The purpose of this commentary is twofold: (1) to identify deficiencies in the 340B statute^[1] related to the use of multiple contract pharmacies and delivery to them—deficiencies that have resulted in the need for courts to resolve issues through judicial interpretation, and (2) to encourage policymaker action to address these deficiencies.

Overview of 340B Program

Under the 340B program, the federal government requires drug manufacturers participating in Medicare or Medicaid to sell certain covered drugs to qualifying health-care organizations at discounted prices.^[2] Health-care organizations that qualify to enter the program—referred to as covered entities—include hospitals and providers serving low-income or rural populations.^[3] The maximum price that drug manufacturers may charge a covered entity for covered drugs is the average manufacturer price for the preceding quarter minus a statutorily mandated rebate.^[4] The discounts provided to covered entities typically range from 20 to 50 percent off the market price of eligible drugs.^[5] As of 2020, there were approximately 50,000 registered 340B covered entity sites, with 2021 discounted drug purchases totaling $44 billion,^[6] or approximately 7.6 percent of the $576.9 billion of nationwide pharmaceutical purchases in 2021.^[7]

Conceptually, covered entities can stretch scarce resource dollars by profiting from the difference between their 340B drug resales—paid at full Medicare and insurance reimbursement rates—and the discounted drug acquisition costs. Covered entities can use the profits to finance affordable patient care for underserved communities.^[8]

Misconduct

However, there are risks that covered entities and drugmakers may operate in ways that contradict Congress’s intentions. For example, of the 189 audits of covered entities performed by regulators in 2022, sixty-six—more than one-third—included findings of misconduct.^[9] Likewise in 2022, regulators issued at least thirty-four citations to drug manufacturers requiring refunds to covered entities.^[10]

Part of this contradiction can be attributed to statutory silence—the 340B statute does not require covered entities to use their profits in a way that subsidizes needed-but-unprofitable care.^[11] But even where the statute expressly prohibits abusive activities, certain business practices by covered entities have amplified the risks of abuse.^[12]

Covered Entities’ Use of Multiple Contract Pharmacies

Of particular concern is the covered entity practice of using multiple contract pharmacies to handle the delivery and dispensing of purchased 340B drugs.^[13]

When the 340B program first began, few covered entities had their own in-house pharmacies to manage purchased drugs.^[14] Thus, in order to expand the reach of the 340B program, the Department of Health and Human Services (“HHS”) allowed covered entities to dispense 340B drugs through contract pharmacies—pharmacies not owned or operated by covered entities.^[15]

The extent to which covered entities can use contract pharmacies to dispense medications purchased under the 340B program for their patients raises some concerns.^[16] Drug manufacturers have alleged that covered entities use multiple contract pharmacies to engage in prohibited practices,^[17] such as diversion of discount drugs to ineligible patients^[18] or duplicative discounting.^[19]

Federal Support for Covered Entities’ Use of Multiple Contract Pharmacies

Despite these concerns, federal regulators have required drugmakers to accept covered entity demands for use of multiple contract pharmacies. Under the HHS “ship to, bill to” process, the covered entity owns the drugs after purchase and is billed directly for them, but the drugmaker must physically deliver the drugs to all contract pharmacies that the covered entity designates.^[20] Beginning in 2010, HHS permitted covered entities to use an unlimited number of contract pharmacies as long as applicable legal requirements were satisfied. Drugmakers objected to the practice out of fears that it enables covered entities to avoid compliance mechanisms.^[21]

Pushback from Drugmakers

The 340B statute says nothing about contractual delivery terms, where drugmakers must physically deliver drugs sold, or what party has the right to make the delivery determination. Rather, the statute only imposes price restrictions on drugmakers.^[22] Thus, in 2020, three drugmakers—Sanofi, Novo Nordisk, and AstraZeneca—began requiring 340B covered entities to accept the drugmakers’ conditions for place of delivery.^[23] Essentially, the three drugmakers offered to deliver purchased drugs to either an in-house pharmacy or a single contract pharmacy of the covered entity’s choosing, but not multiple contract pharmacies.^[24]

HHS: Advisory Opinion No. 20-06

HHS responded by issuing Advisory Opinion No. 20-06, which stated that once drugs have been “purchased by” covered entities, the delivery point is irrelevant to the agreement.^[25] Likewise, because contract pharmacies have long been used in connection with the 340B program, HHS found that drugmaker-imposed restrictions on their use was impermissible.^[26] Thus, according to HHS, covered entities should be free to require physical delivery to contract pharmacies—and drugmakers must comply.^[27]

HHS: Lack of Broad Rulemaking and Interpretive Authority

Unfortunately for federal regulators, HHS lacks broad rulemaking or interpretative authority to achieve its policy goals.^[28] In general, a federal agency’s administrative powers are limited to those powers delegated to it statutorily by Congress.^[29] Furthermore, while courts will generally defer to reasonable agency interpretations of ambiguous statutes,^[30] such deference is granted only when the agency acts under statutorily delegated rulemaking authority.^[31] If an agency adopts a statutory interpretation beyond its statutory authority, the interpretation lacks the force of law.^[32]

Regarding the 340B program, HHS has only narrow rulemaking authority pertaining to three specific administrative functions. First, Congress authorized HHS to establish an administrative dispute resolution process for drugmakers and covered entities contesting the conduct of their counterparties.^[33] Second, the statute allows HHS to establish by regulation a schedule of civil monetary penalties for violations.^[34] Neither of these provisions grants HHS the authority to create contractual rights or impose contractual duties upon drugmakers or covered entities in their dealings with each other.

Finally, the statute directs HHS to issue regulations to define the standards and methodology for calculating the maximum price that drugmakers can charge covered entities—referred to as the ceiling price in the statute.^[35] This provision deals with the complex process of determining the average manufacturer price and the statutorily mandated rebate to which covered entities are entitled for each drug covered by the statute.^[36] Thus, HHS does have some authority to create substantive contractual rights between covered entities and drugmakers—the agency establishes the maximum price for any sale. But the authority to calculate the ceiling price is not necessarily a grant of authority to regulate other aspects of the contractual relationship between the drugmaker and the covered entity.

Third Circuit Ruling

Clearly, regulators are limited in their ability to achieve policy goals via regulatory guidance. Thus, after HHS issued Advisory Opinion No. 20-06 and then violation letters to Sanofi, Novo Nordisk, and AstraZeneca (on the basis that the companies were in violation of the contract pharmacy delivery requirement as specified by the advisory opinion), the drugmakers challenged the regulatory actions in court.^[37] In January 2023, the U.S. Court of Appeals for the Third Circuit ruled in favor of the plaintiffs in Sanofi Aventis U.S. LLC v. U.S. Department of Health & Human Services.^[38] The case consolidated conflicting federal district court rulings over whether Advisory Opinion No. 20-06 and the resulting violation letters were valid.^[39]

According to HHS, the ability to regulate the delivery point was inherent to its statutory authority to regulate the “purchase” of eligible drugs.^[40] HHS relied on the Uniform Commercial Code (U.C.C.) for its logic.^[41] Under the U.C.C., by default, ownership of goods passes from seller to buyer when the seller’s delivery responsibilities are complete.^[42] According to HHS, because a “purchase” by a covered entity necessarily requires a transfer of ownership, HHS may dictate that the covered entity gets to designate how it takes title by designating the place of delivery.^[43]

Furthermore, in Advisory Opinion No. 20-06 and before the Third Circuit, HHS conceded its limited regulatory rulemaking authority^[44]—but that was of little consequence, according to the agency. Because it had long required that drugmakers sell to contract pharmacies, HHS claimed Advisory Opinion No. 20-06 did not create any new substantive rights or duties.^[45] HHS argued that this long-standing practice, combined with the statutory authority inherent in its role of regulating 340B sales relationships between drugmakers and covered entities, justified its regulatory actions.^[46]

The Third Circuit disagreed, finding that HHS’s requirements on drugmakers exceeded what the statute permits:

The “purchased by” provision imposes only a price term for drug sales to covered entities, leaving all other terms blank. HHS has suggested that covered entities get to fill in those blanks so long as they foot the bill. However, when Congress’s words run out, covered entities may not pick up the pen.^[47]

Essentially, because the statute’s language states nothing about how the parties are to handle physical shipment and delivery of purchased drugs, there is no indication that Congress intended to give covered entities the authority to dictate those terms in their purchase agreements with drugmakers.

Implicit in the Third Circuit’s opinion were concepts from the U.C.C. distinguishing different rights under a contract for the sale of goods.^[48] An understanding of these distinct rights is key to understanding the flaws in HHS’s logic, as HHS was essentially dictating what rights must arise in a sales contract between covered entities and drugmakers without the statutory authority to do so.

Under the U.C.C., a contract may exist even if the parties do not agree on all terms, with “gap filler” provisions operative only when the parties do not have express agreement on the specific term.^[49] Among the U.C.C. gap filler terms are default provisions on price^[50] and place of delivery.^[51] Under those provisions, the parties’ express agreement trumps the U.C.C. default terms.

The Third Circuit opinion acknowledged that the 340B program allowed HHS to restrict the parties’ abilities to set their prices—drugmakers must sell at no more than the ceiling price set by HHS.^[52] But because the 340B statute is silent regarding place of delivery, there is no corresponding restriction on negotiating delivery terms.^[53]

The HHS advisory opinion misconstrued the U.C.C. provisions on this point. By default, under the U.C.C., ownership of goods transfers when the seller’s delivery obligations are complete. But contractual parties are free to negotiate an alternative moment of title transfer.^[54] Furthermore, if the parties do not agree on a place of delivery, delivery of goods is deemed to occur at the seller’s place of business.^[55]

Thus, under the default U.C.C. provisions, ownership of goods transfers at the seller’s place of business, and delivery to the buyer’s chosen location is not required by the U.C.C. for transfer of title or completion of sale. Contrary to HHS’s interpretation, the U.C.C. expressly contemplates that the buyer and seller can negotiate these terms.

HHS took the position that because it is responsible for enforcing the parties’ rights and duties with regard to the sale as a whole, it can regulate these sale terms.^[56] But, as the Third Circuit held, the 340B statute does not empower HHS to impose these contractual terms on the parties.^[57] The statute only expressly permits HHS to regulate price.^[58] HHS’s limited 340B rulemaking and interpretive authority prevents it from conflating other sale rights to reconcile ambiguity in the statute and otherwise achieve policy goals.

Other Court Action

As of February 2023, similar cases were pending in the U.S. Court of Appeals for the Seventh Circuit and the U.S. Court of Appeals for the D.C. Circuit, and court watchers do not expect a circuit split.^[59]

Likewise, other courts have ruled in favor of drugmakers that received violation letters from HHS for imposing contract pharmacy restrictions. For example, in November of 2021, in a lawsuit by Novartis and United Therapeutics, the district court found that the plaintiffs’ conditions imposed on qualifying 340B entities did not violate Section 340B as alleged in HHS’s violation letters.^[60] The court also found that the drugmakers provided “credible evidence” that using multiple contract pharmacies “increased the potential for fraud in the 340B program.”^[61] The court recognized, however, that HHS has “legitimate concerns about the degree to which the manufacturers’ new conditions have made it difficult for covered entities to obtain certain drugs at discounted prices.”^[62]

Significant Challenges for Covered Entities

If, as the Third Circuit held, the 340B statute imposes restrictions only on price, drugmakers can force acceptance of all other contract terms—and will have gained significant leverage in negotiating purchase agreements with covered entities.

A 2022 survey of 482 covered entities with contract pharmacy relationships details an anticipated $448,000 per entity annual loss for critical-access hospitals and a $2.2 million per entity annual loss for more extensive facilities after fourteen drugmakers announced restrictions, with more than 75 percent of covered entities needing to cut programs and services if the restrictions remain permanent.^[63]

Congressional Action Needed

Drugmakers, pharmacy benefit managers, and covered entities have competing interests related to the profit on the drug sales. In between, federal regulators seek to control their own Medicare reimbursement costs while promoting the congressionally intended benefits to health-care providers. Unfortunately, ambiguity in the 340B statute raises questions about the appropriate interpretation of the statute and the scope of HHS’s authority to ensure compliance with program goals.

While the 340B program has the attention of some lawmakers, proposed legislation does not address the specific issues with contract pharmacies or the general issues of regulatory empowerment. For example, on April 6, 2023, Representatives Abigail Davis Spanberger and Dusty Johnson introduced the “PROTECT 340B Act of 2023” in the U.S. House of Representatives.^[64] The bill primarily addresses reimbursement discrimination against covered entities by health insurers and pharmacy benefit managers.^[65] While the bill acknowledges the use of contract pharmacies, it does not give HHS the explicit statutory authority to direct when and how contract pharmacies may be used in the delivery of drugs.^[66]

The multitude of policy questions surrounding the 340B program will not be answered through litigation alone. These questions go beyond the use of contract pharmacies by covered entities and restrictions by drugmakers. Like a loose thread on a sweater, the more one pulls on 340B, the more the legislation unravels. For example, it is unclear whether the program fulfills its goal of expanding care to needy communities.^[67] And from a policy standpoint, observers question the appropriate use of the revenue generated by covered entities from 340B discounted drugs and who should qualify as a “patient” of a covered entity.^[68] Other commentators have highlighted the numerous administrative difficulties associated with the 340B program.^[69]

Courts are only willing to implement HHS’s reforms with explicit statutory authority.^[70] As courts strike down HHS efforts to pursue policy goals, congressional inaction may signal implicit acquiescence of a paralyzed administrative agency. To preserve the long-standing and often critical role of contract pharmacies in the 340B system, Congress must pass legislation expressly empowering HHS to coordinate their use.

The views expressed in this publication represent those of the author(s) and do not necessarily represent the official views of HCA Healthcare or any of its affiliated entities.

1. Public Health Service Act § 340B, 42 U.S.C. § 256b (2022). ↑

2. Id. § 256b(a). ↑

3. Id. § 256b(a)(4); see also Casey W. Baker et al., Is the 340B Hospitals Battle at the Supreme Court Over?, 11 Pharmacy Times Health Sys. Edition 34 (2022). ↑

4. 42 U.S.C. § 256b(a)(1)–(2). The 340B program incorporates pricing mechanics of § 1927(c) of the Social Security Act (codified at 42 U.S.C. § 1396r-8(c)) for calculating the required rebates. ↑

5. Karen Mulligan, The 340B Drug Pricing Program: Background, Ongoing Challenges, and Recent Developments (U.S.C. Schaeffer Ctr. for Health Pol’y & Econ. 2021). ↑

6. See Bobby Clark & Marlene Sneha Puthiyath, The Federal 340B Drug Pricing Program: What It Is, and Why It’s Facing Legal Challenges, Commonwealth Fund (Sept. 8, 2022). ↑

7. Eric M. Tichy et al., National Trends in Prescription Drug Expenditures and Projections for 2022, 79 Am. J. Health-Sys. Pharmacy 1158 (2022). ↑

8. See Joseph D. Bruch & David Bellamy, Charity Care: Do Nonprofit Hospitals Give More than For-Profit Hospitals?, 36 J. Gen. Internal Med. 3279 (2021); see also, Baker, supra note 3; Am. Hosp. Ass’n v. Becerra, 142 S. Ct. 1896, 1905–06 (2022). ↑

9. Program Integrity: FY22 Audit Results, Health Res. & Servs. Admin. (last updated May 22, 2023). ↑

10. Manufacturer Notices to Covered Entities, Health Res. & Servs. Admin. (rev. July 2023). ↑

11. See Stuart Wright, OEI-05-13-00431, Memorandum Report: Contract Pharmacy Arrangements in the 340B Program 3 (2014); see also 340B Reporting and Accountability Act, S. 1182, 118th Cong. § 2 (2023), which would require covered entities to pass savings on to patients upon the resale of the drugs. ↑

12. Wright, supra note 11, passim. ↑

13. Id. ↑

14. See Sanofi Aventis U.S. LLC v. U.S. Dep’t of Health & Hum. Servs., 58 F.4th 696, 700 (3d Cir. 2023). ↑

15. 59 Fed. Reg. 25,110, 25,111–12 (May 13, 1994) (In response to a comment requesting that the use of contract pharmacies be disallowed, HHS stated, “It is a customary business practice for manufacturers to sell to intermediaries as well as directly to the entity. Entities often use purchasing agents or contract pharmacies, or participate in GPOs [group purchasing organizations]. By placing such limitations on sales transactions, manufacturers could be discouraging entities from participating in the program. Manufacturers may not single out covered entities from their other customers for restrictive conditions that would undermine the statutory objective.”); see also Sanofi, 58 F.4th at 700. ↑

16. Sanofi, 58 F.4th at 700. ↑

17. Id. ↑

18. 42 U.S.C. § 256b(a)(5)(B) (2022). ↑

19. Id. § 256b(a)(5)(A)(i). ↑

20. 75 Fed. Reg. 10,272, 10,276–77 (Mar. 5, 2010). ↑

21. Sanofi, 58 F.4th at 700. While HHS does have the ability to audit covered entities, including those that have a contract pharmacy model in place, it is unclear how effective this practice is at preventing unlawful activities. See Program Integrity: FY22 Audit Results, supra note 9. ↑

22. See 42 U.S.C. § 256b(a). ↑

23. Sanofi, 58 F.4th at 700–01. ↑

24. Id. ↑

25. Dep’t of Health & Hum. Servs. Off. Gen. Couns., Advisory Op. 20-06 on Contract Pharmacies Under the 340B Program 2–3 (Dec. 30, 2020) [hereinafter Advisory Op. 20-06]. Note that HHS rescinded Advisory Opinion 20-06 while the litigation was pending. Nevertheless, the U.S. Court of Appeals for the Third Circuit considered the advisory opinion because HHS continued to hold the positions asserted therein. See Sanofi, 58 F.4th at 703. ↑

26. Advisory Op. 20-06, supra note 25, at 3–5. ↑

27. See Sanofi, 58 F.4th at 704. ↑

28. See Pharm. Rsch. & Mfrs. of Am. v. U.S. Dep’t of Health & Hum. Servs., 43 F. Supp. 3d 28 (D.C. Cir. 2014). ↑

29. See id. at 35 (citing Bowen v. Georgetown Univ. Hosp., 488 U.S. 204, 208 (1988); Atl. City Elec. Co. v. Fed. Energy Regul. Comm’n, 295 F.3d 1, 8 (D.C. Cir. 2002)). ↑

30. Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984). ↑

31. United States v. Mead, 533 U.S. 218, 226–27 (2001). ↑

32. See Pharm. Rsch. & Mfrs. of Am., 43 F. Supp. 3d at 36–37 (citing Mead, 533 U.S. at 234). ↑

33. 42 U.S.C. § 256b(d)(3)(A) (2022). This authority is limited to just six functions expressly enumerated in the statute—(1) designating or establishing a decision-making official or decision-making body to review and resolve claims by covered entities concerning overcharges, (2) establishing deadlines and procedures to make sure that claims are resolved fairly and expeditiously, (3) establishing discovery procedures for covered entities in connection with such claims, (4) requiring drugmakers to conduct audits of covered entities prior to initiating any claim for misconduct, (5) allowing consolidation of claims by more than one drugmaker against the same covered entity, and (6) allowing joint claims by multiple covered entities against the same drugmaker. See 42 U.S.C. § 256b(d)(3)(B); see also Pharm. Rsch. & Mfrs. of Am., 43 F. Supp. 3d at 42. ↑

34. 42 U.S.C. § 256b(d)(1)(B)(vi). ↑

35. Id. § 256b(d)(1)(B)(i)(I). ↑

36. See Pharm. Rsch. & Mfrs. of Am., 43 F. Supp. 3d at 43–44. ↑

37. Sanofi Aventis U.S. LLC v. U.S. Dep’t of Health & Hum. Servs., 58 F.4th 696, 701 (3d Cir. 2023). ↑

38. Sanofi, 58 F.4th 696. ↑

39. AstraZeneca Pharms. LP v. Becerra, 2022 U.S. Dist. LEXIS 27842 (D. Del. Feb. 16, 2022); Sanofi-Aventis U.S., LLC v. U.S. Dep’t of Health & Hum. Servs., 570 F. Supp. 3d 129 (D.N.J. 2021). ↑

40. Sanofi, 58 F.4th at 703–05. ↑

41. Advisory Op. 20-06, supra note 25, at 3. ↑

42. U.C.C. § 2-401(2) (2002). ↑

43. Advisory Op. 20-06, supra note 25, at 2–3. ↑

44. Sanofi, 58 F.4th at 703. ↑

45. Advisory Op. 20-06, supra note 25, at 4. ↑

46. Id. at 4–5. ↑

47. Sanofi, 58 F.4th at 704. ↑

48. U.C.C. art. 2 (2002). ↑

49. See id. § 2-204(3) (“Even though one or more terms are left open, a contract for sale does not fail for indefiniteness if the parties have intended to make a contract and there is a reasonably certain basis for giving an appropriate remedy.”). ↑

50. Id. § 2-305. ↑

51. Id. § 2-308. ↑

52. Sanofi, 58 F.4th at 704–05. ↑

53. Id. ↑

54. U.C.C. § 2-401(2) (“Unless otherwise explicitly agreed title passes to the buyer at the time and place at which the seller completes his performance concerning the physical delivery of the goods.” (emphasis added)). ↑

55. Id. § 2-308(a) (“Unless otherwise agreed . . . the place for delivery of goods is the seller’s place of business.” (emphasis added)). ↑

56. Sanofi, 58 F.4th at 704. ↑

57. Id. ↑

58. Id. ↑

59. Avalon Zoppo, SCOTUS Bound? After Appellate Ruling, What Is Next in 340B Drug Discount Cases?, N.Y. L.J., Feb. 15, 2023, at 2. ↑

60. Novartis Pharms. Corp. v. Espinosa, 2021 U.S. Dist. LEXIS 214824 (D.D.C. Nov. 5, 2021). ↑

61. Id. at *29. ↑

62. Id. ↑

63. 340B Health, Contract Pharmacy Restrictions Represent Growing Threat to 340B Hospitals and Patients Survey Results (2022). ↑

64. PROTECT 340B Act of 2023, H.R. 2534, 118th Cong. (2023). ↑

65. Id. § 3. ↑

66. Id. ↑

67. See Sunita Desai & J. Michael McWilliams, Consequences of the 340B Drug Pricing Program, 378 New Eng. J. Med. 539 (2018). ↑

68. See Mulligan, supra note 5. ↑

69. See Lowell M. Zeta, Comprehensive Legislative Reform to Protect the Integrity of the 340B Discount Program, 70 Food & Drug L.J. 481 (2015). ↑

70. See Novartis Pharms. Corp. v. Espinosa, 2021 U.S. Dist. LEXIS 214824, at *30 (D.D.C. Nov. 5, 2021) (“[A]ny future enforcement action must rest on a new statutory provision, a new legislative rule, or a well-developed legal theory that Section 340B precludes the specific conditions at issue here.”). ↑

Start-ups and emerging companies are always seeking future investment opportunities. In recent years, a financing alternative called Simple Agreements for Future Equity (“SAFEs”) has gained popularity and proven useful for emerging companies when conducting their early-stage raises. SAFEs offer an efficient mechanism for raising capital in the early stages of an emerging company.

SAFEs emerged due to the need to bridge the financing gap during early-stage investments where the value of the company was unknown or difficult to determine. SAFEs enable companies to raise capital by granting investors the right to receive equity in the future, upon the occurrence of specific triggering events. This article explores the key provisions and advantages of utilizing SAFEs in comparison to other financing instruments. Additionally, this article will outline some of the key issues emerging companies should be aware of when structuring SAFEs and how to best avoid pitfalls that may arise when utilizing this financing option.

What Are SAFEs?

SAFEs are company-friendly investment contracts between the company and each investor that give the investor the right to receive equity of the company in the future upon the occurrence of certain triggering events. The main purpose of a SAFE is to enable an early-stage investment in a company to bridge finances until the occurrence of a ‎larger financing round. Upon such future financing round, the advance investment will convert into shares, ‎with the investor benefiting either from a discount in purchase price or a capped value.

SAFEs have gained popularity in recent years due to their distinct advantages over convertible notes, a topic that will be covered in a future article. Convertible notes often create conflicts with existing debt obligations and involve complex negotiations among different investors and institutions. Conversely, SAFE agreements offer a streamlined model that eliminates the need for intricate discussions surrounding interest rates and specific terms. This simplified process benefits both companies and SAFE holders, making SAFEs an attractive financing option.

Structuring the SAFE

It is important to note that SAFEs come in different variations, such as post-money SAFEs and pre-money SAFEs. Post-money SAFEs provide investors with a predetermined ownership percentage in the company after the occurrence of a future financing round. On the other hand, pre-money SAFEs do not account for the valuation of the future financing when determining the ownership percentage. Companies should carefully consider which type of SAFE best aligns with their financing goals and the expectations of their potential investors, as post-money SAFEs may lead to unintended anti-dilution protection on a full-ratchet basis in the event of a down round.

Key Provisions

In order to understand the benefits of and potential drawbacks to utilizing SAFEs, companies should be aware of the key provisions in a SAFE agreement, namely provisions relating to triggering events, valuation caps, discount rates, and most favored nations clauses.

Triggering Events

One of the main characteristics of a SAFE is that equity rights are granted whereby if the company undergoes a triggering event (which is defined in each SAFE agreement), the SAFE will convert into securities of the company. Triggering events tend to be subsequent financings of the company or liquidity events, such as the company commencing the bankruptcy or dissolution process. When a triggering event occurs, the holder has the benefit of the SAFE converting to equity at the negotiated discount in the SAFE, which allows the holder to obtain rights as a shareholder. Upon a dissolution, SAFE holders who have not converted their SAFE into securities would be paid the purchase amount they were guaranteed by the company before common shareholders are paid.

Discount Rate

This is a discount to the price per share outlined in the SAFE agreement that will be issued by the company to SAFE holders upon a triggering event. It is an incentive for investors to enter into a SAFE agreement, because purchasing the SAFE at earlier stages locks investors in to convert their SAFEs at a lower price upon a triggering event.

As an example, a company may incentivize early-stage investors through offering a SAFE that will convert at a price per share of $1.00. Upon the occurrence of a future financing at $1.20/share, the SAFE holder will receive the upside because the financing (which would constitute a triggering event) allows the SAFE holder to convert their SAFE into shares at $1.00/share.

Valuation Caps

Valuation caps are often used to establish the upper limit on the valuation of the company at which a SAFE will convert into shares. This has the effect of creating a floor for the percentage of the company the investor is purchasing. The valuation cap ensures that the SAFE holder receives a lower price per share than subsequent investors.

Most Favored Nations Clause

Most favored nations clauses may be used to provide a SAFE holder with certainty that, upon a future financing, if the terms of the future financing are more favorable to the investors than the SAFE is to the SAFE holder, the SAFE holder will receive the benefit of receiving the best terms for themselves. This serves as another incentive for investors to acquire SAFEs, because they won’t face the repercussions of investing too early if subsequent financings contain better terms.

Investor Protection

To ensure investor protection, SAFEs can incorporate provisions that grant transparency and information rights to SAFE holders. Regular updates on the company’s financials, milestones, and progress can be provided to investors, enabling them to make informed decisions about their investment. By fostering a relationship of trust and transparency, companies can attract and retain investors who feel confident in the growth trajectory of the company.

Tax Implications

Companies and investors should be mindful of the potential tax implications associated with SAFEs. The tax treatment of SAFEs can vary depending on the jurisdiction and individual circumstances. It is advisable to consult with tax professionals who can provide guidance on the specific tax implications of SAFEs, including any applicable capital gains taxes, reporting obligations, and potential tax advantages or disadvantages. By understanding the tax implications, companies and investors can effectively plan and strategize their financial decisions, ensuring compliance and optimizing their tax positions.

Exit Strategies

SAFE holders should consider the potential exit strategies available to them. While SAFEs provide the opportunity to convert into equity upon triggering events, investors may also seek liquidity through other avenues. Acquisition by another company, initial public offerings (IPOs), or secondary market sales are possible exit strategies for investors. Companies can proactively communicate their long-term plans and potential exit scenarios to investors, allowing them to evaluate the feasibility of realizing their investments and potential returns. By understanding the available exit strategies, investors can make informed decisions about their participation in early-stage companies.

Limitations and Considerations

It is important to acknowledge that SAFEs may not be suitable for all companies or industries. While SAFEs offer advantages, institutional investors or certain industries may prefer more traditional financing instruments, such as convertible notes or preferred stock. Companies should carefully assess their financing goals, investor preferences, and industry norms before deciding to adopt SAFEs. Additionally, legal and regulatory considerations, including compliance with securities laws and the enforceability of SAFEs, should be evaluated. Consulting legal professionals can help companies navigate the legal landscape and ensure that SAFEs are structured and implemented in a legally compliant manner.

Conclusion

For start-ups and emerging companies, SAFEs provide a compelling capital raising alternative, particularly in the early stages or when the company’s valuation is not yet established. SAFEs offer a simplified process, company-friendly provisions, and lower costs compared to other financing instruments. Investors are incentivized to participate early through discounted rates upon conversion of the SAFE into securities and potential preferential treatment during insolvency scenarios. By leveraging SAFEs, companies can access streamlined capital and fuel their growth without hindering immediate progress.

The creation and implementation of SAFEs should involve consultation with legal professionals. Legal counsel can provide guidance on complying with applicable securities laws, assessing the enforceability of SAFEs in different jurisdictions, and addressing any jurisdiction-specific regulations. By seeking legal advice, companies can mitigate potential legal risks, ensure compliance, and protect the rights of both the company and the investors. Legal professionals can also assist in drafting and negotiating the terms of SAFEs to accurately reflect the intentions and expectations of the parties involved, further enhancing the legal robustness of the agreements.

Introduction

“I have not failed. I’ve just found ten thousand ways that won’t work.” — Thomas Edison

Failed ideas and inventions, also known as “negative information,” can be economically valuable because anyone starting with knowledge of the dead ends can avoid spending time and resources on attempts that are ultimately going to fail. Clearly, negative information is valuable, but how does an economist value negative information? In this article, we explore techniques to overcome the challenges of determining the value of negative information, and show how negative information can inform allegations of trade secret theft in IP disputes.

Edison’s quote implies that failed ideas and inventions are valuable because they embody information on what does not work when creating something new. Unlike successful ideas and inventions, however, negative information is not priced by the market and is unlikely to directly generate any income. And yet a need to value negative information can arise in trade-secret-related disputes. In fact, the Uniform Trade Secrets Act from 1979 explicitly recognizes negative information as “information that has commercial value from a negative viewpoint, for example the results of lengthy and expensive research which proves that a certain process will not work could be of great value to a competitor.”^[1]

Waymo’s February 23, 2017, lawsuit^[2] against Uber for alleged theft of its trade secrets illustrates both the existence of and the need for valuing negative information. According to Waymo, Uber tried and failed to develop its own technology for a self-driving car, so it acquired Otto, a company started by a former Waymo employee who allegedly misappropriated Waymo’s technology. Waymo alleged that its employee’s theft of its intellectual property, including information about “dead-end designs,” allowed Uber (through Otto) to save a substantial amount of development time and cost. Waymo also claimed that its “extensive experience with ‘dead-end’ designs” and research findings that were unsuited for the market continued to be critical for its ongoing development^[3] and likely underpinned Otto’s $680 million valuation at acquisition despite having been on the market for only six months. In this example, negative information consists of Waymo’s dead-end designs and know-how of what does not work when developing technology for a self-driving car.

Cases similar to Waymo are common in the technology space, where cutting-edge research can often be unfruitful or unmarketable and yet informative for product development.^[4] In addition to ventures that are successful but only after many failed attempts (as in the Waymo example), negative information is often present in ventures that are ultimately deemed unsuccessful. Negative information can also be present in the valuation of ventures with significant research investments but prior to the development of any income-generating intellectual property.

The rationale for why negative information can be valuable is fairly intuitive; however, quantifying the value of negative information in general and particularly in the context of a trade secret dispute can be less straightforward. In the absence of comparables in the market and any attributable income, the only viable method for valuing negative information is a “cost to replicate” analysis.

A “cost to replicate” analysis attempts to answer a key “but-for” question: absent the alleged infringement of negative information, how much would it have cost the defendants to replicate the at-issue trade secret on their own? Importantly, the value of negative information is not how much it cost the plaintiffs in “creating” the negative information—a relatively simple accounting exercise—but what it would have cost the defendants to replicate it—an unknown counterfactual.

We begin in the next section with a brief note on recent trends in trade secret cases that underscore the importance of appropriately measuring the value of negative information.

Recent Trends in Trade Secret Cases in the US

Trade secret disputes in general—and particularly those in the technology space—have become more frequent due to a confluence of economic, legal, and regulatory factors. First, as the US workforce becomes increasingly more mobile—as has been the trend since the Great Recession^[5]—trade secret disputes are expected to increase. This is particularly true in the technology sector, where increasing demand and compensation have resulted in the largest churn in employees relative to all other job sectors.^[6] Negative information is at issue when an employee moves to a competitor and uses their knowledge of mistakes from their prior work to avoid making the same mistakes at their new place of employment. For example, in Novell, Inc. v. Timpanogos Research Group, Inc.,^[7] following a settlement between the parties, the defendant recognized that he “mistakenly believed that, because [he and others] had developed certain technology while employed by Novell, [they] could take elements of that technology with [them] when [they] left.”^[8]

Second, recent court decisions invalidated the patentability of certain types of subject matter (including patents related to software), thereby increasing reliance on trade secrets as an alternative for protecting intellectual property.^[9] All else being equal, a general increase in trade secrets implies a concurrent increase in trade secret disputes, including ones involving negative information.

Third, the Defend Trade Secrets Act of 2016 (DTSA) enabled business to sue and seek remedies for theft of trade secrets in either state or federal courts, thereby further increasing the likelihood of trade secret cases.^[10] And finally, trial outcomes for trade secret cases appear to be heavily skewed in favor of plaintiffs—almost 70% of the time in favor of plaintiffs—thus incentivizing plaintiffs to continue bringing their cases to court.^[11]

Typical Approaches to IP Valuation

As trade secrets disputes increase in volume and prominence, analysts need guidance for appropriately valuing the negative information components of these disputes. Valuation methods for intangible assets like intellectual property include income approaches, market approaches, or cost approaches.^[12] In the context of valuing negative information, the income and market approaches are typically inapplicable.

Income Approaches. Income approaches value intellectual property based on its potential to generate revenue or decrease future costs. For example, intellectual property that adds value to a product and increases its selling price can be valued by a discounted cash flow analysis of incremental profits. Negative information, however, does not manifest as any value-adding feature in a product or service and therefore lacks any attributable income. Market approaches value intellectual property based on arm’s-length transactions. For example, the price for licensing a patent can be informed by the licensor’s past or existing licenses for the same patent. Trade secrets are valuable in part because they are held in secret, and so it is rare for trade secrets in general to be licensed at arm’s length—and anyway it is difficult to imagine a traded market could exist for negative information.

Cost Approaches. Cost approaches are the valuation methods that can be applied to valuing negative information. A cost approach values intellectual property based on development costs. For negative information, cost approaches consider the costs avoided from not having to have invested in dead-end designs or failed procedures. For example, the costs incurred to develop intellectual property can inform on the cost savings proffered to a potential user of such intellectual property. Cost approaches don’t require consideration of future profits resulting from the use of intellectual property, which is useful because negative information is generally not associated with generating profit streams.

Academic studies of cost approaches distinguish between creation costs and re-creation costs.^[13] The former refers to the original development costs of intellectual property, while the latter are what it would cost to develop intellectual property at a later point in time, which may be different for multiple reasons, for instance changes in labor or materials prices, or advances in public knowledge.^[14]

A cost to replicate analysis aims to estimate re-creation costs, because it considers the cost the defendant would have incurred to replicate the intellectual property had they developed it themselves. In other words, the defendant saved itself development costs by misappropriating intellectual property. This can be considered unjust enrichment, and it can be calculated. In the Waymo-Uber matter, Waymo’s expert witness opined on Uber’s savings on development time by analyzing “the time periods that relate to the value of each of the trade secrets” and “the work that was foregone by virtue of… acquisition of the trade secrets.”^[15]

Cost to Replicate Analyses Can Be Complicated by Negative Information

Negative information can be valued with a cost to replicate analysis; however, there are complications unique to negative information. Academic studies have noted “the difficulty in proving that the nonuse of a mistake or dead-end experiment damaged the plaintiff or unjustly enriched the defendant.”^[16] When assessing economic harm, economic experts attempt to model the “but-for” world absent the alleged infringement. But it may be unreasonable to assume that defendants would have necessarily made the same mistakes or followed the same dead-ends as the plaintiffs did—in fact, defendants might have committed more errors, or made fewer mistakes. To illustrate using Waymo, let’s assume that Waymo undertook ten failed attempts prior to the successful development of its self-driving technology. Further, let’s assume that Uber acquired knowledge of these ten failed attempts, and with this negative information in hand, proceeded directly to developing its own successful technology for a self-driving car.

In this scenario, the value of Waymo’s negative information depends on how many of the ten failed attempts Uber would have undertaken in the but-for world. In part, that depends on the degree of interconnectedness of the failed attempts. Some efforts may necessitate sequential and iterative attempts, each new attempt learning from the prior ones; for other efforts the order may be random, making it imprudent to assume that the defendant in the but-for world would have undertaken the same number of attempts and in the same order as the plaintiff. So, while we can estimate the cost to replicate each of the attempts, we also have to have a choice framework to determine which of these failed attempts defendants would have pursued in the but-for world.

As a starting point for such a choice framework, we can examine plaintiffs’ failed attempts to identify which are relevant negative information. Waymo may have undertaken many failed experiments, not all of them necessarily linked to the development of its self-driving technology. Therefore, even before determining the potential mistakes the defendants would have likely made, experts must assess which failed experiments were undertaken in pursuit of the relevant goal (i.e., the product being replicated by the defendant).

Among plaintiffs’ relevant failed experiments, the damages expert must assess which ones would have been undertaken by the defendants in the but-for world, and which ones would have been undertaken in parallel or in sequence. In the Waymo case, Waymo’s expert analyzed the specific time periods for each trade secret before opining that some of the trade secrets, but-for the alleged misappropriation, “might have been done in a series,” while other trade secrets “probably would have gone in parallel.”^[17] If it appears that the plaintiff chose from several approaches at random until arriving at last at the successful one, it may be appropriate to assume that the defendant would have followed a different order of approaches, and so would not have made all the same mistakes before finally finding the successful approach. Damages experts should account for the defendants’ existing knowledge—for example, a more advanced incumbent competitor, already equipped with relevant knowledge, may perform fewer failed experiments than a new entrant in the market.

In deriving the choice framework, the expert should also be informed by the age of the negative information. Mistakes made in research many years ago may be less relevant to current technology, and therefore less likely to be repeated. Academic studies support such consideration of obsolescence when valuing intellectual property.^[18]

Similarly, changes in public knowledge will affect whether it is reasonable to assume a failed approach would have been tried in the but-for world. Since public knowledge by definition cannot be a trade secret, if any dead ends become publicly known before the alleged misappropriation by a defendant, then they should not be included in the analysis. This is especially relevant when plaintiffs release products into the market that make public certain results of their research. An example of this is when a company releases a product which incorporates a specific method, then the public may conclude that alternative methods are less desirable, making negative information about those alternative methods less valuable.

Determining which of the defendant’s projects were undertaken in pursuit of the relevant intellectual property requires understanding the defendant’s intent at the time of development. To this end, case-specific information in the form of documents produced in the usual course of business and testimony from those involved in the projects can be instrumental. Such information can guide the expert when modeling her choice framework. For instance, internal documents and testimony could indicate that defendants considered and were most likely to pursue a particular subset of the plaintiff’s full list of failed experiments. In such situations, the expert’s cost to replicate analysis would be deterministic and include the cost for the specific subset of experiments. Alternatively, when the testimony and documents do not identify a clear subset, the expert can resort to a probabilistic model. For example, if the defendants considered two experiments but did not indicate which one they would undertake, the expert could assign a 50 percent probability to both and calculate an expected value for her cost to replicate analysis.

Concluding Remarks

A well-supported valuation of negative information cannot be approached as a one-size-fits-all solution. Factors discussed in this article—including the number of potential failed ventures, the ordering of these ventures, and age of the technology in question—can vary from one case to another, which in turn impacts the expert’s modeling choices and final valuation. Nonetheless, identifying the relevant set of factors for consideration and appropriate means to account for them provides a useful framework for conducting the necessary individualized valuation of negative information.

Ideas and inventions that fail have economic value. We may associate market success with value, but the existence of negative information raises the possibility that some failed ideas and inventions can be valued in the right context. When Sir Isaac Newton said “if I have seen further, it is by standing on the shoulders of giants,” he was likely referring to those responsible for giant insightful failures as much as successful ones.

The opinions expressed are those of the authors and do not necessarily reflect the views of the firm or its clients. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

1. Unif. Trade Secrets Act § 1 cmt., 14 U.L.A. 637–38 (1985). ↑

2. Waymo LLC v. Uber Techs. Inc. No. C 17-00939 WHA (N.D. Cal. Jan. 29, 2018). ↑

3. Waymo LLC v. Uber Techs., Inc., Complaint, at 10.

   Waymo also created a vast amount of confidential and proprietary intellectual property via its exploration of design concepts that ultimately proved too complex or too expensive for the mass market; Waymo’s extensive experience with “dead-end” designs continues to inform the ongoing development of Waymo’s LiDAR systems today. The details actually used in Waymo’s LiDAR designs as well as the lessons learned from Waymo’s years of research and development constitute trade secrets that are highly valuable to Waymo and would be highly valuable to any competitor in the autonomous vehicle space. ↑

4. See, e.g., Fitbit v. Jawbone (three separate lawsuits: D. Del. 15-cv-775 and D. Del. 15-cv-0990, and N.D. Cal 15-cv-4073); Genentech, Inc. v. JHL Biotech, Inc., No. C 18-06582 WHA (N.D. Cal. Mar. 1, 2019). ↑

5. Neil Eisgruber, “Trends in Trade Secret Litigation Report 2020,” Stout, Apr. 2, 2020, at 21. ↑

6. Paul Petrone, “See The Industries With the Highest Turnover (And Why It’s So High),” LinkedIn Learning Blog, Mar. 19, 2018. ↑

7. 46 U.S.P.Q.2d 1197, 1217 (Utah Dist. Ct. 1998). ↑

8. “Novell settles suit against Timpanogos,” Deseret News, Aug. 29, 1998. ↑

9. Eisgruber, supra note 6, at 16–18. ↑

10. Id. at 21. ↑

11. Id. at 17–18. ↑

12. Robert F. Reilly & Robert P. Schweihs, Valuing Intangible Assets 96 (1998). ↑

13. Id. at 97–98. ↑

14. Id. at 97–98. ↑

15. Deposition of Lambertus Hesselink (September 26, 2017) at 264:11–265:11, Waymo LLC v. Uber Techs. Inc., No. C 17-00939 WHA (N.D. Cal. Jan. 29, 2018) (“Hesselink Deposition”). ↑

16. Charles Tait Graves, The Law of Negative Knowledge: A Critique, 15 Tex. Intell. Prop. L.J. 387, 412. ↑

17. Hesselink Deposition, supra note 16, at 264:11–265:11. ↑

18. Reilly & Schweihs, supra note 13, at 99–100. ↑

Over the past year, rising interest rates and stifling market conditions have contributed to a slowdown of leveraged transactions and overall deal-making in private equity. We’ve seen a historically deep decline in exits that poses a potential long-lasting drag on limited partner returns. As a result, there is a growing number of private equity funds (PE funds) looking for the right opportunity to exit existing investments.

This article explores the various strategies commonly employed by PE funds to achieve profitable exits for their portfolio companies and how PE funds can navigate the challenging landscape of exits to optimize their investments.

Structuring the Initial Investment

To maximize returns and control the exit process, private equity sponsors should plan for the exit during the initial investment stage. This includes ensuring sufficient control and liquidity through agreements like board control or veto rights, registration rights, redemption rights, drag-along rights, and tag-along rights. Management incentives are crucial for a successful exit, and equity incentive plans can align the interests of management and the sponsor fund. These plans may include time or performance vesting equity awards, which incentivize management to stay with the portfolio company after the sponsor exits.

When looking to exit, PE funds will need to review how the investment was structured to understand what rights it has to facilitate the exit of the investment and understand how the exit should be structured.

Strategic Sale

One of the most prevalent exit strategies is a strategic sale. This approach involves selling a portfolio company to a strategic buyer within the same industry or a related one. Strategic sales offer several advantages, including the realization of potential synergies between the strategic buyer and the target company. By integrating the portfolio company with the strategic buyer, the selling fund can often secure a higher return, thanks to the premium paid for the acquisition. Moreover, strategic sales generally have shorter transaction timelines, providing a quicker path to completion and increased deal certainty when compared to other exit strategies, such as initial public offerings (IPOs) or secondary buy-outs. When looking to execute on a strategic sale, the sponsor fund can choose to negotiate with a single buyer or shop the portfolio company in an auction process and receive multiple offers from bidders. While an auction typically provides the selling fund with more control over the sale and the drafting of the transaction documents, the process can take longer to complete as compared to a single-buyer negotiation.

Strategic sales tend to result in a complete exit by the selling fund, which typically effects the sale of the target portfolio company in exchange for cash consideration. Partial strategic sale exits are less common and usually result in the selling fund receiving shares in the strategic buyer instead of straight cash. From a structuring perspective, strategic sales can be effected either though a share sale or asset sale. Alternatively, the parties may decide to execute the sale through a merger of the target portfolio company and the strategic buyer. There are several considerations that may impact the type of transaction structure employed by the parties, including regulatory and tax matters that are beyond the scope of this article.

Secondary Buy-Outs

Another popular exit strategy is the secondary buy-out, which entails selling a portfolio company to another PE fund. In this scenario, the selling fund achieves a full exit, while the target company remains a private entity. Secondary buy-outs are favored for various reasons. For instance, the selling fund may opt to divest its ownership interest in a particular portfolio company to focus on other investments that better align with its strategy. Alternatively, the selling fund may believe that the portfolio company has reached a stage of growth or value where another PE fund is willing to pay a premium for the business. Moreover, the limited availability of exit opportunities through IPOs may influence the decision to pursue a secondary buy-out as the most viable exit option at a given time. Successful secondary buy-outs require rigorous due diligence, effective communication, and alignment of interests between the buying and selling parties.

Challenges posed by a secondary buy-out exit include a limited buyer pool, which can put constraints on the competitive bidding process and potentially result in fewer options for sellers. There may also be resistance from company management, as the purchasing fund will often replace existing management with members of its own team. Furthermore, financial buyers like PE funds may not be able to pay as much as strategic buyers because financial buyers cannot factor synergies into their cost and are less likely to pay a higher premium as a result.

Initial Public Offerings

When structuring the initial investment, PE funds will generally seek to retain the flexibility to sell their ownership stake in a portfolio company. This will typically include the right to cause the portfolio company to undertake an IPO. PE funds often prefer IPO exits because IPOs typically result in higher valuations for portfolio companies as compared to other possible exits. It also allows the PE fund to judge when to exit due to real-time fluctuations in value of the company based on open trading of shares on the public market. When an exit transaction is consummated via an IPO, the PE fund will often continue to maintain a significant stake in the company for a period of time following closing, allowing the fund to benefit from any post-IPO increase in the company’s valuation. Consequently, the PE fund will be subject to exchange rules and securities laws relating to resale restrictions on the post-IPO shares and certain types of related party transactions. In many cases, the PE fund will also be subject to lock-up agreements with the underwriters of the IPO.

In addition, the nature of the ownership stake retained by the PE fund will often impact the approach taken in connection with the rights the fund may want to retain following a portfolio company IPO. Most underwriters will seek to place significant limitations on the rights of PE funds following an IPO over concerns that retaining such rights may negatively impact the marketability of the offering. For this reason, certain rights that benefit the PE fund—such as pre-emptive rights, rights of first refusal, and drag-along and tag-along rights—usually do not survive a portfolio company IPO. However, PE funds will often retain board nomination rights, registration rights, and information rights post-IPO, and they may retain certain veto rights, depending on the level of board control and the size of the retained ownership stake. It is important to note, however, that exiting via an IPO also presents a number of disadvantages. These disadvantages include a lack of a complete exit, increased execution risk, increased transaction timelines, increased transaction costs, and increased regulatory scrutiny and disclosure obligations under various securities regulatory regimes.

Partial Exits

In addition to these strategies, PE funds can leverage recapitalizations for partial exits by restructuring the capitalization of portfolio companies. Recapitalizations involve financial maneuvers such as issuing dividends or raising additional debt against the company’s assets. By adjusting the capital structure, PE funds can distribute cash to investors while retaining an ownership stake. Recapitalizations are effective exit strategies when the portfolio company has stable cash flows, valuable assets, and growth potential. However, careful analysis of the company’s financial position, its debt capacity, and market conditions is crucial in implementing this strategy. Another option to partially exit the portfolio company is where the PE fund has a redemption right that allows it to require the portfolio company to repurchase the PE fund’s shares. This right is typically negotiated at the time of initial investment and would require the company to have assets available to repurchase all or a portion of the shares the PE fund holds.

Conclusion

Successful exits are critical for PE funds to achieve their desired returns. By carefully considering the various exit strategies available and analyzing the specific circumstances of each portfolio company, PE funds can optimize their exits and maximize profitability. The key is to understand the market dynamics, assess the potential for synergies, and adapt to changing conditions to execute the most appropriate exit strategy for each investment. Through strategic planning and meticulous execution, PE funds can navigate the complex exit landscape and deliver successful outcomes for themselves and their investors.

Since the release of ChatGPT in November 2022, there has been a seemingly endless onslaught of coverage about the chatbot and generative AI software like it. These stories range from the fear-inducing (the world will be taken over by AI-controlled bots) to the ridiculous (a lawyer relied on ChatGPT to draft a brief and had to face a very mad judge when it turned out that the software fabricated cases). In the legal realm, much of the focus of conversations around ChatGPT has been on the intersection between copyright law and AI, and rightly so. From questions around whether a work generated by AI qualifies for copyright protection to investigations around if an AI app’s ingestion of copyrighted works is covered by fair use, generative AI technology has introduced a lot of big issues, and answers are being decided in real time.

One often overlooked area of intellectual property where AI is poised to have a big impact is the right of publicity. By way of background, the right of publicity allows individuals to control the commercial exploitation of their identity and reap the rewards associated with their fame or notoriety by requiring others to obtain permission (and pay) to use their name, image, or likeness. As the law in this area develops along with the technology, there are several key issues practitioners need to be aware of.

The challenge with generative AI is that it makes the creation of a credible simulacrum of a celebrity much, much easier. In the past, this would have required finding a real person who could sound like a celebrity or be done up like a celebrity. Generative AI allows users to skip this. For example, earlier this year, an anonymous creator operating under the name Ghostwriter uploaded a song in the style of musicians Drake and The Weeknd. The song, which effectively mimicked the real artists, quickly went viral and was played millions of times on TikTok, Spotify, and YouTube before being removed at the behest of Universal Music Group, which is home to both the artists.

While in this case, there was no action for violation of Drake and The Weeknd’s right of publicity, this will not necessarily be the case going forward, particularly as the technology continues to evolve and its output becomes even more sophisticated.

Practitioners representing entities that make and use generative AI need to be aware of the contours of the right of publicity so they can minimize risk of such claims or appropriately address them when they arise. Here are five things to keep in mind as the technology develops:

1. Right now, there is no federal cause of action for the right of publicity. For the time being, the right of publicity is a creature of state law, with about two-thirds of states recognizing some form of this claim. This means that there is some variation between states and that many right of publicity claims are brought in state—not federal—court.
2. It’s not just a replica of a celebrity’s face or body that is protected. Rather, the courts may give plaintiffs a bit of leeway to proceed where a defendant has used characteristics that call a celebrity to mind. For example, the Ninth Circuit, applying California law, recognized that an ad featuring a robot dressed in a long gown, wearing a blonde wig, and turning block letters as part of something that looked like a game show was meant to depict Vanna White and infringed her right of publicity by appropriating her identity. Similarly, the Ninth Circuit found that Bette Midler could bring a right of publicity action against an advertiser and its ad agency for creating a commercial with a singer who was hired to sound like Midler.
3. The output of a generative AI platform may be protected by the First Amendment. This means that, as with other forms of intellectual property, an individual’s interest in protecting their right of publicity must be balanced against the rights of users to creative or self-expression. This is true even if the product of generative AI is being sold for a profit. Taking a non-AI example, the Sixth Circuit concluded that Tiger Woods could not maintain a right of publicity claim against the painter of a painting entitled The Masters of Augusta that commemorated Wood’s 1997 victory at the Masters. In this case, the Sixth Circuit found that, although the painter sold prints of the painting, the work was protected by the First Amendment because there was substantial “creative content” that outweighed Woods’s interest in profiting from his image.
4. It is unclear if Section 230 applies. This section of the Communications Decency Act can limit a platform’s liability for its users’ conduct. However, at least for now, there is no case law saying that this law applies to AI-generated materials. There are also questions of what that would look like, such as who is the creator of a work generated by an AI platform based on user prompts and whether right of publicity claims fall within an exception to Section 230 for intellectual property claims. Until these details become clearer, platforms should be wary of hosting AI-generated materials featuring a celebrity.
5. The nature and extent of the license granted by a celebrity may mean that the celebrity’s right of publicity claims are preempted. Thus, for example, in late 2022 the Second Circuit Court of Appeals affirmed a district court’s dismissal of a lawsuit against Sirius XM by John Melendez, who used to appear on The Howard Stern Show under the moniker “Stuttering John.” The plaintiff claimed that Sirius XM breached his right of publicity by airing past episodes and ads that featured him. The court found that, in light of Sirius XM’s license to these materials, the plaintiff’s claims were preempted by the federal Copyright Act.

Practitioners need to monitor each of these areas for new developments, particularly as the technology continues to improve and change.

Introduction

On June 22, 2023, the United States Supreme Court decided two consolidated cases that may have a significant impact on the enforcement of foreign arbitral awards in the United States. In a majority opinion authored by Justice Sonia Sotomayor, the Supreme Court held that in certain circumstances, a foreign plaintiff may bring a private action under the Racketeer Influenced and Corrupt Organizations Act (“RICO”) for the purpose of collecting an international arbitration award. The Court’s decision in these cases—Yegiazaryan v. Smagin (No. 22-381) & CMB Monaco v. Smagin (No. 22-383)—dealt primarily with RICO’s “domestic injury” requirement, finding that a party’s actions to delay and prevent the execution of a U.S. judgement confirming a foreign arbitral award can satisfy that requirement. In doing so, the decision may pave the way for a powerful new avenue for foreign individuals and companies to reach U.S.-based assets for the purpose of collecting foreign arbitration awards.

What Is RICO?

RICO is a criminal and civil statute that Congress enacted in 1970 to combat the influence of “organized crime” on American commerce. Congress initially conceived RICO as a way “to prevent ‘known mobsters’ from infiltrating legitimate businesses.”^[1] RICO penalized any person involved in an enterprise of racketeering activity in violation of certain federal and state criminal laws (called “predicate acts”) such as bribery, fraud, embezzlement, and money laundering.^[2] To prove a RICO claim, based on any combination of predicate acts, a RICO plaintiff must show that the conduct of an enterprise, through a pattern of racketeering activity, caused injury to the plaintiff’s business or property.^[3]

RICO also provides a private right of action to “[a]ny person injured in his business or property by reason of a violation of” RICO.^[4] There is strong incentive for a civil plaintiff to bring a RICO claim because Congress mandated that prevailing civil RICO plaintiffs shall recover triple the actual damages caused by the defendant’s racketeering activity plus the costs of litigation, including attorneys’ fees.^[5] Accordingly, over the years RICO has taken on countless interpretations. It has been described as “one of the nation’s most powerful laws.”^[6] Courts have noted its “breathtaking scope,”^[7] labeled it “an unusually potent weapon,”^[8] and described it as “the litigation equivalent of a thermonuclear device.”^[9]

The Domestic Injury Requirement for Civil RICO Claims and “Tangible Property”

RICO is notorious for its numerous elements and, thus, rigorous pleading standards. But there is an additional step for individual plaintiffs who are not U.S. residents or corporate plaintiffs that do not have their principal place of business in the United States. To establish standing under RICO, such a foreign plaintiff must demonstrate that it suffered a “domestic injury” to its business or property. That is, the plaintiff must establish an injury that was suffered in the United States, rather than abroad.

The Supreme Court first addressed RICO’s “domestic injury” requirement in RJR Nabisco, Inc. v. European Community.^[10] There, foreign plaintiffs filed a RICO suit against the tobacco corporation RJR Nabisco alleging international money laundering (including acts involving foreign drug traffickers and the sale of cigarettes to Iraq). The Supreme Court established that for foreign plaintiffs asserting a RICO claim there is a presumption against extraterritoriality, and that presumption requires a plaintiff to prove a “domestic injury” in support of a RICO action.^[11] The Court found that RICO is not limited solely to domestic schemes, but it remains that “not . . . every foreign enterprise will qualify.”^[12]

In 2017, the Second Circuit addressed the “domestic injury” requirement in Bascuñán v. Elsaca. In that case, the plaintiff, a resident of Chile, alleged a RICO claim based on allegations that his cousin stole millions of dollars from his U.S. bank account through various schemes.^[13] The district court concluded that there was no “domestic injury” because the plaintiff suffered economic injuries only that he felt at his place of residence, which was Chile, not the United States.^[14]

The Second Circuit, however, reversed this decision, holding that “[w]here the injury is to tangible property [money in a U.S. bank account], we conclude that, absent some extraordinary circumstance, the injury is domestic if the plaintiff’s property was located in the United States when it was stolen or harmed, even if the plaintiff himself resides abroad.”^[15] Because there was a domestic injury to tangible property, the Second Circuit’s decision in Bascuñán allowed the RICO claim to proceed.^[16]

Neither Bascuñán nor RJR Nabisco, however, addressed how the presumption against extraterritoriality applies to intangible property belonging to a foreign plaintiff, thus leaving an open question that the Supreme Court addressed in Yegiazaryan v. Smagin, which involved the intangible property of a judgment enforcing a foreign arbitral award.

Armada in the Seventh Circuit—Where Does the Plaintiff Live?

In 2018, the Seventh Circuit, in Armada (Sing.) PTE Ltd. v. Amcol Int’l Corp., affirmed that a judgment of a United States District Court recognizing a foreign arbitral award is “intangible property.”^[17] Per the decision in Armada, the “location” of an injury to that intangible property had to be the foreign claimant’s home abroad.^[18]

The plaintiff in Armada (a Singaporean shipping company) was awarded more than $70,000,000 in two awards in ad hoc arbitration in London.^[19] The Southern District of New York recognized those awards and entered a judgment, and the plaintiff sought to enforce its judgment by filing maritime attachment proceedings.^[20] When those efforts proved unsuccessful, the plaintiff filed a RICO action alleging that it suffered an injury to its property (i.e., its recognized judgment) and that the defendants “by means of racketeering activity, injured that property by divesting [the defendant] of assets, thereby making the judgment and other claims against [the defendant] uncollectable.”^[21]

The Seventh Circuit held that the foreign plaintiff’s “principal place of business [was] in Singapore, so any harm to [the plaintiff’s] intangible bundle of litigation rights was suffered in Singapore.”^[22] Therefore, there was no domestic injury to the plaintiff’s intangible property and the plaintiff “failed to plead a plausible claim under civil RICO.”^[23]

Humphrey in the Third Circuit—Where Did the Plaintiff Suffer?

Later in 2018, the Third Circuit scrutinized Armada and departed from it in Humphrey v. GlaxoSmithKline PLC.^[24] The plaintiffs in Humphrey were American cofounders of an investigation firm based in China.^[25] Following a Chinese regulatory investigation that resulted in the arrest, conviction, and deportation of the plaintiffs back to the United States,^[26] the plaintiffs sued for civil RICO, alleging that their business was “destroyed and their prospective business ventures eviscerated.”^[27] The district court found there was no domestic injury because “Plaintiffs’ business was in China, their only offices were in China, no work was done outside of China, Plaintiffs resided in China, and … any destruction of Plaintiffs’ business occurred while Plaintiffs were imprisoned in China by Chinese authorities.”^[28]

The Third Circuit affirmed. In doing so, however, it rejected the residency-based rule from Armada and opted instead for a multi-factor test to determine when injury to intangible property is a “domestic injury.”^[29] The court’s inquiry “focus[ed] primarily upon where the effects of the predicate acts were experienced.”^[30] There were several factors the Humphrey court deemed relevant to consider, including (but not limited to):

1. where the injury arose;
2. the plaintiff’s residence or principal place of business;
3. where any alleged services were provided;
4. where the plaintiff received or expected to receive benefits of those services;
5. where any business agreements were entered into;
6. the laws binding those agreements; and
7. the location of the activities in the underlying dispute.^[31]

Applying these factors, the Third Circuit concluded there was no domestic injury because the alleged harm to the plaintiffs’ business occurred mainly abroad.^[32]

Smagin in the Ninth Circuit—A “Context-Specific” Inquiry

The Seventh Circuit’s decision in Armada and the Third Circuit’s decision in Humphrey set the stage for the Supreme Court’s June 22, 2023, decision in Yegiazaryan v. Smagin and CMB Monaco v. Smagin.

These cases arose from a Ninth Circuit appeal involving the enforcement of an $84,000,000 arbitral award from the London Court of International Arbitration (“LCIA”).^[33] In December 2014, the California federal court confirmed the LCIA arbitral award, entered judgment against Ashot Yegiazaryan for $92,000,000 (the award plus interest), and issued a temporary protective order freezing Yegiazaryan’s assets in California.^[34]

After Yegiazaryan’s continued refusal to pay, the claimant Vitaly Ivanovich Smagin filed a civil RICO action alleging that Yegiazaryan and other defendants conducted a RICO enterprise to prevent Smagin from enforcing the arbitral award.^[35] In his suit, Smagin sought not only actual damages (i.e., the amount of his LCIA award), but also attorneys’ fees and treble damages as authorized under RICO. The Central District of California dismissed the complaint for lack of domestic injury.^[36] In deciding, the district court noted the relevant Humphrey factors, but found it “most significant” that Smagin is a resident and citizen of Russia—and thus not the subject of a domestic injury.^[37]

The Ninth Circuit reversed, adopting a “context-specific” approach.^[38] Applying that approach, the Ninth Circuit concluded that Smagin had pleaded a domestic injury. Smagin, the appellate court reasoned, was trying to execute on a California judgment, in California, against a California resident. He alleges that his efforts were foiled by a pattern of racketeering activity that “occurred in, or was targeted at, California” and was “designed to subvert” enforcement of that judgment in California.^[39]

The court concluded there was a domestic injury, and noted that Smagin’s “central allegation is that those predicate acts injured his right to seek property in California from a California resident under the California Judgment.”^[40] Rejecting the Seventh Circuit’s bright-line rule in Armada and embracing the Third Circuit’s factor-based approach in Humphrey, the Ninth Circuit held that “whether a plaintiff has alleged a domestic injury is a context-specific inquiry that turns largely on the particular facts alleged in a complaint.”^[41]

Yegiazaryan in the Supreme Court—A Context-Specific Inquiry Prevails over a Bright-Line Rule

After the Ninth Circuit denied petitions for an en banc rehearing, Yegiazaryan and one of the other defendants, CMB Monaco (a foreign bank), both filed petitions for certiorari. On January 13, 2023, the Supreme Court granted the petitions and consolidated the cases. During argument on April 25, 2023, Chief Justice John Roberts and Justice Sonia Sotomayor seemed to favor affirming the Ninth Circuit’s decision, with Chief Justice Roberts noting “the plaintiff obtained a California judgment to collect California property against someone living in California based on conduct in California. Right? Why can’t we consider, with all those connections, that . . . a domestic injury?”^[42]

For her part, Justice Elena Kagan seemed uncomfortable with how this foreign dispute came before the Court: “It is a little bit odd . . . yes, there’s a California judgment and acts, alleged acts, taken to avoid that judgment. But all of that is derivative on a dispute that was fundamentally foreign in nature between foreign parties involving foreign conduct initially adjudicated in another foreign country, so the fact that this has migrated, if you will, to the United States, you know, comes about only with respect to enforcing the first judgment.”^[43]

In the end, the justices affirmed the Ninth Circuit and permitted Smagin to pursue his RICO claim to try to enforce his $92 million judgment. Justice Sotomayor authored the majority opinion, which the Court issued on June 22, 2023. The Court held that Smagin’s allegations showed the alleged racketeering activity occurred in or was targeted at California, thus creating a domestic injury sufficient to establish RICO standing for the foreign plaintiff.

The Court rejected the bright-line residency rule from Armada, opting instead to follow the Ninth Circuit’s context-specific inquiry. “[D]epending on the allegations, what is relevant in one case to assessing whether the injury arose may not be pertinent in another,” the majority held. “While a bright-line rule would no doubt be easier to apply, fealty to the statute’s focus requires a more nuanced approach.”^[44] The Court emphasized the facts surrounding the California judgment and Yegiazaryan’s “domestic actions” taken to avoid enforcement.^[45]

The rights that the California judgment provide to Smagin exist only in California, and “[t]he alleged RICO scheme thwarted those rights, thereby undercutting the orders of the California District Court and Smagin’s efforts to collect Yegiazaryan’s assets in California.”^[46] Looking to what the Court viewed as the relevant factors, the Court concluded there was a domestic injury.

Three justices dissented. Justice Samuel Alito was joined fully in his dissent by Justice Clarence Thomas and joined in part by Justice Neil Gorsuch. Their concern was that a context-specific inquiry offers little help to future courts grappling with this issue.^[47] “Of course, under the majority’s all-factors-considered approach, many other features of this very suit could be relevant,” the dissent opined.^[48] It was unclear from the majority’s opinion which factors are relevant, and in what context.

The dissenting justices also raised concerns about overreach, noting that this decision gives foreign plaintiffs with arbitral awards significant power. “A thrust of our international-comity jurisprudence is that we should not lightly give foreign plaintiffs access to U.S. remedial schemes that are far more generous than those available in their home nations,” the dissent noted. “In light of RICO’s unusually plaintiff-friendly remedies, that concern applies in spades here.”^[49]

Takeaways

The Supreme Court’s decision is significant, and there are several key takeaways of which international arbitration and RICO practitioners should be aware.

First, the Supreme Court has recognized—for the first time—that a United States judgment confirming a foreign arbitral award is “property” within the meaning of RICO. Thus, a plaintiff who can allege an injury to that foreign arbitral award can satisfy the damages requirement of the RICO statute (i.e., injury to one’s “business or property”). This holding gives claimants who are successful in international arbitration proceedings a new weapon to enforce arbitral awards against reluctant defendants with U.S.-based assets.

Second, by allowing Smagin’s RICO claim to proceed, the Supreme Court opened a path for Smagin to recover treble damages and attorneys’ fees, and thus significantly increase the value of his arbitration victory. As we have seen in other areas, plaintiffs are very eager to use RICO whenever possible in order to take advantage of these provisions. It would not be surprising at all to see other plaintiffs try to emulate Smagin’s success here, thus creating an uptick in lawsuits in U.S. courts seeking foreign arbitral award enforcement under the cover of civil RICO.

Third, given the context-specific approach the Supreme Court endorsed, it would likewise not be surprising to see other federal courts try to place limitations and/or guardrails on the application of this decision. Courts will still require foreign plaintiffs to meet the rigorous civil RICO standards, including establishing predicate criminal offenses and a connection to an “enterprise.” And while the threat alone of treble damages and attorneys’ fees may motivate debtors to pay up when they might otherwise be reluctant, the context-specific analysis of this opinion does leave them escape hatches that a bright-line rule likely would not have.

This, in part, is the dissenting justices’ concern. Smagin may have received the blessing he needed to pursue a private RICO action. But the defendant in this case is a California resident with assets in California. The context-based analysis changes considerably if the defendant, for example, does not reside in California, or did not have assets in California. If these circumstances are changed, even slightly, that may prove to be enough for other federal courts to distinguish such a case and not be bound by these Supreme Court precedent.

It is too early to tell the practical impact of the Supreme Court’s decision. Regardless, beyond the question of enforcing foreign arbitral awards against U.S.-based assets, this decision will be of interest to all seeking clarity on when and under what circumstances non-U.S. plaintiffs may invoke RICO.

[1] S. Rep. No. 91-617, at 76 (1969).

[2] 18 U.S.C. § 1961(1).

[3] United Bhd. of Carpenters & Joiners of Am. v. Bldg. & Const. Trades Dep’t, 770 F.3d 834, 837 (9th Cir. 2014).

[4] 18 U.S.C. § 1964(c).

[5] 18 U.S.C. § 1964(c).

[6] Nathan Koppel, They Call It RICO, and It Is Sweeping, Wall Street Journal, Jan. 20, 2011.

[7] R.A.G.S. Couture, Inc. v. Hyatt, 774 F.2d 1350, 1355 (5th Cir. 1985).

[8] Turner v. New York Rosbruch/Harnik, Inc., 84 F. Supp.3d 161, 167 (E.D.N.Y. 2015) (quoting Miranda v. Ponce Fed. Bank, 948 F.2d 41, 44 (1st Cir.1991)).

[9] Id.

[10] 579 U.S. 325, 326 (2016) (“A private RICO plaintiff therefore must allege and prove a domestic injury to its business or property.”).

[11] Id. at 335 (noting that “[a]bsent clearly expressed congressional intent to the contrary, federal laws will be construed to have only domestic application.”).

[12] Id. at 344.

[13] 874 F.3d 806, 809 (2d Cir. 2017).

[14] Id.

[15] Id. at 820–21 (emphasis added).

[16] Id. at 824 (“…with respect to the particular type of property injury alleged here—the misappropriation of Bascuñán’s trust funds from a specific bank account located in the United States—we conclude that the location of the property and not the residency of the plaintiff is the dispositive factor.”).

[17] 885 F.3d 1090, 1092 (7th Cir. 2018).

[18] Id. at 1091.

[19] Armada Pte Ltd. v. Ashapura Minechem Ltd. (Ad hoc Arbitration Feb. 16, 2010) (Baker-Harber, Arb.) (Jus Mundi).

[20] Armada, 885 F.3d at 1092.

[21] Id. at 1093.

[22] Id. at 1094; see also Humphrey v. GlaxoSmithKline PLC, 905 F.3d 694, 701 (3d Cir. 2018).

[23] Armada, 885 F.3d at 1094.

[24] 905 F.3d 694 (3d Cir. 2018).

[25] Id. at 697.

[26] Id.

[27] Id.

[28] Id. at 697–98.

[29] Id. at 708–09 (“Although the ease with which [Armada’s] bright-line rule can be applied gives it some surface appeal, we resist the temptation to adopt it as the law of this circuit.”).

[30] Id. at 707 (emphasis added).

[31] Id.

[32] Id. at 707–08 (noting “Plaintiffs lived in China; had their principal place of business in China; provided services in China (albeit to some American companies – but even they were operating in China); entered the Consultancy Agreement in China and agreed to have Chinese law govern it; met with Defendants’ representatives only in China; and themselves indicated on the civil cover sheet that the underlying incident arose in China.”).

[33] Smagin v. Yegiazaryan, 37 F.4th 562, 565 (9th Cir. 2022).

[34] Id.; see also Smagin v. Compagnie Monegasque de Banque, Case No. 2:20-cv-11236-RGK-PLA, 2021 WL 2124254 (C.D. Cal. May 5, 2021).

[35] Smagin, 37 F.4th at 565.

[36] Smagin v. Compagnie Monegasque de Banque, Case No. 2:20-cv-11236-RGK-PLA, 2021 WL 2124254 (C.D. Cal. May 5, 2021).

[37] Id. at *4 (“Though the Court here considers all of the relevant Humphrey factors, the Court places great weight on the fact that Smagin is a resident and citizen of Russia and therefore experiences the loss from [his] inability to collect on his judgment in Russia.”) (internal quotations omitted).

[38] Smagin v. Yegiazaryan, 37 F.4th 562, 568–70 (9th Cir. 2022)

[39] Id. at 567–568.

[40] Id. at 569.

[41] Id. at 570.

[42] Oral Argument Transcript at 8:16–25, Yegiazaryan v. Smagin, 599 U.S. ___ (2023) (No. 22-381).

[43] Id. at 39:14–40:1.

[44] Yegiazaryan v. Smagin, ___ S. Ct. ___ (2023); 2023 WL 4110234, at *7.

[45] Id. (“Zooming out, the circumstances surrounding Smagin’s injury make clear it arose in the United States.”).

[46] Id. at *8.

[47] Id. at *9 (“This analysis offers virtually no guidance to lower courts, and it risks sowing confusion in our extraterritoriality precedents. Rather than take this unhelpful step, I would dismiss the writ of certiorari as improvidently granted.”).

[48] Id. at *10 (emphasis in original).

[49] Id. at *11.

In the ongoing war against cyber fraud, a whistleblower is one of the most valuable soldiers. With insider access and detailed knowledge about a contractor’s operations, whistleblowers are uniquely poised to reveal cyber fraud in the intricate landscape of government contracts. The U.S. Department of Justice’s Civil Cyber-Fraud Initiative (“Initiative”), launched in 2021, further empowers these individuals, arming them with the formidable False Claims Act (“FCA”).

This piece, the second in a two-part series about the Initiative, is designed to enlighten potential whistleblowers on their journey to unveiling cyber fraud. It offers an in-depth look at the FCA, essential cybersecurity standards integral to potential claims, and strategic advice for whistleblowers.

The False Claims Act: Arming Whistleblowers in the Battle Against Fraud

The FCA provides the government with a potent weapon to counteract fraud, helping recover billions of stolen taxpayer dollars annually. The FCA covers all government programs. Examples of FCA actions include those brought against healthcare providers who defraud Medicare and Medicaid by overbilling, contractors who charge federal agencies for goods and services not delivered, and individuals who defraud federal agencies by using misrepresentations to obtain grants or loans. The FCA provides for recovery of triple the damages incurred by the United States, plus a penalty for each violation.

In qui tam actions, individuals or entities with inside information about fraudulent conduct file suits on behalf of the United States. The government then investigates the allegations. If a case is successful, whistleblowers can receive a percentage of the government’s recovery. If the government intervenes or takes over the lawsuit, the relator is typically entitled to between 15 and 25 percent of the recovery. The exact percentage within this range often depends on the extent of the relator’s contribution to the prosecution of the action. If the government decides not to intervene, the relator can proceed with the lawsuit independently. In this case, the relator can receive a higher recovery percentage, typically between 25 and 30 percent. The rate could be more or less depending on factors detailed in the FCA.

Cybersecurity Standards: The Core Battlefront for FCA Claims

In cases involving allegations of cyber fraud, noncompliance with cybersecurity standards and contractual requirements—by neglecting to meet mandated data protection measures, utilizing components from restricted foreign countries, or allowing unauthorized access to systems, for example—can be the basis for an FCA claim. Whistleblowers and their counsel should be familiar with these requirements, including the following.

Federal Information Security Modernization Act (“FISMA”)

FISMA requires federal agencies and contractors to develop, document, and implement an agency-wide program to provide information security for their information systems and data.

National Institute of Standards and Technology (“NIST”) Guidelines

NIST provides a framework for improving critical infrastructure cybersecurity. It comprises a set of standards, guidelines, and practices to manage cybersecurity risk, including detailed technical recommendations for securing information systems.

Defense Federal Acquisition Regulation Supplement (“DFARS”)

For contractors working with the Department of Defense (“DoD”), compliance with DFARS’s cybersecurity requirements is mandatory. These requirements include implementing NIST standards and reporting cyber incidents to the DoD within a prescribed time frame.

Agency-Specific and Contractual Cybersecurity Requirements

Various government agencies may introduce additional, specific cybersecurity requirements in their contracts. For example, the Department of Health and Human Services has its own Health Insurance Portability and Accountability Act (HIPAA) Security Rule for protecting sensitive patient health information. Additionally, individual contracts often dictate specific cybersecurity measures tailored to the project, such as implementing particular security software, limiting data access, or mandating regular security audits.

Suiting Up for Battle: Key Steps in Preparing a Whistleblower Claim

To maximize recovery under the FCA, a whistleblower must carefully prepare and plan. Below are a few essential steps to consider.

Keep Detailed Records

Document any suspected violations meticulously. Include dates, locations, individuals involved, and actions taken. It is crucial to respect laws and company policies while collecting this information.

Know Your Rights

The FCA protects against employer retaliation, including provisions for reinstatement, double back pay, and compensation for any costs or damages. Familiarize yourself with these provisions.

Seek Legal Guidance

Navigating an FCA claim is a complex process. Retain an attorney experienced in FCA litigation and cybersecurity issues to guide you through the process. An attorney can assist in investigating a potential FCA violation, filing the claim, prosecuting the case, and negotiating your share in the recovery.

Maneuvering the Minefield: Tips for a Successful Whistleblower Campaign

While the path of a whistleblower is long and arduous, careful navigation can avoid potential landmines. Below are some tips to steer clear of common pitfalls.

Don’t Delay

The FCA operates on a “first-to-file” rule, precluding later suits based on the same facts. For this reason, promptly filing your claim is wise once you’ve amassed sufficient evidence of a violation.

Maintain Operational Secrecy

Keep the details of your suit confidential until the government decides whether to intervene. Prematurely disclosing allegations may jeopardize your eligibility to share in any recovery.

Avoid Public Intelligence Leaks

Publicly disclosing allegations can potentially bar your claim under the FCA’s public disclosure rule. A whistleblower should avoid divulging information to the media, social media, or other public forums before bringing a complaint.

Secure Personal Boundaries

While collecting evidence to support your claim, remain within the confines of the law and your employment agreement. Illegally obtained evidence could discredit your claim and expose you to legal liability.

Brace for Repercussions

The whistleblower journey can often be challenging, personally and professionally. Understand that you may face pushback or ostracism at your workplace. Prepare for these challenges mentally and emotionally, and seek support where needed, such as from legal professionals or support networks for whistleblowers.

Remain Committed

Throughout the process, keep sight of the importance of your role. Whistleblowing is crucial to uncovering cyber fraud, contributing significantly to a safer digital landscape. This sense of purpose can give you the resilience to navigate the challenges.

Conclusion

The FCA and the Initiative empower whistleblowers to combat cyber fraud within government contracts. Whistleblowers stand as critical defenders on the front line of cybersecurity enforcement. An intimate understanding of cybersecurity standards and careful documentation of suspected infringements are essential for strong FCA claims. The FCA’s protections against retaliation further equip these brave individuals for the task.

A whistleblower’s journey may be fraught with challenges. Still, the potential financial and psychological rewards—the gratification of being a crucial ally in the fight against cyber fraud—are compelling. Through their courage and commitment, whistleblowers contribute significantly to maintaining the integrity of government contracts, ensuring a safer and more reliable digital landscape for all. By sounding the alarm, they help fortify our nation’s cybersecurity defenses and drive us toward a more secure digital future.

The famous hoary aphorism holds that the law is a seamless web. Seamless it may be, but with each passing day the web weavers expand its size and use it to cover spaces that in earlier times did not even exist. And as these new fields of endeavor grow, disputes about them inevitably find their way to the country’s courts.

Like others, litigators cannot fail to have noticed the rapid advance of technology into all corners of modern life. This advance has radically transformed the practice of law and the busines­ses of clients. Ongoing innovations in law practice, client relationships, and relationships with the bench have added to the ferment. So it is no surprise that any treatise that describes busi­ness liti­gation would need to be updated on a regular basis. That is the case with Business and Com­mercial Litigation in Federal Courts (Robert L. Haig, ed.), a multivolume work published by the ABA’s Litigation Section. Previous editions were published in 1998, 2005, 2011, and 2016. The fifth edition was published in December 2021.

The fifth edition in its hardcopy form stretches over sixteen volumes. It includes 180 chap­ters, of which twenty-six are on entirely new topics. Hundreds of attorneys and judges contributed to the fifth edition as authors, including some of the most prominent names in their fields.

The treatise is not limited to describing legal and strategic issues or recent developments in specified areas of business law. Each chapter also ends with a checklist and, where appropriate, cus­tomizable forms. Depending on the topic, the checklists vary from lists of tasks to accomplish to lists of issues an attorney should consider. The overall result is a work that provides an effective overview of business litigation in numerous substantive areas, as well as detailed coverage of proce­dural topics, together with practical pointers and reminders.

Comparisons with other court systems

Although the title of the treatise posits a focus on federal litigation, the fifth edition has ad­ded several chapters comparing business litigation in US federal courts with business litigation in US state courts generally, and with New York and Delaware courts in particular—New York and Dela­ware being the states whose courts most commonly en­counter business litigation, both domestic and cross-border. The new edition also adds chapters comparing business litigation in US federal courts with similar litigation in Canada and Mexico. With these additions the treatise can serve as a val­ua­ble jumping-off point for litigators who find themselves in need of guidance either when deciding which court system they prefer or in counseling clients at the outset of litigation about what issues they need to be concerned about. These new chapters are not, and can­not be, compre­hensive analy­ses of procedure in these jurisdictions—each one has treatises of its own dedicated to just that—but they do provide a use­ful starting point.

The chapter on state courts generally is necessarily a broad overview; after all, a deep dive into fifty different court systems would likely have been impractical. But as a place to begin, it provides useful analysis of how to think about the differences between federal and state court litiga­tion, as well as issues to consider in the decision about which state court to sue in. For exam­ple, li­tigators selecting a forum should look at such matters as quality of procedures, perceived qua­lity of judges, whether the state system has a specialized business court, how the state handles dis­covery issues, what the privilege rules are, how difficult it is to get interim relief, and how long the trial backlog is. The checklist at the end of the chapter sets forth the issues litigators should consider in fo­rum selection.

New York and Delaware are two of the premier American locations for business litigation. Let’s look at the chapter on New York as an example of how the new edition approaches the com­parison between federal and other courts. The chapter begins with strategic considerations in choo­sing between federal and New York courts. One feature that is unique to New York is the availa­bi­li­ty of interlocutory appeals. Almost alone among states, New York practice permits most orders to be appealed, rather than requiring the parties to wait until the end of the case. This can affect cost, settlement prospects, and many of the decisions counsel must make during the course of the case.

Actual litigation procedures are more alike than different, though there are variations in ti­ming and nuance. For example, summary judgment motions in New York may be made only after an answer is filed. A jury may be requested until discovery closes, with the filing of a “note of is­sue.” Unlike in federal court, a plaintiff in New York state court who advances both legal and equi­table claims in the same case is deemed to have waived a jury on the legal claims.

Even where the normal New York rules differ noticeably from the federal rules, the Com­mercial Division of the New York Supreme Court has adopted many rules that adjust normal New York state procedures to bring them more into line with the federal rules, particularly with respect to dis­covery and some aspects of motion practice. So the differences tend to be more in the details than in the broad strokes. But some differences do remain.

The chapters comparing business litigation in Delaware, Canada, and Mexico with federal litigation likewise provide useful guideposts to the most salient differences. These chapters are accompanied by useful checklists of issues and strategic decision points.

Given the constraints of the space and the breadth of the subject matter, these chapters are a valuable addition to the treatise that will serve users in good stead—not as exhaustive surveys but as useful bird’s-eye views of the various considerations to take into account. One may perhaps quibble with the omission of a chapter comparing US federal courts with the proverbial 800-pound gorilla, California, which has its own unique procedures and a much more statute-oriented legal system than many other states. California generates an enormous volume of litigation, and its courts’ decisions are influential in a number of other states. Perhaps it will be included in the next edition.

New Chapters on Law Practice

Other new chapters look at emerging issues in law practice. Among these are “Budgeting and Controlling Costs,” “Coordinating Counsel,” “Fee Arrangements,” “Third-Party Litigation Funding,” and “Use of Jury Consultants.”

Let’s take as an example a subject most practicing attorneys care about deeply (for obvious reasons): fee arrangements. Litigators no doubt are familiar with various alternative fee arrange­ments and have taken note of increased use of billing methods other than straight hourly billing, such as contingencies or flat fees. But how to choose which arrangement works best? What incen­tive structures does each create for the attorney and the client? How can the downsides of each structure be minimized? Are there feasible ways to combine features of various structures into a mutually acceptable arrangement? What ethical issues can come into play in each structure?

The new chapter tackles these issues in systematic fashion. It gives pointers regarding how to think about what kind of fee arrangement to use. For example: as a practical matter, what kind of fee arrangement is feasible in any particular case? How do the incentives line up for the client and for the lawyer? What sort of arrangement is most likely to permit the client to achieve its goals?

The chapter describes each of the usual kinds of fee arrangements, together with hypothetic­al examples of how they work. The risks of a mistaken expectation should be considered when structuring the fee arrangement. Some ways of dealing with this risk include combinations or varia­tions of different kinds of structures, such as by caps, escalators, partial contingencies, guaranteed minimums, collars, or using a monthly floor or ceiling to control expectations.

The checklist at the end of the chapter goes step by step through the analysis that is needed at each stage of the process for either hourly or flat fee arrangements or for conventional contingent fee setups. It does not include checklists for other possible structures, but one may infer that is be­cause the universe of possibilities is so large that no checklist can account for every conceivable variation. The forms supply model paragraphs for inclusion in an engagement letter in a number of different types of fee agreements.

Another new chapter discusses third-party litigation funding. This subject has been in the news lately, with some high-profile cases going ahead with the backing of litigation funders. But many practitioners are unfamiliar with the nuts and bolts of how litigation funding works and don’t have a good idea of what the pitfalls might be. The new chapter lays out the basics: when is funding feasible or sensi­ble? How is it set up? How does an attorney or client locate and vet a funder? What terms are typical? What does a funder expect from an attorney or from the client? What kind of vetting should the attorney and client expect from the funder? How does the process work once a funder is in place, in terms of periodic reports and control of litigation? How much input does the funder have on settlement decisions?

Perhaps most interesting are the sections on ethical issues. The presence of a funder can af­fect the scope of work product and privilege, and care must be taken to avoid waivers. Here the chapter provides some specific recommendations. Another ethical consideration is how to structure the funding agreement to ensure it does not run afoul of the fee-splitting rules. Interestingly, some of the recent case law highlights the need to avoid running afoul of champerty statutes; these sta­tutes may be antiquated, but certain states still enforce them and will refuse to uphold funding ar­rangements that run afoul of them.

It remains to be seen how much development there will be in this area, whether on the busi­ness side or the case law side. But for now, this chapter is an effective overview of the issues that an at­torney can comfortably consult at the beginning of his or her analysis of the subject.

Other chapters likewise build on new developments in both law and technology. For exam­ple, the chapter “Budgeting and Controlling Costs” contains extensive discussion of electronically stored information (ESI) discovery and the rules governing it, as well as discussion of using technology at trial. But it also covers ways to think about, plan for, and budget for other time-tested features of American litigation such as pleadings, motions, conferences, and appeals.

New Areas of Substantive Law

Several of the new chapters address areas of substantive law that either did not exist in deve­loped form at the time of the fourth edition or, for whatever reason, were not included in earlier edi­tions. Some of the new substantive law chapters include “Art Law,” “Fraudulent Transfer,” “Monitor­ships,” “Political Law,” “Shareholder Activism,” “Trade Associations,” and Virtual Currencies.

One obvious new area of law is artificial intelligence. It is likely that the chapter is already in need of updating, what with the advent just this year of ChatGPT, BingAI, Bard, and other new AI interfaces. The availability of these tools has raised a host of new issues that are being discussed in the legal press and in the profession generally. The issues include serious questions about how pro­fessional responsibility meshes with the use of AI as a tool for lawyers.

Although the chapter obviously does not address new questions that arose after publication, the chapter is illuminating for its focus on the basics of what AI is, how it works, what assumptions may be built into the algorithms, and how it can be used in law practice consistent with applicable ethical rules. It starts with the basics: what is AI and how does it work? Conceptually, it is not hard to demystify: AI is simply software that uses algorithms to find patterns in large volumes of data and incorporates what it “learns” into its continuing operation. But each of those steps contains pitfalls: are there biases in the algorithm? Is the algorithm selecting appropriate features from the data? Is it weighting the inputs properly? For this reason, use of AI in business decisions may lead to tussles over discovering the algorithm if the decisions lead to litigation. The degree to which it is discover­able is not yet established—case law is still developing. And attorneys’ need to analyze algorithms will undoubtedly lead to an increase in demand for both consulting and testifying experts.

AI has already made its way into discovery. The most familiar manifestation is predictive co­ding, which is actually just an application of AI to identify patterns in the contents of documents that indicate whether documents are responsive to document requests or otherwise relevant. The availability of this AI tool may affect a litigant’s ability to argue a request is burdensome if that liti­gant declines to use predictive coding or other technology-assisted search techniques. AI may also provide new ways for assessing probabilities of outcomes at various steps in a litigation as well as the ultimate outcome of a case.

All this raises issues of professional responsibility, which the chapter addresses forthrightly. Consider: does the availability of AI imply that lawyers must become familiar with it as part of the normal standard of care? Must the attorney consult with the client about whether and to what ex­tent to use AI? Is the AI constructed in a manner that will adequately preserve confidentiality, and are technology vendors blocked from seeing the contents of what is provided to them? Can “out­sourcing” some work to AI skate close to facilitating the unauthorized practice of law?

The chapter concludes with a checklist that addresses the issues a practitioner should ac­count for in a protective order when a case involves use of AI, and a sample request for production of AI-related documents pertaining to such items as the underlying algorithm, weighting, or validity studies. Of course this area is de­veloping so quickly that new issues arise seemingly by the week. Undoubtedly pocket part/updates will be on the way.

Another new chapter addresses an area that existed before but has been transformed by technology: art law. Digital creation and consumption of art has massively increased the volume of art business and, consequently, of art-related litigation. The nature of art—such as its highly subjective appeal, its lack of readily ascertainable market value, and the uniqueness of each piece—creates issues of its own. For example, consider: how is the work to be valued for purposes of deciding whether an underlying dispute meets the $75,000 threshold for diversity jurisdiction?

Even traditional art raises unique issues of provenance and authenticity that other business endeavors may not. Certainly this field has wide scope for use of experts. And the chapter deals with longstanding issues concerning art: stolen artwork, contracts for art, dealing with auction hou­ses, licensing, copyright, fair use—the list goes on and on. The chapter also addresses statutes (both federal and state) that affect art, artists, and others.

Updated and Revised Chapters

The bulk of the fifth edition updates the fourth edition. To get an idea of how thorough the update is, consider the chapters in two areas that have experienced a great deal of case law develop­ment. First, “Class Actions.” This chapter could be a book in itself, weighing in at more than 400 pages. The table of contents for this one chapter alone spreads over six pages.

It is no secret that class action jurisprudence has developed extensively in the past six or se­ven years. The sheer number of issues relating to class action litigation and the pace of develop­ment in this area are reflected in the size of the chapter on the subject.

The chapter begins by discussing the basic theory of having a class action rather than multi­ple individual actions. It goes on to cover the basics of what is needed to be able to proceed under Rule 23, followed by class certification and the mechanics of how to sue as a class, including: notice to absent class members, how to set up issue classes and subclasses, settlement, appeals, and appoint­ment and compensation of class counsel. There are also sections on defendant classes and preclu­sive effect of a class action judgment. The chapter is quite thorough: it also covers subject matter jurisdiction, standing, statute of limitations issues, class action waivers and arbitration, choice of law, and certain ethical issues. Subchapters examine specific types of class actions: antitrust, securities, consumer fraud, intellectual property, employment, ERISA, and privacy/cybersecurity.

There has been ferment in certain areas. For example, after the Supreme Court’s 2017 deci­sion in Bristol-Myers Squibb Co. v Superior Court, 137 S. Ct. 1773 (2017) (no pendent jurisdiction in mass actions), courts have been faced with the issue of whether personal jurisdiction over absent mem­bers of the plaintiff class must be demonstrated. Most courts have said no: the named plaintiff is the relevant actor for jurisdictional purposes, and the interests of absent class members are protected through the procedural safeguards of Rule 23.

Especially in securities fraud class actions, which typically are brought under Rule 23(b)(3), an important question is which issues are legitimately addressed at the class certification stage, as opposed to being left for the merits. To certify a Rule 23(b)(3) class, the plaintiff has to show that common questions of law and fact predominate. In 1988, in Basic v. Levinson, 485 U.S. 224 (1988), the Supreme Court adopted the “fraud on the market” theory, under which reliance normally is pre­sumed at the class certification stage because the entire market is deemed to have been affected by the claimed misrepresentations—unless the defendant can rebut the presumption. (If the defendant rebuts the presumption, then each plaintiff would need to show reliance individually, and the class could not be certified.) Can the defendant rebut the presumption of reliance by showing the price of the relevant stock was not affected by the claimed misstatements? Or is that a merits issue that should not be addressed at the certification stage? The Supreme Court’s 2021 decision in Goldman Sachs Group Inc. v. Arkansas Teacher Retirement System, 141 S. Ct. 1951 (2021) holds that a district court should consider all evidence relevant to class certification, even if it overlaps substantially with the merits.

Consumer class actions have become common in recent years, especially under federal sta­tutes such as the Fair Debt Collection Practices Act, the Telephone Consumer Protection Act, and the Fair Credit Reporting Act. Some recent case law has questioned whether there is Article III standing under certain of these statutes because of the lack of a concrete injury—in other words, just because Congress provides for statutory damages does not mean there is a redressable injury that qualifies a dispute as an Article III “case or controversy.” Circuits have come to different con­clu­sions about different claims. The Supreme Court held in TransUnion LLC v. Ramirez, 141 S. Ct. 2190 (2021) that a bare statutory violation without an actual injury does not confer standing to sue. As the treatise notes, it is likely that Ramirez will lead to extensive further litigation about what is and is not a “concrete injury” that can confer standing on a named plaintiff and absent class mem­bers.

The checklists at the end of the class action chapter focus on the issues any class counsel must think about. For the most part these are pitched at a reasonably high level of generality. It may be that more granular checklists simply aren’t feasible, given the large variety of possible class actions and the wide spectrum of possible claims. The forms likewise are pitched at a fairly high level of generality. Again, this is probably unavoidable.

Another subject matter chapter that has seen a great deal of activity and thus necessarily has been thoroughly updated is “Derivative Actions by Stockholders.” This chapter is also large, more than 120 pages. Various aspects of derivative litigation have seen significant development in recent years, and the treatise provides a useful overview of the new case law developments in the context of an overall approach to derivative litigation.

One such issue is defining when a derivative plaintiff may proceed without first making a de­mand on the board of directors. Ordinarily, because the board is vested with the responsibility for overseeing the company’s activities, it is for the board to decide whether to sue on behalf of the cor­poration (often, this decision is referred by the board to a special litigation committee). As a corol­lary to that principle, a shareholder cannot sue on behalf of the corporation without first bringing the matter to the body legally entrusted to act for the company, namely, the board of directors, and demanding that the board act. Demand is excused if it would be futile, but how to establish futility has been an ongoing issue for courts. Different states’ standards may vary in their details. The pre­mier state for corporation law, Delaware, offers the Aronson^[1] and Rales^[2] standards for measuring whether demand is futile for a challenge to a corporate decision or corporate inaction, respectively. As the treatise points out, both these tests essentially ask whether the directors were disinterested and whether their decisions reflect a business judgment protectable under the business judgment rule. This issue is heavily litigated, and recent case law highlights the obligations of directors to edu­cate themselves and make reasoned, good faith decisions. Several recent litigations, set forth in the chapter, saw denials of motions to dismiss based on allegations of director lassitude or perfunctori­ness.

It is worth noting that other states (including New York) apply somewhat tighter tests to evaluate demand futility (meaning that futility may be established less often). Counsel should heed the treatise’s caution to apply carefully the precise legal formulation in the relevant state, and to ana­lyze in advance of suit what the standard might be. In the event more than one possible venue is possible, the divergent standards (and choice-of-law rules) should be taken into account.

Even deciding which claims are derivative has seen recent ferment. The Delaware Supreme Court reformulated its test for distinguishing individual from derivative claims in 2004,^[3] clarified it in 2016, and revisited it again in 2021.^[4] It makes a huge difference which side of the line a claim falls on: derivative claims are subject to demand on the board; may be handled through a special litigation subcommittee; and may be subject to bonding requirements to secure the corporation’s expenses. And, as the Court of Chancery observed in 2020, derivative claims are extinguished when the under­lying corporation ceases to exist. None of these are true of individual claims.

Given the exacting procedural and analytical hurdles that confront both sides in a derivative suit scenario, the checklists are of especial importance and utility. The steps for making a demand are listed. So are the steps for appointing a special litigation committee. The chapter also has a checklist of factors to consider in formulating a settlement. Because of the complexity of the analy­sis at each stage of the litigation, perhaps an issues checklist would have been useful: what questions should a prospective plaintiff think about? What questions should a defendant company and board think about? It may well be that state-by-state variations, subtle though they may be, make any such issues list close to impossible. But perhaps a checklist focusing on the Delaware issues would have been helpful because of Delaware’s outsized influence, even for disputes relating to companies orga­nized elsewhere.

Class actions and derivative litigation are but two of the dozens of subject matter areas the treatise has covered in the past and has now updated in this new edition. Merely listing some of them will convey a sense of the broad range of topics the treatise encompasses: subject matter ju­risdiction; provisional remedies; privileges; settlements; cross-examination; punitive damages; arbi­tration; judgments; enforcement of judgments; social media; antitrust; securities; mergers and acqui­sitions; professional liability; banking; trademarks; licensing; ERISA; employment discrimination; products liability; negotiable instruments; advertising; fraud; civil rights; energy—plus dozens and dozens more.

Closing Thoughts

The treatise represents a monumental effort by, literally, hundreds of attorney authors to share their wisdom in providing an overview of scores of areas of law. By its nature, business liti­gation is far too diverse and sprawling to be summarized exhaustively even in a multivolume treatise like this one. But despite this, as a first stop for litiga­tors encountering issues for the first time—or even not for the first time—the treatise provides a useful guide to point them in the right direction and to highlight the salient points that must be con­sidered in an array of legal fields.

This spotlight has occasionally quibbled with the choices the authors or editors made, but those quibbles are just that—quibbles. They do not detract from the overwhelmingly positive con­tribution this treatise has made to the practice of business litigation. The authors and editors have provided a true service to the profession.

1. Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984), overruled on other grounds, Brehm v. Eisner, 746 A.2d 244 (2000). ↑

2. Rales v. Blasband, 634 A.2d 927 (Del. 1993). ↑

3. Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004). ↑

4. Brookfield Asset Mgmt. v. Rosson, 261 A.3d 1251 (Del. 2021). ↑

If you live or do business in California, state taxes can be a significant part of the overall taxes you pay, even if your bill to the IRS is bigger.^[1] Even if you don’t call California home, the state does an aggressive job of drawing people into its tax net of high individual (13.3 percent) and high business (8.84 percent) tax rates. If you once lived in California but move away, you might end up in a tax fight over whether you really left, and when.

Even if you never set foot in California, you can be taxed. Suppose you just do some consulting for a California-based company or law firm, from your home or office out of state. California can’t possibly tax you, right? Think again. The Golden State usually takes the position that you delivered the benefit of your services inside California when you sent in your work product, or just talked to the California client over the phone.

And since you might never have filed a California tax return to report that California source income, there is no statute of limitations. For all these reasons, it pays to know something about how and when to fight back when California sends off a volley of tax due or audit notices. When you add the state’s notoriously aggressive enforcement and collection activities, it’s even more important to know your rights.

California’s tax system is complex. Rather than adopt federal tax law wholesale, California’s legislators pick and choose, adopting some rules and not others. Often, if a federal rule favors taxpayers, California will not conform. Conversely, if a federal rule favors the IRS, California is more likely to agree and to say “me too.”

Statute of Limitations

How long you are at audit risk might surprise you. You may be used to clocking the IRS three-year statute of limitations. For completeness, it’s important to mention the six-year IRS statute of limitations, too. The IRS gets six years to audit if you omit over 25% of your income, or in certain other cases. Still, the main IRS statute of limitations is three years, and that is the one the IRS tracks carefully.

In contrast, the California Franchise Tax Board (FTB) always gets an extra year, so it has four years, not three, to launch an audit. That can invite some planning. Say that you are involved in an IRS audit, but the IRS has not yet issued a Notice of Deficiency. You may want to drag your feet and hope that your federal tax dispute will put you outside California’s four-year reach.

Maybe you’re thinking that you can slow-walk your IRS audit so that an IRS Notice of Deficiency is not issued until after California’s four-year statute has run. It would seem logical that if California hasn’t audited within the four years the statute provides, it would be too late for California to try to piggyback on the IRS audit. However, there is another California statute of limitations that applies any time there is an IRS adjustment, even if the IRS adjustment doesn’t occur until years after the four-year California statute of limitations has expired.

If an IRS audit changes your tax liability, you lose your IRS case. or you agree with the IRS that you owe a few more dollars to it, you are obligated to notify the California FTB within six months. Under Cal. Rev. & Tax. Code section 19060, if you fail to notify the FTB of the IRS change to your tax liability, the California statute of limitations never runs. California usually will bill you promptly, but you might get a tax bill ten years later—with lots of additional interest. So, if you settle up with the IRS, you should settle up with the FTB too.

When California Audits First

What if the “me too” runs the other way? Given California’s aggressive tax enforcement, the FTB often audits first, when the IRS is not involved. Suppose that you have a California tax audit first, and by the time it is resolved, the federal statute of limitations has run. What happens then? Happily, with the IRS statute of limitations closed, the answer should be nothing. Frequently, California tax advisers count on this result.

Because the California statute of limitations is four years, not three, it is possible that California may initiate its audit after the federal statute is already closed. More likely, if the California audit is initiated one to two years after a return filing, there will be a year or two left on the three-year federal statute. Even without trying to cause a delay, the California audit and ensuing administrative appeals may not be resolved until after the three-year federal statute (or even the six-year federal statute) has run. In that event, it may be too late for the IRS to say, “me too.”

Disputing a Notice

A notice from the FTB is rarely welcome news. Sure, it might just tell you that you are getting a refund. But more often than not, an FTB notice says you owe additional taxes. Or even before that, it may start simply with a letter that says you were selected for audit. Since representing yourself is usually a mistake, a tax lawyer or accountant should handle it. Which professional you select to interface with the FTB depends on your issues, the type of return, and the sensitivity of the audit.

But once you sign a power of attorney on the required Franchise Tax Board form, you should not need to deal directly with the FTB. Having a lawyer or accountant out front gives you more protection. Although field audits are possible, most audits are done by correspondence, with lots of back and forth in what the FTB calls Information Document Requests (IDRs).

This process operates similarly to the IRS, which also uses IDRs to solicit and collect information. These IDRs serve to gather the facts and documents necessary to understand and verify the items you reported on your tax return. The IDRs and your responses provide a record of communication between you and the FTB that will be important later.

Audit Issue Presentation Sheet (AIPS)

As the FTB gathers information, they will prepare an Audit Issue Presentation Sheet (AIPS) that details adjustments the FTB proposes to make to your tax return. An AIPS includes a discussion of the facts, the relevant law, and the proposed adjustment. Some auditors prepare one big AIPS about your return, while others prepare several AIPS for different tax issues. You can respond in writing, laying out the facts and arguments based on the tax case law, regulations, etc. Since the FTB usually follows federal tax law when there is no conflicting California law, it is okay to cite to federal tax authorities when you respond to the FTB.

Notice of Proposed Assessment (NPA)

Eventually, the FTB will write up its findings and send a Notice of Proposed Assessment (NPA) that proposes additional taxes based on the audit results. If you receive a Notice of Proposed Assessment and agree with the proposed change to your tax liability, there are various payment options available.

Interest Is Running: Should You Pay to Stop It?

If the FTB proposed additional tax in a Notice of Proposed Assessment, there will be interest too, and possibly penalties. Interest accrues on the tax from the original due date of the tax return for that tax year. Applicable interest will also accrue on certain penalties if they are assessed. If you pay the balance due as reflected on the notice within fifteen days of the notice, no additional interest will be assessed.

As with other tax debts, interest can add up fast. Filing a protest or appeal alone does not stop the accrual of interest. It may take months or years to resolve your protest or appeal, and the accrual of interest will not stop during this period. However, to limit the accrual of interest, you may make payments in connection with a protest and/or appeal, which would be held in suspense pending the outcome of the protest or appeal.

Of course, if you win your tax dispute and do not owe any additional taxes, you win the interest point too. But if you are risk averse, you may want to make a deposit to stop the running of interest. This is done in many California tax disputes, and is often worth exploring. Notably, you do not lose your right to protest the proposed audit adjustments if you make a payment.

You can designate the payment as a deposit without prejudicing your position in the FTB dispute. And if you prevail, you can even get interest back from the state. That is, if the FTB withdraws or reduces the amounts on its NPA following protest or appeal, the FTB will pay interest on the tax deposit or on any overpaid amount.

Protest

If you do not agree with the proposed adjustments, you can file a protest by the due date shown on the front of the Notice of Proposed Assessment. If you do not timely protest, the assessment becomes final, and the FTB will start billing you for the amount due, including penalties and interest. A protest is a formal document. Apart from a variety of identifying information, a protest must include the amounts and years you are protesting, a statement of facts, an explanation of why you believe the FTB is wrong, and evidence and documentation to substantiate your position.

You have the right to request an oral hearing on your protest. If you want to have an oral hearing, you must include the request in your protest. Hearings can be conducted at an FTB field office, or by phone or video conference. The hearing officer is independent from the FTB auditor who wrote the NPA, but the hearing officer still works for the FTB. This means some California taxpayers worry that the hearing officer may rubber-stamp what the auditor did.

In any case, the hearing officer makes a determination of what the FTB believes is the correct amount of tax based on the facts and the law. Can you split the difference with the auditor or the hearing officer? That would be nice, but the auditor and the hearing officer do not have the ability to compromise cases. Instead, there is a separate process for settlement proposals discussed below.

Notice of Action (NOA)

After the FTB considers your protest and makes a final decision, they will send you a Notice of Action (NOA) that documents the FTB’s findings. It may affirm, revise, or withdraw the proposed assessment. If you agree with the amount shown on the NOA, there are various payment options available. If you disagree, you can appeal to the Office of Tax Appeals (OTA) within thirty days of the date of the NOA.

Office of Tax Appeals (OTA)

The Office of Tax Appeals is a separate agency that is independent of the FTB. Up until 2017, tax appeals were heard by the California State Board of Equalization (BOE). The BOE was a five-member elected administrative body, the only elected tax board in the country. However, the BOE became very controversial, and in 2017, then-Governor Brown signed a bill that slashed the agency’s employees from 4,800 to just 400.

As a result, the elected, five-member Board of Equalization no longer hears tax appeals, which are now handled by the Office of Tax Appeals. The OTA functions like a state tax court. When you file a timely appeal with the OTA, you are given an opportunity to provide additional supporting information.

There is a briefing process in which the taxpayer and the FTB submit briefs to the OTA. OTA cases are normally decided by a panel of three administrative law judges, although in some small cases, there may be a single judge. You may also request an oral hearing before OTA so that you can present witnesses and testimony.

Following the OTA’s consideration of the law and facts in your appeal, it will issue a decision in writing. Both sides, the taxpayer and the FTB, have the right to petition for a rehearing within thirty days of the decision. If no petition for rehearing is filed, the OTA’s decision becomes final after thirty days.

If you do not file an appeal with the OTA within the prescribed time the taxes, penalties, and interest become due and payable. However, you may pay the balance due and file a claim for refund, which must generally be filed within one year from the date of payment.

Superior Court

Not many tax disputes go beyond the OTA. However, if you have waged a contest with the FTB and before the OTA and you still want to fight, in some cases, you can go to court. However, once you exhaust your remedies at the OTA, subject to a few exceptions, you generally must first pay any tax amounts owed before bringing an action against the state.

Thus, you can pay the tax liability and file a claim for refund. If you appealed the FTB’s denial of your claim for refund and do not agree with the OTA’s decision, you may generally file an action against FTB in California Superior Court within ninety days. But not all the rules are consistent. For example, a suit for refund on a residency case must be filed within sixty days. After the California Superior Court makes a decision, either you or FTB may file an appeal of the decision to the California Court of Appeal.

Compromises

Many disputes of all sorts settle. That is true with taxes too, and both the IRS and the California FTB will entertain settlement proposals at the appropriate levels. In general, it is easier to settle a case with the IRS than it is with the FTB. For one thing, in IRS Appeals, the IRS Appeals Officer can compromise cases.

In contrast, the FTB appeal process is more rigid. Indeed, the main place that FTB settlements can be explored is with a separate unit of the FTB. The FTB Legal Division has a separate Settlement Bureau that is responsible for settling tax, penalties, and interest when you enter the Settlement Program. One can divert a case into the FTB Settlement Program at several stages, even when the case is already being considered by the OTA.

Residency Audits

One common type of audit concerns whether you are a California resident. There are all sorts of California tax disputes, but the alluring nature of a move before a sale and the presence of residency audits makes them appropriate for a couple of comments. It can be tempting for a California taxpayer who expects a large income event to pull up stakes and move before the income hits. It might be the settlement of a large legal dispute, the sale of a block of stock or hoard of cryptocurrency, or the sale of a company.

What type of income or gain is involved will influence whether a move before the sale can help. But whatever the income or gain may be, timing is always relevant. A move right before a sale understandably attracts attention from the FTB. One reason is the tax return itself. A taxpayer who moves and sells in the same year will need to show the entire tax year on their part-year California return. Showing a modest amount of income in the first (California) part of the year followed by vast sales proceeds in the latter (non-California) part of the year may prompt an audit.

The larger the time buffer between a move and sale, the better. And the cleaner the facts, the better. Keeping a spouse or children in California can make it difficult or impossible to prevail. Having moved back into California by the time of an audit can also be hard to explain, unless some unusual and unexpected event has transpired that made the permanent move out of California short-lived—a death in the family, divorce, new dream job in California, etc. might help to explain. However, the FTB may see a move out of state followed by a move back (no matter what the reason) as a temporary relocation, and as insufficient to change the tax bill on the sale.

In some residency audits, the state is arguing that the domicile of the taxpayer did not change, period. However, much of the time, the dispute is about timing. That is, by the time of the audit, it may be clear that the taxpayer is no longer a California resident. But the FTB may say that the move was not effective until after the sale. In some cases, the FTB may say that the transaction was far enough along (fully negotiated, a signed letter of intent, etc.), that even though the closing happened when the taxpayer was no longer a California resident, California can tax it.

A move generally involves a continuum of dates, so the FTB may try to move the needle by whatever number of days is needed to collect the tax. There is also an increasing body of California tax law about California sourcing, so that even if a sale is made by a person who is unquestionably a non-resident, the asset sold may have acquired a California situs. In short, California’s tax net is expanding rather than contracting.

Other Notices

Residency audits are not the only common variety. Disputes over non-residents earning California source income are extremely common. A Form 1099 from a California company can draw a non-California independent contractor into California’s net. A sale by out-of-state persons of an LLC or partnership interest can trigger a notice too.

For years, many non-California taxpayers have preferred selling an interest in an entity that holds California real property or business assets, rather than having the entity sell the real property and distribute the proceeds to the owners. The idea is that the former is a sale of an intangible, sourced to the residence of the seller of the intangible. The latter, of course, is a sale of California property, so it is California source income.

In Legal Ruling 2022-02,^[2] however, the FTB held that if a portion of the owner’s gain from the sale of a partnership interest is characterized as ordinary income under section 751(a), that gain is sourced as if the partnership had actually sold the relevant portion of its assets. Whatever portion of the gain would have been “business income” apportionable to California under the Uniform Division of Income for Tax Purposes Act (UDITPA) will be treated as California source income even though the owner sold a partnership interest.

The FTB has also successfully argued that the California sourcing of an S corporation’s sale gain passed through to its out-of-state shareholders despite the fact that the property (goodwill) was an intangible.^[3] On this principle, one could expect that gain realized by one pass-through entity (Holdco) from the sale of an interest in a second pass-through (Subco) will retain its character as California source income despite the fact that Holdco’s interest in Subco is an intangible. Given how common LLC holding company structures have become, a lot of out-of-state taxpayers may find themselves on the wrong end up an FTB notice following the sale of an operating company conducting business in California.

Conclusion

Tax audits and disputes in California are common, but they don’t have to be overwhelming. If you have one, consider the state’s unique system and procedures, and you will improve your odds of a good result.

1. Robert W. Wood practices law with Wood LLP (www.WoodLLP.com) and is the author of Taxation of Damage Awards and Settlement Payments (5^th ed. 2021) available at www.TaxInstitute.com. This discussion is not intended as legal advice. ↑

2. https://www.ftb.ca.gov/tax-pros/law/legal-rulings/2022-02.pdf. ↑

3. The 2009 Metropoulos Family Trust, et al. v. Franchise Tax Bd., 79 Cal.App.5th 245 (2022). ↑

This is a summary of the Hotshot course “No-Shops: Termination and Forcing the Vote,” covering termination of a deal for a superior proposal, break-up fees, and a look at what it means to “force the vote.” View the course here.

Termination

• If the target company’s board changes its recommendation, the buyer has the right to terminate the merger agreement.
• If the board determines that a competing bid actually is a Superior Proposal (not just one that could be) and changes its recommendation, then the target often has the right to terminate the agreement too.

Force the Vote

• Sometimes, instead of letting the target terminate the deal to take a Superior Proposal, the buyer may negotiate for a “force the vote” provision.
  • This requires that the target board put the original transaction in front of its shareholders, so they can decide whether to take it despite the board’s changed recommendation.
    • The principal impact is that it grants a timing and tactical advantage over the competing bid.

Break-up Fees

• If either the target or the buyer does terminate the deal, then the target must pay the buyer a break-up fee.
  • Fees aren’t very high, usually ranging around 2% to 4% of the deal value.
    • That’s because of case law developed over the years to ensure that fees don’t preclude competing bids.

This course also includes interview footage with Jenny Hochenberg from Freshfields Bruckhaus Deringer and Igor Kirman from Wachtell, Lipton, Rosen & Katz.

Download a copy of this summary here.