SEC Releases Memo on Market Based Methods for Valuing Employee Stock Options

9/9. The Securities and Exchange Commission (SEC) released a memorandum, dated August 31, 2005, and titled "Economic Evaluation of Alternative Market instrument designs: Toward a Market-Based Approach to Estimating the Fair Value of Employee Stock Options".

It was written by Chester Spatt, Cindy Alexander, M. Nimalendran, and George Oldfield of the SEC's Office of Economic Analysis (OEA). See also, statement by Donald Nicolaisen, the SEC's Chief Accountant, and statement by SEC Chairman Chris Cox.

This OEA memorandum reviews market based approaches to estimating the grant date fair value of employee stock options under the December 2004 FASB FAS 123R.

The memorandum reaches several conclusions. First, it finds that "Market exchanges between willing buyers and sellers of instruments that are designed to track the future flow of net obligations of the company or net receipts by employees under the grant can produce reasonable market-based estimates of fair value consistent with the measurement objective of Statement 123R."

Second, it finds that "Market exchanges of instruments that have been proposed to replicate the terms and conditions of employee options do not produce reasonable estimates of fair value."

Finally, it finds that "The tracking approach to the design of market instruments appears easier to implement than does the terms-and-conditions approach."

In addition, the Financial Accounting Standards Board (FASB), released a memorandum [6 pages in PDF], dated August 31, 2005, numbered FAS 123(R)-1, and titled "FASB Staff Position" and "Classification and Measurement of Freestanding Financial Instruments Originally Issued in Exchange for Employee Services under FASB Statement No. 123(R)".

Background. In October 1995 the FASB issued its Statement of Financial Accounting Standards No. 123 [134 pages in PDF] titled "Accounting for Stock-Based Compensation".

In March 2004, the FASB proposed to mandate the expensing of all employee stock options. See also, story titled "FASB Proposes Expensing of Stock Options" in TLJ Daily E-Mail Alert No. 867, April 1, 2004.

Members of Congress reacted by introducing HR 3574 (108th Congress) and S 1890 (108th), both titled the "Stock Option Accounting Reform Act". These bills, had they been enacted into law, would have required expensing of stock options for only the top officers of a company.

Following public comment, in December 2004, the FASB issued its revised FAS 123. See, Statement of Financial Accounting Standards No. 123 (revised 2004) [295 pages in PDF] titled "Share Based Payment". This document, FAS 123R, requires the expensing of stock options.

On March 29, 2005, the SEC issued its Staff Accounting Bulletin No. 107 [64 pages in PDF], regarding the implementation of the FASB's FAS 123R.

Statements by Cox and Nicolaisen. Cox (at right) wrote in his September 9 statement that "It has been nine months since the Financial Accounting Standards Board issued its statement requiring the expensing of stock options, and almost six months since the SEC published a Staff Accounting Bulletin regarding the implementation of the FASB standard. Today, the Commission's staff are issuing informal commentary that assesses progress toward using market approaches to valuation of employee stock options. This commentary is intended to stimulate discussion and promote further efforts at the development of market instruments to value employee stock options."

Nicolaisen wrote that "my staff has become aware of several different strategies being considered by issuers in an attempt to bring market forces to bear on the valuation of employee stock options. These strategies include attempts to design instruments that could be sold into the market at a value intended to be reasonably equivalent to the fair value of employee stock options."

He also stated that "it should be possible to design instruments whose transaction prices would be a reasonable estimate of the fair value of underlying employee stock options using either of the methodologies that seek to track returns to holders of options or the obligations of the issuer of those options". But, "we are not aware of any instruments that have actually been sold in the market in an effort to obtain an observable market price for use in valuing employee stock options".

He added that "we have significant doubts based on OEA's views, as to whether it would be possible to design an instrument that would achieve the measurement objective of Statement 123R by relying on similar contractual terms and conditions. That is primarily because of the difficulties inherent in replicating the employer-employee relationship in an issuer-investor arrangement."

He concluded that the SEC encourages "interested parties to continue to provide us with any further thoughts they have on this issue".

GAO Writes Yet Another Report Criticizing FBI's Info Tech

9/9. The Government Accountability Office (GAO) released a report [47 pages in PDF] titled "Information Technology: FBI Is Taking Steps to Develop an Enterprise Architecture, but Much Remains to Be Accomplished".

This report states that the Federal Bureau of Investigation (FBI), which is a part of the Department of Justice (DOJ), "has historically relied extensively on IT. For example, it relies on such computerized IT systems as the Combined DNA Index System to support forensic examinations and the National Crime Information Center and the Integrated Automated Fingerprint Identification System to help state and local law enforcement agencies identify criminals. The FBI reports that it collectively manages hundreds of systems, networks, databases, applications, and associated IT tools. As we previously reported, the FBI’s IT environment includes outdated, nonintegrated systems that do not optimally support mission operations."

The report states that the post 9/11 mission shift of the FBI, and the changing law enforcement environment, has "strained its existing patchwork of IT systems, which were developed and deployed on an ad hoc basis. The bureau reports that these circumstances will require a major overhaul in its IT systems environment."

The FBI "will spend approximately $390 million on modernization projects in fiscal year 2005 out of a total IT budget of $737 million."

The report concludes that the FBI's "the architecture program office does not yet have adequate resources, the bureau’s “as is” and “to be” architectures are not complete, and the bureau has not yet begun to develop its investment plans for transitioning from the ``as is´´ to the ``to be´´ states. Until the bureau has a complete and enforceable architecture, it remains at risk of developing systems that do not effectively and efficiently support mission operations and performance."

"The FBI is relying heavily on contractor support to develop its EA, but it has not employed effective contract management controls in doing so."

The report continues that "it has not used performance-based contracting, an approach that is required by federal acquisition regulations whenever practicable. Also, the bureau is not employing effective contractor tracking and oversight practices, as specified in relevant acquisition management guidance. More specifically, although the contract’s statement of work defines when products are due (i.e., timeliness standards), it does not specify the products in results-oriented, measurable terms. Further, it does not specify quality standards for products and does not define incentives for addressing either timeliness or quality standards. Finally, the bureau has not developed a plan for assuring the quality of the work produced by the contractor."

The GAO, which is an arm of the Congress, has issued many similar reports in the past. One year ago, on September 10, 2004, the GAO released a report [62 pages in PDF] titled "Information Technology: Foundational Steps Being Taken to Make Needed FBI Systems Modernization Management Improvements". See also, story titled "GAO Again Finds FBI IT Management Lacking" in TLJ Daily E-Mail Alert No. 975, September 13, 2004.

On March 23, 2004, the GAO wrote in prepared testimony [40 pages in PDF] for the Senate Appropriations Committee that the "FBI's longstanding approach to managing IT is not fully consistent with the structures and practices of leading organizations. A prime example of the consequences of not employing these structures and practices is the cost and schedule shortfalls being experienced on Trilogy, the centerpiece project to modernize infrastructure and case management applications." See also, story titled "GAO Finds That FBI's IT Transformation is Over Budget and Behind Schedule" in TLJ Daily E-Mail Alert No. 862, March 24, 2004.

Two years ago, on September 25, 2003, the GAO released a report [30 pages in PDF] titled "Information Technology: FBI Needs an Enterprise Architecture to Guide Its Modernization Activities".

Criticism of the FBI has not been limited to the GAO. For example, on December 19, 2002, the DOJ's Office of the Inspector General (OIG) released a report titled "Federal Bureau of Investigation's Management of Information Technology Investments". This OIG report concluded that the "FBI has not effectively managed its IT investments because it has not fully implemented the management processes associated with successful IT investments." See also, story titled "DOJ OIG Report Criticizes FBI Management of IT Resources" in TLJ Daily E-Mail Alert No. 572, December 20, 2002.

The 9/11 Commission's report, released in 2004, also noted deficiencies in the FBI's information technology.

See also, story titled "FBI Loses 317 Laptops" in TLJ Daily E-Mail Alert No. 485, August 6, 2002. And see, story titled "FBI Employee Pleads Guilty to Computer Crime" in TLJ Daily E-Mail Alert No. 791, December 3, 2003.

EPIC Wants Judiciary Committee to Question Roberts on Electronic Privacy

9/9. The Electronic Privacy Information Center (EPIC) wrote a letter [23 pages in PDF] to the members of the Senate Judiciary Committee (SJC) regarding the confirmation hearing for Judge John Roberts, which will begin on September 12.

The EPIC urges the SJC "to explore the views of Judge Roberts on the right to privacy". It also argues that "In the privacy area, his views are clear, extreme and disturbing."

The letter states that "In the contemporary environment, Constitutional and statutory protections of privacy are more vital than ever. Fear of terrorism has prompted a substantial increase in government surveillance. Technological change and lax corporate data security have made privacy a matter of pressing legislative concern. Given the dramatic expansion of the government's surveillance capabilities during the last several years and the likelihood that the issues the Supreme Court will face in the next few decades will be heavily influenced by the advance of technology, we believe it is important to understand how the nominee views the relationship between Constitutional principles and emerging threats to privacy."

The letter covers many cases and issues, including unlawful searches and the exclusionary rule, proposals for a national identification card, and "the application of Fourth Amendment principles in settings heavily influenced by the advent of new technology".

The EPIC argues that "Judge Roberts's political views, as expressed in his memos on the exclusionary rule and a national ID card, suggest too little regard for the legal mechanisms that limit police misconduct and little concern for the implications of a national ID system in the United States. The privacy cases that he has argued in the Supreme Court concerning databases maintained by the government agencies ignore concerns about the misuse of personal information and little regard for efforts by Congress to safeguard privacy by statutes."

The SJC has scheduled two days for questioning of Judge Roberts (Tuesday and Wednesday), and one day for outside witnesses (Thursday). One witnesses possess expertise in some of the issues raised by the EPIC letter -- Patricia Bellia, a professor at Notre Dame Law School, who teaches internet law and electronic surveillance law.

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9/9. The Office of the U.S. Trade Representative (USTR) announced in a release that "United States and Saudi Arabia have concluded bilateral negotiations on issues related to Saudi Arabia's World Trade Organization (WTO) accession". The USTR added that "Saudi Arabia has taken important steps to reform its trade regime, revising legislation, most notably in the areas of intellectual property protection ..."

9/9. The Motion Picture Association of America (MPAA) and the Recording Industry Association of America (RIAA) joined Internet2 as corporate members. See, RIAA release.

NCTA Continues Opposition to Multicast Must Carry

9/8. The National Cable Telecommunications Association (NCTA) continued its efforts to defeat broadcast industry proposals regarding cable multicast must carry requirements. On September 7, the NCTA sent a paper [17 pages in PDF] to members of Congress titled "The Economic Impact of Multicast Must Carry" prepared by Kane Reese Associates. It asserts that the cost to the cable industry could be over $100 Billion. On September 8, the NCTA sent a legal opinion [31 pages in PDF] prepared for the NCTA by the law firm of Cooper & Kirk that asserts that multicast must carry would violate the first amendment and the takings clause of the Constitution, and that the federal government might have to compensate the cable industry for this taking.

The NCTA's economic analysis states that "Broadcasters have argued that in order to facilitate the transition to digital television, Congress should require cable systems to carry, in addition to a broadcaster’s primary digital signal, multiple digital streams -- called multicasting -- which could include three, four, five, even six channels for each local station. Cable systems, however, do not have unlimited capacity. Most cable systems already have used their recently expanded capacity to offer a vast array of new enhanced services (e.g., faster High-Speed Data service, cable telephony, Video on Demand, and high definition television)." (Parentheses in original.)

This paper continues that "given current capacity constraints and, more significantly, the value of cable's broadband bandwidth, the economic burden to add mandatory multicast programming will be substantial."

The NCTA paper estimates that "under even the most conservative valuation approach (``the leased access approach´´), the cost to cable operators to implement a mandatory multicast regime would be in the $4.2 - $5.6 billion range. Under an ``opportunity cost approach´´ -- which we believe is a very reasonable methodology to use in this instance -- the cost of a multicast regime to cable operators exceeds $115.6 billion." (Parentheses in original.)

The NCTA's legal opinion then asserts that the taxpayer might have to compensate the cable industry. It states that "The broadcasters have now asked Congress to expand the forced carriage requirement to encompass broadcasters’ multicast programming. ... such an enactment not only would raise grave First Amendment concerns ... but would also impose a taking of cable operators’ property that would expose the federal Treasury to liability for billions of dollars in just compensation ..."

NCTA P/CEO Kyle McSlarrow wrote in a letter to members of Congress that "there is no reason to reward broadcasters with multicast must carry rights simply for returning spectrum that they were never meant to keep any longer than necessary to facilitate the digital transition. And there is no reason to do so when such a taking of property could expose taxpayers to enormous claims against the Treasury."

DOJ Sues National Association of Realtors for Obstructing Internet Based Brokers

9/8. The Department of Justice's (DOJ) Antitrust Division filed a civil complaint in U.S. District Court (NDIll) against the National Association of Realtors (NAR) alleging violation of federal antitrust laws in connection with its obstruction of real estate brokers who use internet tools to offer services to consumers. See, full story.

FCC Announces Agenda for September 15 Meeting

9/8. The Federal Communications Commission (FCC) announced the agenda [PDF] for its September 15 event titled "Open Meeting". The FCC is not scheduled to consider the adoption of anything. Rather, the FCC will hear "presentations regarding the effects of Hurricane Katrina on communications services in the Gulf Coast states."

This event is scheduled for 9:30 AM on Thursday, September 15, 2005 in the FCC's Commission Meeting Room, Room TW-C305, 445 12th Street, SW. The event will be webcast by the FCC. The FCC does not always follow its published agenda. The FCC does not always start its monthly meetings at the scheduled time.

Federal Circuit Issues Opinion on State Secrets Privilege

9/7. The U.S. Court of Appeals (FedCir) issued another opinion [22 pages in PDF] in Crater v. Lucent, a long running patent and trade secrets case. Crater asserts patent infringement, breach of contract, and misappropriation of trade secrets by Lucent. Lucent, and the intervening United States, defend, not on the merits, but rather on the basis that the proceeding cannot go forth without violating the state secrets privilege.

Crater is the holder of U.S. Patent No. 5,286,129, which pertains to an underwater coupling device for fiber optic cable. Crater asserts that it provided technical data, drawings, and other information about its coupler to Lucent under an agreement to use it for research purposes, not to reveal the information to third parties, and not to produce the coupler without a license from Crater. Crater asserts that Lucent proceeded to both disclose the information, and to produce the coupler without license, for the U.S.

Crater filed its complaint in 1998 in U.S. District Court (EDMo) against Lucent and AT&T alleging patent infringement (a federal claim) and breach of contract and misappropriation of trade secrets (state law claims). Federal jurisdiction was based on the patent claim; there was not diversity of citizenship.

Defendants moved to dismiss for lack of subject matter jurisdiction and for failure to state a claim, on the grounds that since their use of the invention was pursuant to contracts with the federal government (U.S. Navy), 18 U.S.C. § 1498(a) provides that the only action available to the plaintiff is against the government in the U.S. Court of Federal Claims. The District Court agreed, and dismissed the action.

§ 1498(a) provides in part that "Whenever an invention described in and covered by a patent of the United States is used or manufactured by or for the United States without license of the owner thereof or lawful right to use or manufacture the same, the owner's remedy shall be by action against the United States in the United States Court of Federal Claims ..."

In addition, the federal government intervened in the District Court. It asserted the state secrets privilege to prevent Crater from obtaining information in pretrial discovery, and from introducing evidence.

In a previous opinion, issued on June 6, 2001, the Appeals Court affirmed the District Court's finding that § 1498 bars the patent infringement action, but reversed the holding as to lack of jurisdiction. The Appeals Court held that there was jurisdiction over the patent claim, and hence, supplemental jurisdiction over the state law claims. It remanded to the District Court. See also, story titled "Crater v. Lucent" in TLJ Daily E-Mail Alert No. 203, June 7, 2001. That appeal was No. 00-1125. That opinion is reported at 255 F.3d 1361.

On remand, the District Court determined that the government's proper assertion of the state secrets privilege made it impossible for Crater to engage in discovery or to make out a prima facie case of misappropriation of trade secrets or breach of contract, and also made it impossible for Lucent to defend against Crater's claims. On this basis, the District Court dismissed the action. Crater then brought the present appeal.

The Court of Appeals, in a divided opinion, reversed, and remanded. It held that "the government has properly invoked the state secrets privilege and that a valid state secret exists in this case".

It wrote that "further proceedings are required because we do not believe the record in the case -- as it relates to Crater’s two state law claims -- is sufficiently developed to enable a determination as to the effect of the government’s assertion of the privilege on those claims, in terms of Crater’s ability to assert the claims and Lucent’s ability to defend against them. If Crater establishes that it has one or more trade secrets in connection with the Crater coupler, the district court will know precisely what the secrets are. The government can then provide an affidavit or declaration -- or otherwise address -- how the precise questions involved, such as whether a particular trade secret was incorporated in a government device, would impermissibly implicate the state secrets privilege. Armed with that knowledge and with the knowledge of the state secret that must be protected, the court will be able to assess whether any misappropriation of trade secrets claim can go forward."

The majority opinion adds that "the question of whether the state secrets privilege would be implicated by the production of particular documents is not ripe for resolution, and our discussion should not be read as resolving that question."

Judge Newman concurred in the reversal, but dissented as to the instructions as to how the District Court should proceed. She wrote that the Crater should get its discovery and trial, but that the District Court should conduct a closed and in camera proceeding.

She wrote that the majority's opinion places "is a serious cloud on Crater's ability to describe the ``trade secrets´´ that Crater provided to Lucent with the Crater Coupler, for the government has asserted that all information related to the Crater Coupler is a state secret."

She continued that "Crater should have the opportunity to establish that it had trade secrets and that they were disclosed by Lucent to the government without authorization. However, the claim of military/state secrecy appears to extend to the information that Crater provided to Lucent in connection with this project, for if that information was indeed used by Lucent, as Crater asserts and Lucent does not deny, it is covered by the secrecy order. Thus we appear to have devised a remedy impossible of performance."

This case is Crater Corporation v. Lucent Technologies Inc. and AT&T Company, U.S. Court of Appeals for the Federal Circuit, App. Ct. 04-1349, an appeal from the U.S. District Court for the Eastern District of Missouri, D.C. No. 98CV0913, Judge Weber presiding. Judge Schall wrote the opinion of the Court, in which Judge Dyk joined. Judge Pauline Newman concurred in part and dissented in part.

The appeal brief of the U.S. lists several names, including Peter Keisler, the Assistant Attorney General in charge of the DOJ's Civil Division. Keisler previously was a partner in the law firm of Sidley & Austin, where he represented AT&T, which is a defendant in this case.

People and Appointments

9/7. Donald Nicolaisen, Chief Accountant of the Securities and Exchange Commission (SEC), will leave the SEC in October 2005. See, SEC release.

9/7. Chris Guttman-McCabe was named VP Regulatory Affairs at the Cellular Telecommunications Industry Association (CTIA). He will be the CTIA's chief liaison to the Federal Communications Commission (FCC). He has worked for the CTIA since 2001. Before that, he worked for the law firm of Wiley Rein & Fielding. See, CTIA release.

9/7. Christin Baker was named Assistant USTR for Public and Media Affairs. She was previously Communications Director for the House Ways and Means Committee, which has jurisdiction over most trade issues. Before that, she was spokesman for Rep. Anne Northup (R-KY). Before that, she worked for Citizens for a Sound Economy, And before that she worked for former Rep. Dan Miller (D-FL). See, USTR release.

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9/7. The General Accounting Office (GAO) released a report [67 pages in PDF] titled "Information Technology: Management Improvements Needed on Immigration and Customs Enforcement's Infrastructure Modernization Program". It states that the "2004 Department of Homeland Security Appropriations Act provided $40 million for Immigration and Customs Enforcement's (ICE) program to modernize its information technology (IT) infrastructure. The goals of the program -- which ICE refers to as ``Atlas´´ -- are to, among other things, improve information sharing, strengthen information security, and improve workforce productivity." The report finds that the DHS has "satisfied each of the applicable legislative conditions specified in the act". However, it continues that "The Atlas program does not have a current life-cycle cost estimate nor a current cost-benefit analysis showing return on investment. It also does not have a complete set of performance measures. Further, the program does not have an up-to-date security plan that includes Atlas, and officials have yet to develop a privacy impact assessment for the program."

9/7. The General Accounting Office (GAO) released a report [74 pages in PDF] titled "Globalization: Numerous Federal Activities Complement U.S. Business’s Global Corporate Social Responsibility Efforts".

9/7. Viviane Reding, the European Commissioner for Information Society and Media gave a speech titled "Software and services: powering the European digital economy" in Brussels, Belgium, on September 7, and a speech titled "i2010 : a new start for Lisbon and for European Information Society and Media policies" in London, United Kingdom, on September 6.

William Rehnquist's Legacy in Technology Law

9/6. The Supreme Court's record in leading technology related cases is different from its record on many other issues, such as abortion, race, and religion, that now animate the debate over judicial nominees. The Court has decided many of its technology related cases with unanimous, or nearly unanimous, opinions. Moreover, when the Court has been divided, the division has not followed ideological or partisan lines.

Rehnquist, as Chief Justice since 1986, has had the opportunity to assign the task of writing the opinion of the Court in those cases in which he is in the majority. He has rarely assigned technology related opinions to himself. And when he has dissented, he has rarely written an opinion. Hence, his record in technology related cases has largely been that of joining in the opinions written by others.

There are, however, a few leading cases in which he wrote notable opinions. In Bartnicki v. Vopper (2001) he wrote a dissent in which he advocated privacy in electronic communications. In US v. American Library Association (2003) he wrote the opinion of the Court upholding the Children's Internet Protection Act, which requires libraries receiving federal funds to use filtering technology. In Seminole Tribe v. Florida and Florida Prepaid he wrote that the Congress cannot abrogate state sovereign immunity, including in suits for infringement of intellectual property rights.

See, full story.

Court Holds Hearing on Microsoft's Motion for Preliminary Injunction Against Google

9/6. Microsoft filed a Motion for Preliminary Injunction in state court in Washington in its action against Google and Kai-Fu Lee on August 22, 2005. The court held a hearing on the motion on September 6 and 7. Microsoft released a redacted version [26 pages in PDF] of the motion on September 6.

Microsoft filed its complaint in the Superior Court, King County, Washington, on July 19, 2005, alleging that a key employee, Kai-Fu Lee, breached his employee confidentiality and non-compete agreement with Microsoft, by going to work for Google on competing projects. See also, story titled "Microsoft Sues Former Employee Who Joined Google" in TLJ Daily E-Mail Alert No. 1,178, July 20, 2005.

The agreement states that "While employed at Microsoft and for a period of one year thereafter, I will not (a) accept employment or engage in activities competitive with products, services or projects (including actual or demonstrably anticipated research or development) on which I worked or about which I learned confidential or proprietary information or trade secrets while employed at Microsoft ..." (Parentheses in original.)

Microsoft seeks to prevent Kai-Fu Lee from going to work for Google. The Court has not yet ruled on the motion.

See also, e-mail message [PDF] from Kai-Fu Lee to Eric Schmidt, Sergey Brin, and Larry Page in which he states that "I am currently a Corporate VP at Microsoft, working on areas very related to Google", and excerpts [PDF] from Kai-Fu Lee's deposition.

This case is Microsoft Corporation v. Kai-Fu Lee and Google, Inc., Superior Court for the State of Washington in and for King County, No. 05-2-23561-6 SEA, Judge Steven Gonzalez presiding.

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9/6. Peter Mandelson, the European Commissioner for Trade, gave a speech titled "Challenges and Opportunities for EU and China" in Beijing, China, on September 6, 2005. He said that "Due to unprecedented progress in transport technology and communication, globalisation is bringing about a fantastic acceleration of exchanges between the nations of the world." He argued that this is beneficial. He also stated that protectionism "inhibits innovation and adjustment" and "entrenches uncompetitiveness". But he said, "I operate in the sphere of practical politics not pure economic theory. I have to recognise and manage public pressures, and try to reconcile them when they clash." Mandelson will be in Washington DC on September 13 and 14, 2005. See, notice. He will give a luncheon address on Tuesday, September 13, at the National Press Club.

9/6. The government of the Dominican Republic approved the Central America-Dominican Republic Free Trade Agreement (CAFTA-DR). El Salvador, Guatemala, Honduras and the United States have already done so. See, USTR release.

Go to News from September 1-5, 2005.