All posts by Paul E. Paray

Accounting Firm, Financial Reporting, Law Firm, Middle Market Business, Risk Management

Lehman, D&O Liability and Mark-to-Market Reporting

The Devil’s Casino, Vicky Ward’s first book, is the latest account of the fall of Lehman Brothers.  Released in April, this Lehman tome applies  a gossipy approach to storytelling.  Although we learn much about the shopping habits of some Lehman wives, repo transactions are nowhere to be found.   The book, however, becomes noteworthy when Ward details a September 9, 2008 meeting between JPMorgan’s Jamie Dimon and the Fed’s head Ben Bernake (on page 200) that purportedly directly led to JPMorgan’s request that Lehman provide $5 billion more in collateral. Less than a week later, Lehman filed its bankruptcy petition (the largest in US history) ostensibly given its lack of liquidity brought on by the collateral call of its clearing bank, JPMorgan. 

In a Report by Lehman’s bankruptcy examiner, dated March 11, 2010, the issue of JPMorgan’s collateral demand was analyzed and determined to be barely actionable.  The Report states: 

the Examiner concludes that the evidence may support the existence of a colorable claim – but not a strong claim – that JPMorgan breached the implied covenant of good faith and fair dealing by making excessive collateral requests to Lehman in September 2008.  A trier of fact would have to consider evidence that the collateral requests were reasonable and that Lehman waived any claims by complying with the requests.  

(Report of Anton R. Valukas, Examiner at page 1073)

On the heels of this Report and the Ward book, on May 27, 2010, the Lehman estate sued JPMorgan.  The suit takes a different position regarding the relationship between JPMorgan and Lehman by alleging that JPMorgan’s breach of duty was actionable. 

Unlike JPMorgan, Lehman’s board and officers were essentially given a free pass by Lehman’s bankruptcy estate as well as all regulators.  The Lehman Examiner’s Report actually spends much ink analyzing Delaware fiduciary law yet concludes numerous potential fiduciary lapses were not colorable claims.   On the other hand, a bank that potentially obtains crucial information from a third party (a governmental third party with a near real-time raw account of Lehman’s financial status) and merely seeks to protect its own interests, is forced to defend itself in a costly legal battle.   To many, it makes little sense that Lehman’s directors and officers were exonerated by regulators and Lehman’s bankruptcy Examiner.  Although the existing shareholder suits and claims made by those who sustained direct harm may eventually hit their mark, it is just not the same as potential jail time or a large personal SEC fine.  Not even close.  It is easy to argue that some Lehman folks should have paid with more than the inconvenience of a deposition.

If FASB had acted a bit more aggressively two years ago, maybe none of this would have even happened.  It would have been interesting to have seen FASB actually go through with its Exposure Draft of two years ago regarding FASB Statement 5 (loss contingency accounting) and FASB Statement 133 (hedging strategy accounting).  The vast opposition to the drafts caused FASB to abandon its plans.   Much of the opposition was typified in the McDermott Will & Emery letter that opined if the suggested changes to FASB Statement 5 were made, the opposing side to a filing entity would be able to learn litigation strategy.  If the proposed changes had matured (FASB Statement 5 has not changed since 1975) some of the decisions made by Lehman may have been altered or some of the actions may have been more cleanly delineated as wrongful.  Either way, there would have been more clarity regarding the propriety of their actions. 

As it stands, the Lehman saga provides some guidance to directors and officers looking to see how insulated they are from their financial accounting decisions.  They are pretty insulated given current standards. 

FASB may now be ready to change that dynamic.  It will revive the FASB Statement 5 Exposure Draft in the second quarter of 2010 – now with only a 30-day comment period.  And, FASB issued on May 26, 2010 an Exposure Draft that provides guidance regarding the financial reporting of derivative instruments and hedging strategies.  The overall approach taken moves towards a “mark-to-market” approach for derivative instruments that will have a “seismic effect” on how banks value loan portfolios beginning in 2013 (for large banks) and 2017 (for regional and community banks).  It remains to be seen what FASB will ultimately do given the negative comments it is certain to receive prior to the September 30, 2010 comment deadline.   The takeaway is that FASB  is finally taking a serious look at how companies report on loss contingencies and asset valuations.

All reporting companies – not just financial institutions – should obviously monitor how this and other related financial reporting initiatives evolve.   To a large degree, these accounting standards dictate the extent to which firms such as Lehman can push the envelope.  Although a widening of the reporting net may bring with it a separate set of problems, the change will certainly cause executives to think twice before being coy about a lack of liquidity.  As seasoned investors themselves, reporting officers should probably apply a “Would I want to know this information?” test the next time they are on the fence about the materiality of an item.  True mark-to-market reporting (not Lehman’s “mark-to-make believe” strategy) may bring on headaches for companies with many assets  having big value swings.  Nevertheless, it certainly seems to be part of the reporting standard of the future so you might as well get used to it.

Middle Market Business, Network Security, PCI Compliance, Risk Management, Small Business

Most Important Lesson Learned from Supermarket Data Breach

It has been over two years since the grocery chain Hannaford Brothers announced a breach of its network security that exposed over 4 million credit card numbers and led to 1,800 cases of fraud.   In fact, a quick review of the Privacy Clearinghouse’s Chronology of Data Breaches shows that Hannaford is not the only supermarket chain to have sustained a data breach. 

Several years ago, Ahold USA (parent company of Stop & Shop and Giant stores) sustained a breach via its subcontractor Electronic Data Systems.   Numerous Stop & Shop Supermarkets in Rhode Island and Massachusetts had credit and debit card account information stolen, including PIN numbers, by thieves who apparently tampered with checkout-line card readers and PIN pads.  Albertsons (Save Mart Supermarkets) in Alameda, California also had credit and debit card numbers stolen using bogus checkout-line card readers.   And, Lunardi’s Supermarket in Los Gatos, California had a similar experience with  ATM and credit card readers that quickly led to the theft of  $300,000.  

What makes the Hannaford incident noteworthy is the fact that the chain was supposedly PCI compliant at the time.  According to the indictment filed against the Hannaford mastermind, the theft was a result of a hack into corporate computer networks that allowed placement of malware which, in turn, provided backdoor access to the networks — and credit card information.  The means of attack was the commonly used SQL Injection Attack. 

In other words, being PCI compliant should never be the ultimate goal of your security strategy.   Whether you are a supermarket chain or a large law firm, a risk management approach to network security and privacy should always take precedent.   Most companies — large and small — still apply a uniform approach to security that treats all data the same.  The ultimate lesson learned from the Hannaford breach:   Always make sure your most valuable data is always most protected.   It really does not matter whether your company sells fruits and vegetables or builds nuclear missiles.

Accounting Firm, Law Firm, Middle Market Business, Network Security, Privacy, Risk Management, Small Business

Small Professional Service Firms Put Implementation of FTC Red Flags Regs on Hold

According to a recent article in Lawyers USA, small and middle market business owners are so jaded by the number of times the FTC has delayed enforcement of its Red Flags Regulations, they have pushed compliance to the back burner.  Tanya Forsheit, of InformationLawGroup, is quoted in the article as saying, “I suspect a lot of small businesses were hoping this ultimately wouldn’t happen.”   As it stands, all businesses that bill for goods and services and accept payment on a deferred basis are covered by these regulations.  Unfortunately, most such firms do not have any sort of written procedure or policy specifically dealing with identity theft — a main requirement of these regulations.   Moreover, as recognized in the article, “[s]mall businesses without extensive in-house resources have found it challenging to comply with the specifics of the rules, such as the recommendations for data encryption, regular review and annual updates of the policy, procedures for responding to red flags, training of staff, and approval of the policy by the company’s board of directors.” 

Professional service firms have been fighting hard to avoid compliance.  Lawyers successfully challenged the applicability of the regulations to law firms with an appeal currently pending.  Accountants filed suit last year and are still waiting for a decision.   Doctors and dentists have sought a legislative answer by seeking a statutory exemption.    Come the date of enforcement – June 1st- only law firms currently have a free pass.

It is recommended that all professional or consulting businesses who defer payment should immediately consult with their professional advisers to see how a cost effective compliance solution can be implemented.

Law Firm, Risk Management

Law Firms Need to be Diligent on Delinquent Accounts

Times remain tough for law firms.  The legal sector lost another 1,100 positions in April  — making it the second month in a row of four-digit losses.  Since April 2009, the legal sector has lost a total of roughly 28,000 jobs.   It is no surprise some firms are choosing to sue clients for non-payment rather than work things out.  Unfortunately, as Squire Sanders & Dempsey recently found out, such suits usually lead to a malpractice claim.  Squire Sanders waited until the unpaid tab reached $1.2 million before suing. 

In an article published by the Daily Business Review, Steve Zelkowitz, managing partner of GrayRobinson’s Miami office, said “the trend of clients suing law firms, which are considered deep pockets, is growing, particularly when a firm loses a case.”  According to Zelkowitz, “[o]nce clients lose, they will do anything to try not to pay.”   Zelkowitz also said disputes over unpaid bills are “definitely becoming more prevalent, and law firms need to be more vigilant.  No one should get more than 90 days behind with clients.”  All words of wisdom. 

Thankfully, there exist risk management solutions that immediately address “slow pay” or “no pay” law firm clients.

Electronic Health Records, Middle Market Business, Network Security, Privacy, Risk Management

Colorado Casualty: Stolen Health Records Not a Covered Event

As detailed by the Salt Lake Tribune, Colorado Casualty Insurance Co. contends it is not obligated to cover costs incurred in 2008 by the University of Utah after tapes containing electronic medical billings records on 1.7 million patients were stolen from a car.   The insurer filed a declaratory judgment action on April 9, 2010 seeking a declaration that the commercial package insurance purchased by the vendor who was to safeguard the records, Perpetual Storage, did provide coverage for the claims made against the insurer.   A review of the seven-page complaint provides no insight as to the terms of the policy in question. 

The claim is ultimately based on first-party costs incured by the University of Utah.   Not including 6,232 in personnel hours responding to the breach, the University allegedly spent over $3.2 million on:  (1) $646,149 in printing and mailing costs; (2) $81,389 for a call center that fielded over 11,000 calls within two weeks; and (3) $2.5 million for credit-monitoring services. 

Notwithstanding what the Colorado Casualty policy may actually state, the above claim would have been covered under most network security and privacy policies.   Lesson learned:   It is critical to confirm a vendor’s insurance clause lists the necessary coverages — including NSAP coverage if they are to handle sensitive data.

Electronic Health Records, Middle Market Business, Network Security, Privacy, Risk Management

White House Cyber Security Plan Focuses on EHR Management

According to an article in Government Health IT, the White House is looking to develop a network security strategy “that pays particular heed to the importance of building a trusted arena for electronic health care transactions.”    Howard Schmidt, the White House Cyber Security Czar, said at a May 11 HIPAA conference on privacy and security that the administration will roll out a “trust framework” based on  technologies, standards, services and policies that will eventually be adopted by the government, industry and consumers. 

According to Schmidt, “[o]ne-person physician offices have to be part of this system.  They have to have the capacity to trust identity and to trust medical records and information because they don’t have infrastructure and they don’t have a CIO.”  The White House’s ultimate goal is to instill enough “trust” in the system so that small practice groups and individual providers would be willing to adopt electronic health records (EHRs).   This initiative comes on the heels of the HITECH Act’s goal of prodding the use of EHRs throughout the health care food chain.

Since the passage of the HITECH Act, there has been much criticism regarding the utility of EHRs (the time needed to transcribe notes, mistakes made in such transcriptions, content limitations, etc.) so it remains to be seen whether widespread use will ever take hold notwithstanding the HITECH Act’s stick/carrot approach to prodding implementation.  Indeed, some have argued that one of the goals of the Act, i.e.,  the improvement of health care by changing patient behavior, will likely take a turn for the worse after EHR implementation.  

To the extent practice groups and providers actually take the plunge and devote resources to a new EHR implementation, they should likely apply a holistic approach to security and privacy that applies general risk management principles.   This article recently published by AHRMNY in its Risk Management Quarterly provides an EHR risk management overview that can help start that process.   As well, here is a link to the presentations from the recent HIPAA conference (minus Mr. Schmidt’s keynote address).   There are several linked presentations that talk to risk assessments and other security considerations of interest to providers and those folks who advise them.

Law Firm, Network Security, Privacy, Risk Management, Small Business

Law Firms Feel the Data Breach Heat and Start Buying Insurance

Here are just a few of the many network security and privacy (NSAP) headline incidents that have hit law firms over the years:

  • “Employee at a Palo Alto law firm steals 90 laptops and 120 desktop computers and sells them”
  • “Eighteen laptops stolen from the Orlando office of a major law firm”
  • “Paralegal at a New York law firm downloads a 400 page trial plan in a major case and offers to sell it to the adverse party.”
  • “Employee of a vendor at the Los Angeles office of a major law firm steals a client’s highly confidential encryption data and posts it on hacker websites.”
  • “Thief remains in the offices of a Phoenix law firm after it closes and steals 3 laptops.”
  • “Laptop is stolen from a Cincinnati law firm and is found on eBay.”

Although some insurers are now offering network security and privacy coverage endorsements on their Lawyers Professional Liability (LPL) policies, the vast majority of law firms are generally without any coverage for data loss or theft.   For many years, the old guard broker heaviest in LPL told its clients that coverage for data breach events would be covered under the traditional LPL coverage grant given any breach of confidentiality – including one involving a data breach – would trigger coverage as the provision of legal services.   Fast forward to today and the tune has changed.  It is pretty much standard now for law firms to at least evaluate NSAP options.   Here are just a few of the reasons why NSAP options make sense for law firms: 

  • There is no other available coverage for post-breach expenses such as forensics.
  • Coverage for data and other non-physical perils is routinely excluded under Property policies.
  • The “intentional acts” exclusion found in the standard LPL policy might eliminate coverage if the breach was caused by an insider.
  • Coverage may be unavailable for acts that are outside the provision of professional services.
  • Liability arising out of the destruction of electronic data is not typically covered under the standard General Liability or Property policies.
  • Direct losses caused by vendors may not be covered under crime policies.
  • Crime policies generally only cover theft of money, securities or other tangible property – not information theft or the destruction of electronic data.

For a more “in depth” look at the relevant digital coverage gaps for law firms, read this now timely article written over six years ago.

Law Firm, Middle Market Business, Small Business

The $60 Email

By now most have heard of the lady who fumed when a courtesy eight word e-mail response (“I hope everything is O.K.  Take your time.”) was billed by her attorney at $60 (.2 hours x $300 hourly rate).   Her experience left her asking one question:  “How does anyone treat people like this and still manage to stay in business?”  That is the problem in a nutshell.  Lawyers are trained to be lawyers and not profit-focused business people.   In other words, they are not focused on staying in business.

Ignoring for a second the fact that taking twelve minutes to compose such a response may not have been very efficient use of time, the associate who wrote it was just thinking like a lawyer when it came to billing his or her time.   The time was spent so it should be billed.  Whereas a profit-focused law firm would have likely collected such non-substantive email, tallied the time, put all such time on the bill — and then assign a zero charge to this “non-billable time”, more often than not such over-the-top charges fall through the cracks and end up actually going out to clients.  A profit-focused law firm would never have let such a bill leave its doors given such a business realizes just how damaging it would be to its bottom line to charge for eight word emails that involve no true billable time.

Middle Market Business, Network Security, Privacy, Risk Management, Small Business, Technology Law

Regulatory and Judicial Enforcement of “Reasonable Security”

On April 12, 2010, Brokerage firm D.A. Davidson & Co. was hit by The Financial Industry Regulatory Authority (FINRA) with a $375,000 fine due to a 2007 data breach.    The breach potentially impacted 192,000 customers and involved social security numbers, dates of birth and other confidential information.  In what has been for years now a fairly  common occurrence, the firm was exploited by a SQL injection vulnerability that allowed hackers to break into a database server holding the data.

Davidson learned of the breach after it received an extortion note from one of the hackers seeking money to keep silent.  According to FINRA, the breach was caused by Davidson’s failure to implement “well-known and recommended security measures for protecting customer data.”   It said that Davidson had failed to encrypt sensitive customer data, and had kept its customer database on a Web server with a default vendor password and a “constant open Internet connection.”

This case should not be looked upon in isolation.  A failure to implement reasonable security is giving rise to a  growing regulatory risk.   For example, on March 25, 2010, the FTC settled a case claiming that the Dave & Busters restaurant and arcade chain failed to inadequately protect consumer information.  The FTC alleged in its complaint that a hacker exploited vulnerabilities in Dave & Buster’s systems to install unauthorized software and access approximately 130,000 credit and debit cards. 

Negligence claims based on the lack of “reasonble security” has also been gaining ground in the courts.  For example, last year the U.S. District Court for the Northern District of Illinois allowed suit to proceed against Citizens Financial Bank given that plaintiffs’ home equity loan was depleted to the tune of $26,500 by an online thief who transferred the money to a bank in Austria.  The negligence claim against Citizens Financial Bank was allowed to proceed given there was a factual issue as to whether the bank utilized adequate security controls.  There are other pending cases where the court has reasoned that the lack of reasonable security can be the underpining of a negligence claim.   The moving target in all of these cases is determining what exactly constitutes “reasonable security”.

UPDATE:  February 22, 2021

The Sedona Conference (TSC) – a nonpartisan, nonprofit charitable research and educational institute “dedicated to the advanced study of law and policy in the areas of antitrust law, complex litigation and intellectual property rights”, released in February 2022 what it perceived to be the proper definition of “reasonable security”.  As a reminder, TSC famously previously helped Courts determine the proper contours of e-discovery.  

Recognizing that cybersecurity reasonableness crosses both legal and technology issues, the Technology Resource Panel of TSC recognized that a reasonableness test would help to bridge that divide.  The Sedona Conference, Commentary on a Reasonable Security Test, 22 SEDONA CONF. J. 345, 355 (forthcoming 2021).  Accordingly, the proposed test for reasonable security was designed to be consistent with “models for determining reasonableness that have been used in various other contexts by courts, in legislative and regulatory oversight, and in information security control frameworks.”  Id. at 358.

The Sedona Conference Commentary on a Reasonable Security Test consists of the following formula:  “B2 – B1 < (P x H)1 – (P x H)2” where B represents the burden, P represents the probability of harm, H represents the magnitude of harm, subscript 1 represents the controls (or lack thereof) at the time the information steward allegedly had unreasonable security in place, and subscript 2 represents the alternative or supplementary control.  Id. at 360.  This test is ultimately based on the landmark Learned Hand negligence test in United States v. Carroll Towing Co., 159 F.2d 169, 173 (2nd Cir. 1947).  

TSC’s Commentary should be studied for numerous reasons, including the fact it is applied to actual recent enforcement actions and provides solid arguments for its judicial application.  No different than the highly cited TSC e-discovery initiatives, this new TSC reasonable security test may very well be relied on by future courts tackling this important question.

Law Firm, Litigation Management, Middle Market Business, Risk Management

CLT: Law Firms Resort to Suing Their Clients to Collect Fees

According to an article in the Connecticut Law Tribune, during the past several years there has been an uptick in the instances of law firms suing to recover their fees.  O’Connell, Flaherty & Attmore based in Hartford, Connecticcut, has been suing clients since 2008, and the firm “has 29 pending cases seeking about $523,000 in unpaid fees.”   The Hartford office of Bingham McCutchen, “is seeking $764,000 in fees from former client Richard D. Cohen of Capital Properties.”   And, Pepe & Hazard, now part of McElroy, Deutsch, Mulvaney & Carpenter, filed three collections lawsuits in the past two years –  which is one more than it filed in the past ten years.    

As recognized in the article, some of the largest law firms nationwide have been filing collection actions during the past few months, including Debevoise & Plimpton, McDermott Will & Emery, and Williams & Connolly. And, earlier this year, a jury awarded Drinker Biddle & Reath $1.8 million in a fee dispute case.

This agressive collection strategy has been criticized by some.  According to Bill Jawitz, a law firm consultant in Milford, Connecticut, more law firms are asking Jawitz about the strategy of filing lawsuits against clients.  He is quoted in the article as saying he “strongly” advises against it given such suits can lead to bad publicity for a firm and often invites malpractice counterclaims.  As well, he says, “It sucks up time and money to fight these battles.  It’s a sign of bad financial management.” 

Although it is true that law firms have traditionally been hesitant to file a claim against clients for fear of being hit with a counterclaim sounding in malpractice, the article’s author points out that a check of Connecticut court records “revealed no pending malpractice claims filed by clients sued over past-due bills.”   More than likely at least a few such counterclaims exist and the author merely missed them.  On the other hand, plaintiff’s burden in proving a malpractice claim is not slight.   A plaintiff often needs to prove “a case within a case” in order to recover. 

And, getting plaintiff’s counsel to take on a malpractice counterclaim may not be as easy as it once was given the costs involved in battling  a law firm hungry for its fees and seeking to protect its reputation.   In other words, maybe the counterclaims are really not as frequent as they once were.  In any event, professional liability insurers should be pursuaded not to penalize those law firms who fight to recover fees.

It is clear that malpractice insurers currently take notice of fee disputes.  Indeed, a common question found in most any professional liability application is:  “How many suits for collection of fees have been filed by the Applicant Firm during the past 2 years?”  The obvious assumption being that such suits bring with them malpractice claims.  And, whether frivolous or not, such suits must be defended. 

There are strategies that exist which completely obviate the need to file suit against a client.  These strategies apply risk management techniques usually undertaken by manufacturers and not professional service firms.   Moreover, not only would they help on the collection backend, they would help on the front-end when a decision is made to take on the client in the first instance.   As a final added benefit, these strategies will also serve to lower professional liability insurance rates.