal entries are recorded in “journals,” usually an actual book or a computer file.
Each journal entry includes the date, the account amounts, and a description of the
transaction. A journal entry looks like this:

Cash...100

Accounts Receivable...100

To record the collection of the Smith receivable

Accounting systems usually have two types of journals: general journals and specialized
journals. General journals are used to record all of the journal entries. Specialized
journals are used to summarize transactions with common characteristics. Specialized
journals include cash receipts journals, sales journals, purchases journals, and
cash payments journals.

To see the utility of journal entries, imagine a case in which a patent owner is claiming
that its patent is very valuable. Assume that the patent owner purchased the patented
technology around the time that infringement allegedly began. The defense could
request the journal entry created when the plaintiff purchased the technology. The entry
would reveal the fair market value (per the plaintiff) as of the date of the purchase. It
would be difficult for the plaintiff to argue that the patent had more value at that time
than was recorded in its journal entry.

Step 3: Posting from Journals to the Ledger

The next step in the accounting cycle is to transfer the transaction data from the journal
to the general ledger. This process is called “posting.” Posting reclassifies the data from
the journal’s chronological format to an account classification format in the ledger. This
step creates a single place to find all of the transactions that took place in a similar
account. An account is simply a detailed category of assets, liabilities, equity, revenue,
or expenses. For example, “sales,” “costs of goods sold,” “auto expenses,” “vehicles,”
and “accounts payable” might all be separate accounts in a general ledger.

General ledger information is most useful in situations such as the following scenario.
Imagine a defendant who allegedly has violated a noncompete agreement with his
former employer. The defendant’s sales ledger would give a detail of sales (usually
organized by customer name). The ledger could be used to identify the customers that
were previously customers of his prior employer (the plaintiff).

Step 4: Trial Balance Preparation

Once the transaction entries have been recorded in the journals and posted to the ledger,
an unadjusted trial balance is prepared. Despite its litigious-sounding name, the trial


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

balance is a standard step in the accounting cycle that takes place regardless of whether
the firm’s legal department is particularly busy. The unadjusted trial balance lists all of
the accounts and their totals in one document. Basically, the unadjusted trial balance is
a more detailed version of the income statement and balance sheet.

An unadjusted trial balance could be used in a case in which the defendant is accused
of selling infringing hardware and the defendant is known to sell noninfringing software
as well as the allegedly infringing hardware. The trial balance will show the hardware
sales independent of the software sales. In contrast, the income statement may simply
lump all sales together, which would be less than helpful to the plaintiff’s damage expert.

Step 5: Journalize and Post Adjusting Journal Entries

As discussed at the beginning of this chapter, many privately held firms use the cash
method of accounting during the year but report their financials using the accrual
method. At the end of the year, these firms convert from the cash basis to the accrual
basis. This conversion is done by “adjusting journal entries.” This step comes into play
for a damage expert where it is necessary to compare a firm’s financials in June (calculated
on a cash basis) to its December financial statements (done on an accrual basis).
In that case, the damage expert would want the adjusting entries in order to make a similar
type of adjustment to the June financials. With the adjusting entries, the damage
expert can reasonably compare the financial statements from the two periods. In other
words, the journal entries reflecting the “adjustment” may be necessary to ensure that
your damage calculations are not comparing apples to oranges.

Step 6: Adjusted Trial Balance

Once the adjusting journal entries are made, an adjusted trial balance is prepared.
Thus, the adjusted trial balance is more detailed than the financial statements and represents
accounts that are stated under the accrual method. This document should be
requested whenever litigation requires a detailed summary under the accrual method
of accounting.

Exhibit 4-5 depicts the six steps previously discussed, as laid out in a typical accounting
document.

1.
Under the column “Journal Entries,” you can see the entries made to record six
different sales. The entries are organized in the order in which the sales were
made (Steps 1 and 2).
2.
The next column, “General Ledger,” lists all of the transactions, still in chronological
order. However, all of the sales are in one place and all of the receivables
are in another location (Step 3).
3.
The “Sales Ledger” column sorts the sales by the type of sale. If the accounts
receivable ledger were shown, it would sort the receivables by customer name
(Step 3).

Journal Entries


Account Receivable—Williams 100
Hardware Sale (1) 100
Account Receivable—Mackenzie 100
Software Sale (2) 100
Account Receivable—Smith 200
Maintenance Sale (3) 200
Account Receivable—Kennedy 200
Hardware Sale (4) 200
Account Receivable—McNichols 300
Software Sale (5) 300
Account Receivable—Tatos 300
Maintenance Sale (6) 300
General Ledger Sales Ledger
Sales Sales
1 Hardware Sale 100 1 Hardware Sale 100
2 Software Sale 100 4 Hardware Sale 200
3 Maintenance Sale 200 Total Hardware Sales 300
4 Hardware Sale 200
5 Software Sale 300 3 Maintenance Sale 200
6 Maintenance Sale 300 6 Maintenance Sale 300
Total Sales Total Maintenance Sales 500
Accounts Receivable
1 Account Receivable—Williams 100 2 Software Sale 100
2 Account Receivable—Mackenzie 100 5 Software Sale 300
3 Account Receivable—Smith 200 Total Software Sales 400
4 Account Receivable—Kennedy 200
5 Account Receivable—McNichols 300
6 Account Receivable—Tatos 300
Total Account Receivable 1200

(continues)

EXHIBIT 4-5 Accounting Documentation of Steps

89


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

4.
The “Unadjusted Trial Balance” lists the totals from the Sales Ledger. It also has
the total accounts receivable balance (Step 4).
5.
The “Adjustments” column shows the adjustments necessary to make the
financial statements conform to GAAP. In this case, it has been determined
that the Smith receivable is bad debt. As such, it is necessary to reserve an
amount in the account “Allowance for Doubtful Accounts.” Note that the adjustment
is in a similar form as the journal entry made to create the account receivable
in the first place (Step 5).
6.
The “Adjusted Trial Balance” reflects the trial balance after the adjusting journal
entries have been made. Of course, for a real company, the sales and bad
Unadjusted Trial Balance Adjustments
Hardware Sale 300 Bad Debt Expense 200
Maintenance Sale 500 Allowance for Doubtful Accounts 200
Software Sale 400
Total Sales 1200 To reflect the bad debt of Smith
Account Receivables 1200
Adjusted Trial Balance Financials
Income Statement
Hardware Sale 300 Sales 1200
Maintenance Sale 500 Less: Bad Debt .200
Software Sale 400
Total Sales 1200 Balance Sheet
Accounts Receivable (net) 1000
Account Receivables 1200
Allowance for D.A. .200
1000

EXHIBIT 4-5 (continued)


ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

debt would be recorded on the income statement, whereas the accounts receivable
and allowance for doubtful accounts would be recorded on the balance
sheet (Step 6).

After completing the six steps, the financials are complete and need only to be prepared
(Step 7). The “Financials” column reveals the information that became available
via the first document request. Note that the accounts receivable balance is “net” of the
allowance for doubtful accounts and that all sales are lumped together. While this type
of consolidation makes it easier to read the financial statements, it often is too generic
for an expert to use effectively in preparing a sophisticated damages report.

In summary, these seven steps constitute the portions of the accounting cycle that are
most useful to damage experts. The steps typically are performed every fiscal period to
prepare the financial statements.

ALL FINANCIAL STATEMENTS ARE NOT CREATED EQUAL

The problem with a good discovery request is that once made, the practitioner has to
decipher the documents. The following section is intended to assist in that process. As
it is typical to receive more than one document with the same information, one must be
able to determine the best of those documents.

Unreliable financial statements result in a problematic basis for a damage calculation.
Fortunately, accountants make it easy to determine the relative reliability of
financial statements. Accountants include a written explanation of the work they
have done with regard to preparing the financial statements. In that explanation,
accountants indicate whether they have “compiled,” “reviewed,” or “audited” the financial
statements. If there is no explanatory paragraph, it is likely that no independent
accountant has done any work at all on the financials. In other words, if there is no
written explanation, the financial statements are only as good as the ability of the
firm’s management.

Compiled Financial Statements

When a CPA “compiles” financial statements, he or she simply takes the information
from the client and puts it into a conventional format. He or she does not do any work
or opine on the appropriateness of the amounts within the categories.

Reviewed Financials Statements

When a CPA “reviews” financial statements, he or she performs a very limited set of
analytical procedures. While reviewed financial statements are often reliable, they usually
do not contain all of the information that is provided in audited financial statements.


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

Specifically, they do not contain all of the footnotes to the financials; these footnotes
can be very significant to a damages analysis.

AUDITED FINANCIALS

Audited financial statements are the most reliable financial statements available. You
can tell that an audit has been performed by the existence of an audit opinion. The audit
opinion is in a letter format from the auditor and is attached to the front of the financial
statements. There are two primary reasons an audit opinion is beneficial. First, the existence
of an audit opinion means that the financial statements probably conform to
GAAP. Second, auditors create documents that can be extremely useful in preparing
a damage claim. To most effectively take advantage of audited financial statements,
the practitioner should have a fundamental understanding of: (1) the significance of
the dates identified in the audit report, (2) the different opinions issued by auditors, and

(3) which documents created by auditors are the most useful for damage calculations.
SIGNIFICANT DATES IDENTIFIED IN THE REPORT

There are two dates contained within all audit opinions that are significant to the damage
expert: (1) the report date and (2) the date of the opinion.

Report Date

The report date refers to the last day of the accounting period. After the company name,
the heading of the financial statement says one of two things: either (1) the balance
sheet states “As of December 31, 2002,” indicating the date of the “snapshot”; or (2) the
income statement and statement of cash flows state “For the Period Ending December
31, 2002,” indicating that the document covers a specific period (usually one year).
Thus, when making a discovery request for the income statement, the practitioner
should request the “Income Statement for the Period Ending December 31, 2002.”
Conversely, when making a request for a balance sheet, the practitioner should ask for
the “Balance Sheet as of December 31, 2002.”

Date of the Opinion

The accounting firm that conducted the audit signs and dates the audit opinion. The date
is sometimes useful in a damage case. For example, if the auditors are aware of a significant
event that occurred after the report date but before the date of their opinion, they
will disclose the event in the footnotes. The event is significant if it would reasonably be
expected to affect the financial statements (i.e., a fire at the headquarters, a strike, a loss


ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

of financing, etc.). Imagine a situation in which the plaintiff claims that your client stole
their trade secret on January 9. They claim that their business was totally destroyed as a
result. Assume that their expert calculates damages based on the premise that the business
was destroyed the day of the theft. However, the December 31 audit report (issued
January 31) is done without a footnote regarding subsequent events. The lack of a significant
event footnote about the theft is strong evidence that, as of January 31, the plaintiffs
did not have reason to think that their business was destroyed.

DIFFERENT AUDIT OPINIONS

Nearly all audits result in the same type of opinion—an unqualified opinion. However,
since there are various types of opinions, the practitioner should be aware of the different
possible types. The following discussion outlines the main types of audit opinions.

Unqualified Opinion

An unqualified opinion, also called a “clean” opinion, is the most common opinion
issued. A clean opinion generally means that the auditor believes that the financial statements
are materially in compliance with GAAP. In other words, there may be known
problems in the financial statements that are not material. “Material” generally is considered
to be the amount that would influence a reasonable user of the financial statements.
The amount that is considered “material” changes based on the size of the
company. It is easy to appreciate why this is the case. A $500,000 overstatement of revenues
in a company that has $1 billion in revenues is not likely to influence a user.
However, a $500,000 overstatement of revenues in a company with $1 million of revenue
is likely to be very “material” to the user.

Qualified Opinion

A qualified opinion is issued when the auditor does not believe that the financial statements
conform to GAAP. It is rare for an auditor to issue a qualified opinion. While
auditors often find portions of the financial statements that do not conform to GAAP,
they typically bring the problem to management. Management then generally corrects
the problem, allowing the auditor to issue a clean opinion.

Going-Concern Opinion

A going-concern opinion is issued when the auditor believes the company may not survive
for one more year. It is somewhat common among businesses that, in fact, ultimately
fail. Such an opinion often can be very useful to an attorney or an expert. Imagine
that your client is sued for stealing a trade secret. Further assume that the plaintiff claims


LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

that the alleged theft caused his business to fail. As proof, the plaintiff points out the fact
that the business failed within three months of the theft. The plaintiff also offers up the
fact that the company had existed for 50 years prior to the theft as another indicator of
the impact of the loss of the trade secret. However, the defense discovers that the trade
secret allegedly was stolen nine months after the plaintiff’s auditors issued a “goingconcern”
opinion. The existence of a “going-concern” opinion is very strong evidence that
the company’s failure was looming long before the alleged theft. The additional documents
that would help demonstrate this defense are described in subsequent sections.

Scope Opinion

A scope opinion is another rare opinion. Generally, this opinion means that after considering
the evidence provided, the auditor believes that the company’s financial statements
comply with GAAP. However, it also indicates that the auditor was not able to
analyze everything it asked the client to provide (i.e., the auditor’s scope was limited).
A common scenario in which a scope opinion is issued involves a company that has
been in existence for many years, but has never before had an audit. Such a client often
has lost track of the documents needed by the auditor. As a result, the auditor must issue
a “scope limitation.”

While an opinion can be helpful on its own, the more likely benefit of audited financial
statements is related to the documents that must be created during the course of the
auditors completing their audit. The following section describes some of the most useful
documents that are kept by the auditors. It should be noted that usually only the auditors
keep a copy of these documents. Thus, it often is necessary to subpoena the auditors
to obtain the desired documentation.

MANAGEMENT REPRESENTATION LETTER

Management often does not want to live with their previously audited financial statements
during litigation. All auditors obtain a management representation letter (MRL)
as part of their steps in completing the audit. In short, the MRL is a letter written by the
management to the auditors telling the auditors that management has disclosed everything
that is material to readers of the financial statements. In the course of conducting
an audit, the company’s management typically represents the following facts:

1.
Management has told the auditors the truth.
2.
Management has told the auditors about all transactions that have occurred.
3.
Management has told the auditors about all existing liabilities (including lawsuits).
4.
There have been no significant events that have happened during the time
period between the report date and the opinion date.

ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

5. Management is in compliance with laws, debt covenants, etc.
6. The financial information is the responsibility of the company’s management.
The actual letters include many more representations. However, the significance of
all the representations is that the MRL makes it very difficult for management not to
take responsibility for the accounting and financial statements contained within the
audited statements.

SUMMARY OF PROPOSED ADJUSTMENTS

Although the name of the actual worksheet varies from firm to firm, all audit firms maintain
the same type of information regarding their proposed adjustments. The proposed
adjustments schedule is a list of all adjustments that were proposed by the auditors. In
other words, the schedule discusses all of the problems the auditors found during the
course of conducting the audit. When auditors find such problems, they discuss them
with management. The typical schedule of proposed adjustments also discusses management’s
response to the auditor’s proposed correcting journal entries. Finally, the
schedule details the resolution. The schedule is the fastest mechanism by which to identify
the company’s accounting weak spots. Since the worksheet does not have a standard
name, a subpoena should request something like, “Provide all work papers depicting proposed
journal entries to the financial statements of ABC Company for the period ending
December 31, 2002, including adjustments, reclassifications, and/or eliminating entries.”

ADJUSTED TRIAL BALANCE

An adjusted trial balance is a document that all auditors will keep and most of their
clients will keep as well. As discussed earlier in this chapter, the adjusted trial balance
provides a summary of the accounts that is more detailed than the financial statements.
The adjusted trial balance is to an accountant what the Rosetta stone is to a historian. This
is because the financial statements employ large general categories, whereas the adjusted
trial balance uses detailed summaries. Most auditors use the term adjusted trial balance,
so discovery requests should be able to target the desired documents fairly easily.

DEBT COVENANT COMPLIANCE

One of the steps required to complete an audit relates to the classification of debt. As
discussed previously, a debt that is due within one year is a current liability. A debt that
is due later than one year from the date of the financial statements is classified as a long



LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES

term liability. Virtually all loans have covenants with which the debtor must comply. If
the debtor does not comply with the covenants, it is typical for the loan to become due
immediately. In other words, failure to comply with certain provisions can transform a
long-term loan into a current obligation. This would devastate most firms. Accordingly,
auditors always check to see if the firm is in compliance with its debt covenants. Since
bankers are concerned with many of the same issues as damage experts (i.e., profitability,
expectations of future earnings, etc.), a request for the auditors’ work papers regarding
compliance with debt covenants is often a fruitful request.

FINANCIAL STATEMENT TREND ANALYSIS

As a standard part of most audits, the auditor performs trend analysis on the company’s
financial statements. The auditor spots material changes and inquires of management
the cause of such changes. The auditor then documents the response from
management in their trend analysis. This schedule has no standard, industry-wide
name. A document request for “ratio analysis performed on any of the financial statements
for the period ending December 31, 2002” or “trend analysis performed on any
of the financial statements for the period ending December 31, 2002” should produce
such schedules.

Imagine that a plaintiff claims that your client’s patent infringement caused the plaintiff
to suffer lost sales. Assume that you obtained a subpoena requiring the plaintiff’s
auditor to produce its trend analysis on the audit conducted one year before the alleged
infringement and one year after the alleged infringement. Further assume that you learn
that the auditors analyzed the decrease in sales. Finally, assume that the auditors’ analysis
indicates that management told the auditors that the sales decrease was related to the
loss of a major customer. The auditors’ schedules facilitate identifying and interviewing
the proper fact witnesses and possibly result in a determination that the loss was unrelated
to the alleged infringement. Obviously, this information would greatly reduce
damages and may even help with establishing liability.

Ratio analysis also can be used to assess the health or performance of a company.
Ratio analysis helps to expose a company’s strengths and weaknesses by creating percentages,
rates, or proportions from a company’s financial statements. These ratios
express the mathematical relationship between one quantity and another and can be
used to chart a company’s performance over time or to compare two competitors.

Four general categories of ratio analysis exist: (1) liquidity ratios, (2) activity ratios,

(3) profitability ratios, and (4) coverage ratios. Each category evaluates a particular area
of performance.
For example, liquidity ratios measure the enterprise’s short-term ability to pay its
maturing obligations. One such ratio, the current ratio, is defined as current assets
divided by current liabilities. Companies with a higher current ratio have better short



ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

term debt-paying ability than companies with a lower current ratio. Another type of
ratio analysis, activity ratios, measures how effectively the enterprise is using their
employed assets (e.g., how efficiently assets are used to generate sales). Profitability
ratios measure how successful a company is in a given period; these ratios measure
such things as a company’s profit margin on sales or their rate of return on assets.
Finally, coverage ratios measure the degree of protection and security for long-term
creditors and investors. For instance, debt to total assets measures the percentage of
total assets provided by creditors.

Exhibit 4-6 illustrates ratios often used in ratio analysis.1 Ratio analysis is most useful
in implementing the income approach and the market approach, and in analyzing the
firm’s capacity, which is necessary to recover lost profits, as discussed in Chapter 14.

DETAIL OF ACCOUNTS

In the course of conducting an audit, an auditor details the most significant accounts.
For instance, sales most often are detailed by geography, channel, or customer. Likewise,
the most significant expenses, assets, and liabilities are also analyzed on a very
detailed level. Using the previous example, a request for the “audit work papers related
to the revenue account” would likely have resulted in evidence that the infringement
did not cause the lost sales. Again, there is no term of art for the appropriate
schedules. However, a request for the work papers associated with the desired account(s)
should suffice.

Fortunately, an audit also produces valuable information that does not have to be
obtained from the auditor. The most useful information often is contained in the footnotes
to the financial statements. Footnotes are perhaps the most difficult part of the
financial statements to appreciate, yet they also can provide valuable information. The
footnotes are located just following the financial statements. Some footnotes appear
in all financial statements. However, most footnotes change depending on the type of
business and its particular characteristics. The following footnotes frequently have
been found useful in performing IP damage analysis.

Purchase Price Allocation

When the audited company acquires another company, the purchase price of the
acquired company must be allocated across the various asset categories. All of the
amounts listed in the purchase price allocation are stated at “fair market value.” Patents,
trademarks, trade secrets, goodwill, and other identifiable assets (both tangible and
intangible) are analyzed separately from the other assets. The footnotes to the financial
statements discuss the purchase price allocation. However, for more detailed information,
you may need to obtain the underlying work papers from the company.


RATIO FORMULA PURPOSE
Liquidity
Current ratio Current Assets/ Measures short-term debt-
Current Liabilities paying ability
Quick or acid-test ratio Cash, Marketable Securities, Measures immediate
and Net Receivables/ short-term liquidity
Current Liabilities
Current cash debt Net Cash Provided by Measures a company’s
coverage ratio Operating Activities/ ability to pay off its
Average Current Liabilities current liabilities in a given
year from its operations
Activity
Receivable turnover Net Sales/Average Trade Measures liquidity
Net Receivables of receivables
Inventory turnover Cost of Goods Sold/Average Inventory Measures liquidity
of inventory
Asset turnover Net Sales/Average Total Assets Measures how efficiently
assets are used to generate sales
Profitability
Profit margin on sales Net Income/Net Sales Measures net income generated
by each dollar of sales
Rate of return on assets Net Income/Average Total Assets Measures overall
profitability of assets
Rate of return on Net Income Minus Measures profitability
common stock equity Preferred Dividends/Average of owners’ investment
Common Stockholders Equity
Earnings per share Net Income Minus Preferred Dividends/ Measures net income
Weighted Shares Outstanding earned on each share
of common stock
Price earnings ratio Market Price of Stock/ Measures the ratio of the
Earnings per Share market price per share
to earnings per share
Payout ratio Cash Dividends/Net Income Measures percentage of
earnings distributed in the
form of cash dividends
Coverage
Debt to total assets Total Debt/Total Assets or Equity Measures the percentage
of total assets
provided by creditors
Times interest earned Income Before Interest and Taxes/ Measures the ability to meet
Interest interest payments as they come
due
Cash debt coverage Net Cash Provided by Operating Measures a company’s ability
Activities/Average Total Liabilities to repay total liabilities in a
given year from its operations
Book value per share Common Stockholders’ Equity/ Measures the amount each share
Outstanding Shares would receive if the company
were liquidated at the amounts
reported on the balance sheet
EXHIBIT 4-6 Ratios
98


ACCOUNTING PRINCIPLES IN INTELLECTUAL PROPERTY DAMAGES

Goodwill Valuation

Accounting rules recently have changed to require companies to make an annual determination
of whether their goodwill is “impaired.” Goodwill is considered to be
“impaired” if the fair market value of the goodwill is less than its book value (amount on
the balance sheet). However, the reverse is not true. If the fair market value is expected to
be greater than the book value, the goodwill is left on the books at its cost, as accountants
are loath to risk overstating assets. The footnotes to the financial statements typically will
provide significant details regarding the impairment analysis. Again, the footnotes will be
supported by more detailed analyses that may be obtained via subpoena.

Related Party Transactions

Another frequently used footnote relates to disclosing any transactions between the
company and related parties. Related parties generally are described as owners, directors,
officers, spouses of the preceding, and so on. It is common for privately held companies
to have several related party transactions. Furthermore, the related transactions
frequently are not being conducted at their fair market value. To properly analyze the
company, it is common for practitioners to adjust the financial statements to account for
the related party transactions. Such adjustments are made by adjusting the affected
accounts to make them reflect the amount that would be reported if the expense had
been done at fair market value.

SUMMARY

This chapter addressed the basic accounting principles that attorneys and experts
must understand to conduct effective discovery. Moreover, the a,ccounting principles
discussed herein enable the analysis of the relevant financial information. In most IP
damages cases, the financial information of both parties should be analyzed to determine
the existence and extent of damages. Therefore, the effective utilization of
accounting skills facilitates understanding the financial information retrieved and reaching
a proper value for IP.

ENDNOTE

[1]
D.E. Kieso and J.J. Weygandt, Intermediate Accounting, New York: John Wiley & Sons
(1998).
ADDITIONAL READING

Thomas R. Dyckman, Roland E. Dukes, and Charles J. Davis, Intermediate Accounting,
Chicago: Irwin (1995).


100 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES


Ernst & Young, Understanding and Using Financial Data, New York: John Wiley & Sons
(1996).

Andrew A. Haried, Leroy F. Imdieke, and Ralph E. Smith, Advanced Accounting, New
York: John Wiley & Sons (1994).

Donald Kieso and Jerry Weygandt, Intermediate Accounting, New York: John Wiley &
Sons (1998).

George Mundstock, A Finance Approach to Accounting for Lawyers, New York:
Foundation Press (1999).

K. Fred Skousen, Harold Q. Landerderfer, and W. Steve Albrecht, Accounting Principles
and Applications, Cincinnati: South-Western Publishing (1993).
Clyde P. Stickney, Roman L. Weil, and Sidney Davidson, Financial Accounting: An
Introduction to Concepts, Methods, and Uses, Englewood Cliffs, N.J.: Academic Press
(1991).

Ciaran Walsh, Key Management Ratios, Englewood Cliffs, N.J.: Prentice-Hall99 (1996).

Gerald White, Ashwinpaul Sondhi, and Dov Fried, The Analysis and Use of Financial
Statements, New York: John Wiley & Sons (1998).


5


Financial Principles Used in
Intellectual Property Damages


A third scientific discipline useful in intellectual property (IP) damage analysis is financial
economics. The field of financial economics has a very broad scope, similar to but
distinct from the related fields of accounting and microeconomics. Financial economists
study primarily three topics: investments, option theory, and corporate finance.
The area of financial economics that is most useful to constructing a sophisticated damage
analysis in an IP case is the portion that addresses business valuation. The tools
used in business valuation are required to properly perform the mechanics of the IP
damage calculation. We use these tools in Chapter 14 on the mechanics of damage
analysis. This chapter discusses the general principles of valuation, a critical topic for
understanding a damage analysis because of the many ways in which general valuation
principles overlap damage calculations and theories.

PRELIMINARY ISSUES

Standard of Value

It is essential for both the attorney and the damage expert to have a clear understanding
of the appropriate standard of value in a business valuation. In the United States, the most
common standard of value used is fair market value. Fair market value is defined by the
American Society of Appraisers as “the amount at which property would change hands
between a willing seller and a willing buyer when neither is acting under compulsion and
when both have reasonable knowledge of the relevant facts.”1 This standard of value commonly
is applied in valuations for mergers and acquisitions, estate and gift tax purposes,
charitable contributions, buy–sell agreements, property taxes, as well as in litigation.

Another concept of value, investment value (also called strategic value), represents
the value ascribed to an asset from a specific investor’s point of view. For example, if
a potential buyer views a purchase as a synergistic purchase, the buyer may offer a pre


101



102 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES


mium over and above the price that another independent investor would offer for the
same company. Consider the following scenario. An office building with inadequate
parking is located next to a vacant lot. The owner of the office building is likely to pay
more than fair market value for the lot because the lot has a specific utility to him
(providing the necessary parking space) that is worth paying a premium. In other words,
the investment value of the lot from the building manager’s perspective is higher than
the amount that might be accorded the lot under a more objective fair market value. In
the litigation context, investment value generally is closer to the concept captured by a
reasonable royalty damage calculation.

Finally, fair value usually is a statutorily defined standard of value that varies from
state to state. An example of fair value is a value that does not consider discounts for
lack of marketability and/or control. Fair value is a common standard of value for dissenting
stockholder actions and for divorce settings, but it is less useful in IP litigation.

Law of One Price

The law of one price is a basic concept in financial economics that provides a basis for
performing valuations. The law of one price states that assets that have identical future
payoffs must trade at the same price. This is the case because different prices for identical
assets create arbitrage opportunities. While initially this seems obvious, the law
of one price goes on to state that two different assets must be valued equally after
adjusting for all relevant differences. In other words, a stock that is slightly more risky
than its counterpart stock must have a slightly lower price than the counterpart stock
to compensate for the additional risk. A much riskier stock must have a much lower
price. By making this type of adjustment, the two stocks are valued equally, while
accounting for differences in risk. This is helpful only if the practitioner knows the
value of the counterpart stock. Yet, by applying this thought process to the investments
whose value is known and agreed upon, the expert can effectively use a variation of
the law of one price (because the payoffs on each side of the equation are not identical)
to perform a reasonableness check on a valuation. The variation can be algebraically
performed as:

(RFR)(RFI)t = (VU)(PU)t + (VD)(PD)t

where

RFI = risk-free investment

RFR = risk-free return

t = time periods over which the investment is measured

VU = investment’s value in the up stage

PU = probability of the investment going to the up stage

VD = investment’s value in the down stage

PD = probability of the investment going to the down stage


FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 103


The following example illustrates the principle. Assume that the valuation is related
to the value of a biotechnology firm. The firm is performing clinical tests that have a
2 percent chance of great success, a 38 percent chance of mediocre results, and a 60
percent chance of failure. Accordingly, based on the results of clinical tests, the firm
has a 2 percent chance of being worth $20 million. It is determined that if the product
fails or gets very poor clinical results, it has a 60 percent chance of being valueless.
Finally, if the results are mediocre, the product has a 38 percent chance of being worth
$5 million. In other words, an investor can choose to take the following risk:
(.02)(20,000,000) + (.60)(0) + (.38)(5,000,000) = $2,300,000 (in one year), or the
investor can buy a risk-free bond from the government. If we assume that the risk-free
rate of return currently is 5 percent, the investor would need to buy $2,196,476 worth
of bonds to be certain of having $2.3 million one year from today. Thus, the value of
the business is $2,196,476.

This exercise is still useful when there is insufficient evidence about the probability
of an event. For instance, assume that you are valuing the aforementioned biotech firm.
However, this time there is no information regarding the probability of the firm’s succeeding
in its clinical trials. The opposing expert prepares a valuation that results in
a value of $15 million. You determine that the most successful project is likely to lead
to a value of $20 million, whereas a failure leads to a worthless project. Next, you perform
the following calculation as a reasonableness check of their conclusion2:

$15,000,000 = (x)(20,000,000) + (1 . x)(0) =
$15,000,000 = (x)(20,000,000) + (0) =
$15,000,000 / $20,000,000 = x
75% = x


In other words, the opposing expert’s valuation implies that there is a 75 percent
chance of the project’s being successful. Even though you were unable to determine the
probability of successful clinical trials, it is likely that you can gather information that
proves the true probability is much less than a 75 percent chance. If there is less than a
75 percent chance, the opposing expert’s value is overstated because it does not comply
with the law of one price. Although the law of one price is often a useful reasonableness
check, more rigorous analyses are needed to actually determine a proper estimate
of value.

Valuation theory includes three conventional approaches for determining the value of
a company’s stock: the income approach, the market approach, and the cost approach
(asset-based approach). If performed properly, all three approaches will indicate a similar
range of value. It is precisely for that reason that the expert must consider undertaking
all three approaches where possible. Since each of the three approaches includes
subjective steps, an expert can use the various methods of valuation to act as “sanity”
checks for the other calculations (see Exhibit 5-1).


104 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES


VALUATION APPROACHES


There are three conventional approaches to valuation that may apply in estimating
damages for an IP case. These approaches are (1) the income approach, (2) the market
approach, and (3) the cost approach.

Income Approach

The income approach estimates the value of a business or IP based on future cash-
generating ability. This approach quantifies the expected value of the future economic
benefits that accrue to the owners of the IP. These benefits, or future cash flows, are discounted
to the present or (if constant over time or growing at a constant rate) capitalized
at a rate of return that is commensurate with the risk associated with the future cash
flow and the time value of money.

The four steps typically conducted in performing the income approach are:

1.
Estimate the expected future cash flows for a certain discrete projection
period.
2.
Discount these future cash flows to present-value dollars at a rate of return that
considers the relative risk of achieving the future cash flows and the time value
of money.
Let n = years, r = interest rate, F = future value, P = present value, A = annuity payment,
g = growth rate

n

1 Future value:
F = P (

() 1 + r)
F

2 Present value: P() = n

(1 + r)
..

.
1 . n

.1 ..

.1 + r.

(3) Present value of an annuity: P = A..
. r .

..

A

(4) Present value of a perpetual annuity: P =
R

(5) Present value of F growing at
F
P =

rate g indefinitely:

r . g

EXHIBIT 5-1 Some Useful Financial Formulas


FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 105


3.
Estimate the residual value of cash flows (if any) subsequent to the discrete
projection period.
4.
Combine the present value of the residual cash flows (if any) with the present
value of the discrete projection period cash flows.
The methodology for each of these steps is discussed in the following sections.

Step 1: Project the Expected Future Cash Flows of the Subject Intellectual Property.

The first step in the income approach is to create a projection of the expected future
benefit stream of the asset. Whenever possible, cash flow should be used as the appropriate
benefit stream. Investors are concerned with the actual cash that they will receive
from an investment and the timing and risk associated with those cash flows. Not only
is this principle accepted in theory, but also the proposition has growing empirical support.
Most studies of accounting changes that impact cash and earnings differently find
that security prices are determined by the change in cash flows.3 Earnings, or the net
income on a firm’s income statement, is not the most appropriate measure of the benefit
stream if cash flows are known or can be reasonably predicted and are significantly
different from net income.4 As discussed earlier, net income is defined according to
the accounting principles of matching and conservatism, which can be independent of the
true time of payment. Moreover, empirical work on investor perceptions of value tend
to confirm that investors see through accounting conventions and react to underlying
changes in cash flow.5 However, when informational problems exist, earnings can be a
better measure of future cash than current cash flows. For example, if information concerning
cash flow is known only for two years and during those two years the firm has
significant capital investments that are not expected to yield returns until more than two
years in the future, the matching principle that is used to construct earnings may provide
a better measure of future cash flow than present cash flows. When earnings are
used to proxy cash flows, an appropriate earnings model (which has an equivalence to
the dividend discount model or discounted cash flow model) should be adopted.6

Once a benefit stream is selected, it is important to determine whether the valuation
should relate to total invested capital (i.e., interest-bearing debt holders and equity holders)
or just equity holders. Assuming that cash flow is used, the net cash flow to total
invested capital is computed using the following formula:

Earnings Before Interest and Taxes (EBIT)
. Estimated federal and state tax expense


+ Noncash expenses (e.g., depreciation, deferred taxes, etc.)
± Requirements to fund working capital
. Capital expenditures
+ Preferred dividends, if any
= Net cash flow to invested capital

106 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES


Net cash flow to equity is computed using the following formula:


Net income
+ Noncash expenses (e.g., depreciation, deferred taxes, etc.)
± Requirements to fund working capital
. Capital expenditures
± Changes in long-term debt
= Net cash flow to equity holders

After the appropriate future cash flow benefit stream is identified, it is appropriate to
begin the projection analyses. The projection should approximate the expected value of
the future cash flows. The expected value is not the expert’s subjective intuition about
the future. Rather, it represents the weighted value of all future possible cash flow scenarios
weighted by their probabilities. This expected future cash flow must take account
of both the probability of a project’s utter failure and the probability of miraculous success.
To be consistent, the expected value of the future cash flows is the place in the valuation
procedure where the unsystematic or the unique risk faced by the company
should be taken into account. The benefit stream should be an expected value of several
possible future scenarios.

Projections are estimated most easily in situations where the subject IP has established
a long track record. The historical results often are very useful in predicting the
future performance of the property. However, the historical results should not be the
sole basis for establishing the projections. The projections also must consider the asset’s
situation at the date of the valuation, the outlook for the relevant industry, and any relevant
expected changes in the law, new competition, and so on.

Projections usually are best determined by starting with the revenues. Ideally, a relationship
between sales and an identifiable independent variable can be established. For
example, it is possible that there will be a relationship between new home sales in a particular
city and the revenue for furniture companies in the same city. Other factors that
must be considered include new competitors moving into the city, interest rates, new
technology, price changes, and so on. Although a certain portion of the revenue projection
is subjective, reasonable projections must conform to considerations of the particular
subject property. For instance, the revenue must be based on manufacturing, sales,
and financial limitations specific to the firm at issue as well as market developments
outside the firm.

Once the revenue has been projected, all of the expenses that must be incurred to generate
this specific revenue should be calculated. Many practitioners use econometric
analysis to assist in this calculation. Additionally, the expenses should include amounts
that may not historically have changed with sales but would be necessary to produce the
projected revenue. For example, if the projected revenues are based on adding a third
shift, the required expenditures for the additional supervisors, management, and so on
required for adding a third shift must be determined.


FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 107


Finally, any required costs for capital expenditures and working capital must be considered.
Although neither capital expenditures nor working capital is an expenditure in
the true sense of the word, both categories reduce cash flows and therefore must be
considered.

Working capital typically reduces the cash flows in periods of growth. Working capital
represents the value of the current assets less current liabilities. Current assets
include items such as cash, receivables, and inventory that are partially used to finance
the short-term liabilities. The short-term liabilities generally include the accounts
payable, accrued expenses, and so on. The necessity of accounting for the investment
in working capital can be illustrated by the following example. Assume that a firm
begins business on January 1. Although the company makes sales on the first business
day, it offers credit to its customers and does not begin to collect on its receivables for
30 days. The employees must be paid before the 30 days have elapsed. Thus, the firm
must have capital (either from borrowing it or from an additional investment by the
owners) to pay the employees. This capital is called working capital. Just as a new firm
needs working capital funds, nearly all firms that are growing their revenues require
working capital investment. If a firm’s revenues are decreasing, the change in working
capital may actually contribute to cash flows.

Capital expenditures are also an investment that typically reduce cash flows. The relevant
capital expenditures represent the cost of buying buildings, office space, computers,
trucks, and so on that are required to make the projected sales. Capital expenditures
are usually required for firm growth. However, some firms can experience enormous
growth with very little investment in capital expenditures. For instance, many Internet-
based firms require very little additional capital expenditure beyond what is needed to
make the first sale. In contrast, even firms that are experiencing stabilized revenues may
have significant required capital expenditures. For instance, airlines must continually
invest in new airplanes or airplane maintenance, even if sales are low.

Finally, some reasonable economic theory must guide the benefit projection process.
Experts should not assume that a firm will receive returns above the competitive average
for an extended period unless there is a very good explanation for that assumption.
This caution is empirically justified because high returns induce entry and, in the case
of IP, significant design-around efforts by competitors. These consequences in turn
should reduce the original firm’s returns until the market stabilizes.

Step 2: Determine the Discount Rate Applicable for the Projected Cash Flows. The
discount rate is a mechanism for reflecting the systematic risk and the time value of
the future estimated cash flow streams. Once an expert determines the expected future
cash flow from the asset being valued, he or she must construct the proper discount rate.

The Time Value of Money. The adjustment for time value of money results from the
fact that investors value a dollar received today more than they value a dollar received


108 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES


in the future. Thus, to value future cash flows from a business, a security, or an asset
such as IP, the expected future cash flow must be converted to an equivalent value
today, or into its “present value.” The present value represents what investors are willing
to pay today for each dollar received in the future, abstracting from any risk. This
present value represents the opportunity cost of funds invested today at a risk-free rate
of return for the number of periods involved. To determine the opportunity cost of funds
at a risk-free rate, it is necessary to find the spot rate or interest rate on a risk-free asset.
The set of spot rates for each period can change, and the term structure of interest rates
represents the entire set of spot rates on risk-free assets for different holding periods.
The term structure of interest rates generally (but not always) is upward-sloping.
Because the term structure of interest rates can change and there is no consensus on the
factors determining the term structure, it often is appropriate to assume a flat term structure
and use a single interest rate, such as the interest rate on a 20-year government note,
as a proxy for the risk-free rate of return in all periods.

Adjusting for Risk. Risk simply refers to variability in expected returns. For example,
asset A may be certain to generate $10 in cash flow in one year, whereas asset B may
generate a 50 percent chance of receiving $20 in one year and a 50 percent chance of
receiving $0 in one year. The expected returns on both assets are the same (10 percent),
yet asset B is more risky. To understand why asset B is less desirable, financial economists
have constructed a theory of investor preferences over uncertain outcomes. The
basic assumption of the theory is that investors are “risk-averse,” meaning that where
possible, investors like to avoid risks. This assumed aversion implies that investors have
a utility function7 with the following characteristic:

.UW(

″)

UW( )> 0

U″ is the second derivative of the utility function with respect to W, or wealth, and
U′ is the first derivative with respect to W. A utility function with risk aversion can be
depicted as:

Utility
U
Wealth


FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 109


As an investor’s wealth increases, his utility increases, albeit at a decreasing rate. The
impact of such a utility function is that reductions in wealth result in a greater loss
of utility than increases in wealth yield increases in utility. Therefore, investors lose utility
overall by variation in returns. As a result, all other factors being equal, investors dislike
variation in returns.

Investment theory assumes that the risk-averse utility function is described by the
mean and variance, σ,2 of the asset’s return. The typical assumption is that asset returns
are multivariate normally distributed, so even if investors cared about other aspects of
the asset’s return, such concerns would not impact investment behavior because normally
distributed returns are fully defined by the mean and variance alone.

If μis the mean return, then the variance is:

2

σ =Σ
n (Xi .μ)2

i =1

That is, the variance is simply the sum of the squared deviations of the asset’s returns
from the mean return. One important characteristic of the variance is that the sum of
several variances will yield a lower variance to the extent that the returns of the assets
being summed are not perfectly positively correlated. This observation has led modern
portfolio theory to theorize about how investors will select an optimal portfolio. For
example, the capital asset pricing model (CAPM) uses this observation to develop
appropriate risk premiums. Under CAPM, investors are interested in minimizing risk
per unit of expected return. Because of the characteristic of the variance described
previously, investors optimize by holding diversified portfolios. The result is that the
total risk of an asset can then be divided into two components: (1) the unsystematic or
unique risk that can be diversified away, and (2) the systematic or market risk, which
is related to the economy as a whole and cannot be reduced by diversification. In the
CAPM model, only systematic risk or market risk is the risk for which investors are
compensated in the form of a risk premium. This systematic risk can be measured by
the variable beta. Beta, βi, measures the contribution of an asset to the total risk of a
well-diversified portfolio; stated differently, beta is the variability in the price of the
asset in relation to the total market variability.

ri =rf +βi [E(rm) .rf]

where ri is the risk-adjusted discount rate, rf is the risk-free rate of return, and the last
term represents the systematic risk premium, E(rm) .rf. In the income method, the
unique risk is captured by the expected value of future cash flows in the numerator, and
only systematic risk is considered in determining the discount rate.


110 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES


It should be noted that discount rates developed in the CAPM model are based on
data derived from publicly traded securities. Consequently, the resultant value derived
from using this discount rate represents value attributable to a noncontrolling investor
of a marketable investment. As such, the analyst should consider, based on the interest
being valued, whether a control premium and/or a discount for lack of marketability are
applicable.

The Build-Up Approach. An alternative approach to determining the risk premium
that strays from financial theory and instead relies on empirical findings is called the
“build-up” method. The build-up approach estimates the cost of equity by “building up”
the required rate of return on equity. The build-up method is performed by estimating
each of the risks. The components most often considered are:

Risk-free rate

+ Equity premium
+ Size premium
+ Specific company premium
= Total cost of equity
A comparison of the CAPM approach and the build-up approach reveals that both
calculations consider similar risks. One difference is that in the CAPM the only
source of risk is completely captured by beta, whereas the build-up method relies on
the expert’s judgment. The build-up method deviates from the CAPM assumption in
that the CAPM assumes that only systematic risk is priced by diversified investors. A
frame of reference regarding required rates of return can be found in the next section.
Historically, small firms have had higher rates of return than large firms. This belief
is widely held among the valuation community. There have been several studies
demonstrating that this relationship holds true empirically, although there is no
consensus regarding the theoretical explanation for this effect, or whether it is true
at present.8 Thus, if the business is a very small firm, the cost of its equity probably
should be high.

The Weighted Average Cost of Capital. In certain situations, it is appropriate to value
more than the portion of the business owned by the equity holders. For example, if one
is valuing a controlling interest of a company where the owner has to incur debt, it
may be appropriate to value the business on a total invested capital basis (i.e., interest-
bearing debt and equity), assuming the industry’s capital structure, to properly reflect
value. In that type of situation, it may be appropriate to value the company based on its
weighted average cost of capital (WACC).

The discount rate for a firm or asset that is not all equity financed is the WACC. The
WACC is calculated by weighting the required returns on interest-bearing debt and


FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 111


common equity capital in proportion to their estimated percentages in an expected capital
structure.

Several possible methods are used in the determination of the appropriate WACC
rate. The general formula for calculating the WACC rate is:

WACC = Kd × (d%) + Ke × (e%)

where
WACC = weighted average cost of capital
Kd = after-tax rate of return on debt capital
d% = debt capital as a percentage of the sum of the debt, preferred and
common equity capital (total invested capital) measured in
market terms
Ke = required rate of return equity capital
e% = common equity capital as a percentage of the total invested
capital, measured in market terms

We have discussed two alternative methods of determining the required return on
equity, CAPM and the build-up approach. In contrast, the rate of return on debt capital
is the rate a prudent debt investor would require on interest-bearing debt. Since
the interest on debt capital is deductible for income tax purposes at the corporate level, the
after-tax interest rate is most often used in the WACC calculation. The effective income
tax rate is the federal income tax rate plus the effective state income tax rate (adjusted
for federal income tax deductibility).9

The after-tax rate of return on debt capital is typically calculated using the formula:

Kd = K × (1 × t)
where
Kd = after-tax rate of return on debt capital
K = pretax rate of return on debt capital
t = effective federal and state income tax rate

Combining the discount rates for debt and equity with the WACC identity provides a
discount rate for valuing the total assets of a firm, thus removing any specific financing
decisions from the valuation.

Step 3: Estimate the Residual Value of Cash Flows (If Any) Subsequent to the
Discrete Projection Period. Since businesses, and occasionally IP, are unlike humans
in that they do not have to die (but they do pay taxes), the expert faces a problem with
establishing the number of years to project revenues. Experts project the cash flows to
the point that a reliable terminal value can be determined. The terminal value is the
nomenclature used for the valuation of the firm for all of the years that are beyond


112 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES


the last year of the projections. It is reflected in a lump-sum amount that usually is
calculated via the Gordon growth model or via application of a market-based multiple
of earnings or sales.

The Gordon growth formula is:

CF0 (1 + g)

PV =

Kg

.

where
PV = present value at time 0
CF0 = prior periods projected cash flow (or other economic benefit stream)
g = projected growth, compounded annually into infinite future
K = required rate of return

Thus, the projections are made for the number of years necessary to do one of the
following:

1.
The revenue growth levels off to a point at which it will remain relatively
steady for the future.
2.
The firm grows to the point of having public firms/private transactions that are
suitable comparisons.
Once the revenue growth rate subsides to a long-term sustainable rate, the Gordon
Growth Model can effectively be applied. Even if the firm is still growing at a rate that
is too fast to sustain on a long-term basis, it is appropriate to end the projections if a
reliable comparative firm or transaction can be used to value the firm.

Regardless of the method used to calculate the terminal value, the value must be discounted
back to the present from the date at which the terminal value is calculated.

Step 4: Other Adjustments. Several other adjustments may be necessary when valuing
an asset. The first potential adjustment concerns inflation. The valuation equation
must be consistent. Both the numerator and the denominator should be measured consistently
in either real terms or nominal terms. When a conversion from nominal terms
to real terms is required, an approximation to the Fisher equation is often used. The
approximation formula is:

r (nominal) = r (real) + i

where i represents the inflation rate. Quoted interest rates are nominal interest rates. The
key is ensuring that cash flow projections are also in nominal terms when using nominal
discount rates.


FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 113


Step 5: Combine the Present Value of the Residual Cash Flows (If Any) with the
Discrete Projection Period Cash Flows. Next, the present value of the projected cash
flows is added to the present value of the terminal value to arrive at the total value,
incorporating all adjustments. A further adjustment may concern marketability (liquidity)
and control. For example, shares in a closely held corporation are more difficult to
sell than publicly traded assets. To adjust for these differences, a marketability discount
often is applied to the underlying asset value.

THE MARKET APPROACH

The market approach is a conventionally accepted valuation method that leads to a
value estimate based on the transactions of other purchasers and sellers in the marketplace.
This approach is based on the principle of substitution. The principle of substitution
states that the limit of prices, rents, and rates tends to be set by prevailing prices,
rents, and rates for equally desirable substitutes. Use of the market approach results in
an indication of value based on an estimate of the price one may reasonably expect to
realize on the sale of the subject asset.

This concept is largely intuitive. Many people have employed the same technique
during the process of buying a house. For example, assume that a person wanted to buy
a house in an exclusive neighborhood (“subject” home). The person would obtain the
recent actual sales prices of similar homes. Ideally, the similar homes would be located
in the same neighborhood (“comparative” homes). The person would also consider the
physical differences between the “subject” home and the “comparative” homes. For
instance, if a “comparative” home had a swimming pool and the “subject” home did not,
an adjustment would be made to reflect the anticipated difference in the value of each
home. Similarly, the person may make price adjustments for other significant features,
such as size, style, and so forth.

The market approach is performed in the same manner when valuing a business. The
approach generally is accomplished through the following steps:

Establish Criteria for Identifying Comparative Transactions

As with the preceding example, the starting point for this method is identifying “comparative”
firms. The advent of the Internet has provided many web sites that are dedicated
to providing financial data to the valuation community. Nearly all of the web sites
have a search function that facilitates the identification of companies that can be used
as comparative firms. Depending on the nature of the engagement, it may be more beneficial
to use a database of privately held firms.

Regardless of the database searched, the most common way of locating suitable comparative
firms is by searching based on industry (standard industrial classification


114 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES


code) and/or size, usually revenue, total assets, or market capitalization (number of
shares multiplied by the share price). Factors that should be considered include company
size, growth, liquidity, leverage, and profitability, among others.

The most useful data are gathered from the same period as the date of the damage
date. Additionally, as the comparative firms become more similar to the subject
business, fewer comparative companies are needed. Conversely, a larger sample of
firms can “smooth” differences between the comparative firms and the subject firm.
Revisiting the example regarding the price of a home discussed previously illustrates
this point. Imagine that the comparative home sales took place three years earlier. Such
comparative sales may yield a poor analysis depending on how the market changed
during the period between the date of the comparative sale and the valuation date of
the subject home. Next, imagine that the comparative home sales involved homes
of the same size, sold on the same date, and of the same style as the subject home. However,
the comparative homes were in a neighborhood with a view of the ocean, whereas
the subject home had no such view. Again, without adjustment, the expert is likely to
come to a poor conclusion of value.

If Necessary, Refine the Search by Adding More Criteria and Thus Reduce the
List to Those That Are the Most Comparative

Because of the importance of identifying the best comparative firms, it is most common
to make initial searches that are rather broad and then refine the search. When
the search criteria produce too many comparative companies, it is necessary to refine
the search. Shannon Pratt’s book on performing business valuations discusses the process
under a section called “How Many Guideline Companies.” The book suggests that
“the answer depends on a number of factors:

. Similarity to the subject—the more similar, the fewer needed.
. Trading activity—again, the more actively traded, the fewer needed.
. Dispersion of value measure data points—the wider the range of relevant measure
data points, the more companies it takes to identify a pattern relevant to the
subject company.”
Further insight is found in Corporate Finance: A Valuation Approach, which also
discusses the refining step:

Since we scale prices of other firms to value the firm being analyzed, we would like to use
data of firms that are as similar as possible to the firm we value. The flip side of this argument,
however, is that by specifying too stringent criteria for similarity, we end up with too
few firms to which we can compare. With a small sample of comparable firms, the idiosyncrasies
of individual firms affect the average multiples too much so that the average multiple


FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 115


is no longer a representative multiple. In selecting the sample of comparable firms, you have
to balance these two conflicting considerations. The idea is to obtain as large a sample as possible
so that the idiosyncrasies of a single firm don’t affect the valuation by much, yet not to
choose so large a sample that the “comparable firms” are not comparable to the one that you
value.10

Additional rigor can be added to this step by using econometric analysis. For instance,
a large initial search can be refined using cluster analysis, factor analysis, or other statistical
techniques.

Rather than relying on intuition, these techniques can identify how close comparable
companies are based on predetermined factors. This will be a fruitful area of future
analysis by financial analysts. Sometimes it is useful to identify two or more groups of
comparative firms. Revisiting the home price example, imagine that the subject home
is unusually small and has a view of the ocean. Assume that you are unable to find
homes of a similar size that have a view of the ocean. Instead, you find a group of home
sales that are very similar in the date of the sale, their style, and size; however, this
group of comparative sales does not have a view of the ocean. You also identify a second
group of home sales that are similar to each other in size, have an ocean view,
yet are different from the subject home’s size. Finally, you find a third group of sales
that are similar to the size of the homes in the second group and similar to the location
of the first group of smaller homes. You can use the difference between the second
group and the third group to estimate the value of the view, then add that to the value
established by the first group for homes of the same size as the subject home. Such a
process is not uncommon when valuing a business. Many firms have segments or components
of the business that are more easily valued individually rather than based on the
entire business.

Obtain Appropriate Financial Data for the Comparative Companies

Once the comparative firms have been identified, their financial data must be obtained.
This typically is an easy step to perform because the same web sites that perform the
searches typically provide the financial statements. The most common data obtained are
the income statement, balance sheet, and statement of cash flows. Additionally, it is
useful to obtain any projections or analysts’ reports. Finally, the number of shares and
the respective share price must be obtained. It is important that all of these data be the
financial information as of the date of the valuation.

A valuation generally occurs as of a specific date. The value of a company changes
daily. In fact, it is not uncommon for the value of a company to change dramatically in
a very short period. Experts and attorneys must always keep the valuation date in mind
in the course of gathering discovery and conducting their analyses. Generally, valuation
experts believe that the only information that should be considered is the information
that is known or knowable as of the date of the valuation. This is particularly important


116 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES


when valuing IP. For example, there can be a great deal of uncertainty as to the rate of
a technology’s adoption. Frequently, after a claim is filed, both parties gain a much
better understanding as to the actual rate of adoption. Generally, it is inappropriate to
value the technology based on the information that has been learned subsequent to the
date of valuation. This convention can be segregated into two situations:

1.
Event-Specific—The practitioner should ignore event-specific information
that has become known after the date of valuation. For instance, a fire that
burned down a manufacturing plant or terrorist acts that changed the industry
generally should not be relied on when performing a valuation if they occurred
after the valuation date.
2.
Information Regarding the Parties’ Expectations—Since value is ultimately
based on the expectations of a business at a particular point in time,
it is important to base value on projections that would have been made at
the time of the valuation. Practitioners typically begin their analysis with the
parties’ projections (created at or around the valuation date) rather than actual
results. However, it would be careless to ignore the actual results because projections
may be found to consistently be very optimistic (or pessimistic). The
actual results sometimes can be used to indicate a proxy that represents reasonable
expectations the parties’ would have had at the valuation date.
Once the data have been gathered, it is typical to perform ratio analysis on the financial
statements. The purpose of the ratio analysis is twofold. First, the analyst is trying
to identify similarities between firms. As more similarities are found, the practitioner
gains confidence that the comparative firms are suitable. Second, the analysts are looking
for differences. Differences indicate either that the firm may not be a suitable comparison
on which to base a valuation or that there are accounting differences between
the firms. As unsuitable companies are identified, they should no longer be considered
(or at least they should be given less weight). To the extent that there are significant accounting
differences, the financial statements must be adjusted so that the ratio analysis
(and the financial statements) is comparable. This process is discussed in the next step.

Consider Adjusting or Normalizing Financial Data of the
Comparative Companies

In certain instances, generally accepted accounting procedures (GAAP) allow two firms
to use different methods of accounting for the same type of transaction. If the transaction
is prevalent in the firm’s financial statements, the different accounting methods could
cause material differences between the financial results of the two firms. Furthermore,
two firms may also make operational decisions that affect the financial statements but
really do not affect the firm’s value. Examples of such differences are the following:


FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 117


Accounting for Inventory. Firms typically choose between one of two methods—
LIFO (last in first out) and FIFO (first in first out). For example, assume that there are two
businesses that are the same in all respects except their inventory accounting. The firm
using the LIFO method will look less profitable than the other business. Additionally,
the LIFO firm will appear to have less valuable inventory. Of course, the firms have the
same value. However, failing to adjust for such differences in accounting methods will
yield an analysis that indicates deceptively different values for the two firms.

Owning a Building Versus Renting a Building. Again, assume that the two businesses
differ only with respect to their property interest in the building. The building
owner is likely to have a lower level of profitability (due to depreciation, debt, insurance,
etc.) than the identical business that rents its space. Thus, the financial statements
must be adjusted.

Even more common, it is necessary to make such adjustments when comparing a private
firm with a public company. For instance, owners of privately held firms frequently
have the business pay for many items that may otherwise be considered personal (car
allowance, gym fees, etc.). Similarly, owners of private firms often pay family members
something other than the fair market rate as a wage.

Select the Valuation Multiples That Are the Most Appropriate to
Measure the Comparative Companies and Calculate the
Multiples for the Comparative Companies

The valuation multiples that have been used by practitioners are nearly limitless. Some
of the most commonly used valuation multiples include price to earnings, price to sales,
price to EBIT, price to earnings before interest, taxes, depreciation, and amortization
(EBITDA), and so on. Most analysts tend to select several multiples. Next, they look at
the variance of the multiples. Ideally, a multiple that is consistent across several firms
gives an indication that it is a good proxy for establishing value. For example, if the following
multiples were calculated, it is likely that the analyst would conclude that price
to sales is an appropriate proxy.

COMPANY A COMPANY B COMPANY C
Price to sales
Price to EBIDTA
Price to earnings
1.9
12
16
1.7
7
1,0
1.7
18
31

Econometrics also can be helpful in performing this step because techniques are available
that can identify the most significant multiples among firms.

When making the necessary subjective portion of this assessment, the most important
point to keep in mind is ensuring that investors actually trade on the multiple. This
point is highlighted by the main drawback of this approach, which is that a multiple of


118 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES


anything can be calculated. For instance, a multiple of price to numbers of letters in the
company’s name can be calculated. Obviously, such a multiple has nothing to do with
the value of a firm. Accordingly, evidence of the proper multiple is the multiple’s applicability
across different firms that have been determined to be suitable comparisons.

Select and Adjust Multiples to Make Them Appropriate
to Apply to the Subject Company

Often the multiples will be further adjusted to account for remaining differences between
the comparison companies and the subject firm. The most common type of adjustment is
based on size. There is significant evidence that investors pay less for smaller companies
than they pay for larger companies. Many times the comparison firms are much larger
than the subject firm and the multiple must be adjusted accordingly.

Apply the Multiples to the Subject Company

The last step in the market approach is the application of the multiple(s) to the subject
company. The primary thing to keep in mind while implementing this step is to apply
the multiple to the subject company in the same way that it was calculated. Upon application
of the multiple, the expert has completed the market approach (before consideration
of any applicable discounts and/or premiums).

THE COST APPROACH

The cost approach estimates the fair market value of an asset using the concept of
replacement cost as an indicator of fair market value. The premise of the cost approach
is that a prudent investor would pay no more for an asset than the amount for which
the asset could be replaced. Replacement cost new, which refers to the cost to replace
the property with like utility using current material and labor rates, establishes the
highest amount a prudent investor would pay. To the extent that an existing asset will
provide less utility than a new one, the value of that asset is less. Accordingly, replacement
cost is adjusted for loss in value due to physical deterioration, functional obsolescence,
and economic obsolescence.

Physical deterioration is the loss in value brought about by wear and tear, action of
the elements, disintegration, use in service, and all physical factors that reduce the life
of an asset. Functional obsolescence is the loss in value due to changes in technology,
discovery of new materials, and improved manufacturing processes. Economic obsolescence
is the loss in value caused by external forces such as legislative enactments,
overcapacity in the industry, changes in supply and demand relationships in the market,
and so on. Obsolescence typically is measured by identifying excess operating costs,
overcapacities, or the inadequacies of an asset.


FINANCIAL PRINCIPLES USED IN INTELLECTUAL PROPERTY DAMAGES 119


Although the cost approach should yield the same valuation conclusion that the other
two approaches yield, the underlying data needed to perform the cost approach often are
more subjective and more difficult to find than the supporting evidence for the other
two methods. Accordingly, the market approach and the income approach are used more
frequently than the cost approach. However, the cost approach can be the best approach
when valuing certain intangible assets such as research libraries, partially completed
software code, and so on.

SUMMARY

Calculation of IP damages requires the successful implementation of valuation principles.
Such calculations often require the effective utilization of finance, economic, and
accounting skills to properly consider the various factors surrounding the subject property.
As a result of the significant disagreement regarding IP damages, experts often are
employed to value and explain the damages to the judge and jury.

To properly estimate IP damages, it is essential to determine what is being valued and
to specify the valuation date. Then it is appropriate to consider the three common valuation
approaches: the income approach, the market approach, and the cost approach.
Each of these approaches, if determined to be applicable, not only will indicate the
value of the property in dispute, but also will act as a sanity check on the conclusions
derived under any of the other approaches.

This chapter set forth the basic financial concepts involved in the valuation of an
asset. Valuation concepts are often present in expert damage analysis in IP cases, and
in trade secret cases in particular. We use many of the concepts developed in this chapter
in our discussion of the mechanics of IP damage analysis.

ENDNOTES

[1] American Society of Appraisers, Business Valuation Standards, Definitions.
[2] In practice, one should also include an intermediate state.
[3]
See review in Tom Copeland, Tim Koller, and Jack Murrin, Valuation Measuring the
Value of Companies at 62–87.
[4] Accountants have developed a model of “abnormal earnings” which is mathematically
equivalent to a cash flow model but uses accounting earnings as an input. We plan to
address such models in the first supplement to this text.
[5]
See, e.g., Gary C. Biddle and Fredrick W. Lindahl, Stock Price Reactions to UFO
Adoptions: The Association Between Excess Returns and UFO Tax Savings, 20 J. Acctng.
Res., 551 (1982); E. Lindberg and M. Russ, To Purchase or to Pool: Does It Matter? 12
J. Applied Corp. 23 (1999); Bradford Cornell, Corporation Valuation, at 104–108 (1993).

120 LEGAL, ECONOMIC, AND FINANCIAL FOUNDATIONS OF IP DAMAGES


[6]
See discussion in Gerald White, Ashwinpaul Sondi, and Dov Fried, The Analysis and Use
of Financial Statements, at 1062 et seq. (1998).
[7]
A utility function is merely a function in which preferences are converted to real numbers.
[8] For a discussion of this point, see Zvi Bodie, Alex Kane, and Alan Marcus, Investments,
New York: McGraw-Hill (1999) at Chapter 13.
[9] Personal taxes can also have an impact on rates of return required by debt and equity
investors. We will discuss this in more depth in the first supplement.
[10] Simon Benninga and Oded Sarig, Corporate Finance: A Valuation Approach, New York:
McGraw-Hill (1977).
ADDITIONAL READING

Bradford Cornell, Corporate Valuation, New York: McGraw-Hill (1993).

Krisha Palepu, Paul Healy, and Victor Bernard, Business Analysis & Valuation, Cincinnati:
South-Western College Publishing (2000).

Simon Benninga and Oded Sarig, Corporate Finance: A Valuation Approach, New York:
McGraw-Hill (1997).

Tom Copeland, Tim Kuller, and Jack Murrin, Valuation: Measuring and Managing the
Value of Companies, New York: John Wiley & Sons (2000).

Shannon Pratt, Robert Reilly, and Robert Schweihs, Valuing Small Business &
Professional Practices, New York: McGraw-Hill (1998).

F. Peter Boer, The Valuation of Technology: Business and Financial Issues in R&D, New
York: John Wiley & Sons (1999).
Richard Razgaitis, Early Stage Technologies: Valuation and Pricing, New York: John
Wiley & Sons (1999).

Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a Business: The
Analysis and Appraisal of Closely Held Companies, 3rd ed., New York: McGraw-Hill
(1996).

Robert F. Reilly and Robert P. Schweihs, Valuing Intangible Assets, New York: McGraw-
Hill (1998).


Part Two


Patent Infringement
Damages



6


Introduction to Patent Law


A BRIEF HISTORY

The American patent tradition derives from the “letters patent” issued by England’s
monarchs, which granted 14 years of exclusive use to the “first and true inventor” of
new manufactures. The Statute of Monopolies of 1623 required letters patent only to
issue with respect to new devices that were “not contrary to law, nor mischievous
to the State, by raising prices of commodities at home, or hurt of trade, or generally
inconvenient.”1 Interestingly, the American patent system never adopted standards
that so explicitly referenced the potential economic disadvantages to these limited-
term monopolies.

The U.S. Constitution, art. I, sec. 8, gives Congress the power “to promote the
Progress of Science and useful Arts, by securing for Limited Times to Authors and
Inventors the exclusive Right to their respective Writings and Discoveries.” Although
the term patent is not used in the Constitution, the Constitutional Convention’s records
make clear that the clause was intended to authorize the granting of patents.

The first U.S. patent statute was passed in 1790 (authored by Thomas Jefferson). It
called for patent applications and a 14-year term of exclusive use by the inventor if the
invention was deemed “sufficiently useful and important.” The statute granted a 14-year
monopoly on the invention in exchange for disclosure sufficient to enable someone
skilled in the art to construct or use the invention.

The U.S. patent law has been revised several times. In 1836, the U.S. Patent Office
was established to review patent applications. In 1861, the patent term was extended
to 17 years, and three criteria were established for patentability: “novelty,” “usefulness,”
and “priority.” In other words, the invention must be a new and useful improvement
over existing devices or processes, while “priority” requires that the inventor be
the first and true inventor. These requirements are discussed in more detail in the following
sections.

123



PATENT INFRINGEMENT DAMAGES

The current patent law was passed in 1952 (the Patent Act) and is located in Title 35
of the United States Code (U.S.C.). The Patent Act was partially revised in 1995,
extending the patent term to 20 years from the date of filing2 and classifying “offers to
sell” as infringement.3 The legal standards applied in patent cases are rooted in the
statutory language, as interpreted by federal courts. It is important to understand how
courts have developed the requirements for patentability because many vital principles
cannot be found in the Patent Act alone.

Charles Duell, the American Commissioner of Patents, is widely credited with the
statement, “Everything that can be invented has been invented.” Duell supposedly made
this statement in 1899.4 Regardless of the accuracy of the quotation, no one could have
forecast the spectacular increases in the number of patent applications. On December
10, 1999, the U.S. Patent and Trademark Office (PTO) granted its six millionth patent.5
In fiscal year 2001, the PTO expected to receive 335,000 patent applications—a 12 percent
increase in applications over the filings received in fiscal year 2000.

DESCRIPTION OF A PATENT

Patents may be identified by their titles or by patent number. All patents are assigned
numerical identifications. Patent numbers are sequential, so a higher number indicates
a more recently issued patent. Because the titles can be cumbersome, a patent often is
reduced to three numbers for quick reference, especially in litigation. Those three numbers
are the last three digits of a patent number. For example, U.S. Patent No. 1,234,567
would be referred to as “the ′567 patent.”

The body of a patent has two main parts: the “specification” and the “claims.” The
specification follows the cover page; it contains a description of the invention, including
drawings when necessary. The specification should also describe related art and the
relevant prior art (i.e., similar inventions or techniques that precede the patent). The specification
further must describe how to make and use the invention (“enabling” the invention)
and the “best mode” of carrying out the invention known to the inventor at the time
of filing the patent application.6

The claims are the most important part of a patent. The claims identify the scope of
what is “claimed” for the inventor’s exclusive use during the term of the patent.
Generally, claims are broader than what is described in the specification in order to
include obvious alterations within the scope of the invention. Claims are either “independent”
or “dependent”; an “independent claim” refers to a relatively broad claim that
is not a subset of another claim. Narrower, “dependent claims” typically follow and
incorporate material from an independent claim. The aim of the patent’s drafter is to
ensure that if the broader independent claim is held invalid, the narrow dependent
claims may survive. Dependent claims generally are also attempts by the drafter to preclude
small variations on the invention from being patentable.


INTRODUCTION TO PATENT LAW

Each claim usually has three parts: a preamble, a transition, and the body. The preamble
generically defines an invention, for example, “an apparatus for writing.” A
process patent typically begins with “a method for.” The transition uses language like
“comprising” or “consisting of.”7 The body limits the invention to certain elements (e.g.,
“an apparatus for writing comprising a wood shaft and a graphite core”).

THE SUBJECT MATTER OF UTILITY PATENTS

There are three types of patents: design, plant, and utility patents. We consider only utility
patents—the category of patents one is most likely to encounter as a damage expert.8

To be patentable, an invention must come within one of the four categories set forth
in section 101 of the Patent Act:

Whoever invents or discovers any new and useful process, machine, manufacture, or composition
of matter, or any new and useful improvement thereof, may obtain a patent therefore,
subject to the conditions and requirements of this title.9

Thus, only four types of inventions can be patented: (1) a process, (2) a machine, (3) a
manufacture, and (4) a composition of matter.10 A process is a new means of achieving
a goal or product. Categories (2), (3), and (4) cover types of products made from
patentable subject matter. A composition of matter consists of a combination of known
things, where the combination itself is the invention. For example, a new combination
of known chemicals is patentable as a “composition of matter.” A manufacture is an
object made by human labor, such as a chair. It does not include products that exist in
nature. A machine is an invention that embodies a process. The machine itself is the
invention under this category, not the process.

Courts also have excluded certain categories of things or discoveries from patentable
subject matter. These excluded categories include printed matter, laws of nature, mathematical
algorithms, natural forces, natural principles, methods of calculation, and
abstract ideas. As the following cases illustrate, inventions that include elements from
some of these categories are not absolutely precluded from constituting patentable subject
matter (e.g., mathematical algorithms may be used in patentable applications).

The accepted justification for the categorical exclusions is that patenting such fundamental
categories would impede rather than advance innovation and technological
progress. Theoretically, awarding exclusive rights to a very broad concept or fundamental
principle precludes varied approaches to development, improvements, and
applications. However, without the incentive of at least a limited-term monopoly, the
inventor lacks the motivation to invest significant time and resources in research and
development at all. Moreover, a process or thing that is present in nature supposedly
does not require as significant an investment of resources by the inventor, and therefore


PATENT INFRINGEMENT DAMAGES

less reward is necessary to compensate the inventor and preserve his incentive to invent.
Patent law is a perpetual attempt to balance the competing interests of diversity of
development and inventor incentives. This delicate balancing test is a recurring theme
that guides, either explicitly or implicitly, judicial decisions in many areas of patent law,
including the scope of patentable subject matter, the breadth of the patent, and the relationship
between prior art and the allegedly new invention.

To understand patent law (or any area of intellectual property), it is necessary to gain
a familiarity with some judicial opinions. Because reading entire cases can be tedious,
difficult, and time-consuming, throughout this book we present the highlights of certain
cases. The selected cases were included either because they establish precedent on a
particular issue or because they offer a particularly helpful explanation of a legal principle.
On certain topics, courts have reached apparently conflicting results; being aware
of the potential for varying outcomes and the factors that influence those decisions can
be as valuable as learning a straightforward answer.

Several cases epitomize the current analysis of patentable subject matter. Diamond v.
Chakrabarty is well known for its description of the breadth of the standard for patentable
subject matter and its application to modern inventions. State Street Bank & Trust Co. v.
Signature Financial marks a relatively recent shift in the law that permits the patenting
of business methods and transformative applications of mathematical algorithms.

Diamond v. Chakrabarty11

Diamond v. Chakrabarty should help you understand how courts analyze the question
of patentable subject matter. The Chakrabarty court famously described the
scope of patentable subject matter as “anything under the sun that is made by
man.” Chakrabarty held that the inventor must change the product’s naturally
occurring physical properties, not merely take advantage of inherent qualities.
Chakrabarty developed a bacterium that broke down crude oil; the genetically
altered bacteria were useful for cleaning up oil spills. In upholding the patent, the
court emphasized that, although a natural biological phenomenon would not be
patentable, a man-made biological product, even a living creature, can be patented.

State Street Bank & Trust Co. v. Signature Financial Group, Inc.12

The patented invention in this case was a data processing system that allowed a
user to record financial information and make calculations necessary for maintaining
a particular financial service called a “partner fund” for mutual funds. The


INTRODUCTION TO PATENT LAW

State Street Bank & Trust Co. v. Signature Financial Group, Inc.
(continued)

district court found that the claimed invention fell into one of two judicially created
exceptions to statutory subject matter: the mathematical algorithm exception or the
business method exception. However, the Federal Circuit held that neither of those
categories is necessarily unpatentable subject matter. First, the transformation of
data by a machine using algorithms is patentable where it produces a “useful, concrete
and tangible result.” The court cited to earlier cases such as Diamond v. Diehr
and In re Alappat for the rule that computer software code alone is not patentable,
but a machine or manufacture that embodies both hardware and software elements
can be patented. This results-oriented analysis means that practical applications of
purely mathematical algorithms merit patent protection. Second, the court found
that “business methods” are statutory subject matter for patents.

In short, the court held that patentable subject matter should be evaluated not
by which of the four statutory categories it most closely matches, but by its
“essential character,” particularly the inventor’s “practical utility.” This holding
opens the door to a wide range of business methods and activities as patentable
subject matter.

These two cases represent a pragmatic and expansive approach to patentability. This
approach is particularly relevant for Internet companies today. Internet companies
have been awarded patents for fairly traditional business methods, simply because they
are “new” and original in the context of e-commerce. These patents are controversial and
often are the subject of current litigation.

THE STANDARDS OF PATENTABILITY

Qualifying as patentable subject matter is necessary, but not sufficient, for patentability;
the invention must also possess certain specific characteristics. In addition to falling
within the scope of patentable subject matter, an invention must meet three statutory
criteria. A patentable invention must be novel, have utility, and be nonobvious. Section
101 requires novelty and utility.13 Section 103 requires an invention to be a nonobvious
development compared to prior art.14

Utility

Section 101 of the Patent Act provides that a patentable invention must be “useful.” The
courts require an invention to have a specific beneficial use. It need not be a successful
commercial product, but the value of the invention cannot be purely hypothetical. In the


PATENT INFRINGEMENT DAMAGES

vast majority of cases, courts require only a very low threshold of proof of utility.
Typically, usefulness is only an issue for chemical combinations, as illustrated by
Brenner v. Manson.

Brenner v. Manson15

Brenner emphasizes that patents are related to the world of commerce, not philosophy
or pure science. The invention at issue was a new chemical process for
making a known steroid. There was presently no use for the steroid, but the inventor
asserted that potential future uses existed. The Court held that vague potential
utility is insufficient to satisfy section 101. The Court stated, “a patent is not a
hunting license. It is not a reward for the search, but compensation for its successful
conclusion.” The patent system grants a monopoly in exchange for disclosure
of a specific useful invention that benefits the public. If there is no present
use, then the monopoly not only does not benefit the public, but it can discourage
subsequent discovery of additional uses.

Clearly, the Brenner court’s opinion relies heavily on the balancing test described
above. Awarding the Brenner inventor a patent would have been equivalent to granting
a monopoly on knowledge for which the inventor had not yet figured out a useful application,
and would have excessively preempted other inventors from developing a
method and a beneficial use for the method.

Novelty

Sections 101 and 102(a), (b), (e), and (g) require that an invention be “new” or novel
before it can be patented. These sections work together to ensure that the first person to
invent the product, not necessarily the first person to file for a patent, receives the
patent. Under section 102, an invention cannot be novel if there was “anticipation” of
the invention. In the United States, any of the following events, for example, could constitute
anticipation of the claimed invention: (1) each and every element of the invention
was described in a prior patent or printed publication, (2) all claimed elements
existed in an unabandoned and unconcealed invention by others, or (3) the claimed
invention was used by others in the United States before the person applying for the
patent invented it. In other countries, each and every element must be described in a
prior patent or printed publication in order to anticipate a claimed invention. A product
or process that would infringe the applicant’s invention if it came later in time anticipates
the invention if it came before.

When discussing “anticipation” and other issues relating to inventions preceding the
allegedly patentable invention, we often use the term prior art. Prior art simply refers


INTRODUCTION TO PATENT LAW

to the state of knowledge and known discoveries that existed in the relevant field of art
before the invention in question. Prior art can encompass published articles, theses,
machines, models, other products, and so on. Experts commonly are called on to distinguish
the supposedly new invention from the prior art or to discuss the scope of the
prior art.

Scripps Clinic & Research Found., Inc. v. Genentech, Inc.16

Scripps analyzes the extent to which a prior disclosure may put the invention in
the hands of the public. The invention in this case involved a method for making
a protein related to the clotting of blood. One issue in the case was whether the
claims under which infringement was alleged were anticipated by a Ph.D. dissertation
that was published before the invention. The dissertation was cited in
the application as prior art. The court stated that “invalidity for anticipation
requires that all of the elements and limitations of the claim are found within a
single prior art reference.” If multiple references are necessary to cover all the
elements of the claimed invention, then the invention cannot be anticipated and
therefore is “novel,” but nevertheless may still fail to qualify as nonobvious
under section 103.

The justification for novelty requirements is that there is no need to encourage innovation
if the invention is already known by people in the relevant field. Patent law
should not punish prior users of a product or method by creating a monopoly where
there previously was free access and open availability.

To avoid rejection of patent claims on the basis of novelty, an inventor may “swear
behind” the date of the use or publication that allegedly anticipates his or her invention.
The effective date of a reference is the date on which an ordinary person in the relevant
field of art has effective access to the disclosure. Clearly, this may vary from the date
of publication to the date of indexing by a library (in the case of a publication that does
not circulate widely). The critical date for the inventor is the date on which he or she
completed the invention; this date is assumed by the PTO to be the date on which the
applicant filed a complete application disclosing the invention. However, if the examiner
produces anticipating prior art dated before the inventor’s date of filing, the inventor
is permitted to establish that she invented the invention before the date of filing. The
usual procedure for establishing this invention date is to “swear behind” by filing an
affidavit under Patent Office Rule 131 claiming “completion of the invention in this
country” before the date of the anticipatory reference.17 An invention is “completed”
when the invention has been “reduced to practice” or the inventor establishes “conception
coupled with due diligence” from the date of the reference to reduction to practice.


PATENT INFRINGEMENT DAMAGES

Statutory Bar—“Loss of Right”

The purpose of the statutory bar or “loss of right” is to encourage inventors to seek
patent protection for their inventions diligently.18 The statutory bar focuses on the activities
of the applicant and the public more than one year before the date of filing of the
patent application (not the issuance of the patent). Section 102(b) invalidates a patent if
the invention was on sale in the United Sates more than one year before the application
(the “on-sale bar”). In addition, a patent can be invalidated if the invention is patented
or described in a printed publication in the United States or a foreign country one year
before the date of the application. Finally, if the invention is in public use by anyone in
the United Sates one year before the application, the patent will be invalid (“public use
bar”). In general terms, if the inventor or patent owner is responsible for any of these
activities, the patent statutes bar the patent even though the invention is novel, and
thus the result is a “loss of right.” If someone other than the inventor or patent owner
is responsible for these activities, then the patent is barred because the invention is
not “novel.”

Pfaff v. Wells Electronics, Inc.19

Pfaff filed a patent application on a computer chip socket invention on April 19,
1982. The statutory bar therefore concerns events occurring prior to April 19, 1981.
On March 17, 1981, Pfaff showed the invention to Texas Instruments. On April
8, 1981, Pfaff received written confirmation of a previous oral purchase order.
The order was filled in July 1981. The court found that the patent was invalid.
The court found that an offer for sale was enough for the product to be considered
“on sale” under section 102(b), because an “attempt to commercialize”
may be sufficient if the invention was “ready for patenting” at the time of the offer
for sale.

Pfaff’s two-pronged test governs application of the on-sale bar, although the courts have
had some difficulty applying the two tests to the facts of particular cases.

Crystal Semiconductor Corp. v. TriTech Microelectronics Int’l, Inc.20

In this case, the Federal Circuit clarified the on-sale bar doctrine. Crystal filed a
patent application for its analog-to-digital converter technology on October 2,
1987, thus creating a “critical date” of October 2, 1986, for purposes of the
statutory bar. Crystal received a purchase order confirmation for five of its converter
chips on September 11, 1986. The court found that the purchase order could


INTRODUCTION TO PATENT LAW

Crystal Semiconductor Corp. v. TriTech Microelectronics Int’l, Inc.
(continued)

qualify as a “commercial exploitation” of the patented technology even though
Crystal placed the order “on hold” and did not accept the offer until after the critical
date. Apparently the fact that the order was capable of being accepted was
sufficient to satisfy the commercialization prong of Pfaff.

Linear Tech. Corp. v. Micrel, Inc.21

Linear Technology filed a complaint against Micrel alleging infringement of
Linear Technology’s patent pertaining to adaptive transistor drive circuitry used
in telecommunications, cell phones, and computers. The District Court held the
patent invalid due to the on-sale bar.

The Federal Circuit reversed, holding that none of the activities in question constituted
an “offer” to sell. In order to interpret “offer,” the court looked to the common
law definitions of the term and concluded that an offer must (1) communicate
with potential customers, and (2) must indicate that assent by the customer will
constitute an agreement (i.e., that Linear Technology intends to be bound by its
offer, if accepted). Mere advertising, such as promotional materials sent to distributors,
may simply qualify as “an invitation for offers,” but not an actual offer.

Finally, Monon examines not whether an offer or sale was made, but whether that transaction
was commercial in nature.

Monon Corp. v. Stroughton Trailers, Inc.22

A sale prior to the critical date does not necessarily establish invalidity; if the sale
or public use of the patented device was primarily experimental (as opposed to
primarily commercial), the patent may survive the statutory bar. In Monon, the
patentee manufactured trailers. Since the patentee did not also operate its trailers,
it completed a sale in order to subject the patented device to conditions of actual
use. Specifically, the court heard testimony that the sale was necessary to determine
whether the trailer could withstand the stress of heavy loading and long
hauls. The Federal Circuit held that this evidence was sufficient to withstand summary
judgment because it raised a genuine issue of material fact as to whether the
sale was primarily for “commercial” or “experimental” purposes.


PATENT INFRINGEMENT DAMAGES

Nonobviousness

Section 103 of the Patent Act requires that a patentable invention must not be obvious
at the time of the invention to a person of ordinary skill in the relevant art. Prior art must
be in the same field, or an “analogous art” (i.e., a field of expertise that would be logical
to search if confronted with the particular problem facing the inventor). Where
the prior art “teaches away” (i.e., discourages the inventor’s approach to the problem, the
prior art can be good evidence of nonobviousness). To render an invention obvious,
the prior art must provide both an enabling suggestion, teaching, or motivation to combine
the prior art in the manner that the invention is claimed in the patent, and must
contain a reasonable expectation of success.

Graham v. John Deere Co.23

This case sets out the factors to be considered in determining nonobviousness:

(1) determine the scope and content of the prior art; (2) determine the differences
between the prior art and the patent claims at issue; (3) determine the level of
ordinary skill in the art; and (4) determine secondary considerations, such as commercial
success, long-felt need, failure of others, and the acquiescence of others
to the validity of the patent as demonstrated in licensing or development agreements.
The Court first recounts the history leading up to the 1952 Patent Act. The
1952 Act added section 103, requiring nonobviousness (and replaced the earlier
“new and useful” tests). The invention at issue in Graham was a spring clamp that
allowed a plow to be pushed upward if it hits obstructions, thus preventing the
plow from breaking as frequently. The defendant who was alleged to infringe
Graham’s patent claimed the patent would have been obvious. Under the four-
pronged test, the Court found that the Graham patent would have been obvious to
one skilled in the art at the time of the invention. The difference in structure
between the Graham clamp and the prior art was the only other possible effective
structure, as the simple inversion of the shank and hinge plate was the only way
to increase the flex. Thus, the product would have been obvious and not worthy
of patent protection.
PATENT INFRINGEMENT


Section 271 of the Patent Act governs infringement. There are two types of infringement.
The first type of infringement is “direct” infringement, which occurs when a
person makes, uses, sells, or offers to sell in the United States an apparatus or process
encompassed by any claim of a patent. Intent or knowledge of infringement is irrele



INTRODUCTION TO PATENT LAW

vant. The second type of infringement is “indirect” infringement, which occurs when
the defendant causes another to directly infringe and the defendant actively and knowingly
aids in the direct infringement. Indirect infringement also includes “contributory”
infringement. Contributory infringement is a subset of indirect infringement; under
section 271(c), offers to sell, sale, or import a component that is a “material part” of the
patented invention, made with the knowledge that the component will likely result in
infringement by the purchaser, constitute contributory infringement. However, if the
allegedly infringing component is a “staple article or commodity of commerce suitable
for substantial noninfringing use,” then the offer to sell, sale, or import the component
cannot be the basis for contributory infringement. In other words, if the product incorporating
the component could be used in a substantial manner that would not infringe
the patent, the courts will not protect the patent owner from its sale.

Infringement is determined by comparing the allegedly infringing, or “accused,”
product or process with the claims of the “patent in suit.” Infringement is “literal” if
the product or process falls within the literal meaning of the words of each element of
a claim. Section 112, paragraph 6, allows patents to include claims in which some or
all of the claimed elements or steps are stated in “means plus function” format, and
such claims that may be the basis for literal infringement. A “means plus function”
format describes elements in broad terms of what function the element accomplishes
rather than reciting the structure of the element. For example, a claim might include “a
means of linking A to B,” instead of specifying “a nail.” However, “means plus function”
elements are limited to the specific structures disclosed in the patent specification
and “equivalents” thereof. This proviso acts as a check on potentially broad claim
elements.

Infringement can also be shown by the “doctrine of equivalents.” Proof of infringement
under the doctrine of equivalents requires proof of “substantial equivalency” of all
the limitations of a claim that are not “literally” satisfied. A patent owner may sue for
infringement under the doctrine of equivalents if the accused device performs “substantially
the same function in substantially the same way to obtain the same result.”24
Equivalency considers the type of patent (pioneer invention or improvement), the prior
art, the prosecution history, the content of the specification, and other factors. Individual
elements, not the invention as a whole, must be considered for application of the doctrine
of equivalents.

Graver Tank & Mfg. Co. v. Linde Air Prods. Co.25

Graver Tank analyzes infringement under the doctrine of equivalents, examining

what constitutes “equivalence.” The Court held that equivalency must be deter


mined in the context of the patent, the prior art, and the particular circumstance of

(continues)


PATENT INFRINGEMENT DAMAGES

Graver Tank & Mfg. Co. v. Linde Air Prods. Co. (continued)

the case. In this case, the Court found that the substitution of manganese for the
particular alkaline earth metal used in the patent’s welding process was a substitution
taught by prior art, and thus still infringed. The purpose for an ingredient,
the way in which it serves its function, and the result are all factors that enter an
analysis of equivalence. Thus, a patent’s protection cannot be circumvented by
unimportant or insubstantial alterations to a patented device.

Hilton Davis Chemical Co. v. Warner-Jenkinson Co., Inc.26

Hilton Davis presented a slightly different way of analyzing the doctrine of equivalents
to establish infringement as compared to the function/way/result test outlined
in Graver Tank. In Hilton Davis, the Federal Circuit emphasized that the
doctrine of equivalents applies “if and only if the differences between the claimed
and accused products or processes are insubstantial.”

The factors to be determined in evaluating the “substantiality” of the differences
between the products or processes include: (1) whether persons with skill
in the relevant art actually knew of the equivalence of the claimed and accused
inventions; (2) whether a person with skill in the relevant art could have known
of the equivalence; and (3) how the defendant invented or designed her product.
This last factor examines whether the defendant intended to copy the patented
invention (which could indicate that the differences were only trivial), had
intended to design around the patented invention (which might imply that the
defendant had attempted to make substantial changes), or had inadvertently
arrived at the same invention through independent research (which may neutralize
this factor for purposes of the evaluation).

Despite these limitations on applying the doctrine of equivalents, the doctrine is commonly
asserted in patent litigation, at least as an alternative grounds for establishing
infringement. Many plaintiffs will argue that the defendant infringes both literally and
under the doctrine of equivalents, and possibly narrow their theory as discovery progresses.
However, a recent Federal Circuit decision appears to place extensive new limits
on the use of the doctrine of equivalents to establish infringement.


INTRODUCTION TO PATENT LAW

Festo Corp. v. Shoketsu Kinoki Kogyo Kabushiki27

Festo marks a shift in the Federal Circuit’s approach to the doctrine of equivalents
by limiting the potential applications of the doctrine and thus confirming the
court’s narrower approach to claim construction. The Federal Circuit held that
when a party amended a claim during prosecution of the patent for any reason
related to the statutory requirements for a patent, no range of equivalents is available
for the amended claimed element. In other words, the patentee must prove
that the accused product or process literally satisfies the language of the amended
element. The court also found that “voluntary” claim amendments—i.e., those not
required by the examiner or made in response to a specific rejection by an exam-
iner—must be treated the same as any other claim amendments if the result of the
amendment was to narrow the scope of the claim. Since the patent owner, Festo,
had not established explanations unrelated to patentability for its claim amendments,
the Federal Circuit found that the doctrine of equivalents was not available
to Festo as a theory of infringement.

Since many patent applications go through several amendments, and arguably all
amendments are related to meeting the patentability requirements, Festo casts a daunting
shadow on the scope of the doctrine of equivalents. Many commentators think that
the Federal Circuit went too far and essentially eliminated the doctrine of equivalents in
all but a few, unusual cases where the patent application did not go through the typical
revision and amendment process. Upon appeal of the Federal Circuit’s decision, the
United States Supreme Court granted cert. and heard oral arguments in early 2002. At
the time of drafting and submission of this manuscript to publisher, the authors were
awaiting the Supreme Court’s decision. The Supreme Court decision issued on May 28,
2002, effectively reaffirmed the importance of the doctrine of equivalents while recognizing
its limited application where claims were amended for patentability reasons.
However, the Supreme Court rejected a complete bar on infringement by equivalents in
those cases in favor of a rebuttable presumption. The first supplement to this book will
discuss the Supreme Court decision and its aftershocks in detail.

SUMMARY

This chapter addressed the basic law of patents. It is critical that both attorneys and
experts working in the area of patent damages understand the foundation elements of
patent law. This chapter described what a patent is, how to read a patent, the requirements
of validity, the requirements to demonstrate infringement, and the defenses to


PATENT INFRINGEMENT DAMAGES

infringement. Only after a patent is found to be valid and infringed will damages be
awarded. Yet damage experts must undertake their analysis before the resolution of
these issues. As a result, damage experts must understand how their arguments impact
the liability arguments, and they must be able to make intelligent decisions concerning
the breadth of the patent claims. This chapter attempted to lay the foundation for these
skills.

ENDNOTES

[1] Great Britain, Statutes at Large, 21 Jam. 1, ch. 3, § 6 (1623).
[2] 35 U.S.C. § 154.
[3] 35 U.S.C. § 271.
[4] Some sources dispute the accuracy of this quotation, especially in light of Duell’s 1899
report, which documents an increase of about 3,000 patents over the previous year and
nearly 60 times the number granted in 1837. See Samuel Sass, A Patently False Patent
Myth, Skeptical Inquirer 13 (1989), at 310–312. However, the quotation still is popularly
attributed to Duell and frequently used as an example of predictions that do not come to
pass.
[5]
USPTO Performance and Accountability Report: Fiscal Year 2000, at 13. The patent was
awarded to 3Com Corporation for the HotSync Technology, which allows Palm users to
synchronize their information with a computer at a single touch of a button.
[6] 35 U.S.C. § 112.
[7] The particular language used in a claim indicates precise limitations on the scope of the
patent. It is important to be aware that words or phrases commonly understood to be synonymous
may have distinctly different meanings in the context of a patent. For example,
“comprising” indicates that the following terms are a nonexclusive list (“comprising A”
thus means “including at least A, and possibly other elements”), while “consisting of ” is
an exclusive phrase that implies “A and only A.” Accordingly, “comprising” is generally
appropriate in descriptions of new areas, where the obvious substitutes for certain elements
are not yet clear. Patent drafting is a highly particular process, and the lesson for
most experts simply is not to make assumptions about the meanings of claim language.
[8] Design and plant patents have slightly different requirements, which are not discussed in
detail here. Designs must be new, original, nonobvious, and ornamental in order to receive
patent protection. Plant patents are awarded only to distinct, new, asexually reproduced
varieties of plants. (Sexually reproduced plants receive protection under the agricultural
statutes. See Plant Variety Protection Act, 7 U.S.C. § 2402.)
[9] 35 U.S.C. § 101.
[10] Improvements on inventions within any of the four categories are also patentable if they
are new, useful, and nonobvious.
[11]
Diamond v. Chakrabarty, 447 U.S. 303 (1980).
[12]
State Street Bank & Trust Co. v. Signature Financial Group, Inc., 149 F.3d 1368 (Fed. Cir.
1998).

INTRODUCTION TO PATENT LAW

[13] 35 U.S.C. § 101.

[14] 35 U.S.C. § 103.

[15]
Brenner v. Manson, 383 U.S. 519 (1966).

[16]
Scripps Clinic & Research Found., Inc. v. Genentech, Inc., 927 F.2d 1565 (Fed. Cir.
1991).

[17]
See 37 C.F.R. § 1.131.

[18] 35 U.S.C. § 102(b), (c), and (d).

[19]
Pfaff v. Wells Electronics, Inc., 525 U.S. 55 (1998).

[20]
Crystal Semiconductor Corp. v. TriTech Microelectronics Int’l, Inc., 246 F.3d 1336 (Fed.
Cir. 2001).

[21]
Linear Tech. Corp. v. Micrel, Inc. 275 F.3d 1040 (Fed. Cir. 2001).

[22]
Monon Corp. v. Stoughton Trailers, Inc., 239 F.3d 1253 (Fed. Cir. 2001).

[23]
Graham v. John Deere Co., 383 U.S. 1 (1966).

[24]
Graver Tank & Mfg. Co. v. Linde Air Prods. Co., 399 U.S. 605 (1950).

[25]
Id.

[26]
Hilton Davis Chemical Co. v. Warner-Jenkinson Co., 62 F.3d 1512 (Fed. Cir. 1995).

[27]
Festo Corp. v. Shoketsu Kinoki Kogyo Kabushiki, 187 F.3d 1381 (Fed. Cir. 1999).

ADDITIONAL READING

Suzanne Scotchmer, Standing on the Shoulders of Giants: Cumulative Research and the
Patent Law, 5 Journal of Economic Perspectives 29 (Winter 1991).

Kimberly Moore, Paul Michel, and Raphael Lupo, Patent Litigation and Strategy, New
York: West Publishing (1999).

Margreth Barrett, Intellectual Property: Cases and Materials, New York: West Publishing
(1995).

Arthur Miller and Michael Davis, Intellectual Property in a Nutshell, New York: West
Publishing (1990).

Robert Harmon, Patents and the Federal Circuit, Washington, D.C.: BNA (2001).


7


How to Calculate Patent Damages


In this chapter, we describe how experts and lawyers should approach the calculation
of patent infringement damages. The chapter combines skills in law, econom,ics, and
accounting.

THE PATENT STATUTE

The starting point for any analysis of patent damages is Title 35 of the United States
Code (U.S.C.), section 284 (the Patent Statute), which provides that:

Upon finding for the claimant the court shall award the claimant damages adequate to compensate
for the infringement, but in no event less than a reasonable royalty, for use made of
the invention by the infringer.

Before 1946, the precursor to section 284 went beyond “compensation,” allowing for
both recovery of compensation and the infringer’s profits. The 1946 Amendment Act of
August 1, 1946, Ch. 726, § 1, eliminated the language regarding the infringer’s profits
and added the reference to compensation.1

This revision is important. Before 1946, patent owners were awarded damages that
included both the lost profits to the patent owner and the infringer’s profits.2 Essentially,
a successful plaintiff was placed in a better position than had the infringement not
occurred because profits on some sales were counted twice—once as lost profits to the
patent owner and again as the actual profits the infringer received. The Supreme Court
interpreted the 1946 revision as correcting this situation, holding that the intent of the
revised statute was to limit a plaintiff’s damages to “compensation for the pecuniary
loss [the patent owner] has suffered from the infringement, without regard to the question
whether the defendant has gained or lost by his unlawful acts.”3 According to the
Court, the statutory reference to compensatory damages means that damages are limited

139



PATENT INFRINGEMENT DAMAGES

to “the difference between [the patent owner’s] pecuniary condition after the infringement,
and what his condition would have been if the infringement had not occurred.”4
In other words, “[h]ad the infringer not infringed, what would [the] Patent Holder...
have made?”5

King Instruments, Inc. v. Perego6

In King Instruments, a manufacturer of machines for loading magnetic tape into
cassettes claimed that a competitor was infringing his patent. The Federal Circuit
found that the competitor’s reel changer infringed the patent and held that the
manufacturer was entitled to both lost profits and a reasonable royalty. The Court
maintained that the only limitation on the types of harm for which damages may
be awarded is that the plaintiff must prove that the injury was caused by the
alleged infringement. The Court also upheld the patent owner’s right to withhold
the subject of the patent where it led to higher profits from manufacturing and
marketing nonpatented products that would otherwise compete with the patented
product. To compensate for infringement of the right to exclude, damages may include
lost profits on competing products not covered by the infringed patent claims.

THE CHOICE BETWEEN LOST PROFITS AND REASONABLE ROYALTIES

The first decision the lawyer or expert must make is to decide which method to use
in calculating damages in a particular case: “lost profits,” a “reasonable royalty,” or a
combination of both. The courts view lost profits as the preferred method when it is
appropriate for the facts of the case. As stated in Hansen v. Alpine Valley Ski Area,
Inc., “If the record permits the determination of actual damages, namely, the profits
the patentee lost from the infringement, that determination accurately measures the
patentee’s loss. If actual damages cannot be ascertained, then a reasonable royalty
must be determined.”7

There are situations in which the patent owner would be better off licensing to others
the right to use the patent in exchange for royalties. A classic example is the garage
inventor, who has a great idea but lacks the necessary manufacturing, marketing, distribution,
or other assets necessary to fully exploit the value of the patent. The best use of
the patent is to license the technology to a firm with the requisite manufacturing and
marketing assets to develop the product into a commercially successful product.
Another example of licensing is when a product requires the use of multiple patents
owned by different firms. In this case, since each patent owner can prevent the other


HOW TO CALCULATE PATENT DAMAGES

from producing the product, it frequently will make sense to break the deadlock by
cross-licensing each other.

In each of these licensing examples, the crucial feature is that the patent owner cannot
make optimal use of the patent by himself. As discussed subsequently, licensing
requires some sharing of the profitability gained from the invention between licensor
and licensee. Therefore, when the patent owner can use the patent without licensing, it
generally will be more profitable to do so.

The lost profits damages scenario—embodied in the four-part Panduit test discussed
in the next section—essentially identifies a clear case in which a patent owner can profitably
go it alone, producing and selling the patented product without having to recruit
the assistance of others. Although subsequent cases have recognized that while the
Panduit test identifies a clear case where lost profits are appropriate, the criteria may be
too narrow and exclude other cases in which lost profits would also be appropriate.
Consider the first part of the test, whether there is a market for the patented product. In
Rite-Hite the court recognized that the real issue is what sales the patent owner has
lost, whether those sales are of the patented product.8 This is because the patent owner’s
right is to exclude others from using the patent and does not require that the patent
owner use the patent. Therefore, Rite-Hite established the principle that the patent
owner’s lost sales need not necessarily be of the patented products, but would
include any lost sales that are attributable to the infringement. As discussed below, the
practical effect of Rite-Hite is to allow a patent owner to claim lost profits on products,
including functionally related “convoyed” products, by showing that infringement displaced
sales of such products.

LOST PROFITS

Proof of lost profits requires the patent owner to demonstrate that, absent infringement,
he would have made the sales that the infringer actually made. The standards for such
proof have changed measurably in the last 15 years. Before the establishment of the
Federal Circuit, the burden of proof to establish lost profits was substantial. Any possibility
that someone other than the patent owner could have made any sales of the
infringer completely negated a recovery of lost profits.9 In contrast, the Federal Circuit
has adopted a lower standard of “reasonable probability.” Under that standard, the
patent owner must show only that it is more probable than not that he would have made
the infringer’s sales but for the infringement.

Although the Federal Circuit has made it clear that there is no single method by
which the patent owner must carry its burden of proving lost profits, by far the most
common approach is the four-part test outlined in Panduit Corp. v. Stahlin Brothers
Fibre Works, Inc.10 (mentioned previously). The Panduit test requires that the plaintiff


PATENT INFRINGEMENT DAMAGES

establish (1) the existence of demand for the patented product; (2) the absence of
acceptable noninfringing substitutes; (3) the patent owner’s ability to meet demand; and

(4) some proof of the amount of profit lost per lost sale.11 Satisfying these four factors
results in the establishment of the fact that, absent infringement, the patent owner would
have made the infringer’s sales.
The first prong of the Panduit test rarely is difficult for the plaintiff to meet. Likewise,
the fourth factor may require little more than the production of the plaintiff’s
income statement. It is not surprising, then, that the key inquiries involved in proving
lost profits are the absence of acceptable noninfringing substitutes and the patent
owner’s ability to produce, market, and sell to the infringer’s customers. Both of these
questions are well suited for economic analysis, and the Federal Circuit has increasingly
incorporated economic analysis when addressing these issues.

Pall Corp. v. Micron Separations, Inc.12

In Pall Corp., the court held that, in order to be acceptable, a noninfringing alternative
must be free of any pending litigation. The proposed noninfringing alternatives
(certain membranes used in microfiltration) were themselves the subject of infringement
litigation during the time of Micron’s infringement, until they were licensed.
The Federal Circuit held that the trial court should have recognized “the distinction
between the legal and market situation before and after the licensing,” and held that
during the period that the proposed design-arounds were not licensed, their presence
in the market did not provide an acceptable noninfringing alternative such that
would defeat Pall’s entitlement to lost profits for all of Micron’s infringing sales.

Zygo Corp. v. Wyko Corp.13

Zygo, the patent owner, manufactured and sold a patented interferometer. Wyko
produced the Wyko 6000 interferometer, which was found to infringe Zygo’s
patent. As a defense to awarding lost profits, Wyko argued that it could have sold
SIRIS instead, a similar product that Wyko had sold before launching the infringing
Wyko 6000. Zygo did not contend that SIRIS was infringing. However, the
court rejected Wyko’s argument, holding that in order to be an acceptable noninfringing
alternative, the product must be available in the market. Since Wyko had
discontinued production of SIRIS, the court found that SIRIS was only “available
on the market” during the period that it was still being marketed by Wyko.


HOW TO CALCULATE PATENT DAMAGES

Fiskars, Inc. v. Hunt Manufacturing Co.14

Fiskars involved evaluation of a potential noninfringing alternative not disclosed
until several years after the conclusion of the trial. The procedural posture of
Fiskars therefore is somewhat unusual, but it offers informative guidance on the
nature of noninfringing alternatives for the purposes of calculating patent damages.
The manufacturer Hunt claimed, subsequent to the trial, that he was entitled
to relief from the trial court’s damages award because of his new, noninfringing
alternative to Fiskars’s patented paper trimmer. The Federal Circuit rejected the
manufacturer’s claim, holding that he was not entitled to a second opportunity to
present his case.

The manufacturer argued that he could not have introduced evidence of the
new product at trial because he lacked sales data at the time to demonstrate
the acceptability of the noninfringing product. However, the Court rejected this
argument, finding that although sales data could provide significant evidence of
an alternative’s acceptability, such data “is not the sole means for demonstrating
acceptability.” The Court held that accused infringers could rely on witness testimony
to show that the alternative was acceptable because customers did not
require the patented features that were (necessarily to avoid infringement) absent
from the substitute product. Although parties must support their positions with
“sound economic proof,” absolute certainty is not required in constructing the
hypothetical but for market.

Accordingly, Hunt was denied relief from the trial verdict because it could
have argued the existence of the noninfringing alternative at the time of the damages
award.

Initially, the Federal Circuit required proof that noninfringing substitutes did
not possess all of the attributes of the patented product.15 Such a test cannot withstand
even cursory scrutiny, however, because substitutes that possess literally all
of the attributes of the patented product would be infringing, not “noninfringing.”
Accordingly, the effect of this early Federal Circuit doctrine was to ensure that
patent owners virtually automatically met the critical second prong of the Panduit
test.

The logical defect in this first approach led the Federal Circuit to focus on the attitudes
of consumers toward the patented product and any substitutes rather than on their
physical attributes.


PATENT INFRINGEMENT DAMAGES

Slimfold Mfg. Co. v. Kinkead Indus.16

In Slimfold, the court denied awarding lost profits to the patent holder because

Slimfold was unable to attribute demand for the infringing product to the patented

feature. The patent covered a part for a metal door; however, Slimfold could not

establish that the defendant’s inclusion of the patented part resulted in a change in

demand or market share for either Slimfold or the defendant’s door. Moreover,

Slimfold failed to prove the absence of noninfringing substitutes that would have

been equally acceptable to the customers. Accordingly, the defendant could sim


ply have shifted to marketing one of the acceptable substitutes.

The court also affirmed the court’s award of a relatively small royalty—

0.75 percent—because the advantage of the patented invention primarily was a
manufacturing advantage (for which the court awarded damages separately) and
did not significantly increase the value of the entire door.
Although this change of focus marked an improvement, the Federal Circuit also held
that acceptable noninfringing substitutes are legally absent when some set of customers
can be shown to prefer the patented product.17 The difficulty with this approach is that,
if consumer tastes are not uniform, some subset of consumers will always prefer the
patented product. As a consequence, this second approach also negated any serious
analysis and ensured that the patent owner could satisfy the second Panduit prong.

Federal Circuit case law has now advanced significantly. In State Industries, Inc. v.
Mor-Flo Industries, Inc., the Federal Circuit held that lost profits are available to the
patent owner only for the share of the infringing sales that would have gone to the patent
owner absent the infringement.18 Thus, the Federal Circuit dispensed with the rigid “all
or nothing” approach of Panduit. Under this new procedure, a court can award lost profits
to the patent owner on the portion of the infringer’s sales that are equal to the patent
owner’s market share. For example, assume that there are three competitors in a market:
the patent owner, the infringer, and another firm that sells a noninfringing substitute.
Each competitor sells 100 units, so the market shares are one-third each. If the
infringer were removed from the market and the customers of the infringer were redistributed
to the remaining firms (the patent owner and the noninfringing substitute producer),
the result would be that the patent owner’s “but for” infringement sales would
be increased by half the infringer’s sales. The resulting damages in such a circumstance
would be a “hybrid” of lost profits and a reasonable royalty. A lost profits analysis
applies to half of the infringer’s sales based on the reasoning in Mor-Flo, and a reasonable
royalty applies to the remaining sales.

To establish the applicability of a Mor-Flo–type analysis, the expert must establish
that the customers of the infringer are reasonably likely to redistribute themselves


HOW TO CALCULATE PATENT DAMAGES

among the other sellers according to market share “but for” the infringement. Examination
of marketing, advertising, and historical changes in market share can be useful
in this analysis. This approach, although a substantial improvement, is still not without
problems. One is likely to find that the Mor-Flo approach is accurate only for cases in
which the products at issue are “homogeneous,” that is, where the products lack significant
brand-name recognition or significant physical or quality differences. However, in
cases in which products are heterogeneous, the Mor-Flo market share approach may
still lead to erroneous conclusions.

In applying the Mor-Flo approach, consider the following example of infringement in
the carbonated soda industry where products theoretically are heterogeneous. Suppose it
were found that Pepsi had been infringing the patented formula used by Coca-Cola (in
reality the formula is a trade secret). Further assume that the relevant market is defined
as branded soda in the United States and includes the sales of 7-Up, Dr. Pepper, several
root beer brands, and a few other products sold nationally.19 Moreover, for purposes of
illustration, assume that in this market, Coca-Cola’s market share is 30 percent and
Pepsi’s share is 20 percent. We would now have the situation depicted in Exhibit 7-1.

In this example we assume, following Mor-Flo, that once the infringer is removed
from the market, consumers will choose products in the same proportions as they did
prior to the infringer being removed. This approach makes the calculation of lost sales
easy. Lost sales are the difference between Coke’s sales in the “but for” world absent
the infringer and its sales in the actual world. In this case, lost sales are 37.5 percent of
the market less 30 percent of the market, or 7.5 percent of the sales of branded soda.

However, it is evident that consumers of Pepsi may have chosen Coke as a closer
substitute than other sodas. If this is true, the Mor-Flo approach underestimates Coke’s
lost sales. In BIC Leisure Products, Inc. v. Windsurfing Int’l, Inc., the Federal Circuit
recognized the importance of product differentiation to the lost profits analysis.20 In that
case, the patent owner sold a high-end, high-priced windsurfing board, while the alleged
infringer sold a similar, but lower-priced, low-end board. The Federal Circuit reached
beyond the standard market share approach to lost profits and held that the two products
at issue, while arguably part of the same product market, were sufficiently differentiated
that the patent owner probably would have sold to very few of the infringer’s

ACTUAL “BUT FOR”
MARKET SHARES MARKET SHARES


Coke 30% Coke (30/8020) 37.5%
Pepsi 20% Pepsi 0
Dr Pepper 10% Dr Pepper 12.5%
7-Up 10% 7-Up 12.5%
Private label 0% Private label 0
Others 30% Others 37.5%

EXHIBIT 7-1 Market Shares in Soda Brands


PATENT INFRINGEMENT DAMAGES

customers. This was the court’s conclusion despite the fact that the patent owner had a
significant overall market share. BIC Leisure thus represents a clear advance in economic
thinking for the Federal Circuit. Finally, in a recent case, Grain Processing Corp.

v. American Maize-Products Co., the Federal Circuit held that a noninfringing substitute
need not be “on the market” or “for sale.”21 All that is required is that the substitute
be “available” to be included in the market.22
In order to be entitled to lost profits damages, the patent owner also must demonstrate
that he possesses the marketing, manufacturing, and financing capability to make
the infringer’s sales. The reason for this requirement is that, even if it could be shown
that demand for the patent owner’s product would have increased absent the infringement,
the patent owner must show that he had the ability to meet the additional demand
and actually increase his sales.23

Hebert v. Lisle Corp.24

In Hebert, the patentee admitted that he had never sold one of his patented exhaust
manifold spreaders. The court noted that where the patentee does not seek to make
and sell the invention, lost profits are not an appropriate measure of damages.
However, Hebert presented evidence of his activities that allegedly established his
intent to manufacture the tool. Hebert also claimed that Lisle’s action in flooding
the market with its infringing version of the tool deprived him of the opportunity
to market and sell the patented invention. The court found that it would be incorrect
to bar a patentee who is not yet manufacturing the product from proving that
his actual damages were larger than a reasonable royalty, but that the burden on
such a patentee was “commensurately heavy” to prove what he would have
earned but for the infringement. “Damage awards cannot be based upon speculation
or optimism, but must be established by evidence,” concluded the court, and
remanded the issue to the trial court for evaluation of the evidence that Hebert
would have and could have captured Lisle’s profits but for the infringement.

Although in the past, the ability to make the infringer’s sales was considered solely
from the point of view of manufacturing capacity, courts today also inquire whether
the patent owner has the ability to market and service the infringer’s customers.25 This
is important because, as any business people know, the ability to procure sales requires
much more than merely producing the product. The ability to distribute, market, and
service a product is equally as important as the manufacturing capacity to produce it.
Other factors that an expert should consider include:

. Is there distribution capacity?
. Are the infringer’s sales made to longtime customers?

HOW TO CALCULATE PATENT DAMAGES

. Does the patent owner have the required marketing, full line of products, services,
or other attributes required to make the infringer’s sales?
. Do the cash flow statements indicate any capital constraints?
. Is there sufficient inventory of the product available?
THE CALCULATION OF INCREMENTAL PROFITS

Once the amount of lost sales has been established, all that remains is to determine the
amount of profits that would have been earned on those lost sales. Since we are attempting
to determine how much better off the patent owner would have been had there
been no infringement, an appropriate method is to measure the “incremental” profits or
income that would have resulted from the lost sales. As stated in Paper Converting:

[t]he incremental income approach to the computation of lost profits is well established
in the law relating to patent damages. The approach recognizes that it does not cost as
much to produce unit N + 1 if the first N (or fewer) units produced already have paid the
fixed costs. Thus fixed costs—those costs which do not vary with increases in production,
such as management salaries, property taxes, and insurance—are excluded when determining
profits.26

Thus, the patent damages expert is directed to determine how much additional cost is
incurred to make the additional sales that would have been made “but for” the infringement.
Elements of cost that would have been incurred in either case obviously do not
enter into this calculation; only costs that vary with the changes in the sales volume at
issue should be deducted from the sales at issue to determine incremental profits.

The determination of incremental costs can be an area of significant contention in a
patent damages case. For example, the patent owner may claim that it could produce the
additional volume of sales in question without adding any additional plant, equipment,
overhead, or infrastructure, so that only the variable cost of goods sold need be subtracted
to calculate incremental profitability. The patent owner would argue that the
“gross margin” line on his income statements is the appropriate benchmark for calculating
incremental profitability. The infringer, however, may claim that in order to produce
the incremental output, the patent owner would have to increase all his costs
proportionately (i.e., adding to plant, equipment, overhead, and infrastructure as output
increases). The infringer would argue that the “net profits” line on the patent owner’s
income statement more accurately represents the patent owner’s incremental profitability.
Depending on the facts, the truth could lie anywhere in the range bounded by these
two positions.

The expert must carefully examine how costs change with sales of the products
in question over the range of output claimed as incremental sales. The most direct
approach usually entails a detailed examination of each discrete line item of costs, bro



PATENT INFRINGEMENT DAMAGES

ken down as finely as possible. For each cost line item, the patent damages expert
should determine whether such costs are variable or fixed over the range of the incremental
output.27

Alternatively, or as a check on the detailed cost item calculation, the expert can examine
the historical behavior of total costs at different ranges of output. Changes in the
patent owner’s output comparable to the claimed incremental sales can yield important
information relevant to the amount of incremental costs that would have to be incurred
to make those incremental sales. Of course, the patent damages expert should be careful
to remove any extraordinary or nonrecurring cost items that would not be expected.

In addition, it may be possible to apply econometric methods to cost and input data
to estimate the effect on cost of incremental sales volume. Over the past several
decades, the use of the ordinary least squares to estimate cost functions has grown
widely. Although this method is a powerful tool for the analysis of data, it is important
that the expert have a thorough understanding of when and how the method is appropriately
used and of the limitations of the methodology (see Chapter 3).28

THE DAMAGE PERIOD

The damage period over which lost profits are available begins at the onset of infringement
of an issued patent if the patent owner’s products are marked as patented (if such
marking is possible).29 In no case can damages be awarded for infringement committed
more than six years prior to the filing of the complaint.30 If the patent owner’s patented
products are not marked, the damage period begins when the infringer receives actual
notice of infringement. The damage period ends on the date of trial because presumably,
if the infringer loses its case on liability, an injunction will be imposed. An interesting
issue, however, concerns whether a patent owner can be compensated for an infringer’s
future impact on the patent owner’s sales that results from the market effect of the
infringer’s past infringement.

PRICE EROSION

Lost profits include not only the loss of sales due to infringement but also the price
reduction that results from the unlawful competition from the infringer. This reduction
in price, or “price erosion,” is now a recognized part of the lost profits damage measure.
According to the Federal Circuit:

lost profits may be in the form of diverted sales, eroded prices, or increased expenses. The
patent owner must establish causation between his lost profits and the infringement. A factual
basis for causation is that, “but for” the infringement, the patent owner would have made the
sales that the infringer made, charged higher prices, or incurred lower expenses.31


HOW TO CALCULATE PATENT DAMAGES

The earliest case to establish a price erosion element of lost profits was Yale Lock
Manufacturing Co. v. Sargent.32 In Yale Lock, the Supreme Court found that the
infringer was selling locks that included the infringing device at a lower price than
the patent owner was. As a result, the patent owner was forced to lower his price by one
dollar on some types of locks and by two dollars on other types of locks. The Court
awarded, as part of the patent owner’s lost profits, the erosion of the patent owner’s lock
price multiplied by the sales on which the lower price had been applied. But Yale Lock
failed to consider the impact that the hypothetical price increase might have had on output
or sales. As some later courts have recognized, it is not consistent for the patent
owner to claim that “but for” the infringement, prices would have been higher, while
simultaneously contending that total sales would have remained unchanged.33

Economic principles teach that there is a direct relationship between the price level
and the level of output or sales.34 Some courts have recognized this connection. For
example, in the seminal case of Panduit Corp. v. Stahlin Bros. Fibre Works, Judge Markey
held for the purposes of calculating lost profits that demand was sufficiently elastic that
“any loss in Panduit’s profits due to the price reduction was more than compensated
by the gain in profits due to the increase in plaintiff’s sales volume because of the
price reduction.”35 Similarly, in Polaroid Corp. v. Eastman Kodak Co., the Massachusetts
District Court concluded that no lost profits from price erosion were justified because
“the higher prices Polaroid says it would have charged would have depressed demand
so substantially that the strategy they historically pursued is actually the more profitable
one.”36 In other words, the court found that price elasticity was already too high to justify
an award based on price erosion.

Despite the apparent simplicity of this principle, the majority of courts that have
awarded damages for price erosion have done so without adjusting the level of output
on which lost profits are calculated. The case of Micro Motion, Inc. v. Exac Corp. is
illustrative.37 The case involved Exac’s infringement of Micro Motion’s patent for flow
meters. Before Exac entered the market, Micro Motion was the only supplier of the
flow meters at issue. Micro Motion claimed patent damages in the form of lost profits
on Exac’s sales for which Micro Motion had the capacity to produce and a reasonable
royalty on the remainder of Exac’s sales. But Micro Motion also claimed that, but for
the infringement, its prices on its sales would have been higher. Micro Motion called
Professor Daniel Rubinfeld, a nationally recognized economist, who testified that
absent infringement, Micro Motion’s prices would have been 4 percent higher, and as a
result, total output would have been 1 percent lower (thus, elasticity was 0.25). Citing
this testimony, the court awarded the plaintiff an additional 4 percent of sales on the lost
profits portion of Exac’s sales, but surprisingly did not reduce the size of the total output
base consistent with Rubinfeld’s analysis.

The court was clearly in error. Either output should have been reduced based on the
theorized price increase, as plaintiffs’ expert conceded, or the court should have refused
to grant damages for price erosion altogether. The theory would be that if Micro Motion


PATENT INFRINGEMENT DAMAGES

had licensed Exac (the basis for the reasonable royalty award), Exac would have competed
with Micro Motion for all sales (since it had a license), thus eliminating any ability
of Micro Motion to raise its prices.

To illustrate the problem with awarding price erosion damages without also adjusting
for resulting decreases in the quantity demanded, consider Exhibit 7-2. The original “but
for” price and quantity combination, representing total sales of both infringer and patent
owner, is denoted Pc, Qc. A damage award that does not take into account price erosion
would award the patent owner profits equal to the area corresponding to Pc, Qc, less the
profits actually earned by the patent owner. However, absent infringement, Micro Motion
would have been able to attain even greater profits with the price and quantity combination
of Pm, Qm. Doing so would gain a higher margin on sales that remained despite the
higher price, denoted by area a, while losing the margin on sales that are lost due to the
higher price, denoted by the area b.38 Whenever area a is larger than area b, it is profitable
to charge the higher price and sell fewer units. Therefore, the typical damage award, not
accounting for price erosion, undercompensates the patent owner by the amount of area
(a . b). However, in the Micro Motion case, in attempting to account for price erosion, the
court appears to have awarded profits based on a price and quantity combination of Pm,
Qc. The result is to overcompensate the patent owner by the sum of areas b and c.

THE ENTIRE MARKET RULE

Another issue often raised in patent infringement cases is what product sales are eligible
for compensation to the patent owner—that is, can the sale of products not covered
by the patent in suit be a basis for lost profits? The contours of the proper legal and economic
limitations to recovery on the sales of nonpatented items raises serious legal and


a
Qm Qc


b
c
Pm

Pc

EXHIBIT 7-2 Price Erosion Damages


HOW TO CALCULATE PATENT DAMAGES

constitutional issues. Only a brief outline of the pertinent rules is provided here.39 The
Federal Circuit recently addressed this issue in Rite-Hite Corp. v. Kelley Co., Inc.40
There, the Federal Circuit held that lost profits on nonpatented components or complementary
products sold with the patented product must satisfy the so-called entire market
rule to be compensable. The entire market rule requires that, to be recoverable, the
“unpatented components must function together with the patented components in some
manner so as to produce a desired end product or result. All the components together
must be analogous to components of a single assembly or be parts of a complete machine,
or they must constitute a functional unit.”41 Thus, the sale of products that are complements
to a patented product (i.e., convoyed sales) but not functionally integrated are
not compensable.42 The court reasoned that the Patent Statute sought to compensate
only competitive injury, and products sold with the patented product do not necessarily
compete directly with the infringer.

Although this reasoning narrows the lost profits recovery by eliminating awards for
convoyed sales, it also expands potential recoveries for lost sales on products that are
not covered by the patent in suit, but nonetheless compete with the infringer’s products.
To illustrate such a situation, suppose that the patent owner sells two products, A and B.
Further assume that the infringer infringes the patent covering product A, but sells its
product in competition with product B. According to Rite-Hite, the patent owner can
recover for lost profits on its lost sales of product B, even though product B does not
use the patented technology.

The Rite-Hite holding is likely to raise future controversy.43 The foundation of the
Rite-Hite rule lies in the court’s definitions of “competition” and “functional integration.”
Both concepts are defined narrowly by the Federal Circuit. Functional integration
is defined in physical terms rather than economic terms, focusing on how products
physically relate to each other in use, rather than the efficiencies or inefficiencies from
their complementary features. Likewise, competition is limited to a direct product by
product confrontation and does not consider broader strategic rivalry among firms.
Economic analysis can be useful in unpacking the logic of the Rite-Hite holding as these
issues are revisited in the future.

REASONABLE ROYALTY

As an alternative to the lost profits method of calculating damages, the patent owner can
claim reasonable royalties for use of the patented technology. This analysis can be used
to determine damages for any portion of the infringing sales for which the patent owner
cannot establish lost profits. A reasonable royalty analysis seeks to determine the royalty
the patent owner would have obtained in a voluntary “hypothetical negotiation”
between the patent owner (as a willing licensor) and the infringer (as a willing licensee)
just prior to the onset of infringement, assuming that both parties agreed that the patent


PATENT INFRINGEMENT DAMAGES

is valid and that the infringers’ products infringe the patent.44 This analysis is guided by
economic principles bearing on the costs and benefits of a license to each participant
and the relative bargaining leverage of the parties.

The Georgia-Pacific Factors

The case law on reasonable royalties contains valuable guidelines for conducting such
an analysis. Georgia-Pacific Corp. v. U.S. Plywood Corp.45 provided a list of 14 factors
that should be considered in the analysis. These factors are:

1. The royalties received by the patentee for the licensing of the patent in suit,
proving or tending to prove an established royalty.
2. The rates paid by the licensee for the use of other patents comparable to the
patent in suit.
3.
The nature and scope of the license, as exclusive or nonexclusive; or as
restricted or nonrestricted in terms of territory or with respect to whom the
manufactured product may be sold.
4.
The licensor’s established policy and marketing program to maintain his
patent monopoly by not licensing others to use the invention or by granting
licenses under special circumstances designed to preserve that monopoly.
5.
The commercial relationship between the licensor and licensee, such as
whether they are competitors in the same territory in the same line of business
or whether they are inventor and promoter.
6. The effect of selling the patented specialty in promoting sales of other products
of the licensee; the existing value of the invention to the licensor as a
generator of sales of his nonpatented item; and the extent of such derivative
or convoyed sales.
7. The duration of the patent and the term of the license.
8. The established profitability of the product made under the patent, its commercial
success, and its current popularity.
9. The utility and advantages of the patent property over alternative products or
methods, if any, that had or could have been used to obtain similar results.
10. The nature of the patented invention, the character of the commercial embodiment
of it as owned and produced by the licensor, and the benefits to those
who have used the invention.
11. The extent to which the infringer has made use of the invention, and any evidence
probative of the value of the use.
12. The portion of the profit or of the selling price that may be customary in
the particular business or in comparable businesses to allow for the use of the
invention or analogous inventions.
13. The portion of the realizable profits that should be credited to the invention as
distinguished from nonpatented elements, services provided in conjunction

HOW TO CALCULATE PATENT DAMAGES

with the product, the manufacturing process, business risks, or significant features
or improvements added by the infringer.

14. The opinion testimony of qualified experts.
The Georgia-Pacific factors identify economically important areas of inquiry and
types of evidence that should be considered in an analysis of reasonable royalties sufficient
to compensate for alleged infringement. However, as the Georgia-Pacific
court recognized, the 14 factors necessarily fall short of providing a formula for
weighing and quantifying the factors to arrive at a solution to the royalty rate question.
Rather, the factors provide an important framework for the analysis and a checklist
of information that should be examined in a rigorous economic analysis of
reasonable royalty rates.

A Useful Classification of the Georgia-Pacific Factors. For purposes of this discussion,
it is convenient to parse the Georgia-Pacific factors into five groups corresponding
to the major economic considerations they address. Factors 3 and 7 ask us
to identify the major parameters of the license at issue. Although we are, by necessity,
required to construct a license agreement resulting from “hypothetical negotiations
between the patentee and the infringer (both hypothetically willing) at the time infringement
began,”46 this hypothetical construction must nonetheless comport with the
market realities and opportunities available at the time of the hypothetical negotiation.
For example, the hypothetical license should reflect the number of years remaining in
the life of the patent. Chapter 14 discusses the Georgia-Pacific factors again in a more
practical context.

The Georgia-Pacific factors 1, 2, and 4 direct us to examine whether other licenses
provide useful information. This is discussed in the subsequent section covering comparable
licenses.

Factors 4 and 5 direct us to consider costs to the licensor of granting a license.
Considerations such as alternatives to licensing or the potential creation of a competitor
through licensing affect the royalty rate that would be acceptable to a patent owner.
In particular, a patent owner would not be willing to accept a royalty rate that does not
cover his costs of licensing. These “opportunity costs” to the licensor play an important
role in defining one of the boundaries of a mutually acceptable license in the hypothetical
negotiation.

Factors 6 and 8 to 13 require examination of benefits to the licensee of obtaining a
license. Generally, the more profitable the resulting products, the more important the
technology is in allowing the production of profitable products and the less the alternatives
available to the licensee, the higher the royalty rate. The important point is that a
licensee will not willingly pay more than the expected benefits from licensing. This
consideration determines the other boundary of a mutually acceptable license agreement
in the hypothetical license negotiation.


PATENT INFRINGEMENT DAMAGES

Finally, the issue of relative bargaining power between licensee and licensor must be
addressed. A number of rules of thumb or methods of identifying a likely royalty rate
from among mutually acceptable rates have been employed. Having identified the general
type of license at issue, the maximum acceptable price to a licensee and the minimum
acceptable price to a licensor, and the outcome of bargaining in similar situations,
we can draw better inferences about the likely outcome in this particular situation.
Considerations such as the risks borne by the licensee in developing a salable product
and the importance of other resources that the licensee brings to the process can help to
narrow the area of mutually beneficial royalty rates.

Comparable Licenses. When there is an established industry price for the technology
at issue or similar technology, this “prevailing” royalty rate may be a good indicator of
the result of a hypothetical royalty negotiation for the subject patent. For example, other
licenses for the same patent can be highly instructive. However, it often is the case that
there are no established or prevailing royalty rates and that other licenses are not comparable
for a variety of reasons.

First, patents are by definition unique. The technology covered by one patent is sufficiently
different from the technology covered by another patent; otherwise it would
not be patentable.

Second, experience with licensing and examination of publicly available data indicates
that license fees for patents exhibit impressive range; most licensed patents
are worth little or nothing, while a few command very high fees. Moreover, the terms
of actual license agreements are typically complex and do not lend themselves to easy
extrapolation to other situations. For example, licenses can contain provisions that
require subsequent performance by the parties, contingencies that affect the ultimate
payments such as caps, and either lump-sum and running royalties or a combination of
royalties. Many licenses border on joint venture agreements to develop future products
rather than simple payments for the right to use a technology. Similarly, cross-licenses
and licenses for portfolios of patents present difficulties in assigning values to individual
patents in the portfolio.

Third, in the typical nonlitigation negotiation between a willing licensee and licensor,
there is uncertainty regarding whether the patent is valid or whether it is infringed.
Thus, in real-world licenses, there is some discounting of the value of the patent
owner’s right to prevent infringing use of a valid patent. For example, suppose each
party believes there is a 50 percent chance of invalidity. If the royalty agreed upon is
3 percent, then the reasonable royalty at trial arguably must be 6 percent. As the example
shows, most nonlitigated patent royalty rate agreements reflect a discount for uncertainty
with respect to validity and infringement. In contrast, in the litigation context, the
patent damages expert is asked to determine a reasonable royalty for a patent assuming
that it is both valid and infringed. Thus, there should be no discounting for uncertainty
regarding the infringement in a royalty rate established through litigation, because the


HOW TO CALCULATE PATENT DAMAGES

facts of validity and infringement are known and the parties have borne the risk of finding
out. A “reasonable royalty” for the purposes of assessing damages for past patent
infringement may often be significantly different from (i.e., higher than) royalty rates
negotiated outside the litigation context for otherwise comparable patents. The case
law recognizes that royalty rates established through litigation are fundamentally not
comparable to royalty rates agreed to in nonlitigation negotiation. As stated in Panduit,

The setting of a reasonable royalty after infringement cannot be treated, as it was here, as the
equivalent of ordinary royalty negotiations among truly “willing” patent owners and
licensees. That view would constitute a pretense that the infringement never happened. It
would also make and election to infringe a handy means for competitors to impose a “compulsory
license” policy on every patent owner. Except for the limited risk that the patent
owner, over years of litigation, might meet the heavy burden of proving the four elements
required for recovery of lost profits, the infringer would have nothing to lose, and everything
to gain, if he could count on paying only the normal, routine royalty noninfringers might have
paid. As said by this court in another context, the infringer would be in a “heads I win, tails
you lose” position.47

Finally, there is a sample bias in comparing licensed patents to the patent in question.
Most patents are not licensed, probably because they have little or no market value.
Comparing a litigated patent only to licensed patents is comparing the subject patent
only to the patents that turn out to be market successes.

Empirical Surveys of Royalty Rates. Sometimes industry data on royalty rates can
serve as a useful sanity check. Several surveys of the membership of the Licensing
Executives Society (LES) have been conducted and published in the LES journal, Les
Nouvelle. The first survey, which was conducted by McGavock, Haas, and Patin and
published in the March–April 1991 issue,48 was based on a sample of 118 respondents
who filled out questionnaires on a variety of licensing topics. The respondents came
from a variety of industries, so the survey allows for a cross-tabulation of industry type
and average royalty rate, as well as royalty type, relation to profit, and other information.
Degnan and Horton conducted a second survey of LES members, which involved
428 respondents and was published in the June 1997 issue of Les Nouvelle.49 Finally,
McGavock and Lasinski performed a third survey of LES members (186 of whom
responded), which was published in the September 1998 issue of Les Nouvelle.50 This
last survey focused on intellectual property (IP) policy and, strategy employed by LES
members. Although far from determinative of the applicable royalty in a particular
case, these surveys can provide helpful estimates of a range of reasonable royalties and
proffer a good check on outrageously high or low figures.

To qualify as admissible evidence rather than merely internal sanity checks, surveys
must meet several judicial criteria. Survey evidence must be “material, more probative
on the issue than any other evidence and... [have] guarantees of trustworthiness.”51


PATENT INFRINGEMENT DAMAGES

The trustworthiness of a survey depends on its conformity to generally accepted survey
principles, including sampling “an adequate or proper universe of respondents.”52 To
some extent, technical or methodological deficiencies affect the weight accorded a survey,
not its admissibility, so long as the survey complies with generally accepted survey
principles to establish a proper foundation for admissibility.53 However, surveys may
be excluded where the flaws are so substantial that any probative value of the survey is
outweighed by the inaccuracies.54 Precisely what constitutes a “generally accepted survey
principle” is subject to some debate, but the courts have identified certain primary
standards as follows:

The trustworthiness of surveys depends on foundation evidence that (1) the “universe” was
properly defined, (2) a representative sample of that universe was selected, (3) the questions
to be asked of interviewees were framed in a clear, precise and non-leading manner, (4) sound
interview procedures were followed by competent interviewers who had no knowledge of the
litigation or the purpose for which the survey was conducted, (5) the data gathered was accurately
reported, (6) the data was analyzed in accordance with accepted statistical principles
and (7) objectivity of the entire process was assured. Failure to satisfy one or more of these
criteria may lead to exclusion of the survey.55

Courts have criticized unreliable means of selecting the interviewees and found that a
sample that is not properly representative warrants exclusion of the survey at trial.56
Moreover, leading and suggestive questions undermine the legitimacy of the results.57
The Les Nouvelle surveys do not appear to meet these criteria for admissibility other
than as a sanity check.

Generally, the proponent of the survey will establish these criteria by using the testimony
of the individuals responsible for various parts of the survey.58 Where the proponent
cannot proffer this type of testimony, the survey itself may lack sufficient
foundation for admissibility. For example, in Toys “R” Us, Inc. v. Canarsie Kiddie Shop,
Inc., the expert witness relying on the survey for evidence of trademark confusion conceded
that he had no knowledge of what the interviewers actually did in conducting the
interviews, no personal knowledge of whether they followed their instructions, and
no knowledge of the accuracy of the content analysis because that work, too, was subcontracted
to another company.59 Based on the expert’s lack of the necessary knowledge
of the survey’s methodology and calculations, the court excluded the survey and the
opinions of the experts based on that survey.60 In concluding that the survey could not
be used as evidence at trial, the court noted that the “absence of any testimony by others
who were responsible” for the survey raised doubts as to the survey’s trustworthiness.61

Hypothetical Negotiation: The Boundaries. A basic economic principle is that a
rational economic agent will not willingly enter into an agreement that makes him
worse off. As discussed previously, the Georgia-Pacific factors include consideration of
the cost to the hypothetical licensor (the patent owner) of granting a license to the patent


HOW TO CALCULATE PATENT DAMAGES

$
Mutually
acceptable
range
Licensor Licensee

EXHIBIT 7-3 Range of Acceptable Royalty Rates

and the benefits to the hypothetical licensee from taking a license to the patent. These
considerations determine the boundaries of a mutually beneficial license; the patent
owner will not accept less than his cost of granting the license, while a potential licensee
will not pay more than his gain from licensing.

In the willing licensor–willing licensee hypothetical situation, it must be assumed
that there are mutual gains from voluntary trade, that is, that both the licensor and the
licensee will be better off if a license is granted. If this were not the case, no trade
between the parties would occur.

Exhibit 7-3 represents the range of acceptable royalty rates for both licensor and
licensee. The area of overlap, the “mutually acceptable range,” defines the set of royalty
rates that make each party better off by licensing.62

Thus, the expert must determine the boundaries of the set of mutually agreeable royalty
rates. Typically, the opportunity cost of the patent owner is the amount of profit that
could be earned by not licensing (i.e., producing the product himself) or by licensing to
somebody else.

On the other side of the hypothetical bargaining table, the potential licensee’s benefit
from licensing typically is the profit that could be gained by producing and selling
products that use the patented technology.63 In calculating the licensee’s profit from
using the technology, it is important to consider the licensee’s opportunity costs. Opportunity
cost means the benefits that could have been derived from the licensee’s next
best opportunity. Therefore, the appropriate maximum that a licensee would be willing
to pay is equal to the profit that the licensee expects to receive from using the new
technology net of the profit that it could obtain by utilizing the next-best alternative
technology available.

It would be a fundamental error to consider the licensee’s potential gains to be the
actual accounting profits. Yet some courts have made this error in calculating patent


PATENT INFRINGEMENT DAMAGES

damages.64 An example will illustrate the problem. Suppose that a licensee can make
$5,000 using technology A, but using this technology will infringe a patent covering
technology A. In the alternative, the licensee can make $4,000 using a noninfringing
technology. Therefore, the licensee will be unwilling to pay more than $1,000 to license
the patent to technology A, even though his income statement would show a profit of
$5,000 using technology A. Quite simply, paying more than $1,000 for a license to technology
A would not be as profitable as simply using technology B. Thus, one must know
what the opportunity cost of the infringer is to correctly identify the maximum royalty
that the infringer would pay. Most courts have recognized that taking account of opportunity
cost is the only correct method.65

One open issue is when the expert should consider the bargaining situation as taking
place. Although the case law tells us that the bargaining should occur at the “onset” of
infringement, an expert must be careful to consider whether the situation is prior to the
infringer incurring significant sunk costs. Once sunk costs are incurred, the infringer’s
opportunity costs will be higher than prior to such commitments. For example, once
a company has undertaken a massive investment in a project only to discover on the eve
of the product launch that its product infringes, obtaining a license could be a “bet the
company” issue. Conversely, had the potential infringement been discovered earlier,
the company’s willingness to pay would be determined by the value of undertaking the
infringing project compared to undertaking the next-best net present value project.

Experts often rely on forecast documents to attempt to understand how the infringer
would value a license. Forecast documents can be useful, but they also reflect the hidden
assumptions and institutional motives of their author. Such documents cannot be
taken at face value. Instead, interviews or discovery should be used to understand their
contextual meaning before relying on them.

In any event, there typically will be a range of royalty rates that satisfy the requirements
of the mutually acceptable range. A particularly difficult issue in calculating reasonable
royalties involves determining where within the mutually acceptable range the
negotiating parties would end up. Which amount is the most reasonable royalty? Of
course, this also determines the split between the licensor and licensee of the benefits
of the patented technology. In the following sections, we discuss several approaches
that have been used to address this indeterminacy.

The Rule of Thumb. One rule of thumb, sometimes used as a starting point in license
negotiations, is to set a royalty rate such that 0.25 to 0.33 of the licensee’s profits from
using the patent go to the patent owner as a license fee. The rationale for leaving 0.75
to 0.66 of the profits to the licensee is because the licensee is expected to assume greater
financial risk in commercializing the technology. This is appropriate in situations in
which the patent owner is unable to commercialize the technology without significant
assistance from a licensee with complementary assets, such as manufacturing, marketing,
distribution, or product development skills. Recently, Jarosz, Mulhern, and Vigil of


HOW TO CALCULATE PATENT DAMAGES

Analysis Group conducted an empirical survey of royalty rates and concluded that,
despite the fact that royalty rates varied significantly, royalty rates tended to range
between 21 and 40 percent of successful licensee profits.66

Analytical Method. Another approach is called the “analytical method.” The analytical
method is based on the premise that any rate of return in excess of normal can be
attributed to the patent and constitutes the profits to be divided between the negotiation
parties. The analytical method takes the profits of the infringer, subtracts the infringer’s
“normal” profit, and awards some portion of the remainder to the patent owner. The approach
in Tektronix67 is typical. In that case, the court calculated the reasonable royalty
as follows. First, the court determined the infringer’s sales and subtracted both
variable and fixed costs to arrive at gross profits and a gross profit rate. Next, the court
subtracted the infringer’s rate of profit on his other products from this gross profit rate.
Finally, the court divided the remainder among the infringer and the patent owner to
provide some return to the infringer for the risks of manufacturing the patented product.

Design-Around Costs. The “design-around costs” method is based on the observation
that a willing licensee will not be willing to pay more for the right to use the patent than
it would cost him to “design around” the patent. If the patent owner demands more than
the design-around costs, the potential licensee is better off using his own resources to
avoid the patent. Of course, there may be some risks associated with attempting to
design around a patent, and such risks should be considered when assessing design-
around costs. This method pegs the maximum value of a patent as the advantage of the
patent over the next-best alternative, consistent with Georgia-Pacific’s factor requiring
the examination of acceptable noninfringing substitutes.

Other Patent Damages. In addition to lost profits and reasonable royalties, the patent
statute allows for an injunction preventing future sales of the infringing product. When
there is a finding of willful infringement, a court can increase damages up to three times
the amount and assess attorney fees. “Willfulness” requires that the infringer (1) was
aware of the patent, and (2) failed to investigate the patent’s scope and form a good-
faith belief that the patent was invalid or not infringed by the product or process in question.
Finally, the statute makes clear that an infringer will be assessed interest and costs.

Stryker Corp. v. Intermedics Orthopedics, Inc.68

Stryker, the patent owner, sued Intermedics for infringement of its patent for a

hip implant prosthesis. The court affirmed a finding of willful infringement, not


ing that “slavish copying” is not required to establish “deliberate” infringement.

(continues)


PATENT INFRINGEMENT DAMAGES

Stryker Corp. v. Intermedics Orthopedics, Inc. (continued)

Copying is relevant, but not a necessary element of willful infringement, although
it could be evidence of a lack of good faith. Moreover, the infringing product need
not be “virtually an exact copy of the patentee’s product.” The court found that
Intermedics had failed to investigate the scope of the patent at issue once it knew
of its existence and had no good-faith belief that the patent was invalid or not
infringed by its prosthesis. Intermedics had an affirmative duty of due care to avoid
infringement of the known patent rights of others, including seeking and obtaining
competent legal advice before engaging in potentially infringing activity.

Minco provides an example of the available remedies and possible damages enhancements
once a court determines that a defendant willfully infringed the patent at issue.

Minco, Inc. v. Combustion Engineering, Inc.69

In Minco, the district court found willful infringement on the part of Combustion
Engineering. Since courts have the discretionary power to increase a damage
award up to three times the original amount where willfulness is proven, the court
doubled the sum of the lost profits and reasonable royalty that it had awarded,
then added attorneys fees and prejudgment interest. Moreover, the royalty was
already a “relatively high royalty” of 20 percent based on the fact that the parties
were close rivals in the same market, the absence of noninfringing alternatives,
the inferiority of Combustion Engineering’s product before infringement, and the
high rate of profitability enjoyed in the industry.

SUMMARY

This chapter is a core chapter presenting the basic principles that must be employed in
the calculation of patent damages. The chapter began where every lawyer and expert
must, with the applicable statute. The patent statute sets out a scheme for damage calculation
from which courts have developed a methodology that is very compatible with
economic theory. This chapter explained how economic principles can be used to satisfy
the statutory and judicial aims in devising appropriate remedies for patent infringement.
In Chapter 13 we build on and contrast with the principles discussed in this chapter,
while discussing the means of calculating damages for other types of IP infringement.


HOW TO CALCULATE PATENT DAMAGES

ENDNOTES


[1] The legislative history of the Patent Statute is discussed in Kori Corp. v. Wilco Marsh
Buggies & Draglines, Inc., 761 F.2d 649, 654 (Fed. Cir. 1985).
[2]
See Kori Corp., 761 F.2d at 655.
[3]
Aro Manufacturing Co. v. Convertible Top Replacement Co., 377 U.S. 476, 507 (1964).
[4]
Id.
[5]
Id.
[6]
King Instruments, Inc. v. Perego, 65 F.3d 941 (Fed Cir. 1995).
[7]
Hansen v. Alpine Valley Ski Area, Inc., 718 F. 2d 1075, 1078 (Fed. Cir. 1983).
[8]
Rite-Hite Corp. v. Kelley Co., Inc., 56 F.3d 1538 (Fed. Cir. 1995).
[9]
See Tektronix, Inc. v. United States, 552 F.2d 343, 349 (Ct. Cl. 1977) (“if lost profits are
ever to be awarded . . . it should be only after the strictest proof that the patentee would
actually have earned and retained those sums in its sales”).
[10]
Panduit Corp. v. Stahlin Brothers Fibre Works, Inc., 575 F.2d 1152 (6th Cir. 1978).
[11]
Id. at 1156.
[12]
Pall Corp. v. Micron Separations, Inc., 66 F.3d 1211 (Fed. Cir. 1995).
[13]
Zygo Corp. v. Wyko Corp., 79 F.3d 1563 (Fed. Cir. 1996).
[14]
Fiskars, Inc. v Hunt Manufacturing, Co., 279 F.3d 1378 (Fed. Cir. 2002).
[15]
See, e.g., TWM Manufacturing Co., Inc. v. Dura Corp., 789 F.2d 895, 901 (Fed. Cir. 1986)
(“a product lacking the advantages of the patented [product] can hardly be termed a substitute
acceptable to the consumer who wants those advantages”).
[16]
Slimfold Mfg. Co. v. Kinkead Indus., 932 F.2d 1453 (Fed. Cir. 1991).
[17]
See Standard Havens Products, Inc. v. Gencor Industries, Inc., 953 F.2d 1360, 1373 (Fed.
Cir. 1991) (“if purchasers are motivated to purchase because of particular features available
only from the patented product, products without such features—even if otherwise
competing in the marketplace—would not be acceptable noninfringing substitutes”).
[18]
State Industries, Inc. v. Mor-Flo Industries, Inc., 883 F.2d 1573 (Fed. Cir. 1989)
[19]
This is how the Federal Trade Commission has defined the relevant market in this industry.
[20]
BIC Leisure Products, Inc. v. Windsurfing Int’l, Inc., 1 F.3d 1214, 1218 (Fed. Cir. 1993).
[21]
Grain Processing Corp. v. American Maize-Products Co., 185 F.3d 1341 (Fed. Cir. 1999).
[22]
See also Riles v. Shell Exploration and Prod. Co., No. 01-1553 (Fed. Cir. July 31, 2002)
(holding that a reasonable royalty rate must consider potential noninfringing alternatives
as limit on hypothetical negotiations).
[23]
This third Panduit prong is connected to the second prong because the size of the patent
owner’s capacity impacts the number of noninfringing substitutes in the market. If the
patent owner cannot meet demand, then the class of acceptable noninfringing substitutes
must expand as consumers turn to other products to satisfy their needs. Despite their connection,
the two issues can be treated separately.
[24]
Hebert v. Lisle Corp., 99 F.3d 1109 (Fed. Cir. 1996).

PATENT INFRINGEMENT DAMAGES

[25]
See Polaroid Corp. v. Eastman Kodak Co., 16 U.S.P.Q. 2d 1481 (D. Mass. 1990).
[26]
Paper Converting Machine Company v. Magna-Graphics Corporation, 745 F.2d 11, 22
(Fed. Cir. 1984).
[27] Preexisting classifications of costs among “variable,” “fixed,” and “semivariable” may
not be reliable because such classifications may not have been assigned according to the
scale of output that is relevant in a particular case.
[28] This topic is too large and technically involved to be adequately discussed here. The
reader is advised to consult some of the many texts available on the topic. We list several
texts at the end of Chapter 3. See, e.g., Rubinfeld Reference Guide on Multiple
Regression, in Reference Manual on Scientific Evidence; Fisher, Multiple Regression in
Legal Proceedings, 80 Columbia Law Review 702 (1980); Rubinfeld, Econometrics in
the Courtroom, 85 Columbia Law Review 1048 (1985).
[29] 35 U.S.C. § 287.
[30] 35 U.S.C. § 286.
[31]
See LAM, Inc. v. Johns-Manville Corp., 718 F.2d 1056, 1065 (Fed. Cir. 1983) (emphasis
added); see also General American Transp. Corp. v. Cryo-Trans, Inc., 893 F. Supp. 774,
796 (N.D. Ill. 1995) (“price erosion occurs when a plaintiff is forced to lower prices due
to the presence in the market of the defendant’s infringing product”); Saf-Gard Products,
Inc. v. Service Parts, Inc., 491 F. Supp. 996, 1002 (D. Ariz. 1980) (“Computation of the
plaintiff’s lost profits also requires determination as to the plaintiff’s effective selling
price. If the plaintiff’s reduced selling prices are used in the computation of lost profits,
the defendant would receive a substantial benefit as a result of its infringing competition
with the plaintiff.”)
[32]
Yale Lock Mfg. Co. v. Sargent, 117 U.S. 536, 548 (1886).
[33] Courts have granted damages based on a price erosion theory on the basis of a variety of
types of evidence. For example, in TWM Mfg. Co., Inc. v. Dura Corp., 789 F.2d 895, 902
(Fed. Cir. 1986), the Federal Circuit upheld an award of damages based on price erosion
because of proffered evidence that TWM “had to give special discounts to compete with
Dura’s pricing practices.” Id. at 902. The court further dismissed defendant Dura’s argument
“that there was no correlation between the special discounts and its infringing activity.”
Id. Similarly, in Brooktree Corp. v. Advanced Micro Devices, Inc., 977 F.2d 1555,
1579 (Fed. Cir. 1992), the Federal Circuit upheld an award of lost profits based on price
erosion because of evidence presented by Brooktree that “it was forced to reduce its prices
when AMD announced its chips at lower prices, and that but for the infringement,
Brooktree would have continued to sell its chips at the prices that had already been established.”
Id. at 1579.
[34] As discussed in Chapter 3, this relationship is measured by the concept of “elasticity.”
Demand for a product is said to be very elastic when consumers are willing to switch to
a different good that is only slightly less expensive. In contrast, demand for a product is
said to be inelastic when significant increases in price fail to cause equally significant
reductions in the quantity purchased.
[35]
Panduit Corp. v. Stahlin Bros. Fibre Works, 575 F.2d 1152, 1157 (6th Cir. 1978).
[36]
Polaroid Corp. v. Eastman Kodak Co., 16 U.S.P.Q. 2d 1481, 1506 (D. Mass. 1990).

HOW TO CALCULATE PATENT DAMAGES

[37]
Micro Motion, Inc. v. Exac Corp., 761 F. Supp. 1420 (N.D. Cal. 1991).
[38] For simplicity in exposition, this example assumes that costs are zero. However, the conclusion
does not depend on assumptions about costs.
[39] Those readers interested in the deeper issues raised by the entire market rule should consult
the complete set of opinions cited in Rite-Hite Corp v. Kelley Co., Inc., 56 F.3d 1538
(Fed. Cir. 1995).
[40]
Rite-Hite Corp. v. Kelley Co., Inc., 56 F.3d 1538, 35 U.S.P.Q. 2d 1065, 1071 (Fed. Cir.
1995).
[41]
Id. at 1071.
[42]
Prior to Rite-Hite, convoyed sales were compensable if they were normally sold with the
patented product.
[43] For a discussion, see Lisa C. Childs, Rite Hite Corp. v. Kelly Co., The Federal Circuit
Awards Damages for Harm Done to a Patent Not in Suit, 1996 Loy. U. Chi. L. Rev. 665.
[44]
See, e.g., Mahurkar v. C.R. Bard Inc., 79 F.3d 1572, 1579 (Fed. Cir. 1996) (“Hypothetical
results of hypothetical negotiations between the patentee and the infringer (both hypothetically
willing) at the time infringement began.”); Georgia-Pacific Corp. v. U.S.
Plywood Corp., 318 F. Supp. 1116, 1120 (S.D.N.Y. 1970), modified on other grounds, 446
F. 2d 295 (2d Cir. 1971), cert. denied, 404 U.S. 870 (1971).
[45]
Georgia-Pacific Corp. v. U.S. Plywood Corp., 318 F. Supp. 1116, 1120 (S.D.N.Y. 1970),
modified on other grounds, 446 F. 2d 295 (2d Cir. 1971), cert. denied, 404 U.S. 870
(1971).
[46]
Mahurkar v. C.R. Bard, Inc., 79 F.3d 1572, 1579 (Fed. Cir. 1996).
[47]
Panduit Corp., 575 F.2d at 1158.
[48] Daniel McGavock, David Haas, and Michael Patin, Factors Affecting Royalty Rates, Les
Nouvelles, March–April 1991 at 205.
[49] Stephen Degnan and Corwin Horton, A Survey of Licensed Royalties, Les Nouvelles, June
1997 at 91.
[50] Daniel McGavock and Michael Lasinski,
IP Survey Finds Gap in Information, Les
Nouvelles, September 1998 at 107.
[51]
Harolds Stores, Inc. v. Dillard Dep’t Stores, Inc., 82 F.3d 1533, 1544 (10th Cir. 1996); see
also Starter Corp. v. Converse, Inc., 170 F.3d. 286 (2d Cir. 1999) (affirming exclusion of
trademark survey where the survey did not effectively test consumer confusion of the two
marks and thus was irrelevant); C.A. May Marine Supply Co. v. Brunswick Corp., 649
F.2d 1049 (5th Cir. 1981); Simon Prop. Group L.P. v. mySimon, Inc., 104 F. Supp. 2d 1033,
1041 (S.D. Ind. 2000) (excluding surveys where flaws are “so fundamental that the court
does not believe it would be fair to treat them as matters going only to the weight of the
evidence”); Fed. R. Evid. 402; 4 McCarthy on Trademarks § 32:170.
[52]
Id.
[53]
Id.; Indianapolis Colts, Inc. v. Metropolitan Baltimore Football Club, L.P., 34 F.3d 410,
416 (7th Cir. 1994) (finding that imperfect survey may still be admissible); AHP
Subsidiary Holding Co. v. Stuart Hale Co., 1 F.3d 611, 618 (7th Cir. 1993) (holding that
flawed survey is admissible except in “rare” occasions); McGraw-Edison Co. v. Walt Disney
Prods., 787 F.2d 1163, 1172 (7th Cir. 1986) (same).

PATENT INFRINGEMENT DAMAGES

[54]
Simon Property Group, L.P. v. mySimon, Inc., 104 F. Supp. 2d 1033, 1039 (S.D. Ind. 2000)
(excluding survey regarding Internet home pages because the survey so grossly distorted
the marketplace conditions as to strip the survey of any significant probative value);
Starter Corp. v. Converse, Inc., 170 F.3d 286, 297 (2d Cir. 1999); A.H.P. Subsidiary
Holding Co. v. Stuart Hale Co., 1 F.3d 611, 618 (7th Cir. 1993) (finding that flawed surveys
may be completely unhelpful to the trier of fact and therefore inadmissible);
Spraying Systems Co. v. Delavan, 975 F.2d 387, 394 (7th Cir. 1992) (affirming summary
judgment where survey of consumer opinion was too flawed to create a genuine issue of
material fact).
[55]
Toys “R” Us, Inc. v. Canarsie Kiddie Shop, Inc., 559 F. Supp. 1189, 1205 (E.D.N.Y. 1983)
(emphasis added); see also Ramdass v. Angelone, 530 U.S. 156, 172 (2000) (excluding
death penalty poll and citing Toys “R” Us, Inc. for factors to consider in determining survey
reliability).
[56]
See Harolds Stores, Inc., 82 F.3d at 1544, citing Bank of Utah v. Commercial Sec. Bank,
369 F.2d 19, 27 (10th Cir. 1966); Toys “R” Us, Inc., 559 F. Supp. at 1204 (random intercept
survey method and inaccuracies in recording the responses might yield unreliable
results); Amstar Corp. v. Domino’s Pizza, Inc., 615 F.2d 252, 264 (5th Cir. 1980) (noting
inadequate universe of survey recipients); Dreyfus Fund, Inc. v. Royal Bank of Canada,
525 F. Supp. 1108, 1116 (S.D.N.Y. 1981) (unreliable survey technique); Kingsford
Products Co. v. Kingsfords, Inc., 715 F. Supp. 1013, 1016 (Kan. 1989).
[57]
Simon Property Group, L.P. v. mySimon, Inc., 104 F. Supp. 2d 1033 (S.D. Ind. 2000);
Sterling Drug, Inc. v. Bayer AG, 792 F. Supp. 1357, 1373 (S.D.N.Y. 1992) (disapproving
of improperly drafted survey questions); Conagra, Inc. v. Geo. A. Hormel & Co., 784 F.
Supp. 700, 726 (Neb. 1992) (survey flawed in that failed to inquire regarding reasons certain
answers were selected).
[58]
Id.
[59]
Toys “R” Us, Inc. v. Canarsie Kiddie Shop, Inc., 559 F. Supp. 1189, 1203 (E.D.N.Y.
1983).
[60]
Id. at 1205.
[61]
Id.
[62] If the analysis determines that there is no royalty rate that makes both parties better off,
this probably is a signal that a “lost profits” rather than a “reasonable royalty” is appropriate.
[63] One vexing problem is that the boundaries of the mutually acceptable range are sensitive
to when the negotiation takes place. For example, if the negotiation takes place before
the potential licensee invests in production facilities to make the product, his potential
benefit from taking a license is different than it would be if the licensee had already made
“sunk” investments specific to the patented product. The cases simply state that the hypothetical
negotiation takes place at the onset of infringement.
[64]
See, e.g., Polaroid Corp. v. Eastman Kodak Co., 16 U.S.P.Q. 2d 1481 (D. Mass. 1990);
Fromson v. Western Litho Plate & Supply Co., 853 F.2d 1568, 1575 (Fed. Cir. 1988).
[65]
See, e.g., Columbia Wire Co. v. Kokomo Steel & Wire Co., 194 F.108, 110, 114 C.C.A. 186
(C.C.A. 1911); Union Carbide Corp. v. Graver Tank & Mfg. Co., 345 F.2d 409, 411, 145
U.S.P.Q. 240 (7th Cir. 1965); Hanson v. Alpine Valley Ski Area, Inc., 718 F.2d 1075, 1078,

HOW TO CALCULATE PATENT DAMAGES

219 U.S.P.Q. 679 (Fed. Cir. 1983); Smith International, Inc. v. Hughes Tool Co., 1986 WL
4795, 299 U.S.P.Q. 81, 83 (C.D. Cal. 1986); Ellipse Corp. v. Ford Motor Co., 461 F. Supp.
1354, 1369, 201 U.S.P.Q. 455 (N.D. Ill. 1978); and Slimfold Mfg. Co., Inc. v. Kinkead
Industries, Inc., 932 F.2d 1453, 1458, 18 U.S.P.Q. 2d 1842 (Fed. Cir. 1991).

[66] John Jarosz, Carla Mulhern, and Robert Vigil, “Industry Royalty Rates and Profitability:
An Empirical Test of the 25% Rule,” Presentation to LES Annual Meeting, October 30,
2001.
[67] Tektronix, Inc. v. United States, 552 F.2d 343 (Ct. Cl. 1977).
[68] Stryker Corp. v. Intermedics Orthopedics, Inc., 96 F.3d 1409 (Fed. Cir. 1996).
[69] Minco, Inc. v. Combustion Eng’g, Inc., 95 F.3d 1109 (Fed. Cir. 1996).
ADDITIONAL READING

Russell L. Parr, Intellectual Property Infringement Damages: A Litigation Support
Handbook, New York: John Wiley & Sons (1993).
Everett M. Rogers, Diffusion of Innovations, 3rd ed., New York: The Free Press (1995).


Jay B. Abrams, Quantitative Business Valuation, New York: McGraw-Hill (2001).
Geoffery A. Moore, Paul Johnson, and Tom Kippola, The Gorilla Game, New York:
Harper Business (1999).


Clayton M. Christensen, The Innovator’s Dilemma, New York: Harper Business (2000).


Frederick P. Brooks, Jr., The Mythical Man-Month, 20th Anniversary Edition, AddisonWesley-
Longman (1995).
Geoffery A. Moore, Inside the Tornado, New York: Harper Perennial (1999).
Damages: Lost Profits on Lost Sales of Unpatented Items, 5 Federal Circuit Bar Journal


242 (Summer 1995).


Dorsey Baker, Patent Damages—Quantifying the Award, Journal of the Patent & Trademark
Office Society 121 (March 1987).
Jonathan Bloom et al., Federal Circuit Addresses Patent Infringement Damages Issues,


7 Journal of Proprietary Rights 21 (Aug. 1995).


Patricia N. Brantley, Patent Law Handbook 1993–94 ed., § 604, Clark Boardman
Callaghan, Ltd.
Alex Chartove, Patent Law Developments in the United States Court of Appeals for the

Federal Circuit During 1991, 9 Computer & High Technology Law Journal 109 (1993).

Alex Chartove, Patent Law Developments in the United States Court of Appeals for the
Federal Circuit During 1989, 39 The American University Law Review 1142 (1990).
Lisa C. Childs, Rite-Hite Corp. v. Kelley Co.: The Federal Circuit Awards Damages for

Harm Done to a Patent Not in Suit, 27 Loyola University of Chicago Law Journal 665
(Spring 1996).


PATENT INFRINGEMENT DAMAGES

Ned L. Conley, An Economic Approach to Patent Damages, 15 AIPLA Q.J. 354 (1987).

Ronald B. Coolley, Overview and Statistical Study of the Law on Patent Damages, Journal
of the Patent & Trademark Office Society 515 (July 1993).

Robert J. Cox, Recent Development: But How Far?: Rite-Hite Corp. v. Kelley Co.’s
Expansion of the Scope of Patent Damages, 3 Journal of Intellectual Property Law 327
(Spring 1996).

John D. Culbertson and Roy Weinstein, Product Substitutes and the Calculation of Patent
Damages, Journal of the Patent & Trademark Office Society 749 (Nov. 1988).

Robert Goldscheider, Companion to Licensing Negotiations, Licensing Law Handbook
(1993–1994).

Robert Goldscheider, Measuring Damages in U.S. Patent Litigation, 5 Journal of
Proprietary Rights 2 (1993).

Robert Goldscheider, Value of Patents from a Damages Expert’s Point of View, 12 Licensing
Law & Business Report 109 (Nov.–Dec. 1989).

Robert L. Harmon, Damages, Interest, and Costs, Patents and the Federal Circuit 478
(3rd ed., 1994).

Robert L. Harmon, Patents and the Federal Circuit, § 12.2 (2d ed., 1991).

Robert L. Harmon, Seven New Rules of Thumb: How the Federal Circuit Has Changed the
Way Patent Lawyers Advise Clients, 14:3 George Mason Law Review 573 (1992).

Paul M. Janicke, Contemporary Issues in Patent Damages, 42 The American University
Law Review 691 (1993).

Wm. Marshall Lee, Determining Reasonable Royalty, Les Nouvelles 124 (Sept. 1992).

Nancy J. Linck and Barry P. Golob, Patent Damages: The Basics, 34 IDEA: The Journal
of Law & Technology 13 (1993).

Frederick A. Lorig and David J. Meyer, Maximizing Patent Damages, 321 Practicing Law
Institute 367 (1991).

Timothy J. Malloy and Melissa M. McCaulley, Rite-Hite: Has the Federal Circuit
Expanded the Legal Limits on Damages Awarded in Patent Infringement Actions? 424
Practicing Law Institute 515 (1995).

Timothy J. Malloy and Robert P. Renke, Patent Damages Revisited: Recent Issues Before
the Federal Court, 397 Practicing Law Institute 277 (1994).

Daniel M. McGavock and Rochelle Kopp, Emerging Topics in the Calculation of
Economic Damages in Patent Litigation, 5 Journal of Proprietary Rights 17 (March 1993).

William E. McGowan, Patent Law—Limiting Infringement Protection for Product-by-
Product Claims, 27 Suffolk University Law Review 300 (1993).

Joel Meyer, State Industries v. Mor-Flo and the Market Share Approach to Patent
Damages: What Is Happening to the Panduit Test? Wisconsin Law Review 1369 (1991).


HOW TO CALCULATE PATENT DAMAGES

George F. Pappas and April J. Sands, Law of Patent Damages, CA42 ALI-ABA 1 (Sept.
28, 1995).

Laura B. Pincus, The Computation of Damages in Patent Infringement Actions, 5 Harvard
Journal of Law & Technology 95 (Fall 1991); reprinted in Journal Business Law (U.K.)
(March 1992), 213.

N. Richard Powers, At the End of the Second Rainbow—Calculation of Damages in Patent
Cases, Delaware Lawyer 18 (March 1989).
Richard T. Rapp and Philip A. Beutel, Patent Damages: Rules on the Road to Economic
Rationality, 321 Practicing Law Institute 337 (1991).

Charles Shifley, Upfront and Benchmark Payments as Part of Reasonable Royalty Patent,
4 Federal Circuit Bar Journal 33 (Spring 1994).

Charles W. Shifley, Alternatives to Patent Licenses: Real-World Considerations of
Potential Licensees Are—and Should Be—a Part of the Courts’Determinations of Reasonable
Royalty Patent Damages, 34 The Journal of Law & Technology 1 (1993).

John M. Skenyon and Frank P. Porcelli, Patent Damages, Journal of the Patent & Trademark
Office Society 762 (Nov. 1988).

Gerald Sobel, Damages for Patent Infringement, 416 Practicing Law Institute 197 (1995).

Stephen I. Willis, Economic Modeling of Patent Infringement Damages, 321 Practicing Law
Institute 331 (1991).

Harold E. Wurst and Anne Wang, The Law of Patent Damages, 376 Practicing Law
Institute 7 (1993).


8


Introduction to the Antitrust Laws


This chapter provides a basic overview of the antitrust laws. A working knowledge of
antitrust principles is important to the analysis of intellectual property (IP) damages
because there are significant areas of overlap between the IP laws and the antitrust laws.
In addition, many of the tools developed by the courts in antitrust cases, such as the concept
of a relevant market, have been imported into the IP arena. This chapter provides
a historical background concerning the two principal antitrust statutes, the Sherman Act
and the Clayton Act; describes the evolving goals of the antitrust laws; and discusses
the essential components of the major antitrust claims.

THE HISTORICAL FOUNDATIONS OF THE ANTITRUST LAWS

In contrast to the IP laws that find their roots in the U.S. Constitution, the antitrust laws
were born in the upheaval of the Industrial Revolution at the end of the nineteenth century.
Contemporary descriptions of the time describe it as a period of “excess competition.”
The increased intensity of competition after the Civil War occurred in part as a
result of advances in transportation that brought formerly isolated geographic markets
into rivalry with each other. The rising competitive pressure impacted unevenly on large
and small firms, and the years following the Civil War coincided with an accelerated
process of mechanization, which widened the gap between large and small enterprises.1
Mechanization had significant consequences for competition. Thorelli states that as a
result of “heavy fixed investments” by the new industrial firms:

Many old enterprises [were] unable or unwilling to expand fast enough and raise the capital
necessary to keep abreast in their fields [and] were gradually, or in the recurrent slumps suddenly,
forced to the wall. To this extent at least a certain concentration of production to fewer
firms became concomitant with the increase in optimum size. . . .2

169



PATENT INFRINGEMENT DAMAGES

It was under these circumstances that the most dynamic large firms in the economy
attempted to avoid the detrimental effects on accelerated competition by organizing
profit pools, cartels, and trusts. As a result of these successful efforts to control inter-
firm rivalry, major tensions were created between big business and their smaller competitors,
farmers, and urban workers.

Before to the Industrial Revolution, traditional firms were insulated from competitive
pressure by their small size and the distance from their competitors. As the
Industrial Revolution took hold, new technologies led to larger firms with increased
capacity and new forms of communication and transportation that broke down old barriers
to competition. The result was severe price competition as large firms selling
homogeneous commodities clashed in the market. The response to the downward pricing
pressure was to form new corporate forms that reduced competition by collective
price-setting.

Not surprisingly, other groups in the economy—particularly farmers organized by
the granger movement, small businesses that formed the backbone of the progressive
movement, and urban workers—vehemently opposed the large trusts. The trusts
became an object of ridicule and hatred, and the political pressure mounted to heightened
levels prompting action by Congress. Few people deny that Congress passed the
Sherman Act because public condemnation of trusts was becoming increasingly violent.
In introducing his antitrust bill, Senator John Sherman explained:

The popular mind is agitated with problems that may disturb social order, and among them all
none is more threatening than the inequality of condition, of wealth, and opportunity that has
grown within a single generation out of the concentration of capital into vast combinations to
control production and trade and to break down competition . . . They had monopolies and
mort mains of old, but never before such giants as in our day. You must heed their (the voters’)
appeal or be ready for the socialist, the communist and the nihilist.3

Congressional debate and revision of the antitrust bill represented a condensation of
many conflicting political forces caused by the economic upheaval of the Industrial
Revolution.

The Origins of the Sherman Act

The original purpose of Sherman’s antitrust bill was to protect the small traditional
firms.4 Although Sherman tried to keep the bill in the Finance Committee, which he
controlled, the Judiciary Committee, after much debate, obtained jurisdiction and
within a week had produced a different bill that employed the language of the old common
law of restraints of trade. Many historians contend that the final legislative language
was essentially a political compromise between the interests of both large firms
and small firms. It was the compromise nature of the Sherman Act and the difficulty of
its interpretation that may have fostered its overwhelming support (it was passed with


INTRODUCTION TO THE ANTITRUST LAWS

only one dissenting vote in the Senate) and may account for the initial weak enforcement
efforts in the first decade following its enactment.

The final draft of the Sherman Act5 stated:

An Act To Protest Trade and Commerce Against Unlawful Restraints and Monopolies.

Section 1. Every contract, combination in the form of trust or otherwise, or conspiracy, in

restraint of trade or commerce among the several States, or with foreign nations, is declared

to be illegal. Every person who shall make any contract or engage in any combination or con


spiracy hereby declared to be illegal shall be deemed guilty of a felony. . . .

Section 2. Every person who shall monopolize, or attempt to monopolize, or combine or

conspire with any other person or persons, to monopolize any part of the trade or commerce

among the several States, or with foreign nations, shall be deemed guilty of a felony. . . .

The final draft that became the Sherman Act replaced Sherman’s original words
requiring “free competition” with a more ambiguous prohibition on “restraints of
trade” and “monopolization.” By returning to these older and more malleable common
law concepts, a measure of protection for smaller businesses was accomplished, but
essentially without sacrificing or stemming the corporate revolution that was transforming
the economy. In addition, because of the ambiguous language, the meaning
of the Sherman Act at the time was not obvious to lawyers who needed to advise their
corporate clients and also was unclear to enforcement officials. Congress had left
the arduous task of interpreting and applying the terms of the Sherman Act to the
Supreme Court.

It was not until 1897 that the Supreme Court first heard a series of restraint of trade
cases and first interpreted the ambiguous language of section 1, which literally stated
that “[e]very contract, combination in the form of trust or otherwise, or conspiracy, in
restraint of trade . . . is declared to be illegal.” The issue first arose in United States v.
Trans-Missouri Freight Association,6 in which the government filed a lawsuit, under
section 1 of the Sherman Act, against 18 railroads that controlled most of the commerce
west of the Mississippi River and that regularly fixed prices. The railroads defended on
the grounds that, absent the cartel, the railroads would be destroyed because of “ruinous
competition.” The railroads contended that the Sherman Act should outlaw only “unreasonable”
restraints, and a restraint that prevents ruinous competition must be “reasonable.”
The majority decision of the Supreme Court rejected the railroad’s argument,
reasoning that the plain language of the statute makes illegal “every” contract, combination,
or conspiracy that is in restraint of trade, not just unreasonable agreements.7
Therefore, the ruinous competition defense was without merit. The Court further made
clear its concern that such restraints of trade as the railroads proposed would “drive out
of business all the small dealers in the commodity.”8 Justice White wrote a forceful dissent,
to which four members of the Court concurred, supporting the view (which is now
prevailing law) that when Congress used the term restraint of trade it meant only
“unreasonable” restraints of trade, as the term was used in the common law.9


PATENT INFRINGEMENT DAMAGES

The majority’s interpretation of the Sherman Act not surprisingly was supported by
small business and its political allies in the progressive movement. In contrast, organizations
such as the National Civic Federation, which represented big business, lobbied
Congress to reject the majority’s interpretation and to overturn the Trans-Missouri opinion.
At the same time, Justice Peckham authored several more opinions holding fast to a
narrow interpretation of the Sherman Act and to the interpretation offered in the dissenting
opinion in Trans-Missouri Freight Association. Specifically, in 1898, Justice
Peckham authored United States v. Joint Traffic Assoc.10 and Hopkins v. United States.11

Between Judge Peckham’s opinions in Trans-Missouri Freight Association and Joint
Traffic, Judge Taft rendered his famous and highly lauded opinion in United States v.
Addyston Pipe & Steel Co.,12 in which he offered an alternative interpretation of the
Sherman Act. The Addyston Pipe case involved a challenge by the government to a cartel
of six pipe makers that had allocated customers through a bid-rigging arrangement.
Under the arrangement, one cartel member was designated as the real bidder and others
would submit (phony) high bids. The pipe makers claimed that stricter law applied to
the railroad industry than to other industries, and under the common law the pipe makers’
agreement should be judged reasonable. Judge Taft disagreed. Judge Taft distinguished
between “naked restraints,” those not ancillary to any larger legitimate contract,
and “ancillary restraints,” those reasonably necessary to fulfill the “main and lawful
purpose” of a contract. For an ancillary restraint to be legal, it must make the main
transaction more effective in accomplishing its legitimate purpose.13 Taft provided a
nonexhaustive list of transactions to which a restraint could be ancillary. The first example
Taft recited was “agreements by the seller of property or business not to compete
with the buyer in such a way as to derogate from the value of the property or business
sold.”14 In Judge Taft’s opinion, ancillary restraints are illegal only if they are part of a
transaction that involves a general scheme to control a market. The Supreme Court did
not adopt Judge Taft’s approach.

The Supreme Court also did not reevaluate how the Sherman Act should be applied
to horizontal restraints until 1911, when it issued its opinion in Standard Oil Co. of New
Jersey v. United States.15 In Standard Oil, the United States filed suit against John D.
Rockefeller’s Standard Oil, contending that Standard Oil had engaged in a series of
predatory pricing and cartel activities. Justice White, writing for the new majority on
the Court, overturned the earlier broad interpretation of the Sherman Act,16 stating
instead that “it follows that it was intended that the standard of reason which had been
applied at the common law and in this country in dealing with subjects of the character
embraced by the statute was intended to be the measure used for the purpose of determining
whether, in a given case, a particular act had or had not brought about the wrong
against which the statute provided.”17 In other words, the Court held for the first time
that only “unreasonable” restraints of trade, not “every” restraint of trade, are illegal.

Contrary to Justice Harlan’s dissent, Justice White’s opinion did not set forth an
open-ended rule of reason. Instead, Justice White clearly reasoned that the statute does


INTRODUCTION TO THE ANTITRUST LAWS

not mean “all” restraints of trade are illegal, but that Congress intended “to leave it to
be determined by the light of reason, guided by the principles of law,” which restraints
were to be prohibited.18 White’s rule of reason also contained structure. For instance, a
restraint on trade that by its inherent nature is anticompetitive should be condemned.19
This suggests a per se concept, even though little guidance is provided for which types
of conduct come within this category. If a restraint is not judged by its “inherent nature,”
the Court was then to examine its “inherent effect” (or market power) and its “evident
purpose” (or intent).20

The Standard Oil decision caused an immediate reaction in Congress. Progressive
movement forces feared that a conservative Supreme Court would take the teeth out of
the Sherman Act by determining much of the conduct of the trusts and monopolies to
be “reasonable.” Immediate work began on a new bill in Congress to specifically define
what acts would be unreasonable and would violate the law. This new bill eventually
would be the Clayton Act in 1914.

The Clayton Act and the Federal Trade Commission

The Clayton Act21 and the Federal Trade Commission Act22 were enacted simultaneously <,BR>in 1914. The Clayton Act aimed at defining specific practices that were anticompetitive
and to reach these anticompetitive practices in their incipiency.23 The Federal
Trade Commission (FTC) proscribed “unfair methods of competition” and established
an administrative enforcement procedure.24

The simultaneous enactment of these acts established a new framework, which some
believed to be an additional congressional step toward curbing the power of big business.
Other historians disagree. For example, Weinstein advanced the following view:

The Federal Trade Commission Act of 1914 is most often thought of as a Wilsonian reform
embodying a bias against “big business.” In fact, the principles underlying the FTC were
enunciated by corporation leaders and their lawyers consistently through the Progressive
Era in response to a series of legislative and judicial actions stretching over some seventeen
years.25

As in the case of the Sherman Act, the impact of the Clayton Act depends in part on
how it is enforced. According to Wise, with respect to the FTC:

doing something about the trusts was no longer the central issue of the day. Rather, it was a
consensus whose details were being worked out. But the devil is in the details; the form the
compromise package took foreshadowed the Commission’s almost immediate troubles.26

Specifically, the Clayton Act originally contained several loopholes that favored big
business. Section 7 of the Clayton Act covered acquisitions of “the whole or any part of
the stock or other share capital of another corporation.” Use of the term stock originally


PATENT INFRINGEMENT DAMAGES

excluded asset acquisitions from regulation. Likewise, the section 8 prohibition on
interlocking directors was easily circumvented by indirect interlocks.

Like the Sherman Act, the Clayton Act can be viewed as a political compromise.
Representatives of small business supported a law that specified that certain practices
were anticompetitive. In contrast, big business was particularly supportive of the FTC,
because it satisfied a long-standing desire for an administrative approach to antitrust
that would provide some certainty and consistency in enforcement.

The Clayton Act addresses the following practices:

a.
Section 3 prohibits tie-in sales, exclusive dealing and requirements contracts
where the effect “may be substantially to lessen competition or tend to create
a monopoly” in a relevant market.27
b.
Section 4 allows private plaintiffs to bring treble damages actions under the
Sherman Act and Clayton Act.28
c.
Section 6 exempts labor unions and agricultural cooperatives from the antitrust
laws.29
d.
Section 7 prohibits mergers and acquisitions where the effect “may be substantially
to lessen competition or tend to create a monopoly” in any relevant
market.30
e.
Section 8 prohibits interlocking directors of competing companies.31
Subsequent to 1914, the Clayton Act was amended several times. For example, the
Robinson-Patman Act32 of 1936 substantially amended section 2 to prohibit price discrimination
except in certain defined situations.33 The Celler-Kefauver34 Act of 1950
amended section 7 to close the loophole for “stock acquisitions” and generally tightened
the antimerger provisions.35 In 1976, a premerger reporting requirement was added
as section 7A.36 Finally, in 1990, section 8 was amended to prohibit both interlocking
directors and officers.37

The Federal Trade Commission Act created the FTC and gave it broad powers to
enforce the Sherman Act and the Clayton Act concurrent with the Department of Justice
(DOJ) and private parties. Section 5 of the Federal Trade Commission Act gave the
FTC exclusive authority to prosecute “unfair methods of competition” and “unfair or
deceptive acts or practices.”38 Section 5 has been subsequently interpreted to give the
FTC wide-ranging enforcement powers.

Antitrust Enforcement from World War I to World War II

Despite passage of the Clayton Act, prosecution of antitrust claims during the 1920s
was minimal. In the 1920s, business was encouraged to adopt “scientific management”
and to participate in trade associations that could provide industry data. The Supreme
Court curbed some abuses, but collaboration and mergers went largely unchecked.


INTRODUCTION TO THE ANTITRUST LAWS

During the Depression, the prominent theory of the collapse was excess competition. As
a result, during the first half of the New Deal, the National Recovery Administration
(NRA) organized business into industrial groups and suspended antitrust enforcement.
The views of Leon Henderson, the chief economist for the NRA, were typical of the
1920s. Henderson stated:

The Anti-Trust Acts are a throw-back to the Neolithic Age of statesmanship, and their blind
sponsorship is a sort of jittering caveman ignorance.39

By 1935, however, the NRA was under heavy criticism and was considered by many
to be unmanageable. That same year, the NRA was declared unconstitutional. Although
the economy certainly was not out of the Depression in 1935, the immediate emergency
situation was over, and the time was ripe for more conventional approaches. At the end
of the first New Deal, Franklin Roosevelt was tempted to reorganize industries using a
scheme similar to that of the NRA, but under private control in the tradition of trade
associations of the 1920s. However, he ultimately decided to return to vigorous antitrust
enforcement as a method to resolve price flexibility problems. The historian Herbert
Stein summarizes Roosevelt’s dramatic change in attitude as follows40:

At the same time many of the President’s advisors, even the “planners” among them, were
afraid of giving so much control to the businessmen [within new “private” codes]. The prevailing
view of this subject within the administration ran in the opposite direction—to take
steps to curb the “concentration of economic power.” Roosevelt went along with this to the
extent of sending Congress a special message on the subject in April, 1938. Congress
responded by setting up the Temporary National Economic Committee. . . .41

The Depression itself had a devastating effect on the traditional sector of industry.
The collapse of obsolete firms was a major factor in the long duration of the Depression,
but it also is important to stress the other side of the coin: that the Depression also was
an important event in the transition to a new economy dominated by large efficient
enterprises, both politically and institutionally. Without the rivalry of the traditional
small firms, the post–World War II period became an era of reevaluation and revamping
of the goals and objectives of the antitrust laws, and an increase in importance of
intellectual property.

THE GOALS OF THE ANTITRUST LAWS

In the post–World War II period, four competing goals of the antitrust laws emerged.
These goals include the need to protect simple businesses, to encourage allocative efficiency,
to prevent wealth transfers from buyers to sellers, and to encourage dynamic or
innovative efficiency.


PATENT INFRINGEMENT DAMAGES

Protection of Small Business

Many earlier antitrust opinions held that the antitrust laws should protect the independence
of small, often locally owned, businesses. In attempts to protect small businesses,
the courts and commentators alike have relied on various democratic rationales. For
example, in United States v. Trans-Missouri Freight Ass’n,42 the Supreme Court’s decision,
authored by Justice Peckham, stated that large firms and concentrated industries
were not in the substantial interest of the country or its citizens. The Court reasoned:

[I]t is not for the real prosperity of any country that such changes should occur which result
in transferring an independent business man, the head of his establishment, small though it
might be, into a mere servant or agent of a corporation for selling the commodities which he
once manufactured or dealt in, having no voice in shaping the business policy for the company
and bound to obey orders issued by others.43

In addition, many commentators have suggested that the concentration of wealth would
lead to the concentration of political power. Therefore, the argument goes, preservation
of small business protects the vitality of democracy.

Allocative Efficiency

The ascendant view of the goals of antitrust laws in the post–World War II period is that
antitrust laws are aimed at protecting consumers, not small business. It is conceivable
that this change may have been made possible by the destruction of the political power
of small business during the Depression. Nonetheless, once the interests of consumers
take center stage, microeconomics provides an elegant and powerful tool to analyze the
impact of corporate practices on consumer welfare. According to economists, consumer
welfare is maximized at the competitive price and output. Any price and output pair
other than the competitive price and output generates some “deadweight loss” to society.
This means that resources are not deployed to their highest valued use. Some
judges, including Judge Robert Bork and Judge Richard Posner, have prominently
advocated the view that the only viable goal of the antitrust laws is to maximize consumer
surplus.44

Wealth Transfers

The result of reducing prices from monopoly pricing to competitive pricing is twofold:
it increases consumer surplus and reduces monopoly profits. Lande has argued in
response to a pure consumer welfare goal that Congress, in passing various antitrust
laws, was more interested in preventing transfers of wealth from consumers to monopolies
than in increasing consumer surplus.45 The DOJ recognizes the need to protect
against the transfer of wealth from buyers to sellers and the misallocation of resources
as goals in its enforcement statements.46


INTRODUCTION TO THE ANTITRUST LAWS

Dynamic Efficiency or Innovation Efficiency

More recently, the antitrust agencies and the courts have recognized that innovation is
an important source of consumer welfare. Dynamic efficiency was discussed at length
in Chapter 3. As a result of new research on technological change, preventing conduct
that reduces competition for future innovation has become an object of antitrust
enforcement. The Intellectual Property Guidelines address concerns about innovation
efficiency by considering the impact of IP acquisitions and licensing on three types
of markets: (1) traditional “goods” markets, (2) “technology” markets that consist of IP
and their substitutes, and (3) “innovation” markets that consider the impact of conduct
on research and development activities.

ANTITRUST CLAIMS UNDER SECTION 1 OF THE SHERMAN ACT

This section summarizes the primary recognized violations of the antitrust laws. It is not
exhaustive, but instead is meant only as an introduction to be used by lawyers and
experts in IP cases to identify possible issues for further research.

Section 1 of the Sherman Act47 prohibits any “contract, combination...or conspiracy”
that creates an unreasonable restraint of trade.48 Intellectual property license often
involves horizontal restraints. These restraints can take the form of territorial divisions,
covenants not to compete, or other restrictions on competition between licensors and
licensees. Attorneys and experts must be careful not to allow such restraints, whether in
the form of a settlement to infringement litigation or a licensing arrangement to be
structured in a manner that violates section 1 of the Sherman Act.

A section 1 claim requires that two elements be proven. First, an agreement between
two or more persons must exist (“contract, combination, or conspiracy”). Second, the
agreement must involve an “unreasonable” restraint of trade.

An Agreement

An agreement requires either a meeting of the minds to accomplish some goal or the
coerced cooperation of several parties under the leadership of a ringleader. An agreement
can be demonstrated from either direct evidence or circumstantial evidence.
Circumstantial evidence requires such evidence “that tends to exclude the possibility
that the alleged conspirators acted independently.”49 In other words, circumstantial evidence
consistent with unilateral action is not sufficient to establish an illegal agreement.

Unilateral conduct cannot be a basis for a section 1 claim. This was made clear in
1987 by the Supreme Court in Copperweld Corp. v. Independence Tube Corp.50 There,
the Court stated that “Section 1 of the Sherman Act . . . reaches unreasonable restraints
of trade effected by a ‘contract, combination...or conspiracy’ between separate
entities, and does not reach conduct that is ‘wholly unilateral.’”51 The Court went on to


PATENT INFRINGEMENT DAMAGES

hold that wholly owned subsidiaries of a corporation cannot conspire for section 1 purposes.
52

Rule of Reason, Per Se, and Quick-Look Approaches to
Conduct Under Section 1 of the Sherman Act

Once an agreement has been demonstrated, it also must be shown that the restraint at
issue is unreasonable. An unreasonable restraint of trade can be established under the
per se test, the rule of reason test, or more recently the quick-look test. This is one of
the most difficult and controversial areas of antitrust jurisprudence, yet it is a critical
area for IP licensing and joint development.

Rule of Reason. It is arguable that the full-blown rule of reason approach was established
in 1918 by Justice Brandeis in Board of Trade of Chicago v. United States,53 as
opposed to being established in Standard Oil. Board of Trade of Chicago involved a
challenge to the Chicago Board of Trade’s call rule in which dealers agreed that grain
purchased after the trading session ended (in transit to Chicago) would be purchased at
the closing price. The case, however, is important not for its facts but for its method.
According to the majority decision authored by Justice Brandeis, a restraint on trade
violates section 1 of the Sherman Act when it suppresses or destroys competition as
opposed to merely regulating and perhaps promoting competition.54 To determine the
effect of a restraint, the Court mandated a full inquiry into the:

[F]acts peculiar to the business to which the restraint is applied, its condition before and after
the restraint was imposed; the nature of the restraint and its effect, actual or probable. The history
of the restraint, the evil believed to exist, the reason for adopting the particular remedy,
the purpose or end sought to be attained, are all relevant facts.55

The Court concluded that these factors were important because intent was relevant to
the analysis. Specifically, the Court stated that knowledge of intent may help the Court
to interpret facts and predict consequences.56 There is a simple efficiency explanation
for this rule. Large dealers had much better information about grain in transit and could
obtain better deals from small dealers after the trading session closed than they could
during the day when information was revealed during the bidding process. Justice
Brandeis came to the right conclusion, but he never clearly stated why.

Following the Board of Trade of Chicago opinion, the prevailing legal opinion was
that the rule of reason applied to all or most restraints of trade.57 The extent of the penetration
of the rule of reason analysis can be judged from the Supreme Court’s subsequent
1933 opinion in Appalachian Coals, Inc. v. United States.58 In Appalachian Coals,
the government challenged a classic cartel of coal producers that set prices for the sale
of coal through a single selling agency. This “selling agency” was formed in response
to the depressed conditions in the coal market due to oversupply and the eroding


INTRODUCTION TO THE ANTITRUST LAWS

demand resulting from the Depression. The plan was enjoined by the district court, but
the Supreme Court reversed, holding that the serious decline in the industry justified “an
honest effort to remove abuses, to make competition fairer, and thus to promote the
essential interests of commerce.”59 Thus, the Court applied the rule of reason and
upheld a restraint that was nothing more than a price-fixing scheme. The Court did this
on the grounds of preventing ruinous competition,60 an argument that had been consistently
rejected since the Supreme Court’s 1897 decision in the Trans-Missouri case. The
Appalachian Coals decision shows how strong the prevailing view—that the rule of
reason should be widely applied to horizontal restraints—was at that time.

The Rise of the Per Se Rule. The Supreme Court first articulated a per se rule for
price-fixing in 1927 in United States v. Trenton Potteries Co.61 Trenton Potteries upheld
a trial court opinion that a price-fixing scheme involving 82 percent of the market for
pottery fixtures for bathrooms and lavatories was conclusively unreasonable without a
rule of reason analysis and therefore illegal under the Sherman Act.62 In upholding the
lower court, the Supreme Court held that even if a cartel set a reasonable price today, it
is dangerous for the cartel to possess pricing power because that same reasonable price
may prove unreasonable in the future.63 Moreover, the Court reasoned that relying on a
judicial determination of what is reasonable independent of the competitive process is
a useless endeavor. The Court could have obtained the same result by contending that
the agreement was not ancillary to a contract with a lawful purpose. Instead, the Court
essentially held that price-fixing was per se illegal, ancillary or not.64

The tension between Trenton Potteries and Appalachian Coal was resolved by Justice
Douglas’s opinion in United States v. Socony-Vacuum Oil Co. Inc.65 Socony-Vacuum represents
the apex of per se condemnation. Socony-Vacuum involved a buying scheme that
impacted the spot price of gasoline. There was no direct price-fixing as in Trenton
Potteries. The spot price of gasoline impacted numerous contracts and had a dramatic
impact on overall prices. Under the NRA, which repealed the Sherman Act for approved
industry coordination, the petroleum industry had attempted to control the spot price of
gasoline. However, even after the repeal of the NRA, the petroleum industry continued
to try to prevent the decline of spot prices by establishing “dancing partners” between the
major oil producers and the independents. Under the plan, the majors would purchase
“distress” gas from independents, which provided a floor for the spot price. In now-
famous language, the Supreme Court struck down the scheme as per se illegal holding:

Under the Sherman Act a combination formed for the purpose and with the effect of raising,
depressing, fixing, pegging, or stabilizing the price of a commodity in interstate or foreign
commerce is illegal per se.66

The language of Socony-Vacuum is very broad. The Socony-Vacuum Court essentially
held that any horizontal constraint that impacts prices is presumed to be unreasonable


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per se.67 This abbreviated approach stands in stark contrast to the broad application of
the rule of reason approach announced in Board of Trade of Chicago.

Finally, the Supreme Court returned to articulating the per se rule in Northern Pacific
Railway Co. v. United States.68 Although the case was a tying case, the Court took the
opportunity to explain the rationale behind the per se approach:

However, there are certain agreements or practices which because of their pernicious effect
on competition and lack of any redeeming virtue are conclusively presumed to be unreasonable
and therefore illegal without elaborate inquiry as to the precise harm they have caused or
the business excuse for their use. This principle of per se unreasonableness not only makes
the type of restraints which are proscribed by the Sherman Act more certain to the benefit of
everyone concerned, but it also avoids the necessity for an incredibly complicated and prolonged
economic investigation. . . .69

To date, Socony-Vacuum and Northern Pacific are the most widely cited cases advocating
a broad application of the per se rule.

Recent Erosion of the Per Se Rule. The Supreme Court revisited the per se rule in
National Society of Professional Engineers v. United States.70 In National Society, the
association of engineers required as a condition of membership that its members not
discuss the question of fees until a client had selected an engineer. The United States
challenged the restriction as an agreement to suppress price competition. The engineers
disagreed, arguing that bidding to the lowest price could threaten public health and
safety. The district court rejected the defense, and the Court of Appeals affirmed. The
Supreme Court also affirmed, but indicated that, under some conditions, restrictions on
certain practices that impact competition might be reasonable.71 The Court went on to
state that only two categories of antitrust analysis exist. The first category involves
“agreements whose nature and necessary effect are so plainly anticompetitive that no
elaborate study of the industry is needed to establish their illegality—they are ‘illegal
per se.’”72 The Court identified these agreements as the proper province of the per se
rule. The second category includes “agreements whose competitive effect can only be
evaluated by analyzing the facts peculiar to the business, the history of the restraint, and
the reasons why it was imposed.”73 These agreements require treatment under the rule
of reason. The Court concluded, however, that a ban on competitive bidding fell within
the per se category.74

A year earlier, the Supreme Court had overturned the rule, announced in United
States v. Arnold Schwinn & Co.,75 that all vertical territorial restrains were per se illegal.
In Continental T.V., Inc. v. GTE Sylvania, Inc., the Court held that such restraints
would in the future be governed by the rule of reason.76 In the opinion, the Court recognized
that the rule of reason is the prevailing standard, and thus retreated from
Socony-Vacuum, stating:


INTRODUCTION TO THE ANTITRUST LAWS

Since the early years of this century a judicial gloss on [Section I] has established the “rule of
reason” as the prevailing standard of analysis. Under this rule, the fact finder weighs all of the
circumstances of a case in deciding whether a restrictive practice should be prohibited as
imposing an unreasonable restraint on competition. Per se rules of illegality are appropriate
only when they relate to conduct that is manifestly anticompetitive.77

The Court went on to claim that the market impact of vertical restrictions “is complex
because of their potential for a simultaneous reduction of intrabrand competition and
stimulation of interbrand competition.”78 The Court further described the per se rule as
a “demanding standard” and made clear that any “departure from the rule of reason
standard must be based upon demonstratable economic effect rather than . . . upon formalistic
line drawing.”79 As a result, the court concluded that vertical nonprice
restraints are not an appropriate candidate for per se treatment.80

The Supreme Court further retreated from Socony-Vacuum in three cases involving
claims of horizontal price-fixing: Broadcast Music, Inc. v. Columbia Broadcasting
System, Inc. (BMI)81; Arizona v. Maricopa County Medical Society (Maricopa)82; and
NCAA v. Board of Regents of University of Oklahoma (NCAA)83. BMI followed
Sylvania’s assertion that the per se rule should be limited to restraints that are clearly or
manifestly anticompetitive. For years, BMI and its codefendant (ASCAP) represented
composers and holders of copyrights to musical works. Broadcast Music, Inc. offered
buyers a blanket license to all of its copyrighted works or a program license for a use
of all of its works for a specific program. Columbia Broadcasting System challenged
the license as per se price-fixing. Under Socony-Vacuum, there is no doubt that CBS
should have prevailed. Instead, however, the Court upheld BMI’s licensing plan. The
BMI Court introduced a two-step approach to analyzing horizontal restraints in the following
passage:

As generally used in the antitrust field, “price-fixing” is a shorthand way of describing certain
categories of business behavior to which the per se rule has been held applicable. The
Court of Appeals’ literal approach does not alone establish that this particular practice is one
of those types or that it is “plainly anticompetitive” and very likely without “redeeming
virtue.” Literalness is over simplistic and often over broad. When two partners set the price
of their goods or services they are literally “price-fixing,” but they are not per se in violation
of the Sherman Act.... Thus, it is necessary to characterize the challenged conduct as falling
within or without the category of behavior to which we apply the label “per se price-fixing.”
That will often, but not always be a simple matter....84

The BMI Court went on to hold that the horizontal price-fixing rule should not be
applied to the blanket copyright license at issue, because it “is not a naked restrain[t] of
trade with no purpose except stifling of competition, but rather accompanies the integration
of sales, monitoring, and enforcement against unauthorized copyright use.”85
The BMI opinion linked the concept of ancillary restraint to the effect of an agreement
that increased productive efficiency through integration. The Court deemed as signifi



PATENT INFRINGEMENT DAMAGES

cant the fact that without the pricing limitation, it would not be possible to offer the
product itself.86

The Supreme Court’s decision in Maricopa is consistent with BMI, despite the fact
that it reached a different result. In Maricopa, the Court dealt with an arrangement in
which doctors in Arizona fixed maximum prices. The Court held that these maximum
price schedules were simply an invitation to set minimum prices and declared the agreement
per se illegal.87 The Court contrasted the arrangement among the independent
doctors with the efficiencies that would result from an integration such as a merger or
a joint venture:

If a clinic offers complete medical coverage for a flat fee, the cooperating doctors would have
the type of partnership arrangement in which a price-fixing agreement among the doctors
would be perfectly proper. But the fee agreements disclosed by the record in this case are
among independent competing entrepreneurs. They fit squarely into the horizontal price-fixing
mold.88

Accordingly, because no production efficiencies were created and because no new product
was developed, the Court held that the scheme was a naked constraint that was per
se illegal.89

The Supreme Court’s opinion in NCAA is also consistent with BMI and Maricopa. The
litigation involved a challenge to the NCAA plan that allocated rights to televise college
football games. The NCAA Court found that the plan prevented schools from conducting
separate price negotiations and artificially limited output.90 Nevertheless, the Court
rejected the per se approach because the “case involves an industry in which horizontal
restraints on competition are essential if the product is to be available at all.”91 The NCAA
Court then concluded that the restraint violated the Sherman Act because it was not truly
necessary for the production of the product, “college football.”92 Put differently, the Court
found potential production efficiencies from the NCAA joint venture, but the output
restriction at issue was not be shown to be linked to the attainment of these efficiencies.
Had this link been demonstrated, the Court likely would have approved the restraint.

In 1986, the Supreme Court again addressed the issue of per se treatment of a group
boycott in FTC v. Indiana Federation of Dentists.93 Briefly, the facts involved a joint
effort by Indiana dentists to resist insurance company requests for dental X rays as part
of the paperwork required for reimbursement. The Court stated as follows:

[W]e decline to resolve this case by forcing the Federation’s policy into the “boycott” pigeonhole
and invoking the per se rule. As we observed last term in Northwest Wholesale
Stationers, Inc. v. Pacific Stationary Printing Co., 472 U.S. 284, 105 S. Ct. 2613, 86 L.Ed.2d
202 (1985), the category of restraints clauses as group boycotts is not to be expanded indiscriminately,
and the per se approach has generally been limited to cases in which firms with
market power boycott suppliers or customers.... [W]e have been slow to . . . extend per se
analysis to restraints imposed in the context of business relationships where the economic
impact of certain practices is not immediately obvious....94


INTRODUCTION TO THE ANTITRUST LAWS

The Court went on to condemn the dentists’ practice under the rule of reason.95

The Quick Look. The trend toward erosion of the per se rule has continued in the
Supreme Court. The NCAA, in particular, ushered in an approach to horizontal restraints
called the “structured rule of reason” or “quick look.”96 The quick-look approach is
applied when the Court is not sufficiently familiar with the specific fact pattern, yet the
conduct is suspicious enough that it could fall within a suspect per se category.97 Under
the quick look, the plaintiff need prove only that a restraint is a type of agreement that
is likely to have anticompetitive effects. After such a showing is made, the burden of
proof shifts to the defendant to demonstrate any procompetitive justification for the
restraint. If the defendant can make such a showing, then the analysis reverts to a full-
scale rule of reason analysis.

In California Dental Ass’n v. FTC,98 the Ninth Circuit used a quick-look analysis to
address a restraint by California dentists that limited advertising. The dentists’ argument
that the restraint prevented false advertising was rejected by the Ninth Circuit.99 On
appeal, the Supreme Court reversed, holding that “the Court of Appeals erred when it
held as a matter of law that quick look analysis was appropriate.”100 The Court
remanded the case, not for per se treatment, but for a full rule of reason analysis.101 In
addition, the Court concluded that there is “no categorical line to be drawn between
restraints that give rise to an intuitively obvious inference of anticompetitive effect and
those that call for more detailed treatment. What is required, rather, is an enquiry meant
for the case, looking to the circumstances, details, and logic of a restraint.”102 “The truth
is that our categories of analysis of anticompetitive effect are less fixed than terms like
per se, quick look, and rule of reason tend to make them appear.”103 The Court, therefore,
pushed even farther away from perfunctory per se condemnation toward the
approach used in Chicago Board of Trade.

In the dissent, Justice Breyer agreed with the majority that a rule of reason approach
was appropriate but sought to provide guidance and structure to the analysis. To this
end, he set forth an approach to horizontal restraints that many commentators believe
probably will be adopted by courts in the future:

I would break that question down into four classical, subsidiary antitrust questions: (1) What
is the specific restraint at issue? (2) What are its likely anticompetitive effects? (3) Are there
offsetting competitive justifications? (4) Do the parties have sufficient market power to make
a difference?104

The Views of the Federal Antitrust Enforcement Agencies. Both the FTC and the
DOJ (collectively, the Agencies) have specifically rejected a strict per se approach in all
but the most narrow of circumstances.

In the Department of Justice Antitrust Enforcement Guidelines for International
Operations, the DOJ adopted an approach where the per se rule was restricted to


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“restraint[s] that [are] inherently likely to restrict output or raise price and [are] not
plausibly related to some form of economic integration (by contract or otherwise) of the
parties’ operations that in general may generate procompetitive efficiencies.”105 More
recently, in 1996, then Assistant Attorney General Joel Klein unveiled the DOJ’s “stepwise”
approach for review of horizontal restraints.106 Under the stepwise approach, the
DOJ first determines whether the restraint clearly falls within a per se category. When
determining whether an agreement should be subject to per se treatment, the DOJ looks
to see whether the agreement is ancillary and necessary for accomplishing a lawful
agreement. If the agreement is not ancillary, the inquiry ends. If the restraint is ancillary,
then the DOJ further inquires into whether there is a procompetitive justification.
If there is, then the DOJ will determine whether such procompetitive benefits outweigh
any anticompetitive effects. Interestingly, Klein specifically criticized the Topco decision
for ignoring the clear procompetitive effects that resulted from the private label
program. Such efficiencies would have removed the restraint from per se scrutiny by
the DOJ. William Kolasky, the deputy to the current Assistant Attorney General Charles
James, responded to the DOJ’s stepwise approach in an article, published in Antitrust
Magazine, contending that it misplaces the burden on defendants to show efficiencies
in the second step.107 Kolasky’s article may or may not be indicative of the current DOJ
position after Klein’s departure.

The recent United States Department of Justice and Federal Trade Commission
Antitrust Guidelines for Collaborations Among Competitors (Joint Venture Guidelines)
also counsel that the Agencies will consider efficiencies prior to condemning a restraint
as per se:

If, however, participants in an efficiency-enhancing integration of economic activity enter into
an agreement that is reasonably related to the integration and reasonably necessary to achieve
its procompetitive benefits, the Agencies analyze the agreement under the rule of reason, even
if it is of a type that might be considered per se illegal.108

In the FTC’s 1988 decision, In re Massachusetts Board of Registration in Optometry,
the FTC rejected the per se rule of reason dichotomy and replaced it with a three-step
decision analysis. The FTC stated:

First, we ask whether the restraint is “inherently suspect.” In other words, is the practice the
kind that appears likely, absent an efficiency justification, to “restraint competition and reduce
output?”. . . If the restraint is not inherently suspect, then the traditional rule of reason, with
attendant issues of definition and power, must be employed. But if it is inherently suspect, we
must pose a second question: Is there a plausible efficiency justification for the practice? That
is, does the practice seem capable of creating or enhancing competition (e.g., by reducing the
costs of producing or marketing the product, creating a new product, or improving the operation
of the market)? Such an efficiency defense is plausible if it cannot be rejected without
extensive factual inquiry. If it is not plausible, then the restraint can be quickly condemned.
But if the efficiency justification is plausible, further inquiry—a third inquiry—is needed to


INTRODUCTION TO THE ANTITRUST LAWS

determine whether the justification is really valid. If it is, it must be assessed under the full
balancing test of the rule of reason. But if the justification is, on examination, not valid, then
the practice is unreasonable and unlawful under the rule of reason without further inquiry—
there are no likely benefits to offset the threat to competition.109

Former chairman Pitofsky has contended that the per se approach still exists, but
only for restraints that both are “naked” and have no efficiency justification.110
Nonetheless, the FTC’s Massachusetts Board decision still provides insight into how
the FTC approaches the characterization of horizontal restraints.

Types of Conduct That Can Be Per Se Illegal
Under Section 1 of the Sherman Act

The potential per se categories of conduct include price-fixing (and bid-rigging), market
allocation, group boycotts, minimum resale price maintenance, and tying. Because
price-fixing has been discussed in the context of the development of the per se rule, we
begin our discussion with market allocation.

Market Allocation. Intellectual property licenses have sometimes been viewed as a
vehicle to divide territories or customers. As a result, it is important to understand the
characterization problem in connection with market allocation. In an early case,
National Ass’n of Window Glass Manufacturers v. United States, Justice Holmes actually
upheld an agreement among makers of handblown glass to operate only during half
the year.111 The purpose of the agreement was to allocate scarce labor between the factories.
112 Justice Holmes applied the full-blown rule of reason approach of Chicago
Board of Trade to uphold the agreement on the grounds that the industry could not survive
without it, and massive unemployment would result.113

Subsequent to Window Glass Manufacturers, the Supreme Court decided the Socony-
Vacuum case. In 1951, the Court had an opportunity to clarify its view on how to treat
horizontal market allocation in Timken Roller Bearing Co. v. United States.114 In
Timken, the government charged that Timken, British Timken, and French Timken
restrained trade in the sale of antifriction bearings. The parties had allocated territories
among themselves and attempted to fix prices on the products whenever one firm sold
in the territory of another firm. Timken defended its restraints as reasonable, arguing
that they were ancillary to a joint venture between the parties that was organized to
exploit the Timken trademark. The Supreme Court rejected this argument, holding that
the “dominant purpose for the restrictive agreements . . . was to avoid all competition.”
115 With respect to the trademark defense, the Court found that the parties had
gone far beyond what was necessary for trademark protection.116 Nevertheless, the
Court did not explicitly condemn the market allocation as per se illegal.

In 1966, the Supreme Court again addressed the post–Socony-Vacuum characterization
of market allocation in United States v. General Motors Corp.117 This case


PATENT INFRINGEMENT DAMAGES

involved General Motors’ “location clauses” contained in their dealer agreements that
prohibited a dealer from moving to or establishing “a new or different location.” Dealer
associations policed the agreements to prevent discounters. The Court struck down the
agreements as per se illegal on the grounds that the dealers were openly cooperating to
prevent discounters.118

Similarly, United States v. Sealy, Inc.119 involved an agreement among mattress manufacturers
that created mutually exclusive territories. Sealy retailers themselves monitored
and enforced agreements that set exclusive territories, retail prices, advertised
prices, and other terms of sale. The Court found concerning these practices that “[t]heir
anticompetitive nature and effect are so apparent and so serious that the courts will not
pause to assess them in light of the rule of reason.”120 As in Timken Roller, the Court
rejected Sealy’s defense that the territorial allocation was ancillary to the use of the
Sealy trademark.121

United States v. Topco Associates, Inc.122 was the first case before the Court in which
horizontal market division was presented in its pure form. The facts of the case were
that 25 small regional supermarkets (with market shares all below 10 percent) formed
Topco, a cooperative, to distribute to its members “private label” brand-name products.
Topco argued that this was required if its members were to compete successfully with
large chain stores, such as A&P, that had their own brands. The agreement between the
members contained an ancillary restraint that Topco private label products could only
be sold in the geographic area assigned to it by Topco. Citing Northern Pacific, Justice
Marshall wrote that “[o]ne of the classic examples of a per se violation of § 1 is an
agreement between competitors at the same level of the market structure to allocate territories
in order to minimize competition....We think that it is clear that the restraint
in this case is a horizontal one, and, therefore, a per se violation of § 1.123 As discussed
below, Topco is inconsistent with subsequent Supreme Court precedent and has been
widely criticized, although it has not been overruled.124

Since Topco, and following the precedent in BMI, Maricopa, Sylvania, and NCAA,
lower courts that have addressed horizontal market allocation have advocated a flexible,
non–per se approach.125 The three most important cases from the appellate courts
addressing division of territories are: (1) General Leaseways, Inc. v. National Truck
Leasing Ass’n (General Leaseways)126; (2) Polk Bros., Inc. v. Forest City Enterprises,
Inc. (Polk)127; and (3) Rothery Storage & Van Co. v. Atlas Van Lines, Inc. (Rothery
Storage)128. Each of these cases suggests that the application of the per se rule must
take into account possible efficiencies that may result from, and justify, any transaction
at issue.

In General Leaseways, Judge Posner recognized the per se rule expressed by Topco,
Sealy, and Timken, but indicated that the rule should not apply where the defendants
establish that their agreement facilitates market efficiencies. The defendants in General
Leaseways consisted of 130 competing trucking companies that had agreed not to operate
their leasing or repair businesses within certain designated territories. The agree



INTRODUCTION TO THE ANTITRUST LAWS

ment also contained a provision that required that participants perform emergency
repairs on each others’ trucks if the trucks happened to break down in their territories,
such repairs being subject to reimbursement from the other party. The Seventh Circuit
examined the possibility that the agreement contributed to certain economic efficiencies,
but it concluded that the territorial division was broader than necessary (i.e., not
the least restrictive means) to achieve the legitimate purpose of creating a nationwide
system of truck repairs, and therefore was per se illegal.129 However, by analyzing the
relationship between the per se rule and the alleged efficiencies of horizontal restraints,
the court indicated that the per se rule could not be applied without examining potential
economic efficiencies.130

Judge Posner even suggested that a division of geographic markets might have been
justified in Topco if Topco had established that its program would have prevented a market
inefficiency such as a free-rider problem (i.e., one grocer benefiting unfairly from
the promotional investment made by another grocer in a particular market).131
Regardless of whether the facts of Topco support that analysis, Judge Posner’s introduction
of efficiency considerations into the per se characterization problem undercuts
the simplified approach of merely classifying a type of transaction as a horizontal market
allocation once it is “alleged” and then declaring it per se illegal. Accordingly, Judge
Posner artfully constructed his analysis to be consistent with BMI, Maricopa, and
NCAA, indicating that those cases might best be explained by the “enormous efficiency”
of the arrangements involved therein and the need for those arrangements in order to
attain the efficiencies.132

In Polk, the Seventh Circuit addressed how to characterize market allocation after
BMI, Maricopa, and NCAA. The case involved two stores that agreed to share a single
building for the sale of their complementary products (lumber/hardware and home
appliances). The two companies also contracted not to sell competing products at that
store location. Although the arrangement was construed as a horizontal allocation of
market and customers, the Polk court examined the market effects of the agreement
rather than characterizing it as per se illegal.133 It held that if an agreement arguably
“promoted enterprise and productivity at the time it was adopted,” then the rule of reason
must be applied to distinguish legitimate competition from anticompetitive
effects.”134 Moreover, the Polk court noted that per se characterization is an unusual
step that should apply only to classic naked restraints, not ancillary restraints contributing
to “productivity through integration of efforts.”135 The court concluded that the
noncompetition provisions between the parties were necessary for “productive cooperation,”
or production efficiencies, and that consumers would benefit from the arrangement.
136 Accordingly, the court held that the per se rule did not apply to the agreement
at issue and ruled in favor of the defendants.137

The last important post-Topco market decision case (prior to Palmer, which is discussed
next) is Rothery Storage. In that case, Judge Bork (of the District of Columbia
Circuit Court) emphasized the inconsistency between Topco and subsequent Supreme


PATENT INFRINGEMENT DAMAGES

Court decisions, stating: “[R]ecent Supreme Court decisions... demonstrate[] . . . that,
to the extent Topco and Sealy stand for the proposition that all horizontal restraints are
illegal per se, they must be regarded as effectively overruled.”138 Rothery Storage concerned
a challenge to the Atlas network’s policy of terminating its agents (independent
moving companies throughout the country) that persisted in handling interstate carriage
on its own account as well as for Atlas as a group boycott. The Rothery Storage court
held that the restraints at issue were ancillary to the joint venture that constituted the
Atlas van line.139 In rejecting application of the per se rule, the court stated that “[t]he
restraints preserve the efficiencies of the nationwide van line by eliminating the problem
of the free ride.”140 The free-rider argument referred to the market efficiencies that
result from preventing these agents from benefiting from Atlas’s training, services, and
equipment without paying Atlas anything.

The court also rejected the per se rule because, after evaluating the specific facts, it
appeared that there was no possibility that the restraints could suppress market competition
or decrease output.141 The facts showed that Atlas had less than 6 percent of the
relevant market and therefore lacked the market power to impact market prices through
decreasing output.142 In addition, the Rothery Storage court ruled that a joint venture
made more efficient through ancillary restraints was equivalent to a corporate merger
and therefore should be evaluated under the rule of reason used in section 2 cases.143

Despite the opportunity to do so in its 1990 decision Palmer v. BRG of Georgia,
Inc.,144 the Supreme Court did not validate the erosion of Topco and the per se rule. In
Palmer, two competing companies offering bar review courses and related materials
entered into a noncompetition agreement for certain territorie,s. Part of the agreement
provided for one company to license its material and well-known name to the other
company for use in Georgia in exchange for a share of the resulting revenue. The two
companies argued that the noncompetition provisions were reasonable and were merely
ancillary to the IP license. Notwithstanding this argument, the Court found that the
revenue-sharing formula, particularly viewed in light of the price increase that took
place immediately after the licensor withdrew (as per the agreement) from Georgia,
established that the agreement was formed for the illegal purpose of raising prices and
thus constituted a per se violation.145

Group Boycotts. Another area in which antitrust law is applied to IP is concerted
refusals to deal or group boycotts. Boycotts can arise from certain patent pools and
cross-licensing agreements. Some types of group boycott and concerted refusals to deal
have been held to be per se illegal.146 For instance, in Klor’s, Inc. v. Broadway-Hale
Stores, Inc. (Klor’s), a large San Francisco department store, Broadway-Hale, secured
the agreement of several appliance manufacturers to boycott Klor’s, a small competitor
next door. Broadway defended on the grounds that even if Klor’s closed, it would not
impact competitors. The Supreme Court held that because the boycott was horizontal
and concerted, no analysis of competition was required.147 Earlier, in Fashion


INTRODUCTION TO THE ANTITRUST LAWS

Originators’ Guild of America v. FTC (Fashion Originators), the Supreme Court struck
down an effort by the Fashion Originators’ Guild to boycott retailers who sold copies of
the guild members’ “original creations.” The Court noted that the guild had market
power and engaged in activities beyond what could be justified by the control of copying.
148 The Court therefore held the boycott to be illegal.149 Radiant Burners, Inc. v.
Peoples Gas Light and Coke Co. involved a boycott in a standard-setting situation. In
that case, the Supreme Court determined that an agreement among gas companies to sell
natural gas only to customers using equipment approved by an industry organization
comprised of manufacturers of such equipment to be per se illegal.150

Not all boycott cases are per se cases. Generally, the cases in which the Supreme
Court has applied the per se rule to group boycotts typically have involved two types of
situations. In the first type of situation, a group of sellers or buyers refuses to allow a
competitor to participate in a trade association or other type of cooperative. In such
cases, the Court generally has held that per se treatment is reserved for cases where “the
cooperative possesses market power, or exclusive access to an element essential to
effective competition.”151 The second type of situation in which the Supreme Court typically
applies the per se rule involves a group of sellers boycotting customers to enforce
a price-fixing cartel. For example, in Federal Trade Commission v. Superior Court Trial
Lawyers Association,152 the Court held that an agreement by members of the Superior
Court Trial Lawyers Association to refuse representation to indigent criminal defendants
until the District of Columbia increased their compensation was subject to analysis
under the per se rules.153 The Court stated that the conduct involved “not only a
boycott but was also a horizontal price-fixing agreement—a type of conspiracy that
has been consistently analyzed as a per se violation for many decades.”154 In contrast,
in situations in which market power is not present or where important efficiencies can
be claimed as a result of the boycott, the Supreme Court has applied a rule of reason
approach.155

A more difficult fact situation is presented when the group boycott is undertaken by
consumers or buyers rather than by sellers. Although there have been numerous cases
involving boycotts by buyers, none has articulated a clear basis for distinguishing an
unlawful “buyer conspiracy” from a procompetitive joint purchasing arrangement.
Typically, if a court concludes that the boycott or joint action by the buyers has a negative
impact on competition with little legitimate business justification, it will invoke
the per se rule and then apply the analysis developed in seller cases.156 However, if
a court finds a plausible justification for the joint buyer activity, it will apply a rule of
reason analysis and thereafter require a substantial showing of competitive harm to
find liability.157

Minimum Resale Price Maintenance. Vertical arrangements that fix minimum resale
prices are included among the per se violations. The Supreme Court first addressed vertical
arrangements in Dr. Miles Medical Co. v. John Park & Sons Co.158 In Dr. Miles,


PATENT INFRINGEMENT DAMAGES

the Supreme Court considered a situation in which a manufacturer of proprietary medicines
(essentially “snake oil”) sought “to maintain certain prices fixed by it for all the
sales of its products both at wholesale and retail.”159 The Court likened the facts to
horizontal price-fixing, because the impact was the same as if the retailers had fixed
prices among themselves.160 The Court concluded that such vertical price-fixing was
per se illegal.161

Since the Dr. Miles decision, the rule against vertical price-fixing has withstood challenge.
Many economists have contended that manufacturers must establish retail margins
by limiting intraband competition, so that retailers can provide services and quality
assurance that allows the manufacturer to compete more effectively with other
brands.162 In contrast to vertical minimum price-setting, the Supreme Court has recently
held that vertical maximum price-setting is not a per se offense.163

Tying. The last per se section 1 category is tying. Tying or bundling the sale of two
products together can be a per se offense if (1) the seller has market power in the tying
product, (2) two separate products exist, (3) the sale of one product is conditioned on
the sale of the other product, and (4) substantial commerce in the tied market is
affected.164 In Jefferson Parish Hosp. Dist. No. 2 v. Hyde, an anesthesiologist challenged
East Jefferson Hospital’s practice of requiring all surgery patients to use a single
medical group for anesthesiology services. The danger that a tie posed for
competition was that the defendant may gain a monopoly in the tying and tied markets,
which would harm competition in the tied market. Moreover, tying could make entry
more difficult because a new entrant would have to sell in both markets to compete.
Conversely, tying could have procompetitive consequences.165

Although tying can have anticompetitive, procompetitive, or neutral effects, the
black-letter law is that tying is per se illegal when each of the abovementioned elements
is present. First, the bundle or tie must involve at least two products. Separate
products exist when there is separate consumer demand for each product.166 Second,
the defendant must have market power in the tying market.167 This typically is defined
as a large market share in the relevant market. Third, the sale of the separate products
must be conditioned (i.e., you cannot reasonably buy one without the other).168
Fourth, there must be some “not insubstantial” impact on the tied market.169 In addition,
some but not all courts require some showing of an anticompetitive effect of a relevant
market.170

Although tying is considered a per se offense, courts have often considered business
justifications for tying. For example, in United States v. Jerrold Electronics
Corp.,171 the district court upheld a tie of components of a system and service during
a company’s development period because it ensured the proper functioning of
a complex system. Ties also have been used when it is required to protect trade
secrets.172 Quality control generally is not a defense if less restrictive alternatives
are available.173


INTRODUCTION TO THE ANTITRUST LAWS

Finally, if a plaintiff cannot prove the elements of a per se tying case, tying can
be brought under the rule of reason if significant adverse effects on competition can be
shown.174

Conduct Judged Under the Rule of Reason for Purposes of Section 1

In contrast to the per se test, the rule of reason approach requires a full competitive
analysis to determine whether a restraint on balance harms competition. According to
the Supreme Court, under a rule of reason analysis “the fact finder weighs all of the circumstances
of a case in deciding whether a restrictive practice should be prohibited as
imposing an unreasonable restraint on competition.”175 The rule of reason does not
“open the field” to any argument. Instead, the rule of reason takes into account all of the
factors necessary to determine whether the restraint “is one that promotes competition
or one that suppresses competition.”176 In other words, the rule of reason requires an
analysis of markets and market power, and any direct evidence of prices and output to
determine the extent of any anticompetitive impact of a restraint. It then weighs this
effect against all procompetitive efficiencies, increased competition, and legitimate
business justifications. The rule of reason offenses that could relate to IP include vertical
non-price restraints, such as exclusive dealing or exclusive territories. Each of these
offenses requires a more complete competitive analysis.

Exclusive Dealing. The early law of exclusive dealing did not involve a full rule of
reason analysis. In Standard Oil Co. of California and Standard Stations, Inc. v. United
States (Standard Stations),177 a full-blown rule of reason analysis was not available
because, as the Court reasoned:

To insist upon such an investigation would be to stultify the force of Congress’ declaration
that requirements contracts are to be prohibited wherever their effect “may be” to substantially
lessen competition. . . . We conclude, therefore, that the qualifying clause of Section 3
[of the Clayton Act] is satisfied by proof that competition has been foreclosed in a substantial
share of the line of commerce affected.178

Under this so-called “quantitative substantiality test,” the aftermarket entrant would
need only to demonstrate the existence of foreclosure in the distribution channel, and
no effective competitive effects defense would be possible.179

In 1961 the Supreme Court revisited the issue of exclusive dealing in Tampa Electric
Co. v. Nashville Coal Co. (Tampa)180 In Tampa, the Court rejected the quantitative substantiality
test advocated by the Standard Stations Court and instead adopted what has
come to be known as the “qualitative substantiality” test.181 The Tampa Court summarized
its guidelines for analyzing exclusive dealing arrangements as follows: “First, the
line of commerce... involved must be determined.... Second, the area of effective
competition in the known line of commerce must be charted.... Third, and last, the


PATENT INFRINGEMENT DAMAGES

competition foreclosed by the contract must be found to constitute a substantial share
of the relevant market.”182 The requirement of defining the relevant market was a critical
advance.183

The Court’s decision in Jefferson Parish Hospital District No. 2 v. Hyde184 may have
increased the importance of a competitive effects analysis when analyzing an exclusive
dealing contract. Although not addressed by the majority opinion, the issue was discussed
in Justice O’Connor’s concurrence, in which she stated: “[W]hether or not the
Hospital-Roux contract is characterized as a tie between distinct products, the contract
unquestionably does constitute exclusive dealing. Exclusive dealing arrangements are
independently subject to scrutiny under Section 1 of the Sherman Act, and are also analyzed
under the Rule of Reason.”185 Justice O’Connor further reasoned that “[e]xclusive
dealing arrangements may, in some circumstances, create or extend market power
of a supplier of the purchaser party to the exclusive dealing arrangement,” and thus may
restrain horizontal competition.186

In his typical style, Judge Posner, on the heels of the Jefferson Parish decision, cut
right to the point in Roland Machinery Co. v. Dresser Industries, Inc., stating187:

The exclusion of competitors is cause for antitrust concern only if it impairs the health of the
competitive process itself. Hence, a plaintiff must prove two things to show that an exclusive
dealing arrangement is unreasonable. First, he must prove that it is likely to keep at least one
significant competitor of the defendant from doing business in a relevant market. If there is
no exclusion of a significant competitor, the agreement cannot possibly harm competition.
Second, he must prove that the probable (not certain) effect of the exclusion will be to raise
prices above (and therefore reduce output below) the competitive level, or otherwise injure
competition; he must show in other words that the anticompetitive effects (if any) of the
exclusion outweigh any benefits to competition from it.188

More recently, several lower courts explicitly have given prominence to a competitive
effects analysis in exclusive dealing cases through full-blown rule of reason analyses.
For example, in Actom v. Merle Norman Cosmetics Inc.,189 the district court
introduced its analysis of an exclusive dealing arrangement by stating that “[v]ertical
non-price restraints of the type at issue in this case are subject to the Rule of Reason
analysis.”190 Citing the Ninth Circuit’s opinion in Thurman Industries v. Pay’N Pak
Stores, Inc.,191 the district court stated that “in order to prove injury to competition as
required by the rule of reason, plaintiffs must prove the relevant product and geographic
markets, and demonstrate the effects of the alleged restraints within those markets.”192
Then, combining the three-part test in Tampa with the traditional requirements of a rule
of reason analysis, the court concluded that “[t]o condemn exclusive dealing arrangements
after Tampa requires a detailed depiction of circumstances and the most careful
weighing of alleged dangers and potential benefits, which is to say the normal treatment
afforded by the rule of reason.”193


INTRODUCTION TO THE ANTITRUST LAWS

A similar approach can be found in Ryko Manufacturing Co. v. Eden Services.194
Extrapolating from Tampa, the Eighth Circuit held that the proper “test requires us to
examine the character of the relevant market and to assess the competitive impact of the
alleged constraints.”195 According to the court, where “the supplier imposing the provisions
has substantial market power, we may rely on the foreclosure rate alone to establish
the violation.”196 Moreover, “the plaintiff must show that the restraint . . . has a
probable adverse affect on interbrand competition.”197

Vertical Non-Price Restrictions. The rule of reason is also applied to exclusive distributors
or exclusive distributor territories. A contract in which a manufacturer appoints
a distributor as his sole or exclusive outlet is subject to the rule of reason.198 In United
States v. Arnold Schwinn & Co.,199 the government challenged an exclusive territorial
system of Schwinn distributors. The Court held, in a weakly reasoned opinion, that
territorial restraints were per se illegal. Schwinn later was overturned in 1977 in Continental
T.V., Inc. v. GTE Sylvania, Inc. (Sylvania).200 In Sylvania, the Court held that
non-price vertical restraints would be governed by the rule of reason.201 Because vertical
restrictions simultaneously reduce competition between dealers of a single brand but
may stimulate competition between brands, the Court held that a balancing of the harms
and benefits was necessary.202 In practice, a non-price vertical restraint will be upheld
if there exist good business justifications for the restraint, such as control of free riders
or to induce fixed investments by dealers. Lower courts have addressed such factors as
the purpose of the restrictions, analyzing whether less restrictive alternatives exist and
determining the market share of the supplier involved.

ANTITRUST CLAIMS UNDER SECTION 2 OF THE SHERMAN ACT

Although certain IP licensing practices can run afoul of section 2 of the Sherman Act,
it is far more likely that IP antitrust challenges will arise under section 1 of the Sherman
Act. Nonetheless, this chapter briefly addresses the basic elements of a section 2 antitrust
claim. Section 2 of the Sherman Act prohibits unilateral monopolization, attempted
monopolization, and conspiracy to monopolize. All section 2 claims are tested under the
rule of reason. Monopolization and attempted monopolization require possession of monopoly
power (or the dangerous probability of obtaining monopoly power for attempt),
plus an element of deliberateness. For example, in United States v. Grinnell Corp.,203
the Supreme Court expressed the elements of a monopolization case as follows:

The offense of monopoly under § 2 of the Sherman Act has two elements: (1) the possession
of monopoly power in the relevant market and (2) the willful acquisition or maintenance of
that power as distinguished from growth or development as a consequence of a superior product,
business consumer, or historic accident.204


PATENT INFRINGEMENT DAMAGES

The first element, monopoly power, is inferred from evidence of large market shares
in the relevant market along with barriers to entry.205 Typically, market shares at least
as large as 70 percent are required.206 For an attempt to monopolize, case market shares
above 60 percent are typically required.207

The second element of a monopolization case requires exclusionary or predatory
conduct. Various specific types of conduct can support a section 2 claim when monopoly
power is present, including predatory pricing, monopolization of an essential facility,
other types of exclusionary activity, anticompetitive use of an invalid patent,
leveraging monopoly power into another market, and raising rivals’ costs.

Predatory Pricing. There is a long and complicated history of the law and economics
of predatory pricing. Under current federal law, a predatory pricing claim now requires
two elements. First, a competitor must set prices below some level of incremental cost.
In addition, the competitor must have a realistic chance to recoup its losses after the target
competitor is driven from the market.208

Essential Facilities. Monopolization of an essential facility means that a monopolist
controls a bottleneck monopoly over some product or service required by others to be
viable competitors. In MCI Communications Corp. v. AT&T,209 the Seventh Circuit
identified four elements required to establish section 2 liability under the essential
facilities doctrine:

(1) control of the essential facility by a monopolist; (2) a competitor’s inability practically or
reasonably to duplicate the essential facility; (3) the denial of the use of the facility to a competitor;
and (4) the feasibility of providing the facility.210
Leveraging. Another type of exclusionary conduct that can support a section 2 claim
is leveraging. Leveraging is the use of monopoly power in one market to monopolize or
attempt to monopolize another market. In Alaska Airlines, Inc. v. United Airlines,
Inc.,211 the Ninth Circuit helped to clarify that a plaintiff alleging leveraging must show
that “the monopolist uses its power in the first market to [actually] acquire and maintain
a monopoly in the second market, or . . . attempt to do so. . . .”212

Raising Rivals’ Costs. Raising rivals’ costs refers to engaging in conduct that raises a
competitor’s costs. Such cost increases allow the predatory firm to raise its price and
thereby hurt consumers. Firms can raise a rival’s costs by causing its input prices to
increase, refusals to deal, or other conduct. Such cases often arise when the predator
firm is vertically integrated.213


INTRODUCTION TO THE ANTITRUST LAWS

ANTITRUST CLAIMS UNDER THE CLAYTON ACT


The only Clayton Act section that is relevant to IP issues is section 7. Section 7 of the
Clayton Act is the primary merger statute. It prohibits mergers or acquisitions of stock
or assets if their effect “may be substantially to lessen competition, or to tend to create
a monopoly.” Horizontal mergers increase concentration by reducing the number of
competitors in the market. Early cases applying section 7 to mergers interpreted even
small increases in concentration as pushing a competitive threat.214 The Supreme Court
also considered the trend in concentration.215 In United States v. Philadelphia Nat’l
Bank, the Supreme Court held that an increase in concentration was enough to establish
a presumption of illegality.216

Later cases have focused on a host of competitive factors such as ease of entry, buyer
power, efficiencies, and others. The 1992 Horizontal Merger Guidelines discussed in
Chapter 3 are a good indicator of how a court will analyze a merger. These guidelines
describe a five-step analytic process to determine whether a merger substantially harms
competition. The steps are: (1) define the relevant product and geographic markets that
would be impacted by the merger, (2) assess how much additional concentration will be
caused in those markets by the merger, (3) assess whether entry barriers into the relevant
markets are high, (4) consider the competitive effects of the merger, and (5) consider
any merger specific efficiencies that may result. Courts have followed a similar
approach to section 7 of the Clayton Act.

SUMMARY

This chapter introduced a brief history and the basic elements of the federal antitrust
laws. Intellectual property law is closely akin to antitrust law. Attorneys and experts
must be in a position to spot potential antitrust issues, avoid IP arguments that invoke
antitrust problems, and structure settlements or damage solutions that are not anti-
competitive.

ENDNOTES

[1] In concert with a sudden rise of the labor cost in the first half of the 1880s, these movements
resulted in significantly diminished returns on capital despite the increasing size of
the production units.
[2]
See Hans B. Thorelli, The Federal Antitrust Policy: Organization of an American
Tradition, Baltimore: The Johns Hopkins Press (1955), 66.
[3]
Hans B. Thorelli, The Federal Antitrust Policy, at 180–85, 226–29.

PATENT INFRINGEMENT DAMAGES

[4] The preservation of small producers was an explicit concern in the drafting of the
Sherman Antitrust bill. See id. at 27.

[5] Sherman Act of July 2, ch. 647, 26 Stat. 209 (1890).

[6] 166 U.S. 290 (1897).

[7] See United States v. Trans-Missouri Freight Ass’n, 166 U.S. 290, 327-29 1007 (1897).

[8] Id. at 323.

[9] See id. at 353–54 (J. White dissenting).

[10] 171 U.S. 505 (1898).

[11] 171 U.S. 578 (1898).

[12]
85 F. 271 (6th Cir. 1898).

[13]
Id. at 282.

[14]
Id. at 281. For an economic analysis, see generally Wesley L. Liebeler, 1984 Economic
Review of Antitrust Developments: Horizontal Restrictions, Efficiency, and “the Per Se
Rule,” 31 UCLA L. Rev. 1019 (1986).

[15] 221 U.S. 1 (1911).

[16]
See id. at 67–68.

[17]
Id. at 60.

[18]
Id. at 63, 64.

[19]
Id. at 75–77.

[20]
Id.

[21] Clayton Act, ch. 323, 38 Stat. 730 (1914).

[22]
Federal Trade Commission Act, ch. 311, 38 Stat. 717 (1914).

[23]
See generally 15 U.S.C. §§ 372a (1997).

[24]
See generally 15 U.S.C. §§ 1-58 (1997).

[25]
James Weinstein, The Corporate Ideal in the Liberal State, 1900–1918, Boston: Beacon
Press (1968), at 62.

[26]
Michael Wise, Robert M. Lafollette’s Progressive Wisconsin Idea and the Origin of the
Federal Trade Commission, Antritrust Report (1995) at 20–21.

[27] Currently codified at 15 U.S.C. § 14 (1997).

[28] Currently codified at 15 U.S.C. § 15 (1997).

[29] Currently codified at 15 U.S.C. § 17 (1997).

[30] Currently codified at 15 U.S.C. § 18 (1997).

[31] Currently codified at 15 U.S.C. § 19 (1997).

[32]
Robinson-Patman Act, ch. 592, §§ 2–4, 49 Stat. 1526 (1936).

[33]
See 15 U.S.C. §§ 13a, 13b (1997).

[34]
Celler-Kefauver Act, ch. 1184, 64 Stat. 1125 (1950).

[35]
See 15 U.S.C. §§ 18, 21 (1997).


INTRODUCTION TO THE ANTITRUST LAWS

[36]
See Pub. L. 94-435, Title II, § 201, 90 Stat. 1390 (1976); section 7 is currently codified at
15 U.S.C. § 18a (1997).
[37]
See Pub. L. 101-588, § 2, 104 Stat. 2879 (1990); section 8 of the Clayton Act is currently
codified at 15 U.S.C. § 19 (1997).
[38]
See 15 U.S.C. § 45 (1997).
[39] Arthur M. Schlesinger, The Politics of Upheaval, Houghton Mifflin Co. (1960), 390.
[40] Leon Henderson also had a dramatic change in attitude. Schlesinger summarizes Henderson’s
about-face as follows: “Leon Henderson, the vigorous and resourceful chief economist
of NRA, viewing the economic future late in 1935 from the rubble of his agency,
outlined one program to test the possibilities of competition. . . . The key problem as
Henderson saw it, was to restore price competition. He appreciated the strength of the tendency
toward economic concentration, and price inflexibility....I favor a positive program
for securing laissez faire, said Henderson—a multiple attack on concentration and
price rigidity, including the active use of the taxing power; the revision of the patent laws;
vigorous antitrust action; encouragement in co-operatives; yardstick competition; tariff
reduction, and so on.” Schlesinger, supra note 147, at 388.
[41] Herbert Stein, The Fiscal Revolution In America, American Enterprise Institute for Public
Policy Research (1969), 104.
[42] 166 U.S. 290 (1897).
[43]
Id. at 324.
[44]
See Robert Bork, The Antitrust Paradox 16 (1978); Richard Posner, Antitrust Law: An
Economic Perspective, Chicago: Univ. of Chicago (1976) at 8.
[45]
See Robert Lande, Wealth Transfers as the Original and Primary Concern of Antitrust:
The Efficiency Interpretation Challenged, 34 Hastings L.J. 65 (1982).
[46]
See, e.g., 1992 Horizontal Merger Guidelines § 0.1 (“[T]he result of the exercise of market
power is a transfer of wealth from buyers to sellers or a misallocation of resources”)
(emphasis added).
[47]
See 15 U.S.C. §§ 1–7 (1997).
[48] 15 U.S.C. § 1 (1997).
[49]
Matsushira Elec. Indus. Co. v. Zenith Radio Corp., 475 U.S. 574, 588 (1986)
[50] 467 U.S. 752, 767–68 (1987).
[51]
Id. at 753, 104 S. Ct. at 2733.
[52]
Id. at 771.
[53] 246 U.S. 231, 238–39 (1918).
[54]
Id. at 238.
[55]
Id.
[56]
Id. at 238–39.
[57] One exception was the trial court ruling in Trenton Potteries, discussed in the next section.
[58] 288 U.S. 344 (1993), overruled by Copper Crop. v. Independence Tube Corp., 467 U.S.
752, 104 S. Ct. 2731, 81 L. Ed. 2d 623 (1984).
[59]
Id. at 372.

PATENT INFRINGEMENT DAMAGES

[60]
Id. at 372–73.
[61] 273 U.S. 392 (1927).
[62]
Id. at 400–01.
[63]
Id. at 397–98.
[64]
Id. at 401–02, 47 S. Ct. at 381.
[65] 310 U.S. 150 (1940).
[66]
Id. at 223.
[67]
Id. at 223–24.
[68] 356 U.S. 1 (1958).
[69]
356 U.S. 1 at 549.
[70] 435 U.S. 679 (1978).
[71]
Id. at 688.
[72]
Id. at 692.
[73]
Id.
[74]
Id. at 696.
[75] 388 U.S. 365 (1967), overruled by Continental T.V., Inc. v. GTE Sylvania, Inc., 433 U.S.
36 (1977).
[76] 433 U.S. 36, 58 (1997). The Court, however, clarified that the opinion does not foreclose
the possibility that particular applications of vertical restrictions might justify per se prohibition.
See id.
[77]
Id. at 49–50.
[78]
Id. at 51.
[79]
Id. at 58–59; see also Center Video Indus. v. United Media, Inc., 995 F.2d 735, 737 (9th
Cir. 1993).
[80]
Id. at 59. In 1997, the Supreme Court ruled that maximum resale price restraints also
would no longer be subject to per se condemnation. See State Oil Co. v. Khan, 522 U.S.
3 (1997).
[81] 441 U.S. 1 (1979).
[82] 457 U.S. 332 (1982).
[83] 468 U.S. 85 (1984).
[84]
BMI, 441 U.S. at 9.
[85]
Id. at 2 (citations omitted).
[86] The next year, the Court appeared to somewhat retreat to Socony-Vacuum in Catalano,
Inc. v. Target Sales, Inc., 446 U.S. 643 (1980). In Catalano, the Court held that agreements
on credit arrangements were per se illegal. See id. at 648. The Catalano Court
apparently had no trouble “characterizing” the arrangement. See id.
[87]
See Maricopa County, 457 U.S. at 348.
[88]
Id. at 357.

INTRODUCTION TO THE ANTITRUST LAWS

[89]
Id. at 356–57.
[90]
See NCAA, 468 U.S. at 106-07.
[91]
Id. at 103–04.
[92]
Id. at 118–19.
[93] 476 U.S. 447 (1986).
[94]
Id. at 458–59.
[95]
Id. at 459. Following the Supreme Court’s line of cases on per se conduct, the Third
Circuit in United States v. Brown University, 5 F.3d 658 (3rd Cir. 1993), found that a cartel
of universities that met annually to exchange information and set financial aid amounts
was not per se illegal. The Court rejected per se treatment holding that “the test for determining
what constitutes per se unlawful price-fixing is one of substance, not semantics...
the fact that overlap may be said to involve price-fixing in a literal sense therefore
does not mean that it automatically qualifies as per se illegal price-fixing.” Significantly,
the Court found that evidence of direct impact was sufficient, and no market power
inquiry was necessary.
[96] In fact, the “quick look” approach originated in Chief Justice Berger’s dissent in Topco.
The first judge to use the term quick look was Judge Posner in Vogel v. American Society
of Appraisers, 744 F.2d 598 (7th Cir. 1984).
[97]
See NCAA, 468 U.S. at 109-10 and n.39, 104 S. Ct. at 2964-65 and n.39; Law v. NCAA,
134 F.3d 1010, 1019–21 (10th Cir. 1998); Chicago Pro. Sports LTD Partnership v. NBA,
961 F.2d 667, 674 (7th Cir. 1992) (applying quick look); Lie v. St. Joseph Hosp., 964 F.2d
567, 569 (6th Cir. 1992) (stating that quick-look approach applies “when the agreement
at issue is very similar to per se violations and might, but for prudential constraints, be
analyzed under the per se presumption”).
[98]
128 F.3d 720, 727 (9th Cir. 1997).
[99]
See id.
[100]
Cal. Dental Ass’n v. FTC, 526 U.S. 756 (1999).
[101]
Id. at 769 n.8.
[102]
Id. at 780–81.
[103]
Id. at 779.
[104] 526 U.S. at 782 (J. Breyer, dissenting).
See Stephen Calkins, California Dental
Association: Not a Quick Look But Not the Full Monty, 67 Antitrust L.J. 495 (2000);
Timothy J. Muris, The Rule of Reason After California Dental, 68 Antitrust L.J. 527
(2000).
[105] 4 Trade Reg. Rep. (CCH) 13, 109.
[106]
See Joel I. Klein, A Stepwise Approach to Antitrust Review of Horizontal Agreements
(Nov. 7, 1996).
[107] William Kolasky, The Department of Justice’s “Stepwise” Approach Imposes Too Heavy
a Burden on Parties to Horizontal Agreements, 12 Antitrust 41 (1998).
[108] Joint Venture Guidelines § 3.2.

PATENT INFRINGEMENT DAMAGES

[109]
In re Massachusetts Bd. of Registration in Optometry; 110 F.T.C. 549, 604 (1988)
(emphasis added). See application of this standard in Detroit Auto Dealers Ass’n, 955 F.2d
457, 469-70 (6th Cir.), cert. denied, 506 U.S. 972 (1992) (making rule of reason inquiry
into defendants’ market power and alleged efficiency justifications where defendants had
reached agreement limiting showroom hours and impact of that limitation was not immediately
apparent).
[110]
See Muris, The Rule of Reason After California Dental, 68 Antitrust L.J. 538 (2000).
[111] 263 U.S. 403, 413 (1923).
[112]
Id.
[113]
Id. at 411–12.
[114] 341 U.S. 593 (1951), overruled by Copperweld Corp. v. Independence Tube Corp., 467
U.S. 752 (1984).
[115]
Id. at 597.
[116]
Id. at 598.
[117] 384 U.S. 127 (1966).
[118]
Id. at 145.
[119] 388 U.S. 350.
[120]
Id. at 355.
[121]
Id. at 357 n.4.
[122] 405 U.S. 596 (1972).
[123]
Id. at 608, 92 S. Ct. at 1133.
[124]
See, e.g., Herbert Hovencamp, Federal Antitrust Policy 190–92 (1994) (“Although Topco
has never been overruled, it is widely criticized and not infrequently honored”).
[125] In applying the rule of reason analysis rather than the per se rule, the Eleventh Circuit
Court of Appeals stated that:
[T]he purpose of the per se rule is to dispose of cases quickly without the more detailed and
costly inquiry required under the rule of reason test. It is to be applied, however, “only when
history and analysis have shown that in sufficiently similar circumstances the rule of reason
unequivocally results in finding of liability under the Sherman Act. . . .” To use the per se rule
as a means of avoiding rule of reason analysis when it is unclear what the result would be
under the rule would subvert the intention and purpose of the rule.

Consultants & Designers, Inc. v. Butler Serv. Group, Inc., 720 F.2d 1553, 1562 (11th Cir.
1983). In accord with this logic, the Ninth Circuit applied the rule of reason where the
type of contract at issue was a novel agreement with which the judiciary lacked sufficient
experience to classify as a per se violation. See Northrop Corp. v. McDonnell Douglas
Corp., 705 F.2d 1030 (9th Cir. 1983) (analyzing “teaming agreement” between government
contractors that allowed the parties to allocate certain military projects between
them while pooling their expertise in relevant areas). But see United States v. Capitol
Serv., Inc., 568 F. Supp. 134, 151 (E.D. Wash. 1983) (finding that it was not necessary for
the court to have had experience with this particular type of agreement, so long as the
agreement fell within one of the designated per se categories, such as price-fixing). The


INTRODUCTION TO THE ANTITRUST LAWS

Ninth Circuit noted that, “[m]ore important, however, is the fact that... not only do the
agreements not preclude all competition between the parties’ respective variants of the F18,
they actually foster competition by allowing both parties to compete in a market from
which they were otherwise foreclosed.” Northrop, 705 F.2d at 1052–53. Accordingly, the
agreements could not constitute naked restraints of trade with the sole purpose of stifling
competition. See id. at 1053; see also SCFC ILC, Inc. v. Visa USA, Inc., 36 F.3d 958 (10th
Cir. 1994) (affirming application of rule of reason to restraints, and concluding that the
factors to examine in rejecting the per se rule included whether the restriction was ancillary,
whether the agreement resulted in decreased output, and whether the prices increased
after the agreement).

[126] 744 F.2d 588 (7th Cir. 1984).
[127] 776 F.2d 185 (7th Cir. 1985).
[128] 792 F.2d 210 (D.D.C. 1986).
[129]
General Leaseways, 744 F.2d at 595.
[130]
Id. at 595-96.
[131]
Id. at 592.
[132]
Id. at 594; see also Continental T.V., Inc. v. GTE Sylvania, Inc., 433 U.S. 36, 54–57
(1977); NCAA v. Bd. of Regents of the Univ. of Okla., 468 U.S. 85 (1984) (suggesting in
dicta that this kind of balancing would apply in horizontal restraints as well).
[133]
See Polk, 776 F.2d at 188–89.
[134]
Id. at 189 (citing BMI and NCAA in support of horizontal agreements that involve cooperation
among rivals and might produce “larger output and more desirable products”).
[135]
Id. at 188–90. For a criticism of Polk, see Ross, Principles of Antitrust Law, Agreements
to Divide Markets, at 57–158.
[136]
Id. at 189–90.
[137]
Id. at 191.
[138]
Rothery Storage, 792 F.2d at 226.
[139]
Id. at 229.
[140]
Id.
[141]
Id. at 229.
[142]
Id.
[143]
Id. at 230; see also Departnent of Justice Business Review Letter (Sept. 28, 2000) (analyzing
proposed collaboration as a merger and applying the rule of reason to proposed
restraints where restraints did not give the parties the ability to raise prices).
[144] 498 U.S. 46 (1990) (per curiam).
[145]
Id. at 49–50.
[146]
See, e.g., Radiant Burners, Inc. v. Peoples Gas Light & Coke Co., 364 U.S. 656 (1961);
Klor’s, Inc. v. Broadway-Hale Stores, Inc., 359 U.S. 207 (1959); Fashion Originators’
Guild of Am. v. FTC, 312 U.S. 457 (1941).
[147]
See Klor’s, 359 U.S. at 212–13.

PATENT INFRINGEMENT DAMAGES

[148]
See Fashion Originators, 312 U.S. at 467–68.
[149]
Id. at 468.
[150]
See Radiant Burners, 364 U.S. at 659–60.
[151]
See, e.g., Northwest Wholesale Stationers, Inc. v. Pacific Stationery & Printing Co., 472 U.S.
284, 296, 105 S. Ct. 2613-21, 86 L.Ed.2d 202 (1985); Registered Physical Therapists v.
Intermountain Health Care, 1988-2 Trade Cas. (CCH) and 68, 233 at 9, 484 (Dt. Utah 1988).
[152] 493 U.S. 411 (1990).
[153]
Id. at 436.
[154]
Id. at 436 n.19.
[155]
See, e.g., FTC v. Indiana Fed’n of Dentists, 476 U.S. 447 (1986) (analyzing refusal by a
group of dentists to forward X rays to insurance companies for medical reasons under
the rule of reason and held anticompetitive on balance); NCAA v. Bd. of Regents of the
Univ. of Okla., 468 U.S. 85 (1984) (stating exclusion had efficiency justification because
a sports league “would be completely ineffective if there were no rules”).
[156] Buyer conspiracies to depress prices have been found illegal per se in at least 18 cases.
See, e.g., Mandeville Island Farms, Inc. v. Am. Crystal Sugar Co., 334 U.S. 219 (1948);
Harkins Amusement Enters. v. Gen. Cinema Corp., 850 F.2d 477, 485-86 (9th Cir. 1988),
cert. denied, 488 U.S. 1019 (1989); United States v. Capitol Serv., Inc., 756 F.2d 502 (7th
Cir.), cert. denied, 474 U.S. 945 (1985); Reid Bros. Logging Co. v. Ketchikan Pulp Co.,
699 F.2d 1292 (9th Cir.), cert. denied, 464 U.S. 916 (1983); In re Beef Industry Antitrust
Litig., 600 F.2d 1148 (5th Cir. 1979), cert. denied, 449 U.S. 905 (1980), later appeal, 907
F.2d 510 (5th Dir. 1990); United States v. Champion Int’l Corp., 557 F.2d 1270 (9th Cir.),
cert. denied, 434 U.S. 938 (1977); Cackling Acre, Inc. v. Olson Farms, Inc., 541 F.2d 242
(10th Cir. 1976), cert. denied, 429 U.S. 1122 (1977); Nat’l Macaroni Mfrs. Ass’n v. FTC,
345 F.2d 421 (7th Cir. 1965); Union Carbide & Carbon Corp. v. Nisely, 300 F.2d 561
(10th Cir.), cert. dismissed, 371 U.S. 801 (1962); Live Poultry Dealers Protective Ass’n v.
United States, 4 F.2d 840 (2d Cir. 1924); Transor (Bermuda) Ltd. v. BP N. Am. Petroleum,
1990-1 Trade Cas. (CCH) and 68,998 (S.D.N.Y. 1990); United States v. Seville Indus.
Mach. Corp., 696 F. Supp. 986 (D.N.J. 1988); Barr v. Dramatists Guild, Inc., 575 F. Supp.
555 (S.D.N.Y. 1983); Gen. Cinema Corp. v. Buena Vista Dist. Co., 532 F. Supp. 1244
(C.D. Cal. 1982); Bray v. Safeway Stores, 392 F. Supp. 851 (N.D. Cal.), vacated following
settlement, 1975-2 Trade Cas. (CCH) and 60,533 (9th Cir. 1975); Robertson v. NBA,
389 F. Supp. 867 (S.D.N.Y. 1975); Denver Rockets v. All-Pro Mgmt., Inc., 325 F. Supp.
1049 (C.D. Cal 1971); United States v. Olympia Provision & Baking Co., 282 F. Supp.
819 (S.D.N.Y. 1968), aff’d mem., 393 U.S. 480 (1969). See also Kapp v. NFL, 586 F.2d
644 (9th Cir. 1978), cert. denied, 441 U.S. 907 (1979); Cinema-Tex Enters. v. Santikos
Theaters, Inc., 535 F.2d 932 (5th Cir. 1976); Twentieth Century-Fox Film Corp. v.
Goldwyn, 328 F.2d 190 (9th Cir.), cert. denied, 379 U.S. 880 (1964); United States v. N.Y.
Great Atl. & Pac. Tea Co., 173 F.2d 79 (7th Cir. 1979).
[157]
See, e.g., White & White v. Am. Hosp. Supply Corp., 723 F.2d 495 (6th Cir. 1983); Webster
County Mem’l Hosp. v. UMW, 536 F.2d 419 (D.C. Cir. 1976); Langston Corp. v. Standard
Register Co., 553 F. Supp. 632 (N.D. Ga. 1982); see also Central Retailer-Owned
Grocers, Inc. v. FTC, 319 F.2d 410 (7th Cir. 1963). In United States v. Topco Assocs., Inc.,
405 U.S. 596 (1972), a cooperative association owned by competing retail food chains

INTRODUCTION TO THE ANTITRUST LAWS

had a “basic function [of] serv[ing] as a purchasing agent for its members.” Id. at 598.
Although the government challenged (and the Court condemned) Topco’s exclusive distribution
territories, the joint purchasing aspect of the Topco organization was not challenged
and remained intact under the decree. See 1973-1 Trade Cas. (CCH) and 74,391
and 74,485 (N.D. Ill.), aff’d by an equally divided Court, 414 U.S. 801 (1973).

[158] 220 U.S. 373 (1911).
[159]
Id. at 383.
[160]
Id. at 407–08.
[161]
Id. at 409.
[162]
See, e.g., Howard Marrel and Stephen McCafferty, The Welfare Effects of Resale Price
Maintenance, 28 J. Law Econ. 363 (1985).
[163]
State Oil Co. v. Kahn, 522 U.S. 3 (1997).
[164]
See generally Jefferson Parish Hosp. Dist. No. 2 v. Hyde, 466 U.S. 2 (1984). Tying can also
be held illegal under section 3 of the Clayton Act if the products involved are “commodities.”
[165]
See, e.g., Roger Blair and David Kaserman, Vertical Control with Variable Proportions:
Ownership Integration and Contractual Equivalents, 46 So. Econ. I. 1118 (1980).
[166]
See, e.g., Eastman Kodak Co. v. Image Tech. Servs., 504 U.S. 451, 462 (1992) (“there
must be sufficient consumer demand so that it is efficient for a firm to provide service separately
from parts”).
[167]
See, e.g., United States Steel Corp. v. Fortner Enter., 429 U.S. 610, 611–12 (1977)
(“appreciable economic power” in the tying market is required).
[168]
N. Pac. Ry. v. United States, 356 U.S. 1, 6 n.4 (1958) (stating “where the buyer is free to
take either product by itself there is no tying problem”).
[169]
See, e.g., Jefferson Parish, 466 U.S. at 16.
[170]
See, e.g., Commodore Plaza at Century 21 Condo. Assoc., Inc. v. Saul J. Morgan Enters.,
746 F.2d 671 (11th Cir.), cert. denied, 467 U.S. 1241 (1984).
[171] 187 F. Supp. 543 (E.D. Pa. 1960), aff’d per curiam, 365 U.S. 567 (1961).
[172]
See, e.g., Krehl v. Baskin Robbins Ice Cream Co., 664 F.2d 1348, 1350, 1353 and n.14 (9th
Cir. 1982).
[173]
Id. at 1353 and n.12.
[174]
See, e.g., Town Sound & Custom Tops, Inc. v. Chrysler Motor Corp., 959 F.2d 468 (3rd
Cir.), cert. denied, 506 U.S. 868 (1992).
[175]
Continental T.V., Inc. v. GTE Sylvania Inc., 433 U.S. 36, 49 (1977).
[176]
Nat’l Soc’y of Prof’l Eng’rs v. United States, 435 U.S. 679, 691 (1978).
[177] 337 U.S. 293 (1949).
[178]
Id. at 313–14.
[179] In Standard Stations, the Court struck down Standard Oil’s use of exclusive dealing contracts
as a “potential clog on competition,” even though, according to the Court, only 6.7
percent of the total gross business was affected.

PATENT INFRINGEMENT DAMAGES

[180] 365 U.S. 320 (1961).
[181] The Court in Tampa analyzed a requirements contract between an electric utility and a
coal company that had a 20-year term and involved approximately $128 million of coal
sales. The Court held that the relevant market to be analyzed was the coal market in
approximately seven states. The coal, subject to the requirements contract, was found to
be approximately 0.77 percent of that market.
[182]
Id. at 327–28.
[183]
Queen City Pizza, Inc. v. Domino’s Pizza, Inc., 124 F.3d 430, 443-44 (3d Cir. 1997) (dismissing
an exclusive dealing action for failure to define the relevant market).
[184] 466 U.S. 2 (1984).
[185]
Id. at 44–45 (J. O’Connor, concurring).
[186]
Id. at 45 (J. O’Connor, concurring).
[187] 749 F.2d 380 (7th Cir. 1984).
[188]
Id. at 394 (citation omitted).
[189] 1995-1 Trade Cas. (CCH) . 71,025 (C.D. Cal. 1995).
[190]
Id. at 74,818.
[191] 875 F.2d 1369, 1373 (9th Cir. 1989).
[192]
Actom, 1995-1 Trade Cas. (CCH) . 71,025, at 74,818. See also Kaplin v. Burroughs Corp.,
611 F.2d 286, 291 (9th Cir. 1979) (proof that the defendant’s activities had an impact upon
competition in a relevant market is an absolutely essential element of a rule of reason
case).
[193]
Actom, 1995-1 Trade Cas. (CCH) . 71,025, at 74,819.
[194] 823 F.2d 1215 (8th Cir. 1987)
[195]
Id. at 1233.
[196]
Id.
[197]
Id. at 1234; see also Queen City Pizza, Inc. v. Domino’s Pizza, Inc., 124 F.3d 430 (3d Cir.
1997).
[198]
See, e.g., Packard Motor Car Co. v. Webster Motor Car Co., 243 F.2d 418 (D.C. Cir.
1957).
[199] 388 U.S. 365 (1967), overruled by Continental T.V., Inc. v. GTE Sylvania, Inc., 433 U.S.
36 (1977).
[200] 433 U.S. 36 (1977).
[201]
Id. at 58–59.
[202]
Id.
[203] 384 U.S. 563 (1966).
[204]
Id. at 570–71.
[205]
Id.
[206]
United States v. Aluminum Co. Am., 148 F.2d 416, 424 (2d Cir. 1945) (stating 90 is
enough, 60 or 64 percent may not be).

INTRODUCTION TO THE ANTITRUST LAWS

[207]
See, e.g., Am. Tobacco Co. v. United States, 328 U.S. 781, 797 (1946).
[208]
Brooke Group, LTD. v. Brown & Williamson Tobacco Corp., 509 U.S. 209 (1993).
[209] 708 F.2d 1081 (7th Cir.), cert. denied, 464 U.S. 891 (1983).
[210]
Id. at 1132–33.
[211] 948 F.2d 536 (9th Cir. 1991), cert. denied, 503 U.S. 977 (1992).
[212]
Id. at 548.
[213]
See, e.g., Premier Elec. Constr. Co. v. Nat’l Elec. Contractors Ass’n, Inc., 814 F.2d 358
(7th Cir. 1987).
[214]
See, e.g., Brown Shoe Co. v. United States, 370 U.S. 294 (1962).
[215]
See, e.g., United States v. Von’s Grocery Co., 384 U.S. 270 (1966).
[216] 374 U.S. 321, 365.
ADDITIONAL READING

Antitrust Developments (Fifth), Section of Antitrust Law, ABA.
Stephen Ross, Principles of Antitrust Law, New York: Foundation Press (1993).
Lawrence Sullivan and Warren Grimes, The Law of Antitrust: An Integrated Handbook,


New York: West Publishing (2000).
Herbert Hovenkamp, Federal Antitrust Policy: The Law of Competition and Its Practice,
New York: West Publishing (1994).



9


The Intellectual Property–
Antitrust Interface


Chapter 8 described how patent law is closely related to antitrust law. Because intellectual
property (IP) and the antitrust laws have similar theoretical foundations, the tools
of analysis overlap and concrete cases often involve claims in both areas. At first blush,
patent law and antitrust law appear to be direct opposites. Antitrust laws seek to reduce
abuse of market power, while IP laws grant legal monopolies. One recent court has
remarked: “[w]hile the antitrust laws proscribe unreasonable restraints of competition,
the patent laws reward the inventor with a temporary monopoly that insulates him from
competit[ion]. . . . [T]he patent and antitrust laws necessarily clash.”1 To the extent that
the goals of antitrust laws are interpreted as “allocative” efficiency (i.e., the movement of
resources to their highest valued use by competitive prices as described in Chapter 3),
IP laws and antitrust laws are indeed antithetical. However, to the extent that the
goals of antitrust laws are to increase “dynamic” or “innovation” efficiency, i.e., growth
through innovation, the two bodies of law are quite complementary. The Federal Circuit
has taken the latter position, noting that “the two bodies of law are actually complementary,
as both are aimed at encouraging innovation, industry and competition.”2

BACKGROUND

The patent–antitrust inter,face has evolved over time. The interrelationship between IP
and antitrust emerged from the development of the doctrine of patent misuse. The term
patent misuse refers to an affirmative defense to patent infringement based on a claim
that the patent owner has attempted to extend the scope of the patent. Under the patent
misuse doctrine, until the misuse has been “purged,” a patent is unenforceable against
an infringer.

Early attempts by defendants to use antitrust laws as a defense to a patent infringement
claim were largely unsuccessful. Until World War II, the Supreme Court and

207



PATENT INFRINGEMENT DAMAGES

many lower courts rejected claims by alleged infringers that the patent owner was illegally
extending his monopoly by, for example, placing restrictions on unpatented products
tying.

This is an aversion to a legal concept of patent misuse changed as patent owners
began to assert contributory infringement claims. The misuse concept developed to
limit contributory infringement claims. Contributory infringement (described in Chapter
6) occurs when an infringer supplies an unpatented input with the intent that it be
used with an infringing product or process. By selling the unpatented product, the
defendant is inducing others to infringe. The contributory infringement doctrine arose
to protect patents from joint infringement where several parties sell aspects of a product,
but each sale taken separately does not infringe. Taken together, however, the sum
of the parts infringe once they are used in combination.3 To combat such joint
infringement, patent owners began to include licensing terms restricting the sale of
necessary but unpatented products. In response, infringers contended that the restriction
of the sale of unpatented products extended the patent grant beyond its legal monopoly.

The Supreme Court attempted to strike a balance between the extension of the patentor’s
rights and genuine protection from contributory infringement in Morton Salt Co.

v. G.S. Suppiger Co.4 Morton Salt had a patent on a salt tablet machine. Morton required
that lessees of its patented machines purchase unpatented salt from Morton. The
Supreme Court viewed the restraint on the salt as “misuse of the patent,” which rendered
the patent unenforceable until the practice was abandoned.5 The Court reasoned
that the patent on the machine should not be extended to cover salt.6 Morton Salt and
cases that followed balanced misuse and contributory negligence, but generally to the
detriment of the contributory negligence claim. Congress then joined the debate and, in
1952, enacted section 271(c) of the Patent Act, which created a statutory cause of action
for contributory infringement when nonstaple goods are involved. Nonstaple goods are
products that have no use other than an infringing one.
The question naturally arose whether patent misuse and antitrust law are coextensive.
In Zenith Radio Corp. v. Hazeltine Research, Inc.,7 the Supreme Court suggested a possible
relationship between patent misuse and an antitrust violation. The Court in Zenith
held that, while the doctrines were related, misuse could be found from conduct that
does not rise to the level of an antitrust violation and, conversely, that a finding of misuse
does not mean that an antitrust violation has occurred.8

Although elegant in theory, the line between misuse and violations of the antitrust law
was unclear and without a reasoned foundation. As a result, the misuse doctrine began to
slowly merge with antitrust law. In USM Corp. v. SPS Technologics, Inc.,9 for example,
Judge Posner, writing for the Seventh Circuit, addressed the issue of whether discriminatory
royalties constitute misuse. Judge Posner concluded that discriminatory royalties
do not extend the patent monopoly (since the patent owner need not even license the
patent); however, he explicitly recognized that traditional patent misuse situations might
have to be judged by a different standard than the antitrust laws.10 Posner resolved the
problem by applying antitrust principles to all but the so-called convention applications


THE INTELLECTUAL PROPERTY–ANTITRUST INTERFACE

of misuse including tying nonstaple goods and selling minimum prices.11 The Federal
Circuit in Windsurfing International, Inc. v. AMF, Inc.,12 appeared to follow suit, albeit
in dicta.

Congress again intervened on this issue in 1988 by amending section 271(d) of the
Patent Act.13 Congress added sections (4) and (5), which provided that misuse cannot
be found from a refusal to license and that no misuse can result from tying, absent market
power in the tying market.14 The 1988 amendment brought the misuse and antitrust
doctrines into even closer alignment. Hoerner offers a concise summary of what remains
of the patent misuse doctrine. In summary, his main conclusions are:

. In all patent misuse cases, an anticompetitive effect must be proved.
. The anticompetitive effect is demonstrated by the antitrust rule of reason concept,
which requires a market.
. If a restriction is reasonably within the patent grant, it is not misuse.15
In sum, the patent–antitrust interface arose out of the patent misuse doctrine, which
was intended to curb abuses of contributory infringement. Over time, misuse and antitrust
have become to a large extent coextensive.

OVERLAP OF PATENT AND ANTITRUST PRINCIPLES

In addition to the evolution of the patent misuse concept, antitrust jurisprudence has
developed an independent analysis of the IP–antitrust interface. An excellent summary
source for IP lawyers and experts confronting IP–antitrust interface issues is the Antitrust
Guidelines for the Licensing of Intellectual Property, promulgated by the Federal
Trade Commission (FTC) and the Department of Justice (DOJ) in 1995 (the IP Guidelines).
16 The IP Guidelines apply to patent, copyright, and trade secret law, but they
expressly exclude trademark licenses.17 The IP Guidelines diligently attempt to reconcile
antitrust and IP principles. The IP Guidelines describe their originating principle as
treating IP like any other form of tangible property for antitrust purposes. This is a bit
of a misnomer because IP actually is not like other forms of property in one critical
respect. Compare a patent owner with a homeowner. A homeowner’s property right
allows the homeowner to exclude others from enjoyment of the home. But a patent
owner can exclude others not only from the home he or she builds, but also from reproducing
the home. The IP Guidelines implicitly recognize the additional dimension of IP
rights (but incompletely) by making clear that IP may or may not confer market power.
Market power is not conferred if a sufficient number of substitutes exist for the patented
product such that the patent alone cannot give the patent owner the ability to raise prices
above competitive levels.18

The general theme of the IP Guidelines might best be described as follows. The
antitrust laws aim to restrict the patent owner to his legal patent grant and no more. If


PATENT INFRINGEMENT DAMAGES

through some additional transaction the patent owner seeks to extend the legal monopoly,
the antitrust laws are triggered. In practice, however, application of this principle
can be difficult. This chapter provides a sample of current examples. Nonetheless, the
DOJ’s guiding principles are a useful guide to IP lawyers and experts who must navigate
through competitive issues in IP cases.

ANTITRUST LAW AND SPECIFIC PATENT PRACTICES

The IP Guidelines and antitrust case law have applied antitrust analysis to several specific
patent practices. Lawyers and experts confronted with a specific IP–antitrust issue
should consult the abundant literature and case law addressing the practice at issue in
their case.

Intellectual Property Obtained by Fraudulent Means

A direct application of the principle that antitrust laws attempt to prevent the exercise
of market power beyond the statutory grant is the antitrust treatment of fraudulently
procured patent rights. A patent obtained by fraud involves the exercise of market power
obtained by illegitimate means. For example, in Walker Process Equipment, Inc. v.
Food Machinery & Chemical Corp.,19 the Supreme Court found that enforcement of a
patent obtained by fraud can form the basis for a cause of action under section 2 of the
Sherman Act.20 In Walker, the defendant alleged that the patent owner filed a false oath
and did not disclose a statutory bar. The Court held that these allegations were enough
to satisfy the conduct element of a section 2 claim.21 The elements of a so-called Walker
antitrust claim are:

a. Fraud in the procurement of the patent. Fraud satisfies the “willful acquisition” element of
a Section 2 claim. In the case of attempted monopolization, fraud is sufficient to satisfy
“specific intent.” Courts have emphasized that the deception must be deliberate; a mistake
or so-called “technical fraud” is not enough.22 A misrepresentation can consist of either a
misstatement or a purposeful withholding of information, however, the misrepresentation
must be material. This means, absent the misrepresentation, the patent would not have
issued and, therefore, patent is invalid.23 The standard for demonstrating fraud is high,
specifically a plaintiff must demonstrate fraud by clear and convincing evidence.24
b. As in all Section 2 claims, a plaintiff asserting a Walker claim must show market power in
the relevant market.25
c. Finally, the plaintiff must also show that he/she was injured as a proximate cause of some
conduct based upon the invalid patent. As discussed below, Walker claims are often barred
as an IP counterclaim because good faith litigation by a patent owner is immunized from
antitrust liability under the Noerr doctrine.26 A successful counterclaim would require both
a showing of “sham” litigation as well as fraud on the patent office.27
Even if no fraud exists, a patent owner who attempts to injure competition by enforcing
a patent that he or she knows is invalid (often called a Handguards claim), or in


THE INTELLECTUAL PROPERTY–ANTITRUST INTERFACE

other words in “bad faith,” may violate section 2 of the Sherman Act.28 The elements
of a section 2 claim based on bad-faith enforcement of a patent are:

1.
The patent owner must have knowledge that would prevent him or her from
having a good-faith belief that the patent was valid. Moreover, the patent must
in fact be invalid. There will be an initial presumption that a patent infringement
case was brought in good faith. This presumption must be rebutted by
clear and convincing evidence.
2.
A plaintiff must show every other element of a section 2 claim, for example,
market power, standing, etc.
Again, because the conduct supporting the antitrust claim in a section 2 claim based
on “bad-faith” enforcement of a claim is the filing of a lawsuit, the plaintiff in such a
case must overcome the defendant’s Noerr immunity under the First Amendment by
showing that the lawsuit itself was a “sham.”

As discussed previously, claims asserted under Walker and Handguards must overcome
the Noer–Pennington doctrine. In Professional Real Estate Investors, the Supreme
Court set forth the two elements to demonstrate that litigation is not protected under
the First Amendment. First, a plaintiff must prove that the litigation was not “objectively
reasonable,” that “no reasonable litigant could realistically expect success in the
merits.”29 Second, a plaintiff must also show that the litigation is “subjectively” baseless
(i.e., it was brought for an improper purpose and was known to be baseless).30 The
Ninth Circuit has limited application of Professional Real Estate to situations in which
there is no series of cases or a broader pattern of anticompetitive conduct.31

Refusal to License Intellectual Property

The antitrust laws generally do not require that a patent owner either use or license a
patented technology. The right to refuse to license is also part of the patent grant.
However, the right can have limits. This is one of the most controversial areas of
antitrust law. For example, it is unclear whether a patent owner can use patent rights to
exclude a competitor from an essential technology required to compete in an unpatented
product. Antitrust laws prohibit the refusal of access to an “essential facility” required
for competition.32 Courts, however, have not applied this concept to a patent. Nonetheless,
in Image Technical Servs., Inc. v. Eastman Kodak Co.,33 the Ninth Circuit stated
that the Sherman Act prohibits a monopolist from refusing to sell products covered by
patents when it will “create or maintain a monopoly absent a legitimate business justification.”
34 The Ninth Circuit forced Kodak to provide independent service organizations
with numerous patented parts required to service Kodak photocopy equipment.35
Similarly, a federal district court in Alabama followed the Ninth Circuit’s reasoning. In
Intergraph Corp. v. Intel Corp.,36 however, the Federal Circuit has come down squarely
against this approach.37 As a result, the bounds of a patent owner’s ability to reduce
competition by refusal to license IP are not yet clear.


PATENT INFRINGEMENT DAMAGES

Can a Patent Be Used to Protect a Monopolist’s Aftermarket?

Several courts have addressed this issue with conflicting answers. In Data
General Corp. v. Grumman Systems Support Corp., 36 F.3d 1147, 1187 (1st Cir.
1994), the First Circuit held that copyrighted software can be withheld from independent
service providers only if valid business justifications exist. In contrast,
the Ninth Circuit, in Image Technical Services, Inc. v. Eastman Kodak Co.,
125 F.3d 1195, 1226–27 (9th Cir. 1997), held that Kodak could not withhold parts
from independent service organizations even though many of the parts were
patented. The Federal Circuit, in In re: Independent Service Organization Antitrust
Litigation, 203 F.3d 1322, 1328 (Fed. Cir. 2000), held that Xerox did not
violate the antitrust law by refusing to sell necessary patented parts to independent
service organizations.

Price and Quantity Limitations

The present case law and the IP Guidelines deviate in a few areas from the general
principle that a patent owner can conduct business within the bounds of this statutory
monopoly free of antitrust scrutiny. One such area involves resale price maintenance.
Resale price maintenance means that the patent owner sets the prices by which his
licensees sell the licensed product. Such a practice arguably does not exceed the patent
grant, because the patent owner could set the price directly to the end user by eliminating
the licensee. Early on, the Supreme Court analyzed price restrictions in this way. In
United States v. General Electric Co.,38 the Supreme Court concluded that a provision
in a license setting the price at which a licensee can sell the patented product “is reasonably
within the reward which the patentee by the grant of the patent is entitled to
secure.39 Because of the strong judicial history of application of per se illegality to vertical
price-fixing, the General Electric rule has been challenged twice before the
Supreme Court. In both cases, the Court upheld the rule.40 Although not overruled,
General Electric has been severely limited and is now honored in its breach. As a result,
in practice, price restrictions in an IP license are likely to be violative of the antitrust
law even though the General Electric rule is still good law and makes intuitive sense.41

Output restrictions in patent licenses have also been held to be unlawful because
price and quantity are simultaneously determined.42 This rule makes sense in light of
the effective prohibition on vertical price-fixing.

Acquisition of Patents

The assignment, licensing, or purchase of patents may raise antitrust concerns under
section 2 of the Sherman Act or section 7 of the Clayton Act if the patent owners’ acqui



THE INTELLECTUAL PROPERTY–ANTITRUST INTERFACE

sition of additional patents creates market power. This is clearly the law today despite
some early Supreme Court pronouncements to the contrary.43 This current rule is a
straightforward application of the principle discussed previously. If the combination of
technologies can create market power beyond the individual patent grants, and is not
offset by efficiencies resulting from the combination, it violates the antitrust laws. The
IP Guidelines reaffirm this intuition by indicating that acquisition of IP will be analyzed
under the merger guidelines used to analyze mergers of tangible assets. Thus, the typical
step-by-step analysis of whether the acquisition substantially harms competition will
be undertaken.

Patent Pools

The pooling of patents through cross-licensing or other agreements also may violate
section 1 of the Sherman Act. A patent pool covers a variety of arrangements in which
patent owners combine patents. Regardless of structure, the patent owners typically
agree to jointly exercise rights under the pooled patents. The structure, however, may
differ. Patent pools can be exclusive, restricting third-party licensing, or they can be
open. The precise nature of the arrangement and the market must be analyzed to determine
whether there is injury to competition beyond the patent grants. In some cases,
pools are necessary to resolve conflicts involved in complex technologies requiring
multiple licenses. A patent pool can be an effective way of resolving conflicting rights.
This is the situation, for example, in the production of many high-tech products such
as computer chips and other computer hardware. Patent pooling in such cases is scrutinized
to determine whether the provisions are the least restrictive method of achieving
efficiencies. In Standard Oil Co. v. United States,44 the Supreme Court upheld a patent
pool by several oil companies. The Court applied a rule of reason analysis and concluded
that the competing companies held blocking patents and that without the pool
each company would be precluded from practicing its own technology.45 Issues of
patent pooling often arise in a settlement context.

Conversely, patent pools can also have anticompetitive effects.46 A patent pool can
dampen incentives to invest in research and development and the discovery and use of
design-around alternatives.47 Patent pools can also simply constitute anticompetitive
horizontal restraints. For example, two competitors with nonblocking patents could
pool their rights to block competitors from entering the market using a combination of
blocking patents. A patent pool could be used both to restrict licensing and reduce competition
between the patent owners and to fix prices in downstream markets.48

To determine the type of patent pool at issue, courts and agencies define the relevant
market that includes all the technologies that compete with the patent pool. Next, the
share of that market occupied by the patent pool is assessed. Then the intent of the pool
and the degree of access to the pool are considered.49 Courts and agencies judge open
pools to be far less dangerous than closed pools. An open pool eliminates the danger


PATENT INFRINGEMENT DAMAGES

that the parties involved in the patent pool are creating a monopoly or facilitating a
cartel. The full competitive analysis of a patent pool considers additional factors such
as the relevant market, the parties’ intent, the degree of access, and the pro- and anti-
competitive effects.

In sum, patent pools can serve important procompetitive purposes. In some cases,
however, a patent pool can cause anticompetitive harm. In these later cases, because
patent pools often involve agreements between competitors, patent pools likely will
violate section 1 of the Sherman Act.

Royalties

There is no antitrust violation when a very high royalty is charged. However, competitors
who coordinate royalties could be engaged in illegal price-fixing.50 Moreover, any
attempt to extend the royalty beyond the patent term is illegal.51 In addition, royalty discrimination
among licensees that clearly harms competition could rise to the level of an
antitrust case. In several early cases involving shrimp-cleaning machines, some courts
condemned price discrimination using different royalties.52 Subsequent commentary
and decisions, however, have criticized these cases.53 The basis of the criticism is that
the patent grant allows the patent owner to refuse to license altogether. Licensing at a
high price or at different prices is therefore a less restrictive practice than the legal
monopoly allows. As a result, unless a strong showing of injury to competition can be
made out, price discrimination among licenses is likely to be upheld.

Non-Price Restrictions

The Patent Statute allows exclusive licensing of a patent to the whole or any specified
part of the United States. This implies that Congress has approved territorial restrictions
in patent licensing. This is limited by the exhaustion principle, which provides that
patent rights end at first sale. As limited by the exhaustion principle, territorial restrictions
are legal.

Field of use restrictions refer to the restrictions of a licensee to use the invention in
one or more fields. Field of use restrictions generally are legal because they merely
divide the original market power granted by the patent. Numerous cases and agency
opinions have approved field of use restrictions in patent licenses.54 Only in the rare
case in which a field of use restriction somehow extends the patent grant will it raise
antitrust concerns.55

Grant-Back Clauses

A grant-back clause requires the licensee to grant back to the licensor patent rights that
the licensee later develops. A grant-back clause may be exclusive or nonexclusive.


THE INTELLECTUAL PROPERTY–ANTITRUST INTERFACE

Grant-backs can dilute the incentive of the licensee to innovate. For example, if a grant-
back is exclusive, which requires the licensee to assign all future patents to the licensor,
it will reduce the incentive of the licensee to engage in research and development.
Moreover, it potentially could give the licensor monopoly power. For this reason, grant-
backs of long duration and wide scope may violate the antitrust laws. This is another
case in which the general principle of limiting patent owners to the legal patent monopoly
is violated. In a grant-back situation, the driving principle is preventing dilution
of incentives to discover improvement patents, not limiting market power.56 However,
nonexclusive grant-backs cause little competitive concern. Even exclusive grant-back
provisions that are limited in time or involve circumscribed areas of technology will
have little anticompetitive impact.

Tying

Conditioning the sale of a patented product on the sale of an unrelated unpatented product
violates the antitrust law. There is, however, a gray area. When several licenses are
packaged together for a single royalty, there may be significant cost savings that can
justify the practice. A tying arrangement involving a patent will violate the antitrust
laws only when each of the four elements of a tying claim is satisfied: (1) market power
in the tying market where no presumption of market power exists because of the patent,

(2) two separate products, (3) a conditioned sale, and (4) substantial commerce in the
tied market affected. The tying law applied to IP is the same as that described in the previous
chapter. However, when the tying product is covered by a patent or copyright,
courts often presume that the market power element was satisfied. This presumption
was eliminated by section 271(d) of the Patent Act. As a result, a plaintiff alleging tying
in the IP context must demonstrate all of the elements of tying under section 1 of the
Sherman Act or section 3 of the Clayton Act.
Tying claims often arise when package licenses are offered. In a package license
one patent is offered only on the condition that several others are accepted. The general
rule is that voluntary packages are legal, whereas compulsory packages are illegal.57
Mandatory packages can be procompetitive when blocking patents are involved. In
these cases, courts have upheld the package.58

SUMMARY

Intellectual property cases often bleed over into antitrust concerns when the patent
owner engages in some form of restrictive practice. This chapter presented a skeletal
outline of the antitrust laws and attempted to familiarize IP experts and attorneys with
some of the common overlap areas they may encounter.


PATENT INFRINGEMENT DAMAGES

ENDNOTES


[1]
SCM Corp. v. Xerox Corp., 645 F.2d 1195, 1203 (2d Cir. 1981), cert. denied, 455 U.S.
1016 (1982).
[2]
Atari Games Corp. v. Nintendo of America, Inc., 897 F.2d 1572, 1577 (Fed. Cir. 1990).
[3]
See, e.g., Heaton-Peninsular Button-Fastener Co. v. Eureka Specialty Co., 77 F. 288 (6th
Cir. 1896), discussed in George Gordon and Robert Hoernes, Overview and Historical
Development of the Misuse Doctrine, in Intellectual Property Misuse: Licensing and
Litigation, 2000 A.B.A. Sec. Antitrust Law.
[4] 314 U.S. 488, 62 S. Ct. 402, 86 L. Ed. 363 (1942), cert. denied, 315 U.S. 826 (1942).
[5]
Id. at 491–93, 62 S. Ct. at 404–06.
[6]
See id. at 491–92, 62 S. Ct. at 404–05.
[7] 395 U.S. 100, 89 S. Ct. 1562, 23 L. Ed. 2d 129 (1969), judgment rev’d by 401 U.S. 321
(1971).
[8]
See id. at 134–35, 89 S. Ct. at 1533.
[9]
694 F.2d 505 (7th Cir. 1982).
[10]
See id. at 510–11.
[11]
See id. at 511–12.
[12]
782 F.2d 995 (Fed. Cir. 1986).
[13] 35 U.S.C. § 271(d) (2001).
[14]
See id. § 271(d)(4), (5) (2001). Amended by 1988, Pub. L. 100-418, Title IX, § 9003, 102
Stat. 1564 (Aug. 23, 1988).
[15]
Robert J. Hoerner, The Decline (and Fall?) of the Patent Misuse Doctrine in the Federal
Circuit, 69 Antitrust L. J. 669 (2002).
[16]
See Appendix C.
[17]
See Guidelines at 1.0, included in Appendix C.
[18]
See, e.g., Jefferson Parish, 466 U.S. at 37 n. 7, 104 S. Ct. at 1571–72 n. 7 (O’Connor, J.,
concurring); C.R. Bard, Inc. v. M3 Systems, Inc., 157 F.3d 1340, 1367 (Fed. Cir. 1998).
[19] 382 U.S. 172, 86 S. Ct. 347, 15 L. Ed. 2d 247 (1965).
[20]
See id. at 178, 86 S. Ct. at 351.
[21]
See id. at 177–78, 86 S. Ct. at 350–51; (see also Chapter 8).
[22]
See Cataphote Corp. v. De Soto Chemical Coatings, Inc., 450 F.2d 769, 772 (9th Cir.
1971), cert. denied, 408 U.S. 929 (1972) (“affirmative dishonesty” required).
[23]
Litton Indus. Prod., Inc. v. Solid State Sys. Corp., 755 F.2d 158, 166 (Fed. Cir. 1985).
[24]
Vetiker v. Jurid Werke GMH, 671 F.2d 596, 600 (D.C. Cir. 1982) (“A finding that a patent
was procured by fraud must be based on ‘clear, unequivocal and convincing’ evidence.”).
[25]
See American Hoist & Derrick Co. v. Sowa & Sons, Inc., 725 F.2d 1350, 1366 (Fed. Cir.),
cert. denied, 469 U.S. 831 (1984).

THE INTELLECTUAL PROPERTY–ANTITRUST INTERFACE

[26]
See, e.g., United Mine Workers of America v. Pennington, 381 U.S. 657, 659–70, 85 S. Ct.
1585, 1593, 14 L. Ed. 2d 626 (1965).
[27]
See, e.g., Professional Real Estate Investors, Inc. v. Columbia Pictures Indus., Inc., 508
U.S. 49, 61–62, 113 S. Ct. 1920, 1928–30, 123 L. Ed. 2d 611 (1993). Recent Federal
Circuit Law on Walker Process Claims can be gleaned from C.R. Bard, Inc. v. M3 Systems,
Inc., 157 F.3d 1340 (Fed. Cir. 1998).
[28]
See, e.g., Handguards, Inc. v. Ethicon, Inc., 743 F.2d 1282, 1289 (9th Cir. 1984).
[29]
See Professional Real Estate Investors, 508 U.S. at 60, 113 S. Ct. at 1928.
[30]
See id. at 61, 113 S. Ct. at 1928–29.
[31]
See, e.g., USS-POSCO Indus. v. Contra Costa County Bldg. & Const. Trades Council, 31
F.3d 800, 810–11 (9th Cir. 1994).
[32]
See, e.g., Otter Tail Power Co. v. United States, 410 U.S. 366, 93 S. Ct. 1022, 35 L. Ed.
2d 359 (1973), United States v. Terminal R.R. Ass’n, 224 U.S. 383, 32 S. Ct. 507, 56 L.
Ed. 810 (1912).
[33]
125 F.3d 1195 (9th Cir. 1997).
[34]
Id. at 1209.
[35]
See id. at 1226–27.
[36]
3 F. Supp. 3d 1255 (M.D. Ala. 1998).
[37]
See In re Independent Service Organization Antitrust Litigation, 203 F.3d 1322 (Fed. Cir.
2000).
[38] 272 U.S. 476, 47 S. Ct. 192, 71 L. Ed. 362 (1926).
[39]
Id. at 490, 47 S. Ct. at 197.
[40]
United States v. Huck Mfg. Co., 382 U.S. 197, 86 S. Ct 385, 15 L. Ed. 2d 268 (1965);
United States v. Line Materials Co., 333 U.S. 287, 68 S. Ct. 550, 92 L. Ed. 701 (1948).
[41]
See Guidelines § 5.2, included in Appendix C.
[42]
See United States v. E.I. DuPont de Nemours & Co., 118 F. Supp 41 (D. Del. 1953), aff’d
351 U.S. 377 (1956).
[43]
See, e.g., Automatic Radio Mfg. Co. v. Hazeltine Research, Inc., 339 U.S. 827, 834, 70 S.
Ct. 894, 898, 94 L. Ed. 1312 (1950), overruled in part by Lear, Inc. v. Adkins, 395 U.S.
653, 89 S. Ct. 1902, 23 L. Ed 2d 610 (1969).
[44] 283 U.S. 163, 51 S. Ct. 421, 75 L.Ed. 926 (1931).
[45]
See id. at 174–79, 51 S. Ct. at 425–28.
[46]
See, e.g., Business Review Letter from Department of Justice to Gerrard R. Beeney, Esq.
(June 26, 1997) (approving pooling of MPEG-2 technologies).
[47]
See United States v. Manufacturers Aircraft Ass’n, Inc., 1976-1 Trade Cas. (CCH) . 60,810
(S.D.N.Y. 1975).
[48]
See Standard Oil, 283 U.S. at 174, S. Ct. at 425.
[49]
See, e.g., Cutter Laboratories, Inc. v. Lyophile-Cryochem Corp., 179 F.2d 80, 93–94 (9th
Cir. 1949).

PATENT INFRINGEMENT DAMAGES

[50]
See In re Yarn Processing Patent Validity Litigation, 541 F.2d 1127, 1136–37 (5th Cir.
1976), cert. denied, 433 U.S. 910 (1977).
[51]
See Brulotte v. Thys Co., 379 U.S. 29, 32–33, 85 S. Ct. 176, 179, 13 L.Ed. 2d 99 (1964).
[52]
See, e.g., Peelers Co. v. Wendt, 260 F. Supp. 193 (W.D. Wash. 1966); Laitran v. King
Crab, Inc., 244 F. Supp. 9 (D. Ala.), modified, 245 F. Supp. 1019 (1965).
[53]
See, e.g., Official Airline Guides, Inc. v. FTC, 630 F.2d 920 (2d Cir. 1980), cert. denied,
450 U.S. 917 (1981).
[54]
See e.g., United States v. Studiengesellschaft Kohl, m.b.H., 670 F.2d 1122 (D.C. Cir.
1981).
[55]
See, e.g., Ethyl Gasoline Corp. v. United States, 309 U.S. 436, 60 S. Ct. 618, 84 L. Ed.
852 (1940).
[56]
See Appendix C.
[57]
See, e.g., United States v. Paramount Pictures, Inc., 334 U.S. 131, 63 S. Ct. 915, 92 L. Ed.
1260 (1948).
[58]
See, e.g., International Mfg. Co., Inc. v. Landon, Inc., 336 F.2d 723 (9th Cir. 1964), cert.
denied, sub nom. Iacuzzi Bros. Inc. v. Landon, Inc., 379 U.S. 988 (1965).
ADDITIONAL READING

Peter Boyle, Penelope Lister, and J. Clayton Everett Jr., Antitrust Law at the Federal
Circuit: Red Light or Green Light at the IP-Antitrust Intersection, 69 Antitrust Law
Journal 739 (2002).

Herbert Horenkampe, Mark Janis, and Mark Lemley, IP and Antitrust, New York: Aspen
Law and Business (2002).

William C. Holmes, Intellectual Property and Antitrust Law, New York: West Publishing
(2001).

Robert J. Hoerner, Innovation Markets: Old Wine in New Bottles, 64 Antitrust Law Review 1
(1995).

American Bar Association Section of Antitrust Law, Understanding and Refining the Role
of Misuse in Intellectual Property Licensing and Litigation (March 28, 1996).

Washington, DC, Spring Meeting 1997, Intellectual Property Committee Meeting: The
Aftermath of Professional Real Estate Investors: New Directions and New Alternatives for
Bad Faith Litigation of Intellectual Property (April 9, 1997).

American Bar Association Section of Antitrust Law, Intellectual Property Committee
Program: An Intensive Look at Technology and Innovation Markets (April 5, 1995).

Richard J. Gilbert, The 1995 Antitrust Guidelines for the Licensing of Intellectual
Property: New Signposts for the Intersection of Intellectual Property and the Antitrust
Laws (April 6, 1995).

Norman E. Rosen, Current Intellectual Property Antitrust Issues (August 9, 1993).


Part Three


Copyright, Trademark,
and Trade Secret
Damages



10


Introduction to Copyright Law


The copyright laws can be understood as a system of legal protections designed to balance
the incentives for authors with the need for public access to new works. Copyright
protection is designed to reward authors for their original, creative expressions of ideas
to encourage further such creation. However, the creation of endless original works
would be meaningless to society at large if there were no means of guaranteeing some
degree of access to those works. Copyright law is meant to encourage dissemination of
expressive works by compensating authors for the costs of creation. Without copyrights,
authors would be systematic losers, incurring all costs related to creation and dissemination,
while enjoying a return on those investments only for the limited time that it
took others to copy the work. Copycat publishers could expend only the price of replication
and massively undercut the author’s prices until the original work lost most of its
fiscal worth. In contrast, if there were no limit on an author’s rights, the public might
be deprived of access to artistic works indefinitely. Copyright law attempts to balance
the incentives for creation and publication with the access costs related to restricting the
free use of an author’s work.

A BRIEF HISTORY OF COPYRIGHT LAW

The law of copyright grew out of the conflict between authors and publishers in
England during the seventeenth and eighteenth centuries. Before the development of the
printing press, copying a work of literature was a time-intensive labor. However, as the
printing industry became more established, duplicating literary works became a relatively
inexpensive and simple matter.1 Fearing the prevalence of copying, some authors
opted to withhold new literature from publication, opting instead to disseminate privately
their works in small, exclusive circles. The arrangement resulted in poor incentives
for authors and inadequate dissemination of new works of art and science to the

221



COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

public. In the early eighteenth century, the British Parliament struck a balance between
the rights of publishers and the rights of the public by recognizing copyright protection
of a literary work for only a finite period. This legislation was known as the Statute
of Anne.2 Although the statute provided for an author’s copyright, the benefit to authors
was short-lived because most publishers required the author to assign their rights to
the publisher as a condition of publication. Accordingly, the publishers generally had
exclusive rights to publish, copy, and sell the work during the term of the copyright.
However, once the copyright expired, a work entered the “public domain.” This structure
prevented an unlimited monopoly on the part of the booksellers and preserved the
incentives for authors to publish their works.3

When the English common law was imported to the United States at the time of
the American Revolution, English common law copyright notions were also adopted.4
The U.S. Congress derives its power to regulate copyrights from the same section of the
Constitution that authorizes patent statutes. This clause, often referred to as the “Patent
and Copyright Clause,” states that: “The Congress shall have Power . . . to promote
the Progress of Science and useful Arts, by securing for limited Times to Authors
and Inventors the exclusive Right to their respective Writings and Discoveries.”5
Accordingly, the stated purpose of U.S. copyright law is the promotion of science and
the “useful arts.”6 The mechanism selected to accomplish this purpose was legislation
that secured the exclusive rights of authors for a limited time.

Like the patent statute, the copyright statute has been revised several times; the major
revisions were made in 1831, 1870, 1909, 1976, and 1989. These revisions were driven
primarily by new forms of expression that gained economic importance over time. The
current governing copyright statute is the Copyright Act of 1976, as amended.7 Although
works created before 1976 are governed by earlier statutes, this chapter focuses only on
the 1976 statutory scheme, as modified by the Berne Convention in 1989.

STANDARDS FOR COPYRIGHT PROTECTION

Copyrightable expressions can occur in many mediums; although copyright commonly
is associated with literary works, copyright protection can apply to everything from computer
code to sculptures, from oil paintings to music. Under the Copyright Act, copyright
protection is available for “original works of authorship fixed in any tangible medium of
expression.”8 Moreover, copyright protection cannot apply to “any idea, procedure, process,
system, method of operation, concept, principle or discovery.”9 Thus, there are three
primary standards for copyright protection; copyright protection applies to works that
are (1) original, (2) fixed, and (3) expressions of ideas rather than the ideas themselves.

Originality

Originality requires that the author created his or her work through independent intellectual
or artistic effort. Although the requirement is not as rigorous as the “novelty” require



INTRODUCTION TO COPYRIGHT LAW

ment in patent law, it does have some bite. The work must be independently created by
the author; merely copying another source of information or expression is precluded.10
Theoretically, two authors could compose identical sonnets, completely independent of
each other, and neither sonnet would be “novel,” yet both could be original and subject
to copyright protection.11

Moreover, borrowing some elements of a copyrighted work may be permissible if the
overall result is sufficiently original to qualify as a “derivative work.”12 Derivative
works are discussed in detail in a subsequent section of this chapter; for purposes of
understanding originality, it simply is noteworthy that not all aspects of a work must be
original for the work to deserve copyright protection.

Eden Toys, Inc. v. Florelee Undergarment Co., Inc.13

Eden Toys involved the popular children’s book character, Paddington Bear. Eden
Toys had an exclusive license to market Paddington merchandise in North America.
In order to capitalize on that license, Eden Toys had a series of drawings made
based on the copyrighted Paddington Bear illustrations. Eden Toys then registered
those drawings as derivative works, properly made with the permission of the
Paddington copyright holder. Florelee subsequently began selling nightshirts
featuring a print of Paddington Bear that was nearly identical to Eden Toys’ copyrighted
drawings. The district court found that Eden Toys’ copyright was invalid
because it was insufficiently original given the preexisting illustrations.

On appeal, the Second Circuit held that the lower court’s standard for originality
was too high. The proper standard for sufficient originality is “whether a work
contains ‘some substantial, not merely trivial, originality.’” In this case, the minor
variations to the original sketch were substantial enough to satisfy the originality
requirement. These changes included “the changed proportions of the hat, the
elimination of individualized fingers and toes, and the overall smoothing of
lines.” These cumulative effect was a “different, cleaner ‘look’” than the illustrations
on which the drawings were based. Accordingly, the Eden Toys drawings
were sufficiently original and worthy of copyright protection.

Beyond merely requiring that a work be original, the originality requirement implies
the presence of “at least some minimal degree of creativity” in the authorship process.14
Works of meager artistic merit or minimum creativity may not be proper subject matter
for a copyright. Although “original” may appear to encompass “creative” (after all, the
fact that a work is an original implies some degree of creativity), a work may be original
and still lack the minimal creativity necessary for a copyright.15 For example, the
difference in appearance between a two-dimensional symbol and a three-dimensional
version of that symbol may be insufficiently original to merit copyright protection, even


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

as a derivative work.16 Copyright protection can apply only to works that are more than
a “trivial variation of previous work.”17

Magic Marketing, Inc. v. Mailing Services of Pittsburgh, Inc.18

Magic Marketing was a designer of mass mailing advertising campaigns that
contracted with Mailing Services to supply it with basic supplies and printing
work. Magic Marketing alleged that Mailing Services infringed its copyrighted
envelopes by selling copies of the envelopes to other companies. In response,
Mailing Services argued that Magic Marketing’s envelopes were insufficiently
original to be copyrighted.

The envelopes in question were typical of the unsolicited “junk mail” that
many individuals receive in their mail every day. The envelopes were conventional
in size and contained the words “PRIORITY MESSAGE: CONTENTS
REQUIRE IMMEDIATE ATTENTION” and other similar instructions on the
front of the envelope. The court agreed with Mailing Services, calling the lack of
originality “lethal” to the claim of copyright infringement. The terse phrases on
the envelopes merely described the contents and/or instructed the recipient as
to the desired use (“open immediately”). The phrases were “generic in nature and
lack[ed] the minimal degree of creativity necessary for copyright protection.”

Certain terms have been excluded from copyright protection because their very
brevity implies a lack of creativity. This latter category includes words and “short
phrases such as names, titles, and slogans.”19 Copyright protection does not extend to
blank forms and common property such as calendars and area code maps.20 Clichéd language
and stereotypical expressions also are not copyrightable.21 Even directions and
instructions, which arguably are more than generic, are insufficiently creative to merit
protection because they are dictated solely by functional considerations.22

Fixation

An author’s expression must be “fixed in any tangible medium” to be protected under
the Copyright Act.23 Section 101 defines “fixed” as “when its embodiment in a copy or
phonorecord, by or under the authority of the author, is sufficiently permanent or stable
to permit it to be perceived, reproduced, or otherwise communicated for a period of
more than transitory duration.”24 Under the law, the medium of fixation includes a wide
range of media, including print materials, film, microfilm, CDs, DVDs, audiotapes, and
so on. Moreover, the statute anticipates the continuing progression of technology,
explicitly including within “copies” any work fixed “by any method now known or
later developed.”25 Broadcasting, or other means of “simultaneous transmission” of the
work, also qualifies as adequate fixation.26


INTRODUCTION TO COPYRIGHT LAW

However, improvised live performances or unrecorded speeches cannot be copyrighted.
For example, in 1972, performance artist Vito Acconci developed a work
that he called “Seedbed.” Seedbed consisted of Acconci lying under a wooden ramp
that rose up from the gallery floor and masturbating for eight hours a day over a two-
week period. During Acconci’s performance, he would voice his sexual fantasies
about the audience into a microphone as the audience walked around the gallery and
over Acconci.27 Regardless of its questionable artistic merit, Acconci’s work could not
qualify for copyright protection because it was not “fixed” as required by the Copyright
Act.
The requirement that fixation occur “by or under the authority of the author” can be
explained by the advantage to the author of knowing where any and all copies of his or
her work are (at least when they are first made). This knowledge offers the author some
modicum of control over the uses and dissemination of his or her work. However
appealing this rationale might be, it does not explain why the author whose work is
recorded without permission has created less of a “fixed” work or is less deserving of
copyright protection. Possibly the better explanation is that the requirement of authorized
fixation places a premium on the value of preserving original works for future audiences
by giving authors an incentive to ensure that their works are fixed.

Copyright Protection Does Not Extend to Ideas

Ideas are not a proper subject for copyright protection; only a particular expression of
an idea can be protected.28 For example, an article describing a new treatment for cancer
could be copyrighted, but the underlying drug or process could not be copyrighted.
Patents are the appropriate means for protecting new and nonobvious ideas.29

Homan v. Clinton30

Homan filed suit for copyright infringement against Bill Clinton (then president
of the United States), Al Gore, and the Democratic Party, among others. Homan
alleged that he authored a copyrighted article entitled “Bridge Village,” which
contained “the central theme and motto about BUILDING BRIDGES TO THE
FUTURE.” Homan claimed that Clinton’s presidential campaign infringed on that
article when it adopted the slogan “Building Bridges to the 21st Century” during
the 1996 election. The court held that Homan’s complaint should be dismissed as
frivolous because it was merely an attempt to copyright an idea or general concept,
which cannot be protected under copyright law. Moreover the court noted
that there was no evidence that the Clinton campaign had expressed the idea
in precisely the same way that Homan did in his copyrighted article. Accordingly,
Homan could not establish copyright infringement.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Consistent with the copyright laws’ resistance to extending protection to ideas, the
existence of only a limited means of expression may preclude infringement because
copyright protection effectively would allow a few parties to control the idea.31
Moreover, a work that can be expressed in only one way cannot be given copyright protection
because it would remove the underlying idea from the public domain.32 This
principle is known as the merger doctrine.33

The merger doctrine can be understood as simply an extension of the idea–expression
dichotomy; the concern with copyrighting a work that reflects the only possible
expression of an idea probably is that the work is likely to be more of a factual work
than a creative expression. In other words, the merger doctrine and the idea–expression
requirements may really be another way of getting at the requirement of minimal creativity.
Moreover, with a generic work, the access costs of restricting public use (particularly
of ideas) probably outweigh the costs to the author of creating the work; this
imbalance weighs in favor of reducing the legal protections of the work and encouraging
the author to seek protection under the patent laws. Finally, the merger doctri,ne
operates in favor of certainty and judicial efficiency—if purely factual ideas could be
copyrighted, it would be nearly impossible to know whether infringement had taken
place or merely independent creation.

Feist Publications v. Rural Telephone Service Co.34

In Feist, the Supreme Court considered whether a telephone book could be protected
by a copyright, despite the factual nature of the contents. Feist had copied
thousands of listings from Rural’s white pages, including four fictitious listings
that Rural had included in order to detect copying. Rural filed suit against Feist
alleging copyright infringement and arguing that the effort necessary to compile
the entries in the book rendered the work more than purely factual.

The Court began with the established law that “facts” alone are not copyright-
able, while certain compilations of facts are. The Court also rejected the “sweat of
the brow” doctrine—a common law notion that a significant effort alone established
copyrightable material. Instead, the Ccourt recognized that compilations may involve
choices as to selection and arrangement that merit copyright protection. According
to the Court, “the requisite level of creativity is extremely low, even a slight amount
will suffice.” A directory can be copyrighted even if it contains only facts if it features
“an original selection or arrangement.” However, the simple compilation of
telephone numbers in alphabetical order by surname did not meet this low standard.

Post-Feist, some courts have struggled to determine exactly what kinds of works are
uncopyrightable because they are primarily factual and lack sufficient creativity.35 Other
cases have established that compilations are copyrightable where the bundling of facts


INTRODUCTION TO COPYRIGHT LAW

or distinct components creates a whole that has a greater value to consumers than simply
the sum of the parts.36

In the context of computer software and technology, the idea–expression principle
can become more muddled. The basic functions of a software program cannot be protected
by copyright for the very reasons that the merger doctrine exists—software may
be both expressive and functional—but technological progress would stall if programmers
were able to co-opt large chunks of code that are the only means of achieving certain
functionality.37

Lotus Development Corp. v. Borland International, Inc.38

Borland’s Quattro Pro spreadsheet copied the Lotus 123 command hierarchy so
that Quattro Pro could remain compatible with the Lotus product. The issue was
whether user interface command hierarchy is entitled to copyright protection. The
court found that the Lotus menu command hierarchy is a “method of operation,”
making it uncopyrightable under section 102(b). The menu commands are not
merely expression, but the method by which the program is operated and controlled.
Without access to these commands, macros designed for use on Lotus
could not be transferred to Quattro Pro. This is distinct from the screen layout
itself which contains expressive elements that could be accomplished by many
means. Similarly, the underlying source code is expression because many different
strings of code could be used to accomplish the same Lotus operations.

Under the court’s analysis, copyright protection applied when the purpose for
the menu commands was explanatory expressions, but such protection could not
be extended to those commands with a purpose of enabling use.

SUBJECT MATTER OF COPYRIGHTS

Section 102(a) of the copyright statute specifies eight categories of works that can be protected
by copyright: (1) literary works, (2) musical works, (3) dramatic works, (4) pantomimes
and choreographic works, (5) pictorial, graphic, or sculptural works, (6) motion
pictures and other audiovisual works, (7) sound recordings, and (8) architectural works.39
Each of these categories is defined by statute, with the exception of musical works, dramatic
works, and pantomimes and choreographic works.40 When dealing with a case
involving a statutorily defined category of work, the specific definition should be closely
examined. Moreover, the requirements discussed in the preceding section, including the
legal distinction between ideas and expression, must be applied to each category to determine
whether a copyright would be valid. For example, utilitarian aspects of sculptured
works or articles are not copyrightable.41 Blueprints of buildings are copyrightable, but
until 1990 the building itself was not copyrightable and could be copied.42


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Section 103 extends copyright protection to compilations and derivative works, both
of which were mentioned earlier.43 Derivative works require a bit more explanation.

Derivative Works

Derivative works achieve copyright status by making some creative addition to underlying
material (which material may or may not be copyrighted). A derivative work is
defined as:

a work based upon one or more preexisting works, such as a translation, musical arrangement,
dramatization, fictionalization, motion picture version, sound recording, art reproduction,
abridgment, condensation, or any other form in which a work may be recast, transformed or
adapted.44

Derivative works consisting of “editorial revisions, annotations, elaborations or other
modifications” (such as new editions of books) must, as a whole, represent an original
work of authorship in order to be copyrighted as a derivative work.45

An overly broad interpretation of derivative works (or a restrictive approach to the
creativity requirement) might swamp both the courts and the copyright system. Arguably,
nearly every work is “derivative” in some sense of preexisting works. In fact, Henry
Louis Mencken once said of Shakespeare, “After all, all he did was string together a lot
of old, well-known quotations.” For this reason, derivative works must be subject to
some limitation. The Seventh Circuit has explicitly addressed this potential problem:

Defined too broadly, “derivative work” would confer enormous power on the owners of copyrights
in preexisting works. The Bernstein–Sondheim musical West Side Story, for example,
is based loosely on Shakespeare’s Romeo and Juliet, which in turn is based loosely on Ovid’s
Pyramus and Thisbe, so that if “derivative work” were defined broadly enough (and copyright
were perpetual) West Side Story would infringe Pyramus and Thisbe unless authorized by
Ovid’s heirs. We can thus imagine the notion of pervasiveness being used to distinguish a
work fairly described as derivative from works only loosely connected with some ancestral
work claimed to be their original.46

In other words, a derivative work must be more than simply “loosely connected” to the
preexisting work, but not so similar as to lack an insubstantial variation from the original.
A derivative work must possess a degree of originality in order to prevent overlapping
claims.47 For example, merely employing a different medium from that used by
the copyright holder does not constitute a novel addition to the underlying work.48
Moreover, the courts are split regarding copyright treatment of allegedly derivative
works that make actual physical use of a copyrighted work, such as pasting a copy of
a painting onto a tile.49

A derivative work may be based on a copyrighted preexisting work or a work that
resides in the public domain. Works in the public domain may be the basis for copyright
protection in a derivative work so long as the latter has more than a trivial amount of


INTRODUCTION TO COPYRIGHT LAW

variation from the original.50 The degree of skill required to make the derivative work
may also influence judicial treatment of the “variation” from the preexisting work.51

An author has the exclusive right to prepare derivative works of his or her copyrighted
material unless that right has been transferred.52 “A work which makes nontrivial
contributions to an existing one may be copyrighted as a derivative work and
yet, because it retains the ‘same aesthetic appeal’ as the original work, render the holder
liable for infringement of the original copyright if the derivative work were to be published
without permission from the owner of the original copyright.”53 Accordingly, unauthorized
derivative works can be the subject of infringement actions.

Pickett v. Prince54

The singer Prince changed his name to an unpronounceable symbol, which was
not only his trademark, but also a copyrighted work of visual art that Prince’s
licensees embodied in various forms, including jewelry, clothing, and musical
instruments. Pickett designed a guitar in the shape of Prince’s unpronounceable
symbol. Shortly after Pickett showed his guitar to Prince, Prince began performing
with a very similar guitar. Pickett brought suit for copyright infringement,
claiming that he had created a derivative work worthy of copyright protection and
that Prince’s suspiciously similar guitar infringed that derivative work.

The Seventh Circuit held that Pickett had no right to make a derivative work
without Prince’s permission, as only the copyright owner and his licensees have
that right. The court explained that the justification for concentrating the right to
make derivative works in the copyright owner was avoiding the potential for infinite
disputes between competing authors of extremely similar derivative works.
For example, it would be nearly impossible to resolve whether Prince’s guitar
was a copy of Pickett’s version or simply a derivative work of his own symbol.
Accordingly, the law and public policy supported dismissal of Pickett’s claim
against Prince because Pickett had no rights in an unauthorized derivative work.

A classic example of a derivative work is the second edition of a treatise. The second
edition is copyrightable even though it makes only minor changes and additions to the
original edition. However, if someone were to publish a second edition of the treatise
without the permission of the copyright owners, the second edition would infringe on
the original copyrighted work.55 Only the copyright owner (or his or her assignees) has
the right to make derivative works.56

The justification for this allocation of rights is simple: if there were no limitation on who
could create derivative works, there would be a proliferation of copyright disputes that
could not be resolved by reference to standard copyright principles.57 For example, two


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

scholars could independently draft translations of a copyrighted foreign-language novel.
The translations necessarily would be very similar (unless one author was considerably
less skilled as a translator than his compatriot), and both would be sufficiently original.
Without an initial allocation of authority to the author of the original work, the courts would
have a difficult time resolving which derivative author should acquire the copyright.58

Regardless of the nature of the underlying work, the scope of a derivative work copyright
is limited to the extent of the material contributed to the preexisting work; it does
not confer a copyright on the underlying work.59 Authors of derivative works are entitled
to copyright protection only for any “novel additions” made by their work to the
existing copyrighted work.60

Computer Programs

Original computer programs, regardless of the computer language used, are copyrightable.
It is now settled law that at least the source code and object code of a computer
program are copyrightable under section 102 as “literary works.”61 The code itself
is equivalent to the “writing” element present in a literary work, while the typical storage
media (software, diskettes, and computer chips) constitute tangible media that satisfy
the fixation requirement.62 However, the basic functions of a computer program
cannot be protected by copyright because they constitute more “ideas” than “expressions.”
63 Courts struggle with whether certain aspects of software are expressions, and
thus subject to copyright protection, or ideas that should be covered by patent law, if at
all. The following case defined “idea” in the context of a computer program and established
a three-pronged test of possible infringement.

Computer Associates International v. Altai, Inc.64

In Altai, the owner of a copyrighted computer program brought suit for infringement
of the nonliteral elements of its operating system’s compatibility components.
The program at issue concerned a scheduling function that specified when
the computer should run various tasks. The plaintiff also marketed an adapter program
which translates a given computer program’s language into the computer’s
operating system. The court refers to this program as a “common system interface.”
Altai used some of the adapter source code to create its own interface system.
Altai then modified its interface to excise the copied adapter source code.
Nonetheless, Altai’s program was similar to the copyrighted program.

The court explained that it wanted to strike a balance between “incentives to
create” and “monopolistic stagnation.” After finding that the literal elements of
computer programs such as source and object code are copyrightable, the court
framed the problem as whether “ideas” or “expression” were at issue. The court defined
“ideas” as components that are (1) necessarily incidental to the function of the program;


INTRODUCTION TO COPYRIGHT LAW

Computer Associates International v. Altai, Inc. (continued)

(2) dictated by efficiency or externalities; (3) merged with the idea of the program;
(4) stock components that are commonly used; or (5) taken from the public domain.
The court then adopted a three-step test, commonly referred to as “Abstraction-
Filtration-Comparison” or “Successive Filtration” test. First, break down the alleged
infringing program into its parts, starting with the lowest level of abstractions and
moving toward the most general level. Next, through a process of “filtration,” separate
protectable expression from nonprotectable ideas. This step utilizes the definition
of “ideas” outlined above. Finally, compare the remaining alleged infringing
aspects with the copyrighted expression, and consider the relative importance of the
copied portions to the overall program. The similarity between the elements remaining
in the final comparison determines whether infringement exists. In this
case, the similar, nonliteral aspects of the programs were essential ideas dictated by
the nature of the programs and thus could not be protected by copyright.

As Altai illustrates, the merger doctrine is vital to assessing copyright protection for
computer software.65 Where there are only limited ways to effectively interface the user
with a computer, such as a printer icon or the word “print” to indicate the print function,
such interfaces are not likely to be copyrightable.66

Authors of copyrighted computer programs have an important restriction on their
exclusive rights. Section 117 of the Copyright Act states that it is not infringement for
the owner of a copy of a program to make a copy of that program for archival purposes
(i.e., as backup) or if that copy is created as an essential step in the use of the program
on a computer.67 Moreover, it is not an infringement for the owner of a computer to
make (or authorize making) a copy of the program “for purposes only of maintenance
or repair of that machine.”68 These “repair copies” can be used only for those purposes
and must be destroyed immediately after the maintenance or repair is completed.69

These exceptions are narrowly tailored in an attempt to prevent rampant software
copying. For example, none of these exceptions authorizes the owner of a program to
post or download a copy of that program to or from the Internet. Additionally, any
archival copy prepared under section 117 can be transferred to another person only if
the original copy is also transferred and the transfer is part of the sale of all rights in the
program.70 The limitations of section 117 represent the copyright law’s continuing
attempt to adjust to the particular facts of new and evolving mediums.

Characters

Characters, such as David Copperfield or Papa Smurf, are protected by the copyright laws
if they are developed with sufficient specificity so as to constitute protectable expres



COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

sion.71 Some courts adopt a more restrictive approach, requiring the character to “constitute
[ ] the story being told” in order to be copyrightable.72 The latter approach has been
increasingly criticized, and limited in its application.73 Under either test, stock characters
are not likely to be copyrightable because they are merely vehicles of the story.74 On the
other hand, where the character is the story, copyright protection generally adheres.75

Several courts appear to limit the more stringent requirements for copyright protection
to purely literary characters rather than those characters that are visually
depicted in a movie or a comic book, as well as sketched out by the written word.76
Where the author adds a visual, physical image to his concept of the character, the
courts may be more likely to find that the character contains the requisite unique elements
of expression.77 For example, comic book characters have satisfied even the
more stringent test for copyright protection of characters due, in part, to their identifying
visual characteristics.78

Anderson v. Stallone79

Anderson v. Stallone involved a dispute regarding the authorship of the script for
the movie Rocky IV. A screenwriter, Anderson, claimed that Sylvester Stallone
and the MGM Studios had stolen his ideas from a sample screenplay and used
that screenplay as the basis for Stallone’s script. Stallone owned the copyright for
the first three “Rocky” movies, but Anderson argued that the Rocky characters
did not merit copyright protection as they were merely “stock characters.”
Accordingly, Anderson claimed that he had every right to use the Rocky characters—
including the boxer Rocky Balboa, his loyal wife Adrienne, tough but
loving coach Mick, and competitor-turned-coach Apollo Creed—in a sequel.

The court rejected this argument, describing the character of Rocky Balboa as
“such a highly delineated character that his name is the title of all four of the
Rocky movies.” In fact, the court stated that “if any group of movie characters is
protected by copyright, surely the Rocky characters are protected from bodily
appropriation into a sequel.” The court concluded that the Rocky characters meet
either test for copyright protection, and thus Anderson’s script was merely a derivative
work. Since the script was an unauthorized derivative work, Anderson’s
claim to authorship of Rocky IV was dismissed.

It is interesting that the court treated the “Rocky” characters with such deference.
Arguably, the characters were recognizable primarily because they are such simple,
stock characters—the tough, blue-collar boxer from the streets, his loyal and constantly
worried wife, and even the hard-nosed coach who ends up loving Rocky like a son—
these characters are present in many boxing films. In fact, the traits cited by the court
as evidence of Rocky’s highly developed character (his speaking mannerisms and


INTRODUCTION TO COPYRIGHT LAW

physical characteristics) are primarily associated with the actor who played the character,
Sylvester Stallone, rather than evident from the printed page. The court’s decision
implicitly recognizes that an actor’s characteristics may blur with the script to form a
total character for copyright purposes. Other courts certainly have also recognized that
“speech is only a small part of a dramatist’s means of expression.”80 However, where
the primary “expressive” features of a character are contributed by the well-known
actor who portrays the character, the traditional justifications for awarding copyright
protection to the author of the screenplay do not seem to apply.

Music

There are two statutory categories of music that may be subject to copyright protection:
“musical works, including any accompanying words” and “sound recordings.”81 The
former category covers the actual piece of sheet music or fixation of the lyrics rather
than the sounds themselves. The latter category proffers protection to the audible works
that result from the fixation of “a series of musical, spoken or other sounds, but not
including the sounds accompanying a motion picture or other audiovisual work....”82
The same requirements of originality and fixation discussed previously apply to both
categories of copyrightable music. The Copyright Act uses the term phonorecord in the
context of fixation of music. Despite its apparently dated meaning, “phonorecord” is
defined by the Act as any material object in which sounds are fixed “by any method now
known or later developed, and from which the sounds can be perceived, reproduced, or
otherwise communicated....”83 Accordingly, “phonorecords” can refer to CDs, audiocassette
tapes, or any future means of recording sounds.

Unlike other copyrightable works, musical works are subject to a compulsory licensing
scheme.84 Essentially, the author’s “exclusive” rights to make and distribute
phonorecords under sections 106(1) and 106(3) are subject to compulsory licensing of
covers of nondramatic musical works. The compulsory licensing allows any artist to
pay a fee and make his or her own recording of the musical work, but not to simply
reproduce another’s copyrighted sound recording.85 The would-be cover artist must
notify the copyright holder of intent to produce a licensed recording and pay a royalty
rate established by federal arbitration panels.86 The royalty rate is adjusted periodically;
for example, in 1999, the royalty rate was 7.1 cents per recording or 1.35 cents per
minute, whichever amount was larger.87

There are limits on the compulsory licensing scheme. The highly technical distinctions
and requirements are beyond the scope of this discussion, but there are a few
basic parameters. First, the primary purpose of the cover must be public distribution of
the sound recording for private use.88 Second, a compulsory licensee can rearrange the
work to conform to individual style, but he or she cannot change the “basic melody or
fundamental character of the work” and thus shall not be independently copyrightable
as a derivative work.89 Third, it is important to remember that audiovisual works are
excluded from compulsory licensing and the written lyrics may be independently copyrighted
as a literary work.90


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

No

No copyright
Useful article?
PG&S work
Original?
Design separable?
No copyright Design is PG&S work
No Yes
Yes No
Yes
Copyright
EXHIBIT 10-1 Design of a Useful Article
Pictorial, Graphic, and Sculptural Works

Under section 101, copyright protection may apply to “two-dimensional and three-
dimensional works of fine, graphic and applied art. . . .”91 Moreover, copyright protection
can apply to the form of an object, but only to those aspects that are neither mechanical
nor utilitarian (see Exhibit 10-1).92 This means that it is possible to copyright the design
of a useful article where that design incorporates “pictorial, graphic, or sculptural features
that can be identified separately from, and are capable of existing independently of, the
utilitarian aspects of the article.”93

The practical analysis of copyright protection for pictorial, graphic, and sculptural
works can be broken down as follows:

First, the practitioner must determine whether an article qualifies as “useful.” “Useful
articles” are defined as objects with an intrinsic utility beyond portraying the
appearance of conveying information.94 If the article is “useful,” then the question
becomes whether there are design aspects that can be separated from the utilitarian
functions of the article. If not, then the article cannot be copyrighted. Finally, if the
overall design or at least certain aspects of the design qualify as a pictorial, graphic, or
sculptural work, then the standard originality analysis must be applied to determine
whether copyright protection can apply.

For example, a lamp base shaped like a Balinese dancer holding the bulb functions
both as a structural lighting support and as a sculptural work. The dancer is both physically
and conceptually separate from the rest of the lamp. Accordingly, the dancer
design aspects of the lamp probably could be copyrighted.95 Of course, the copyright
owner could not prevent others from using the idea of human figures supporting light,
but he could preclude competitors from copying his particular copyrighted dancers.96

In contrast, where the allegedly artistic features are dictated by the function of the article,
the features probably are inseparable from the utility and thus are not copyrightable.
For example, a mannequin’s torso is not copyrightable, despite the superficial similarity


INTRODUCTION TO COPYRIGHT LAW

to sculptural works, because the artistic features are inseparable from the utility of facilitating
clothing display.97 Moreover, the wavy design of a bike rack has also been assessed
merely as “form following function” and thus is not a proper sculptural work.98

Patents are also available to protect designs. In fact, there may be some overlap
between the two legal regimes in this area. Design patents offer greater protection
than copyrighted designs because they bar any copy of the design, even those that are
independently created. However, it may be more difficult to satisfy the legal requirements
for a patent than for a copyright. Furthermore, design patents have shorter duration
than copyrights (see subsequent discussion of copyright duration). Accordingly, in
some cases, copyright protection is more attractive and cost-effective than undergoing
the technical proceedings associated with acquiring a design patent.

Finally, authors of pictorial, graphic, and sculptural works have unique rights under
the Copyright Act that do not apply to the authors of other types of copyrighted works.
In 1990, Congress added the Visual Artists Rights Act (VARA) to the Copyright Act
to protect the moral rights of authors.99 The VARA provides two distinct rights to
the authors of visual art: the right of attribution and the right of integrity.100 The right
of attribution ensures that the author shall always have the right to take credit for
authorship of the work and deny credit for work that either (a) the author did not create,
or (b) has been so mutilated that attribution would be prejudicial to the author’s
honor or reputation.101 The right of integrity allows the author to prevent any intentional
“distortion, mutilation or other modification” of the visual work that would be
prejudicial to the author’s honor or reputation.102 The right of integrity may also allow
an author to prevent the destruction of a work of “recognized statute.”103

This discussion simply outlines the VARA; any particular claims raised under this
section of the Copyright Act should spur careful review of the statutory requirements.
Moreover, VARA rights have some important limitations, a few of which bear mention
here. First, the rights adhere only to the author, even if the author is no longer the owner
of the copyright (due to transactions transferring the copyright to another party).
Second, the rights of attribution and integrity are subject to the fair use defense (discussed
later in this chapter).104 Finally, if the work is a part of a building and the author
consented to that incorporation, then the rights are curtailed.105

PUBLICATION

Under common law and early federal law, publication was a significant act triggering
or ending the legal protection of copyrighted works. Initially, publication marked a transition
from common law protection to the federal protection scheme. Prior to the 1976
Act, federal law did not protect unpublished works. Instead, such works were covered
by common law copyright. In contrast, common law copyright protection expired
upon publication. “Published” signifies the point at which copies of the work were first
distributed to the public by sale or other transfer of ownership.106


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Currently, the issue of publication is less significant because it affects only the duration
of copyrights preceding 1978 and copyrights of works for hire. Fixation in a tangible
medium is sufficient to invoke federal copyright protection for original works.

COPYRIGHT FORMALITIES

The primary formal requirements for copyright protection are notice and registration.
Before 1976, works had to carry a notice of copyright to preserve statutory rights upon
publication. This requirement was weakened by the 1976 Act, which allowed a correction
to be made within five years of publication, and eliminated altogether in 1989.
After 1989, the federal law ceased requiring formal notice.107 The importance of notice
today is that when the work does include a notice of copyright, an infringer cannot
assert the defense of “innocent” infringement.108

Registration of the copyright (with the Copyright Office of the Library of Congress)
also is optional under the current regime.109 However, registration within five years of
first publication gives rise to prima facie evidence that the copyright is valid; also,
registration is a prerequisite for a copyright infringement suit under the act.110 Although
registration is not a precondition for copyright protection (i.e., the rights of the owner
are still in effect), it is necessary to register before bringing an action under the act.111
Moreover, since a work that falls within the subject matter of federal copyright cannot
receive common law protection, the unregistered owner may be without any legal
recourse until he or she registers the work.112 Registration can occur after the infringement
begins, but this type of tardy action by the copyright owner affects the damages
available. As discussed in subsequent chapters, statutory damages and attorney fees are
available only after registration occurs.113

OWNERSHIP

Ownership of a copyright is conceptually distinct from ownership of a copyrighted
object.114 Transferring ownership of a copyrighted object does not transfer the copyright
embodied in that object.115 For example, purchasing a Picasso painting does not
transfer the copyright from Picasso (or his heirs) to the purchaser. Ownership of a copyright
resides in the author of the work in question.116 The analysis becomes more complicated
if more than one individual contributed to the work.

Two or more authors are treated as co-owners of the copyright if their intention was that
their contributions be “merged into inseparable or interdependent parts of a unitary
whole.”117 The product of this type of collaboration is called a “joint work.”118 Where this
standard of intentional intermingling is not met, the resulting work is deemed a “collective
work.”119 Each author of a collective work is presumed to have acquired a copyright only
as to his or her contribution and may copy and distribute copies only of that portion of the


INTRODUCTION TO COPYRIGHT LAW

collective work.120 In contrast, joint authors have rights to the entire work and may transfer
the copyright only upon reaching an agreement among a majority of the authors.121

But what happens when a company hires a programmer to produce new software? The
statute considers this situation under the “work for hire” doctrine.122 Although the statute
has a lengthy definition of a “work for hire,” essentially when a work is prepared by a
regular employee acting within the scope of employment, the work is considered a work
for hire, and the copyright in that work belongs to the person for whom the work was
prepared.123 With independent contractors, the copyright belongs to the creator unless the
work was created under a contract that explicitly indicates that the work being specially
ordered or commissioned will be treated as a work for hire.124 In other words, the parties
may contract to treat any work as a work for hire, resulting in the employer or the commissioning
party being considered the author of the work and the owner of the copyright.

Community for Creative Non-Violence v. Reid125

This case lays out the factors for determining copyright ownership of a work produced
as part of a job. CCNV hired Reid to create a statue depicting the plight of
the homeless. After completion of the statue, the parties filed competing copyright
registrations. CCNV argued that the work was a work for hire under the statutory
definition, while Reid claimed that he had been merely an independent contractor
and thus retained the copyright as author.

To resolve this conflict, the court looked to whether the artist was an employee
within common law definitions of the master–servant relationship. The court
rejected CCNV’s argument that the hiring party’s right to control or actual control
tests should determine whether the statue was a work for hire. In fact, the court
concluded that Reid was not an employee as he was hired only for a single, well-
defined task, worked in his own studio, provided his own materials for the statue,
and was a skilled sculptor. These factors indicated that Reid was an independent
contractor, and therefore owned the copyright.

COPYRIGHT HOLDER’S RIGHTS

Unlike the limited right of exclusion granted to a patentee, a copyright owner is entitled
to several affirmative rights. The Copyright Act grants six categories of basic rights to
the copyright holder126:

1. Only the copyright holder can grant permission to copy the work.
2. Only a copyright owner can create a derivative work.
3. Only a copyright owner can sell or distribute copies of the work.

COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

4.
Only the copyright owner can grant permission to publicly perform his or her work.
5.
Only the copyright owner has the right to display the work in public.
6.
Only the copyright owner can perform a sound recording by means of a digital
audio transmission.
Copyrights have a limited duration, varying based on the type of work at issue. With
standard, single-author works, copyright protection runs for the life of the author plus
70 years.127 In the case of joint works, the copyright covers the life of the last surviving
author plus 70 years.128 If the work is anonymous, pseudonymous, or a “work for
hire,” the duration of protection runs for 120 years from the date of fixation or 95 years
from the date of publication, whichever is shorter.129 Finally, the public can presume
that the author is dead 95 years after the year of the first publication of the work, or 120
years after the year of the work’s creation (whichever expires first), unless the author
indicates otherwise.130 Reliance in good faith on the presumption of an author’s death
is a complete defense to infringement.131

INFRINGEMENT

Infringement is the unauthorized exercise of one of the copyright holder’s exclusive
rights.132 Frequently, the issue is whether copying actually occurred. It is possible that
the alleged infringer merely came up with the same work without copying; so-called “independent
creation” or “accidental duplication” is a defense to copyright infringement.133
Copying typically is proven either by showing direct copying (e.g., a photocopy of the
copyrighted work) or by circumstantial evidence that (1) the defendant had access to
the protected work, and (2) that the accused work is substantially similar.134 Substantial
similarity can be seen in overall structure, specific wording, or elements composing
important fragments of the infringing work.135 An inference of copying (generally
established by probable access) in conjunction with substantial similarity can establish
infringement.136 Overall, the courts appear to be engaged in a constant balancing of the
trade-off between striking similarity of the two works and likelihood of access; the finding
of infringement must appear reasonable in light of all the evidence, but some courts
place a greater emphasis on similarity, while others seem to want evidence of access
before finding liability for infringement.

Ty, Inc. v. GMA Accessories137

Ty involved alleged infringement of the popular “Beanie Babies” toy animals,
particularly a bean bag pig and cow. The court analyzed infringement by a two-step
test—access and similarity. The court determined that access could be inferred “when
two works are so similar to each other and not to anything in the public domain
that it is likely that the creator of the second work copied the first, but the inference


INTRODUCTION TO COPYRIGHT LAW

Ty, Inc. v. GMA Accessories (continued)

can be rebutted by disproving access or otherwise showing independent creation.
. . .” Accordingly, establishing lack of access could overcome substantial
similarity. However, the court held that “similarity so close as to be highly unlikely
to have been an accident of independent creation is evidence of access.”

This analysis works best where the copyrighted work is both unusual and dissimilar
to anything in the public domain. In those cases, extremely close similarity
can establish infringement despite protestations of independent creation.

An alternative interpretation of the access requirement is the theory of subconscious
copying, as first explained in the following case.

Bright Tunes Music Corp. v. Harrisongs Music, Ltd.138

Bright Tunes alleged that former Beatle George Harrison’s song “My Sweet Lord”
infringed the copyrighted song “He’s So Fine,” originally recorded by a group
known as the Chiffons. Bright Tunes owned the copyright to “He’s So Fine” and
argued that the musical motifs and harmonies in the songs were virtually identical.
Harrison conceded the possibility of access, given the popularity of “He’s So Fine”
and his own musical background, but contended that he came up with his song
while “vamping” some guitar chords after a concert. Several witnesses observed
Harrison while the idea was germinating and the basic structure of the song evolved.

The court concluded that Harrison had engaged in “subconscious copying.”
Specifically, the court found that while Harrison experimented with different
musical combinations, he hit upon a combination that he felt would be appealing
to an audience. The court decided that, at that moment, Harrison’s “subconscious
knew it already had worked in a song his conscious mind did not remember.”
Despite Harrison’s lack of awareness that he was utilizing the theme to “He’s So
Fine,” the two songs were virtually identical, other than the difference in lyrics.

Accordingly, the court found that Harrison infringed Bright Tunes’s copyright “no
less so even though subconsciously accomplished.” Access plus substantial similarity
were sufficient evidence of infringement, despite the conceded absence of intent.

Although not every court accepts the theory of subconscious copying, the theory does
suggest that courts may be increasingly skeptical about the independent creation
defense, particularly in a world where information travels so quickly and access can be
easily attained. However, damages may be reduced in these cases to account for the possibility
of independent creation and credit the defendant’s lack of bad faith.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

COPYRIGHT IN THE DIGITAL AGE


Copyright law is being brought into the digital age as individuals attempt to apply copyright
protection where patents are unavailable, particularly to software code. The
increasing presence of copyrights in the technology context has produced several interesting
developments. First, the legal debate over computer code’s dual role as command
and expression continues, even as new code threatens to undermine technical copyright
protections erected by copyright owners. As discussed earlier in this chapter, the idea–
expression dichotomy breaks down to some extent when dealing with computer code, as
it can be both command and expression. If the code itself is copyrighted, then the copyright
owners exclusive right to copy and distribute that code may conflict with other
copyright owners’ attempts to protect their works from that code. Universal City Studios

v. Corley exemplifies these dilemmas and the interaction between copyright law and
First Amendment concerns.
Universal City Studios v. Corley139

Universal City Studios examines First Amendment law in the digital age, and its
interaction with copyright protection. Corley appealed from an injunction barring
him from posting a decryption program known as “DeCSS” on his web site or
from knowingly linking his web site to any other web site on which DeCSS was
posted. DeCSS was designed to circumvent CSS, the encryption technology that
motion picture studios place on DVDs to prevent unauthorized viewing and copying.
Corley argued that the decryption program was protected speech under the
First Amendment and that those constitutional concerns trumped the copyright
protections threatened by DeCSS.

The court determined that although “computer code is not likely to be the language
in which a work of literature is written,” computer code and programs are
“speech” and therefore protected under the First Amendment. However, since
computer code causes a computer to accomplish tasks with minimal human
action, computer code should be treated as combining nonspeech and speech elements
(sometimes referred to as functional and expressive elements) for purposes
of free speech analysis. The court concluded that the prohibition on posting and
linking to DeCSS was constitutional because it was targeted only at the nonspeech
component of the code, as the injunction was concerned solely with DeCSS’s
capacity to instruct a computer, not the limited information it might convey to a
human reader. Furthermore, the court maintained that encryption undertaken to
protect economic interests, such as the interest of the moviemakers in protecting
their copyrighted DVDs, was lawful and making deciphering software available
for the primary purpose of circumventing encryption was not protected by the
same law it sought to undermine.


INTRODUCTION TO COPYRIGHT LAW

Second, the congressional response to copyright problems in cyberspace resulted in
the Digital Millenium Copyright Act (DMCA).140 The DMCA has two purposes: (1) the
prevention of copyright infringement by banning technologies that allow circumvention
of copyright protections such as encryption; and (2) the creation of a “safe harbor” for
on-line service providers (OSPs) for certain types of copyright infringement. The former
provisions are highly technical and have been the subject of recent criminal prosecutions.
The latter provides OSPs with immunity from monetary liability for direct,
vicarious, and contributory copyright infringement so long as the OSP has complied
with certain procedural requirements and had no actual knowledge of the infringement.
141 To take advantage of the safe harbor provisions, OSPs must develop and
post a policy regarding the termination of accounts of repeat offenders and general
compliance with copyright laws. Moreover, the OSPs must comply with specific notification
requirements for disabling and restoring access to allegedly infringing material.
If the OSP has complied with the statutory requirements, then it cannot be held
liable in any monetary sense for unknowing storage of infringing materials, links or
referrals to infringing materials, caching of infringing materials, or removing access to
infringing materials.

Hendrickson v. eBay, Inc.142

In a matter of first impression in the federal courts, the Internet auction company
eBay successfully used the safe harbor provisions of the DMCA as a defense to
allegations of copyright infringement. Hendrickson sued eBay because the company
refused to take down DVDs and videotapes of his 1972 documentary
Manson that he alleged were pirated copies. Hendrickson refused to submit a
sworn, written statement in compliance with eBay’s “Verified Rights Owner
Program” and the DMCA’s requirement of written notification of the copyright
infringement claim before filing suit. Absent such notification, the court held that
although eBay may have facilitated the sale of infringing material, eBay did not
have the right or ability to exert control over those sales. eBay is not required to
proactively monitor the postings on its site or affirmatively search for infringing
material. Accordingly, the court granted eBay’s motion for summary judgment.

FAIR USE DEFENSE

There are several possible defenses to copyright infringement. Many of them have been
discussed already, including: invalidity of the copyright (because it is asserted by a
nonowner, applies to inappropriate subject matter, is insufficiently original, or not
fixed); independent creation; and the section 117 defenses for uses of computer software.
The remaining primary defense, “fair use,” immunizes an alleged infringer from


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

liability for the “fair use” of a copyrighted work.143 Fair use of copyrighted works can
be made for criticism, comment, news reporting, scholarship, or research. These “fair
uses” share the trait of being productive uses, not simply duplicative of the original,
copyrighted work. The following statutory factors determine whether use of a copyrighted
work is “fair use” or infringement144:

1.
The purpose and character of the use. In general, transformative uses of copyrighted
works, such as a parody of a copyrighted song, are favored.145
Moreover, uses that are of a commercial nature are less likely to be deemed a
fair use than uses that are purely nonprofit or educational. For example, including
a copyrighted poster in the background of a television sitcom is simply a
decorative use, not “incidental” or transformative. Accordingly, it probably
will not qualify for a fair use defense.146
2.
The nature of the copyrighted work. This factor examines whether the work is
derived more from facts or fantasy. The closer a work is to being factual, the
more likely an unauthorized use of that work is to be found a fair use. The
courts may also consider whether the work is rare or out of print. If a work is
hard to find, the use may be justified on the basis of increasing the public
access to an otherwise unattainable work.
3.
The amount of the work used relative to the copyrighted work as a whole.
Courts determine the amount and substantiality of the portion of the copyrighted
work used, relative to the copyrighted work as a whole. Minimal uses
are more likely fair uses than those uses that excerpt the heart of the work.
Penalizing uses of a small amount of the work merely increases transaction ,
costs and diminishes the probability that there will be any substantial effect on
the market for the original work.147
4.
The impact of the use on the market or value of the copyrighted work. Generally,
this is the most important factor, as where the use will result in a loss of sales or
licensing of the copyrighted material through substitution, the use is disfavored
and the fair use defense probably will not prevail. Courts examine the market
effects of the conduct taken to its logical extreme, for example, the crucial factor
is the impact of allowing everyone to engage in the conduct, not simply ignoring
an isolated act of infringement that, by itself, lacks significant market effects.148
Harper & Row v. Nation Enterprises149

The case involved publication by Nation magazine of a portion of the unpublished
autobiography of Gerald Ford that was scheduled to appear in Time magazine. Time
canceled its publication after the Nation article appeared and sued for copyright
infringement. The issue was whether the Nation article constituted “fair use.”


INTRODUCTION TO COPYRIGHT LAW

Harper & Row v. Nation Enterprises (continued)

The Court addressed the section 107 factors. It found that an author makes
implied consent to “reasonable and customary” use of a released work. However,
in this case the Nation article preempted the value of the Time article. The significant
market effect of the use, as well as the fact that a substantial portion of the
work was used, precluded the fair use defense. Moreover, it does not matter that
the issue was newsworthy, although this can be a factor.

The Court described the unpublished status of the autobiography as a “key but
not determinative factor.” Fair use is less persuasive when the copyrighted work
is unpublished because use by any other person irrevocably destroys the author’s
right of first publication. Focusing on the section 107 factors, the Court found that
the Nation had infringed and did not come within the fair use doctrine.

The “market effect” factor has spawned a slightly different fair use defense, that
of a “substantial noninfringing use.”150 In Sony Corp. of America v. Universal City
Studios, the Supreme Court examined the use of VCRs to record copyrighted shows as
a possible fair use of those copyrighted works. The Court determined that there was
the possibility of a substantial noninfringing use, for example, that many television
shows would have no objection to being recorded, particularly educational programs,
sporting matches, religious services, and so on.151 Moreover, the home recording was
not a commercial use of the copyrighted shows, nor did it appear that there were any
substantial market effects related to the practice. The Court did not appear concerned
with whether the primary uses actually would be the substantial noninfringing uses
that fell under the fair use defense, but focused on the fact that the technology was
“merely capable” of those uses. Accordingly, the Court refused to hold Sony liable for
marketing VCRs that enabled their users to infringe others’ copyrights because the
technology also allowed fair uses.

SUMMARY

Copyright law seeks to grant the copyright owner the right to restrict others from reproducing,
distributing, publicly performing or displaying, transmitting, or creating derivative
works of the owner’s protected work. The exclusive rights serve as incentives and
rewards for the creation of unique expressions in art, literature, and nearly any other
medium, including computer code. Whatever the medium, works must be “original”
and “fixed” in order to qualify for copyright protection, and the legal protection extends
only to that particular expression, not to the underlying idea or concept itself. An alleged
copyright infringer may raise several defenses, including independent creation, fair
use, and the invalidity of the copyright itself.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

ENDNOTES


[1]
See David L. Bainbridge, Intellectual Property 28, 3rd ed. Pitman Publishing (1996) (discussing
ancient roots of copyright laws).
[2]
See generally Matthew D. Bunker, Eroding Fair Use: The Use Doctrine After Campbell,
7 Comm. L. Pol’y 1 (2002) (discussing history of copyright laws).
[3]
See generally Roberta Rosenthal Kwall, Author-Stories: Narrative’s Implications for
Moral Rights and Copyright’s Joint Authorship Doctrine, 75 Cal. L. Rev. 1, 17–20 (2001)
(discussing history of copyright laws).
[4]
See id. at 20–21.
[5] U.S Const., art. I, § 8, cl. 8.
[6]
Constant v. Advanced Micro-Devices, Inc., 848 F.2d 1560, 1564 n.4 (Fed. Cir. 1988). (“The
power to grant patents to inventors is for the promotion of the useful arts, while the power
to grant copyrights to authors is for the promotion of ‘Science,’ which had a much broader
meaning in the 18th Century than it does today.”)
[7] 17 U.S.C.A. §§ 101-1332 (1998 and Supp. 2000).
[8]
Id. §102.
[9]
Id. § 102(b).
[10]
Harper & Row Publishers, Inc. v. Nation Enterprises, 471 U.S. 539, 547–49 (1985); 1 M.
Nimmer and D. Nimmer, Copyright §§ 2.01[A], [B] (1990).
[11]
See Feist Publications, Inc. v. Rural Telephone Svc., 499 U.S. 340 (1991), citing Sheldon
v. Metro-Goldwyn Pictures Corp., 81 F.2d 49, 54 (2d Cir. 1936).
[12] 17 U.S.C. § 101; United States v. Taxe, 540 F.2d 961, 965 n.2 (9th Cir. 1976), cert. denied,
429 U.S. 1040 (1977).
[13]
Eden Toys, Inc. v. Florelee Undergarment Co., 697 F.2d 27 (2d Cir. 1982).
[14]
Feist Publications, 499 U.S. 340; see also Eden Toys, 697 F.2d at 34.
[15]
See 1 Nimmer on Copyright § 20.01[B] at 2-13 (illustrating class of cases where even
independent efforts may be too trivial or insignificant to merit a copyright).
[16]
Pickett v. Prince, 207 F.3d 402, 405 (7th Cir. 2000) (noting that plaintiff’s guitar built in
the shape of the symbol adopted by the artist formerly known as Prince probably lacked
the requisite incremental originality, even if plaintiff had obtained Prince’s permission to
build the guitar (which he had not)); see also 1 Nimmer on Copyright § 2.15 (identifying
line of cases holding that types of lettering and typefaces are not copyrightable).
[17]
Magic Marketing, Inc. v. Mailing Services of Pittsburgh, Inc., 634 F. Supp. 769 (W.D. Pa.
1986); Woods v. Bourne Co., 60 F.3d 978, 990 (2d Cir. 1995) (quoting L. Batlin & Son,
Inc. v. Snyder, 536 F.2d 486, 491 (2d Cir.) (en banc), cert. denied, 429 U.S. 857, 97 S. Ct.
156 (1976)).
[18]
Magic Marketing, 634 F. Supp. 769.

INTRODUCTION TO COPYRIGHT LAW

[19]
37 C.F.R. § 202.1(a); Shaw v. Lindheim, 919 F.2d 1353, 1362 (9th Cir. 1990); Sem-Torq,
Inc. v. K Mart Corp, 936 F.2d 851, 854–55 (6th Cir. 1991); Arthur Retlaw & Assocs., Inc.
v. Travenol Labs, Inc., 582 F. Supp. 1010, 1014 (N.D. Ill. 1984).
[20]
See, e.g., Harper House, Inc. v. Thomas Nelson, Inc., 889 F.2d 197 (9th Cir. 1989).
[21]
Magic Marketing, 634 F. Supp. at 772; Merritt Forbes & Co. v. Newman Investment
Securities, Inc., 604 F. Supp. 943, 951 (S.D.N.Y. 1985); Perma Greetings v. Russ Berrie
& Co., 598 F. Supp. 445, 448 (E.D. Mo. 1984).
[22]
See Kitchens of Sara Lee, Inc. v. Nifty Foods, Corp., 266 F.2d 541 (2d Cir. 1959) (declining
to apply copyright protection to serving directions on a frozen dessert package);
1 Nimmer on Copyright § 2.01[B] at 2-13–14. This logic parallels the treatment of pictorial,
graphic, and sculptural works discussed later in this chapter.
[23] 17 U.S.C. § 102(a). If a work is not fixed, it falls within common law copyright protection,
or any applicable state law. See 17 U.S.C. § 301(b)(1) (regarding scope of federal
preemption of other copyright laws).
[24] 17 U.S.C. § 101.
[25]
Id.
[26]
Id. (“A work consisting of sounds, images, or both, that are being transmitted, is ‘fixed’
for purposes of this title if a fixation of the work is being made simultaneously with its
transmssion.”)
[27]
See R. R. Kwall, Copyright and the Moral Right: Is an American Marriage Possible? 38
Vand. L. Rev. 1, 75 (1985).
[28] 17 U.S.C. § 102(b); see, e.g. Mazer v. Stein, 347 U.S. 201, 217 (1954); Mihalek Corp. v.
Michigan, 814 F.2d 290, 294 (6th Cir. 1987); Arica Institute, Inc. v. Palmer, 761 F. Supp.
1056, 1062 (S.D.N.Y. 1991); Wickham v. Knoxville Int’l Energy Exposition, Inc., 739 F.2d
1094, 1097 (6th Cir. 1984).
[29]
See Chapter 6; see also Baker v. Selden, 101 U.S. 99 (1879) (finding that idea for bookkeeping
system was more properly within the purview of patent law than copyright).
[30]
Homan v. Clinton, No. 98-3844, 1990 U.S. App. LEXIS 13401 (6th Cir. June 14, 1999).
[31]
See, e.g., Morrissey v. Procter & Gamble Co., 379 F.2d 675 (1st Cir. 1967) (finding that
sweepstakes rules were not copyrightable).
[32]
See, e.g., Kregos v. Assoc. Press, 937 F.2d 700 (2d Cir. 1991); Consumers Union v. Hobart
Mfg. Co., 199 F. Supp. 860 (S.D.N.Y. 1961) (quotations from Consumer Reports were
“bald statement[s] of fact” that could not have been stated in a different fashion); see also
37 C.F.R. § 202.1(d) (copyright protection does not extent do common property such as
standard calendars and area code maps).
[33]
Some courts treat the merger doctrine as a principle best evaluated in the context of determining
whether infringement has occurred, rather than as an issue of copyright validity.
See Kregos v. Assoc. Press, 937 F.2d 700 (2d Cir. 1991); 3 Nimmer on Copyright §
13.03[B][3] at 13–58 (1990).
[34]
Feist Publications, 499 U.S. 340.

COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

[35]
See, e.g., Key Publications, Inc. v. Chinatown Today Publishing Enters., Inc., 945 F.2d
509 (2d Cir. 1991) (finding selective yellow pages to merit copyright protection);
BellSouth Advertising & Publishing Corp. v. Donnelly Information Publishing, Inc., 999
F.2d 1436 (11th Cir. 1993) (finding yellow pages were not copyrightable); Transwestern
Pub. v. Multimedia Marketing Assoc., 133 F.3d 773 (10th Cir. 1998) (declining to protect
yellow pages under copyright law).
[36]
See Roth Greeting Cards v. United Card Co., 429 F.2d 1106, 1109 (9th Cir. 1970); Sem-
Torq, Inc. v. K Mart Corp, 936 F.2d 851, 854–55 (6th Cir. 1991) (bundling several unoriginal
signs together for sale did not create a copyrightable work where the bundling did
not add anything of value to the work of authorship); Apple Computer v. Microsoft, 779
F. Supp. 133, 136 (N.D. Cal. 1991) (upholding copyright for original combination of
independently unprotectable elements); Barris Fraser v. Goodson-Todman, 5 U.S.P.Q.
2d 1887, 1891 (S.D.N.Y. 1988); Baldine v. Furniture Comfort Corporation, 956 F. Supp.
580, 587 (M.D.N.C. 1996).
[37]
See, e.g., Gates Rubber Co. v. Bando Chem. Indus., Ltd., 9 F.3d 823 (10th Cir. 1993).
[38]
Lotus Dev. Corp. v. Borland Int’l, Inc., 49 F.3d 807 (1st Cir. 1995), aff’d 516 U.S. 233
(1996).
[39] 17 U.S.C. § 102(a).
[40]
See id § 101.
[41]
See e.g. Mazer v. Stein, 347 U.S. 201, 217 (1954).
[42]
See, e.g., Imperial Homes Corp. v. Lamont, 458 F.2d 895, 899 (5th Cir. 1972); 17 U.S.C.
§§ 101,102; see also Architectural Works Copyright Protection Act (AWCPA), Pub. L.
No. 101-650, tit. 7, § 706(1), (2), 104 Stat. 5133, 5134 (1990).
[43] 17 U.S.C. § 103(a), (b).
[44]
Id. § 101.
[45]
Id.
[46]
Pickett v. Prince, 207 F.3d 402, 407 (7th Cir. 2000).
[47]
Gracen v. The Bradford Exchange, 698 F.2d 300, 304 (7th Cir. 1982).
[48]
See Pickett, 207 F.3d at 405 (noting that copyright was not limited to two-dimensional
version of defendant’s unpronounceable symbol); see also Eden Toys, 697 F.2d at 35
(finding the fact that one drawing was printed on gift wrap while the other was printed
on clothing was irrelevant); Entertainment Research Group, Inc. v. Genesis Creative Group,
Inc., 122 F.3d 1211 (9th Cir. 1997), cert. denied, 118 S. Ct. 102 (1998) (finding that inflatable
versions of copyrighted characters for use in a parade lacked sufficient originality to
be derivative works); L. Batlin & Son, Inc., 536 F.2d 486 (2d Cir. 1976); Davis v. E.I.
DuPont deNemours & Co., 240 F. Supp. 612 (S.D.N.Y. 1965).
[49]
See Mirage Editions, Inc. v. Albuquerque A.R.T. Co., 856 F.2d 1341 (9th Cir. 1988) (finding
that mounting pictures on tiles constituted a derivative work); Lee v. A.R.T. Co., 125
F.3d 580 (7th Cir. 1997) (criticizing Mirage and holding that pictures mounted on tiles
could not be a derivative work because they did not differ from simply changing the
means of display, as with a frame).
[50]
Alfred Bell & Co. v. Catalda Fine Arts, Inc., 191 F.2d 99 (2d Cir. 1951) (recognizing copyright
for mezzotint engravings of public domain paintings).

INTRODUCTION TO COPYRIGHT LAW

[51]
Id.; see also L. Batlin & Son, Inc. v. Snyder, 536 F.2d 486 (2d Cir. 1976) (denying copyright
protection as a derivative work for plastic version of metal “Uncle Sam” piggy bank).
[52] 17 U.S.C. § 106(2).
[53]
Eden Toys, 697 F.2d at 34.
[54]
Pickett, 207 F.3d 402.
[55]
Eden Toys, 697 F.2d at 34.
[56]
Pickett, 207 F.3d 402.
[57]
Pickett, 207 F.3d at 406-7.
[58]
Id.
[59] 17 U.S.C. §103(b).
[60]
Eden Toys, 697 F.2d at 33; G. Ricordi & Co. v. Paramount Pictures, 189 F.2d 469, 471
(2d Cir. 1951).
[61]
See Whelan Assoc. v. Jaslow Dental Lab., Inc., 797 F.2d 122, 1233 (3d Cir. 1986); Apple
Computer, Inc. v. Franklin Computer Corp., 714 F.2d 1240, 1249 (3d Cir. 1983).
[62]
Id.
[63]
Gates Rubber Co. v. Bando Chem. Indus., Ltd., 9 F.3d 693, 705 (2d Cir. 1993).
[64]
Computer Associates International v. Altai, Inc., 982 F.2d 693 (2d Cir. 1992).
[65]
See also Apple Computer, Inc. v. Microsoft Corp., 35 F.3d 1435 (9th Cir. 1994); ILOG,
Inc. v. Bell Logic, LLC., 181 F. Supp.2d 3 (D. Mass. 2002).
[66]
Computer Associates, 982 F.2d at 706–10; see also Lotus Dev. Corp. v. Borland Int’l, Inc.,
49 F.3d 807 (1st Cir. 1995), aff’d 116 S. Ct. 804 (1996) and the discussion of Lotus supra.
[67] 17 U.S.C. §117 (a).
[68]
Id. §117 (c).
[69]
Id. §117 (c)(1).
[70]
Id. §117 (b).
[71]
Nichols v. Universal Pictures, 45 F.2d 119, 121 (2d Cir. 1930), cert. denied, 282 U.S. 902
(1931).
[72]
Warner Bros. v. Columbia Broadcasting System, Inc., 216 F.2d 945, 950 (9th Cir. 1954).
[73]
See, e.g., Metro-Goldwyn-Mayer, Inc. v. American Honda Motor Co., 900 F. Supp. 1287
(C.D. Cal. 1995); Anderson v. Stallone, 11 U.S.P.Q. 2d (BNA) 1161 (C.D. Cal. 1989);
Walt Disney Prods. v. Air Pirates, 581 F.2d 751, 755 (9th Cir. 1978).
[74]
See, e.g., Nichols, 45 F.2d 119; cf. Sheldon v. Metro-Goldwyn Pictures Corp., 81 F.2d 49
(2d Cir. 1936).
[75]
Anderson v. Stallone, 11 U.S.P.Q.2d (BNA) 1161 (C.D. Cal. 1989).
[76]
See, e.g., Anderson, 11 U.S.P.Q.2d (BNA) 1161; Walt Disney Prods, 345 F. Supp. 108.
[77]
Walt Disney Prods, 345 F. Supp. 108; see also Anderson, 11 U.S.P.Q.2d (BNA) 1161 (noting
that a less stringent test may apply to the copyright protection of graphic characters).
[78]
Walt Disney Prods, 345 F. Supp. 108 (finding that lewd comic book portrayal of the
Mickey Mouse character infringed Walt Disney’s copyright because it mimicked Mickey
Mouse’s physical characteristics too closely).

COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

[79]
Anderson, 11 U.S.P.Q.2d (BNA) 1161.
[80]
Sheldon, 81 F.2d 49.
[81]
See 17 U.S.C. § 102(2), (7).
[82]
Id. § 101.
[83]
Id.
[84]
Id. § 115.
[85]
Id. § 114 (copyright owner of sound recording only has exclusive rights to the actual
sounds of the original recording, not to independent fixation of other sounds, even if they
sound identical).
[86]
Id. § 115(b), (c).
[87]
Id. § 115(c).
[88]
Id. § 115(a)(1).
[89]
Id. § 115(a)(2).
[90]
Id. §115; ABKCO Music, Inc. v. Stellar Records, Inc., 96 F.3d 60 (2d Cir. 1996) (finding
that karaoke machines infringed music copyrights because they were audiovisual works
and incorporated written copy of lyrics).
[91] 17 U.S.C. § 101.
[92]
Id.
[93]
Id.; Mazer v. Stein, 347 U.S. 201 (1954).
[94] 17 U.S.C. § 101.
[95]
See Mazer, 347 U.S. 201 (affirming the validity of copyrights on similar lamps); see also
Kieselstein-Cord (finding designer belt buckle copyrightable because the buckle had conceptually
separate sculptural elements that made it more akin to jewelry worn on the waist
than simple pants support).
[96]
Mazer, 347 U.S. 201.
[97]
See Carol Barnhart, Inc. v. Economy Cover Corp., 594 F.Supp. 364 (E.D.N.Y. 1984).
[98]
Brandir Int’l, Inc. v. Cascade Pac. Lumber Co., 834 F.2d 1142 (2d Cir. 1987).
[99]
See 17 U.S.C. § 106A.
[100]
Id. § 106A(a); see Quality King Distrib., Inc. v. L’Anza Research Int’l, Inc., 523 U.S. 135,
149 n.21 (1998).
[101] 17 U.S.C. § 106A(a).
[102]
Id.
[103]
Id.; but see Martin v. Indianapolis, 192 F.3d 608 (7th Cir. 1999) (rejecting artist’s claim
under VARA because the destruction of his sculpture was due to bureaucratic failure
rather than willful destruction).
[104]
Id. § 107.
[105]
Id. § 113(d).
[106]
Id. § 101.

INTRODUCTION TO COPYRIGHT LAW

[107]
See Id. §§ 405.
[108]
Id. § 401(d).
[109]
See Id. §§ 408, 409, 410.
[110]
Id. § 411; See, e.g., Store Decor Div. of Jas Int’l, Inc. v. Stylex Worldwide Indus., Ltd., 767
F. Supp. 181, 184 (N.D. Ill. 1991); Tree Pub. Co. v. Warner Bros. Records Div. of Time-
Warner, Inc., 785 F. Supp. 1272, 1274 (M.D. Tenn. 1991); Pristine Indus., Inc. v.
Hallmark Cards, Inc., 753 F. Supp 14, 148 (S.D.N.Y. 1990).
[111]
See Pickett, 207 F.3d at 403; See 17 U.S.C. § 408(a).
[112]
See Om v. Weathers, No. 91 C 4005, 1992 U.S. Dist. LEXIS 8915 (N.D. Ill. June 19,
1992). Federal preemption doctrine is beyond the scope of this chapter; however, it is
important to realize that common law or state protection should not be presumed available
as a backup for failure to comply with federal registration requirements.
[113]
See also Chapter 14 for a more complete discussion of the impact of nonregistration on
available remedies.
[114] 17 U.S.C. § 202.
[115]
Id.
[116]
Id. § 201(a).
[117]
Id. § 101.
[118]
Id.
[119]
Id. §§ 101, 201(c).
[120]
Id. § 201(c).
[121]
Id. §§ 201(a), 203(a)(1).
[122]
Id. §§ 101, 201(b).
[123]
Id. § 201(b).
[124]
Id. § 101.
[125]
Community for Creative Non-Violence v. Reid, 490 U.S. 730 (1989).
[126] 17 U.S.C. § 106. These rights are subject to the compulsory licensing for audio recordings
set forth in section 115.
[127]
Id. § 302(a). These durations apply only to works fixed after January 1, 1978. Older works
have different calculations of their copyright duration that are increasingly less relevant
to most litigation taking place today.
[128]
Id. § 302(b).
[129]
Id. § 302(c).
[130]
Id. § 302(e).
[131]
Id.
[132]
Id. § 501(a).
[133] Note that the act does not define “infringement” per se, but merely states that anyone who
violates the exclusive rights is an infringer. See 17 U.S.C. §§ 106, 501.

COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

[134]
See, e.g., Columbia Pictures Industries, Inc. v. Redd Horne, Inc., 749 F.2d 154 (3d Cir.
1984); Gaste v. Kaiserman, 863 F.2d 1061 (2d Cir. 1988); Selle v. Gibb, 741 F.2d 896 (7th
Cir. 1984).
[135]
Id.
[136]
Id.
[137]
Ty, Inc. v. GMA Accessories, 132 F.3d 1167 (7th Cir. 1997).
[138]
Bright Tunes Music Corp. v. Harrisongs Music, Ltd., 420 F. Supp. 177 (S.D.N.Y. 1976).
[139]
Universal City Studios, Inc. v. Corley, 2001 WL 1505495 (2d Cir. 2001).
[140] 17 U.S.C. § 512.
[141]
Id. §512.
[142]
Hendrickson v. eBay, Inc., 2001 U.S. Dist. LEXIS 14420 (C.D. Cal. Sept. 4, 2001).
[143] 17 U.S.C. § 107.
[144]
See id.
[145]
Campbell v. Acuff-Rose Music, Inc., 114 S. Ct. 1164 (1994).
[146]
Ringgold v. Black Entertainment Television, Inc., 126 F.3d 70 (2d Cir. 1997).
[147]
Harper & Row v. Nation Enterprises, 471 U.S. 539 (1985).
[148]
Princeton University Press v. Michigan Document Svcs., Inc., 99 F.3d 1381 (6th Cir.
1996) (en banc), cert. denied, 117 S.Ct. 1336 (1997).
[149]
Harper & Row, 471 U.S. 539.
[150]
Sony Corp. v. Universal City Studios, 464 U.S. 417 (1984).
[151] The Court’s analysis on this point may have hinged more on the lack of harm to those
copyright owners from the recording than on a theory of implied consent.
ADDITIONAL READING

Michael G. Anderson and Paul F. Brown, The Economics Behind Copyright Fair Use: A
Principled and Predictable Body of Law, 24 Loyola University of Chicago Law Journal
143 (1993).

Richard Colby, The First Sale Doctrine: The Defense That Never Was? 32 J. Copyright
Society 77 (1984).

Copyright Symposium Parts I and II: Copyright Protection for Computer Databases, CD-
ROMs and Factual Compilations, 17 Univ. Dayton Law Review 323–629, 731–1018
(1992).

2 Goldstein on Copyrights, 2nd ed. (1998).

Pamela Hobbs, Methods of Determining Substantial Similarity in Copyright Cases
Involving Computer Programs, 67 Univ. Detroit Law Review 393 (1990).

Intellectual Property and the Construction of Authorship, 10 Cardozo Arts & Entertainment
Law Journal 277–720 (1992).


INTRODUCTION TO COPYRIGHT LAW

Bernard Korman & I. Fred Koenigsberg, Performing Rights in Music and Performing
Rights Societies, 33 Journal of the Copyright Soc’y of the USA 332 (1987).

Leslie A. Kurtz, Speaking to the Ghost: Idea and Expression in Copyright, 47 Univ. Miami
Law Review 1221 (1993).

Leslie A. Kurtz, The Independent Legal Lives of Fictional Characters, 1986 Wisconsin
Law Review 429 (1986).

William M. Landes, Copyright, Borrowed Images and Appropriation Art: An Economic
Approach. 9 George Mason Law Review 1 (2000).

William M. Landes and Richard A. Posner, “An Economic Analysis of Copyright Law,” 18
Journal of Legal Studies 325 (June 1989).

Laura G. Lape, Transforming Fair Use: The Productive Use Factor in Fair Use Doctrine,
58 Albany Law Review 677 (1995).

Laura G. Lape, The Metaphysics of the Law: Bringing Substantial Similarity Down to
Earth, 98 Dickinson Law Review 181 (1996).

Alan Latman, “Probative Similarity” as Proof of Copying: Toward Dispelling Some Myths
in Copyright Infringement, 90 Columbia Law Review 1187 (1990).

Karen Burke LeFevre, The Tell-Tale “Heart”: Determining “Fair” Use of Unpublished
Texts, 55 Law & Contemporary Problems 153 (1992).

Mark A. LoBello, The Dichotomy Between Artistic Expression and Industrial Design: To
Protect or Not to Protect, 13 Whittier Law Review 107 (1992).

Jessica Litman, Copyright and Information Policy, 55 Law & Contemporary Problems 185
(1992).

Raymond T. Nimmer & Patricia Ann Krauthaus, Software Copyright: Sliding Scales and
Abstracted Expression, 32 Houston Law Review 317 (1995).

NOTE: Copyright Implications of “Unconventional Linking” on the World Wide Web:
Framing, Deep Linking and Inlining +, 49 Case Western Reserve Law Review 181 (1998).

Mark Sableman, Link Law Revisited: Internet Linking Law at Five Years, 16 Berkeley
Technology Law Journal 1273 (Fall 2001).

Edward Samuels, The Idea–Expression Dichotomy in Copyright Law, 56 Tennessee Law
Review 321 (1989).

David E. Shipley, Copyright Law and Your Neighborhood Bar and Grill: Recent
Developments in Performance and the Section 110(5) Exemption, 29 Arizona Law Review
475 (1987).

Symposium on Industrial Design Law and Practice, 19 University of Baltimore Law
Review 160 (1989).


11


Introduction to Trademark Law
and Trade Secret Law


This chapter outlines the basics of trademark and trade secret law, including the elements
of proof to prevail on a trade secret case or a trademark infringement claim.
Where trade secrets maintain their value through a lack of public discovery, the value
of a trademark lies in its potential for permanent public use and the accompanying brand
recognition.

Although commonly thought of merely as logos and catchphrases, legally enforceable
trademarks actually include a much broader array of devices. Any mark or device that is
sufficiently distinctive to identify the owner’s product or services can be a trademark.
Trademarks range from slogans like “Just do it” (Nike’s popular advertising slogan) to
the colorful packaging of a children’s cereal. In fact, a single product may be associated
with more than one trademark. For example, in the case of a children’s cereal, the
cereal company potentially could trademark the name of the cereal, the designs on
the cereal box, and the shape of the cereal itself. Of course, this assumes that these product
traits meet all of the requirements for legally enforceable marks, which are discussed
in detail in subsequent sections. Essentially, a trademark must be more than a generic or
purely descriptive name for the goods to which it is affixed. Accordingly, “Shredded
Wheat” probably would not qualify as a trademarked cereal name, but “Captain Crunch”
probably is sufficiently fanciful to meet at least the basic requirements.1

BRIEF HISTORY OF TRADEMARK PROTECTION

Trademarks initially were protected under the common law, which permitted a firm to
obtain rights in a distinctive mark simply by designing the mark and applying it to the
firm’s products. The actual use requirement prevented the waste of resources that might
otherwise be expended protecting marks not in use and precluded firms from simply
stockpiling trademarks to limit the marks available to their competitors. The common

253



COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

law did not require registration of the mark as a prerequisite to legally enforceable rights
in the mark. The lack of a registration requirement could make it difficult to resolve priority
disputes under the common law because it is often difficult to tell which firm actually
used a mark first.

The common law distinguished between “trademarks” and “trade names.” The former
referred to arbitrary or distinctive marks that identified the user’s goods, while the
latter generally had a primary meaning other than as an identifying mark created for
the purpose of distinguishing the goods. For example, the name of the producer might
qualify as a trade name, such as “Swensen’s Raspberry Jam.” In order to enforce rights
to a trade name, the owner was required to establish that the mark had attained a “secondary
meaning” or special significance in the eyes of the potential customer that distinguished
the goods to which it was affixed. In other words, Ms. Swensen could not
simply trademark her own surname without having proven that it had acquired a distinctive
market meaning when affiliated with Ms. Swensen’s delicious raspberry jam.

Currently, trademarks are also protected by the Lanham Act.2 The Lanham Act is a
federal statute that provides for a right of action for trademark infringement, as well as
the possibility of statutory damages in some cases (discussed later). Many states also
have trademark registration acts that are largely modeled after the Lanham Act. As under
the common law, a merchant must affix the mark at issue to her goods and sell the goods
in commerce in order to attain enforceable rights to the mark. In other words, whether
considering a common law regime or the statutory requirements, no trademark rights
can accrue without use of the mark. One distinction from the common law treatment of
marks is that under the Lanham Act, once the mark is in use, the mark owner must file
a formal registration application to qualify for trademark protection. Additionally, the
distinction between trademarks and trade names was eliminated under the federal trademark
statute, which includes trade names in its definition of trademarks.

TYPES OF MARKS

The Lanham Act allows the registration of four types of marks: trademarks, service
marks, certification marks, and collective marks.3 A trademark is any “word, name,
symbol or device, or any combination thereof” used to distinguish goods from those
manufactured by others and to indicate the source of the goods.4 A service mark is similar,
but it identifies a particular owner’s services, as opposed to products.5 Trademarks
and service marks probably represent the types of marks that the public commonly considers
to be protected marks, such as Pepsi and AAA Auto Repair.

Certification marks identify goods that satisfy a particular standard or originate from
a particular geographic region. For example, a certification mark might be an indication
that a product has passed an underwriter’s laboratory standard or that the balsamic vine



INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

gar is an authentic product of Modena, Italy. The owner of a certification mark cannot
be the producer of the goods to which the mark is attached; clearly, if a certification
mark could be affixed in a purely subjective manner, the mark would lose its informative
value and sheen of legitimacy.6 Moreover, if a producer owned the certification
mark, the mark could be used by the producer as a barrier to entry in the market in order
to reduce competition. The Lanham Act provides legislative support for the aura of
legitimacy attached to certification marks, as it provides for the cancellation of marks
that are applied in a discriminatory or uncontrolled manner.7 In other words, certification
marks cannot be withheld from producers who meet the qualifications for the particular
certification mark, or awarded without any control over the recipients.

Finally, a collective mark identifies a member of “a cooperative, an association, or
other collective group or organization.”8 Like certification marks, collective marks are
owned and controlled by an organization, but used by actual producers. Collective
marks are adopted by organizations to identify their members or the goods and services
of their members, such as the Opticians Association of America. Although the Lanham
Act defines the two types of marks separately, it is unclear how distinct they really are.
It appears that if an organization has certain prerequisites or standards for membership,
then joining the organization truly is indistinct from receiving a certification mark indicating
that those standards have been met.9

A mark that identifies merely the business itself, rather than its goods or services, is
known as a trade name. Trade names are not entitled to protection under the Lanham
Act, although they are protected under the common law against confusingly similar
uses.10 Moreover, in some situations, a mark functions as both a trademark and a trade
name. AAA Auto Repair, as mentioned previously, may operate as a service mark
because it identifies the services provided, but it also may be the name of the business,
and thus a trade name.11 This issue of whether a trade name qualifies for protection as
a service mark is a question of fact resolved by the courts by evaluating the way in
which the mark is used and the possible impact of that use on potential consumers.12

Owners register a mark by submitting an application to the United States Patent and
Trademark Office (commonly referred to as the PTO). Applications are screened for the
requirements of registration, and approved marks are published in the Trademark
Office’s Official Gazette. This publication notifies the public that a mark is registered
and identifies the owner of that mark.

Registration affords several competitive advantages. First, registration entitles the
owner to a presumption that the mark is valid.13 Second, only registered marks can
carry the commonly recognized symbol of the “r in the circle,” “..” Third, registration
provides nationwide constructive notice of the mark, even in areas where the merchant
does not do business.14 As is discussed later in this chapter, this prevents an alleged
infringer from avoiding liability by simply claiming that he or she did not know the
mark belonged to someone else.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Finally, after continuous and exclusive use for five years, a registrant may apply to
have the mark declared incontestable.15 An incontestable mark cannot be challenged by
accused infringers on the basis of invalidity. Although some defenses remain, an incontestable
mark has more value in litigation than a mark that will have to defend its status
as a legitimately issued trademark as well as establish the facts of infringement.

To be deemed incontestable, the registrant must satisfy several other requirements in
addition to the prerequisite continuous and exclusive use. First, there must also be no
final decision in existence that was adverse to the registrant’s claim. Second, there can
be no pending proceedings involving the registrant’s rights. Third, the registrant must
file an affidavit setting forth the goods or services connected with the mark and swearing
to the absence of the aforementioned adverse decision and pending proceedings.
Finally, the mark cannot have become a “generic” name for the goods or services.
Generic marks are discussed in detail in the next section.

Incontestable marks are not invincible. They can be attacked on several fronts, as
outlined in section 33(b) of the Lanham Act. Section 33 indicates that an incontestable
mark can be defeated if the defendant establishes that the mark itself is generic or has
been abandoned by the owner.16 Additionally, fraud in the owner’s application, flaws in
the issuance of a certification mark, or abuse of the mark may be defenses to infringement.
17 Finally, the alleged infringer may assert defenses justifying his or her own conduct,
such as that the use of the mark was a “fair use” in that it was purely descriptive,
or that no confusion resulted from the use.18

PRIMARY CLASSIFICATIONS OF TRADEMARKS

Marks are classified by the distinctiveness of the association they create with the product
or service. In descending order of legal strength, a mark is either fanciful, arbitrary,
suggestive, or descriptive. “Fanciful” means that the mark was made up purely for the
purpose of this brand and lacks any independent meaning. Examples of fanciful marks
include Jeep and Xerox. The difficulty with fanciful marks is that they can become
generic terms for the type of product. For example, many people use “Xerox” simply to
mean “photocopy,” and “Band-Aid” has become nearly synonymous with adhesive
bandages. As mentioned above, a mark that becomes a generic description for the general
category of product or service may be cancelled.19 This presents owners with an
interesting dilemma—the more successful their marketing of the fanciful brand is, the
more likely it is to become simply a description of the product that lacks legal significance.
Of course, the trademark owner can stave off this sort of pyrrhic victory by vigilantly
enforcing the mark against infringers and preserving the distinctive association
of that brand with a particular producer. Moreover, new drugs are often designated with
both a brand name and a generic name to avoid losing their trademark status for the
brand name.


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

“Arbitrary” marks are terms in common parlance, but their common usage is neither
inherently descriptive nor suggestive of the goods or services to which the mark is
affixed. An easy example of a successful arbitrary mark is Apple computers. Although
“apple” is a common word, it was not (prior to Steve Jobs’ efforts) associated with personal
computing. “Apple” remains a mark that could not be legally enforceable as a
trademark for a seller of apple fruit, but it is arbitrary with relation to computers, and
hence appropriate for trademark protection.

“Suggestive” marks require the audience to “think about” the connection in order to
perceive the link between the mark and the related product or service. In other words,
suggestive marks may bring to mind a good or service, although they are not straightforward
descriptions of the underlying products. For example, Coppertone tanning
lotion is suggestive of the pleasant brown glow that might accompany successful use
of the product, but it is not a generic description such as “sunscreen.”

“Descriptive” marks indicate an important quality or characteristic of the related
product. Vision Center and Raisin Bran are examples of descriptive marks. Empirically,
courts (and scholars) have great difficulty distinguishing between suggestive marks
and descriptive marks. The Fifth Circuit has provided one example of the interesting, and
often subjective, analysis that goes into making this distinction:

[T]he trier of fact must be aware of, or informed of, common, up-to-date usage of the word or
phrase. Furthermore, even were usage not constantly changing, the context in which a word or
phrase appears is relevant to determining the proper category for purposes of trademark eligibility.
The word or phrase must be compared to the product or service to which it is applied.
For example . . . [u]sed in the phrase “FishWear” for dive clothing, “fish” may be suggestive if
the intent is to suggest that divers who wear this clothing will be able to “swim like a fish.” On
the other hand, with respect to clothing worn while fishing, “FishWear” might be descriptive.20

This discussion indicates the type of reasoning that courts apply to questions of
trademark eligibility, although it cannot provide a definitive answer as to what will
and will not be deemed “suggestive” versus “descriptive.”21 “Raisin Bran” cereal has been
found to be descriptive, while “Orange Crush” orange drink was deemed suggestive.22
The creative litigant can find ample support for arguments going either way on the fine
line between these two categories of trademarks.

Finally, generic terms are not entitled to any legal protection because they are necessary
to indicate a product or service. In fact, generic terms or names do not function
as “marks” at all. Generic terms may have begun as protectable marks, but the marks
decline to generic status once the common usage is simply a generic reference to the
product. Examples of generic terms include “aspirin,” “trampoline,” and “thermos.”
These terms are also examples of trademarks that lost their distinctiveness status and
become generic. “Kleenex” may soon become generic. The following case exemplifies
the judicial treatment of generic terms and the analytical factors that go into finding a
mark “generic.”


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Genesee Brewing Co. v. Stroh Brewing Co.23

The issue in this case was whether the term “honey brown” could be a valid trademark
for lager beer. The court found that “honey brown” was a generic name incapable
of receiving trade protection. The honey brown title was generic because
its principal significance was an indication of a class of beers rather than a particular
source. The rationale for this holding is that it would contravene public policy
to allow an individual to gain exclusive rights over terms necessary to describe a
characteristic of the good. If there is no equally efficient means of describing a good,
then the terms are “necessary” and the mark incorporating the terms is generic.

Any trademark must be distinctive in order to receive legal protection. This means
that the mark identifies goods in an unambiguous way. Fanciful, arbitrary, and suggestive
marks are deemed inherently distinctive because they have no other common meaning.
For example, the term “Two Gods” has no relationship to a pencil and therefore
could be an inherently distinctive designation for a pencil. Moreover, a trademarked
phrase may contain elements of varying distinctiveness, and the courts may opt to give
greater weight to certain portions of that phrase. Accordingly, “Blue Gods” as a trademark
for pencils arguably could infringe the “Two Gods” mark if the facts indicated
that the Blue Gods company was banking on resulting confusion of the two marks. The
following recent case presents a similar type of analysis involving only “partial” infringement
of a trademarked phrase.

Ty, Inc. v. The Jones Group, Inc.24

This case demonstrates that certain parts of a mark may be stronger, and thus
more likely the basis for an infringement action, than others. Ty, Inc. manufactured
popular plush bean bag toys under the name “Beanie Babies” and similar
marks. The Jones Group, a NASCAR licensee, made bean bag toys that replicated
NASCAR racecars. The racecar beanbags utilized similar materials and had
similar dimensions to the Beanie Babies. The Jones Group marketed these toys as
“Beanie Racers.” Ty brought suit, claiming that the use of “beanie” in the toy’s name
confused customers as to the source of the toys and the possible affiliation with
Ty’s Beanie Babies. Ty did not have a registered trademark for “beanie,” but
argued that common law trademark rights protected its use of the word “beanie.”
The court ruled that, given the arguable similarity of the products themselves, the
use of the word “beanie” referred to the composite “beanie babies” mark and thus
infringed on that mark.


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

Ty, Inc. v. The Jones Group, Inc. (continued)

The court rejected The Jones Group’s argument that the entire phrase should
be compared (i.e., “Beanie Babies” to “Beanie Racers”), because “if one word
or feature of the composite trademark is the salient portion of the mark, it may
be given greater weight than the surrounding elements.” Arguably, “beanie” is
merely descriptive of the type of materials used in the toys, but the court found
that partial infringement, even of an arguably descriptive mark, constituted a
plausible infringement claim. The court noted that Ty marketed other toys featuring
the word “Beanie,” such as “Beanie Buddies” and “Beanie Kids,” and may
also have been influenced by Ty’s survey indicating that 70 percent of the respondents
identified the words “Beanies” and “Beanie” with Beanie Babies and Ty.
Accordingly, the court denied defendant’s motion for summary judgment, holding
that Ty had presented sufficient evidence of infringement to go before a jury.

Generic names and descriptive marks fall at the other end of the distinctiveness spectrum
from the first three types of marks. Although generic names can never acquire trademark
protection, descriptive marks can qualify for trademark if (and only if) they obtain
“secondary meaning.” Secondary meaning attaches to a mark when the primary significance
of that mark is that it identifies the source, or producer, of a good rather than merely
describing the good itself. If a mark has become incontestable, secondary meaning is
presumed. Otherwise, the mark owner must establish that consumers associate the mark
with the producer, commonly either through the testimony of actual customers or through
surveys that purport to indicate the overall impressions from taking a scientific sample.
Secondary meaning is not immutable; like other types of marks, if a descriptive mark
becomes synonymous with the type of product to which it is affixed, it has lost its secondary
meaning and will no longer be enforceable. “Elevator” is an example of a descriptive
mark that has evolved into the generic term for that type of apparatus, even though
once it may have possessed secondary meaning.

Protection for secondary meaning marks generally is weak, as other firms can still
use the mark in its nontrademark (i.e., purely descriptive) sense. This potential defense
is fertile ground for alleged infringers.

Car-Freshner Corp. v. S.C. Johnson & Son, Inc.25

Car-Freshner emphasizes that the key to defending against allegations of infringing
a secondary meaning mark is not how the owner uses the mark, but how the
alleged infringer uses the mark. Car-Freshner sells tree-shape car fresheners that
dangle from rearview mirrors in a variety of colors and scents, including pine.

(continues)


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Car-Freshner Corp. v. S.C. Johnson & Son, Inc. (continued)

Johnson sells a seasonal pine-tree-shaped plug-in for use with an electrical socket;
the plug-in came in a scent called “Holiday Pine Potpourri.” Although the products
were ostensibly in different markets, Car-Freshner claimed that the plug-in
infringed its exclusive right to a pine-tree shape for the purpose of air freshening.
The court found that “it should make no difference whether the plaintiff’s mark is
to be classed on the descriptive tier of the trademark ladder.... What matters is
whether the defendant is using the protected word or image descriptively, and not
as a mark.” Accordingly, the court examined the plug-in, and found that the pine-
tree shape refers to the scent, as well as the Christmas season during which it is
sold. Moreover, the packaging for the plug-ins prominently displayed Johnson’s
marks and corporate logo, rather than attempting to pass off the product as something
made by Car-Freshner.

Car-Freshner’s complaint was dismissed.

Certain types of names are explicitly excluded from trademark protection. These
names include: (1) deceptive terms (such as “glass wax”); (2) geographic terms that
are primarily geographically descriptive with no secondary meaning; and (3) surnames
that have not acquired a secondary meaning. The latter exclusion is justified by the judicial
reluctance to prevent people from using their own name simply because they were
preceded in the market by someone with the same surname. However, surnames are
subject to an exception where they have achieved significant renown as mark, although
later competitors seeking to use the same or a similar surname must take “reasonable
precautions.”

Taylor Wine Co. v. Bully Hill Vineyards26

This case indicates that a surname may become a trademark if and only if it has
achieved secondary meaning. In this case, the trademark owner was a winery
founded 100 years earlier by the defendant’s grandfather. The winery marketed
wine under the Taylor label since 1880 and registered 13 trademarks. Defendant
Walter S. Taylor founded a competing winery and began marketing a line of
“Walter S. Taylor” wine, prominently displaying the Taylor name on the wine bottles.
Taylor argued that his use of his surname did not infringe because his wines
were “better” and not in actual competition with the Taylor Wine Company.

The court rejected this argument, finding that “the average American who
drinks wine on occasion can hardly pass for a connoisseur of wines . . . [and]
remains an easy mark for an infringer.” Finding that “subtlety of taste” did not


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

Taylor Wine Co. v. Bully Hill Vineyards (continued)

protect Taylor’s infringing use of the Taylor trademarks, the court held that confusion
was likely and an injunction appropriate. However, the court noted that it
would not completely forbid Taylor from using the family ,name so long as he
included an appropriate disclaimer that he was not connected with, or a successor
to, the Taylor Wine Company. In other words, his continued use was contingent
on preventing confusion of the two marks.

TRADE DRESS


The courts’ unease with applying trademark protection to generic or necessary aspects
of goods is evident in their approach to trade dress protection. The shape, color, and
art style of goods may be trademarked as “trade dress” if they indicate source and are
not merely “utilitarian.” “Utilitarian” aspects are defined as those qualities that are superior
in function or economy in light of a competitive necessity to copy. Even secondary
meaning is insufficient if the design is primarily functional. The product or packaging
design must be evaluated as a whole; the presence of some functional features does not
mean that the entire design is unprotectable.

Qualitex offers one example of the judicial treatment of nonfunctional elements
under a trademark analysis, specifically colors.

Qualitex v. Jacobson Products27

The issue in this case was whether color could serve as a trademark, specifically
the green-gold dry cleaning press pads sold by Owens-Corning. The Court found
that color could be protected as a trademark, as can a distinctive nonutilitarian
shape. However, to qualify for protection, the color must not be functional and
must obtain a secondary meaning. The Court noted that “over time, customers
may come to treat a particular color on a product or its packaging...as signifying
a brand.” Moreover, colors can never be inherently distinctive.

The Court examined, and rejected, defendant’s “color depletion theory.” The
“theory” was that allowing trademarks on colors would limit the colors available
to competitors and eventually preclude effective competition altogether. The Court
indicated that this scenario was avoidable by requiring courts to examine whether
the color is a necessary, nontrademark part of the product. If it is, then the color
depletion theory might preclude enforcement of an allegedly trademarked color.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Another example of protectable trade dress is the décor and various elements making
up the ambience of a restaurant.

Two Pesos v. Taco Cabana28

The Supreme Court found that the trade dress of the Mexican restaurant Taco
Cabana was protected despite lacking evidence of the trade dress having acquired
secondary meaning. The Court decided that the trade dress in question was
“inherently distinctive” and thus did not require evidence of secondary meaning.
Trade dress was defined as the “total image of the business,” including the shape
and general appearance of the exterior, the identifying sign, the décor, the menu,
and the server’s uniforms. In this case, Taco Cabana’s vivid color scheme, festive
eating atmosphere, and neon stripes on the exterior of the restaurant were all part
of its inherently distinctive trade dress. One stated justification was that the
trademark laws should protect new products and expansions into new markets
where there has not yet been an opportunity to establish secondary meaning.

One further interesting note about this case: After the Supreme Court’s decision affirm


ing the jury verdict of $3.7 million, Taco Cabana brought a second suit against Two

Pesos alleging damages of $5 million. Shortly thereafter, Two Pesos signed a letter of

intent to sell its entire chain of 34 restaurants to Taco Cabana.29
Subsequent cases have clarified that the ruling of Two Pesos is limited in application

to product packaging rather than product design. This distinction appears sustainable

based on the less functional nature of the trade dress involved in packaging rather than

the design of the actual product.

Wal-Mart Stores v. Samara Brothers30

In Wal-Mart, the Court had the opportunity to overrule Two Pesos, but opted
instead to draw a distinction between product design trade dress and product packaging
trade dress. Samara Brothers sued Wal-Mart for selling “knockoff” versions
of its children’s clothing designs. The main product at issue was a line of one-piece
seersucker outfits decorated with appliqués of flowers, hearts, and so on. Wal-Mart
intentionally developed a clothing line based on the Samara Brothers’ designs with
only minor modifications. The Court treated the clothing design as a form of trade
dress (specifically product design trade dress) and found that without evidence of
secondary meaning, Samara Brothers could not prevail on its claim.

The Court held that trade dress, like other trademarks, must be distinctive
in order to merit protection. Accordingly, trade dress must either be inherently


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

Wal-Mart Stores v. Samara Brothers (continued)

distinctive or have acquired secondary meaning. Product design, unlike product
packaging, can never be inherently distinctive because it is not reasonable to assume
“customer predisposition to equate the feature with the source.” Customers are
aware that even the most unusual product designs, such as a cocktail shaker shaped
like a penguin, are intended primarily to render the product itself more appealing
rather than to identify the source of the product. Since product design will always
be serving these alternative purposes, it would be detrimental to the public to eliminate
competition among producers with regard to particular utilitarian and aesthetic features.

Two Pesos thus survives Wal-Mart, but only because the trade dress at issue was not
treated as product design. Restaurant décor, to the judicial eye, is more akin to packaging
(and hence more likely to be accepted by customers as an indication of source) than
product design. Furthermore, the Court left open the possibility that Two Pesos could
be further narrowed as it noted that the décor was either product packaging or “some
tertium quid that is akin to product packaging.”31 Accordingly, it is possible that this
undefined third category could evolve into the sole appropriate ground for application
of “inherent distinctiveness” to trade dress. Moreover, the increased evidentiary burden
on design owners seeking protection under the Lanham Act may encourage the owners
to apply for protection under copyright laws or design patents instead.

PRIORITY

Where ownership of a mark is contested by multiple parties, the courts evaluate which
party should be granted “priority” over the others and awarded full legal rights of enforcement.
The common law and the Lanham Act have contrasting definitions of priority.
Under the common law, the first merchant to use a mark on a minimal number of sales
has priority over all subsequent users in the area where the first use occurred. Furthermore,
the mark must be physically attached to the goods or their container, thus preventing
firms from making use of the mark before the related product is on the market.
This is known as the “affixation” requirement, and the date of affixation can establish
priority under the common law.

There are some weaknesses in the common law’s approach to priority. For example,
because product development often requires significant time, a company could be without
protection until it is capable of meeting the affixation requirement. This dilemma
creates incentives for an inefficient race to be the first to market, regardless of any
corresponding trade-offs in product quality. Moreover, as mentioned earlier in the chapter,
the regime can lead to uncertainties in the priority context because of the possible
difficulties in establishing first use. In one case, three separate companies began using


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

the mark “Kimberly” for clothing on May 9, May 10, and May 11, respectively.32 This
near-simultaneous use of the same mark forces courts to either award the mark to the
user who preceded the others by a matter of days, or even hours, or construct an equitable
alternative. In this particular case, the Second Circuit held that the uses were close
enough in time to make awarding priority inequitable, so henceforth each company
would be required to differentiate its product from that of the other companies.

Near-simultaneous use causes less uncertainty where a claim is brought under the
Lanham Act. The Lanham Act awards priority to the first user to register the mark,
regardless of the date of the first use.33 The affixation requirement is somewhat looser
than the common law interpretation, as the statute defines a use in commerce “on
goods” as being when:

[the mark] . . . is placed in any manner on the goods or their containers or the displays associated
therewith or on the tags or labels affixed thereto, or if the nature of the goods makes
such placement impracticable, then on documents associated with the goods or their sale.34

Similarly, the affixation requirement is met as to services when the mark is “displayed
in the sale or advertising of services.”35 This relaxed requirement still prevents
the establishment of trademark priority through advertising use alone, even where services
are concerned.36 Accordingly, use is necessary, but not sufficient, for priority under
the Lanham Act.

The only exception to this rule allows an applicant to file for registration before
actual commercial use. In that case, the applicant must file an “intent-to-use” (ITU) statement
with his or her application for registration.37 The ITU application must indicate
a “bona fide intention, under circumstances showing the good faith of such a person, to
use a trademark in commerce.”38 An ITU applicant has up to six months from the date
of the notice of allowance to file a statement verifying actual commercial use. The six-
month deadline may be extended for up to two years upon written request and a showing
of good cause for the extension and continuing bona fide intent to use the mark in
commerce.39 The significant advantage offered by an ITU (versus simply waiting to
apply) is that priority is retroactive to the date that the ITU application was filed.

The Lanham Act’s treatment of the priority issue essentially allows an ITU to constitute
constructive notice of use.40 This approach successfully addresses the flaws in
the common law system by offering a clear test of priority. Moreover, the ITU protects
premarket investments by firms in their trademarks and avoids inefficient races
to market.

INFRINGEMENT

In general, the unauthorized use of a valid trademark by a party who competes in
the same market with the trademark owner constitutes infringement. Section 32 of the
Lanham Act provides the statutory definition of infringement of a registered mark:


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

Any person who shall, without consent of the registrant—use in commerce any reproduction,
counterfeit, copy or colorable imitation of a registered mark in connection with the sale, offering
for sale, distribution or advertising of any goods or services on or in connection with
which such use is likely to cause confusion, or to cause mistake, or to deceive... shall be
liable in a civil action by the registrant for the remedies hereinafter provided.41

Most infringement cases turn on whether the unauthorized use results in a “likelihood
of confusion.”

Plaintiffs typically demonstrate a likelihood of confusion through a survey or other
evidence that the use of the mark confuses customers as to the source or sponsorship of
the goods. Factors considered in determining the likelihood of confusion can include the
similarities between the sound, sight, and meaning of the allegedly confusing marks;
the strength of plaintiff’s mark; survey information; consumer sophistication; whether the
goods are cheap or expensive; and actual instances of confusion.42 Courts will not simply
examine the products side by side, but will consider the circumstances of their sale,
such as where they usually are sold, their sale price, the wrapping or packaging, any relevant
promotions, and so on.43 Moreover, confusion of noncustomers may be relevant
where an indirect experience with the product, such as observing it in public, leads to
an inaccurate attribution of source.44 In short, any factor that points to confusion regarding
the actual source of a product or service may be considered as indicative of likelihood
of confusion, and thus possible causation of damages.45 However, the most
important factors generally are the similarity of the marks, the intent of the claimed
infringer, and evidence of any actual confusion.46

Apart from contesting the likelihood of confusion, the alleged infringer has several
potential defenses available to him or her.47Although we do not provide a complete list of
possible defenses, the following discussion does outline the bases on which an infringement
action may be defeated.

First, the infringer can attack the validity of the mark, either by arguing that it has
become a functional or generic term, or that the registration or right to use the mark was
obtained through fraud.

Second, the infringer can argue that the mark has been abandoned by the owner, and
thus has entered the public domain and cannot be infringed. Abandonment is defined as
discontinuing use made in the ordinary course of trade with the intent not to resume such
use.48 The intent can be inferred from the circumstance, and the nonuse will not be
defeated by a purely nominal use made merely to reserve the owner’s rights in the mark.49
Nonuse for three consecutive years constitutes prima facie evidence of abandonment.50

Third, the Lanham Act stipulates that evidence that the mark “has been or is being
used to violate the antitrust laws of the United States” is a defense to infringement.51
We discuss trademark misuse in detail in Chapter 12. Finally, use of the mark in a non-
trademark manner cannot be infringement.52 This defense is sometimes referred to as a
“fair use” defense. In essence, good faith use of the mark only to describe the goods and
services of owner is a use “otherwise than as a mark” and does not violate the owner’s


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

trademark rights.53 Nontrademark uses of a mark might include uses that identify the
owner for purposes of comparative advertising or parody.54 The fair use defense is consistent
with the definition of infringement, since there should not be a likelihood of confusion
when the use distinguishes the mark owner, rather than conflating the owner’s
product with a competing product.

There are several variations on a straightforward infringement action, including
infringement of an unregistered mark, false advertising, and metatag infringement.

Infringement of an Unregistered Mark

Another type of unauthorized trademark use is the false designation of the product’s origin
or false descriptions of its qualities. Section 43(a)(1)(A) of the Lanham Act prohibits
“any false designation of origin, false or misleading description of fact, or false
or misleading representation of fact,” that is likely to cause confusion or mistake as to
the affiliation of such person with another person, or as to the “origin, sponsorship or
approval of his or her goods, services or commercial activities by another person.”55
Essentially, section 43(a)(1)(A) is directed at those individuals who attempt to “pass
off” their products as those of the trademark owner, an aim that arguably overlaps with
the protection already available to the registered trademark owner. However, unlike section
32, section 43(a)(1)(A) does not require registration as a prerequisite to bringing
suit. This may be the primary difference between actions brought under the two statutory
sections and may help explain the need for the section.56

False Advertising

The Lanham Act’s concern with the deception of consumers is further exemplified in its
prohibition of false advertising, a short statutory provision that goes beyond the regulation
of trademarks to address more general misrepresentations to the public.57 Although
this cause of action arguably goes beyond the protection of intellectual property, we
address it briefly here as a corollary to the trademark laws. The Lanham Act proscribes
any commercial advertising or promotion that “misrepresents the nature, characteristics,
qualities, or geographic origin of his or her or another person’s goods, services, or commercial
activities.”58 This provision is the statutory basis for “false advertising” claims.

To prevail on a false advertising claim, the misrepresentation in question must be
“material” to consumers. A misrepresentation is material if it has deceived more than an
insubstantial number of consumers and consumers actually relied on the misrepresented
fact in making their purchasing decisions. Materiality may be established through survey
evidence of customer confusion or evidence that the defendant knew the advertising was
misleading.59 Moreover, courts presume that evidence of expenditures on willfully
deceptive advertising implies that the defendant thought the misrepresentation would
affect customers’ purchasing decisions.60 “Willfully deceptive” advertisements are those
that are facially false and egregiously misleading (even if actually true).61 However, if a
statement is literally true, the plaintiff must present evidence that the advertisement has
a tendency to mislead based on how the intended audience would perceive the message.


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

Avis Rent A Car System v. Hertz62

In this battle between car rental services, the court’s decision provides a helpful
example of how courts examine the “falsity” of alleged false advertising in context
rather than taking a strictly literal approach. Hertz placed a print advertisement
that read “Hertz has more new cars than Avis has cars.” At the time that
the advertisement was published, the number of cars that Hertz had available for
rental was slightly larger than the number of Avis’s available rental cars, but
Avis’s total fleet of cars was much larger than Hertz’s total fleet. The trial court
found that the literal language of the advertisement clearly referred to total cars,
not merely rental cars, and thus was false. However, on appeal, the Second Circuit
reversed and held that the full context of the advertisement—including other references
to rentals, both parties’ reputations as car renters, and consumer studies
supporting the narrower interpretation—indicated that the phrase accurately
referred to the number of rental cars owned by each company. Accordingly, the
Second Circuit ordered the trial court to dismiss the complaint against Hertz.

A false advertising plaintiff must also establish that he is “likely to be damaged” by
the defendant’s advertising.63 If the plaintiff is asking a court to enjoin a defendant’s
promotional activities, there is a lower threshold for injury than if the plaintiff is
seeking to recover damages for the conduct.64 Where the advertising in question singles
out a particular competitor, as in comparative advertising, it generally is easier for the
plaintiff to demonstrate a likelihood of injury.65 Moreover, if the products are competing
in the relevant market and it appears likely that the advertising will decrease the
plaintiff’s sales, it is not necessary for the plaintiff to establish more than a “logical causal
connection.”66 In contrast, where the products are not in obvious, direct competition,
the plaintiff must show that consumers view the products as comparable substitutes
for each other in order to establish a likelihood of injury.67

The plaintiff does not need to establish any particular state of mind on the part of the
advertiser making misrepresentations; false advertising is a strict liability offense,
meaning that intentional conduct is sufficient, regardless of whether the consequences
were intended. Although evidence that the defendant is intentionally making misrepresentations
in her advertising is relevant to the materiality of the statements and
also possibly to causation, it is not necessary for the plaintiff to recover on her claim.
The absence of a requisite mental state reduces the costs to plaintiffs of bringing suit,
decreases administrative costs, and may increase consumer trust in the information
function of advertisements. However, the lack of this element may be overly harsh,
because it makes litigation easier, and thus more likely. Additionally, making false
advertising a strict liability offense reduces the victim’s incentives to take reasonable
and efficient precautions because the defendant will be liable for all harm caused by his


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

actions. Some courts might respond to this criticism by noting that the real “victim” of
a false advertising claim is the consumer who is misled, not the competitor who may
lose some sales. Unlike the competitor, the consumer victim does not recover any
money from a successful false advertising suit, so regardless of the legal elements for
false advertising, consumers have full incentives to be informed and take precautions to
avoid being duped.

Metatag Infringement

Metatags are words inserted in each web page that ordinarily are visible to search
engines, but not to the visitor who accesses the site with a standard browser. The
metatags are intended to function as an index of the site’s content. Because search
engines read metatags to determine the potential relevancy of a site to users’ queries,
some companies have begun using a competitors’ trademarks in their metatags to
increase the prominence of their site in response to queries for the competing product
or company. The unauthorized use of a trademark in metatags constitutes trademark
infringement.68 Faced with increasing allegations of trademark infringement through
use of the marks in metatags, the courts created a new doctrine, specific to the Internet
context, to address their concern with the potential for consumer confusion—“initial
interest confusion.”69

Brookfield Communications v. West Coast Entertainment70

In Brookfield, the plaintiff had a registered trademark for “MovieBuff” as a mark
designating both goods and services related to providing entertainment industry
news and information via computer software. However, West Coast Entertainment,
a chain of video rental stores, registered the domain name “moviebuff.com” before
Brookfield applied for its trademark registration. West Coast allegedly picked that
name because it is part of its own service mark, “The Movie Buff’s Movie Store.”
Brookfield sued for trademark infringement and unfair competition under the
Lanham Act and sought an injunction precluding West Coast from using the mark
“moviebuff ” in their domain name or in their metatags.

The court found that traditional understandings of a “likelihood of confusion”
did not capture the potential for confusion on the Internet, noting that “Web surfers
are more likely to be confused as to the ownership of a web site than traditional
patrons of a brick-and-mortar store would be of a store’s ownership.” The court
was particularly concerned with the unique confusion that can result from manipulation
of search engine results, since search engines are the primary means of
navigating the Internet. Accordingly, the court developed the theory of initial interest
confusion.


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

Brookfield Communications v. West Coast Entertainment (continued)

The theory of initial interest confusion recognizes that a trademark owner may
be harmed by the alleged infringement, even if once the user actually accesses the
site it becomes clear that the site is not affiliated in any sense with the trademark
owner. Supposedly, by diverting the user to its site, the infringer improperly
benefits from the goodwill associated with the mark, even if the user is only distracted
for a moment and no actual sale is completed as a result of the infringement.
The rationale for the theory is that the infringer has at least increased the
chance that the user will give up trying to find the actual site he was searching for
and settle for the one that he has accessed.

Accordingly, the court held that the Lanham Act barred West Coast from
including in its metatags any term confusingly similar with Brookfield’s mark,
unless that term was necessary for a good faith index of the content of the site.

A related tactic, “cyberstuffing,” occurs when a mark is inserted repeatedly in a
metatag (e.g., Apple, Apple, Apple, Apple, Apple) so that the site may appear higher on
a search engine’s hit list.71 Alternatively, competitors may achieve the same result by
placing excessive references to their competitors in the content of their sites rather than
in the metatags.

J.K. Harris v. Steven Kassel72
In this recent case, J.K. Harris, a tax firm, accused its competitor, taxes.com, of
unfair competition, false advertising, and a slew of other related claims. On one
claim, J.K. Harris alleged that taxes.com manipulated search engine results by
using J.K. Harris’s trade name up to 75 times in headlines, header tags, and underlined
tags. The resulting “keyword density” allegedly resulted in taxes.com
appearing first on the list of results compiled by search engines when a user
searched for “J.K. Harris.” This high placement on search engines allowed
taxes.com to lure consumers away from their search for J.K. Harris’s site.

The court was persuaded that this conduct presented a potential for irreparable
harm to the plaintiff and issued a preliminary injunction barring taxes.com from
using the trade name more than reasonably necessary to identify J.K. Harris,
including excessive use in headers and as underlined words.

Arguably, this opinion expands the initial interest confusion theory by applying it to the
excessive use of a mark in the content of the site, rather than the more subtle use in the
invisible metatags.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Liability for metatag trademark infringement is still subject to the fair use defense
(e.g., comparative advertising, nondescriptive use, parody, etc.).73 Metatags must be
allowed if they constitute a good faith index of the content of the site and no confusion
is likely.74 However, evidence of repetitious usage or of the defendant’s general intent
to harm the mark owner may defeat the argument that the use is merely a good faith
effort to index site content.75

Playboy Enterprises v. Terri Welles, Inc.76

Terri Welles, a former Playboy “Playmate of the Year,” established a web site that
included the terms “playboy” and “playmate” in the metatags for the site. Playboy
Enterprises sued Welles for trademark infringement, unfair competition, and dilution
of trademark. The court found that although initial interest confusion is
actionable, it does not guarantee a finding of infringement or bar a fair use
defense. A plaintiff seeking to prevail on this theory must develop facts that indicate
whether the initial interest confusion is “damaging and wrongful,” whether
the confusion between the products will cause consumers to mistakenly believe
there is a connection between the two products, or evidence that the confusion
“offers an opportunity for sale not otherwise available” to the defendant.

In this case, the court found no evidence that any of these factors were established,
and there was no evidence that Ms. Welles had intended to divert Playboy
Enterprises’ customers through her use of the metatags. Rather, Ms. Welles
wished to benefit from her fame and recognition as the Playboy Playmate of the
Year 1981, and the logical way for a consumer to find her site on the web is by
entering those key words on a search engine. The court also noted that Playboy
Enterprises had not suggested any alternative, nonoffending words to properly
identify Ms. Welles and her web site. Ms. Welles’s use of the marks was descriptive
and beyond the scope of trademark law. Since the use of Playboy’s marks was
a nominative, fair use of the terms to describe Ms. Welles’s goods and services,
summary judgment was awarded to the defendants.

TRADEMARKS AND DOMAIN NAME DISPUTES

One by-product of the proliferation of Internet sites has been the problem often referred
to as “cybersquatting.” Cybersquatting refers to the bad faith registration of a domain
name that includes or consists entirely of a well-known trademark in order to sell the
domain name to the mark owner at a tidy profit. Other problems arise when two or more
companies appear to have equal rights to use a particular phrase as their web site
address. Either situation can be classified as a domain name dispute.


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

There are three statutory means of resolving domain name disputes: (1) the Lanham
Act (as already discussed), (2) the Uniform Dispute Resolution Procedures (UDRP),
and (3) the Anti-Cybersquatting Consumer Protection Act (ACPA).

The UDRP was implemented in December 1999, proffering an administrative dispute
resolution process that can reach a decision much faster, and for less cost, than litigating
the matter in court. Most proceedings take less than two months. However, the only
remedies available to the complaining party are transfer or cancellation of the domain
name. Damages or monetary awards are not an option. Arguably, this structure provides
inadequate deterrence for the would-be cybersquatter. The losing party has 10 days after
the UDRP decision is posted (on the Internet) to file a complaint in court; otherwise
the transfer or cancellation will be implemented automatically. Not all domain names
disputes use the UDRP because it must be invoked by a contractual provision; it does
not simply kick in whenever trademark laws might be violated by a domain name.
Generally, the UDRP applies where the contract with the Internet service provider provided
for all disputes to be resolved under the rules and regulations of the UDRP.

The ACPA also targets cybersquatting and was implemented around the same time as
the UDRP. Unlike the UDRP, the ACPA provides for statutory damages, capped at
$100,000 per domain name, and anticipates proceedings in court.77 Despite the availability
of monetary damages under the ACPA, it appears that most trademark owners
prefer the faster and less expensive resolution of the UDRP. The ACPA also contains
a safe harbor provision, protecting defendants who both “believed and had reasonable
grounds to believe that the use of the domain name was fair use or otherwise lawful.”78

Virtual Works, Inc. v. Volkswagen of America Inc.79

In Virtual Works, the Fourth Circuit examined the intent element of the ACPA,
which requires the defendant to have had a bad faith intent to profit from the
domain name registration. Virtual Works, an Internet service provider, registered
the domain name “vw.net” in October 1996. Approximately three years later,
Volkswagen filed a protest seeking to have the domain name put on hold because
it allegedly infringed their trademark, “VW.” The trial court found that Virtual
Works was cybersquatting, relying in part on the fact that Volkswagen was the
only entity with rights in the mark since Virtual Works never registered the VW mark
or conducted business under that mark. Moreover, the use of vw.net caused confusion
and disparaged Volkswagen by describing it as a Nazi enterprise supported by
slave labor. The differences between the two companies’ products was irrelevant
because “both parties use the Internet as a facility to provide goods and services.”

On appeal, the court found sufficient evidence of bad faith on the part of Virtual
Works in registering the domain name vw.net to affirm summary judgment in

(continues)


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Virtual Works, Inc. v. Volkswagen of America Inc. (continued)

favor of Volkswagen. The court’s analysis focused on three factors: (1) evidence
that Virtual Works was aware of Volkswagen; (2) Virtual Works’ attempt to make
a significant profit by selling the domain name to Volkswagen (until Volkswagen
initiated the action to claim the domain name); and (3) Virtual Works’ threat to
sell the domain name to the highest bidder unless Volkswagen purchased the
name. The Fourth Circuit was not convinced that Virtual Works’ legitimate business
uses of the mark outweighed the evidence of bad faith intent. Accordingly,
the court upheld the award of summary judgment for Volkswagen.

The following case also examines the “bad faith” requirement of cybersquatting.
However, unlike Virtual Works, the following case did not involve a famous mark and
was resolved in arbitration rather than in the courtroom.

Broadcom Corp. v. Becker80

Broadcom recently attempted to clarify the meaning of “bad faith” in the context
of domain name disputes. In Broadcom, the arbitration panel stated that putting a
fairly generic domain name such as <cyberbroadcomm.com> up for open sale
qualifies as a legitimate interest in and use of that domain name. When the domain
name in question is also a well-known trademark, the same actions can constitute
bad faith, particularly where the domain name is offered for sale to the trademark
owner or a competitor of that owner. However, the domain name in this case was
not famous, nor was there any evidence that the defendant knew of Broadcom or
its trademark (Broadcom) when he registered the domain name and offered it for
sale to the public.

The fact that the domain name in question differed slightly from the trademark
was not a determining factor. If the defendant had registered the domain name to
prevent the trademark owner from obtaining a domain name that would reflect her
mark, even though the name was not identical to the mark, such registration might
be found to be in bad faith. In short, if the trademark owner proves that defendant’s
registration was done primarily to disrupt the business of the trademark
owner, or so that the registrant might benefit from the likely resulting confusion,
the owner has demonstrated bad faith.

Several individuals have attempted to satisfy the “legitimate use” requirement with
less than fully developed web sites. However, the courts do not appear willing to blindly
accept that any use of the domain name on a web site qualifies the registrant’s actions
as legitimate use.


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

Hewlett-Packard Co. v. Rayne81

Mike Rayne registered the domain names <hpcopier.com> and <hewlettpackardfax.
com> with Network Solutions, Inc. As a contractual condition of the registration,
Rayne was required to resolve any domain name disputes related thereto
under the UDRP. Accordingly, when Hewlett-Packard complained about the
domain names infringing its famous trademarks “Hewlett-Packard” and “HP,”
the matter was heard by an arbitration panel. The arbitration not only found the
domain names to be confusingly similar to the plaintiff’s trademark, but also
stated that the unsupported claim that the web site was “under construction” did
not constitute legitimate use of the domain. Ten months after registering the
domain names, Rayne still had not made any use of the site, despite the posted
claim that it was “soon to be” a consumer chat web site. This passive holding of
the disputed domain name, without significant use, permitted an inference of bad
faith on Rayne’s part.

Another factor considered by the panel in Hewlett-Packard v. Rayne was Rayne’s pattern
of registering infringing domain names and then offering them for sale to the trademark
owner. Rayne also owned the domain names: <cannoncopiers.com>, <fujitsu
fax.com>, <hitachifax.com>, and <xeroxfax.com>, among others. This type of repeated
registration of domain names that incorporate well-known marks is coming under great
scrutiny from the judiciary. Similarly, transparent attempts to sell the domain names
rather than use them can indicate bad faith by the alleged infringer.

PRIMEDIA Magazine Finance, Inc v. Manzo82

The WIPO arbitrator examined claims that Richard Manzo’s registration of
<powerandmotoryacht.com> and <powerandmotoryachts.com> infringed the
registered trademark “Power & Motoryacht” for magazines dealing with boating.
The arbitrator found that it was clear from the web sites that the primary purpose
of the sites were to offer the domain names for sale. Manzo could not claim that
he had a legitimate use for the marks, as his web site did not offer any goods or
services, but simply provided a link to an unaffiliated web site. The arbitrator
rejected Manzo’s argument that he was simply using the links until he had
the “time and motivation” to set up a permanent web site, particularly in light of
Manzo’s inability to provide any information about the site he claimed he would
develop or any other evidence of legitimate use. Accordingly, the arbitrator required
the domain names to be transferred to the trademark owner.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

As the reader may have already noticed from cases cited in this chapter, web sites with
sexual content have been a driving force in shaping the law applicable to trademarks in
cyberspace. Playboy, in particular, has been very active in enforcing its marks. Accordingly,
several of the seminal cases involving metatag infringement and domain name
disputes stem from litigation involving the venerable “Playboy” and “Playmate” marks.

Playboy Enterprises International v. Tonya Flynt Foundation83

Despite Playboy’s well-known and registered “Playboy” mark (in connection
with adult entertainment in various media), Playboy had difficulty registering the
domain name <playboyonline.com>. Tonya Flynt, the daughter of Larry Flynt and
publisher of Hustler magazine, registered the domain and refused to transfer it
to Playboy, despite entering negotiations at one point. Instead, Flynt used the site
to advertise various goods, including videos. The arbitrator agreed with Playboy
that Flynt was well acquainted with the adult entertainment industry and the mark
was sufficiently famous for Flynt’s actions to be construed as being in “bad faith.”
Moreover, the panel was satisfied that Flynt’s use of the disputed domain name
web site to sell products that are also products the public would expect Playboy
to sell indicated bad faith and did not constitute a legitimate use of the mark.

Moreover, trademark owners who are not involved in the adult entertainment industry
tend to be extremely concerned about infringing uses of their marks that appear to affiliate
them with pornography.

Trump v. olegevtushenko a/k/a/ Oleg Evtushenko84

This case involved another pornography dispute, in particular a dispute involving
Donald Trump and an individual, Oleg Evtushenko, who registered the domain
name <porntrumps.com>. Donald Trump had used and registered the TRUMP service
mark in connection with high-class casino and entertainment services, while
Evtushenko had used the domain name for a pornographic video web site offering
“extreme XXX” pornography and membership in a pornographic video club.
Despite the international recognition of Donald Trump, the arbitration panel noted
that the common use of the word “trump” both as a noun and a verb predated Mr.
Trump. Moreover, the panel found that there was no likelihood of confusion
between TRUMP and <porntrumps.com>. The use of “trumps” as a verb was meant
to suggest that pornography “gets the better of” things. This particular use was not
a trademark use and therefore did not infringe Trump’s rights as a mark owner. The
complaint was therefore dismissed.


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

The Internet has forced trademark law to evolve in ways that recognize the particular
harms and types of infringement possible only in cyberspace. Traditional doctrines
of likelihood of confusion and infringement have given rise to judicial concepts such as
initial interest confusion and metatag misuse. Another doctrine that has found new life
since the advent of the World Wide Web is the cause of action for dilution.

DILUTION AND REVERSE CONFUSION

Under section 43(c) of the Lanham Act, a trademark owner may sue for a commercial
use of his or her mark when the use dilutes the mark’s value. In 1995, Congress enacted
the Federal Trademark Anti-Dilution Act (FTDA) to establish a uniform set of standards
for the common law claim of dilution.85 Dilution commonly takes two forms: blurring
and tarnishment. “Blurring” causes customers to pause and think for a moment as to
what source is being identified by the mark (sort of a temporary confusion), whereas
“tarnishment” refers to negative effects on a mark’s positive meanings or associations
(often by linking it with sexual matters or by other means of reducing its prestige value).
The cause of action for dilution allows a trademark owner to preclude use of a mark on
noncompeting goods if the use of the mark could dilute the mark’s distinctiveness or
tarnish the brand association.

Mead Data Central, Inc. v. Toyota Motor Sales, U.S.A. Inc.86

Mead Data provides an example of a dilution claim under the blurring theory.
The case dealt with two similar marks: “Lexis” (in connection with Mead Data’s
legal research service) and “Lexus” (in connection with Toyota’s luxury cars).
Ultimately, the court determined that there could be no blurring because the relevant
consumers for each product were very sophisticated and would easily distinguish
between the marks. Moreover, the “Lexis” mark circulated only in a very
limited market, so it lacked recognition among the general population and was
unlikely to be associated with a dissimilar product. Moreover, given the vastly
different product contexts, there was no reason to think that consumers would
forge even a brief mental link between the two products. Accordingly, the court
held that it was unlikely that there would be any significant amount of blurring
between the Lexis and Lexus marks in Mead Data’s market.

Ford Motor Co. v. Lapertosa87

This case held that use of a famous trademark in the domain name of a pornographic
site tarnished the mark and constituted dilution. Lapertosa registered a

(continues)


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Ford Motor Co. v. Lapertosa (continued)

domain name for <fordrecalls.com>, which it used for an adult entertainment web
site. Ford naturally took offense at this use and sued Lapertosa, alleging that the
use of the famous mark “Ford” in the domain name of a pornographic web site
tarnished the mark and diluted its value. The court found that Lapertosa’s
use of the mark was “fundamentally inconsistent with the otherwise wholesome
and commercial nature of the mark” and preliminarily enjoined Lapertosa from
using the domain name. Moreover, the court forbade Lapertosa from auctioning,
selling, or transferring the domain name to another user other than Ford, and
ordered the defendant to transfer the <fordrecalls.com> to the trademark owner.

Although blurring and tarnishment remain the primary theories of dilution, courts
have recognized that dilution encompasses more than actions that fall into those two
categories. As elsewhere, the Internet has forced courts to consider new twists on the
traditional cause of action.

Panavision Int’l, L.P. v. Toeppen88

In this case of dilution on the Internet, the defendant had registered <panavision.
com> as his domain name. “Panavision” was the plaintiff’s registered trademark
in connection with motion picture camera equipment. Toeppen used the
web site to display photographs of the City of Pana, Illinois—ostensibly his
“Panavision.” Although that might have provided some sort of legitimate use
defense, Toeppen’s subsequent conduct undermined that position. After Panavision
demanded that he cease using their trademark, Toeppen offered to sell the
domain name to Panavision. When Panavision declined, he registered Panavision’s
other trademark, “panaflex,” as the domain name <panaflex.com>; that web page
displayed only the word “Hello.” Moreover, Toeppen had registered domain names
incorporating the trademarks of over 100 other companies and offered to sell those
names to the mark owners.

The court found that both the Lanham Act and California law provide for
injunctive relief for the owner of a famous mark if an unauthorized commercial
use causes “dilution of the distinctive quality of the mark.” Toeppen claimed that
use of a mark as a domain name is not commercial use. The court disagreed, particularly
because it found that Toeppen misstated his use of the panavision mark.
The court described Toeppen’s actual business as the registration and sale of
domain names that incorporate famous marks. Accordingly, Toeppen’s use
“traded on the value of Panavision’s marks,” limiting Panavision’s ability to


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

Panavision Int’l, L.P. v. Toeppen (continued)

exploit the value of its trademarks on the Internet until and unless Panavision paid
Toeppen for the domain name. The courtheld that it did not matter that the mark
was not attached to a particular product, because his attempt to sell the trademarks
themselves constituted a commercial use.

Although the court noted that Toeppen’s conduct varied from the two classic
dilution theories of “blurring” and “tarnishment,” it held that these traditional definitions
were not necessary to find a defendant liable for dilution. Toeppen’s conduct
constituted dilution because it diminished “the capacity of the Panavision
marks to identify and distinguish Panavision’s goods and services on the Internet.”

Regardless of the particular theory of dilution, the mark at issue must be “famous.”
In determining whether a mark is famous, the courts consider multiple factors, including
those set forth by the FTDA:

a.
the degree of inherent or acquired distinctiveness of the mark;
b. the duration and extent of use of the mark in connection with the goods or services with
which the mark is used;
c.
the duration and extent of advertising and publicity of the mark;
d. the geographical extent of the trading area in which the mark is used;
e.
the channels of trade for the goods or services with which the mark is used;
f.
the degree of recognition of the mark in the trading areas and channels of trade used by the
marks’ owner and the person against whom the injunction is sought;
g. the nature and extent of use of the same or similar marks by third parties; and
h. whether the mark was registered....89
Despite these guidelines and the enactment of the FTDA, courts still vary greatly
in their approach to dilution claims. Some courts have attempted to limit the applicability
of a dilution claim by taking a narrow view as to the type of mark that, qualifies for
protection.

TCPIP Holding Co. v. Haar Comm, Inc.90

Plaintiff operated a chain of stores that sold children’s clothing and accessories
under the registered trademark “The Children’s Place.” Haar registered the domain
name <thechildrensplace.com> as a web site for children. Plaintiff brought suit
claiming dilution of its mark. The court found that in order to be protectable, the
mark had to possess a certain degree of inherent distinctiveness to satisfy the act’s
requirement of “distinctive quality.” “The Children’s Place” was not inherently

(continues)


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

TCPIP Holding Co. v. Haar Comm, Inc. (continued)

distinctive, and so could not qualify for protection under the FTDA. Moreover,
the court found that a mark must also have achieved a sufficient degree of consumer
recognition (“acquired distinctiveness” or secondary meaning) to satisfy
the act’s requirement of fame. Merely acquiring secondary meaning would not
satisfy the distinctiveness requirement and thus would be insufficient to qualify
the mark for protection; a mark must be both inherently distinctive and famous.

There are already several circuit splits concerning crucial elements of a claim under the
FTDA. For example, there is a split between the circuits regarding whether the mark
must be famous in a broad sense or merely acquire niche fame. Some jurisdictions hold
that the plaintiff need only prove the famousness of the mark within the particular market
in which it is used, and not the market in a broader sense.91 Other courts find that
niche market fame is not sufficient to render the mark famous under the FTDA unless
the allegedly diluting use is directed toward the same market.92

Furthermore, the courts differ over whether the plaintiff must demonstrate actual
dilution of his or her mark or whether a likelihood of dilution is adequate to maintain
an action. The Fourth and Fifth Circuits have interpreted the Dilution Act to require
actual dilution in order to prevail on a cause of action under the Act.93 In contrast, the
Second, Third, Seventh, Eighth, and Ninth Circuits merely require evidence of a likelihood
to cause dilution.94 Since the Supreme Court has not resolved this split, Congress
may implement some type of legislative clarification in the near future.

Defenses to dilution include: fair use of the mark in comparative advertising; noncommercial
use; use in all forms of news or news commentary; and the nominative use
defense.95 Use of a mark in comparative advertising, as discussed earlier, is not a use of
a mark as a trademark and thus is not actionable. Use of a mark in a noncommercial context
(e.g., as nonprofit parody or news reports) is protected by free speech concerns from
qualifying as infringement. “Nominative use” is a defense where (1) the product is not
readily identifiable without the mark; (2) the mark is used only as much as is reasonably
necessary; and (3) the user does not suggest sponsorship by, or affiliation with, the
mark’s owner.96

Hormel Foods Corp. v. Jim Henson Productions, Inc.97

Hormel Foods involves the parody defense to a dilution action. Hormel sued Jim
Henson Productions over the creation of a new Muppet—an exotic wild boar
named “Spa’am.” Henson thought that the association between the crazy boar
and the tame, familiar pork blend known as SPAM would be humorous. Hormel


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

Hormel Foods Corp. v. Jim Henson Productions, Inc. (continued)

apparently could see nothing funny about Spa’am, and alleged that the “grotesque”
and “untidy” wild boar would inspire “negative and unsavory associations with
SPAM. luncheon meat.” However, the court found that Spa’am was a likable character,
unlikely to tarnish the SPAM mark. The court also noted that the Muppet
merchandise would not directly compete in any sense with SPAM meat. In fact,
the defendant had no incentive to diminish SPAM sales, as SPAM was vital to the
humor of the new Muppet’s name. Finally, the court held that “parody inheres in
the product” so there was no likelihood of dilution under a tarnishment theory.

Even if the use is open criticism of the trademark owner, rather than lighthearted parody,
courts have recognized that such uses are not commercial uses of the mark, and
thus cannot qualify as dilution.

Ford Motor Co. v. 2600 Enterprises98

This case involved an unauthorized use of a registered trademark that the court
found to be permissible, as it merely directed web users to the official Ford site.
2600 Enterprises had incorporated “Ford” into their code so that any user who
entered their web site would be automatically redirected to the web site operated
by Ford at <www.ford.com>. The catch, at least from Ford’s perspective, was that
defendant’s web site had the domain name <www.fuckgeneralmotors.com>. Ford
complained that the public might believe that the obscene domain name was sponsored
or approved by Ford, and that the association with obscenity tarnished Ford’s
famous mark.

The court rejected Ford’s motion for a preliminary injunction, finding that Ford
was unlikely to prevail on its claim for dilution because the mark was not being
used in commerce. The decision stated, “This court does not believe that Congress
intended the FTDA to be used by trademark holders as a tool for eliminating
Internet links that, in the trademark holder’s subjective view, somehow disparage
its trademark. Trademark law does not permit Plaintiff to enjoin persons from
linking to its homepage simply because it does not like the domain name or other
content of the linking web page.” The court also noted that the offending web site
neither sold products or services nor linked to a page (other than plaintiff’s own
page) that engaged in e-commerce.

A recent visit to the web site at issue in Ford Motor Co. v. 2600 Enterprises revealed
a new addition—just before the web user is automatically transferred to the official



COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Ford site, there is an optional link, “To learn more about FuckGeneralMotors.com,
click here.” Clicking on that link takes you to a new page with the web address
www.fordreallysucks.com, and information about the site owners’ legal battle with Ford.
Although much more obvious than the use of Ford’s trademark already addressed by
the court, this use of “Ford” in the domain name probably falls even more clearly within
protected speech or commentary, and thus permissible use.

Finally, a related cause of action recognized by some courts is the doctrine of reverse
confusion. With reverse confusion, the junior user of the mark saturates the market with
a similar mark and overwhelms the senior user.99 Instead of attempting to trade off of
the renown of the original mark user, the junior user overtakes the senior user in popularity,
thus destroying the value of the mark for the senior user.

A&H Sportswear, Inc. v. Victoria’s Secret Stores, Inc.100

This case involved a dispute between the plaintiff, owner of the registered
trademark “The Miraclesuit” in connection with swimwear, and Victoria’s Secret,
who used its own trademark “The Miracle Bra” in connection with lingerie and
swimwear. The court had already determined that there was no likelihood of
direct confusion between the products and found that Victoria’s Secret was causing
reverse confusion of the marks through its extremely successful marketing of
its own swimwear under the confusingly similar mark. The sole issue at this stage
was the appropriate remedy for reverse confusion.

Victoria’s Secret initially had only used the mark in connection with lingerie,
and the court noted that the extension into swimwear was merely a legitimate
good faith attempt to capitalize on its own success. Accordingly, the court found
that there was no bad faith or malicious intent on the part of Victoria’s Secret, so
awarding a portion of the profits on Miracle Bra swimwear was not appropriate.
However, the court entered a permanent injunction forbidding Victoria’s Secret
from using the mark in connection with swimwear. Because a partial injunction
permitting the mark to be used in conjunction with a disclaimer would be difficult
to enforce, the court opted to completely enjoin use of the mark in the specific line
of products that threatened reverse confusion.

SUMMARY OF TRADEMARK LAW


The trademark laws attempt to benefit both consumers and producers by offering legal
protection of certain marks. Consumers benefit from the increased reliability of marks
indicating the source of specific products or services, while firms benefit from the



INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

increased efficiency of their advertising and precluding imitators from free-riding on
the firms’ accumulated goodwill. To be protected as a trademark, a mark must be distinctive,
either inherently so (because it is fanciful or arbitrary) or because it has
acquired secondary meaning that affiliates it with its owner or product. A trademark
owner can establish infringement where the defendant used the mark in commerce, in
connection with the sale or promotion of goods or services, and the particular use is
likely to confuse potential customers as to the origin of the goods or services.

INTRODUCTION TO TRADE SECRET LAW

Unlike patents, copyrights, and trademarks, trade secrets are governed exclusively by
state law. Therefore, as an expert or attorney in a trade secret case, it is important to read
the relevant state’s trade secret statute and any seminal case law relating to remedies.
Currently, approximately 40 states and the District of Columbia have adopted some
version of the Uniform Trade Secrets Act (the Uniform Act)101; 2 states—Massachusetts
and Alabama—afford protection under separate statutes, and 8 states—Michigan,
Missouri, New Jersey, New York, Pennsylvania, Tennessee, Texas, and Wyoming—protect
trade secrets under common law.102 Nonetheless, almost all states follow or find
persuasive the definitions stated in the Restatement of Torts103 and the Restatement
(Third) of Unfair Competition.104 Despite the various attempts to define a trade secret,
courts and commentators alike have remarked on the difficulty in defining “trade
secret,” primarily because almost any subject matter can be claimed as a trade secret.105
In fact, what constitutes a trade secret is “one of the most elusive and difficult concepts
in law to define.”106 This section will help elucidate the different definitions and factors
used in determining whether certain information may be protected as a trade secret.

WHAT IS A TRADE SECRET?

Whether certain information qualifies as a trade secret depends on the type of information,
the applicable state law, and the measures taken to ensure secrecy. The identification
of trade secrets is a dynamic process. Information that a business may consider
a trade secret is constantly changing—some information becomes obsolete and may no
longer be commercially valuable, while new, developing information gains value. In
addition, given that trade secrets today may appear in either paper or electronic form,
the rules governing protection of trade secrets are evolving, and companies are, or
should be, careful about identifying and protecting their trade secrets.

Providing a precise definition of a trade secret that applies in every situation may not
be possible. The most commonly accepted sources, the Uniform Act, the Restatement
of Torts, and the Restatement (Third) of Unfair Competition, provide varied, yet similar,
approaches to defining a trade secret.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

The Uniform Trade Secrets Act

The definition of a trade secret likely will vary from jurisdiction to jurisdiction. The majority
of jurisdictions, however, accept some form of the definition stated by the Uniform Act:

“Trade Secret” means information, including a formula, pattern, compilation, program,
devise, method, technique or process that: (i) derives independent economic value, actual
or potential, from not being generally known to, and not being readily ascertainable by
proper means by, other persons who can obtain economic value from its disclosure or
use, and (ii) is the subject of efforts that are reasonable under the circumstances to maintain
secrecy.107

Under the Uniform Act, there are three defining characteristics of a trade secret: (1) the
information must not be generally known or readily ascertainable by competitors or
the general public through proper means, (2) it must derive actual or potential commercial
or economic value from being unknown, and (3) it is kept confidential through
affirmative steps to maintain secrecy.

The Common Law: Restatement of Torts and Restatement (Second)
of Unfair Competition

The common law also provides substantial guidance in defining and identifying trade
secrets. In fact, the common law is the exclusive authority in jurisdictions that are not
governed by any particular trade secret statute. The Restatement of Torts, originally
published in 1939, provides one of the first cogent definitions of a trade secret. While
recognizing that “[a]n exact definition of a trade secret is not possible,” the Restatement
of Torts provides:

A trade secret may consist of any formula, pattern, device or compilation of information
which is used in one’s business, and which give him an opportunity to obtain an advantage
over competitors who do not know or use it. It may be a formula for a chemical compound, a
process of manufacturing, treating or preserving materials a process, a pattern for a machine
or other device, or a list of customers.... Generally it relates to the production of goods, as,
for example, a machine or formula for the production of an article. It may, however, relate to
the sale of goods or to other operations in the business, such as a code for determining discounts,
rebates or other concessions in a price list or catalogue, or a list of specialized customers,
or a method of bookkeeping or other office management. ...A trade secret is a
process or device for continuous use in the operation of a business.108

In addition, the Restatement of Torts identified several factors useful in considering
whether certain information constitutes a trade secret, including: (1) the extent to which
the information is known outside the business, (2) the extent to which it is known by
employees and others involved in the business, (3) the extent of measures taken to guard
the secrecy of the information, (4) the value of the information to the business and to
competitors, (5) the amount of effort or money expended to develop the information, and


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

(6) the ease or difficulty with which the information could be properly acquired or duplicated
by others.109
In 1995, trade secret law principles were refined by the Restatement (Third) of
Unfair Competition. The Restatement (Third) of Unfair Competition defines a trade
secret as “any information that can be used in the operation of a business or other enterprise
and that is sufficiently valuable and secret to afford an actual or potential
economic advantage over others.”110 Arguably, the Restatement (Third) of Unfair
Competition expands the definition of trade secret. Notably, the new definition proffers
trade secret protection to “any information” rather than focusing on the form in which
it is presented (e.g., formula, pattern, device, etc.). In addition, there is no requirement
that the trade secret be in “continuous use in the operation of a business.” In fact, the
new Restatement definition extends trade secret protection to “blind alleys” or “dead
ends,” because negative information, such as knowing the failures involved in developing
a process or method, can have value and may provide an economic advantage in
competition.111

Although there are some differences between the definitions of trade secret articulated
by the Uniform Act, the Restatement of Torts, and the Restatement (Second) of
Unfair Competition, the common thread that runs through all three is that a trade secret
is something that is confidential, provides some value to the business, and whose value
would be reduced if it were known by competitors. The distinctions between the
three definitions often are blurred by the courts. In interpreting and applying the Uniform
Act and various state statutes, courts often look to the Restatement of Torts and
the Restatement (Second) of Unfair Competition for guidance. As one court stated,
“Although all of the Restatement’s factors no longer are required to find a trade secret,
those factors still provide helpful guidance to determine whether the information in a
given case constitutes ‘trade secrets’ within the definition of the statute.”112

FACTORS INDICATIVE OF TRADE SECRETS

Various factors have been used by courts to resolve the ultimate issue in a trade secret
case: Is the valuable information secret? The sine qua non of trade secret status is, of
course, secrecy. While certain factors may be given different weight throughout the different
jurisdictions, most courts view the following factors as persuasive in determining
whether specific identified information can be protected as a trade secret.

Public Awareness

To be protected as a trade secret, the information must not be generally known or readily
ascertainable by competitors or the general public through proper means. The law
makes clear that a company can have no legitimate interest in restricting the use of


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

easily accessible information or information readily accessible by a reasonably diligent
competitor.113 A trade secret is not “readily ascertainable” if the replication or acquisition
of alleged trade secret information requires a substantial investment of time,
expense, or effort.114

Although a competitor may be reasonably diligent, the Uniform Act makes clear that
there are proper and improper means by which to obtain trade secret information. For
instance, “proper means” to obtain information might include independent discovery,
observation in public use, obtaining information from published materials, and, in some
instances, reverse engineering. Indeed, the United States Supreme Court has declared: “A
trade secret law... does not offer protection against discovery by fair and honest means,
such as by independent invention, accidental disclosure, or by so-called reverse engineering,
that is by starting with the known product and working backward toward to
divine the process which aided in its development or manufacture.”115 By contrast,
“improper means” include “theft, bribery, misrepresentation, breach or inducement of a
breach of duty to maintain secrecy or espionage through electronic or other means.”116
Although the Supreme Court has approved of reverse engineering (because the information
is obtainable), some state courts have held reverse engineering to be an improper
means of obtaining information because of the expense and time involved in obtaining the
otherwise “secret” information.117 The bottom line is the more extensively the information
is known or the easier it is to access the information outside the company, the less
likely it will be regarded as a trade secret.

Intracompany Awareness

The greater the number of employees who know the information at issue, the less likely
it is that the information is a protected trade secret. Although limiting the number of
employees who have access to or know the trade secret information may be important,
of particular importance are the measures taken by the company to protect the trade
secret information and prevent its dissemination to other employees, competitors, and
the public.

Reasonable Measures

In virtually every jurisdiction and under the Uniform Act, the trade secret owner must
take some affirmative steps to protect the trade secret. In particular, the Uniform Act
will not protect information unless its owners have taken reasonable measures to protect
its secrecy. Specifically, the Uniform Act provides: “The efforts required to maintain
secrecy are those ‘reasonable under the circumstances.’ The courts do not require
that extreme and unduly expensive procedures be taken to protect trade secrets against
flagrant industrial espionage.”118 Although what is “reasonable under the circumstances”
will vary from case to case, several basic measures commonly are discussed as
reasonable protections of trade secrets:


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

a.
Marking documents and materials as “confidential”;
b.
Use of confidentiality and nondisclosure agreements with employees, contractors, suppliers,
and all parties given access to confidential information;
c.
Restricting access to physical facilities;
d. Securing confidential information within a facility and limiting access to those only with
a “need to know”;
e.
Requiring special passwords to gain access to confidential computerized information and
databases;
f.
Policies to track and retrieve copies of documents containing sensitive information; and
g. Employee exit interviews and document return procedures.119
Absolute secrecy, however, is not required, and would in fact make most trade secrets
devoid of value inside the company. Generally, some employees must be allowed to
know the “secret” in order for it to be of value to the company. However, reasonable
steps to preserve secrecy must be taken, with “reasonableness” evaluated in light of
the business, the type of secret, the feasibility of certain measures, and the circumstances
of the situation. For example, the most famous trade secret is the formula for
Coca-Cola. According to certain sources, the Coca-Cola Company protects the secrecy
of its formula by limiting disclosure of the ingredients to only two people within the
company.120 The names of these individuals are not publicly known, and they are not
allowed to travel together. The written formula is stored in a bank vault that can be
released only by approval of the Coca-Cola Company’s Board of Directors.121

The type of measures that are appropriate will vary from case to case and likely will
be dependent on the type of business involved and the information sought to be protected.
However, trade secrets law clearly does not require the company to take every
possible precaution to ensure the security of its trade secrets, nor does it require that the
steps taken be foolproof. Rather, the “owner of the secret must take reasonable, though
not extravagant, measures to protect the secrecy.”122

Degree of Competitive Value

To qualify for trade secret protection, not only must the information be secret, but also
the company must derive actual or potential commercial or economic value from keeping
the information relatively unknown. The value can be derived from the amount of
time, money, or effort invested in the development of the information, whether positive
(it works) or negative (it does not work). Value also can be derived from the detail, complexity,
or sophistication of the knowledge. Nonetheless, the greater the value, the more
likely that the information will be protected as a trade secret.

Effort to Create the Information

The more time, effort, and money invested in developing the information, the more
likely it is that the information is a protected trade secret.123


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Ease of Replication

The easier the information is to replicate or properly obtain, the less likely the information
will be considered a protected trade secret.

TYPICAL PROTECTABLE TRADE SECRETS

In general, several types of subject matter have traditionally been protected as trade
secrets. These types of traditional trade secrets include (1) manufacturing processes; (2)
prepatented disclosures; (3) software (object code or source code), software equipment,
and documentation; (4) designs, drawings, and models; (5) internal specifications and
testing procedures; (6) strategic plans; (7) marketing, development, and research plans;

(8) novel techniques, ideas, concepts, discoveries, or inventions; (9) negative information
(i.e., procedures, processes, methods, etc., that did not work); (10) customer lists;
(11) client information; (12) vendor and supplier information; and (13) pricing and cost
information. Unique compilations or combinations of information, even if the underlying
information is known in the trade, may be subject to trade secret protection. In fact,
“a trade secret can exist in a combination of characteristics and components, each of
which, by itself, is in the public domain, but the unified process, design and operation
of which, in unique combination, affords a competitive advantage and is a protectable
trade secret.”124
Interestingly, a trade secret can be the proper subject matter for a patent. However, the
disclosure requirements of a patent force the trade secret owner to make a conscious
choice between protection through secrecy or through the patent. It certainly is not a given
that a trade secret would qualify for a patent. The subject matter for a trade secret is not
the same as the novelty requirement for patentability. In Kewanee Oil Co. v. Bicron Corp.,
the Supreme Court held that a trade secret requires only “minimal novelty,” for example,
a trade secret will not necessarily meet the novelty requirements for a patent.125 At a
minimum, however, a trade secret must have some utility and competitive significance.

INFORMATION NOT PROTECTED AS A TRADE SECRET
AND TREATMENT OF CONFIDENTIAL INFORMATION


Information that a company does not attempt to keep secret is not considered a trade
secret.126 In addition, merely labeling information as a “trade secret” does not guarantee
such protection. Generally, there is no trade secret protection for information that merely
constitutes general business knowledge or experience. For example, a company cannot
prevent a former employee from using information that is generally known or available in
the industry by merely having the employee agree in writing that the information is a trade
secret. There also is no trade secret protection over an employee’s general knowledge of


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

how to do his or her jobs (although the employee could be enjoined from developing or
using information revealed in confidence and under a confidentiality agreement). Finally,
there is no trade secret protection for information that is already in the public domain.127

Although information deemed “confidential” does not necessarily rise to the level of
a trade secret, courts often afford protection for such information. In fact, both courts
and commentators recognize that certain information need not rise to the level of a trade
secret to be considered valuable and confidential.128 For example, one court has
acknowledged: “Although given information is not a trade secret, one who receives the
information in a confidential relationship is under a duty not to disclose or use that
information.”129 Moreover, if the owner of the information fails to take reasonable steps
to keep the information secret, the information may not be protected under the Uniform
Act, despite the fact that the information still may be unknown to the public, and the
owner may well consider the information confidential and valuable. Under such circumstances,
the information may be protected under certain confidentiality agreements.

MISAPPROPRIATION OF TRADE SECRETS

The Uniform Act prohibits the actual or threatened “misappropriation” of trade secrets
through “improper means.” As stated previously, “improper means” includes theft,
bribery, misrepresentation, breach or inducement to breach a duty to maintain secrecy, or
espionage through electronic means or otherwise. The Uniform Act defines “misappropriation”
as:

(1) the acquisition of a trade secret by a person who knows or has reason to know that the
trade secret was acquired by improper means, or (2) the disclosure or use of a trade secret
without the express or implied consent of the owner by a person who: (a) used improper
means to acquire the trade secret; or (b) knew or had reason to know that the knowledge of
the trade secret that the person acquired was derived from or through a person who had utilized
improper means to acquire it, was acquired under circumstances giving rise to a duty to
maintain its secrecy or limit its use, or was derived from or through a person who owed a duty
to the person seeking relief to maintain its secrecy or its use; or (c) before a material change
of their position, knew or had reason to know that it was a trade secret and that knowledge of
it had been acquired by accident or mistake.
Appropriation of a trade secret by improper or unauthorized means by someone who
knows that such information is proprietary constitutes a violation of trade secret law.
In addition, the disclosure of a trade secret by someone who legally possesses the
secret and has a duty of confidentiality (by contract or otherwise) also is a violation.
In fact, hiring a competitor’s former employee in order to gain trade secret information,
despite the employee’s nondisclosure agreement, can qualify as misappropriation
of a trade secret. Courts may consider it “inevitable” that the new employee would use
the trade secret in the new job,130 or weigh the fact that the employee was less than
forthcoming with his former employer regarding the new job as an indicator of the


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

likelihood that the trade secret will be disclosed in determining whether the secret was
in fact “misappropriated.”131

Chemetall GBMH v. ZR Energy, Inc.132

Chemetall sued ZR for misappropriation of its trade secrets for the manufacture,
marketing, and sale of zirconium metal powder products. The court found that ZR
had, in fact, acted maliciously, but also that ZR had asked Chemetall on several
occasions whether the alleged trade secret was confidential information, and
Chemetall assured ZR that it was not. However, despite these assurances, the
court found that ZR should have known that it was acquiring trade secrets when
it hired one of Chemetall’s former employees. The court also decided that ZR’s
actions were more akin to recklessness than deliberate misappropriation.

The court held that Chemetall’s disputed process was not a trade secret in many
respects and therefore denied fees, as injunctive relief constituted a sufficient
deterrent. The decision also affirmed the right of a business to enforce existing
employee confidentiality agreements when acquiring all or part of another
company, since Chemetall had acquired a specialty metals division of Morton
International and sought to prevent a former Morton employee from using the
trade secrets when he joined ZR.

If, however, the secret is acquired by proper means, then there is no violation. For
example, if the secret is disclosed in a patent, then there cannot be liability for misappropriation
of a trade secret because the invention has been disclosed to the public.
Similarly, obtaining a trade secret from a publication of the secret, disclosure to the public
(even accidental disclosure) or reverse engineering is not misappropriation.

Generally speaking, the available remedies for misappropriation of a trade secret
may include actual damages, punitive damages, and, in some cases, attorneys’ fees.
Injunctive relief may also be available—to prevent either the competitor or the former
employee from using or disclosing the protected trade secret. The available remedies
are discussed in more detail in later chapters.

SUMMARY OF TRADE SECRET LAW

Trade secret law allows a company or individual to protect confidential information from
unauthorized disclosure or use. In contrast to patents, trade secrets exist only until they are
disclosed to the public. A trade secret relies on private security measures such as nondisclosure
agreements and restricted access to preserve the status of the valuable information


INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

as a trade secret. The law only becomes involved after there has been a misappropriation
of that information, generally through theft or breach of a confidentiality agreement.
Defendants can be held liable for uses or disclosures of the information, particularly
where their use is in direct competition with the trade secret owner’s products or services
and places the continuing existence of the owner’s products or services in jeopardy.

ENDNOTES

[1]
See Kellogg Co. v. Nat’l Biscuit Co., 305 U.S. 111 (1938) (finding that “Shredded Wheat”
was a purely generic term for the cereal and thus could not afford its owner an exclusive
right to use the name).
[2] 15 U.S.C. § 1051 et seq.
[3]
See Lanham Act § 45.
[4]
Id.
[5]
Id.
[6]
See id. § 14(5)(D) (providing for the cancellation of any certification mark abused in this
way).
[7]
Id. § 14(5)(D), (A).
[8]
Id. § 45.
[9]
See also Opticians Assoc. v. Independent Opticians, Inc., 920 F.2d 187 (3d Cir. 1990).
[10]
Id.; see also Lawyers Title Ins. Co. v. Lawyers Title Ins. Corp., 109 F.2d 35 (D.C. Cir.
1939), cert. denied, 309 U.S. 684 (1940) (noting that both confusion of the public and
injury to the public generally will be found where a trade name is used by a second
company).
[11]
See In re Amex Holding Corp., 163 U.S.P.Q. 558 (TTAB 1969); Communications Satellite
Corp. v. Comcet, Inc., 429 F.2d 1245 (4th Cir. 1970), cert. denied, 400 U.S. 942 (1971).
[12]
Id. It should also be noted that the Lanham Act does provide protection to foreign nationals
for trade names “without the obligation of filing or registration whether or not they
form parts of marks.” Lanham Act § 44(g) (emphasis added). This chapter deals primarily
with domestic filings, but the reader should be aware that there are separate provisions for
foreign applicants. See Lanham Act § 44.
[13]
Lanham Act § 7(b).
[14]
Id. § 7(c).
[15]
Id. § 15.
[16]
Id. § 33(b).
[17]
Id.; see also id. § 14 (flaws in certification process).
[18]
Id. §§ 33(b), 32.
[19]
Id. § 14(3).
[20]
Union Nat’l Bank of Texas, Laredo v. Union Nat’l Bank of Texas, 909 F.2d 839 (5th Cir. 1990).

COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

[21]
See J. Thomas McCarthy, Trademarks and Unfair Competition §§ 11.24, 11.72 (providing
examples of marks found descriptive and marks held suggestive).
[22]
See id.
[23]
Genesee Brewing Co., Inc. v. Stroh Brewing Co., 124 F.3d 137 (2d Cir. 1997).
[24]
Ty, Inc. v. The Jones Group, Inc., No. 99 C 2057, 2001 WL 1414232 (N.D. Ill. Nov. 9,
2001).
[25]
Car-Freshner Corp. v. S.C. Johnson & Son, Inc., 70 F.3d 267 (2d Cir. 1995).
[26]
Taylor Wine Co., Inc. v. Bully Hill Vineyards, Inc., 569 F.2d 731 (2d Cir. 1978).
[27]
Qualitex Co. v. Jacobson Prods Co., Inc., 514 U.S. 159 (1995).
[28]
Two Pesos, Inc. v. Taco Cabana, Inc., 505 U.S. 763 (1992).
[29]
Wall Street Journal, p. B8, col. 1, Jan. 14, 1993.
[30]
Wal-Mart Stores, Inc. v. Samara Bros., Inc., 529 U.S. 205 (2000).
[31]
Id. Note that “tertium quid” simply means “a third something.”
[32]
Manhattan Industries, Inc. v. Sweater Bee by Banff, Ltd., 627 F.2d 628 (2d Cir. 1980). The
sudden interest in the mark was due to the fact that the previous mark owner had formally
abandoned the mark on May 7 of the same year. Id.
[33]
See Lanham Act § 33 (“Any registration issued . . . and owned by a party to an action shall
be admissible in evidence and shall be prima facie evidence of the validity of the registered
mark and of the registration of the mark, of the registrant’s ownership of the mark,
and of the registrant’s exclusive right to use the mark in commerce...”).
[34]
See Lanham Act § 45.
[35]
See Lanham Act § 33.
[36]
See In re Sanger Telecasters, Inc., 1 U.S.P.Q. 2d 1589 (TTAB 1986) (finding that extensive
advertising does not constitute “use” for purposes of registration where the actual
services had not yet been rendered).
[37]
See Lanham Act § 1(b)–(d).
[38]
Id. § 1(b)(1).
[39]
Id. § 1(d)(2).
[40]
See Warnervision Entertainment, Inc. v. Empire of Carolina, Inc., 101 F.3d 259 (2d Cir.
1996) (refusing to enjoin ITU applicant’s use of a mark despite subsequent use by third
party). Constructive use can also be obtained by a foreign filing for registration under certain
circumstances. See Lanham Act § 44(d).
[41]
Lanham Act § 32(1)(a).
[42]
See Smith Fiberglass Prods., Inc. v. Ameron, Inc., 7 F.3d 1327 (7th Cir. 1993); Dr. Seuss
Enters. v. Penguin Books USA, Inc., 109 F.3d 1394, 1404 (9th Cir. 1997); Dreamwerks
Prod. Group v. SKG Studio, 142 F.3d 1127 (9th Cir. 1998).
[43]
Libman Co. v. Vining Indus., Inc., 69 F.3d 1360 (1995), cert. denied, 116 S. Ct. 1878 (1996)
(comparing two brooms to determine whether the similar contrast-coloring of the bristles
infringed a trademark).
[44]
Ferrari S.P.A. Esercizio v. Roberts, 944 F.2d 1235 (6th Cir. 1991), cert. denied, 112 S. Ct.
3028 (1992).

INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

[45]
Eli Lilly & Co. v. Natural Answers, Inc., No. IP 99-1600-CH/G, 2000 U.S. Dist. LEXIS
1930 (S.D. Ind. Jan. 20, 2000) (list of factors not intended to be a mechanical checklist,
“myriad of variables” must be considered); Dorr-Oliver, Inc. v. Fluid-Quip, Inc., 94 F.3d
376 (7th Cir. 1996).
[46]
G. Heileman Brewing Co., Inc. v. Anheuser-Busch, Inc., 873 F.2d 985 (7th Cir. 1989).
[47]
See Lanham Act § 33(b)(1)–(9) (listing potential defenses to infringement, even of incontestable
marks).
[48]
Id. § 45.
[49]
Id.
[50]
Id.
[51]
Id. § 33(b)(7).
[52]
Id. § 33(b)(4).
[53]
Id.
[54]
See, e.g., New Kids on the Block v. News America Publ., Inc., 971 F.2d 302 (9th Cir.
1992); Playboy Enterprises, Inc. v. Netscape Communications Corp., 5 F. Supp.2d 1070
(C.D. Cal. 1999).
[55]
Lanham Act § 43(a)(1)(A).
[56]
See Wal-Mart Stores, Inc. v. Samara Bros., Inc., 529 U.S. 205 (2000) (recognizing that
section 43(a) is the appropriate framework for owners of unregistered trademarks to seek
damages or injunctive relief).
[57]
See Jean Wegman Burns, Confused Jurisprudence: False Advertising Under the Lanham
Act, 79 B.U. L. Rev. 807, 808 (1999).
[58]
Lanham Act § 43(a)(1)(B).
[59]
Johnson & Johnson v. Carter-Wallace, Inc., 631 F.2d 186 (2d Cir. 1980) (finding plaintiff’s
case supported by the “logical causal connection” between the ads and plaintiff’s
sales, the testimony of a consumer witness, and surveys regarding people’s reaction to the
ads); see also Ortho Pharmaceutical Corp. v. Cosprophar, Inc., 32 F.3d 690 (2d Cir. 1994).
[60]
Johnson & Johnson * Merck Consumer Pharmaceuticals Co. v. Smithkline Beecham
Corp., 960 F.2d 294 (2d Cir. 1992).
[61]
U-Haul Int’l, Inc. v. Jartran, Inc., 793 F.2d 1034 (9th Cir. 1986).
[62]
Avis Rent A Car System, Inc. v. Hertz Corp., 782 F.2d 381 (2d Cir. 1986).
[63]
Lanham Act § 43(a)(1).
[64]
Johnson & Johnson, 631 F.2d 186 (actual loss is not a prerequisite to § 43(a) injunctive
relief).
[65]
Ortho Pharmaceutical Corp. v. Cosprophar, Inc., 32 F.3d 690 (2d Cir.) (requiring a more
substantial showing of injury and causation where plaintiff’s products were not in direct
competition with defendant’s products and the advertisements in question did not draw
direct comparisons between the two); Johnson & Johnson, 631 F.2d 186.
[66]
See Johnson & Johnson, supra.
[67]
See Ortho Pharm. Corp., supra.

COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

[68]
Brookfield Communications, Inc. v. West Coast Entertainment Corp., 174 F.3d 1036 (9th
Cir. 1999).
[69]
Id.; Paccar, Inc. v. Telescan Techn., L.L.C., 115 F. Supp.2d 772 (E.D. Mich. 2000); Nitron
Corp. v. Radiation Monitoring Devices, Inc., 27 F. Supp.2d 102 (D. Mass. 1998); but see
Bigstar Entertainment, Inc. v. Next Big Star, Inc., 105 F. Supp.2d 185 (S.D.N.Y. 2000)
(declining to apply initial interest confusion in an Internet context for seven reasons,
including that the dispute did not involve competitors or metatag misuse); The Network
Network v. CBS, Inc., No. CV 98-1349 NM, 2000 U.S. Dist. LEXIS 4751 (C.D. Cal. Jan.
16, 2000) (distinguishing initial interest confusion from the instant case).
[70]
Brookfield Communications, Inc. v. West Coast Entertainment Corp., 174 F.3d 1036 (9th
Cir. 1999).
[71]
See Trans Union LLC v. Credit Research, Inc., 142 F. Supp.2d 1029 (N.D. Ill. 2001).
[72]
J.K. Harris v. Kassell, No. 02-0400 (N.D. Cal. March 2002).
[73]
Bihari v. Gross, 119 F. Supp.2d 309 (S.D.N.Y. 2000); Trans Union LLC v. Credit
Research, Inc., 142 F. Supp.2d 1029 (N.D. Ill. 2001); but see Eli Lilly & Co. v. Natural
Answers, Inc., No. IP-99-160-CH/G, 2000 U.S. Dist. LEXIS 1930 (S.D. Ind Jan. 20,
2000) (noting that it is difficult to see how manipulative metatag use of a mark could ever
be a fair use, except in “unusual situations”).
[74]
Playboy Enterprises, Inc. v. Welles, 7 F. Supp.2d 1098 (S.D. Cal. 1998); Playboy
Enterprises, Inc. v. Terri Welles, Inc., No. 98-CV-0413-K, 1999 U.S. Dist. LEXIS 21047
(S.D. Cal. Dec. 1, 1999).
[75]
SNA, Inc. v. Array, 51 F. Supp.2d 554 (E.D. Penn. 1999).
[76]
Playboy Enterprises, Inc. v. Terri Welles, Inc., No. 98-CV-0413-K, 1999 U.S. Dist. LEXIS
21047 (S.D. Cal. Dec. 1, 1999).
[77]
There are some other, more subtle distinctions between the two schemes that are not discussed
here.
[78] 15 U.S.C. § 1125(d)(1)(B)(ii).
[79]
Virtual Works, Inc. v. Volkswagen of America, Inc., CV 99-1289-A, 2001 U.S. App.
LEXIS 831 (4th Cir. Jan. 22, 2001).
[80]
Broadcom Corp. v. Becker, Claim No. FA0108000098819, Oct. 22, 2001 (Hill, Arb.),
available at www.arbitration-forum.com/domains/decisions/98819.htm.
[81]
Hewlett-Packard Co. v. Rayne, Claim No. FA0110000101465, Dec. 17, 2001 (Johnson,
Arb.), available at www.arbitration-forum.com/domains/decisions/101465.htm.
[82]
PRIMEDIA Magazine Finance, Inc. v. Manzo, No. D2001-1258, Dec. 13, 2001
(Thompson, Arb.), available at: http://arbiter.wipo.int/domains/decisions/html/2001/
d2001-1258.html.
[83]
Playboy Enterprises Int’l, Inc. v. Tonya Flynt Found., Case No. D2001-1002, Nov. 16,
2001 (Foster, Arb.), available at http://arbiter.wipo.int/domains/decisions/html/2001/
d2001-1002.html.
[84]
Trump v. olegevtushenko, Claim No. FA0110000101509, Dec. 11. 2001 (Carmody, Arb.),
available at www.arbforum.com/domains/decisions/101509.html.
[85] 15 U.S.C. § 1125(c) (1995).

INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

[86]
Mead Data Central, Inc. v. Toyota Motor Sales, U.S.A. Inc., 875 F.2d 1026 (2d Cir. 1989).
[87]
Ford Motor Co. v. Lapertosa, 2001 U.S. Dist. LEXIS 253 (E.D. Mich. January 3, 2001).
[88]
Panavision Int’l, L.P. v. Toeppen, 1998 WL 178553 (9th Cir. 1998).
[89]
Lanham Act § 43(c)(1).
[90]
TCPIP Holding Co. v. Haar Comm, Inc., 244 F.3d 88 (2d Cir. 2001).
[91]
Advantage Rent-A-Car, Inc. v. Enterprise Rent-A-Car Co., 238 F.3d 378 (5th Cir. 2001);
Syndicate Sales Inv. v. Hampshire Paper Corp., 192 F.3d 464 (7th Cir. 1999).
[92]
Hartog & Co. AS v. Swix.com, 136 F. Supp.2d 531 (E.D. Va. 2001).
[93]
See, e.g., Ringling Bros.-Barnum & Bailey Combined Shows Inc. v. Utah Div. of Travel
Development, 170 F.3d 449 (4th Cir. 1999); Westchester Media Co. v. PRL USA Holdings
Inc., 214 F.3d 658 (5th Cir. 2000).
[94]
Nabisco Inc. v. PF Brands Inc., 191 F.3d 208 (2d Cir. 1999); Times Mirror Magazines,
Inc. v. Las Vegas Sports News, L.L.C., 212 F.3d 157 (3d Cir. 2000), cert. denied, 69
U.S.L.W. 3259 (2001); Eli Lilly & Co. v. Natural Answers, Inc., 2000 WL 1735075 (7th
Cir. 2000); Luigino’s, Inc. v. Stouffer Corp., 170 F.3d 827 (8th Cir. 1999); Panavision
Int’l, L.P. v. Toeppen, 141 F.3d 1316 (9th Cir. 1998).
[95]
See 15 U.S.C. § 1125(c)(4).
[96]
New Kids on the Block v. News America Publ., Inc., 971 F.2d 302 (9th Cir. 1992).
[97]
Hormel Foods Corp. v. Jim Henson Prods., Inc., 73 F.3d 497 (2d Cir. 1996).
[98]
Ford Motor Co. v. 2600 Enterprises, 177 F. Supp.2d 661 (E.D. Mich. 2001).
[99]
A&H Sportwear, Inc. v. Victoria’s Secret Stores, Inc., 237 F.3d 198, 228 (3d Cir. 2000);
Fisons Horticulture, Inc. v. Vigoro Indus., Inc., 30 F.3d 466, 475 (3d Cir.1994); Ameritech,
Inc. v. American Info. Techs. Corp., 811 F.2d 960, 964 (6th Cir. 1987).
[100]
A&H Sportwear, Inc. v. Victoria’s Secret Stores, Inc., No. 94-cv-7408 (E.D. Pa. Jan. 9,
2002), available at www.paed.uscourts.gov/documents/opinions/02D0027P.htm.
[101] Uniform Trade Secrets Act, 14 U.L.A. 437 (1990) (hereinafter UTSA).
[102]
See William G. Porter II and Michael C. Griffaton, Identifying and Protecting Employers’
Interests in Trade Secrets and Proprietary Information, 68 Def. Couns. J. 439, 439 (2001);
Linda K. Stevens, Trade Secrets and Inevitable Disclosure, 36 Tort & Insur. L. J. 917, 918
(2001).
[103]
See generally Restatement of Torts §§ 757–59 (1939).
[104]
See generally Restatement (Third) of Unfair Competition §§ 39–45 (1995).
[105]
See 2 Rudolph Callman, The Law of Unfair Competition, Trademarks and Monopolies,
§ 14.06, 14-35 (4th ed. 1992); James Chapman, California Uniform Trade Secrets Act:
A Comparative Analysis of the Act and the Common Law, 2 Computer High Tech. L.J.
389, 392 (1986) (stating trade secrets are “extraordinarily difficult to define”).
[106]
Lear Siegler Inc. v. Ark-Ell Springs, Inc., 569 F.2d 286, 288 (5th Cir. 1978).
[107] UTSA § 1(4).
[108] Restatement of Torts § 757, cmt. b (1939).
[109]
See id.

COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

[110] Restatement (Third) of Unfair Competition § 39 (1995).
[111]
See id. § 39 cmt. e; see also Stevens, supra at 919; Porter and Griffaton, supra at 440.
[112]
Optic Graphics Inc. v. Agee, 591 A.2d 578, 585 (Md. App. 1991); see also Minuteman,
Inc. v. Alexander, 434 N.W.2d 773 (1989).
[113]
See Primo Enter. v. Bachner, 539 N.Y.S.2d 320, 321 (N.Y. App. Div. 1989); see also
Surgidev Corp. v. Eye Tech. Inc., 648 F. Supp. 661, 682 (D. Minn. 1986).
[114]
See Amoco Prod. Co. v. Laird, 622 N.E.2d 912, 196 (Ind. 1993).
[115]
Kewanee Oil Co. v. Bicron Corp., 415 U.S. 470, 476 (1974); Banito Boats, Inc. v. Thunder
Craft Boats, Inc., 489 U.S. 141, 155 (1989).
[116] UTSA § 1(1) & § 1 cmt.
[117]
See, e.g., Hamer Holding Group, Inc. v. Elmore, 560 N.E.2d 907, 918 (Ill. Ct. App. 1990).
(“Conversely, information which can be duplicated only by an expensive and time-
consuming method of reverse-engineering, for instance, could be secret, and the ability to
duplicate it would not constitute a defense.”)
[118] UTSA § 1 cmt.
[119]
See Stevens, supra at 920 and n.17 (citing var,ious cases requiring certain “reasonable”
steps to protect trade secrets); see also Gary E. Weiss, Biting the Hand That Stops
Feeding: How to Protect Trade Secrets from Misappropriation by Laid Off Employees,
661 Prac. L. Inst./Lit. 469, 487–89 (2001).
[120]
See, e.g., The Trade Secret Handbook: Protecting Your Franchise System’s Competitive
Advantage 23, American Bar Association, Michael J. Lockerby, ed., Chicago, IL: 2000.
[121]
See id.
[122]
Flotec, Inc. v. Southern Research, Inc., 16 F. Supp.2d 992, 999–1000 (S.D. Ind. 1998).
[123]
See, e.g., Public Sys. Inc. v. Towry, 587 So.2d 969, 972 (Ala. 1991).
[124]
See Restatement of Torts § 757 (1939).
[125]
See Kewanee Oil, 416 U.S. at 476.
[126]
See, e.g., Motorola Inc. v. Fairchild Camera & Instruments. Corp., 366 F. Supp. 1173 (D.
Ariz. 1973) (rejecting trade secret protection where company failed to take rudimentary
steps to secure what it claimed to be a trade secret); Gordon Employ., Inc. v. Jewell, 356
N.W.2d 738 (Minn. Ct. App. 1984) (rejecting trade secret protection to unsecured client lists,
where there was no secrecy program and no discussion with employees not to disclose).
[127]
See generally Porter II and Griffaton, supra at 443.
[128]
See generally Stevens, supra at 923 (discussing difference between trade secret and confidential
information); see also Robert Unikel, Bridging the “Trade Secret” Gap:
Protecting “Confidential Information” Not Rising to the Level of Trade Secrets, 29 Loy.
U. Chi. L. J. 841, 860–62 (1998).
[129]
Digital Dev. Corp. v. International Memory Sys., 185 U.S.P.Q. 136, 141 (S.D. Cal. 1973).
[130] For a more thorough discussion of the “inevitable disclosure doctrine,” see generally
Porter II and Griffaton, supra at 444–45 (stating at least 20 states recognize doctrine,
which restricts former employees’ post-employment activities when the employees will
inevitably disclose the former employer’s trade secrets in their new position, by nature of

INTRODUCTION TO TRADEMARK LAW AND TRADE SECRET LAW

the new employment); see also PepsiCo v. Redmond, 54 F.3d 1262, 1271 (7th Cir. 1995).
(“PepsiCo finds itself in the position of a coach, one of whose players has just left, playbook
in hand, to join the opposing team before the big game”).

[131] PepsiCo., Inc. v. Redmond, 54 F.3d 1262 (7th Cir. 1995).
[132] Chemetall GMBH v. ZR Energy, Inc., 2002 U.S. Dist LEXIS 158 (N.D. Ill. Jan. 8, 2002).
ADDITIONAL READING

Trademark Reading

A Practical Guide to Monetary Relief in Trademark Infringement Cases, 85 Trademark
Reporter 263 (May–June 1995).

Remedies, 85 Trademark Reporter 263 (May–June 1995).

Roger D. Blair and Thomas F. Cotter, An Economic Analysis of Damages Rules in
Intellectual Property Law, 39 William and Mary Law Review 1585 (May 1998).

Sheri A. Byrne, Nintendo of America, Inc. v. Dragon Pacific International: Double
Trouble—When Do Awards of Both Copyright and Trademark Damages Constitute Double
Recovery? 31 University of San Francisco Law Review 257 (Fall 1996).

Stephen L. Carter, The Trouble with Trademark, 99 Yale Law Journal 759 (January 1990).

Dennis S. Corgill, Measuring the Gains of Trademark Infringement, 65 Fordham Law
Review 1909 (April 1997).

Robert C. Denicola, Some Thoughts on the Dynamics of Federal Trademark Legislation
and the Trademark Dilution Act of 1995, 59 Law and Contemporary Problems 75 (1996).

Terrell W. Mills, METATAGS: Seeking to Evade User Detection and the Lanham Act, 6
Richmond Journal of Law and Technology 22 (Spring 2000).

Rachel Jane Posner, Manipulative Metatagging, Search Engine Baiting, and Initial
Interest Confusion, 33 Columbia Journal of Law and Social Problems 439 (Summer 2000).

Keith M. Stolte, Remedying Judicial Limitations on Trademark Remedies: An Accounting
of Profits Should Not Require a Finding of Bad Faith, 87 Trademark Reporter 271 (1997).

Trade Secret Reading

Annotation: Use of Idea or Invention—Remedies, 170 ALR 449 (1947).

American Law Institute, Restatement of Torts, Miscellaneous Trade Practices §§ 757, 758
(1939).
Uniform Trade Secrets Act § 2, 1990 Comments.
Uniform Trade Secrets Act § 3, 1990 Comments.
Restatement (Third) of Unfair Competition §§ 44, 45 (1993).



COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Jonathan Bloom, et al., Seventh Circuit Affirms Jury Award in Trade Secret Case, 4 Journal
of Proprietary Rights 31 (April 1994).

David D. Friedman, et al., Some Economics of Trade Secret Law, 5 Journal of Economic
Perspectives 61 (Winter 1991).

Wayne A. Hoeberlein, Trade Secrets: Damages, 340 Practicing Law Institute 599 (1992).

Craig N. Johnson, Assessing Damages for Misappropriation of Trade Secrets, 27 Colorado
Lawyer 71 (August 1998).

Christopher S. Marchese, Patent Infringement and Future Lost Profits Damages, 26
Arizona State Law Journal 747 (Fall 1994).

Patricia A. Meier, Looking Back and Forth: The Restatement (Third) of Unfair Competition
and Potential Impact on Texas Trade Secret Law, 4 Texas Intellectual Property
Law Journal 415 (Spring 1996).

Roger M. Milgrim, Milgrim on Trade Secrets § 1.02 (1967).

Roger M. Milgrim, Milgrim on Trade Secrets § 15.02[1][d] (1967).

Gale R. Peterson, Recent Developments in Trade Secret Law in an Information Age, 507
Practicing Law Institute 351 (February 1998).

Felix Prandl, Damages for Misappropriation of Trade Secret, 22 Tort & Insurance Law
Journal 447 (Spring 1987).

Michael A. Rosenhouse, Proper Measure and Elements of Damages for Misappropriation
of Trade Secret, 11 ALR 4th 12 (1982).

Ferdinand S. Tinio, Propriety of Permanently Enjoining One Guilty of Unauthorized Use
of Trade Secret From Engaging in Sale or Manufacture of Device in Question, 38 ALR 3d
572 (1971).

Stephen I. Willis, An Economic Evaluation of Trade Secrets, 269 Practicing Law Institute
737 (1989).

Donald M. Zupanec, Annotation: Disclosure of Trade Secret, 92 ALR 3d 138 § 2[b]
(1979).


12


Misuse of Copyrights, Trademarks,
and Trade Secrets


Like patent owners, the owners of copyrights and trademarks can forfeit their rights
where the alleged infringer successfully establishes that the owner has misused his
or her intellectual property (IP) rights, particularly in ways that mimic violations of
antitrust law. We have already discussed this defense as it applies to patent infringement
(see Chapter 9). However, the misuse defense applies slightly differently to copyrights
and trademarks. In part, the distinctions between patent misuse and misuse of copyrights
or trademarks exist because the latter types of IP offer a lesser degree of exclusivity
than patents. Patent rights are limited only by time, not by the popularity of the
underlying work or possible defenses such as independent creation. During the term of
a patent, the owner has a nearly complete monopoly on the patented work. Additionally,
the enforcement process differs from proving patent infringement. These differences
have made some courts leery of extending the misuse defense beyond the patent context.
In fact, although copyright misuse appears to be gaining credibility as a defense, the
misuse argument is far from accepted as a defense to trademark infringement.1

Accordingly, this chapter discusses the misuse defense separately in the context of
each area. Readers should keep in mind that this area of law is not settled and probably
will evolve further as the courts find increasing occasion to apply the defense.

COPYRIGHT MISUSE

The defense of copyright misuse was first accepted by a U.S. court in 1948. The federal
district court in Minnesota found that a copyright owner’s blanket licensing practices
(requiring would-be users of the copyrighted work to purchase a license covering every
work owned by the owner, instead of simply a license for the desired work) were an
impermissible use of the owner’s copyright, creating a monopoly beyond the intended
scope of copyright protection. Accordingly, the court refused to enforce the copyright

297



COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

against the alleged infringers, holding that “[o]ne who unlawfully exceeds his copyright
monopoly and violates the anti-trust laws is not outside the pale of the law, but where
the Court’s aid is requested,... and the granting thereof would tend to serve the plaintiffs
in their plan...to extend their copyrights in a monopolistic control beyond their
proper scope, it should be denied.”2 It would be another 42 years before a court applied
the copyright misuse doctrine again to bar an infringement action.3

During those 42 years, the Supreme Court did hear antitrust cases dealing with copyright
misuse such as tying arrangements, but it did not deal with the defense directly.
The Supreme Court has affirmed injunctions prohibiting a party from conditioning one
license upon the purchase of additional licenses, but it has yet to go beyond enjoining
the offending practice. The language of the Court’s decisions is rooted in classic analysis
of tying arrangements under antitrust law, not copyright infringement. In other
words, the Court has yet to find a copyright unenforceable or require mandatory licensing
based on the owner’s misuse of the copyright.4

Since the Supreme Court has not yet provided controlling guidance on the judicial
response to copyright misuse, the primary case for understanding the current judicial
treatment of copyright misuse is probably Lasercomb America, Inc. v. Reynolds.5

Lasercomb America, Inc. v. Reynolds

Lasercomb addressed the impact of certain clauses in the copyright owner’s
licensing agreement that precluded licensees of the protected work (computerassisted
die-making software) from competing with the copyright owner. These
extremely broad noncompetition clauses prevented any licensee, its directors, and
employees from directly or indirectly writing, developing, producing, or selling
competing software for 99 years. However, the defendant in the case had refused
to sign the licensing agreement. Accordingly, although the Court found that the
defendant had intentionally infringed the copyright, the Court had to consider
whether the misuse defense would apply even where the defendant had not itself
been affected by the alleged misuse.

The Court examined whether the copyright owner was using its copyright in a
manner contrary to the public policies that justify granting a copyright in the first
place. The alleged misuse does not need to constitute an antitrust violation in order
to provide the defendant with a viable defense. Theoretically, copyrights are issued
to promote and reward new expressions of ideas; the broad restrictions in plaintiff’s
licenses operated to restrict and stifle any new expressions related to the subject
matter of the copyrighted work. This function directly violated the public
policies behind copyright protection, and therefore constituted copyright misuse,
even though the defendant had not personally been harmed by the misuse.


MISUSE OF COPYRIGHTS, TRADEMARKS, AND TRADE SECRETS

Subsequent cases have held that even less explicit restrictions on licensees may
constitute copyright misuse. For example, the Fourth Circuit determined that a clause
requiring licensees to use their “best efforts” to promote the copyright owner’s work
implicitly prohibited independent development of a competing product, and thus created
a misuse defense.6 Moreover, using copyright licenses to indirectly gain control
over a noncopyrighted element of the product or service also has been found to be a
misuse of copyright, regardless of whether the conduct rises to the level of an illegal
tying arrangement under antitrust law.

Alcatel USA, Inc. v. DGI Technologies7

In Alcatel, DGI Technologies wanted to develop software that would operate on
telephone switches protected by the plaintiff’s copyright. The software, contained
in microprocessor cards, did not infringe any copyright. However, the copyright
owner effectively prohibited all licensees from testing microprocessor cards other
than those purchased from the copyright owner. The Fifth Circuit held that by prohibiting
that type of conduct, the owner effectively gained a commercial advantage
over noncopyrighted products. This type of unauthorized (albeit limited)
monopoly formed the basis for a misuse defense.

It should be noted that many other courts that have considered this issue have found that
similar unilateral refusals to license certain technology or products are not misuse.8

Although an antitrust violation is not necessary for a successful copyright misuse
defense, if the defendant cannot establish an antitrust violation, he or she must prove
some other illegal extension of the copyright monopoly or other violation of public
policy.9 For example, misrepresentations by a copyright owner as to the scope of his
or her rights may create a misuse defense. In qad., Inc. v. ALN Assoc., Inc., the court
agreed with the defendant’s argument that the owner’s failure to disclose in its copyright
registrations that its software was a derivative work was a misuse of copyright.10
The owner had been engaged in litigation with the defendant for years, asserting that
the software was a completely original work. Accordingly, the court declined to enforce
the copyright on the basis of the owner’s improper use of legal proceedings to
protect an illegitimate extension of the copyright. Similarly, a plaintiff’s attempt to enforce
copyrights that he or she acquired through registering works that were copied from
others constitutes copyright misuse.11 Essentially, it appears that fraud by the copyright
owner in acquiring or enforcing the copyright can raise a misuse defense to any
infringement action.

Several courts have recognized copyright misuse as a potential defense, even though
they refrained from applying it in the particular cases at hand. These decisions at least


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

indicate that the defense might find a receptive judiciary in those jurisdictions, given
appropriate facts.12

Some courts have been more reluctant than others to bar infringement actions based
on copyright misuse. Some courts may be waiting for explicit approval of the doctrine
from the Supreme Court before they will apply it in their jurisdictions.13 Other courts
have taken a narrow view of the copyright misuse defense, finding that an antitrust violation
is required to establish misuse. For example, the rationale of the Seventh Circuit’s
approach surfaces in many courts’ interpretations of the standards applicable to establishing
the defense. In Saturday Evening Post Co. v. Rumbleseat Press, Inc., the Court
found it too difficult to examine misuse claims without incorporating conventional
antitrust principles, stating “[o]ur law is not rich in alternative concepts of monopolistic
abuse; and it is rather late in the day to try to develop one without in the process subjecting
the rights of patent holders to debilitating uncertainty.”14 In the context of
copyright misuse, the Seventh Circuit found that the need for using established antitrust
principles was even more pronounced, given that substantial market power is rarely
inherent in a copyright. The threat of holding copyright owners to an uncertain and possibly
shifting standard has motivated a number of courts to require an antitrust violation
as evidence of copyright misuse.15

Even if the court does not require the defendant to establish a violation of antitrust
laws, the principles that govern antitrust analysis likely will impact judicial discussions
of copyright misuse. One way that antitrust jurisprudence shows up in
copyright misuse cases is the analysis of the copyright owner’s market power.
Clearly, market power will be an issue if a court relies on patent misuse principles
in analyzing tying allegations as a defense to copyright infringement. However,
some commentators claim that the copyright owner’s market power should be a relevant
consideration in every case, even where the misuse allegations are not based
on an antitrust violation. The theoretical justification for examining the copyright owner’s
market power in the latter category of cases is that where the copyright owner is
unable to coerce third parties through exercise of the copyright, there is a decreased
likelihood of significant harm and a greater likelihood that the alleged misconduct
has some economic or social benefits.16 Arguably, the presence or absence of market
power often distinguishes coercive behavior from allegedly offending contractual
terms that are the product of consensual conduct, and therefore less troubling
to the courts.17

However, market power appears to be less closely tied to copyright ownership than
it is to patent ownership. As discussed at the outset of this chapter, patents generally are
thought to grant broader rights of exclusivity than copyrights or trademarks. A patent
awards the patent owner monopoly power over a particular product or process that is
limited only by the term of the patent. Being in essence a legal monopoly, a patent thus
can be seen as granting potential market power through its right to exclude others. Since
the legal monopoly awarded to copyright owners is not as sweeping as the scope of a
patent, a copyright seldom confers market power on its owner.


MISUSE OF COPYRIGHTS, TRADEMARKS, AND TRADE SECRETS

In re: Napster, Inc. Copyright Litigation18

In the much-publicized litigation concerning Napster’s music file-sharing service,
Napster asserted copyright misuse as a defense to the infringement action.
Napster’s ability to get licenses for the music on its computer system was
restricted by its exclusive contract with plaintiff MusicNet. MusicNet’s conditions
included requiring Napster to go through MusicNet for all licenses, even licenses
to third-party works that were not held by MusicNet. Additionally, there were
extensive financial penalties if Napster failed to use MusicNet as its exclusive
licensor for content. This resulted in a de facto expansion of MusicNet’s copyrights
to cover the music catalogs of the other plaintiffs.

The court noted that copyright misuse, if proven, prevented plaintiff from
enforcing its rights; misuse does not simply limit the period during which damages
are available. Moreover the court rejected the argument that Napster’s own
unclean hands should bar the defense, as the focus of the misuse doctrine is preventing
copyright owners from thwarting the public policies behind copyright
law, not the protection of individual defendants. Similarly, the court found it irrelevant
to the misuse claim that Napster had voluntarily signed the contract with
MusicNet. Accordingly, the court denied summary judgment for MusicNet on the
misuse claim and ordered further discovery into the facts of the misuse.

Legally, there is no recognized presumption of market power for copyrights, trademarks,
or patents. The Federal Trade Commission and the Department of Justice take
the position that IP rights do not create a presumption of market power in the antitrust
context.19 Despite the potential rights of exclusivity conferred by IP, the agencies
explain that “there will often be sufficient actual or potential close substitutes for such
product, process, or work to prevent the exercise of market power.”20 In other words,
the right to exclude others lacks significance in the context of market power if the exclusivity
applies to a product market where consumers have several noninfringing alternatives
available to them. It follows that no presumption of market power should exist
where there is, in fact, no market power. At any rate, the government’s position clearly
is that market power is an issue to be proven, not assumed from the existence of a copyright
or trademark.

DEFENSES TO COPYRIGHT MISUSE

Judicial reluctance to extend the misuse defense to copyright infringement may affect
both the ultimate outcome of the litigation and the availability of interim relief such
as preliminary injunctions. For example, in Data Gen. Corp. v. Grumman Sys. Support
Corp., the court opted to grant temporary relief to the copyright holder, despite the


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

defendant’s allegations of copyright misuse, because of uncertainty regarding the
defense’s viability.21

In addition to bearing the initial burden of convincing the court to accept misuse as
a defense, the proponent of the theory must overcome several potential arguments that
may be raised by the alleged misuser. For example, the party asserting misuse must not
itself have “unclean hands.” The “unclean hands” doctrine is legal shorthand for an
equitable defense based on an opponent’s misconduct. In the presence of unclean hands,
a court may refuse to enforce certain rights because of the right holder’s own misconduct.
For example, a party asserting breach of contract against another party will have
a difficult time obtaining full damages if he or she has also failed to meet contractual
obligations. Generally, the unclean hands defense can be asserted only where: (1) the
offending act of the other party has an immediate and necessary relation to the matter
in controversy, and (2) the party asserting unclean hands has been personally injured by
the other party’s conduct.22

The misuse defense itself may be seen as an extension of the unclean hands doctrine,
as it protects alleged infringers where the IP owner has abused his rights, thereby dirtying
his hands and forfeiting judicial protection. However, the two defenses are distinct in
that copyright misuse generally relies on an analysis of the misconduct’s relationship to
the public policy foundation of copyright law; the mere presence of some general misconduct
does not in itself give rise to the misuse defense. Market power and antitrust principles
are extraneous factors in most cases where unclean hands are raised as a defense.

Generally, if the court observes that both parties have unclean hands, it will not
enforce an equitable defense against either party. However, several courts, including the
Fourth Circuit in Lasercomb (discussed earlier in this chapter), have held that a copyright
owner who abused the copyright is barred from enforcing that copyright under the
misuse doctrine, even where the alleged infringer also has unclean hands. In other
words, some courts allow equity to turn a blind eye to the “unworthiness” of the alleged
infringer when the infringer asserts a misuse defense. The underlying justification for
this judicial stance may be that the copyright owner has abused the legal system to a
greater extent than the infringer by asking for judicial assistance in increasing the scope
of IP rights already stretched beyond the intended legal limits.23

However, other jurisdictions have declined to recognize misuse as a defense to infringement
of copyrights where the defendant infringer has its own unclean hands (beyond the
fact of the alleged infringement itself). The following case exemplifies this judicial stance.

Atari Games Corp. v. Nintendo of America, Inc.24

In Atari, the alleged infringer lied to the Copyright Office to acquire a copy of its com


petitor’s copyrighted program. When the competitor sued for copyright infringe


ment, the alleged infringer asserted the misuse defense. However, the Federal


MISUSE OF COPYRIGHTS, TRADEMARKS, AND TRADE SECRETS

Atari Games Corp. v. Nintendo of America, Inc. (continued)

Circuit found that the alleged infringer could not prevail on the misuse defense
because of its own misconduct (the fraud on the Copyright Office) and, hence, its
unclean hands. The court emphasized that copyright misuse is not a defense established
by statute, but “solely an equitable doctrine.” Without the misuse defense
in the picture, the copyright owner prevailed on its copyright infringement claim
at summary judgment.25

In short, some courts must be satisfied not only with the evidence of misuse by the
copyright owner, but also with the defendant’s “worthiness” before they will apply the
misuse defense.

Given the judicial reluctance to apply the copyright misuse defense, it is not surprising
that misuse generally is limited to use as a defense, not an affirmative claim for relief.
Most courts have not indicated an interest in recognizing copyright misuse as a basis for
bringing suit or recovering damages.26 Arguably, conduct causing harm unrelated to possible
infringement litigation is more likely to rise to the level of an antitrust violation. In
such a case, the antitrust laws, not equitable theories and the public policy surrounding the
copyright misuse defense, offer superior potential for personal recovery from the overreaching
copyright owner. However, a small number of courts have indeed allowed a party
to prevail using copyright misuse as a claim for relief, rather than simply a defense for their
own alleged infringement. This approach is similar to the usual judicial approach to patent
misuse claims.27 Electronic Data Systems provides an example of the minority view.

Electronic Data Systems Corp. v. Computer Assoc., Inc.28

In Electronic Data Systems, copyright misuse was raised as an affirmative claim
by the licensee of certain software. The licensee alleged copyright misuse, using
principles of antitrust law, and asked the court to award damages and a declaratory
judgment that the licensor’s copyright misuse rendered the copyrights themselves
invalid. The licensee alleged restraints of competition, restrictions of the use of
copyrighted software beyond the valid rights granted by copyright laws, and tying
arrangements that linked purchases of copyrighted software to purchases of other
products sold by the licensor. Although the licensor argued that copyright misuse
did not give rise to a claim for affirmative relief such as damages and declaratory
judgment, the court found that the misuse claim should be permitted to the extent
that the licensee sought a declaration of noninfringement due to misuse, and held
that the misuse allegations concerning software tying arrangements rose to the
level of an antitrust violation under section 2 of the Sherman Act.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

A final limit on the application and acceptance of the copyright misuse defense is the
time elapsed following the alleged misuse by the copyright owner. The factual requirements
of this argument are unsettled, but the gist of the argument is that misuse does
not preclude all enforcement of copyrights postdating the misuse. In other words, there
must be a limit on the period during which a copyright owner’s rights are restricted by
their misuse of the copyright.29 After some period of “purging,” a copyright owner, in
essence, washes off the taint of misuse and regains full status as a copyright owner
accorded certain rights of enforcement under the law.30 Like the unclean hands argument,
this position is rooted in equity and the need for a connection between the alleged
misuse and the punishment of nonenforcement.

The patent misuse defense recognizes the same types of temporal restrictions on the
life of a misuse defense. Accordingly, the factors that indicate that patent misuse has
been “purged” probably also will influence a court evaluating the copyright misuse
defense. For example, evidence that the copyright owner has abandoned the practice
allegedly constituting copyright misuse and that the deleterious effects of the misuse
have dissipated may be sufficient for a court to reject misuse as a defense to infringement.
Ultimately, the extent to which a copyright owner’s misuse is removed from the
infringement at issue, and the effect of that distance on the misuse defense, will be a
factual issue to be resolved at the court’s discretion.31

TRADEMARK MISUSE

The doctrine of unclean hands plays an even more prominent role in the trademark misuse
analysis than it does in copyright or patent misuse. In fact, unclean hands was the early
basis for the trademark misuse defense, rather than the market analysis and examination
of public policy that misuse involves in patent or copyright contexts.32 As one court noted,
“it is inappropriate to predicate trademark misuse upon the same anticompetitive practices
which constitute patent misuse . . .” because a trademark use analysis examines the significance
that a mark has to the public more than the anticompetitive practices of stifling
original works or preempting matter that should be in the public domain.33 One court
expressed the judicial hesitance to recognize trademark misuse thusly:

[A] trademark, unlike other intellectual property rights, does not confer a legal monopoly on
any good or idea; it confers rights to a name only. Because a trademark merely enables the
owner to bar others from the use of the mark, as distinguished from competitive manufacture
and sale of identical goods bearing another mark, the opportunity for effective antitrust misuse
of a trademark . . . is so limited that it poses a far less serious threat to the economic health
of the nation [than patent misuse].34
Despite these distinctions between trademark rights and other IP rights, as early as
the nineteenth century, courts refused to enforce trademarks where it appeared that the


MISUSE OF COPYRIGHTS, TRADEMARKS, AND TRADE SECRETS

trademark owner had engaged in misconduct, despite the defendant’s intentional
infringement of the protected mark. In Manhattan Medicine Co. v. Wood,35 the plaintiff
manufactured medicine for jaundice and bottled it in distinctive glass containers with
the name of the product (Atwood’s Vegetable Physical Jaundice Bitters) and a notation
that the product was made “by Moses Atwood, Georgetown, Massachusetts, and sold
by his agents throughout the United States.” The latter notation was false, although Mr.
Atwood had originally created and marketed the medicine in Georgetown, Massachusetts.
The defendants began to market a knockoff elixir that they sold in packaging
nearly identical to Manhattan’s glass bottles and labels. The Supreme Court found that
the trademark owner (Manhattan) could not enjoin the defendants from selling the imitation
medicine because of Manhattan’s own misconduct in deceptively labeling the
medicine. The Court held that the false label constituted a misrepresentation to the public
and declined to assist the trademark owner in perpetuating that fraud.

The Court’s concern was that the trademark laws exist to protect the public from
fraud, and neither potential unfairness to this particular defendant nor the market implications
of the trademark owner’s actions entered into the analysis. This approach is
consistent with the theoretical function of trademark laws (i.e., not to protect new and
unique ideas or novel expressions of ideas, but instead to guard against public confusion).
The protection of individual interests such as a trademark owner’s possible
investment in establishing goodwill affiliated with its mark is only a secondary concern.
Although trademark rights preserve the trademark owners’ incentives to invest in marketing,
develop goodwill, and maintain quality control, these benefits are valued by the
courts and the case law only to the extent that they serve the public’s interest in
improved knowledge regarding products and their source.

Similarly, the Lanham Act is not entirely clear on the role of a misuse defense in
trademark infringement actions. Section 1115(b)(7) states that use of a mark to violate
the antitrust laws is a defense to the incontestability of a mark.36 However, it is unclear
whether misuse affects only a trademark owner’s ability to assert incontestability or
whether it also might be a general defense to trademark infringement. It may be that
trademark misuse constitutes a general defense when the misuse violates antitrust
laws.37 Consistent with that approach, some cases place a greater emphasis on antitrust
principles than on equitable analysis.38

From the available case law, it appears that a trademark misuse defense is applicable
where (1) the trademark owner’s conduct severely compromises the significance of a
mark; or (2) the trademark owner wrongfully seeks to exclude others from using generic
words or functional features, and the possible effect of that exclusion would be a substantial
restriction of competition in a relevant product or service market.39 Practices
that frequently are argued to constitute trademark misuse involve franchise tying
arrangements.40 It is common practice for a franchise to require would-be franchisees
to purchase not only a license for use of their mark but also recipes, supplies, building
and training plans, and other goods from the franchiser. Although these arrangements


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

probably are tying agreements, the franchisee still must establish that the franchise
trademark has market power in a relevant economic market, and this can be difficult to
demonstrate. Most franchises face strenuous competition from other franchises in the
same market. For example, even McDonald’s competes with Burger King and several
other restaurants, which makes it hard to show that the McDonald’s trademarks confer
any significant degree of control over the relevant product market. In other words,
requiring McDonald’s franchisees to purchase their ground beef and chicken parts from
the franchiser will not grant McDonald’s the ability to dominate any relevant markets.
Moreover, there are multiple significant procompetitive effects of the franchise tying
arrangements that weigh against punishing the franchiser for trademark misuse. The
franchiser has an interest in maintaining quality control over the products associated
with its marks, and the public benefits from arrangements that allow the franchise to
monitor and control the conduct of its franchisees.41 Accordingly, although tying
arrangements frequently are alleged to be the basis for trademark misuse, the misuse
claim may not be successful in the face of an efficiency defense.42

Since the trademark laws exist to prevent confusion of the public, nonenforcement is
not the preferred remedy for trademark misuse. Clearly, prohibiting trademark owners
from enforcing their mark where they have misused their IP rights could undermine the
very purpose for legal protection of those marks as it would allow infringing uses to
continue unabated. Accordingly, the preferred remedy for trademark misuse is to restrict
the trademark owner’s ability to recover for the infringement or predicate injunctive
relief on the cessation of the misuse by the trademark owner.43 For example, the court
might limit relief to damages, or the ability to terminate a particular license, rather than
allowing the trademark owner to enjoin all unauthorized users of the protected mark.

Recent cases have indicated that trademark misuse might provide an affirmative
claim where tying arrangements were the basis for the alleged misuse. As in antitrust
cases, the claim revolves around the definition of the relevant market. This focus is clear
in the cases dealing with allegations of franchise tying arrangements. Where the relevant
market is defined as the market for a franchiser’s trademarked goods (such as demand
for a McDonald’s franchise), the law favors the franchisees because the franchiser
appears to have complete control in the relevant market. In contrast, defining the market
as the demand for franchises in general, or even franchises simply in the same line of
business (such as all burger joints), allows the franchisers to argue that they lacked sufficient
market power to affect competition through their alleged misuse of trademarks.

Queen City Pizza v. Domino’s Pizza44

Queen City Pizza addressed the definition of the relevant market in an alleged

franchise tying arrangement. The plaintiffs complained that they could have sup



MISUSE OF COPYRIGHTS, TRADEMARKS, AND TRADE SECRETS

Queen City Pizza v. Domino’s Pizza (continued)


plied Domino’s franchisees with supplies, and would have done so for a lesser
price, but for Domino’s allegedly abusive restrictions on its trademark licensees.
The Third Circuit defined the relevant market as all franchises originally available
to the franchisees rather than simply the franchise that they ultimately selected.
The court held that the “aftermarket” is a valid definition of the market only if it
consists of unique goods or services. Since that was not the case with pizza restaurants,
the market was defined as all the franchises potentially available to a would-
be franchisee at the time of entering the franchise relationship. Accordingly, the
court upheld Domino’s practice of requiring its franchisees (i.e., trademark
licensees) to buy up to 90 percent of their supplies from Domino’s.45

Another trademark misuse claim rooted in antitrust law involves the use of a trademark
licensing agreement to facilitate the allocation of territories or markets between
competitors. The key identification of such agreements is that they delineate where the
parties will sell all of a particular good or service, extending beyond simply the use of
the mark itself. The Supreme Court addressed such a scenario in Timken Roller Bearing
Co. v. United States.46 The Court found that a license agreement, ostensibly for trademarks,
actually was primarily the means of illegally dividing the market, with the trademarks
transferred merely to facilitate that division. The Court’s decision emphasized
that the trademark license was only secondary to the main purpose of illegal market
allocation; if the trademark license had been the primary goal of the agreement, a
resulting territory division might be only “ancillary” and therefore acceptable.47

Recent cases have reevaluated whether trademark misuse can form the basis of an
affirmative claim. In Juno Online Svcs, L.P. v. Juno Lighting, Inc., the court considered
Juno Online’s claim that it was entitled to damages (as well as declaratory relief, injunctive
relief, and cancellation of Juno Lighting’s Internet registration) for Juno Lighting’s
trademark misuse.48 Juno Lighting had tried to have Juno Online’s Internet domain
name “juno.com” cancelled and registered the domain name “juno-online.com” for
itself. The court concluded that although it might be possible to recover for trademark
misuse “where the mark holder does attempt to destroy its competitors through the use
of its mark,” Juno Online’s case was not an appropriate case to establish the doctrine.49
Although Juno Online alleged that Juno Lighting’s domain name was misleading and
false, it did not establish that Juno Lighting had “used” the domain name. Apparently,
Juno Lighting never created a web page for the domain name, so the court found
that merely registering the address could not be a “use in commerce” under section
43(a) of the Lanham Act. Without an allegation of “use,” the court dismissed the claim
in its entirety.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Indeed, the Internet may provide the catalyst for a new line of cases examining the
potential for misuse of trademarks. However, some plaintiffs have discovered that the
courts are unwilling or unable to extend their rights in the context of cyberspace. The
following explanation of the interrelationship between courts, the Internet, and trademark
law indicates that the doctrine of trademark misuse faces even more of an uphill
battle in cyberspace than it does in bricks-and-mortar commerce. Or it may simply
reflect the unwillingness of one judge to compensate for perceived failures in the relevant
technologies.

If the Internet were a technically ideal system for commercial exploitation, then every trademark
owner would be able to have a domain name identical to its trademark. But the parts of
the Internet that perform the critical addressing functions still operate on the 1960s and 1970s
technologies that were adequate when the Internet’s function was to facilitate academic military
research. Commerce has entered the Internet only recently. In response, the Internet’s
existing addressing systems will have to evolve to accommodate conflicts among holders of
intellectual property rights, and conflicts between commercial and non-commercial users of
the Internet....No doubt trademark owners would like to make the Internet safe for their
intellectual property rights by reordering the allocation of existing domain names so that each
trademark owner automatically owned the domain name corresponding to the owner’s
mark....Various solutions to this problem are being discussed, such as a graphically based
Internet directory that would allow the presentation of trademarks in conjunction with distinguishing
logos, new top-level domains for each class of goods, or a new top-level domain for
trademarks only. The solution to the current difficulties faced by trademark owners on the
Internet lies in this sort of technical innovation, not in attempts to assert trademark rights over
legitimate non-trademark uses of this important new means of communication.50

TRADE SECRET MISUSE

The federal antitrust agencies have indicated that they will apply the same antitrust principles
to trade secrets that they apply to patents and copyrights.51 Trade secrets, by their
nature, have the power to effectively limit competition. Like patent owners, trade secret
owners have monopolies over certain information. Unlike patents, however, trade
secrets probably will always be commercially significant, as without a link to substantial
profits, there is no incentive to engage in the type of secrecy and confidentiality necessary
to preserve the information’s status as a trade secret. Moreover, trade secret
owners cannot cite the public policies underlying patent law as justification for
allegedly anticompetitive actions. Accordingly, misuse of trade secrets, through bad
faith assertion of trade secret claims or overly restrictive licensing terms, may constitute
a violation of the antitrust laws.52

Bad faith assertion of trade secrets entails claiming that certain information is subject
to trade secret protection when the alleged owner knows that no such trade secrets exist.
Such conduct can support a violation of either section 1 or section 2 of the Sherman
Act.53 In CVD, Inc. v. Raytheon, Co., the court held that “the threat of unfounded trade


MISUSE OF COPYRIGHTS, TRADEMARKS, AND TRADE SECRETS

secrets litigation in bad faith is sufficient to constitute a cause of action under the antitrust
laws.”54 Other factors that influence whether a bad faith assertion of trade secrets constitutes
misuse may include the potential impact of the threatened litigation on the purported
defendant and whether the assertion would foreclose competition.55

Unreasonable restrictions in trade secret licenses may also constitute trade secret
misuse. Restrictive licensing arrangements are particularly troubling in the trade secret context
because trade secrets, unlike patents, have no expiration date. Even eventual disclosure
of the trade secret may not nullify payment obligations under a licensing
arrangement.56 The primary issue for a court will be whether the restrictions are ancillary
to a legitimate purpose, such as protection of the trade secret, or whether they are
merely an attempt to extend control over the competition.57 For example, territorial
restrictions that are not part of a trade secret owner’s plan to suppress competition may
be lawful,58 while the same type of territorial restraints are unlawful where they function
merely as part of a larger conspiracy to allocate geographic markets.59 Similarly,
using trade secret licenses to leverage the trade secret into power in other competitive
areas will be problematic. Examples of this type of leverage could include package
licenses where the trade secret owner conditions the trade secret license upon licensing
other IP from him or her, as well as tying arrangements and refusals to deal.60

SUMMARY

The doctrines of copyright and trademark misuse are available as defenses for alleged
infringers, particularly where the misuse threatens to undermine the public policies that
favor legal enforcement of copyrights and trademarks. However, courts are reluctant to
grant the same recognition to the misuse defense in these contexts (particularly trademark
misuse) that they award to patent misuse, at least in part because of the different
rationales behind the legal protection of patented ideas versus mere expressions or
marks. Moreover, courts are not likely to view either doctrine as a basis for recovery
of damages, at least not without a significant competitive injury that can be attributed
to the alleged misuse. In the trade secret context, misuse lacks significant public policy
standards apart from the antitrust laws’ concern with anticompetitive actions. Accordingly,
trade secret misuse probably will be successful only where the claims parallel, or
even rise to the level of, antitrust violations.

Many of the recent misuse cases deal with the computer industry and copyrighted computer
code. In fact, the increasing recognition of copyright misuse probably is directly
attributable to the fact that the computer industry is one of the few venues where a copyright
may grant market power to the owner. If the courts begin to recognize the Internet
as a similar venue for purposes of trademark misuse (i.e., since trademarked domain
names may confer greater market power than simply the mark itself in a non–e-commerce
context), we may see a similar increase in the recognition of trademark misuse.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

ENDNOTES


[1] The Fourth, Fifth, and Ninth Circuits accept the doctrine of copyright misuse, as do some
lower courts from other circuits. Among the district courts that have not applied it are several
that appear to be uncertain about the defense’s status in their circuits.
[2]
M. Witmark & Sons v. Jensen, 80 F. Supp. 843, 850 (D. Minn. 1948).
[3]
See Lasercomb, 911 F.2d 970.
[4]
See United States v. Loew’s, Inc., 371 U.S. 38 (1962); United States v. Paramount
Pictures, Inc., 334 U.S. 131 (1948).
[5]
Lasercomb America, Inc. v. Reynolds, 911 F.2d 970 (4th Cir. 1990).
[6]
See PRC Realty Systems v. National Assoc. of Realtors, 1992 U.S. App. LEXIS 18017 (4th
Cir. 1992).
[7]
Alcatel USA, Inc. v. DGI Technologies, 166 F.3d 772 (5th Cir. 1999).
[8]
In re Independent Serv. Orgs, 203 F.3d 1322 (Fed. Cir. 2000); Service & Training, Inc. v.
Data Gen. Corp., 963 F.2d 680 (4th Cir. 1992); Triad Sys. Corp. v. Southeastern Express
Co., 64 F.3d 1330 (9th Cir. 1995); Advanced Computer Servs. v. MAI Sys. Corp., 845 F.
Supp. 356 (E.D. Va. 1994); Warner/Chappel Music, Inc. v. Pilz Compact Disc, Inc., 52
U.S.P.Q.2d 1942 (E.D. Pa. 1999).
[9] Several courts have indicated that a defendant may assert a copyright misuse defense
based on violations of public policy underlying the copyright l,aws, rather than an antitrust
violation such as a tying arrangement. See K-91, Inc. v. Gershwin Pub. Corp., 372 F.2d 1
(9th Cir. 1967); Broadcast Music, Inc. v. Moor-Law, Inc., 527 F. Supp. 758 (D. Del. 1981);
Nat’l Cable Television Ass’n, Inc. v. Broadcast Music, Inc., 772 F. Supp. 614 (D.D.C.
1991); Sega Enterprises v. Accolade, Inc., 785 F. Supp. 1392 (N. D. Cal. 1991); Atari
Games Corp. v. Nintendo of Am., Inc., 975 F.2d 832 (Fed. Cir. 1992); Microsoft Corp. v.
BEC Computer Co., 818 F. Supp. 1313 (C.D. Cal. 1992); Advanced Computer Servs. v.
MAI Sys. Corp., 845 F. Supp. 356 (E.D. Va. 1994).
[10]
qad., Inc. v. ALN Assoc., Inc., 770 F. Supp. 1261 (N.D. Ill. 1991).
[11]
See Michael Anthony Jewelers, Inc. v. Peacock Jewelry, Inc., 795 F. Supp. 639 (S.D.N.Y.
1992).
[12]
See, e.g., Practice Mgmt. Info. Corp. v. American Med. Assoc., 121 F.3d 516 (9th Cir.
1997) (following reasoning of 4th circuit and explicitly adopting copyright misuse as a
defense); Religious Tech. Ctr. v. Lerma, 40 U.S.P.Q.2d 1569 (E.D. Va. 1996) (finding
copyright owner’s alleged intent to harass the defendant with infringement litigation did
not establish a misuse defense); In re: Independent Servs. Orgs. Antitrust Litig., 989 F.
Supp. 1131 (D. Kan. 1997) (recognizing copyright misuse as a possible defense, but holding
unilateral refusal to license was not misuse); F.E.L. Publications, Ltd. v. Catholic
Bishop of Chicago, 214 U.S.P.Q. 409 (7th Cir. 1982) (refusing to apply copyright misuse
defense because equities favored the copyright owner in case at issue); Triad Sys. Corp.
v. Southeastern Express Co., 64 F.3d 1330 (9th Cir. 1995); Mastercraft Fabrics Corp. v.
Dickson Elberton Mills, Inc., 821 F. Supp. 1503 (M.D. Ga. 1993); LucasArts
Entertainment Co. v. Humongous Entertainment Co., 870 F. Supp. 1503 (N.D. Cal. 1993).

MISUSE OF COPYRIGHTS, TRADEMARKS, AND TRADE SECRETS

[13]
See Rural Telephone Svc. Co., Inc. v. Feist Publications, Inc., 663 F. Supp. 214 (D. Kan.
1987), aff’d, 916 F.2d 718 (10th Cir. 1990), rev’d on other grounds, 499 U.S. 340 (1991)
(not addressing the issue of the copyright misuse defense).
[14]
Saturday Evening Post Co. v. Rumbleseat Press, Inc., 816 F.2d 1191, 1200 (7th Cir. 1987).
[15]
See Edward B. Marks Music Corp. v. Colorado Magnetics, Inc., 497 F.2d 285 (10th Cir.
1973); Saturday Evening Post Co., 816 F.2d 1191; United Tel. Co. v. Johnson Publishing
Co., 855 F.2d 604 (8th Cir. 1988); Bell South Advertising & Publishing Corp. v. Donnelley
Info. Publishing, Inc., 933 F.2d 952 (11th Cir. 1991); Basic Books, Inc. v. Kinko’s Graphics
Corp., 758 F. Supp. 1522 (S.D.N.Y. 1991); Electronic Data Sys. Corp. v. Computer Assoc.
Int’l, Inc., 802 F. Supp. 1463 (N.D. Tex 1992).
[16]
See Troy Parades, Copyright Misuse and Tying: Will Courts Stop Misusing Misuse? 9:2
High Tech. L. J. 271, 303–09 (1994); James Kobak, Jr., A Sensible Doctrine of Misuse for
Intellectual Property Cases, 2 Alb. L. J. Sci. Tech. 1, 34–35, 45 (1992).
[17] Courts are not in agreement over whether market power should be presumed as an inherent
product of the right to exclude granted with a patent or copyright. In 1962, the
Supreme Court found that copyrights give rise to a presumption of market power given
the necessarily unique nature of a copyrighted work. See United States v. Loew’s, Inc.,
371 U.S. 38 (1962); see also MCA Television, Ltd. v. Public Interest Crp., 171 F.3d 1265
(11th Cir. 1999) (following Loew’s presumption). However, recent cases have moved
away from presuming market power simply from the existence of a copyright. One reason
to question the presumption of market power is the presence of close substitutes for
the copyrighted work. If another uncopyrighted work would be satisfactory to the consumers,
then that substitutability indicts the theory that holds copyrights are tantamount
to market power. See Abbot Lab. v. Brennan, 952 F.2d 1346 (Fed. Cir. 1991); Xeta, Inc.
v. Atex, Inc., 852 F.2d 1280 (Fed. Cir. 1988); Mozart Co. v. Mercedes Benz of N. Am.,
Inc., 833 F.2d 1342 (9th Cir. 1987); A.I. Root Co. v. Computer/Dynamics, Inc., 806 F.2d 673
(6th Cir. 1986); Ralph C. Wilson Indus., Inc. v. Chronicle Broadcasting, Co., 794 F.2d 1359
(9th Cir. 1986); SCM Corp. v. Xerox Corp., 645 F.2d 1196 (2d Cir. 1981); Broadcast
Music, Inc. v. Hearst/ABC Viacom Entertainment Svcs., 746 F. Supp. 320, 328 (S.D.N.Y.
1990).
[18]
In re: Napster, Inc. Copyright Litig., No. MDL 00-1369 MHP (N.D. Calif. Feb 21, 2002),
available at <http://news.findlaw.com/hdocs/docs/napster/napster022102ord.pdf>.
[19] U.S. Department of Justice and Federal Trade Commission, Antitrust Guidelines for the
Licensing of Intellectual Property § 2.0 (1995).
[20]
Id. at § 2.2.
[21]
Data Gen. Corp. v. Grumman Sys. Support Corp., 1988 U.S. Dist. LEXIS 16427 (D.
Mass. Dec. 29, 1988). Ultimately, the copyright misuse defense failed on appeal as well.
See Data Gen. Corp. v. Grumman Sys. Support Corp., 36 F.3d 1147 (1st Cir. 1994); see
also Orth-O-Vision v. Home Box Office, 474 F. Supp. 672 (S.D.N.Y. 1979) (holding that
violations of the antitrust laws were not a defense to copyright infringement, and noting
the Supreme Court’s lack of express holdings concerning copyright misuse as a
defense).
[22]
Intellectual Property Misuse: Licensing and Litigation, Chicago, IL: American Bar
Association Section of Antitrust Law (2000), at 187.

COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

[23]
See Alcatel USA, Inc. v. DGI Techs., Inc., 166 F.3d 772 (5th Cir. 1999); Lasercomb Am.,
Inc. v. Reynolds, Inc., 911 F.2d 970 (4th Cir. 1990); qad. Inc., 770 F. Supp. 1261, 1266 n.
16 (N. D. Ill. 1991).
[24]
975 F.2d 832, 846 (Fed. Cir. 1992).
[25]
See Atari Games Corp. v. Nintendo of America, Inc., 1993 U.S. Dist. LEXIS 6786 (N.D.
Cal. May 18, 1993).
[26]
See Broadcast Music, Inc. v. Hearst/ABC Viacom Entertainment Servs., 746 F. Supp.
320, 328 (S.D.N.Y. 1990); Warner/Chappel Music Inc. v. Pilz Compact Disc, Inc., 52
U.S.P.Q.2d 1942, 1947, n.3 (E.D. Pa. 1999); Juno Online Servs. L.P. v. Juno Lighting,
Inc., 979 F. Supp. 684, 688–90 (N.D. Ill. 1997) (rejecting affirmative claim for trademark
misuse); Susan G. Braden, Copyright Misuse: If Not a Shield, a Sword, Practicing Law
Institute, Patents, Copyrights, Trademarks and Literary Property, Practicing Law Institute:
Intellectual Property/Antitrust (1993).
[27]
See, e.g., B. Braud Med. Inc. v. Abbot Lab., 124 F.3d 1419 (Fed. Cir. 1997).
[28]
Electronic Data Systems Corp. v. Computer Assoc., Inc., 802 F. Supp. 1463 (N.D. Tex.
1992).
[29]
Lasercomb Am., Inc. v. Reynolds, 911 F.2d 970, 979 n.22 (4th Cir. 1990); Budish v.
Gordon, 784 F. Supp. 1320, 1337, n.12 (N.D. Ohio 1992) (noting in dicta that a plaintiff
will not be precluded from enforcing the copyright if any alleged misuse is purged).
[30]
See Preformed Line Prods. Co. v. Fanner Mfg. Co., 328 F.2d 265 (6th Cir. 1964);
McCullough Tool Co. v. Well Surveys, Inc., 343 F.2d 381, 410 (10th Cir. 1965).
[31]
See United States v. United States Gypsum Co., 340 U.S. 76, 89 (1950); International Salt
Co., Inc. v. United States, 332 U.S. 392, 400–01 (1947); Preformed Line Prods., 328 F.2d
at 279.
[32]
Carl Zeiss Stiftung v. V.E.B. Carl Zeis, Jena, 298 F. Supp. 1309, 1314 (S.D.N.Y. 1969)
(noting that a “sharp distinction must be drawn between the antitrust misuse defense in
patent infringement suits, on the one hand, and trademark suits, on the other.”).
[33]
Northwestern Corp. v. Gabriel Mfg. Co., 48 U.S.P.Q.2d 1902, 1908 (N.D. Ill. 1998).
[34]
Clorox Co. v. Sterling Winthrop, Inc., 117 F.3d 50, 56 (2d Cir. 1997) (quoting Carl Zeiss
Stiftung v. V.E.B. Carl Zeiss, Jena, 298 F. Supp. 1309, 1315 (S.D.N.Y. 1969)).
[35]
Manhattan Medicine Co. v. Wood, 108 U.S. 218 (1883).
[36]
15 U.S.C. 1115(b)(7) (1946, as amended).
[37]
Carl Zeiss Stiftung v. V.E.B. Carl Zeiss, Jena, 298 F. Supp. 1309 (S.D.N.Y. 1969).
[38]
See id.; Phi Delta Theta Fraternity v. J.A. Buchroeder & Co., 251 F. Supp. 968, 974–78
(W.D. Mo. 1966) (examining legislative history and determining that trademark misuse
with anticompetitive effects could be a general defense to infringement).
[39]
Intellectual Property Misuse: Licensing and Litigation, “Copyright and Trademark Misuse”
at 202; see also Restatement of Unfair Competition (Third) § 31(e) (1995).
[40]
See Valley Prods. v. Landmark, 128 F.3d 398, 405 (6th Cir. 1997); Mozart Co. v.
Mercedes-Benz of N. M., 833 F.2d 1342, 1346 (9th Cir. 1987); Queen City Pizza
v. Domino’s Pizza, 124 F.3d 430 (3d Cir. 1997).

MISUSE OF COPYRIGHTS, TRADEMARKS, AND TRADE SECRETS

[41] Apart from the market incentives to police uses of its trademarks, the trademark owner
risks invalidation of the marks if it engages in unsupervised or “naked” licensing. See
Stanfield v. Osborne Indus., 52 F.3d 867 (10th Cir. 1995); Dawn Donut Co. v. Hart’s Food
Stores, 267 F.2d 358 (2d Cir. 1959) (Lumbard, J., dissenting); 3 J. Thomas McCarthy,
McCarthy on Trademarks and Unfair Competition § 26.14.
[42]
See also Ben Klein and Larry Saft, The Law and Economics of Franchise Tying Contracts,
28 J. L. Econ. 345 (1985).
[43]
See Colt Beverage Corp. v. Canada Dry Ginger Ale, 146 F. Supp. 300, 303 (S.D.N.Y.
1956).
[44]
See, e.g., Queen City Pizza v. Domino’s Pizza, 124 F.3d 430 (3d Cir. 1997).
[45]
But see Collins v. Int’l Dairy Queen, Inc., 980 F. Supp. 1252 (M.D. Ga. 1997) (disagreeing
with Queen City’s definition of the market to the extent that it limited the aftermarket
to those markets consisting of unique goods or services); see also Alan H. Silberman, The
Myths of Franchise “Market Power,” 65 Antitrust L.J. 181 (1996).
[46]
Timken Roller Bearing Co. v. United States, 341 U.S. 593 (1951).
[47]
See also United States v. Sealy, 388 U.S. 350 (1967); United States v. Topco Assoc., 405
U.S. 596 (1972); Palmer v. BRG, 498 U.S. 46 (1990) (per curiam). These cases also deal
with trademark licenses that became the basis for alleged antitrust violations.
[48]
Juno Online Svcs, L.P. v. Juno Lighting, Inc., 979 F. Supp. 684 (N.D. Ill. 1997).
[49]
Id. at 690.
[50]
Lockheed Martin Corp. v. Network Solutions, Inc., 985 F. Supp. 949, 967–68 (C.D. Calif.
1997) (emphasis added).
[51]
See Antitrust Law Developments (5th), Intellectual Property, 1107.
[52]
CVD, Inc. v. Raytheon, Co., 769 F.2d 842 (1st Cir. 1985), cert. denied, 475 U.S. 1016
(1986).
[53]
Id. at 851.
[54]
Id.
[55]
Id. (noting that litigation would have been “ruinous” to new competitor in the market and
would have “effectively foreclosed competition”).
[56]
See, e.g., Aronson v. Quick Point Pencil Co., 440 U.S. 257 (1979); Warner-Lambert
Pharm. Co. v. John J. Reynolds, Inc., 178 F. Supp. 655 (S.D.N.Y. 1959).
[57]
A. & E. Plastik Pak Col. v. Monsanto Co., 396 F.2d 710, 715 (9th Cir. 1968).
[58]
See, e.g., Shin Nippon Koki Co. v. Irvin Indus., 186 U.S.P.Q. (BNA) 296 (N.Y. Sup. Ct.
1975); United States v. E.I. duPont de Nemours & Co., 118 F. Supp. 41, 219 (D. Del.
1953); Foundry Servs. v. Beneflux Corp., 110 F. Supp. 857 (S.D.N.Y.), rev’d on other
grounds, 206 F.2d 214 (2d Cir. 1953); Thoms v. Sutherland, 52 F.2d 592 (3d Cir. 1931).
[59]
See, e.g., United States v. Pilkington plc., 1994-2 Trade Cas. (CCH) . 70,842 (D. Ariz.
1994); United States v. Imperial Chem. Indus., 100 F. Supp. 504 (S.D.N.Y. 1951); United
States v. Timken Roller Bearing Co., 83 F. Supp. 284, 315–16 (N.D. Ohio 1949).
[60]
See, e.g., In re Data General Corp. Antitrust Litig., 529 F. Supp. 801 (N.D. Cal. 1981),
aff’d in part and rev’d in part sub nom, Digidyne Corp. v. Data Gen. Corp., 734 F.2d 1336
(9th Cir. 1984); Technograph Printed Circuits, Ltd. v. Bendix Aviation Corp., 218 F. Supp.
1, 50 (Md. 1963), aff’d per curiam, 327 F.2d 497 (4th Cir.), cert. denied, 379 U.S. 826
(1964).

COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

ADDITIONAL READING


Intellectual Property Misuse: Licensing and Litigation, Chicago IL: American Bar
Association Section of Antitrust Law (2000).

Troy Paredes, Copyright Misuse and Tying: Will Courts Stop Misusing Misuse? 9:2 High
Technology Law Journal 271, 324–25 (1994).

Alan H. Silberman, The Myths of Franchise “Market Power,” 65 Antitrust Law Journal
181 (1996).

Stephen A. Stack, Jr., Recent and Impending Developments in Copyright and Antitrust, 61
Antitrust Law Journal 331 (1993).

Jere M. Webb and Lawrence A. Locke, Intellectual Property Misuse: Developments in the
Misuse Doctrine, 4 Harvard Journal of Law & Technology 257 (Spring 1991).

Leslie Wharton, Misuse and Copyright: A Legal Mismatch, 8:3 Computer Law 1 (1991).


13


How to Calculate Copyright,
Trademark, and
Trade Secret Damages


Although the preceding chapters dealt with copyrights, trademarks, and trade secrets as
separate and distinct bodies of law, the damage principles applicable to those forms of
intellectual property (IP) are quite similar. Our approach is to build on the foundations
developed in Chapter 6, on patent infringement damages. For each IP area, we point out
similarities and differences with patent damages. Many of the differences will apply to
all three areas, and therefore, after reading this chapter’s explanation of calculating
copyright damages, the reader should have an excellent foundation for understanding
trademark and trade secret damages. Recurring themes such as “actual damages” and
“infringer’s profits” will resurface throughout the chapter. However, the reader should be
careful not to allow the similarities to blur the vital distinctions between the remedies
available under each type of infringement or the evidentiary requirements for obtaining
those remedies. For example, although defendant’s profits and actual damages are recoverable
for both copyright infringement and trademark infringement, under the trademark
regime a plaintiff must establish willfulness in order to merit monetary damages at all.
That said, approaching this chapter in sequence should render each successive damage
theory slightly easier to understand, culminating in a discussion of trade secret damages
that amounts to reviewing old concepts in a new context (with one important exception).

COPYRIGHT DAMAGES

As in patent law, the starting point for determining damages in a copyright case is the
relevant federal statute. Section 504(b) of the Copyright Act provides that:

The copyright owner is entitled to recover the actual damages suffered by him or her as a
result of the infringement, and any profits of the infringer that are attributable to the infringement
and are not taken into account in computing the actual damages. In establishing the
infringer’s profits, the copyright owner is required to present proof only of the infringer’s

315



COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

gross revenue, and the infringer is required to prove his or her deductible expenses and the
elements of profit attributable to factors other than the copyrighted work.

As outlined by the statute, a copyright owner who establishes infringement may recover
not only his or her actual damages, but also any profits that the infringer accrued as
a result of the infringement (so long as there is no double-counting; i.e., the copyright
owner may not recover the profits that the infringer made and the profits that the owner
would have made, except to the extent that those two categories do not overlap).
Because of the practical difficulties in accurately calculating actual damages and lost
profits, a subsequent section of the statute provides that a successful copyright plaintiff
may elect to forgo the estimation of damages altogether and accept statutory damages
as compensation for their injury.

Frequently, plaintiffs in copyright infringement actions are more concerned with stopping
the offending behavior than with recovering any amount of money. Even a large sum
of money may be inadequate compensation to a copyright owner who has lost exclusive
control over his or her work and possibly faces the difficulty of making any profits in a
market overrun by cheap or poor-quality copies. Accordingly, the Copyright Act allows
copyright owners to obtain injunctive relief (i.e., a court order preventing or restraining
the infringing behavior). Infringing copies already in existence may also be impounded
and/or destroyed under the authority of the Copyright Act. Actual damages, statutory
damages, and injunctive relief are discussed in greater detail in subsequent sections.

In addition to any of these remedies, the Copyright Act permits the prevailing party
to recover attorneys’ fees as well as other costs that the court has the discretion to
award.1 However, where the copyright owner prevails on liability but recovers nothing
in damages, the court may decline to award any costs.2 The award of costs and fees is
within the courts’ discretion, allowing courts to take into account the particular facts and
circumstances regarding the infringement at issue and reimburse the plaintiff where
those facts and circumstances warrant additional compensation. In particular, several
circuits look to the “objective reasonableness” of the factual and legal components of
the case in determining whether to award attorneys’ fees.3 The award of attorneys’ fees
is not necessarily insubstantial—recently, a court awarded $2.7 million in what may be
the largest award of attorneys’ fees ever in a copyright case.4

Similarities and Differences with the Patent Scheme

As in patent law, the plaintiff is entitled to lost profits from the infringement. Lost profits
should be determined in the same manner as under patent law, with one notable
exception. In a copyright case, a reasonable royalty calculation can be used to approximate
the copyright owner’s lost profits if the facts so warrant. Moreover, unlike the
patent statute, the Copyright Act makes no mention of treating a reasonable royalty as
a form of minimum damages.5 Instead, the Copyright Act allows the plaintiff to elect to
receive statutory damages as a substitute for actual damages if the copyright was regis



HOW TO CALCULATE DAMAGES

tered.6 Thus, statutory damages are the true equivalent to a reasonable royalty in the
patent situation, in that such damages generally are the minimum amount recoverable
(assuming prior registration). Another significant difference between the types of damages
available in copyright cases and patent cases is that the Copyright Act allows for
recovery of the infringer’s profits.7 The infringer’s profits are explicitly disallowed as
a measurement of the appropriate remedy under patent law. However, to recover the
infringer’s profits, section 504(b) of the Coypright Act requires an allocation of the infringer’s
profits into those profits due to the copyright right infringement and those that
are not caused by the infringement. The copyright owner may recover only those profits
that are caused by the use or sale of the infringing product.

These three possible measures of damages—actual damages, infringer’s profits, and
statutory damages—form the framework for damage analysis under the Copyright Act.
Each of the three damage theories has specific evidentiary requirements, some of which
may be more difficult to establish than others. In general, most copyright owners will
attempt to prove both actual damages and an entitlement to at least a portion of the
infringer’s profits. However, statutory damages can be a valuable remedy, particularly
where neither the infringer nor the copyright owner had profits attributable to the copyrighted
work, such as where the copyright owner had not yet published the work. Each
of these three theories is discussed in the following sections.

Actual Damages

The actual damages suffered by a copyright owner may be actual lost profits (from sales
or licensing of the copyrighted work) or some other measure of the extent that the market
value of the work was diminished, in part or entirely, by the infringement. As with any
damage theory, copyright damages must be caused by the alleged bad act (here, the
infringement of the copyrighted work) and be calculable without undue speculation. Once
the copyright owner establishes a causal link between the infringement and some loss of
anticipated revenue, the court may allow limited speculation as to the precise amount lost.
Uncertainty as to the precise amount of damages does not preclude recovery of damages
where the causal relationship—and thus the fact of damages—is established.

Neither the Copyright Act nor its legislative history defines “actual damages,”
leaving a substantial amount of discretion to the courts for evaluating damages calculations.
8 Actual damages may be measured by lost profits, a reasonable royalty, or a
“market value” test. Each of these measures attempts to capture the value of the copyright
owner’s loss attributable to the infringement. Lost profits represent the profits that
the copyright owner failed to achieve as a result of the infringement. One means of
computing a plaintiff’s lost profits involves calculating the average revenue for a period
before infringement and then subtracting the revenue earned during the period of
infringement.9 The lost profit test typically will apply only where the copyright owner
and the infringer were actual or potential competitors; otherwise the infringement could
not have caused the copyright owner to lose sales. Where the infringing work and the


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

copyrighted work compete at the same price in the same market, the infringer’s sales
could be used as a measure of sales lost by the copyright owner. (However, the copyright
owner’s overhead expenses may need to be deducted from the amount of sales to
determine the lost profits.)

Faced with this type of damage theory, a defendant can argue that his sales of the
allegedly infringing product are not an adequate measure of lost sales because of the differences
in marketing, manufacturing costs, and pricing, as well as other aspects that
differentiate the sales of the two products. In fact, a one-to-one sales comparison usually
is unsupported by adequate evidence of similarity. For example, a defendant may argue
that is not reasonable to assume that sales of an infringing product directly trade off
with sales of the copyrighted work if the infringing product is sold at a significantly
lower price than the price at which the copyrighted work is actually sold. This argument
would assume completely inelastic demand. To justify a one-to-one substitution of
the infringer’s sales for the copyright owner’s lost sales, the copyright owner must show
that all of the infringer’s customers would have bought the copyrighted work “but for”
the availability of the infringing product. Significant differences in retail price may render
such a showing extremely difficult, or even impossible, because an inexpensive product
may acquire some customers who were precluded from buying the original product
at its higher price. Although the copyright owner may be entitled to recover the infringer’s
profits from some of those sales to prevent the infringer from profiting from his or
her bad act, the profits are not a simple substitute for lost sales on the owner’s part. Put
succinctly, the infringing sales eventually may be part of the remedy for infringement,
but they do not always represent actual damages to the copyright owner.

Where the court decides that a reasonable royalty is appropriate, the court will attempt
to determine the amount that the infringer would have paid for the right to legally use the
copyrighted work. As in patent cases, any preexisting licenses may offer a measure of the
appropriate reasonable royalty. However, a defendant may attempt to distinguish preexisting
licenses on the basis of the types of uses that they authorized, the amount of the
copyrighted work that was used, the changing value of the copyrighted work over time,
and so forth. The reasonable royalty might take the form of a lump sum representing
the reasonable value of the work, or the royalty might be a percentage of the licensee’s
profits. A copyright owner may testify as to the value of the copyrighted work, but the
owner’s testimony generally should be corroborated by some other evidence.

Stevens Linen Assoc., Inc. v. Mastercraft, Corp.10

Stevens Linen involved the determination of a reasonable damages award to compensate
for Mastercraft’s infringement of Stevens Linen’s copyrighted fabric
designs. The trial court declined to award compensatory damages because
Mastercraft had lost money on its infringing fabrics, and therefore no profits


HOW TO CALCULATE DAMAGES

Stevens Linen Assoc., Inc. v. Mastercraft, Corp. (continued)

could be awarded. Moreover, the court refused to award any actual damages to
Stevens Linen because it found that although it was “reasonable to assume that
the infringement affected plaintiff’s sales,” the damages were too speculative.

On appeal, the appellate court held that there were two alternative measures of
damages and that the trial court should have awarded whichever of the two sums
proved to be the greater. The trial court was correct that Stevens Linen could not
simply assume that it would have sold the entire amount of fabric sold by
Mastercraft, in part because the infringing fabric was sold at a discounted price.
However, the appellate court found that damages should be measured either

(1) by lost profits that Stevens Linen would have realized from sales to customers
who, during the infringement, bought from both Stevens Linen and Master-
craft (minus those sales that Mastercraft could prove Stevens Linen would not
have made); or (2) based on the difference between Stevens Linen’s actual sales
of the infringed fabric and the average sales of all Stevens’s other fabrics during
the period in question. Both theories attempted to account for changes in the market
and for changes in the value of the copyrighted work over time.
Films, songs, and software are most often licensed by their creators. Such transactions
provide industry benchmarks from which to establish an estimated royalty
amount. If the industry practice is to license the use of a copyrighted product, a reasonable
royalty might be used to estimate damages. Consider the following examples.

Assume that an architect designs a home and creates a copyrighted plan. The architect
sells the plan for $500 per home. The amount charged by the architect is consistent
with the amounts charged by other architects for other home designs. Assume that a
builder buys one copy and then proceeds to build two homes using the plan. Further
assume that the builder usually makes a profit of $10,000 per home. Finally, assume that
the builder has built many other homes of a similar size with a different design and also
made a $10,000 profit per home. The property damage amount is $500 per infringement.
Although some plaintiffs may claim that they lost $10,000 per infringement, the
total profit is attributed to many things beyond the design (i.e., building costs, labor,
equipment, etc.). This is proven by the fact that the home builder makes the same profit
on homes that do not use the copyrighted plans. All methods of calculating damages
lead to the same set of conclusions:

. The architect’s lost profits are $500. Because there are no incremental costs associated
with using the same design, the revenue and the profits are equivalent.
. The unjust enrichment is $500. The builder avoided paying $500 by stealing
the design. The builder would be expected to make $10,500 on the home with

COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

the stolen design ($10,000 of normal profit plus the $500 of saved expense). Of

that amount, only the $500 is “unjust enrichment.”

. The fact that the architect regularly sells the design for $500 could constitute an
“established royalty rate.”
Next assume that a widget maker copyrights a design for an assembly line. Through
improved efficiencies, the design allows the widget maker to save one dollar per widget
made. The designer has never shared the plans with any other firm (nor licensed them).
A competitor misappropriates the design and duplicates it in its own facility. Finally,
assume that the competitor experiences a $1.75 per widget savings after infringing on
the design.

. The designer’s lost profits are zero, so they did not lose any sales as a result of
the theft.
. The unjust enrichment is $1.75 per unit based on the infringer’s profits.
. A reasonable royalty would be an amount less than one dollar. Although there is
no established royalty, the infringer is likely to have expected a one-dollar savings
(royalty ceiling) and the designer would not be afraid of losing any sales
(zero royalty floor). Other factors (such as the Georgia-Pacific factors) could
determine where within the range the reasonable royalty lies.
Accordingly, the facts of the case are critical to the damage calculation in a copyright case.

Where neither lost sales nor a reasonable royalty have any empirical basis, the copyright
owner may employ the “market value test” as an alternative measure of actual
damages. The market value test requires determining the copyright’s fair market value
by determining what a willing buyer would have freely paid to a willing seller for the
use of the work.11 This is the same approach sometimes applied in patent cases for
determining a reasonable royalty—the court assumes that hypothetical negotiations
took place, and the resulting award represents the probable outcome of those negotiations
if undertaken at the onset of infringement. Some courts attempt to determine the
value to the infringer of his use of the copyrighted work. This determination is simply
another attempt to approximate the result of the hypothetical negotiations between a
willing buyer and a willing seller. Alternatively, the copyright owner or her expert witnesses
may testify as to the detrimental effect of the infringement on the copyright’s
market value.12

As mentioned previously, copyright owners can employ the market value test where
they cannot prove that they lost sales and where a reasonable royalty would be difficult
to calculate given the lack of preexisting licenses or other reasons. The market value test
can apply where the infringement detracted from the reputation of the copyrighted
work, decreased its value in a particular market, or harmed the copyright owner’s goodwill,
without necessarily resulting in lost sales or profits to the infringer. At times, the


HOW TO CALCULATE DAMAGES

infringer may have been unsuccessful in marketing his infringing product, yet the presence
of the unauthorized copies still damages the copyright owner by reducing the
market value of the copyright. (This scenario is similar to the trademark actions brought
for “blurring” or dilution of the value of a particular brand due to the promotion and sale
of low-quality knockoffs, which are discussed in subsequent sections.) The market
value test may also be useful to a copyright owner where the particular market factors
make it unlikely that a license would be negotiated (e.g., where the copyright owner
wishes only to preserve exclusive use of the work rather than to create licensees and
permissible uses by other parties).

Deltak v. Advanced Systems, Inc.13

In Deltak, the infringing material was used in defendant’s marketing brochures,
but there was no evidence that any profits were garnered from these brochures.
Nonetheless, the court found that the infringer obtained value from its use of a
marketing tool. The value was equal to “the acquisition cost saved by infringement
instead of purchase, which [defendant] was then free to put to other uses.”
As the court recognized, the “value in use” measure is very close to “what a willing
buyer would have been reasonably required to pay to a willing seller for plaintiff’s
work.” Nonetheless, the court contended that the concept is not identical to
a reasonable royalty. Value is used as a measure of actual damage, not a substitute
for lost profits. Moreover, not mentioned by the court is the fact that value of use
does not depend on what the infringer would have been willing to pay, but only
on the likely acquisition price.

Some courts have declined to expand the definition of damages in accordance with
Deltak (see case study), holding that the copyright statutes provide adequate remedies
to a copyright owner in the absence of actual damages or profit to the infringer.14
However, the “value in use” appears to be a viable estimation of damages where statutory
damages and other methods of calculating actual damages are unavailable.15

Finally, copyright law recognizes that lost sales, reasonable royalty, market value,
or any combination of those theories may not fully compensate the copyright owner
for actual damages. Accordingly, there are several categories of additional recoverable
damages in the copyright context. First, a copyright owner may recover damages for
loss of the value of receiving credit as the author of the work and any related loss of
goodwill. Courts are aware that damage to an author’s professional reputation may not
be captured by lost sales and may be completely unrelated to the value to the infringer
of using the copyrighted work. Second, a copyright owner may also recover the value


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

of sales lost on noninfringed goods. In other words, where the copyright owner sells
goods that are linked to the copyrighted good, the owner may have suffered a decrease
in those sales as well as the sales of the copyrighted work itself. This theory of damages
parallels the line of thought in patent law that allows recovery for lost sales of
noninfringed goods that are related to the patented product, such as the sales of re-
writable CDs that are compatible with a specific type of CD burner. Third, the copyright
owner may recover additional miscellaneous expenses directly related to
infringement. For example, any changes in the work necessitated by the infringement
may be compensated. Furthermore, some courts have awarded the monetary value of
time spent working on the copyrighted work, travel and research expenses, and other
similar costs.

Measuring the Infringer’s Profits

As explained at the outset of this chapter, a copyright owner may recover not only actual
damages, but also the infringer’s profits attributable to the infringement. The clear purpose
of this statutory scheme is to prevent the infringer from unfairly benefiting from a
wrongful act. In other words, the Copyright Act aims to remove the incentives for an
“efficient breach,” for example, an unauthorized act that is economically rational in that
the infringer has the ability to profit more from the illegal act than the copyright owner
does from the legal exercise of his or her rights. Absent the possibility of recovering the
infringer’s profits, the infringer could rationalize that the unauthorized use of the copyrighted
work would be on net profitable (discounting the potential for protracted litigation
and its related expenses) if he or she stands to lose only the profit for those
sales that would have been made by the copyright owner. The argument against this
approach, of course, is that it may result in a windfall to the copyright owner, particularly
the owner who has done nothing to market or profit from the copyrighted work.

Although the copyright owner is entitled to both lost profits and the infringer’s profits,
the copyright owner’s damage calculations must exclude any double-counting. It is
evident from the case law and the Copyright Act that the phenomenon of “doublecounting”
must be avoided in copyright damage calculations. Section 504(b) of the
Copyright Act explicitly states that a copyright owner is entitled to collect only that
portion of the infringer’s profits that was not already “taken into account in computing
the actual damages.”16 As an example of what is meant by double-counting, consider

Customers

Copyright owner
Infringer

1 2 3 4 5 6
5 6 7 8 9 10

EXHIBIT 13-1 Customers of the Copyright Owner and the Infringer


HOW TO CALCULATE DAMAGES

the following hypothetical case. Suppose that Exhibit 13-1 depicts the customers of the
copyright owner and the infringer.

Assume that the infringer made sales to all 10 customers, but absent the infringement,
the copyright owner and the infringer would have sold to their own customers.
In this case, the copyright owner would be entitled to lost profits on customer sales
1 through 4, and the infringer’s profits on customer sales 7 through 10, but only lost
profits or the infringer’s profits on customer sales 5 and 6, not on both.

The Copyright Act clearly places the burden on the plaintiff/copyright owner of
proving the size of the infringer’s revenue from infringement. The burden of establishing
the expenses related to producing and selling the infringing work is on the
defendant/alleged infringer. From an economic standpoint, only avoided costs should
be deducted. The case law supports this view by stating that only costs related to the
infringing work itself can be deducted.17 Such costs can include royalties, advertising,
marketing, production and selling costs, and overhead. Overhead expenses
should be subtracted only if they would not have been incurred absent the infringement.
Any doubt regarding the amount of deductible expenses and profits will be
resolved in favor of the copyright owner. In fact, if the infringer failed to present evidence
supporting his argument that not all of the profits were attributable to the
infringement, or indicating the existence of certain deductible expenses, the court
could assume that the infringer’s entire gross revenues are profits recoverable by the
copyright owner (at least to the extent that they have not been taken into account in
lost sales calculations).

Infringers can also be liable for profits on related goods or works that are proximately
caused by the infringement; sometimes this class of profits is referred to as
“indirect profits.” Courts can consider any enhancements of the infringer’s business
that are directly attributable to the infringement. If the indirect profits are only
remotely or speculatively attributable to the infringement, the copyright owner may
not recover those profits. The Knitwaves case offers an example of the type of indirect
profits that may be recoverable.

Knitwaves v. Lollytogs, Ltd., Inc.18

Knitwaves was a clothing manufacturer that owned a copyright on the design of
its sweaters. Knitwaves sold its sweater designs separately as matching sets, a top
sweater and a bottom. Lollytogs began marketing an infringing version of the
sweater, but sold it as a complete outfit with top and bottom. Knitwaves was able
to recover all of Lollytog’s profits on the sweater outfits because the court found
that the value of Lollytog’s entire product (i.e., the complete sweater set, even the
noninfringing parts) was derived from its infringing aspects.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Allocating the Infringer’s Profits

The copyright statute requires that damages be limited to the portion of the infringer’s
profits caused by the infringement. This presents a difficult allocation problem. In
Sheldon v. Metro-Goldwyn Pictures Corp., the Supreme Court held that “what is required
is not mathematical exactness but only a reasonable approximation.”19 Causation
is a very important element of an expert damage analysis in a copyright case.

Frank Music Corp. v. Metro-Goldwyn-Mayer Inc.20

The case involved the copyright infringement of five songs that were part of a
musical revue staged at the MGM Grand Hotel called “Hallelujah Hollywood.”
One issue in the case was how much of the revue’s profits could be attributed to
the five infringing songs. The infringing portion constituted six minutes of music
in a 100-minute musical revue. The court made clear that an allocation is required
by law and some reasoned method based on the facts of each case must be undertaken.
Because the district court did not provide an explanation for its allocation,
the case was remanded. The court also allowed for the apportionment of not only
the direct profits from the revue, but also the indirect profits from the hotel and
casino that sponsored the show. Although mathematical certainty was not necessary,
“a reasonable and just apportionment of profits is required.”

Statutory Damages

Unlike in patent cases, the Copyright Act provides for statutory damages. (Since statutory
damages are available only when the copyright was registered, cases may still exist
in which no damages are available.) However, the owner of a registered copyright may
elect to recover statutory damages in any event, even where there is evidence of lost
profits or infringer’s profits. In fact, the copyright owner may choose statutory damages
at any time before final judgment. The Supreme Court has even permitted the election
of statutory damages after the copyright owner sees the jury’s verdict and award of
actual damages.21 Once the copyright owner has elected to collect statutory damages,
he or she may no longer seek actual damages, even on appeal. Given the low mathematical
range of possible awards under the statutory scheme (relative to the sums available
under the other damages schemes) and the irreversible nature of the decision,
copyright owners generally will elect statutory damages only where neither their use
nor the infringing use was very profitable.

As set forth in section 412 of the Copyright Act, the availability of statutory damages
is conditioned on registration of the copyright.22 Although a suit may be brought for


HOW TO CALCULATE DAMAGES

infringement that took place before the registration (e.g., where the copyright owner
becomes aware of the infringement and registers the copyright as a precursor to litigation),
section 412 limits the ability of a copyright owner to claim statutory damages for
infringement that took place before the effective date of the copyright registration.23 For
an unpublished work, statutory damages are not available for any infringement that
predates the work’s registration. For a published work, copyright owners may not seek
statutory damages for any “infringement of copyright commenced after first publication
of the work and before the effective date of its registration, unless [the] registration is
made within three months after the first publication of the work.”24 This provision perpetuates
the incentives for authors to register their copyrights; even though registration
is no longer mandatory for an author to claim a copyright, registration is a prerequisite
to suits brought under the Copyright Act and to the recovery of statutory damages.25 It
also limits the recoverable damages where a copyright owner neglects to register until
immediately preceding litigation.26

Once the initial hurdle of registration is cleared, the statute prescribes a floor and a
ceiling for the amount of statutory damages available in any given case. All infringement
actions arising from January 1, 1978, to March 1, 1989, are governed by a range
of statutory damages from $250 to $10,000 per work. However, on March 1, 1989, the
Berne Implementation Act allowed for a doubling of statutory damage awards in an
attempt to increase the incentives for registration. Aside from certain limited exceptions,
the current statutory minimum damage award for copyright infringement is
$700 per work, while the maximum statutory damage award is $30,000 per work.27
This heightened range of damages applies to works both created and registered after
March 1, 1989. However, it is not clear whether the Berne Implementation Act applies
to works created, published, or registered before that date, where the complaint was not
filed or a verdict entered until after March 1, 1989.

Within that statutory range of possibilities, the court has the discretion to award any
amount, adjusted appropriately for the facts of the particular case. In exceptional circumstances,
the court may even award an amount outside the statutory range where the
defendant’s actions merit a departure from the guidelines. Courts consider several factors
in determining statutory damages, including the infringer’s state of mind (e.g.,
whether the infringement was deliberate and in bad faith), the infringer’s profits, the
copyright owner’s lost profits, and the expenses the infringer managed to avoid by his
infringement. In other words, actual damages become a factor even in the calculation of
statutory damages. Courts also may consider the fair market value of the copyrighted
work, the amount and type of the infringement (e.g., whether it was technical or substantive),
and defendants’ conduct after becoming aware of the copyright owner’s
objections (usually in the form of a cease and desist letter or a request that the defendant
obtain a license for use of the copyrighted work).

Where there is little evidence of actual damages, substantial profits by the infringer,
or bad faith, the courts commonly award the statutory minimum amount.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Additionally, the Copyright Act allows courts to award less than the statutory minimum
award where the infringer proves that he “was not aware and had no reason to
believe that his or her acts constituted an infringement of copyright.”28 To meet this
evidentiary burden, the infringer must prove that: (1) his infringing actions were
based on a good faith belief that the actions in question did not constitute copyright
infringement; and (2) the good faith belief that the actions were not infringing was a
reasonable belief. When a valid notice appeared on published copies to which the
infringer had access, the infringer cannot rely on the innocent infringer defense to
mitigate statutory damages. Moreover, the decision as to what amount of damages to
award is still a discretionary one, and the court could elect to award the maximum
statutory amount despite proof that the infringement was “innocent.” After March 1,
1989, generally even an innocent infringer cannot mitigate statutory damages below
$700 unless the original work was unpublished, had an invalid notice, or was inaccessible
to the infringer.

Storm Impact, Inc. v. Software of the Month Club29

The Storm Impact case demonstrates the courts’ discretion when awarding statutory
damages. Storm Impact developed a copyrighted computer game called
“MacSki” that it distributed over the Internet as “shareware.” Shareware generally
is free to users for testing and review, subject to payment if the user would
like to play the full version of the game, including higher levels, additional features,
and so on. In this case, MacSki would stop when the virtual skier was
halfway down the ski slope and ask the user to register with Storm Impact and
purchase a “key” if the user wanted to continue. Software of the Month Club
(SOM,C) collected shareware programs on CD-ROMs and sold them to its subscribers
as the “latest and greatest” shareware. SOMC included MacSki on one of
its monthly CDs, apparently without reading the express restrictions on MacSki
requiring Storm Impact’s permission before mass distribution of the program.

Storm Impact successfully established that this use infringed its copyright on
MacSki and requested the greater of actual or statutory damages. The actual damages
were quite low, so the court calculated statutory damages. Without a finding
of willful infringement, the court noted that the damages could range from $500
to $20,000 for each program, subject to the court’s discretion. The court found
that SOMC did not willfully infringe the copyrighted material because it made a
plausible (although ultimately unsuccessful) argument of implied consent and
removed MacSki from its monthly compilations once it was notified of the
alleged infringement. However, the court also held that an absence of willfulness
did not merit merely minimal damages. Storm Impact had suffered some damage


HOW TO CALCULATE DAMAGES

Storm Impact, Inc. v. Software of the Month Club (continued)

to its goodwill from the use of its product (although it was difficult to quantify),
and it was impossible to determine precisely how much of SOMC’s profits were
due to Storm Impact’s product. Accordingly, the court awarded $10,000 per infringement,
for a total of $20,000 (there was one other copyrighted work besides
MacSki that was included on the disk).

Where the copyright owner establishes that the infringer “willingly” infringed (i.e.,
that the infringer’s state of mind was not merely innocent), the court may award damages
above the $30,000 maximum, up to a sum of not more than $150,000. Section
504(c)(2) authorizes such a departure from the statutory range of damages. The culpable
state of mind may be proven by the infringer’s conduct after being asked to
stop, repeated unauthorized uses, and so on. To have acted willfully, an infringer must
have had actual knowledge that the infringing conduct constituted copyright infringement.
In other words, the infringer must have personal knowledge of the infringement,
not merely knowledge imputed by an employee or agent who was aware of the infringement.
An infringer may negate willfulness by showing that he received legal advice
indicating that the conduct was not infringement. Thus, an infringer who received notice
from the copyright owner that his conduct was infringing, but received a contrary opinion
from his counsel, may assert a good faith defense to the “willfulness” aspect of the
infringement. Courts also have awarded damages above the statutory maximum to punish
an infringer whose conduct directly led to the copyright owner’s inability to establish
or reasonably calculate actual damages. For example, an infringer’s refusal to
answer questions about the volume of their infringing sales, or their profits from those
sales, may entitle the copyright owner to maximum statutory damages.30

Where an infringer copied from multiple works owned by the same owner, the
statutory damages will be multiplied by the number of infringed copyrights. For example,
where the infringer copied three copyrighted works, the copyright owner is entitled
to statutory damages of at least $1,500 and up to $60,000. If the infringer had unauthorized
use of several different versions of a copyrighted work, the Act suggests that
only a single statutory damages award is available. The test for whether more than
one “work” has been infringed for the purpose of deciding whether to multiply the
statutory damages is whether “all the parts of a compilation or derivative work constitute
one work.”31

An infringer frequently will infringe a single copyrighted work by several different
acts. The Copyright Act provides for a single award for “all infringements involved
in the actions, with respect to any one work. . . .”32 This means that an infringer will
be liable for a single statutory award whether the infringer made 1 copy or 99 copies.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

However, courts will take into account the number of individual infringements when
determining the appropriate award within the statutory range.

Summary of Copyright Damages

The Copyright Act allows a plaintiff to recover damages where he or she can establish
ownership of the copyright and copying by the defendant. Under the statute, a successful
plaintiff may recover both actual damages and the defendant’s profits attributable to
the infringement. Since actual damages may be difficult to calculate and the defendants
have not always profited from infringement, the Copyright Act also allows a plaintiff to
elect statutory damages (instead of actual damages) as compensation for the harm to the
protected work. Courts also have the power to enjoin the defendant from further infringing
acts, impound the infringing items, and award attorneys’ fees and costs to the copyright
owner.

TRADEMARK DAMAGES

The three primary sources of law concerning trademark damages are:

1. Section 35 of the Lanham Act
2. Section 36 of the Restatement of Unfair Competition Third (the Restatement)
3. The case law
Availability of Monetary Damages

An important difference between the law of damages in the patent and copyright areas
and the damages available for trademark infringement is the judicial reluctance in trademark
cases to award monetary damages rather than simply enjoining the infringement.
Some courts, in accord with pre–Lanham Act case law, require a trademark owner to
make an initial showing of either willful infringement or actual lost profits before monetary
damages will be awarded for trademark infringement. Sections 36(3) and 37(2)
of the Restatement appear to codify this threshold requirement by offering factors
that should be considered before “damages for pecuniary loss are appropriate” or “defendant’s
profits” can be awarded.

The historical basis for this reluctance can be traced to the old divisions between the
different types of courts. Originally, trademark infringement was brought in equity
courts, and the remedy was an injunction and an accounting of the infringer’s profits.
Actual damages were an available remedy only in a court of law, and thus were unavailable
to the trademark owner. After the merger of courts of law and equity courts, many
courts continued the tradition of awarding only an injunction and the infringer’s profits.
It was not until the passage of the Lanham Act in 1946 that a plaintiff’s actual damages
became available.


HOW TO CALCULATE DAMAGES

Although the Lanham Act allows trademark owners to recover both the defendant’s
profits and the owner’s actual damages, the extent of an owner’s recovery is explicitly
“subject to the principles of equity. . . .”33 Consistent with this codified consideration of
equitable factors, shortly after the Lanham Act was enacted, the Supreme Court held
that damages for trademark infringement would not be automatic.34 Moreover, infringers
who merely reproduce a registered mark on labels or packaging “intended to be used
in commerce” (as opposed to actually used in commerce) are not liable for profits or
actual damages unless their acts were committed “with knowledge that such imitation
is intended to cause confusion.”35 Lower courts have justified awarding an injunction
without monetary damages because trademark infringement can be innocent (when
the infringer is aware of the mark) and may not cause actual consumer confusion.

Injunctive relief is the standard remedy for trademark infringement, requiring only a
demonstration of a likelihood of confusion.36 In general, damages are available when

(1) actual confusion exists, or (2) the infringement is willful.37 Despite this general rule,
some courts have awarded damages when actual confusion is lacking (typically a reasonable
royalty)38 and where infringement is innocent (often the innocent infringer benefits
from the infringement).39
Types of Damages Available

Assuming that monetary damages are available, section 35 of the Lanham Act provides
for the recovery of: (1) “any damages sustained by the plaintiff”; (2) “defendants’ profits”;
and (3) “the costs of the action.”40 The Lanham Act also gives the courts discretion
to increase the actual damages up to three times such amount, whichever is
greater, so long as the increase represents “compensation and not a penalty.”41 In “exceptional
cases,” the courts may also award attorneys’ fees to the prevailing party.42 Moreover,
if the infringement consists of “intentionally using a mark or designation, knowing
such mark or designation is a counterfeit mark,” courts are required to award attorneys’
fees as well as trebled damages or trebled profits, whichever is greater.43 Finally, statutory
damages are available for use of counterfeit marks, as defined by the statute.44

As an IP expert or attorney, it is important to be familiar with the means of calculating
plaintiff’s actual damages, defendant’s profits, and statutory damages.

Plaintiff’s Actual Damages

A trademark owner’s actual damages can be measured by at least three types of harm:

(a) lost profits on sales, (b) price erosion, and (c) lost goodwill or future sales because
of harm to reputation.45 Moreover, plaintiffs may recover their expenditures on advertising
necessary to rectify the market confusion resulting from the infringing use of
plaintiff’s mark. The costs of this “corrective advertising” are another recognized type
of actual damage to the mark owner. Finally, a reasonable royalty may be available to
the trademark owner where actual damages exist but are difficult to calculate.

COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Lost Profits. Lost profits are the profits that the trademark owner would have made
absent the infringement. As in the copyright damages context, the plaintiff’s lost profits
and the defendant’s profits can be duplicative, and any double-count must be eliminated
from the total damages award. The other principles for calculating lost profits
generally do not differ from those already explained in the discussion of damages for
patent infringement. However, there is no authority to use the Panduit factors explicitly
to establish lost sales in trade infringement cases. Instead, lost sales in trademark cases
typically are determined directly by using the plaintiff’s noninfringed products that use
the same mark as a yardstick or estimating lost sales from a pre- and postinfringement
analysis of the trademark owner’s sales.46 In a two-supplier market, the defendant’s
infringing sales may be used as a good proxy for the plaintiff’s lost sales.47 After lost
sales have been identified, the lost profits are determined by applying the trademark
owner’s profit margin to the number of lost sales. The authors believe that a credible
market analysis performed in accordance with the case law on patent damages likely
will render acceptable results in a trademark case.

Price Erosion. As with other types of IP, the erosion of a plaintiff’s prices resulting
from the alleged infringement constitutes another form of actual damages available for
trademark infringement.48 Price erosion in the trademark context must be proven in
the same manner that it would be established in a patent infringement case. However,
credible proof that prices would be higher “but for” the infringement of plaintiff’s mark
is difficult, and damage awards for price erosion are rare in trademark cases.

Damage to Reputation and Goodwill. A plaintiff may recover for damage to its goodwill
or reputation associated with the infringed trademark. Since the purpose of a trademark
is to signal information to consumers about the quality or the characteristics of the
trademark owners’ products, infringement by an inferior good or forms of false advertising
can undermine the trademark owner’s investment in the mark. The Lanham Act
recognizes this potential harm from trademark infringement and allows recovery for
damage to the mark owner’s goodwill or reputation.

Measuring injury to reputation can be difficult. One method of estimation is to compare
the performance of the trademark owner before and after the infringement began.
However, damage to reputation may overlap with lost profits and corrective advertising,
although it is not coextensive with those amounts. Damage to goodwill can affect
a mark owner’s future performance, not simply past sales, and lost profits may fail to
account for the negative effect of the infringement on future sales, even once the
infringing use has ceased. Moreover, although corrective advertising expenses may
indicate an owner’s concern with (and possibly their valuation of) their diminished
goodwill, the corrective advertising ultimately may be unable to completely repair
the damage. Accordingly, any overlap between the amount determined to represent the


HOW TO CALCULATE DAMAGES

damage to plaintiff’s goodwill and the amounts of any lost profits and corrective advertising
should be subtracted as duplicative damages; the difference constitutes an independent
amount of recoverable damages.

Corrective Advertising. A trademark owner may undertake corrective advertising in
an attempt to restore the brand value of his mark. The cost of this advertising may be
recoverable as a type of actual damage to the plaintiff. For example, in Big O Tire
Dealers, Inc. v. Goodyear Tire & Rubber Co., the district court upheld a jury verdict of
$2.8 million based on a need for corrective advertising.49 The jury based its verdict
on the ratio of states in which infringement occurred to all states where Big O sold
tires and multiplied this percentage by the defendant’s advertising budget. The Tenth
Circuit upheld the concept of corrective advertising damages, but reduced the percentage
to 25 percent based on a formula used by the Federal Trade Commission.50

Corrective advertising also is available for prospective advertising. In other words,
although the plaintiff may not yet have undertaken any corrective advertising, he or she
may be able to recover the estimated amount that the advertising will cost. In cases
where the damage to reputation is very difficult to measure, the cost of corrective advertising,
established through the testimony of advertising personnel and sufficient expert
analysis, may be a means of proving the amount of actual damage to the mark’s reputation.
There is a danger of undue speculation in this approach, and several commentators
have criticized this use of corrective advertising.51

Reasonable Royalty. Another means of determining the appropriate damages for
trademark infringement is the calculation of a reasonable royalty.

Sands, Taylor & Wood v. Quaker Oats Co.52

This case involved an advertising battle between sports drinks, specifically the
trademarks “Gatorade” and “Thirst Aid.” Gatorade began using the slogan
“Gatorade is Thirst Aid for That Deep Down Body Thirst,” which plaintiffs
alleged infringed their Thirst Aid mark. Somewhat surprisingly (given the
arguably descriptive use of the term thirst aid), the district court granted summary
judgment for Sands and awarded it 10 percent of Quaker’s pretax profits on
Gatorade—a total award of nearly $43 million. In an appeal of that award, the
Seventh Circuit rejected the award of defendant’s profits because the profits
were insufficiently related to the use of plaintiff’s mark. Since the plaintiff had
not marketed a sports drink under the Thirst Aid mark for several years, there
were no possible lost sales, so the appeals court remanded with instructions to
calculate a reasonable royalty.

(continues)


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Sands, Taylor & Wood v. Quaker Oats Co. (continued)

On remand, the district court noted that the hypothetical determination of a reasonable
royalty in the trademark context is “a form of restitution designed to prevent
unjust enrichment.” The defendant had knowingly and in bad faith infringed
the incontestable Thirst Aid mark, so the court wanted to award an amount that
would act as a deterrent to future infringement. In other words, the reasonable
royalty may strike a balance between a “windfall” to the plaintiff in the form of
profits unrelated to its mark and the perceived undercompensation of pure injunctive
relief. Moreover, the court was concerned with the potential failure of a reasonable
royalty to discourage infringement if the royalty was simply the “normal,
routine royalty, noninfringers might have paid.” Accordingly, the court exercised
its discretion under the Lanham Act and doubled the amount of the hypothetical
royalty. After the application of prejudgment interest (to the original, undoubled
award only), this resulted in a royalty of over $26 million.

As in patent infringement cases, a court first will determine whether an established
royalty exists.53 If no established royalty exists, then a reasonable royalty in a trademark
infringement case is determined (just as in a patent infringement case) by use of
the “willing licensor, willing licensee” test.54 The same analysis discussed in connection
with the calculation of a reasonable royalty in a patent infringement case
applies to a trademark infringement case. As reflected in Sands, the courts also may
consider the efficacy of the selected royalty as a deterrent to future misconduct, particularly
in light of the defendant’s profits from the infringing use.55

Defendant’s Profits

The Lanham Act and the Restatement, like the Copyright Act, provide for the plaintiff
to recover the defendant’s profits.56 Moreover, the burdens of proof and the calculations
of defendant’s profits in a trademark case are the same as in a copyright case.
Essentially, the plaintiff attempts to calculate (or “account for”) the defendant’s profits
attributable to the infringing use of plaintiff’s mark.

George Basch Co., Inc. v. Blue Coral, Inc.57

Blue Coral marketed a metal polish with a trade dress similar to that of Basch’s
metal polish. The district court denied Basch’s claim for actual damages because
it found no evidence of consumer confusion or intent to deceive; however, the
court awarded Basch Blue Coral’s profits on the metal polish.


HOW TO CALCULATE DAMAGES

George Basch Co., Inc. v. Blue Coral, Inc. (continued)

On appeal, the court considered the requirements for awarding the infringer’s
profits as a remedy. The court held that, under section 35(a) of the Lanham Act, a
plaintiff must prove that the infringer acted with “willful deception” in order for
the plaintiff to recover the infringer’s profits by way of an accounting. This “bad
intent” requirement operates to limit the frequency with which a plaintiff might
recover a windfall and precludes the “innocent” or “good faith” infringer from being
unduly penalized.

A finding of willful deceptiveness is necessary but not sufficient to warrant an
accounting for the infringer’s profits. The other factors that should be considered
include the egregiousness of the fraud; the degree of certainty that the defendant
benefited from the infringement; the adequacy of other available remedies; the
role of a particular defendant in the infringement; plaintiff’s laches arguments;
and any evidence of plaintiff’s own unclean hands that might mitigate against a
generous award. In this case, the court reversed the award of profits because there
was no showing that sales had been diverted by the infringing use, nor were the
failed negotiations between the parties before the infringement sufficient evidence
of bad faith on Blue Coral’s part.

There is little judicial guidance for determining the infringer’s profits under an
accounting theory of damages. Typically, the trademark owner will obtain the infringer’s
financial records in discovery and use the revenue or sales line of the income
statement as a rough cut at estimating profits. The burden then shifts to the defendant
to prove the “deductions” that must be made to arrive at actual profit. Acceptable deductions
have included cost of goods sold, depreciation, utilities, advertising, commissions,
administrative costs, discounts, start-up costs, maintenance, rent, insurance, nonlitigation
legal expenses, returns, and taxes.58 Opportunity costs are also a category of costs
that have been allowed by courts. In a competitive market, opportunity costs will equal
the infringer’s profits. However, presumably the infringement led to increased profits
over the competitive level. Deduction of opportunity costs allows for the measurement
of the incremental contribution of the infringement itself. Practically, however, opportunity
costs are difficult to measure, and the risk-free rate of return might be considered
as a proxy for “normal” profits.

Another judicial controversy involves whether the infringer should be allowed to
deduct fixed costs. The correct rule is that only incremental costs (fixed and variable)
should be deducted. As discussed in Chapter 4, incremental costs are those costs that
would have been avoided if the infringement had not occurred. However, different circuits
have adopted different rules on this topic, and courts within the same circuit have


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

rendered conflicting decisions. In short, it is important to check controlling law before
deciding which deductions are appropriate.

Statutory Damages

Section 35(c) of the Lanham Act provides for statutory damages as an alternative to
other damages when use of a counterfeit mark has occurred. Counterfeit marks are
defined as unauthorized counterfeits of a registered mark that is in use or “a spurious
designation that is identical with, or substantially indistinguishable from,” designations
specifically protected by the Trademark Counterfeiting Act of 1984.59 An example of
the latter category is designations identified in the Olympic Charter Act.60 Election of statutory
damages can occur any time before the final judgment. The statutory amount
ranges between $500 and $1,000 per counterfeit mark per type of good or service sold
when the infringement is not willful and up to $1 million per counterfeit mark per good
or service sold if infringement is willful.61

Summary of Trademark Damages

Trademark damages have a lot in common with patent and copyright infringement damages,
and the underlying methods used in those two areas of the law can and should be
imported to the trademark damage arena. Some important differences also exist. By
nature, a trademark conveys information to consumers concerning the nature of a product
or services brand. As a result, damage to reputation that impacts future sales can
result in damage beyond lost profits. Corrective advertising is one approach to measuring
lost reputation, but other methods may be more appropriate under a particular fact
scenario. Depending on the factual context, corrective advertising and damage to reputation
may only partially overlap. Finally, experts and attorneys must be careful to
identify the appropriate statute and the controlling law of the jurisdiction in which
the litigation takes place in order to pin down the precise standards for recovery of monetary
damages.

TRADE SECRET DAMAGES

Trade secret damages seek to address the ethical concerns and basic fairness principles
at the heart of trade secret protection. “The necessity of good faith and honest, fair
dealing, is the very life and spirit of the commercial world.”62 To fully discourage the
misappropriation of trade secrets, the case law generally requires wrongdoers to compensate
the trade secret owner for the value of the trade secret, including, but not necessarily
limited to, all of their gains. Moreover, although the trade secret genie can never
be completely returned to the bottle, the courts often genuinely attempt to restore the
trade secret owner to as near his or her pretheft position as possible.63


HOW TO CALCULATE DAMAGES

Trade secret damages, like the cause of action itself, generally are governed by state
law. However, the principles already discussed with reference to the calculation of damages
for patent and copyright infringement influence trade secret damages as well. In
general, “the proper measure of damages in the case of a trade secret appropriation is to
be determined by reference to the analogous line of cases involving patent infringement,
just as patent infringement cases are used by analogy to determine the damages for
copyright infringement.”64 As a result, trade secret damages mirror patent damages to
some extent, while varying depending on the relevant jurisdiction. Most states (43 at
last count) have adopted some form of the rules for damages contained in the Uniform
Trade Secret Act (Uniform Act), while the remaining states generally follow the principles
contained in the Restatement of Unfair Trade (Restatement). These resources are
provided in Appendices I and J. Although both the Uniform Act and the Restatement
discuss the remedies for misappropriation of a trade secret, the two sources take different
approaches to calculating the appropriate amount of damages. A brief overview of
the types of damages available may provide a helpful foundation for the following discussion
of particular calculations.

Under section 3 of the Uniform Act, a plaintiff can recover (1) damages for the trade
secret owner’s actual losses, and (2) damages reflecting the amount of the defendant’s
unjust enrichment from use of the misappropriated trade secret, so long as double-
counting is eliminated. In other words, to the extent that the defendant’s profits capture
the trade secret owner’s losses, that number should be counted only once, but both the
defendant’s gains and the plaintiff’s losses may be recovered. Moreover, “in lieu of
damages measured by any other methods, the damages caused by misappropriation may
be measured by imposition of liability for a reasonable royalty....”65 This means that
a reasonable royalty is also available as an alternative measure of damages. The case
law under the Uniform Act appears to adopt the Patent Statute standard for calculating
lost profits and the reasonable royalty.66 If misappropriation is willful, the Uniform Act
also allows for increasing the damage award up to twice the original amount, including
attorneys’ fees.67 The Uniform Act also allows for injunctive relief.68

Under section 45 of the Restatement, monetary damages are measured as “the pecuniary
loss to the [trade secret owner] caused by the appropriation or . . . the [infringer’s]
own pecuniary gain resulting from the appropriation, whichever is greater....”
Accordingly, under the Restatement approach, the damages are the larger of lost profits
or the infringer’s total profits. This is a distinct departure from the typical rule of summing
the lost profits and the infringer’s profits and eliminating the double-count.69
Moreover, while the text of section 45 does not mention a reasonable royalty, comment
d to the text makes it clear that a reasonable royalty is available and should be measured
as “the price that would be agreed upon by a willing buyer and a willing seller for
use made of the trade secret by the defendant.”

Keeping these differences in mind, this section outlines the available damages for
misappropriation of trade secrets.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Losses to the Trade Secret Owner

Both the Uniform Act and the Restatement provide for lost profits due to the misappropriation.
Generally, calculating the loss to the trade secret owner is essentially a valuation
where the misappropriation has destroyed the value of the secret, often through
public disclosure of the confidential information.70 In contrast, where the misappropriator
preserved the secrecy of the trade secret (beyond the fact of the initial misappropriation)
but used the trade secret for personal benefit, the owner’s losses may
be an inadequate measure of damages. Under that scenario, the owner’s losses fail to
reflect harm resulting from changes in the relative positions of the owner and the misappropriator
in the relevant market.71 At least the following four categories have been
identified as potential factors in measuring the trade secret owner’s losses.

Lost Profits. The Restatement specifically refers to recovery of lost profits.72 Lost
profits in a trade secret case should be calculated as they are calculated in a patent
infringement case. Although the authors are not aware of authority for use of market
analysis instead of directly identifying diverted sales, in principle the two methods
have the same objective. The Restatement refers to both “specific customers diverted”
and “a general decline in sales.”73 In a two-firm market, the sales of the misappropriator
probably can be safely used as a proxy for lost sales. Although the more sophisticated
approaches used in patent infringement cases should also be applicable in trade
secret cases, we have not seen them in reported cases to date.

DSC Communications Corp. v. Next Level Communications74

Next Level Communications was formed by former employees of DSC Communications.
DSC sued Next Level for misappropriation of trade secrets, specifically
the technology for DSC’s new broadband access product, switched digital
video (SDV). The jury found Next Level liable for misappropriation and awarded
damages of $369,200,000 premised on Next Level’s developing an SDV system
that competed with DSC’s system.75

On appeal, Next Level argued that the lost profits award was overly speculative
given that DSC had yet to sell its SDV product and there was no established market
for the product. However, the court affirmed the damage award, finding that
DSC adequately established lost sales through extensive market research, known
history of the telecommunications industry, empirical success of a precursor product
to the SDV system, and DSC’s history of strong performance. The court held
that “Even if a product is not yet fully developed, a plaintiff is not prevented from
recovering future profits if it was hindered in developing that product, and the evidence
shows the eventual completion and success of that product is probable.”


HOW TO CALCULATE DAMAGES

Price Erosion. As in other IP cases, price erosion is a potential basis for damages
attributable to trade secret misappropriation. Price erosion should be measured in the
same manner that it is measured in patent, copyright, and trademark infringement cases.

Value of the Trade Secret. A trade secret’s value varies depending on the chosen perspective.
The trade secret may have a much greater value to the owner who developed
it than to the misappropriator. Once a trade secret enters the public domain, its value is
destroyed. Where the trade secret’s value has been destroyed, the secret should be valued
from the owner’s perspective.76 Conversely, the value of the secret to the misappropriator
usually is the appropriate measure where the secret has not been destroyed
and specific injury to the plaintiff is not evident.77

A trade secret can be valued like other forms of intangible property, or when informational
difficulties exist, the owner’s investment in the trade secret can be used as
a proxy for the trade secret’s minimum value. Such a proxy can be based on the “cost
approach” discussed in Chapter 4. The cost approach requires more than just consideration
of the out-of-pocket expenses. Consider the following example:

Imagine that a plaintiff has developed a trade secret that allows him to dry his company’s
product very quickly. The plaintiff developed the product in his spare time
over three years. He is the founder and CEO of the company. Finally, assume that he
developed the process in a spare room on-site at the company. By stealing the trade
secret, the defendant is able to duplicate the drying process. In discovery, the defendant
obtains the trial balance (see Chapter 4 for a discussion of the trial balance) of
the plaintiff and discovers that it has a line item titled “Drying Process Costs.”
According to the trial balance, the plaintiff spent $200,000 on developing the drying
process. This amount spent by plaintiff is the minimum value of the trade secret for
several reasons.

First, the plaintiff’s cost likely does not include all of the costs incurred during the
process of creating the trade secret. For instance, most companies would not allocate
any cost of the CEO’s salary or a proportionate share of rent to such a project. Thus, if
the defendant had to create the trade secret on its own, the actual costs probably would
be higher than the amount recorded on the trial balance.

Second, the plaintiff, on its trial balance, would never record the costs that should be
considered in valuing the trade secret (e.g., the value of avoiding failed invention
attempts). As with any invention, the defendant may have had to go through more
attempts than the plaintiff did to duplicate the secret. With each failed attempt, the
defendant would incur labor costs, material costs, etc.

Third, the cost approach requires that the value of the asset also include a return on
the investment that was made to create the asset. In other words, the value of the trade
secret is not just the materials, labor, and risk of failure. It also includes a return on the
investment in materials, labor, and risk of failure. The rate of return can best be determined
using the techniques described in Chapter 5.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Head Start Damages. In trade secret cases, the damage period typically includes a
“head start” period. The head start period is the period of time required to eliminate any
competitive advantage obtained by the misappropriator. The head start, or “lead time,”
approach allows defendants to argue that damages should be limited to that period
in which the defendant could have become aware of those secrets through legitimate
business procedures.78

Kilbarr Corp. v. Business Systems, Inc.79

The trade secrets at issue in this case concerned an electric typewriter. The court
determined that in order to adequately compensate the plaintiff, it was necessary
to consider factors such as the impact of the defendant’s refusal to return the trade
secret to the plaintiff. Because of that refusal, plaintiff was completely precluded
from also manufacturing electromechanical typewriters. Not only was plaintiff
precluded from licensing others, and entering the market individually, but also the
plaintiff still (at the time of the decision) was unable to enter the market because
the defendant refused to comply with the court orders requiring the return of the
critical information. Nevertheless, the defendant argued that its liability should
be limited by the head start rule to that period during which it could have learned
the proprietary information through reverse engineering or independent research.

Given the knowing misappropriation and defendant’s “grossly improper” conduct,
the court refused to limit the monetary remedy by a lead time valuation.

The head start rule is well established in trade secret cases.80 The Uniform Act also
contains a comment endorsing the head start concept:

Like injunctive relief, a monetary recovery for trade secret misappropriation is appropriate
only for the period in which information is entitled to protection as a trade secret, plus the
additional period, if any, in which a misappropriator retains an advantage over good faith
competitors because of misappropriation. Actual damage to a complainant and unjust benefit
to a misappropriator are caused by misappropriation during this time period alone.81

The Restatement contains a similar limitation:

Monetary remedies, whether measured by the loss to the plaintiff or the gain to the defendant,
are appropriate only for the period of time that the information would have remained unavailable
to the defendant in the absence of the appropriation. This period may be measured by the
time it would have taken the defendant to obtain the information by proper means such as
reverse engineering or independent development.82

However, strict application of the head start rule risks potential undervaluation of the
trade secret and the impact of its misappropriation. Specifically, it is important to note


HOW TO CALCULATE DAMAGES

any aspects of the relevant market that might render a “head start” completely preclusive
of subsequent entrants. In other words, in industries that change very rapidly or that
quickly standardize the first product to market, the first to market may be the only competitive
force in the market. Under that scenario, the value of the trade secret to the
defendant may be the better measure of damages.83

The Misappropriator’s Gain

Using the value of the trade secret to the defendant is an appropriate calculation where
the value of the trade secret is destroyed and the plaintiff cannot show specific injury,
such as lost sales.84 In fact, it is not necessary for the trade secret owner to have ever
profited from the trade secret in order to recover damages from the misappropriator.85
There are many possible variations in the means of calculating a defendant’s benefit
from the stolen trade secret.86 Under both the Restatement and the Uniform Act,
damages can be calculated as the unjust enrichment or the profits of the misappropriator.
Although the misappropriator’s profits can be awarded even when the trade
secret owner has incurred actual losses, if the owner has been awarded lost profits,
no duplicative damages are appropriate.87 Moreover, as mentioned earlier, the Restatement
requires plaintiffs to elect which type of damages they prefer rather than
taking both.

As in other IP cases, the plaintiff bears the burden of proving the misappropriator’s
revenue. However, with trade secrets cases, the courts tend to be less stringent in enforcing
the requirement that damages must not be unduly speculative.88 Doubts are resolved
against the wrongdoer to preserve disincentives to steal confidential information.89 In
response to plaintiff’s numbers, the misappropriator can seek to reduce her liability by
establishing sales not caused by the misappropriation and proving that some expenses
must be deducted from revenue. The categories of expenses that may be excluded differ
by state, so state law should be consulted on this issue.

When a trade secret contributes to a reduction in costs by the misappropriator, the difference
between costs incurred with the trade secret and costs incurred without the trade
secret constitutes the unjust enrichment. As previously discussed, another possible measure
of the misappropriator’s gains are the costs saved by not having to develop the trade
secret independently. However, when the trade secret results in a reduction of costs,
it often is very difficult to determine reasonably a date at which the damages end. For
example, assume that the trade secret relates to the organization of an assembly line. The
trade secret reduces operating costs. Once the defendant knows how to more efficiently
arrange its assembly line, it would be nearly impossible to take back the trade secret. In
such cases, it typically is more appropriate to compute damages based on the value of the
technology. By taking a trade secret that effectively cannot be returned, the defendant has
effectively “bought” the secret. Damages based on the value of the trade secret compensate
the plaintiff for the defendant’s use of the trade secret in perpetuity.90


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Reasonable Royalty

When lost profits and unjust enrichment cannot be measured, the Uniform Act and the
Restatement authorize a court to determine a reasonable royalty as the appropriate remedy
for the misappropriation of a trade secret.91 “[T]he lack of actual profits does not
insulate the defendants from being obliged to pay for what they have wrongfully
obtained in the mistaken benefit their theft would benefit them.”92 The Restatement
defines a reasonable royalty by the “willing licensor, willing licensee” test, which we
have discussed at some length. However, the reasonable royalty in a trade secret context
may be increased to adequately punish the defendant.93 This is sometimes referred
to as placing the risk on the wrongdoer rather than on the trade secret owner. The legal
system also has an interest in discouraging would-be misappropriators from gambling
on escaping with merely a minimum royalty payment equivalent to what they would
have paid absent any wrongdoing.

Moreover, some factors in the patent context that operate as checks on the amount
of a reasonable royalty are notably absent in trade secret cases. For example, patent
licenses often account for uncertainties regarding the patentee’s ability to prove
infringement and validity of the patent. The technical natures of these questions can
prolong litigation and mitigate in favor of a reduced royalty rate. Moreover, patent cases
typically assume that the patent owner is a willing licensor. Although this certainly is
not always true in a patent case either, in the trade secret context, the assumption is virtually
always wrong. The very nature of a trade secret requires that the owner is unwilling
to disclose the secret to others, even for a price.94 Otherwise, the trade secret owner
might simply apply for a patent on the secret process and rely on the patent laws to protect
his or her rights.

University Computing Co. v. Lykes-Youngstown Corp.95

In University Computing Co., the defendant (LYC) bribed an employee to steal
the trade secret information related to Universal Computing Co.’s (UCC’s) computer
system. The facts could be the script for a Hollywood version of a trade
secret theft: the bribed employee delivered a suitcase filled with computer tapes
and other materials to LYC, then later was paid to fly to Atlanta from Dallas with
additional tapes and documents when the original materials were found to be insufficient.
On appeal, LYC did not contest the fact of liability for misappropriation,
but it disputed the amount of the damages awarded. Despite its best efforts, LYC
had not been able to sell the trade secret computer system at a profit and thus had
no actual profits to indicate the value of the secret to LYC.

The Fifth Circuit emphasized that the absence of profits should not insulate the
defendant’s conduct from liability and affirmed the royalty awarded by the district


HOW TO CALCULATE DAMAGES

University Computing Co. v. Lykes-Youngstown Corp. (continued)

court. The court described the factors for determining a reasonable royalty as
follows:

“In calculating what a fair licensing price would have been had the parties
agreed, the trier of fact should consider such factors as the resulting and foreseeable
changes in the parties’ competitive posture; the prices past purchasers or licensees
may have paid; 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; the
nature and extent of the use the defendant intended for the secret; and finally whatever
other unique factors in the particular case which might have affected the parties’
agreement, such as the ready availability of alternative processes.”

The court upheld UCC’s estimation of the value of the trade secret. UCC’s
expert calculated the value of the trade secret information by multiplying UCC’s
costs in developing the materials by a multiple of 2.5. Despite recognizing “a certain
amount of speculation” involved in the calculation, the court affirmed that
the expert had the expertise to determine the proper means for estimating sales
price as a function of costs.

Royalties also may be awarded as a lump sum by considering the defendant’s sales

projections over the useful life of the product and discounting to present value. This

approach is utilized in several patent cases.96

Interactive Pictures Corp. v. Infinite Pictures, Inc.97

Interactive Pictures involved infringement of a patented image viewing system.
The court affirmed a lump sum royalty award as damages based on Infinite
Pictures’s sales projections made shortly before the infringement began. Despite
the fact that the actual performance of Infinite Pictures’s product was substantially
below the projections (only $66,500 in sales versus the $1 million of projected
sales), the court agreed that the sales projections provided a snapshot of the
defendant’s valuation of the technology at that time. The court stated that
while “Infinite’s subsequent failure to meet its projections may simply illustrate
the ‘element of approximation and uncertainty’ inherent in future projections,” the
lump sum royalty based on those projections was not unduly speculative or
grossly excessive.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Summary of Trade Secret Damages

Trade secret damages are governed by state law. Most states have adopted in some form
the rules contained in the Uniform Trade Secret Act and the Restatement (Third) of
unfair competition. Both of these sources provide for remedies similar or identical to
those available in patent, copyright, and trademark infringement cases. However, in a
trade secret case, no statutory damages exist. Moreover, trade secrets are the only area
of IP damage law in which the head start doctrine may limit the available damages.

ENDNOTES

[1] 17 U.S.C. § 505; see also Fogerty v. Fantasy, 510 U.S. 517 (1994) (holding that standard
governing award of attorneys’ fees under section 505 should be identical for prevailing
plaintiffs and prevailing defendants).
[2]
See Marobie-FL. v. Nat’l Assoc. of Fire Equipment Distrib., No. 96 C 2966, 2002 U.S.
Dist. LEXIS 2350 (N.D. Ill. Feb. 13, 2002) (requiring each party to bear costs and attorneys’
fees where jury awarded $0 for infringement of plaintiff’s copyrighted works).
[3]
See Lotus Dev. Corp. v. Borland Int’l, Inc., 140 F.3d 728 (7th Cir. 1998); Maljack Prods.,
Inc. v. GoodTimes Home Video Corp., 81 F.3d 881 (9th Cir. 1996); Diamond Star Bldg.
Corp. v. Freed, 30 F.3d 503 (4th Cir. 1994).
[4] David Horrigan, Compaq Wins $2.7M Fee Award in Copyright Case, Nat’l Law J., May
1, 2002 (the court cited numerous discovery abuses and even ordered the attorneys to
reimburse Compaq $101,822 for their “unreasonable and vexatious conduct” during
discovery).
[5] 17 U.S.C. § 504.
[6]
Id. §§ 412, 504(c).
[7]
Id. § 504(a), (b).
[8]
Storm Impact, Inc. v. Software of the Month Club, 13 F. Supp.2d 782 (N.D. Ill. 1998);
Joseph J. Legat Architects, P.C. v. United States Dev. Corp., 1991 U.S. Dist. LEXIS 3358
(N. D. Ill.).
[9]
Taylor v. Meirick, 712 F.2d 1112 (7th Cir. 1983).
[10]
Stevens Linen Assoc., Inc. v. Mastercraft Corp., 656 F.2d 11 (2d Cir. 1981).
[11]
Big Seven Music Corp. v. Lennon, 554 F.2d 504 (2d Cir. 1977) (,comparing sales of
infringed Lennon album with sales of his other contemporary albums).
[12]
See, e.g., Stevens Linen Assoc., Inc. v. Mastercraft Corp., 656 F.2d 11 (2d Cir. 1981).
[13]
Deltak, Inc. v. Advanced Systems, Inc., 767 F.2d 357 (7th Cir. 1985).
[14]
See, e.g., Business Trends Analysts, Inc. v. Freedonia Group, Inc., 887 F.2d 399 (2d Cir.
1989); Quinn v. City of Detroit, 23 F. Supp. 2d 741 (E.D. Mich. 1998).
[15]
Storm Impact, Inc. v. Software of the Month Club, 17 F. Supp.2d 782, 791 (N.D. Ill. 1998).
[16]
See also Blackman v. Hustler Magazine, Inc., 585 F.2d 274, 281 (6th Cir. 1988).

HOW TO CALCULATE DAMAGES

[17]
See Stevens Linen Assocs. v. Mastercraft Corp., 656 F.2d 11 (2d Cir. 1981) (discussed previously).
[18]
Knitwaves, Inc. v. Lollytogs, Ltd., 71 F.3d 996 (2d Cir. 1995).
[19]
Sheldon v. Metro-Goldwyn Pictures Corp., 309 U.S. 390 (1940).
[20]
Frank Music Corp. v. Metro-Goldwyn-Mayer Inc., 772 F.2d 505 (9th Cir. 1985).
[21]
See Feltner v. Columbia Pictures Television, Inc., 523 U.S. 340, 343–344 (1998).
[22] 17 U.S.C. § 412.
[23]
Id. § 412.
[24]
Id. § 412(2).
[25] Because of earlier legislation, causes of action arising before January 1, 1978, permit the
owner to seek statutory damages even if there was no registration at the time of infringement,
so long as the owner registers the copyright prior to filing a complaint. Cases
involving this older legislation seldom occur anymore, so we will not discuss the particular
laws and requirements of registration that attach to those causes of action.
[26]
See, e.g., Eden Toys, Inc. v. Florelee Undergarment Co., 697 F.2d 27, 33 (2d Cir. 1982).
[27] Copyright Damages Improvement Act of 1999 (Pub. L.106-160), signed into law
December 9, 1999 (the “normal” and “maximum” statutory damages were increased by
50 percent; previously, the normal range of statutory damages was $500 to $20,000 for
each work).
[28] 17 U.S.C. § 504(c)(2).
[29]
Storm Impact, Inc. v. Software of the Month Club, 17 F. Supp.2d 782 (N.D. Ill. 1998).
[30]
See Dive N’Surf, Inc. v. Anselozitz, 834 F. Supp. 379 (M.D. Fla. 1993).
[31] 17 U.S.C. § 504(c)(1).
[32]
Id.
[33] 15 U.S.C. § 35(a).
[34]
See Champion Spark Pkg. Co. v. Sanders, 331 U.S. 125 (1947); Intel Corp. v. Terabyte
Inter. Inc., 6 F.3d 614 (9th Cir. 1993).
[35] 15 U.S.C. § 32(1).
[36]
See id. § 34; see also Brown, Civil Remedies for Intellectual Property Invasions: Themes
and Variations, 55 L. Contemp. Probs. 45, 51, 65 (1992).
[37]
See, e.g., George Basch Co., Inc. v. Blue Coral, Inc., 968 F.2d 1532 (2d Cir. 1992); see
also Texas Pig Stands, Inc. v. Hard Rock Café Int’l, 951 F.2d 684 (5th Cir. 1992).
[38]
See, e.g., Taco Cabana International, Inc. v. Two Pesos, Inc., 932 F.2d 1113 (5th Cir.
1991).
[39]
See, e.g., Maltina Corp. v. Cawx Bottling Co., Inc., 613 F.2d 582, 585 (5th Cir. 1980).
[40] 15 U.S.C. § 35(a).
[41]
Id.
[42]
Id.
[43]
Id. § 35(b).

COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

[44]
Id. § 35(c).
[45]
Id. § 36(2)(a), (b), (c).
[46]
See, e.g., BASF Corp. v. Old World Trading Co., Inc., 41 F.3d 1081 (7th Cir. 1994).
[47]
See, e.g., Intel Corp. v. Terabyte Int., Inc., 6 F.3d 614 (9th Cir. 1993).
[48]
See, e.g., Burndy Corp. v. Teledyne Industries, Inc., 748 F.2d 767 (2d Cir. 1984).
[49]
Big O Tire Dealers, Inc. v. Goodyear Tire & Rubber Co., 408 F. Supp. 1219 (D. Colo.
1976).
[50]
Big O Tire Dealers, Inc. v. Goodyear Tire & Rubber Co., 561 F.2d 1365 (10th Cir. 1977).
[51]
See, e.g., James E. Heald, Money Damages and Corrective Advertising: An Economic
Analysis, 55 U. Chi. L. Rev. 629 (1988); Restatement (Third) of Unfair Competition § 36
(1995).
[52]
Sands, Taylor & Wood v. Quaker Oats Co., 34 F.3d 1340 (7th Cir. 1994).
[53]
Bandag, Inc. v. Al Bulser’s Tire Stores, Inc., 750 F.2d 903 (Fed. Cir. 1984); Restatement
(Third) of Unfair Competition § 36 (1995).
[54]
Sands, Taylor & Wood, 34 F.3d 1340.
[55]
Id.
[56] 15 U.S.C. § 35(a); Restatement (Third) of Unfair Competition § 37.
[57]
George Basch Co., Inc. v. Blue Coral, Inc., 968 F.2d 1532 (2d Cir. 1992).
[58]
See discussion in James M. Koelemay, Jr., A Practical Guide to Monetary Relief in
Trademark Infringement Cases, 85 Trademark Rep. 263 (1995).
[59] 15 U.S.C. §§ 35(c), 34(d)(1)(B).
[60] 18 U.S.C. § 2320(e)(1).
[61] 15 U.S.C. § 35(c).
[62]
Kewanee Oil Corp. v. Bicron Corp., 416 U.S. 470, 482 (1974) (citations omitted) (emphasizing
the importance of trade secret law to maintaining commercial ethics).
[63]
Telex Corp. v. IBM Corp., 510 F.2d 894 (10th Cir.), cert. denied, 423 U.S. 802 (1975)
(identifying as a common thread throughout trade secret cases that “the plaintiff should be
made whole”).
[64]
University Computing Co. v. Lykes-Youngstown Corp., 504 F.2d 518, 535 (5th Cir. 1974)
(quoting Int’l Indus., Inc. v. Warren Petroleum Corp., 248 F.2d 696, 699 (3rd Cir. 1957)).
[65]
Uniform Trade Secrets Act § 3(a).
[66]
See Metallurgical Industries, Inc. v. Fourtek, Inc., 790 F.2d 1995 (5th Cir. 1986).
[67]
Uniform Trade Secrets Act § 3(b); See, e.g., Jannotta v. Subway Sandwich Shops, Inc.,
125 F.3d 503 (7th Cir. 1997) (awarding punitive damages against a corporation for acts
of its employees where employee was acting in a managerial capacity or the corporation
ratified the employee’s acts); Weibler v. Universal Technologies, Inc., 61 U.S.P.Q.2d
(BNA) 1599 (10th Cir. 2002) (declining to award attorneys’ fees for trade secret misappropriation
where the conduct lacked an element of “meaningful control and deliberate
action” normally associated with willful and malicious acts); Mangren Research and
Dev. Corp. v. Nat’l Chemical Co., Inc., 87 F.3d 937 (7th Cir. 1996) (finding exemplary

HOW TO CALCULATE DAMAGES

damages appropriate where actions indicated “conscious disregard of the rights of
another”); RKI, Inc. v. Grimes, No. 01 C 8542, 2002 U.S. Dist. LEXIS 7974 (N.D. Ill.
May 2, 2002) (awarding $150,000 in exemplary damages where intentional misappropriation
and attempted cover-up).

[68]
Uniform Trade Secrets Act § 2.
[69]
See, e.g., Brown v. Ruallam Ents., Inc., 44 S.W.3d 740 (Ark. App. 2001) (applying
Arkansas trade secret law to preclude the recovery of both plaintiff’s lost profits and
defendant’s profits); see also Saforo & Assocs., Inc. v. Porocel Corp., 991 S.W.2d 117
(Ark. 1999) (comparing two veins of authority on this topic).
[70]
University Computing Co. v. Lykes-Youngstown Corp., 504 F.2d 518, 535 (5th Cir. 1974);
Precision Plating v. Martin Marietta, 435 F.2d 1262 (5th Cir. 1970) (holding that the
value of a trade secret process had been completely destroyed upon public disclosure).
[71]
Id. (distinguishing defendant’s use of the trade secret from a disclosure that would destroy
the value of the secret to plaintiff); see also Servo Corp. v. General Elec. Co., 393 F.2d
551 (4th Cir. 1968) (outlining aspects of disclosure in a trade secrets context).
[72] Restatement § 45(1) (trade secret damages include liability for “the pecuniary loss to the
other”); see also related comments.
[73]
See comments to Restatement § 45.
[74]
DSC Comm. Corp. v. Next Level Comm., 107 F.3d 322 (5th Cir. 1997).
[75] After posttrial reductions and interest, the award amounted to approximately $140.7 million.
See also DSC Comm. Corp. v. Next Level Comm., 929 F. Supp. 239, 246 (E.D. Tex.
1996) (noting that since neither party had produced a product ready for sale to customers,
the purchase price of Next Level itself [whose assets consisted almost exclusively of
DSC’s allegedly stolen ideas] might be the least speculative method of deriving the value
of the trade secrets).
[76]
University Computing, 504 F.2d at 535–36.
[77]
Id.
[78]
See, e.g. Abernathy-Thomas Eng. Co. v. Pall Corp., 103 F. Supp. 2d 582, 607 (E.D. N.Y.
2000) (limiting appropriate measure of damages to the lost profits during that period from
the date the misuse began until the date that the defendant could have compiled the stolen
customer list independently); Schiller & Schmidt, Inc. v. Nordisco Corp., 969 F.2d 410,
415–16 (7th Cir. 1992).
[79]
Kilbarr Corp. v. Bus. Systems, Inc., 679 F. Supp. 422 (D.N.J. 1988), aff’d 869 F.2d 589
(3d Cir. 1989).
[80]
See, e.g., Sokol Crystal Products v. DSC Communications Corp., 15 F.3d 1427, 1422 (7th
Cir. 1994) (“[W]here a misappropriation of a trade secret only gives a competitor a ‘head
start’ in developing a product, damages should be limited to the injury suffered in that
‘head start’ period”); Micro Lithography, Inc. v. Inko Indus., Inc., 20 U.S.P.Q. 2d 1347,
1353 (Cal. St. App. 1991) (“The duration of the accounting period is generally limited in
two ways: the disclosure of the trade secret itself or application of the ‘headstart’ rule.”);
Molinaro v. Burnbaum, 201 U.S.P.Q. 150, 163 (D. Mass 1978) (“The award for damages
compensates the plaintiff for the head start that the defendants obtained through its misappropriation.”);
Carboline Co. v. Jarboe, 454 S.W.2d 549, 552 (Mo. 1970) (“Plas-Chem

COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

should be given the opportunity to establish the ‘head start’ time as to these products, and
the injunction should be limited to that period of time if shown”).

[81]
Uniform Trade Secrets Act comment to § 3.
[82] Restatement (Third) of Unfair Competition § 45 cmt. H.
[83]
See, e.g., Kilbarr Corp. v. Bus. Systems, Inc., 679 F. Supp. 422 (D.N.J. 1988), aff’d 869
F.2d 589 (3d Cir. 1989); Sikes v. McGraw-Edison Co., 665 F.2d 731, 736–37 (5th Cir.
1982); USM Corp. v. Marson Fastener Corp., 467 N.E.2d 1271, 1285 (Mass. 1984).
[84]
University Computing Co., 504 F.2d at 536; Uniform Trade Secrets Act § 3(a).
[85]
Perdue Farms, Inc. v. Hook, 777 So.2d 1047 (Fla. App. 2001) (affirming $25 million
award despite fact that plaintiff had never profited or received any royalty for the trade
secret).
[86]
Id.
[87]
Uniform Trade Secrets Act § 3(a) (“Damages can include both the actual loss caused by
misappropriation and the unjust enrichment caused by misappropriation that is not taken
into account in computing actual loss.”); Telex v. IBM, 510 F.2d 894, 931–32 (10th Cir.)
(per curiam), cert. dismissed, 423 U.S. 802 (1975).
[88]
See University Computing, 504 F.2d at 539; see also Olson v. Nieman’s, Ltd., 579 N.W.2d
299 (Iowa 1998) (allowing plaintiff “considerable leeway” on speculation involving damages
in order to prevent unfair competitors to profit from their misdeeds); Koehler v.
Cummings, 380 F. Supp. 1294 (M.D. Tenn. 1974).
[89]
See, e.g., BE&K Constr. Co. v. Will & Grundy Counties Bldg Trades Council, AFL–CIO,
156 F.3d 756, 770 (7th Cir. 1998) (holding that damages need not be proven “with the certainty
of calculus” and doubts should be resolved against the wrongdoer); Sunds
Defibrator Ab v. Beloit Corp., 930 F.2d 564 (7th Cir. 1991); Weston v. Buckley, 677 N.E.2d
1089 (Ind. App. 1997).
[90]
But see Sonoco Prods. Co. v. Johnson, 23 P.3d 1287 (Colo. App. 2001) (rejecting plaintiff’s
model based on the misappropriator’s “cost of capital” savings from use of the trade
secret process for manufacturing toilet paper rolls).
[91]
See American Sales Corp. v. Adventure Travel, Inc., 862 F. Supp. 1476 (E.D. Va. 1994);
RKI, Inc. v. Grimes, No. 01 C 8542, 2002 U.S. Dist. LEXIS 7974 (N.D. Ill. 2002); Perdue
Farms, Inc. v. Hook, 777 So.2d 1047 (Fla. App. 2001).
[92]
University Computing Co., 504 F.2d at 536.
[93]
Id.; King Instruments Corp. v. Perego, 65 F.3d 941 (Fed. Cir. 1995) (approving awards
higher than reasonable royalty in a patent context in order to discourage infringers from
“heads-I-win, tails-you-lose” tactics); Panduit Corp. v. Stahlin Bros. Fibre Works, 575
F.2d 1152 (6th Cir. 1978) (same).
[94]
See University Computing Co., 504 F.2d at 544 (noting that one should take into account
the reasons the seller is unprepared to sell and consider the plaintiff’s interest in preserving
its competitive positions, possibly by diminishing the focus on a royalty that the
defendant actually would have accepted).
[95]
University Computing Co. v. Lykes-Youngstown Corp., 504 F.2d 518 (5th Cir. 1974).

HOW TO CALCULATE DAMAGES

[96]
See, e.g., Interactive Pictures Corp. v. Infinite Pictures, Inc., 274 F.3d 1371 (Fed. Cir.
2001); Snellman v. Ricoh Co., Ltd., 862 F.2d 283 (Fed. Cir. 1988); TWM Mfg. Co. v. Dura
Corp., 789 F.2d 895 (Fed. Cir.), cert. denied, 479 U.S. 852 (1986).
[97]
Interactive Pictures Corp. v. Infinite Pictures, Inc., 274 F.3d 1371 (Fed. Cir. 2001).
ADDITIONAL READING

Copyright Reading

David Nimmer, Infringement Actions—Remedies, 4 Nimmer on Copyright ch. 14 (1963,
1999).

Sheri A. Byrne, Nintendo of America, Inc. v. Dragon Pacific International: Double Trouble—
When Do Awards of Both Copyright and Trademark Damages Constitute Double Recovery?

31 University of San Francisco Law Review 257 (Fall 1996).

Andrew Coleman, Copyright Damages and the Value of the Infringing Use: Restitutionary
Recovery in Copyright Infringement Actions, 21 American Intellectual Property Law
Association Quarterly Journal 91 (1993).

Charles Ossola, Registration and Remedies: Recovery of Attorney’s Fees and Statutory
Damages Under the Copyright Reform Act, 13 Cardozo Arts & Entertainment Law Journal
559 (1995).

Barry I. Slotnick, Copyright Damages, Statutory Damages and the Right to a Jury Trial,
533 Practicing Law Institute 655 (1998).

Trademark Reading

Ralph S. Brown, Civil Remedies for Intellectual Property Invasions: Themes and Variations,
55 Law & Contemporary Problems 45, 51, 65 (1992).


McCarthy on Trademarks, Chapter 30.
James M. Koelemay, Jr., A Practical Guide to Monetary Relief in Trademark Infringement
Cases, 85 Trademark Reporter 263 (1995).


James M. Koelemay, Jr., Monetary Relief for Trademark Infringement Under the Lanham


Act, 22 Trademark Reporter 458 (1982).
Terence P. Ross, Trademark Infringement Damages, in Intellectual Property Law: Damages
and Remedies, Chapter 4 (2000).


Siegrum D. Kane, Trademark Law: A Practitioner’s Guide, PLI, Chapter 16 (2001).


Trade Secret Reading

Patricia A. Meier, Looking Back and Forth: The Restatement (Third) of Unfair Competition
and Potential Impact on Texas Trade Secret Law, 4 Texas Intellectual Property Law
Journal 415 (1996).

Michael A. Rosenhouse, Proper Measure and Elements of Damages for Misappropriation
of Trade Secret, 11 ALR 4th 12.


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Craig N. Johnson, Assessing Damages for Misappropriation of Trade Secrets, 27 Colorado
Lawyer (1998).

Wayne A. Hoeberlein, Trade Secrets: Damages, 340 PLI/Pat 599 (1992).
Felix Prandl, Damages for Misappropriation of Trade Secret, 22 Tort & Insurance Law
Journal 447 (1987).


Milgram on Trade Secrets, Chapter 3.

Christopher Marchese, Patent Infringement and Future Lost Profits Damages, 26 Arizona
State Law Journal 747 (1994).
Stephen I. Willis, An Economic Evaluation of Trade Secrets, 269 PLI/Pat 737 (1989).



14


The Nuts and Bolts
of Intellectual Property
Damage Calculation


This final chapter focuses on the actual process or “nuts and bolts” of determining intellectual
property (IP) damages. When actually faced with the need to develop a coherent
damage theory in an IP dispute, the sophisticated practitioner should undertake several
steps. First, it is necessary to address whether the calculation of damages in a particular
case will consist of a reasonable royalty, lost profits, or a combination of both. Then
the focus should shift to the means of determining a reasonable royalty and/or lost profits
related to an established product. Finally, this chapter guides the practitioner through
the process of determining lost profits related to an unestablished product. These steps
should provide a pragmatic outline of a reasonable approach to IP damage calculations.
The following outline is intended to provide a format for the thought process behind
determining damages as well as a general description of some of the mechanics of
preparing such an analysis. The authors, in conjunction with many other experts in damage
analysis, are currently working on a supplement to the book. The supplement deals
almost exclusively with the mechanics of a damage calculation. We are optimistic that
court rulings and advancements in financial analysis will have a lesser effect on this
chapter than on the chapters in the supplement. However, since new rulings are made
every day, we encourage readers to make sure they are considering rulings that have
been made since the printing of this book.

THE PROCESS OF DETERMINING WHETHER THE PROPER DAMAGES
CONSIST OF A REASONABLE ROYALTY, LOST PROFITS,
OR A COMBINATION OF BOTH


All infringing sales ultimately must be considered in determining damages. As a consequence,
the first practical step in a damage analysis is to identify the sales of both parties
that are generated by the IP at issue. As will be discussed in detail, the sales of the


349



COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

owner (referred to herein as “the plaintiff”) must be considered to determine capacity and
profitability. The infringer’s sales are needed to determine the number of infringing units.

As a practical matter, access to the detailed sales ledger is extremely important to the
successful completion of this first step. The detailed sales ledger is likely to contain sales
sufficiently detailed to allow the practitioner to cull the alleged infringing sales from other
sales. However, because sales ledgers typically record only the dollar amount of the sales
(as opposed to the number of units), it is likely that either production reports (a non-
accounting document generated by the manufacturing department which will detail units)
or invoices (which detail prices so that one can estimate the number of units by dividing
sales by price) also will be needed. It also is helpful to obtain information concerning the
customer’s name and the location at which the sale was made, as well as the sales channel
and the date of the sale. All such data should be gathered from both parties if possible.

Once identified, the defendant’s sales can be divided into two broad categories:

(1) the infringing sales that would have been made by the plaintiff absent infringement,
and (2) the infringing sales that would not have been made by the infringed party absent
infringement. (see Exhibit 14-1). The plaintiff is entitled to lost profits on all of the
sales in the first category and a reasonable royalty on the sales in the second category.1
As discussed in Chapter 7 of this book, an important component in determining
whether a plaintiff is entitled to lost profits or reasonable royalties is the determination
of whether there is a market or demand for the infringing product. Typically, the
defendant would not have infringed if there were no demand for the infringing product.
Companies often generate marketing materials that can be useful in establishing
whether market demand existed. However, in rare instances, a product can be infringed
on in a manner that does not require market demand for the product. Where there is
no market demand for the product, there can be no lost profits because the “but for” causation
is lost.

Once the practitioner determines that market demand exists (or existed), the next step
is examining whether the defendant had a noninfringing substitute available to it at the
time the infringement began. The size and importance of noninfringing substitutes is key

Subject to a reasonable
royalty—The plaintiff
would not have otherwise
made the sale absent the
infringement.
Subject to lost profits—
The plaintiff would have
made the sale absent the
infringement.
EXHIBIT 14-1 Total Infringing Sales by Defendant


THE NUTS AND BOLTS OF IP DAMAGE CALCULATION

to both the lost profits and reasonable royalty analyses. The defendant’s noninfringing
alternatives to the technology must be considered in the hypothetical royalty negotiation.
No economically rational, self-interested party would pay a royalty amount that is greater
than the cost to design around the technology at issue. This notion is consistent with valuation
theory. The “cost approach” (described in Chapter 5) often is depicted as a
methodology based on estimating value by quantifying the amount of money that would
be required to replace the future service capability. Moreover, the availability of
noninfringing substitutes may prevent the plaintiff from receiving lost profits. If the
defendant had noninfringing substitutes available that would not have substantially
affected sales volumes, prices, production costs, or product quality, the plaintiff would
not have obtained any infringing sales in the “but for” world. Accordingly, many defendants
initially claim that such a substitute existed. Proof of an acceptable substitute typically
requires testimony by persons with personal knowledge or technical expertise
concerning the design-around prospects. There typically is an economic disadvantage to
using a noninfringing substitute over the patented product. In other words, it usually
costs money to switch to the noninfringing substitute because the alternative may not
perform as well as the patented technology. The quantification of this potential disadvantage
can, in some cases, represent the proper amount of damages.

A third issue is whether the plaintiff had the capacity to make the defendant’s sales.
The analysis of capacity has several dimensions. Determining the plaintiff’s capacity to
make the infringing sales requires an analysis of the plaintiff’s manufacturing, selling,
and financing ability.

Manufacturing Capacity

The ability to physically produce the patented product often is determined through interviews
with production managers and an analysis of production documents. Even companies
that are operating at their plants’ physical limits may still have additional capacity
through expansion. However, expansion is possible only through incurring increased
costs. These costs are not solely the cost of increasing the manufacturing capacity. For
example, if the plaintiff claims that it would have had increased manufacturing capacity
by leasing additional space, adding a shift, and so on, the additional building costs, supervisor
pay, and overtime expense must be considered. Of course, if the plaintiff argues that
it would have built a facility to create additional capacity, the time necessary to complete
the facility and the risk that the plant will not operate properly are additional costs and
should be considered. If a single additional shift is needed, the cost of adding manufacturing
capacity may involve additional overtime. Finally, if the plaintiff already had
excess capacity in place, there may be little or no cost to expansion. The actual analysis
of capacity expansion is performed in the same manner as in a valuation exercise. The
cost of adding capacity can be determined either through the creation of projections
(the income approach) or by examining competitors’ costs (the market approach).


COPYRIGHT, TRADEMARK, AND TRADE SECRET DAMAGES

Financing Capacity

Additional sales require additional investment in working capital. As described earlier,
working capital represents the difference between current assets (cash, receivables, and
other like items) and current liabilities (accounts payable, accrued liabilities, etc.). The
plaintiff must have the financial ability to provide the working capital necessary to
make the infringing sales and thus obtain lost profits. The analysis of a plaintiff’s ability
to finance lost sales is most often performed in two steps. The practitioner must
determine (1) the amount of investment that is needed, and (2) the plaintiff’s ability and
the costs of obtaining the required funds.

Determining the Amount of Investment Needed. The methodology for determining
the necessary investment is similar to the manner in which working capital requirements
are determined in conducting a business valuation. Nearly all firms with increasing sales
must make some investment in working capital. For example, imagine a new law firm
that is composed of two attorneys, one being the owner and the other an associate. The
lawyers have good reputations that cause their practice to have billable work beginning
on the first day of operation. By the end of the first month, both attorneys worked 200
hours and billed $200 per hour ($80,000 dollars, 200 × 200 × 2). On the first day of the
second month, the firm sends its clients a bill for the work done during the first month
of operation. The clients pay within 30 days. Accordingly, 2 months pass before the attorneys
begin receiving any revenue. During that time, light bills, the associate’s salary,
rent, and other expenses must be paid by the law firm. As a result, the owner must resort
to savings (equity) or borrowed funds (debt) to pay the bills. Some expenses can be
deferred beyond the two-month period. Thus, the amount of financing capacity needed
is defined as the difference between the total expenses incurred and the portion of total
expenses that did not have to be paid in the first 60 days.

A firm’s financial statements make it relatively easy to calculate the firm’s financing
capacity. Working capital is calculated from the balance sheet as the “total current assets”
less the “total current liabilities.” The difference between these quantities must be
financed. If balance sheet information is not relevant for use in a “but for” scenario, it may
be necessary to estimate the amount of working capital needed based on industry averages
or historical changes in working capital. The “liquidity” ratios discussed in Chapter 4 are
a common approach to determining the amount of working capital a firm requires.

Determining the Plaintiff’s Ability to Obtain the Required Amount of Financing.

Once the necessary amount of financing is determined, a firm’s ability to finance such
an amount must be established. The easiest way to establish a firm’s ability to finance is
by identifying existing credit lines. Many businesses have credit lines on which they can
draw funds. Alternatively, an analysis that compares the debt level of the plaintiff to the
levels of its similarly situated competitors may provide evidence concerning the amount
a firm can borrow and the likely cost of borrowing. The leverage ratios discussed in
Chapter 4 are also a common means of analyzing a firm’s ability to obtain funds.


THE NUTS AND BOLTS OF IP DAMAGE