In Klipsch Group v. ePRO E-Commerce, No. 16-3637-cvNo. 16-3726-cv (2d Cir. Jan. 25), the U.S. Court of Appeals for the Second Circuit affirmed the Southern District of New York's order that “the likely valuation of actual damages” in the matter was “$25,000,” the defendant had to pay the plaintiff $2.68 million as “compensation” for “additional discovery efforts” the plaintiff had to take because of the defendant's misconduct. The court further “imposed an additional $2.3 million restraint, which amount it determined would be appropriate to secure the plaintiff's “likely recovery of treble damages and attorney fees at the conclusion of the case.”

The defendant's misconduct in producing discovery, then, turned a $25,000 case into a $5 million one. There is nothing in the opinion to suggest that the defendant's counsel played any part in its client's misdeeds. There is, however, a strong lesson to be taken from the matter: advise one's client to be honest with regard to e-discovery production. Counsel your client to forego all improprieties that may give it client a benefit, since you do not know when or how your client might get caught acting improperly and once that occurs, the matter will be about e-discovery, to the detriment of your client, and not about the merits of the case.

Background

In August 2012, the plaintiff, a manufacturer of sound equipment including headphones, sued a subsidiary of the defendant on the ground that it was selling counterfeit plaintiff headphones. The defendant admitted that “some infringing sales occurred,” but argued that “the sales of the relevant products amounted to less than $8,000 worldwide,” while the plaintiff alleged that the defendant had “sold at least $5 million in counterfeit or otherwise infringing” products. The Second Circuit noted that “initially,” the district court found the defendant's valuation of the case “persuasive,” but, as the matter proceeded, the defendant's “failure to comply with its discovery obligations began to cast doubt on the reliability of its representations” generally, including those pertaining to valuation.

By March 2013, as the plaintiff was preparing to take depositions of the defendant's employees in Hong Kong, the defendant “had produced fewer than 500 documents,” a remarkably small number of documents in a matter involving worldwide sales. As an example of suspicious activity by the defendant, the court noted that the defendant “insisted that it did not possess any original sales documents, and instead turned over spreadsheets created specifically” for the litigation “that purported to list all relevant sales.” When the defendant's CEO was deposed, “it became clear that” the defendant “had not placed a litigation hold on a substantial portion of its electronic data, including any emails or faxes.” As well, at about the time, the defendant “also admitted that it did possess transactional sales documents that should have been disclosed.” To remedy those problems, the defendant retained (for the first time in a complex matter involving voluminous e-documents) an e-discovery vendor, “to conduct a keyword search of its electronic documents.” The vendor's “search resulted in the production of an additional 40,000 documents, including 1,236 original sales documents.” Some of the documents contradicted the CEO's testimony, suggesting that the defendant “had misidentified the suppliers of the counterfeit products.” As well, the new production contained “indications” that the defendant “had artificially limited” its discovery vendor's “investigation into its electronic records.” The magistrate judge overseeing discovery then allowed the plaintiff to re-depose the defendant's employees. At the CEO's second deposition, 15 months after the complaint was filed, “it became clear that, despite the magistrate judge's clear directive,” the defendant “still had not imposed an adequate litigation hold,” despite the advice of counsel to comply with the court's order and the counsel's warning “that noncompliance would bring consequences.”

In December 2013, the plaintiff moved for discovery sanctions, claiming that the defendant's “failure to initiate a proper litigation hold or to promptly disclose documents” led to a loss of “large quantities of relevant documents that would have reflected a larger volume of infringing sales had been lost.” The magistrate judge mainly agreed, noting that the defendant's “false and misleading representations” led to “uncertainty about the plausibility, as well as the accuracy,” of the defendant's “current factual assertions about the scope of infringing sales and resultant profits.” The magistrate, however, declined to impose sanctions at that time, choosing instead to authorize the plaintiff to undertake an independent forensic examination of the defendant's computer systems. The plaintiff would pay the examiner but could move to shift payment obligations if the results showed wrongdoing by the defendant.

The forensic examiner's first finding of note was that the defendant “employees who were custodians of responsive information had deleted files, emails and other potentially relevant data.” Live sales databases showed evidence of editing and omissions and therefore offered unreliable evidence of historical sales data. Because the defendant had, suspiciously, failed to preserve “the backup copies of its databases that it routinely generated for disaster recovery purposes,” the examiner concluded that “no reliable record of historical data was available.” Focusing upon the computers and email accounts used by the defendant's employees, the examiner found that “the custodians had engaged in various forms of spoliation,” which included “manually deleting thousands of files and emails, using data-wiping software shortly before” the “forensic examination was scheduled to begin,” and “updating … operating systems during the litigation period, which had the result of clearing out data regarding” the usage of programs by the employees. The examiner was “also denied access” to the email and private messenger accounts of several employees, despite the defendant's “admission that those accounts were sometimes used for business purposes.”

In light of the examiner's report, the plaintiff moved the district court to increase the hold on the defendant's assets and enter a default judgment in the plaintiff's favor. The court increased the hold on the defendant's assets from $20,000 to $5 million and ordered the defendant “to show cause why a default judgment should not be entered against it.” The district court held a four-day evidentiary hearing on the plaintiff's motion.

The defendant filed an interlocutory appeal “challenging the resulting imposition of discovery sanctions,” including, inter alia, the order that it pay the plaintiff's costs incurred as a result of the defendant's misconduct, and the restraint on $5 million of the defendant's assets. The defendant challenged many of the district court's evidentiary rulings and factual findings and also argued that the resulting sanctions were “impermissibly punitive” because they were “disproportionate to the likely value of the case.” The court found “no error in the district court's factual findings,” and concluded that the monetary sanctions awarded “properly compensated” the plaintiff “for the corrective discovery efforts it undertook with court permission in response” to the defendant's misconduct. The Second Circuit accepted five findings by the district court supporting its finding of spoliation and its imposition of sanctions:

• About 4,596 responsive files or emails were manually deleted;
• Seven employees used data-wiping programs shortly before the forensic examination began, resulting in 31 permanently unrecoverable files;
• Eighteen employees ran operating systems upgrades during the litigation hold period, which resulted in the loss of their program usage data;
• The defendant failed to provide access to the email accounts of seven employees who had worked on its email direct marketing homepage but were no longer employed with the company, and deleted or failed to provide access to the email accounts of 12 other custodians of discoverable data; and,
• Thirty-two out of 36 identified custodians, including the defendant's CFO and the employee coordinating the plaintiff's examiner's access to the defendant's data for his examination, refused to permit access to their accounts on a private messaging system, which, although primarily used for personal communication, were listed on their corporate email signatures.

The court, therefore, affirmed all of the district court's orders imposing sanctions.

The Second Circuit rejected all of the defendant's arguments that the district court's factual and legal findings were either incorrect or overstated. The defendant argued that the district court misstated “exactly which employee used which data-wiping program at which time,” but since it did not contest that “multiple custodians of discoverable data had data-wiping software on their devices during the litigation hold period,” that “at least some of those programs were last used at a time very close to the initiation of” the plaintiff's examiner's forensic examination, and, that “the use of those programs resulted in the permanent deletion of 31 files,” the court found those facts “sufficient to support the district court's finding of willful spoliation.” As well, the court rejected the defendant's contention that its “inability to provide access to certain email and messaging accounts should not have been construed as evidence of willful spoliation because those accounts were primarily for private use,” finding that because “those accounts … were also sanctioned for business use” and the defendant had no “software usage policy in place requiring its employees to segregate personal and business accounts or to otherwise ensure that professional communications sent through personal accounts could be preserved by the company for litigation purposes was the company's own error,” the defendant could not use such practices “to avoid discovery,” nor could it “complain because the resulting and wholly foreseeable deletion of material that could well have contained relevant evidence gave rise to sanctions.”

Finally, the court rejected the defendant's argument that the $5 million in sanctions violated Rule 37(e) of the Federal Rules of Civil Procedure, which governs when a court may impose sanctions for the spoliation of electronically stored information. The court observed that the district court did not rely on Rule 37, but rather imposed sanctions “under the court's inherent power to manage its own affairs.”

The court first noted that “there is no special rule requiring parties to suffer an opponent's open and notorious discovery misconduct in small value cases.” The court furthermore observed that the “history of the case” made clear “that the sanctions and fees awarded … were carefully limited to costs” the plaintiff incurred “in direct response” to defendant's “misconduct,” and that each step the plaintiff took only after obtaining approval from the magistrate judge and only after the defendant “had already squandered an opportunity to correct its own errors.” The defendant's failure, for example, to implement a litigation hold was first discovered during the the plaintiff's first round of depositions with the defendant's employees, but the defendant was not sanctioned at that time, nor was the plaintiff “given carte blanche” to explore the defendant's files. Instead, the defendant was permitted to hire its own discovery expert to correct the error, which resulted in the production of substantial additional discovery. The plaintiff then spent approximately $550,000 on a second round of depositions occasioned by that late production. Only many months later, after the defendant “had repeatedly shown itself to be an untrustworthy participant in the discovery process, did the magistrate judge determine that” the plaintiff was “fully justified” in seeking to undertake an independent forensic examination. The size of the sanctions, then, were the result of the defendant's failure to undertake the discovery process honestly.

Finally, the Second Circuit rejected the defendant's argument that “the sanction should be reduced in light of the small amount of money likely at issue on the merits.” The court noted that the defendant failed to identify “any authority limiting a district court's discretion to award a compensatory discovery sanction on the basis of the ultimate damages award,” and cited two cases in support of its observation that “courts routinely award such sanctions without any discussion of the ultimate merits recovery.”

Discussion

No evidence was presented that the defendant's counsel acted unethically in any way. Nevertheless, the evidence paints a detailed picture of what it looks like when a party acts unethically, what are the biggest and most typical ethical errors, how that can be avoided, and why they should be avoided?

First, it is important to note that all of the issues begin with issues of data preservation and collection. No legal hold was put in place, and evidence was uncovered to indicate that, when data should have been preserved, some of it was actually systematically destroyed on the devices that held that data.

In the last 15 years or so, while e-discovery has grown from an esoteric specialty to one of the most dominating aspects of litigation, attitudes toward data preservation and collection have changed but there has not been anything close to a universal acceptance as to how to do such tasks properly. Initially, they were mysteries. When vendors introduced forensic data collection, clients complained of its cost, principally because they did not recognize that that cost was a wise investment, a small portion of the total cost of an e-discovery production. Instead, clients thought of it as the first cost, coming on too early in the litigation, i.e., before the good lawyer would allow the client to avoid spending anything at all on discovery because the lawyer would get the case dismissed. As e-discovery became more and more the rule and less the exception, data preservation and collection was accomplished in three principal ways: many parties engaged analysts to perform forensic collections; sophisticated clients employed IT experts who could set up internal litigation holds; and, companies created a business culture whereby litigation hold letters (or emails) were sent out and users simply did not delete anything that fell under the hold. Compliance through the third means became sufficiently widespread that the issue of data collection ceased being the most discussed one among e-discovery clients and vendors, but it did not solve the problem, meaning that it left the world of potential e-discovery producers to act as the defendant did here.

Whether forensic data collection is the first cost in litigation or a total waste of money because there should be no costs accrued is one way of stating the problem of rationalization that leads a party away from acting ethically. If you think of litigation as something that always has its own steps, then the quoted cost of one step will first be vetted to determine whether it is reasonable in the marketplace and, if it is, will then be placed onto a list of each step and its estimated cost, so that the litigant can get a realistic sense of the cost of taking the matter to trial. The ethical questions that arise from such a way of thinking have to do with what is realistically required of the client, here what the client must preserve. An accurate, factual background regarding the matter should lead the party to determine whose data must be preserved and where that data resides. There will always be judgment calls regarding peripheral users, but while decisions regarding preservation of their data may be questioned, they rarely will be on an ethical level.

In the context just discussed, nothing the defendant did with regard to data preservation could be deemed to be ethically sound. Here, the defendant went beyond simply not discharging its duty to preserve: it actively destroyed data. Once such actions have been established, any presumption that data that was simply missed by an ethical litigant is transformed into the opposite presumption that the unethical litigant destroyed the smoking gun email. Obviously, the same will hold true for counsel who advises to do what the defendant did here, does not take proper steps to stop such behavior, conceals that behavior, or does not disclose it when he or she has an obligation to do so.

Conclusion

Examination of the unethical behavior of the defendant in Klipsch Group v. ePRO E-Commerce, provides great guidance in how counsel should act ethically when dealing with issues of data preservation and collection. Typically, writings on e-discovery, as is true for everything, focus on the “next big thing,” which today is the change in European Union (EU) laws regarding data privacy, the Internet of Things, the use of Technology Assisted Review (TAR) and other topics far more sophisticated than what would be taught in e-discovery 101. Fundamental issues, however, never disappear, as the case at issue demonstrates. Unless data production in a particular matter ends up proving the merits of the requesting party, if one starts with unethical data preservation or collection, whatever is produced is meaningless, or worse. The client here who sought to avoid a $25,000 judgment was assessed with a $5 million one. Perhaps relating that to a new client might get their attention.

Leonard Deutchman is vice president, legal for KLDiscovery. Before joining KLDiscovery, he was a chief assistant district attorney at the Philadelphia District Attorney's Office, where he founded the Cyber Crime Unit and conducted and oversaw hundreds of long-term investigations involving cybercrime, fraud, drug trafficking and other offenses.

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