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Hunton & Williams, LLP

Texas Supreme Court Holds that Insurer May Not Rely on Extrinsic Evidence to Establish No Duty to Defend
In a recent decision, the Texas Supreme Court held that, in determining an insurer's defense obligation under a commercial general liability contract, an insurer may not rely on extrinsic evidence that is relevant both to an issue of coverage and the merits of the underlying case to prove that it does not have a duty to defend.

07-24-2006

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Hughes, Hubbard & Reed, L.L.P.

Bankruptcy Court Finds That Directors And Officers Of A Wholly-Owned Insolvent Subsidiary Owe Fidiciary Duty To Subsidiary: Opinion Underscores Breadth Of Zone Of Insolvency
Recently, the U.S. Bankruptcy Court for the District of Delaware issued a decision that has significant ramifications for directors and officers overseeing distressed subsidiaries. The bankruptcy court ruled that upon insolvency directors and officers of a wholly-owned subsidiary owe a fiduciary duty to both the subsidiary and its creditors. The bankruptcy court rejected the argument that, under Delaware law, upon insolvency directors and officers of a wholly-owned subsidiary owe a fiduciary duty to that subsidiary's creditors, but not to the subsidiary itself.

07-24-2006

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Fredrikson & Byron, P.A.

Employee Embezzlement: Prevention, Detection, and Cure
Employee embezzlement costs American employers about $6 billion per year. Embezzlement is the fraudulent taking of personal property with which one has been entrusted. By definition, the offender is someone trusted by the employer. When detected, embezzlement brings great heartache to the perpetrator’s victims and families. The typical motive for embezzlement is simple greed. However, theft arising out of addiction to gambling has grown along with the Minnesota gaming industry.

The most common embezzlement methods are:

Failure to record cash transactions.
Claims for false reimbursements.
Use of company accounts for personal transactions.
Payroll fraud.
Fraud through supplier accounts and other payables.
Kickbacks.
How does an employer prevent embezzlement? As a famous judge once observed, “Sunshine is the best disinfectant.” Or, as the Americans and Soviets agreed, “Trust but verify.” A business should screen new hires thoroughly. References should be checked, and criminal and credit background checks performed.

This process is not, of course, foolproof. Employers will want to lay off some of the risk by making sure that all employees who handle finances are appropriately bonded. Blank checks and deposit slips should be secured, and when payments come in, they should be restrictively endorsed immediately. When asked to sign checks, employers should require supporting documentation, and review it. If unknown vendors appear, employers should ask questions about them. Employers should also review their processes for collecting and spending money. There should be checks and balances at each stage, with especially strict procedures for cash transactions.

An employer should not expect its auditors to catch an embezzler, who may be experienced with audit procedures. Rather, the employer should break up the embezzler’s routine by reviewing unopened monthly bank and credit card statements, cancelled checks, deposit slips, and receipts, looking for checks out of sequence or written to “cash.” Write-offs warrant special attention, since that is how an embezzler will try to put the theft out of sight and mind.

Those unannounced, informal checks become especially important when there are warning signs of fraud. While the employee who appears to be living beyond her means bears watching, perhaps the best indicator of fraud is the employee who fights to protect job responsibilities involving access to money. Beware the employee who guards zealously some particular portion of the process, or who self-righteously insists on doing everything. An embezzler may resist taking vacation time, for fear that any substitute might become suspicious. Similarly, the employee who fights to keep using a particular vendor, against all economic rationality, may be protecting an illegal relationship.

Sudden, unexplained changes in revenue, cash flow, or profit are other warning signs, as are increased write-offs or transfers. Supplier complaints about slow payments and double-billing may increase when embezzlement is occurring. A security breach in the company’s computer system may also be a warning.

What should a business do when strong suspicions arise? A false accusation can lead to civil liability. Instead, employers should contact their attorneys and accountants for advice.

If, after investigation, it is confirmed that an employee has embezzled funds, prosecution is typically recommended. This sends a strong message to other employees that cheating will not be tolerated, and it may save another employer from the embezzler. Further, while the embezzler may have spent most of the money, a criminal court restitution order, which is not dischargeable in bankruptcy, will hang over the criminal’s head for a long time.

07-24-2006

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Fredrikson & Byron, P.A.

Leveraging Your Intellectual Property: Trade Secret vs. Patent Protection
You have created valuable intellectual property. Now you want to leverage it to create value for your business. Should you apply for a patent, or should you keep it as a trade secret? This article briefly summarizes these approaches to leveraging intellectual property and provides guidance on choosing the best course of action between these two mutually exclusive options.

A patent is a grant of exclusive rights from a government that prohibits others from making or using an invention. Advantages include the ability to force a competitor to stop exploiting the invention and the possibility of generating revenue from licensing arrangements or damages for infringement. Disadvantages include considerable upfront costs, complete public disclosure of the invention, and a limited term before exclusive rights expire.

A trade secret, by contrast, is something that confers a business advantage, is not generally known, and that the owner of which takes steps to maintain as a trade secret. Examples of steps to maintain a trade secret include restricting access to the information and having anyone that comes in contact with it sign a non-disclosure agreement. Trade secret protection allows you to stop an employee or party to a non-disclosure agreement from publicly disclosing the information, or to seek damages from such parties if the information is disclosed.

Advantages of trade secrets include that the information is not revealed to the public or to your competitors. The protection lasts as long as the trade secret is not publicly revealed, and potentially has an infinite term. For example, the formula for Coca-Cola has successfully been kept as a trade secret for decades. Trade secrets do not require registration costs, although there may be large, continuing costs related to keeping the information secret.

There are several disadvantages of trade secrets. If the secret is embodied in a product released into the market, a competitor can inspect the product and discover the secret. If the secret is discovered in this manner, the competitor can exploit it. Once it has been made public, anyone may have access to a trade secret and use it. In fact, if a competitor were to independently invent the substance of the trade secret, it could obtain a patent and stop you from continuing to exploit it.

A major factor in determining your approach to leveraging your intellectual property is your business plan. For example, if your business generates revenue by inventing or branding new products and contracting out their production, patents will likely provide the most competitive advantage. However, if your business thrives in a mature market by improving in-house production techniques, trade secrets might provide more value.

Within the context of your business model, the factors described above can weigh for or against leveraging intellectual property as a patent or a trade secret. Say your company has invented an improved fastener to connect components in a medical device. The medical device is released into the market and the fastener improvement can be easily identified and understood by your competitors. Since the invention can be easily reverse engineered, keeping this information as a trade secret will not provide a significant competitive advantage to your business.

On the other hand, say your company has invented a more efficient method to smooth metal weld joints in a manufacturing process for the same medical device. The process occurs in a limited-access facility and the devices produced by your method and the prior method look the same. Since the invention is a process improvement that cannot be determined by examination of the product released into the market, a trade secret may provide a larger competitive advantage than a patent.

Deciding how to best leverage intellectual property is a complex endeavor. For best results, contact your patent attorney.

07-24-2006

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Fredrikson & Byron, P.A.

U.S. Patent Law Implications of: Transnational Production
Have you ever considered supplying raw materials to a foreign manufacturer with instructions for creating a final product? How about selling parts to foreign customers, knowing they will be incorporated into a larger final product? Owners of U.S. patents that cover such final products (“Covered Products”) may have something to say about your plans, even if the Covered Products never enter the U.S. These and other transnational production schemes raise interesting issues under the U.S. patent law.

Sections 271(a)-(c): No Problem Unless Complete Invention is Within the U.S.

Though patent holders commonly resort to sections 271(a)-(c) of the patent statute to establish infringement, these provisions pose little threat to U.S. exporters of raw materials or parts. They apply only when the complete patented invention—not merely parts or raw materials—are either imported into the U.S. or made, used, sold, or offered for sale within our borders. If the Covered Product is never within the U.S. borders, these statutory provisions do not apply.

Section 271(f): Suppliers of Components from the U.S. Take Notice

A patentee’s most potent weapon against many transnational production schemes is the lesser known section 271(f) of the patent statute. Providing raw materials along with manufacturing instructions may implicate the first subsection of section 271(f), while providing parts for incorporation into larger assemblies may implicate the second subsection of section 271(f)(2).

Section 271(f)(1): Actively Inducing from the U.S.

Section 271(f)(1) prohibits supplying “all or a substantial portion of the components of a patented invention . . . in such manner as to actively induce the combination of such components outside of the United States in a manner that would infringe” the patent if in the U.S.

Case law is clear that transnational production schemes in which nothing physical is supplied from the U.S. do not implicate section 271(f)(1). But, more recent cases take a more expansive view, suggesting that one need not supply very much that is physical to trigger section 271(f)(1). Supplying raw materials along with instructions for creating a Covered Product raises two critical issues under section 271(f)(1).

The first issue is whether the raw materials constitute “components.” Would section 271(f)(1) cover a U.S. entity that supplied steel to a foreign manufacturer from the U.S., along with instructions stating, “Make component X out of this steel, and then combine component X with component Y to make Covered Product Z”? Though the Federal Circuit has not weighed in, legislative history suggests that a “component” is something that need only be assembled into the Covered Product. If the Federal Circuit adopts this view, raw materials—materials that must first be fashioned into parts that only later can be assembled—likely would not constitute “components” for purposes of section 271(f)(1).

The second issue is how much of the Covered Product must be made of the supplied raw materials to constitute a “substantial portion.” Would supplying the raw materials that make up 20 percent of the Covered Product’s parts constitute a substantial portion? Fifty percent? Ninety percent? Again, the Federal Circuit has not taken a position. It would be unwise to simply conclude that a scheme was clear of section 271(f)(1) because it involved supplying only an insubstantial portion of a patented invention. Also noteworthy: Section 271(f)(1) can be triggered even if the materials supplied are staple articles.

Section 271(f)(2): Contributing from the U.S.

Section 271(f)(2) prohibits supplying “any component of a patented invention that is [i] especially made or especially adapted for use in the invention and [ii] not a staple article or commodity of commerce suitable for substantial noninfringing use, . . . [iii] knowing that such component is so made or adapted and [iv] intending that such component will be combined outside of the United States in a manner that would infringe” the patent if in the U.S.

Two issues concerning section 271(f)(2) emerge when analyzing schemes that involve supplying a part for incorporation into a larger Covered Product. First, unlike section 271(f)(1), section 271(f)(2) does not include a “substantial portion” requirement. Supplying a part that is incorporated into a machine with a thousand other parts may still trigger section 271(f)(2). Second, section 271(f)(2) exempts staple articles and commodities of commerce. The supplier of a staple article may know that the part will be incorporated into a Covered Product and may even intend such incorporation. One need only avoid actively inducing such incorporation, as active inducement would trigger section 271(f)(1).

The Takeaway

Suppliers of raw materials and components, and their counsel, should be aware of the patent issues raised by transnational production. Moreover, they should keep an eye on pending patent reform legislation. At least one such proposal would repeal section 271(f) altogether, though any repeal would likely apply only prospectively.

07-24-2006

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Duane Morris, LLP

U.S. Consumer Product Safety Commission Proposes Changes to Rules for Reporting Potential Product Hazards
The U.S. Consumer Product Safety Commission has proposed changes to the rules requiring reports to the CPSC about potential product hazards.1 The reporting requirements have long been controversial. Although the proposal appears to be intended as an easing of the reporting requirements, it is not clear what the actual effect in practice will be. The proposed changes probably will not substantially reduce the likelihood that a report will be required, and the prudent course for businesses will continue to be ""when in doubt, report.

Existing Rules
The current rules under the Consumer Product Safety Act2 require manufacturers, importers, distributors and retailers of a consumer product to report to the CPSC if they obtain information which reasonably supports the conclusion that their product either (1) fails to comply with a consumer product safety rule or with a voluntary consumer product safety standard, (2) contains a defect which could create a ""substantial product hazard,""3 or (3) creates an unreasonable risk of serious injury or death.4 A report may trigger a product recall,5 and failure to make timely reports may result in substantial civil penalties.6

It is important to note that existing rules require reports regarding a defect that ""could create a substantial product hazard,"" not just a defect that in fact creates a substantial product hazard. The CPSC takes an aggressive view of the need to report possible hazards that might in fact turn out not to be actual hazards, and numerous reports have been made for products that have not caused any injuries. The CPSC takes the position that a company should report to the CPSC even if it is in doubt as to whether a defect or substantial product hazard exists. Reporting a product to the CPSC does not automatically mean that the CPSC will conclude that it poses a substantial product hazard or that corrective action is required. The CPSC works with the reporting firm to determine if corrective action is appropriate, and many of the reports received require no corrective action because the CPSC concludes that the reported product defect does not create a substantial product hazard.

The revisions to the rule would add new factors for determining when reports must be made. Specifically, the proposal would modify the CPSC's current interpretive regulations regarding product reporting to add certain factors to the definition of ""defect""; to add provisions allowing the evaluation of the risk of substantial injury to take into account that the risk may decline over time as the number of products being used by consumers decreases; and to add a provision regarding consideration of whether a product complies with voluntary or mandatory consumer product safety standards in determining whether a report is required.

The revised definition of defect7 would include the obviousness of the risk, the adequacy of warnings and instructions to mitigate the risk, the role of consumer misuse of the product and the foreseeability of such misuse. The provision of the rule regarding the criteria for determining how substantial a hazard the defect creates (and whether a report to the CPSC is therefore necessary) also has been revised. The existing rule includes a discussion of how the number of defective products distributed in commerce may affect the risk. The proposed rule would add a new factor to the list of factors to be considered: that the risk of injury from a product may decline over time as the number of products being used by consumers decreases.

Finally, the proposal would add a new section to the rules intended to explain how the CPSC views compliance with voluntary or mandatory product safety standards. Essentially, the revisions encourage compliance with product safety standards and state that the CPSC may consider a product's compliance with a standard in determining whether a report is required and to what extent corrective action is necessary. As pointed out by Commissioner Thomas Moore in a statement criticizing the proposed rule, under existing law, a report must be made if a product fails to comply with a mandatory or certain voluntary product safety standards. So the new provisions presumably would apply only to products that do comply with those standards, but have some other characteristic that results in a hazard. However, in the preamble to the proposed rule, the CPSC stated that this ""policy statement is not intended to reduce the volume of reporting.""8 Thus, it appears that the new rule would not establish a safe harbor relieving a company from reporting and corrective action requirements for products that comply with product safety standards, and therefore it provides only limited additional guidance as to whether reports and corrective action are required.

07-24-2006

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Reed Smith

NASD to Require Sales Charge and Expense Disclosure in Fund Performance Ads
On July 5, 2006, the SEC issued a Release approving amendments to NASD Rules 2210 and 2211 to generally require member communications with the public (other than "institutional sales material" and "public appearances") that present mutual fund performance information ("performance sales material") to disclose the fund's fees, expenses, and standardized performance.

07-24-2006

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