How the government could have destroyed Yahoo

Imagine a well-known, publicly traded company suddenly ceased operating, and the CEO couldn’t explain why. Picture shareholders losing everything, with zero warning.

This might sound like Soviet-style intrigue or Ayn Randian dystopia. But this bizarre scenario could have unfolded in the United States in 2008, when the government tried to force Yahoo (YHOO), the corporate parent of Yahoo Finance, to turn over data on select users as part of the National Security Agency’s PRISM electronic surveillance program. Yahoo fought the government’s request and appealed a secret court order to turn over the data, which led the government to threaten an escalating series of fines that could have overwhelmed Yahoo within weeks.

At Yahoo’s request, a federal judge recently unsealed 1,500 pages of classified documents showing how the company battled government in the secret court. The New York Times, first to report the story, cited documents showing the government threatened to fine Yahoo $250,000 per day if it refused to provide the data a secret body called the Foreign Intelligence Surveillance Court (FISC) ordered Yahoo to turn over to the NSA.

Larger than thought

But the amount of the threatened fines was actually much greater than the Times reported. A motion filed by Justice Dept. lawyers, representing the NSA, in May 2008 shows fines would have started at $250,000 per day, then doubled every week until they reached disastrous proportions — with no ceiling.

Had Yahoo actually paid the fines, rather than turning over the user data the government was seeking, it would have quickly become the biggest expense on Yahoo’s books. The first week, the fine would have totaled $1.75 million. The second week — when the daily fine doubled to $500,000 —  the total would have been $3.5 million. By the third week — when the daily tally was $1 million — the total would have hit $7 million. Within 12 weeks, Yahoo would have racked up about $7.2 billion in fines — an amount equal to its entire revenue in 2008.

Attorney Marc Zwillinger, who represented Yahoo before the secret court, wrote in a blog post that the government put “great pressure” on Yahoo to comply. Yahoo received the initial, classified order from the FISC demanding it turn over data on May 5, 2008. The FISC said Yahoo needed to decide that day whether it would comply or appeal. The NSA had already told the court a delay in getting information from Yahoo “could cause great harm to the United States.” The magnitude of the threatened fines may have reflected the NSA’s sense of urgency. Yahoo appealed to another secret court, the Foreign Intelligence Surveillance Court of Review, or FISC-R, which denied the appeal on May 9. At that point, Yahoo began turning over the info the government wanted.

There’s nothing unusual about a court threatening to fine a company that refuses to comply with a court order. What’s unique about the Yahoo case is the fines were threatened in secret and would have been paid in secret had Yahoo not turned over the information the government wanted. Since company executives were forbidden from disclosing anything about the case — including that the NSA’s request even existed — Yahoo could have ended up writing larger and larger checks that overwhelmed its profits, with no public notice at all.

At some point, that would have violated another law governing what publicly owned companies such as Yahoo are required to disclose to the investing public. The Securities and Exchange Commission says companies that issue stock “must make available all information, whether it is positive or negative, that might be relevant to an investor's decision to buy, sell or hold the security.” A one-time fine of $250,000 may not have affected Yahoo’s financial prospects, but an escalating fine in the millions would have.

Incompatible laws

So if fines had been levied, Yahoo executives could have violated one law had they kept mum, and another law had they disclosed news of the fine. “It would be nearly impossible for Yahoo, or any other company for that matter, to pay such a fine without violating its disclosure obligations to its shareholders under SEC rules,” says Alan Butler, a lawyer with the Electronic Privacy Information Center, a nonprofit that advocates for greater government transparency.

It’s not clear whether there’s ever been a case in which a company failed to disclose material information to shareholders because it was classified, especially in a situation in which the government was essentially punishing the company. Defense contractors such a Northrop Grumman (NOC) and Boeing (BA) deal with classified programs all the time, including ones in which rising costs could affect profitability. In such cases, companies typically describe in broad terms information that could affect financial performance, without going into detail. Yahoo could have done something similar, by disclosing the payment of a fine without specifying what it was for, except to say the nature of the matter was classified.

It’s also possible a judge or the Justice Dept. would relent if court-ordered fines were causing visible damage to a company. The government has the power in some cases to cause profound harm to a company through legal maneuvering, but it’s also sensitive to charges of needlessly bullying companies. Aggressive government prosecutors essentially drove the Arthur Andersen accounting firm out of business for its role in the Enron fraud in the early 2000s, putting 28,000 people out of work and drawing sharp criticism for heavy-handedness. Since then, the government has been more careful about punishing firms when it might cost jobs.

The Justice Dept. defends its actions by saying it was legally protecting national security. "The government only sought penalties after Yahoo litigated its position in court and then refused to comply with the court order," a Justice spokesperson wrote in an email.

Yahoo had about 14,000 employees in 2008, and ranked 353rd on Fortune’s list of companies by size. At the time it was secretly fighting the government’s data requests, it was also the target of a high-profile takeover bid by Microsoft (MSFT), which ultimately failed. Unexplained costs on its income statement would have undoubtedly attracted notice had they become large enough. Even if nobody leaked the real story, it likely would have eventually become apparent the government was draining Yahoo, which might have put pressure on the feds to ease up.

Other big tech companies, including Google (GOOG), Microsoft (MSFT), Verizon (VZ) and AT&T (T), have also resisted government efforts to tap into user data. But none seems to have appealed as Yahoo did. The companies haven’t said that explicitly (because they’re not allowed to), but it stands to reason Yahoo wouldn’t have appealed in 2008 if another company in a similar position had already set a precedent by doing so. And no company would have done it after Yahoo’s appeal failed, unless they were willing to meet the same fate and perhaps appeal all the way to the Supreme Court.

The seeming incompatibility between the public disclosure required under securities law and the secrecy required by FISA Court proceedings will persist unless one of two things occurs. Congress passed the laws requiring companies to turn over electronic data beginning in 2007, and those laws have never made it to the Supreme Court. If any company ever went that far, the justices could declare the law unconstitutional. That’s basically what Yahoo argued when it appealed the initial order. A Yahoo spokesperson said the odds of getting a reversal on the Supreme Court seemed low and simply ending the litigation, after two different federal courts had ruled against the company, became the company's main priority.

Congress could also pass a new law that alters or revokes the earlier law and clears up potential conflicts in terms of what companies are allowed to say publicly about their dealings with intelligence agencies. Sen. Ron Wyden (D-OR), for instance, has proposed intelligence reform legislation that, among other things, would make it harder for the NSA or other federal agencies to obtain certain types of data from companies. For now, however, silence on matters involving the NSA seems to trump disclosure.

Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.