Tuesday, January 15, 2008

Laptop Hard Disks May be Searched upon Entering the U.S.

This post departs from the usual theme of this blog in order to bring an alarming practice of the U.S. Customs and Border Protection service (the CBP) to the attention of persons in the European venture capital industry -- fund managers, managers of venture-financed companies, and professionals advising them -- who travel from time to time to the U.S.

A series of recent cases in the federal courts in the U.S. have brought to light the fact that the CBP claims an unrestricted right to search hard disks on laptops of persons entering the U.S. The policy behind the practice is not written down and has no formal guidelines, so far as we know. It is therefore difficult to know anything about it unless one has the bad luck to experience it or has read some of the cases challenging it.

The policy and practice of the CBP, as reflected in the cases now moving through the U.S. courts, may be summarized as follows:

  • Customs agents have the unrestricted right to search hard disks on laptops of persons entering the U.S. They do not need probable cause or even a reasonable suspicion to do so. They may act on the basis of hunches, whims or at random. It is the same as searching a traveler's suitcase.
  • The right to search hard disks extends to searches of other devices or media such as Blackberries, CD's and memory sticks.
  • Customs agents conduct such searches by requiring the traveler to open and boot his laptop. The customs agent then takes over and systematically searches files on the laptop's hard disk.
  • If the agent finds files of interest he confiscates the traveler's laptop, and the traveler must continue his travel without it.
  • While it has the laptop in its possession the CBP may create and retain a mirror image of the hard disk.
  • Copies of the hard disk may thereafter be circulated by the CBP to other U.S. governmental agencies.
  • In due course, the laptop will be mailed back to the traveler, unless criminal charges are brought, in which case it may be retained as evidence.
As it happens, the three principal cases challenging the CBP practice of searching laptops have all involved child pornography. The business traveler from Europe can take no comfort from that fact, however. In one case the search was apparently triggered by nothing more than the fact that the traveler arrived at Los Angeles International Airport from the Phillipines and had a goatee (U.S. v. Arnold). In another case the search was triggered by the fact that the CBP agent spotted a laptop in the back seat of the defendant's car as he crossed the border with his father from Canada to the U.S (In re Boucher).

Recognizing the threat this practice of the CBP poses for business travelers, a business travel organization, the Association of Corporate Travel Executives, intervened and filed a brief on behalf of the traveler in the Arnold case. And just this month (February 2008) a leading U.S. law firm based in Washington, D.C., Arnold & Porter LLP, issued a Client Advisory, entitled "Working on the Plane? How International Travel can Result in Government Officials Examining Your Electronic Data," bringing this risk to the attention of their clients.

The CBP's interest in intercepting pornographic material not only offers no comfort to business travelers it may itself heighten the risk of a laptop search for those travelers whose passports show recent travel to countries known as sex tourism destinations, e.g., Thailand.

To date the results of the cases involving laptop searches are mixed. One appellate court has ruled that the CBP has the unqualified right to search a laptop hard disk and does not need a reasonable suspicion in order to do so (U.S. v. Ickes). The laptop search was likened to a search of a suitcase, which everyone agrees is permissible. The U.S. District Court in the Arnold case went the other way and ruled that the CBP must have a reasonable suspicion of wrongdoing in order to search a laptop, else the search violates the Fourth Amendment. The judge said such a search is not like a search of a laptop, it is like a search of the traveler's own memory. In the case before it the court found that the CBP officer who conducted the search did not have a reasonable suspicion and therefore entered an order suppressing the evidence obtained in the search of Arnold's laptop. The Arnold case is now on appeal to the Ninth Circuit Court of Appeals. It was argued in October 2007 and now awaits decision.

In the Boucher case the traveler had saved his pornographic photos on a separate drive on his laptop and had encrypted the drive using Pretty Good Privacy (PGP). The CBP was unable to break the encryption and access the drive, so the prosecution had a grand jury subpoena issued compelling Boucher to divulge his password. Boucher moved to quash the subpoena on the ground that it violated his Fifth Amendment privilege against self-incrimination. The federal Magistrate hearing the motion agreed and quashed the subpoena. The case contains some important lessons for travelers carrying laptops. We will come back to the question of encryption in a subsequent post.

The probability of a laptop search of an innocent traveler coming into the U.S. from Europe on a business trip may be low. Then again it may not be. We do not know. And we have no way of finding out. Therefore, it is in the interest of business travelers from Europe to proceed with extreme caution when entering the U.S. carrying a laptop.

Sunday, January 13, 2008

The Toxic German Venture Capital Tax Regime

If I were to be appointed a deputy minister for venture capital tax policy in the finance ministry of a western European nation, and if I were then mandated to construct a framework of rules designed to suppress and hinder the development in my country of a venture capital industry, I would promulgate a set of rules along the following lines:

Investment Holding Period: I would impose a mandatory minimum holding period of three years for all investments within a venture fund. Venture capital investment is, of course, short to medium term by definition. It is the job of a venture fund investment manager to exit an investment as soon as it is possible to capture a desired gain. This rule would, therefore, put the venture fund manager in conflict with his duty to his investors. This rule would be a stand-alone venture-fund-breaker. But it would be a stealth rule -- only knowledgeable venture industry insiders would appreciate its devastating effect.

No majority holdings: I would prohibit a venture fund from taking a majority interest in a portfolio company. There are times in the lives of many venture investments that an investment manager must take control of a portfolio company in order to save the company and/or protect the fund's investment. Likewise, a venture fund might find itself to be the only possible source of new capital for a struggling start up company under circumstances in which the depressed valuation of the company would lead inevitably to the venture fund's stake exceeding 50% if it were to inject additional capital. This rule would therefore force the venture fund to let the company go under or to lose all or part of its investment notwithstanding its willingness to provide additional capital.

No active participation in management: Venture fund investment managers would be prohibited from taking an active role in the management of their portfolio companies. It is part of the job of venture fund investment managers to bring not just capital but also experience, expertise and special skills to their portfolio companies. Those companies are normally early stage and are often managed by unproven, inexperienced, first-time entrepreneur-managers. This rule would therefore tie an investment manager's hands and force him or her to stand on the sidelines while a portfolio company management team struggled and failed.

No re-investment of gains. Investment managers would be prohibited from re-investing proceeds acquired, e.g., through the IPO or trade sale of a portfolio company. Instead, they would be required to distribute such proceeds to the venture fund's investors. Such a rule would, of course, normally be left to agreement between the managers of the venture fund and its investors. By imposing this rule we would seek to limit the growth of venture funds in our country by allowing them to grow only through infusions of outside capital.

The penalty for violation of any one of these rules would be a re-classification of the venture fund as a trade or business, with the resulting imposition of our standard trade tax. This would dramatically lower the IRR of the venture fund and impair its ability to raise capital. We would further provide that violation of any of the rules in connection with even one portfolio company would subject the entire fund, and all of its investments, to re-classification as a trade or business.

As deputy minister for venture capital tax policy I would confidently tell the Finance Minister that we had hereby crafted a framework that could not fail to limit the growth of the venture capital industry in our country. Our proposed regime would simultaneously restrict the ability of venture fund investment managers to rationally conduct their business and would inhibit the flow of capital from outside investors into venture funds based in our country.

German readers will recognize, of course, that this regime is in fact the regime adopted by the German Finance Ministry. It helps explain why at least one leading German venture fund has left the country and re-incorporated itself elsewhere and why 50% of the members of the German venture capital association are considering doing likewise.

On the face of it, it is absurd to think that the motivation given above, to deliberately suppress the development of a venture capital industry in Germany, is in fact the motivation of the German Finance Ministry. Yet, if that is not in fact the policy, then it is difficult to see what is the policy.

A possible alternative explanation is that the tax policy officials within the ministry are simply profoundly ignorant of the nature and character of venture capital investment. That, too, is implausible. These officials have had voluminous input from the venture industry, have seen the public studies showing Germany at or near the bottom of venture-capital-friendly jurisdictions within the European Union, and have witnessed the withering of the venture capital industry in their country over the last seven years. This regime, which is so toxic to the venture industry, is no accident.

Whatever the true German policy may be the result is painfully clear: (1) no sensible venture fund group would today form a fund in Germany, and (2) no institutional investor that had done its due diligence and fully understood the German rules would invest in a German venture fund.

So far as it appears at this time, the battle is over. These are the new rules, and there is no liklihood that they will change in the foreseeable future.