R&D spend increases the value of trade secrets – are you protecting them?

December 2023 | SPOTLIGHT | INTELLECTUAL PROPERTY

Financier Worldwide Magazine

December 2023 Issue

According to Visual Capitalist, the top 10 Nasdaq companies averaged a 30 percent or more increase in research and development (R&D) spending over the last 24 months. Seven of these 10 spend over 10 percent of their total revenue on R&D annually, adding up to $222bn. If only 20 percent of those assets qualify as ‘trade secrets’ (a number likely to be low), that equates to $44bn in uninsured assets in these 10 companies alone.

These are staggering numbers that show the increase in investment and the velocity of innovation companies are seeking in the age of artificial intelligence (AI), crypto, green energy, autonomous vehicles, AgTech, FinTech, and the list goes on. If a company has not done so already, now is the time to get arms around trade secret misappropriation risk.

R&D is where most trade secrets live, although unlike patents, trade secrets can include business processes (such as logistics and manufacturing) and strategic information (such as acquisition, sales, pricing and distribution) created elsewhere in the company too.

There are many advantages to keeping an innovation asset a secret, including: (i) trade secrets never ‘expire’ as long as they are still valuable and remain secret; (ii) these assets do not have to be registered or approved, saving time and lots of money on the rollout and patent prosecution process; (iii) patent applications become public, which lends to copycat inventions, and the only recourse is expensive and protracted litigation; (iv) patents can be (and more often are) overturned by the Patent Trial and Appeal Board (PTAB) so they are really almost all ‘provisional’, until they are not; and (v) there is a lot of money behind patent ‘trolling’, including litigation funding by organisations whose motives are questionable – trying to bury companies in legal fees and court battles for the purposes of bleeding them dry. Though not all litigation funding is bad – some is quite necessary, but not this kind.

But trade secrets are only ‘trade secrets’ if they are properly identified and protected. Gone are the days of using non-compete agreements as a hard hammer – and the only real protection of these critical assets. Agreements suggesting that anything marked ‘confidential’ is a trade secret and no employee can take anything with them when they leave are becoming unenforceable. Today there is much more robust IT/physical security and legal protection for these key assets. If the proposed Federal Trade Commission (FTC) ban goes through, it will be painful for companies that are not prepared.

Benefits of managing trade secret risk

Any solid risk management process follows the same fundamental steps: identify, value the risk, assess countermeasures, insure where possible and recover. Yet the vast majority of companies do not follow this process when it comes to intellectual property (IP). They absolutely should.

Once a company creates a culture of documenting (on blockchain ideally) the innovation assets as they create them (including how they are protecting them and who has access), this documentation will both prove the existence and ownership of that trade secret and provide the added bonus of staving off frivolous patent infringement litigation from third parties.

Once identified, the value of a company’s ‘crown jewels’ can be determined. This is when the discussion with potential investors or buyers becomes totally different. Once the trade secrets have been valued, they can be insured for misappropriation enforcement and forensic expenses, as well as the predetermined value of the trade secret asset. Unfortunately, it is not uncommon for trade secret theft to result in losses in the nine or even 10 figure range.

What does trade secret insurance cover?

The average costs to take a trade secret action to trial are $4.2m and it takes on average 2.7 years (much higher for bigger secrets). Much of the time the defence prevails, and this time and money is wasted, largely because companies simply cannot demonstrate they actually had trade secrets.

Assuming due diligence shows appropriate trade secret asset risk management (TSARM), the insurance can cover misappropriation response and recovery expenses and the value of the covered assets themselves. The availability of this insurance is nascent, but as demand grows, capacity will grow too.

Financing and investment ecosystem in the making

There is an entirely new, untapped ecosystem here, once lenders accept the value of these assets, backed by insurance proceeds, as collateral. Similarly, venture capital and private equity firms can now protect, value and insure their investments.

Property insurance is required for a bank to offer a mortgage loan to a company using its buildings as collateral. Without insurance for the perils most likely to devalue the asset, lenders will not play ball. And in order to get insurance, the owner must have certain construction and protection standards in place. Furthermore, and even without a lender requiring a company to have it, if a company’s most valuable asset is coastal real estate, it is going to buy insurance against wind, storm surge and flood, among others.

Insurance for trade secrets will have the same effect, but it has not been available until now.

As for investors, today they carry the very real risk of misappropriation when investing in highly innovative companies, with little to no recourse. In 2022, 1156 misappropriation cases were litigated in federal district courts – a low number compared to overall claims because the vast majority never see a courtroom. It is a much bigger problem than most people realise.

Regulation and legislation

As of today, there is no regulatory requirement around any of the steps in a risk management process. These steps should include, first, identifying for shareholders or other stakeholders what a company’s trade secret misappropriation risk is. Second, knowing the approximate and relative value of these assets. Third, applying the proper resources (reasonable measures) to protect them. And fourth, having a financial backstop like insurance if there is a catastrophic loss (several trade secret cases have resulted in $1bn-plus verdicts or settlements in the past three years).

Even for critical infrastructure industries, there is little to no public requirement around reporting or disclosure of a theft and misappropriation when it happens. But why not? Assets which truly represent a competitive advantage, are far more valuable to individual companies and to the economy as a whole than personally identifiable information (PII) or protected health information (PHI), yet those are the assets protected by law and regulation today. It makes no sense.

Tangential to cyber risk, trade secret assets are just a different kind of confidential information, and much more valuable than PII. Yet cyber insurance is now a staple; a mandatory requirement for investors, customers, vendors and anyone else with a vested interest. We are certainly some way off from this now, but a change in legislation or regulation could catapult trade secret insurance to the fore.

A robust TSARM process, similar to existing property and cyber risk management programmes, dramatically decreases the likelihood of a loss in the first place.

Director and officer implications

If a shareholder of a company whose value is largely based on IP (for example Google for its algorithms or Amazon for its logistics and supply chain efficiency), and that IP is not well protected, walks out to the door to a competitor, then that company is either not even aware of it or cannot do anything about it because it did not protect its IP as a trade secret, and the stock price tanks as a result, then the company is not going to be happy. How can it assert the ‘prudent person rule’ if it does not know what or where the trade secrets are or how they are being protected?

Most senior executives (and board members) do not know what their company’s trade secrets are or the value of them. There are many reasons for this, the most important of which is that they have not been educated properly on what, exactly, a trade secret is. It is an admittedly difficult legal area, and we live in a ‘patent or die’ culture, so it makes sense that there is a far better understanding of patents. This is all changing. Trade secrets are becoming the new favoured way of protecting IP by necessity. Risk managers and in-house counsel can educate their boards on what is at stake before a massive lawsuit comes in or a company’s most valuable asset walks out the door, and they are caught flat footed.

Eventually, the Securities and Exchange Commission (SEC) and plaintiff bar will catch on and this will become a boardroom issue overnight. Implementing a formal way of protecting trade secrets should insulate boards and prevent the worst potential outcome of trade secret theft: bankruptcy.

Conclusion

Trade secrets, particularly the ones furthest along the development chain in R&D or already in use, can be more valuable than any other assets a company has. They are only ‘trade secrets’ if they are independently developed, have value largely based on the fact that no one else has them, are protected using ‘reasonable measures’ (a minefield for interpretation), which one could argue should be at least as robust as the measures taken to protect PII, and they must be difficult or very difficult to reverse engineer without using ‘improper means’. That definition has a lot of hair on it. Each factor of this litmus test must be met with intention, and the implementation of an automated process to manage this risk is critical. It is a challenge, but it is doable.

Mary Guzman is chief executive officer and founder of Crown Jewel Insurance. She can be contacted by email: mguzman@crownjewelinsurance.com.

Mary Guzman

Crown Jewel Insurance