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

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