Attorney Kathleen McLeroy has been selected as the 2022 recipient of the American Bar Association (ABA) Business Law Section’s Jean Allard Glass Cutter Award. The award is presented to an exceptional woman business lawyer who has made significant contributions to the profession and the Business Law Section, achieved professional excellence in her field, and advanced opportunities for other women in the profession and Business Law Section.
Kathleen paved her own path to becoming an accomplished trial lawyer. She began her career as bank loan officer where she gained business expertise and insight into a banking client’s perspective. Today, as a shareholder at Carlton Fields, P.A., Kathleen represents commercial banks, mortgage holders, property owners, insurers, and real estate developers in disputes. She has extensive experience resolving disputes as a litigator, mediator, and arbitrator. In addition, she works with judgement holders to enforce and collect domestic and international judgements. Her business acumen and legal expertise supply her clients with astute legal advice to meet their business goals and needs. Kathleen earned her MBA at Louisiana State University and JD from Washington and Lee University School of Law.
Kathleen McLeroy, 2022 Jean Allard Glass Cutter Award Recipient.
According to Law360, women constitute only 23% of equity partners at law firms—Kathleen is one such equity partner. Her hard work representing her clients and pro bono clients alike exemplifies how she has overcome hurdles within the legal profession. Her path to becoming an equity partner was no simple feat as she dedicated thousands of billable and nonbillable hours in her profession; she continues be a pillar of representation for women at the equity partner level. Her peers agree that Kathleen is a committed leader.
Kathleen’s devotion to the legal field extends beyond her clients, as she represents individuals on pro bono matters ranging from landlord-tenant disputes to mortgage foreclosure actions. Kathleen spends countless hours improving access to justice for those who cannot afford legal representation. For example, she represented an elderly client faced with excessive fees that were unrelated to the relevant loan instruments. Kathleen spent countless hours reviewing documents and understanding every detail of the case before justice could be served to her pro bono client. She worked tirelessly for thirteen months to reinstate the client’s mortgage, as the client was the head of household for her daughter; her son, who has a disability; and two grandchildren. Kathleen’s advocacy plays a pivotal role in her career within her local community and extends throughout the United States. She champions the rights of her pro bono clients and associations.
When Kathleen was the president of the Bay Area Legal Services (BALS), she increased and diversified the organization’s funding, which led to improved technology and staff. Most notably, she ran a successful campaign to raise $500,000 for the BALS’s endowment. She has also chaired the ABA Business Law Section’s Pro Bono Committee, served on the ABA Commission on Interest on Lawyer’s Trust Accounts, and was a member of the inaugural board of directors for the Florida Justice Technology Center (FJTC). Her leadership in the area of IOLTA resulted in a Florida Supreme Court mandate—since emulated nationwide—requiring that IOLTA monies be used to fund civil legal services and be paid interest rates commensurate with those offered to non-IOLTA depositors.
While her accomplishments are evidenced by Kathleen’s numerous speaking engagements, published articles, and awards received, the arduous labor behind the scenes is not captured through the same lens. Kathleen received the Florida Bar Foundation’s 2016 Medal of Honor Award, which is the Foundation’s highest award. She has also been recognized as a Florida Super Lawyer by Super Lawyers Magazine from 2011 to 2022; been noted as one of the Best Lawyers in America, Bankruptcy and Creditor Debtor Rights/Insolvency and Reorganization Law, Commercial Litigation from 2019 to 2022; and received the William Reece Smith Jr. Public Service Award from Stetson University College of Law in 2017, to name only a few of her accolades. She has blazed a trail in her legal career as a litigator, mediator, and arbitrator and is the well-deserving 2022 recipient of the ABA Business Law Section’s Jean Allard Glass Cutter Award.
The Great Recession taught an important lesson: if economic pressures prevent your organization from buying new software, then be on the lookout for an audit of your existing software licenses. Software vendors have seized upon noncompliance issues as leverage in convincing reluctant customers to buy new products.
For the past fifteen years, we have advised clients on how to manage software audits, even litigating when necessary. Over time, we’ve seen audits become consistently more sophisticated—employing well-known consulting firms, elaborate and tricky reporting mechanisms, and vendor-friendly scripts or automated review processes.
In part one of this two-part article series, we delved into the steps of a software audit and tips for managing audits. Now, in part two, we will explore ways to improve your license agreements to limit audits or avoid them entirely.
Part Two – Contractual Strategies to Mitigate the Risk of Software Audits
By Andrew Geyer and Christina Edwards
Drafting the Scope of the License to Align with Your Anticipated Use
When preparing and negotiating your license agreements, it is critical that the license grant is comprehensive, accurate, and clear. This process must be supported by a business team with a thorough understanding of who will be using the licensed product, why the organization is procuring the licensed product, and what purpose it is intended to serve.
Intended Users
First, you need to understand who will use the licensed product. This involves an analysis at both the entity level and user level. Consider whether the contracting entity will be the only party using the license or whether the license should extend to the contracting party’s affiliates, business partners, third-party service providers, customers, and other third parties. Once you have determined which entities may need a license, you need to consider which users will need access and how the term user is defined. Vendors often limit the definition of users to named users and limit how licenses can be transferred or reassigned. Closely review any restrictions on seat counts or other licensing metrics and ensure that you are purchasing enough units to cover your anticipated population of users (see recommendations regarding excess usage below). When licenses are restricted by units or quantities, it is important to consider limitations on transferring and reassigning licenses between users. If relevant to your business concerns, negotiate the ability to freely transfer or reassign licenses; if you cannot obtain the unfettered right to do so, provide for a certain number of transfers and reassignments per license over a certain period of time (for example, provide that a license can be transferred or reassigned up to two times in any contract year). Without the ability to reassign or transfer licenses, even ordinary employment changes such as resignations and reassignments can create situations where licenses are fully paid but unable to be used.
Intended Use
Now that you know who will be using the licensed product, you need to determine how they will be using it. Be sure that you have the right to access (including remote access), use, load, and install the product, and consider whether you will need to copy, distribute, make, have made, incorporate, combine, sell, offer for sale, develop, maintain, or make derivative works of the licensed product. This analysis involves a review of both the license grant and any restrictions on usage. First, you should revise the license grant to expressly permit the anticipated usage. Second, you need to closely review any sections of the license agreement that detail restricted or prohibited uses of the licensed product. While it is always wise to include an “except as otherwise permitted herein” proviso at the outset of the restricted or prohibited use section, you should also delete any restrictions that conflict with your anticipated use of the licensed product.
Intended Products
Watch out for licenses that are limited to use with a specific product. If the license is limited to use with certain products, carefully consider how such products may change in the future, and draft the restriction as broadly as possible.
Unintended Geographic or Location-Related Restrictions
Finally, make sure the license grant is not limited geographically, especially if your intended use or users may have cross-border implications. Depending on the type of licensed product, the license agreement may also require that the licensed product is and remains installed or hosted solely by you and on specific equipment or servers. Consider your technology infrastructure, information systems architecture, and potential future plans as they relate to outsourcing or migrating to the cloud, and ensure that you are providing your organization with future flexibility for continued use of the licensed product.
Protecting Yourself from Indirect Access and Excess Usage
Once you have clearly established a comprehensive and accurate license grant, you need to protect yourself in the event that you exceed the scope of the license. This is a real and present concern that you must consider when the license grant is tied to a specific number of users or units. To mitigate this risk, add provisions to the license agreement that address indirect access, and provide the vendor with a sole and exclusive remedy for excess usage.
Indirect Access
Clearly define what does and does not constitute “access” or “use” for purposes of the license grant. The license agreements of certain vendors require you to license users who are not directly accessing or using the licensed product—so-called indirect access. Indirect access can occur when a company’s employees or business partners exchange information with the licensed product through another application or application interface without holding an individual license to the licensed product. To prevent indirect access claims, add language stating that only individuals directly accessing and using the licensed product are considered users for purposes of counting the total number of users and that any indirect access or use by any individuals, bots, sensors, chips, devices, etc., including third-party platforms or third-party software connected to the licensed product, are not chargeable.
Sole and Exclusive Remedy for Excess Usage
Without the contractual protections discussed in this section, if you exceed your license grant, you are in breach of the license agreement, which can result in damages, termination, and copyright infringement claims. To protect yourself from these risks, you should include an excess usage provision that gives the vendor a single remedy in the event of excess usage, namely, the receipt of additional fees for such usage. The provision should state that the vendor’s sole and exclusive remedy for any usage in excess of the number or nature of users provided in the license agreement is to collect additional fees from you for such use. Provide further that the license fees for such excess use should be charged at the per-unit fee set forth in your agreement or, if no such fee is stated, should be determined based on the then-existing charges. Finally, expressly state that any excess usage will not be deemed to be a breach of the license agreement and will not give rise to any other legal claim (such as a claim for copyright infringement).
Identifying and Combating an Audit Provision
Now that you’ve carefully considered the structure of the license and protected your organization from excess usage claims, you need to address any audit provisions in the license agreement—including those that may be hidden in plain sight.
Audit Provisions
When faced with an audit provision in a license agreement, your first negotiation position should be to delete the provision and replace it with self-certification language. If unsuccessful, and if it is a product-based license (e.g., a license for software that will be incorporated into your own products), then try to limit the audit provision to a financial report audit only (i.e., the audit is limited to the accuracy of any financial reports that you are obligated to provide to the vendor). If these options are thwarted by the vendor and you must work with the language of the audit provision, consider negotiating for the following limitations on the vendor’s audit right: (i) conducting the audit only in accordance with a mutually agreed audit plan, (ii) limiting the vendor’s ability to audit to no more than once per year, (iii) requiring adequate advance written notice of an audit (at least sixty days), (iv) requiring that the audit not interfere with your business operations, (v) limiting your involvement in the audit to the vendor’s reasonable requests, and (vi) limiting the vendor’s access to only the information that is necessary for purposes of the audit.
In addition to guardrails around how the audit is conducted, you should also provide protections for the results of the audit, such as (i) requiring all external auditors to sign a nondisclosure agreement that prohibits them from disclosing the results to any entity other than you and the vendor; (ii) obligating the vendor to disclose the results of the audit to you; (iii) providing for your ability to dispute the audit results; (iv) prewiring the license agreement to include a negotiated rate for additional licenses (related to the above recommendation regarding excess usage); and (v) ensuring that the information obtained during an audit, and the results of the audit, are confidential and may not be used against you in court.
Books and Records
Always look closely for a “books and records” provision that allows the vendor to inspect your books and records. These are akin to audit provisions hidden in plain sight, and, if this provision cannot be deleted, you should consider implementing similar guardrails as suggested above.
Conclusion
In conclusion, there are now three certainties in this world: death, taxes, and software audits. While these types of audits can be challenging and strain your organization and its resources, if you have aligned the scope of your license to your anticipated use, protected yourself from indirect access and excess usage, and combated the audit provision (or eliminated it entirely), you will be much better situated when the auditor inevitably comes knocking.
As we think about business development and marketing plans for the upcoming year, it is time to reconsider your strategy for attendance at and involvement in professional conferences and in-person industry events. Although attending conferences has long been a preferred method for business and professional development for people in almost every industry and practice, individual preferences and expectations have shifted substantially since 2020. Some attorneys are finding that the events they used to attend are no longer yielding the results they once did. Professionals who attended information-intensive conferences in hopes of engaging with current and prospective clients are finding that it might now be mainly their competitors and industry vendors in attendance at these same conferences. Many prospective clients are now finding information through other more flexible and less time- and energy-consuming platforms such as webinars, Zoom meetings, video recordings, articles, podcasts, and one-on-one conversations.
But conference organizers recognize that people will continue to attend events if their attendance creates benefits that cannot be achieved through some other less costly and time-intensive method. Growing our networks strategically and building professional relationships, friendships, and mentorships with people we can collaborate and work with are vital components to career development and professional fulfillment. Today there are fewer opportunities for serendipitous, professional, in-person connection and collaboration than ever before, so being intentional and proactive about investing your time and energy in in-person events could prove invaluable to your professional success.
Benefits of attending in-person conferences
Attending conferences that are specific to your practice and are of interest to your target connections can provide a multitude of benefits. Conferences provide an opportunity to reconnect with your existing contacts and meet new people. You can hear industry updates and new perspectives in your field, and CLE is often provided. And stepping away from your day-to-day work to collaborate and learn from industry experts can be inspiring and can generate renewed focus in your work. Lastly, and importantly, conferences should be fun.
Deciding which conferences to attend
Because professional goals shift, the first consideration when approaching any business development initiative is to clarify the kind of work you want more of, who your ideal client is, and who your best referral sources are. With that in mind, busy professionals should choose to attend conferences that meet both of the following criteria:
The attendees are people who can further your career and there will be opportunities to connect
The topics discussed are relevant to your ideal client and your ideal practice
Once you decide that you want to attend a conference, determine what the goal of your attendance is. Is it to raise your visibility, connect with a specific person or type of professional, reconnect with your colleagues? Decide on your desired outcomes, and focus your actions to help you reach that goal.
Getting the most out of your attendance
Before the conference or event
Reach out to your best contacts individually to find out if they will be attending and make a plan to reconnect one-on-one. Even if those contacts are not attending, use the opportunity to schedule time to catch up after the conference; you can run through some of the conference highlights with them.
Update your LinkedIn profile, ensuring it represents you and your practice accurately. You should be using LinkedIn to connect and stay connected with the people you meet at the conference, so be sure your headshot looks like you. These new connections should be able to tell from a brief glance at your profile exactly what you do and for whom. It’s also useful to post on LinkedIn letting your network know you will be in attendance and asking your connections to reach out if they are also planning to attend.
Request the list of registered attendees. Reach out to those you know and those you would like to connect with, letting them know you look forward to seeing them at the conference and asking to schedule one-on-one time to chat. Identify presenters you would like to meet, too. Connect with them on LinkedIn, and include a note letting them know you are looking forward to hearing their presentation.
Consider hosting drinks or a meal with those you know will be in attendance. If appropriate, encourage them to invite their friends or colleagues also present to join. People will appreciate the opportunity to connect and meet new people in a casual setting.
Help out. If you are involved with the host organization, explore the volunteer opportunities available during the conference. This is especially helpful if you don’t know many people in attendance because you will likely meet people when volunteering.
Consider speaking at the event. Being on stage is a fantastic way to boost your credibility and visibility. You typically need to submit a proposal to speak well in advance of the event, so make sure to research and calendar submission deadlines. You can read more about speaking at an event in the previous article in the Attorney Career Advancement series.
Think about what you are going to saywhen new connections ask you what you do. Keep it short and simple, but specific. For example, an informative but concise response might look something like this: “I am an employment litigator. Lately I have represented tech companies with employee issues arising out of remote work.”
Think about what you will say when existing contacts ask how things are going. It’s helpful to write down three recent issues or matters that represent the type of work you want more of, briefly highlighting the client and their issue, how you are helping them solve that issue, and what it ultimately meant to the client.
Order updated business cards if you don’t have them—and don’t forget to bring them with you.
During the conference or event
Attend as much as you can. Networking breakfasts, keynotes, breakouts, lunches, cocktail hours—some conferences even host physical activities like an early morning run or yoga session. You invested your time and the monetary expense of attending, so make sure you are really showing up.
Actively participate in the sessions, ask thoughtful questions, and provide useful commentary.
Introduce yourself and make introductions. Most people are very uncomfortable in these situations, so they will be relieved if you break the ice and take the lead.
Take good notes in the sessions you find valuable. Write down three key takeaways after each session.
Stay after the session to connect with the speaker to ask a question, grab their card, and let them know you enjoyed the session.
Take photos and post them on LinkedIn. Tag the speakers and colleagues in the photos, and comment on what you are learning or experiencing that you find valuable.
After the conference or event
Send connection requests on LinkedIn to everyone you met with a brief note reminding them where you met.
Send short, individual emails to the people you met or reconnected with that include a reason for them to respond (offer to make an introduction, send an article, collaborate on a presentation, etc.) Be intentional about staying in touch.
Consider writing a summary of key learnings to share with your colleagues. You may want to take this further and publish your conference highlights on your firm’s blog and on social media as well, emailing it directly to contacts who weren’t able to attend.
There is something about people physically being together that can’t be replaced with technology. Leveraging technology, forethought, and effort will ensure you get the most out of your professional in-person interactions.
Business Law Today’s winter video collection explores topics from sustainable finance to books and records demands, bringing together experts to share cutting-edge insights. The videos delve deeper into in the subjects of CLE programs at the ABA Business Law Section’s recent Hybrid Annual Meeting, talk with authors of newly released business law books, and discuss topical issues relevant to both novices and seasoned practitioners. Watch now!
Read more about the three business law video series and thirteen videos in the collection below.
Bankruptcy filings are currently at historic lows. In this wide-ranging discussion, U.S. Bankruptcy Judge Christopher M. Alston discusses potential drivers of this change, from new state laws to Subchapter V of Chapter 11 of the U.S. Bankruptcy Code, as well as other notable developments and trends in the world of bankruptcy law. The video delves into the continuing effects of the pandemic on bankruptcy and foreclosures; efforts to make bankruptcy courts more diverse; mass tort bankruptcy cases; and more.
In this engaging discussion, Emily V. Burton and Oderah C. Nwaeze explore books and records demands under Section 220 of the Delaware General Corporation Law, which gives stockholders the right to inspect corporate books and records for certain proper purposes. Providing insights from both the stockholder and corporate sides, they discuss everything from the specificity needed for a demand to notable Section 220 litigation and its impact on best practices for corporate record production. They also touch on the role of directors, including the unique dynamics of their inspection rights and when director emails are produced. Throughout, Burton and Nwaeze highlight tips and strategies for the reality of this area of practice.
This discussion with Commodity Futures Trading Commission (CFTC) Commissioner Kristin N. Johnson features excerpts of her appearance at the ABA Business Law Section’s Hybrid Annual Meeting in September 2022. In Commissioner Johnson’s keynote fireside chat with the Section’s Private Equity and Venture Capital Committee, she offered thoughts on the legal and regulatory framework for cryptocurrency and digital assets, collaboration with the Securities and Exchange Commission, and more.
Interested in a career in M&A? This video will provide an understanding of not only the role of the corporate lawyer in M&A deals but the numerous elements that encompass a typical M&A transaction. The featured speakers—Samantha Horn, Matthew B. Swartz, and Daniel Rosenberg—are seasoned M&A lawyers who have a firm grasp of this unique legal practice. In this video, they identify the legal issues and key players involved in an M&A deal and offer tips for getting started in the field. With so many moving parts, the attorney must have the knowledge and skills to navigate the legal due diligence of an M&A transaction.
With cyberattacks on the rise, every organization needs to be proactive in cybersecurity incident response planning. Such planning is essential to formulate policies to help resolve cyberattacks and meet legal obligations. In this video, two cybersecurity specialists, Garylene (Gage) Javier and Romaine Marshall, describe the current threat landscape, in which increasingly sophisticated cybercriminals treat ransomware attacks as a “business.” They walk viewers through best practices for incident response plans and recovering from an attack—highlighting how responsible governance requires understanding and planning for a robust response that will safeguard the organization.
Nathaniel M. Cartmell III, Nicholas D. Mozal, Youmna Salameh, and former Vice Chancellor of the Delaware Court of Chancery Joseph R. Slights III provide keen insight into recent decisions under Delaware law that address controlling stockholders, extending the discussion of a CLE program at the ABA Business Law Section’s 2022 Hybrid Annual Meeting (now available as on-demand CLE). Their conversation delves into the determination of whether a control group exists, considerations around trading process for price in the context of the MFW decision, key differences in negotiating with a controller stockholder, and more.
Kyriakoula Hatjikiriakos, Lisa Mantello, Robert J. Lewis, and Sara Gerling explore recent market trends in the rapidly evolving world of sustainable finance loan transactions, extending the discussion of a CLE program at the ABA Business Law Section’s 2022 Hybrid Annual Meeting (now available as on-demand CLE). These experts reflect on the current landscape in the US, European, and Canadian markets, including emerging regulatory developments. Topics covered include the role of sustainability coordinators, key performance indicators used in sustainability linked loans and what within ESG they focus on, and more.
Maritza T. Adonis, Bruce F. Freed, and Jason Kaune delve into the new pressures on corporations to engage with social movements and environmental, social, and governance criteria, extending the discussion of a CLE program at the ABA Business Law Section’s 2022 Hybrid Annual Meeting (now available as on-demand CLE). “Companies today really have to address what they’re associated with through their spending,” Freed said. Their conversation touches on what those counseling corporate leadership need to consider in planning how to address these issues, the role of different stakeholders, and the education and foundational work attorneys can undertake in this space.
Gary J. Ross and Alan J. Wilson explore the securities law framework for capital raising by early stage and other private businesses, extending the discussion of a CLE program at the ABA Business Law Section’s 2022 Hybrid Annual Meeting (now available as on-demand CLE). In a conversation ranging from the impact of the JOBS Act to tricky aspects of blue sky requirements to the evolution of SAFEs, Ross and Wilson highlight useful practice tips and share insights from their varied experience. The program their discussion draws on was part of Business Law Essentials, a curated selection of CLE programs designed to provide practice area updates, developments, and primers on key business law issues.
Jody R. Westby was spurred to writeD&O Guide to Cyber Governance: Fiduciary Duties in the Digital Age in a time of increasingly sophisticated cyberattacks. “Boards and CEOs are not aware of what really needs to be done,” she said. “I wanted to develop a book that would tell boards and C-suites, here’s what you do to manage cyber risks, and to do it right according to the law and to best practices.” In this conversation, Westby highlights key points where board members get tripped up, delves into the book’s practical resources, and explains why she dedicated the book to E. Norman Veasey, former Chief Justice of the Delaware Supreme Court and former Chair of the Business Law Section.
As terrorist groups and tactics evolve, government authorities and the private sector have focused on preventing financial and commercial systems from being leveraged and abused to fund terrorist activities. Leading experts came together to create Countering the Financing of Terrorism: Law and Policy after they realized there was a “gap in the literature” on this subject, says editor John M. Geiringer. The result is a comprehensive overview of the key legal tools and strategies used to combat this dynamic challenge. In this conversation, Geiringer discusses the extent of the terror financing problem; the role of financial institutions and banking lawyers in countering it; and the book’s insights into terror financing typologies.
“You need to understand fraudulent transfer law because of its broad scope. It might be an old, ancient law, but it is more than capable of handling today’s modern, sophisticated transactions,” says David J. Slenn. In The Fraudulent Transfer of Wealth: Unwound and Explained, Slenn outlines steps that planners can take to minimize a transaction’s exposure to avoidance and proactive measures that creditors can take to reduce the chance of losing assets. Here, Slenn discusses the risks of misunderstanding fraudulent transfer law, the book’s step-by-step guide to key issues, and top lessons learned.
With intellectual property rights assuming greater importance in today’s world and licensing issues and developments constantly evolving, The Practical Guide to Software Licensing and Cloud Computing, 7th Edition is an essential resource. In this conversation, author H. Ward Classen discusses the new edition’s expanded discussion of cloud computing, how he tracks new developments, and the evolution of the book over nearly twenty years. As the practice of software law has expanded, “It’s blossomed,” Classen said. “It’s much more comprehensive, and it seems to resonate with practitioners endlessly.”
ABA Model Rule 4.2 is seeing an apparent renewed emphasis in 2022. Rule 4.2—commonly known as the “no contact rule”—provides: “In representing a client, a lawyer shall not communicate about the subject of the representation with a person the lawyer knows to be represented by another lawyer in the matter, unless the lawyer has the consent of the other lawyer or is authorized to do so by law or a court order.” The stated purpose behind this Rule is “protecting a person who has chosen to be represented by a lawyer in a matter against possible overreaching by other lawyers who are participating in the matter, interference by those lawyers with the client-lawyer relationship and the uncounselled disclosure of information relating to the representation.” ABA Model Rule 4.2, cmt. 1.
This renewed emphasis on Rule 4.2 is evidenced by the ABA Standing Committee on Ethics and Professional Responsibility issuing two consecutive ABA Formal Ethics Opinions in quick succession addressing different aspects of the lawyer’s ethical obligations under the “no contact rule.”
Application of the “No Contact Rule” to the Self-Representing Lawyer
On September 28, 2022, the Committee issued ABA Formal Opinion 502 addressing “Communication with a Represented Person by a Pro Se Lawyer.” Early on, the Opinion recognized that Rule 4.2 does not prohibit parties from communicating directly with one another. See ABA Formal Op. 502, at 2-3, citing ABA Model Rule 4.2, cmt. 4. In fact, in a previous ABA Formal Ethics Opinion, the Committee opined that it is not a violation of Rule 4.2 to help coach a client about communications that the client can have with a represented opposing party. See ABA Formal Op. 11-461 (“Advising Clients Regarding Direct Contacts with Represented Persons”) (Aug. 4, 2011).
However, in Formal Opinion 502, a majority of the Committee concluded—based on both the text of Rule 4.2 itself and the purposes behind the Rule—that a lawyer proceeding in a matter pro se is “representing a client,” namely himself or herself, and therefore, the “no contact rule” applies. Specifically, the majority stated that:
When a lawyer is self-representing, i.e., pro se, that lawyer may wish to communicate directly with another represented person about the subject of the representation and may believe that, because they are not representing another in the matter, the prohibition of Model Rule 4.2 does not apply. In fact, both the language of the Rule and its established purposes support the conclusion that the Rule applies to a pro se lawyer because pro se individuals represent themselves and lawyers are no exception to this principle.
ABA Formal Op. 502, at 1.
In reaching this conclusion, the majority admitted that “when a lawyer is acting pro se, application of Model Rule 4.2 is less straightforward” and that in applying Rule 4.2 “to pro se lawyers, the scope of the rule is less clear.” ABA Formal Op. 502, at 2 and 3. Despite reliance on the principles behind Rule 4.2, the majority also acknowledged: “This opinion does not address the related question of applicability of Rule 4.2 when a lawyer is represented by another lawyer and the represented lawyer wishes to communicate with another represented person about the matter.” Id., at 3, n. 10. The majority even recognized that its stance about the language “in representing a client” applying to the self-representing lawyer may create an ambiguity when applied to a pro se lawyer and that its stance is contrary to that of the Restatement of the Law Governing Lawyers. Id., at 5 and 5, n. 25.
In a somewhat unusual move, not only was there dissent within the Committee on this issue, but the Committee published the dissenting opinion. From the outset, the dissenting minority disagreed with the notion that the language of Rule 4.2 itself supports the majority’s conclusion: “While the purpose of the rule would clearly be served by extending it to self-represented lawyers, its language clearly prohibits such application.” ABA Formal Op. 502, dissenting op. at 6–7 (italics in original). The dissent further explained:
But it is, I hope, unusual for a committee to nullify plain language through interpretation, especially when the committee has jurisdiction to propose rule amendments.
***
Applying Rule 4.2 to pro se lawyers is supported by compelling policy arguments. It is not the result I object to, it is the mode of rule construction that I cannot endorse. Self-representation is simply not “representing a client,” nor will an average or even sophisticated reader of these words equate the two situations. Rather, this is an “ingenious bit of legal fiction.” Further, this approach to construing the rule’s language renders the phrase “in representing a client” surplusage, contrary to a basic canon of construction.
It is also simply wrong to perpetuate language that was clear but has been made misleading by opinions effectively reading that language out of the rule. When an attorney consults the rule, it is highly unlikely that the phrase “in representing a client” will be considered to include self-representation. If the attorney goes further and consults Comment [4], the Comment will assure the attorney that, “Parties to a matter may communicate directly with each other.” Given this apparent clarity, what will tip off the attorney that further research is required? The lesson here must be that nothing is clear. Clear text cannot be relied upon but may only be understood by reading ethics opinions and discipline decisions. Does the text mean what it actually says, as it does in Connecticut, Kansas, and Texas? Or, does it mean what we wish it said, as several other states have declared?
ABA Formal Op. 502, dissenting op. at 7–8 (internal citations omitted) (italics in original).
Indeed, if Rule 4.2 is to be applied to a lawyer representing themself, that applicability is certainly less than clear from the language of the Rule or its Commentary. As the dissent suggests, if this is how the Rule is to be applied, then perhaps the Rule itself should be revised through the Rule amendment process to provide the clarity that the majority appears to see but that others do not. Otherwise, as it stands, ABA Formal Opinion 502 appears to set an ethical trap for the unsuspecting pro se lawyer who does not think they are “representing a client” when representing themself.
Rule 4.2 and the “Reply All” Email
On November 2, 2022, the Committee subsequently issued ABA Formal Opinion 503 addressing the issue of “‘Reply All’ in Electronic Communications.” Formal Opinion 503 addresses the ethical propriety of an opposing counsel recipient (“receiving counsel”) sending a “reply all” email when the originating attorney (“sending counsel”) copies their client on the original email. The Opinion addresses the extent to which the sending counsel, by copying their client, has impliedly authorized the recipient counsel to respond to all recipients of the original email (including the sending counsel’s client).
While acknowledging that a number of jurisdictions take the position that the sending counsel has not impliedly consented to a “reply all” response under these circumstances, the Committee concluded: “given the nature of the lawyer-initiated group electronic communication, a sending lawyer impliedly consents to receiving counsel’s ‘reply all’ response that includes the sending lawyer’s client, subject to certain exceptions [discussed therein].” ABA Formal Op. 503, at 2. The Committee supported its conclusion by noting that consent under Rule 4.2 need not be express but may be implied. The Committee also placed responsibility on the sending counsel for initially including their client on the communication, noting that such placement of responsibility on the sending counsel was fairer, especially if the list of recipients in the group email is large and especially where the sending counsel can avoid this issue altogether (and likewise avoid the possibility of the client also sending a “reply all” which may disclose “sensitive or compromising information”) by forwarding the client the original email in a separate email solely between the client and the lawyer. Id., at 3–4. In fact, the Committee itself noted that forwarding the email to the client—as opposed to “bcc’ing” a client—may be safer “because in certain email systems, the client’s reply all to that email would still reach the receiving counsel.” Id., at 4, n. 14.
Formal Opinion 503’s focus on the sending counsel’s responsibility, as opposed to that of the receiving counsel, is consistent with the 2002 amendment to ABA Model Rule 4.4(b) with respect to the duties of the unintended recipient of information relating to the representation of a client. Prior to 2002, the unintended recipient’s ethical obligations were to refrain from reading the document, notify the sender, and abide by the sender’s instructions. The 2022 amendment of Rule 4.4 limited the unintended recipient’s ethical obligation to only that of notifying the sender. See ABA Model Rule 4.4(b); ABA Formal Op. 05-437 (“Inadvertent Disclosure of Confidential Information: Withdraw of Formal Op. 92-368 (Nov. 10, 1992)”) (Oct. 1, 2005). As such, greater responsibility is placed on the sender to take care not to misdirect the communications in the first place.
As to the exceptions to this implied authorization to “reply all,” Formal Opinion 503 noted that an express oral or prominent written instruction from the sending counsel to receiving counsel that receiving counsel is not to send a “reply all” email that includes the client will eliminate any suggestion that the sending counsel has impliedly authorized such direct communication with the client. See ABA Formal Op. 503, at 4. The Opinion also noted that this implicit authorization for the receiving counsel to “reply all” should be limited to email and other group electronic communications. Seeid., at 4. In other words, the same implicit authority is not present if the sending counsel carbon copies their client on a traditional paper letter.
And again, some jurisdictions disagree with the position taken by ABA Formal Op. 503 with respect to the sending counsel impliedly authorizing the receiving counsel’s direct communication with the carbon copied client via a “reply all” response email. For example, Kentucky Bar Association Ethics Opinion E-442 (Nov. 17, 2017) took the opposite approach: “A lawyer who, without consent, takes advantage of ‘reply all’ to correspond directly with a represented party violates Rule 4.2. Further, showing a ‘cc’ to the client on an email, without more, cannot reasonably be regarded as consent to communicate directly with the client.” See KBA E-442, at 1–2. The KBA Opinion also cautioned that the sending counsel, without the client’s express or implied consent, may be violating Rule 1.6’s duty of confidentiality when copying the client because doing so provides the following information to the receiving counsel: “1) the identity of the client; 2) the client received the email including attachments, and 3) in the case of a corporate client, the individuals the lawyer believes are connected to the matters and the corporate client’s decision makers.” Id., at 2.
Conclusion
Perhaps the lesson behind both of these ABA Formal Ethics Opinions addressing Rule 4.2 is this: it has always been true that a lawyer should pause whenever wanting to communicate directly with a person represented by counsel. But there are grey areas in the application of this Rule, and different jurisdictions interpret the Rule differently. Some jurisdictions would follow ABA Formal Opinion 502 and apply Rule 4.2 to self-representing lawyers, while other jurisdictions would not. Some jurisdictions would follow ABA Formal Opinion 503 and maintain that, generally speaking, a sending counsel who copies their client on an email has impliedly authorized the receiving counsel to send a “reply all” response email, while other jurisdictions would not. As such, when a lawyer finds themself in these grey areas, it is important to determine how the applicable jurisdiction applies Rule 4.2. Finally, if all else fails, the lawyer can always attempt to secure the explicit consent of opposing counsel to allow for direct communication with opposing counsel’s client, with such consent preferably confirmed in writing to eliminate any confusion.
On October 26, 2022, the U.S. Securities and Exchange Commission (the “SEC” or the “Commission”) adopted final rules (the “Final Rules”)[1] implementing the clawback provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”). In particular, the Final Rules require:
national securities exchanges (“exchanges”) and national securities associations to establish listing standards that require listed companies to develop and implement policies providing for the recovery of “erroneously awarded” incentive-based compensation received by current or former executive officers where such compensation is based on erroneously reported financial information and an accounting restatement is required (a “clawback policy”); and
listed companies to provide disclosures about their clawback policies and how they are being implemented.
Historical Background and Commissioners’ Views
Section 954 of the Dodd-Frank Act added Section 10D to the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Section 10D directed the SEC to adopt a rule requiring companies to develop, implement, and disclose clawback policies designed to recover “erroneously awarded” incentive-based compensation from current or former executive officers during the three-year period preceding the date on which the company was required to prepare an accounting restatement due to the company’s material noncompliance with any financial reporting requirement under the securities laws.
The SEC first proposed clawback rules on July 1, 2015, and received significant public comment. After the proposal languished for years, and in light of regulatory and market developments since 2015, the Commission reopened the comment period for these rules on October 14, 2021. On June 8, 2022, the Commission released a memo prepared by the staff in its Division of Economic and Risk Analysis that contained additional analyses and data relevant to the proposed clawback rules and reopened the comment period again. The SEC adopted the Final Rules on October 26, 2022, in a 3-2 vote.
SEC Chair Gary Gensler and Commissioners Caroline Crenshaw and Jaime Lizárraga voted in favor of the Final Rules. Their statements indicated that they supported the Final Rules largely because they believe the Final Rules will benefit investors and promote accountability, including by, among other things, “strengthen[ing] the transparency and quality of corporate financial statements, investor confidence in those statements, and the accountability of corporate executives to investors.”[2]
Commissioners Hester Peirce and Mark Uyeda dissented from the adoption of the Final Rules. Their statements included concerns that the Final Rules are overly broad by, among other things, applying to so-called “little r” restatements (rather than only “Big R” restatements),[3] covering too broad a swath of company executives (rather than only individuals involved in the events leading to the restatement), applying to all listed companies (rather than excluding or providing exemptions for emerging growth companies [“EGCs”], smaller reporting companies [“SRCs”], and foreign private issuers [“FPIs”]), and defining “incentive-based compensation” too broadly (rather than limiting it to compensation based on accounting-based metrics). Commissioner Uyeda also expressed his concern that the Final Rules may misalign the interests of shareholders and corporate executives, as companies may restructure executive compensation arrangements to decrease incentive pay vulnerable under clawback policies in favor of increasing discretionary bonuses.[4]
Important Things to Know
The Final Rules will require companies to adopt clawback policies and provide related disclosures. Below are questions highlighting issues of note for companies, directors, and advisors about the Final Rules, which are separated into sections discussing the Final Rules generally, clawback policies, and disclosure requirements.
General Information
1. Which companies are affected?
All listed issuers—including EGCs, SRCs, FPIs, Canadian companies reporting under the multijurisdictional disclosure system, and controlled companies—will be subject to the Final Rules.
2. When will this new regime go into effect?
The Final Rules, which, as noted, are structured to direct the exchanges to adopt new listing standards, will become effective on January 27, 2023. Exchanges will need to file proposed listing standards no later than February 26, 2023, and these listing standards must then be effective no later November 28, 2023. A listed company must adopt a clawback policy no later than sixty days following the date on which the applicable listing standard becomes effective and must begin to comply with the Final Rules’ disclosure requirements in proxy and information statements and annual reports filed on or after the effective date of the applicable listing standard.
3. May companies indemnify or otherwise assist their executive officers in mitigating the impact of the clawback policy?
No. Companies are prohibited from insuring or indemnifying their executive officers with respect to recoverable amounts, including from paying or reimbursing the executive officer for premiums on an insurance policy covering recoverable amounts.
Clawback Policies
4. What must be included in a company’s clawback policy?
A listed company will be required to adopt and comply with a written policy providing that the company:
will recover reasonably promptly the amount of erroneously awarded incentive-based compensation in the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws, including any required accounting restatement to correct an error in previously issued financial statements that is material to the previously issued financial statements, or that would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period. (Final Rules; emphasisadded to highlight defined terms.)
5. Which employees need to be covered by the clawback policy?
A company’s current and former executive officers will be subject to the clawback policy.
“Executive officers” in the new Rule 10D-1(d) are the same as officers as defined by Rule 16a-1(f) for Section 16 purposes and therefore broader than the definition of “executive officer” provided in Rule 3b-7 under the Exchange Act. So, for domestic issuers, the group covered will include any executives subject to Form 4 reporting. The group includes a company’s president; principal financial officer; principal accounting officer (or if there is no such accounting officer, the controller); any vice president of the company in charge of a principal business unit, division, or function (such as sales administration or finance); any other officer who performs a policy-making function; or any other person who performs similar policy-making functions for the company.
Importantly, the definition of executive officer is broader than the definition of “named executive officer” (NEO) and the group of executives subject to clawback under the Sarbanes-Oxley Act of 2002. The company’s principal accounting officer (or controller if the listed company does not have a principal accounting officer) is covered by the Final Rules even if the company does not otherwise consider that person to be among its executive officers.
Note that the definition of executive officer is not limited to executive officers who may be “at fault” for, or have knowledge of, errors that led to a restatement or those who are directly responsible for the preparation of the financial statements. Recovery of compensation received while an individual was serving in a non-executive capacity prior to becoming an executive officer will not be required, but for an employee who served as an executive officer and then returned to employee status, recovery for compensation following service as an executive officer would be required.
The Final Rules do not apply to non-employee directors.
6. What is incentive-based compensation?
The Final Rules define incentive-based compensation broadly as “any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure” and includes cash awards, bonuses from a “pool” the size of which is determined based on financial reporting measures, equity awards, and proceeds from shares acquired pursuant to such equity awards. Notably, however, incentive-based compensation excludes equity awards that were not granted based on the attainment of any financial reporting measure and vest solely based on continued service.[5]
Note that compensation contracts or arrangements that existed at or prior to the Final Rules’ effective date must be subject to clawback policies if any incentive-based compensation is received on or after the effective date of the listing standards (e.g., a performance-based equity award granted in 2021 with a performance period that ends in 2025). In other words, currently existing compensation contracts are subject to potential clawback if any applicable compensation will be received on or after the effective date of the exchanges’ standards.
7. What are financial reporting measures?
Financial reporting measures are:
measures that are determined in accordance with the accounting principles used in the company’s financial statements, whether presented in or outside of the company’s financial statements,
any measures derived wholly or in part from such measures (including non-GAAP measures and other measures, metrics, and ratios that are not non-GAAP measures, e.g., same-store sales), and
other performance measures—including stock price, Total Shareholder Return (“TSR”), and relative TSR—that are affected by accounting-related information.[6]
8. When is incentive-based compensation deemed to have been erroneously awarded?
Incentive-based compensation will be deemed erroneously awarded and subject to a company’s clawback policy if the compensation was tied to financial performance measures and the issuer is required to restate or correct the financial statements upon which the payouts were based (i.e., the payout was a higher amount than it would have been had the corrected financial statements been the ones initially prepared).[7]
This means that clawback policies must cover both “Big R” and “little r” restatements. The Final Rules do not provide a separate definition for either “materiality” or “accounting restatements”; instead, the Final Rules look to existing accounting standards and guidance to define such terms in order to help ensure standards are consistently applied across companies and over time.[8]
9. What time period must the clawback policy cover?
The clawback policy must provide for a three-year look-back period, which comprises the three completed fiscal years (rather than the preceding thirty-six months) immediately preceding the date when the company is required, or should have reasonably concluded that it was required, to prepare an accounting restatement for a given reporting period.[9]
This means that if a company with a December 31 fiscal year-end determines in November 2024 that a restatement is required going back to 2021 and files restated financial statements in January 2025, the clawback policy would apply to incentive-based compensation received in 2023, 2022, and 2021 (see next section for the definition of “received”). If a company changed its fiscal year-end during the three-year look-back period, it must recover incentive-based compensation received during the transition period occurring during, or immediately following, that three-year period in addition to during the three-year look-back period (i.e., a total of four periods).
Notwithstanding the three-year lookback, the Final Rules apply only to (i) incentive-based compensation received after a person began service as an executive officer and served as an executive officer at any time during the performance period for that incentive-based compensation, and (ii) incentive-based compensation received while the company’s securities are listed.
10. When is incentive-based compensation “received” for purposes of the three-year lookback?
Incentive-based compensation is deemed to be “received” in the fiscal year during which the financial reporting measure included in the incentive-based compensation award is attained or satisfied, regardless of whether the payment or grant occurs after the end of that period or if the executive officer has established only a contingent right to payment at that time. The Adopting Release notes that ministerial acts or other conditions necessary to effect issuance or payment (e.g., calculating the amount earned or obtaining the board of directors’ approval of payment) do not extend the date of receipt.
11. What portion of erroneously awarded compensation must be recovered?
“[T]he amount of incentive-based compensation received that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the restated amounts”[10] is subject to recovery.
The Adopting Release provides the following, non-comprehensive, guidance for calculating the amount of erroneously awarded compensation:
For equity awards, if the equity award or shares are still held at the time of recovery, the number of such securities received in excess of the number that should have been received based on the accounting restatement (or the value of that excess number), provided that if options or SARs have been exercised, but the underlying shares have not been sold, the erroneously awarded compensation is the number of shares underlying the excess options or SARs (or the value thereof).
The SEC did not clarify if by “the value thereof” it intends to capture the value at the time of grant or at the time of clawback.
For cash awards paid from bonus pools, the erroneously awarded compensation is the pro rata portion of any deficiency that results from the reduction in the aggregate bonus pool based on applying the restated financial reporting measure.
For incentive-based compensation attained only partially based on the achievement of financial reporting measures, recalculate only the portion of such compensation based on or derived from the financial reporting measure that was restated.
If the erroneously awarded compensation is not able to be calculated from information in an accounting restatement (e.g., TSR, relative TSR,[11] or stock price measures), a reasonable estimate of the effect of the accounting restatement on such measure should be used (with documentation of such determination provided to the relevant exchange).
All amounts of erroneously awarded compensation would be calculated on a pre-tax basis (i.e., without respect to any tax liabilities that may have been incurred or paid by the executive).
12. How and when must recovery occur?
As noted above, the Final Rules mandate recovery on a no-fault basis, without regard to any “scienter” on the part of relevant executive officers and with very limited discretion by the board of directors to forgo recovery. The Final Rules provide that recovery need not be pursued if the compensation committee (or in the absence of a compensation committee, a majority of the board’s independent directors) determines recovery is impracticable in light of one of the following three conditions:
the direct cost paid to a third party to assist in enforcing recovery would exceed the amount of recovery, provided that the company has first made a reasonable attempt to recover such erroneously awarded compensation, has documented such reasonable attempt(s) to recover, and has provided that documentation to its listing exchange;
the recovery would violate a home country law that was adopted prior to November 28, 2022, provided that the company has obtained an opinion of home country counsel acceptable to the company’s listing exchange that recovery would result in such a violation and the company has provided such opinion to its listing exchange; or
the recovery would likely cause an otherwise tax-qualified retirement plan, under which benefits are broadly available to employees of the registrant, to fail to meet the requirements of 26 U.S.C. 401(a)(13) or 26 U.S.C. 411(a) and regulations thereunder.
Absent a finding of impracticability, companies are permitted to exercise discretion in what specific means to use to accomplish recovery, but generally must pursue recovery and should endeavor to prevent executive officers from retaining the full amount of compensation to which they were not entitled under the company’s restated financials. Partial recovery can only be sufficient with a showing of impracticability, as described above.
Recovery must occur “reasonably promptly.” The Final Rules do not define “reasonably promptly,” but the Adopting Release notes that companies may consider costs related to recovery efforts when determining what is “reasonable.” For example, it may be reasonable, depending on the facts and circumstances, to establish a deferred payment plan allowing an executive officer to repay erroneously awarded compensation as soon as possible without unreasonable economic hardship or to establish compensation practices that account for the possibility of the need for future recovery (e.g., holdbacks).
There are no de minimis exceptions for small amounts of recovery (except to the extent it may implicate the impracticability analysis described above).
13. What happens if a company does not adopt a clawback policy?
A company will be subject to delisting if it does not adopt and comply with a clawback policy that meets the requirements of its exchange’s listing standards, and no exchange will be able to list the company’s shares until it has adopted a compliant policy.
Disclosure Requirements
14. Where do clawback policies and related information need to be disclosed?
Disclosures will need to be provided in proxy and information statements, as well as in companies’ annual reports.
15. What disclosures does a company need to make regarding its clawback policy?
The Final Rules require companies to provide a number of new disclosures related to their clawback policies. A listed company will be required to:
file its clawback policy as an exhibit to its annual report; and
include check boxes on the cover of its Form 10-K, 20-F, or 40-F, as applicable, disclosing whether the financial statements included in the report reflect the correction of an error to previously issued financial statements and whether any such error corrections are restatements that required a compensation recovery analysis pursuant to the company’s clawback policy.
A listed company that has prepared an accounting restatement that triggered its clawback policy, along with any company that has an outstanding balance of excess incentive-based compensation relating to a prior restatement, will also be required to provide the following disclosures in its proxy or information statement or annual report containing executive compensation disclosures pursuant to Item 402 of Regulation S-K:
the date the accounting restatement was required to be prepared, the aggregate amount of any related erroneously awarded compensation, and a description of how the recoverable amount was calculated or why the amount has not yet been determined;
the aggregate amount of the erroneously awarded compensation outstanding at the end of the last fiscal year;
if the erroneously awarded incentive compensation was determined based on stock price or TSR metrics, the estimates used to determine the amount of erroneously awarded compensation attributable to an accounting restatement and an explanation of the methodology used for those estimates;
the amount of recovery forgone and a description of the reasons recovery was not pursued if recovery would be impracticable; and
for each covered current or former executive, the amount of any erroneously awarded compensation that is owed and has been outstanding for 180 days or longer after the company determined the amount owed.
Disclosure would also be required if an accounting restatement occurred and the registrant concluded recovery of erroneously awarded compensation was not required under the clawback policy.
Next Steps
16. What steps should be taken now to ensure compliance with the Final Rules?
Companies should work with counsel to update existing clawback policies or adopt new clawback policies to comply with the Final Rules. Companies should also review existing contracts and forms (e.g., employment agreements, separation agreements, bonus plans, and equity award agreements) and consider updates addressing the company’s clawback policy. Members of management should expect to engage with both their nominating and governance committees as well as compensation committees on efforts to comply with the Final Rules. Members of these committees should make appropriate inquiries of management to understand the timing and nature of any changes that might be required in a company’s clawback policies.
A version of this publication originally appeared as a Cravath, Swaine & Moore LLP client memo.
The text of the final rule and the Commission’s related adopting release (the “Adopting Release”) can be found on the SEC’s website. ↑
“Big R” restatements are restatements where historical financial statements are restated to correct errors material to previously issued financial statements. “Little r” restatements are restatements that correct errors that are not material to previously issued financial statements, but would result in a material misstatement if (a) the errors were left uncorrected in the current report or (b) the error correction was recognized in the current period. ↑
The Adopting Release provides non-exhaustive examples of compensation that is not incentive-based compensation, including salaries; bonuses paid solely at the discretion of the compensation committee or board that are not paid from a bonus pool determined by satisfying a financial reporting measure performance goal; bonuses paid solely upon satisfying one or more subjective standards (e.g., demonstrated leadership) and/or completion of a specified employment period; non-equity incentive plan awards earned solely upon satisfying one or more strategic measures (e.g., consummating a merger or divestiture) or operational measures (e.g., opening a specified number of stores, completion of a project, increase in market share); and equity awards for which the grant is not contingent upon achieving any financial reporting measure performance goal and vesting is contingent solely upon completion of a specified employment period and/or attaining one or more nonfinancial reporting measures. ↑
The Adopting Release provides a non-exhaustive list of financial reporting measures, including revenue; net income; operating income; profitability of one or more reportable segments; financial ratios; net assets or net asset value per share; earnings before interest, taxes, depreciation and amortization; liquidity measures; return measures; earnings measures; sales per square foot or same-store sales, where sales are subject to an accounting restatement; revenue per user, or average revenue per user, where revenue is subject to an accounting restatement; cost per employee, where cost is subject to an accounting restatement; any of such financial reporting measures relative to a peer group where the company’s financial reporting measure is subject to an accounting restatement; and tax basis income. ↑
When errors are both immaterial to previously issued financial statements and immaterial to the current period, they are often corrected in the current period in so-called “out-of-period” adjustments. The Adopting Release explains that an out-of-period adjustment should not trigger a compensation recovery analysis under the Final Rules, because it is not an “accounting restatement.” ↑
The Adopting Release does, however, provide a list of changes to a company’s financial statements that do not represent error corrections, and therefore do not trigger application of its clawback policy, including retrospective application of a change in accounting principle; retrospective revision to reportable segment information due to a change in the structure of a company’s internal organization; retrospective reclassification due to a discontinued operation; retrospective application of a change in reporting entity, such as from a reorganization of entities under common control; retrospective adjustment to provisional amounts in connection with a prior business combination (for international financial reporting standards only); and retrospective revision for stock splits, reverse stock splits, stock dividends, or other changes in capital structure. ↑
Accounting restatements are required to be prepared on the earlier of (1) the date the board of directors, a committee of the board of directors, or the officer(s) of the company authorized to take such action concludes, or reasonably should have concluded, that the company is required to prepare an accounting restatement due to the material noncompliance of the company with any financial reporting requirement under the securities laws, or (2) the date a court, regulator, or other legally authorized body directs the company to prepare an accounting restatement. ↑
Note that with respect to relative TSR, only an accounting restatement by the issuer, not accounting restatements by other issuers in the peer group, would result in application of the Final Rule and potential recovery. ↑
Commercial disputes are a fact of life in every industry. From counterparties that fail to honor contracts, to companies that use deceitful tactics, to individuals who misappropriate proprietary information for their own benefit, running a business regularly requires consultation with an attorney and frequently involves the business in litigation. Historically, businesses faced with a legal conflict had just three options: fight a lawsuit by hiring counsel on expensive retainer, instead find a lawyer who offers “no win, no fee” contingency billing, or abandon the case (by either paying a settlement or giving up on a claim). More recently, third-party litigation funding has given attorneys and their clients a powerful alternative to these traditional solutions.
The costs of hiring a lawyer, discovery procedures, arranging depositions, and retaining experts can snowball quickly—especially in cases that span several years. Wrongdoers know this. They therefore can, and often do, weaponize any financial superiority in court, much to the detriment of plaintiffs who cannot, or prefer not, to pay full litigation costs upfront. It is no surprise, then, that corporate legal departments are frequently perceived by management as cost centers necessary to put out legal fires—not as the strategic revenue sources they can become.
With litigation finance, however, businesses can lift the financial burden of litigation, reduce financial risk, build a stronger case, and achieve fairer legal outcomes in court.
What, exactly, is litigation finance?
Litigation finance is the practice of a third party providing capital to a plaintiff, such as a business or individual. This third party, known as a litigation funder, is a specialty finance firm that is otherwise unrelated to the lawsuit in question. The litigation funder invests in the action and, in return for this investment, is promised a portion of any monetary recovery. Typically, this is structured either a multiple of the original investment, or a percentage of the gross recovery.
Commercial litigation finance is almost always a non-recourse arrangement wherein the only collateral for the investment is a single case or portfolio of cases. If the case does not resolve favorably, the recipient of the funds owes the litigation funder nothing. If the claim is successful, the litigation funder will usually receive first dollar in until it is repaid, while the remainder of the proceeds will be divided between the claimant and the attorneys as agreed between them.
How can businesses use litigation finance?
Litigation finance investments are highly customizable, rendering them suitable for a wide variety of needs. Bespoke agreements are common, especially as the size of the investment increases and the relationship between funder and company deepens. In that vein, businesses can use funding to pay for case-related legal expenses, including attorney fees, expert witness fees, depositions, court reporter fees, arbitration filing fees, discovery, appeals, and more.
In addition, as litigation progresses, companies can also use the funds received to cover business operating expenses when existing sources of working capital are insufficient. This option can be critical for companies that have been actively harmed by the actions of the defendant(s) and would otherwise find it challenging to continue doing business while the lawsuit is pending if not for additional sources of capital.
Thus, litigation finance can support both the pursuit of meritorious litigation and ensure the financial survival of thinly capitalized commercial claimants.
How can litigation finance help manage corporate balance sheets?
Under Generally Accepted Accounting Principles, litigation costs are reflected as expenses. Carrying and reporting such expenses can negatively impact a company’s financials and quarterly performance. This is especially true for public companies that are valued on earnings or cash flow or require certain financial criteria to be met to comply with credit obligations.
For companies in that position, litigation costs paid from company funds must be recorded as expenses when incurred, thereby diminishing reportable earnings. Moreover, even if litigation results in a favorable outcome (whether via judgment or settlement), such outcomes sometimes take months or years to enforce and actually pay out, leaving a temporary gap in a company’s cash flow despite obtaining a ruling in their favor. Worse yet, recoveries from successful legal matters may not offset the adverse impact of lawsuit-related costs because such recoveries are generally treated as below-the-line items that do not increase earnings. General counsel and in-house legal departments can shift both the risk and financial burden of litigation to third-party funding specialists in exchange for a portion of any recoveries.
For instance, litigation finance companies can make funds available in a segregated account so that law firms bill against those funds, rather than through the business, keeping the ongoing expenses off the company’s balance sheets until resolution of the matter. In this way, businesses do not have to carry and report expenses on an ongoing basis but will only have to do so at the end of the dispute. Further, once the matter resolves, the company incurs the liability of having to repay the investment but can then simultaneously report the funds received from resolution of the matter. This simultaneous reporting creates a more accurate accounting of the events because the payment to the litigation finance company (which subsumes the expenses) appears on the claimant-business’s financial statements at the same time as any recovery realized from the underlying litigation.
Ultimately, securing third-party funding for operating expenses can transform otherwise illiquid liquid claims into a valuable source of capital.
What types of cases do litigation funders invest in?
Litigation finance companies invest in a wide range of cases that varies based on their particular risk profile, expertise, and available capital. Whether a company’s dispute revolves around trade secrets, contracts, shareholders, IP, or some other matter, litigation finance can support virtually any claim type.
In October, LexShares published “The Litigation Funding Barometer,” an analysis of the types of cases that are often best suited for non-recourse financing. The data presented in the Barometer report was based on data produced by the firm’s proprietary Diamond Mine software, which in 2021 scored more than 30,000 state and federal cases based on several different factors. Among other conclusions, the report found that a higher percentage of strong funding opportunities existed among federal cases than state cases. Federal trade secrets, antitrust, and contract disputes also presented some of the strongest funding opportunities across jurisdictions. While this data represents the investment potential of various case types, we feel it is nevertheless a valuable gauge of how the funding industry generally views the U.S. litigation landscape.
Notably, litigation finance companies are also not limited to investing in contingency cases. Financing can be made available to hourly representation, usually requiring deferral of a portion of the hourly attorney’s rate and ongoing billing against segregated amounts.
What are some attributes of reputable litigation finance companies?
Evidently, the idea of receiving funding—at some times substantial amounts of funding—from a third party can raise some concerns. Attorneys seeking out and recommending litigation finance to their clients should watch for the following things:
First, a reputable litigation finance company will implement a demanding due diligence process. While this is frustrating while already dealing with the litigation process, a robust underwriting process signals a serious partner. The old adage holds true: if something is too good to be true, it probably is.
Second, a litigation finance company should never attempt to control or direct the litigation. There are a number of reasons for this, including rules of ethics pertaining to an attorney’s duty of loyalty. If a litigation finance company attempts to insert itself into the actual litigation, this is a sign that another funder may be a better choice.
Reputable litigation finance companies are an excellent resource for savvy businesspeople and their legal advisors. Careful vetting and selection of that tool is of paramount importance.
In-house legal departments leveraging a powerful new tool for accessing justice.
Maya Steinitz, a legal scholar and University of Iowa College of Law professor, refers to litigation finance as “likely the most important development in civil justice of our time.” As founders and executives grow more familiar with commercial litigation finance as a useful financial resource, the potential appeal of offsetting litigation risk and optimizing corporate balance sheets for legal action stands to become more mainstream. For CEOs and founders weighing the prospect of litigation, the ultimate question is no longer why they should be using litigation finance. The real question is: why not?
Knobbe Martens 2040 Main St., 14th Floor Irvine, CA 92614 [email protected]
Contributors
Julia Hanson
Knobbe Martens 2040 Main St., 14th Floor Irvine, CA 92614 [email protected]
Alistair McIntyre
Knobbe Martens 2040 Main St., 14th Floor Irvine, CA 92614 [email protected]
Nyja Prior
Knobbe Martens 2040 Main St., 14th Floor Irvine, CA 92614 [email protected]
Clint Saylor
Knobbe Martens 2040 Main St., 14th Floor Irvine, CA 92614 [email protected]
Michelle Ziperstein
Knobbe Martens 2040 Main St., 14th Floor Irvine, CA 92614 [email protected]
§ I. Patent Cases
I.a. Supreme Court decisions
Minerva Surgical, Inc. v. Hologic, Inc., 141 S. Ct. 2298 (2021)
Facts: This case concerns the conditions for applying assignor estoppel where a party who assigns its patent rights later asserts an invalidity defense to that patent.
In the late 1990s, Csaba Truckai invented a device for treating abnormal uterine bleeding using a moisture-permeable applicator head and assigned the patent application to his company Novacept. Hologic later acquired Novacept. Truckai also founded Minerva Surgical, and obtained a patent directed to an improved device to treat abnormal uterine bleeding using a moisture-impermeable applicator head. Meanwhile, Hologic filed for another patent in the same patent family as the Novacept application, and obtained a broad patent claim to applicator heads, without regard to whether they are moisture permeable.
Hologic sued Minerva for patent infringement of this newly obtained claim. In response, Minerva argued that Hologic’s patent was invalid because the new, broad claim to applicator heads did not correspond to the invention’s written description, which addressed applicator heads that were water permeable. Hologic then invoked the doctrine of assignor estoppel, arguing that Truckai and Minerva could not challenge patent validity. The District Court granted summary judgment to Hologic, holding that assignor estoppel barred Minerva’s invalidity defense, and the Court of Appeals for the Federal Circuit affirmed in relevant part. The Supreme Court granted certiorari.
Held: The doctrine of assignor estoppel is upheld, but the judgment was vacated and remanded. Assignor estoppel applies only when the assignor’s assertions of invalidity contradicts explicit or implicit representations the assignor made in assigning the patent.
Reasoning: The doctrine of assignor estoppel, which limits an inventor’s ability to assign a patent to another for value and later contend in litigation that the patent is invalid, is based on equitable principles. Assignor estoppel reflects a demand for consistency and fair dealing with others. A person should not be able to sell his or her patent rights—making an implicit representation that the patent at issue is valid—and later raise an invalidity defense, disavowing that implied warranty. But when an assignor has made neither explicit nor implicit representations in conflict with an invalidity defense, then there is no unfairness in the assertion of invalidity and no ground for applying assignor estoppel.
The Court noted three situations where this may occur: 1) when an employee assigns patent rights to his or her employer in any future inventions he or she may develop during his or her employment; 2) when a later legal development renders the warranty given at the time of assignment irrelevant; and 3) when the assignees of a patent application make a post-assignment change that materially broadens the patent claims. In the last situation, relevant here, the assignor could not have warranted the validity of the broader claims. The Court noted that as long as there is no inconsistency in the assignor’s positions, then there is no basis for estoppel, and he or she can challenge the new claims in litigation. As a result, the Court vacated the decision and remanded the case to the Federal Circuit to determine whether Hologic’s new patent claim was materially broader than the claims originally assigned by Truckai.
The Court further noted that beyond promoting fairness, patent assignor estoppel furthers some policy goals, because assignors—with their knowledge of the relevant technology—are especially likely to be infringers. By preventing assignors from raising an invalidity defense in a later infringement suit, the doctrine gives assignees confidence in the value of what they have purchased. The Court further noted that even when an assignor is barred from asserting in an infringement suit that the patent is invalid, the assignor can still argue about how to construe the patent’s claims.
Justice Alito filed a dissenting opinion, stating that the question in this case cannot be decided without deciding whether Westinghouse Elec. & Mfg. Co. v. Formica Insulation Co., 266 U.S. 342 (1924)—which approved the use of assignor estoppel in the U.S.—should be overruled. Justice Barrett also filed a dissenting opinion, in which Justices Thomas and Gorsuch joined. The dissent noted that this case turned on whether the Patent Act of 1952 incorporated the doctrine of assignor estoppel and concluded that it did not.
I.b. Federal Circuit Decisions
Bot M8 LLC v. Sony Corp. of Amer., 4 F.4th 1342 (Fed. Cir. 2021)
Facts: This case concerns the pleading requirements for patent infringement.
Bot M8 owns five patents directed to video game machines. Bot M8 sued Sony for patent infringement based on Sony’s PlayStation 4 (“PS4”) console and accompanying game software. Following a transfer to the Northern District of California, a case management conference resulted in the district court sua sponte directing Bot 8 to file an amended complaint detailing “every element of every claim that [Bot M8] say[s] is infringed and/or explain why it can’t be done.” Bot M8 filed its 223-page first amended complaint. Sony moved to dismiss for failure to state a claim of infringement. The district court granted Sony’s motion as to four of the five patents.
The court then denied Bot M8’s second motion for leave to amend, reasoning that Bot M8 failed to raise concerns about the legality of reverse engineering Sony’s software at the time it was first ordered to file an amended complaint. For the same reasons, the court also denied Bot M8’s motion for reconsideration.
Applying Alice, the district court also found one claim of the last remaining patent to be patent ineligible. Alice Corp. v. CLS Bank International, 573 U.S. 208, 217-18 (2014).
Bot M8 and Sony then entered a joint stipulation dismissing the remaining claims without prejudice, and with Bot M8 reserving its right to appeal. On appeal, the Federal Circuit affirmed in part and reversed in part.
Held: Patent owners do not need to prove their entire case at the pleading stage, but they cannot rely solely on conclusory statements of infringement.
Reasoning: The Federal Circuit affirmed (1) dismissal of the infringement allegations as to two patents for being conclusory; (2) denial of leave to file a second amended complaint as to four patents; and (3) summary judgment in favor of Sony on one patent in view of the claims being directed to patent ineligible subject matter. The Court reversed and remanded as to the remaining two patents because the infringement claims were found to plausibly state a claim at the early pleading stages.
The panel acknowledged the district court’s authority to request an amended complaint, but disagreed with its requirement that Bot M8 explain “every element of every claim” because a plaintiff “need not prove its case at the pleading stage.” The panel explained that any district court approach that employs a “blanket element-by-element” requirement for patent infringement cases exceeds the scope of the Supreme Court’s pleading standard set forth in Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009) and Bell v. Twombly, 550 U.S. 544, 570 (2007). Instead, plaintiffs must only articulate a “plausible claim for relief.”
However, the panel stated that merely reciting claim elements and concluding that an allegedly infringing product has each element will not be enough to meet this pleading standard, as there must be some factual allegations suggesting a plausible claim. Under this reasoning, allegations of infringement for two patents were deemed conclusory and lacking in factual allegations. Similarly, the panel found no error in the district court’s application of Alice, and affirmed summary judgment in favor of Sony. But the panel determined that the district court erred by dismissing the other two patents for failure to state a claim of infringement by demanding highly specific allegations too early in the proceedings. The panel found that Bot M8 alleged specific instances of infringement sufficient to meet the plausibility requirements for Bot M8’s claim.
The Federal Circuit also found no abuse of discretion in the district court’s denial of Bot M8’s request for leave to file a second amended complaint. While the court acknowledged that requiring reverse engineering of the accused device may not have been necessary, Bot M8 waived any objection to this requirement by volunteering to complete the task without suggesting that compliance would be difficult in terms of labor or obtaining legal permissions.
Yu v. Apple Inc., 1 F.4th 1040 (Fed. Cir. 2021)
Facts: This case concerns whether claims directed to a device that implements an abstract idea are patent ineligible under 35 U.S.C. § 101.
Yu owns U.S. Patent No. 6,611,289 (“the ‘289 patent”) titled “Digital Cameras Using Multiple Sensors with Multiple Lenses.” Yu sued Apple Inc. and Samsung Electronics Co., Ltd. (“Defendants”) for infringement of claims 1, 2, and 4. Claim 1 is representative and recites:
1. An improved digital camera comprising:
a first and a second image sensor closely positioned with respect to a common plane, said second image sensor sensitive to a full region of visible color spectrum;
two lenses, each being mounted in front of one of said two image sensors;
said first image sensor producing a first image and said second image sensor producing a second image;
an analog-to-digital converting circuitry coupled to said first and said second image sensor and digitizing said first and said second intensity images to produce correspondingly a first digital image and a second digital image;
an image memory, coupled to said analog-to-digital converting circuitry, for storing said first digital image and said second digital image; and
a digital image processor, coupled to said image memory and receiving said first digital image and said second digital image, producing a resultant digital image from said first digital image enhanced with said second digital image.
Defendants filed a Rule 12(b)(6) motion to dismiss. The district court found that the asserted claims were directed to “the abstract idea of taking two pictures and using those pictures to enhance each other in some way,” decided that each asserted claim was patent ineligible under § 101, and granted the motion to dismiss. Yu appealed to the Federal Circuit.
Held: Affirmed. The claims are directed to an abstract idea and lack an inventive concept sufficient to transform the abstract idea into a patent-eligible invention.
Reasoning: The Court applied 9th Circuit law, which reviews a district court’s grant of a Rule 12(b)(6) motion de novo. It also applied its own law and reviewed the district court’s determination of patent ineligibility under § 101 de novo.
The Court used the Mayo/Alice two-step framework to analyze whether a patent claim is eligible under § 101. The first step analyzes whether “a patent claim is directed to an unpatentable law of nature, natural phenomenon, or abstract idea.” Alice Corp. v. CLS Bank Int’l, 573 U.S. 208, 217 (2014). If it is, then the court determines “whether the claim nonetheless includes an ‘inventive concept’ sufficient to ‘transform the nature of the claim’ into a patent-eligible application.” Id. (quoting Mayo Collaborative Servs. v. Prometheus Labs., Inc., 566 U.S. 66, 72 (2012)).
At step one, the Court found that “claim 1 is directed to the abstract idea of taking two pictures (which may be at different exposures) and using one picture to enhance the other in some way.” Reading the claim language in view of the specification, the Court noted that claim 1 results in “producing a resultant digital image from said first digital image enhanced with said second digital image,” and that “Yu does not dispute that . . . the idea and practice of using multiple pictures to enhance each other has been known by photographers for over a century.”
The Court further found that “[o]nly conventional camera components are recited to effectuate the resulting ‘enhanced’ image” and that “it is undisputed that these components were well-known and conventional.” It therefore concluded that “[w]hat is claimed is simply a generic environment in which to carry out the abstract idea.”
Yu asserted that claim 1 is “directed to a ‘patent-eligible improvement in digital camera functionality’ by ‘providing a specific solution’ to problems such as ‘low resolution caused by low pixel counts’ and ‘inability to show vivid colors caused by limited pixel depth.’” The Court, however, found that “claim 1’s solution to these problems is the abstract idea itself—to take one image and ‘enhance’ it with another.”
Yu also argued that parts of the specification provide support that the patentable advance in the claims is “the particular configuration of lenses and image sensors.” The Court, though, found that “[e]ven a specification full of technical details about a physical invention may nonetheless conclude with claims that claim nothing more than the broad law or abstract idea underlying the claims.” ChargePoint, Inc. v. Sema-Connect, Inc. 920 F.3d 759, 769 (Fed. Cir. 2019). For instance, the specification refers to a “four-lens, four-image-sensor configuration” as an advance over the prior art, where “three of the sensors are color-specific while the fourth is a black-and-white sensor.” Claim 1, however, is limited only to a “two-lens, two-image-sensor configuration in which none of the image sensors must be color.” The Court found “the mismatch between the specification . . . and the breadth of claim 1 underscores that the focus of the claimed advance is the abstract idea and not the particular configuration discussed in the specification that allegedly departs from the prior art.”
At step two, the Court found that there was no inventive concept sufficient to transform the claimed abstract idea into a patent-eligible invention. The Court reasoned that claim 1 failed under step two because it is “recited at a high level of generality and merely invokes well-understood, routine, conventional components to apply the abstract idea.” Yu asserted that the prosecution history shows that the claim was allowed over multiple prior art references. The Court, however, found that “even if claim 1 recites novel subject matter, that fact is insufficient by itself to confer [patent] eligibility” and went on to explain that “[t]he claimed [two-lens, two-image-sensor] configuration does not add sufficient substance to the underlying abstract idea of enhancement—the generic hardware limitations of claim 1 merely serve as ‘a conduit for the abstract idea.’” In re TLI Commc’ns LLC Pat. Litig., 823 F.3d 607, 612 (Fed. Cir. 2016).
Additionally, the Federal Circuit found that the district court’s recognition of a “century-old practice” at the pleadings stage was appropriate, that the 12(b)(6) motion could properly be determined without hearing expert testimony, and that it was not error for the district court to consider only the intrinsic record (the patent itself) to conclude that it was patent ineligible.
The Federal Circuit therefore affirmed the district court’s decision that the claims of Yu’s patent are ineligible under § 101 and affirmed the order granting the 12(b)(6) motion.
Judge Newman dissented and argued that the majority was “further enlarge[ing] . . . and further obfuscat[ing] the statute.” She argued that the claimed “camera is a mechanical and electronic device of defined structure and mechanism; it is not an ‘abstract idea.’ Observation of the claims makes clear that they are for a specific digital camera . . . . not for the general idea of enhancing camera images.” Such a device “easily fits the standard subject matter eligibility criteria.” While the patent specification describes the superior image definition capabilities of the claimed camera, “[a] statement of purpose or advantage does not convert a device into an abstract idea.”
Trimble Inc. v. PerDiemCo LLC, 997 F.3d 1147 (Fed. Cir. 2021)
Facts: This case concerns whether a patentee is subject to specific personal jurisdiction in the federal district where an alleged infringer is headquartered, when the alleged infringer files a declaratory judgment action in that district after the parties have engaged in licensing negotiations.
PerDiemCo LLC (“PerDiemCo”) is a Texas LLC. It owns eleven patents all related to electronic logging devices and/or geofencing designed to help employers track commercial vehicles and drivers. PerDiemCo’s sole owner, officer, and employee lives and works in Washington, D.C. PerDiemCo rents office space in Marshall, TX, but its sole owner, officer, and employee has never visited the space and it has no employees there.
Trimble Inc. (“Trimble”) and its wholly owned subsidiary Innovative Software Engineering, LLC (“ISE”) make and sell GPS navigation products and services, which include electronic logging and geofencing devices and services. Trimble is a Delaware Corporation with its headquarters in the Northern District of California. ISE is an Iowa LLC with its headquarters and principal place of business in Iowa.
PerDiemCo sent a letter to ISE in Iowa alleging that ISE was infringing PerDiemCo’s patents. This letter was forwarded to Trimble’s Chief IP Counsel in Colorado. Between October and December 2018, the parties engaged in licensing negotiations, and PerDiemCo threatened to sue Trimble and ISE for patent infringement in the Eastern District of Texas. During these negotiations, PerDiemCo communicated with Trimble at least twenty-two times via letter, email, or telephone.
In January 2019, Trimble and ISE filed a complaint in the Northern District of California, where Trimble is headquartered. They sought a declaratory judgement that they did not infringe any of the patents PerDiemCo asserted.
PerDiemCo moved to dismiss for lack of personal jurisdiction under Red Wing Shoe Co. v. Hockerson-Halberstadt, Inc., 148 F.3d 1355 (Fed. Cir. 1998), which states that “[a] patentee should not subject itself to personal jurisdiction in a forum solely by informing a party who happens to be located there of suspected infringement” because “[g]rounding personal jurisdiction on such contacts alone would not comport with principles of fairness,” id. at 1361.
The district court found that while PerDiemCo had established sufficient minimum contacts with California through its negotiations with Trimble, it would be constitutionally unreasonable to exercise personal jurisdiction over PerDiemCo in view of Red Wing. It therefore dismissed Trimble and ISE’s complaint. Trimble and ISE appealed to the Federal Circuit.
Held: Reversed and remanded. The exercise of personal jurisdiction over PerDiemCo in the Northern District of California is not unreasonable and satisfies due process.
Reasoning: The Court applied Federal Circuit law “because the jurisdictional issue is intimately involved with the substance of the patent laws.” Autogenomics, Inc. v. Oxford Gene Tech. Ltd., 566 F.3d 1012, 1016 (Fed. Cir. 2009). Therefore, because the parties did not dispute the jurisdictional facts, the Court reviewed the question of personal jurisdiction de novo.
The exercise of personal jurisdiction over an out-of-state defendant involves an evaluation as to whether the forum state’s long-arm statute permits service of process and whether the assertion of personal jurisdiction violates due process. California allows service of process to the limits of the Due Process Clauses, and therefore the “two inquiries fold into one”—whether personal jurisdiction over PerDiemCo was consistent with due process.
A Court may exercise personal jurisdiction over a defendant when the defendant has had sufficient minimum contacts with the forum state and when the exercise of personal jurisdiction “does not offend traditional notions of fair play and substantial justice.” Int’l Shoe Co. v. Washington, 326 310, 316-17 (1945).
Minimum contacts are typically established when the defendant intentionally reaches out to the forum state and purposefully avails itself of doing business there. The plaintiff’s claims must arise out of or relate to those contacts. To satisfy fair play and substantial justice, the Court considers the burden on the defendant, the forum state’s interest in adjudicating the dispute, the plaintiff’s interest in convenient and effective relief, the interstate judicial system’s interest in obtaining an efficient resolution, and the shared interest of the states in furthering fundamental substantive social policies.
The Court noted that Supreme Court cases following Red Wing make clear that special patent policies and considerations cannot impact the personal jurisdiction analysis.
The Supreme Court has held that communications sent into a state may give rise to specific personal jurisdiction and that a defendant that repeatedly communicates with the forum state “clearly has fair warning that [its] activity may subject [it] to the jurisdiction of a foreign sovereign.” Quill Corp. v. North Dakota, 504 U.S. 298, 308 (1992). The Federal Circuit has interpreted this to mean that “negotiation efforts, although accomplished through telephone and mail . . . can still be considered as activities purposefully directed at residents of [the forum].” Inamed Corp. v. Kuzmak, 249 F.3d 1356, 1362 (Fed. Cir. 2001) (discussing Quill). The Court noted that it previously held that Red Wing did not create a rule that “patent enforcement letters can never provide the basis for jurisdiction in a declaratory judgement action.” Jack Henry & Associates, Inc. v. Plano Encryption Technologies LLC, 910 F.3d 1199, 1206 (Fed. Cir. 2018).
Other circuits have found that communications from outside a forum state can lead to specific personal jurisdiction in the forum. See, e.g., Yahoo! Inc. v. La Ligue Contre le Racisme et l’Antisemitisme, 433 F.3d 1199, 1208 (9th Cir. 2006) (en banc) (cease-and-desist letter can be basis for personal jurisdiction); Oriental Trading Co. v. Firetti, 236 F.3d 938, 943 (8th Cir. 2001) (directing communications into state gives rise to personal jurisdiction).
Other activities have also led to minimum contacts relevant to declaratory judgment patent cases, such as hiring an attorney or patent agent in the forum state, Elecs. for Imaging, Inc. v. Coyle, 340 F.3d 1344, 1351 (Fed. Cir. 2003); physically entering the state to demonstrate the technology, id., or to discuss infringement allegations with the plaintiff, Xilinx, Inc. v. Papst Licensing GmbH & Co. KG, 848 F.3d 1346, 1357 (Fed. Cir. 2017); the presence of an exclusive licensee in the state, Breckenridge Pharm., Inc. v. Metabolite Labs., Inc., 444 F.3d 1356, 1366-67 (Fed. Cir. 2006); and “extra-judicial patent enforcement” targeting businesses in the state, Campbell Pet Co. v. Miale, 542 F.3d 879, 886 (Fed. Cir. 2008).
Further, the Court evaluated the Supreme Court’s recent decision in Ford Motor Co. v. Mont. Eighth Jud. Dist. Ct., which found that the “link” or “connection” between the defendant’s contact with the state and the plaintiff’s suit requires only that the complaint “arise out of or relate to the defendant’s contacts with the forum.” 141 S.Ct. 1017, 1026 (2021). The Federal Circuit interpreted this to mean that nonexclusive patent licenses in a forum state can support personal jurisdiction over the licensor.
Here, the Court found that PerDiemCo’s contacts with California were extensive, including twenty-two communications with Trimble in California over three months. This is “far beyond solely informing a party who happens to be located in California of suspected infringement.” Therefore, PerDiemCo had sufficient minimum contacts to justify personal jurisdiction in California.
Further, the Court found that the factors of fair play and substantial justice each lean in favor of personal jurisdiction being reasonable. The Federal Circuit reversed the district court’s order finding a lack of personal jurisdiction and remanded for further proceedings.
Hyatt v. Hirshfeld, 998 F.3d 1347 (Fed. Cir. 2021)
Facts: Hyatt bulk filed 381 patent applications in 1995. These applications claimed priority to applications filed in the ‘70s and ‘80s, through Hyatt’s practice of submarine patenting, which allowed an applicant to extend the term of a patent by claiming priority to an earlier filed, and subsequently abandoned, application in the patent family.
Within the bulk filing, the 381 applications ranged from 289 to 576 pages of text and 40-60 pages of figures, much longer than a typical patent application. While Hyatt initially agreed with the USPTO to focus his claims on distinct subject matter, he instead filed amendments over the next several years to increase the number of pending claims to about 300 per application, or 115,000 total. Of these claims, 45,000 were independent claims. Some amendments resulted in entirely new claims. In others, Hyatt reintroduced claims that had previously been lost in interference proceedings.
The USPTO began to examine Hyatt’s filings, but due to the sheer volume and the subsequent amendments, examination was slow. Because each filing claimed priority to several earlier filings, it was difficult for examiners to determine priority dates to identify prior art. The size of the patents also made it difficult to determine whether the applications complied with 35 U.S.C. § 112 written description requirements. Further, examination of Hyatt’s patents was stayed from 2003 to 2012 due to pending litigation. Examination restarted in 2013. The USPTO created an art unit dedicated to examining Hyatt’s filings. It was estimated that to complete examination, it would take a single examiner over 500 years.
The USPTO ultimately rejected the applications. Hyatt appealed to the Board of Patent Appeals and Interferences, which placed only a small subset of his claims in condition for allowance.
Hyatt filed a district court action under 35 U.S.C. § 145 against the USPTO to obtain four patents from his bulk filing, totaling 1592 claims. The PTO asserted an affirmative defense of prosecution laches. The district court held that the USPTO did not meet its burden of proving prosecution laches and that the claims were not invalid. Specifically, the court found that the USPTO had not provided Hyatt with adequate warning of a laches rejection, had not shown prejudice, had not issued laches rejections for the four applications at issue, and had not met its burden of proving “unreasonable and unexplained delay” by a preponderance of the evidence. The USPTO appealed the decision.
Held: Prosecution laches is an affirmative defense available to the USPTO in a 35 U.S.C. § 145 proceeding. The USPTO may assert prosecution laches even if it did not previously issue rejections based on laches. The USPTO met its burden to shift the burden of proof to Hyatt. Delay by the USPTO does not excuse delay by the applicant.
Reasoning: Prosecution laches “render[s] a patent unenforceable when it has issued only after an unreasonable and unexplained delay in prosecution that constitutes and egregious misuse of the statutory patent system under a totality of the circumstances.”
The Court first addressed whether the USPTO may assert prosecution laches in a § 145 proceeding. The Court reasoned that the USPTO can reject applications based on prosecution laches, and 35 U.S.C. § 282 evidences congressional intent to allow the USPTO to assert affirmative defenses, such as prosecution laches, in any patent validity action. Thus, the Court held that prosecution laches was available.
Second, the Court addressed whether the USPTO can raise the issue of prosecution laches in a §145 proceeding even if it had not raised it previously. Because § 145 proceedings permitted the plaintiff to introduce new evidence and arguments, fairness dictated that the USPTO must also be able to assert new meritorious defenses, such as prosecution laches.
Third, the Court considered which facts the district court should have considered when determining whether the delay in prosecution was “unreasonable.” Though the “totality of the circumstances” must be considered, the Court held that the consideration should place more weight on delays caused by the applicant than delays caused by the USPTO.
Fourth, the Court held that the USPTO had presented enough evidence to shift the burden of proof to Hyatt. It found that Hyatt’s actions “all but guaranteed indefinite prosecution delay,” and that, even though he had not literally violated regulations or statutes, he had “clear[ly] abuse[d] the patent system.” Further, the Court found that the USPTO had proven prejudice. In a proceeding between an accused infringer and a patentee, a prosecution of delay of over six years raises a presumption of prejudice. Here, the Court reasoned that Hyatt’s admission that there was a delay of seven years between the claimed priority date and the filing date of the patents at issue triggered this presumption. Alternatively, the Court reasoned that Hyatt’s “clear abuse” of the examination system was also sufficient to raise the presumption.
The Court remanded the case so that Hyatt could present his own evidence against prosecution laches.
Facts: Mylan petitioned for inter partes review (IPR) to challenge the validity of a Janssen patent. Janssen argued that the IPR would be inefficient, since two pending court cases involving that patent would likely reach a final judgment on validity prior to the IPR. One of those cases was also between Janssen and Mylan. The Patent Trial and Appeal Board (Board) agreed with Janssen and denied institution of the IPR. Mylan filed a direct appeal and a request for mandamus to the Federal Circuit.
Held: The Federal Circuit has no jurisdiction to consider a direct appeal of a decision to deny IPR institution. The Federal Circuit does, however, have jurisdiction over a mandamus request to review a failure to institute an IPR.
Reasoning: The Court found that it had no jurisdiction to consider Mylan’s direct appeal. It reasoned that federal courts can only hear “cases and controversies” within the meaning of Article III of the Constitution. Further, lower federal courts may only hear causes of action identified by statute. The Court held that no statute grants jurisdiction over direct appeals for denial of IPR institution. 28 U.S.C. § 1295(a) merely enables federal courts to review final written decisions of an IPR, but 35 U.S.C. § 314(d) prevents appeal of denial of IPR institution.
The Court held that it had jurisdiction to review Mylan’s petition for mandamus. 28 U.S.C. § 1651(a) authorizes federal courts to issue “necessary and appropriate” writs in aid of their jurisdiction. Because 28 U.S.C. § 1295(a)(4) grants federal courts “exclusive jurisdiction” over Board decisions if that decision is appealable (e.g. in the case of a final judgement in an IPR), the Court reasoned that a denial of IPR institution effectively prevents the Federal Circuit from reviewing a final decision, thereby diminishing its jurisdiction. The Court concluded that, to protect its prospective jurisdiction, it must be able to conduct review when presented with a mandamus request.
The Court held that Mylan’s mandamus request failed on the merits, however. Mandamus is reserved for “extraordinary” circumstances, but the Court found that Mylan could not show that it was being denied a legal right and that it had no other method of obtaining relief. The Court reasoned that Mylan, through its ongoing litigation against Janssen, could easily try the validity of Janssen’s patent even after the Board denied IPR institution. Thus, the Federal Circuit rejected Mylan’s mandamus request.
§ II. Copyright Cases
II.a. Supreme Court decisions
Google LLC v. Oracle America, Inc., 141 S. Ct. 1183 (2021)
Facts: This case concerns whether copying the “declaring code” of an Application Programming Interface (“API”) is fair use, and thus avoids copyright infringement, when the copying party has written and implemented its own “implementing code.”
In 2005, Google purchased Android, Inc. to develop a software platform for mobile devices. The Android software platform used Java, a programming language many software programmers were already using. Java is a programing language developed by Oracle’s predecessor Sun Microsystems and Oracle owns the copyright in the software platform Java SE.
Google originally planned to license the Java platform from Oracle for Android, but after negotiations broke down, Google decided to build its own software platform for Android. Google developed the Android platform specifically with mobile devices in mind. The Android platform includes millions of lines of code written by Google engineers. However, the Android platform also includes about 11,500 lines of code copied from the Application Programming Interface (“API”) of the Java SE platform.
An API is a tool for programmers to access prewritten code aimed at performing functions rather than writing the raw code that provides that functionality. The Court broke down the portions of an API at issue into three parts: a “method call,” the “declaring code,” and the “implementing code.” A “method call” is a line of code a programmer will use to ask the program to perform a task. The “implementing code” is the set of instructions that will instruct the processor how to perform that task. The “declaring code” performs the needed link to between the “method call” and the “implementing code” so the desired functionality occurs. As such, while both are essential to the operation of the API, “the implementing code” requires a much greater amount of code than the “declaring code” does.
The 11,500 lines of code that Google copied were of the Java SE API’s “declaring code” so that programmers coding for Android could use the same “method calls” they were accustomed to while coding in the Java programing language.
In 2010, Oracle brought action against Google in the Northern District of California for copyright infringement. The district court ruled at trial that the API’s “declaring code” was not protected under copyright law. On appeal, the Federal Circuit reversed, stating that the “declaring code” was also entitled to copyright and remanded to the district court on the issue of fair use. The Supreme Court, at that time, denied certiorari on the Federal Circuit’s copyrightability determination.
The district court found fair use and the case was once again appealed to the Federal Circuit. The Federal Circuit again reversed, finding that “there is nothing fair about taking a copyrighted work verbatim and using it for the same purpose and function as the original in a competing platform” and remanded on the issue of damages. 141 S. Ct. 1183, 1195 (2021) (internal quotations omitted). The Supreme Court granted certiorari to review the Federal Circuit’s determinations on both the copyrightability and fair use issues.
Held: The Court did not rule on whether the API was entitled to copyright protection and instead reviewed only whether Google’s use of part of that API constituted fair use. The Court ultimately concluded that Google’s use of that portion of the API was fair use and thus did not constitute copyright infringement.
Reasoning: The Court analyzed Google’s use under the four factors of 17 U.S.C. § 107 but noted that “applying copyright law to computer programs is like assembling a jigsaw puzzle whose pieces do not quite fit.” Id. at 1998 (internal quotations omitted). The Court gave specific attention to the following factors of the “fair use” defense to copyright infringement:
Nature of the Copyrighted Work: While Congress has declared computer programs as subject to copyright, “declaring code” differs from other kinds of copyrightable computer code. First, “declaring code” is “inextricably bound” to the general system and the organizing tasks that the Court determined are not copyrightable. Second, “declaring code” is similarly bound to the “method calls” and the “implementing code” that either were not contested or were not the subject of any evidence of copying. Additionally, “declaring code” derives its value from the programmers using it who do not hold the copyright. Therefore, the Court identified that this factor “points in the direction of fair use.” Id. at 1202.
Purpose and Character of the Use: The Court said the analysis of this factor must go further than determining if the copying itself was transformative and should include the purpose and character of the use as dictated by § 107. Here the Court focused on Google’s expanding use toward new products. This “reimplementing” use furthered the development of computer programs. Id. at 1203. Since the purpose and character was transformative, even if the code was copied verbatim, this factor weighed in favor of fair use.
The Amount and Substantiality of the Portion Used: The Court suggested that the better way to view this factor in this context is to view that amount of “declaring code” copied (around 11,500 lines of code) against the much larger amount of “implementing code” (millions of lines of code) that Google wrote. The “declaring code” is inseparably bound to those “task-implementing lines.” Id. at 1205. The Court also disagreed with the Federal Circuit that Google could have only copied the 170 lines of code fundamental to writing in Java, stating that determination construed Google’s “legitimate objectives too narrowly.” Id. Therefore, this objective weighted in favor of fair use.
Market Effects: Google has made significant money from Android in the mobile computing market, a market that Oracle’s predecessor had attempted to enter. However, the Court pointed to Oracle’s predecessor’s failure to compete in that market, the sources of its lost revenue, and the risk of public harm as helping this factor weigh towards fair use. To the Court, Google’s revenue was not supplanting Oracle. Rather, it came because of third party programmer’s investments of time in learning the Java language and Google’s own efforts to developing a platform geared towards high functionality mobile devices.
Therefore, the Supreme Court found Google’s copying of portions of Java SE’s API constituted fair use.
II.b. Circuit Court decisions
Unicolors, Inc. v. H&M Hennes & Mauritz, L.P., 959 F.3d 1194, 1196 (9th Cir. 2020), cert. granted in part, 141 S. Ct. 2698 (2021)
Facts: This case determines the scope of the knowledge inquiry under 17 U.S.C. §411(b), which prevents the filing of a lawsuit for copyright infringement without a valid copyright. This case also determines the meaning of the Copyright Act’s publication standard, deciding the requirements for a single-unit registration.
Unicolors Inc. (“Unicolors) filed suit against H&M Hennes & Mauritz L.P. (“H&M”) claiming that H&M infringed its copyright by selling two clothing items made from Unicolors’ copyrighted fabric design. Unicolors filed its copyright registration (‘400 Registration) as a single-unit registration of thirty-one separate designs. Unicolors registered the date of first publication as the date when it presented the designs collectively to its salespeople. At a later date following the presentation, Unicolors placed nine of the works in its showroom available for public view and purchase.
H&M argued that because Unicolors sold nine of the works in the ‘400 registration separately to customers, the works identified in the ‘400 single-unit registration were not first sold together or at the same time. To register a copyright as a “single unit” the works must have been first sold or offered for sale in some integrated manner. H&M further argued that because Unicolors knew that the works were not sold as a single unit, the intent requirement to invalidate a copyright registration under 17 U.S.C. § 411(b) was met, and the copyright registration was invalid.
The district court upheld the validity of Unicolors’ registration on two grounds. First, H&M failed to show that Unicolors intended to defraud the Copyright Office at the time of filing its application and thus its registration was valid. Second, although Unicolors may have sold the works separately, the collection of works were made available to the public at the same time and thus “published” on the same day. The jury reached a verdict in favor of Unicolors. H&M appealed and argued that the court erred in finding Unicolors’ copyright registration valid.
Held: The Ninth Circuit reversed the district court’s decision and held that a single-unit registration under 37 C.F.R. § 202.3(b)(4) requires that the work is first made available for sale to the public in a singular, bundled collection. The Ninth Circuit also held that a copyright registration can be invalidated through constructive knowledge under 17 U.S.C. § 411(b). Therefore, Unicolors’ knowledge that the works were not first published in a singular bundled collection was enough to invalidate Unicolor’s registration.
Reasoning: The Ninth Circuit applied the principles of statutory interpretation to determine the requirements for a single-unit publication under the Copyright Act. The Ninth Circuit looked to the definition of publication under the Copyright Act as “offering to distribute” the “work to the public by sale or other transfer of ownership” regardless of whether a sale occurred. Because Unicolors did make the designs available for the public’s purchase at the same time, Unicolors did not meet the single-unit registration requirement.
The Ninth Circuit interpreted the knowledge requirement under 17 U.S.C. § 411(b) as not whether Unicolors knew that the registration ran afoul of the single-unit requirement but whether Unicolors knew that certain designs in the registration were published separately to exclusive customers. The court expressly chose to not infer an intent-to-defraud requirement in the statute. This left a split between the Eleventh and Ninth Circuit.
Unicolors filed a petition and the Supreme Court granted certiorari to determine (1) whether the Ninth Circuit misapplied the publication standard when it determined that a single-unit registration requires a collection to be “offered for sale as part of a ‘bundled collection and (2) whether 17 U.S.C. § 411(b) requires a fraud standard to invalidate a copyright.
§ III. Trademark/Trade Dress Cases
Ezaki Glico Kabushiki Kaisha v. Lotte Int’l Am. Corp., 986 F.3d 250 (3d Cir. 2021), as amended (Mar. 10, 2021), cert. denied sub nom. Glico v. Lotte Int’l Am., No. 20-1817, 2021 WL 5043589 (U.S. 2021)
Facts: This case concerns the doctrine of functionality in trade dress protection of product designs.
Ezaki Glico (“Ezaki”) a Japanese confectionary company, sells a product line of thin, stick-shaped cookies. The cookies are partly coated with chocolate or a flavored cream with an uncoated portion to serve as a handle. Ezaki has two incontestable trade dress registrations for the elongated rod partially covered with chocolate, another for almonds on top of the chocolate or cream, and a utility patent for “Stick Shaped Snack and Method for Producing the Same.”
Lotte International American Corporation (“Lotte”) began selling Pepero, a similar-looking stick shaped cookie partly covered in chocolate with an uncoated portion. Ezaki filed suit for trade dress infringement in the district court. The district court granted summary judgment in favor of Lotte holding that the Ezaki’s product configurations were functional, and therefore nonprotectable trade dress.
Ezaki appealed the district court’s order for summary judgment on the grounds that its product design is not essential and therefore not functional.
Held: To be considered functional and thus ineligible for trade dress protection, product designs do not need to be essential, just useful. Because both the stick shape and the uncoated handle were useful for holding the snack, the Third Circuit held that Ezaki’s trade dress was functional and thus nonprotectable, thus affirming the district court’s holding.
Reasoning: The Third Circuit determined that the prohibition on trade dress protection for functional elements is not narrowly limited to essential product configurations. The Supreme Court’s decision in Qualitex Co. v. Jacobson Products Co., 514 U.S. 159 (1995) listed several ways in which a product feature is functional but not hold that a product feature is considered functional “only” if it is essential. Because functionality is intended to keep trade dress protection as a workaround from patent law, the test for functionality should be interpreted similarly to patent law.
In analyzing the functionality of Ezaki’s trade dress, the Third Circuit looked to the usefulness of the uncoated portion of the snack, the shape of the snack itself, and the design as a whole. The Third Circuit also pointed to Ezaki’s promotion of its snack’s utilitarian advantages.
The Third Circuit noted that the availability of alternative designs was unimportant for the functionality determination because even if there are alternatives, a product design can still be functional. The Third Circuit also determined that the district court erroneously considered Ezaki’s utility patent for the making of the snack’s stick shape. Because the features claimed in the trade dress were for the shape itself and the shape was not the “central advance” of the utility patent, the patent shed no light on whether the trade dress was functional.
The Great Recession taught an important lesson: if economic pressures prevent your organization from buying new software, then be on the lookout for an audit of your existing software licenses. Software vendors have seized upon noncompliance issues as leverage in convincing reluctant customers to buy new products.
For the past fifteen years, we have advised clients on how to manage software audits, even litigating when necessary. Over time, we’ve seen audits become consistently more sophisticated—employing well-known consulting firms, elaborate and tricky reporting mechanisms, and vendor-friendly scripts or automated review processes.
In this two-part article series, we will first delve into the steps of a software audit and tips for managing audits. Then, we will explore ways to improve your agreements to limit audits and put you in the best position possible when the auditor comes knocking.
Part One – Steps of the Software Audit and How to Manage It
By John Gary Maynard, III
What should I do upon receipt of an audit demand?
When you receive an audit demand, there are several things you should do immediately.
Ownership. First, determine who will “own” the software audit. Is it your legal department or IT? The worst thing you can do is create ambiguity about who is managing the audit. You should also consider whether outside counsel should be engaged. Outside counsel can provide key advantages, particularly with respect to preserving privilege and avoiding admissions.
Collect Relevant Documents. At its core, a software audit is a contract dispute. Identifying and collecting all governing contracts and related documents is therefore imperative. If in doubt, collect it. Of course, there may be executed contracts between the parties that govern, but note that many vendors use clickwrap agreements. It may be difficult to obtain copies of these agreements, or even to verify through the vendor’s website which version applies to your software. Don’t forget that related documents, including settlements of prior disputes, may be set forth in emails or letters rather than in formal agreements. Vendors sometimes refer to these as “close letters.” These can be crucial. Whether due to the passage of time or sloppiness on the part of the vendor, it is not uncommon for vendors to present noncompliance fees based upon usage that was previously released.
Confirm Basic Terms. Although the terms of software contracts are as varied as the types of software, you should conduct an initial review of the relevant documents to answer the following questions: (a) which legal entities of the company are subject to the audit? (b) what is the geographic scope of the audit? (c) what software products are covered by the audit? and (d) what are the relevant deadlines? On that last point, you don’t want to waive arguments by failing to respond in a timely manner.
Control Communications. Put procedures in place to control communications with, and about, the vendor. Establish a single point of contract, preferably someone with sound judgment and a good understanding of the business issues. We recommend a businessperson for this role rather than a lawyer. Once you’ve identified the single point of contact, notify the vendor and your employees. Guard against employees unwittingly making admissions regarding noncompliance. Relatedly, verify whether the vendor has any on-site personnel. If so, ensure your employees with regular interaction with the on-site vendor personnel do not talk about the audit.
What does the audit process look like?
Each vendor has its own process, but large vendors typically employ outside consultants as auditors. Shortly after issuing the audit demand, the vendor will likely introduce you to the auditor. Don’t be surprised if the vendor does not participate in the audit from that point forward.
Kickoff Meeting. Once the auditor has been identified, you will be asked to participate in a kickoff meeting. There are several issues to consider before participating in this meeting, but, at a minimum, you need to confirm confidentiality of the audit. Your software contract likely contains confidentiality obligations between you and the vendor, but you likely will need a separate agreement with the auditor.
The Rest of the Audit Process. In general, the next steps will include: (a) an explanation of the data collection process, (b) collection of the data, (c) review of the data, (d) confirmation of the data by each party, and (e) monetization of any noncompliance issues. Each step is potentially fraught with peril. Whether you use inside counsel or engage outside counsel, it is imperative that counsel be involved at this point in the process, even though counsel likely will not communicate directly with the auditor.
How do I manage the audit process?
The goal with any audit is to resolve it with the least disruption to the company’s business, and at the lowest price. Treating the audit as a business transaction, not an adversarial proceeding, is the best approach. Most vendors do not want to sue their customers. But this does not mean the audit process is not adversarial. Audits routinely identify alleged noncompliance issues, which vendors then attempt to monetize. The numbers can be extremely large—we’ve seen initial demands in excess of $100 million. Software agreements are simply too complicated for noncompliance issues not to arise. But those complicated agreements also provide opportunities for reasonable disagreement about the scope of noncompliance. It is a tricky process.
Role of Lawyers. Lawyers have important roles to play and should be involved from the very beginning. Obvious roles for lawyers include reviewing and revising confidentiality agreements with auditors, as well as drafting any final settlement agreements or close letters. But the real value of lawyers is preserving privilege issues and avoiding admissions. At the outset, one way for lawyers to do this is to help business personnel establish reasonable parameters for the scope of the audit. Providing auditors with more information than they are entitled to rarely benefits the company. The single point of contact will convey the company’s message in business terms, but that message will be guided by the terms of the relevant agreements that benefit the company.
Similarly, lawyers should help establish the parameters of the data collection process and the subsequent review of such data. This is particularly important for businesses in highly regulated markets. An audit should not unwittingly trigger regulatory breaches. Relatedly, several vendors use automated review procedures with prepopulated language that cannot be modified. These tools may appear to be an innocuous way to confirm usage information, but the prepopulated fields often contain admissions the company should not make. For example, the template might state all information is final and cannot be changed or modified. We’ve even seen some forms that have the company swear under penalty of perjury that the information is accurate and complete.
Finally, at the end of every audit, the business and its lawyers should work together to conduct a post-mortem. It is important to know if any noncompliance issues arose from inadequate internal controls. Any such issues should be addressed. Similarly, the company should consider whether technical problems or practices undermined or interfered with the audit. Finally, the company should also evaluate the vendor: was the vendor a good business partner during the audit? We once assisted a client who generated most of its revenue during a particular quarter. The vendor agreed to move the audit to prevent disruption during the company’s busiest season. It was a simple gesture by the vendor, but it generated a lot of goodwill with the company.
Are there events within the control of the company that trigger an audit?
As previously noted, economic downturns can trigger audits. But other events that are within the control of the company can also trigger audits. For example, corporate restructuring can trigger an audit, because such restructuring may make changes to the identity of the licensed user. Most software agreements not only limit use to specific entities but also prevent an assignment to other legal entities—including affiliates of the original licensee—without the prior written consent of the vendor. Rapid growth can also trigger an audit. Most licensing metrics are tethered to the size of the licensee, such as the number of processors. Rapid growth, therefore, increases the incentive of a vendor to audit a licensee. Finally, nonrenewal of an existing software license can trigger an audit.
Final consideration: Not all licensed software is the same.
Broadly speaking, there are two types of licensed software. First, there is software that facilitates the operation of a business. Here, the business does not incorporate the software into a product that it sells but simply uses the software to make daily operations easier. For example, a doctor’s office may use billing software in this way. Conversely, there is software that a company incorporates into its own product—the code that operates a vehicle’s entertainment system, for example. Not surprisingly, this second type of software is typically unique. Audits regarding business operation software rarely result in formal litigation. It is simply in neither party’s interest to formally litigate. Product-based software, however, can and often does result in litigation.
With respect to business operation software, each vendor generally has its own licensing metric. Understanding that metric can go a long way toward identifying the likely focus of noncompliance issues. One common metric is the number of “users.” This may seem like a relatively benign term, but disputes can arise over terms like “named users,” “concurrent users,” and “access.” For example, with respect to the term “access,” ambiguity in the agreement might allow the vendor to define a user as anyone with the ability to access the software as opposed to anyone who actually accesses the software. This definitional distinction could literally be the difference in millions of noncompliance fees.
With respect to product-based software licenses, it is difficult to generalize, because these are typically not off-the-shelf licenses that follow familiar patterns.
In any event, regardless of the nature of the software, the terms of the agreement will be crucial in determining noncompliance issues. In the next article, we will discuss ways to improve your agreements to avoid or limit an audit.
Historically, the legal industry has lagged behind many other professions in the diversity, equity, and inclusion space. The industry is working to change that today, as DEI-focused recruitment and retention efforts take high priority within the offices of forward-thinking law firms and in-house legal departments.
Executive management and recruiters are embracing every opportunity to build teams that not only fulfill client expectations for diversity but also benefit their own organizations. Research, including yearslong tracking by McKinsey, has repeatedly shown that companies with higher levels of diversity outperform their peers financially, as well as in other areas. When a team includes people of various genders, ages, ethnicities, cultural backgrounds, sexual orientations, etc., it is not only the right thing to do, but it also holds the potential to produce more creative, innovative, and effective results.
Achieving the diversity goals of your firm or department requires attention on two fronts: attracting a diverse group of new talent and working to support and retain attorneys already on your team. Engaging contract attorneys can support achieving both of these objectives.
How Contract Attorneys Can Help You Retain Diverse Talent
Lawyers’ perceptions of their organization’s culture are built on their experiences in a wide range of areas. Work-life balance, collaboration, equitable compensation, the opportunity to work remotely, and the quality of work they are assigned register high on the list of what matters to lawyers as they determine whether to switch jobs or stay put.
Some of these factors can be particularly important to women and people of color. A recent ABA report found, for example, that 68% of women lawyers and 68% of lawyers of color cited better work-life balance as an important factor when deciding to change jobs. Law firms and legal departments looking to retain top talent, especially in underrepresented groups, must understand these priorities, evaluate where their organizations may be falling short, and enact more supportive policies.
How can engaging contract attorneys help? Contract attorneys fill staffing gaps and lessen internal workload, promoting improved work-life balance and preventing burnout among associates. Contract staff can also reduce the burdens associated with routine tasks, such as document review and discovery, to help ensure associates can do the higher-level work that makes them feel more valued and fulfilled. Additionally, having a blended team of associates and contractors can increase team productivity, fueling higher morale and a greater sense of camaraderie.
Bringing contract attorneys into the mix demonstrates empathy for the challenges the lawyers on your team face and communicates your commitment to creating a nurturing culture where they can thrive.
How Your Alternative Legal Service Provider Can Help You Attract Diverse Talent
When you demonstrate your commitment to diversity and present your organization as welcoming to all, you are much more likely to attract diverse candidates. Again, that perception of your firm or department is created when candidates discover that your culture provides work-life balance, equitable compensation, remote work opportunities, and so on.
If you work with contract attorneys, this perception can also be augmented by your choice of alternative legal service provider (ALSP). Working with a woman- or minority-owned firm, or another ALSP that truly understands and supports your DEI goals and initiatives, can give you a leg up in recruiting diverse talent. In general, reputable ALSPs have access to a deep and diverse pool of candidates, for a number of reasons. For example, they are not limited by geography; they can recruit across a much broader expanse of talent and specialization. They can also offer, through contract work, the work-life balance that is especially important to women and attorneys of color, as well as esteemed lawyers in later stages of their careers, who are often looking to share their expertise on their own terms.
As you connect with these candidates and incorporate them into your staff, you can not only bring diversity of thought to your team today but also tee up the potential for bolstering your organization’s diversity in the long term. While contract attorneys are typically brought on for temporary assignments, you may have the option to convert those who prove to be ideal matches for your organization into permanent staff. Your ALSP can help you recruit and onboard those individuals as full-time members of your team.
Talk with your ALSP about your DEI policies and goals. Let them know what you are doing internally to provide an inclusive culture, and discuss ways they can partner with you to achieve your short- and long-term objectives. A good ALSP will have the capability to connect you with exceptional contract attorneys to energize your initiatives and strengthen your team.
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