Corporate The Counselor - Sughrue · The Corporate Counselor P0000-233 Periodicals Postage Pending at Philadelphia, PA POSTMASTER: Send address changes to: Incisive Media 120 Broadway,

By Sandra Feldman

This edition of the Quarterly State Compliance Review looks at legislation of interest to cor-porate lawyers that went into ef-fect from May 1 through July 1. It also examines recent decisions of interest from the courts of Dela-ware, Texas, and Washington.

IN THE STATE LEGISLATURES

This has been a busy quarter for those who track changes to state business entity statutes — a significant number of amend-ments went into effect. Below are some of the legislative high-lights from around the country.

In Alabama, Senate Bill 404, effective May 21, stated that a corporation has to provide its financial statements only to those shareholders who request them, rather than to all share-holders, and that the financial statements may be delivered by electronic transmission. In Colorado, House Bill 1248, ef-fective May 14, provided that a person may be admitted to a limited partnership as a partner without making or being obli-gated to make a contribution or acquire a partnership interest if such admission is pursuant to a written partnership agreement or other writing.

In Georgia, House Bill 308, effective July 1, provided that a one-member LLC may have an enforceable operating agree-ment, that an LLC is bound by

By Robert S. Reder and Matthew A. Thiel

Complex and systemic, the current financial crisis is nearly certain to yield extensive legislation regulating everything from the financial markets to mortgage brokers to ratings agencies. Any such legislation may raise inter-

pretive issues similar to those that have arisen in recent Federal Court decisions interpreting section 304 and section 1514A(a)(1) of the sweeping Sarbanes-Oxley Act of 2002 (“SOX”). Although these sections cover very different subjects, the manner in which the courts strictly construed, and thereby limited the reach of, these sections may provide insight into how Federal Courts will apply any broad powers granted by the looming round of legislation. SOX SEcTION 304

Section 304 of SOX provides for “the forfeiture of certain bonuses and profits by corporate officers who fail to comply with securities law reporting requirements.” In both In re Digimarc Corporation Derivative Litigation (2008 WL 5171347 (9th Cir. 2008)), and U.S. v. Shanahan (2008 WL 5211909 (E.D. Mo.)), Federal Courts narrowly interpreted SOX section 304. In Digimarc, the Ninth Circuit found that section 304 does not create a private right of action on the part of shareholders of affected corporations. In Shanahan, the U.S. District Court for the Eastern District of Missouri determined that section 304 requires the “actual filing of restated ac-counting reports” before its provisions will apply.

Under section 304:If an issuer is required to prepare an accounting restatement due to the mate-rial noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer for — (1) any bonus or other incentive-based or equity-based compensation re-ceived by that person from the issuer during the 12-month period following

In This IssueFederal Courts and SOX . . . . . . . . . . . . . 1Quarterly State Compliance Review . . 1An Inerview with Susan Perng Pan . . . . 3Insurance for Data Security Breaches . . . 5SEC’s Impact on Discovery . . . . . . . . . 7

PERIODICALS

Volume 24, Number 3 • July 2009

Corporate Counselor®

The

Federal Courts Adopt Narrow Constructions Of Sarbanes-Oxley LegislationRecent Decisions May be a Harbinger of Federal Courts’ Approach In Future Legislation

Quarterly State Compliance Review

continued on page 9

continued on page 2

2 The Corporate Counselor ❖ www.ljnonline.com/alm?corp July 2009

EDITOR-IN-CHIEF . . . . . . . . . . . . Adam J . SchlagmanEDITORIAL DIRECTOR . . . . . . . . Wendy Kaplan AmpolskMARKETING DIRECTOR . . . . . . . Jeannine KennedyGRAPHIC DESIGNER . . . . . . . . . . Louis F . Bartella

BOARD OF EDITORSJONATHAN ARMSTRONG . . Eversheds, LLP London, UKSTEVEN M . BERNSTEIN . . . . Fisher & Phillips, LLP AtlantaVICTOR H . BOYAJIAN . . . . . .Sonnenschein Nath & Rosenthal LLP Short Hills, NJJONATHAN M . COHEN . . . . Gilbert Oshinsky LLP Washington, DCDAVID M . DOUBILET . . . . . . . Fasken Martineau DuMoulin, LLP TorontoSANDRA FELDMAN . . . . . . . CT Corporation New YorkWILLIAM L . FLOYD . . . . . . . McKenna Long & Aldridge LLP AtlantaJONATHAN P . FRIEDLAND . . Levenfeld Pearlstein LLP ChicagoBEVERLY W . GAROFALO . . . Thelen Reid Brown Raysman & Steiner LLP Hartford, CT

ROBERT J . GIUFFRA, JR . . . . Sullivan & Cromwell LLP New YorkMICHAEL L . GOLDBLATT . . Tidewater, Inc New OrleansHOWARD W . GOLDSTEIN . . Fried, Frank, Harris, Shriver & Jacobson New YorkROBERT B . LAMM . . . . . . . .Pfizer Inc . New YorkJOHN H . MATHIAS, JR . . . . . Jenner & Block ChicagoPAUL F . MICKEY JR . . . . . . . . Steptoe & Johnson LLP Washington, DCELLIS R . MIRSKY . . . . . . . . . The Network of Trial Law Firms Tarrytown, NYREES W . MORRISON . . . . . . Rees Morrison Associates Princeton Junction, NJE . FREDRICK PREIS, JR . . . . Lemle & Kelleher, L .L .P . New OrleansSEAN T . PROSSER . . . . . . . . Morrison & Foerster LLP San DiegoROBERT S . REDER . . . . . . . . Milbank, Tweed, Hadley & McCloy LLP New YorkERIC RIEDER . . . . . . . . . . . . Bryan Cave LLP New YorkDAVID B . RITTER . . . . . . . . . Neal, Gerber & Eisenberg LLP ChicagoDIANNE R . SAGNER . . . . . . .FTI Consulting, Inc . Annapolis, MDMICHAEL S . SIRKIN . . . . . . Proskauer Rose LLP New YorkR . MICHAEL SMITH . . . . . . . Gordon, Feinblatt, Rothman, Hoffberger & Hollander, LLC Washington, DCSTEWART M . WELTMAN . . . Futterman Howard Watkins Wylie & Ashley, Chtd . Chicago

The Corporate Counselor® (ISSN 0888-5877) is published by Law Journal Newsletters, a division of Incisive Media . © 2009 . Incisive

US Properties, LLC . All rights reserved . No reproduction of any portion of this issue is allowed without written permission

from the publisher . Telephone: (877)256-2472 Editorial e-mail: wendy .ampolsk@incisivemedia .com Circulation e-mail: customercare@incisivemedia .com

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the first public issuance or filing with the Commission (whichev-er first occurs) of the financial document embodying such fi-nancial reporting requirement; and (2) any profits realized from the sale of securities of the issuer during that 12-month period. The Securities and Exchange

Commission (“SEC”) has not adopt-ed rules specifically implementing section 304. Instead interpretation of the statute has been left to the courts.

DigimarcBackground

As a result of overestimated earn-ings over a period of six quarters, Digimarc Corporation was forced to restate its financial results for the af-fected fiscal periods. A shareholder derivative action was filed in the U.S. District Court for the District of Oregon which, among other claims, sought disgorgement under SOX section 304 of bonuses and prof-its earned by Digimarc’s CEO and CFO during the relevant period. The District Court dismissed the action, concluding that there was no pri-vate right of action under section 304. The shareholder appealed this decision to the Ninth Circuit. The Court’s Analysis

To give rise to a private cause of action in favor of an injured person, “the statute must either explicitly create [that right] or implicitly con-tain one.” The Ninth Circuit noted that “Section 304 does not explic-itly create a private right of action.” However, because section 304 also does not explicitly deny a private right of action, the court found the section to be “at best ambiguous,”

and turned its focus to whether the section implicitly creates such a right. This in turn required an in-quiry into Congressional intent.

To conduct this inquiry, the court turned to the second of the four-factor test articulated by the U.S. Supreme Court in Cort v. Ash (422 U.S. 66 (1975)): whether “‘there [is] any indication of legislative intent, explicit or implicit, either to cre-ate such a [private] remedy or to deny one.’” Parsing the language of the statute, the Digimarc court re-marked that “[s]ection 304 focuses on ‘the person regulated’ rather than the ‘individual … who will ul-timately benefit from [the statute's] protection.’” This indicated to the Court that “congressional intent weighs decisively against finding a private right of action.”

The court also rejected plaintiff’s argument that because some sec-tions of SOX expressly disclaim the availability of a private right of ac-tion, while section 304 does not, Congress must (through its silence) have intended to provide a private right of action under section 304. Rather, the court looked to an anal-ogous section of SOX, section 306, which also requires non-compliant directors and officers to reimburse the issuer through disgorgement of profits in the event of a breach of the statute. Section 306, although otherwise analogous to section 304, explicitly provides a private right of action for affected company share-holders. Thus, the court concluded that it “cannot find in Congress’ si-lence in section 304 an intent to cre-ate a private right of action where it was not silent in creating such a right to similar equitable remedies in other sections of the same Act.”

ShanahanBackground

Michael Shanahan, Sr. served as CEO and Chairman of the Board of Directors of Engineered Support Systems, Inc. According to an SEC complaint, Engineered Support, with Shanahan’s “participation, knowl-edge and consent,” issued back-dated stock options in violation of

Sarbanes-Oxleycontinued from page 1

continued on page 10

Robert S. Reder, a member of this newsletter’s Board of Editors, is a New York-based partner and co-Practice Group Leader of the Global Corporate Group of Milbank, Tweed, Hadley & McCloy LLP, New York. Matthew A. Thiel is an associate in the same office.

July 2009 The Corporate Counselor ❖ www.ljnonline.com/alm?corp 3

By Adam J. Schlagman

According to a survey by the Merg-ermarket Group in late 2008, “more than half of corporate and private equity executives believe intellectual property will become a more impor-tant factor in M&A deals during the next five years.” With the economic downturn, competition in the mar-ketplace has only stiffened as com-panies struggle to ease the minds of shareholders and consumers. Follow-ing high-cost settlements and royalty payouts over the past few years, in-tellectual property portfolios have proven to be an invaluable asset to companies across industries.

Here, Susan Perng Pan, Washing-ton, DC-based patent attorney and partner of the intellectual property firm SUGHRUE MION, PLLC, dis-cusses best practices and strategies for in-house counsel to assess, pro-tect, and evaluate the worth of their portfolios, both domestically and globally. Ms. Pan focuses her prac-tice on preparing and prosecuting patent applications before the U.S. Patent and Trademark Office, and represents U.S. and international cli-ents, with a special focus on Asia.

Q.: According to the Mergermar-ket Group, intellectual property (IP) portfolios are becoming a major contributing factor to the success of a merger & acquisition. Why do you think companies are now starting to pay attention to IP portfolios as part of their larger business decisions?

A.: For a long time, the vast ma-jority of a company’s value stemmed from its intangible assets, rather than its tangible holdings. How-ever, it was only recently that the valuation of intangibles, patents in particular, started becoming demys-tified. Further, of a company’s intan-gible assets, intellectual property is likely to be the most concrete, since

it usually includes a government-backed document such as a patent or a trademark registration.

With the continued increase in technology-driven businesses, pat-ents have clearly assumed charac-teristics of assets, which can be flex-ibly sold or licensed as a form of capital to further business ventures, to create a revenue stream or to serve as “collateral” for smaller com-panies seeking financial backing. This would account for the higher recent visibility of patent portfolios in M&A deals.

A number of valuation tools have cropped up in the past few years to attempt to put a dollar figure on a patent portfolio. However, even with traditional accounting methods and new valuation methodologies specific to patents, patent portfolio valuation remains difficult. For ex-ample, 85% of corporations view IP assets as having equal or greater im-portance than other corporate assets in M&A deals. Despite the acknowl-edged importance of IP assets, only 32% of corporations investigated IP value in depth before completing such transactions.

Q.: How can a company's IP port-folio — or lack thereof — impact a company's overall value? How are they evaluated?

A.: Without at least a rudimentary patent portfolio to protect its inven-tions and innovations, a company is at the whim of competitors and copy-cats as soon it enters the marketplace. The value of a patent portfolio ac-crues to the patent holder in multiple forms. Traditionally, patents confer the right to exclude others from op-erating in the market area that is cov-ered by one or more patent claims, thus providing a legal monopoly. In this regard, the patent further entitles its owner to recover monetary dam-ages from anyone who uses the tech-nical subject matter covered by the patent claim without authorization. As a strategic tool, a patent operates as a counter measure to barter for market entry and co-existence with other patent holders who would oth-erwise seek to exclude the patentee from the market.

Because a patent can serve as the source of a licensing revenue stream or accord a company limit-ed monopoly status, a rudimentary value can be placed on patent as-sets. As with all assets, the values rise and fall with the economic tide. Traditional valuation tools include: 1) the 25% method, which assigns approximately 25% of a company’s operating profits to its patent hold-ings; 2) the income method, which evaluates a patent as a present val-ue of a future income stream; 3) the market method, which evaluates patents relative to similar patents; and 4) the cost method, which as-signs values as the cost of designing alternatives for patented technology. However, the unique character of patents and other IP renders stan-dard application of these valuation tools extremely difficult.

New valuation tools geared specif-ically to set a value on large portfo-lios take into account basic informa-tion of the patent. This may include the number of times that a particular patent (or patents) is externally refer-enced in the general body of patent literature. Some valuations models analyze the word count in claims of the patent, because the claims actu-ally set the legal boundary of protec-tion. Such word-count valuations are premised on the concept that a claim with fewer words is less restrictive and thus more valuable. Even assum-ing that any statistical correlations can be derived from these newer evaluation tools, such analyses sim-ply cannot be a sole or even primary indicator of patent value. For exam-ple, if a claim includes even a single word that excludes a significant por-tion of what is being practiced in the marketplace, then that claim is not commercially viable even if it is oth-erwise expressed with great econo-my in language. On the other hand, special forms of patent claiming ac-tually would accord higher value to claim scope if the claim has more words. Nevertheless, these new valu-ation tools do have their place, espe-cially those that have demonstrated strong statistical showing between

IP’s Impact on M&A And Corporate ValuesAn Interview with Susan Perng Pan

continued on page 4Adam J. Schlagman is Editor-in-Chief of this newsletter.


the quantitative characteristics that they monitor and historic financial performance of the patent holder.

Traditional valuation tools in con-junction with a statistical tool to-gether help form a comprehensive picture of the value to place on a portfolio.

Q.: What are the top challenges in evaluating a portfolio’s value? What key factors do in-house counsel need to look for?

A.: Even as patents, along with other intangible assets, become re-ported as financial entries, it is im-portant to remain cognizant of the patent as a form of technical estate, its value being determined by legal boundaries.

Individual value assessment for patent claim in any sizeable portfo-lio, including a liability determina-tion and revenue stream, is impos-sible. The value of a patent thus lies largely in its potential. If due care is not taken to preserve that potential while prosecuting the patent in the U.S. patent office, the patent’s value easily becomes deflated. When a patent application is originally filed, the applicant may have attempted to claim a large piece of a techni-cal estate. The U.S. patent examiner will attempt to force to the patent applicant to accept a narrower set of rights. An unwitting patent appli-cant may make representations or modify the application to exclude a particular technical sector, leaving only a portion of the original claim intact. Though it sounds counter-in-tuitive, the best strategy before the U.S. Patent Office is to avoid tout-ing the benefits of the invention and to focus on the procedural errors of the U.S. Patent Office in refusing to grant a patent. If at all possible, it is also important to resist narrowing of the original patent claims due to legal precedents that tend to penal-ize such activity.

Q.: Are there additional challeng-es in evaluating the value of a port-folio during M&A negotiations with a foreign company?

A.: Each country has its own re-quirements for patenting technology and enforcement of those patents. Therefore, where clear liability at-taches in one country, this may not be so clear in another jurisdiction. As a result, the accounting methods and metrics that apply to patent valuation in the U.S. may have less relevance for the patent holdings in a foreign country. The pertinent experts should be consulted in each country where a company holds any sizeable patent portfolio. In addition, repatriation of money from foreign countries may also affect the value of a portfolio, even if liability or valuation in that foreign jurisdiction is clear.

Q.: What can in-house counsel do now to bolster and protect their port-folios in preparation for future M&A deals?

A.: A sound strategy would be to identify a small number of patents in a group that are deemed to be of the greatest commercial value, at least in the short term. In this group, evaluate the strength of the patent against market products. This will help set a baseline of the value of the portfolio as linked to current market conditions.

Next, evaluate patents of the group that appear to fall around the edges of the above “core” group, and which are “improvement” tech-nologies over the core group. A dense patchwork of protection over improvement technologies will help provide a basis for future revenues. Such improvement patents should be spaced appropriately over time to afford the maximum benefit.

The overall portfolio can become weakened when the basic technolo-gy is held by the corporation, but all the improvement patents are held by third parties or by competitors. The lack of holdings in the improvements area may signal a corporation’s lack of commitment to that particular technology. Moreover, significant third-party holdings of improvement patents will decrease the company’s leverage at the negotiating table.

Q.: What key strategies can in-house counsel implement to avoid a lapse in IP coverage for those compa-nies with large portfolios?

A.: Never overlook the adminis-trative components. These include verification of proper ownership of the patents by necessary assignment documents, timely payment of patent office maintenance fees, verification that all possible validating informa-tion has been considered by the U.S. Patent Office, and verification that the filing dates for the patents have been properly preserved.

Q.: We’ve seen in recent years how court rulings in IP cases — whether favorable or not — can directly im-pact a company’s stock values. What strategies can a company implement to minimize concern among its share-holders and other interested parties?

A.: In an economic downturn, a company can find itself on the re-ceiving end of legal complaints from disgruntled shareholders who claim a company has been too passive in management of its IP. These can stem from allegations that a corpo-ration has not been active enough in pursuing potential patent infring-ers. They can also stem from not be-ing active enough in pruning a large portfolio such that unnecessary fees are accrued in pursuing or maintain-ing certain patent assets that hold no commercial value.

To guard against such claims, a sound strategy is to devise a sys-tematic monitoring of the company’s patent portfolio in two respects. The first aspect includes routine analysis of the maintenance of the appro-priate patents and abandonment of those patents whose value become diminished as the commercial land-scape matures. The second aspect includes an external analysis of the market to enjoin potential infringers from treading on patented technol-ogy or to negotiate a royalty for use of the patent where infringement is apparent. The system should include regular documentation, audit and up-date, preferably on a yearly basis.

Q.: What strategies can a company follow to successfully monitor and enforce its IP rights against infring-ers to further protect its portfolio’s value?

Susan Perng Pancontinued from page 3



By Reynold L. Siemens and Tanya Forsheit

Every other day we read about some new data security breach or proposal to regulate the use of consumer’s private data. However, there is good news too: Most courts are intolerant of privacy claims brought by plaintiffs who have suf-fered no actual damage, and most companies have insurance for pri-vacy claims without knowing it.THE cURRENT LEGAL LANdScApE: dATA SEcURITy BREAcH LITIGATION

In 2002, legislators across the country began passing laws requir-ing consumer notification when there is a security breach involving private information. As of February 2009, 44 states, the District of Columbia, Puer-to Rico, and the U.S. Virgin Islands have passed security breach notifica-tion laws affecting private entities.

This legislation has spawned many lawsuits. Plaintiffs allege a variety of common law claims, in-cluding negligence, breach of con-tract, breach of implied covenant, and breach of fiduciary duty. Plain-tiffs also bring claims for violations of state or federal consumer pro-tection statutes or deceptive and unfair trade practices acts like the Fair Credit Reporting Act, Electron-ic Communications Privacy Act, or California’s Business & Professions Code section 17200.

Courts are almost universally in-tolerant of claims brought by plain-tiffs whose only alleged injury is an enhanced “risk of identity theft,” as opposed to actual damages. How-ever, the courts are split, and even some of these claims may proceed to trial.

In Pisciotta v. Old National Ban-corp, 499 F.3d 629 (7th Cir. 2007), the only published circuit court opinion to date, the Seventh Circuit ruled that, where the only “damag-es” alleged following a data security breach were the increased risk of future identify theft, or the costs of credit monitoring, a plaintiff had no case. The decision dealt a blow to so-called “identity exposure” plaintiffs seeking to recover damages stem-ming from the unauthorized disclo-sure of their personal information. In doing so, the Seventh Circuit joined a chorus of federal district courts that had already rejected credit monitor-ing costs as a form of cognizable in-jury sufficient to support legal claims for damages. See, e.g., Kahle v. Litton Loan Serv. LP, 486 F. Supp. 2d 705, 712-13 (S.D. Ohio 2007); Forbes v. Wells Fargo Bank, N.A., 420 F. Supp. 2d 1018, 1021 (D. Minn. 2006); Guin v. Brazos Higher Educ. Serv. Corp., 2006 WL 288483 (D. Minn. Feb. 7, 2006); Hendricks v. DSW Shoe Ware-house, 444 F. Supp. 2d 775, 783 (W.D. Mich. 2006).

In Shafran v. Harley-Davidson, Inc., 2008 WL 763177 (S.D.N.Y. Mar. 20, 2008), the court likewise dis-missed the plaintiff’s lost laptop law-suit because it found that the alleged claimed injury — credit monitoring costs sought to protect against specu-lative identity theft that might occur because of the data loss — was not actual, legally cognizable injury. In so holding, the court noted that “[c]ourts have uniformly ruled that the time and expense of credit monitoring to combat an increased risk of future identity theft is not, in itself, an injury that the law is prepared to remedy.”

At least one court has found to the contrary. The Northern District of California has, in a published opinion, allowed claims to proceed even in the absence of actual injury. In Ruiz v. Gap, Inc., 540 F. Supp. 2d 1121, 1125-26 (N.D. Cal. 2008), the court found that an allegation of “increased risk of identity theft” from a lost Social Security number was sufficient “injury in fact” to es-tablish standing and survive a mo-tion to dismiss plaintiff’s negligence claim. See also Pinero v. Jackson Hewitt Tax Serv. Inc., --F. Supp. 2d --, 2009 WL 43098 (E.D. La. Jan. 7, 2009) (dismissing all claims except

for an invasion of privacy claim after data that had been given to defen-dant was found in a dumpster, but not misused). It remains to be seen whether more courts will follow the principles set forth in Pisciotta and the majority of district court cases, and cut these cases off at the plead-ing stage or on summary judgment, or whether they will be allowed to proceed to trial, even in the absence of a demonstration of actual loss.

Regardless of whether these cas-es proceed to trial, they can be ex-pensive to defend. Most companies have insurance that may cover the costs, without even knowing it. cGL pOLIcIES

An often-overlooked provision of the standard comprehensive general liability (“CGL”) carried by most com-panies promises to cover claims al-leging “oral or written publication of material that violates a person’s “right of privacy.” The “right of privacy” claims covered under CGL policies include both common law and statu-tory claims. For example, courts have found CGL policies to cover claims that an insured disclosed confidential medical information in violation of state law (LensCrafters, Inc. v. Liberty Mut. Fire Ins. Co., 2005 WL 146896 (N.D. Cal. Jan. 20, 2005)), distributed consumer credit history informa-tion in violation of the Fair Credit Reporting Act (Am. Family Mut. Ins. Co. v. C.M.A. Mortgage, Inc., 2008 WL 906230 (S.D. Ind. Mar. 31, 2008); Pietras v. Sentry Ins. Co., 2007 WL 715759 (N.D. Ill. Mar. 6, 2007); Zurich Am. Ins. Co. v. Fieldstone Mortgage Co., 2007 WL 3268460 (D. Md. Oct. 26, 2007)), or shared data about users’ Web browsing activities in violation of the Electronic Communications Pri-vacy Act (Netscape Commc’ns Corp. v. Fed. Ins. Co., 2007 WL 2972924 (N.D. Cal. Oct. 10, 2007)).

Whether coverage exists for a particular kind of privacy claim depends on what the insurance policy means by “publication” and “right of privacy.” Not surprisingly, insurance companies have advocat-ed that these terms be interpreted narrowly, while policyholders have advanced broad interpretations.

Insurance companies often con-tend that “publication” requirement

Insurance for Data Security Breaches And Consumer Privacy Claims

continued on page 6

Reynold L. Siemens is a partner in the Insurance Coverage Practice Group at Proskauer Rose LLP, Los Angeles. Tanya Forsheit is a part-ner in the Privacy and Data Security Practice Group in the same office.


means that there can be no coverage absent a widespread distribution of private information to a large audi-ence. Some courts have accepted this interpretation (especially when the policy language additionally required the publication to be in the context of “advertising”), but others have rejected it. For example, one court held that a company’s disclosure of patients’ private eye exam results to its affiliate for the purpose of dis-pensing prescription eyewear was a “publication.” The court explained that although the common law tort of invasion of privacy may require wide-spread disclosure, the word “publica-tion” can refer to disclosure to a sin-gle person — as in defamation cases — and therefore is flexible enough to cover a “less than public dissemina-tion of information.” See LensCrafters, 2005 WL 146896, at *10.

Another court confronted with a common variant on the standard policy language (covering the act of “making known” private informa-tion, as opposed to “publishing” it) held that a company’s transmission of private data about its customers’ Web browsing habits to its parent for the purpose of generating targeted advertising was potentially covered. Netscape, 2007 WL 2972924. at *6; cf. Res. Bankshares Corp. v. St. Paul Mer-cury Ins. Co., 407 F.3d 631, 641 (4th Cir. 2005) (holding that the “mak-ing known” language only applies if there is broad transmission). Many Telephone Consumer Protection Act or “junk fax” cases have held that the unlawful transmission of unwanted faxes to a plaintiff is a “publication” for purposes of CGL coverage, re-gardless of whether it involves the disclosure of information to anyone else. Park Univ. Enters., Inc. v. Am. Cas. Co. of Reading, PA, 442 F.3d 1239, 1250-51 (10th Cir. 2006).

Insurance companies also com-monly argue that there is no cover-age unless the publication discloses private information. Courts are split on this question, which they have addressed mainly in the context of claims for coverage “junk fax” law-suits. Some courts have agreed that there is no coverage for such suits unless they involve the publication

of private information. See, e.g., Am. States Ins. Co. v. Capital Assocs. of Jackson County, Inc., 392 F.3d 939 (7th Cir. 2004); ACS Sys., Inc. v. St. Paul Fire & Marine Ins. Co., 53 Cal. Rptr. 3d 786 (2007) (same, under the “making known” language). Others have found coverage for such claims because the “right of privacy” encom-passes not only the right of “secrecy,” but also the “right to be left alone.” See, e.g., Park Univ. Enters., Inc. v. Am. Cas. Co. of Reading, PA, 442 F.3d 1239, 1250-51 (10th Cir. 2006); Valley Forge Ins. Co. v. Swiderski Elecs., Inc., 860 N.E.2d 307 (Ill. 2006). Interesting-ly, some courts have also found cov-erage for “junk fax” suits under the separate “property damage” provi-sions of CGL policies, due to the loss of printer paper and ink and the loss of use of the fax machine involved in the receipt of unwanted faxes. See, e.g., Acuity v. Superior Mktg. Sys., Inc., 2003 WL 24004567 (Ill. App. Ct. May 30, 2003); Prime TV, LLC v. Travelers Ins. Co., 223 F. Supp. 2d 744 (M.D. N.C. 2002); cf. Western Rim Inv. Advi-sors, Inc. v. Gulf Ins. Co., 269 F. Supp. 2d 836 (N.D. Tex. 2003), aff’d, 96 Fed. Appx. 960 (5th Cir. 2004) (finding no coverage on the ground that the property damage was intended by the insured).E&O pOLIcIES

Another kind of insurance that may cover privacy claims is errors and omissions (“E&O”) coverage, which typically promises to defend and in-demnify the insured against claims alleging “acts, errors or omissions” in the course of providing a “profes-sional service.” There are many varia-tions on this theme: for example, Media Liability policies cover errors and omissions in connection with the insured’s “media activities,” and Internet Liability policies cover errors and omissions in connection with the insured’s “Internet activities.” Insur-ance companies are now even selling Security Breach policies specifically to cover errors and omissions in con-nection with handling of data.

Whether data security breach and other privacy claims are covered under such policies will depend largely on the individual policy’s definition of the covered activity. Some policies limit their coverage to the conduct of one specific pro-

fessional activity; insurers can be expected to argue that ancillary activities, such as administrative or marketing activities that might give rise to a security breach or privacy claim, are not covered. But E&O policies are often broadly written to cover essentially any business activity of the policyholder, or they are ambiguous, and such policies should be construed against the insurer that wrote them and in fa-vor of coverage. See generally PMI Mortgage Ins. Co. v. Am. Int’l Spe-cialty Lines Ins. Co., 394 F.3d 761 (9th Cir. 2005).

Assuming that the claim arises out of a kind of business activity that is covered, the coverage afforded by an E&O policy for privacy claims will generally be broader than CGL coverage in one key respect: it is not limited to “publications” that violate the “right of privacy.” For that reason, it may be easier to find coverage under an E&O policy for some kinds of privacy claims than it would be under a CGL policy.

There is another respect in which insurance companies may argue that E&O coverage for privacy claims is narrower than CGL coverage. Un-like CGL policies, which do not lim-it coverage to negligent disclosure, some E&O policies promise to cov-er only “unintentional omissions” and “negligent acts.” In one of the few decisions to date regarding the availability of E&O coverage for pri-vacy claims, the court construed this language to preclude coverage for all but accidental privacy breaches. There, the insured sought coverage for a lawsuit alleging that it had vio-lated a plaintiff’s privacy rights by installing spyware onto his comput-er. In rejecting the insured’s argu-ment that it was entitled to cover-age because its intentional conduct had caused unintended injury, and therefore was negligent, the court explained that the insured had in-tentionally installed the software but the policy language required that the insured’s “act” be uninten-tional. Eyeblaster, Inc. v. Fed. Ins. Co., 2008 WL 4539497 (D. Minn. Oct. 7, 2008).

The Eyeblaster decision probably does not mark the beginning of a

Data Security Breachescontinued from page 5

continued on page 8


By Virginia P. Henschel

In October 2008, the Securities and Exchange Commission (SEC) for the first time made public its Enforcement Manual, the agency’s internal reference guide for En-forcement Division staff in the in-vestigation of potential violations of the federal securities laws. Law firms and corporations involved in matters before the SEC will find it a valuable resource to aid their un-derstanding of SEC operations.

The 129-page Enforcement Man-ual addresses many topics, chief among them the management of Electronically Stored Information (ESI). It is critical that financial in-stitutions and corporations facing or anticipating SEC investigation become familiar with the guide-lines related to the preservation and production of electronic evidence, so they may respond accurately and in compliance with mandated timeframes. Readiness for an inves-tigation under the new guidelines may call for both changes to busi-ness policies concerning collection, review and production of ESI, and adoption of new e-discovery tools to properly identify and manage rel-evant documents.

In preparation for these changes, the SEC upgraded its ability to re-tain, review and expertly search

data that is produced. Although this is similar to the December 2006 amendments to Federal Rules of Pro-cedure, the impact is more clearly defined. The focus is now shifting to increasing the level of preparedness of the responding party in terms of its ability to:

produce electronically stored •information; andnegotiate scope and form of •production at the inception of a subpoena, voluntary re-quest, and a complaint.

By far, the most revealing aspect of the updated manual is the con-sistent theme of seeking to obtain an inadvertent waiver of privilege, or sanction, for certifying to a com-pleteness of production. These changes translate into one key find-ing: the risk in litigation is clearly focused on the very earliest stages of discovery. This means that corpo-rations and legal teams need to be very, very prepared. Those caught off-guard or naively unaware, will risk stumbling. Now is the time to be alert relative to e-discovery prep-aration and practices because the SEC is clearly serious about sanc-tions, or inadvertent waivers.SEc E-dIScOvERy pREpAREdNESS

The SEC states that it is look-ing to eliminate paper productions to increase both cost effectiveness and efficiencies in terms of search-ing, tagging, and reviewing docu-ments. In addition to requiring that paper documents be produced in a scanned collection, the SEC specifi-cally requires that the responding party maintain original paper docu-ments. Organizations need to dove-tail their document management system with clear policies for litiga-tion preservation and quality con-trol, whether the origin of the docu-ment is electronic or hard copy.

Further, the SEC manual now re-quires a respondent to determine more details including: the size of the production; disclosure of the software used to store documents; and the medium used for produc-tion. Organizations that have under-taken comprehensive data mapping strategies will be well-positioned to respond promptly and comprehen-sively to these requests.

The new manual delineates three categories of electronic production: 1) scanned collections; 2) e-mail; and 3) native files. The SEC requires that all productions be organized by the custodian, and further clarifies that the production of databases cannot be accepted without prior approval from the SEC’s information technology (IT) staff.

Concurrent with the document production to the SEC, the respond-ing party is required to deliver a summary of images, including the number of records, e-mails and at-tachments. This enables the SEC to confirm that a complete production has been loaded into their review platform. An experienced e-discov-ery solution provider can assist with this type of summary.

Important electronic documenta-tion details and considerations:

Format of production• : Accept-able electronic media are CD, DVD or hard drive. Take note that the SEC prefers the small-est number of media be used. However, it will provide the hard drive if the collection mer-its submission on hard drive.Responding party obligation •to confirm the completeness of production: This is subject to penalty of perjury, and the cer-tification is required for both voluntary production and pro-ductions pursuant to subpoe-na. Of particular note is the use of preservation subpoenas at the inception of an investi-gation. These can be issued if a reasonable good-faith effort exists that documentation is at risk of destruction. However, this could become exceed-ingly expensive if the data the SEC is seeking to preserve is derived from a database that is regularly overwritten in its or-dinary course of operation. SEC internal organization of •electronic files: The updated enforcement manual states that the SEC should “strive to main-tain and retain documents in an orderly manner.” However, this falls short of the standard chain of custody procedure that is a best business practice for re-sponding party’s production.

Deciphering SEC Enforcement and Its Impact on e-Discovery

continued on page 8

Virginia P. Henschel is vice presi-dent, E-Discovery Affairs for Applied Discovery, Inc. She provides thought leadership and industry knowledge to clients and the industry through position papers, speaking engage-ments and other channels. Prior to joining Applied Discovery, Ms. Hen-schel was E-Discovery Counsel at a Fortune 100 corporation, where she managed all facets of ESI for litiga-tion, including designing and man-aging defensible data collection, review and production for large, complex legal matters. She can be reached at virginia.henschel@ applieddiscovery.com.


BEST E-dIScOvERy pRAcTIcES fOR MANAGING SEc ENfORcEMENT cASES

With the growing SEC enforcement emphasis on electronic submissions, it is clear that to be optimally pre-pared, many organizations will need to review and possibly change some of their document management policies and systems. Although a highly experienced e-discovery ser-vice provider should be consulted to review and advise strategies for a company’s unique situation, there are a number of best practices that will help organizations take steps to-ward improving preparedness.Voluntary Production of Documents

The SEC routinely relies upon voluntary requests for production. However, the problem with volun-tary requests is that the respondent will be subject to the same certifica-tion standards as for document pro-ductions pursuant to a subpoena, in-cluding preparation and submission of a comprehensive privilege log.

Best Practice: To limit the scope of the collection, it is recommended that voluntary production respondents apply the same rigorous standards in negotiating up front as they would in response to a subpoena. Diligent re-view prior to production is essential. Be circumspect on relevance of iden-tified liability issues, and prepare a comprehensive privilege log that will satisfy all the elements stated in the SEC enforcement manual. Form of Production

The updated standard states that “the subpoenaed entity is required to produce all subpoenaed items in possession, custody or control.”

Best Practice: It is recommended that upon receipt of subpoena, clari-fication is sought regarding which third-party providers/vendors the re-sponding will be required to search and produce documents from. Note: it is incumbent upon the responding party to attain an affidavit from the third-party provider/vendor produc-ing documents subject to the sub-poena that replicates the certifica-tion that is required by the SEC for the directly responding party.Certification of Completeness

For all forms of production, the SEC requires a certification that the responding party has met its ob-ligation of a thorough search and comprehensive production. Concur-rent with the certification, the SEC is seeking immediate submission of the responding party’s privilege log.

Best Practice: It is recommended that the respondent take steps to ne-gotiate the form of the certification with the SEC. This will help to en-sure that the organization represents that it has complied in good faith and provided for continuing pro-duction, as additional relevant docu-ments are located. The respondent should negotiate the elements of the certificate of production — prior to commencing review — upon receipt of the subpoena or voluntary pro-duction request.Financial Data

The SEC enforcement manual ad-vises corporations to focus on elec-tronic documents as a “rich source of metadata that is easier to navigate.” However, acknowledging that many companies and financial institutions are reluctant to permit the wholesale production of proprietary programs, the manual does permit Web-based production or production on a dedi-cated hard drive.

Best Practice: It is recommended that review be conducted using an

online review application. In fact, providing the SEC access to your on-line review tool can be preferable to making the production directly. Most e-discovery service providers can eas-ily grant the SEC special access rights to enable easy and specialized navi-gation. For example, access to only the production set can be set up, while maintaining the ability to quar-antine the review of production. This preserves the right to produce the documents directly to the SEC until such time as the form of production is agreed upon and relevancy issues are resolved. cOLLABORATION: THE KEy TO STRATEGIc pREpARATION

The SEC enforcement manual changes provide a new window of transparency. It clearly reveals SEC expectations and how enforcement issues will be handled. It also pro-vides organizations with a roadmap to ensure advanced preparedness, for any potential involvement in an enforcement case. However, it is also clear that corporations and their le-gal advisors shouldn’t go it alone. With the increased SEC emphasis on electronic documentation, the best-prepared organizations will be those that strategically and proactively col-laborate with their IT teams and a knowledgeable e-discovery solution provider.

Opportunities to collaborate are revealed throughout the SEC enforce-ment manual. Therefore, the most important strategic advice is this: Be proactively prepared by establish-ing sound e-discovery and document management practices based on the advice of your best legal counsel. This will help to protect a corporation’s best interests over the long term.

SEC Enforcementcontinued from page 7

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trend, for two reasons. First, most E&O policies are not restricted to “uninten-tional omissions” and “negligent acts”: They simply cover wrongful “acts” and “omissions,” and many affirmatively promise to defend the insured against allegations of intentional misconduct.

Second, in most jurisdictions, it is well-established that policy provisions limiting coverage to negligent conduct do not bar coverage for intentional conduct as long as it causes unintend-ed injury. See, e.g., J.C. Penney Cas. Ins. Co. v. M.K., 278 Cal. Rptr. 64 (1991).cONcLUSION

The bottom line is this. If you face a data security breach or other privacy

claim, make sure your counsel is well-versed not only in privacy and data security law, but also in insurance. Tender the claim to your insurers and if they deny coverage, do not assume they are right. Depending on the lan-guage of your insurance policy and which state’s law applies, you may have coverage without knowing it.

Data Security Breachescontinued from page 6

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an operating agreement whether or not it executes it, that an operating agreement may provide enforceable rights to any person, and that judg-ment creditors of members have no right to interfere with management, force dissolution or seek foreclosure of a membership interest. In Hawaii, Senate Bill 886, effective July 1, pro-vided that a nonprofit corporation may give notice to members by electronic transmission consented to by the members.

In Indiana, Senate Bill 450, effec-tive July 1, stated that if shareholders may cumulate votes, directors may not be elected by less than unani-mous consent, that a resignation of a director that is conditioned upon failing to receive a specified vote for election may be irrevocable, and that a director’s taking advantage of a corporate business opportunity may not be the subject of sanctions if all material facts were known by the board or shareholders, who dis-claimed the corporation’s interest in the opportunity.

In Minnesota, Senate Bill 1288, effective May 16, eliminated the re-quirements that a foreign LLC pro-vide a certificate of good standing along with its application for author-ity and file a certificate evidencing that it changed its name, dissolved or merged. In Mississippi, House Bill 515, effective July 1, provided that an administratively dissolved or revoked corporation may apply for reinstatement at any time after the effective date of dissolution or revo-cation. (Formerly, within five years). In South Dakota, House Bill 1069, and in Utah, Senate Bill 2, both effec-tive July 1, increased the filing fees for many business entity documents, including those filed to organize and register corporations and LLCs.

In Virginia, House Bill 2445, ef-fective July 1, provided that any for-eign corporation that has converted to a different entity type, effective on or before its annual report due date, will not be required to pay the registration fee for that year. And in Utah, Senate Bill 148, effective May 12, and in Wyoming, House Bill 182, effective July 1, authorized the formation of a low profit lim-ited liability company — which is an LLC formed and operated to fur-ther charitable or educational pur-poses and where the production of income or the appreciation of prop-erty is not a significant purpose.

IN THE STATE cOURTSDE Chancery Court Upholds LLC Member’s Right to Approve Amendments to LLC Agreement

In re Nextmedia Investors, LLC, C.A. No. 4067 (Delaware Chancery Court), decided May 6, 2009, in-volved a Delaware LLC, formed in 2008. The LLC agreement stated that it would dissolve in eight years. In March 2008, with the dissolution date looming, the LLC’s board of managers proposed an amendment to the LLC agreement to extend the LLC’s duration. Sec. 17.5 of the LLC agreement required the consent of “each member to be adversely af-fected” in order to amend the LLC agreement. Approximately 97% of the members approved the amend-ment. Two of the members who did not consent asked the board to be-gin dissolution procedures. When the board indicated that it consid-ered the amendment extending the duration to be validly adopted, the members filed a petition with the Chancery Court seeking an order of dissolution.

The Chancery Court granted the members’ motion for summary judg-ment, finding that they had dem-onstrated that their interpretation of Sec. 17.5 of the LLC agreement was the only reasonable one. The members contended that Sec. 17.5 required the consent of all members to approve the amendment because all members were adversely affected by the extension of the LLC’s dura-

tion. The court agreed, noting the importance of the ability to with-draw from an investment and take one’s capital elsewhere.

The LLC argued that Sec. 17.5 could reasonably be interpreted to require consent only from those members that the board intended to adversely affect. The court reject-ed that argument because it was at odds with the section’s plain mean-ing — which was to allow each in-vestor to veto changes to certain economically meaningful terms of the LLC agreement regardless of the board’s intent. The court also re-jected the LLC’s argument that the members had to prove that they were adversely affected. Accord-ing to the court, the members only had to show that their approval was needed. And because the amend-ment would alter an economically meaningful term, their right to ap-prove was triggered. TX Supreme Court Holds That Derivative Suit Demand Must Name Shareholder

In re Schmitz, No. 07-0851 (Texas Supreme Court), decided May 22, 2009, involved a shareholder deriva-tive suit filed on behalf of a Texas corporation. The defendant officers and directors moved to dismiss for failure to make a proper demand. The defendants asserted the de-mand was insufficient because it failed to name a shareholder or describe the subject matter of the claim with particularity. The trial and appellate courts denied relief. However, the Texas Supreme Court agreed with the defendants and or-dered dismissal of the suit.

The court acknowledged that the section of the Texas corporation law requiring a demand did not expressly state that a shareholder must be named. However, the court found, in construing the article of the corporation law on derivative

Sandra Feldman, a member of this newsletter’s Board of Editors, is a publications and research attorney for New York-based CT (www.ctle-galsolutions.com), a Wolters Kluwer business.

Compliance Reviewcontinued from page 1


The publisher of this newsletter is not engaged in rendering legal, accounting, financial, investment advisory or other professional services, and this publication is not meant to constitute legal, accounting, financial, investment advisory or other professional advice. If legal, financial, investment

advisory or other professional assistance is required, the ser-vices of a competent professional person should be sought.


the company’s shareholder-approved stock option plans. According to the SEC, this backdating caused En-gineered Support to file financial statements containing materially false and misleading statements and omissions of material facts with the Commission. In addition to other relief, the SEC sought disgorgement by Shanahan of bonuses and profits under SOX section 304. In response, Shanahan filed a motion for partial summary judgment, asserting that the SEC “cannot prove a necessary element of” section 304.The Court’s Analysis

Shanahan argued that because Engineered Support never actually filed restated financial statements, section 304 did not apply. The SEC countered that, because an account-ing restatement was required under general accounting principles to cor-rect the material errors in the com-pany's financial statements, the fact that such a restatement was not ac-tually filed did not bar the SEC from seeking disgorgement under sec-tion 304. The court disagreed with the SEC, ruling that “the ordinary, contemporary, common meaning of section 304 is that, before penalties may be imposed, an issuer must be compelled or ordered to prepare a financial restatement, and must ac-tually file the restatement.” Accord-ingly, because Engineered Support had not actually filed restated finan-cial statements, the court, based on its narrow reading of the statute, granted Shanahan’s motion and dis-missed the SEC’s section 304 claim.

SOX SEcTION 1514ASection 1514A(a)(1) of SOX was

designed to protect so-called “whis-tleblowers” at publicly traded com-panies “by prohibiting employers from retaliating against employees [who] provided information about specified potentially unlawful con-duct.”

In Day v. Staples, Inc. (No. 08-1689 (1st Cir. 2009)), and Harp v. Charter Communications, Inc. (No. 07-1445 (7th Cir. 2009)), the U.S. Courts of

Appeals for the First and Seventh Circuits, respectively, joined the Fourth and Fifth Circuits in narrowly defining the “reasonable belief” re-quirement of the SOX whistleblower protection provision to encompass both “subjective reasonableness” and “objective reasonableness.”

Under section 1514A: No [publicly traded company] … may discharge, demote, sus-pend, threaten, harass, or in any other manner discriminate against an employee in the terms and conditions of em-ployment because of any law-ful act done by the employee … to provide information, cause information to be provided, or otherwise assist in an investi-gation regarding any conduct which the employee reasonably believes constitutes a violation of … [Federal statutes relating to mail fraud, wire fraud, bank fraud or securities fraud], any rule or regulation of the [SEC], or any provision of Federal law relating to fraud against share-holders, when the information or assistance is provided to … a person with supervisory au-thority over the employee … . [emphasis added]As in the case of section 304, there

are no SEC rules to help the courts interpret this statute.

Day ANd harp Background

Kevin M. Day filed a complaint with OSHA against his employer, Staples, Inc., “alleging retaliatory termination in violation of the SOX whistleblower protection provi-sions.” Employed by Staples for less than three months before his termi-nation, Day repeatedly complained to his supervisors regarding certain billing and collection practices at Staples. In Day’s view, these practic-es raised the (obviously contradic-tory) risks of a reduction in Staples’s profits and an inflation of supervi-sors’ bonuses. Before Day was ter-minated due to his “inflexibility,” failure to perform “his job well” and threats “not to follow his managers’ instructions,” he was permitted to air

his grievances in a battery of meet-ings with senior managers. Staples’ internal investigation uncovered no wrongdoing on the company’s part. After an administrative court dismissed Day’s complaint, he filed suit in Federal District Court, which granted summary judgment in favor of Staples. Day appealed to the First Circuit, which affirmed the lower court’s decision.

In contrast to Day, Mary L. Harp was an experienced supervisor of the Technical Audit Department of Charter Communications’ St. Louis marketing region. As part of her duties, she voiced concerns to her then immediate supervisor, Barry Wilson, that a contractor (“MSTA”) was improperly charging for ser-vices outside of the scope of its contract. Wilson was receptive to Harp’s complaints and scheduled a meeting with Harp, MSTA and oth-ers to discuss the allegations. Prior to the meeting, but for reasons that were not made clear in the decision, Wilson arranged for Harp to report to an intermediate supervisor, Tom Baker, who would in turn report to Wilson. Once the meeting devolved into mutual accusations between Harp and MSTA, Wilson “abruptly” called it to a halt without a resolu-tion having been reached.

Harp eventually concluded that her concerns were not being prop-erly addressed. Fearing that Wilson was going to pay the full invoiced amounts to MSTA despite her mis-givings, Harp made an oral report of company ethics violations, on the part of Wilson, through the proper internal channels. As it turns out, Charter apparently never made pay-ment of the full amounts claimed by MSTA.

Six weeks after the meeting with MSTA, Charter terminated Harp’s employment, along with that of her entire 25-person department, as part of a 50-person reduction in force (“RIF”) in response (accord-ing to Charter) to an unexpected budgetary shortfall in the compa-ny’s St. Louis marketing area. Harp brought suit in the Southern District




of Illinois, alleging that her termi-nation was really in retaliation for her “whistleblowing activities” in violation of SOX section 1514A. The District Court granted summary judgment in favor of Charter. Harp appealed to the Seventh Circuit, which affirmed the lower court’s decision.

THE cOURTS’ ANALySISEach court began its analysis by

focusing on whether “the employee reported specific conduct that con-stituted a violation of federal law,” regardless of whether the employee “correctly identified that law.” The Day court had little trouble deter-mining that Day’s assertions did not “meet the basic components of fraud or of securities fraud,” because “a complaint about corporate effi-ciency is … not within the intended protection of SOX.” Conversely, the Harp court found that, because the conduct that Harp reported, if sub-stantiated, would in fact constitute fraud in violation of federal law, the fact that her whistleblower report complained of company ethics vio-lations, rather than identifying “the appropriate federal law by name,” was not fatal to her claim.

Next, in analyzing each plaintiff’s specific claims, the courts (consis-tent with previous Federal Circuit court decisions) addressed the “rea-sonable belief” language in SOX section 1514A. According to the courts, “reasonableness must be scrutinized under both a subjective and objective standard. [O]bjective reasonableness ‘is evaluated based on the knowledge available to a rea-sonable person in the same factual circumstances with the same train-ing and experience as the aggrieved

employee.’” The First Circuit frankly declared Day’s “generalized allega-tion of inaccuracy in accounting … insufficient to establish a reason-able belief in a violation of GAAP, much less a reasonable belief in shareholder fraud.” Reviewing the substance of Harp’s allegations, the Seventh Circuit concluded that her subjective belief with respect to her supervisor’s allegedly fraudulent conduct provided “simply no objec-tive basis for Harp to have believed that fraudulent payments were au-thorized on January 12th, or at a later date for that matter.”

In dicta, the Seventh Circuit went on to consider whether, even if Harp could have convinced the court that she had an objectively reasonable belief that her employer was en-gaged in fraudulent conduct, she also could have satisfied her “bur-den of establishing by a preponder-ance of the evidence” that her termi-nation constituted a whistleblower violation. Again, the court was not willing to accept Harp’s view of the underlying facts regarding whether the RIF was a legitimate basis for her termination of employment, noting that the circumstances of her termination would make her task in carrying her burden of proof “insur-mountable.” The court noted that “the sheer scope of the RIF is rel-evant to what inference may reason-ably be drawn.”

Notably, a dissenting opinion in Harp marshaled the facts differ-ently from the majority, leading the dissenting judge to conclude that “there are several factual matters that are sufficiently contested to warrant, in my opinion, determina-tion by a jury.” Based on his read-ing of the facts presented by Harp, the dissenting judge wrote that “it appears to me that she reasonably

believed, both subjectively and ob-jectively, that she had been called off the hunt, that her documented findings of fraud were being swept under the rug, and that Barry Wil-son had ordered MSTA to be paid in full.” Moreover, he was sympathetic to the plight of the concerned em-ployee who believes that a fraudu-lent act is about to occur, writing that “[t]he employee should not have to wait until the fraud has been ac-complished to register a concern.” Similarly, the dissenting judge was not prepared to conclude, at least not at the summary judgment stage, that the RIF was the full explanation for the circumstances leading to the termination of Harp’s employment.

cONcLUSIONSOX was enacted in reaction to

what appeared to be systemic mis-feasance amongst public companies, including the infamous cases of En-ron, Worldcom and others. Each section of SOX addresses a separate shortcoming in the then-current regulation of public companies that was exposed by one or more of the accounting scandals. In large part because it was reactionary legisla-tion, many of the provisions of SOX were broadly drafted and, arguably, over-inclusive.

The current financial crisis is ex-ponentially more complex and far-reaching than the accounting and other scandals that spawned SOX, and legislation adopted in the wake of the current crisis may prove pro-portionately more vast. Thus, the narrow interpretation of SOX sec-tions 304 and 1514A adopted by the Federal Courts in the cases described above may provide valuable insight into how Federal Courts will ap-proach any future legislative regime.


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A.: As patents continue the transi-tion from legal documents to finan-cial assets, it is increasingly impor-tant that a company’s finance and accounting unit, technology center

and marketing departments ex-change information and coordinate on a regular basis. If the market-ing department observes commer-cial success for a particular product (whether its own or the competi-tors), this information should be passed to the business unit handling

the patents for that product (or simi-lar product) so that the relevant pat-ents can be identified and evaluated against potential infringers.

On the other hand, if commercial viability of one product wanes, this will also be most apparent to the




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suits as a whole, that demand was required.

The court first noted that the ar-ticle presumes that a corporation knows the identity of the share-holder making the demand. For ex-ample, it permits filing a suit before 90 days after the demand is made if the corporation notifies the share-holder it is rejecting the demand. The court also pointed out that the identity of the shareholder may play an important role in how the cor-poration responds to the demand and that a corporation cannot be expected to incur the time and ex-pense involved in fully investigating a demand without verifying that it came from a valid source. In addi-tion, the court expressed a concern over the potential for abuse if a de-mand could be sent without identify-ing any shareholder. The court also found that the demand in this case was not stated with particularity be-cause it demanded the board of di-rectors stop a merger after receiving a superior offer, but gave no reason why the later offer was superior.

WA Supreme Court Adopts Delaware Law in Derivative Suits Alleging Improper Backdating of Stock Options

Certified from the U.S. District Court in In re F5 Networks, Inc. Derivative Litigation v. McAdam, No. 81817-7 (Washington Supreme Court), decided May 21, 2009, began as a shareholder derivative suit filed in federal district court in Washington. The plaintiffs al-leged that the defendants backdated stock options in violation of federal and state laws and their fiduciary du-ties. The defendants moved to dismiss because the plaintiffs failed to make a demand on the board of directors. The judge certified questions to the Washington Supreme Court, asking whether Washington follows the Del-aware demand futility standard, and, if so, if it follows Delaware’s reason-ing in cases alleging improper back-dating of stock options.

The Washington Supreme Court first concluded that Washington follows Delaware’s demand futil-ity standard. Under the Delaware standard, a shareholder can go di-rectly to court without first asking the board to take action, under cer-tain circumstances. The defendants

claimed that Washington follows the “universal demand” standard. Under that standard, a demand is always re-quired. In rejecting the universal de-mand standard the court noted that Washington’s statute provides that a derivative suit complaint must allege the demand made, if any, and that if a demand was not made, the reason why not. Thus, the legislature clearly contemplated that there would be times a demand would not be made. The court then stated that in deriva-tive suits alleging improper back-dating of stock options Washington would adopt Delaware’s reasoning, as set forth in Ryan v. Gifford, 918 A.2d 341 (Del. Ch. 2007). This would allow plaintiffs to rely on circum-stantial evidence that tends to show a pattern indicative of wrongdoing as part of their initial case.

Compliance Reviewcontinued from page 9

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marketing departments. This informa-tion should be relayed to the technol-ogy, or R&D unit, so that the patent portfolio for that particular product can be pruned in a productive man-ner. This could mean licensing out, sale, donation or simple abandon-ment of the patent(s) in question.

Recognition of the above commer-cial shifts will also aid R&D deci-sions as to where future technologi-cal investments should be made and funded.

Q.: What are the top challenges in doing so in the U.S. as well as inter-nationally?

A.: The information exchange dis-cussed above is rendered more dif-

ficult and even more decentralized when such information must cross national boundaries and span mul-tiple time zones. In such dispersed markets, it is even more important to maintain the concerted effort to manage the relevant product, tech-nical and financial information in a comprehensive way.

Q.: Do you have any additional advice to in-house counsel regard-ing their IP portfolios?

A.: Because of the dual character-istics of a patent document as both a legal instrument and financial in-strument, legally trained counsel can use patents to find even footing with a company’s business-trained managers. In-house counsel would bring many benefits to their depart-ments by trying to identify ways to move IP from a company’s expense

column to the asset column. Some of the responses above generally outline how this can be accom-plished.

In the context of an M&A transac-tion, the flexibility and uncertainty in patent portfolio valuations cuts both ways. Because valuation is not a con-crete exercise, there can be many factors to focus on if one wishes to undercut a portfolio’s value if one is seeking to purchase a company with significant patent holdings. By the same token, there are also factors to focus on if one is seeking to buoy the value of a portfolio. This fluidity should assist in the closing of M&A deals on terms that are amenable to all parties.


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