Today's General Counsel (Formerly Executive Counsel), V8 N2, April/May 2011

EXECUTIVE COUNSEL april /may 2011

e-discovery

The Promise of Predictive Coding

L IGITA D R OU ITION : ED

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intellectual property

EU Trademark Litigation • Regulating the Geolocation Apps

ABLE L I A AV OW N

Securities Fraud Class Actions • Hot Spots • Grundfest Opines • Point-Counterpoint: Dubbs v. Sokenu

• The Logic of Separate Settlement Counsel

april / maY 2011 volUME 8 /nUMBER 2

Volume 8 / number 2

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LITIGATION AHEAD?

Editor’s Desk This issue of Executive Counsel features a special section on developments in the always contentious arena of securities fraud class action lawsuits. In an exclusive interview, Joseph Grundfest, Stanford Professor and founder of the Stanford Law School Securities Class Action Clearinghouse, comments on the annual study his organization publishes. He notes that the SEC has to compete with other recipients of taxpayer dollars for its budget, and that people have different points of view about the relative importance of spending money in areas as diverse as defense, health care, education and regulating securities markets. In a point-counterpoint in the same section, white collar defense attorney Claudius Sokenu and plaintiff attorney Thomas A. Dubbs come to different conclusions regarding such issues as the effects of the Private Securities Litigation Reform Act of 1995, fraudulent IPOs. and state-level regulatory changes that will become increasingly important if federal regulation proves inadequate.

Institutional investors with lobbying clout have already suffered losses that many argue were due to lack of regulation. Will they fight to hold the line on oversight, or are they willing to let the invisible hand and the services of plaintiff attorneys determine their fortune? That might be viewed as the capital markets’ version of a question that all economic and social sectors face in the debate about government funding, which is increasingly becoming the kind of high-stakes either/or proposition that Grundfest describes.

Catherine Kunz and Richard Arnholt note that last year the federal government purchased over $500 billion in goods and services, making it the world’s largest consumer. Trend lines suggest that number may drop precipitously in 2012, but the government will still spend a lot on contracts. The writers explain that contractors will be subject to some relatively new regulatory provisions that mandate self-reporting when they violate certain laws or receive overpayments, and some difficult practical questions will arise. What, for example, constitutes credible evidence of those violations? To whom should the disclosure be made, by whom, and what should it include?

Kevin Pomfret’s article about geolocation apps concerns technologies that are potentially useful but easily misused, and may not get the kind of thoughtful regulation they require, whether because of misleading PR or budget constraints. I-Phones and other electronic devices are capable of tracking a user’s whereabouts, and that data can be combined with other data as personal as birth date, home address and physical appearance. Pomfret discusses some areas of law in which issues raised by the poor regulation of geolocation technology will become a field for expensive litigation around such issues as personal privacy, breadth of copyrights on geolocation data, and liability when the use of such data contributes to injury or financial loss. He advises the increasingly large field of stakeholders in this industry to prepare as best they can and in the meantime, while regulations are still in flux, weigh in and make their voice heard.

Bob Nienhouse Editor-In-Chief Editor@executivecounsel.info

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Departments Edi tor-in- Chief

14 Intellectual Property LITIGATION PITFALLS IN EU TRADEMARK REGISTRATION Robert J. Kenney and Niclas Hannerstig Defendant can dispute venue, not discovery.

17 Canada/Cross-Border STUDY ANALYZES CROSS-BORDER DEALS

John F. Clifford Small but crucial differences in deal-making.

Cross-Border M&A Update: BILLION DOLL AR REAL ESTATE AND RESOURCE DEALS

Divya Balji Mining companies increase assets, production.

22 Human Resources NEW REGS PUT INVESTMENT COMMITTEE ON THE SPOT

Bob Auditore and Paul Escobar

Publ isher

Robert Nienhouse

Julie Duff y

E xecu t ive Edi tor

Managing Direc tor , Executive Counsel Institute

Bruce Rubenstein

Managing Edi tor

Neil Signore

David Rubenstein

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DEPUTY Art Direc tor jessie cle ar

Con t ribu t ing Edi tor s and Wri t er s Michael R. Annis Richard W. Arnholt Bob Auditore Divya Balji John Clifford Thomas Dubbs Paul Escobar M. Travis Foust Niclas Hannerstig Anastasia Kelly Robert J. Kenney J. Catherine Kunz

Kenneth Leissler Kevin D. Pomfret Brad L. Pursel Chad A. Shultz Claudius Sokenu Evan Slavitt Wai M. Yip

Department of Labor seeking accountability.

28 E-Discovery Benefits and Risks of Predictive Coding

By Ken Leissler and Wai M. Yip Humans drive the algorithm.

30

Governance

An Executive Counsel Special Section: FEDERAL SECURITIES FRAUD CL ASS ACTIONS, STATUS REPORT 32 FEDERAL SECURIT Y CL ASS ACTION FILINGS IN 2010 Key findings in a report from the Stanford Law School Securities Class Action Clearinghouse and Cornerstone Research 33 PL AINTIFF L AWYER’S REACH FOR THE LOW-HANGING FRUIT

Q&A with Professor Joseph A. Grundfest 35 Point-Counterpoint:

Edi torial Advisory Board Dennis Block Cadwalader, Wickersham & Taft Thomas Brunner Wiley Rein James Christie Blake, Cassels & Graydon Adam Cohen FTI Consulting Thomas Frederick Winston & Strawn Jamie Gorelick WilmerHale Robert Haig Kelley, Drye & Warren Jean Hanson Fried Frank Robert Heim Dechert Dale Heist Woodcock Washburn Joel Henning Joel Henning & Associates Sheila Hollis Duane Morris David Katz Wachtell, Lipton, Rosen & Katz Steven Kittrell McGuireWoods Jerome Libin Sutherland, Asbill & Brennan Timothy Malloy McAndrews, Held & Malloy Jean McCreary Nixon Peabody Steven Molo MoloLamken Thurston Moore Hunton & Williams Ron Myrick Finnegan Henderson Robert Profusek Jones Day Art Rosenbloom Charles River Associates George Ruttinger Crowell & Moring Victor Schwartz Shook, Hardy & Bacon Jerome Shestack Schnader Harrison Segal & Lewis Jonathan Schiller Boies, Schiller & Flexner Robert Townsend Cravath, Swaine & Moore David Wingfield WeirFoulds Robert Zahler Pillsbury Winthrop Shaw Pittman

Thomas A. Dubbs and Claudius Sokenu 60 Who Says Excerpts from Congressional hearings, commissions and official reports.

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Features

42 THE MANDATORY DISCLOSURE RULES FOR GOVERNMENT CONTRACTORS

J. Catherine Kunz and Richard W. Arnholt 38 RETAINING SEPARATE SETTLEMENT COUNSEL FOR EMPLOYMENT LITIGATION

By Chad A. Shultz and M. Travis Foust A two-track approach.

When to offer it up.

46 PLANNING FOR LITIGATION OVER ACQUIRED IP

Mike Annis and Brad Pursel Valuate with the future in mind.

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50 LAWMAKERS EYE GEOLOCATION APPS

Kevin D. Pomfret Powerful tool faces regulatory issues.

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EXECUTIVE Counsel A p r i l / m ay 2011

54 CORPORATE ETHICS: A SOCRATIC DIALOGUE

62 THE INEVITABLE CRISIS

Evan Slavitt

Rehearse communication lines, not disaster scenarios.

Can corporations be “ethical”?

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Anastasia Kelly

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Executive Summaries P. 17 STUDY ANALYZES CROSS-BORDER DEALS

By John F. Clifford McMillan LLP

P. 20 BILLION DOLLAR REAL ESTATE AND RESOURCE DEALS

By Divya Balji mergermarket

Trademark rights in the EU can be obtained by filing national registrations country-by-country; by filing a Community Trademark (CTM) which offers uniform protection in all 27 countries of the EU; or by extension of an International Registration under the Madrid Protocol to specific designated countries.

A fourth method relates to mergers and acquisitions in which trademarks are assigned to the purchaser.

The first three methods share some common principles: Protection is obtained through being first to file rather than first to use the mark. Prior trademark rights of another party must be asserted through opposition, rather than by an examiner’s refusal to register on the grounds of confusion with the prior mark. There is a grace period of five years for non-use. And, the registrations are valid for 10 years with unlimited options for renewal. In most instances it makes sense to choose a CTM application.

U.S. trademark owners who seek rights in the EU must be aware that European courts or administrative agencies might obtain jurisdiction.

For example, the unitary character of a CTM in respect to enforcement gives the proprietor the option of commencing infringement proceedings in a “CTM Court” in one member state, even if the infringing act took place in other member states.

Under most European national laws, in actions against an alleged infringer domiciled within the European Community, the notion of discovery that has evolved in the United States will not apply.

Separate analyses of deal agreements filed in the United States and Canada reveal differences in the deal-making cultures withiin the two countries.

Lawyers engaged in cross-border transactions can profit by keeping those differences in mind. This article highlights and comments on several points of difference.

The two countries approach purchase price adjustments differently. The Canada study found that the negotiated purchase price was adjusted postclosing in only 50 percent of the deals surveyed. In the U.S. the frequency was significantly higher, at 79 per cent.

“Material Adverse Effect” (MAE) clauses are prevalent in both countries.

But for deals that do not close on the date the acquisition agreement is signed, the agreement typically includes a condition to the effect that all representations and warranties of the seller are true and correct at closing.

Savvy sellers often will seek to include a materiality qualifier in the “condition” to prevent giving unwilling buyers an opportunity not to close because of a non-material inaccuracy in the representations. But, if both the representation and the condition are qualified by materiality, then the parties have created a double materiality standard for the representation, perhaps unwittingly. The study finds that U.S. deal lawyers are especially good at dealing with this, by “scraping away” one layer of materiality. Only 24 percent of the deals surveyed for the Canada study had double materiality carved-out from the closing condition.

Indemnity caps are much higher in Canada, and survival periods are longer.

M&A activity between Canada and the United States started this year with several deals worth more than a billion dollars.

The mining sector started the New Year with a mega-deal, the proposed $4.9 billion CAD acquisition of Consolidated Thompson Iron Mines by Cliffs Natural Resources. This reflects Cliffs’ strategy to build scale by owning expandable and exportable steel-making raw material assets that serve international markets. Fraser Milner Casgrain LLP is Consolidated’s legal advisor, and Cassels Brock Blackwell LLP is acting as legal advisor to the transaction committee for Consolidated. Jones Day and Blake, Cassels & Graydon LLP are legal counsel to Cliffs.

The mining sector saw another megadeal with the $2.3 billion CAD acquisition of Fronteer Gold by Newmont Mining in February. Fronteer’s Long Canyon project is close to Newmont’s existing infrastructure in Nevada, and it will contribute significantly to Newmont’s growth profile in North America, according to a company press release. Newmont’s legal counsel is Goodmans LLP; Fronteer’s legal advisor is Davies Ward Phillips & Vineberg LLP. “These are the types of deals you’ll see take place in mining. Companies with strong balance sheets and good technical expertise will come in and make buys in order to increase their asset base and production. Targets with assets close to majors’ operations will be highly attractive,” said one industry analyst.

Mid-market deals occurred in the business services, financial services and technology sectors.

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Executive Summaries

P. 14 LITIGATION PITFALLS IN EU TRADEMARK REGISTRATION

By Robert J. Kenney and Niclas Hannerstig Birch Stewart Kolasch Birch LLP

Executive Summaries P. 22 NEW REGS PUT INVESTMENT COMMITTEE ON THE SPOT

By Bob Auditore and Paul Escobar Bay Colony Partners

P. 26 BENEFITS AND RISKS OF PREDICTIVE CODING

By Ken Leissler and Wai M. Yip Protiviti Inc.

New regulations instituted by the Department of Labor’s Employee Benefits Security Administration have implications for corporate fiduciary practices with regard to 401(k)plans and other participant-directed investment programs. They make the role of investment committees critical when establishing an oversight process regarding investment options. In the absence of an investment committee and related best practices oversight, a company could open itself up to DOL complaints and law suits from plan participants.

Beginning with plan years starting after November 1, 2011, all fees and expenses must be plainly detailed on a quarterly basis, so that investors can easily compare investments and costs.

Plan administrators must provide pertinent information on investment performance and fees in writing and/or online. The presentation must be in a format that allows for easy comparisons.

The new regulations require plan administrators to disclose the amount of fees and expenses deducted for each $1,000 invested, expressed as a percentage and in a dollar amount. Plans must present current, one-year, fiveyear and ten-year performance figures, compared to a relevant benchmark. All fees charged against a participant’s account must be included in the quarterly statement. The fee can be expressed as one number, but participants maintain the right to request additional details.

Plan sponsors must propose at least one low-cost index fund to participants.

The plan and its service providers must make their financial relationships, if any, known, as a guarantee against conflicts of interest.

Document review continues to be the costliest and most time-consuming aspect of e-discovery, and organizations are looking for new and cheaper ways to do it by using technology. But fullblown “artificial intelligence” in this field does not yet exist, according to the authors. Software and technology cannot replace lawyers.

However, technology is beginning to perform certain tasks that lawyers have customarily handled. The authors detail a particular task that can now be handled by technology, with the caveat that the process will work only if seasoned lawyers first lay the ground work and then guide its use. The task is called “predictive coding.”

The process begins with an algorithm that finds “hot” data within a larger mass of data. Lawyers then examine that data and further refine the search process.

“To maximize the benefits of predictive coding, a litigation team should be an active participant,” the authors write. “To this end, many prominent law firms are designating ‘information lawyers,’ typically senior lawyers who are experienced with new technologies and identified as advocates for it.”

The authors lay out the pro and cons of predictive coding, and how companies should weigh the arguments for adopting it.

“It’s been shown,” they write, “that properly designed predictive coding technologies, with competent human oversight, can speed up the identification of relevant documents and substantially reduce many risks associated with one area attorneys prefer to delegate: first-tier review.”

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Executive Summaries an executive counsel special section P. 33 PL AINTIFF L AWYERS REACH FOR THE LOW-HANGING FRUIT Q&A with Professor Joseph A. Grundfest Stanford Law School Founder, Stanford Securities Class Action Clearinghouse

P. 35 Point-Counterpoint: Claudius Sokenu Arnold & Porter LLP and Thomas A. Dubbs Labaton Sucharow LLP

This article summarizes and provides some highlights from a recent report on federal security class actions. The report, Securities Class Action Filings – 2010 Year in Review, is one of a series of annual reports issued by the Stanford Law School Securities Class Action Clearinghouse and Cornerstone Research.

In terms of overall frequency of filings, the report found no marked change in 2010 compared with 2009. However, it did find that in comparison with the annual average for the years between 1997 and 2009, there was about a 10 percent decrease.

Within these fairly unremarkable general trends, there were some interesting high points. Federal securities fraud class actions related to M&A activity were up sharply. There were forty suits filed in 2010, compared to seven in 2009.

Actions targeting U.S. health care companies also were up sharply. Last year 15.4 percent of the companies in the health care sector, representing 33.7 percent of the sector’s market capitalization, were named defendants. That was a big increase from 2009.

In contrast, class actions targeting the financial sector were down, and filings specifically related to the credit crisis were way down. Filings targeting Chinese companies were up.

Among other findings: The most likely time period for a company to be targeted is the second year after an IPO. Overall, about one out of 19 S&P 500 companies at the beginning of 2010 was a defendant in a class action filed during the year, compared with an average of about one in 15 such companies between 2000 and 2009.

Professor Grundfest sees some major findings of the study, Securities Class Action Filings – 2010 Year in Review, as a manifestation of plaintiff lawyer opportunism. The striking increase in the number of federal securities fraud class action lawsuits arising from an M&A is explained by the fact that more traditional avenues have become less inviting and plaintiff lawyers have “idle resources.”

Typically these M&A-related lawsuits allege failure to describe material valuation information and as a practical matter, he says, there is little that companies can do to ward them off. There always will be undisclosed information and thus the potential for plaintiffs’ lawyers to allege it should have been disclosed.

These suits, he says, are relatively easy to bring because the claims in many cases will already have been brought in state courts.

He notes that the interpretation of the requirement of the Private Securities Litigation Reform Act of 1995 that complaints state “with particularity” facts which underlie a belief about fraud has not been consistent and varies among the circuits. With regard to “scienter,” he says the PSLRA’s strict requirement has been interpreted to distinguish a willful act from negligence.

As for the question of whether the SEC has adequate funding to do its job, he says he considers that a matter of social balancing, noting the SEC will always have to compete with other budget items, from health care to national defense, and reasonable people will disagree on the proper balance.

Corporate defense attorney Claudius Sokenu and Thomas Dubbs, a member of the plaintiffs’ bar, come to sharply different conclusions about findings in the report Securities Class Action Filings – 2010 Year in Review.

Sokenu views the increase in class actions related to M&A transactions as a reflection of plaintiff activism against good faith efforts to preserve shareholder value by boards and management of cash strapped companies.

Dubbs sees it as a statistical anomaly brought about by the report’s failure to distinguish between Delaware M&A cases and securities class actions, and claims that frivolous suits have been virtually eliminated due to significant impediments to class certification created by the Private Securities Litigation Reform Act. The report references a study that found 18.5 percent of companies that completed an IPO in 1996 through 2009 became defendants in a securities class action.

Dubbs observes that Congress has enacted statutes requiring such companies to prepare a detailed prospectus as part of the IPO. The primary means to address false and misleading statements is pursuant to Section 11 of the Securities Act of 1933, which he calls “notable because it has no intent requirement, which means it actually has teeth for enforcement.”

Sokenu notes that IPOs tend to be risky investments, which raises the specter of litigation. He advises companies contemplating IPOs to familiarize themselves with the obligations that come with being publicly traded.

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Executive Summaries

P. 32 SECURITIES FRAUD CL ASS ACTIONS, STATUS REPORT Securities Class Action Filings – 2010 Year in Review

Executive Summaries P. 38 RETAINING SEPARATE SETTLEMENT COUNSEL IN EMPLOYMENT LITIGATION

By Chad A. Shultz and M. Travis Foust Ford & Harrison

P. 42 MANDATORY DISCLOSURE RULES FOR GOVERNMENT CONTRACTORS

By J. Catherine Kunz and Richard W. Arnholt Crowell & Moring

P. 46 PL ANNING FOR LITIGATION OVER ACQUIRED IP

By Mike Annis Husch Blackwell LLP and Brad Pursel Brown Smith Wallace LLC

Federal government contractors are subject to a host of requirements, among them some relatively recent regulations that require them to self-report when they violate certain laws or receive overpayments. Those regulations add a new basis for suspension or debarment from government contracting: the knowing failure of a “principal” to disclose credible evidence of certain infractions. This applies to all government contractors.

A second component of these regulations adds a new contract clause that requires the contractor to report whenever it has credible evidence of a violation. This clause applies only to contracts that were awarded or modified after December 12, 2008, and that are expected to be worth more than $5 million and to be performed over more than 120 days.

The authors note that compliance will inevitably require interpretation, and they offer some guidance.

Companies must decide, for example, what constitutes credible evidence, precisely who is a “principal,” what constitutes “timely” disclosure, and to whom and how disclosures should be made.

Companies should investigate to ensure there is in fact credible evidence of a reportable violation before making a disclosure. “Neither the government nor a contractor wants to have the government look into a matter that turns out to be baseless,” the authors note.

Some disclosures will be made to agency inspectors general, and companies should keep in mind that in those cases many if not all disclosures are shared with DOJ for possible prosecution.

This article discusses GAAP requirements with regard to accounting for acquired intellectual property, and the discoverability of accounting work papers in the event acquired IP is subject to infringement litigation.

The valuation of allegedly infringed intellectual property and the assumptions used in the valuation can be central issues in determining damages in IP litigation, so they should be addressed carefully, not only to comply with accounting standards but keeping in mind that the work papers will be discoverable. If the acquired IP is later subject to an infringement claim, its valuation will likely become a subject of discovery and significant discussion. Acquired intellectual property is sometimes valued at zero dollars, but such a valuation will negatively impact any claims for damages in an infringement suit.

There are similarities between the methodologies often used to value IP assets under GAAP and those used to calculate damages in IP infringement cases.

Reasonable royalty awards are the most common form of damages awarded in patent infringement litigation. Whether valuing a patent or calculating a reasonable royalty for a patent infringement claim, the primary inputs are the same: royalty base and royalty rate.

Appropriate recognition and valuation of intangible assets are the responsibility of management. SarbanesOxley specifically requires corporations to manage internal processes, such as IP due diligence, for identification and reporting of assets. This includes the accounting, reporting, and presentation of any financial statements in accordance with GAAP.

Executive Summaries

Noting that all U.S. companies are nearly certain to be drawn into employment litigation sooner or later, the authors suggest two contrasting although not mutually exclusive strategies for handling these matters. The first is to use litigators – outside counsel, attorneys from the company’s legal department, or both.

The second is to retain separate counsel that specialize in evaluating the matter for its settlement potential and then, if it’s deemed to be warranted, pursuing settlement.

The authors argue that even when litigators prevail, the result in most cases can’t really be called a “win,” and therefore that the second track is usually far more cost-effective. While acknowledging that some cases need to be litigated to the bitter end, the authors contend that litigators by temperament and by self-interest are not fit to evaluate cases for settlement potential or pursue settlement.

They make their case by way of a list of “ten things lawyers know are true about litigation, but don’t want to admit.” (Among them: that defendants “can afford to invest more money in early settlement because they haven’t invested as much in litigation. Overall cost should be the issue, not just what is ultimately paid to the plaintiff.”)

According to the authors, even cases deemed appropriate for full-bore litigation will benefit from having been through the separate settlement evaluation process.

“Having this information,” they write, “is a significant strategic leg up for the litigator and ultimately a cost savings for the defendant.”

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The Magazine for the General Counsel, CEO & CFO

Executive Summaries P. 50 LAWMAKERS EYE GEOLOCATION APPS

By Kevin D. Pomfret LeClairRyan

P. 54 CORPORATE ETHICS: A SOCRATIC DIALOGUE

By Evan Slavitt AVX Corporation

P. 62 prepare in advance for THE INEVITABLE CRISIS

By Anastasia Kelly DLA Piper

The author fictionalizes a conversation between himself and two old acquaintances that he has run into at a coffee shop. One of them is developing a course on corporate ethics. The other has become a senior attorney with the Department of Justice.

The conversation concerns the meaning of “ethics,” the difference between ethics and compliance, and whether that distinction can be made when assessing a corporation as opposed to a person.

The issues they discuss include obligations to shareholders and how they might differ from moral obligations; the oddity of an entity that is staffed by and in effect composed of individual persons, yet which has its own legal personhood; and the number of ethical or unethical acts a person or a corporation must commit before he, she, or it can legitimately be called ethical or unethical.

With many twists and turns, the conversation delves into the relationship among corporations, their executives and their employees, and what it means to say that any or all of those entities are or are not ethical.

One character notes that companies themselves can’t be said to make any ethical choice. All they do is promulgate rules for their employees to follow.

One character observes that pirate gangs “were notable for their lack of racial and ethnic discrimination compared to more mainstream organizations of the time. So does that mean that such pirate organization would be considered to have a good corporate culture even though its objectives are patently illegal?”

Recently companies such as Toyota, BP, Johnson & Johnson and Hewlett Packard experienced crises that distracted management, cost million of dollars in time and resources, reduced shareholder value and resulted in lawsuits that will take years to resolve. These occurrences are examples of a trend. The rate of corporate crises is increasing, and responsible companies and thoughtful boards need to realize that no business is sheltered from a crisis, no matter how well-managed or low profile it may be.

The author suggests five steps a company should take to get ready for a crisis: (1) Establish a reasoned crisis response approach developed by a team that draws from businesses and functions across the company. The most effective strategy is an evolving process in which designated managers meet or communicate periodically about potential crises.

(2) Agree in advance about how the company will react to crisis situations.

Policies should be vetted with the board of directors, the CEO and senior management, and understood by the management team, (3) Recognize that in most cases, the company will need outside resources to supplement and guide the crisis management team.

(4) Identify the potential outside resources the company can access and prepare those resources.

(5) Clearly delegate authority to a Crisis Response Team and a lead executive who will be responsible for development, implementation, coordination and communication of the strategy, in close coordination with the CEO, senior management and the board of directors.

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Executive Summaries

Geolocation technology enables devices like smart phones to collect data “about where people go and what they do,” the author explains. “This information can be aggregated with other information to determine ‘who they are’ with precision and accuracy.”

Geolocation technology raises concerns in part because significant benefits of the technology often are overshadowed by sensationalized media accounts of real or perceived privacy breeches, according to the author.

Among the benefits he notes are advances in map making, emergency response and “smart grid” energy distribution.

He acknowledges there are legitimate privacy concerns but sees a danger that regulators will overreact, and he encourages businesses with an interest in this technology to weigh in.

Issues that will need clarification include: Who should have access to one’s geolocation data? Should someone’s location on a public street be protected in the same way as medical or bank account information? Which public and private entities should have access to locationbased data, and under what circumstances? Meanwhile, companies can take steps to protect themselves from liability by, for example, identifying and protecting geolocation data that can be associated with an individual.

Some liability issues, like damages alleged to be the result of faulty GPS navigational information, are unrelated to privacy.

Geolocation regulation is a worldwide issue, the author says, and different national jurisdictions will inevitably resolve it in view of their own privacy notions, which vary widely across cultural and national boundaries.

Intellectual Property

Litigation Pitfalls in EU Trademark Registration

By Robert J. Kenney and Niclas Hannerstig

u . s . trademark owners

most often view the EU as the most logical area for market expansion other than Canada and Mexico. Seeking protection for marks in Europe often makes sense even if there is no impending expansion, because it can help to establish priority of rights, thereby avoiding future trademark conflicts.

This article focuses on two issues to be considered in relation to trademarks in the EU: obtaining the trademark protection that makes most sense for your business circumstances, and understanding how courts and administrative agencies get jurisdiction over U.S. owners of European trademark rights with respect to disputes involving those rights.

SEVERAL REGISTRATION OPTIONS

In order to obtain enforceable intellectual property protection, one must be in 14

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possession of valid intellectual property rights. In the EU such rights can be obtained by: (1) filing national registrations country-by-country; (2) filing a Community Trademark (CTM) which offers uniform protection in all 27 countries of the EU on the strength of a single registration procedure and (3) extension of an International Registration under the Madrid Protocol to specific designated countries.

A fourth method relates to mergers and acquisitions in which trademarks are assigned to the purchaser of assets.

This article will not address this method, but if it is pursued, a trademark specialist should make a full assessment of the risks involved.

The other three methods share some common principles. Protection is obtained through being first to file rather than first to use the mark. Prior trademark rights of another party must be asserted through opposition, rather than by an examiner’s refusal to register on the grounds of confusion with the prior mark. There is a grace period of five years for non-use, and the registrations are valid for 10 years with unlimited options for renewal.

While all four methods can be utilized by U.S. companies, there are advantages and disadvantages to consider for each.

The limitations associated with filing in individual countries are obvious.

The trademark rights would be limited to those countries. In addition, filing for

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Intellectual Property

protection in such a piecemeal manner can add significantly to costs.

On the other hand, where there is evidence that another party owns prior rights to a similar mark in one of the EU countries such that a CTM registration will probably fail, it makes no sense to pursue the CTM registration.

The focus may shift to filing individual applications in the remaining EU countries where protection is important and no such prior rights exist.

The owner of a national registration who uses the mark on a website on which its products or services can be viewed in other European countries where its mark is not covered may open the website owner to an action for infringement. This is true even if products or services associated with the mark cannot be ordered in those countries.

This is not the case if the trademark owner’s rights derive from a CTM registration, as long as that registration has effect in all member states.

Thus the principal advantages of the CTM system include a unitary registration, which enables the owner to use the mark in all member states of the EU; the cost effectiveness of one filing; and the ability to enforce a single infringement judgment throughout the entire EU. The disadvantages include the fact that a superior trademark right or a successful opposition or invalidation from a third party in only one EU country can deprive the applicant of the right to the mark, or the chance of obtaining a CTM registration.

A U.S. trademark owner can also apply to register internationally under the Madrid protocol, and extend protection of a prior registered trademark in the United States to any country of choice. This means only the countries of actual commercial interest need be included. The existing trademark acts as a basis for the registration, thus determining the scope of protection in accordance with applicable law.

The International Registration does not affect the underlying registration, since it is limited to the designated country and acts independently.

If problems arise in one country, it does not affect others. The principal advan15

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JURISDICTION IN INFRINGEMENT

U.S. trademark owners who seek rights in the EU must be aware that European courts or administrative agencies might obtain jurisdiction, thus making the trademark owner subject to action in those jurisdictions.

For example the unitary character of a CTM in respect to enforcement gives the owner the option of commencing infringement proceedings in a “CTM Court” in one member state, even if the infringing act took place in other member states.

Moreover, when it comes to enforcing or defending trademark rights in Europe, regardless of whether you own a CTM or national registration, applicable law embodies both national substantive law and European Community law.

Jurisdiction for proceedings relating to infringement and validity of a CTM 16

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is solely governed by the Community Trade Mark Regulation, which supersedes the Brussels I Regulation on Jurisdiction and the Enforcement of Judgments in Civil and Commercial Matters. However, this does not render the Brussels I Regulation completely inapplicable. It is still in force for matters not relating to infringement or validity.

In addition to those two instruments, national laws still play a vital role in the determination of the precise remedies available. Therefore, the locus of the court (if more than one has jurisdiction) is a very important factor in pan-European Trademark litigation.

It will determine the breadth of remedies granted.

Jurisdiction can be based either on where the parties are domiciled or have an establishment, or on where the alleged infringement occurred.

If the defendant is not domiciled in a member state, then the claimant's domicile can be used to establish appropriate forum. In the event neither party is domiciled in a member state, proceedings are to be brought in the Spanish Courts. (Spain is home to OHIM, the registration office of Community Trademarks.)

In general, the extent of relief that may be granted by a CTM Court will vary depending on the basis of jurisdiction asserted. A CTM Court will have the ability to grant pan-European relief to prevent infringement in any member state if jurisdiction is based on the domicile of the defendant. However, if jurisdiction is based on where the infringement occurred, a CTM Court can grant relief only with respect to acts committed or threatened in that state.

An owner of national rights and a CTM may bring proceedings and assert rights based on both, in a single proceeding, without triggering the issue of multiplicity of actions. However, this is not possible if proceedings involving the same cause of action between the same parties are brought in the courts of different member states.

In sharp contrast to litigation practice in the United States, the defendant may move to dismiss an action by asserting that plaintiff’s choice of forum

was inappropriate. In effect, this means that European Courts must automatically decline jurisdiction if another court has already seized jurisdiction over an issue relating to the same subject matter.

In addition, under most European national laws, in actions against an alleged infringer domiciled within the European Community, the U.S. notion of discovery does not exist. The implications of this can prove especially hard on the plaintiff, especially in countries where substantive law requires them to provide all necessary evidence to support the alleged infringement.

In summary, in most instances where a U.S. trademark owner wishes to extend protection for its mark to the European Union, it makes sense to choose a CTM application. However, as noted above, there are limitations to this strategy that should be considered.

U.S. trademark owners should also be mindful that use of a mark in the EU can expose it to the jurisdiction of courts and agencies in the EU. The mark’s owners will have little or no control over where the action is instituted, and no power to change the venue.

kenney is a partner at Birch Stewart Kolasch Birch LLP. His specialties include all aspects of trademark practice, including portfolio management, anti-counterfeiting counseling, prosecution, inter partes matters and litigation, as well as litigation of unfair competition, patent and copyright matters.

He coordinates the firm’s annual U.S. Trademark Practice Seminar, and he has lectured in the United States and abroad on U.S. trademark practice and IP litigation in U.S. courts and the International Trade Commission. robert

niclas hannerstig, Jur. Kand (Jurist), is

a citizen of Sweden. He assists at Birch Stewart Kolasch Birch LLP in the firm’s trademark department, including by preparing response letters to office actions and conducting legal research in U.S. and European trademark law.

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Intellectual Property

tages include speed – a faster priority date than CTM applications – cost, and individuality.

However, an International Registration is dependent upon the U.S. application or registration. If that for any reason fails, the International Registration will also fail.

Generally speaking, deciding whether and when to apply for a CTM registration, individual national registrations or both will depend on a variety of factors. Some general guidelines, however, may be helpful.

•• For companies that don’t intend to expand outside current markets, and that have national registrations in Europe that are in use in some countries, a CTM registration would be of marginal benefit.

•• For companies that intend to expand, a CTM registration would probably be worthwhile to protect future rights to the mark.

•• For companies with new or unregistered marks, a CTM registration may be preferable to filing several separate national registrations.

•• For companies aware of potentially conflicting marks, a CTM registration or additional national registrations are worthwhile to reserve rights where the other mark is not yet used or registered.

Canada/Cross-Border

Deal Points Differ in Canada

By John F. Clifford

often when negotiating an asset or share purchase agree-

ment, the parties get to an impasse on a deal point and want to know, “What’s market?” Investment bankers for years have had market metric data at their fingertips from third party suppliers such as Thomson Reuters and Securities Data Corp., while deal lawyers lacked a reliable, dependent source.

Much of that changed in 2006, when the American Bar Association Business Law Section M&A Committee (subcommittee on Market Trends) published its first deal points study. That study surveyed and reported on the frequency of use of various deal terms in agreements in which U.S. private companies were acquired. There have since been annual updates of the U.S. private target study, as well as addi17

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tional studies reporting on deal points in transactions involving U.S. private equity buyers/public targets, and strategic buyers/public targets.

The U.S. studies were followed by a Canadian private target study and a European private target study, each released in 2008.

An updated Canadian Private Target M&A Deal Points Study (the “Canada Study”) was released by the

ABA in December 2010. It provides a wealth of useful data for the deal lawyer, including many pages comparing the results of the Canada Study with the 2009 U.S. Private Target M&A Deal Points Study (the “U.S. Study”). These are useful resources for lawyers involved in cross-border transactions.

Points of particular interest from the Canada Study and the U.S. Study are discussed below.

METHODOLOGY

The Canada Study analyzes 62 acquisition agreements filed by public companies on the Ontario Security Commission’s System of Electronic Document and Analysis (the Commission’s database for documentation of acquisition of private companies). The deals closed in 2007 through 2009.

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closing date balance sheet in 83 percent of the deals surveyed.

Dollar value of deals reviewed

• • Material Adverse Effect clauses are prevalent. Perhaps reflecting a conver-

Canada Study found that the negotiated purchase price was adjusted postclosing in only 50 percent of the deals surveyed. This is surprisingly low, given the experience of the author and his colleagues, and may indicate fewer reported deals that were priced based on working capital, or another metric that could not be determined with certainty prior to closing. The U.S. Study reported a much higher instance: 79 percent of deals surveyed.

The Canada Study reported that of the deals which contemplated postclosing purchase price adjustments, the buyer prepared the first draft of the closing date financial statements in only 29 percent of the deals. Sellers prepared the first draft in 58 percent of those deals.

The U.S. Study reported that the seller prepared the first draft of the

• • Buyers want to know the seller has disclosed what it knows. The Canada

Study reported that 56 percent of the deals surveyed included a representation from the target to the effect that none of its representations or warranties in the acquisition agreement, or factual matters disclosed in the schedules to the agreement, contained any untrue

How 'material adverse affect' clauses are handled

POINTS OF INTEREST

Six findings reported in the Canada Study are summarized below, and compared with findings in the U.S. Study.

•• Canada and the U.S. approach purchase price adjustments differently. The

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Canada/Cross-Border

The final study sample excluded agreements for deals having a transaction size of less than C$5 million, transactions involving non-arm’s length parties, transactions not governed by Canadian law and transactions otherwise deemed inappropriate for inclusion.

A team of 26 experienced Canadian deal lawyers reviewed the agreements and identified the frequency of use of deal terms such as financial provisions (e.g. purchase price adjustments), pervasive qualifiers (e.g. “material adverse change”) representations and warranties, conditions to closing, indemnification and dispute resolution. In many instances they compared the negotiated provision with comparable provisions in the ABA’s Model Stock Purchase Agreement or Model Asset Purchase Agreement. Each individual’s work was checked to ensure consistent quality and interpretation of results.

The final pool drew agreements from a variety of industries and sectors.

Almost half of the deals surveyed were small/mid-market, involving a total consideration of between C$5 million and C$50 million. A further 25 percent had transaction values between C$50 million and C$200 million.

gence of Canadian and U.S. deal practice, pervasive qualifiers based on material adverse effects (MAE) are common in both jurisdictions.

A definition of material adverse effect (or similar term) appeared in 73 percent of deals surveyed for the Canada Study, and 92 percent for the U.S. Study. The defined term was forward-looking in 69 percent of Canadian deals and included a reference to the target’s “prospects” in 40 percent of those deals. Similar trends were reported in the U.S. Study.

One interesting finding is that the financial market downturn was specifically carved-out from the MAE definition in 70 percent of Canadian deals that had the defined term, but was carved-out in only 49 percent of U.S. deals. This may reflect the currency of the U.S. study’s pool, deals that closed in 2008 – a time when financial markets were down and the parties wanted to ensure their deals closed notwithstanding market conditions.

Canada/Cross-Border

statement of material fact, or failed to disclose a material fact necessary to make its representations or disclosures not misleading.

In only 37 percent of those agreements which included the full disclosure representation was the representation qualified by the actual or constructive knowledge of the seller.

This is slightly less than in the United States, where 68 percent of deals included some form of full disclosure representation. Interestingly, in 90 percent of those U.S. deals the representation was qualified by knowledge.

•• Canadians don’t “scrape.” Representations and warranties in acquisition agreements often are qualified by materiality, to ensure that insignificant inaccuracies in a representation or warranty do not give rise to post-closing indemnity claims. So, for example, the agreement might include a representation to the effect that the target has complied in all material respects with contracts to which it is a bound.

For deals that do not close on the date the acquisition agreement is signed, savvy sellers often will seek to include a materiality qualifier in the condition – e.g. provide that all representations and warranties of the seller are true and correct in all material respects on the closing date, as if made on that date - to prevent giving unwilling buyers an opportunity not to close because of a non-material inaccuracy in the reps. But if both the representation and the condition are qualified by materiality, the parties have created a double materiality standard for the representation, perhaps unwittingly.

U.S. deal lawyers are good at dealing with this, by “scraping away” one layer of materiality. This can be achieved by providing in the conditions to closing that materiality qualifications are made on the basis that any materiality qualifiers in the representations are disregarded. U.S. deal lawyers did this in 84 percent of the deals surveyed for the U.S. Study that included the “bring down” condition.

In contrast, in only 24 percent of the deals surveyed for the Canada Study was double materiality carved-out from 19

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the closing condition (for deals that included a “bring-down” requirement to closing). It was carved out in only 29 percent of deals that referred to the accuracy of the reps when they were made (i.e. at the time of signing).

• • Survival periods are longer in Canada. The Canada Study reported

that in 84 percent of deals, claims for indemnification (for example, to recover losses incurred by reason of a representation or warranty being inaccurate) must be made within 24 months of closing, which (at 31 percent) was the most common survival period.

In 16 percent of deals, claims could be brought during periods longer than 24 months. Notably, the survival period was 12 months in 18 percent of the deals surveyed and 18 months in only 14 percent.

This is markedly different from the United States, where the survival period for 38 percent of deals was 18 months, while in 20 percent of deals surveyed it was only 12 months. Only 17 percent of deals had a survival period of 24 months. A mere six percent had a longer survival period.

• • Indemnity caps are much higher in Canada. The Canada Study confirms

what most Canadian deal lawyers have long suspected: Indemnity caps – that is, the maximum amount a buyer can recover from a seller for indemnification claims under an acquisition agreement – generally are higher in Canada than in the United States. But the gap is narrowing.

The Canada Study reported that, of the subset of deals surveyed which included survival provisions, 60 percent expressly provided that the indemnification provisions contained in the acquisition agreement were the exclusive remedy for post-closing claims. In only 14 percent of those deals was it provided that the indemnity provisions were a non-exclusive remedy. The balance were silent on the point.

Remarkably, in the Canada study, only 76 percent of the deals that included express survival periods provided for a cap on indemnity claims. This is a notable change from 2008, when 44 percent of the deals surveyed for that

study did not have an indemnity cap.

The practice is quite different in the United States. The U.S. Study reported that 92 percent of deals had an express cap on indemnity claims.

Interestingly, the U.S. Study reported that with regard to those deals that provided for a cap on indemnity claims, the cap was less than the purchase price in 95 percent of deals. This differs markedly from Canada where the indemnity cap was equivalent to the purchase price in 45 percent of the

Indemnity caps are much higher in Canada. deals that had a cap. Indeed, in a large majority of deals in Canada – 62 percent – the indemnity cap was more than 50 percent of the purchase price. This was the case in only nine percent of the deals that had indemnity caps surveyed for the U.S. study.

The Canada Study and its U.S. and European companion studies are very useful tools for deal lawyers. The Canada Study’s framework and reporting style make it a convenient checklist for principal points of consideration when drafting an acquisition agreement. The data points are useful benchmarks against which to measure (and help resolve) sometimes difficult points for negotiation.

All of the studies are available on the ABA M&A Committee’s website at http://apps.americanbar.org/dch/committee.cfm?com=CL560003).

john f. clifford

is a partner at McMillan LLP in Toronto. He advises Canadian and international clients on domestic and cross-border transactions, debt financings, complex re-organizations, and on antitrust/competition matters. He has advised clients on Competition Act implications in hundreds of merger transactions. john.clifford@mcmillan.ca

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cross-border m & a update

Billion Dollar Real Estate and Resource Deals

By Divya Balji

Investments and Motricity’s $150 million USD purchase of Adenyo. Metastorm worked with Venable LLP and Open Text retained Crowell & Moring. Adenyo retained LaBarge Weinstein and DLA Piper as legal advisors, and Motricity worked with Kirkland & Ellis LLP and Blake, Cassels & Graydon LLP. Other sectors that have seen some deal activity between the neighboring countries include energy, utilities, telecommunications, media, technology, industrials, chemicals and consumer.

Baby boomers who own small businesses and don’t have a succession plan could be a key driver for more M&A activity in the small market within North America, and globally.

Meanwhile, private equity firms will continue to look at exiting their investments as markets improve.

joined mergermarket, an independent mergers and acquisitions intelligence service, in June 2007 as a financial reporter and became Canada bureau chief in August 2009. She oversees the company’s M&A coverage in Canada, with a specific focus on energy and mining.

Prior to working with mergermarket, she completed her degree in Economics & Mathematics at the University of Toronto. divya.balji@mergermarket.com divya balji

Canada/Cross-Border

M&A activity between Canada and the United States has seen a jumpstart this year, with several deals worth more than a billion dollars.

The mining sector started the New Year with a mega-deal, the proposed $4.9 billion CAD acquisition of Consolidated Thompson Iron Mines by Cliffs Natural Resources, announced in January. This reflects Cliffs’ strategy to build scale by owning expandable and exportable steel-making raw material assets serving international markets, according to a Cliffs press release. Fraser Milner Casgrain LLP is Consolidated’s legal advisor, and Cassels Brock Blackwell LLP is acting as legal advisor to the transaction committee for Consolidated.

Jones Day and Blake, Cassels & Graydon LLP are acting as legal counsel to Cliffs.

The mining sector also saw another mega-deal with the $2.3 billion CAD acquisition of Fronteer Gold by Newmont Mining in February. Fronteer’s Long Canyon project is close to Newmont’s existing infrastructure in Nevada and will contribute significantly to Newmont’s growth profile in North America, according to a company press release. Newmont’s legal counsel

is Goodmans LLP, and Fronteer’s legal advisor is Davies Ward Phillips & Vineberg LLP. “These are the types of deals you’ll see take place in mining,”said an industry analyst who declined to be named. “Companies with strong balance sheets and good technical expertise will come in and make buys in order to increase their asset base and production. Targets with assets close to majors’ operations will be highly attractive.”

The real estate sector also saw a billion dollar deal, with the announcement that Brookfield Asset Management, in February, acquired an 11 percent stake in General Growth Properties from Fairholme Capital Management for $ 1.7 billion USD. Sullivan & Cromwell LLP and Blake, Cassels & Graydon LLP were legal advisors for Fairholme. Willkie Farr & Gallagher LLP acted as legal counsel for Brookfield.

While industry experts could not say if we will see similar minority stake buys of companies in this sector, they did speculate that real estate buys between Canada and the United States will continue to take place, especially given that both countries are politically stable and have good assets.

Mid-market deals occurred in the business services, financial services and technology sectors. Typical were deals like the acquisition by Open Text of Metastorm for $182 million USD, Sprott Inc’s $172 million USD purchase of Global Resource Investments, and Terra Resource Investment Management and Resource Capital

Human Resources

New Regs Put Investment Committees on the Spot

By Bob Auditore and Paul Escobar

the department of l abor ’s

Employee Benefits Security Administration has instituted new regulations, with the goal of providing increased transparency for 401(k)plans and other participant-directed investment programs.

The forthcoming changes have some major implications for corporate fiduciary practices. They make the role of investment committees more critical than ever when establishing a governance and oversight process regarding investment options.

Beginning with plan-years starting after November 1, 2011, all fees and expenses must be plainly detailed on a quarterly basis. This overview will allow investors to easily compare investments and costs in order to make more informed decisions. Under the new fee 22

EXECUTIVE Counsel a p r i l / m ay 2 0 1 1

disclosure regulations, plan administrators must provide pertinent information on investment performance and fees in writing and/or online. The presentation must be in a format that allows for easy comparison of all available funds.

Other investment information of the type typically contained on fund “fact sheets” must be provided prior to enrollment in a plan. This includes investment objectives, returns, and risk.

The requirements mandate availability of a chart that allows eligible employees to easily compare past performances of their investment options to those of benchmark investments.

In the absence of an established investment committee with strong fiduciary practices, meeting the regulated goals of these new fee disclosure provisions will be a challenge.

BEWARE OF HIDDEN FEES

The primary responsibility of the plan’s fiduciaries is to act prudently in the sole and exclusive interest of participants and beneficiaries. Duties include avoiding conflicts of interest, properly diversifying the plan’s assets and ensuring that the plan pays only reasonable and necessary fees and expenses.

Fulfilling these obligations is no

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PERSONAL LIABILITY

These changes underline the essential role of an investment committee, whose composition should include several senior company executives, including the CEO, CFO, heads of operations and Human Resources.

It must be noted that should the company not have the internal expertise to perform the required due diligence, there is a legal obligation to seek “prudent experts” from outside to advise on these matters.

An investment committee is not a titular panel. Each member has personal fiduciary responsibility and personal liability, in the event of plan losses. Therefore, members must have comprehensive knowledge not only of their fiduciary responsibilities, but of all committee policies and procedures, all plan expenses and fees, and the performance, risk, appropriateness, and expenses of each investment option compared against a benchmark.

Responsible investment committees convene formally at least four times a year to monitor all investment options, notices of change, and to discuss any factors that might affect a fund’s appropriateness for employees. The new

fee disclosure regulations will likely create a need for additional meetings, as updates to contracts with third party plan administrators and other service providers are certain to increase.

The new requirements should also motivate investment committees to examine their charters and investment policies statements and determine whether revisions are needed to address any increased fiduciary responsibilities.

Regrettably, a plan sponsor all too often doesn’t have an established investment committee. Instead, it relies on one or a few members of the executive management team to perform a cursory review of a report prepared by the vendor. The Department of Labor has specifically indicated that a provisional panel constitutes neither the independent review nor the due diligence performance necessary to satisfy the sponsor’s fiduciary obligations.

In fact, in the absence of an investment committee and related best practices oversight, a company could open itself up to complaints to the DOL, and potential law suits from plan participants and their beneficiaries.

Bob Auditore is a founding principal at Bay Colony Partners and serves as the firm’s managing partner of the Qualified Plan practice. Prior to the formation of Bay Colony Partners, he was a managing director of his own Broker Dealer, L&M Securities Co, Inc. He received his undergraduate degree in economics from Tufts University. bauditore@baycolonypartners.com Paul Escobar is senior vice president of the Wealth Management Division for Bay Colony Partners, a privately held independent retirement planning firm specializing in the development of process-driven plans and strategies for companies and individuals. He has a BA degree in Mathematics & Economics from Yale University and an MBA from Cornell. pescobar@baycolonypartners.com

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Human Resources

simple task. Many plans are bundled, with fees sometimes hidden rather than broken out for easy comparison.

Specifically, the new regulations require plan administrators to disclose the amount of plan-related fees and expenses deducted for each $1,000 invested, expressed both as a percentage and in a dollar amount. Plans must present current, one-year, five-year and ten-year performance figures, compared to a relevant benchmark.

All fees charged against a participant’s account must be included in the quarterly statement. The fee can be expressed as one number, but participants maintain the right to request additional details from the plan administrator.

Plan sponsors must propose at least one low-cost index fund to participants.

The plan and its service providers must make their financial relationships (if any) known, as a guarantee against conflicts of interest.

E-Discovery

Benefits and Risks of Predictive Coding

By Ken Leissler and Wai M. Yip

to be the costliest and most time-consuming aspect of e-discovery, and organizations are looking for new approaches and technologies to make it cheaper. document review continues

Could technologies such as artificial intelligence (AI) soon replace first-tier – or even second-tier – review in major litigations? Has AI achieved enough reasoning power and legal capability to stand in for lawyers and contract attorneys in a meaningful and defensible manner? Is the market even asking the right questions about the capabilities of these new technologies?

The answer to these questions is no, at least not yet. Computers and technology are not replacing lawyers. Rather, as in many other professions and industries, they are beginning to perform 26

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certain tasks that they have customarily handled. Technological advances in the legal profession and e-discovery are making certain human document review functions obsolete, because the technology can do it better, faster and cheaper.

The fact is that the proper application of technology is an enabler.

Predictive coding is commonly defined as a software process that is applied to a data set in order to identify responsive records. Predictive coding utilizes a learning process that includes a mathematical algorithm to find identi-

cal or similar data deemed “hot” within a larger data population.

Attorneys then examine the results to identify a responsive subset of the data population, creating a benchmark for responsive documents. This subset is confirmed as responsive by counsel, and then the search parameters are applied to the rest of the data without reviewers examining each record.

Historically the legal industry, because it follows formalized guidelines and case law, has not been an early adopter of technology. Thus widespread acceptance of alternatives to traditional review methodologies may take time.

Few attorneys would want to be the first to champion a new technology like predictive coding to the courts. Nonetheless the process is becoming more accepted, as vendors bring down the price.

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pro and con

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• • Prioritize the relevant documents for attorneys to review.

• • Significantly reduce the volume, and therefore the cost and time, associated with document reviews.

• • Minimize the risks associated with inconsistent interpretations resulting from document reviews.

In light of these potential benefits, lawyers should answer the following questions in considering the use of predictive coding: • • To what extent will a predictive coding platform support the legal review process?

• • Will there be an auditable process documentation trail that supports the decisions made by counsel?

• • Does the advanced review technology provide an improved workflow that can increase the accuracy and expedite the decision process?

• • Does the technology require proper implementation throughout an enterprise?

• • Will there be adequate execution and project oversight, enough to reduce the risks in data handling?

Predictive coding can provide value early in a case through the early coding decisions made on a large population of documents in a way that can support (or negate) legal strategies. But for now computer-based analysis still requires, along with a well-designed process, situational understanding, human guidance and technical aptitude by experienced professionals.

OTHER CONSIDERATIONS

Here are some other risks and benefits companies should keep in mind as they consider machine-enabled search and retrieval systems.

• • Predictive coding is a process that can exceed the accuracy of human review when properly deployed and managed.

• • A successful outcome depends in large part on the accuracy of the sample, which ideally will be generated by way of the reasoned analysis of experienced document reviewers. In other words, the reliability of predictive coding depends on solid methodologies and the expertise of the initial document reviewers.

• • Predictive coding alone is not a solution and cannot replace attorneys conducting the review.

Accordingly, companies and counsel should make sure that lawyers and others using the process understand its limits as well as its possibilities. It’s essential to rely on professionals with technical knowledge of predictive coding to guide its deployment and use.

The implementation should include a validation process, so that application decisions and the responsiveness of the document identification can be audited.

Predictive coding is a tool that extends the decision-making capabilities of counsel to a wider set of documents, including data not otherwise accessible because of its size and/or because it lies within an accumulation of irrelevant data.

One final note: Be wary of getting caught up in the multiple technology naming conventions that may be applied to this process. The marketplace terminology varies, but “early case assessment and predictive coding” is one term that makes sense, because of the fact that early coding enables good predictive assessments.

is a managing director for the Protiviti Electronic Discovery and Records Information Management team in New York City. He has more than 34 years of government and corporate investigative experience, including developing information governance programs, business process mapping, transformation from paper to electronic records, records management, and e-mail and ediscovery initiatives. kenneth leissler

wai m. yip

is a director of the Protiviti Electronic Discovery and Records Information Management team in New York City. He consults with corporations, law firms and e-discovery service providers regarding the identification, preservation, collection, review and production of electronically stored information. He has extensive experience leading corporate investigations and corporate responses to government inquiries.

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E-Discovery

Still, predictive coding for e-discovery remains the subject of debate. It appeals to lawyers, particularly corporate counsel, because it leverages the economies and efficiencies of technology to reduce the need for seasoned attorneys to review every document.

However, there are a number of arguments against it.

•• It is not yet a standard methodology.

•• There are concerns about the acceptability and defensibility of the process in judicial systems, both national and global, as well as in regulatory proceedings.

•• There is a lack of understanding about how the technology works, how effective it is and how it fits into the overall discovery process.

•• There are lingering questions about personnel, process, technology and risk controls.

Put another way, predictive technology entails certain known risks. They include: •• Inconsistent interpretations of data reviewed for the benchmark subset.

•• Over-production of non-relevant data.

•• The risk of revealing confidential or potentially privileged data.

However, it’s been shown that properly designed predictive coding technologies, with competent human oversight, can speed up the identification of relevant documents and substantially reduce many risks associated with one area attorneys prefer to delegate: firsttier review.

To maximize the benefits of predictive coding, a litigation team should be an active participant. To this end, many prominent law firms are designating “information lawyers,” typically senior lawyers who are experienced with new technologies and identified as advocates for it.

Human judgment in any case is still required for predictive coding, to create the validated first production or learning data set. Careful consideration should be given to who is supervising and making the decisions.

How should a lawyer evaluate whether predictive coding is right for a particular matter? Predictive coding can be beneficial in identifying electronically stored documents if it can:

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An Executive Counsel Special Section

Federal Securities Fraud Class Actions, Status Report

Securities class action lawsuits and the ground rules under which they are filed and litigated remain as one of the most contentious and least understood of political issues, and for many in the corporate world, one of the most consequential. The positions, at their extremes, come down to something like this: ••(A) Securities class action lawsuits are a drain on the economy, an impediment to business and growth of jobs, and a racket that enriches a few lawyers at the expense of risk-taking, value-creating entrepreneurs and companies.

••(B) Securities class action lawsuits are a valuable enforcement tool. They augment a chronically under-resourced SEC and are an avenue by which corporate and individual malfeasance may be discovered, additional malfeasance deterred, and victims compensated.

To get a handle on the current federal securities class action environment and prospects, one of the best places to start is the annual report from the Stanford Law School Securities Class Action Clearinghouse and Cornerstone Research. This special section begins with highlights from that reports’s major findings about federal securities fraud class actions in

2010, followed by a Q&A interview with Stanford University Law School Professor Joseph A. Grundfest, a widely published expert in the field and founder of the Stanford Securities Class Action Clearinghouse.

Finally, lest anyone think that a report based on hard data will definitely settle the major questions, two attorneys, pre-eminent in the field but on opposing sides, square off with sharply divergent views about some key report findings.

On the plaintiff side is Thomas A. Dubbs, a senior partner at Labaton Sucharow LLP and one of the most feared and respected securities class action lawyers in the business. On the defendant side is Claudius Sokenu, partner at Arnold & Porter, distinguished practitioner, adjunct professor of law at the Georgetown University Law Center, and former SEC senior attorney.

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Federal Securities Fraud Class Action Filings in 2010

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An Executive Counsel Special Section

There were 40 such filings 2010, a 471 percent increase over 2009 (when there were seven such filings). Most of these actions alleged breach of fiduciary duty but did not allege stock price inflation. Typically these filings allege “an unfair transaction price or claim that shareholders received Numbers of Filings Stable inadequate or misleading information about the transaction M&A Players Targets of Choice from the company.”

The report observes that in general securities litigation Federal securities fraud class action activity generally was activity can be correlated with stock market volatility. It at low idle in 2010, but there were some notable exceptions. notes, for example, that volatility during the fourth quarter Lawsuits related to M&A activity were up sharply. So were of 2008 by one measure was at a historic peak, and that actions targeting U.S. health care companies and a more was associated with a flurry of securities class actions. obscure niche, the for-profit college.

That raises the question of why there were so many filBut actions targeting the financial sector were down, ings in the third and fourth quarter of 2010, at a time when and filings specifically related to the credit crisis were way there was a slight decline in volatility. The answer, the report down. Filings targeting Chinese companies were up, sharp- authors suggest, is that much of that activity was related to ly. There were no filings in 2010 against S&P 500 compa- mergers and acquisitions instead of the stock market declines nies in “Consumer Staples, Industrials, Telecommunication that precipitate more traditional class actions.

Services, and Utilities.”

The study authors note that many analysts expect a These are some of the key findings in Securities Class large number of M&A transactions in 2011, due to low borAction Filings – 2010 Year in Review, a report prepared by rowing costs and high cash reserves, and that an increase the Stanford Law School Securities Class Action in deals could mean an increase in the number of M&Arelated class actions, as well.

Clearinghouse and Cornerstone Research.

For the year 2010, there were 176 federal securities class Another angle was suggested by Professor Joseph actions filed, according to the report. This was a slight in- Grundfest, Director of the Stanford Law School Securities crease from 2009, but down by almost 10 percent from the Class Action Clearinghouse. annual average between 1997 and 2009. There was a slight “The sharp increase in federal litigation alleging disincrease in the second half of the year. closure violations in M&A transactions suggests that plainThe increase in M&A related lawsuits was dramatic. tiff lawyers are scrambling for new business as traditional fraud cases seem to be on the decline,” he said. “There is little reason to believe that this trend will reverse or slow down. If anything, plaintiff lawyers may well bring an increasing percentage of these claims in federal court in an effort to control the litigation and to share in any fees that might result.” (An Executive Counsel exclusive inter v iew w it h Professor Grundfest begins on page 33.)

The report found that Health Care was “the hottest sector on the heat maps,” a reference to the report’s trademarked graphic presentation of securities litigation sorted by industry classification.

“In 2010 15.4 percent of the companies in the Health Care sector, representing 33.7 per* The chart is based on the composition of the S&P 500 as of the last trading day of the previous year. cent of the sector’s market capSectors are based on the Global Industry Classification Standard. italization, were named defenPercent of Companies Subject to New Filings equals the number of companies subject to new securities class action filings in federal courts in each sector divided by the total number of companies in that sector. dants in a class action,” the Filings against the same company were consolidated so that the number of companies involved in new securities litigation reflects unique companies. © 2011 by Cornerstone Research. All Rights Reserved. report says. This was a marked

An Executive Counsel Special Section

increase from 2009, when only 3.7 percent of S&P 500 health care companies, representing 1.7 percent of the sector’s market capitalization, were involved in class actions.

“Filings related to the credit crisis were sharply lower for the year, with 13 such filings in 2010, a 76.4 percent decrease from the 55 filings in 2009,” the report notes. “Creditcrisis filings in 2010 represented just 7.4 percent of all filings compared with 32.7 percent in 2009.”

Other findings in the report relate to the likelihood of litigation as a function of time elapsed following an IPO. “We found that there is more than a 10 percent chance that firms would be targeted within three years of an IPO, and firms face the highest risk of being sued in their second year of public trading.” said Dr. John Gould, Senior Vice President of Cornerstone Research.

The study found that companies were at the highest risk of being targeted in the second year after an IPO, when they faced a 4.1 percent chance of being sued.

In the 11 years following its IPO, a newly public company has a 28.7 percent chance of being subject to at least one securities class action.

Overall, about one out of every 19 S&P 500 companies at the beginning of 2010 was a defendant in a class action filed during the year, compared with an average of about one in 15 such companies between 2000 and 2009.

The study found that companies that were in the S&P 500 as of the end of 1999 (controlling for the fact that over time some of the companies cease to be independent entities) had nearly a 50 percent chance of being subject to at least one securities class action in the subsequent 11 years.

Among other key findings: ••The three circuits with the highest number of filings in 2010 were the Ninth Circuit with 51 filings, the Second Circuit with 45 filings, and the Third Circuit with 14 filings.

The Second and Ninth Circuits have been the most active circuits in each year since 1996. The fact that the Ninth Circuit surpassed the Second Circuit in 2010 is at least partially attributable to the decline in credit-crisis filings, which tend to be concentrated in the Second Circuit.

••Class actions filed in more recent years tend to reach dismissal more quickly, though the time to reach settlement has remained stable. For example a higher percentage of dismissed class actions filed between 2001 and 2005 reached dismissal within three years compared with class actions filed between 1996 and 2000, and dismissed class actions filed between 2003 and 2005 were much less likely to take more than four years to reach dismissal compared with class actions filed before 2003.

Stanford Law School Securities Class Action Clearinghouse is a provider of data and analysis on federal securities fraud class action litigation. Cornerstone Research is a provider of economic and financial consulting and expert testimony in litigation. The full text of Securities Class Action Filings – 2010 Year in Review is available on both their web sites: http://securities.stanford.edu and http:// www.cornerstone.com/securities.

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Plaintiff Lawyers Reach For the Low Hanging Fruit Q&A with Professor Joseph A. Grundfest

Executive Counsel: We wanted to ask you first about the

big increase in M&A-related filings.

Professor Joseph A. Grundfest: That’s really interesting. Because the underlying M&A business was up only about 20 percent. Yet we saw more than a six-fold increase in these filings.

EC: What in laymen’s terms are the allegations in these suits?

Professor Grundfest: The allegations are generally that there is fraud in the proxy statement filings related to the proposed merger.

EC: What kind of misstatements?

Professor Grundfest: Various aspects of the transactions aren’t properly described. It ranges the gamut. Failure to describe all aspects of the transaction. Failure to describe material valuation information – that’s probably the most common.

EC: What can companies do to insulate themselves against this kind of lawsuit?

Professor Grundfest: The answer as a practical matter is, to insulate themselves against the lawsuit – very little.

Because you’re not going to disclose everything. You’re not going to do a data dump of everything. You can’t. So there will always be the opportunity for the plaintiffs to file a complaint to say you didn’t disclose x, y and z, and we think x, y and z are material, and you should have disclosed it.

EC: What about the health care sector spike? Would you expect health care filings to increase further because of the new regulations related to the reform legislation?

Professor Grundfest: No. You get spikes that aren’t necessarily part of trends. The M&A increase I think is part of a trend. The reason for that is: The percent – the volume of traditional securities class action cases being filed – is down pretty significantly. So the plaintiffs lawyers are looking for business. They’ve got idle resources. And one of the things that they will try to do is try to find additional complaints that they can file.

EC: And why is this a ripe area? Given they are looking.

Professor Grundfest: The merger ...?

EC: Yes. Professor Grundfest: Because there is a sense in which they are relatively easy to bring. The claims are in just about every situation already brought in state court. So the plaintiffs lawyers looking for a piece of that business wait for the filing of the proxy statement in any of those deals that require the filing of a proxy statement, and then they file their complaint.

I would predict that over the coming years, we will see a very high percentage of these complaints being filed – a very high percentage of merger transactions being subjected to federal class action securities fraud litigation.

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in the statute. Where if you go and look at the statute, the words used by Congress, in the view of the Supreme Court, clearly contemplate a willful act as opposed to a result of negligence.

That’s not a yes or no answer. And it can’t be a yes or no answer to that sort of question. It’s a social balancing. And we have that interpretation because of the words used by Congress. Clearly some people would prefer a different interpretation. And you can have a debate about that, but the right place to have that debate is in Congress.

EC: One more question about the study. The analysis shows that exposure to securities class actions is highest during the first few years after an IPO – I think the second year is the highest.

Professor Grundfest: I think that’s right.

EC: Is that because senior executives still kind of view themselves as owners, rather than managers?

Professor Grundfest: No, no, no. It’s because plaintiffs typically don’t file a securities fraud claim until there is a statistically significant decline in the stock price. And the statistically significant declines tend not to happen until the after the company is out for a bit over a year.

EC: So it’s a matter of how the process goes forward.

Professor Grundfest: Yes sir.

EC: You were an SEC commissioner in the 80s…

Professor Grundfest: Yes? EC: …1985 to 90. It’s been said that enabling legislation for the SEC envisioned a large role for plaintiffs law firms because of a tacit acknowledgment that special interests would prevent Congress from funding the Commission adequately.

Professor Grundfest: Said by whom?

EC: That’s a good rejoinder. I don’t know.

Professor Grundfest: I am not going to comment on anonymous statements. I have learned not to go for that bait.

EC: Then independent of that: Did you think the Congressional funding was adequate for the SEC at the time you were a Commissioner? Did you feel the resources were adequate?

Professor Grundfest: My view on that has been consistent. The SEC has always, and always will have to, compete with other socially valuable uses of tax payer dollars. The government has to spend it’s resources on the national defense. On health care. Education. And also protecting our securities markets. And these again are very difficult social balancing questions, as different people will have different points of view about the relative importance of each.

joseph a. grundfest is W. A. Franke Professor of

Law and Business at Stanford Law School and a senior faculty member with the Arthur and Toni Rembe Rock Center for Corporate Governance at Stanford. He served as an SEC commissioner in the late 1980s, and in 1984-85 served on the staff of President Reagan’s Council of Economic Advisors as counsel and senior economist for legal and regulatory matters. An expert on capital markets, corporate governance, and securities litigation, he founded the Stanford Securities Class Action Clearinghouse. grundfest@stanford.edu The Magazine for the General Counsel, CEO & CFO

An Executive Counsel Special Section

EC: In terms of how easy it is to file a suit – you testified before Congress regarding the Private Securities Litigation Reform Act that we don’t know how the courts will interpret the Act’s requirement that complaints state with particularity all facts.

Professor Grundfest: Well, that was 15 years ago.

EC: What do you think the courts interpretation has been?

How do you read that?

Professor Grundfest: The answer simply is we’ve had Supreme Court decisions on that issue. There was initially a split among the circuits. There was strong disagreement about how to interpret. We then had a Supreme Court decision called Tellabs [Tellabs, Inc. v. Makor Issues & Rights, Ltd.] that was designed to introduce consistency in the area. And instead of introducing consistency, it has generated a different set of splits.

EC: Unclear then?

Professor Grundfest: No, the answer is: It depends on in which geography you are bringing the case, and even so the interpretation is often unclear.

EC: Regarding scienter. The Act requires plaintiffs to create a ‘strong inference’ in order to proceed against the defendant. This is a higher standard than for any other alleged fraud. Does that serve investors…

Professor Grundfest: Wait, first of all, let’s back up.

That is not necessarily true. There are other causes of action that require that you allege scienter in order to demonstrate fraud. There are other causes of action that will allow for negligent misrepresentation. So it’s not accurate to say that the securities laws are the only cause of action that requires scienter in order to demonstrate liability for fraud. That is not accurate.

EC: Well, the second part of the question: Does that requirement serve investors and the general public well? Or does it make it easier to defraud them?

Professor Grundfest: There are several answers to that. First, if you have a look at what constitutes a fraud. Let’s take a step back. There are many approaches people can take to answering that question. Some people will argue that when a fraud happens, a fraud is not inadvertent. That if I am trying to get money out of you, then it is not going to be a careless or negligent step on my part. I will consciously be trying to get money from you. And some people will argue that’s the appropriate definition of fraud.

Other people will argue there is another category of fraud where you wind up just not being careful, and because you are not careful you wind up telling a lie that winds up defrauding me.

Then there is another perspective that says, “Wait a minute. The potential damages in these federal securities cases are so large that what we need to do is balance the potential exposure against the trigger for creating liability.” So it makes sense, some people would argue, that since the liability is so large, you want to have higher confidence that the person has actually engaged in fraud.

Those are the parameters of the debate. And reasonable people can have different views, as to what the right social balance is. But the law is interpreted as it is, because of the way the courts have interpreted the actual language used by Congress

POINT-COUNTERPOINT:

Plaintiff and Defense Lawyers Square off on Key Report Results Though it's based on hard data, it turns out that when the report, Securities Class Action Filings – 2010 Year in Review, was subject to scrutiny by two opposing experts, there was plenty of room for interpretation. In this commentary, defense attorney Claudius Sokenu, Arnold & Porter, and plaintiff attorney Thomas A. Dubbs, Labaton Sucharow, field some selected report excerpts and come to very different conclusions. Excerpts are printed first, followed by comments from each of the attorneys.

An Executive Counsel Special Section

There was a significant increase in the number of class actions related to M&A transactions in 2010, most of which alleged a breach of fiduciary duty but did not allege stock price inflation. In 2010 there were 40 filings with allegations relating to M&A transactions, which was a 471 percent increase from the seven such filings in 2009.

Thomas A. Dubbs:

Securities class action cases are designed to recoup investor losses caused by securities fraud to deter such conduct in the future and often to improve corporate misbehavior by improving corporate governance.

In its prior reports, Cornerstone implicitly acknowledged the distinction between Delaware M&A cases and securities class actions by tabulating them separately. Once Delaware M&A cases are removed from the report, the ongoing decline in securities class action cases is evident.

The Private Securities Litigation Reform Act [PSLRA], along with recent Supreme Court decisions such as Iqbal and Twombley, are working as they were intended to. They have limited the securities actions to only the most meritorious cases. There are few, if any, frivolous suits being brought today because instituting such suits is simply not worth the time and effort.

To argue, based on the addition of Delaware M&A numbers, that securities class action filings are increasing and, by implication, to suggest that the system is still not working, is incorrect.

Claudius Sokenu:

Last year’s spike in mergers and acquisition-related class actions appears, at least in part, attributable to the rebounding economy and the concomitant surge in mergers and acquisition activity. According to Cornerstone Research, mergers and acquisition-related lawsuits raising, 35

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among others, breach of fiduciary duty claims accounted for most of the mergers and acquisition-related filings for 2010.

Plaintiff firms typically file these lawsuits on behalf of disappointed shareholders who allege that management and/or the board of directors improperly, and in their own self-interest, agreed to enter into a transaction at a price that plaintiffs contend was artificially or temporarily depressed.

In reality, however, companies facing a challenging economic climate may have few, if any, options to raise capital sufficient to continue as a going concern. In such economic crises, companies increasingly turn to merger and acquisition opportunities as a means to preserve shareholder value. From the plaintiff's perspective, taking advantage of these merger and acquisition opportunities – even when management and the board are acting in the best interests of the company – results in the sale of a company at a depressed value and, consequently, improperly divests investors of their ownership interests.

There were 12 filings against Chinese issuers in 2010, accounting for 42.9 percent of filings against all foreign issuers, the highest ever observed in a single year. The high incidence of filings against Chinese issuers occurred against the backdrop of a year when filings against foreign issuers accounted for 15.9 percent of all filings, which is among the highest ever observed.

Dubbs:

Many Chinese companies enter U.S. exchanges not through a traditional IPO, but by purchasing a shell company and effecting a reverse merger. By doing so, a Chinese corporation can avoid the rigors of due diligence by an investment bank that goes hand in hand with an IPO, as well as any review by the SEC. More importantly, there is no need, as with an IPO, for the company to undergo a GAAS audit and have certified financial statements. According to the Report, nine of the 12 Chinese companies named in class action suits in 2010 were listed on American exchanges through this reverse merger mechanism.

Also, many of the class action suits against Chinese companies have, at their root, Chinese reporting requirements that differ significantly from those in the U.S. as set out by the SEC. The difference in disclosure cultures between the U.S. and China is exacerbated by the fact that none of the 59 Chinese auditing firms who have registered with the Public Company Accounting Oversight Board has actually had an inspection by that body because China considers such an inspection to be a breach of sovereignty. It is then a question as to whether Chinese management is fully committed to the American disclosure process and, as evidenced by the securities class actions brought against them, many are not.

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However, any consideration of securities suits against foreign companies has to be taken in the context of Morrison v. National Australia Bank. It is possible that many of these suits will not survive post-Morrison or that they will be dismissed on grounds of forum non conveniens.

Sokenu:

Companies that recently completed an IPO tend to be higher-risk companies that are in their high growth stage of development. These companies tend to have higher company-specific risk, i.e., are more likely to have extreme positive and negative surprises and hence may have higher litigation exposure. According to University of Florida Professor Jay Ritter’s data set of IPOs, there were a total of 3,510 IPOs between January 1, 1996 and December 31, 2009. Out of these companies, 648 were defendants in at least one securities class action between 1996-2010, which corresponds to 18.5 percent of the sample IPOs. Dubbs:

A company undergoing an IPO is, almost by definition, a company with a lower capitalization than a Fortune 500 company. In order to protect investors, Congress has enacted statutes which require such companies to prepare extensive disclosures and put forth a detailed prospectus as part of the IPO. If they issue false information in this prospectus, they are subject to liability under the federal securities laws because they are misleading the public as to the status of the company and its value. The primary means to address false and misleading statements in a prospectus is pursuant to Section 11 of the Securities Act 36

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Sokenu:

IPOs tend to be risky investments, which, in turn, raises the specter of high litigation exposure. In Cornerstone’s study tracking companies over an eleven year period following their initial public offering, over 35% of the companies did not see their fourth year as a public company. For those public companies that do survive, however, the risk of securities filings decreases significantly after the first few years. In a company’s infancy, the risk of inadvertent but material misstatements is greater, and such missteps can lead to litigation. Plaintiffs can sue under the Securities Act of 1933, which holds a corporation strictly liable for material misstatements or omissions. Directors and officers can also be held liable for such misstatements or omissions if they result from a failure to exercise due diligence.

In order to avoid the risks of litigation that inherently follow an initial public offering, companies should be cautious when pricing their stock so that future investors do not perceive a false sense of hope for their returns. Taking steps to meet future compliance requirements before the public offering is another measure companies should undertake to minimize the potential for future securities litigation. Particularly in the post Sarbanes-Oxley Act of 2002 and Dodd-Frank Act of 2010 world, there are significant differences between private and public companies, and private companies should familiarize themselves with the many varied obligations (and associated costs) that come from being a publicly traded company before opting for going public,

In terms of cumulative litigation exposure, at the end of 2010, all S&P 500 companies as of year-end 1999 had a 49.9 percent chance of being subject to at least one federal securities class action in the following 11 years.

Dubbs:

Provided that these suits are not brought randomly, but are rather concentrated by industry or systemic abuses, to describe all S&P 500 companies as having a 49.9 percent chance of being subject to a lawsuit is debatable. Misbehavior across a specific industry or a specific practice, such as options backdating, is usually responsible for class actions over a “baseline” number of suits. That is why Cornerstone The Magazine for the General Counsel, CEO & CFO

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The growing list of Chinese companies that have been sued in federal securities class actions this year appears to be the result of an increase in the number of Chinese companies listed on the U.S. exchanges. One potential explanation for the large number of securities class action lawsuits against foreign issuers is that some of these Chinese companies have struggled to adapt to the comprehensive reporting and disclosure regimes to which listed companies are subject.

Another potential explanation relates to Chinese companies that have gone public in the U.S. through reverse mergers.

Commentators have accused these companies of, among other things, having questionable auditing, internal controls, and financial reporting standards.

Although the increase in the number of class action lawsuits against Chinese issuers is noteworthy, particularly in light of China’s growing presence in the global economy, it is important to place this observation into the appropriate context. There are over 220 Chinese companies listed on the NYSE, AMEX and NASDAQ. There have been only twelve filings this year, involving a handful of these companies. Viewed more broadly, the number of lawsuits involving Chinese issuers appears far less significant.

of 1933. Section 11 is notable because it has no intent requirement, which means it actually has teeth for enforcement.

Investment banks are supposed to act as gatekeepers for the public on IPOs by finding the best companies to go public. One of the reasons we’re seeing so many securities class actions in response to IPOs however, is that in spite of the threat of Section 11, investment banks have simply become less picky about what IPOs they will push forward; they have become less averse to reputational risk and the deterrent effect of Section 11 seems to have been lessened.

focuses on “hot zones.” There was an upsurge in securities class actions filed after the Internet bubble of the 90s, then a host of options backdating cases, and most recently we have seen a large number of credit-crisis-related cases. As Joseph Grundfest, director of the Stanford Law School Securities Class Action Clearinghouse, said in his commentary on the 2007 Cornerstone Report, “For the past two years, securities fraud class action litigation has been driven by market-wide events, such as the 2006 options backdating scandals and the 2007 subprime crisis. If these systemic shocks are excluded from consideration, the ‘core’ litigation rate continues to be remarkably low. When litigation related to the subprime crisis is excluded from the calculation—on the assumption that the subprime crisis is a nonrecurring event—the resulting core litigation rate remains well below historical norms.”

Thus, post-credit crisis litigation, as the current Cornerstone statistics suggest (after removal of M&A cases), we have now returned to a baseline “core” of cases which is the by-product of the PSLRA and subsequent decisions.

Sokenu:

An Executive Counsel Special Section

It should come as no surprise that over the past decade, S&P 500 companies had a nearly 50% chance of finding themselves as defendants in securities class actions. And it should come as no surprise that securities class actions will remain a standard litigation risk for S&P 500 companies in the future. The staggering amount of money involved in securities class action litigation effectively guarantees that it will remain a vital part of the securities litigation landscape for years to come. The Report indicates that, on average, securities class action settlements in 2010 reached $32 million and the average breach of fiduciary duty suit settled for about $17 million. The potential for eye-catching settlements in such actions provides ample motivation for plaintiff firms to pursue such cases.

In 2010, 15.4 percent of the S&P 500 Health Care companies were involved in new filings, representing 33.7 percent of the sector’s market capitalization, making it the second hottest sector on the Heat Maps for the year.

Dubbs:

We are seeing a number of health care companies named in new securities class action suits because there are reimbursement issues that lend themselves to aggressive accounting and overheated guidance to the market; and, accordingly, these companies are taking advantage of the many regulatory changes at both the federal and state levels to engage in misbehavior. As I mentioned before, securities class actions usually come in waves and are based on industries. Right now, the health care industry is an extremely active and controversial sector, so there may be an upsurge in class action suits. However, the numbers are not significant enough to lift the overall total above Professor Grundfest’s “core” level.

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Sokenu:

Last year a number of pharmaceutical companies were named in securities class action suits and this trend is likely to continue in years to come. Plaintiffs’ firms have increasingly filed securities class action suits over alleged safety issues, adverse event studies, or unfavorable FDA rulings. Any one of these events could trigger a material drop in a company’s stock price, and with it, a flood of lawsuits. What should worry pharmaceutical companies, and what could lead to a further increase in securities fraud suits, is the Supreme Court’s forthcoming decision in a case captioned Matrixx Initiatives, Inc. v. Siracusano.

The Court recently granted certiorari in Matrixx to decide whether a plaintiff can state a federal securities fraud claim “based on a pharmaceutical company’s nondisclosure of adverse event reports even though the reports are not alleged to be statistically significant.” Should the Supreme Court conclude that the respondents’ claims against Matrixx are sufficient to withstand a motion to dismiss, pharmaceutical companies potentially face a significant burden to disclose adverse information in connection with announcements regarding their products. The disclosure requirement would likely be triggered even when that adverse information is based on statistically insignificant data about side effects.

If the Matrixx decision does ultimately place this additional burden on pharmaceutical companies, the trend toward increased securities filings against corporations in the health care sector will likely continue to surge in the upcoming years.

is a partner in the securities enforcement and litigation, white collar defense, congressional investigations, and commercial litigation practice groups at Arnold & Porter, where he maintains a global practice representing multinational corporations, hedge funds, private equity firms, broker-dealers, investment banks, accounting firms, auditors, and public and private companies and their employees. He is also an adjunct professor of law at the Georgetown University Law Center in Washington, D.C. and a former senior counsel in the SEC enforcement division.

Claudius.Sokenu@aporter.com claudius sokenu

thomas a. dubbs

is a senior partner at Labaton Sucharow LLP. He specializes in the representation of institutional investors, including pension funds, in securities fraud and other types of litigation. He represented the first major private institutional investor to become a lead plaintiff in a class action under the Private Securities Litigation Reform Act, and he currently serves as lead or co-lead counsel in federal securities class actions against, among others, AIG, Wellcare and Bear Stearns. tdubbs@labaton.com The Magazine for the General Counsel, CEO & CFO

By Chad A. Shultz and M. Travis Foust

States, 2010, there were 13,036 employment cases commenced and 15,452 cases pending in U.S. district courts in 2008. In 2009, the number of civil rights or labor related cases filed in federal courts rose to 51,480.

With increased lay-offs and reductions in force continuing across many industries, these trends are likely to continue.

Employee-related disputes at the government administrative level are also on the rise. According to the a U.S. House committee report on Labor Department funding, the Office of Federal Contract Compliance Programs has received an additional $19 million – a funding increase of more than 20 percent – to allow the agency to conduct more than 5,000 audits per year of private company contractor practices.

The EEOC also received a $23.3 million funding increase. which it will use to hire 140 employees, according to an agency report submitted to Congress. The total EEOC 39

EXECUTIVE Counsel a p r i l / m ay 2011

The Magazine for the General Counsel, CEO & CFO

budget for 2010 was about $367 million.

Thanks to these multi-million dollar increases, while many companies are cutting back their workforce, the agencies are on track to hire hundreds of investigators, lawyers, mediators and support staff.

A recent survey conducted by the Chubb Group of Insurance Companies found that more than one in five private companies, or 21 percent of those surveyed, experienced an employment-related charge of discrimination or a lawsuit

over the past five years. Among the companies that experienced a charge or a lawsuit, the average cost of defense was $51,975. Nearly half of the companies that dealt with a charge or lawsuit reported costs ranging between $20,000 and $750,000.

These are costs that can be managed more effectively.

THE OLD-SCHOOL LITIGATION APPROACH

Companies embroiled in these conflicts may hire litigation counsel or utilize their in-house litigators. In either case, the job of a litigator is to prepare for and succeed at trial.

Litigators aggressively pursue their opponents in formal written discovery, depositions and pre-trial hearings.

Employment litigators are cost centers. They do not produce revenue. They want to win at all costs.

Consider the following ten things lawyers know are true about litigation, but don’t want to admit: (1) Once your company has been sued it can’t win. You may get the case dismissed, or a jury may return a verdict in your favor, but the associated costs make it impossible to view either of those outcomes as a win. A dismissal at the summary judgment level is likely to cost the company in excess of $75,000 in attorneys’ fees, and that number is likely to more than double through trial. This not a win. The real question is to what degree the company lost.

(2) Cases get resolved in one of three ways: They are dismissed, typically through costly motion practice following extensive discovery. They are settled. Or, they are tried.

Very few cases (about 4 percent) get tried, and those that do get tried most often result in a significant increase in jury awards for successful plaintiffs. It was reported by Jury Verdict Research (in “Employment Practices Liability, 40

EXECUTIVE Counsel a p r i l / m ay 2011

Jury Award Trends and Statistics,” 2009 edition), that the median compensatory damages award for employment cases was $326,640.

A large number of cases (about 21 percent) get dismissed, but only after significant legal costs and fees, as discussed above. Usually those costs are more than it would have cost to settle.

The remaining cases – the vast majority of those filed, about 75 percent – are settled eventually. But too often settlement isn’t really explored until after discovery has closed, a dispositive motion is paid for and pending, or trial is imminent – and a company has run up substantial fees.

(3) Good plaintiff lawyers see value in early settlement.

Plaintiff attorneys take cases on contingency arrangements, where the attorney is not paid until the case is resolved.

Wise plaintiff lawyers will settle a case for less if it can be done before they have to invest significant time and money in litigation. This is an inherent truth with contingency fee arrangements.

(4) Defendants can afford to invest more money in early settlement because they haven’t invested as much in litigation. Overall cost should be the issue, not just what is ultimately paid to the plaintiff.

(5) Most discovery costs are a waste of money and rarely find a silver bullet that will significantly change the outcome of the case. Most trials end up with 30 or fewer crucial exhibits, even though most litigation results in thousands of documents being exchanged and tens of thousands of dollars being spent on attorneys after months of discovery battles.

In fact, with more electronic discovery delving into companies’ computer servers and e-mail systems, plaintiff counsel are using the discovery process to substantially increase defense costs, so as to make settlement at a higher dollar amount seem more attractive. As is the case with written

discovery, electronic discovery seldom changes the face of the litigation. The case rarely looks much different than it did when the answer was filed.

(6) Litigators are most effective when they are passionate about their client’s position. They see the goal (to “win”), and they go for it. This can cause them to lose their objectivity, overestimate their ability to prevail and underestimate litigation risks. Calling on a litigator/trial lawyer to objectively evaluate the case for settlement purposes may get them off point and diminish their value for the “warrior” duties they were hired to perform.

(7) Litigation is prohibitively expensive. The process is long, slow, and inefficient. The most recent statistics from The Magazine for the General Counsel, CEO & CFO

U.S. courts show that the average length of litigation in federal courts, from filing through trial, is 25.3 months.

The resulting expense is not manifest in attorneys’ fees alone. Employment litigation is driven by the facts and by the witnesses, and the costs discussed in this article do not take into account the time and productivity that is lost by way of preparing witnesses – employees and managers – for deposition or trial.

The courts, meanwhile, often are overburdened and give little thought to the extra expense that inefficient procedures and local rules bring to the parties.

(8) Litigation advocacy is not the same as settlement advocacy. Litigation is a form of combat. Settlement principally requires finesse and consensus building. Mediators, who have experience as litigation and trial lawyers, can bring that experience to the table in their role as settlement counsel. But litigators all too often shoot in the dark con-

cerning settlement, because they view it as another battle in the litigation war they were hired to “win” – a term that, as they should, they define as total victory. Settlement counsel defines a win as a resolution their clients view as successful under the circumstances.

(9) Usually cases that can be settled can be settled much earlier than they are. Opportunities for early resolution are missed because they weren’t presented and managed early enough, or because the opportunity was missed in the course of preparation geared towards the long haul.

When a case is settled late in the game, virtually all the arguments against early settlement are set aside as less important than the reasons to settle. It has been said that a trial is the result of failed negotiation, just as a war is the result of failed diplomacy.

(10) Settlement counsel hired solely to evaluate and settle disputes can get cases resolved faster and cheaper than in-house lawyers and outside litigators can. They are in a unique position to motivate plaintiffs and their counsel to settle for an acceptable sum.

out a prior demand, settlement counsel should be retained before the answer is even filed and before the litigation firm is retained to defend the case.

The settlement counsel’s sole job is to evaluate the case, assess it for settlement and get it resolved. If the case is not right for settlement (and some are not), or if it can’t be settled within 60 days, the case should be turned over to the litigators.

In this way, the litigators need not be distracted by the “fight-settle” dance. Litigators are hired to fight because the potential for early, cost-effective settlement has already run its course. They are hired to get the case dismissed or obtain a defense verdict after trial.

The settlement counsel approaches the case from a different angle and provides the company with crucial information. First, the assessment is not a “can-we-win” question. Rather, it is: “Does it make sense to settle? Can we get it settled within the parameters the company has agreed to?

What is this case worth?”

Settlement counsel gets the opposition to consider settlement in a way that the litigator is often reluctant to try, because it will be viewed as a weakness or fear of losing. With settlement counsel, the opposition is told from the beginning that counsel has been hired only to see if the case can be resolved before significant money is spent on litigators.

Their involvement does not signal weakness or fear. It only represents sound business judgment and economic reality.

Where settlement counsel has been employed, as soon as it becomes evident that the case can’t be settled, the litigator starts out with at least some knowledge of what prevented resolution. Having this information is a significant strategic advantage for the litigator and ultimately a cost savings for the defendant.

Most parties to lawsuits and their counsel still operate under the old model, where resolution of the suit is briefly discussed before suit is filed, and then is put on the shelf until the motion for summary judgment is pending or denied.

Our justice system is just too slow, expensive, and overburdened for this approach. For a more efficient and less expensive resolution, settlement counsel is worth considering.

chad a. shultz

is a partner in the Atlanta office of Ford & Harrison. He focuses his practice on helping clients avoid lawsuits and defend those that can’t be avoided. cshultz@fordharrison.com

A SETTLEMENT COUNSEL APPROACH

Companies facing potential litigation or that already have been sued should consider hiring an experienced negotiator with litigation and mediation expertise to evaluate and assess cases as early as possible.

Settlement counsel should be retained upon receipt of the first demand from a plaintiff’s lawyer. If suit is filed with41

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m. travis foust

is senior counsel in Ford & Harrison’s Atlanta office. He focuses his practice on counseling, training and representing management clients in federal and state courts, as well as before state and local agencies. tfoust@fordharrison.com The Magazine for the General Counsel, CEO & CFO

Mandatory Disclosure Rules for Government Contr actors

By J. Catherine Kunz and Richard W. Arnholt

Last year the feder al government purchased over $500 billion in goods and services, making it the world’s largest consumer. Even during downturns, the feder al marketplace continues to offer opportunities to companies across a r ange of industries.

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However, entry into this marketplace is not without risk.

Federal contractors are subject to a host of regulatory requirements, among them provisions issued in November, 2008, mandating that contractors self-report to the government when they violate certain laws or receive overpayments from the government.

Given the significant business risks – including exclusion from the federal marketplace – associated with noncompliance with these disclosure requirements, it is vital that management understand them and ensure that they are complied with.

TWO COMPONENTS, WIDE APPLICATION

The November 2008 regulations included two components.

First, they added a new basis for suspension or debarment from government contracting: a knowing failure by a “prinThe Magazine for the General Counsel, CEO & CFO

cipal” to timely disclose “credible evidence” of (1) violations of certain criminal fraud laws, including conflict of interest, bribery, or gratuity violations, (2) violations of the civil False Claims Act or (3) significant government overpayments.

“Principal” is defined to include an “officer, director, owner, partner, or a person having primary management or supervisory responsibilities within a business entity.”

Second, they added a new contract clause, which requires contractors to report violations of the same criminal fraud laws, or of the civil False Claims Act – again, if there is “credible evidence” of such violations. The contract clause applies only to contracts or contract modifications that were awarded after December 12, 2008, and that are expected to exceed $5 million in value and be performed over more than 120 days.

However, the new grounds for suspension and debarment are applicable to all government contractors.

This means that every company that contracts with the federal government, regardless of contract size, the type of good or service or the place of performance, must disclose credible evidence of the listed violations. Otherwise, should the government later learn of the violation, the company risks suspension or debarment for failure to timely disclose.

WHAT IT MEANS

From such a seemingly simple concept – mandatory disclosure of certain violations to the government – a number of practical questions arise. What, for example, is credible evidence? To whom should the disclosure be made, and what should it include?

Contractors have answered such questions in various ways, depending on their situation, but there are best practices that apply generally. Management and boards of directors need to know them well enough to be able to exercise oversight of their company’s compliance infrastructure. In general, given the difficult judgment calls involved, in-house counsel should be engaged in these determinations, and for entities without in-house counsel experienced with government contracts law, outside counsel is advisable.

What is credible evidence?

The rules don’t define the term, but the definition has been fleshed out in practice. In short, having credible evidence is having more than a reasonable belief that an allegation is true and less than confirmation that it is true.

While contractors are not expected to complete a fullblown internal investigation to determine if credible evidence exists, prudent contractors should perform some review of the relevant facts.

Whether or not there is credible evidence of a reportable violation is a judgment call and will be fact-specific.

For example, a vague, anonymous allegation would likely not be considered credible evidence and likely would not be grounds for the contractor to investigate. However, a report from a reliable individual with direct knowledge of the alleged violation likely would warrant an internal investigation and could lead to credible evidence that would require a disclosure to the government.

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Who must have knowledge of the credible evidence?

While the contract clause requires mandatory disclosure where the “contractor” has credible evidence of a violation, the requirement in the suspension and debarment provision is limited to situations where there is a knowing failure by a “principal” to disclose a covered violation.

Arguably, the fact that the suspension and debarment provision is focused on a “principal’s” failure to disclose suggests it is narrower than the contract clause. But given the draconian consequences – no more federal contracts and significant harm to the organization’s reputation – companies should not make too much of this distinction. If someone at the company believes a covered violation has occurred, it should be reported to the compliance team or legal department. It should then be investigated to the extent necessary to determine whether credible evidence exists, and if it ex-

The new grounds for suspension and debarment are applicable to all government contr actors. ists, it should be reported.

Corporate leadership should ensure that reporting mechanisms are in place, and they should foster a corporate culture that encourages their appropriate use.

To whom should the disclosure be made?

Where the contract clause applies, disclosure must be made to the contracting agency’s inspector general and to the contracting officer. When the reportable conduct applies to more than one contract, the contractor should make a disclosure to the inspector general and contracting officer responsible for the largest dollar value contract involved. If the reportable conduct applies to a government-wide acquisition contract, such as a GSA Schedule contract, the contractors must report both to the inspector general of the ordering agency and to the inspector general of the agency responsible for the basic contract, as well as to the respective agencies’ contracting officers.

In contrast, where only the suspension and debarment terms apply, disclosure is required to be made to “the government.” This lack of specificity should not be abused, but it does mean such reports do not necessarily need to be made to an agency inspector general. While a conservative approach would follow the reporting requirements of the contract clause and submit the report to the relevant agency inspector general and contracting officer, a prudent approach where only the suspension and debarment clause applies would be submission of a report to the relevant contracting officer.

What is timely disclosure?

Unfortunately, the mandatory disclosure rules provide The Magazine for the General Counsel, CEO & CFO

only general guidance, and there is tension between the requirement for “timely” – usually read to mean prompt – disclosure, and the expressed desire of the inspectors general and DOJ that disclosures be complete.

Rather than attempt to address this issue for the first time when a potential mandatory disclosure situation occurs, management should consider implementing mandatory reporting procedures as soon as possible to ensure a framework is in place for promptly addressing disclosures issues when they arise.

In general, to avoid questions about timeliness, disclosures should be made as soon as practicable after a determination has been made that credible evidence exists. As discussed, this credible evidence determination should not be made until the contractor has something more than reasonable belief that the allegation is correct, at which point the file on the matter should be well -developed.

There is no prohibition against continuing an internal investigation after the disclosure and subsequently providing the results of that investigation to the government. And this approach may mitigate the risk that any adverse action will be taken for failure to meet the timeliness requirement.

However, a contractor should not rush to make what turns out be an incorrect report. On balance, it is more important to investigate sufficiently to ensure there is in fact credible evidence of a reportable violation before making a disclosure.

Neither the government nor a contractor wants to have the government look into a matter that turns out to be baseless.

What should the disclosure include?

Many government agencies have established web-based reporting forms that require contractors to input information in response to questions and prompts. While these on-line forms are relatively easy to use, many contractors have decided instead to prepare individualized reports. These are usually in the form of a letter, with necessary attachments that provide context, discuss the development of evidence and include data about a reportable violation, and provide information on how the contractor intends to rectify the reportable violation.

The primary advantage of an individualized report, as opposed to one using the government’s on-line form, is that it gives the contractor greater control of the type and amount of information submitted. Significantly, where the on-line forms require the contractor to certify that the information submitted is “true and accurate,” the individualized letter does not ask for – and should not include – such certification.

Also, by submitting an individualized report, the contractor can protect its information by including a protective legend on the report. This legend should indicate that the contractor considers the information to be proprietary and confidential, and not subject to disclosure under the Freedom of Information Act. THE LOOK-BACK REQUIREMENT

The so-called “look-back” requirement is one of the more challenging aspects of the mandatory disclosure rules.

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The suspension and debarment provision applies to failure to report credible evidence of a violation on a contract “until three years after final payment on any Government contract awarded to the contractor,” potentially reaching back in time from the effective date of the rule – December 12, 2008 – to include all contracts upon which final payment was received after December 11, 2005.

The contract clause also requires a look-back for contractors who are not small businesses or businesses selling commercial goods or services to the government.

To take this requirement literally, a contractor would have to go back to all contracts performed during the look-back window and thoroughly review the company’s performance, its submissions to the government and any other aspect of the contract that could have generated a reportable violation.

Given the impracticability of this approach, some government officials have indicated that a good faith effort to look into events or circumstances known to the contractor to possibly involve a reportable violation is sufficient. This means that, for example, if an internal audit has indicated a possible overpayment, the contractor would be wise to revisit the facts of the situation to determine if a report and repayment should be made.

Another way to demonstrate a good faith effort is to conduct a one-time survey of company officials about known or suspected reportable violations relating to contracts in the look-back window and follow up with responses to the surveys as appropriate.

In sum, the mandatory disclosure rules require that federal government contractors timely disclose credible evidence of covered violations, and failure to make a required disclosure puts the contractor at risk of being excluded from the federal marketplace. However, because many if not all disclosures submitted to the agency inspectors general are shared with the Department of Justice for possible prosecution, contractors must carefully consider what these rules require prior to opting for a disclosure. j.

catherine kunz is a partner in the Washington D.C. office of Crowell & Moring and a member of the firm’s Government Contracts group. Her practice involves both counseling and litigating on behalf of clients in a range of government contract law areas, including GSA Schedule contracting, claims and disputes, fraud and abuse, cost accounting issues, purchasing and subcontracting, and federal health care contracting. ckunz@crowell.com richard w. arnholt

is a Washington D.C.based counsel in Crowell & Moring’s Government Contracts Group. He focuses on government procurement law, including bid protests, contract claims, compliance counseling, and suspension and debarment matters. rarnholt@crowell.com The Magazine for the General Counsel, CEO & CFO

Planning For Litigation Over Acquired IP

By Mike Annis and Brad Pursel

Intellectual property has become a critical asset. Companies in many industries allocate significant amounts of capital to create intellectual property or acquire it from third parties.

As a result, companies must carefully manage their portfolios to maximize value and protect IP rights.

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This article discusses U.S. Generally Accepted Accounting Principles (GAAP) requirements related to accounting for acquired IP, and the discoverability and use of accounting work papers if the acquired IP is subject to infringement litigation.

The valuation of allegedly infringed IP and the assumptions used to do the valuation can be central issues in determining damages in IP litigation. Although there is often limited information about a company’s internally developed IP, accounting standards under GAAP require the valuation of IP acquired during an acquisition. If the acquired IP is later subject to an infringement claim, the valuation of the acquired IP will likely become a subject of discovery and significant discussion during the litigation.

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Corporate executives should plan carefully for the accounting and valuation of acquired IP, not only to comply with accounting standards, but also because the work papers will be discoverable.

Here’s a scenario that illustrates what can happen: Alpha Company acquires Beta Corporation. In performing the accounting for the acquisition, Alpha must record the fair value of any acquired assets, including IP, regardless of whether the asset was previously recorded on the balance sheet of Beta. However, in accounting for the acquisition, Alpha does not record as an asset Beta’s patent portfolio.

This implies that the fair value of the patent portfolio is $0.

Subsequent to the acquisition, Alpha discovers that Cash Company is infringing on Alpha’s patent portfolio in the manufacture and sale of a competing product. The question then becomes: Does Alpha’s accounting for the acquired IP patent portfolio negatively impact Alpha’s ability to seek damages for patent infringement?

IMPORTANCE OF IP IN M&A

Executives should be aware of the potential legal consequences of any IP valuation should the IP later become the subject of infringement litigation. These valuations should not be considered an exercise in accounting compliance unrelated to the protection of rights and maximization of value from such rights.

In a 2008 survey sponsored by CRA International and K&L Gates LLP, the vast majority of respondents (85 percent of corporate executives and 72 percent of private equity executives considered IP assets as important or more important than

Executives who may be motivated to maximize earnings per share by assigning either no value or a small value to acquired IP should be cautioned: Such short-term decisions could have significant negative consequences if the acquired IP is the subject of infringement litigation. other assets when evaluating a target. (In addition, 58 percent of respondents said that insufficient time is the biggest challenge they face when conducting due diligence of IP assets.)

A thorough due diligence process supplemented by a postacquisition IP audit is one way to ensure that all material IP 48

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assets are identified and assigned value. If IP identification is not completed during initial due diligence, GAAP compliance offers another opportunity to track and value acquired IP. Although companies may choose to focus on the target’s IP that appears to provide the highest value maximization potential, other IP may result in significant value through licensing opportunities.

Since the 2001 issuance of FAS 141 by the Financial Accounting Standards Board, GAAP has required that acquired intangible assets – including intellectual property – be recognized and valued upon acquisition. The basic requirements as applied to acquired IP were generally unchanged by subsequent guidance.

If anything, the prevalence of fair value based measurements under GAAP has increased. For example, FAS 141R expanded the scope of fair value measurements and the requirements related to such IP-intensive items as in-process research and development projects.

Companies that account for acquisitions under FAS 141 may report limited data on acquired IP in their financial statements. However, even if the financial statements do not disclose significant details, other documentation – including third-party or internally prepared valuation reports and analyses – as well as auditor work paper files, typically provide significant detail related to acquired IP. This type of documentation necessarily includes detailed assumptions used in identifying and valuing the IP. Moreover, such valuation reports and work papers also include IP that was not valued, effectively valuing those assets at $0.

The FAS 141 valuation process typically entails selection of a third-party valuation specialist, analysis by the specialist, identification of acquired intangible assets, and review of the work completed by the valuation specialist by an auditor working for an independent firm. The number and types of intangible assets are important factors in assessing fees related to a FAS 141 valuation, as they determine the amount of effort that will be involved.

Even if a third party is hired to perform the IP valuation, the appropriate recognition and valuation of intangible assets is ultimately the responsibility of management. This includes the accounting, reporting, and presentation of any financial statements in accordance with GAAP. For instance, the Sarbanes-Oxley Act specifically requires corporations to manage internal processes – such as IP due diligence – for identification and reporting of assets. Additionally, it requires that executives be personally responsible for corporate financial reports and other internal processes which control accounting disclosures. It is, therefore, important that corporate executives stay knowledgeable about their company’s assets, including acquired IP. CALCULATING IP VALUE AND INFRINGEMENT DAMAGES

There are similarities between the methodologies frequently used to value IP assets under FAS 141 and those used to calculate damages in IP infringement cases. For instance, reasonable royalty awards are the most common form of damages The Magazine for the General Counsel, CEO & CFO

awarded in patent infringement litigation. From 1990 to 2004 over 75 percent of all damage awards in patent cases were based solely or in part on a reasonable royalty.

Application of the relief from the royalty method typically involves estimating the fair market value of an intangible asset by quantifying the present value of the stream of market-derived royalty payments that an asset owner is “relieved” from paying. Whether valuing a patent under FAS 141 or calculating a reasonable royalty for a patent infringement claim, the primary inputs are the same: royalty base and royalty rate.

The purpose of patent protection is to provide the patentee proper economic return. Therefore, a jury should consider the valuation of the infringed asset at the time of its acquisi-

The appropriate recognition and valuation of intangible assets under FAS 141 is ultimately the responsibility of management. tion when assessing alleged damages caused by infringement.

FAS 141 valuations may be particularly useful to a defendant if the plaintiff previously allocated only nominal value to the infringed IP. Moreover, a difficult fact pattern would likely develop if the plaintiff failed entirely to list or value the acquired IP. Conversely, a plaintiff who properly valued – or even overvalued – an infringed asset when it was acquired may reap a benefit in litigation.

The amount paid by a plaintiff in acquiring a company with desired patents is unquestionably relevant in the calculation of damages should those patents later be asserted in litigation.

Litigants have long stressed the importance of balancing the consideration paid for declared assets against damages claimed for their subsequent infringement. Courts have also recognized the relevance of a company’s allocated value to patents in the context of reviewing a damage award for those assets.

DISCOVERABLITY OF VALUATIONS

Valuations prepared pursuant to FAS 141 should be discoverable in cases involving the alleged infringement of acquired IP under the standards set forth in Rule 26(b) of the Federal Rules of Civil Procedure. The rule sets broad standards, allowing parties to obtain discovery for any non-privileged matter that is relevant to a claim or defense of any party. A plaintiff’s financial records are relevant for purposes of calculating damages in an action for patent infringement. Accordingly, valuations prepared pursuant to FAS 141 should be discoverable in cases involving the alleged infringement of acquired IP. Although courts have not specifically referenced FAS 141 when ruling on the discoverability of financial statements in the context of infringed IP, at least one court has compelled 49

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discovery of a company’s financial statements and other documentation related to acquisition of a company that previously owned the patent subject to litigation.

A likely scenario in which prior FAS 141 valuations of IP would be admitted comes about when the valuations are used in support of or in opposition to expert witness testimony on damage calculations because of the valuation’s impact on opinions regarding reasonable royalty determinations. The FAS 141 valuations are undoubtedly relevant to the royalty rate itself and the base to which it is applied.

Judicial decisions addressing the discoverability of financial statements reflecting the sale of patents both before and after infringement strongly support the concept that FAS 141 valuations are germane and relevant to damage calculations in IP infringement suits. Although there may be concerns that FAS 141 valuations that assign minimal or no value to a patent are overly prejudicial, such evidence should nonetheless be admissible.

Compliance with accounting standards related to acquisitions does not necessarily receive the attention of executives outside of the finance or accounting departments of large corporations. However, due to the importance of IP assets, executives should understand the impact of such accounting if the IP is later subject to infringement litigation.

Similarly, executives who may be motivated by assumptions that maximize earnings per share by assigning either no value or a small value to acquired IP should be cautioned: Such shortterm decisions could have significant negative consequences if the acquired IP is the subject of infringement litigation.

Although not believed to prevent an injured party from seeking legal remedy, the allocation of $0 to acquired IP could become a difficult fact pattern for the plaintiff to explain to a judge or jury. We recommend that executives carefully consider the assumptions used in the valuation of acquired IP. In situations where either no value or low value is assigned to acquired IP, executives should carefully document the process used to derive the underlying assumptions behind such an assessment.

is a partner with Husch Blackwell LLP. His practice is focused on patent and trademark litigation in federal courts nationwide, and on advising clients on matters relating to infringement, validity and enforceability of U.S. patents and trademarks. mike.annis@huschblackwell.com. mike annis

brad pursel ,

a CPA accredited in business valuation and a chartered financial analyst, is a member in the Financial Advisory Services practice of Brown Smith Wallace LLC. He specializes in the valuation of businesses and intellectual property for various purposes, including financial reporting and litigation support. bpursel@bswllc.com.

The Magazine for the General Counsel, CEO & CFO

Lawmakers Eye Geolocation Apps

By Kevin D. Pomfret

If it bleeds, it leads. So goes the cliché about the mainstream media. Little wonder, then, that news about the farreaching economic and social benefits of geolocation technology tends to be overshadowed by stories like “Woman Sues Google for Showing Image of Underwear” (The Telegraph) or “How One App Sees Location Without Asking” (Wall Street Journal).

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For companies that collect, use or distribute geolocation data, this media dynamic may have some unfortunate implications. Calls for regulation of this new and versatile technology are on the rise, both in the United States and across the globe.

Privacy-related fears are the major motivation. In the United States, Rep. Bobby Rush’s privacy protection bill, the so-called “Best Practices Act,” targeted “precise geolocation information” as sensitive data subject to greater protection.

The bill was first introduced in 2010, and a similar bill is expected to be introduced in this session of Congress. Other Congressional initiatives are likely, as well.

Meanwhile, both the Federal Trade Commission and the Department of Commerce have cited location-based data as a privacy concern. The FTC’s 123-page report, “Protecting Consumer Privacy in an Era of Rapid Change,” explicitly states that precise geolocation information is sensitive and should be subject to greater protection.

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STREET-VIEW FLAP IN EUROPE

These concerns are not just an American phenomenon. Last year, one of the biggest stories in geolocation was the backlash against Google Street View across Europe.

The service, launched in 2007, provides detailed streetlevel images. Europeans became even more concerned after Google admitted that its Street View data collection vehicles had collected personal information over unsecured wi-fi networks while on their tours of various cities. Google said

These applications could prove invaluable for such things as crisis and emergency response, public transportation, economic development and land management. that was inadvertent, but in the wake of the incident the company was hit by a number of lawsuits and government investigations.

Germany introduced privacy protections that included preventing the introduction of Street View in that country until November 2010. About 250,000 Germans took advantage of those regulations and requested that images of their homes be blurred on Street View. In South Korea, meanwhile, revelations about Street View’s accidental collection of personal data prompted authorities to raid a Google office and accuse the company of breaking the law.

Today, GPS location-aware smart phones and other devices collect enormous amounts of data about where people go and what they do. This information can be aggregated with other information to determine “who they are” with precision and accuracy. The level of available detail and the potential privacy risks associated with it will only increase with time, compounding concerns about such issues as “cyber-stalking” and Fourth Amendment privacy rights.

Clearly, geolocation is becoming an increasingly important component of our daily lives, and as the technology evolves, geolocation companies both in the United States and abroad will face a raft of new regulations. With the first wave already taking shape, the industry needs to move quickly to educate lawmakers and executive agencies about geolocation’s complexity, its enormous potential, and its many variations.

While lawmakers tend to favor language that applies broadly to many categories of regulated entities, there are as many different types of location data as there are ways to collect and use that data.

This means that a detailed, fully informed discussion about geolocation is essential if the sector is to avoid suffering the ill effects of “the law of unintended consequences.”

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location data can be collected and used before they can really address the questions that will arise. Should someone’s location on a public street be protected in the same way as medical records or bank account information? Can bright lines be drawn to determine what public and private entities should have access to location-based data, and under what circumstances? How will the answers to such questions affect the growth and development of this industry?

Industry involvement in resolving these issues is critical.

Overly broad legislation could stymie the many governmental and societal location-based applications currently being developed. These applications could prove invaluable for such things as crisis and emergency response, public transportation, economic development and land management. They also will play an important role in the development of the Smart Grid and Intelligent Transportation Systems.

IMPACT ON BUSINESS

In anticipation of new regulations, companies should take steps to protect themselves from liability and defend their interests. They should, for example, begin to identify and protect geolocation data they collect or use if it could be associated with an individual. They will need to know what spatial data assets they have throughout the organization, and how that information is aggregated and used. This will give them the ability to understand how they will be impacted by proposed regulations and, should it prove necessary, how to provide proper disclosures.

These issues don’t apply only to firms that would think of themselves as part of the geolocation industry. Increasingly, company databases connect customers, employees and vendors to specific locations, even at particular times. Such data could become subject to regulation if laws are not carefully drafted. Indeed, drafting laws and regulations governing geolocation will be a major challenge. Even the basic definition of what is meant by “precise geolocation information” – a term that seems to have slipped fairly easily into the parlance of lawmakers and U.S. government agencies – is far from clear.

GOVERNMENTS AND GEOLOCATION

Private citizens and lawmakers alike are concerned about the possibility of location data being extracted from smart phones without the user’s knowledge or permission, and that’s a legitimate issue. Another controversy is over law enforcement use of GPS or other tracking devices to monitor someone’s movements without a warrant. Courts have issued conflicting decisions about whether there is legal authority for this, and clarity would be welcomed by the geolocation industry.

Another important issue is whether police need to obtain a warrant before they can access peoples’ cell phone records to obtain historical location information (i.e. where they have been). In a 2010 case, the Third Circuit Court of Appeals found that a magistrate was permitted to ask for a warrant but not required to do so.

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Congress is now looking at updating relevant portions of the Electronic Communications Protection Act, an effort supported by a broad coalition of technology companies and think tanks.

In December of 2010, meanwhile, private citizens filed two lawsuits against Apple and some application developers for collecting personal information, including location, associated with iPods and iPads, without their owners’ consent.

This unresolved issue is likely to become more pressing in 2011 and may extend to Android phones.

Governments world-wide are facing similar uncertainties. In January, law and policy issues were a major part of the discussions at the Geospatial World Forum in Hyderabad, India. This international conference brings together a variety of stakeholders and end-users in this industry. The goal is to find ways to facilitate the collection, sharing and use of spatial data for commercial and public purposes, while also addressing the emerging legal and policy issues.

Among those who will be impacted are national mapping agencies, which deal with infrastructure development and national security among other issues, and which stand to benefit greatly from new sensors and technologies that make it easier to collect, map and share data. Many of these agencies are concerned about such issues as intellectual property, national security, liability and privacy. Similarly, the law with respect to weather and other types of data (spatial or otherwise) is often confusing and contradictory, making it difficult for an attorney to identify the risks. If you are an attorney representing a governmental agency that is asked to share this kind of data, how do you respond?

For corporations that do business overseas, the lines that are eventually drawn by governments will be important. They will, for example, determine the extent to which geolocation companies can participate in public-private projects involving location-based data.

NOTIONS OF PRIVACY

The privacy issue is challenging in part because the notion of privacy itself is rooted in culture and varies dramatically from one nation to the next. The novelty of the technology compounds the complexity. People want to protect privacy, but with regard to location they are not sure what “privacy” is. Europeans are nervous about Google Street View, while Americans are more troubled by the idea of “Big Brother” – the government – tracking them. Europeans, meanwhile, tend to be less troubled by the wide use of government-monitored closed-circuit TVs. As national governments develop policies that are appropriate for their own legal systems and cultural mores, multinational corporations need to develop business models that mesh with those policies. Failure to do so will make it difficult or impossible to grow a business in these countries, while at the same time it will expose the company to unacceptable levels of risk.

The geolocation sector must also address intellectual property rights, and various kinds of potential liability. The 53

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importance of these issues will increase with the introduction of technologies like Smart Grid and Intelligent Transportation Systems.

An accident implicating a navigation device is an obvious example of a scenario that could raise a liability issue.

Last year, there were several high-profile cases where directions from satellite navigation devices were alleged to have caused accidents, including at least one reported fatality.

Also, a lawsuit was filed against Google claiming an injury related to use of Google Maps.

It’s not surprising that plaintiff lawyers are discussing the risks associated with using this technology, and corporate clients should develop risk-reduction strategies. But in this realm too, there are many uncertainties. What level of

Companies are going to need to know what spatial data assets they have throughout the organization, and how that information is aggregated and used. data quality is required for a particular application? Under what circumstances should companies be liable if their location-based products are found to contribute to an accident? Case law will clarify some of these questions, but it will take time.

Among the intellectual property issues raised by location data is the breadth of copyright. Does a copyright apply to a particular data set, and what constitutes a derivative product?

Then there is the question of who owns an individual’s location data. The issues become more complex when business begins to incorporate data from volunteers’ so-called “crowd-sourced data.”

We are in the midst of an exciting era for the geospatial industry. New applications and business models, many of them unimaginable just a few years ago, are emerging every day. But as the industry matures and achieves greater success, companies that use location-based data can expect greater scrutiny from legislators and regulators. At this point, it’s important that all segments of the industry prepare for potential outcomes, while at the same time they stay engaged in what is happening and make their voice heard. kevin d. pomfret

is a partner at LeClairRyan, in the Richmond VA office. He counsels in the rapidly developing fields of spatial law and technology. He also serves as executive director of the Centre for Spatial Law and Policy. kevin.pomfret@leclairryan.com The Magazine for the General Counsel, CEO & CFO

Corporate Ethics: A Socratic Dialogue

By Evan Slavitt

I ran into my law school classmate, Danny Rencko, outside a coffee shop.

He and I had taken different paths after graduation; I was now an inhouse counsel and he was a senior attorney at the Department of Justice.

As we sat at the table outside, John Phipps, an acquaintance of ours, happened by with a large notebook under his arm.

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Hi Phipps. What’s that big notebook you have?

It’s the new course on corporate ethics I’m developing. It’s a big thing now and my firm makes beaucoup bucks selling it to corporations around the world. r encko : Pretty impressive, but what is it exactly? phipps : The whole idea of mere corporate compliance is passé.

Now, corporations want to shoot higher and become truly ethical companies, and I’m there to help them. r encko : Do you have some time to explain it? ph i pps : Glad to. da nn y r encko : joh n ph i pps :

WHAT DO WE MEAN BY ETHICS? r encko : So before we get to the “corporate” part, let’s start

with something basic – individual ethics. Suppose you were to say that “John Doe is an ethical person” or “Jane Roe is an unethical person,” what would you mean by that?

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Well that is pretty obvious. I would be making a judgment about basic character of Mr. Doe or Ms. Roe. r encko : OK, but what do you want me to understand from such a statement? phipps : Well, it means that Doe meets or exceeds the standard I have in mind for ethical conduct and Roe does not. r encko : So you and I have to agree ahead of time on what that standard is? phipps : Not really. Even if you disagree with me you can still understand the statement. I am giving you my evaluation of their nature, their character. r encko : I see, but what do you mean by “nature” and “character”? ph i pps : Quite simply that we all have some basic core that generally governs an individual’s actions. We don’t just act randomly. Ethical people are likelier to do ethical things; unethical people are likelier to do unethical things. r encko : So there is some central set of rules or principles governing each person’s actions? phipps : Exactly. r encko : Hmm. Well, Stalin had a central set or principles that instructed his actions. He did some pretty horrible things, but he was very consistent. phipps : Don’t be dense. It’s not just that there is this core, but that the core consists of good principles or rules. r encko : You mean we can’t all just have our own principles?

There has to be some way to judge them objectively? phipps : Now you’re getting it. If everyone could have their own set of principles, there is no way I could say that one person is ethical and another unethical. r encko : So your statement assumes that there is some common standard that everyone can be measured against? phipps : There you have it. r encko : So if I see someone do something unethical, like dropping a candy wrapper on the floor rather than putting in the trash, I am safe to say that the person has an unethical character? phipps : Don’t be silly. One minor action does not reveal their basic character. r encko : I thought you said that ethical people behave ethically? phipps : Not all the time. I mean that in general they act ethically. r encko : So we can just sort of look at each and every action and put a check mark in a box called ethical or unethical and then count the boxes? phipps : I suppose so. r encko : So 51 per cent means the person is ethical even if they act unethically 49 per cent of the time? phipps : No, that’s silly. It has to be much higher. r encko : 80 per cent? 90 per cent? phipps : You can’t be that precise. Just most of the time. rencko: Well, what about this: can we agree that a pirate is unethical? phipps : Of course. r encko : I bet, however, that a successful pirate generally tells the truth to his shipmates and his captain. In the long term, booty is shared reasonably evenly, and so forth. Otherwise the pirate crew just would not function. phipps : I don’t see what you are getting at. r encko : Well if you rated each action of this imaginary pirate, phipps :

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I would think most of the time he, or I suppose she, would be telling the truth, dealing fairly with his friends and work mates, taking his turn at the helm – basically acting in a way that you seem to think of as ethical. So we would have to say this is an ethical person. phipps : That’s stupid. It’s the other things that make him unethical. r encko : But actual piracy is probably pretty uncommon. Most days, the pirate spends cleaning the ship, sharpening swords, sewing new eye patches. ph i pps : But the actual piracy is really important. r encko : So I guess the standard “most of the time” isn’t really what you mean? ph i pps : I meant most of the time when it is really important. r encko : So a colleague of mine who tells the truth when it really matters, but routinely cheats on his expense vouchers, steals change out of my desk, takes towels from hotels, and so forth I would have to say is an ethical person? ph i pps : Well, that doesn’t seem correct either.

WHAT IS A CORPORATION? r encko : Is there anything magical about corporate status? phipps : No, it is just a mechanism to shield individuals from liability. r encko : So when I say, for example, that Evan’s company,

BWY Corporation, is a good company, what I am really saying is that this purely corporate device designed to shield him, among others, from liability is a good legal device? ph i pps : That does sound kind of funny, but yes. r encko : Meaning that the legal device has been correctly drawn up and registered in Delaware or wherever? ph i pps : You’re being troublesome again. It means that the corporation, taken as a whole, is good or bad. r encko : I see. So we should think of the corporation as separate from the individuals that make it up. ph i pps : That’s not so hard, is it? People do it all the time. r encko : I guess they do. At least, I hear it all the time. eva n sl av i t t : I hate to side with Phipps here, but you do it too. You can charge corporations with a variety of crimes.

Whether to charge the company in addition to its employees inherently requires some judgment about the corporation.

Your colleague, in the post-Enron meltdown, was faced with the decision whether to charge Arthur Anderson as well as several of the accountants who were responsible for the audits. This decision must have turned, at least in part, on the judgment that the company “deserved” to be charged. Put another way, from his or her perspective, the inevitable civil suits were insufficient to demonstrate society’s moral displeasure with the corporate entity. Judges do it too when they decide on sentencing for a corporation.

What Is the Difference Between Ethics and Compliance? r encko : So now we are talking about society’s judgment? ph i pps : Yes. r encko : But I don’t know everyone. How can I tell what soci-

ety wants? Doesn’t that mean the laws that it passes?

That seems to be right.

ph i pps :

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So a corporation that abides by the law is ethical?

Well, it’s more than just observing the law. For example, there are mutual funds that advertise based on investment only in ethical corporations. Activists feel free to identify companies that are acting perfectly legally as ethically suspect. r encko : That’s certainly true. But they seem to know what being ethical means for a corporation, and I am still trying to find out. r encko : phipps :

CAN A CORPORATION BE ETHICAL? r encko : Maybe we’ll make progress in another direction. It

does seem that people make ethical judgments about companies, but I am unclear on what that really means. phipps : You confused me before, but on this I can set you straight. r encko : That’s great. We can agree that the statement “Bob Smith is ethical” and the statement “Orange juice is ethical” are both grammatically correct, right? phipps : Well, yes. r encko : But the second seems somehow wrong? phipps : I can certainly agree with that. r encko : Why? ph i pps : That’s obvious. Orange juice can’t act ethically or unethically. r encko : How so? phipps : Orange juice is just a thing. It isn’t alive or even conscious of the world. r encko : So you are saying that being conscious of the world is necessary for something to be judged as ethical or unethical. phipps : That’s it precisely. r encko : It reminds me of the saying “guns don’t kill people, people kill people.” phipps : See, it is pretty clear. Guns certainly kill people in the sense that they are instruments that can be the direct causal link to the death of a victim. In the same sense, a tornado can kill a person. But from an ethical point of view, it is clearly correct to say that guns do not murder people. Only creatures with some consciousness of the world can murder. r encko : That’s very helpful. Let me make sure I get it. If I am out hiking and I get bitten by a mosquito, I can accuse it of being unethical for stealing my blood? phipps : Of course not. Mosquitoes may be aware of the world and so technically conscious, but they have no idea that they exist as separate entities. They operate totally on instinct. r encko : So in addition to having awareness of the world, to be subject to ethical judgments there has to be self-awareness? phipps : That goes without saying. People are aware of themselves as having some aspects of existence that are different from, or separate from, the rest of the universe. Without such distinction, there is no ability to differentiate between the actor and the thing acted upon. A fish is conscious, but it has no ability to form the thought that “I am this particular fish and those things outside are not this particular fish.” So it would be improper to accuse a fish of acting unethically. r encko : I think I have it now. Even with some level of selfawareness, there must also be the ability to form an intention.

How about this: Someone injects me with curare. They put a gun in my paralyzed hand and then when someone they don’t 57

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like goes by, they press my finger until the gun shoots. I am, I think, conscious, self aware and have the ability to form an intention. So I guess I must be acting unethically? ph i pps : You come up with the strangest ideas. Of course not.

To be subject to ethical judgments, the actor must have free will. No one would accuse the bank teller who fills the robber’s bag at the point of a gun of unethical behavior. Such a person is acting under compulsion and, therefore, is not ethically responsible. r encko : You have cleared things up. So we can agree that the statement “Aardvark Corporation is unethical” is a nonsense statement? ph i pps : No, absolutely not. This whole project that I am working on is so that people can say things like that. r e ncko : I’m confused again. We’ve already agreed that a corporation is a legal device. It has no mind, so it has no consciousness in itself. Similarly, there is no “I/thou” concept that a company has. It can act only through its employees, officers and directors; whatever they do is also the action of the corporate entity. So those employees are like the person who gives me curare and uses my paralyzed hand to hold the gun. ph i pps : I’d like to give you some curare right now. r encko : Am I wrong that a corporation has none of these three essential characteristics you yourself identified as absolutely essential? As trained professionals, we aren’t distracted by the legal fiction. Don’t you agree that there is no entity we can point to that has any of those attributes? phipps : You are ignoring the persons involved in the corporation. r encko : Not at all, I have a few questions about them. But if we treat the corporate entity as separate from those persons, there is nothing left that can meaningfully make a moral decision as you have explained it.

IS A DEFINITION NECESSARY? ph i pps : Wait a minute. Why do we need to do all this fussing

around? I know an ethical corporation when I see one.

I see. So even though you can’t explain it, you are satisfied with your own intuitive judgment? ph i pps : Exactly. r encko : And you and Evan here think exactly alike, then? ph i pps : Well, of course not. You know that. r encko : So if Evan wants to make sure that his company is ethical, he needs to call you in to use your intuition? That’s a pretty sweet deal. phipps : I may disagree with him, but he has an intuition as well. r encko : So you use yours, he uses his, and you’ll get to Scotland before him? ph i pps : That seems ok. r encko : Is that good for you too Evan? sl av i t t : Not really. I need something that will be generally seen as ethical. And something I can hand on to my successor. r encko : That seems to put the ball back in your court, Phipps. ph i pps : All right, we can always look at the corporation’s “corporate culture.” r encko :

IS “CORPORATE CULTURE” A PROXY FOR ETHICS?

The Magazine for the General Counsel, CEO & CFO

I’m not sure I know what corporate culture is.

There is a field called “Organizational Studies” which uses the concepts of corporate culture or organizational culture.

Organizational culture has been defined as “the specific collection of values and norms that are shared by people and groups in an organization and that control the way they interact with each other and with stakeholders outside the organization.” phipps : You see? Even a blind squirrel can find an acorn now and then. Clearly such a culture is not a characteristic of any one person in the company but relates to the organization as a whole. r encko : So when you say “corporate culture” you are talking about an ethical culture. phipps : Not exactly. The notion of a corporate culture is much broader than the concept of ethical behavior. It includes not just decisions about actions, but also modes of discussion, how the organization is organized, what its rituals are, and so forth. r encko : That seems like a pretty wide-ranging concept. phipps : It is kind of broad, but at least a part of it can relate to ethical codes. r encko : Sounds like a pretty blunt instrument. But how do you know what a company’s corporate culture is? phipps : You observe and describe it of course. r encko : But how do you evaluate it? phipps : You look at that part of the corporate culture and measure it against ethical standards. r encko : That seems to bring us back to what the ethical standards are and how to apply them to a corporate entity. So aren’t we just back to the basic question of what it means for corporations to be ethical? phipps : I suppose so. r encko : And another thing. When we talk about people, don’t we recognize the difference between the fundamental character of a person and the choices they make? phipps : Sure. r encko : So a generally good person can sometimes make a bad choice, and a generally bad person can sometimes make a good choice from an ethical point of view? phipps : Clearly. No one is perfect or always one thing or another. r encko : Also, sometimes a lie is the right thing to do, isn’t it? phipps : I’m not sure about that. r encko : Well an undercover police officer has to lie about who he is or he would be pretty ineffective. phipps : Sure, he has to if he wants to accomplish his goals. r encko : Doesn’t that mean that we have to look at the general process a person goes through to make ethical choices over time rather than the specific acts or even their basic characteristics? phipps : That is true. r encko : So just knowing the act or the basic characteristics is not enough. phipps : Yes. r encko : So for a corporation, its character – that is, its culture – is not enough for us to decide whether it is an ethical corporation. ph i pps : Now that you mention it, there does seem to be a need for more. r encko : And by the way, the culture of a company is distinct r encko : sl av i t t :

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from its goals, right? ph i pps : Yes, that is clearly true. r encko : A company can have a good goal, but act unethically? ph i pps : Sure. It happens all the time. r encko : A pirate crew could be entirely loyal to their captain, entirely honest in the division of their booty, and so forth. Indeed, historically pirate organizations were notable for their lack of racial and ethnic discrimination compared to more mainstream organizations of the time. So does that mean that such pirate organization would be considered to have a good corporate culture even though its objectives are patently illegal? ph i pps : It does seem that way, but it bothers me. r encko : And we can imagine a hospital truly dedicated to saving lives but riddled with cronyism, kickbacks, false claims to the government and so forth. ph i pps : Sure. You have prosecuted some of them. r encko : With all of those reservations, do you still want to use corporate culture as the real test? phipps : Somehow it doesn’t seem as good as I thought. But we can at least look at the decisions of the company’s employees.

CAN WE JUDGE A CORPORATION BY ITS EMPLOYEES DECISIONS? r encko : Now we seem to be making process. At least we can

agree that individuals can make ethical choices? ph i pps : That is true. r encko : So all we have to do is attribute the actions of the individuals to the company and we are done? ph i pps : At last you are talking straight. r encko : OK, so let’s take the situation in which an employee violates the internal set of policies of a company and makes an immoral decision. The company would, if asked, assert that the person was a “rogue employee” whose values and actions, while possibly legally binding, do not represent the company as a whole. phipps : That is play number one in the corporate defense playbook. r encko : But if we accept that position, then we are implicitly judging the company by something other than the actions of its employee, aren’t we? phipps : Well, it can’t just be any employee. It has to be limited to senior management and the board of directors. r encko : So if senior management keep their hands clean but the lower level employees are routinely lying, cheating, and so forth, we should still characterize the company as acting ethically? ph i pps : Naturally not. r encko : And what if the chief financial officer embezzles money? Is the company the victim or the perpetrator? ph i pps : Clearly the victim. r encko : But I thought you said that we can attribute the ethical choices of senior managers to be the actions of the company? phipps : OK forget that. Let’s just focus on the employees. Ignore the corporation as a separate entity. r encko : How does that work? ph i pps : Well, it’s simple. There are lots of corporate codes of conduct, corporate policies, and white papers on the benefits The Magazine for the General Counsel, CEO & CFO

to a company of having such codes or policies in place to make the employees act ethically. The role of the company is to implement such codes or policies, and the role of the employees is to follow them. r encko : I see. But then where are the ethical choices of the company? It seems that under this approach, the company never itself makes any ethical choice; all it does is promulgate a set of rules for its employees to follow. Isn’t saying that such action itself is ethical like giving an award for valor not to the soldier, but to the officer safely behind the front lines for ordering the soldier into action? phipps : I see what you mean. r encko : And let’s look at it from the employee’s point of view.

It seems that the employee does not make any ethical choices either. Instead he or she simply ensures that his or her conduct conforms to the promulgated code and policies. If an employee is told not to accept gifts valued at more than fifty dollars from suppliers under penalty of being fired, the decision not to take such gifts is not an ethical choice, it is a decision made under implicit compulsion. The employee simply has a more elaborate set of mandates or prohibitions than those already imposed by statute and regulation. phipps : Well, if you say it like that, it does seem correct. r encko : Or look at it this way. If all the company does is tell its employees to follow existing laws and regulations, there is very little ethical component to such a decision, wouldn’t you agree? phipps : Sure, that is nothing really. In fact, the legislatures and enforcers probably do not even think that compliance with the law requires a decision. r encko : Good. Now let’s suppose the company imposes rules that are designed to improve its own internal operations – such as a limit on gifts in order to ensure that its purchasing agents get the lowest price – is that an ethical action or a purely business decision? phipps : I’m not sure what you mean. r encko : Well, one can imagine Dr. Evil from the Austin Powers movies imposing exactly the same rule on his minions for the same reason. It is not an ethical choice but a way to improve operations, isn’t it? phipps : Fair enough. r encko : Similarly, if the company imposes any rules because it has made a judgment that those rules will improve its public image, then again this is not based on ethical considerations but on cold commercial judgment, am I right? phipps : That does seem to be a different kind of decision. r encko : So if we eliminate rules that simply improve a company’s operations, insulate it from potential liability, or improve its public image, what is left for the role of corporate ethics? phipps : You seem to have eliminated the reasons that I sell this idea to corporations. r encko : And what about Evan here? BWY is a publicly traded company. That means that he and the other officers and directors have fiduciary obligations to a group of owners that cannot easily be identified or polled. So if the company (a) is not required to engage in or avoid some activity, (b) is not implementing it for its own internal purposes, and (c) can59

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not justify it from a long term public relations/governmental relations view, and also (d) has an obligation to owners and creditors not to dissipate assets and to seek long term profits, then what is the conceptual foundation for the company to engage in other actions or to forbear from other actions? ph i pps : Can’t corporations in that situation appeal to some overarching social, cultural or religious norms that do not precisely fit within those items you just identified? That may be a justification. r encko : Well, BWY is a global company. Can you guarantee that any given community’s ethical framework will satisfy those outside the community? ph i pps : No, obviously not. sl av i t t : For example, the current ethos in the United States is to encourage employees to report a company’s wrongdoing by every means possible, including anonymous reporting. In Europe, where personal privacy and restrictions on disseminating personal information are given much higher weight, it is improper to encourage anonymous reporting. r encko : Exactly. Where does a Delaware corporation with principal offices in – sl av i t t : Ahem. r encko : – well, somewhere in the South and with significant operations in Asia, the Middle East, and Europe look to find these non-mandatory but ethically required actions? Does it simply impose either Delaware or California community norms on the rest of the company? ph i pps : That does seem to be problematic. r encko : Or, I suppose a global company looking for nonstatutory ethical norms could let each facility institute its own version of ethical conduct. ph i pps : That seems unworkable as a practical matter. It would lead to conduct being permitted or encouraged in one locale that is discouraged or prohibited in another. So that can’t work either. r encko : I’m afraid I’m still confused. Where are we now on this concept of “corporate ethics”? ph i pps : Well look at the time. I have to toddle. We have to do this again sometime later. Lots later. r encko : Bye Phipps. sl av i t t : You know he is never going to talk about this again with you, right? r encko : Perhaps not. But it seems this topic needs to be looked at more deeply to make sure that proponents of corporate ethics can explain the objectives they seek.

is vice president for business and legal affairs at AVX Corporation in Myrtle Beach, South Carolina. He served as a trial attorney in the antitrust division of the U.S. Department of Justice, and as an assistant U.S. attorney for the District of Massachusetts, and he was a trial attorney in private practice in Boston for twenty years. At Harvard Law School, he was an editor of the Harvard Law Review. “Danny Rencko” and “John Phipps” are fictional characters. eslavitt@avxus.com evan slavitt

The Magazine for the General Counsel, CEO & CFO

Who Says? committee hearings , commissions and official reports

marketplace that the CfTC [Commodity futures Trading Commission] currently oversees is approximately $40 trillion in notional amount. The swaps market that the act [Dodd-frank] tasks the CfTC with regulating has a notional amount roughly seven times the size of that of the futures market and is signifi cantly more complex ... The CfTC’s current funding is far less than what is required to properly fulfi ll our signifi cantlyw expanded mission.

the futures

gary gensler , Chairman, Commodity futures Trading

Commission 1

the high school called my mom to ask if i was willing to intern at Booz allen hamilton that summer. however, there was one condition: i had to be able to get to work on my own ... my family and i discussed our options and my mom started training me on taking the bus to work. she went with me a few times showing me how people get on and off. she made sure i understood some basic security in crossing the roads and that i knew where to take the bus and where to get off. it took a week and then i was completely on my own. i have been taking the bus now for the past 15 years .... i am treated like other employees at Booz allen hamilton. i receive benefi ts, time off, and an annual 360 degree assessment like everyone else.

in 1996,

daVid egan , Booz allen hamilton employee, special

olympics athlete ... Board member of the Down syndrome affi liates in action 2 60

EXECUTIVE CoUnsEl a p r i l / m ay 2011

many people question whether we can actually have very large scale biofuels without causing food shortages or environmental devastation ... [m]y research group [great lakes Bioenergy research Center, Department of energy] looked at how we could innovate in agriculture to provide large scale cellulosic biofuels, lots of food and big environmental improvements. The answer turns out to be quite simple – grow lots of double crops. Double crops are annual grasses and legumes planted after the corn or soy crop is harvested in the fall and then harvested in the late spring before the new corn or soy crop ... We found that doing this one simple thing would allow us to produce about 100 billion gallons of ethanol, roughly the amount of gasoline we import, provide all the food and animal feed the land currently produces, improve soil quality and biodiversity ... and reduce total us greenhouse gas emissions by 10 percent. bruce e . dale , professor, michigan state university 3

today , a 16-year-old with a smart phone has a more advanced communications capability than a police offi cer or deputy carrying a radio.

raymond w . Kelly , police Commissioner, City of new york 4 some of the most knowledgeable people i know have begun

to stockpile a lifetime supply of incandescent lamps to protect themselves from the need to use Compact fluorescent lamps. i have a particular passion for saving energy – i was a member of the committee that wrote the The magazine for The general Counsel, Ceo & Cfo

first energy code for the USA in 1975. My contribution was the mathematical formula that set the upper power limit for lighting in that code. It was a performance based equation – not a product restricting simplistic solution. ...

It cut in less than half the energy used for lighting by 1990.

and United Therapeutics. We have 19 federal facilities…

As part of the Washington region, we have the unenviable distinction of enduring the highest levels of traffic congestion and delays in the United States-despite the fact that we are second, only to New York City, in the total percentage of commuters using transit or car pools daily.

howard m . brandston , lighting designer, over 50 years experience in approximately 60 countries, including US Pavilion, Expo 70, Japan; Women’s Rights National Historic Park; and the relighting of the Statue of Liberty 5

isiah leggett, County Executive, Montgomery County,

Maryland 8

[ m ] embers of the TARP Congressional Oversight Panel have noted it was virtually impossible to decipher from existing disclosures, the amount and magnitude – and value – of troubled assets in the financial statements of financial institutions. In a discussion held just this month at the PCAOB SAG [Public Company Accounting Oversight Board, Standing Advisory Group] meeting, a member of the FASB [Financial Accounting Standards Board] was unable to describe which of their standards required disclosure of such information in a concise, transparent fashion. …The FASB’s own Investor Technical Advisory Committee (ITAC) a couple of years ago requested the FASB to adopt a disclosure framework to help fill in the “holes” in the FASB’s own disclosure requirements …

However, at a meeting this month of the PCAOB SAG, a member of the FASB indicated such a project would not be forthcoming any time soon.

justification for tax credits and expenditures whose intended incentives are not understood by families .... For example, the official IRS publication on the EITC [Earned Income Tax Credit ] ... simply states the EITC amounts in the form of a 7 page table that has 4,770 entries. Low-cost efforts to explain the incentives created by the EITC more transparently to the public would be valuable. As another example, tax credits to reduce electricity usage are likely to be more effective if coupled with smart meters that allow consumers to directly monitor their electricity usage in real time. there is little

raj chetty, Professor of Economics, Harvard University 9

due to complexity and the lack of transparency and standardization, it was difficult for investors and regulators to identify the extraordinary increase in mortgage credit risks as reckless underwriting and risky mortgage products increasingly overtook the system ...

While proposed legislation being considered today addresses the underpricing of the government guarantee fee, it is also true that the private market significantly underpriced risk. In fact, the private sector was first to underprice risk. The resulting information failure enabled low mortgage rates, risky products and reckless underwriting to persist causing the housing price boom ...

lynn e . turner , Former Chief Accountant, SEC 6

assuming that we already know everything we need to know is the surest strategy for catastrophe. dr . john r . hayes , jr ., Director, the National Earthquake

Hazard Reduction Program (NEHRP), Engineering Laboratory, National Institute Of Standards and Technology, U.S. Department Of Commerce 7

susan m. wachter , The Richard B. Worley Professor of

we are literally next door to the nation’s capital and home to over 250 biotech companies and industry leaders such as Human Genome Sciences, MedImmune,

1

Before the Senate Committee on Banking, Housing, and Urban Affairs, “Oversight of Dodd-Frank Implementation: A Progress Report by the Regulators at the Half-Year Mark,” February 17, 2011

4

Before the Senate Health, Education, Labor and Pensions Committee, “Improving Employment Opportunities for People with Intellectual Disabilities,” March 2nd, 2011

Before the Senate Energy Committee, “Testimony on S.398, a bill to amend the Energy Policy and Conservation Act to improve energy efficiency of certain appliances and equipment, and for other purposes, and S.395, the Better Use of Light Bulbs Act,” March 10, 2011

2

Before the Senate Agriculture Committee, ““Fundamentals and Farming: Evaluating High Gas Prices and How New Rules and Innovative Farming Can Help,” March 30, 2011 3

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Before the Senate Committee on Commerce, Science, & Transportation, “Safeguarding Our Future: Building a Nationwide Network for First Responders,” February 16, 2011

Financial Management, Professor of Real Estate and Finance, The Wharton School, University of Pennsylvania 10

Before the Senate Committee on Banking, Housing and Urban Affairs, Subcommittee on Securities, Insurance and Investment, “The Role of the Accounting Profession in Preventing Another Financial Crisis,” April 6, 2011 6

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EXECUTIVE Counsel a p r i l / m ay 2011

Before the House Committee on Science, Space, and Technology, Subcommittee on Technology and Innovation, “Are We Prepared?

Assessing Earthquake Risk Reduction in the United States,” April 7, 2011

7

Before the Senate Finance Committee, “How Do Complexity, Uncertainty and Other Factors Impact Responses to Tax Incentives?” March 30, 2011 9

10 Before the House Committee on Financial Services, Subcommittee on Capital Markets and Government-sponsored Enterprises, “Immediate Steps to Protect Taxpayers from the Ongoing Bailout of Fannie Mae and Freddie Mac,” March 31st, 2011

Before the Senate Environment and Public Works Committee, “State and Local Perspectives on Transportation,” April 6, 2011

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Prepare in Advance for the Inevitable Crisis

By Anastasia Kelly

Recently companies such as Toyota, BP, Johnson & Johnson and Hewlett Packard have experienced crises that distracted management, cost millions of dollars in time and resources, reduced shareholder value and resulted in lawsuits that will take years to resolve. The occurrence rate of corporate crises is increasing, for many reasons, among 63

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them the establishment of employee hotlines, whistleblower procedures, and the fact that information is instantly accessible across the internet and social networking sites, thus shortening the news cycle significantly.

Whatever the reason, responsible companies and thoughtful boards must realize that no business, no matter how wellmanaged or low-profile, is immune from a crisis. When it comes, it might not be as damaging and public as BP’s or Toyota’s, but that does not mean it can’t cause damage.

There are at least five steps a company should take to prepare in advance for a crisis: (1) Establish a reasoned crisis response approach with input from a team that draws from business and functions across the company.

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(2) Develop an agreed upon philosophy for reacting to crisis situations. It should be vetted by the board of directors, the CEO and senior management, and understood by the management team.

(3) Recognize that in most cases the company will need outside resources to supplement and guide the internal crisis management team.

(4) Identify the potential outside resources the company can access and prepare those resources.

(5) Clearly delegate authority to a crisis response team and a lead executive who will be responsible for development, implementation, coordination and communication of the strategy, in close coordination with the CEO, senior management and the board of directors.

All of this may sound simple, but many companies fail to take one or more of these steps. As a result they are not prepared for the crisis when it hits.

After 9/11, many companies embarked on an effort to define in advance potential crises and how they might respond to them.

In many cases the end product was a crisis response handbook that outlined possible events (e.g. crash of the corporate jet, arrest of a senior executive, terrorist attack). The handbook was then distributed to the responsible executives, put on a shelf, and has been collecting dust ever since.

The more effective strategy is to implement an evolving process in which designated managers meet or communicate periodically about potential crises, and learn how to come together and operate as a team when the crisis occurs.

Some companies do scenario exercises. While helpful, this may put too much strain on the time and resources of busy management teams. What’s more important is that the crisis team members know who each member is, understand how to come together, and that they are available when the situation requires it.

Every crisis differs, but one element consistently present is the need to disseminate information, whether on blogs, by twitter or in the traditional media. It’s critical that a company have an agreed upon approach for responding. There should be ready answers to

such questions as: “Do we make comments on the record?” and “Who makes these comments?” The board should understand and agree with the protocol.

It may be difficult for CEOs and other C-Suite executives to accept the fact that they need outside help. Typically they like to be in control of their company, and they wonder why they should abdicate their authority, especially in a crisis. In fact they can remain in control, but still benefit from the perspective of lawyers and public relations firms that can help manage the message at a critical time.

It is important to have pre-selected outside resources who will not be on a steep learning curve in the middle of a crisis. If the chosen experts already understand the strategy and philosophy of the company, they will be able to help when quick action is needed.

Being able to quickly identify whom to contact and provide them with needed information can save precious time during a crisis.

Clearly delegate the authority to develop and execute a response to a leader of the crisis team. This person must be authorized (by the CEO) to bring together the businesses and functions that need to respond.

A company cannot predict what crises will hit it, but it can take steps to prepare for any crisis. Preparation will make all the difference when it comes to implementing an effective response.

is a partner in DLA Piper’s White Collar, Corporate Crime and Investigations practice, based in Washington, DC. She is also a member of the firm’s Corporate and Finance and Public Company and Corporate Governance practices. She formerly was at American International Group, Inc. (AIG), starting as executive vice president, general counsel and senior regulatory and compliance officer in 2006. In the wake of the financial crisis, she was named vice chairman in January 2009. stasia.kelly@dlapiper.com anastasia kelly

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