Now It's Personal: Intangible Asset Mismanagement Liability

When an aspiring writer pens “The prophets of financial cataclysms” in the not too distant future, some now-household names will grace the table of contents. Nouriel Roubini, an economist nicknamed “Dr. Doom,” has earned his place in this book for writing in 2006 that ” ' the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession.” Harry M. Markopolos, a securities fraud investigator, earned his place for repeatedly tipping off the U.S. Securities and Exchange Commission since 1999 that it was not legally possible for Bernard Madoff to deliver the returns he'd claimed to deliver. Cathy L. Reese ' maybe you haven't heard of her yet. Allow me to share.

Cathy L. Reese is a principal in the Delaware office of Fish & Richardson P.C., where she heads the firm's corporate and Chancery litigation practice. Readers of this newsletter no doubt appreciate that these courts render judgment on the conduct of directors and officers of Delaware corporations, especially their fiduciary obligations to shareholders. Since 70% of U.S. public companies are formed under Delaware law, decisions arising from these courts receive wide attention.

The Cost of Sleeping at the Switch

On Friday, Feb. 6, 2009, Reese led a conference call hosted monthly by the Intangible Asset Finance Society (www.iafinance.org). The topic was the director's duty of oversight with respect to intangible asset management, and Reese shared her view of the implications of recent rulings.

Intangible assets (“IA”) are valuable corporate assets. Companies are expected to monetize them. Companies are expected to have systems to identify, track, protect, and report their monetization activities to their Boards. Boards are expected to oversee this process on behalf of shareholders. As a result of two watershed cases, a Board that fails in its duty of oversight now places individual directors at risk for personal liability.

Being in the corporate reputation protection business, this caused me to sit up. Surely, I thought, boards enable those charged with oversight to exercise their best business judgment without fear of personal financial ruin. Director and officer duties include: due care, loyalty, duty of candor, and good faith. As long as they are exercised appropriately, directors and officers are immunized from second-guessing by the business judgment rule. Or so I thought. Now, as I learned, failure to act may no longer be protected.

According to Reese, the logic that placed cross hairs on individual board members comprises three steps. First, through In re Caremark Int'l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996), and Stone v. Ritter, 2006 Del. LEXIS 597 (Del. 2006), the courts extended the duty of care to include oversight and affirmed that directors and officers could be held liable for “unconscionable failure[s] of the board to act in circumstances in which due attention would, arguably, have prevented the loss” or in “circumstances in which loss eventuates not from a decision but, from unconsidered inaction” (i.e., “liability for failure to monitor”); the court suggested that oversight comprised systems and controls to set guidelines, systems to monitor and enforce compliance, and systems to monitor and mitigate risks (emphasis added). Third, critically, is that a director or officer who fails to uphold his duty of care ' now more broadly defined to include oversight ' could be personally liable.

Reese then recapped for the laymen on the call. The bottom line, she said, is that directors and officers cannot seek shelter behind Delaware's business judgment rule if they are unaware of what is going on in their companies and do not exercise judgment.

A Reign of Terror?

Is a bloodbath imminent? Does the financial market collapse that wiped out $30 trillion in IA value and reduced the median intangible asset fraction of corporate value from 70% to around 50% mark the beginning of an interminable string of litigation?

Not necessarily, suggests Reese. She notes that in both landmark cases, the boards were found not liable because they had oversight systems in place. The boards acted on the advice of counsel, they had compliance plans and dedicated compliance officers, they had ongoing employee training, they had both internal and external audit plans, and reports wound their way up to the Board of Directors. Any relief experienced by the corporate officers and directors on the call, however, would have been tempered by Reese's report of a 2003 Accenture survey where 50% of the companies said they relied on intangible assets to build shareholder value, but only 5% of the companies had IA systems and internal controls.

Is This Not Merely Academic?

No. The foundation is real. Directors and officers are liable for inactions that destroy corporate asset value. Intangible assets have no formal home on the corporate balance sheet. Except for certain circumstances, their value is neither recorded nor reported according to Generally Accepted Accounting Principles (“GAAP”). Intangible assets comprise patents and trademarks that enable companies to provide goods and services; the customer promises embedded in brand; and the ability to deliver on those promises through the business processes that govern quality, safety, security, integrity, sustainability, risk management, etc.

Absent an arms-length market transaction for an asset such as a patent, trademark, or business process, the value of intangible assets cannot be determined according to GAAP. There are many proprietary non-GAAP methods that provide indications of value. Financially, the value of most IA is closely linked like the stones in a Roman arch so that collectively, the intangible assets comprise an enterprise's reputation value ' the difference between market capitalization and book value. To continue the analogy, like a Roman arch, the loss of any one key intangible asset may destroy a disproportionate amount of reputation value.

Reputation ' the impression formed by stakeholders of how a company manages its intangible assets ' can be measured, however. Stakeholders comprise employees, suppliers, customers, competitors, and investors. The first four cast their votes through wages, cost of goods, and pricing; investors cast their votes through earnings multiples and price volatility.

Reputation metrics have an added dimension as of late through the opinions of independent rating agencies. By the second quarter of 2009, S&P expects all companies to have at least one initial enterprise risk management discussion with their analysts.

For purposes of litigation, there are, therefore, means of measuring value loss through both gains in enterprise risk and losses in enterprise value.

What Are the Most Likely Lurking Risks?

In the cases cited by Reese, employees violated business practices in areas for which there were well-defined procedures and well-established compliance systems. Risks are lurking in companies where critical business processes are not governed by best practices or are not monitored for compliance.

In Caremark, the company incurred real costs and reputation damage because employees violated federal and state laws applicable to health care providers. Caremark was indicted, pled guilty, and agreed to pay $250 million in fines and penalties. The court found no oversight violation by the board because the company had robust systems in place to enforce compliance with federal law dealing with health care providers.

In Stone v. Ritter, the company incurred real costs and reputation damage because employees failed to file Suspicious Activity Reports required by the Bank Secrecy Act and anti-money laundering regulations. The federal investigations of AmSouth stemmed from an unlawful “Ponzi” scheme and resulted in $50 million in fines and penalties. The court found no oversight violation by the board because the company had robust systems in place to enforce compliance with federal law dealing with anti-money laundering.

The risks we see lurking vary by business sector. In the technology sector, where patents are among the key corporate assets, we see risks lurking in companies that lack well-established processes for creating and protecting intellectual property. Elements would include best practices for both R&D and patent management; compliance monitoring and enforcement systems; and communications systems both internally for oversight and externally for value appreciation.

In the food products and toys sector, risks are lurking in safety processes. In the airlines and hotel industries, we see risks lurking in security and customer service. In heavy industrial companies, risks are lurking in ethical practices, and in consumer retail in sustainability practices.

In all of these sectors, the named risks are business processes that drive the key intangible assets that support reputation. To appreciate the downside risk, consider the breadth of losses caused by the current peanut butter contamination and reflect on recent history including Mattel with lead paint, Marriot hotel bombings, Jet Blue's St. Valentine's Day disaster, Seimens' bribery scandal, and Wal-Mart's historic challenges with labor.

Beyond Immunization: Value Creation

There is good news, though. Firms can immunize themselves to the downside risks by deploying world-class intangible asset value creation, compliance monitoring, and enforcement systems.

Better still, and going to the heart of ROI concerns in these challenging economic times, is the prospect of rapid market recognition of the value of these efforts. There are ample data suggesting that firms that deploy such systems, authentically commit themselves to becoming superior stewards of their intangible assets ' be they derived from processes for innovation, safety, security, integrity, or sustainability ' can expect to be rewarded in the near-term for these efforts with superior capital market returns and better credit ratings.

In fact, if companies take to heart what Reese is saying and proactively act to mitigate risk and create value, then what Reese predicts may not come to pass. In that case, rather than a legacy as prophet, she will be a hero.

Nir Kossovsky, MD, a member of this newsletter's Board of Editors, is CEO of Steel City Re, a risk management and assurance company. Dr. Kossovsky also serves as the Executive Secretary of the Intangible Asset Finance Society. Peter J. Gerken is President, Risk Transfer Agency and Insurance, at Steel City Re. He may be reached by e-mail at [email protected].

When an aspiring writer pens “The prophets of financial cataclysms” in the not too distant future, some now-household names will grace the table of contents. Nouriel Roubini, an economist nicknamed “Dr. Doom,” has earned his place in this book for writing in 2006 that ” ' the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession.” Harry M. Markopolos, a securities fraud investigator, earned his place for repeatedly tipping off the U.S. Securities and Exchange Commission since 1999 that it was not legally possible for Bernard Madoff to deliver the returns he'd claimed to deliver. Cathy L. Reese ' maybe you haven't heard of her yet. Allow me to share.

Cathy L. Reese is a principal in the Delaware office of Fish & Richardson P.C., where she heads the firm's corporate and Chancery litigation practice. Readers of this newsletter no doubt appreciate that these courts render judgment on the conduct of directors and officers of Delaware corporations, especially their fiduciary obligations to shareholders. Since 70% of U.S. public companies are formed under Delaware law, decisions arising from these courts receive wide attention.

The Cost of Sleeping at the Switch

On Friday, Feb. 6, 2009, Reese led a conference call hosted monthly by the Intangible Asset Finance Society (www.iafinance.org). The topic was the director's duty of oversight with respect to intangible asset management, and Reese shared her view of the implications of recent rulings.

Intangible assets (“IA”) are valuable corporate assets. Companies are expected to monetize them. Companies are expected to have systems to identify, track, protect, and report their monetization activities to their Boards. Boards are expected to oversee this process on behalf of shareholders. As a result of two watershed cases, a Board that fails in its duty of oversight now places individual directors at risk for personal liability.

Being in the corporate reputation protection business, this caused me to sit up. Surely, I thought, boards enable those charged with oversight to exercise their best business judgment without fear of personal financial ruin. Director and officer duties include: due care, loyalty, duty of candor, and good faith. As long as they are exercised appropriately, directors and officers are immunized from second-guessing by the business judgment rule. Or so I thought. Now, as I learned, failure to act may no longer be protected.

According to Reese, the logic that placed cross hairs on individual board members comprises three steps. First, through In re Caremark Int'l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996), and Stone v. Ritter, 2006 Del. LEXIS 597 (Del. 2006), the courts extended the duty of care to include oversight and affirmed that directors and officers could be held liable for “unconscionable failure[s] of the board to act in circumstances in which due attention would, arguably, have prevented the loss” or in “circumstances in which loss eventuates not from a decision but, from unconsidered inaction” (i.e., “liability for failure to monitor”); the court suggested that oversight comprised systems and controls to set guidelines, systems to monitor and enforce compliance, and systems to monitor and mitigate risks (emphasis added). Third, critically, is that a director or officer who fails to uphold his duty of care ' now more broadly defined to include oversight ' could be personally liable.

Reese then recapped for the laymen on the call. The bottom line, she said, is that directors and officers cannot seek shelter behind Delaware's business judgment rule if they are unaware of what is going on in their companies and do not exercise judgment.

A Reign of Terror?

Is a bloodbath imminent? Does the financial market collapse that wiped out $30 trillion in IA value and reduced the median intangible asset fraction of corporate value from 70% to around 50% mark the beginning of an interminable string of litigation?

Not necessarily, suggests Reese. She notes that in both landmark cases, the boards were found not liable because they had oversight systems in place. The boards acted on the advice of counsel, they had compliance plans and dedicated compliance officers, they had ongoing employee training, they had both internal and external audit plans, and reports wound their way up to the Board of Directors. Any relief experienced by the corporate officers and directors on the call, however, would have been tempered by Reese's report of a 2003 Accenture survey where 50% of the companies said they relied on intangible assets to build shareholder value, but only 5% of the companies had IA systems and internal controls.

Is This Not Merely Academic?

No. The foundation is real. Directors and officers are liable for inactions that destroy corporate asset value. Intangible assets have no formal home on the corporate balance sheet. Except for certain circumstances, their value is neither recorded nor reported according to Generally Accepted Accounting Principles (“GAAP”). Intangible assets comprise patents and trademarks that enable companies to provide goods and services; the customer promises embedded in brand; and the ability to deliver on those promises through the business processes that govern quality, safety, security, integrity, sustainability, risk management, etc.

Absent an arms-length market transaction for an asset such as a patent, trademark, or business process, the value of intangible assets cannot be determined according to GAAP. There are many proprietary non-GAAP methods that provide indications of value. Financially, the value of most IA is closely linked like the stones in a Roman arch so that collectively, the intangible assets comprise an enterprise's reputation value ' the difference between market capitalization and book value. To continue the analogy, like a Roman arch, the loss of any one key intangible asset may destroy a disproportionate amount of reputation value.

Reputation ' the impression formed by stakeholders of how a company manages its intangible assets ' can be measured, however. Stakeholders comprise employees, suppliers, customers, competitors, and investors. The first four cast their votes through wages, cost of goods, and pricing; investors cast their votes through earnings multiples and price volatility.

Reputation metrics have an added dimension as of late through the opinions of independent rating agencies. By the second quarter of 2009, S&P expects all companies to have at least one initial enterprise risk management discussion with their analysts.

For purposes of litigation, there are, therefore, means of measuring value loss through both gains in enterprise risk and losses in enterprise value.

What Are the Most Likely Lurking Risks?

In the cases cited by Reese, employees violated business practices in areas for which there were well-defined procedures and well-established compliance systems. Risks are lurking in companies where critical business processes are not governed by best practices or are not monitored for compliance.

In Caremark, the company incurred real costs and reputation damage because employees violated federal and state laws applicable to health care providers. Caremark was indicted, pled guilty, and agreed to pay $250 million in fines and penalties. The court found no oversight violation by the board because the company had robust systems in place to enforce compliance with federal law dealing with health care providers.

In Stone v. Ritter, the company incurred real costs and reputation damage because employees failed to file Suspicious Activity Reports required by the Bank Secrecy Act and anti-money laundering regulations. The federal investigations of AmSouth stemmed from an unlawful “Ponzi” scheme and resulted in $50 million in fines and penalties. The court found no oversight violation by the board because the company had robust systems in place to enforce compliance with federal law dealing with anti-money laundering.

The risks we see lurking vary by business sector. In the technology sector, where patents are among the key corporate assets, we see risks lurking in companies that lack well-established processes for creating and protecting intellectual property. Elements would include best practices for both R&D and patent management; compliance monitoring and enforcement systems; and communications systems both internally for oversight and externally for value appreciation.

In the food products and toys sector, risks are lurking in safety processes. In the airlines and hotel industries, we see risks lurking in security and customer service. In heavy industrial companies, risks are lurking in ethical practices, and in consumer retail in sustainability practices.

In all of these sectors, the named risks are business processes that drive the key intangible assets that support reputation. To appreciate the downside risk, consider the breadth of losses caused by the current peanut butter contamination and reflect on recent history including Mattel with lead paint, Marriot hotel bombings, Jet Blue's St. Valentine's Day disaster, Seimens' bribery scandal, and Wal-Mart's historic challenges with labor.

Beyond Immunization: Value Creation

There is good news, though. Firms can immunize themselves to the downside risks by deploying world-class intangible asset value creation, compliance monitoring, and enforcement systems.

Better still, and going to the heart of ROI concerns in these challenging economic times, is the prospect of rapid market recognition of the value of these efforts. There are ample data suggesting that firms that deploy such systems, authentically commit themselves to becoming superior stewards of their intangible assets ' be they derived from processes for innovation, safety, security, integrity, or sustainability ' can expect to be rewarded in the near-term for these efforts with superior capital market returns and better credit ratings.

In fact, if companies take to heart what Reese is saying and proactively act to mitigate risk and create value, then what Reese predicts may not come to pass. In that case, rather than a legacy as prophet, she will be a hero.

Nir Kossovsky, MD, a member of this newsletter's Board of Editors, is CEO of Steel City Re, a risk management and assurance company. Dr. Kossovsky also serves as the Executive Secretary of the Intangible Asset Finance Society. Peter J. Gerken is President, Risk Transfer Agency and Insurance, at Steel City Re. He may be reached by e-mail at [email protected].