Thursday 20 June 2024

UK and US Hewlett Packard v Autonomy litigation: highlights corporate technology, intangibles and IP rights accounting standards and reporting reform

IP Finance is pleased to have this guest post from Dr Janice Denoncourt, professor at Nottingham Law School.  

One of the biggest British tech deals involved Autonomy, a software company created in 1996 by former Cambridge University academic Mike Lynch.  The British and American litigation that ensued highlights the need for wider discussions regarding reforms to accounting for nebulous intangible assets such as software, copyright and licences.  How are these valued, accounted for and reported in company annual reports?   

With hindsight, the evidence showed that the sale of Autonomy to behemoth Hewlett Packard (HP) in August 2011 over a decade ago was unfortunately rather unsuccessful.  Within a year of purchasing Autonomy and with it, access to its knowledge management software, HP identified concerns regarding Autonomy’s accounting practices – alleging serious accounting irregularities including misrepresentation and disclosure errors. HP subsequently wrote down the goodwill value by billions.  In other words, HP overpaid for Autonomy.  HP found that Autonomy's intellectual property rights and perceived overall value were worth much less than its due diligence was able to confirm.  Litigation ensued on both sides of the Atlantic.

The UK’s Serious Fraud Office eventually terminated its criminal investigation into Autonomy due to ‘insufficient evidence for a realistic prospect of conviction’. 

Meanwhile HP was sued by its own disgruntled shareholders under the UK Companies Act 2006.  HP in turn successfully sued former Autonomy former CEO Mike Lynch and former Chief Financial Officer Sushovan Hussain in civil proceedings before the UK High Court to recover its financial losses.   In his defence, Mr Lynch submitted that misunderstandings as to accounting differences between the UK and the US were the problem, not deliberate fraud.  Namely, there were differences between international financial reporting standards (IFRS) use by Autonomy, and the generally accepted accounting principles (GAAP), the financial reporting standards used for US-based companies. Nevertheless, in January 2022, the Court held Mr Lynch and his CFO guilty of fraudulently inflating Autonomy’s value by misleading JP about its performance: Autonomy and others v Michael Richard Lynch and another (17 May 2022) High Court of Justice Business and Property Courts England and Wales.  At paragraph 40 of the judgment, the Court identified the alleged improper practices included:

40.1. artificially inflating and accelerating Autonomy’s revenues;

40.2. understating Autonomy’s costs of goods sold by characterizing such costs as sales and marketing expenses so as to protect gross margins;

40.3. misrepresenting Autonomy’s rate of organic growth; and

40.4. misrepresenting the nature and quality of Autonomy’s revenues as well as overstating its gross and net profits.

The damages award in favour of HP is pending and will likely be circa £4billion.  Autonomy’s auditors were also subject to civil legal proceedings.  The UK Financial Reporting Council (FRC) fined accounting firm Deloitte £15million for auditing failings of the Autonomy accounts between 2009-2011 related to hardware sales and software licences to value-added resellers, rather than to end customers. 

In the United States, the Department of Justice (DoJ) initiated a criminal investigation. In contrast to the UK’s civil judgment, the US court has now found Lynch and Hussain ‘not guilty’ of all 15wire fraud and securities fraud charges. Lynch had been extradited from the UK to San Francisco where he was under home confinement having posted a $100USD million bond. 

Decade long litigation history aside, the wider issue is that this type of financial hole calls into question the contemporary law and practice of corporate governance, financial reporting and accounting standards to the ability of professional auditors, accountants and lawyers during the due diligence phase to identify over-valuation more readily.  Further, how should the system improve standards and practices related to accounting for intangible assets to better assist auditors, purchasers and investors?

Generally speaking, the disclosures of Autonomy's intangible assets, namely, software (copyright protected) and licensing are by their nature more difficult to value than tangible assets, leading to both over and under valuation.  Accounting standard setters such as the International Financial Reporting Standards (IFRS), the European Accounting Association (EAA), and the UK Endorsement Board (UKEB) as well as academic researchers are working on how to categorise different types of intangibles, introduce taxonomies of common terminology and make recommendations to aggregate or disaggregate type of assets in order to elicit higher quality decision-useful information. This article distils the need for a new research agenda to tackle contemporary accounting in terms of granularity and comparability for intangibles, IP rights and licences to a wider audience. 

Company directors should be interested in how accounting ‘faithfully presents’ intangible assets in their own country, and when the company trades internationally.  Dr Lynch was the President of Autonomy, Inc. and subsidiary ASL and he owed legal duties as a company director.  Directors are required to sign off the audited accounts.  The CFO, Mr Hussain was held to be a de jure director of all three relevant subsidiaries, Autonomy Inc, Zantaz and ASL, and owed duties to all three. 

Company directors, auditors, internal accountants and corporate governance professionals are in an increasingly difficult position.  Intangible assets are prolific yet traditional approaches for valuing tangible assets such as computer hardware or plant and equipment do not map well to intangibles.  Therefore, the risk of litigation for misrepresentation (innocent, negligent or fraudulent) is evident.  Valuation and reporting of intangible assets is the new normal yet, intangibles is the term for a huge category of diverse corporate assets.  One sub-set of intangibles is intellectual property (IP) rights.  For example, Autonomy’s software may protected as a copyright work under the Copyright Designs and Patents Act 1988 if it meets certain legal criteria. It is usually valued by the amount of copyright licensing revenue generated. The first allegation was that Autonomy's hardware sales was 'mischaracterised' as licence revenue. The legal issue is whether this was deliberate or not.  It was alleged that both Autonomy's CEO and Finance officer had fraudulently (with knowledge) inflated the figures reported.  

However, the outcome of a series of civil and criminal court cases in two jurisdictions over 13 years turned on the applicable standard of proof. The criminal standard, proven ‘beyond a reasonable doubt’ was too high a hurdle for the prosecution to meet in the US. However, the UK High Court civil judgment decided ‘on the balance of probabilities’ handed down by the Honourable Mr Justice Hildyard stated at paragraphs 101-102:

              101. This has been an unusually complex trial, 93 days long. Dr Lynch was cross-examined for 20 days. There was a database of many millions of documents from which there was extracted a trial bundle containing more than 28,000 documents. These documents have been the most reliable source of evidence. But there were also hundreds of pages of hearsay evidence, largely comprised of transcripts from previous proceedings in the United States, both civil and criminal.

              102. Nevertheless, I have reached clear conclusions in these proceedings on the civil liability of Dr Lynch and Mr Hussain for fraud under Financial Services and Markets Act (FSMA), common law, and the Misrepresentation Act 1967, applying, of course, the civil standard of               proof of the balance of probabilities.

From HP's perspective how the numbers added up in their valuation of the relatively young Autonomy technology firm mattered. Setting fraud aside, the system needs to support stakeholders as to new norms and standards of transparency and disclosure expected for reporting on corporate intangible assets. However, even the accounting standard setters themselves are not sure ‘Which Way to Go?’ with respect to International Accounting Standard (IAS) 38 Intangibles.  International academic researchers such as the IFRS-EAA Intangibles Research Group were commissioned to produce a literature review and are currently working on evidence to underpin policy as how best improve the accounting rules related to intangible assets.  A key component involves when to formally 'recognise' revenue of intangible assets during the business lifecycle and where such material figures and information should be reported - in the accounts, notes to the accounts or in additional narrative 'disclosures' where the company directors give explanations? The research group is also evaluating court cases to study how best to ensure an appropriate governance and stewardship standard to reduce the risk of fraud to promote financial stability and the needs of our modern technology ecosystem. 

Dr Janice Denoncourt

Associate Professor

ORCID ID 0000-0003-2176-8935

IFRS-EAA Intangibles Research Group

Director IP Research Group

Nottingham Law School

Nottingham Trent University

United Kingdom

Wednesday 12 June 2024

Was the U.S. National Institutes of Health conflicted during the COVID-19 pandemic period?

Jon Cohen at Science has an interesting and informative article titled, “Accusers’ bad math: NIH researchers didn’t pocket $710 million inroyalties during pandemic,” published on June 5.  The article addresses allegations that government scientists made $710 million in royalties on COVID-19-related technologies.  Those allegations raise an interesting conflict of interest issue. 

The article is definitely worth a read to provide some clarity to the controversy.  The article does note that government researchers did receive around almost $37 million in royalties during a three-year period that were mostly related to COVID-19-related technologies.  The article also states that there is a significant limit on the amount of royalties an NIH researcher can receive a year: $150,000.  I guess the math adds up to around a maximum of $450,000 over a three period for an individual researcher.  How long will they receive those royalties?  Do we have an issue with this or is this type of system which provides an incentive for government researchers to try to invent useful and valuable inventions for the public a very good thing?  Does the yearly limit effectively eliminate the conflict of interest issue? 

Tuesday 11 June 2024

Licensing Executives Society Silicon Valley Webinar: Data Monetization and Valuation in the Age of AI

The Silicon Valley Chapter of the Licensing Executives Society is holding a webinar on Wednesday, July 17 at noon to 1:00 pm US Pacific Time titled, “Data Monetization and Valuation in the Age of AI.”  The speaker is Efrat Kasnik, LES-SVC Chair, LES Board Member and President of Foresight Valuation Group.  Here is a registration link: FREE REGISTRATION. The following is a description of the webinar and speaker bio:

Want to leverage your data and other digital assets for funding, growth and exit? In the age of AI, data is one of the most valuable assets for technology companies, and yet companies are often struggling with how to monetize and leverage those assets to raise funding or to increase valuation.

In this webinar we will be exploring the intersection of data (and other digital assets) and corporate value. Based on her experiences as a valuation expert, start-up advisor and Stanford Lecturer, Efrat Kasznik will provide practical insights, frameworks and case studies focused on valuing data as a business asset. Some of the topics that will be covered include:

  • Data & Digital Asset definitions
  • Regulatory and ownership issues
  • Data monetization business models: 2-way and 3-way models
  • Data valuation metrics
  • Case studies across industries, such as life sciences, fintech and gaming

Efrat Kasznik, LES-SVC Chair, LES Board Member, President, Foresight Valuation Group   
Efrat is an IP valuation and strategy expert with more than 25 years of consulting experience assisting clients with the valuation, strategic management and monetization of their intellectual property and technologies. She is president of Foresight Valuation Group LLC – a Silicon Valley-based IP valuation and litigation consulting firm – as well as a start-up advisory firm. Efrat is also an appointed lecturer on IP management at the Stanford Graduate School of Business (GSB), where she lectures on IP issues at the GSB’s MBA and executive education programs. Efrat specializes in analyzing IP and technology portfolios for a range of business transactions, including mergers and acquisitions, financial reporting, technology commercialization and business liquidations. She frequently testifies as an expert witness in legal cases involving damages or valuations of intellectual property and start-ups, as well as in high net worth divorce cases involving the valuation of intangible assets and technology startups. Efrat has been listed on the IAM 300 list of World Leading IP Strategists every year since 2013. She is actively involved in leadership roles with LES USA-Canada, where she currently serves as a board member, in addition to serving as Chair of the LES Silicon Valley chapter.

Friday 7 June 2024

Fool’s errand with fallacies in administrative essentiality checking

This is my second article on some topics discussed by my panel on “transparency” and in other sessions at the Patents in Telecoms and the Internet of Things conference in London recently. My first article, also published here, was on how value and royalty costs in standards and SEPs are passed along the supply chain to consumers.

The European Commission’s proposed essentiality checking and patent counting at the EUIPO is troubling. While parties are entitled to present whatever methods and studies they wish to imply Standard Essential Patent (SEP) portfolio strength in licensing negotiations or to the courts in litigation, the proposed registry with mandatory essentiality checking on random samples of patents will give a false sense of security on the applicability, accuracy and reliability of such checks, measures and any royalty charges derived from them. Essentiality determinations and patent counts provide a poor and unproven gauge of patent portfolio strength. Methods fail a key integrity test for any evaluation or measurement system because results are not reproducible. Despite the EUIPO being ordained the official authority on determining patent essentiality, its checking will be as contestable technically as for private evaluators and their studies that already check essentiality, count patents and invariably disagree with each other. Nevertheless, even though determinations are non-binding they will have significant sway with the courts.

A European Parliament press release issued following a January 2024 Legal Affairs Committee vote to adopt “New rules to promote standard-setting innovation in new technologies” states that “in 5G almost 85% of the standard essential patents are in fact non-essential. The new essentiality test will stop the occurrence of over-declaration”.

Some studies do indeed indicate essentiality rates of only 15% (i.e. 100%-85% = 15%) or even less in some cases—which might well be correct—but there is no evidence to support the latter contention that checking will improve the declaration behaviour of patent owners. There is no shame or sanction for over-declaration. Bias in essentiality checking—that is most severe at such low essentiality rates—means that the effects of over-declaration can only be somewhat moderated by checking. Over-declaration can never be anywhere near eliminated. The bias incentivises over-declaration despite checking. Rather than stopping over-declaration, institutionalized checking by the EUIPO will likely motivate patent owners to game the system by declaring even more patents of dubious essentiality.

Essentiality is subjective and only one among various factors affecting patent strength

Patent strength is a function of validity, infringement and technical contribution, as well as essentiality to the standards. While some parts of standards go unimplemented, are rarely used, become obsolete or are peripheral to where standards provide most innovative value, other parts are fundamental to very significant improvements with new technologies such as 5G. For example, various radio access network technology improvements have increased network speeds and capacities one hundred thousand-fold (e.g. from 10 kbps to 1 Gbps) since the introduction of 2G data in the mid-1990s.

Some characteristics can be objectively, reliably and reproducibly checked, others cannot. Patent essentiality and validity are matters of judgment where different assessors will often disagree about what are ostensibly yes-no decisions. As stated by the judges’ decisions in Unwired Planet v Huawei and TCL v Ericsson, respectively:

“Based on my assessment of both experts, I am sure the disagreement represents cases in which reasonable people can differ.” (Paragraph 335.)

“Given the somewhat subjective nature of these determinations, ‘disagreements’ is probably a more accurate label than ‘error.’" (Footnote 16.)

By way of analogy: on the one hand, selections of beauty pageant and international song contest winners are also subjective tasks that can be swayed by judges’ predilections and do not have reproducible results with different assessors; on the other hand, and in marked contrast to all the above, checks such as the UK’s annual car roadworthiness MOT test is highly objective and reproducible. Two different test centres would reliably come up with the same pass-fail result for the same car after verifying that brakes work, turn indicators flash, and measuring that tyre tread depth is sufficient, among other checks.

Determining true essentiality is made more difficult by the fact that patent counters have very different objectives to those agreed by consensus in Standard Setting Organizations. ETSI merely wants to ensure standards such as 5G are not blocked by demanding patent owners declare whether they believe a patent might be or might become essential. ETSI never checks essentiality and does not want to do so. Essentiality declarations such as those in ETSI’s IPR database were never intended to be used for royalty rate determinations in Fair, Reasonable and Non-Discriminatory (FRAND) licensing, as sought by the Commission with the EUIPO’s registry and additional steps of essentiality checking and patent counting.

Only the courts can definitively determine which patents are truly essential, which are not invalid and valuate portfolios. Cases in litigation illustrate how uncertain everything is and how expert opinions differ. The challenges in assessing essentiality were extensively discussed at the conference. Issues include interpretation of patent claims and that the scope of these can be entwined with validity. Prosecution history can be pertinent in making determinations. As patents are amended to cover the standard they can include what has been contributed to the standard by others. With many patents being found invalid by the courts, validity should not be ignored on the path to determining value, as it is in the Commission’s proposed checking. Validity can be the most significant factor affecting SEP value.

In FRAND litigation, highly experienced top minds including judges, experts and those representing the parties spend many months at multi-million dollar costs evaluating and deliberating—with various disagreements on essentiality and validity of litigated patents prior to judgment—even though typically only a few patents are examined.

If all that work including analysis of claim charts and patent prosecution histories is actually required to do a proper job on only a few patents, how can we trust the accuracy of the EUIPO’s experts examining orders of magnitude more patents and whose determinations ignore the crucial issue of validity? While the courts tend only to have the resources to do the required assessments on no more than a handful of patents in each case, there are many tens of thousands of patents and patent families declared essential to standards such as 5G. It is unsurprising that the UK courts have tended to reject patent counting as a means of determining FRAND royalties, except in some cases as a cross-check for determinations primarily based on comparable licensing agreements.

Unscalable checking

One proposed way dealing with the insurmountable task of checking all a standard’s declared patents is to check only random samples of them. The hope is that it would be possible to check a manageably small number of them very thoroughly and accurately. Consensus is that accuracy can best be achieved with the preparation and use of claim charts.

However, there are several problems with this approach, as illustrated in my empirical research in 2021 and 2022:

  • Even when claim charts are used to assist in determining essentiality, different assessors still disagree widely in their determinations with agreement on only around 83% of them. That’s not as good as it might seem when one considers that different assessors can be expected to agree on precisely 50% of them if one assessor was making determinations randomly based on the flip of a coin. If two assessors disagree in their determinations, at least one of them must be wrong. However, if two different assessors are in agreement, that does not mean the determination is correct.

  • Inaccurate determinations cause a substantial upward systematic bias in essentiality rates derived after checking. My empirical research shows that the proportion of false positive essentiality determinations will greatly outnumber false negatives at essentiality rates of 15% or less.

  • Sample sizes need to be large (e.g. >1,000) if true essentiality rates are at 15% or below and if, for example, accuracy within ± 15% at the 95% confidence level is required. Sampling error as a proportion of true essentiality rate increases at lower and lower levels of true essentiality.

  • Sampled patents cannot be appealed and reassessed without destroying the integrity of the sample. For example, if one in ten patents is sampled the determination has a 10x effect implied in the entire population count. With inevitable selection bias in appealed patents, “corrected” determinations will have a distorted and magnified effect implied in the overall population.

  • However, it would be to deny justice not to allow some kind of appeals procedure on determinations made by a public authority. This issue could weigh heavily in FRAND dispute litigation.

  • It’s very costly. Ericsson testified in TCL v Ericsson that it took 50 man-hours per patent to prepare claim charts.

What the Commission is seeking to concoct at the EUIPO will produce yet more patent counting studies, somewhat like what PA Consulting has been producing regularly for years and that several other firms have published from time to time. PA’s studies are widely used because others use and seemingly take heed of their results—not because they are proven to be accurate and reliable, because it is impossible to prove that. Here’s what Justice Smith had to say in the Optis v. Apple judgment:

“So, as with validity – but for different reasons – making a judgement about levels of essentiality in the stack is unreliable and unsafe.

My conclusion is that – accepting entirely that PA Consulting seeks to do a careful job – for the purposes of a judicial determination of what is fact, the PA Consulting/Optis approach to determining Stack size (or the figure for the denominator) is not to be relied upon.

I accept that were a reliable qualitative assessment to be possible, that might well be preferable. But an unreliable qualitative assessment – especially where even the magnitude of the error is unknown – is not (in my judgement) an acceptable metric to use when seeking to answer the FRAND Question.

I cannot use the PA Consulting data as a metric in answering the FRAND Question.”

Patent counting is simplistic

Even checking both essentiality and validity is woefully insufficient in determining patent value. It’s widely recognized that different patents vary in value enormously—by orders of magnitude from virtually worthless to some real gems. The significance of a patent’s technical contribution to a standard and value in implementation can vary from being seldom used or of marginal worth to being fundamental functionality that might enable major cost savings or increases in customer utility or revenues to be generated. Convenience aside, there is, therefore, no basis for assuming that portfolio value is in proportion to any kind of patent count (i.e. of declared, found essential or found not invalid patents). On the contrary, some patent owners likely have a much larger proportion or number of gems than others. However, even approximately how much more is an unanswered empirical question.

Ministry of Patent Counting and Red Tape

The Commission’s proposals for registering, checking and counting patents, among other demands in the proposed legislation, is also in conflict with the stated objectives of European leaders.

French and German leaders Emmanuel Macron and Olaf Scholz recently co-wrote an op-ed in the Financial Times setting out some laudable objectives:

“With an ambitious industrial policy, we can enable the development and rollout of key technologies of tomorrow, such as AI, quantum technologies, space, 5G/6G, biotechnologies, net zero technologies, mobility and chemicals.

We call for strengthening the EU’s technological capabilities by promoting cutting-edge research and innovation and necessary infrastructures.

We call for an ambitious bureaucracy reduction agenda to deliver on simpler and faster administrative procedures and cutting bureaucratic burdens for businesses of all sizes. We welcome the European Commission’s initiative to reduce reporting obligations for our companies by 25 per cent.” (hyperlink added)

The Commission’s proposed demands for patent registration at the EUIPO, together with preparation and submission of additional information such as patent claim charts will substantially increase administrative burdens for European companies such as Ericsson and Nokia that remain dependent on SEP licensing income. These new burdens will cause friction, delays and diminution in the well established, highly effective and self-sustaining innovation loop in which licensing fees are used to fund further R&D, leading to the creation of yet more valuable new technologies.

Better to have scarce and costly technical experts innovating and prosecuting their own patents, or designing and testing new products, rather than tying up hundreds of them generating additional information for checkers and in doing the checking—at patent owners and at the EUIPO, respectively.

Transparency about what?

There was consensus at the conference that greater transparency could help with FRAND licensing for SEPs. However, rather than burdening licensees with voluminous disclosures on patent claims and with delays while conciliators deliberate about aggregate royalties and technical experts check patents for essentiality, it would be better to have licensors and licensees disclose more about actual licensing. This should include terms in licensing agreements and information on licensed trade including volumes and prices. If parties are unwilling to make such information public, then it could be disclosed to a confidential repository with limited access, information anonymised and other safeguards. Let’s find out more about what’s happening already and rely on that, rather than trying to make things up with top-down rate setting.

In Q&A under the Chatham House Rule, I asked another panel whether a modicum of accuracy and reliability can be achieved in essentiality checking to determine patent portfolio strength. Bad news — no. Good news — it’s probably not necessary because most licences get agreed, regardless.

While I believe it would be best for the Commission to abandon is proposed checking and rate setting, if it does proceed it should consider recommendations about how to do that competently and with recognition of limitations, as explained in my publications cited with hyperlinks in this article.

Keith Mallinson, founder of WiseHarbor, has more than 25 years of experience in the telecommunications industry as a research analyst, consultant and testifying expert witness.