In this issue:
Data theft
Breach of warranty claims
Linear regression
Asset protection services
Technology can simplify and speed up a company's processes, but it can also make it easier for employees to steal or misuse company data. In this edition of SWift, we discuss the theft of electronic data.
DATA THEFT
An inside job
In recent years, employers have become increasingly vulnerable to resentful employees misusing or stealing electronic data. John Holden looks at how employers may be at risk and how they can protect themselves.
As more and more businesses rely on technology for essential processes, it is no longer enough for them to think only in terms of controlling access to physical documents.
Modern technology allows for the transfer and/or exchange of huge volumes of electronic data in a matter of minutes. Unfortunately, this means that a disgruntled or departing employee can easily destroy, steal or misuse valuable proprietary information. He/she may even choose to pass on commercially sensitive data to a competitor, leaving his/her former employer potentially exposed to a loss of profit and/or costly litigation.
The internal risk
Employees often wrongly believe that the work they do on their employer's computer and the information stored on it belongs to them. But in most situations the information and data stored on the computer belongs to the employer, even if personal in nature.
Some employees would not hesitate to remove business information using portable storage devices, such as memory sticks or even mobile phones, or by burning data to CDs or DVDs. If it is not possible to remove data physically, they might email it to a personal account, such as Hotmail or Yahoo.
Businesses sometimes find that a vindictive departing employee has deleted or destroyed data and, on occasion, gone to extreme lengths to wipe all information from a computer or other electronic device. There have even been cases where equipment has been physically damaged.
Prevention better than cure
Businesses can safeguard their electronic data by introducing and enforcing policies that cover:
- information security
- practical acceptable usage
- custody and physical handling of electronic devices.
It is vital that all staff are aware of the requirements that these policies place on them.
When it goes wrong
The demand for forensic technology services grew largely out of the need to recover and rebuild computer records and data for use as evidence in criminal proceedings. Such capabilities are now becoming a necessity in employment disputes and commercial litigation.
The following two examples involve the misuse of data.
Cracking the case
Two company directors were discussing staff bonuses via email. Attached to the email was a Word document listing the proposed bonuses. The file was encrypted with a password known only by the two directors.
An IT manager saw the email and decrypted the Word document. Having read it, he approached one of the directors to express disappointment at his bonus payment compared to that of others.
Our Forensic Technology team examined the IT manager's computer and found that he had used password cracking software to access this information. The IT manager resigned shortly after the investigation.
Retrieving the rights
A software programmer was tasked to write a specific software program for resale to the human resources departments of medium and large companies. However, having realised the potential value of the program, the programmer destroyed and falsified records on his employer's computers so that it would look like he owned the rights to the software.
Our Forensic Technology team recovered data from the programmer's computer which revealed the fraud and protected the employer's rights to the intellectual property.
Initiating recovery
In both these cases, the immediate isolation and preservation of all electronic devices connected to the investigation was extremely important. No-one should be allowed to work on a computer that might contain valuable evidence as they could render the evidence unusable, even through their efforts to identify and preserve it.
Employees subject to investigation should not be allowed to access electronic information in case they attempt to destroy and/or alter evidence. If there is reason to believe an employee is hiding electronic devices and/or information at home or on other premises, an appropriate search and seizure order should be considered.
Bringing in the experts
Forensic technology experts operate as private investigators in cyberspace. They can retrieve data often deemed irrecoverable by other IT professionals, such as uncovering user profiles, deleted data (even data deleted by reformatting or overwriting a disk, or destroying the equipment) and records of web surfing. Bringing in experts at the initial stages of an investigation ensures the best chance of maintaining data integrity for evidential purposes.
When involved in an investigation, forensic technologists typically start by imaging (the process of making an exact duplicate) the hard disk drives to preserve the original data forensically.
Using a flexible approach and consultation at every stage, forensic technologists can ensure that only the most relevant work is completed during the investigation process, providing clients with the data they require to pursue their case successfully at a proportionate cost.
ONLY FOOLS OR LIARS?
Breach of warranty claims
A corporate financier might say that only a fool or a liar would find themselves on the receiving end of a breach of warranty claim after the sale of a business.
Arguably, a well-organised, properly advised vendor should be able to sell a business and be reasonably certain that a claim from the purchaser will not follow. But forensic accountants see plenty of cases where a breach of warranty is alleged and a claim is made.
Some of these claims arise due to completing deals in a hurry, or where the commercial desire to 'do a deal' has overridden the need to properly secure both parties' positions through the transaction documentation. Purchasers who choose to claim generally come across a number of stumbling blocks, some of which we consider here.
Damages
The measure of damages in a breach of warranty case will be the difference between the value of the business sold as warranted and its actual value.
It is often assumed that the value of a business sold as warranted is equivalent to the consideration paid. However, sometimes the warranted information supports a lower valuation than the consideration paid. The purchaser may have paid more for a number of reasons, such as their own projections of what the company could achieve in the future.
Understanding what valuation the warranted information would have supported should be the starting point to assess the damages that the purchaser could credibly recover.
Bases of valuation
Arguments over how a business was valued when it was acquired are likely to become central to quantifying potential damages. This was highlighted in Senate Electrical Wholesalers Ltd v Alcatel Submarine Networks Ltd [1999]. The claimant pursued damages in excess of £26m but the Court of Appeal awarded none, even though the court found for a material breach of warranty following an overstatement of profits reported in warranted management accounts.
This decision should serve as a reminder that the eventual outcome of a breach of warranty case may be a finding of a breach, but no loss. An unattractive prospect considering the time and expense involved in bringing such an action.
The claimant's own accounts – having it both ways?
When one company purchases another, the directors of the acquiring company may perceive, after the event, that what they bought is not worth what they paid. But how do they disclose this information in their accounts?
Accounting standards dictate that the identified loss should be recognised in the acquiring company's audited financial statements. But this suggests to their audience, including the company's investors and the financial markets, that the directors made an error of judgment and bought an overpriced company.
The directors can only be vindicated if they pursue a claim for breach of warranty successfully and secure damages to compensate for their perceived overpayment.
This tension can lead claimants to try and have it both ways; they claim for the acquired business being worth less than warranted, but do not reflect this in their accounts. Particulars of claim in a breach of warranty case can therefore be completely at odds with the treatment of the transaction in the claimant's own audited financial statements.
This arose in Senate, where the claimant made what was described as a "massive" claim, but the audited financial statements indicated only a "modest" loss. The Court of Appeal commented: "...it hardly lies in the mouths of the directors or auditors of Senate to say that the accounts were wrong having regard to their statutory duties..."
One of the first courses of action for a defendant in a breach of warranty case should be to examine the financial statements of the acquiring company to see if they can identify such an obvious conflict with the particulars of claim.
Warranties over accounts
A variety of warranties may have been given on the results reported in the audited financial statements and management accounts of the company being sold. A number of these may turn out to be problematic for the warrantor when a claim is brought against them.
For example, giving a warranty that includes the word 'accurate' in relation to accounts is likely to leave the vendor exposed. This term is fundamentally incompatible with the basis on which accounts are prepared, which involve judgment rather than the absolute precision that the word 'accurate' implies.
Furthermore, giving warranties over management accounts can be dangerous for vendors, unless the management accounts in question are really of the standard that the warranty implies.
As this article highlights, claims for breach of warranty may not be as cut and dried as some claimants think.
Breach of Warranty
In-house seminar for lawyers
Smith & Williamson's Forensic Services team has had extensive experience of acting as experts and advising on claims for breach of warranty, both for claimants and defendants.
Using this experience we have developed an in-house seminar suitable for lawyers:
- engaged in advising on the sale and purchase of businesses and companies
- instructed by claimants and defendants in breach of warranty cases.
Our seminar covers:
- relevant case law
- the principles of calculating damages in breach of warranty cases
- valuation issues
- issues arising from examples of actual warranties
- how best to enhance the chances of a successful claim for breach of warranty how best to defend a claim for breach of warranty.
This seminar typically runs for one hour, and is CPD-accredited with the Law Society and ILEX. It can be provided to groups of six or more (including contentious and non-contentious lawyers), free of charge, at your offices or at a location convenient to you.
PREDICTING THE FIT
Statistical analysis
Vanessa Winspeare and Sam Green examine whether basic linear regression reduces the inherent uncertainty when predicting the future.
When forensic accountants quantify damages they may need to analyse accounting and non-accounting information in order to answer the question: "What has the claimant lost as a result of the defendant's actions?"
A major barrier to answering this is the inherent uncertainty in predicting future events and their impact, for example, on future income or profit. In order to reduce this uncertainty, forensic accountants sometimes apply statistical techniques. But how accurate are these techniques and can the results be misleading?
Linear regression
One of the most common statistical tools that forensic accountants use is linear regression, or the 'line of best fit'. This technique models the relationship between two variables – one dependent and one independent. For example, the cost of production in relation to units of output where you would expect the level of output (independent variable) to determine the level of costs (dependent variable), assuming a constant marginal unit cost.
Linear regression, as the name suggests, is based on the assumption that a linear relationship exists between the two variables. Widely used computer packages, such as Microsoft Excel, can easily perform linear regression. Forensic accountants sometimes employ linear regression models to determine losses because they use historical data to predict future trends. However, this approach has its limitations.
The reliability of a future trend predicted by the linear regression of historic data depends on the assumption that past trends will continue into the future. Increasing caution needs to be applied the further the projection into the future.
A linear regression model is also based on the assumption that changes in the one variable can be explained solely by changes in the other. In reality, there are many influences on the data that the model does not take into account. These influences, such as market conditions, exchange rates, prices and the competitive environment, can alter the relationship and thus undermine the quality of the prediction.
Linear regression will always draw a straight line through a set of data points (the 'best fit') regardless of whether a linear relationship exists in reality. But best fit does not necessarily signify a 'good fit', bearing in mind the purpose for which the trend line is being derived; to use historic trends to project into the future.
The coefficient of determination
To determine the quality of the fit, it is necessary to analyse the strength of the relationship between the two variables. The most commonly used measure is the coefficient of determination (r2).
The value of r2 ranges from 0 to 1, where 1 represents a perfect fit/correlation and 0 means no fit at all. A low value thus implies a weak linear relationship between the variables. This may result from trying to derive a trend from a non-linear relationship, other variables not taken into account in the model or that there is simply no relationship between the two variables.
A relatively high level of correlation could lead to the conclusion that for a given independent variable, the dependent variable could be reasonably predicted. But caution still needs to be applied; there may be other influencing factors.
Consider the following example. We statistically analyse the correlation between the number of times a man sleeps with his socks on and the number of times he wakes up with a headache. A high correlation would suggest that if he wanted to avoid waking up with a headache, he shouldn't go to sleep with socks on. But there would be no logic to this inference unless there were other indicators that the wearing of socks in bed can cause headaches. Both variables might be dependent on a third factor that is not included in the model but results in the high correlation. In this example, the third and independent factor is actually that when he goes to bed drunk he forgets to take his socks off!
Provided its limitations are borne in mind, simple linear regression can be a useful tool to assist the court in matters of quantum. However, caution should always be exercised when reviewing or accepting calculations based on these techniques; the sceptism a good forensic accountant will always apply.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
