CISCO SYSTEMS, INC. | 2013 | FY | 3


Commitments and Contingencies
(a)
Operating Leases
The Company leases office space in many U.S. locations. Outside the United States, larger leased sites include sites in Belgium, China, France, Germany, India, Israel, Italy, Japan, Norway, and the United Kingdom. The Company also leases equipment and vehicles. Future minimum lease payments under all noncancelable operating leases with an initial term in excess of one year as of July 27, 2013 are as follows (in millions):
Fiscal Year
Amount
2014
$
367

2015
289

2016
150

2017
92

2018
68

Thereafter
183

Total
$
1,149


Rent expense for office space and equipment totaled $416 million, $404 million, and $428 million in fiscal 2013, 2012, and 2011, respectively.
(b)
Purchase Commitments with Contract Manufacturers and Suppliers
The Company purchases components from a variety of suppliers and uses several contract manufacturers to provide manufacturing services for its products. During the normal course of business, in order to manage manufacturing lead times and help ensure adequate component supply, the Company enters into agreements with contract manufacturers and suppliers that either allow them to procure inventory based upon criteria as defined by the Company or establish the parameters defining the Company’s requirements. A significant portion of the Company’s reported purchase commitments arising from these agreements consists of firm, noncancelable, and unconditional commitments. In certain instances, these agreements allow the Company the option to cancel, reschedule, and adjust the Company’s requirements based on its business needs prior to firm orders being placed. As of July 27, 2013 and July 28, 2012, the Company had total purchase commitments for inventory of $4,033 million and $3,869 million, respectively.
The Company records a liability for firm, noncancelable, and unconditional purchase commitments for quantities in excess of its future demand forecasts consistent with the valuation of the Company’s excess and obsolete inventory. As of July 27, 2013 and July 28, 2012, the liability for these purchase commitments was $172 million and $193 million, respectively, and was included in other current liabilities.
(c)
Other Commitments
In connection with the Company’s business combinations and asset purchases, the Company has agreed to pay certain additional amounts contingent upon the achievement of certain agreed-upon technology, development, product, or other milestones or the continued employment with the Company of certain employees of the acquired entities. The Company recognized such compensation expense of $123 million, $50 million, and $127 million during fiscal 2013, 2012, and 2011, respectively. As of July 27, 2013, the Company estimated that future compensation expense and contingent consideration of up to $1.2 billion may be required to be recognized pursuant to the applicable business combination and asset purchase agreements, which included a maximum potential $863 million in milestone payments related to Insieme as more fully discussed in the subsection entitled “Insieme Networks, Inc.” within section (d) immediately below.
The Company also has certain funding commitments, primarily related to its investments in privately held companies and venture funds, some of which are based on the achievement of certain agreed-upon milestones, and some of which are required to be funded on demand. The funding commitments were $263 million and $120 million as of July 27, 2013 and July 28, 2012, respectively.
(d)
Variable Interest Entities
VCE Joint Venture VCE is a joint venture that the Company formed in fiscal 2010 with EMC Corporation (“EMC”), with investments from VMware, Inc. (“VMware”) and Intel Corporation. VCE helps organizations leverage best-in-class technologies and disciplines from Cisco, EMC, and VMware to enable the transformation to cloud computing.
As of July 27, 2013, the Company’s cumulative gross investment in VCE was approximately $507 million, inclusive of accrued interest, and its ownership percentage was approximately 35%.  The Company invested approximately $93 million in VCE during fiscal 2013 and $276 million during fiscal 2012.
The Company accounts for its investment in VCE under the equity method, and its portion of VCE’s net loss is recognized in other income (loss), net. The Company’s share of VCE’s losses, based upon its portion of the overall funding, was approximately 36.8% for each of the fiscal years ended July 27, 2013, July 28, 2012, and July 30, 2011, respectively. As of July 27, 2013, the Company had recorded cumulative losses from VCE of $422 million since inception, of which losses of $183 million, $160 million, and $76 million were recorded for the fiscal years ended July 27, 2013, July 28, 2012, and July 30, 2011, respectively. The Company’s carrying value in VCE as of July 27, 2013 of $85 million was recorded in other assets.
Over the next 12 months, as VCE scales its operations, the Company expects that it will make additional investments in VCE and may incur additional losses proportionate with the Company’s share ownership.
From time to time, EMC and Cisco may enter into guarantee agreements on behalf of VCE to indemnify third parties, such as customers, for monetary damages. Such guarantees were not material as of July 27, 2013.
Insieme Networks, Inc. In the third quarter of fiscal 2012, the Company made an investment in Insieme Networks, Inc. (“Insieme”), an early stage company focused on research and development in the data center market. As set forth in the agreement between the Company and Insieme, this investment includes $100 million of funding and a license to certain of the Company’s technology. In addition, pursuant to a November 2012 amendment to the agreement between the Company and Insieme, the Company agreed to invest an additional $35 million in Insieme upon the satisfaction of certain conditions. As of July 27, 2013, the Company owned approximately 84% of Insieme as a result of these investments and has consolidated the results of Insieme in its Consolidated Financial Statements effective as of the third quarter of fiscal 2012.
In connection with this investment, the Company and Insieme have entered into a put/call option agreement that provides the Company with the right to purchase the remaining interests in Insieme. In addition, the noncontrolling interest holders can require the Company to purchase their shares upon the occurrence of certain events. If the Company acquires the remaining interests of Insieme, the noncontrolling interest holders are eligible to receive two milestone payments, which will be determined using agreed-upon formulas based on revenue for certain of Insieme’s products. The Company will begin recognizing the amounts due under the milestone payments when it is determined that such payments are probable of being earned, which may occur in the first half of fiscal 2014. When such a determination is made, the milestone payments will then be recorded as compensation expense by the Company based on an estimate of the fair value of the amounts probable of being earned, pursuant to a vesting schedule. Subsequent changes to the fair value of the amounts probable of being earned and the continued vesting will result in adjustments to the recorded compensation expense. The maximum amount that could be recorded as compensation expense by the Company is approximately $863 million. This amount was increased from the previous maximum of $750 million due to a November 2012 amendment to the agreement, as the parties recognized that higher staffing levels may be necessary to perform additional product development. The milestone payments, if earned, are expected to be paid primarily during fiscal 2016 and fiscal 2017.
Other Variable Interest Entities In the ordinary course of business, the Company has investments in other privately held companies and provides financing to certain customers. These other privately held companies and customers may be considered to be variable interest entities. The Company evaluates on an ongoing basis its investments in these other privately held companies and its customer financings and has determined that as of July 27, 2013 there were no other variable interest entities required to be consolidated in the Company’s Consolidated Financial Statements.
(e)
Product Warranties and Guarantees
The following table summarizes the activity related to product warranty liability during fiscal 2013 and 2012 (in millions):
 
July 27, 2013
 
July 28, 2012
 
July 30, 2011
Balance at beginning of fiscal year
$
415

 
$
342

 
$
360

Provision for warranties issued
664

 
661

 
456

Payments
(648
)
 
(588
)
 
(474
)
Balance at end of fiscal year
$
431

 
$
415

 
$
342


The Company accrues for warranty costs as part of its cost of sales based on associated material product costs, labor costs for technical support staff, and associated overhead. The Company’s products are generally covered by a warranty for periods ranging from 90 days to five years, and for some products the Company provides a limited lifetime warranty.
In the normal course of business, the Company indemnifies other parties, including customers, lessors, and parties to other transactions with the Company, with respect to certain matters. The Company has agreed to hold the other parties harmless against losses arising from a breach of representations or covenants or out of intellectual property infringement or other claims made against certain parties. These agreements may limit the time within which an indemnification claim can be made and the amount of the claim. In addition, the Company has entered into indemnification agreements with its officers and directors, and the Company’s Amended and Restated Bylaws contain similar indemnification obligations to the Company’s agents. It is not possible to determine the maximum potential amount under these indemnification agreements due to the Company’s limited history with prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Historically, payments made by the Company under these agreements have not had a material effect on the Company’s operating results, financial position, or cash flows.
The Company also provides financing guarantees, which are generally for various third-party financing arrangements to channel partners and other end-user customers. See Note 7.
The Company’s other guarantee arrangements as of July 27, 2013 and July 28, 2012 that were subject to recognition and disclosure requirements were not material.
(f)
Legal Proceedings
Brazilian authorities have investigated the Company’s Brazilian subsidiary and certain of its current and former employees, as well as a Brazilian importer of the Company’s products, and its affiliates and employees, relating to alleged evasion of import taxes and alleged improper transactions involving the subsidiary and the importer. Brazilian tax authorities have assessed claims against the Company’s Brazilian subsidiary based on a theory of joint liability with the Brazilian importer for import taxes, interest, and penalties. In addition to claims asserted by the Brazilian federal tax authorities in prior fiscal years, tax authorities from the Brazilian state of Sao Paulo have asserted similar claims on the same legal basis in prior fiscal years. In the first quarter of fiscal 2013, the Brazilian federal tax authorities asserted an additional claim against the Company’s Brazilian subsidiary based on a theory of joint liability with respect to an alleged underpayment of income taxes, social taxes, interest, and penalties by a Brazilian distributor.
The asserted claims by Brazilian federal tax authorities are for calendar years 2003 through 2008, and the asserted claims by the tax authorities from the state of Sao Paulo are for calendar years 2005 through 2007. The total asserted claims by Brazilian state and federal tax authorities aggregate to approximately $385 million for the alleged evasion of import and other taxes, approximately $1.1 billion for interest, and approximately $1.7 billion for various penalties, all determined using an exchange rate as of July 27, 2013. The Company has completed a thorough review of the matters and believes the asserted claims against the Company’s Brazilian subsidiary are without merit, and the Company is defending the claims vigorously. While the Company believes there is no legal basis for the alleged liability, due to the complexities and uncertainty surrounding the judicial process in Brazil and the nature of the claims asserting joint liability with the importer, the Company is unable to determine the likelihood of an unfavorable outcome against its Brazilian subsidiary and is unable to reasonably estimate a range of loss, if any. The Company does not expect a final judicial determination for several years.
On March 31, 2011 and April 12, 2011, purported shareholder class action lawsuits were filed in the United States District Court for the Northern District of California against the Company and certain of its officers and directors. The lawsuits were consolidated, and an amended consolidated complaint was filed on December 2, 2011. The consolidated action was purportedly brought on behalf of purchasers of the Company’s publicly traded securities between February 3, 2010 and May 11, 2011. Plaintiffs alleged that defendants made false and misleading statements, purported to assert claims for violations of the federal securities laws, and sought unspecified compensatory damages and other relief. On February 12, 2012, the Company filed a motion seeking to dismiss all claims in the amended complaint. On March 29, 2013, the Court granted the Company’s motion and dismissed the amended complaint, finding no facts or inferences to support the plaintiffs’ allegations. Plaintiffs chose not to file an amended complaint and not to pursue an appeal. The Court dismissed the entire lawsuit with prejudice on April 29, 2013.
Beginning on April 8, 2011, a number of purported shareholder derivative lawsuits were filed in both the United States District Court for the Northern District of California and the California Superior Court for the County of Santa Clara against the Company’s Board of Directors and several of its officers. The federal lawsuits have been consolidated in the Northern District of California. Plaintiffs in both the federal and state derivative actions allege that the Board allowed certain officers to make allegedly false and misleading statements. The complaint includes claims for violation of the federal securities laws, breach of fiduciary duties, waste of corporate assets, unjust enrichment, and violations of the California Corporations Code. The complaint seeks compensatory damages, disgorgement, and other relief. In light of the United States District Court’s dismissal of the purported shareholder class action noted above, the consolidated federal derivative action was dismissed on May 9, 2013, and the state derivative lawsuits were dismissed on May 16, 2013.
The Company was subject to patent claims asserted by VirnetX, Inc. on August 11, 2010 in the United States District Court for the Eastern District of Texas.  VirnetX alleged that various Cisco products that implement a method for secure communication using virtual private networks infringe certain patents. VirnetX sought monetary damages.  The trial on these claims began on March 4, 2013. On March 14, 2013, the jury entered a verdict finding that the Company’s accused products do not infringe any of VirnetX’s patents asserted in the lawsuit. On April 3, 2013, VirnetX filed a motion seeking a new trial on the issue of infringement, which the Company has opposed. The Court held a hearing on VirnetX’s motion for a new trial in June 2013 but has not issued a ruling.
The Company was subject to numerous patent, tort, and contract claims asserted by XpertUniverse on March 10, 2009 in the United States District Court for the District of Delaware. Shortly before trial, the Court dismissed on summary judgment all claims initially asserted by XpertUniverse except a claim for infringement of two XpertUniverse patents and a claim for fraud by concealment. XpertUniverse’s remaining patent claims alleged that three Cisco products in the field of expertise location software infringed two XpertUniverse patents. XpertUniverse’s fraud by concealment claim alleged that the Company did not disclose its decision not to admit XpertUniverse into a partner program. The trial on these remaining claims began on March 11, 2013. On March 22, 2013, the jury entered a verdict finding that two of the Company’s products infringed two of XpertUniverse’s patents and awarded XpertUniverse damages of less than $35 thousand. The jury also found for XpertUniverse on its fraud by concealment claim and awarded damages of $70 million. The Company believes it has strong arguments to overturn the fraud damage award or to obtain a new trial. In May and June, 2013, the Company filed post-trial motions. The Court has not yet set a date for a hearing. If the Court does not grant the Company’s post-trial motions, the Company will pursue an appeal. While the ultimate outcome of the case may still result in a loss, the Company does not expect it to be material.
The Company and a service provider customer were subject to patent claims asserted by TiVo, Inc. (“TiVo”) on June 4, 2012 in the United States District Court for the Eastern District of Texas.  TiVo alleged that the Company’s digital video recorders deployed by the service provider customer infringed certain of its patents.  TiVo sought monetary damages and injunctive relief.  The trial on these claims was scheduled to begin in March 2014.  TiVo previously filed a similar patent lawsuit, which was scheduled for trial in June 2013, against the same service provider customer, accusing digital video recorders manufactured by one of the Company’s competitors.  Beginning in late May 2013, prior to that trial, the parties to that case and the Company conducted a mediation which resulted in a settlement and dismissal of all outstanding litigation between the parties. Under the terms of the settlement, in exchange for a single, lump sum monetary payment to TiVo by the Company of $294 million, the Company received a perpetual license to the patents-in-suit, the Company and TiVo entered into a ten year cross license applicable to the video field, and the Company and TiVo agreed not to sue one another for infringement of any other patents for a period of five years. In connection with the settlement, the Company recorded $172 million to cost of sales during the fourth quarter of fiscal 2013, with the remainder of the settlement recorded against the amounts previously reserved and as an intangible asset to be amortized over its estimated useful life.
In addition, the Company is subject to legal proceedings, claims, and litigation arising in the ordinary course of business, including intellectual property litigation. While the outcome of these matters is currently not determinable, the Company does not expect that the ultimate costs to resolve these matters will have a material adverse effect on its consolidated financial position, results of operations, or cash flows.

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