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Startups and lost profits in the wake of ‘LightLab’

14_neih1027_JOURET_SAMITOThe Supreme Judicial Court in Massachusetts recently recognized the difficulty of applying traditional damages analysis, such as lost profits, in theft of trade secrets cases involving start-up businesses.

In LightLab Imaging, Inc. v. Axsun Technolo-gies, Inc., et al., the court acknowledged the challenge of proving, to a legal degree of certainty, lost-profit damages when a company has potentially valuable intellectual property but no track record of profits, or even sales, where its products are still in development. At the same time, the SJC recognized that that should not preclude such a business from recovering damages.

It invited future litigants to test alternate theories of recovery on this point:

“[W]e express our concern that traditional lost profits analysis as a measure of damages may not be an adequate model for analyzing harm caused by misappropriation of the trade secrets of a ‘start-up’ business. Such businesses often operate for years without profit. This fact should not render them ‘damage proof.’ In this case LightLab recovered other significant damages and attorney’s fees. We recognize that other theories of damages may lend themselves to misappropriation of trade secret cases and that such theories may be ripe for testing in our courts.”

What are these other theories and how might they be applied? We briefly summarize the issues that precluded LightLab from recovering on its lost-profits claim and then discuss some possible alternatives called for in the Uniform Trade Secrets Act.

Massachusetts remains just one of three states that have not yet adopted the UTSA (H.27 and H.4045 of the 188th General Court that ended July 31 aimed to have Massachusetts join the other 47 states that have enacted the UTSA).

Background

LightLab manufactures and sells coronary artery imaging systems that use specialized lasers.

One defendant, Axsun Techno-logies, manufactures industrial lasers and entered into a joint development relationship with LightLab to develop a tunable laser that would be superior to existing imaging systems.

LightLab and Axsun executed confidentiality agreements, after which LightLab shared with Axsun confidential information about its technology.

The other defendant, Volcano Corp., a LightLab competitor, later acquired Axsun.

LightLab filed suit asserting, among other claims, that the defendants had misappropriated LightLab’s trade secrets. LightLab largely prevailed at trial but appealed the trial court’s exclusion of lost-profits opinion testimony by its expert economist.

The trial court, in its Daubert-Lanigan gatekeeping role, and separately finding LightLab’s lost-profits claim to be speculative and conjectural, excluded testimony relating to “future lost profits for twenty years beyond the term of the parties’ contract based on yet-to-be conceived future products.”

The trial court first concluded that the expert’s opinion was based on a “first mover advantage.” See Bilsky v. Kappos, 130 S. Ct. 3218, 3254 (2010) (Stevens, J., concurring in the judgment, stating “firms that innovate often capture long-term benefits from doing so, thanks to various first mover advantages”).

Citing Daubert-Lanigan, the trial court excluded that portion of LightLab’s expert testimony on the grounds that quantification of the “first mover advantage” lacked a demonstrated reliable methodology capable of being validated and tested. The SJC affirmed under an abuse of discretion standard.

Separately, the trial court also excluded LightLab’s lost-profits expert testimony on grounds that it was speculative and conjectural. In affirming, the SJC noted:

“Where LightLab had no history of profitable sales and could point to no lost sales, where [the expert’s] opinion depended on as-yet undeveloped new products, where LightLab had no regulatory clearance for its future products, and where it had no guaranteed funding needed to launch a sales and marketing infrastructure for its new products, we conclude that the judge did not abuse her discretion in determinating [sic] that [the expert’s] opinion should be excluded as grounded in speculation.”

The SJC noted that LightLab “cited no case in which an expert was permitted to testify about future lost profits based on an as-yet uninvented product.”

Instead, LightLab pointed to a case involving “expert testimony about a product that had been invented but not yet marketed,” but where the plaintiff also “had a strong history of profitable sales, and its forecasted profits were supported by ‘intensive market research.’” LightLab, in contrast, had “no history of profitable sales, only losses; and there has been no market research.”

Yet, as the SJC recognized, startups often go years without a profit, leading to the court’s observation that “traditional lost profits analysis … may not be an adequate model for analyzing harm caused by misappropriation of the trade secrets of a ‘start-up’ business.”

The trial court’s rulings precluded LightLab’s recovery for lost profits. Ultimately, so as to obviate the need for a damages trial, the parties stipulated that LightLab was entitled to $200,000 in “nonlost profits damages.”

The trial court applied G.L.c. 93A, §11, doubling damages against each defendant and awarding attorneys’ fees and costs.

Some possible alternatives

While LightLab benefited from the partial remedy of Chapter 93A, the SJC noted the inadequacy. What happens in the event of trade secret misappropriation when the court does not find a Chapter 93A violation warranting multiple damages and fee-shifting?

The UTSA points the way to some potential options. They include, with respect to future use of a trade secret, an injunction conditioned upon payment of royalties in “exceptional circumstances.” UTSA, §3(b).

In such cases, a general, prohibitive injunction would be “inequitable” because of a misappropriator’s “material and prejudicial change of position prior to acquiring knowledge or reason to know of misappropriation.”

“As an alternative to all other methods of measuring damages caused by a misappropriator’s past conduct,” the UTSA also provides for damages to be based on a “demonstrably reasonable royalty.” UTSA, §3(a) & comment.

Separately, the UTSA provides for damages in the form of “actual loss caused by misappropriation and the unjust enrichment caused by misappropriation that is not taken account of in computing actual loss.” UTSA, §3(a).

When it is not feasible to alone enjoin the use of trade secrets developed by another party, royalty awards present one promising approach where no proven track record of profits exists. Such awards allow for certainty.

For example, if a product turns out to be a big success, then the plaintiff would receive appropriately sized royalties. If the product does not succeed in the market, then the royalties may be negligible or nonexistent.

That outcome could be seen as a fitting, and retrospective, way to quantify lost profits. Moreover, an unjust enrichment theory may be applied to compensate a trade secret’s owner for its research and development costs, avoided by the offending party.

Just as the law of negligence developed and adjusted during the 19th century to fit an increasingly industrialized economy, the law of damages will need to evolve during the 21st century to address an increasingly intellectual-property driven economy.

Civil litigators Stefan L. Jouret and Christian G. Samito, Ph.D., are the principals of Jouret & Samito in Boston.

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