February 2010     Vol. 32, No. 11

MCLE Article: Weapon of Choice

The state supreme court may have to decide whether the California Uniform Trade Secrets Act preempts common law claims

By Adam Kargman and Don A. Hernandez

Adam Kargman is an associate and Don A. Hernandez is the managing partner at Hernandez Schaedel & Olson, LLP. Their practice focuses on intellectual property, healthcare, and general business litigation.

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For years, trade secret plaintiffs have asserted claims under the California Uniform Trade Secrets Act (CUTSA) in tandem with claims for interference with contractual relations and unfair competition.1 The ability of plaintiffs to assert these sibling claims has gone largely unchallenged in California, until last year. In K.C. Multimedia, Inc. v. Bank of America Technology and Operations, Inc.,2 the Sixth District of the California Court of Appeal significantly changed the landscape for trade secret practitioners in what appears to be the first published opinion directly on the subject in California. The K.C. Multimedia court ruled that CUTSA preempts all common law claims arising from the "same nucleus of facts."

The ruling affects every action in California containing an alleged or prospective trade secret claim. Claimants who do not carefully plead interrelated common law claims risk having those claims preempted under CUTSA--a statute that contains serious restrictions for claimants. Among those limitations are a cap on exemplary damages and a provision that those damages can only be awarded by the court.

CUTSA was enacted in 1984 to provide trade secret owners with remedies against misappropriation, including injunctive relief, damages, recovery of amounts of unjust enrichment, and, in some cases, payment of a reasonable royalty and attorney's fees.3 While the latter three remedies are not available under common law, damages (including exemplary damages) and injunctive relief are recoverable in common law business interference cases.4 CUTSA was modeled heavily on the Uniform Trade Secrets Act,5 which the National Conference of Commissioners on Uniform State Laws approved in 1979 to clarify the common law and provide uniformity among the states.6

In K.C. Multimedia,7 the plaintiff-appellant, a supplier of technology services, claimed that banking customers and a former employee misappropriated the source code from K.C. Multimedia's banking application. Alleging that the source code was a trade secret, K.C. Multimedia asserted claims for violation of CUTSA, breach of confidence, tortious interference with contract, and unfair competition. Shortly before trial, the trial court dismissed the causes of action for breach of confidence, interference with contract, and unfair competition on the grounds that they were preempted by CUTSA.8 The facts do not clearly establish that the parties disputed whether the source code constituted a trade secret. One of the essential, and generally highly contested, elements of a trade secret misappropriation claim is whether a claimed trade secret actually satisfies the statutory criteria for being one.9

On appeal, K.C. Multimedia first challenged the procedural basis for the trial court's ruling. It argued that the court erred by ruling on the preemption question without first hearing evidence.10 Because K.C. Multimedia had failed to make an objection on the record, the court of appeal ruled that the procedural challenge had been forfeited.11

K.C. Multimedia then attacked the substantive basis of the trial court's ruling. It did so by relying upon CUTSA Section 3426.7(b). Section 3426.7 addresses preemption, with subsection (b) delineating that "[t]his title does not affect (1) contractual remedies, whether or not based upon misappropriation of a trade secret, (2) other civil remedies that are not based upon misappropriation of a trade secret, or (3) criminal remedies, whether or not based upon misappropriation of a trade secret." K.C. Multimedia argued that because subsection (b) only addresses what is not affected, the court should interpret any preemption narrowly.12

The court of appeal disagreed, reasoning that "CUTSA's ‘comprehensive structure and breadth' suggests a legislative intent to occupy the field."13 The court further noted that the language in subsection (b)(2) that "[t]his title does not affect...other civil remedies that are not based upon misappropriation of a trade secret" would "‘appear to be rendered meaningless if, in fact, claims which are based on trade secret misappropriation are not preempted by the state's statutory scheme.'"14 The appellate court then affirmed the trial court's ruling that because CUTSA "preempt[s] claims based on the same nucleus of facts as trade secret misappropriation," the appellant's alternative civil claims were preempted.15

Difficult to Reconcile

To practitioners who have followed federal law on the issue of preemption, the court of appeal's holding may not be surprising.16 Furthermore, the California Supreme Court, in Cadence Design Systems, Inc. v. Avant! Corporation, may have signaled the direction the law would take when it noted, in dicta, that if a continuing misappropriation occurred before and after the 1985 effective date of CUTSA, "the claim must be divided in two...one common law claim...and one [CUTSA] claim."17

Nonetheless, the court of appeal could have interpreted the statute to compel a different rule. As the court in K.C. Multimedia acknowledged, CUTSA does not explicitly address, one way or the other, whether "other civil remedies based upon misappropriation" are preempted.18 By contrast, the corresponding provision of the Uniform Trade Secrets Act unambiguously states that the act "displaces" common law claims: "Except as provided in subsection (b), this Act displaces conflicting tort, restitutionary, and other law of this State providing civil remedies for misappropriation of a trade secret."19

Notably, the California Legislature failed to adopt this provision--although it adopted the Uniform Trade Secrets Act in all other respects "without significant change."20 This could indicate that the legislature intended to preserve the rights of trade secret claimants to bring common law claims.21 In a state that depends heavily on intellectual property rights, it makes sense to give the broadest possible protections to trade secret owners. On the other hand, if the legislature's primary goal was to create uniformity with the laws of other states, it follows that courts will read "displacement" language into the statute.

Arguably, K.C. Multimedia conflicts with prior California case law, which would be a principal basis for challenging the decision. Most notably, in Reeves v. Hanlon--decided by the California Supreme Court two years after Cadence Design Systems--a law firm sued former employees for, among other claims, violation of CUTSA and tortious interference with contractual relations. The claims were premised on the defendants' misappropriation of confidential client information.22 After judgment was entered in favor of the plaintiffs, the court of appeal affirmed, finding that both the CUTSA and interference claims were substantially supported by the record and legally sound.23 At issue before the California Supreme Court was the propriety of the award for violation of CUTSA, and whether the plaintiff could recover under an intentional interference theory. The supreme court affirmed the court of appeal's judgment in its entirety.24

Similarly, in ReadyLink Healthcare v. Cotton,25 the Fourth District Court of Appeal affirmed the trial court's issuance of a preliminary injunction in favor of a provider of nursing services against a former agent. The court ruled that there was ample evidence the plaintiff was likely to prevail on its CUTSA and unfair competition claims. Significantly, both claims shared the same nucleus of facts.26 Likewise, in Fleishman v. Superior Court, the Second District Court of Appeal held that a preliminary injunction applied to CUTSA and common law claims for misappropriation of trade secrets.27

While none of these opinions directly addresses CUTSA preemption, their holdings seem to implicitly recognize that a party can recover under CUTSA as well as an alternative civil theory--even if both are premised on a misappropriation of trade secrets. Thus it is difficult to reconcile these cases--and most particularly Reeves--with the outcome in K.C. Multimedia.

Federal District Court Rulings

To date, only three cases have addressed K.C. Multimedia, and all of them are federal district court opinions. The first, Think Village-Kiwi, LLC v. Adobe Systems, Inc.,28 recognized that K.C. Multimedia presents somewhat of a Catch-22 for claimants. In Think Village, the plaintiff sought to amend its complaint--which asserted a cause of action under CUTSA--to also include claims for common law misappropriation and breach of confidence. The defendants argued that the amendment would be futile because the proposed claims were preempted. The plaintiff did not challenge CUTSA's preemptive effect but argued that it should be allowed to plead the claims as alternative theories.29

The district court agreed with the plaintiff. It reasoned that because the status of the information was still a matter of allegation, and it had not yet been proven whether the information was entitled to trade secret protection, preemption would be premature. If the information was protectable other than as a trade secret, then CUTSA, pursuant to the express limitation embodied in Section 3426.7(b)(2),30 would not apply.31 This more cautious, wait-and-see attitude comports with the approach taken by several other federal courts.32

In the second case, Aversan USA, Inc. v. Jones,33 plaintiff Aversan, a provider of software engineering services, sued two former employees who had begun contracting directly with one of Aversan's customers while impermissibly using Aversan's propriety software. The defendants argued that K.C. Multimedia favored dismissal of Aversan's claims for interference with contractual relations, interference with prospective economic advantage, breach of duty of loyalty, and unfair competition.

As pled, the allegations underlying the claims did not specifically mention trade secrets. Indeed, two of the claims--interference with prospective economic advantage and unfair competition--focused mainly on alleged false representations by one of the defendants that the defendants continued to work for Aversan. Because the "nuclei of fact" appeared to be different, the district court held that the new claims were independent of the CUTSA claim.34 The court expressly stated that it was not reaching the issue of whether, had the new claims involved similar facts, Aversan could plead them as alternative theories.35

Most recently, in Phoenix Technologies Ltd. v. DeviceVM,36 a systems software developer, Phoenix Technologies, asserted CUTSA, tort, and Unfair Competition Law claims against DeviceVM and a former Phoenix employee arising from alleged trade secret theft. The defendants moved to dismiss the non-CUTSA claims on grounds of preemption. The court acknowledged that "most of the allegations...concern Defendants' use of information that appears to fall within the definition of a ‘trade secret' under CUTSA."37 However the court--as in Think Village--refused to dismiss any of the challenged claims at the pleading stage. Instead, it construed them as not based on the same nucleus of facts as the CUTSA claim but noted that "[i]f, following discovery, there is not sufficient evidence to support these claims based on a distinct nexus of facts, Defendants may move for summary judgment at that time."38

The court also enunciated its view that K.C. Multimedia did "not undermine the analytic framework...allowing claims to go forward where the gravamen of the claims does not rest on the misappropriation of trade secrets."39 Thus, Phoenix Technologies is the third federal case in a row that seems to place limitations on K.C. Multimedia.

Practical Effects

Until another court of appeal disagrees or the California Supreme Court addresses the issue, K.C. Multimedia must be viewed as controlling in all trial courts in this state.40 Litigants therefore must assume that all common law claims bearing the "same nucleus of facts" as a claim under CUTSA will be preempted by the statute.

CUTSA preemption has several practical effects. While exemplary damages are available under CUTSA upon a showing that the misappropriation is "willful and malicious," the court--not the jury--assesses the amount of exemplary damages.41 Moreover, these damages are capped at twice the amount of actual damages or unjust enrichment.42 By contrast, claims for intentional interference with contract or prospective economic relations involve no restrictions on the amount of available exemplary damages.43

Another effect, alluded to by the district court in Think Village, may be to foreclose plaintiffs from recovering anything at all in the event that they are unable to demonstrate the existence of a trade secret pursuant to the criteria in CUTSA.44 To avoid the possibility of preemption, plaintiffs could follow the guidance suggested by the district court opinion in Aversan: avoid trade secret allegations entirely, except when pleading direct violations of CUTSA. That approach, however, limits potential remedies and risks sacrificing viable suits involving information that may still be protectable even if it does not quite rise to the level of a trade secret under CUTSA.

Defendants also face a predicament. When a CUTSA claim has not been asserted, defendants must proceed with caution in determining whether to raise the preemption defense. A successful preemption challenge will subject defendants to CUTSA's unjust enrichment remedy. That added exposure should be measured against the amount of uncapped exemplary damages that could be awarded under the common law claim.

Whether the California Supreme Court will uphold K.C. Multimedia is far from clear. Until the law is clarified further, however, the dilemmas that the case evokes will plague parties on both sides of trade secret litigation.

Endnotes

1 See, e.g., Reeves v. Hanlon, 33 Cal. 4th 1140, 1147, 1156 (2004) (Plaintiff's claims under CUTSA and for intentional interference were substantially supported
by record.).
2 K.C. Multimedia, Inc. v. Bank of Am. Tech. & Operations, Inc., 171 Cal. App. 4th 939 (2009).
3 California Uniform Trade Secrets Act (CUTSA), Civ. Code §§3426-3426.11 (remedies, Civ. Code §§3426.2-3426.3).
4 See Pacific Gas & Elec. Co. v. Bear Stearns & Co., 50 Cal. 3d 1118, 1130 n.9 (1990) ("Injunctive relief is available to restrain unjustified interference with
contractual relations when damages would not afford
an adequate remedy."); Anglo-American Gen. Agents v. Jackson Nat'l Life Ins. Co., 83 F.R.D. 41, 45 (D.C. Cal. 1979) (applying California law) ("It is not disputed...that punitive damages may be awarded for the tort of intentional interference with economic relations.").
5 See Cadence Design Sys., Inc. v. Avant! Corp., 29 Cal. 4th 215, 220 (2002) (discussing legislative history of CUTSA).
6 The National Conference of Commissioners on Uniform State Laws, Why States Should Adopt the...Uniform Trade Secrets Act (visited Dec. 9, 2009), http://www.nccusl.org/Update/uniformact_why/uniformacts-why-utsa.asp (discussing how common law regarding trade secrets has become muddled and noting the problem of variations in state laws).
7 K.C. Multimedia, 171 Cal. App. 4th 939.
8 Id. at 945. The procedural context of the dismissal was somewhat unusual. The defendants first raised the issue of statutory preemption in their trial brief. The trial court dismissed the three claims on its own motion. Before ruling, the court gave K.C. Multimedia a chance to respond orally and in writing, and K.C. Multimedia did not object. Id. at 948.
9 Civ. Code §3426.1(d): A plaintiff must establish that the information at issue "(1) Derives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use; and (2) Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy."
10 K.C. Multimedia, 171 Cal. App. 4th at 948.
11 Id. at 950.
12 Id. at 957.
13 Id. (quoting AccuImage Diagnostics Corp. v. Terarecon, Inc., 260 F. Supp. 2d 941, 953 (N.D. Cal. 2003)).
14 Id. at 958 (quoting Digital Envoy, Inc. v. Google, Inc., 370 F. Supp. 2d 1025, 1035 (N.D. Cal. 2005)).
15 Id. at 962. Earlier in the litigation, K.C. Multimedia had conceded that each cause of action rested on the same factual underpinnings of trade secret misappropriation. Id. at 959 & n.8.
16 See, e.g., AccuImage, 260 F. Supp. 2d at 954 (CUTSA preempts common law misappropriation claims.); Axis Imex, Inc. v. Sunset Bay Rattan, Inc., No. 08-3931, 2009 WL 55178, at *5 (N.D. Cal. Jan. 7, 2009) (CUTSA preempts claims for unfair competition and for intentional interference with prospective economic advantage.).
17 Cadence Design Sys., Inc. v. Avant! Corp., 29 Cal. 4th 215, 224 (2002).
18 K.C. Multimedia, 171 Cal. App. 4th at 957; see I. E. Assocs. v. Safeco Title Ins. Co., 39 Cal. 3d 281, 285 (1985) ("The general rule is that statutes do not supplant the common law unless it appears that the Legislature intended to cover the entire subject or, in other words, to 'occupy the field.'") (citations omitted).
19 Uniform Trade Secrets Act §7(a).
20 See Cadence Design Sys., 29 Cal. 4th at 221.
21 See K.C. Multimedia, 171 Cal. App. 4th at 956 ("'[W]hen a Legislature models a statute after a uniform act, but does not adopt the particular language of that act, courts conclude the deviation was deliberate and the policy of the uniform act was rejected.'") (quoting Hughes Elecs. Corp. v. Citibank Del., 120 Cal. App. 4th 251, 258 (2004)).
22 Reeves v. Hanlon, 33 Cal. 4th 1140, 1145-46 (2004).
23 Id. at 1147.
24 Id. at 1156.
25 ReadyLink Healthcare v. Cotton, 126 Cal. App. 4th 1006 (2005).
26 Id. at 1017-21.
27 Fleishman v. Superior Court, 102 Cal. App. 4th 350, 358 (2002).
28 Think Village-Kiwi, LLC v. Adobe Sys., Inc., No. 08-4166, 2009 WL 902337 (N.D. Cal. Apr. 1, 2009).
29 Id. at *2.
30 See text, infra.
31 Think Village, 2009 WL 902337, at *3.
32 See Ali v. Fasteners for Retail, Inc., 544 F. Supp. 2d 1064, 1070 (C.D. Cal. 2008) (Issue of CUTSA preemption raised in motion to dismiss pursuant to Federal Rules of Civil Procedure 12(b)(2) and 12(b)(6) was "premature."); First Advantage Background Servs. Corp. v. Private Eyes, Inc., 569 F. Supp. 2d 929, 942 (N.D. Cal. 2008) (Common law claims could proceed unless it was established that confidential information constituted trade secrets.); Callaway Golf Co. v. Dunlop Slazenger Group Americas, Inc., 295 F. Supp. 2d 430, 437 (D. Del. 2003) (Party could assert alternative theories of recovery if information does not qualify as a trade secret under CUTSA.).
33 Aversan USA, Inc. v. Jones, No. 2:09-00131, 2009 WL 1810010 (E.D. Cal. June 24, 2009).
34 Id. at *4-5.
35 Id. at *5 n.3.
36 Phoenix Techs. Ltd. v. DeviceVM, No. C 09-04697, 2009 WL 4723400 (N.D. Cal. Dec. 8, 2009).
37 Id. at *5.
38 Id.
39 Id.
40 See, e.g., Sarti v. Salt Creek Ltd., 167 Cal. App. 4th 1187, 1193 (2008) (recognizing that "'[d]ecisions of every division of the District Courts of Appeal are binding upon all the justice and municipal courts and upon all the superior courts of this state'" if not disapproved by the California Supreme Court and not in conflict with another appellate decision) (quoting Auto Equity Sales, Inc. v. Superior Court, 57 Cal. 2d 450, 455 (1962) (emphasis in original)). Other districts of the California Court of Appeal are not bound by K.C. Multimedia and may take a different approach. Sarti, 167 Cal. App. 4th at 1193-94.
41 Civ. Code §3426.3(c).
42 Id.
43 See Civ. Code §3294(a); BAJI 14.71 (Spring 2009 ed.). On the other hand, unjust enrichment and attorney's fees, which are available under CUTSA, are not available for business interference torts. See Civ. Code §§3426.3(a), 3426.4; BAJI 7.89.
44 In certain circumstances, a plaintiff may maintain other claims based on misappropriated information even when the information does not meet the criteria of a trade secret. See Combined Metals of Chicago Ltd. P'ship v. Airtek, Inc., 985 F. Supp. 827, 830 (N.D. Ill. 1997) (Plaintiff could fall back on claim for breach of fiduciary duty when information at issue--design information for catalytic converter parts--may not qualify as a "trade secret" under Illinois Trade Secret Act.); Fidelity Appraisal Co. v. Federal Appraisal Co., 217 Cal. 307, 314-15 (1933) (In certain instances, a plaintiff may maintain unfair competition claim based on misappropriation if confidential information is not involved.); Rigging Int'l Maint. Co. v. Gwin, 128 Cal. App. 3d 594, 609 (1982) (construing Fidelity Appraisal Co. and "assum[ing]...that Fidelity does not require a finding that the defendants used or possessed confidential information").

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