Category Archives: Financial Reporting

Blockchain, Digital Assets, DLT, Financial Reporting, NFTs, Risk Management

NFT vs. FTX

Fine art NFTs slowly but surely prop up blockchain technology while also moving the nascent Digital Fine Art movement – like popcorn placed in a Raytheon microwave oven but in a less pedantic manner.  On November 16, 2022, a burning question for NFTs is whether the unfolding FTX disaster advances or hinders their cause.

Over 230 years ago, Courts recognized that fraud taints everything it touches.  Snyder v. Findlay, 1 N. J. Law (Coxe) 48, 51 (1791).  Notwithstanding the good intentions of respected celebrity endorsers Larry David, Tom Brady and Stephen Curry, the fraudster Sam Bankman-Fried – now derided as “Sam Bankrun-Fraud”, incredibly avoided internal detection by stealing and hiding funds using his own personal backdoor software tool.  By trading client assets, his massive fraud did the exact opposite of what his firm contractually promised clients as a condition of FTX’s custody. 

Fried’s fraud has become a major contagion in the crypto world – some are even posturing FTX as Exhibit “A” in their case against crypto adoption.  Despite the pernicious nature of Fried’s massive fraud, there remains underlying positive news given FTX’s failures shine a light on why NFTs will continue having a long and impactive run and why their decentralized nature will eventually become baked into most financial assets.  Indeed, the term “NFT” will hopefully disappear from our vernacular given the underlying technology’s future ubiquity.  Literally no one cares how “Hypertext Transfer Protocol Secure” works so long as the “https” before a website address gets the job done.  Similarly, few really care about the technology behind a “non-fungible token”.   Owners only care about having transferable digital property self-containing proof of ownership, verifiable uniqueness and programmable contract attributes.

The FTX debacle immediately adversely impacted NFT markets because NFTs are purchased and sold using cryptocurrencies – most of which took a major hit beginning on November 2, 2022, the publication date of Coindesk’s expose on FTX.  And, with Solana’s SOL emerging as this worst-performing crypto asset – losing over 41% in value given FTX was an important backer of the network, several Solana NFT marketplaces, namely Magic Eden and Solanart, felt an even greater FTX sting than other NFT marketplaces.   

Despite the fact NFT sales remain on a slow mass adoption cycle, as of November 16, 2022 OpenSea alone still had nearly $33 billion in total NFT trades.  NFTs are well beyond the proof-of-concept stage but mass adoption will continue a slow journey given the constant press assaults.  For example, in a May 3, 2022 Wall Street Journal hit piece suggesting that it may be “the beginning of the end” for NFTs, Zach Friedman, co-founder and chief operating officer of crypto brokerage Secure Digital Markets, is quoted as saying:  “The ones that continue will be utility-focused for sure.” 

That perspective is both correct – utility is an intrinsic feature of all NFTs, and wrong given it begs the question:  Since when does fine art ever need additional utility for it to gain status as “fine art”?  Utility is always found in great art simply by way of the esthetic utility derived.  As of the same month as the WSJ article – May 2022, collectors sent over $37 billion to NFT marketplaces, putting them on pace to beat the total of $40 billion sent in 2021.  Even though the vast majority of these transactions are not for fine art NFTs, the disrespect shown today for Digital Fine Art remains no different than cubist art in 1910. 

At the 1913 Armory Show in New York City, the most famous collectors of modern art originally shunned what they saw.  Indeed, after the show travelled to Chicago, members of the Art Institute of Chicago – the first museum brave enough to display these works, burned mock-Matisse and Picasso effigies on the museum’s steps. Today, the Art Institute of Chicago proudly hangs over five hundred important works created by Matisse and Picasso.  History will always have an uncanny way of repeating itself.

At an Art Basel panel discussion, Esther Kim Varet, owner of the L.A. and Seoul gallery Various Small Fires, reportedly let the cat out of the bag as to why Digital Fine Art runs against the grain of the fine art world: “There are a lot of barriers and it feels exclusive once you get in. And I fear that the more pricing transparency there is … we’re going to have to invent new ways to create this aura of exclusivity or privilege. Not that those things are things that we should value but it’s just kind of what the art world is built on.”

In other words, pricing opaqueness is positioned as a virtue of the art world community.  Not surprisingly, the pricing transparency and documented provenance inherent in Digital Fine Art in the form of NFTs in some ways runs counter to this view of the art world.   While the actual art in Digital Fine Art provides utility plain and simple, the programmable nature of the smart contracts used in NFTs provides a world of opportunity for collectors and artists. Such underlying contractual rights can create a lifetime relationship between collector and artist – one with ties to direct interactions removed from any centralized control.  More to the point, fine art galleries and dealers can readily join in this new form of relationship.  Ultimately, the only barriers to the heights Digital Fine Art can achieve is driven by a lack of imagination and a fear of the unknown.

UPDATE: December 13, 2022

On December 13, 2022, the SEC filed criminal charges against Bankman-Fried. The complaint alleges he “orchestrated a years-long fraud to conceal from FTX’s investors (1) the undisclosed diversion of FTX customers’ funds to Alameda Research LLC, his privately-held crypto hedge fund; (2) the undisclosed special treatment afforded to Alameda on the FTX platform, including providing Alameda with a virtually unlimited “line of credit” funded by the platform’s customers and exempting Alameda from certain key FTX risk mitigation measures; and (3) undisclosed risk stemming from FTX’s exposure to Alameda’s significant holdings of overvalued, illiquid assets such as FTX-affiliated tokens.”

In parallel actions, the U.S. Attorney’s Office for the Southern District of New York and the Commodity Futures Trading Commission also announced their own charges against Bankman-Fried.

Given that he was about to testify before Congress, the timing of the SEC and CFTC actions are not nearly as important as that of the criminal indictment. In effect, the DOJ has prevented a potential treasure trove of wholly admissible statements from being elicited. Now that he has been indicted and arrested in the Bahamas, lawyers will be the only ones talking for money-runner SBF. That’s too bad.

Financial Reporting, IT Consultants, Law Firm, Network Security, Privacy, Risk Management

Alleged cover-up leads to criminal complaint against former Uber CSO

In filing its August 20, 2020 criminal complaint against the former Uber CSO, the US Attorney for the Northern District of California issued a wake-up call to every CISO responding to a federal investigation of a data incident.  And, by stating in its press release, “we hope companies stand up and take notice”, the Justice Department has definitely thrown down a gauntlet against CISOs across the country.  

By way of background, Uber sustained a data breach in September of 2014 that was investigated by the FTC in 2016.  Uber designated its CSO – Joseph Sullivan, to provide testimony regarding the incident.  Within ten days of providing testimony to the FTC, Sullivan received word Uber was breached again but rather than update his testimony before the FTC he allegedly tried very hard to conceal the incident from the FTC.  Indeed, Sullivan allegedly went so far as to concoct a bug bounty program cover story and asked the hackers to sign an NDA as a condition of their getting $100,000 in bitcoin.

The Special Agent’s supporting affidavit swears that “there is probable cause to believe that the defendant engaged in a cover-up intended to obstruct the lawful functions and official proceedings of the Federal Trade Commission. . . . It is my belief that SULLIVAN further intended to spare Uber and SULLIVAN negative publicity and loss of users and drivers that would have stemmed from disclosure of the hack and data breach.”

In other words, a CSO allegedly spared his employer “negative publicity and loss of users” by inaccurately describing an incident and failing to disclose it in timely manner.  Even though the alleged conduct of Uber’s former CSO may have pushed the needle into the red zone, there are also potential arguments in his favor.  In coming up with one such counterargument, several Forrester analysts suggest:  “Sullivan did not inform the FTC during the sworn investigative hearing because he couldn’t have:  Sullivan learned of the 2016 breach 10 days later. To inform the FTC, Sullivan would have needed to reach out and inform them about a separate, new, but similar breach. There’s also some confusion as to whether Sullivan was under any legal obligation to do so.”

Whatever happens in this particular case, the fact remains CISOs sometime inadvertently play too close to the edge.  The underpinnings of an incident are whatever they are – no one can or should ever try to morph them into something different.  Good legal and IT counsel will mitigate loss and certain exposures but only with the assistance of CISOs and CSOs who recount events rather than fabricate them.  Not surprisingly given no company is immune to a breach, it’s only the cover-up that will ever hurt and not the incident itself. 

Accounting Firm, Financial Reporting, IT Consultants, Network Security, Risk Management

Ransomware Has Officially Become a D&O Problem

On April 30, 2020, ZDNet reported that there have been more than 1,000 SEC filings over the past 12 months listing ransomware as a risk factor – with more than 700 in 2020 alone.  These filings include annual reports (10K and 20F), quarterly reports (10Q), and registration forms (S1). 

Even the most sophisticated technology companies now insert the word “ransomware” into their Risk Factors section. See Alphabet, Inc., Form 10-Q, dated April 28, 2020, at 50  (“The availability of our products and services and fulfillment of our customer contracts depend on the continuing operation of our information technology and communications systems. Our systems are vulnerable to damage, interference, or interruption from terrorist attacks, natural disasters or pandemics (including COVID-19), the effects of climate change (such as sea level rise, drought, flooding, wildfires, and increased storm severity), power loss, telecommunications failures, computer viruses, ransomware attacks, computer denial of service attacks, phishing schemes, or other attempts to harm or access our systems.”).   

As reported by ZDNet, companies as varied as American Airlines, McDonald’s, Tupperware, and Pluralsight also list ransomware as a potential risk to their business. 

By inserting the word “ransomware” into a Risk Factors section, reporting companies may have elevated the relevant standard for companies who do not reference ransomware.  By way of background, in October 2011, the SEC began planting cyber risk disclosure seeds when it issued non-binding disclosure guidance regarding cybersecurity risks and incidents.  Back in 2011, the SEC wrote:  “Although no existing disclosure requirement explicitly refers to cybersecurity risks and cyber incidents, a number of disclosure requirements may impose an obligation on registrants to disclose such risks and incidents.” Seven years later, this non-binding guidance became binding.

On February 26, 2018, the SEC issued binding guidance that recognizes:  “Companies face an evolving landscape of cybersecurity threats in which hackers use a complex array of means to perpetrate cyber-attacks, including the use of stolen access credentials, malware, ransomware, phishing, structured query language injection attacks, and distributed denial-of-service attacks, among other means.”   By expressly listing ransomware two years ago in its Statement, the SEC was making it quite clear that the current threat landscape includes the risk of ransomware and that directors and officers have to address this likely risk.

More to the point, the Statement and Guidance on Public Company Cybersecurity Disclosures instructs “that the development of effective disclosure controls and procedures is best achieved when a company’s directors, officers, and other persons responsible for developing and overseeing such controls and procedures are informed about the cybersecurity risks and incidents that the company has faced or is likely to face.” 

Not surprisingly, the failure to disclose a prior ransomware attack would also be actionable.  See SEC Statement at 14 (“In meeting their disclosure obligations, companies may need to disclose previous or ongoing cybersecurity incidents or other past events in order to place discussions of these risks in the appropriate context.  For example, if a company previously experienced a material cybersecurity incident involving denial-of-service, it likely would not be sufficient for the company to disclose that there is a risk that a denial-of-service incident may occur.”).

If ransomware incidents were avoided altogether, however, there would be no liability attached to associated filings no matter what was communicated to the market. Moreover, even when attacks were not avoided, little disclosure risk would exist if the company applied best practices to avoid such an incident and provided an accurate accounting of what took place when an incident did take place. To that end, deploying proactive approaches considered state-of-the-art when dealing with ransomware risk will naturally mitigate against any potential SEC disclosure risk.

For example, there is at least one novel solution that can reduce ransomware attacks by anticipating when a compromised system’s ransomware package will be released and then neutralizing the ransomware threat before any ransomware release actually takes place.  By evaluating and deploying such cutting-edge solutions, companies will be well positioned to neutralize any potential shareholder claims – as well as satisfying the much more important task of protecting corporate data and other digital assets.  Thankfully, “it is never too late to begin importing a more robust security and privacy profile into an organization – which is the only real way to diminish the risk of a ransomware attack.”  As with most successful corporate endeavors, management buy-in will typically be the necessary first step.

Financial Reporting, Network Security, Privacy

First GDPR Proposed Fine Comes in at a Whopping $229 Million

On July 8, 2019, the UK’s Information Commissioner’s Office announced its intention to fine British Airways £183.39M ($229,377,293) for data breach infringements of the General Data Protection Regulation (GDPR).  This first publicly-disclosed GDPR penalty amounts to about 1.5% of British Airways’ worldwide turnover– which is still less than the possible maximum penalty of 4%.  Alex Cruz, British Airways chairman and chief executive officer, said in a press release:  “We are surprised and disappointed in this initial finding from the ICO.  British Airways responded quickly to a criminal act to steal customers’ data. We have found no evidence of fraud/fraudulent activity on accounts linked to the theft.”

According to the ICO, the massive fine was ultimately based on the harvesting of personal data of approximately 500,000 customers only one month after GDPR became enforceable.  The ICO investigation uncovered that “a variety of information was compromised by poor security arrangements at the company, including log in, payment card, and travel booking details as well name and address information.”

Given that the ICO’s final decision will take into consideration a formal response from British Airways and other data protection authorities, the fine will likely be modified in same way – this is also likely given there were new security procedures implemented by British Airways, there is no present evidence of fraud, and British Airways has already threatened an appeal.

At the time of the attack, British Airways provided very little information regarding how it was accomplished other than to say it impacted website and app bookings from August 21 to September 5, 2018 and that it was the victim of a “sophisticated, malicious criminal attack“.  One security expert posited that malicious code was planted on the website’s payments page using a modified version of the Modernizr JavaScript library.  Others have considered this attack caused by a cross-site scripting exploit.  No matter what the attack vector or exploit, this was clearly the sort of security lapse that has dogged many companies over the years.  To now have a potential $229 million fine waiting on the sidelines can only be considered yet another massive motivation to get one’s security house in order as soon as possible.

UPDATE: July 9, 2019

A day after the British Airways proposed fine, Marriott was hit with a $123 million proposed GDPR fine for a November 2018 breach.

Behavioral Advertising, Blockchain, Digital Assets, DLT, Financial Reporting, Network Security, Privacy, Risk Management, Social Media

Do ICOs have any future?

On February 6, 2018, the Senate Committee on Banking, Housing, and Urban Affairs met in open session to conduct a hearing entitled, Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission.  The Honorable Jay Clayton, Chairman, U.S. Securities and Exchange Commission and The Honorable J. Christopher Giancarlo, Chairman, U.S. Commodity Futures Trading Commission provided lengthy and thoughtful prepared statements.  In his statement, Chairman Clayton explained why the SEC was devoting significant resources to ensure ICO founders do not skirt SEC’s regulatory oversight of security offerings and Chairman Giancarlo reaffirmed that the CFTC will similarly enforce its regulations on commodities.

Their testimony provides helpful insight regarding the enforcement direction these agencies will take in the coming months.  According to Chairman Clayton, in 2017 there was $4 billion raised in ICOs -with an unknown amount being sold in the US.   He was generally “very unhappy with ICOs” and mentioned that the SEC was “working the beat hard” to crack down on them.  Accordingly, ICOs are in the “crosshairs of enforcement” and tellingly he testified that “every ICO [he has] seen is a security” subject to enforcement.  This testimony is consistent with prior SEC pronouncements given that  Chairman Clayton previously requested that the SEC’s Enforcement Division “vigorously” enforce and recommend action against ICOs that may be in violation of the federal securities laws.   During his testimony, Chairman Clayton repeated several times that the SEC would continue to “crack down hard” on fraud and manipulation involving ICOs offering an unregistered security.

According to Chairman Clayton, the definition of a security is broad and will turn on whether someone can profit from efforts going forward by buying the token and then trade it with someone else for further profit.  Both Chairmen recognized that no one agency has any direct oversight of virtual currencies and welcomed efforts from Congress to draft new legislation that would help with their coordination efforts.

In probably the most interesting exchange during their two-hour testimony, Senator Mark Warner of Virginia recognized that the SEC went after certain ICO promoters but not others so directly asked Chairman Clayton whether the SEC “will go back [to scrutinize prior ICOs]?”  Correctly avoiding that question – given it requests insight as to future SEC enforcement efforts, Chairman Clayton instead offered that the SEC is counting on lawyers and accountants to also act as “gatekeepers” for future ICOs.

Chairman Clayton’s testimony came on the heels of the SEC’s Cease and Desist Order in the Munchee, Inc. matter that may have closed the lid on many planned 2018 ICO’s given the stringent standard set forth in that SEC Order.  By way of background, Munchee created an iPhone application for people to review restaurant meals.  In October and November 2017, Munchee offered and then sold purported utility tokens issued on the Ethereum blockchain.  “Munchee conducted the offering of MUN tokens to raise about $15 million in capital so that it could improve its existing app and recruit users to eventually buy advertisements, write reviews, sell food and conduct other transactions using MUN.”  Order at 1.

In deeming the MUN utility token a “security” subject to SEC oversight, the SEC made the following finding of fact in its December 11, 2017 Order:

Purchasers had a reasonable expectation that they would obtain a future profit from buying MUN tokens if Munchee were successful in its entrepreneurial and managerial efforts to develop its business. Purchasers would reasonably believe they could profit by holding or trading MUN tokens, whether or not they ever used the Munchee App or otherwise participated in the MUN “ecosystem,” based on Munchee’s statements in its MUN White Paper and other materials. Munchee primed purchasers’ reasonable expectations of profit through statements on blogs, podcasts, and Facebook that talked about profits.

Order at 5.

There remains hope for future ICOs given that the SEC is certainly not going after them all.  One ICO left untouched by the SEC was “gate keeped” by Perkins Coie and involves an ICO for an Ethereum utility token that raised $35 million in under a minute’s time.   See FAQ (“We and our counsel at Perkins-Coie are confident that the Basic Attention Token is properly classified as property with utility on the platform we are building, and not a security.”).  Given the subsequent Munchee C&D Order, it is unclear why the SEC does not “go back” to this ICO as suggested by Senator Warner.

The founders of Brave Software launched the “Basic Attention Token” in May 2017 seeking to improve on the current digital advertising ecosystem:   “Digital advertising is broken [with] unprecedented levels of malvertisements and privacy violations.”  The BAT token looks to fix this broken system by creating an ecosystem tied to consumer attention – which is why it is called the “Basic Attention Token”.  Such ecosystem would certainly be an upgrade from the current digital advertising scheme based on the Web ecosystem of 1995.  BAT tokens can only derive long term value by way of the Brave® Browser.   As set forth by a marketing blogger, “If Brave isn’t adopted, the new advertising structure won’t work.”

By successfully obtaining registered trademark No. 5,362,328 for BRAVE – a mark used to distinguish Brave Software’s “web browser software”, the founders of the BAT token demonstrate ownership rights in the Brave browser, that they are the source of such product, and that they will be the direct cause of the browser’s success.  In other words, buyers of the BAT ICO would necessarily profit from the efforts of Brave Software, Inc.   On the other hand, there remains utility to the BAT token.  Moreover, a utility token will likely always be at least remotely tied to the efforts of its founders – there is little reason to believe a token left in the wild would hatch into anything of value.  The fact that the SEC has not scrutinized the BAT ICO is actually an encouraging sign the SEC will temper its enforcement actions when faced with a disruptive blockchain initiative that begets true intrinsic value in the token.

State and Private Enforcement of ICO schemes

In addition to existing federal enforcement, state agencies are also cracking down on ICOs.  For example, on January 17, 2018, the Massachusetts Securities Division filed an administrative complaint against a Cayman Islands company given that the company operated out of Massachusetts and its ICO offered for sale “a security without such security being registered or exempt from registration.”  Complaint at 2.

And, to the extent state regulatory oversight may be lacking, states will try and enlarge regulatory reach by enacting new laws.  For example, California introduced a year ago the Virtual Currency Act (A.B. 1123), which would have required those involved in a “virtual currency business” within the state to register with California’s Commissioner of Business Oversight.  Even though this attempt at regulating cryptocurrencies died on January 31, 2018 due to political pressure, it may come back in a different from.    Interestingly, there was a carve out in the bill for any “virtual currency business” when it uses “[d]igital units that are used exclusively as part of a consumer affinity or rewards program”.

Class action counsel has also impacted ICOs by directly suing ICO founders in order to recoup millions for class participants.  One recent case is Davy v. Paragon Coin, Inc., et al., Case No. 18-cv-00671 (N.D. Cal. January 30, 2018).  Plaintiff class counsel sued Paragon based, in part, on the Paragon white paper characterizing its PRG token as potentially increasing in value simply based on the reduction of supply and an increase in demand.  Moreover, the paper suggests that “PRG is designed to appreciate in value as our solutions are adopted throughout the cannabis industry and around the world.”  Id. at 31.  In other words, the efforts of the founders would directly generate a more profitable investment result from the ICO.

Another ICO class action fraud case was filed in Paige v. Bitconnect Intern. PLC, et al., Case No. 3:18-CV-58-JHM (W.D. Ky. January 29, 2018).  The plaintiff’s claim of a Ponzi scheme was so strong it resulted in a TRO from the Court a day after filing suit.  Any future ICO that results in a loss in value to “investors” will likely trigger class counsel to spring into action.

The future of ICOs remains viable

Where does this trifecta of enforcement efforts – federal, state and private, leave ICOs?  If bankers are to believed, there is currently not much “there”, there.   In a report dated February 5, 2018, Goldman Sachs Group Inc.’s global head of investment research suggests that investors in ICOs could possibly lose their entire investments.  Goldman’s Steve Strongin said that while he did not know a timeframe for total losses in existing coins and tokens, he ruminated:  “The high correlation between the different cryptocurrencies worries me. . . Because of the lack of intrinsic value, the currencies that don’t survive will most likely trade to zero.”

Given the disruptive nature of ICOs on the IPO and private equity markets, it is not surprising that the global head of Goldman downplays the future of ICOs – even if he is correct in pointing out  the lack of intrinsic value in most every utility token and coin offered in an ICO.  Notwithstanding current enforcement actions and competition from traditional markets, the future for ICOs should remain viable.  Moving forward, the key to a viable and “compliant” ICO will be whether the ICO is conducted for a utility token having  demonstrated intrinsic value connected to the activities of those other than merely the ICO’s founders.

Financial Reporting, Law Firm, Privacy

CNIL Goes Easy With Google Fine

On March 17, 2011, CNIL fined Google €100,000 for improperly gathering and storing data for its Street View application.   Founded over thirty years ago, CNIL is an independent administrative authority that protects the privacy and personal data of French citizens.

Although this is the largest penalty ever awarded by CNIL, it certainly does not begin to move the needle when it comes to hurting Google’s very deep pockets.  This is nothing more than an interesting wrist slap in light of the significant privacy infraction.  The vast amount of personal data that was improperly collected by roaming “Google bikes” and “Google cars” – included e-mails and web browsing histories amounted to 600 gigabytes of unencrypted Wi-Fi data.

Even though US regulators have been hitting hard with recent fines of $4.3 million and $1 million, one lingering threat that was always out there on the privacy regulatory front was from an EU privacy agency holding a firm to unexpectedly high standards.   After seeing CNIL’s Google fine, that threat may have sputtered away.  What US firms need to continue to fear are the many class action suits that quickly sprout up — as they did when Google disclosed this “Wi-Spy” mishap — whenever there is a public disclosure of a privacy breach.

Financial Reporting, Law Firm, Litigation Management, Privacy, Risk Management

Plaintiffs’ Class Action Counsel Running on Empty: “Fear of ID Theft” and “Lost Time and Effort” Damages Theories Just Don’t Cut It

While some data breach victims will eventually sustain an ID theft, it is generally acknowledged that the vast majority will not.  Accordingly, the direct damages sustained by ID theft victims are not very helpful in a class action — there are just not enough plaintiffs.  Over the years, plaintiffs’ class action counsel have spent many hours trying to create a damages theory that would actually be common to all victims of a data breach event.   The two theories that have gotten the most class action traction are based on “fear of ID theft” or “lost time and effort” allegations.  Unfortunately — for plaintiffs’ counsel, that is — neither theory really fits the bill.

Damages Based on the “Fear of ID Theft”

Plaintiffs’ class action counsel chasing down data breach events have generally been unsuccessful in pursuing claims based solely on the “fear of identity theft” or related incidental damages.  Although Ruiz v. Gap, Inc, instructs us there may be an outside chance of surviving a motion to dismiss, a defendant’s summary judgment motion will eventually kill any claim brought by those who have not actually sustained theft of their identities.  In effect, an actual incidence of ID theft – which after a breach can take quite a while to happen – has become the de facto precursor to compensable damages.

Despite what some plaintiffs’ counsel have said after the standing ruling in Krottner v. Starbucks, Nos. 09-35823 and 35824 (9th Cir. , Dec. 14, 2010), nothing has really changed this dynamic.   In fact, as shown in Ruiz and other cases cited below, Krottner is not even the first court to rule federal standing exists for “fear of identity theft” claims.

By way of background, employees at Starbucks sued the company after the October 29, 2008 theft of a laptop computer containing “names, addresses, and social security numbers of approximately 97,000 Starbucks employees.”  Id.  The trial court had previously dismissed the case, finding that Washington law doesn’t recognize a cause of action where the only financial damage is “risk of future harm.” The trial court also found insufficient facts to carry an implied contract claim.

In a pair of rulings issued last month, the Ninth Circuit agreed with the lower court and affirmed dismissal of the action given that, under Washington law, “actual loss or damage is an essential element” of a negligence claim.  This opinion on the merits was not approved for publication.

It is the standing ruling – which was actually approved for publication – that has excited some in the data breach litigation business.  The Ninth Circuit ruled [insert big yawn here] plaintiffs had Article III standing given that “‘generalized anxiety and stress’ as a result of [a data breach] is sufficient to confer standing”.   It is very important to note that the court, quoting from Equity Lifestyle Props., Inc. v. County of San Luis Obispo, 548 F.3d 1184, 1189 n.10 (9th Cir. 2008), recognized as a threshold matter that “[t]he jurisdictional question of standing precedes, and does not require, analysis of the merits.”  In other words, with jurisdictional standing you can reach the federal courthouse but once inside, you still need to prove your case – something plaintiffs here were unable to do given they lost at the district court level and on appeal.

In reaching its decision, the Ninth Circuit cites to cases on both sides of the issue.  Compare Doe v. Chao,540 U.S. 614, 617-18, 624-25 (2004) (suggesting that a plaintiff who allegedly “was ‘torn . . . all to pieces’ and `was greatly concerned and worried’ because of the disclosure of his Social Security number and its potentially ‘devastating’ consequences’” had no cause of action under the Privacy Act, but nonetheless had standing under Article III) and Pisciotta v. Old National Bancorp, 499 F.3d 629, 634 (7th Cir. 2007) (holding that plaintiffs whose data had been stolen but had not yet been misused suffered an injury-in-fact sufficient to confer Article III standing) with Lambert v. Hartman,517 F.3d 433, 437 (6th Cir. 2008) (although plaintiff’s actual financial injuries resulting from the theft of her personal data were sufficient to confer standing, the risk of future identity theft was “somewhat ‘hypothetical’ and ‘conjectural.’”).

Looking to exploit its Pyrrhic victory, plaintiffs’ counsel deftly uses the December 15, 2010 standing decision to solicit Starbucks employees who may have actually sustained an ID theft:

[We] received a favorable precedential opinion from the United States Court of Appeals for the Ninth Circuit in Krottner v. Starbucks Corporation, No. 09-35823.  In the opinion, the Ninth Circuit judges held that plaintiffs whose personal information had been stolen, but not misused, had standing to bring their case in federal court. The opinion held on the facts before it that the increased risk of future harm from identity theft was a credible enough treat [sic] to provide an injury-in-fact for Article III standing…

If you have any information regarding the Starbucks data breach, or if you believe you have been affected by the data breach and would like to discuss your rights and interests in this matter, please contact our Washington D.C. office.

Damages Based on “Lost Time and Effort”

Thankfully (for defendants), there is no compelling precedent that expressly recognizes negligence or contract damages derived solely from the time and effort spent to remediate an alleged wrongdoing.  Although mitigation damages are sometimes awarded in addition to other damages such damages generally never rest as the sole measure of injury in either a negligence or contract setting.  This general rule manifests as the “economic loss rule” in some jurisdictions (used to bar recovery in negligence when the only loss is pecuniary) or is simply bolted on to the concept of damages in other jurisdictions.

Seeking to resolve a “lost time and effort” argument made by plaintiffs in a very public data breach context, on November 24, 2009, Judge D. Brock Hornby, the federal district judge in Maine presiding over the Hannaford Brother data breach litigation, certified the following question to the Maine Supreme Court:

In the absence of physical harm or economic loss or identity theft, do time and effort alone, spent in a reasonable effort to avoid or remediate reasonably foreseeable harm, constitute a cognizable injury for which damages may be recovered under Maine law of negligence and/or implied contract?

See In re Hannaford Bros. Co. Customer Data Sec. Breach Litig., 671 F. Supp. 2d 198, 201 (D. Me. 2009).

On September 21, 2010, the Maine Supreme Court answered this question in the negative.  Relying on longstanding law, Maine’s highest court responded to Judge Hornby without equivocation:  “[Maine case law] does not recognize the expenditure of time and effort alone as a harm.”  In re Hannaford Bros. Co. Customer Data Sec. Breach Litig., 4 A.3d 492 (Me. 2010).  Rejecting a “mitigation of damages” argument that would elevate expended time and effort to the status of a compensable legal injury, the court ruled, “[u]nless the plaintiffs’ loss of time reflects a corresponding loss of earnings or earning opportunities, it is not a cognizable injury under Maine law of negligence.”  Id. And, given that “the time and effort expended by the plaintiffs here represent ‘the ordinary frustrations and inconveniences that everyone confronts in daily life’” damages were also not available under the implied contract claim.  Id. (quoting lower court).

Although other courts have made passing comments regarding the relevance of “lost time” as the sole measure of harm, the Maine Supreme Court decision is the only decision on all fours within a data breach context.  Id. (“In other cases, a passing mention of loss of time without adequate facts to demonstrate how those damages were being measured is insufficient to persuade us that the expenditure of time and effort alone is a harm recoverable in negligence.”) (citing Kuhn v. Capital One Fin. Corp., No 05-P-810, 2006 WL 3007931, at *3 (Mass. App. Ct. Oct. 23, 2006); Freeman v. Missouri Pac. Ry. Co., 167 P. 1062, 1063-65 (Kan. 1917)).

Even if a future court found these damages standing alone somehow compensable, there exists another barrier that would likely stymie future class certification motions relying on this damages theory — courts would have a tough time finding an efficient means of determining on a class-wide basis the value of a plaintiff’s “time and effort”.  Although courts have recognized that the need for individualized proof of damages is not per se an obstacle to class certification, the measure of a plaintiff’s relative “time and effort” would likely not predominate any data breach putative class.

To the extent such thorny class certification issues would possibly resolve differently among the federal circuits, the U.S. Supreme Court may soon add some needed clarity.  On December 6, 2010, the Court agreed to review the April 27, 2010 decision by the U.S. Court of Appeals for the Ninth Circuit granting class certification in the massive Wal-Mart sexual discrimination case.  See Dukes v. Wal-Mart Stores, Inc. , 603 F.3d 571 (9th Cir. 2010), cert. granted, Wal-Mart Stores, Inc. v. Dukes, 178 L. Ed. 2d 530 (2010) (“Petition for writ of certiorari to the United States Court of Appeals for the Ninth Circuit granted limited to Question I presented by the petition.  In addition to Question I, the parties are directed to brief and argue the following question: “Whether the class certification ordered under Rule 23(b)(2) was consistent with Rule 23(a).”) (emphasis added).

Although named plaintiffs in the Wal-Mart case “waived any claim for compensatory damages, forfeiting the rights of individual class members to recover damages authorized by Congress solely in order to facilitate class treatment”, an important commonality ruling remains likely given the Court specifically requested that the parties brief the applicability of Federal Rule of Civil Procedure 23(a).  See Petitioners Brief at 35, dated January 20, 2011.  One way or the other, the Supreme Court’s decision in Wal-Mart will impact the class action landscape – including the potential landscape surrounding breach class action suits.

Data Breach Class Action Suits — Will the Floodgates Ever Open?

It may not arrive this year or next but the time will likely eventually come when class actions are routinely certified after a significant data breach.  As discussed above, these future certified class actions will not likely derive from courts applying a new and improved “fear of” or “lost time” damages theory.   Moreover, this shift certainly won’t happen using a newly varnished claim theory based on lost chattel, conversion, or a constructive bailment.

In part two of this post, I’ll outline the one data breach claim that will very likely eventually clog the class action dockets of judges throughout the country.

Financial Reporting, Law Firm

UK Law Firms Face a Sea Change that May Impact US Firms

As reported in this recent article in American Lawyer, in less than a year, “the UK’s legal landscape will change forever.”   This sea change is taking place given the third and final stage of the UK’s Legal Services Act comes into effect in October 2011 — allowing for UK law firms to accept outside equity investments for the first time.   Specifically,  Alternative Business Structure (ABS) will be allowed to have both lawyer and non-lawyer ownership and management.   These entities will be able to solely provide legal services or provide legal services in combination with non-legal services such as financial services. 

Not surprisingly, UK law firms are busy preparing for this change — a change that will likely reshape the legal profession in the UK and beyond.   Unlike law firms in most parts of the world — including the United States — UK law firms will no longer have an ethical bar prohibiting them from taking on non-lawyer equity owners or managers.  The ethical prohibitions barring non-lawyer equity ownership of US law firms were discussed earlier this year in a post that challenged the status quo.

Come next October, the UK legal community will no longer have several significant barriers to growth and in so doing will reap an immediate advantage compared to US peers.  UK firms will see an influx of capital that mimics what happened after financial services firms first went public years ago.  Coupled with this new capital infusion and partner equity bonanza will be demands from investors for improved processes tied to a reduction in expense.   That’s where the new managers will come in to improve the bottom line.  These changes will likely lead to competitive advantages and a rapid increase in revenue.   US firms will be at a marked disadvantage for years to come on those legal services that can more easily be commoditized and outsourced.   ABS entities may find that success higher up the legal food chain will be more difficult to achieve and will take more time to address.  That is where traditonal firms may be able to obtain an advantage.

In other words, in the short-term, there may actually be some good news for US-based firms competing with ABS entities.  Complex corporate and litigation work may eventually increase — not only will firms be wary of using a hybrid law firm that may sometimes have a perceived conflict of interest, these process/outsource driven firms may not be perceived sophisticated enough to handle high-end business.  Moreover, the “professional touch” found in a traditional firm may also be perceived to be missing from these new UK hybrid firms.  This is obviously all speculation at this point given ABS entities may be part of a yet-unknown corporate structure that takes into account the above potential weaknesses.

All in all, the change that will take place next year in the UK will likely eventually lead to greater billing transparency and stronger competition.   Maybe having such competition will cease $60 empty emails and law firms charging for  nice window views.  It may also prod US state bars to recognize there can be no expanding “business of law” until law firms are allowed to conduct business more like other businesses — which may or may not entail the seismic changes taking place in the UK.   It would be nice, however, if those changes were at least discussed.

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

NJ Appellate Division Rules Shareholders Can Inspect Board Minutes

An August 17, 2010 New Jersey decision may be negative for businesses in New Jersey despite what on the surface is  a win for a large corporation.   In Cain v. Merck & Co., Inc., the New Jersey Appellate Division addressed whether the New Jersey Business Corporation Act entitles shareholders to inspect the minutes of the board of directors and the minutes of executive committees, and if so, the breadth of that right of inspection.  According to the court, resolution of these questions:  centers on the proper construction of N.J.S.A. 14A:5-28(4) of the Act. In pertinent part, that statute allows shareholders, upon proof of a “proper purpose,” to examine “the books and records of account, minutes, and record of shareholders of a corporation.” N.J.S.A. 14A:5-28(4).

In what appears to be a case of first impression in New Jersey, the Appellate Division concluded that the qualified right of inspection under the statute extends to the minutes of the board of directors and the executive committee – and not just to the minutes of the shareholder meeting.   The court, however, limited this right of inspection to only those portions of the board minutes that address their “proper purpose.”  In other words, shareholders are “not entitled to examine the minutes in order to explore unsubstantiated allegations of general mismanagement.”

It is not clear whether Merck will appeal given that it, in effect, won its alternative argument, namely that the review should be limited to discussions related to a study conducted by Merck rather than a broader review that on its face does not have such a  “proper purpose.”  According to a Merck spokesman, “we’re evaluating our next steps.” 

If left as binding authority, this decision may have huge ramifications for large and public businesses in New Jersey.   As it stands, the decision extends the reach of the statute – which appears on its face to be limited to shareholder meetings – to the much more deliberative board meetings of a corporation.  It gives litigants a new tool and may cause directors to be more restrained when providing advice given their decision-making process may now be opened up to a much greater extent.  Moreover, this obviously potentially increases the liability of directors and officers so there may be a potential increase in claims – with a resulting increase in D&O insurance premiums.   Although the lower court did recognize that the minutes should be redacted for privileged material, now that the door is open, future judges will have free reign to decide what is deemed “a proper purpose” or privileged material.   In other words, there is no guarantee a future judge won’t allow the fishing expedition rejected by the Appellate Division in this case.

Financial Reporting, Intellectual Property, Middle Market Business

Business Method Patents Live on Another Day: Bilski Decided by SCOTUS

Today’s Bilski v. Kappos decision rejected having a Federal Circuit test for determining patentable subject matter as a “knock out” test for business methods.  If affirmed, this Machine-or-Transformation Test (if applied as the sole test) would have likely rejected all business method patent applications.  As it stands, the United States is the only country that allows for business method patents.  After today’s United States Supreme Court decision, that remains the case.

In today’s decision, the Court ruled that “business methods” can be patentable if they meet the requirements set forth in longstanding precedent notwithstanding the fact they do not “recite a particular machine or apparatus, nor transform any article into a different state or thing.”  Although the Court ruled that the Machine-or-Transformation Test remains as a helpful tool when resolving patentable subject matter questions, it should not be considered a “knock-out” test.

This is a huge win for financial institutions and software companies with strong patent portfolios — as well as those law firms who help build and protect those portfolios.