The Dangers of Electronic Discovery: Lessons From Morgan Stanley

As has been widely publicized, on May 16 a Florida state court jury awarded $604.3 million in compensatory damages and later an additional $850 million in punitive damages to Coleman Holdings, Inc., the camping gear maker formerly owned by billionaire investor Ronald Perelman, in Coleman's fraud suit against powerhouse investment banker Morgan Stanley & Co. The verdict was notable not only because of its size, but also because of how it came about.

Shortly before the trial, after nearly 2 years of litigation, Judge Elizabeth Maass issued a partial default judgment against Morgan Stanley for what she characterized as a repeated failure to produce e-mails requested by Perelman during discovery. Judge Maass indicated that she would affirmatively instruct the jury to assume that Morgan Stanley had participated in a fraud. At the beginning of the trial, Judge Maass did exactly that; telling the jury that it was to assume that “Morgan Stanley participated in a scheme to mislead (Coleman) and others and to cover up massive fraud.” Though Perelman still needed to prove that he relied on Morgan Stanley, the judge's extraordinary instruction rendered an adverse verdict against Morgan Stanley a fait accompli.

The Morgan Stanley case is the most recent example of the perils that corporate defendants face in the era of electronic discovery. Electronic evidence, and especially e-mail, now plays a starring role in litigation and investigations involving large corporations, particularly in areas such as employment discrimination, fraud and corporate mismanagement. Judges are increasingly familiar with electronic discovery, and are increasingly willing to impose heavy sanctions on corporations who do not comply with electronic discovery requests. As the Morgan Stanley case shows, the consequences of these sanctions can be dire. Therefore, it is important that companies take heed of the lessons of the Morgan Stanley case, and ensure that they have in place a comprehensive and effective system to recover and produce electronically stored documents.

Background of Morgan Stanley

Coleman sued Morgan Stanley over a $1.5 billion transaction in 1998, through which appliance-maker Sunbeam Corp. bought Perelman's 82% stake in Coleman. Not long after the sale, Sunbeam was rocked by allegations of accounting fraud that sent the company into bankruptcy. Coleman alleged that Morgan Stanley, Sunbeam's financial adviser on the deal with whom Perelman had a long history, knew about the accounting fraud and concealed it from Perelman. Coleman served extensive requests for e-mails dating back 5 years before the lawsuit was filed. In April 2004, following objections from Morgan Stanley, Judge Maass ordered that the firm search its “oldest full backup” tapes.

About 2 months later, the technology officer at Morgan Stanley charged with overseeing the firm's search certified that the firm's oldest available tapes dated back to January 2000. However, just weeks earlier, a Morgan Stanley employee found over 1,400 e-mails in a storage closet in Brooklyn that had not been searched. The firm's policies for locating and searching its tapes for relevant e-mails were reportedly insufficient or completely non-existent, the software used for searching had bugs that went undiscovered for months, and new tapes kept popping up. As recently as this February, a Morgan Stanley tech executive found more than 100 additional tapes in a Manhattan office. Though Morgan Stanley claimed that none of the newly discovered e-mails helped Perelman, Perelman's attorneys claimed that they contained “significant information.” The trial was delayed several times, reportedly because of Morgan Stanley's problems producing e-mails. Finally, in March, Judge Maass entered an “adverse inference” order shifting the burden of proof from Coleman to Morgan Stanley. A month later, after more delays, Judge Maass issued the partial default judgment and delivered the critical instruction to the jury.

A Brief Survey of e-Discovery Laws

As is the case with discovery generally, the laws relating to electronic discovery vary greatly among jurisdictions, but some general principles apply. Below are some important questions that companies should consider when faced with litigation that may require electronic discovery.

What electronic information is discoverable?

Courts have uniformly found that electronically stored evidence is discoverable as long as it meets the relevancy standards generally applicable to the discovery of documents and information, such as in Bills v. Kennecott Corp., 108 F.R.D. 459, 461 (D. Utah 1985), in which the court stated that: “It is now axiomatic that electronically stored information is discoverable under Rule 34 of the Federal Rules of Civil Procedure.” Parties may be compelled to produce not only documents that are readily available for printing such as word processing files and e-mails, but also drafts, deleted files and databases. For instance, Federal Rule 34 permits the discovery of any “data compilations from which information can be obtained, translated, if necessary, by the respondent through detection devices into reasonably usable form.”

What is the duty to preserve electronically stored data?

The Morgan Stanley case illustrates the danger of having an unclear document-retention policy ' or having no policy at all. A company that does not maintain a policy for the routine destruction of electronic materials may find itself in the position of having to backtrack on its own representations to the court, as Morgan Stanley did. In addition, companies that do not carefully adhere to document-retention policies may find themselves accused of spoliation. Typically, courts look at the following factors to determine if a party should be sanctioned for spoliation:

• Whether a duty to preserve existed;
• Whether the party acted in bad faith;
• The importance of the evidence and;
• The prejudice to the opposing party.

A duty to preserve may be created by statute or rule, or by dealings between the parties. Some jurisdictions now impose duties on parties and/or their counsel to investigate and preserve electronically stored data at an early point in litigation. For example, New Jersey federal courts require counsel to review their clients' information management systems prior to the initial discovery conference. A common law duty to preserve, however, may exist even before litigation commences if the party “should reasonably know that the evidence may be relevant to anticipated litigation.” Silvestri v. General Motors Corp., 271 F.3d 583, 591 (4th Cir. 2001). Some courts have found spoliation even when the failure to preserve was merely negligent and not in bad faith. In MOSAID Techs., Inc. v. Samsung Elecs. Co., 348 F.Supp.2d 332, 338, for example, the court found that negligent destruction of relevant evidence can give rise to an inference of spoliation and endorsed a jury instruction to that effect.

Courts will respect a company's document-retention policy regarding the routine destruction of data to the extent that it is reasonable. In fact, in its recent opinion in the Arthur Andersen case, the Supreme Court observed that document retention policies “are common in business” and “it is, of course, not wrongful for a manager to instruct his employees to comply with a valid document reduction policy under ordinary circumstances.” Arthur Andersen LLP v. U.S., 2005 WL 1262915 (U.S. May 31, 2005). Reasonableness will turn on factors such as the type of data involved, the likelihood that the data will be relevant to litigation and whether the document retention policy was instituted in bad faith. See, Lewy v. Remington Arms Co., Inc., 836 F.2d 1104, 1112 (8th Cir. 1988).

Who must pay for electronic discovery?

Different courts have adopted different standards to determine who should pay the costs when a party is required to undergo an extensive search of its electronic data. The most influential decisions in this area come from the Southern District of New York, and in particular, Rowe Entertainment, Inc. v. The William Morris Agency, Inc., 205 F.R.D. 421 (S.D.N.Y. 2002) and Zubulake v. UBS Warburg LLC, 217 F.R.D. 309 (S.D.N.Y. 2003). Zubulake set forth a cost-shifting analysis consisting of seven factors ' largely borrowed from Rowe, with some modification ' in order of importance:

1. The extent to which the request is specifically tailored to discover relevant information;
2. The availability of such information from other sources;
3. The total cost of production, compared to the amount in controversy;
4. The total cost of production, compared to the resources available to each party;
5. The relative ability of each party to control costs and its incentive to do so;
6. The importance of the issues at stake in the litigation; and
7. The relative benefits to the parties of obtaining the information.

Zubulake, 271 F.R.D. at 323.

What Counsel Can Do to Reduce the Risk of Sanctions

The best thing that companies and counsel can do to avoid sanctions such as those faced by Morgan Stanley is to plan for disasters before they occur. There are certain things that counsel ought to do at the outset of litigation ' or even when there is no litigation on the horizon ' to protect themselves.

1. Understand the company's technology. Counsel should regularly assess the company's technology infrastructure, to understand how, where and when electronic data is preserved, stored and ultimately discarded.

2. Designate appropriate people with knowledge of the company's data management systems. Companies should know exactly whom the appropriate personnel are to approach when discussing the scope and nature of the company's data management systems to avoid any confusion.

3. Develop a clear document-retention policy. Companies should ensure that their document-retention policies are easily understandable and transparent, that employees are aware of and abide by them, and that there are clear lines of communication between technology personnel and other employees regarding the policies.

4. Establish a “litigation hold” rule. Every document-destruction policy should have clear rules stating when the destruction of data should be halted because of threatened or pending litigation or regulatory investigation.

5. Develop a document production plan early on in litigation. Counsel should assess, at the beginning of litigation, what types of electronic data may be relevant to the litigation and how long it will take to search through and produce electronic files. Interviews should be conducted with all of the appropriate designated people with knowledge of the company's data management system. Estimates of time needed to complete production should be reasonable, and counsel should leave room for unanticipated problems such as software bugs.

Conclusion

The Morgan Stanley verdict is an excellent illustration of the significance of electronic discovery and the serious consequences that can result if companies do not take the utmost care in their procedures for searching and producing electronic files. The case will no doubt be remembered for a long time as a cautionary tale for both companies and their counsel.

[Editor's Note: LJN publishes a newsletter dedicated to electronic discovery issues ' e-Discovery Law & Strategy. For more, see www.ljnonline.com/alm?edisc.]

As has been widely publicized, on May 16 a Florida state court jury awarded $604.3 million in compensatory damages and later an additional $850 million in punitive damages to Coleman Holdings, Inc., the camping gear maker formerly owned by billionaire investor Ronald Perelman, in Coleman's fraud suit against powerhouse investment banker Morgan Stanley & Co. The verdict was notable not only because of its size, but also because of how it came about.

Shortly before the trial, after nearly 2 years of litigation, Judge Elizabeth Maass issued a partial default judgment against Morgan Stanley for what she characterized as a repeated failure to produce e-mails requested by Perelman during discovery. Judge Maass indicated that she would affirmatively instruct the jury to assume that Morgan Stanley had participated in a fraud. At the beginning of the trial, Judge Maass did exactly that; telling the jury that it was to assume that “Morgan Stanley participated in a scheme to mislead (Coleman) and others and to cover up massive fraud.” Though Perelman still needed to prove that he relied on Morgan Stanley, the judge's extraordinary instruction rendered an adverse verdict against Morgan Stanley a fait accompli.

The Morgan Stanley case is the most recent example of the perils that corporate defendants face in the era of electronic discovery. Electronic evidence, and especially e-mail, now plays a starring role in litigation and investigations involving large corporations, particularly in areas such as employment discrimination, fraud and corporate mismanagement. Judges are increasingly familiar with electronic discovery, and are increasingly willing to impose heavy sanctions on corporations who do not comply with electronic discovery requests. As the Morgan Stanley case shows, the consequences of these sanctions can be dire. Therefore, it is important that companies take heed of the lessons of the Morgan Stanley case, and ensure that they have in place a comprehensive and effective system to recover and produce electronically stored documents.

Background of Morgan Stanley

Coleman sued Morgan Stanley over a $1.5 billion transaction in 1998, through which appliance-maker Sunbeam Corp. bought Perelman's 82% stake in Coleman. Not long after the sale, Sunbeam was rocked by allegations of accounting fraud that sent the company into bankruptcy. Coleman alleged that Morgan Stanley, Sunbeam's financial adviser on the deal with whom Perelman had a long history, knew about the accounting fraud and concealed it from Perelman. Coleman served extensive requests for e-mails dating back 5 years before the lawsuit was filed. In April 2004, following objections from Morgan Stanley, Judge Maass ordered that the firm search its “oldest full backup” tapes.

About 2 months later, the technology officer at Morgan Stanley charged with overseeing the firm's search certified that the firm's oldest available tapes dated back to January 2000. However, just weeks earlier, a Morgan Stanley employee found over 1,400 e-mails in a storage closet in Brooklyn that had not been searched. The firm's policies for locating and searching its tapes for relevant e-mails were reportedly insufficient or completely non-existent, the software used for searching had bugs that went undiscovered for months, and new tapes kept popping up. As recently as this February, a Morgan Stanley tech executive found more than 100 additional tapes in a Manhattan office. Though Morgan Stanley claimed that none of the newly discovered e-mails helped Perelman, Perelman's attorneys claimed that they contained “significant information.” The trial was delayed several times, reportedly because of Morgan Stanley's problems producing e-mails. Finally, in March, Judge Maass entered an “adverse inference” order shifting the burden of proof from Coleman to Morgan Stanley. A month later, after more delays, Judge Maass issued the partial default judgment and delivered the critical instruction to the jury.

A Brief Survey of e-Discovery Laws

As is the case with discovery generally, the laws relating to electronic discovery vary greatly among jurisdictions, but some general principles apply. Below are some important questions that companies should consider when faced with litigation that may require electronic discovery.

What electronic information is discoverable?

Courts have uniformly found that electronically stored evidence is discoverable as long as it meets the relevancy standards generally applicable to the discovery of documents and information, such as in Bills v. Kennecott Corp. , 108 F.R.D. 459, 461 (D. Utah 1985), in which the court stated that: “It is now axiomatic that electronically stored information is discoverable under Rule 34 of the Federal Rules of Civil Procedure.” Parties may be compelled to produce not only documents that are readily available for printing such as word processing files and e-mails, but also drafts, deleted files and databases. For instance, Federal Rule 34 permits the discovery of any “data compilations from which information can be obtained, translated, if necessary, by the respondent through detection devices into reasonably usable form.”

What is the duty to preserve electronically stored data?

The Morgan Stanley case illustrates the danger of having an unclear document-retention policy ' or having no policy at all. A company that does not maintain a policy for the routine destruction of electronic materials may find itself in the position of having to backtrack on its own representations to the court, as Morgan Stanley did. In addition, companies that do not carefully adhere to document-retention policies may find themselves accused of spoliation. Typically, courts look at the following factors to determine if a party should be sanctioned for spoliation:

• Whether a duty to preserve existed;
• Whether the party acted in bad faith;
• The importance of the evidence and;
• The prejudice to the opposing party.

A duty to preserve may be created by statute or rule, or by dealings between the parties. Some jurisdictions now impose duties on parties and/or their counsel to investigate and preserve electronically stored data at an early point in litigation. For example, New Jersey federal courts require counsel to review their clients' information management systems prior to the initial discovery conference. A common law duty to preserve, however, may exist even before litigation commences if the party “should reasonably know that the evidence may be relevant to anticipated litigation.” Silvestri v. General Motors Corp. , 271 F.3d 583, 591 (4th Cir. 2001). Some courts have found spoliation even when the failure to preserve was merely negligent and not in bad faith. In MOSAID Techs., Inc. v. Samsung Elecs. Co. , 348 F.Supp.2d 332, 338, for example, the court found that negligent destruction of relevant evidence can give rise to an inference of spoliation and endorsed a jury instruction to that effect.

Courts will respect a company's document-retention policy regarding the routine destruction of data to the extent that it is reasonable. In fact, in its recent opinion in the Arthur Andersen case, the Supreme Court observed that document retention policies “are common in business” and “it is, of course, not wrongful for a manager to instruct his employees to comply with a valid document reduction policy under ordinary circumstances.” Arthur Andersen LLP v. U.S., 2005 WL 1262915 (U.S. May 31, 2005). Reasonableness will turn on factors such as the type of data involved, the likelihood that the data will be relevant to litigation and whether the document retention policy was instituted in bad faith. See , Lewy v. Remington Arms Co., Inc. , 836 F.2d 1104, 1112 (8th Cir. 1988).

Who must pay for electronic discovery?

Different courts have adopted different standards to determine who should pay the costs when a party is required to undergo an extensive search of its electronic data. The most influential decisions in this area come from the Southern District of New York, and in particular, Rowe Entertainment, Inc. v. The William Morris Agency, Inc. , 205 F.R.D. 421 (S.D.N.Y. 2002) and Zubulake v. UBS Warburg LLC , 217 F.R.D. 309 (S.D.N.Y. 2003). Zubulake set forth a cost-shifting analysis consisting of seven factors ' largely borrowed from Rowe, with some modification ' in order of importance:

1. The extent to which the request is specifically tailored to discover relevant information;
2. The availability of such information from other sources;
3. The total cost of production, compared to the amount in controversy;
4. The total cost of production, compared to the resources available to each party;
5. The relative ability of each party to control costs and its incentive to do so;
6. The importance of the issues at stake in the litigation; and
7. The relative benefits to the parties of obtaining the information.

Zubulake, 271 F.R.D. at 323.

What Counsel Can Do to Reduce the Risk of Sanctions

The best thing that companies and counsel can do to avoid sanctions such as those faced by Morgan Stanley is to plan for disasters before they occur. There are certain things that counsel ought to do at the outset of litigation ' or even when there is no litigation on the horizon ' to protect themselves.

1. Understand the company's technology. Counsel should regularly assess the company's technology infrastructure, to understand how, where and when electronic data is preserved, stored and ultimately discarded.

2. Designate appropriate people with knowledge of the company's data management systems. Companies should know exactly whom the appropriate personnel are to approach when discussing the scope and nature of the company's data management systems to avoid any confusion.

3. Develop a clear document-retention policy. Companies should ensure that their document-retention policies are easily understandable and transparent, that employees are aware of and abide by them, and that there are clear lines of communication between technology personnel and other employees regarding the policies.

4. Establish a “litigation hold” rule. Every document-destruction policy should have clear rules stating when the destruction of data should be halted because of threatened or pending litigation or regulatory investigation.

5. Develop a document production plan early on in litigation. Counsel should assess, at the beginning of litigation, what types of electronic data may be relevant to the litigation and how long it will take to search through and produce electronic files. Interviews should be conducted with all of the appropriate designated people with knowledge of the company's data management system. Estimates of time needed to complete production should be reasonable, and counsel should leave room for unanticipated problems such as software bugs.

Conclusion

The Morgan Stanley verdict is an excellent illustration of the significance of electronic discovery and the serious consequences that can result if companies do not take the utmost care in their procedures for searching and producing electronic files. The case will no doubt be remembered for a long time as a cautionary tale for both companies and their counsel.

[Editor's Note: LJN publishes a newsletter dedicated to electronic discovery issues ' e-Discovery Law & Strategy. For more, see www.ljnonline.com/alm?edisc.]