PC bugs: Is the bill coming due?

Those questions are especially important now that four other personal computer makers -- Hewlett-Packard Co. (NYSE: HWP), Packard Bell NEC Inc., Compaq Computer Corp. (NYSE: CPQ) and eMachines Inc. -- face similar class-action lawsuits. If the Toshiba case is any indication, the potential cost of these cases could be considerable. Only Compaq has announced its intention to fight; the others have for the most part declined to comment.

The threat of increased legal scrutiny is unnerving to the fast-moving, $189 billion-a-year PC industry, which tolerates a far higher degree of imperfection than many other consumer industries. PC officials, in fact, often argue that because the hardware and software components of PCs evolve so quickly and are produced by such a large array of suppliers, it is almost inevitable that PCs are prone to unexplained lockups, mystifying bugs and unexpected crashes.

At the heart of the Toshiba matter is a technical flaw in a PC chip known as a floppy disk controller, one that under certain circumstances could damage or destroy data stored on floppy disks. Although that defect was discovered 13 years ago and was corrected a few years later by the original manufacturers of the defective chips, it somehow lived on in Toshiba PCs -- and, the plaintiffs' lawyers say, in those of other PC makers as well.

What may have made Toshiba (OTC: TOSBF) particularly vulnerable to the suit, however, is the fact that in addition to making notebook computers that exhibited the data-corruption problem, it also produced the defective floppy disk controllers as well -- chips it has supplied to other PC makers for years. What is more, some Toshiba engineers had been aware of the problem in its chips for more than a decade, an individual close to the company says, but declined to fix it because they considered the likelihood of data-damaging errors remote. A Toshiba spokesman declined to comment.

Discovery in 1986
The floppy disk bug was first uncovered in late 1986 by Phillip Adams, then an engineer at IBM Corp. (NYSE: IBM), who noted that under certain circumstances floppy-controller chips made by NEC Corp. (Nasdaq: NIPNY) of Japan could damage data stored on floppy disks. Intel Corp. (Nasdaq: INTC), which had licensed the floppy disk controller chip design from NEC, also produced a chip that exhibited the problem.

Even then, the companies say, the problem was difficult to detect, since it didn't result in data loss except in unusual situations, such as when two programs attempted to use the floppy disk drive at the same time. Such conditions could prompt a common data-writing error known as an overrun. The defective chips, however, failed to detect the error and prevent the accidental destruction of existing data.

Both NEC and Intel fixed the problem in subsequent generations of chips released within a few years, and in 1990 and 1991 NEC even ran eye-catching ads warning of the problem and urging PC makers to switch to its newer chips. Neither NEC nor Intel ever received any complaints about data loss related to the controller problem, the companies say.

But the problem wasn't restricted to NEC and Intel chips. A few years earlier, Toshiba semiconductor engineers had reverse-engineered the NEC chip. When NEC found out, the two companies huddled in negotiations that eventually led to a "nonassertion agreement" in 1986. Under its terms, Toshiba agreed to make royalty payments to NEC but acknowledged no wrongdoing. Toshiba continued to produce its controller chip.

NEC Chairman Hajime Sasaki, who previously ran the company's semiconductor division, says NEC informed Toshiba of the floppy disk controller bug once it learned of it. Toshiba, however, took no action, and the bug was apparently forgotten. A Toshiba spokesman declined to comment. When Toshiba Corp. settled a personal computer-related lawsuit for $2.1 billion in October, it left a lasting mystery: Why did the Japanese giant surrender without a court fight and on such relatively generous terms? Moreover, just how serious is the defect?

Those questions are especially important now that four other personal computer makers -- Hewlett-Packard Co. (NYSE: HWP), Packard Bell NEC Inc., Compaq Computer Corp. (NYSE: CPQ) and eMachines Inc. -- face similar class-action lawsuits. If the Toshiba case is any indication, the potential cost of these cases could be considerable. Only Compaq has announced its intention to fight; the others have for the most part declined to comment.

The threat of increased legal scrutiny is unnerving to the fast-moving, $189 billion-a-year PC industry, which tolerates a far higher degree of imperfection than many other consumer industries. PC officials, in fact, often argue that because the hardware and software components of PCs evolve so quickly and are produced by such a large array of suppliers, it is almost inevitable that PCs are prone to unexplained lockups, mystifying bugs and unexpected crashes.

At the heart of the Toshiba matter is a technical flaw in a PC chip known as a floppy disk controller, one that under certain circumstances could damage or destroy data stored on floppy disks. Although that defect was discovered 13 years ago and was corrected a few years later by the original manufacturers of the defective chips, it somehow lived on in Toshiba PCs -- and, the plaintiffs' lawyers say, in those of other PC makers as well.

What may have made Toshiba (OTC: TOSBF) particularly vulnerable to the suit, however, is the fact that in addition to making notebook computers that exhibited the data-corruption problem, it also produced the defective floppy disk controllers as well -- chips it has supplied to other PC makers for years. What is more, some Toshiba engineers had been aware of the problem in its chips for more than a decade, an individual close to the company says, but declined to fix it because they considered the likelihood of data-damaging errors remote. A Toshiba spokesman declined to comment.

Discovery in 1986
The floppy disk bug was first uncovered in late 1986 by Phillip Adams, then an engineer at IBM Corp. (NYSE: IBM), who noted that under certain circumstances floppy-controller chips made by NEC Corp. (Nasdaq: NIPNY) of Japan could damage data stored on floppy disks. Intel Corp. (Nasdaq: INTC), which had licensed the floppy disk controller chip design from NEC, also produced a chip that exhibited the problem.

Even then, the companies say, the problem was difficult to detect, since it didn't result in data loss except in unusual situations, such as when two programs attempted to use the floppy disk drive at the same time. Such conditions could prompt a common data-writing error known as an overrun. The defective chips, however, failed to detect the error and prevent the accidental destruction of existing data.

Both NEC and Intel fixed the problem in subsequent generations of chips released within a few years, and in 1990 and 1991 NEC even ran eye-catching ads warning of the problem and urging PC makers to switch to its newer chips. Neither NEC nor Intel ever received any complaints about data loss related to the controller problem, the companies say.

But the problem wasn't restricted to NEC and Intel chips. A few years earlier, Toshiba semiconductor engineers had reverse-engineered the NEC chip. When NEC found out, the two companies huddled in negotiations that eventually led to a "nonassertion agreement" in 1986. Under its terms, Toshiba agreed to make royalty payments to NEC but acknowledged no wrongdoing. Toshiba continued to produce its controller chip.

NEC Chairman Hajime Sasaki, who previously ran the company's semiconductor division, says NEC informed Toshiba of the floppy disk controller bug once it learned of it. Toshiba, however, took no action, and the bug was apparently forgotten. A Toshiba spokesman declined to comment. From the moment the suit was filed last February, however, Toshiba officials in Tokyo monitored it closely. Their first step was to commission internal studies at Toshiba's PC factory in Tokyo in an attempt to re-create the data problems, efforts that were initially unsuccessful.

But matters soon took a turn for the worse. The first shock came when Toshiba officials realized one of the plaintiffs' attorneys was Wayne Reaud, a key figure in successful class-action lawsuits involving asbestos and tobacco. Heightening Toshiba's concerns was the fact that the suit had been filed in federal court in the Eastern District of Texas, an area renowned for jurors hostile to large corporations -- and even less friendly to foreign concerns.

"If you study class-action cases in the past, especially in Beaumont, we were in a terrible position," one Toshiba official says.

Toshiba's management had taken heart from the fact that the company would defend the suit alongside its cross-town rival NEC, which had also been named as a defendant. But in August, NEC was dropped from the suit after it demonstrated it had fixed the problem years earlier. At roughly the same time, a consulting firm hired by Toshiba's U.S. lawyers finally succeeded in duplicating the data error on Toshiba notebook computers, although only under rare conditions. Still, it was anything but good news.

As expected court proceedings in November drew near, tension ran high within Toshiba. Officials feared that an adverse verdict might require Toshiba to refund the average value of five million notebook PCs, at least $9 billion. And with the judge pressing the sides to come to terms, Toshiba officials gritted their teeth and recommended that President Taizo Nishimuro settle the case.

'Close to a 100 percent chance'
"Initially, I wanted to go to trial," Nishimuro says. "Unfortunately, the lawyers said that there is close to a 100 percent chance that we would lose." In the end, Toshiba officials decided it was safer to swallow the settlement than risk a fight that might drag on for years, cost them billions of dollars and taint the Toshiba brand.

The total cost to Toshiba is likely to be somewhat less than the $2.1 billion headline figure for the settlement. Although the Japanese company is required to pay cash reimbursements of $597.5 million and plaintiffs' attorney fees of $147.5 million, most of the rest of the $2.1 billion consists of coupons for Toshiba products that must be redeemed by Toshiba notebook owners under fairly restrictive conditions.

Other PC makers may be better-positioned should they decide to contest the suits. Several lawyers not connected to the suits argue that the cases rest on a shaky legal foundation, since they allege both breach-of-warranty claims and violations of a federal law that made computer fraud criminal.

"There is a clear question as to whether you can turn a federal criminal statute into a breach-of-warranty case," says Michael Traynor, an attorney in San Francisco. "The real harm here is very questionable."

Perhaps more important, the plaintiffs haven't yet presented any public evidence that the floppy disk controller bug has caused anyone actual harm. And none of the four companies now facing the suits manufacture floppy disk controllers themselves.

A spokesman for the plaintiffs' lawyers in the class-action cases, all of whom are based in Beaumont, said the team is convinced it can demonstrate harm caused by the floppy disk defect. The spokesman added that the lawyers remain confident in the legal standing of their case.

Legal experts such as Susan Koniak, a law professor at Boston University, argue that the remaining cases are unlikely to ever make it to trial. Should they get that far, Koniak and some others argue, the plaintiffs will have a tough time proving that consumers suffered serious harm from the controller problem, which they say in the worst case could cause only economic damage, not personal injury or death. From the moment the suit was filed last February, however, Toshiba officials in Tokyo monitored it closely. Their first step was to commission internal studies at Toshiba's PC factory in Tokyo in an attempt to re-create the data problems, efforts that were initially unsuccessful.

But matters soon took a turn for the worse. The first shock came when Toshiba officials realized one of the plaintiffs' attorneys was Wayne Reaud, a key figure in successful class-action lawsuits involving asbestos and tobacco. Heightening Toshiba's concerns was the fact that the suit had been filed in federal court in the Eastern District of Texas, an area renowned for jurors hostile to large corporations -- and even less friendly to foreign concerns.

"If you study class-action cases in the past, especially in Beaumont, we were in a terrible position," one Toshiba official says.

Toshiba's management had taken heart from the fact that the company would defend the suit alongside its cross-town rival NEC, which had also been named as a defendant. But in August, NEC was dropped from the suit after it demonstrated it had fixed the problem years earlier. At roughly the same time, a consulting firm hired by Toshiba's U.S. lawyers finally succeeded in duplicating the data error on Toshiba notebook computers, although only under rare conditions. Still, it was anything but good news.

As expected court proceedings in November drew near, tension ran high within Toshiba. Officials feared that an adverse verdict might require Toshiba to refund the average value of five million notebook PCs, at least $9 billion. And with the judge pressing the sides to come to terms, Toshiba officials gritted their teeth and recommended that President Taizo Nishimuro settle the case.

'Close to a 100 percent chance'
"Initially, I wanted to go to trial," Nishimuro says. "Unfortunately, the lawyers said that there is close to a 100 percent chance that we would lose." In the end, Toshiba officials decided it was safer to swallow the settlement than risk a fight that might drag on for years, cost them billions of dollars and taint the Toshiba brand.

The total cost to Toshiba is likely to be somewhat less than the $2.1 billion headline figure for the settlement. Although the Japanese company is required to pay cash reimbursements of $597.5 million and plaintiffs' attorney fees of $147.5 million, most of the rest of the $2.1 billion consists of coupons for Toshiba products that must be redeemed by Toshiba notebook owners under fairly restrictive conditions.

Other PC makers may be better-positioned should they decide to contest the suits. Several lawyers not connected to the suits argue that the cases rest on a shaky legal foundation, since they allege both breach-of-warranty claims and violations of a federal law that made computer fraud criminal.

"There is a clear question as to whether you can turn a federal criminal statute into a breach-of-warranty case," says Michael Traynor, an attorney in San Francisco. "The real harm here is very questionable."

Perhaps more important, the plaintiffs haven't yet presented any public evidence that the floppy disk controller bug has caused anyone actual harm. And none of the four companies now facing the suits manufacture floppy disk controllers themselves.

A spokesman for the plaintiffs' lawyers in the class-action cases, all of whom are based in Beaumont, said the team is convinced it can demonstrate harm caused by the floppy disk defect. The spokesman added that the lawyers remain confident in the legal standing of their case.

Legal experts such as Susan Koniak, a law professor at Boston University, argue that the remaining cases are unlikely to ever make it to trial. Should they get that far, Koniak and some others argue, the plaintiffs will have a tough time proving that consumers suffered serious harm from the controller problem, which they say in the worst case could cause only economic damage, not personal injury or death.