The wounds of recession often encounter a particularly painful form of salt: litigation. Corporate attorneys stand ready to pour it on if they sense weakness in a rival, or as a way to compensate for their own economic woes. At the same time, regulators have gotten more aggressive, and the costs and complexity of any legal action continue to climb. In short, CFOs can expect to spend more time with in-house counsel this year, getting briefed on a bevy of risks.
Recession-related litigation last spiked in 2001. As the dot-com bubble burst, an embattled tech sector bore the brunt of angry investors. Today, with global capital markets gravely impaired and consumer confidence at an historic low ebb, recession has a much larger footprint. Legal wrangling is erupting across the board as aggrieved plaintiffs battle over breached labor contracts, unwarranted executive layoffs, dubious financial disclosures, broken supply chains, ailing strategic partnerships, ravaged 401(k) plans, unjust competitive practices, intellectual-property infringements, and curtailed credit lines. And that’s only a partial list.
Among the first manifestations this time has been a spate of broken deals. “With more money at stake, and more people aggrieved, more people will look for deep pockets to hang it on,” warns a corporate defense attorney. A last-minute split between Dow Chemical and its Kuwaiti partners capped a dreadful year of M&A for everyone except the lawyers who picked up the pieces.
Last summer, the Delaware Court of Chancery noted the role that economic weakness played as it ruled on competing claims in two stalled asset acquisitions. A suit filed by Hexion Specialty Chemicals sought safety from uncapped damages if the company elected not to close a purchase of assets from Huntsman Corp. (see “A Civil Ending” at the end of this article). Separately, Henkel Corp. wanted Innovative Brands International to go through with its agreement to buy Henkel assets. Both cases centered on assertions of material adverse changes in the target assets. Hexion argued that a material adverse change should stop its deal. Henkel wanted its deal to close, adverse change notwithstanding. Neither plaintiff prevailed.
Ironically, the same recession that prompts companies to look for legal opportunities often prevents them from taking action. Legal departments are as overworked and, increasingly, understaffed as any other. Backlogs are mounting. But, as Erik Skramstad, who heads the forensic-services practice for PricewaterhouseCoopers, notes, “That’s not going to go on forever. As soon as this immediate crisis is over, people are going to come out of the bunker.” Starting in the second quarter, Skramstad predicts a surge in lawsuits directed at companies.
“Body blows [from litigation] to industry supply chains will keep on coming in 2010,” warns Sam Rovit, who directs the Corporate Renewal Group at Bain & Co., a global business consulting practice. “Because of the lag between macroeconomic factors and defaults, our study finds that a painful business shock wave will extend further into the future than originally thought.”
New audit and disclosure rules may serve as another catalyst. Staff Audit Practice Alert No. 3, issued in early December by the Public Company Accounting Oversight Board, lays out 30 pages of new audit procedures. Intended to minimize fraud, it might instead inspire a rash of legal claims, since a blurred detail on, say, revenue recognition could drum up grounds for a multi-million-dollar civil suit. At the other extreme, says a veteran corporate litigator, government lawyers sometimes prolong cases fueled more by prosecutorial zeal than damages or legal merit. Exhibit A: failed corporate actions by federal prosecutors using the Racketeer Influenced and Corrupt Organizations Act, or RICO statutes. Litigating against the government “is rarely a level playing field,” says the litigator. “Almost no good can come of it, even when you win.”
In 2007, one in five of the largest U.S. companies spent $10 million or more a year on litigation, according to law firm Fulbright & Jaworski LLP’s “Fifth Annual Litigation Survey Findings.” The number of smaller companies spending more than $1 million on litigation increased threefold, while the ranks of midsize companies spending that much rose by half.
So where will legal minefields appear in 2009? Leaving aside an expected avalanche in shareholder class actions and the aforementioned boom in broken-deals litigation, CFO asked a panel of experts what other legal minefields might pose a risk in coming months. They cited four areas: electronic discovery, intellectual-property rights, antitrust initiatives, and foreign corrupt practices.
Not Invented Here
Recessions often inspire an uptick in intellectual-property litigation, warns Mark Lemley, director of the Stanford University Program in Law, Science and Technology. When top lines sputter, managers scrutinize balance sheets for untapped revenue. They might reinvest in lucrative patents, dust off others that might pay off, and cast about for anything that might be deemed a violation of their intellectual-property rights. Rivals, meanwhile, challenge patents in order to carve out their own turf, and bankruptcies can complicate the matter by setting IP rights adrift. “CFOs in particular should be paying attention,” Lemley advises.
One of the most notable cases from last year was inre: Bilski, a decision by the U.S. Court of Appeals regarding a pending patent on business methodology. Bernard Bilski and Rand A. Warsaw lost their final bid to protect a method of hedging risk in commodities trading. Although the precedent applies chiefly to financial services, it may have an impact on many process-related patents. Such patents, long contentious, span a number of familiar activities, such as Amazon.com’s “one-click” ordering option, Netflix’s movie-fulfillment methodology, and H&R Block’s tax-refund system.
Affirming the patent-office and lower-court opinions, an “en banc” decision by the entire appeals court rejected the patentability of activities that rely on basic human skills, behaviors, and interactions. It challenges all applications not tied to a particular machine or apparatus, or that do not transform a particular article into a different state or thing.
“A lot of existing patents may turn out to be invalidated,” says Lemley. Watch for Bilski to rear its head in a number of cases this year.
No Natural Monopoly
Rivals seeking to merge, take note: in this volatile market it is critically important to seal deals in a timely way, says attorney Jim Wilson, section chair of the antitrust division of the American Bar Association.
Consider the antitrust battle regarding the acquisition of Wild Oats Markets by Whole Foods Inc. After the Federal Trade Commission failed to convince a federal judge that combining Wild Oats and Whole Foods threatened to monopolize the premium, natural, and organic food market (or PNOS, a category invented for the lawsuit by the FTC) the two grocers merged under the Whole Foods brand. Executives and investors hoped that the combined entity would operate more efficiently and compete well against national grocery chains as those chains expanded their premium natural food offerings.
Last July, the appeals court delivered a belated blow. It reversed the lower court’s green light on grounds that the court gave too little weight to FTC objections. After rendering a split opinion, the appeals court kicked the merger back to administrative judges operating within the FTC. A hearing is slated for early April. While awaiting that decision, Whole Foods filed suit charging breaches of equal protection and due process when information crossed a wall that is supposed to separate FTC antitrust judges from FTC commissioners.
In Wilson’s view, the court’s decision “basically enables the FTC to bring all of its merger litigation into its administrative process, with a fairly low threshold to stay the transaction.”
Keep It Real
While the recent $450 million criminal fine against Siemens dwarfs a previous record of $44 million, the legal judgment is notable for more than just its unprecedented size. It sends a clear message that in matters of corruption (in this case, systemic bribery of foreign officials in order to land contracts) companies will be pursued and punished, one way or another: the record fine actually stems from a plea agreement with the Securities and Exchange Commission.
Of course, the Siemens case already had a very conspicuous global profile (consider that the vast fine it paid here was just a third of that extracted by German courts), but an attorney familiar with the case predicts wider corruption litigation ahead as a downturn exposes tactics that used to fly under the radar. The publicity — and related awards — is all but sure to lure whistle-blowers, warns Dan Newcomb of law firm Shearman & Sterling, not to mention regulators. In a note to its clients, Shearman pointed out the “towering” determination of Siemens’s prosecutors. Attorneys and accountants paid by Siemens’s audit committee eventually logged 1.5 million billable hours as they chronicled how the company engaged in misdeeds around the world. CFO Joseph Kaeser told CFO last year that the company has invested in new control systems to prevent future abuses.
Sifting the pertinent from the irrelevant in millions of electronic documents and E-mails requires armies of paralegals and aspiring lawyers, alters the litigation cost-benefit analysis, and can even hasten settlements as parties decide that it’s cheaper to pay up than sort out all the data.
Routine discovery entails separate fees to collect data, process it, and eliminate countless duplications or apparent duplications (for example, bank reserves versus reserved seats at a ball game). For top-of-the-line work, figure $300 to $500 per gigabyte of data, says Tom O’Connor, founding director of the Legal Electronic Documents Institute. Outsourcing discovery to overseas firms can lower the tab sharply, but at a risk to oversight that is hard to measure. O’Connor’s rule of thumb assumes every business computer generates 5 or 6 gigabytes of data for review. Even modest cases nowadays can generate 500 gigabytes. Bump that volume up to a terabyte (1,000 gigabytes) and have it reviewed by attorneys versus assistants, and discovery can run into the hundreds of thousands of dollars before the first court date.
And it’s delicate work. While preparing documents for discovery in a case pitting Rhoads Industries against Building Materials Corp. of America, a Rhoads attorney initially identified more than 200,000 unique E-mails broadly fitting the defendant’s discovery requests. A keyword search removed 2,000 due to client-attorney privilege. After further culling, Rhoads shipped 78,000 E-mails to Building Materials, plus 22 boxes of nonelectronic documents.
Two weeks later, the defense notified Rhoads that 800 privileged documents had slipped through. Rhoads immediately asserted privilege nevertheless. Faulting careless review by Rhoads’s technical consultant and counsel even after the error surfaced, Building Materials sought a waiver allowing use of information relevant to its case.
Rhoads ultimately had to sacrifice privilege on 120 documents. The case is still pending, so the impact of that botched discovery has yet to be determined. But it highlights the degree to which discovery is not only costly, but also represents a very real legal vulnerability.
S.L. Mintz is a deputy editor of CFO.
A Civil Ending
The protracted battle between Hexion Specialty Chemicals and would-be target Huntsman Corp. was in many respects a microcosm of the financial chaos of 2008. Huntsman’s results were tanking even as Hexion pursued it, prompting Hexion (and its bankers) to claim that material adverse change released Hexion from its commitment.
Huntsman countersued, seeking $3 billion in damages. Chancery court resisted Hexion’s material-adverse-change charge but offered no opinion on the prospects for Huntsman’s insolvency. Instead, the judges chastised Hexion’s board — controlled by Apollo Management LP and legendary financier Leon Black — for its failure to anticipate and mitigate the postacquisition risk of insolvency. With sufficient due diligence, the court concluded, “the buyer could then have stood on its contract rights and faced no more than the contractually stipulated damages. The buyer and its parent, however, chose a different course.”
Having lost an appeal in chancery court, Hexion also lost its financing as its lender bolted. Still saddled with a commitment to proceed with the deal, Hexion elected to press its case in the Delaware Court of Appeals. Leaving nothing to chance, Huntsman assigned three powerful directors to a litigation committee headed by billionaire founder and former CEO Jon M. Huntsman. The companies ultimately settled, with Hexion abiding by the original $325 million termination fee and Apollo Management agreeing to invest $250 million in Huntsman senior convertible notes.