IP Finance is pleased to have this guest post from Dr Janice Denoncourt, professor at Nottingham Law School.
One of the biggest British tech deals involved
Autonomy, a software company created in 1996 by former Cambridge University academic
Mike Lynch. The British and American
litigation that ensued highlights the need for wider discussions regarding
reforms to accounting for nebulous intangible assets such as software,
copyright and licences. How are these
valued, accounted for and reported in company annual reports?
With hindsight, the evidence showed that the
sale of Autonomy to behemoth Hewlett Packard (HP) in August 2011 over a decade
ago was unfortunately rather unsuccessful.
Within a year of purchasing Autonomy and with it, access to its
knowledge management software, HP identified concerns regarding Autonomy’s
accounting practices – alleging serious accounting irregularities including
misrepresentation and disclosure errors. HP subsequently wrote down the goodwill value
by billions. In other words, HP overpaid
for Autonomy. HP found that Autonomy’s
intellectual property rights and perceived overall value were worth much less
than its due diligence was able to confirm.
Litigation ensued on both sides of the Atlantic.
The UK’s Serious Fraud Office eventually terminated
its criminal investigation into Autonomy due to ‘insufficient evidence for a
realistic prospect of conviction’.
Meanwhile HP was sued by its own disgruntled
shareholders under the UK Companies Act 2006. HP in turn successfully sued former Autonomy former
CEO Mike Lynch and former Chief Financial Officer Sushovan Hussain in civil
proceedings before the UK High Court to recover its financial losses. In his
defence, Mr Lynch submitted that misunderstandings as to accounting differences
between the UK and the US were the problem, not deliberate fraud. Namely, there were differences between
international financial reporting standards (IFRS) use by Autonomy, and the
generally accepted accounting principles (GAAP), the financial reporting
standards used for US-based companies. Nevertheless, in January 2022, the Court
held Mr Lynch and his CFO guilty of fraudulently inflating Autonomy’s value by
misleading JP about its performance: Autonomy and others v Michael Richard
Lynch and another (17 May 2022) High Court of Justice Business and Property
Courts England and Wales. At paragraph
40 of the judgment, the Court identified the alleged improper practices
included:
40.1. artificially inflating and
accelerating Autonomy’s revenues;
40.2. understating Autonomy’s costs of goods
sold by characterizing such costs as sales and marketing expenses so as to
protect gross margins;
40.3. misrepresenting Autonomy’s rate of
organic growth; and
40.4. misrepresenting the nature and quality
of Autonomy’s revenues as well as overstating its gross and net profits.
The damages award in favour of HP is pending
and will likely be circa £4billion. Autonomy’s
auditors were also subject to civil legal proceedings. The UK Financial Reporting Council (FRC)
fined accounting firm Deloitte £15million for auditing failings of the Autonomy
accounts between 2009-2011 related to hardware sales and software licences to
value-added resellers, rather than to end customers.
In the United States, the Department of
Justice (DoJ) initiated a criminal investigation. In contrast to the UK’s civil
judgment, the US court has now found Lynch and Hussain ‘not guilty’ of all 15wire
fraud and securities fraud charges. Lynch had been extradited from the UK to San
Francisco where he was under home confinement having posted a $100USD million
bond.
Decade long litigation history aside, the
wider issue is that this type of financial hole calls into question the
contemporary law and practice of corporate governance, financial reporting and
accounting standards to the ability of professional auditors, accountants and
lawyers during the due diligence phase to identify over-valuation more
readily. Further, how should the system
improve standards and practices related to accounting for intangible assets to better
assist auditors, purchasers and investors?
Generally speaking, the disclosures of
Autonomy’s intangible assets, namely, software (copyright protected) and
licensing are by their nature more difficult to value than tangible assets,
leading to both over and under valuation.
Accounting standard setters such as the International Financial
Reporting Standards (IFRS), the European Accounting Association (EAA), and the
UK Endorsement Board (UKEB) as well as academic researchers are working on how
to categorise different types of intangibles, introduce taxonomies of common
terminology and make recommendations to aggregate or disaggregate type of
assets in order to elicit higher quality decision-useful information. This
article distils the need for a new research agenda to tackle contemporary accounting
in terms of granularity and comparability for intangibles, IP rights and
licences to a wider audience.
Company directors should be interested in
how accounting ‘faithfully presents’ intangible assets in their own country,
and when the company trades internationally.
Dr Lynch was the President of Autonomy, Inc. and subsidiary ASL and he
owed legal duties as a company director.
Directors are required to sign off the audited accounts. The CFO, Mr Hussain was held to be a de
jure director of all three relevant subsidiaries, Autonomy Inc, Zantaz and
ASL, and owed duties to all three.
Company directors, auditors, internal
accountants and corporate governance professionals are in an increasingly
difficult position. Intangible assets
are prolific yet traditional approaches for valuing tangible assets such as
computer hardware or plant and equipment do not map well to intangibles. Therefore, the risk of litigation for
misrepresentation (innocent, negligent or fraudulent) is evident. Valuation and reporting of intangible assets
is the new normal yet, intangibles is the term for a huge category of diverse corporate
assets. One sub-set of intangibles is
intellectual property (IP) rights. For
example, Autonomy’s software may protected as a copyright work under the Copyright
Designs and Patents Act 1988 if it meets certain legal criteria. It is usually valued by the amount of
copyright licensing revenue generated. The first allegation was that Autonomy’s hardware sales was
‘mischaracterised’ as licence revenue. The legal issue is whether this was
deliberate or not. It was alleged that
both Autonomy’s CEO and Finance officer had fraudulently (with knowledge)
inflated the figures reported.
However, the outcome of a series of civil
and criminal court cases in two jurisdictions over 13 years turned on the applicable
standard of proof. The criminal
standard, proven ‘beyond a reasonable doubt’ was too high a hurdle for the
prosecution to meet in the US. However,
the UK High Court civil judgment decided ‘on the balance of probabilities’
handed down by the Honourable Mr Justice Hildyard stated at paragraphs 101-102:
101.
This has been an unusually complex trial, 93 days long. Dr Lynch was
cross-examined for 20 days. There was a
database of many millions of documents from which there was extracted a trial bundle containing more
than 28,000 documents. These documents have been
the most reliable source of evidence. But there were also hundreds of pages of
hearsay evidence, largely comprised of
transcripts from previous proceedings in the United States, both civil and criminal.
102.
Nevertheless, I have reached clear conclusions in these proceedings on the
civil liability of Dr Lynch and Mr
Hussain for fraud under Financial Services and Markets Act (FSMA), common law, and the Misrepresentation
Act 1967, applying, of course, the civil standard of proof of the balance of probabilities.
From HP’s perspective how the numbers added
up in their valuation of the relatively young Autonomy technology firm
mattered. Setting fraud aside, the
system needs to support stakeholders as to new norms and standards of
transparency and disclosure expected for reporting on corporate intangible
assets. However, even the accounting
standard setters themselves are not sure ‘Which Way to Go?’ with respect to
International Accounting Standard (IAS) 38 Intangibles. International academic researchers such as the
IFRS-EAA Intangibles Research Group were commissioned to produce a literature
review and are currently working on evidence to underpin policy as how best
improve the accounting rules related to intangible assets. A key component involves when to formally
‘recognise’ revenue of intangible assets during the business lifecycle and
where such material figures and information should be reported – in the
accounts, notes to the accounts or in additional narrative ‘disclosures’ where
the company directors give explanations? The research group is also evaluating
court cases to study how best to ensure an appropriate governance and
stewardship standard to reduce the risk of fraud to promote financial stability
and the needs of our modern technology ecosystem.
Dr Janice Denoncourt
Associate Professor
ORCID ID 0000-0003-2176-8935
IFRS-EAA Intangibles Research Group
Director IP Research Group
Nottingham Law School
Nottingham Trent University
United Kingdom