10. Commitments and Contingencies

Leases

The Company has operating lease agreements for offices, research and development, and sales and marketing facilities that expire at various dates through 2019. The Company recognizes rent expense on a straight-line basis over the lease term and records the difference between cash rent payments and the recognized rent expense as a deferred rent liability. Rent expense was $2.1 million, $2.0 million and $2.6 million for the years ended December 31, 2016, 2015 and 2014, respectively.

The Company enters into capital leases to finance data center and other computer and networking equipment.

As of December 31, 2016, approximate remaining future minimum lease payments under non-cancelable leases were as follows (in thousands):



Year Ending December 31,	Capital Leases			Operating Leases
2017	$	7,670		$	2,144
2018	4,233			359
2019	2,234			19
2020	186			—
2021	$	—		$	—
Total future minimum lease payment	$	14,323		$	2,522
Less — amount representing interest	(2,178		)
Present value of total capital lease obligation	$	12,145
Capital lease obligation — current portion	6,230
Capital lease obligation — net of current portion	5,915

Hosting, Telecommunication Usage and Maintenance Services

The Company has agreements with third parties to provide co-location hosting and telecommunication usage services. The agreements require payments per month for a fixed period of time in exchange for certain guarantees of network and telecommunication availability. The Company is also committed to make future payments under maintenance service contracts for certain data center equipment.

As of December 31, 2016, future minimum payments under these arrangements were as follows (in thousands):



Year Ending December 31,	Hosting Services		Telecommunication Usage Services		Equipment Maintenance Services
2017	$	1,109	$	1,952	$	517
2018	13		302		83
2019	—		43		29
Total future minimum payment	$	1,122	$	2,297	$	629

Universal Services Fund Liability

During the third quarter of 2012, the Company determined that based on its business activities, it is classified as a telecommunications service provider for regulatory purposes and it should make direct contributions to the federal USF and related funds based on revenues it receives from the resale of interstate and international telecommunications services. Previously, the Company had believed that the telecommunications services were an integral part of an information service that the Company provides via its software and had instead made indirect USF contributions via payments to its wholesale telecommunications service providers. In order to comply with the obligation to make direct contributions, the Company made a voluntary self-disclosure to the FCC Enforcement Bureau and registered with the USAC, which is charged by the FCC with administering the USF. The Company filed exemption certificates with its wholesale telecommunications service providers in order to eliminate its obligation to reimburse such wholesale telecommunications service providers for their USF contributions calculated on services sold to the Company. In April 2013, the Company began remitting required contributions on a prospective basis directly to USAC.

The Company’s registration with USAC subjects it to assessments for unpaid USF contributions, as well as interest thereon and civil penalties, due to its late registration and past failure to recognize its obligation as a USF contributor and as an international carrier. The Company will be required to pay assessments for periods prior to the Company’s registration. As of December 31, 2012, the total past due USF contribution being imposed by USAC and accrued by the Company for the period from 2003 through 2012 was $8.1 million, of which $4.7 million was undisputed and $3.4 million, including $0.8 million that pertains to 2003 through 2007, was disputed. The Company has submitted two separate Requests for Review (a form of appeal) to the FCC's Wireline Bureau challenging the application of FCC rules to the assessments of USF fees for 2003 to 2007, and from 2008 to 2012. In January 2017, the FCC Wireline Bureau ruled in favor of the Company regarding the principal for the 2008 to 2012 assessments, but not the related interest or penalties, resulting in a reversal of $3.1 million to cost of revenue. The Company will continue to dispute the interest and penalties on the back assessments for the period of 2008 through 2012. The FCC has not yet resolved the Company’s Requests for Review challenging assessments for 2003 to 2007. If the pending disputes are not resolved in the Company’s favor, it is still possible that the Company will be required to pay back assessments for one or both of those periods.

In July 2013, the Company and USAC agreed to a financing arrangement for $4.1 million of the undisputed $4.7 million of the unpaid USF contributions whereby the Company issued to USAC a promissory note payable in the principal amount of the $4.1 million and paid off the remaining undisputed $0.6 million. The repayment terms of the promissory note payable are disclosed in Note 6. As of December 31, 2016 and 2015, the principal balance of the promissory note payable was $0.1 million and $1.5 million, respectively, and is included in the notes payable amounts on the consolidated balance sheets. In addition to the promissory note payable, as of December 31, 2016 and 2015, the Company had an accrued liability for the disputed portion of the unpaid USF contributions and estimated interest and penalties of $2.5 million and $4.9 million, respectively, included in accrued federal fees on the consolidated balance sheets. For the years ended December 31, 2016, 2015 and 2014, the Company recorded interest and penalty expenses of $0.6 million, $0.5 million and $0.5 million, respectively, as a charge to general and administrative expense, which were related to its disputed unpaid USF obligations.

On June 12, 2015, in connection with the Company’s disclosure to the FCC, the Company entered into a consent decree with the FCC Enforcement Bureau. In the consent decree, the Company agreed to pay a civil penalty of $2.0 million to the U.S. Treasury in twelve equal quarterly installments starting in July 2015 without interest (Note 6). In the third quarter of 2014, the Company accrued a $2.0 million liability for the then tentative civil penalty. The consent decree also requires the Company to adopt certain internal regulatory compliance monitoring and training requirements, and to report on the status of those compliance efforts to the FCC’s Enforcement Bureau for three years. The Company’s implementation of the internal regulatory compliance monitoring and training requirements were completed in August 2015, and its annual compliance reporting to the FCC will continue until June 2018.

State and Local Taxes and Surcharges

In April 2012, the Company commenced collecting and remitting sales taxes on sales of subscription services in all the U.S. states in which it determined it was obligated to do so. During the first quarter of 2015, the Company conducted an updated sales tax review of the taxability of sales of its subscription services. As a result, the Company determined that it may be obligated to collect and remit sales taxes on such sales in four additional states. Based on its best estimate of the probable sales tax liability in those four states relating to its sales of subscription services during the period 2011 through 2014, during the three months ended March 31, 2015, the Company recorded a general and administrative expense of $0.6 million as an immaterial out of period adjustment to accrue for such taxes.

During 2013, the Company analyzed its activities and determined it may be obligated to collect and remit various state and local taxes and surcharges on its usage-based fees. The Company had not remitted state and local taxes on usage-based fees in any of the periods prior to 2014 and therefore accrued a sales tax liability for this contingency. In January 2014, the Company commenced paying such taxes and surcharges to certain state authorities. In June 2014, the Company commenced collecting state and local taxes or surcharges on usage-based fees from its clients on a current basis and remitting such taxes to the applicable U.S. state taxing authorities.

During 2016, the Company remitted $0.3 million for its contingent sales taxes on both usage-based fees and sales of subscription services. Excluding the credit recorded in 2014 as discussed below, for the years ended December 31, 2016, 2015 and 2014, the Company recognized a gain of $0.4 million, expense of $1.2 million, and expense of $1.1 million, respectively, as general and administrative expense related to its estimated sales tax liability on both usage-based fees and sales of subscription services in the U.S. and Canada, which was not being collected from its clients.

Reversal of contingent sales tax liability - In May 2014, the Company received a letter from a state revenue authority which concluded that the Company's services provided to customers in that specific state are not subject to that state's local taxes. As a result, the Company released $2.8 million of sales tax liability, including estimated interest charges, accrued progressively on a quarterly basis from 2011 through the first quarter of 2014 for that state. No amounts were billed to and collected from customers for this state during that period. Of the total reversal amount, $2.5 million was related to the period 2011 through 2013. The reversal has been recorded through the general and administrative expense caption in the consolidated statements of operations and comprehensive loss.

As of December 31, 2016, the Company had total accrued liabilities of $2.1 million for contingent sales taxes and surcharges that were not being collected from its clients but may be imposed by various taxing authorities, of which $0.6 million and $1.5 million was included in current and non-current “Sales tax liability” on the consolidated balance sheets, respectively. As of December 31, 2015, the Company had total accrued liabilities of $2.7 million for such contingent sales taxes and surcharges, which was included in non-current “Sales tax liability” on the consolidated balance sheets. The Company’s estimate of the probable loss incurred under this contingency is based on its analysis of the source location of its usage-based fees and the regulations and rules in each tax jurisdiction.

Legal Matters

The Company is involved in various legal and regulatory matters arising in the normal course of business. In management’s opinion, resolution of these matters is not expected to have a material impact on the Company’s consolidated results of operations, cash flows, or its financial position. However, due to the uncertain nature of legal matters, an unfavorable resolution of a matter could materially affect the Company’s future consolidated results of operations, cash flows or financial position in a particular period. The Company expenses legal fees as incurred.

The Company is currently involved in the following lawsuits as a defendant.

Melcher Litigation

On September 28, 2016, a complaint was filed in the United States District Court for the Southern District of California against Five9, Inc., or Five9, as the successor in interest to Face It, Corp., or Face It, and Lance Fried, a former Five9 employee who was the former Chief Executive Officer of Face It. The action, captioned Melcher, et al. v. Five9, Inc., et al., No. 16-cv-02440, or the Federal Lawsuit, was filed as a direct action by Carl Melcher, or Melcher, a purported former stockholder of Face It, and his related investment entity Melcher Family Limited Partnership, or MFLP.

In the complaint, the plaintiffs allege that Face It repurchased the plaintiffs’ stock in September 2013 before Five9 acquired Face It, and that in connection with the repurchase, Fried made material misstatements or omissions to Melcher, by failing to disclose that Face It allegedly was in concurrent discussions about a potential sale of the company to Five9. The complaint alleges violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, as well as various claims under state law and common law. The complaint seeks to set aside Face It’s September 2013 stock repurchase from the plaintiffs, as well as an unspecified amount of damages and an award of attorney’s fees and costs, in addition to other relief.

On November 8, 2016, the court entered an order staying the Federal Lawsuit and ordered the parties to proceed to arbitration of the dispute before the American Arbitration Association, or AAA. On November 16, 2016, Melcher and MFLP submitted a Demand for Arbitration to AAA against Five9, asserting claims identical to those alleged in the Federal Lawsuit. No date has been set for the arbitration hearing.

The Company believes that it has indemnification rights against the former stockholders of Face It for losses it incurs in connection with the defense and resolution of this matter.

While the Company does not believe that it is probable that a loss has been incurred, the ultimate resolution of the matter could potentially result in a loss. Management’s best estimate of the low end of the range of the potential loss is zero. At this time, it is not possible to reasonably estimate the high end of the range of the potential loss, which could be material to the Company’s results of operations. Accordingly, the Company has not accrued a loss related to this matter.

NobelBiz Litigation

On August 5, 2011, NobelBiz sent a letter to the Company asserting infringement of a patent related to virtual call centers. On April 3, 2012, NobelBiz filed a patent infringement lawsuit against the Company in the United States District Court for the Eastern District of Texas. The patent asserted in the complaint is different, but related, to the patent asserted in the original letter. The lawsuit, NobelBiz Inc. v. Five9, Inc., Case No. 6:12-cv-00243-LED, alleges that the Company’s local caller ID management service infringes United States Patent No. 8,135,122, or the ‘122 patent. The ‘122 patent, titled “System and Method for Modifying Communication Information (MCI),” issued on March 13, 2012, and according to the complaint is alleged to relate to “a system for processing a telephone call from a call originator (also referred to as a calling party) to a call target (also referred to as a receiving party), where the system accesses a database storing outgoing telephone numbers, selects a replacement telephone number from the outgoing telephone numbers based on the telephone number of the call target, and originates an outbound call to the call target with a modified outgoing caller identification (‘caller ID’).” NobelBiz seeks damages in the form of lost profits as well as injunctive relief. The lawsuit is one of several lawsuits filed by NobelBiz against various companies including TCN Inc., LiveVox, Inc. and Global Connect LLC. On March 28, 2013, the court granted the Company’s motion to transfer the case to the United States District Court for the Northern District of California. Subsequently, NobelBiz amended its complaint to add claims related to U.S. Patent No. 8,565,399, or the ‘399 patent, which is a continuation in the same family as the ‘122 patent and addresses the same technology. The Company responded to the complaint and amended complaint by asserting noninfringement and invalidity of the ‘122 and ‘399 patents. On January 16, 2015, the court issued an order regarding claim construction of the two patents-in-suit. On March 7, 2016, the court stayed the case pending an appeal in lawsuits involving NobelBiz, Global Connect and TCN that also involve the ‘122 and ‘399 patents. The appeal for those cases is likely to last until into 2017, after which time the lawsuit between NobelBiz and Five9 will resume and a new schedule will be entered by the Court.

The Company has investigated the claims alleged in the complaint and believes that it has good defenses to the claims. While the Company does not believe that it is probable that a loss has been incurred, the ultimate resolution of the matter could potentially result in a loss. Management’s best estimate of the low end of the range of the potential loss is zero. At this time, it is not possible to reasonably estimate the high end of the range of the potential loss, which could be material to the Company’s results of operations. Accordingly, the Company has not accrued a loss related to this matter.

Indemnification Agreements

In the ordinary course of business, the Company may enter into agreements of varying scope and terms pursuant to which it will agree to indemnify clients, vendors, lessors, business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of breach of such agreements, services to be provided by the Company or from intellectual property infringement claims made by third parties. In addition, the Company has entered into indemnification agreements with directors and certain officers and employees that will require it, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors, officers or employees. Other than as described below, no demands have been made upon the Company to provide indemnification under such agreements and there are no claims that it is aware of that could have a material effect on the consolidated balance sheet, consolidated statement of operations and comprehensive loss, or consolidated statements of cash flows. On October 27, 2016, the Company received notice from Lance Fried, a former officer and director of Face It, of his claim for indemnification by the Company (as successor in interest to Face It), and for advancement of all legal fees and expenses he incurs in connection with the defense of the Melcher litigation. See PART I, ITEM3 of this Form 10-K. As of December 31, 2016, the Company had advanced Mr. Fried $40 thousand in connection with this claim. To the extent that it is ultimately determined that Mr. Fried is not entitled to indemnification, Mr. Fried has undertaken to reimburse the Company for all amounts advanced to him. In addition, the Company believes that it has indemnification rights against the former stockholders of Face It for all losses that incurred in connection with the Melcher litigation, including without limitation, amounts incurred to indemnify or advance the legal fees and expenses of Mr. Fried pursuant to his indemnification claim against the Company.