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:
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.
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.
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.
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.
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.
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):
where the injury arose;
the plaintiff’s residence or principal place of business;
where any alleged services were provided;
where the plaintiff received or expected to receive benefits of those services;
where any business agreements were entered into;
the laws binding those agreements; and
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.
[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)).
[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.”).
[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.”).
[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.”).
[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.”).
[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).
[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.”).
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.
Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984), overruled on other grounds, Brehm v. Eisner, 746 A.2d 244 (2000). ↑
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.
Robert W. Wood practices law with Wood LLP (www.WoodLLP.com) and is the author of Taxation of Damage Awards and Settlement Payments (5th ed. 2021) available at www.TaxInstitute.com. This discussion is not intended as legal advice. ↑
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.
This is a summary of the Hotshot course “No-Shops: Changing Board Recommendations and Matching Rights,” a look at when a target board can change its recommendation for a superior proposal or an intervening event that also includes a discussion of matching rights. View the course here.
No-Shops: Board Recommendations and Matching Rights
Public M&A agreements require that the target’s board recommend that its shareholders vote in favor of the deal.
The board’s fiduciary duties also require that it maintain the ability to change its recommendation until the shareholders approve the transaction.
That’s why the deal-protection framework contains fiduciary-out exceptions. Under these exceptions:
The target board can change its recommendation; and
Terminate the existing deal to take a topping bid any time before the shareholders approve the existing deal.
Change in Board Recommendation
Usually, for the target board to change its recommendation, it must:
Determine, in good faith, after consulting with its outside legal and financial advisors, that continuing to recommend the transaction would be inconsistent with its fiduciary duties.
Most deals also require that the board conclude that the new deal is a Superior Proposal (and not one that could or would be).
The reason for this higher standard is that, at this stage:
The new bidder should have had an opportunity to review the diligence, negotiate with the target, and make a binding bid.
This lets the target board make a more definitive assessment than during the earlier stages of the deal.
The typical Superior Proposal formulation requires that the new proposal be:
For a minimum amount of the target’s stock or assets (usually at least 50%);
More favorable to the target’s stockholders from a financial point of view than the existing deal (when taking into account all relevant considerations, including timing, regulatory conditions, and deal certainty); and
Occasionally, there is an absolute, rather than a comparative, requirement.
For example, that the new deal be reasonably likely to be completed or that it has financing (if it’s a cash deal).
Matching Rights
Before a board can change its recommendation for a Superior Proposal, the initial buyer generally has 3 to 5 business days after the board’s determination to match the new terms.
If the competing bidder amends its proposal, the initial buyer has subsequent, shorter match periods. In other words:
Before a target board can take action that might destroy the original deal, it agrees to give the original bidder a chance to propose a revised (and better) deal; and
The Superior Proposal determination must include any such revised terms.
Intervening Events
In some deals, the parties also set out the target’s right to change the board recommendation based on an Intervening Event.
Intervening Event is often defined as something significant that occurs after the signing of the deal that wasn’t known or, sometimes, also wasn’t reasonably foreseeable, at the time of signing.
The idea is that a target board can change its recommendation but shouldn’t be able to simply change its mind about what it already knew at signing.
A common example is “discovering gold under the target’s headquarters.”
It’s more likely that some other positive development for the target makes the original deal no longer justifiable—such as FDA approval for a biotech company.
The parties will also often negotiate exceptions to the definition of Intervening Event.
These exceptions clarify instances when the target board does not have the right to change its recommendations. For example:
They might exclude adverse developments at the buyer in a stock-for- stock deal.
The theory is that other provisions protect the target for those events, like the “no Material Adverse Effect” condition.
This course also includes interview footage with Jenny Hochenberg from Freshfields Bruckhaus Deringer and Igor Kirman from Wachtell, Lipton, Rosen & Katz.
This is a summary of the Hotshot course “No-Shops,” a discussion on protective provisions in public M&A agreements, with a close look at the No-Shop provision and its main exceptions, Window-Shops and Go-Shops. View the course here.
Protecting Against the Interloper Risk
When a buyer wants to acquire a public company target one of its main concerns is that between signing and closing, a competing bidder “jumps” the deal with a better offer, and the buyer loses the deal.
This is the so-called interloper risk.
Public company merger agreements protect against this risk through various deal-protection provisions. These provisions create a framework that covers:
If, how, and when the target can engage with a competing bidder.
This includes the no solicitation provision itself (often called the “No-Shop” clause), which restricts the target from soliciting competing bids and engaging with competing bidders.
It also includes the exceptions to these restrictions—Window-Shops and Go-Shops.
The target board’s recommendation to its shareholders and when it can change that recommendation.
This includes the definitions of Superior Proposals and so-called Intervening Events.
When the target or buyer can terminate the merger agreement and the related consequences.
This includes matching rights, forcing the vote, and termination and termination fee provisions.
Deal-protection provisions can also apply to the buyer when buyer-shareholder approval is required (this is less common).
No-Shops, Window-Shops, and Go-Shops
The No-Shop clause is the heart of the deal-protection framework.
It prohibits the target from:
Soliciting competing bids;
Engaging in discussions or negotiations with a competing bidder; and
Providing diligence access to a competing bidder.
These prohibitions apply to:
The target;
Its officers;
Directors; and
Advisors—like its investment bankers.
No-Shops are not usually flat prohibitions.
They often have one or two fiduciary-out exceptions:
A Window-Shop; and
Sometimes a Go-Shop.
Window-Shops
Window-Shop exceptions let the target engage with a competing bidder that makes an unsolicited proposal, but only if:
After good-faith consultation with its outside legal and financial advisors, the target board thinks that the bid could (or would) reasonably lead to a Superior Proposal.
At this stage of the process, the target board doesn’t have to conclude that the new bid is a Superior Proposal—only that it could (or would) reasonably lead to one.
Under a Window-Shop, the target can also grant diligence access.
But it must enter into a confidentiality agreement with the competing bidder that meets certain parameters, like that:
It’s generally at least as favorable to the target as the original buyer’s confidentiality agreement.
If the deal has a two-step structure, the Window-Shop period lasts until:
The tender offer expires; and
The buyer accepts the tendered shares for payment.
In a single-step merger, the Window-Shop period lasts until the target shareholder vote.
This means that even if the deal remains pending for several months (e.g., because of a long regulatory delay), the target’s ability to engage with a competing bidder still ends at the time of the shareholder vote.
Go-Shops
In a minority of cases, the parties also include a Go-Shop provision.
Go-Shops allow the target to actively solicit new bidders for an agreed period after signing.
They’re mostly used in situations when a target board hasn’t run a pre-signing market check, such as a formal or informal auction.
Usually, as long as the No-Shop includes common fiduciary outs, the target board can get comfortable that it’s securing an attractive deal, while preserving the ability to consider unsolicited topping bids.
Sometimes, especially in private equity deals, the target goes one step further with a Go-Shop clause.
A typical Go-Shop clause provides two benefits to the target:
First, it gives the target a limited Go-Shop period (usually 30-60 days postsigning) to actively seek better deals instead of just being open to unsolicited ones.
Second, if the target abandons the deal with the initial buyer and accepts a topping bid that originated during this Go-Shop period, then it doesn’t have to pay the full termination fee.
Often, it only pays half the amount that would’ve been owed outside the Go-Shop period.
Notification Obligations
Before a target can even consider terminating a deal for another bid, it has to first notify the initial buyer—usually within 24–48 hours of receiving the proposal.
The target has to disclose the proposal’s material terms and conditions.
This means that the initial buyer is kept appraised of the competing bid and the terms needed to match the overbidder.
This course also includes interview footage with Jenny Hochenberg from Freshfields Bruckhaus Deringer and Igor Kirman from Wachtell, Lipton, Rosen & Katz.
In our transformative digital age, opportunities abound—but challenges loom large. The constant threats of hacking and data breaches in our interconnected world underscore the critical importance of robust cybersecurity. Cybercrime is expected to cost the world $8 trillion in 2023 and $10.5 trillion by 2025, according to Cybersecurity Ventures.[1]
For government contractors, the stakes are exceptionally high. Government contracts often incorporate exacting cybersecurity requirements, with severe consequences for noncompliance. The U.S. Department of Justice’s Civil Cyber-Fraud Initiative (“Initiative”) has added a new dimension to this landscape, wielding the formidable False Claims Act (“FCA”) to combat cybersecurity deficiencies among government contractors.
This article, the first in a two-part series, provides an in-depth look at the Initiative and the DOJ’s significant enforcement actions since the Initiative’s launch in 2021. Additionally, it offers proactive strategies for government contractors to remain ahead of the curve in this high-stakes, rapidly evolving digital environment.
The DOJ’s Civil Cyber-Fraud Initiative
Launched in October 2021, the Initiative was a landmark step toward clamping down on contractors that fail to comply with federal cybersecurity standards.[2] The Initiative aims to identify, pursue, and prosecute cybersecurity-related fraud against the government. It primarily targets three categories of misconduct:
Noncompliance with cybersecurity standards. The FCA can be used to pursue instances where government contractors knowingly fail to comply with the cybersecurity standards in their contracts with the government. These standards might include specific measures to protect government data, restrictions on non-U.S.-citizen employees accessing systems, or prohibitions on using components from certain foreign countries. Failure to meet these standards deprives the government of what it has contracted for.
Misrepresentation of security controls and practices. FCA liability can arise when a company knowingly misrepresents its security controls and practices during the contracting process or contract performance. Misrepresentations could influence the government’s contractor selection or contract structuring process, violating the FCA. For example, a contractor might misreport details about system security plans, monitoring practices for system breaches, or password and access requirements.
Failure to timely report suspected breaches. A company may violate the FCA if it knowingly fails to report suspected cyber incidents promptly. Government contracts often require prompt reporting of such incidents, which is imperative for the agencies to respond, remediate vulnerabilities, and limit harm.
The False Claims Act: A Key Legal Weapon
The FCA, first enacted during the Civil War to combat fraudulent suppliers, is the government’s primary tool for punishing the known misuse of taxpayer funds. It permits the government and private citizens (acting as whistleblowers or “relators”) to sue those who defraud governmental programs. The Initiative utilizes the FCA to hold contractors accountable for misrepresentations or breaches related to their cybersecurity practices. Penalties can be severe—treble damages and substantial fines per false claim, rendering the FCA a potent deterrent.
Recent Case Developments: The Initiative in Action
Implementing the Initiative has already led to some significant case developments, detailed below, that underline the Initiative’s enforcement capabilities. These cases demonstrate the potential fallout for businesses with government contracts if they provide substandard cybersecurity services, overstate their cybersecurity capabilities, or delay reporting cybercrime. It’s a stark reminder that contractors can be held accountable for fraudulent practices. With the government’s emphasis on cybersecurity enforcement and the increasing pervasiveness of cybercrime, these first few enforcement actions under the Civil Cyber-Fraud Initiative represent only the tip of the iceberg.
Comprehensive Health Services
In March 2022, the DOJ announced its first FCA resolution involving cyber fraud since the Initiative’s inception.[3] Comprehensive Health Services (“Comprehensive”), a medical service provider with contracts and subcontracts with the State Department and Air Force to operate medical facilities in Iraq and Afghanistan, settled FCA claims by agreeing to pay $930,000.
The United States alleged that Comprehensive submitted false claims for reimbursement under its contract and failed to disclose that it had not complied with contract terms requiring it to securely store patients’ medical records.[4] Comprehensive allegedly left medical records in an unprotected network drive, easily accessible to nonclinical staff, a violation it had not reported.
The relators and their counsel collectively received a total recovery of $498,741, consisting of individual shares for the relators, attorney fees, and expenses.
Aerojet
July 2022 saw a significant settlement where defense contractor Aerojet agreed to pay $9 million.[5] This settled allegations of Aerojet misrepresenting its compliance with cybersecurity standards and fraudulently entering into contracts with the Department of Defense and the National Aeronautics and Space Administration despite knowing it did not meet the minimum cybersecurity requirements.
The relator, a former senior director of cybersecurity at Aerojet, initiated the qui tam lawsuit in 2015. The government declined to intervene in the action. Following years of discovery and summary judgment briefing, a jury trial commenced on the relator’s promissory fraud claim. The relator asserted that Aerojet was liable for damages amounting to $19 billion. That figure represented three times the total value of each invoice paid under each agreement allegedly secured through false statements or fraud. If the jury found Aerojet to have violated the FCA, Aerojet also faced the possibility of civil penalties, debarment, and suspension.
The parties settled on the second day of trial, with the whistleblower receiving $2.61 million as his share of the $9 million that Aerojet agreed to pay the government to settle the cyber-fraud allegations.
Jelly Bean Communications Design
In March 2023, another government contractor, Jelly Bean Communications Design (“Jelly Bean”), and its manager agreed to pay $293,771 to resolve FCA allegations.[6]
The United States alleged that Jelly Bean, under its contracts with the Florida Healthy Kids Corporation (“FHKC”), submitted false claims for federal funds.[7] Jelly Bean failed to provide secure hosting and maintain proper software systems for the website HealthyKids.org, which collected and transmitted applicants’ personal information for Medicaid coverage. As a result, more than 500,000 applications were hacked, compromising sensitive data such as names, addresses, Social Security numbers, financial information, family relationships, and secondary insurance details. In response to the data breach and cybersecurity failures, FHKC shut down the application portal in December 2020.
Achieving Cybersecurity Excellence: Key Strategies for Government Contractors
As the digital landscape grows more complex and the threats more sophisticated, government contractors must approach cybersecurity compliance with an assertive and agile mindset. Below are some essential strategies.
Understand Cybersecurity Standards
Familiarize yourself with applicable cybersecurity requirements, including Federal Information Security Modernization Act (“FISMA”) requirements, National Institute of Standards and Technology (“NIST”) guidelines, and specific agency-level standards. Ensure strict adherence to these contractual obligations, and be careful in making assurances to the government when entering into government contracts to avoid any potential FCA violations.
Invest in Robust Security Infrastructure
Ensure that departments tasked with cybersecurity have sufficient resources for risk evaluation, threat mitigation, and adherence to governmental regulations. Allocate resources to develop cutting-edge cybersecurity technology and train skilled personnel. Regularly update and patch all systems to eliminate potential vulnerabilities and secure applications and systems.
Formulate an Incident Response Plan
Develop a comprehensive incident response plan outlining immediate steps in the event of a cybersecurity breach. The company’s plan should encompass notification procedures, evidence-preservation methods, remediation strategies, and a communication plan.
Respond to Internal Complaints
React to internal warnings appropriately. Allocate sufficient resources for investigating claims that surface through internal reporting channels. Importantly, ensure the protection of whistleblowers by not taking adverse actions against those raising internal warnings. Ignoring this advice could lead to additional liability for unlawful retaliation.
Comply with Reporting Timelines and Mandates
Understand and comply with the reporting timelines stipulated in government contracts. Failure to do so could lead to severe violations and potentially trigger FCA liability.
In addition, it is crucial to carefully structure and record any disclosures made to, or waivers from, the government. In the Aerojet case, for example, the government contractor had disclosed its noncompliance to the government. Still, the relator and government maintained that the contractor’s admissions did not reveal the full scope of the noncompliance.
Promote Cybersecurity Awareness
Conduct regular training sessions and awareness programs to help employees appropriately identify and respond to potential threats. Reinforce the importance of their role in maintaining cybersecurity and the possible consequences of noncompliance.
Proactively Engage with Legal Counsel
Independent legal advice is essential in deciphering a company’s legal obligations and mitigating claims of cybersecurity fraud. Good counsel becomes particularly vital in the face of potential whistleblower complaints—and even more so when contemplating any adverse action against the individual raising these concerns. Engaging counsel upholds privilege claims over the investigation and introduces specialized knowledge and experience in dealing with complex issues. By proactively seeking professional legal guidance, your company can maintain its compliance edge, fulfilling its obligations and adeptly resolving whistleblower claims.
Conclusion
The inception of the DOJ’s Civil Cyber-Fraud Initiative signals a heightened era of scrutiny, underscoring the importance of robust cybersecurity compliance for government contractors. Armed with the potent False Claims Act, authorities are poised to enforce stringent compliance. A company’s cybersecurity deficiencies, knowing misrepresentations, or failure to timely report breaches could lead to significant penalties. Engaging legal counsel seasoned in the intricacies of cybersecurity and FCA matters may prove indispensable in successfully navigating these obligations, potentially mitigating grave financial repercussions and safeguarding the future of the business.
