THE SOX PARADOX REVISITED: WHAT THE COURTS WANT YOU TO DO ABOUT INFORMATION TECHNOLOGY AND WHAT YOU CAN GET OUT OF IT

  By Michael A. Gold, Esq. and Nevin Sanli, ASA

Sarbanes Oxley was a headache for businesses, but the transparency it forced on them also blessed many with an unexpected benefit – higher market valuations.  Now the federal court system is about to hit businesses with a different headache that may produce similar results for companies that act now.  

Starting December 1 the federal courts will impose new rules of procedure on business litigants requiring that companies create, handle, and store their business records with one eye on their business needs and the other on the legal system. Why? Because the courts want companies to produce evidence with minimal delay and fuss when they become involved in litigation.

The immediate target of these new rules is the legal profession; the courts want lawyers to adapt to the computer age. But business will do the heavy lifting to enable lawyers to comply with the new rules, and some will have to overhaul their information technology systems from top to bottom, very possibly at considerable expense.  

There is, however, good news in all of this.  If they are proactive in handling the job, companies stand a good chance of enhancing their own value, just as they did with Sarbanes Oxley, because the good bet is that compliance with the new rules will eventually cut their legal bills and improve corporate governance.  

The problem stems from the ease with which businesses collect records in the computer age. In the past, faced with the burden of keeping paper records, businesses limited their record-keeping to essential documents, and the courts found it relatively easy to determine the authenticity of such records as came into evidence. In the computer age, on the other hand, it is easy to store, alter, lose, or even destroy records because they are, after all, merely electronic pulses stashed in one or another of many places – on a server, a work station, a laptop, a flash drive, even a phone.

The consequence is that companies not strictly policing the process keep altogether too many “records,” and they can’t easily distinguish wheat from chaff when they must go to court.

The courts want businesses to get on top of this problem by developing comprehensive policies designed to store, catalog, and preserve electronic records so that they can produce reliable evidence on demand with a minimum of fuss and bother.

In the long run the new rules will cut costs from companies’ legal bills; at present, the discovery process in complex litigation – that is, the process of sifting through company records to find those that are relevant to the issue at hand – can run into hundreds of thousands and sometimes millions of dollars. In the short run companies may run up big tabs to overhaul their record systems, although it’s impossible to put numbers to the effort at the moment, since only the biggest companies appear to have begun the effort and many of them haven’t finished.

For companies that haven’t begun the process, getting into compliance before December 1 may prove difficult, according to Richard Battista, CEO of Gemstar-TV Guide International, Inc.

“Companies that have significant experience with complex litigation may have an advantage in being better prepared because they have dealt with large electronic discovery projects and are more likely to appreciate the implications of the new rules for them,” Battista says.  “But those companies whose counsel has not already begun evaluating the rules changes in conjunction with their IT departments may find themselves in a difficult position in 2007.”

This is not to say, however, that businesses must make it their chief goal to keep the courts happy, according to Ron Naves, who as senior vice president of legal affairs and litigation oversees Gemstar-TV Guide’s efforts to comply with the new rules. Businesses must carry out their legal duty to produce evidence for the courts, Naves says, but not at the expense of business itself.

"You want to make sure that your policies comply with the company’s legal and ethical duties to preserve and produce relevant data when litigation arises, but you start with the company’s business needs and then make adjustments as needed to meet your legal and ethical duties,” Naves says.

“Sometimes a misunderstanding about what the legal requirements actually are can add unnecessary complexity and expense to litigation. For example, do you need to keep ten years’ worth of backup tapes? It is hard to imagine a good business reason for that. The purpose for keeping backup tapes is generally routine disaster recovery. The decision about how long to keep backup tapes should be driven by the company’s business needs, not by misunderstanding or neglect.”

Put another way, companies should discard data in the absence of a good business or legal reason to keep it – and stand guard over what they keep. This means:

• Policing data to ensure its security by controlling both access and distribution before and after litigation commences;

• Developing ways to file, search and retrieve data by subject matter and indexing;

• Training employees to follow proper recordkeeping procedures so that they keep only what they need to do their jobs and discard the rest, including unnecessary e-mail and other data, and

• Monitoring the entire process so as to demonstrate the reliability of the evidence companies produce in court.

At present the new rules apply only to litigants in federal court, but it is only a matter of time before the state courts impose similar rules. This means that any company likely to find itself involved in litigation at any level – meaning any company doing business – will have to comply with the new rules sooner or later, and the sooner they get started on the job, the better.

"I think the new rules are a welcome improvement,” Gemstar-TV Guide’s Ron Naves says, “because they provide adversaries with a useful framework for resolving e-discovery issues at a very early stage in litigation.

“Although most big companies are aware that these new rules are coming down the road," he adds, "I’m not sure how many perceive the importance of updating their document management policies and procedures before the rules go into effect. I do know that many companies do not manage their electronic data efficiently. The new federal rules underscore the need for a close working relationship between a company’s IT and legal departments."

Clearly, complying with the new rules for electronic discovery will present many companies with serious challenges, but if the history of Sarbanes Oxley is a guide, those that do so proactively may well see their market valuations go up, for two reasons. First, for any company, the strict policing of company recordkeeping should ease the burden of discovery in litigation, with savings that can quickly mount into seven figures. Second, in the computer age, good recordkeeping means better corporate governance, and as Cynthia Glassman, SEC chairwoman, noted in a speech in September 2002, only months after SOX became law, better governance under SOX has translated into higher values. This has been borne out since then by the higher multiples being paid by institutional and other financial and strategic buyers for SOX-compliant middle-market companies in particular.

Getting into compliance with the new rules of evidence is a good idea for one other reason – namely that not doing so could be disastrous. Last year, in fighting fraud charges brought against it by investor Ronald Perelman, Morgan Stanley showed itself so sloppy in its e-mail recordkeeping that the judge in the matter ruled that the investment banking house had acted in bad faith. The result? A $1.45 billion verdict in Perelman’s favor.

Michael A. Gold is a partner in the Los Angeles law firm Jeffer Mangels Butler & Marmaro. He is co-chair of the firm’s Discovery Technology GroupTM and has more than 25 years of experience representing companies in the software and technology industries, among others. He may be reached at mag@jmbm.com. Nevin Sanli, ASA, president and co-founder of the Los Angeles business valuation firm Sanli Pastore & Hill, has valued more than 1000 businesses in his career and has provided expert testimony at both the state and federal level. He may be reached at nsanli@sphvalue.com.