Top 10 Things to Focus On When Conducting Due Diligence in a Trade Secret Acquisition (Part One)
As a transactional lawyer, what are the key things that you should focus on in due diligence to determine whether the trade secret your client is considering acquiring is treasure or trash? Anyone can read the various state trade-secret statutes. This article’s purpose is to go beyond the skeletal description contained in the statutes and flesh out the statutory definition with a litigator’s experience regarding what the arbitrators and juries are likely to protect as trade secrets. Accordingly, here are the first five things from a litigator’s perspective that a transactional lawyer should examine when they are conducting trade secret due diligence.
1. Precise Definition
The seller needs to provide the precise description of the trade secret. If there is more than one trade secret being acquired, there should be a detailed schedule as part of the acquisition. Definitions allow the parties to avoid disputes about what was actually sold. Moreover, a precise definition allows the buyer to compare the trade secret to a particular state’s statutory definition and the case law interpreting that definition. The statutory definitions in each state can vary widely, so having a precise definition of what you are purchasing can be critical. For instance, some states include customer lists in the definition of trade secrets, while others do not.
Additionally, a seller’s inability to provide a precise definition is a red flag that signals that information may not be protectable as a trade secret. As a general rule of law, judges and juries are more likely to protect a thing versus a concept. For instance, the court may treat a complex, detailed and lengthy swim instruction manual as a trade secret, while not protecting the general concept of swim instruction as a trade secret. One of the tests that I use to evaluate the strength of a potential trade secret claim in a litigation context is the one-sentence trade-secret test. If a client cannot describe to me its trade secret in one sentence, it is a sign that we are facing an uphill battle.
The seller should closely examine the genesis of the trade secret’s development. Understanding how the trade secret came about is important in at least three respects. First, it helps establish that the buyer actually owns the trade secret. Wyeth v. Natural Biologics, Inc., 395 F.3d 897 (8th Cir. 2005) is an example of what can go horribly wrong when due diligence fails to uncover lack of ownership. Second, the difficultly and length of development will impact the trade secret’s value. The more difficult it is to create or recreate the trade secret, the more value it has. Third, examining the origins of the trade secret will help the buyer understand whether the trade secret is generally known in the industry or readily ascertainable. Information that is generally known or readily ascertainable is not protectable as a trade secret. See Minn. Stat. § 325C.01, subd. 5 (adopting standard trade-secret definition).
A buyer will want to evaluate how easily the trade secret can be reverse-engineered. If an invention can be easily reverse-engineered, it is considered readily ascertainable. Scott Equip. Co. v. Stedman Mach. Co., 2003 WL 21804868, at * 2 (D. Minn. July 31, 2003). Thus, it is not protectable as a trade secret. Oftentimes, a business will come up with a marked improvement to a product, but once the product is introduced to the market, it is easily replicated. In these circumstances, patenting the innovation may be a better route.
4. Public Filings
The buyer should examine public filings to see if the trade secret has been disclosed. Surprisingly, it is not uncommon to see trade-secret claims made regarding information that was subject to a patent or copyright filing. Generally, if the information has been publicly disclosed through filing with a governmental unit, it is unlikely to receive trade secret protection. Coenco, Inc. v. Coenco Sales, Inc., 940 F.2d 1176, 1179 n. 3 (8th Cir. 1991) (rejecting trade-secret status for information that was part of a patent application).
But the fact that some of the information that makes up a trade secret is publicly available, however, is not necessarily fatal to a trade secret claim. The question then becomes whether there are some non-public aspects of the trade secret, or whether the trade secret represents a summary of publicly available information that would be difficult to recreate without substantial effort. Avidair Helicopter Supply, Inc. v. Rolls-Royce Corp., 663 F.3d 966, 974 (8th Cir. 2011); CHS Inc. v. Petionet, LLC, 2011 WL 1885465, at * 8 (D. Minn. May 18, 2011).
In order to qualify as a trade secret, the information must gain independent value from its secrecy. Minn. Stat. § 325C.01. For example, if a competitor would have to spend substantial time and money to replicate the trade secret, it has independent value from its secrecy. Surgidev Corp. v. Eye Tech., Inc., 648 F. Supp. 661, 688 (D. Minn. 1986). In determining whether the information has independent economic value, the seller is a critical source of information. Do the seller’s audit’s, financial statements, or loan applications reflect development costs for the putative trade secret? Do the records reflect the seller placing a value on the information? The seller’s valuation is going to be the likely starting place for any arbitrator or jury that is asked to evaluate a claimed secret.