Litigation strategies for data breach by service providers

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This article examines a case in which the plaintiff, Shanghai Yelixiali Restaurants Management (YLXL), filed a lawsuit against the defendant, Beijing Beidazongheng Management Consultation (BDZH), and the third parties Xi’an Jiuzheyang Restaurants Management (JZY), Panfeng Qian and Xi’an Lianhu District Hongwei Beef Noodle Restaurant (HW Beef Noodle) on disputes regarding a technical service contract.

This case was a dispute over a technical service contract, and the subject matter was the final technical results as agreed in the contract. The attorneys of the plaintiff, referring to the determination of business secrets, had proved that the defendant breached the contract in the deposition and trial, and so the trial court rendered a judgment against the defendant.

王红燕 WANG HONGYAN 六和律师事务所高级合伙人 Senior Partner L&H Law Firm
王红燕
WANG HONGYAN
六和律师事务所高级合伙人
Senior Partner
L&H Law Firm

The key person in the case was Qian, a senior executive of the defendant. He was already involved in restaurant investments before being put in charge of this project, and applied the consultation results to his own restaurants.

There are industrial and moral standards applicable to professional service providers, e.g. lawyers, accountants, investment bankers, yet there are no similar standards for consultants. Therefore, this case also encouraged people to think more about industrial and moral standards for consultation services.

THE BASIC FACTS

In 2013, YLXL executed a technical service agreement with BDZH, which stipulated that BDZH should provide YLXL with consultation services with regard to the business model and development strategy of YLXL, and BDZH was obliged to keep the preliminary results and final results confidential – the penalty for breaching this obligation was twice the consultation fee (RMB2.25 million, or US$340,000). Qian, a partner of BDZH, was appointed as one of the project directors in the contract.

In 2014, YLXL discovered that there were several Xinjiang-cuisine restaurants named Loulan Huli in Xi’an, which were transformed from Teppan noodle restaurants owned by JZY and became quite popular during the term of the contract. Those restaurants substantially replicated the business model of YLXL, and resembled the business model suggested by BDZH in the final results provided to YLXL. The restaurants were jointly established by HW Beef Noodle, Qian, and JZY, which was invested in by Qian, who was one of the shareholders and also executive director.

Therefore, YLXL decided to bring a lawsuit against BDZH, and the author’s team represented the plaintiff in this case.

ISSUES IN DISPUTE

Infringement or breach of contract? This was a case combining a contract dispute and an intellectual property dispute. Therefore, should the plaintiff bring the lawsuit on account of breach of contract or infringement of trade secrets? As attorneys in this case, the author’s firm suggested that it was more favourable to the plaintiff if it went with breach of contract.

We offered that suggestion based on the following reasoning: First, it was widely known that the biggest difficulty for infringement of trade secrets cases had been the burden of proof, which must adhere to the “contact and similarity” principle. In this case, the “contact” requirement could be easily satisfied by using the contract, service records and materials delivery as evidence. However, this case was about dispute in the field of intangible service, so it was difficult to adduce evidence with regard to the business model, marketing and strategy, which were reflected in every aspect of operation. Even though there might be some similarities as to service features, many details of the service in practice were fairly accessible in the public domain (e.g., how to make Xinjiang cuisine), and therefore it was hard to adduce evidence.

In contrast, the burden of proof in a breach of contract case would be relatively easy. The plaintiff would only had to prove that the defendant breached its obligations under the contract, i.e., the defendant had breached the obligation of confidentiality by applying the consultation results (which belonged to the plaintiff) to Qian’s restaurants, and expanding those restaurants as Xinjiang-cuisine restaurants, which brought us back to the key facts of this case – the business model of Qian’s restaurants was substantially similar to the model described in the consultation report. Also, it would not be required for the plaintiff, as opposed to an infringement of trade secrets case, to prove whether the business models of the plaintiff’s and Qian’s were similar in certain ways.

Second, we knew that compensation principles in trademark cases had been usually referred to when the damages in infringement of trade secrets cases were calculated, i.e., the loss of the right holder, the benefit of the infringer, or discretionary judgment of the court.

But those three standards could hardly be applied to this case, since the loss of the plaintiff was the loss of business opportunity, which was intangible, and the benefits of Qian could not be calculated during such an early stage of his business, and the discretionary judgment of the court could be subjective and uncertain, due to evidence provided by the plaintiff.

On the other hand, the contract stipulated the penalty for breach, which was the true representation of the parties’ intention. Therefore, we reasoned that it would not violate the principle of fairness and the principle of good faith for the court to rule in favour of the plaintiff – although the defendant would probably request the reduction of the amount of penalty in accordance with the Contract Law, yet such request would be inflexible and one-sided, and when we could prove that the defendant had the obligation of confidentiality, a judge with intellectual property background would uphold the claim of the plaintiff.

Third, in respective of jurisdiction, the parties agreed that the court where the plaintiff resided should be the court of jurisdiction as to any dispute regarding the contract. If the plaintiff filed the lawsuit based on infringement of intellectual property rights, then the plaintiff must file with courts in Beijing, where the defendant resided. Therefore, it would be advantageous to the plaintiff if the litigation, based on breach of contract, could be conducted in Shanghai.

Also, the plaintiff originated from Shanghai, having more brand influence in Shanghai than in Beijing. The plaintiff enjoyed a good reputation in Shanghai, where it was well known to the public, so we believed that judges living in Shanghai, with more knowledge of the brand, were more likely to make a judgment in favour of the plaintiff if the case could be brought in Shanghai.

Besides, Shanghai has a specialized intellectual property court, that is to say, even if the damages granted by the trial court are not ideal, it is very likely that the appellate court will uphold for the plaintiff when the appellate court is the specialized Intellectual Property Court, given the fact that judges in specialized Intellectual Property Court are prone to grant considerable amounts in damages in recent years.

Was the defendant in breach? If it was, was the penalty of breach agreed upon by the parties too high, and subject to adjustment? The trial court determined that the defendant constituted breach by violating article 8 of the Contract Law, and hence must assume liability of breach. As to the adjustment of the penalty, the trial court determined that the penalty clause was effective and binding – since it was agreed upon by negotiation on an equal basis, and subject to each party’s freedom of choice – with the goal to set explicit liability. Only when the penalty obviously exceeded the reasonable amount of general business risk should the court step in, since such penalty would be separated from its original intention.

The appellate court determined that BDZH was indeed in breach of the contract, and in considering the Contract Law, the nature of the penalty, the positions of the parties, the degrees of fault of the parties, the damages caused by the breach, and the market expectation interests, the court said the penalty in the contract must not be adjusted, and rendered a penalty of RMB2.25 million against BDZH.

The trial court determined the breach of the defendant, yet the judge only rendered RMB0.3 million against BDZH from the perspective of actual damage. The appeal was heard before the specialized Intellectual Property Court in Shanghai. The presiding judge also believed that the penalty in the agreement was the penalty agreed upon by the parties, which served as security for performance. Such stipulation was the true representation of the parties’ intention, and the plaintiff was upheld in the full amount of the penalty.

In conclusion, it is vital to choose the strategy for a case. A lawyer who designs strategies for a case resembles an architect involved in a construction. If the plaintiff in the previous case went with the infringement, the odds of winning the case would have been quite slim. On the other hand, the plaintiff actually went with the breach of contract and prevailed in the trial court, and furthered its victory in the specialized Intellectual Property Court. Litigators specializing in intellectual property may see alternative ways to deal with a case when the conventional mentality of infringement can be broken through.

At the same time, this case can be quite educational in terms of the industrial and moral standards for the consultation services, and people engaged in the services are encouraged to draw reflections from this case.

Wang Hongyan (Grace) is a senior partner at L&H Law Firm. She can be contacted on +86 571 8720 6716 or by email at wanghy@liuhelaw.com