Intellectual
Property Litigation

March
1992

VOL.
IV, No. 2

 

 

A publications of the American Bar Association
Section of Litigation, Committee on International Properties Litigation © 1992
American Bar Association, Section of Litigation, All Rights Reserved

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

This Journal is
published quarterly by the Intellectual

Properties
Litigation Committee of the American Bar

Association’s
Litigation Section.

 

David Nimmer, Co-Chairperson

Janet T. Musa.
Co-Chairperson

Bradfrod P. Lyerla,
Editor-in-Chief

 

The views
expressed in this Publication are those of the

authors and do
not necessarily reflect the position of the

American Bar
Association or the Intellectual Properties

Litigation
Committee. Contributions to this Journal may

be sent to:
Bradford P. Lyerla, Jenner & Block, One IBM

Plaza, Chicago,
Illinois 60611. 312-222-9350

 

 



 



 

 

 

 

 

 

 

 

 

 

GUEST ARTICLE

 

Thomas M. Neches,
CPA

Sabrina A. Thomas1

Simpson &
Company

Los Angeles,
California

 

Expert Accounting Assistance In Intellectual Property Litigation

 

As
the stakes in intellectual property litigation have increased, so have the role
and significance of the expert accountant. The analysis and trial testimony of
a certified public accountant (“CPA”) on liability and damage issues is often
central to sustaining or rebutting a claim. This article discusses ways in
which attorneys can make the most effective use of the services of an
accounting expert in intellectual property litigation.

Document
Requests

One
of the most useful and cost-effective contributions of the CPA early in the
litigation is to assist in the preparation of document requests. First, the CPA
should obtain a preliminary understanding of the case through discussions with
the attorney and a review of existing documents. The CPA can then assist by
listing specific documents needed using correct nomenclature. This may require
no more than a few hours of effort, yet the potential benefits can be dramatic.
This is particularly the case in intellectual properties litigation, in which
financial and accounting evidence is central.

            CPA assistance in preparing requests
for financial and accounting documents reduces the likelihood that the opposing
party will take advantage of loopholes in the wording of a request to avoid
turning over documents. For example, the requests may specify that audited financial statements be produced
when only reviewed or compiled financial statements exist. The
CPA can also assist by preparing affidavits explaining why particular documents
are needed.

            Attorneys should call upon the CPA
to clarify vaguely worded documents requests. An example would be a request to
produce “all financial records from 1982 to the present.” Such poorly worded
requests often result in one of two undesirable outcomes. First, the opposition
may object to the request as vague, overbroad, unduly burdensome and lacking in
reasonable particularity. Expensive and time-consuming motions and hearings often
ensue. Alternatively, the opposition may produce voluminous documents, most of
which are uninteresting, but which force the attorney and expert to expend
valuable time to extract the necessary information. Both unpleasant outcomes
can be avoided or their effects minimized by using the CPA to assist in
developing document requests.

            The Judicial Conference Advisory
Committee on Civil Rules has proposed amendments to the Federal Rules of Civil
Procedure and to the Federal Rules of Evidence which affect discovery
procedures, in particular document requests.1
The proposed rules seek to shift discovery from its traditional adversarial
mode by requiring parties voluntarily to disclose relevant documents.

Damage
Analysis

            Litigators most commonly think of
CPAs in the context of damage analysis. Indeed, this is the most common task
for accounting experts in intellectual property disputes.

Sales
Trend Analysis

            The first step in intellectual
property damage analysis typically is to determine sales trends of infringed,
infringing and collateral products. Sales trend analysis frequently is
important in the liability phase as well. The plaintiff will attempt to blame
sales declines on the infringer’s actions, while a defendant will attempt to
correlate changes in sales trends to other economic or business factors.

            The expert should get beneath the
sales figures provided in accounting statements. For example, a perceived
variation in sales trends may be the result of a change in accounting treatment
rather than the impact of an alleged infringer’s actions. In one case an
economist retained by the defendant testified that there were no damages
because the plaintiff’s financial statements showed an increase in sales. In
fact, the perceived sales increase was the result of a change in accounting
policy to record revenue on the accrual rather than the installment basis. The
plaintiff’s CPA discovered this fact while interviewing the company chief
financial officer and used it to discredit the defendant’s expert’s analysis.

            Attorneys should schedule meetings
with the client’s accounting and financial personnel to assist the CPA in
obtaining this type of significant information. The CPA should prepare
questions for and attend the depositions of financial and accounting personnel
of the opposing party. The CPA should also prepare clear, graphic exhibits of
sales trends. Figure 1 provides an example of actual and projected sales as
well as lost sales3.

Marginal
and Average Profit

            The appropriate measure of damages
in intellectual property disputes usually is marginal profit (the profit earned
by selling additional units) rather than average profit. In most businesses,
fixed expenses (e.g., rents, officer salaries) do not increase with an increase
in sales. As a result, the marginal profit earned by selling extra units
typically is greater than the average profit of all units sold.

            To calculate marginal profit, the
CPA undertakes an analysis in which expenses are segregated into fixed and
variable components. Only expenses which vary with changes in sales are
included in calculating marginal profit. Determining whether expense items are
variable or fixed is not a mechanical process. It requires judgment and an
understanding of the workings of the business. Interviews with client personnel
and depositions of opposing party witnesses and experts are valuable sources to
obtain this understanding. The attorney should work with the CPA to facilitate
this process. Figure 2 provides an example of a marginal profit analysis.

Lost
Profits

            The plaintiff, as the owner of
intellectual property rights, may seek recovery for lost profits from a variety
of causes, including:

            Diverted Sales. These are
sales the plaintiff lost to the infringer. Diverted sales may be calculated as
a fraction of the infringer’s sales. The attorney should work with the CPA,
other experts and fact witnesses to identify and quantify factors which affect
the infringer’s and the plaintiff’s sales.

            Reduced Selling Price. Often the owner of an infringed product must
lower the selling price to compete with the lower prices at which infringing
items are sold. This reduces the profits on all sales of the infringed item.
The CPA often can substantiate or rebut claims for lost profits due to reduced
selling price by analyzing industry average prices and the prices of analogous,
non-infringed products sold by the owner. The CPA may actions which affect
prices and communicate the findings to the attorney.

            Diminished Market. Inferior
quality infringing products can reduce overall demand. A consumer disappointed
by the quality of an infringing item may not choose to purchase a second
(either from the owner or the infringer) or recommend the product to friends.
Contrasting the market sales trend of the infringed item to comparable products
is a frequently-used approach to substantiate or refute a claim for lost
profits due to diminished market.

Damage
Models

            In preparing a damage model the CPA
must be able to adapt the analysis rapidly to a constantly changing litigation
environment. Claims for individual elements of lost profits may be stronger or
weaker depending on the facts and circumstances of the case. The litigator may
decide to modify the damage claim presented at trial based on court rulings,
the flow of evidence, jury reactions, time constraints or other factors. When
liability and damages are bifurcated and multiple liability claims are
presented (e.g., trademark infringement, antitrust and unfair competition),
prior to the conclusion of the liability trial the combination of damage claims
sustained will be unpredictable.

            To maintain the necessary
flexibility, the CPA should calculate each damage element separately and be
prepared to testify to the appropriate damages as the exigencies of trial
dictate. This can be facilitated by computerized damage models in which
individual damage elements are calculated and stored separately so that the
elements can be aggregated or deleted as needed. Figure 3 illustrates an
example of such a model.

Damage
to Goodwill

            Attorneys in intellectual property
disputes at times fail to seek to recover for damage to a company’s reputation,
also known as damage to goodwill. Perhaps the attorney does not see a way to
quantify the impact an inferior quality infringing product has on the
reputation of a firm. It may not be immediately apparent to the attorney how a
CPA can assist in such a calculation.

            The role of the CPA in calculating
damage to goodwill becomes clear once it is understood that the economic impact
of damage to a company’s reputation is its reduced ability to earn future
profits. The CPA can calculate damage to goodwill as the discounted present
value of future lost profits.

            Damage to goodwill can be presented
to the trier of fact either as a separate damage elements or as part of the
lost profits damage calculation. Each approach has advantages and
disadvantages. “Future lost profits” may be deemed speculative while “lost
value of the business” may appear concrete, even though the actual calculations
may be identical. On the other hand, lost future cash flow may be more
compiling to a jury than a “value” placed on reputation. The litigator must
work closely with the CPA to incorporate these considerations in the expert’s
analysis and the litigator’s pleadings and arguments.

Reasonable
Royalty

            CPAs assist in reasonable royalty
analysis by determining the profitability of infringing and related products.
This is an essential element of the “analytical approach.” In which a
reasonable royalty is calculated as the excess profit – above the profit the
infringer ordinarily would have accepted – resulting from the desirable but
infringing characteristics of the object. This is often estimated by comparing
the profit earned on sales of the infringing object to the infringer’s “normal”
profit on other, non-infringing items. Often the expert will use the analytical
approach as a starting point for conducting a hypothetical negotiation between
willing licensor and willing licenses, a second method to determine a
reasonable royalty.

Summary

            CPAs are an essential part of a
successful intellectual property claim or defense. Although, current practice
favors bringing in CPAs at the last minute, the full benefits of expert
assistance can be better achieved if CPAs are brought in early to deal with
discovery issues. This often can reduce the total cost of expert assistance.
CPAs can be utilized in determining damages, calculating reasonable royalties
and analyzing liability issues.

ENDNOTES

[1]   Thomas Neches is Senior Partner and Sabrina
Thomas is an associate of Simpson & Company, a firm of certified public
accountants providing litigation services, including expert witness testimony,
damage claims and investigative accounting. Mr. Neches specialize in
intellectual property and antitrust litigation. The authors gratefully
acknowledge the contributions to this article of Cindy A. Holdorff,
CPA Matthew R. Graczyk.

[2] Preliminary
Draft of Proposed Amendments to the Federal Rules of Civil Procedure and the
Federal Rules of Evidence
, Committee of Rules of Practice and Procedure of
the Judicial Conference of the United States, Administrative Office of the
United Stated Courts, August 1991. Proposed Rule 26 states:

“Each party shall, without awaiting a discovery
request
, provide to every other party a copy of, or a description by
category and location of, all documents, data compilations, and tangible things
in the possession, custody, or control of the party that are likely to bear
significantly on any claim or defense… These disclosures shall be made (i) by a
plaintiff within 30 days after service of an answer to its complaint: (ii) by a
defendant within 30 days after serving its answer to the complaint… The
disclosure should describe and categories the nature and types of documents,
including computerized data, “sufficiently to enable opposing parties (1) to
make an informed decision concerning which documents should be examined, at
least initially, and (2) to frame their document requests in a manner likely to
avoid squabbles resulting from the wording of the requests.”

The proposed amendments have not been
submitted to or considered by Judicial Conference of the United States or the
Supreme Court. If adopted they would be effective December 1, 1993.

[3]   See pages 8, 9 and 10 for Figures 1, 2 and 3
respectively. All names and values used in Figures 1, 2 and 3 are fictitious
and for use only in this article.

 

 



 




 

Figure 1

 

 



 




IF YOU HAVE ANY QUESTIONS, PLEASE CALL THOMAS NECHES DIRECTLY AT 213.624.8150.

CONTACT US