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Harkabi v. SanDisk Corp.

September 12, 2012

DAN HARKABI & GIDON ELAZAR, PLAINTIFFS,
v.
SANDISK CORPORATION, DEFENDANT.



The opinion of the court was delivered by: William H. Pauley III, District Judge

OPINION

Dan Harkabi ("Harkabi") and Gidon Elazar ("Elazar," together, "Plaintiffs") assert a breach of contract claim against SanDisk Corporation ("SanDisk") relating to its sale of flash memory drives incorporating Plaintiffs' technology. In 2004, SanDisk acquired Plaintiffs' start-up company MDRM and promised to pay them a $4 million earn-out if MDRM technology drove sales of SanDisk products. Plaintiffs assert that after SanDisk acknowledged its obligation to pay the earn-out, it reneged and terminated them. While the dispute is relatively straightforward, the litigation has been protracted and hard-fought. SanDisk warned Plaintiffs that pursuing their claim would be very expensive. Regrettably, SanDisk's unyielding tactics ensured its prophecy became reality. After a week-long bench trial, this Court concludes that Harkabi and Elazar are entitled to the full $4 million earn-out plus prejudgment interest. This Court makes the following findings of fact and conclusions of law pursuant to Federal Rule of Civil Procedure 52.

FINDINGS OF FACT

I. The Spoliation of Plaintiffs' Laptops

As an initial matter, in addition to the extensive proof at trial, SanDisk's spoliation of evidence buttresses certain findings of fact and the resulting conclusions of law. By Memorandum & Order dated August 23, 2010 (the "Spoliation Order"),this Court sanctioned SanDisk for its spoliation of Plaintiffs' laptop computers, awarded Plaintiffs attorneys' fees, and authorized an adverse inference against SanDisk at trial. See Harkabi v. SanDisk Corp., 275 F.R.D. 414, 420-21 (S.D.N.Y. 2010). As this Court noted, the missing data "includ[ed] meeting notes, calendar entries, and digital photographs of technical schematics drawn by Elazar on white boards . . . showing [Plaintiffs'] involvement in developing the U3." Harkabi, 275 F.R.D. at 417. Accordingly, and as detailed below, SanDisk's destruction of Plaintiffs' laptops containing highly relevant evidence supports the following findings of fact that cite to the "Spoliation Order."

II. The Parties

Harkabi and Elazar are Israeli citizens with extensive experience in the electronics industry. (Trial Transcript ("Tr.") 4:2-3; Tr. 5:3-7, 5:12-20, 5:21-24, 6:7-14; Tr.228:24-25.) In 2002, they established a company named MDRM, an acronym for "Mobile Digital Rights Management." (Tr. 11:6-22; Tr. 233:18-234:5.) At MDRM, Elazar was in charge of product development and Harkabi handled business matters. (Tr. 12:3-4; Tr. 234:6-11.)

SanDisk is a Delaware corporation with its principal place of business in California. (Complaint, dated Sept. 23, 2008 ("Compl.") ¶ 4; Answer, dated Nov. 14, 2008 ("Ans.") ¶ 4.) During the relevant period, SanDisk was the world's largest manufacturer of computer flash memory storage products. (Tr. 17:16-21; Plaintiff's Trial Exhibit ("PX") 105-2.)

III. MDRM Technology

Plaintiffs created MDRM to develop products using USB flash drive technology.

(Tr. 11:10-14.) Flash memory is a semiconductor chip that retains storage in the absence of power. (Tr. 7:16-18.) For example, a digital camera typically stores photographs on a semiconductor chip with flash memory when the camera is turned off. (Tr. 7:19-23.) A USB flash drive is a consumer electronics device that enables the user to copy and store files on the drive after connecting it to a computer and thereafter transfer the files to another computer. (Tr. 8:25-9:3.)

The first flash drive MDRM created was known as "BookLocker." (Tr. 12:13-18.) BookLocker was a system that enabled schools to acquire educational materials, such as electronic books, and assign a specific book to a specific student based on a BookLocker device in the student's possession. (Tr. 12:19-23.) BookLocker enabled the download of electronic content from a remote server in a secure transaction. (Tr. 13:5-15.) To provide this unique function, the server needed to recognize the specific BookLocker device and differentiate that device from every other BookLocker device. (Tr. 14:3-13.) The differentiating characteristic of each BookLocker device was its device identification, or "DID," which is a unique code programmed into each flash drive. (Tr. 14:17-18; Tr. 341:16-17;Tr. 457:15-17; Tr. 847:3-4.)

MDRM's BookLocker and DID system involved: (i) a dedicated DID server to generate DIDs; (ii) an MDRM server that distributed the DIDs over the network inside the manufacturing plant to production servers; (iii) a "golden unit" (also referred to as a "golden key") that decrypted the DIDs; (iv) the download of a DID into the BookLocker device under production using a specialized testing machine, or "Tanisys" machine; and (v) code on the BookLocker device itself which accepted and verified the integrity of the DID. (Tr. 15:2-16:18; Tr. 713:25-733:4.) While at MDRM, Elazar filed two United States Patent Applications disclosing MDRM's BookLocker technology. (PX 463, PX 464.)

IV. SanDisk Acquires MDRM

In the summer of 2002, Plaintiffs first met with Eli Harari ("Harari"), SanDisk's Chief Executive Officer, and Yoram Cedar ("Cedar"), SanDisk's head of engineering. (Tr. 17:10-15.) During this meeting, Harari informed Plaintiffs that a new SanDisk "controller" would be compatible with MDRM's technology and suggested a collaboration between the two companies. (Tr. 18:11-23.) In 2003, Plaintiffs worked with SanDisk personnel to develop a SanDisk product that incorporated BookLocker technology. (Tr. 18:24-20:8; Tr. 235:3-15.) Elazar explained the BookLocker technology to SanDisk firmware engineers and detailed what MDRM would need from SanDisk to manufacture a product. (Tr. 19:6-15.) As a result of the collaboration, Plaintiffs were able to create prototypes of secure SanDisk flash memory cards with BookLocker technology. (Tr. 20:12-15.)

Beginning in or around January 2004, SanDisk collaborated with Plaintiffs' former employer-M-Systems-in connection with the research and development and marketing of a next-generation USB flash drive. (PX 27-2; Tr. 751:5-9; Tr. 810:10-21, 815:15-816:3.) This new flash drive became known as the U3 device. (PX 27-2, 27-5 at § 1.29, 27-6 at § 1.38; Tr. 751:10-752:5; Tr. 27:12-24; Tr. 242:5-8; Tr. 339:10-340:12; Tr. 816:4-8.) SanDisk and M-Systems created the specification for the U3 (the "U3 Specification"), which included the requirement that the U3 have the ability to create a secure session and safely upload or download content from a remote server. (PX 102-1, 102-54 at § 4.5; Tr. 344:16-345:1.) The U3 Specification did not provide details regarding how to manufacture a U3 device. (Tr. 346:4-6; Tr. 753:7-15.)

In April 2004, SanDisk approached Plaintiffs about buying MDRM. (Tr. 21:5-9; Tr. 235:16-18.) After receiving and rejecting a number of offers from Harari, (Tr. 21:7-25; Tr. 238:1-3; PX 13), Harkabi met with SanDisk Board member Cathy Lego, who made a final offer to acquire MDRM. (Tr. 238:4-23.) The terms of the final offer included an earn-out cash payment based on the number of devices sold over a two-year period that used MDRM's technology, with a maximum payment of $4 million for the qualified sale of 3.2 million devices. (Tr. 22:1-15; Tr. 238:18-239:20.) Plaintiffs accepted SanDisk's final offer in May 2004, in part because Harari told them that SanDisk intended to use MDRM's technology in all of SanDisk's products. (Tr. 21:20-22:22; Tr. 239:8-240:13.)

In July 2004, SanDisk executives prepared a presentation to SanDisk's Board of Directors to obtain approval for the acquisition of MDRM. (PX 24; Tr. 809:14-24.) The presentation included a description of the "Deal Thesis." (PX 24-7.) The "Deal Thesis" set forth SanDisk's reasons for acquiring MDRM: (i) digital rights management was a key enabling function for the growth in commercial content stored on flash memory cards; (ii) MDRM's technology could implement digital rights management; and (\iii) SanDisk wanted to use MDRM technology for SanDisk memory cards to differentiate SanDisk's products and enable the development of unique applications for medical, education, enterprise, and government users. (PX 24-7; Tr. 811:9-814:5.) The board presentation included an explanation that MDRM would aid SanDisk's U3 project with M-Systems. (PX 24-8; Tr. 814:6-16.) Thus, SanDisk executives, including Harari, knew that SanDisk was acquiring MDRM to incorporate its technology into SanDisk products, including the U3. (Tr. 814:21-23; PX 15-1; Tr. 785:4-787:5; PX 29-3.)

In connection with the acquisition, MDRM became an operating group within SanDisk named Secure Content Solutions ("SCS"). (Tr. 23:24-24:2; Tr. 241:1-3.) Harkabi became vice president of SCS, and Elazar became senior director of product management and architecture. (Tr. 24:3-5; Tr. 241:9-11.) Elazar was responsible for helping SanDisk integrate MDRM technology, developing the BookLocker product, and managing the development team. (Tr. 24:6-9.) Harkabi was in charge of SCS, promoted products, recruited personnel, and managed the budget. (Tr. 241:12-16; Tr. 339:4-5.) Both Harkabi and Elazar relocated with their families from Israel to California. (Tr. 24:12-19; Tr. 241:21-22.)

V. The Pertinent Terms of the Merger Agreement and Earn Out Provision

SanDisk and MDRM entered into an Amended and Restated Stock Purchase Agreement on September 13, 2004 (the "Agreement"). (PX 34.) The pertinent terms and provisions of the Agreement are the following:

(a.) Contribution Consideration. At the Closing, Buyer [SanDisk] shall pay to the Sellers [Plaintiffs] (through the Escrow Agent) U.S. $4,000,000 (the "Contribution Consideration"), which amount shall be forwarded to the Sellers in accordance with and subject to the Contribution Consideration Earn-Out provisions set forth below in Section 1.4. (PX 34-4, § 1.1(b)(ii).)

(b.) Contribution Consideration Earn-Out. Forty five days following each fiscal quarter from the Closing Date and through the fiscal quarter during which the second anniversary of the Closing Date (the "Two Year Date") takes place, the Buyer shall provide the Escrow Agent and Seller's Representative with notice of the number of units (whether in the form of Secure Digital cards, USB Drives or other formats) using or embedding the firmware developed by the Company Group [MDRM] before the Closing Date (the "MDRM Technology") and/or Derivatives thereof (as defined below) developed by any member of the Buyer Group [SanDisk] after the Closing Date ("MDRM Units") Sold (as defined below) during the fiscal quarter then ended. (PX 34-5, § 1.4.)

(c.) [Contribution Consideration Earn-Out.] Buyer shall, and shall cause each of the corporations, partnerships, limited liability companies and other entities as to which a majority of the outstanding voting interests are owned, beneficially or of record, directly or indirectly (each, a "Subsidiary") by the Buyer (together, the "Buyer Group") to give Seller's Representative and its authorized representatives (including its attorneys and accountants) reasonable access to all books and records thereof as Seller's Representative may reasonably require, in order to establish the number of MDRM Units Sold as specified in the aforesaid notices of Buyer. (PX 34-5, § 1.4.)

(d.) [Contribution Consideration Earn-Out.] The Escrow Agent will then release to each of the Sellers, in the ratios set forth in Section 1.1(b) of the Disclosure Schedule, an amount equal to: (A) the total Contribution Consideration multiplied by (B) a fraction, the numerator of which is the number of MDRM Units Sold during such preceding calendar quarter and the denominator of which is 3.2 million (the "Proportionate Contribution Consideration"). (PX 34-5, § 1.4.)

(e.) [Contribution Consideration Earn-Out.] "Sales" and "Sold" means the sale, lease or license of products of Buyer which (x) are marketed by a member of Buyer Group by reference to the MDRM Technology or Derivatives thereof or to their functions and/or capabilities, (y) are used by a member of the Buyer Group to provide content stored on such unit, or update firmware, upload or download data, or any other use which is enabled by the MDRM Technology to [sic] Derivatives thereof, or (z) have been pre-activated by a customer, distributor, reseller or any other channel for ultimate sale to an end-user that result in revenue recognition (e.g., not channel inventory or consigned goods) on the sale of the MDRM Unit by the Buyer Group, in each case before the Two Year Date or within the nearest fiscal quarter ending after the Two Year Date. For the avoidance of doubt, a Sale shall not occur (i) merely as a result of the sale of products of Buyer which use or embed the MDRM Technology or Derivatives or a portion thereof (ii) as a result of the routine authentication and logging of contacts between a unit and a central server or (iii) merely as a result of listing the MDRM Technology on data sheets of the Buyer Group. (PX 34-5 to 34-6, § 1.4.)

(f.) [Contribution Consideration Earn-Out.] "Derivatives" means: (a) any computer program (whether in source or object code form.) port, work, product, service, improvement, modification, revision, alteration, enhancement, abridgement, condensation, expansion, new version, translation, adaptation, design, concept, in any medium, format or form whatsoever, that is derived in any manner, directly or indirectly, from the MDRM Technology or any part or aspect thereof or that utilizes or incorporates such a pre-existing work or any part or aspect thereof, or any other form in which the MDRM Technology may be recast, transformed or adapted; (b) all "derivative works" as defined in the copyright law of the United States, the MDRM Technology and (c) all materials and documentation related to each of the foregoing. (PX 34-6, § 1.4.)

(g.) Governing Law. This Agreement and transactions contemplated hereby shall be governed and construed under and in accordance with the laws of the State of New York (without giving effect to any choice of law rule thereof which would cause the application of the laws of another jurisdiction). (PX 34-39, § 10.6.)

VI. Elezar and Harkabi

Integrate MDRM Technology into SanDisk's U3 Devices Prior to 2005, SanDisk did not have a product that had the capability to authenticate itself to a server over the internet. (Tr. 344:8-15; Tr. 951:12-14.) This functionality was a design requirement for the U3 device. (Tr. 343:19-344:7; PX 102-54.) In early April 2005, with the U3 development project underway, SanDisk's Carlos Gonzalez ("Gonzalez"), a senior director on the U3 project, wrote to Elazar proposing a meeting "to go over the U3 infrastructure needs and establish a game plan." (PX 280-1.) Gonzalez and Elazar then discussed a plan in which SanDisk would generate secret keys for the U3 inside the device. Gonzalez also asked whether MDRM's technology could be adapted to load certificates and serial numbers to the U3 using a DID. (Tr. 29:9-22.) SanDisk dubbed this plan for the manufacturing process "Case A." (Tr. 29:6-22, Tr. 37:1-18; PX 65-6; Tr. 369:16- 370:2.)

On May 4, 2005, Elazar described in an e-mail the steps that needed to be added to the process to load certificates using a DID into the U3 device during the Case A manufacturing. (PX 60-1 to -2; Tr. 31:10-16.) The steps described were part of MDRM's BookLocker technology. (Tr. 33:20-22.) More specifically, Elazar outlined the MDRM BookLocker DID technology that would need to be implemented for the U3. He also provided the instruction for storing the DID and verifying its validity. (PX 60-1, 60-2; Tr. 32:24-33:19.)

Elazar sent his e-mail to Sean Chang, head of SanDisk's firmware team for the U3, and several other members of the U3 team. (PX 60-1; Tr. 30:18-31:6; Tr. 779:13-780:10; Tr. 347:23-25; Tr. 358:23-359:4.) In response to Gonzalez's question "What is DID?" Elazar responded that the DID was part of the structure of BookLocker used to store certificates in manufacturing and that it would need to be part of the U3 manufacturing process. (Tr. 34:8-25; PX 60-1.) Elazar subsequently discussed with Gonzalez and other SanDisk personnel further details of the DID and its structure. (Tr. 213:7-214:1.)

On May 9, 2005, Elazar received an e-mail from Steve Needels ("Needels"), a member of the U3 team, regarding "U3 questions for manufacturing process." (PX 475-1.) Needels stated that SanDisk was unable to create unique serial numbers for the U3 under the current methodology for manufacturing first generation storage-only flash drives. (PX 475-1; Tr. 35:8-18.) Needels asked: "Can the server create a unique serial number and pass it along with the two certificates? . . . Have you [Elazar] discussed with [Gonzalez] about using the same device ID as for book locker with the U3 info added into the empty space?" (Tr. 35:14-25; PX 475-1.) Needels then sent an e-mail to Elazar and Gonzalez to schedule an "[u]rgent meeting to resolve serial number and device ID for [the] U3." (PX 283-1.) Elazar met with Gonzalez and Needels, and they concluded that the manufacturing process for the U3 was not finalized because the capability to create a unique serial number in the DID had not been accomplished. (Tr. 36:23-37:3; Tr. 37:1-9.)

Late in the day on May 11, Needels sent an e-mail to various SanDisk personnel, including Gonzalez and others, attaching a document entitled "U3 Manufacturing Requirements," which set forth definitions and specifications for the U3 manufacturing process.

(PX 65-1; Tr. 369:3-15; Tr. 780:11-23.) The document included the Case A plan for the manufacturing process, which was described as "preferred." (PX 65-6.) The document also described a "Case B" plan whereby the keys and certificates were loaded from a CD-ROM. (PX 65-9.) Case B was described as a "fallback" and was "the equivalent system to ...


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