Drilling For Damages

Written on October 28, 2014

Court finds a sweet spot with reasonable royalty rate

As the Texas Court of Appeals has noted, damages in trade secret cases can take a variety of forms based on “flexible and imaginative methods.” But not every method will apply to every case. In some cases — Southwestern Energy Production Co. v. Berry-Helfand, for example — it may be necessary to adopt a damages concept common in patent law.

Lawsuit in formation
In November 1997, a reservoir engineer and a geologist launched an extensive geological and engineering study of the potential gas production from the James Lime formation underlying five Texas counties. The pair spent more than three years producing “probably the most detailed and comprehensive study ever made of the James Lime” in the area.

In 2003, two years after the geologist dropped out of the work, the reservoir engineer joined forces with another geologist to further research the James Lime formation. These two named their partnership Team Works. Southwestern Energy Production Company (SEPCO) signed a confidentiality agreement with Team Works in 2005, and the scientists presented a proposal identifying some “sweet spots” for development. SEPCO declined to participate, but Team Works entered a Prospect Identification Agreement with a company called Petrohawk, which included a royalty interest in any prospects in which Petrohawk elected to participate.

SEPCO bought a block of leases in two of the five counties in 2006 and found natural gas. Virtually all of its leases were in or very near the reservoir engineer’s top ten identified sweet spots. By the time of trial, the revenues from 144 SEPCO wells drilled in these areas amounted to about $382 million.

A jury found that the study constituted a trade secret and awarded damages of about $11.5 million, or 3% of the revenues of $381.5 million accrued. SEPCO appealed.

Court weighs options
The Texas Court of Appeals listed several methods for calculating trade secret misappropriation damages. These included the:

  • Value of the plaintiff’s lost profits,
  • Defendant’s actual profits from the use of the trade secret,
  • Value that a reasonably prudent investor would have paid for the trade secret,
  • Development costs the defendant avoided by the misappropriation, and
  • “Reasonable royalty” that a party would likely consider.

Courts adjust damages determined by these approaches based on the commercial setting of the injury, likely future consequences of the misappropriation, and nature and extent of the defendant’s use of the trade secret. In this case, the court noted that plaintiffs seldom can establish specific injury from the misappropriation, such as lost sales or profits, with the requisite reasonable certainty. Instead, when the trade secret’s value hasn’t been destroyed, “the accepted approach measures the value of the misappropriated trade secret to the defendant,” or “the benefits, profits and advantages” the defendant gained by using the trade secret.

When profits can be proved from the trade secret’s use, the defendant’s actual profits are used to calculate damages. However, a lack of profit from misappropriation and use of the secret doesn’t exempt the defendant from liability in the amount of the trade secret’s value when it’s misappropriated.

Something borrowed
To calculate the damages in this case, the plaintiff’s expert applied a reasonable royalty to the total accrued revenues from the SEPCO wells in areas identified in the report as sweet spots. This approach was borrowed from patent infringement cases that suppose that a license was granted at the time of the misappropriation. Here, the expert applied a 3% royalty, which was the same percentage compensation formula used in the plaintiff’s agreement with Petrohawk.

The court of appeals found that the expert’s method was based on sound accounting and used a reasonable royalty established in industry practice. It stressed that the Petrohawk agreement used the same percentage, involved the same trade secret and was contemporaneous with SEPCO’s misappropriation.

The right fit
The court of appeals observed that several so-called Georgia-Pacific factors commonly used to calculate royalty rates in patent cases were “particularly germane” to this one. Specific circumstances ultimately will determine which method for calculating trade secret misappropriation damages is appropriate for your case.

Appellate court rejects disgorgement damages
In addition to the actual damages awarded by the jury in Southwestern Energy Production Co. v. Berry-Helfand (see main article), the trial court granted the plaintiff judgment for almost $24 million — about twice the amount of actual damages — in disgorgement damages for the defendant’s illicit gains. The defendant also challenged the latter award on appeal.

The court of appeals acknowledged that courts are empowered to fashion equitable remedies such as profit disgorgement for a breach of fiduciary duty. It found, however, that the confidentiality agreement between the parties in this case didn’t create a fiduciary relationship.

Circumstances related to the agreement’s execution also failed to create such a relationship.

Because the defendant owed no fiduciary duty to the plaintiff, the disgorgement award was improper, and the appellate court reversed it.

If you have questions about this, or any other matter, visit www.warrenaverett.com to learn more about our Fraud and Forensic services, as well as Business Valuation and Litigation Support Services.

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