Monday, May 1, 2017

Fixed Costs and the Differential Profits Approach

Dow Chemical Co v NOVA Chemicals Corp 2017 FC 350 Fothergill J
            2,160,705 / film-grade polymers / ELITE, SURPASS

In the liability phase of this action, Dow Chemical Co v NOVA Chemicals Corp 2014 FC 844 aff’d 2016 FCA 216, O'Keefe J held Dow’s 705 patent, related to advanced film-grade “mLLDPE” polymers, to be valid and infringed by Nova: for more background see last Wednesday’s post. Fothergill J’s decision in the remedies phase addresses various issues to allow the parties’ accountants to calculate the actual sums owed by Nova to Dow [6]. Dow elected an accounting [107], and one of the issues requiring clarification was deduction of fixed costs [141]-[165].

The infringer’s profits are its revenues less its costs. The direct costs of producing the infringing goods are clearly deductible, but fixed costs such as rent and general overhead present a difficult problem. The argument against deduction is that the fixed costs would have been incurred in any event; the argument in favour is that a business is not profitable if it doesn’t cover its fixed costs. While this case raised the problem in the context of an accounting of the infringer’s profits, the problem is the same when assessing lost profit damages.

I’ll begin with an important issue of terminology. As noted by Fothergill J [143], the differential profit approach is the preferred approach, but it was not used in this case because:

[146] In this reference, Nova concedes that there were no “direct non-infringing alternatives” available for the purpose of applying the “differential profits” approach.

I would quibble with this statement, at least to emphasize the importance of the word “direct.” It’s not quite right to say that the differential profit approach can’t be applied when there are no non-infringing alternatives. In the differential profit approach, “[a] comparison is to be made between the defendant’s profit attributable to the invention and his profit had he used the best non-infringing option” (Schmeiser, 2004 SCC 34, [102]). Alternatively, the differential profit approach says that the infringer’s profits are the difference between its actual profits and the profits it would have made in “a hypothetical world where the defendant’s impugned conduct did not take place” 2016 FCA 161 [47]. These are equivalent formulations, which means that in a broad sense, the “non-infringing alternative” is whatever the infringer would have done had it not infringed. In this case, on the facts, Nova would have made lower grade products, such as “pail and crate” grade plastics [158]. In the broad sense, that is the NIA. But when Nova conceded that there were no “direct” non-infringing alternatives, what it was saying is that there were no alternative products that it could have made that would have taken any share of the market from the patented product: the pail and crate grade plastics do not compete with mLLDPE. That is a narrower use of the term “non-infringing alternative.”

The term “non-infringing alternative” tends to be used in the narrower sense, as it was used in this case. That is understandable, because when the infringer’s alternative would take market share from the patented product, that raises a host of issues, such as the size of the NIA’s market share, that do not arise otherwise. However, we shouldn’t lose sight of the fact that there is only one basic question: what is the difference between the infringer’s actual profits (or patentee’s profits, when damages are assessed) and the profits it would have made had it not infringed.

Now, turning to the issue at hand, in US law of damages fixed costs are generally excluded when determining profits: Paper Converting Mach Co 745 F.2d 11, 22 (Fed Cir 1984). The English and Australian courts, on the other hand, will allow deduction of some part of the overhead if it can be shown on the facts that, but for the infringement, the infringer would have used its capacity to manufacture non-infringing product. The leading case is Dart Industries Inc v Decor Corporation Pty Ltd [1993] HCA 54, in which the High Court stated the following:

[14] In calculating an account of profits, the defendant may not deduct the opportunity cost, that is, the profit forgone on the alternative products.

The opportunity cost is the profit that the defendant would have made if it had made a non-infringing alternative, so this is, strictly, a rejection of the differential profit approach. The High Court continued:

[14] But there would be real inequity if a defendant were denied a deduction for the opportunity cost as well as being denied a deduction for the cost of the overheads which sustained the capacity that would have been utilized by an alternative product and that was in fact utilized by the infringing product.

[15] Where the defendant has forgone the opportunity to manufacture and sell alternative products it will ordinarily be appropriate to attribute to the infringing product a proportion of those general overheads which would have sustained the opportunity. On the other hand, if no opportunity was forgone, and the overheads involved were costs which would have been incurred in any event, then it would not be appropriate to attribute the overheads to the infringing product.

If, on the facts, the infringer would have simply cut back production, and let the plant sit idle, then there is no deduction; but if it can be proven that there were indeed other opportunities that were forgone in order to make the infringing product, then the fixed costs may be deducted accordingly, though there is no deduction for the foregone profits. In effect, fixed costs are used as a partial proxy for true opportunity costs, except that the opportunity is limited to cost recovery, and excludes profit that would have been made in the “but for” world: see Duff & Phelps Group, Siebrasse & Stack, “Monetary Relief – Quantum,” in Dimock, IP Disputes 19-103-04.

Even though the Dart Industries approach is, strictly, a departure from the differential profit approach, it may nonetheless be justified on the basis of administrability. That was basically the view of McHugh J, concurring in Dart. But I wonder if there are circumstances in which a full absorption cost approach, which would deduct a portion of fixed costs even if there were no other opportunity, might make sense? All costs are variable in the long run, and suppose the infringement took place over a long period in a purpose built plant that was not suitable for any other product. (Perhaps the infringer had independently created the invention.) We might say that but for the infringement, the infringer would have let the plant sit idle, in which case the costs of the plant would not be deducted; but we might also say that but for the infringement, the infringer would not have built the plant at all, in which case a full absorption approach might be consistent with the differential profit approach. In any event, the Dart Industries approach is clearly preferable to the US approach, as opportunity costs are real costs, which should not be ignored.

In summary, the current Canadian approach, following Dart Industries, seems basically sound, though there is an argument for the pure opportunity costs approach; but the problem is inherently difficult, and different results might be warranted, particularly on unusual facts. For a discussion of the different approaches, see generally Cotter, Comparative Patent Remedies, 206-07.

Idiosyncratic costs [134]-[140]
On a different issue, Nova produced ethylene, the basic feedstock for the production of the patented plastic, at its own facility, at a significantly lower cost than the market price [137]. The question was whether the cost to be deducted should be the market price, or Nova’s actual costs [134]. Fothergill J held that Nova’s actual costs should be used, on the principle that “one must take the infringer as one finds them” [138].


  1. You're right that the U.S. doesn't deduct allocable fixed costs, or any sort of "opportunity benefit," when calculating lost profits. As I discuss in my book (p.116 & n.139), however, if we did I'm not sure that the marginal gains in accuracy would be worth the cost. Since don't award infringer's profits in utility patent cases, the converse issue of whether we should deduct allocable overhead in that context doesn't arise. In the copyright and trademark realm, however, the courts I believe are not united in their approach to the issue (see Stephen Margolis, The Profits of Infringement: Richard Posner v. Learned Hand, 22 Berkeley Tech. L.J. 1521 (2007). (I wonder what rule the courts will start following with respect to design patents?)

    I also argue in my book that, with regard to award of the infringer's profits, a differential profits approach properly applied would render the question of allocable overhead irrelevant. A deduction for allocable overhead serves as sort of a proxy for differential profits, though maybe not a very good one (see my book pp. 207-08). Do I have that right?

  2. I agree that a strict application of differential profits would take care of the question of overhead, and decision of a portion is an imperfect proxy. But I wonder if it might be justified on the same kind of administrative cost basis you mention in your first paragraph?