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Rothgerber Johnson & Lyons

Jurassic Park Revisited: Violation of the Computer Fraud and Abuse Act by Employees
Remember the computer guy in “Jurassic Park” who created a program to prevent his employer from accessing the system, which allowed T-Rex to escape the electric fence and eat the lawyer? If the computer guy had not met his own ugly demise, could his employer sue him for what he did to his computer and what he was planning to do with the dinosaur DNA? A recent case from the federal 7th Circuit Court of Appeals provides employers with the answers.

In International Airport Centers, LLC v. Citrin, 440 F.3d 418 (7th Cir. 2006), the court found the employer had stated an appropriate claim against its former employee, Citrin, for breach of the duty of loyalty and a violation of the Computer Fraud and Abuse Act, 18 U.S.C. § 1030. According to the complaint, the employee decided to go into business for himself in violation of his employment contract and loaded onto his laptop a secure-erasure program designed to overwrite all information he had stored on his computer, including that which he had deleted. This information apparently included data he had gathered for his employer during his employment and information that would incriminate him regarding his competitive activities. The employer sued under the Computer Fraud and Abuse Act, which provides, in part, that whoever “knowingly causes the transmission of a program, information, code, or command, and as a result of such conduct, intentionally causes damage without authorization, to a protected computer [a defined term that includes the laptop that Citrin used], violates the Act.”

The employee argued that merely erasing a file from a computer is not a “transmission.” However, the court held that “in either the internet download or disk insertion, a program intended to cause damage . . . includes any impairment to the integrity or availability of data, a program, a system, or information, if transmitted to the computer electronically.” Failing in this argument, the employee then argued that he was authorized to delete and destroy this information. The court responded that the employee had exceeded his authority in destroying this computer information, and, that his authorization to access his laptop terminated when he engaged in the misconduct in violation of his duty of loyalty to his employer. The court held, “Citrin’s breach of his duty of loyalty terminated his agency relationship and with it his authority to access the laptop.”

In our “Jurassic Park” example, the computer guy breached his duty of loyalty when he planned to sell the park’s secrets. This act terminated his agency relationship with his employer and his authority to further access the computer. Moreover, his intentional transmission of computer data blocking his employer’s access to its computer system could have created a violation of the Computer Fraud and Abuse Act, which provides for both criminal and civil penalties. But, of course, he was eaten by a small extinct lizard, so justice prevailed in that case as well.

Practical Significance. This case teaches employers that a cause of action exists against employees who intentionally download programs to their computers that cause the erasure of files or information lawfully belonging to the employer. This adds yet another tool to the employer’s arsenal to prevent employees from unlawfully destroying computer files and reinforces the employee’s duty of loyalty to act in the best interests of the employer.

Michael D. Nosler is RJ&L's managing partner and brings more than 25 years of experience in labor and employment law. He represents employers in all aspects of employment relationships, including defense of wrongful discharge, discrimination, and ERISA matters. Mr. Nosler represents clients before administrative agencies such as the EEOC, the National Labor Relations Board, and the Colorado Civil Rights Commission. He counsels employers in threatened union organizing campaigns and acts as management spokesman for companies in collective bargaining proceedings. Mr. Nosler is a graduate of Drake University Law School. He can be reached at 303-628-9562 or by e-mail at mnosler@rothgerber.com

07-20-2006

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Rothgerber Johnson & Lyons

Retaining Control of Gifts to Minors: UTMA and IRC 2503(c) Trust Options
In an era when young people often delay responsibility past the legal age of majority and have their own ideas on managing finances, many parents and donors of previously transferred assets may seek legal assistance to help delay or restrict the soon-to-be adult's access to and control of these assests.

07-20-2006

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Rothgerber Johnson & Lyons

Section 409A and Stock Options
We are fielding a lot of questions about Internal Revenue Code Section 409A—some of which have rather startling answers. One of these questions concerns the application of Section 409A to a stock option granted by a private company.

The problem. Section 409A applies to an option other than an incentive stock option or an option granted under an employee stock purchase plan if the strike price is below the fair market value of the underlying stock on the option grant date. This type of option is frequently called a discounted stock option. A discounted stock option that does not comply with the requirements of Section 409A creates adverse tax consequences for the optionee and a corresponding withholding and employment tax obligation for the granting company.

More specifically, the optionee is taxed when her option vests (instead of when the option is exercised or later) and is also subject to a 20 percent tax in addition to regular income and employment taxes and a possible interest charge. These tax consequences might occur again when the underlying stock value increases after it vests and before the option is exercised. When it vests (and possibly subsequently when the value of the underlying stock increases before the option is exercised), the granting company is required to withhold income and employment taxes as well as pay its portion of the related employment taxes.

When a discounted stock option is intended, the grant can be structured to comply with the requirements of Section 409A to avoid adverse tax consequences. Consequently, the question quickly becomes an inquiry about how fair market value is determined so as to avoid an unintentional discounted stock option as might be discovered, for example, when an audit of a granting company or its optionee the Internal Revenue Service determines a fair market value for stock underlying the company’s option that is greater than that value as determined by the granting company.

Alternatives offered by proposed regulations

Newly proposed Section 409A regulations provide that fair market value is determined by “the reasonable application of a reasonable valuation method,” and then provide several alternatives to a private company for setting its option strike prices.

Internal stock valuation. A granting company can perform an internal stock valuation to set its option exercise prices. If the Internal Revenue Service later determines that these option prices are below fair market value, the granting company must prove that its valuation of the underlying stock is reasonable.

To be considered reasonable, according to the proposed regulations, the valuation method must take into account, as applicable,

the present value of the granting company’s future cash flows;
public trading price or private sale price for stock or equity interests of similarly situated companies;
the value of the granting company’s tangible and intangible assets; and
any other relevant factors, such as control premiums or marketability discounts; and whether the particular valuation method is used by the granting company for other material purposes.

The use of a valuation method will only be considered reasonable if all available material information is considered, the valuation date is no more than 12 months prior to the option grant date, and valuation is updated for any subsequent events that affect the stock value. A granting company that uses an informal valuation practice that does not refer to these factors and methods or that does not use any valuation method for stock underlying an option will be unable to prove that its determination of fair market value is reasonable. It also seems likely that the granting company’s valuation practice should be recorded in some detail to establish successfully the reasonableness of this practice.

Safe-harbor methods

The Section 409A proposed regulations also offer three presumptive or safe-harbor valuation methods for private company stock underlying an option that involve a written valuation by an appraiser or other person with stock valuation knowledge and experience, or a universally applied binding formula. A stock value consistently determined by the granting company with one of these methods is considered to be fair market value, unless the Internal Revenue Service can demonstrate that either the method or the use of the method is grossly unreasonable.

Independent appraisal. Under this method, the valuation of the stock underlying an option is very similar to the appraisal required by the tax laws for an employee stock ownership plan that owns private company stock. A qualified independent appraiser prepares a written valuation of the stock using traditional appraisal methodologies. The appraisal must value the granting company’s stock as of a date that is no more than 12 months before the option grant date and must be updated for any events that occur after the appraisal date and have a material effect on the stock value.

Early-stage company. This method can be used if the granting company has conducted business for less than 10 years and does not reasonably anticipate a sale, change of control, or initial public offering within 12 months following option grant, and the stock underlying the option is not generally subject to any put, call, or right of first refusal. A fair market valuation of such an illiquid start-up company’s stock is presumed reasonable if it is contained in a written report; performed by a person with significant similar valuation knowledge or training; takes into account the factors described above with respect to an informal fair market valuation; and is performed within the 12 months prior to option grant date and updated for any subsequent events that affect the stock value.

Binding formula. A valuation based on a binding formula that is used in a shareholder buy-sell or similar binding agreement can be used to set option prices if this formula price is also used to value the granting company’s stock for all non-compensatory valuation purposes (such as valuations for loans, regulatory filings, and sales to third parties), and if the buy-sell or similar agreement governs all transfers of granting company stock.

Practical considerations

The application of Section 409A to a discounted option, including an unintentional discounted option, depends on when the option was granted and vested and whether any modifications have been made to the option subsequent to its grant date. Generally, an option granted after October 3, 2004, should be examined to determine any necessary corrective action to comply with Section 409A pricing requirements. Such action might include an after-the-fact valuation for the stock underlying the option and/or modifications to the option terms. Any corrective action must be taken by the earlier of the exercise of the subject option and December 31, 2006.

Effective dates

The above-described option pricing alternatives are provided in proposed regulations that technically will only apply to grants made on or after the effective date of these regulations (probably some time in 2007). For option grants prior to the effective date of the proposed Section 409A regulations, the Internal Revenue Service offers several other pricing alternatives depending on the option grant date.

Good-faith efforts. For an option granted prior to January 1, 2005, the granting company must have made a good-faith attempt to value the underlying stock at not less than its fair market value on the option grant date. The IRS has not specifically described what constitutes such a good-faith attempt, stating just that option pricing principles similar to those provided in the regulations governing an incentive stock option or “ISO” apply until further guidance is issued. The ISO regulations provide that a good-faith attempt is demonstrated by the relevant facts and circumstances. But these regulations offer only the example of a stock value determined by a completely independent and well-qualified valuation expert as an example of a good-faith attempt to determine an option exercise price. Furthermore, the granting company must maintain adequate books and records to demonstrate that the pricing requirements were met.

Reasonable valuation. For an option granted after December 31, 2004, and until the final Section 409A regulations are issued, the granting company can use any reasonable valuation method or an appropriate method provided under the proposed regulations to determine the underlying stock value on the option grant date. Although the Internal Revenue Service provides no definition or description of a reasonable valuation method, presumably any such method requires a higher standard for determining fair market value than that required for determining this value for an option granted prior to January 1, 2005.

Be cautious in valuation. Since in some ways the good-faith-attempt pricing alternative may be more rigorous and more limited than one available under the proposed regulations, it is hard to imagine that the presumably higher standard required by a reasonable valuation method offers more flexibility for any such determination than that offered by the proposed regulations. Consequently, a granting company in many instances might be better served by treating the proposed Section 409A regulations as immediately effective in evaluating whether an outstanding option granted after October 3, 2004, is exempted from Section 409A with an exercise price that is not less than the fair market value of the underlying stock on the option grant date.

If the option price does not satisfy the proposed regulations, the company then should consider whether reliance on either the good-faith attempt or any reasonable valuation methods is appropriate to determine whether its pricing for the option requires corrective action. Given the lack of guidance offered for these alternative methods, the company should be quite cautious and should carefully weigh the risks involved with this reliance.

Federal tax advice disclaimer. Any tax advice in this article is intended for discussion purposes only; such advice is not intended for marketing, promoting or recommending any transaction or for use by any person to prepare a tax return. Consequently, this advice is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under U.S. tax laws. (The foregoing statement is made in accordance with Circular 230, 31 C.F.R. Part 10.)

A partner in RJ&L's Colorado Springs office, Jan A. Steinhour practices exclusively in the area of employee benefits planning and administration. Her experience includes assistance to employers with pension and welfare benefits plan issues involving fiduciary responsibility, plan administration, benefits claims, and federal and state tax and labor law consequences. She frequently assists clients with design, implementation, and maintenance of executive compensation programs, severance programs, health benefits, stock option plans, golden parachute arrangements, and tax-qualified retirement plans. She can be reached at 719-386-3008 or by email at jsteinhour@rothgerber.com.

07-20-2006

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Rothgerber Johnson & Lyons

Some Say "Alito," Some Say "Scalito": What Does it Mean to Employment Law?
After the sideshow that was Harriet Miers’ nomination to succeed retiring U. S. Supreme Court Justice Sandra Day O’Connor, President Bush nominated Judge Samuel Alito to fill Justice O’Connor’s shoes. Formerly a judge on the U. S. Court of Appeals for the Third Circuit, Samuel Anthony Alito Jr. was confirmed and sworn in as the 110th United States Supreme Court Justice on January 31, 2006.

Justice Alito has been described as a “consistent conservative jurist.” Indeed, he has been dubbed “Scalito”—a reference to Supreme Court Justice Scalia, who is known for his conservative views. So what might we expect from Justice Alito in the area of employment law decisions rendered by our High Court? Some of his decisions from his 15 years with the Third Circuit may provide some clues.

Sheridan v. E.I. DuPont de Nemours and Company 00 F.3d 1061 (3rd Cir. 1996)
Judge Alito’s dissent in Sheridan stirs up a good deal of angst for plaintiffs’ lawyers. In this case, a former employee of E.I. Dupont sued the company, alleging it disciplined her in retaliation for her complaints of sexual harassment. The company claimed a legitimate, non-discriminatory reason for disciplining the plaintiff. The plaintiff, therefore, needed to prove that the company’s proffered reasons for disciplining her were false. Judge Alito, the lone dissenter, disagreed with the other 10 judges over the amount of evidence a plaintiff must have to defeat summary judgment. (Summary judgment is when a party, prior to trial, moves to dismiss the case, arguing that a jury looking at the same evidence could decide the case only in the moving party’s favor.)

The majority held that a plaintiff may defeat summary judgment and have her case go to the jury merely by casting sufficient doubt on the credibility of the employer’s proffered, non-discriminatory reasons for its action. Judge Alito dissented, taking the position that, in some cases, a plaintiff must do more than merely shed doubt on an employer’s proffered, non-discriminatory reasons in order to survive a motion for summary judgment. In his view, a defendant-employer’s motion for summary judgment should be granted when the evidence in the record would not convince a jury that discrimination was a “determinative cause” of the adverse employment action—the so-called pretext-plus standard.

Glass v. Philadelphia Elec. Co.34 F.3d 188 (3rd Cir. 1994)
In this case, an African-American employee sued his employer for race and age discrimination and retaliation, after he was passed over for various promotions. The employer proffered evidence that the plaintiff was passed over for promotions, in part due to prior poor work performance. In order to prove that the employer’s proffered reasons for failing to promote him were pretextual, the plaintiff sought to introduce evidence that he had been subjected to racial harassment and a hostile work environment during the time of his alleged poor work performance. The trial judge did not allow the plaintiff to introduce this evidence.

The appellate court held that the trial judge abused his discretion in excluding the plaintiff’s evidence of pretext. In a lone dissent, Judge Alito wrote that the trial judge’s ruling should be afforded substantial deference, and that the trial judge’s rulings should have been upheld. He wrote that allowing the evidence could have caused “substantial unfair prejudice” to the employer as it could have led to a mini-trial on “collateral issues.”

Shelton v. University of Medicine & Dentistry of New Jersey 223 F.3d 220 (3rd Cir. 2000)
A New Jersey hospital’s labor-and-delivery unit performed emergency procedures that resulted in terminated pregnancies. One labor-and-delivery nurse’s religious faith prohibited her from participating “directly or indirectly in ending life.” She sued the hospital, arguing that her opposition to abortion should exempt her from participating in emergency procedures that would result in a terminated pregnancy. The hospital had offered to transfer the plaintiff to the newborn intensive care unit. The issue before the court was whether the hospital reasonably accommodated her religious beliefs. Judge Alito sided with the court’s majority in holding that the hospital’s offer of transfer was a sufficient and reasonable accommodation.

Fraternal Order of Police Newark Lodge No. 12 v. City of Newark 170 F.3d 359 (3rd Cir. 1999)
The Newark Police Department had a policy prohibiting its officers from wearing beards. Exception was made, however, for medical reasons (e.g., a skin condition called pseudo folliculitis barbae, or “razor bumps”), but not for officers whose religious beliefs prohibited them from shaving their beards. The Police Department disciplined two Islamic officers who refused to shave their beards for religious reasons. Writing for the court, Judge Alit held that the Department’s no-beard rule violated the First Amendment since the Department made exemptions from its policy for secular reasons and was unable to offer any substantial justification for refusing to provide similar exemptions for officers required to wear beards for religious reasons.

Practical significance
Justice Alto’s appointment to the U. S. Supreme Court is seen as an important one because he replaces Justice O’Connor, who had been a key swing vote on the Court for years. In the employment law arena, Justice Alto’s opinions as an appellate court judge have been described as pro-employer and unsympathetic to plaintiffs by some, and as evenhanded and balanced by others. There is probably evidence in his record to support both characterizations. To the extent that his previous record is a foreshadowing of how he might rule and perform as a Supreme Court Justice remains to be seen. No doubt, however, his appointment, as well as its possible effect in shaping our nation’s employment laws, is an important one.

S. Kato Crews focuses his practice on litigation and traditional labor and employment law matters. He joined RJ&L in 2001 after serving as an attorney with the U.S. National Labor Relations Board. Mr. Crews advises and represents employers in all aspects of the employment relationship. He can be reached at 719-386-3017 or by email at kcrews@rothgerber.com

07-20-2006

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Rothgerber Johnson & Lyons

When Do You Need Estate Planning?
Estate planning documents are often considered to be a will and possibly powers of attorney. Depending on your own legal and financial circumstances, you might need a “checkup,” review, and even new documents from your estate planning attorney. This is particularly true for business entrepreneurs with grown children. With the federal estate tax in transition, estate plans quickly become out of date. A good estate planner reviews the client’s asset holdings, dispositions under beneficiary designations, and any asset changes that might be needed to accomplish the desired estate plan. This review then allows an evaluation of a changing estate tax structure.

When to revise your estate plan Important events for estate plan revision are any change in family or financial circumstances (e.g., a marriage, divorce, childbirth, new business, benefits, or life insurance). Important events also are changes in the tax law.

As financial assets grow or change, a review is important to ensure that: the total asset values do not now exceed the lifetime estate tax exemption amount ($2 million per decedent in 2006); assets are titled in a manner that accomplishes the tax planning of existing wills; beneficiary designations on retirement plans do not circumvent the intent of the wills; and life insurance proceeds have been removed from the taxable estate where appropriate.

One reason often heard for not having an estate plan is that the individual has no children. Naming a child’s guardian is one key issue that can be accomplished by a parent’s will. In addition, a will is needed for those who want to favor certain friends, family members, or charities rather than letting assets be distributed to immediate family members under Colorado’s intestacy law.

Even if a will is current or state intestacy law provides for acceptable estate distribution, estate planners also can assist in preparing lifetime documents, including powers of attorney and living wills. Powers of attorney, in which one appoints a trusted agent to act on one’s behalf in certain circumstances, can avoid costly court proceedings should a person become unable to manage his or her own affairs or make health care decisions. Financial powers of attorney should be updated every five years.

Health care powers of attorney should be updated to comply with new privacy requirements and “Schiavo” concerns. Living wills can be signed to direct the removal of life support and nourishment (one issue in the Terri Schiavo case) without a family member or court having to intervene. Living wills are state-specific documents. While Colorado accepts any other state’s validly executed living will, some states require their own forms.

Once wills, powers of attorney, and living wills are signed, most people think their estate planning is done. However, the will may not accomplish the client’s desires unless there is coordination between the assets passing under the will and those that are not. For instance, jointly held assets will pass directly to the surviving owner and not to a credit shelter trust established for estate tax savings in some decedents’ wills. Likewise, retirement plans, life insurance, and bank accounts designated as “POD” (pay-able on death) or “TOD” (transfer on death) all pass under beneficiary designations and not pursuant to the terms of a will.

What about beneficiary designations?
Many clients have a significant amount of their wealth in retirement accounts. Designating who gets this wealth has become complicated. Without carefully stated beneficiary designations, accounts may pay out to the beneficiary over the five years following the participant’s death. These distributions are taxable to the beneficiary, and a short payout can create an unnecessary income tax burden. Payment of retirement accounts to trusts is especially tricky and might require revised trust provisions.

Additional life insurance may be needed. Existing policies may no longer work. Three estate planning reasons for life insurance are:
providing liquidity to pay estate tax liability, providing adequate cash flow for the decedent’s family’s support, creating liquidity to buy out partners or shareholders in a closely held company, and replacing wealth for charitable transfers.

When appropriate, insurance policies should be removed from taxable estates by placing them in an irrevocable life insurance trust or transferring them to a partnership. Lifetime gifts can reduce income taxes, too

Once a person’s taxable estate exceeds his or her lifetime estate tax exclusion amount ($2 million in 2006), lifetime wealth planning and transfers can further reduce the potential tax liability (absent an estate tax repeal). At the $2-million asset level, all income tax, gift tax, estate tax, and generation-skipping transfer tax issues should be considered to reduce total tax liability. Annual gifts must be qualified and can be leveraged for the annual gift tax exclusion ($12,000 per donor per recipient in 2006). Lifetime gifts using the $1-million lifetime gift tax exclusion amount can be leveraged and also remove all future appreciation and income from the donor’s estate. Gifts to grandchildren or dynasty trusts can additionally use and leverage the lifetime generation-skipping transfer tax exemption amount.

Business succession planning may require key man insurance, buy-sell agreements, and trusts or partnerships to hold or purchase the business or insurance. Coordination of these vehicles under tax laws and the client’s succession plan is critical to success.

So perhaps it is time to revisit the will in your files. Just as with an annual checkup with your doctor, you should check in with your estate planning attorney every couple of years or right after an important tax law change. The cost of avoidance could be harmful to your financial well-being.

Connie Smith specializes in tax planning for estate disposition, lifetime wealth transfers, business succession, and probate administration. Her experience in multiple areas of law, personal finance, and small business administration aids Connie in drafting custom designed wills, trusts, partnership agreements, and private foundation documents. Connie can be reached at 303-628-9557 or by email at csmith@rothgerber.com.

07-20-2006

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White & Case, LLP

LatinFinance Ranks W&C Second Among Best Securities Law Firms
LatinFinance magazine's capital markets survey, published in the July 2006 edition, ranked White & Case second (tied with another firm) among the Best Securities Law Firms.

LF's article, ""Cream of the Crop,"" also noted that the Firm is ""handy on equity deals,"" and has ""the best price-value ratio on the street,"" according to issuers.

07-20-2006

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White & Case, LLP

Citywealth Names W&C Partner One of Top 100 Advisers & Managers
A recent issue of Citywealth magazine named Win Rutherfurd (New York) as one of the Top 100 Advisers & Managers (North America), according to a survey of 2,000 wealth experts and based on peer recommendations.

07-20-2006

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