Corporate Conversations

What do recent Trump administration actions mean for nonprofits and their leaders?

In the latest episode of Corporate Conversations, Doug Schwartz, Kimberly Kamkar and Kendall Sirica discuss growing concerns among nonprofit organizations regarding audits, tax-exempt status and federal oversight. They break down what has changed, what has not and what nonprofit boards and executives should be doing now to protect their organizations.

Listeners will gain practical insights into the evolving legal landscape, strategies for maintaining compliance and guidance for navigating heightened political and regulatory attention. Most importantly, the conversation helps separate headlines from reality, equipping nonprofit leaders with the information they need to make informed decisions.

Transcript: Dangerous Days for Directors Doing Good: How Do We Protect Our Nonprofit and Ourselves

_{0:00:00.2 Kendall Sirica: Nonprofits and their directors say they are under assault by the Trump administration. They worry about getting audited and keeping their tax exemptions. But nonprofits have always been a target and always need to be proactive and vigilant. Today, we'll try to separate hype from reality and give practical advice about what nonprofits and their boards can do to protect themselves, no matter who is in office.}

_{0:00:22.3 Speaker 2: Welcome to Nossaman's Corporate Conversations podcast, where our corporate attorneys bring practical insights into the deals, disputes, and legal decisions shaping today's corporate world.}

_{0:00:22.3 Speaker 2: Welcome to Nossaman's Corporate Conversations podcast, where our corporate attorneys bring practical insights into the deals, disputes, and legal decisions shaping today's corporate world.}

_{0:00:35.9 KS: I'm Kendall Sirica and I'm a retirement plan and benefits lawyer at Nossaman LLP. Before this, I was a student lawyer with Northwestern Law School's Seigle Clinic for Immigrant Youth and Families, where I helped unaccompanied minors and young adults apply for asylum in the U.S. So I have a particular interest in today's topic, which is what nonprofits and their directors can do to keep their tax-exempt status and protect their missions with the current political mood in Washington. My two colleagues with me today are Kimberly Kamkar, a corporate and business lawyer who has advised nonprofits on these issues for years, and Douglas Schwartz, who brings years of tax experience to these matters. Kimberly and Doug, great to have you both here today.}

_{0:01:14.4 Kim Kamkar: Happy to be here. Thanks, Kendall.}

_{0:01:16.3 Doug Schwartz: Thanks for having us. The topic is near and dear, as they say.}

_{0:01:21.1 KS: So the title of our podcast is "Dangerous Days for Directors Doing Good?" With a question mark. In other words, you're asking a question and not making a statement. Why is that?}

_{0:01:31.4 DS: So if our listeners take anything from this podcast, we'd like it to be five words, "Don't panic, but don't ignore." I got out of law school when Ronald Reagan was president and I can tell you that nonprofits have been a target-rich environment throughout my career. In fact, that's been the case even before I was born. So we say don't panic because this has been going on for decades and nonprofits still have survived and even thrived. But we also say don't ignore because this is always serious. Running a nonprofit is fraught and political and you need to be vigilant and proactive regardless of who's in power.}

_{0:02:09.4 KS: And I understand that both of you not only advise nonprofits, but also serve on nonprofit boards yourselves.}

_{0:02:15.5 KK: That's true. I've been on the board of the Women Lawyers Association of Los Angeles, we call it WLALA, for four or five years now, and this is my second year as an officer. This year I am the secretary for WLALA as well as the foundation.}

_{0:02:32.9 DS: And I've served on committees for my alma mater and as a director and president of its local alumni club. I've been an officer for the tax sections of the California State and Los Angeles County bars. And recently I joined the board of the Arthritis National Research Foundation.}

_{0:02:50.0 KS: So you see these issues both as advisors and from the trenches, so to speak.}

_{0:02:54.3 KK: Yeah, absolutely. And honestly, with WLALA, it feels like every day there's something new.}

_{0:02:59.9 KS: So, Kimberly, putting on your lawyer's cap, what kinds of nonprofits do you and Doug advise?}

_{0:03:05.1 KK: The full gamut, honestly, we advise on everything from typical nonprofits like C3s to C13s, which are, funnily enough, nonprofit cemetery companies. But this might actually be a good time to walk through the three most common types of nonprofits that are out and about in the real world. First, we've got C3s, and that's Internal Revenue Code 501(c)(3). And these are your charities, museums, hospitals, colleges, religious institutions. They're the sort of typical nonprofit that you see and that you think about. And they serve a really essential function, which is to bridge the gap between government policies and community services and community needs like healthcare and education. And after C3s, we're going to go in order, you've got C4s, they're commonly known as social welfare organizations, and they do quite a bit of lobbying and advocacy. And they even have the ability to do some political campaigning. Which, by the way, that is sort of a key distinction between C3s and C4s, because C3s cannot. And third, there are C6s. And yes, we did skip C5. So C6s are called trade organizations, and they promote the interests of their members in a particular trade or industry. And like C4s, C6s can lobby and they can do some political campaigning. And you might be thinking, why would you ever go with a C3 then if a C4 and C6 can do lobbying and political advocacy? Well, C3s can solicit charitable contributions from people who want to claim a charitable deduction on their taxes, and C4s and C6s cannot do that. And that ends up being a really big difference.}

_{0:05:05.4 KS: Thanks, Kimberly. That was really helpful. So now let's dive into our title, "Dangerous Days for Directors Doing Good." What has nonprofits and their directors running scared?}

_{0:05:15.3 KK: To answer that, we kind of have to go back to Inauguration Day, January 20, 2025. On that day, President Trump signed Executive Order 14151. And I'm gonna call them EOs for short from here on out. The EO directed federal agencies to terminate DEI, that's diversity, equity, and inclusion, related offices and programs and grants and contracts throughout the federal government. And a bunch more EOs followed after that, including an EO ordering government agencies to terminate "illegal preferences" in federal policies, grants, and contracts. And that was code for DEI. There was another one that targeted federally funded programs that permit "ineligible non-citizens" to obtain social services. And again, that was code for DEI. And there was another EO that redefined qualified employment under loan forgiveness programs with the intent to exclude employers with a "substantial illegal purpose," again, like DEI or discrimination. And there was a fourth main one that directed the Department of Government Efficiency, or DOGE, to get rid of "outdated or unlawful regulations." Again, code for DEI. And what DOGE ended up actually doing was they cut key staff at a lot of federal agencies, including the IRS. And this has had a really deleterious effect because the remaining staff at the IRS are just completely underwater, which is really unfortunate because nonprofits really benefit from an experienced and functioning IRS. Because the IRS approves exemption applications and it answers all nonprofit questions. And importantly, it audits bad actors, which helps the public maintain trust in nonprofits as a whole, which is really important when you are soliciting money from the general public.}

_{0:07:40.0 DS: And we should mention a couple of other developments. First, the Treasury Department announced in April that it will revise the nonprofit Form 990 annual return to better show government contracts, grants, and fiscal sponsorship arrangements. Now, "fiscal sponsorship," means arrangements where a tax-exempt entity funds another charitable project and initiative. Treasury Secretary Bessent said that the changes were needed to curb abuse, fraud, and extremism. But Democrats and left-leaning nonprofits worry that initiatives like these, plus the EOs, target groups with different ideologies. Second, the House Ways and Means Committee in July approved bills requiring nonprofits to provide more information on their annual returns about contributions they receive from abroad and impose penalties if they give to political entities within two years of receiving money from foreign donors. As Kimberly noted, a 501(c)(3) charity can do only a little bit of lobbying and it can't campaign at all, but a 501(c)(4) can do both those things. So Republicans were trying to curb the ability of foreign interests to contribute to 501(c)(3)s, which then transfer the funds to a 501(c)(4). Again, Democrats and left-leaning nonprofits think that these proposals are ripe for abuse.}

_{0:09:04.4 KS: This all sounds serious and honestly a little scary, but as you suggested earlier, it's not unprecedented.}

_{0:09:11.6 DS: Correct. Nonprofits are, unfortunately, a punching bag for whomever is in power in Washington. Now, there are two reasons for that. First, nonprofits are usually tax-exempt, so the sense is that with your tax exemption comes more scrutiny and accountability to the public. Second, many nonprofits do what the current Washington party in power may not like, for example, being pro or anti-gun rights or pro or anti-reproductive rights. The Clinton, Obama, and Biden administrations were also accused of gunning for nonprofits, just from the other side. Also, a lot of the initiatives against terrorism funding and overseas accounts and activities came from the George Bush administration after 9/11. I mentioned the bills to increase disclosure of overseas funding. Well, we've had battles over donor disclosure for years. During the Obama years, it was the Democrats saying there's too much dark money behind these 501(c)(4) political organizations, we need more disclosure about who's funding them. And it was Republicans saying, "No, you just want to dox and harass the donors." We have a cold peace now where 501(c)(4)s do not disclose their donors to the IRS, but 501(c)(3)s do, but the list is available to the public only if the 501(c)(3) is a private foundation, which we'll discuss later. And by the way, a PAC, which is another species of tax-exempt entity, always discloses its donors to the IRS, and that list is always available to the public. Now, to be fair to both political sides, there are indeed nonprofits that work in the shadows and are aggressive and secretive where the laws are unclear or have loopholes. That's unfortunate because, as Kimberly alluded to earlier, when Congress and the IRS try to plug the holes and enhance transparency, it's all the nonprofits that suffer.}

_{0:11:10.3 KS: You've mentioned words like accountability, disclosure, and transparency. It sounds like nonprofits have long been subject to a lot of scrutiny regardless of who's in the White House or the Capitol.}

_{0:11:21.6 KK: Yeah, absolutely. And I really want to build on what Doug just said because what's going on right now is serious, but it really is not unprecedented. And I'll hit a couple highlights. First, we've talked about Form 990s. That's the Form 990 return, which is the required nonprofit annual filing. The 990s are incredibly detailed. If you thought your personal income taxes were bad, just wait. And all the information filed on a 990, like Doug said, is public information, and copies are available on the IRS's website. It's a couple clicks and you can just download it. And this really trends towards transparency. Anyone can see what the nonprofit is doing and how it's spending its money and what its goals and priorities are. And transparency has been determined to be so important that if the nonprofit doesn't file their Form 990 for three years, three straight years, I guess I should say, then they lose their tax exemption automatically. It's a bright line rule, there's no way around it. Second, C3s and C4s pay penalties on what are called "excess benefit transactions," which really is just a fun way of saying sweetheart deals for insiders. And there's sort of an extra layer of those kinds of penalties and fees that are on top of a special kind of C3 that's called a private foundation, because a private foundation is basically a charity that's funded by one person or a very small handful of people. And Congress put these additional guardrails and disclosure requirements in place for these private foundations because... Well, it's under the theory that they're less accountable to the general public. Third is, if a nonprofit does any kind of lobbying, then they have to file a bunch of reports at the federal and the state and typically the local levels. And again, this goes towards what Doug was talking about, each level of government is trying to ensure transparency around the general public's contributed dollars. And I guess, last but certainly not least, C3s are also required to file reports with the state agency that's in charge of protecting the public interest. And here in California, that is the Attorney General's office. And the policy behind this is that C3s solicit charitable contributions and they hold those funds in trust for the public. So C3s essentially have a higher burden to prove that the contributions that they receive actually do go towards the public good instead of, say, inflated overhead or employee salaries.}

_{0:14:28.3 DS: And that's just the official government oversight. There's also charity monitoring websites where you get a charity's 990s, you can see graphics on how much it spends on overhead versus charitable activities, and even look at a rating of the charity that goes from, say, gold to lead. Think Charity Navigator, Charity Watch, BBB Wise Giving Alliance, or GuideStar. Fair or unfair, many donors go to these websites and spend 30 seconds on them before donating to a charity they don't know.}

_{0:14:59.2 KS: So what you're both saying is that what this current administration is doing, and maybe what prior administrations have also done, is to add unwelcome and biased layers to what's already a robust and maybe even intrusive reporting and oversight system.}

_{0:15:13.9 KK: Yeah, you hit the nail on the head.}

_{0:15:16.7 KS: But even so, I do note that not only has the current administration tried to add all of these burdens, but it's also threatened nonprofits with revocation of their tax exemptions if they don't comply. Harvard University comes to mind. But can the administration really do that?}

_{0:15:31.6 DS: Not really, Kendall. A chief executive can't revoke a nonprofit's exemption unilaterally by an EO. There are statutory procedures in place for that. First, as Kimberly mentioned, if a nonprofit doesn't file its 990 for three straight years, its exemption gets yanked automatically. All it can do is try to get the exemption reinstated going forward. Second, the IRS can audit a nonprofit for compliance with tax laws, including adherence to purpose, excessive lobbying, and private inurement or benefit. There are levels of due process here, including multiple chances for defense and appeal through the IRS levels and then at court. Losing exemption status has historically been a high bar and typically involves some pretty egregious abuse. Now, I should mention that educational institutions, you mentioned Harvard, are different from your typical 501(c)(3)s. In 1971, the IRS adopted official guidance that a private school does not qualify for exemption if it does not have a racially nondiscriminatory policy as to students. The Supreme Court upheld this rule in 1983 in Bob Jones University, which involved a South Carolina nonprofit which lost its exemption because it had a disciplinary rule banning interracial dating and marriage, and it also denied admission to people in an interracial marriage or just supporting the same. The Trump administration, ironically, invoked this rule in threatening Harvard's exempt status on the accusation that it discriminated in its admission policies and its operations.}

_{0:17:12.8 KK: I should jump in here really quickly to say there's another piece to this. Internal Revenue Code Section 501(p), which, funnily enough, was buried in the post-9/11 USA PATRIOT Act back in 2001, says that if a federal authority designates a nonprofit as supporting terrorism, then the IRS has to suspend that nonprofit's tax-exempt status, and there's no due process about this at all. And I guess thinking back, you can probably see why this was slipped into the PATRIOT Act. But on top of that, in September 2025, the Trump administration issued... And this is a mouthful, bear with me, the National Security Presidential Memorandum Number 7, which directs the DOJ, the FBI, the Treasury, and the IRS all to investigate nonprofits and donors that might "sponsor or otherwise aid and abet unlawful activity." And so this language, this memo stops short of actually invoking Code Section 501(p), but it still does threaten revocation through the DOJ referrals. And the scary part of that is that we've seen the kind of damage that inquiries like this do to a nonprofit's reputation and donor confidence and their banking relationships and their daily operations, even if that inquiry is baseless and goes nowhere.}

_{0:18:49.8 KS: You bring up a really important point that even if the administration can't yank a nonprofit's exemption by an EO, just the very fear and uncertainty from these orders does damage anyways.}

_{0:19:00.5 KK: Yeah, it's that lovely expression, the process is the punishment. And I think that's what we're seeing in play here. These initiatives have created a lot of fear around nonprofits losing their exempt status, losing control over their internal functions and their management, and actual management shakeups. I mean, especially for universities, everyone was scrambling to prepare for audits or brace for the next change in the law that everyone assumed was coming for a while. But Doug is right, the government can't revoke your tax-exempt status just by executive order. That's not how our checks and balances system works. What it can do, though, might be just as serious. It can terminate your contracts, it can refuse to make or honor grants, and it can pretty quickly erode the public's trust in the nonprofit. And I think we can take a look at quite a few universities as examples of this, like Columbia or Cornell or Brown or Northwestern.}

_{0:20:12.2 KS: Doug, you mentioned earlier that the IRS can audit a nonprofit as a start to possibly revoking its exempt status. How do these audits typically start?}

_{0:20:21.4 DS: Well, the IRS has a staff to review 990s and uses algorithms to pick up any unusual items. But as Kimberly said, IRS enforcement has kind of withered with the DOGE cutbacks. More often, audits start with some disgruntled ex-employee or a director blowing the whistle, or a blogger who doesn't like the nonprofit's mission writes the IRS saying, "You need to look at these guys." And it doesn't matter if you're doing something non-political like a soup kitchen or community theater. No matter what you do, you're gonna tick someone off sometime. And again, I don't care about the party, but there's always a senator or representative saying the same type of thing. So, basically, your worst enemy is the person out there with an axe to grind. That is why we tell nonprofit clients to follow the New York Times rule: don't do anything you wouldn't want to see on the front page of the New York Times the next day.}

_{0:21:13.4 KS: So what I'm hearing is that nonprofits have always had and will always have targets on their backs, and that being vigilant, careful, and proactive is always a good idea no matter who's in power.}

_{0:21:23.7 KK: It's always a concern, and it's always really important to be careful and proactive. There's nothing wrong with either of those things.}

_{0:21:33.2 KS: What specifically would you suggest to nonprofits?}

_{0:21:36.8 KK: That's a great question. I think I would start from the very beginning, which is the formation of the nonprofit itself. First, in order to form the nonprofit, you file a nonprofit charter with your local state agency, and that charter is typically fairly boilerplate. But after that, you need to prepare bylaws. And the bylaws are an incredibly important document for the nonprofit itself because it governs everything about the nonprofit's governance, including how directors and members meet, and how decisions get vetted and approved, and what to do when there's a conflict of interest, and all sorts of other things. So it's important that that document be well-prepared because that will set the tone and the groundwork for how your nonprofit exists in real-life. And then after the bylaws, I think the next best and most proactive decision a nonprofit can make is to put together and adopt three specific policies, a conflict of interest policy, which, like its name suggests, prevents self-dealing by people within management; a whistleblower policy, which protects people who report wrongdoing from retaliation; and a document retention policy, which tells you what documents to keep and for how long. I say these three policies in particular because nonprofits have to disclose whether these exist on their Form 990 report that's filed annually. And those... If you remember those watchdog websites that Doug mentioned earlier, these watchdog websites expect to see them, and your nonprofit rating will be knocked down if you don't have them. And again, that goes towards the public's confidence in your nonprofit. And so it's important to make sure that you've ticked all of these boxes ahead of time before you ever start to bring money in the door. Doug, any more thoughts? Did I miss anything?}

_{0:23:51.1 DS: No, I think you covered it, but I'd like to make one suggestion about the bylaws, namely, be practical and consider how the nonprofit and its management and members actually operate in real-life. If you can't operate according to your bylaws, then that's a problem. For example, if you have members, consider virtual meetings and how to notice and conduct them, and consider web-based voting platforms like SurveyMonkey to cast ballots. And don't set the quorum at, say, 90% of the members, because you'll never get that in a million years. We've seen bylaw quorum provisions of more than 50% and even 30%, although, to be frank, if you gotta go lower than 30%, you should really consider having voting members if no one's gonna show up for meetings. Another example is director meetings. Meetings are tough to schedule and time consuming, and written consents take time to draft and may involve attorney fees. So build something in your bylaws whereby directors can make decisions by email. As long as there's a complete email chain and some means of storing the email for posterity, remember, we talked about a document retention policy, then it should be easy to figure out who voted for what and what was voted on. Oh, and by the way, I don't like text or social media to conduct decision making. There's no permanent record, and it's much more difficult to figure out who said what or what was decided.}

_{0:25:15.7 KS: Is there anything else to think about or consider at the formation stage?}

_{0:25:22.3 KK: I mean, I guess I would also call the tax exemption application a formation document. So I guess we can talk about that even if it's on a technicality. The exemption application is filed with the IRS, and it's either a Form 1023 for a C3, a 1024-A for a C4, or a 1024 for a C6. And like the 990, the exemption application is public information, so everything that's written in it will be downloadable to the general public, so anyone can see a copy. And this is probably the nonprofit's first chance to tell its story both to the IRS and to the public. Because this is... In the exemption application, you have to set out what the mission is and how it plans to operate and spend its time and its financial plan. Where is it gonna get money? How is it gonna spend it? And who's running the show? What are their qualifications? So it becomes a really big piece of the history and the operations of the nonprofit. And making sure to give this whole suite of information to the public proactively will set you up for success in the future. Now, technically, only C3s are required to file one to get their exempt status. C4s and C6s are sort of assumed to have one even without the exemption application. But we always recommend that C4s and C6s file one too, both in order to provide this really vital information to the public, but also because the exemption letter itself is a really important piece of the nonprofit's exempt status and operations as it moves through the world.}

_{0:27:19.3 KS: So at this stage, I just have to ask because I, and I know our listeners are thinking the same thing, what role can AI play in all of this?}

_{0:27:28.0 KK: That is a great question, Kendall. And Doug, if you don't mind, I'm gonna take this, mostly because I'm on my firm's technology committee and our AI committee, so I am constantly using and testing AI during my day to understand the extent of what it can do and also its limitations. And AI is really great at doing certain things, like taking minutes or preparing talking points or getting you kickstarted on a draft of anything from an initial draft of a document or that first initial search you do for research where you're just sort of taking the lay of the land. It's really great at getting you started on these things. So it is a wonderful tool. But I do always feel the need to make this one caution, which is that AI doesn't replace careful work or experience. And so absolutely use AI within your nonprofit to take your minutes and summarize the action steps for your... That everyone is gonna have to take out of this meeting. But make sure to always double-check what AI has prepared and put together, both in terms of the content and in terms of its sources, because it can hallucinate and it doesn't really think like a human, so it's good to double-check it.}

_{0:28:55.4 KS: That's about the answer that I expected, that AI can be a valuable and even essential tool for the whole life cycle of a nonprofit, but as long as you're careful. And this segues into my next question, which is once you've launched the nonprofit, how should management operate it?}

_{0:29:11.2 DS: Well, to start, directors should remember the three duties of care, loyalty, and obedience. First, the duty of care requires directors to actively participate, stay informed, and exercise reasonable common sense and prudent judgment when making decisions for the organization. Basically, if you sign up to be a director, then show up to meetings and pay attention and answer your emails, please. Second, the duty of loyalty requires directors to put the nonprofit's interest above personal professional gain. And that includes avoiding and properly disclosing any conflicts of interest. Remember we said before the nonprofit should adopt and follow a conflict of interest policy. And third, the duty of obedience requires directors to stay faithful to the organization's core mission and comply with its governing documents and applicable local, state, and federal laws. Now, let me expand on that third duty, which is obedience. First, I said comply with its governing documents, and this is a reason we advise that bylaws be carefully drafted and reflect the way in which the board is likely to operate. If a board can't operate according to the bylaws, then the board can't comply with the governing documents. Second, I said comply with applicable local, state, and federal laws. I didn't say blindly follow every law that purportedly applies to you. So here we are at the podcast talking about the Trump administration's EOs and how they apply. Paying attention to these developments and getting sound professional advice satisfies the duty of obedience, even if the ultimate decision is that these orders are improper or otherwise don't apply to you. In fact, blindly complying with an EO may well conflict with a director's ability to stay faithful to the organization's core mission, setting up an internal conflict with the duty of obedience.}

_{0:31:07.9 KS: Can you give some practical examples of how to meet these duties?}

_{0:31:13.2 KK: Absolutely. I'm gonna reference something Doug said just a minute ago, which is to pay attention. Follow the news, join nonprofit blogs and chat groups, and get professional advice. I know it might be expensive, but it's important. The IRS also has really great resources. You can look up Stay Exempt, and there's also an EO Update newsletter. Second is to document and disclose everything. Remember that major decisions need board approval, and those decisions include things like the budget, leases, programs, personnel contracts, big grants, all sorts of things in that category. And when making these decisions, nonprofits have to make sure that their minutes show that the board was fully informed, had a reasonable discussion about the strengths and weaknesses, goods and bads, pros and cons, and also how everyone voted. I know life moves fast. If you missed getting your approval before the transaction actually happened, a lot of times what you can do afterwards is you still need to make sure to disclose all of the information, but the board, the company, can do what's called a ratification. They can take a look at the transaction, the approval that was missed, and say, "You know what? We agree that was a good decision. We're gonna adopt it as our own action after the fact." And you can do that at your next meeting. Third is, and we're seeing this a lot right now, be extra careful with executive compensation. Document that person's qualifications and their performance and benchmark it against similar organizations and similar employees. And remember that if you're having a really hard time figuring out the right benchmarks, nonprofit 990s are public. You can go take a look at any other nonprofits' 990s and see what they're paying their own employees of a similar title. Sometimes we also see that our bigger clients, bigger organizations, they might commission with a formal market study on compensation, but those can run pretty expensive, around $25,000. So it's not really an option for all clients. And if it's not an option for your nonprofit, there is plenty of information and research that you can do through the web as well as through the IRS's own resources to help set you up there. Doug, do you want to address any other points on this one, of practical examples?}

_{0:33:53.6 DS: Sure, I got three of my own. Number one, self-interested transactions need special attention. Follow your conflict of interest policy and your state's rules. Full disclosure plus approval by disinterested directors, preferably unanimous, will usually protect you. Second, have counsel review any joint venture or affiliation with another organization, whether it be for-profit or nonprofit. Affiliations or ventures can be valuable, but watch out. If a partner does too much lobbying or any political campaigning, that could jeopardize your 501(c)(3) status. And third, know your political activity limits. Keep nonpartisan education separate from campaign activity and document your neutrality in any voter education or candidate forums.}

_{0:34:42.1 KS: Now, you mentioned the 990 returns and how those are all public information. So I'll bet all of this information also shows up on the 990, right?}

_{0:34:50.4 KK: Absolutely. I know I've said it a lot, but it bears repeating. The 990 covers everything, governance, management, disclosure, compensation, board composition, independence, policies, current initiatives, new initiatives, lobbying, finances. I genuinely could go on and on with this list. And as we mentioned earlier, Treasury and Ways and Means wants to expand that even further to cover foreign donors and sponsorships, as if that list wasn't long enough. But I'm gonna say this again as well. I wouldn't look at the 990 as a burden because it really is a chance to tell your nonprofit's story. It's one of the places potential donors are gonna look to learn about your goals and your efforts. So describe your initiatives, explain how they benefit the public, give specific examples. If there's a big bonus, don't be embarrassed, don't try to hide it. Explain why it was justified. Like we said above, if this all sounds really daunting, if it does still sound like a burden, AI can help draft a lot of these different statements. You just have to make sure to check and edit them. But all of this information helps the public to understand and stand behind your story and your nonprofit. So always be upfront, because if you try to hide something, somebody is gonna find it. Everything is on the internet now. Someone will find it, and then you have to be on the defensive.}

_{0:36:23.6 KS: So given everything that we've discussed, should a nonprofit do anything more now if it's concerned about being targeted or facing enhanced scrutiny?}

_{0:36:32.6 DS: Yes, for sure. I can think of six things. First, for federally funded nonprofits, review grant term certifications, DEI program language, and beneficiary eligibility rules in light of the new executive orders. As we mentioned before, the government can't yank your tax-exempt status by executive order, but sure can yank your funding. Second, conduct an internal compliance audit. Review organizing documents, board minutes, compensation practices, and political activity safeguards. Third, engage outside counsel to assess risk exposure, especially for organizations receiving federal funding, engage in advocacy, or operating in areas administration has identified as problematic, which might include DEI, immigration services, environmental work, et cetera. Fourth, develop a rapid response plan in the event of an IRS or other government investigation, including preserving documents and designating a point of contact. Fifth, familiarize yourself and the board with the anti-terrorism provisions of Code Section 501(p) and National Security Presidential Memorandum 7 and do contingency planning. And sixth, as we said before, pay attention to current developments and monitor the outcomes of ongoing legal challenges. I note in this respect that there have been numerous court rulings pausing or even invalidating some of the administration's initiatives.}

_{0:38:00.9 KS: Do you both have any final thoughts for our listeners? What's the one thing that you would want every nonprofit leader to take away from this conversation?}

_{0:38:08.6 DS: Well, as we said before, don't panic, but don't ignore it. The current administration initiatives might seem scary and oppressive, but we've seen this before, and a nonprofit can and should conduct its affairs knowing that there is always and will always be a target on its back. The situation's unfortunate, but it's not desperate and it's not unfixable.}

_{0:38:29.8 KK: And I do so love to echo Doug, so I'm gonna do that again here. He and I deal with these issues every day, both as lawyers and as directors of nonprofits ourselves. We have seen how the scrutiny from the current administration has just sent shockwaves through the community, which makes this a moment where your formation decisions, your governance practices, your compliance posture, it's gonna matter more than ever. And I guess we really just hope that we've been helpful today and given you a bit of grounding and some practical advice that you can take into your everyday life.}

_{0:39:07.6 KS: Thank you so much, Kimberly and Doug, for your insights today. And to our listeners, whether you're in-house counsel, sitting on a board, or running a nonprofit, I hope this conversation gave you some concrete ideas for managing the risks we discussed and maybe making you feel a bit relieved. The landscape is shifting fast, but with the right governance practices, the right attitude, and the right advisors, you can navigate it successfully. For additional information on this topic or other corporate transactional, litigation, or insurance matters, please visit our website at nossaman.com. And don't forget to subscribe to Corporate Conversations wherever you listen to podcasts so that you don't miss an episode. Until next time.}

_{0:39:46.5 S2: Corporate Conversations is presented by Nossaman LLP and may not be copied or rebroadcast without consent. Content reflects the personal views and opinions of the participants. Statements provided in this podcast are for informational purposes only, are not intended as legal advice, and do not create an attorney-client relationship. Listeners should not act solely upon this information without seeking professional legal counsel.}

In this episode of Nossaman's Corporate Conversations podcast, we delve into the evolving risk landscape for Directors and Officers (D&O) liability. Nossaman's Anna Tang, joined by corporate litigation partner Patrick Richard and insurance recovery partner Joe Saka, explore the growing complexities of D&O liability, driven by factors such as cybersecurity breaches, AI-related claims and shifts in state corporate laws that have prompted companies to reconsider Delaware as their domicile.

The discussion covers the essentials of D&O duties, the impact of legislative changes, and practical steps directors and officers can take to minimize exposure, including understanding indemnification provisions, securing adequate D&O insurance and ensuring robust corporate governance practices.

Transcript for: Directors & Officers in the Hot Seat: Where Corporate Law, Litigation Risk and Insurance Coverage Intersect

_{0:00:00.5 Anna Tang: Directors and officers are increasingly finding themselves in the hot seat. AI claims are rising. Cyber risks are growing. State corporate laws are shifting fast. Join us as we break down the new D&O risk landscape and offer practical steps to protect corporate leaders.}

_[music]

_{0:00:18.4 Speaker 2: Welcome to Nossaman's Corporate Conversations podcast, where our corporate attorneys bring practical insights into the deals, disputes, and legal decisions shaping today's corporate world.}

_{0:00:31.8 AT: Hi everyone. My name is Anna Tang and I'm a corporate and M&A lawyer here at Nossaman. Today we're tackling one of the hottest topics in corporate law right now: the evolving risk landscape for directors and officers. We're gonna cover everything from the basics of D&O liability and insurance to the new frontier of AI-related claims, cybersecurity exposure, and the big shifts in state corporate law that have companies seriously rethinking whether Delaware is still home. I'm very excited today to have two guests with me. First, Patrick Richard, a seasoned corporate litigator who's been advising boards and officers on these exact issues for years. And joining him is co-chair of our insurance recovery group, Joe Saka, who helps companies navigate the often confusing world of D&O policies and claims. Patrick and Joe, welcome.}

_{0:01:28.9 Patrick Richard: Great to be here, Anna.}

_{0:01:30.2 Joe Saka: Thanks for having us, Anna. It's a very timely conversation.}

_{0:01:35.3 AT: Let's jump right in. Patrick, let's start with the big picture. Directors and officers were once considered above the corporate fray when it came to corporate responsibility, but we're now seeing them increasingly in the hot seat. What do you think is driving that shift?}

_{0:01:53.7 PR: I'd say it's a combination of things. Historically, that's still the general rule that directors and officers do not face personal liability, certainly for the debts of a corporation. But you have the classic piercing the corporate veil doctrine where a company, corporation failed to observe corporate formalities. Typically it's a smaller company. And directors and officers can also be liable to the corporation for their own gross negligence. Or in some states like California, officers can be liable for their own negligent discharge of their duties. The potential liability really comes, becomes more of an issue, at least from my perspective, if a receiver or trustee is appointed, who is then charged with recouping losses for the failed business. So oversight and good governance standards have certainly broadened in recent years. I think tracing it back 20 years or so ago to Sarbanes-Oxley brought a new focus on individual corporate responsibility for good stewardship of our corporations.}

_{0:03:00.0 AT: Joe, from the insurance side, how are you seeing this play out? I ask because from a transactional side, I'm definitely seeing ripple effects. So boards, when I'm working on an M&A deal, are asking more questions. Buyers, when they're reviewing D&O tail policies, for example, are more careful. And on my M&A deals, I'm certainly seeing the parties spending a lot more time and are being much, much more aggressive in negotiating indemnification provisions, for example, than they were, say, five years ago.}

_{0:03:32.5 JS: Yeah, I mean, I think that tracks with what we're seeing on the claim side as well. And so after any major deal, you have to anticipate the risk that there's gonna be a claim that's made relating to the transaction. So the type of claims that we're seeing triggering D&O policies have really multiplied. It used to be that D&O claims were mostly about traditional securities fraud or shareholder derivative suits, things of that nature. But now we're dealing with cybersecurity incidents, the failure to disclose what your cybersecurity risks are, AI-related disclosures, ESG-related claims. Geopolitical risk, ESG risk, and it just keeps on growing and growing. So the universe of potential claims have really expanded dramatically, and that creates real challenges on the coverage landscape.}

_{0:04:18.3 AT: Patrick, let's break this down. Could you walk us through the legal duties that directors and officers actually owe? Because I think for a lot of business professionals, the specifics here are a little fuzzy.}

_{0:04:31.1 PR: Yes, it's easy to state the two big duties generally owed to the enterprise and to the shareholders to some extent, and that's the duty of loyalty and the duty of care. And under the duty of loyalty, generally that means no self-dealing. Where that gets fuzzy is in some of the details of is this a personal benefit to an insider or not? When I say "is this", the decision that the board made. The duty of care, and that's really where we saw a lot of personal liability after the financial crisis and the lawsuits that followed against directors and officers of failed banks. What would the ordinary prudent person do as a director or officer? And we'll talk more about this, but directors need to be proactive, inform yourself and ask those questions. That all goes to the duty of care. It's basically a negligence or gross negligence standard.}

_{0:05:37.4 AT: And then there's that big shield that you mentioned earlier, the business judgment rule. How strong is that protection really in practice?}

_{0:05:46.2 PR: Well, it's a real thing, and it's addressed in any case where a director or former director or officer has been sued for negligence or gross negligence. But the nuances of that rule, especially here in California, show that it's not a get-out-of-jail-free card, so to speak. In general, courts are reluctant to second-guess a board's business decisions if those decisions were made on an informed basis, in good faith, and a genuine belief that they were serving the company's best interest. Those requirements often present a fact issue, especially for decisions, big decisions that were not well documented so. And of course, California courts and others have always held that it's against public policy to preclude liability for intentional misconduct. So, fraud, embezzlement, things like that. And the business judgment rule certainly wouldn't protect any officer or director from that type of conduct, nor from reckless conduct.}

_{0:06:58.4 PR: That's why gross negligence fails to meet the standards of actually acting to inform yourself, acting in good faith. So I've seen the business judgment rule, we've litigated it in California and federal courts. It's tossed around, but when you get into it, it actually does have predicate requirements that should provide, I would say, warning to directors and officers that you need to discharge your duties, beginning with being well-informed, asking questions. A lot of literature on the importance of being an active rather than a passive board member. That doesn't mean you have to be correct when you're judged with hindsight. It does mean you need to be active and inform yourself.}

_{0:07:44.9 JS: So, Anna, do you mind if I jump in with a question right here?}

_{0:07:49.6 AT: Sure.}

_{0:07:51.0 JS: So this is directed to you corporate attorneys, but what's the practical takeaway? How can individual directors and officers then kind of minimize their exposure in view of the potential limitations to the business judgment rule?}

_{0:08:06.3 AT: No worries, I can take this one, Joe. I would probably boil it down to three key steps. So the first, I think, is that directors should understand the indemnification provisions in their corporate governance documents. So look at the bylaws and making sure that the bylaws require, and I emphasize the word require here, not just permit. So they should require the company to indemnify both current and former directors to the fullest extent permitted by law. And as lawyers, we all know that there's a huge difference between the words may indemnify and shall indemnify. The second step, I think, is that officers and directors should push for the company to get adequate D&O liability insurance. So this is, Joe, where you come in. They need to ensure that the organization has checks and balances in place to catch those mistakes and to really tighten their corporate governance so officers have a complete picture or information when it comes to what their subordinates are actually doing.}

_{0:09:10.7 AT: So you can't say that I didn't know when really what you failed to do was ask the right questions. The final practical step, I would say, is to not only fully investigate and discuss all major decisions, but to also document that process. So the more that you can show that there was an informed decision-making process, the stronger your business judgment rule protection becomes. And this last step seems basic, but I think it's oftentimes overlooked. Let's go back to something that you mentioned earlier, D&O insurance. For our listeners who only deal with these types of insurance at renewal time, maybe put it in a drawer and then forget about it later, can you give us a one-minute overview of what D&O insurance actually covers?}

_{0:10:03.9 JS: Yeah, so I would break it down into coverage for the individuals and coverage for the company itself. Because at its core, D&O insurance protects the personal assets of directors and officers when they're sued either for regulatory proceedings or from shareholders or anything else in their corporate role. But it really extends beyond just the individual, and I think that's a common misconception. So there's side A. There's typically known to be three sides of D&O insurance. Side A is going to cover the individuals for claims made against them. Side B is going to reimburse the company itself when the company indemnifies its directors and officers. And side C, which is sometimes called entity coverage, is going to cover the company itself. And there's going to be a distinction for the coverage between public companies and private companies.}

_{0:10:55.0 JS: For public companies, that side C is going to be limited to securities claims, whereas private companies may have far broader coverage under their D&O insurance policy. So I think that's something that's commonly misunderstood. And one other really important feature of D&O coverage is that it's written on a claims-made basis. That means that it's going to respond to claims first made during the policy period, regardless of when the conduct took place. And this is going to be fundamentally different from most of your commercial general liability or occurrence-based policies, and it makes the timing of notice so much more important.}

_{0:11:39.0 AT: And what are the common exclusions or roadblocks that companies need to be ready for?}

_{0:11:47.8 JS: So I think the first one really is understanding your notice provisions because we see far too many issues relating to late notice. But it also ties into prior notice issues, prior claims exclusions, or known circumstances exclusions. So those can become major issues if the insurer is arguing that there was an earlier demand or an earlier claim, which is when the claim was first made. We'll also commonly see exclusions for fraudulent, dishonest, or intentional wrongful conduct. But those exclusions generally need to be read very carefully because many of them require final adjudication language. So an allegation standing alone is not enough for the carrier to avoid its coverage obligation. Another one that's become a hotly contested issue is the professional services exclusion. And that can be a real battleground because a lot of times carriers are leaving the term professional service undefined.}

_{0:12:51.0 JS: And so the question becomes, what is a professional service and does the claim arise from or relate to a professional service? And then obviously, nothing's gonna be crystal clear in the insurance world. Policies are commonly drafted to be unclear, and so you have a lot of hidden limitations. So two that jump out at me, one is you want to look not just at your exclusions, but at your definitions. And so a lot of the litigation that we've seen over the years relates to the definition of loss in insurance policies and what's carved out from that definition. And then sublimits have become another hotly contested issue where the carrier places a sublimit on certain coverage and is saying that the sublimit restricts rather than expands the coverage. But I think the kind of key takeaway here is language is really critical, and when you're litigating on behalf of policyholders, the tie is typically gonna go to the policyholder, meaning that if there's any ambiguity, it's gonna be construed in the policyholder's favor.}

_{0:13:55.8 AT: Let me ask something that comes up in distress situations, Joe. Just curious, how does bankruptcy or solvency issues impact D&O risks?}

_{0:14:06.3 JS: This is becoming a really big issue. So when a company is approaching insolvency, the D&O policy often is becoming the most valuable asset because the directors and officers themselves don't have the funds available to pay claims. But the tension is, in bankruptcy, the estate often wants to access that D&O policy to pay claims, and there can be fights between the company's creditors, the trustee, the receiver, and the individual directors and officers as to who gets access to the policy proceeds and who gets access to them first. So there's a bespoke insurance policy called Side A D&O insurance, and this is exactly why it's so important because where you have a standalone Side A policy, it's only the directors and officers that are gonna be able to access that coverage. So I think smart directors and officers really need to be considering that as at least part of the solution.}

_{0:15:05.8 AT: Joe, before we move on, let's talk about something that comes up in coverage disputes but is often overlooked, and that's the significance of Delaware law. And I'm not talking about corporate governance, which we'll get into a little bit later, but specifically for you, how does Delaware law matter in the context of D&O insurance coverage?}

_{0:15:27.2 JS: Yeah, it's become one of the most critical issues for D&O insurance right now. And lot of time... To take a step back, insurance law is state law specific, meaning that the same exact dispute can come out completely differently depending on which state's law applies. And so typically you would assume that the place of the company's headquarters is gonna be which law applies, or the place where the policy is delivered is gonna be the state whose law applies. But in Delaware, if you're incorporated in Delaware, which, hint, there's a lot of companies that are incorporated there, Delaware law may apply to their D&O coverage disputes even if the company is headquartered elsewhere or if the policy is delivered elsewhere. So the choice of law fight alone can often be outcome-determinative. So there's been any number of really significant D&O insurance cases in the recent years.}

_{0:16:28.2 JS: So the practical lesson for any in-house counsel who are listening is that when a claim arises, be very careful about which state's law is gonna apply to any coverage disputes. And if you're incorporated in Delaware, you want to be thinking about that.}

_{0:16:40.8 AT: Thanks, Joe. Let's shift to what I think is the most buzzworthy topic in the D&O world right now, artificial intelligence. Patrick, the materials that we've seen all say AI-related developments are transforming the business environment and translating into a new category of D&O risk exposure. Can you tell us more about that?}

_{0:17:03.2 PR: Sure. On the one hand, it is one of the fastest evolving areas just because AI, so much money has gone into that research and promotion and it just dominates so much of our business discussions. On the other hand, it's still the same legal framework in terms of disclosures and being accurate and honest both as to your own AI capabilities and as to the risks posed by AI developments in the marketplace. So for example, from a D&O perspective, we're seeing claims emerge in what's known as AI washing, companies that overstate AI capabilities or prospects to investors. That's the same old thing that's always been done. Our technology can accomplish X. We can determine all of your health issues from a drop of blood. Well, turns out it wasn't true. So a different subject matter for the same motivation of overstating capabilities and raising money.}

_{0:18:10.3 PR: And the SEC, I think it's the Innodata case, goes into... That was filed last year in the Southern District of New York, and there's criminal, parallel criminal proceedings. It's worth looking at because if there's any doubt as to your AI capabilities, you cannot be raising money overstating those capabilities. That's just straight up, straight up fraud. So I would say what's changed is that it's just so much more prevalent and therefore the temptation is that much greater. But one of the other things that we're seeing is sometimes the hype doesn't match the near-term financial results. So if you've priced for perfection because you've wrapped yourself in the AI narrative, and that's going around, even a slight wobble in guidance can cause a massive share price decline. I mean, I'm not saying there's anything untoward, but just looking at IBM, shot up a few weeks ago and then, [chuckle] oh well, there's a difference here between the expectation and the reality.}

_{0:19:26.6 PR: It's actually gonna take longer or not be as effective as folks thought. So time will tell on that front, and I know we'll get into this a little bit further. But the thing I find interesting in terms of disclosed risks and directors and officers is understanding the risks from your competitors, the risks in the marketplace due to the development of AI impacting traditional revenue sources, et cetera.}

_{0:19:55.7 AT: And Joe, from your perspective, is AI changing how underwriters look at D&O risk?}

_{0:20:03.9 JS: Absolutely, but it's still very much kind of a developing landscape. So I think we're starting to see underwriters increasingly ask a lot more questions to companies about their AI governance frameworks and their disclosure practices around AI capabilities. And part of that results from the AI washing claims that we've talked about from the SEC. There was the $65 million Snap settlement that we've mentioned. Carriers are paying close attention to all of these trends. But I think there's also a growing conversation about whether D&O policies are going to cover AI risks or whether they should be channeled into some other type of policy. So I think right now the conventional wisdom is that most D&O policies don't have an explicit AI exclusion and are not going to have one. But I think the coverage landscape is rapidly changing. I think the insurance market's trying to figure out how they want to handle AI risks.}

_{0:21:01.3 JS: And so I could definitely see a situation where AI-related claims are not going to fit neatly into one coverage bucket. So you might see a single claim that makes you look at your D&O policy, your cyber policy, your tech E&O policy, your CGL policy, all at the same time. Policyholders really need to be ready for that.}

_{0:21:25.1 PR: That discussion with all those policies, not that it makes my head spin, Joe, but [chuckle] I'm glad that you love reading insurance policies. But the discussion does remind me of this third category of AI risk that I think we're gonna see grow, and I touched on this earlier. And that is, again, from the director and officer perspective, understanding the risks due to AI in the marketplace and making sure that your disclosures and your public statements are not understating those risks. For example, if web-based advertising is where you drive most your revenue and then Google switches to AI-based search summaries that dramatically reduce click-throughs, that can impact those revenues rather quickly.}

_{0:22:18.4 S?: So the risk of underestimating a known risk is real. And if you underestimate or omit a material known fact, you may be looking at the Reddit situation where it's alleged in a recent complaint that they underestimated Google's AI tools... Which posed not just a theoretical risk, but a lasting threat to Reddit's traffic-dependent revenues.}

_{0:22:40.3 PR: So the critical insight is that it's not just a company's own use of AI that creates risk and overstating your own capabilities. It's understanding that the adoption of AI tools by your customers, competitors, vendors, suppliers, and potentially regulators can reshape your business. And if you don't adequately take a look at that and disclose those risks, you could face liability or investigation, certainly from the SEC.}

_{0:23:09.2 AT: And I think that's a really important point that you make, Patrick, there. The risk isn't just internal, is it? It's coming from the entire ecosystem.}

_{0:23:17.8 PR: I think that's right. And as we move forward and see how the AI washing cases... I think we'll see that those become relatively less significant and that the undisclosed risk cases that we've been talking about, because in hindsight, motivated regulators or shareholders will show, "Well, look, this thing, that this risk came to pass. You were impacted and you should have understood it at the time and disclosed it. And you didn't because you knew that it would impact share price." So undisclosed AI risks from the marketplace, I think, are something to keep an eye on moving forward.}

_{0:24:02.1 AT: Let's stay in the technology lane and talk about cybersecurity. I know this is not a new risk, but it's an area that is constantly evolving. What's the state of play here, Patrick?}

_{0:24:15.9 PR: So this is something that I've always thought is a governance issue, and I've talked to board members about it, that it's a little like for litigators early on not understanding ESI, electronically stored information. You could get a pass early on. Okay, that was 20, 25 years ago. Now the rules of professional conduct require every lawyer, every litigator to understand enough about electronically stored information to understand the pitfalls. I think the same is true for cybersecurity, that corporate leaders are being held personally accountable for their company's cyber governance. Obviously, the prior administration was focused on cybersecurity disclosure guidelines. It's part of consumer protection. You want to know that your personal information hasn't been hacked. And companies obviously don't want to disclose that in great detail because it can impact share price and the success of their business.}

_{0:25:23.1 PR: So from the individual director or officer, you need to ask the questions: what is our cybersecurity policy? What are the protections that are in place? And make sure that the information you're relying on is from a reasonable source. So, for example, I'm sure you've seen it that the DOJ, Department of Justice, recently settled a case with a life sciences company for almost $10 million based on allegations that the company sold products with cybersecurity vulnerabilities to federal agencies. Well, that's gonna draw you right into the False Claims Act. False Claims Act has been around since the Civil War, where you can't sell defective guns to the federal government and get away with it. Well, now, instead of ammunition or guns, we're talking about infected products that fail to meet basic cybersecurity standards. So that's, again, if you're the company that's in that arena and you're a director or officer, ask the questions and ask the hard questions.}

_{0:26:28.7 JS: Yeah, and that kind of dovetails with what we're seeing on the insurance side as well. And I'll note, specific to the False Claims Act, it's become a much more increasingly used tool by this administration, and there is potentially coverage for that under D&O insurance policies. And on the cybersecurity risk front, I think Patrick is exactly right. There's increased responsibility for cyber preparedness, and with that, there's also the risk of claims. And so I think companies are rightly reviewing their D&O insurance policies to make sure that there's not any gaps in coverage there. And so the question isn't just, did the company have a breach? It's also, was the company prepared with their cybersecurity risk, and is the company accurately disclosing what their risks are? So companies really need to make sure that they have both dedicated cyber insurance as well as robust D&O insurance, because the same incident can trigger claims under both.}

_{0:27:31.6 JS: But here's what I'm really telling most of our clients right now: you need to look at these policies together, not just in isolation, because you don't want to be in a situation where you have coverage under neither of your D&O or cyber insurance policies. You really want to understand how they work together.}

_{0:27:48.0 AT: All right, let's pivot to what I think is the most interesting corporate law development of the last two years. And I say this because I've been living and breathing this the most as a transactional lawyer. So what I'm referring to is the movement away from Delaware. We're hearing the term "dexit" being thrown around a lot lately. And honestly, I have to say, a year or two ago, I would have thought that this is just a storm in a teacup, but it's actually turned into something much, much more significant and much bigger. So, Joe, as you mentioned, for decades, Delaware has in the past been the default choice for companies in the US. I think we're seeing figures saying over 65% of Fortune 500 companies are incorporated in Delaware. And this traditionally has been because Delaware has a sophisticated court system. It has a really well-developed body of law, corporate law in particular, and a specialized Court of Chancery for dealing with business disputes.}

_{0:28:51.4 AT: But I think in the last three or so years, and more so gaining a lot of traction through 2024, there has been a growing number of people arguing that Delaware courts have become too aggressive and the courts are starting to second-guess board decisions. Patrick, from the litigation side, you've seen this frustration firsthand, haven't you?}

_{0:29:15.5 PR: I've seen the perception firsthand, absolutely. And the perception, whether it's fair or not, is that Delaware had tipped the scales, perhaps. On the other hand, it could just be more of what the judge in the Maffei versus Palkon decision last year described as a race to the bottom. So whether it was tipping scales or just not moving far enough and fast enough to protect companies and their boards, you have this competition between states: Nevada, Texas, Delaware. "We're the most protective." And so, and of course, Delaware's responded to that. So, yes, the perception's a real thing. I think there are a combination of factors at play on that, though.}

_{0:30:06.1 AT: Yeah. Let's talk a little bit more about what you just mentioned, Patrick. So it seems to me that people are viewing Delaware as leaving the door open to other states. And what you mentioned before about things moving quickly, it seems to me that Nevada and Texas have taken or seized that opportunity and sprinted through that door. Nevada, as we all know, already has no income tax and has a business judgment rule that's arguably broader than Delaware's, but in the last two years, they've gone further. So in February last year, Nevada moved to amend its state constitution to create a specialized business court. So Nevada is basically telling all corporations that what Delaware is known for, we can now offer you the same level of protection. Texas has also been equally aggressive. May last year, Texas created its own business court, and it set a minimum ownership requirement for folks to bring derivative claims and adopted a business judgment rule that appears again to be broader than Delaware's. So all of these changes are making Nevada and Texas very attractive alternatives for boards that feel exposed under Delaware law.}

_{0:31:21.1 PR: It's true, and I would say it's not just cosmetic. Whether you call them reforms or changes, the minimum ownership requirement, for example, will have a real impact and will be a real barrier to smaller-stake shareholder litigation. And the prohibition on fee-only disclosure settlements, that probably eliminates an entire category of what some would call nuisance litigation, right?}

_{0:31:53.0 AT: Yeah, exactly. And you mentioned earlier that Delaware has responded quickly to some of these, and that's in the form of Senate Bill 21, which restricts shareholder rights on claims involving controlling shareholders, particularly in conflict-of-interest transactions. And like Texas, Delaware has also restricted the scope of what constitute corporate documents that are accessible to shareholders. So what I'm seeing is Delaware is trying to address the concerns of its critics to make it harder for plaintiffs to challenge board decisions. But ironically, Patrick, as you mentioned, the Maffei and Palkon case, while the state legislature is trying to keep companies within the state, it seems that the Delaware Supreme Court has made it arguably easier for companies to leave.}

_{0:32:47.1 PR: Well, yes and no. In that case, it was what standard applies to a company's decision to reincorporate from Delaware to Nevada. And one of the contentions from folks who opposed it was, well, this is benefiting some of the major shareholders who were insiders and not others. And that led to, well, which standard applies? Is it the business judgment rule, which we've talked about, or is it the more rigorous entire fairness standard, which gives courts wider discretion to take a second look at a corporation's decision? And the Delaware court said no, simply if reincorporation eliminates the risk of a claim as opposed to an actual claim, we're gonna give the benefit of the doubt to the reincorporation. I view it more as preserving the breadth of the business judgment rule than a broad pronouncement about whether it's, Delaware is taking, whether Delaware courts are taking a position on companies reincorporating elsewhere.}

_{0:33:58.5 PR: But the judge did refer to, or the Court of Appeal did refer to a race to the bottom. Because look, we haven't talked about it, but the flip side is to the extent that you limit shareholder suits, you're removing one aspect of governance that historically you want a remedy for cases of terrible breach of fiduciary duty or self-dealing. So it depends on your perspective. Are those lawsuits just another burden on corporate America or do they promote governance? And certainly I've seen enough of those lawsuits that there's a full spectrum to support either view in that regard.}

_{0:34:40.2 AT: Yeah, and we're also seeing some very high-profile endorsements of dexit. For example, Andreessen Horowitz, the largest venture capital firm in the country, has publicly announced that it's leaving Delaware for Nevada and not only doing that, but also encouraging its portfolio companies to do the same. Of course, that's generated a lot of responses from Delaware supporters stating that this is a very... This is a view that doesn't take into account the bigger picture. But the fact that the country's most prominent VC firm is taking this view tells you that this is no longer a periphery discussion. I'm advising clients on this question a lot now. It comes up as standard part of any corporate restructuring conversation that I'm having with clients. Joe, from your D&O perspective, what does this all mean? If companies move to states where it's harder to sue directors and officers, does that change the risk calculation here?}

_{0:35:46.0 JS: I mean, I think theoretically yes, but I would be very hesitant to think that it's gonna meaningfully change the D&O insurance market. And I think two reasons for that. One, you need a significant volume of data before the insurance market is gonna react to a theoretical reduction in risk. So unless companies really do start moving away from Delaware and the insurance market really does see a dramatic decline in the types of claims out there, I don't think it's gonna really impact how they approach it. And the second reason is, irrespective of what claims are out there at the state law level, it's not gonna change what claims are available under the federal securities law. So those claims are still gonna be out there regardless of where companies are incorporated.}

_{0:36:38.8 PR: Well, and that's exactly right. We hadn't touched on that regardless of changes in state law, those only affect state law claims, breach of fiduciary duty, derivative actions, books and records and the like. But federal class actions under 10b, 10b-5 are governed by federal law. So a significant slice of D&O exposure remains unchanged really regardless of where you incorporate.}

_{0:37:03.2 AT: Okay, let me ask one question, and I think this question has gotten a lot of attention that I think connects directly to this conversation that we're having. How do changes in the political and regulatory environment affect D&O exposure? I ask because as a transactional lawyer, I'm seeing boards grapple with this issue in real time. So they're trying to structure deals, they're trying to come up with a governance framework in an environment where the rules of the road keep shifting. So we've seen changes in SEC enforcement policies, even the current administration's approach to ESG and DEI, Patrick, as you mentioned, is changing. How does all of this factor into the risk picture for directors and officers?}

_{0:37:47.5 PR: Well, certainly the political environment can create a kind of whiplash for corporate governance. Under the prior administration, as I mentioned, companies faced enormous pressure to advance certain policies or initiatives. Some companies arguably overstated their sustainability commitments, so-called greenwashing claims, and they got sued by shareholders. Now under the current administration, companies face scrutiny from the other direction. I think bottom line, the safer course, and this sounds a little like lawyer advice, is to make well-documented, good faith decisions based on what you individually genuinely believe serves the company's long-term interests. And you have to disclose that approach transparently. I would say the political changes and those competing, "Should I be going left? Should I be going right?" reminds me of the lending environment in the run-up to the financial crisis.}

_{0:38:45.0 PR: You had, I mean, think of Warren Buffett. His risk tolerance doesn't change over time. And yet you had a lot of lenders who said, "We're leaving money on the table. Let's make riskier and riskier loans." And then when they blow up, they get sued for it. So you can't just be going with, "Well, this is how the market or the political scene is currently running" or how the wind is blowing. You need to exercise your individual best judgment, inform yourself and document it, and always, always be able to say, "I had the best interests of the company in mind."}

_{0:39:20.9 JS: Yeah. And I think from a coverage perspective, it's very similar, which is that you need to be ready to adapt. And that really strengthens the case for a robust D&O coverage case because you don't know how the wind's gonna blow. So we could go from an aggressive federal government to a federal government that pulls back, but that doesn't mean that your risks go away. Usually they're just changing. So you really just need to make sure that your D&O coverage is designed to address whatever weather is out there.}

_{0:39:55.0 AT: And Joe, I think one thing that's worth mentioning is also the role of state attorneys general in this environment. How does that affect D&O exposure?}

_{0:40:05.2 JS: Yeah, it's a big part of the picture, particularly for individual directors and officers and under private entity D&O coverage. So I think that there was a misconception at the beginning of the Trump administration that the federal government was just gonna stop enforcement. And that's not really what happened. The priorities just shifted. But where those priorities shifted, a lot of times the state attorneys general continue to remain very active. So in consumer protection, antitrust, privacy, and data security, where the federal government may have taken a step backward, the state attorneys general have really filled that void. So from a D&O coverage perspective, you really want to make sure that your policies are designed to cover investigations by both the federal government as well as state attorneys general, because that can create very substantial defense costs and lead to follow-on litigation.}

_{0:41:02.7 AT: Joe, how about the D&O insurance market itself? Because I know that's top of mind for anyone who's managing a corporate insurance program. And I think, honestly, I've seen it come up in virtually every single M&A deal that I've worked on, especially when we're negotiating tail insurance. Where are we in the cycle?}

_{0:41:23.3 JS: We've been in a prolonged soft market, meaning coverage is not only cheaper, but it's easier to get favorable terms. But I think we're starting to see a little bit of a shift. Prices are gonna start going up and it's gonna be harder to get terms. And so I think right now, before that change happens, I think it's really important for companies to take a look at their directors and officers policies, remove as many restrictions as they can, and broaden their coverage as much as possible before it becomes harder to do so.}

_{0:41:56.1 AT: That's very good advice. [chuckle] You also mentioned earlier, Joe, notice. And I want to circle back to that because I think it's one of those issues that seems simple but catches a lot of companies off guard. Why is notice such a recurring problem in D&O claims?}

_{0:42:13.3 JS: Right. It doesn't sound hard, right? When a claim, when a lawsuit hits your desk, report it. The problem is it's not always clear under D&O insurance policies what constitutes a claim. So in some policies, it can be a written or oral demand. In some policies, it can be a request for mediation. So you really need to understand how claim is defined in your insurance policies in order to be able to comply with your notice requirements. And then I think a sub-issue is a lot of times companies are assuming that they only need to report to their primary carrier, and that's a mistake. You really want to look up the tower to the excess carriers as well to make sure that you're not failing to comply with the provision under those policies.}

_{0:42:59.7 AT: And what are some examples of things that might not look like a claim but should be reported?}

_{0:43:06.1 JS: So we mentioned written demands. I think the harder cases are subpoenas, civil investigative demands, Wells notices, informal inquiries. All of those can constitute a claim, depending on the policy. So the mistake companies make is assuming something is too early to report. And so my advice is always don't assume. You want to take a look at the policy, read the definition... Everyone enjoys reading insurance policies... And consider whether you're required to report the issue as a claim. And one other thing that's always worth considering is whether to report it as notice of circumstances or a notice of potential claim. And all that means is you report something that's not yet a claim, but if it comes in at a later point, it's treated as having been made under the existing policy.}

_{0:43:55.6 AT: This is great. I think you've given our listeners a lot of nuggets there, Joe. Let's bring us back to practical advice as we wind down. I know we've covered a lot of ground from directors' duties, insurance, AI, political risk. Patrick, if you could give our listeners three things they could go back and do Monday morning, what would they be?}

_{0:44:17.9 PR: Well, if it's Monday morning, you should probably start with your coffee or drink of choice. [chuckle] But then the thing you're gonna want to do right after that is review your indemnification provisions and bylaws. Do it right now. I thought that point made earlier, Anna, that the difference between a policy that mandates indemnification to the fullest extent permitted by law versus what we see in some language, one that just permits it. Because sometimes when those policies are originally adopted, well, let's just keep our options open. But that can come back to bite you. So, yeah, after your coffee, take a look at those indemnification provisions and make sure that they cover former directors and officers as well, not just current ones. Number two, I'd probably say take a hard look at your board's oversight of AI and cybersecurity. As we discussed, they're not just IT issues anymore.}

_{0:45:16.8 PR: They are, without question, governance issues. And if your board doesn't have a regular reporting cadence on these topics, create one so that you can document that meaningful discussions, not just checking a box, but meaningful reports are going forward and that the directors are being educated on those evolving risks and capabilities. And then number three, and we touched on this, have a serious conversation about the state of incorporation. I'm not saying everyone or anyone should rush to Nevada or Texas, but every board should be making a deliberate, informed decision about where the company is incorporated and why, and just get the current information, request a report and deliberate on it. That's what the duty of the director requires, and that's what I would suggest. So, yeah, those are some of my takeaways from our discussion today.}

_{0:46:17.4 AT: If I could add one more to your list, Patrick, I would say if a company is considering reincorporation, I would advise them not to treat it as a pure governance issue, because I think you need to be bringing your transactional lawyers, like the me in the room, your litigators, like Patrick, and your insurance advisors, like Joe. We should all be having this conversation together in the same room because I think the question of reincorporation touches on all three of these disciplines, so.}

_{0:46:51.9 PR: Good point. I don't want to step on your toes, but it does remind me of in law school, our tax professor said you should never make any business decision based solely on taxes. Don't make an investment based purely on saving money on taxes. So you're absolutely right. You have to look at the broader context.}

_{0:47:10.5 AT: I'm glad you agree with me, Patrick. [chuckle] Joe, same question to you from the insurance side.}

_{0:47:20.6 JS: Yeah, I guess three things from the discussion today. One is try to improve your D&O insurance policy. And I think there's a lot of people out there who think that policies can't be changed. So that's not the case. So you want to take advantage of the current market that we have and keeping in mind that these are really complex legal instruments at the end of the day. So you want to have a seasoned attorney review your insurance policies, see where they can be improved, look for gaps related to AI and cyber. Second is make sure that your policies are responding to your risks. So every single company is going to have a slightly different risk profile depending on the industry, depending on what they do. Consider how your policies are gonna, are going to respond to the risk that you actually face. And third, and this goes back to Patrick's point about indemnification, make sure that you're gonna have dedicated Side A coverage that isn't shared with the entity. And this is both when you don't have indemnification either because the company won't indemnify you or because the company is insolvent. And so you want to be protected under those situations.}

_{0:48:24.1 AT: Fantastic advice, guys. Any final thoughts before we wrap up?}

_{0:48:30.0 PR: Yeah, I guess I'd just say, I mean, having worked with and defended and frankly sued directors and officers over the last several decades, I would just emphasize that in this environment, being proactive makes all the difference. Directors and officers who get into trouble were passive or weren't paying attention or thought someone else was taking care of governance. Anna, there were a thousand companies that had some form of backdating of stock options. And the usual explanation was, "Well, that's how we did it at our last company." Well, that's not a prudent exercise of your governance obligations as a director, certainly, and not as an officer. So you can't assume that another board committee is handling governance or handling the issue of the day. You need to be aware of the risks, ask the questions, be proactive, and document the basis for your decisions. I think that's still the fundamental approach to stay out of governance trouble. And then when you do all those things and you still get sued, you gotta make sure you have the insurance, right, Joe?}

_{0:49:39.0 JS: And that's exactly what I was gonna say. And same basic advice, be proactive. Whenever you get something that smells like a claim or that is a claim, you're gonna want to go to Patrick first so you can make sure that you have your defense in place. But your second, the second thing you should do is make sure that you're considering insurance and making sure that you're evaluating coverage for any potential claim or claims.}

_{0:50:02.8 AT: Thank you so much, guys. I really enjoyed today's conversation and I hope our listeners did as well. To our listeners, whether you're in-house counsel, sitting on a board, or running a company, I hope this conversation gave you some concrete ideas for managing some of the risks we discussed. The landscape is shifting, as we discussed, but with the right corporate governance practices, the right insurance program, and the right advisors, it is possible to navigate this successfully. For additional information on this topic or other corporate transactional, litigation, or insurance matters, please visit our website at nossaman.com. And don't forget to subscribe to Corporate Conversations wherever you listen to podcasts so you don't miss an episode. Until next time.}

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_{0:50:51.1 S2: Corporate Conversations is presented by Nossaman LLP and may not be copied or rebroadcast without consent. Content reflects the personal views and opinions of the participants. Statements provided in this podcast are for informational purposes only, are not intended as legal advice, and do not create an attorney-client relationship. Listeners should not act solely upon this information without seeking professional legal counsel.}

In this episode of Corporate Conversations, Nossaman attorneys Nathan Guttman, Kimberly Kamkar and Patrick Richard introduce the basics of financial statements and how they function as both deal tools and litigation evidence. Our hosts walk through the balance sheet, income statement and cash flow statement, explain additional components like footnotes, management discussion and analysis and highlight key accounting and auditing standards (GAAP, GAAS, PCAOB, AICPA).

From the transactional side, the discussion focuses on how financials drive deal terms, including working capital adjustments and earnout structures. From the litigation side, it covers how those same numbers inform theories of liability and damages, what red flags to look for and how to work effectively with experts such as CPAs, forensic accountants, economists and auditors.

Lawyers don’t need to be accountants, but they do need enough fluency to read the “story behind the numbers” and know when and how to bring in the right experts.

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Transcript for Sandbagging: It's Not Just for Floods

_{0:00:00.1 Nathan Guttman: Financial statements are something most lawyers encounter, but we don't always stop to appreciate how powerful they are as tools. Today's episode is about financial statements, what they mean, how to read them, and why they matter so much in both transactions and litigation. We're focusing on the idea that the same set of numbers can tell very different stories depending on who's looking at them, a transactional lawyer structuring a deal or a litigator building a case.}

_{0:00:27.4 Speaker 2: Welcome to Nossaman's Corporate Conversations Podcast, where our corporate attorneys bring practical insights into the deals, disputes, and legal decisions shaping today's corporate world.}

_{0:00:41.3 NG: I'm Nathan Guttman, a commercial litigator here at Nossaman. I'm thrilled to have two guests with me today. First, Patrick Richard, a seasoned corporate litigator and co-chair of our corporate practice group, who regularly works with financial statements as evidence in high-stakes disputes. And joining him is Kimberly Kamkar, a corporate and M&A attorney who relies on those same financial statements to structure transactions, assess risk, and draft deal terms on the front end. Patrick, Kimberly, thank you so much for being here.}

_{0:01:12.0 Kim Kamkar: Great to be here, Nathan.}

_{0:01:13.8 Patrick Richard: Happy to be here. Looking forward to the discussion.}

_{0:01:17.2 NG: Let's start with the basics. When someone says financial statements, what are we actually talking about?}

_{0:01:24.9 KK: So I don't mind jumping in here and just starting us off. When I think of financial statements, I think of three big main statements. It's the balance sheet, the income statement, and the cash flow statement. And each of them tells... They kind of overlap, but they all tell a very different part of the story if you know how to read them. And if you don't mind, I'll just start with the balance sheet. It's kind of like a snapshot. Like when you take a Kodak photo and you just have this one image, it captures that exact moment in time. And so it's that company's financial health on that given day. So what assets it's got, what liabilities it has, its A/R, all of those amounts as of that date. The balance sheet lists out what the company owns, which can include all of its assets like cash, inventory, any money that's owed to the company, any equipment it has, if it owns cars or laptops, but also on the flip side, liabilities, so accounts payable and debt. And typically, the way you would read this is the difference between the assets and the liabilities would reflect the owner's equity in the company. And so if there's a positive difference, the owners have positive equity in the company. And if the difference is negative, then the owners are in the red and probably have to do some catching up. But if you want to know whether or not a company is liquid in the term that we usually think of that term, it means having enough assets to cover your debts. And you can kind of see that from this one balance sheet, but you're not gonna get any sort of a good picture on the overall health of the company or its trends or its ups and downs. That's not on this sheet.}

_{0:03:42.6 NG: If we do wanna see what you're talking about, how a company has performed over time, then which of those statements would you look at instead?}

_{0:03:51.0 PR: Well, and this comes up a lot in litigation, as you know, Nate, you're gonna want to be looking at the profit and loss, what we call the income statement. And that's where you're looking at the performance of a company over time. Quarter or annual profit loss statement. It's revenues in, expenses out, get to the bottom line. It's also where you can find a narrative, identify unusual expense patterns, and really start to dig into how is this company performing and how is it recording its financial transactions in its profit loss statement. So it's a key document in almost all commercial litigation. And we'll get into this in a bit, especially any case involving damages. Was there a profit? Was there a loss? Well, look in the profit loss statement.}

_{0:04:44.7 KK: Yeah.}

_{0:04:45.9 NG: Right. And then what about the third option, the cash flow statement? How is that different?}

_{0:04:53.5 KK: The cash flow statement is also a kind of recap. It tracks the actual movement of cash in and out of the business over a period of time. And it'll... When you're looking at the statement itself, you can generally expect to see sort of three buckets. The first one is the operating activities, so money in or out from daily core business operations. For example, you own a coffee shop, that would be the sales of coffees and pastries. It could also include payments to suppliers that are in the normal course, so buying nice Arabica beans, that would count in your operating activities. And the second bucket would be investing activities, so think of that as money spent or received from selling assets. And the third would be financing activities, so money in or out from funding sources. So think about taking loans or issuing stock or paying dividends. All of that will count under financing activities. One other key thing to mention here is that cash in and out is not quite the same thing as a profit. You can show that you're bringing in a lot of money but still be hemorrhaging cash. And so that's why it's really important to look at all three statements together, because it's really only together that you'll get a sort of whole picture of how the company is doing.}

_{0:06:39.6 NG: Beyond these big three statements that we've just covered, are there any other financial statements that our listeners should know about?}

_{0:06:47.9 KK: You can also typically see something like a statement of a stockholders' equity, which tracks changes in stockholders' equity over a given time, and also dividends and retained earning and all those fancy terms. There's also a lot of times a management discussion and analysis, which is like the narrative section of, if you've seen it in public company filings, it's basically where the company uses real words to tell you the story of how they are doing, the good and the bad. Patrick, did I miss anything?}

_{0:07:25.7 PR: I wouldn't say you missed anything, but if you're involved in litigation and you have a public entity, for example, that has the annual financial statement, that's gonna provide a lot more information than say a single-owned LLC or some other entity. And when you have the annual financial statement of a publicly traded company, you're gonna have footnotes that discuss the accounting policies, accounting standards, and that is often the first thing. If I can get financial statements with the footnotes, read those for really key information. Because the financial statements really tell you what the numbers are, the footnotes often tell you what the numbers mean. And depending on the dispute, that can be where you really find those nuggets. And when you're in deposition, you cover the footnotes. And early on in my career, I had a case where the whole case was about a footnote in a financial statement. And that was an eye-opener. I was just the junior associate, but the senior partner kept talking about total audit failure, you missed the footnote. So look at the footnotes.}

_{0:08:38.6 NG: Let's touch on another pretty basic idea, which is why are we looking at financial statements in the first place? What is it that we're trying to figure out when financials land on your desk, either in litigation or in transactional work?}

_{0:08:56.6 PR: Yeah, I mean, that's a good question, Nate. For me, the financial statements in commercial litigation is an important data point, either for liability, you're trying to understand what happened to this business because it's relevant, there's a claim involving management or mismanagement or breach of fiduciary duty, but also damages. And oftentimes when if you're the defendant and you're facing a claim of overblown damages because the expert's projecting very rosy performance, this would have happened but for the defendant's conduct, you look at past performance and you get a good expert to dig into the financial statements. So I break it into liability and/or damages. And there's just some basic level of familiarity that the attorney should have if you're doing commercial litigation. You have to know enough to know when do I need to bring in the expert. Obviously, you're gonna need a damages witness, but oftentimes it's the forensic accountant or others who can help you interpret those financial statements.}

_{0:10:10.5 NG: Yeah, I was just gonna ask on the transactional side.}

_{0:10:15.8 KK: Well, it's really similar to what Patrick was saying. When we do, for example, M&A deals, and I'll probably pick on M&A deals frequently in this podcast because I think it's a great example on the transactional side, we typically have accountants that we are working with to do a very detailed analysis of the financial statements. And my job as the transactional attorney is not to redo their work by any means. And as a transactional attorney, you don't need that much of a familiarity with the numbers. Our job is to translate those numbers into the actual deal terms. And so when we're looking at the financial statements, I'm looking at them trying to understand how they are going to impact risk allocation and enforceable mechanisms in the purchase agreement. I just want to walk through an example because I think take working capital. I think that's a great example. The whole point of a working capital mechanism is, I mean, at its core, it's to make sure that the buyer isn't handed a business on closing day that's been totally starved of short-term assets and it just doesn't have the cash to operate, right? So it has nothing on hand. So the parties agree ahead of time, we put it in writing that there's a target number, usually based on some kind of average that gets trued up to the purchase price. It's a funny mechanic. Basically what we're saying is this is the amount we are anticipating as working capital. We talk about working capital as this single term, but it's not a single number by any means. It's a defined formula built based off of the specific items that we pull out of the cash flow statement. So we can look at the cash flow statement to understand, for example, the accrual method or the inventory valuation calculation and use that to impact how we draft what specific numbers and line items will actually make up the working capital mechanism that we write into the purchase agreement. Does that make sense?}

_{0:12:45.5 NG: Yeah, and it sounds like something that could easily be disputed in litigation about a purchase and sale, right?}

_{0:12:54.1 KK: I'll leave that to Patrick.}

_{0:12:55.9 PR: Yeah, I mean, Kimberly's explanation is a little more complicated than what the simple trial lawyer has to deal with. I'm looking for who made the mistake, my guy or someone else. So for example, you can carry a short-term liability. It can have an impact, say, on a bank's balance sheet where what is the valuation of that asset? If you have loans for sale, you don't have to mark those down to market. If they're loans held for investment, what is their market value? And that should be accurately reflected on your balance sheet. A lot of banks had an issue where they were overstating their assets because they characterized those loans in a way that was favorable to the balance sheet. And then when the regulator said, "No, you have to reclassify it," then the bank was terribly undercapitalized. So it matters. We learned a lot about accounting standards and the mischief that can occur when a business changes its accounting standards that it uses in the backdating of stock options cases. Just because everyone was doing it doesn't mean it doesn't violate one or more accounting standards. So those are all issues that if you're reading the financial statements with an expert or with an expert eye, you're gonna learn things that other litigators will miss for sure.}

_{0:14:30.3 NG: And we've spoken about accountants several times now. Now that we've covered a little bit of the what of financial statements, I'm curious to know who prepares them.}

_{0:14:43.4 PR: Yeah, this comes up, Nate, in a lot of cases where you're talking to the company's accountant and they are quick to say, "Look, management prepares these." The outside accountant may just check the math. The auditor certainly does not prepare the financial statements. So understanding the difference between the internal accounting team and understanding the difference between what is the role of a bookkeeper versus a controller versus a CFO. Again, with public companies, you're gonna get into the standards under Sarbanes-Oxley and certification. It's obviously a serious, serious deal because investors and the SEC understand that financial statements are critical and they need to be accurate. For the litigator, you need to understand the different roles so that you're getting the terminology accurate. When you say "the accountant," do you mean the internal fellow, the controller? Do you mean the outside accountants? Do you mean the auditors? And pretty basic, but I'm always surprised at how many commercial litigators don't understand the difference between financial statements that have simply been compiled, reviewed, versus audited, and then what it means to actually audit financial statements. And so compiled is just you're formatting the numbers. Really no accounting expertise has been applied to those financial statements. Reviewed, there's some basic analysis, maybe a plausibility check, but the accountant's not gonna stand behind those. Again, well, management, this is what they delivered and 2 plus 5 was 7 and that's as far as I got. Auditing, yeah, there's supposed to sample and check, but it is a sampling. They're not a substitute for management. And there's... If you can get your hands on auditor work papers, there's a lot that comes out of that because oftentimes the junior auditors have analyzed something that doesn't quite show up in the final audit. So depending on your case, understanding the different roles and then the types of documents generated by each of those different types of accountants and different levels of review can be very, very important.}

_{0:17:03.9 KK: And to just piggyback on what Patrick said, you covered everything beautifully, so I'm just gonna pick up a couple small nits. Like there are a couple also different standards that you can look out for, accounting standards. So there's GAAP, which is not the same thing as GAAS, which is an auditing standard. Those are different terms. There's PCAOB, I think we all colloquially call it Peekaboo, which is the standards for public companies, and then AICPA is the standard for private companies. And I think that goes towards what Patrick was talking about with the working papers. These sort of set the rules for what you can expect to see within the statements themselves, and it sort of goes back to if you understand the equation, you'll understand the answer just a little better.}

_{0:18:02.3 PR: And just to piggyback on that, if you have a case where you're going to be deposing an auditor, understand the difference between GAAP, which are generally accepted accounting practices, and then asking the auditor, "What's the S stand for in GAAS?" Well, those are standards. "Oh, is that something that you should be held to? What are some of those standards?" The skepticism that an auditor is supposed to bring to their engagement. So once you know that there is something called GAAS, these auditing standards, then you review those, ideally with your own consultant or expert, before you start cross-examining the expert on the other side.}

_{0:18:41.4 NG: When these financial statements land on your desk in litigation, is there anything sort of pattern-wise that you're looking for or any approach you take to reading them?}

_{0:18:52.6 PR: I actually like to get financial statements. And I've been in cases where I was told that there were financial statements from co-counsel and then it turned out to be a rent roll or some monthly printout and they were not at all financial statements. And I'm like, "Well, where's the balance sheet?" "The what?" So one, I just want to make sure that I have a relevant time period of financial statements. And Kimberly will certainly certify that the more years you have, the more periods you have, then you can look for patterns. Simply having one year, in most cases, whether it's liability or damages, is not gonna tell you enough. So I start at a general level. What do I have? What time period's covered? And then I try to read through them, not quite like a detective reads a crime scene, but I look for anomalies and inconsistencies and spikes and just some questions that I can either go back to my client or go back to an actual expert and say, "Hey, I noticed this. Looks like the expenses, the general expenses here, were really growing." "Yeah, that's something we should look into. Let's get the further detail on that." So oftentimes it's just a starting point to point you where to look for further information.}

_{0:20:11.8 NG: Looking for patterns, are there particular red flags that jump out at you pattern-wise?}

_{0:20:16.6 PR: For sure. If you see a spike in revenue, often through changing how you account for something, you can either defer or speed up revenue. It can misrepresent the actual financial performance of the entity. So you look for changes in accounting policies. You also sometimes compare board minutes, if I have them, projections to look for differences. Cookie jar accounting is a classic. A company, maybe it's planning to go public, so it wants to have a nice, even trajectory of increasing revenues and increasing profits. And then you see that, well, that was really accomplished through changing accounting characterization. And the accounting characterization shouldn't be driving those things. It should be the actual performance. So it comes down to comparing the same category of expenses or revenue over time. And when you see things that don't match up, maybe revenue is up, but the AR is growing. Well, what's the story? So it's a way to... I don't draw conclusions necessarily. Those are gonna be for the experts, but it helps me start asking the questions and focusing in on what could be the problem areas.}

_{0:21:41.5 NG: That same first scan, Kimberly, would that be different for you than it would be for Patrick?}

_{0:21:48.3 KK: We really look for the same kinds of patterns, maybe just for different reasons. I think Patrick looks for evidence of wrongdoing, whereas when I'm looking at it from a transactional perspective, I'm looking at the risk factors that may one day turn into evidence, but they're not yet quite evidence. They're just risk factors that affect valuation or deal structure. So same camera, different lens.}

_{0:22:21.8 NG: Yeah. Do you have any examples?}

_{0:22:24.0 KK: We had a really interesting one recently. So let's talk about earnouts. We actually talked about earnouts on episode five of our podcast, so a little while ago. But if you haven't had a chance to listen, earnouts are basically a portion of the purchase price that depends on the target company hitting certain financial targets after closing. And the purchase agreement defines how that gets calculated. And to do that, we reference metrics like EBITDA and net revenue and gross profit so that we can set up the calculation to figure out whether or not the earnout has been earned. Just like with the working capital example from earlier, earnout sounds like a single number, but it's an abstract concept and we end up having to look for the key terms and we have to look for those patterns across the financial statements to be able to figure out how to build the earnout calculation. For example, if the earnout, if we want to say that the earnout is based on net revenue calculated in accordance with GAAP, consistently applied, I might dig into the discretion the company exercises in handling things like discounts. Well, I don't know that I would look into it. I would probably ask the experts to look into it. But the question I would ask is, does the company have any sort of discretion in things like discounts or returns, customer incentives, or anything that would increase the deductions that would sort of lower or raise net revenue that might artificially change the earnout, if that makes sense? If I was the buyer, just like Patrick said, we are looking at a large amount of data over a lot of numbers of periods, whether that's quarters or years, so that we can track historical operations and make sure that the earnout is in line with some average annual operation, whether you take the total of four years or the annualized of six months out of those four years or the average of those four, whatever you want to do. Just, it has to be some... There has to be a metric that we can measure against. And then we want to also make sure that we are accounting for variables that could artificially increase or decrease that number.}

_{0:25:21.0 NG: Something that I've heard a couple times now is both of you talking about basically what you don't know and how you handle that, either with experts or hired experts or the accountants that you work with. Can you talk a little bit more about how you handle dealing with what you don't know?}

_{0:25:42.2 KK: Just in case it's not obvious, I am not an accountant. I am a lawyer. And I would like to say that over time, I've developed a kind of working fluency with financial statements, and that lets me do my job effectively even if I'm not an expert in this. And part of that comes from the courses I took in law school on business law and tax and legal accounting classes. And part of it is, I think more of it really comes from a place of curiosity and a willingness to continue learning, even though I'm some number of years out of law school that I won't admit to date myself. And I think what comes with that also is a little bit of humility in knowing that you, at least I don't have all of the answers. And I need to just be willing to ask the right questions and be open to the feedback and the answers that I get. And I think that makes it a lot easier to do my job because my job is to know the deal. I'll know the purchase agreement inside and out. I will have read that thing a hundred times because that's my job. The reps and warranties that we build in, the protective indemnities, the mechanisms, how the purchase price is structured, that makes up the core of my job and the value that I can bring to the table in effectively drafting those provisions in a way that means both parties walk away from the table feeling like we've gotten the job done well. I do not need to be that familiar with financial statements because there are people who do have that familiarity. They do have that same love of their documents as I have of my documents.} 

_{0:28:09.2 PR: Yeah, that's not what we say in litigation, Nate. But no, the... I was listening to Kimberly and it is similar for commercial litigation. The pleadings are going to frame the issues and should provide a clue as to the role of financial statements. But I think for most litigators, financial statements are not top of mind. I was fortunate that I began working with someone and worked with them for decades who began as a litigator at the IRS. And he knew financial statements and kind of drilled into the lawyers that worked with him the importance of it. That's one way to learn is from a lawyer who actually understands the legal relevance of financial statements. The other is there's courses, take a course on financial statements for lawyers, some preliminary vocabulary that you become familiar with. For me, the best way is working with an actual expert: an accountant, a finance expert, an economist. All these professionals rely on financial statements for different purposes. And you can learn a lot if you ask the right questions and listen. So I don't pretend to be an expert on financial statements, but I do enjoy working with experts who are.}

_{0:29:35.2 KK: I think we said the same thing, Patrick. I'm just more poetic about it.}

_{0:29:41.5 PR: No comment.}

_{0:29:44.9 NG: The idea of experts has come up a bunch. They're obviously crucial. What kind of experts would you typically consult with?}

_{0:29:56.6 KK: Yeah, I think that depends on the question you're trying to answer, honestly. And I know everyone hates it when a lawyer says "it depends."}

_{0:30:06.9 NG: But it does.}

_{0:30:07.2 KK: It does. Not all accounting experts "are really doing the same thing". Some people use the term "forensic accountant." That's a really colloquial way of saying someone who is digging through numbers to figure out what happened in the past. That's different from a CPA, that is another type of accounting expert, and that's someone who's focused on compiling the financial statements in compliance with whatever standard they have decided to apply. And that's different from also a finance expert who's maybe putting a value or evaluating the risks, so putting a number to it. It really depends on the question you are trying to ask. You have to match your expert to your issue. Are you trying to understand how the numbers were prepared? Are you trying to figure out if the correct rules were followed and validate that they were followed correctly? Are you trying to quantify some kind of financial risk? I mean, there's more categories, but I think that gets to the heart of it.}

_{0:31:29.5 NG: Right, you need to know what questions you're asking.}

_{0:31:33.1 KK: Yeah.}

_{0:31:34.7 PR: Well, it's easier in litigation. It's either going to be relevant to liability or damages. And for damages, it's either going to be a CPA or an economist, but someone who has done it many, many times before and understands the interface between legal standards and accounting or economic standards. So for me, it's, well, if it's liability where I actually need to understand the accounting standards, was GAAS followed, if it was auditor, you know, the defendant or is it someone else, that really drives the expert. The one certainty I can... Almost every client does not want to bring in an expert too early 'cause they can be expensive and then they start looking at a bunch of documents. And yet, penny wise and pound foolish. The sooner you bring in a financial expert, either an accountant, preferably a CPA, an economist, personally I like finance experts because they understand risk and can often put things in a broader perspective. Bring them in early. They can help frame discovery, they can tell you where to look, absolutely integral when it comes to taking depositions of the other side. I mean, we haven't talked about this, but I had a case where I had to depose owners who were claiming that new regulations during COVID caused owners of apartment complexes that they lost almost all the value of their business. And when I got involved, we did not yet have the financial statements. And they hemmed and hawed and we finally got them and, wait a minute, you actually made more money. Apparently, the plaintiffs' lawyers hadn't looked at the financial statements before filing the complaint. It seems obvious that, get the financial statements and then line up the appropriate expert to help you interpret them. Anyone who's worked with me has heard me say, "Do not get out over your skis." People start making assumptions, lawyers get attached to their own view of the world. You need a good expert who can say, "I'm sorry, that's not what happened here. Follow the money."}

_{0:33:47.3 NG: And shifting topics to another recurring theme here, auditors. What do listeners need to understand about audits and auditors?}

_{0:34:03.7 PR: Yeah, again, in litigation, an audit is supposed to be a systematic examination by an independent third party. And rules have developed that, especially for public companies, the auditor cannot otherwise have an interest. "Oh, I'm also consulting. I also have this other role. I'm also on the board." Supposed to be somewhat independent. And I would say that that's improved over the last couple of decades since Sarbanes-Oxley. But an audit is not a guarantee, and the auditors will be the first to tell you, especially if they're the defendant. It's not a certification. We took a sample. We relied on management. I mean, you had a thousand companies, Nate, who had some form of backdating or misdating stock options. A thousand companies. The auditors didn't see it in any of them. The SEC did not go after a single auditing firm. They relied on them as experts to point the finger at management. Huge oversight. So don't assume that just because they're audited financial statements that the auditors caught everything. They most certainly didn't. But audited financial statements are certainly intended to be more reliable and generally are more reliable than just something that was reviewed or compiled.}

_{0:35:32.7 NG: But there are still practical limits there, right?}

_{0:35:36.4 KK: Yeah, I mean, of course. I think clients sometimes assume audited financials means the numbers have been verified down to every single penny. Unfortunately, they haven't. Auditors express their professional opinion based on their professional standards. It's valuable, but it's limited in that they're not looking at the whole situation with fraud in mind. They're looking at it within the scope of their actual engagement letter. So what's in the letter you guys agreed to? What did you ask them to look at? Did you ask them to look at 10% and to audit 10% of your records? Did you ask them to audit 50%? Did you ask them to look at specific transactions or with a specific issue in mind? That's what they're gonna look at is what you agreed to that's within and complies with their professional standards. If your CEO deliberately withholds information or lies to auditors, the auditors might not be able to catch it. That's not necessarily... I just don't want us to jump and say that's necessarily the auditor's fault. That's not really... The job they're out to do is to catch everyone in the act.}

_{0:37:03.9 PR: I'm thinking back, Nate, now that we're talking about it, I think it was in 2008 or '09, I wrote an article, "Where Were the Auditors?" and it was published in American Banker. So it gives you my perspective that I think they had a job to do. I think that often they turned a blind eye. But in terms of what you need to know about an audit, you get an audit opinion. Is it clean or unqualified? That means they didn't find any material issues. You have to ask what was the standard of materiality? Was it 5% or some other standard? Qualified opinion, that means the auditor flagged something. Adverse opinion, oh, the financial statements are materially misstated. They're probably not gonna get asked to do next year's audit. Disclaimer of opinion, the auditor just couldn't complete their work. That does come up where they didn't have sufficient information, they couldn't get what they said they needed from management. But anything other than a clean opinion is a red flag requiring immediate attention. I was thinking of a case where it wasn't... It was... You need to look for the initials behind the person's name, Nate. So if someone is a CFE, I had a case involving a CFE, Certified Fraud Examiner. Oh, again, there are standards, they're published. If you're looking for fraud, there are red flags. The auditor showed up, asked for receipts. "Oh, I'll get them for you next week." Large cash transactions. I mean, everything was a red flag. This involved, I think it was the Ray Wersching insurance brokerage. It's all public in a lawsuit from 20 years ago. But deposing a Certified Fraud Examiner in a case where they missed multiple red flags was, I'll say it was fun. But it started with understanding the standards that that professional was telling the world they understood. They just didn't deploy them in that particular engagement.}

_{0:39:10.2 NG: Let's wrap up as we're winding down with some key takeaways. Let's go around the table.}

_{0:39:16.4 PR: Well, I think the first thing is financial statements are not just numbers. They can often be evidence in your case. Certainly in depositions, they're gonna be key when you're talking to management. So they're not just numbers, they're evidence. You need to read the story behind the numbers. That would be my first takeaway.}

_{0:39:39.4 KK: First, I guess our second takeaway would be the deal documents and the financial statements, they are joined at the hip. They are two teenage girls constantly texting each other. The purchase agreement is a roadmap and the financials tell you how to get down it. They are gonna have... They have to inform each other, and so you do need to understand them both.}

_{0:40:09.7 PR: I would say another just basic thing for litigators, learn some of the terminology. Learn the difference between compiled financial statements, reviewed, and audited. And the limits and standards for each. That'll put you eons ahead of other commercial litigators or trial lawyers if you can start learning the vocabulary that applies to a lot of these things. And it starts with the level of review. They're not all the same.}

_{0:40:37.4 KK: Yeah, and I'll add my next takeaway is know what you know and know what you don't know and know that it's okay not to know what you don't know. You can always ask for experts to come in to support and to get to a finish line together.}

_{0:40:59.8 PR: Every litigator needs to know enough to know when to bring in the expert. And I've learned the hard way. You don't just rely on the damages expert and say, go calculate damages or go attack the other side's damages. You need to be expert enough to examine them and say, okay, I see you made this assumption. Why did you do that instead of this? What period of financial statements were you looking at? Did you look at the, which income statement? What years? What period? Simply abdicating to the expert you've hired without some scrutiny is, you can learn a lot from the experts, but total reliance is, I don't want to say malpractice, but not a good way to approach things. So learn from the experts, ask the questions, as Kimberly's talking about, and bring the expert in early.}

_{0:41:52.7 KK: You know, Patrick, I think you and I said the same thing again.}

_{0:41:57.0 NG: Yeah.}

_{0:41:59.7 PR: Except I was poetic this time.}

_{0:42:01.2 KK: I loved it.}

_{0:42:03.7 NG: That's a wrap on this episode of Nossman Corporate Conversations. I'd also like to thank our listeners for joining us on this episode. For additional information on this topic or other corporate transactional or litigation matters, please visit our website at nossman.com. And don't forget to subscribe to Corporate Conversations wherever you listen to podcasts so that you don't miss an episode. Until next time.}

_{0:42:27.7 S2: Corporate Conversations is presented by Nossman LLP and may not be copied or rebroadcast without consent. Content reflects the personal views and opinions of the participants. Statements provided in this podcast are for informational purposes only, are not intended as legal advice, and do not create an attorney-client relationship. Listeners should not act solely upon this information without seeking professional legal counsel.}

In this episode of Corporate Conversations, hosts Anna Tang, Doug Schwartz and Kimberly Kamkar explore the challenges of changing residency from high-tax states like California to low-tax states like Florida and Texas. They cover the legal steps needed to change domicile, the scrutiny by state tax boards and practical tips for genuinely severing ties with your former state. They also discuss the implications of potential new tax laws, such as California's proposed billionaires' tax. This episode provides essential insights for taxpayers contemplating a move to reduce their state tax burden.

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Transcript: Getting Out of (Tax) Dodge – Trying to Lose California and Other High-Tax-State Residency

_{0:00:00.4 Anna Tang: It's been all over the news lately. Taxpayers, from billionaires to just normal folks, are leaving high-tax or blue states like California and New York to take up residence in low-tax or red states like Florida and Texas. But blue states are not giving up without a fight and are telling these people, "You gave up residence here? Prove it." So if you're thinking of fleeing, you need to know what it really means to change residence and what a tax audit feels like. The bottom line is this: it's not easy.}

_{0:00:33.3 Host: Welcome to Nossaman's Corporate Conversations podcast, where our corporate attorneys bring practical insights into the deals, disputes, and legal decisions shaping today's corporate world.}

_{0:00:47.1 AT: Hi everyone, and welcome to the Nossaman corporate team's eighth podcast in the Corporate Conversations series. Today's topic is Getting Out of Tax Dodge: Trying to Lose California and Other High-Tax State Residency. My name is Anna Tang, and I am a former Australian tax lawyer turned US corporate and M&A attorney. I also co-chair the corporate practice group here at Nossaman LLP. With me today are two of my fantastic colleagues who have dealt with these issues for years, and even more so lately, it seems. Doug Schwartz is our federal and state tax expert. So he's been in the trenches advising clients on these issues for decades, even back when California was pretty much a red state. And Kimberly Kamkar specializes in business and nonprofit structures and the tax and governance issues that come with them. Doug and Kimberly, thanks for being here today.}

_{0:01:43.3 Doug Schwartz: Happy to be here, Anna. This is a topic that's near and dear to my heart, mostly because I've been at it for so long and seen so many people get it wrong.}

_{0:01:52.9 Kim Kamkar: And I'll add to that, Doug, it's one of those areas where people think they know a lot more than they actually do and think they can cut corners as a result. So hopefully we can clear up some of those misconceptions today.}

_{0:02:08.2 AT: So the title of our session is Getting Out of Tax Dodge: Trying to Lose California and Other Blue State Residency. So before we dive in, I just want to be upfront with our listeners. So this isn't a political commentary, and it's definitely not a how-to guide for tax avoidance, right?}

_{0:02:27.7 DS: Absolutely. Look, we're lawyers. We're here to explain the legal landscape, not to tell anyone what they should do. And honestly, one of the main themes today is that this stuff is hard. There are real legal standards here, not loopholes. If anyone tells you there's some clever trick to avoid state taxes, run the other way.}

_{0:02:48.5 KK: And again, I would add to that that the stakes are really high. And we're not talking about small penalties here. I know everyone hates taxes, but state tax agencies can come after you for years of back taxes and interest and penalties. They are just as scary as the IRS. And we've seen people who thought they'd "moved to Nevada" end up owing California millions of dollars.}

_{0:03:19.5 AT: All right, so let's get into this. Why are we talking about this now? I mean, people have been moving from high-tax to low-tax states forever, haven't they?}

_{0:03:29.7 KK: They have, but it's really accelerated in the last, say, 20 years. The gap between how blue and red states approach taxation has really just gotten wider and wider. And recently, there have been some major developments that have really put this on everyone's radar.}

_{0:03:47.9 DS: Yes. And let's walk through what's been happening. There are four big things making headlines right now. First, and this is huge, there's a proposed California billionaires' tax likely to make it on the November 2026 ballot. This isn't an income tax, it's a one-time wealth tax. 5% of your entire net worth if you're a billionaire living in California. They're still gathering signatures, but it's polling well. My gut says it passes. We'll talk more about this at the end of our session.}

_{0:04:20.8 KK: And I'll take the second one. This affects a lot of our East Coast friends is what's happening in New York City and state. Mayor Zohran Mamdani just got elected on a really progressive platform, and he wants to fund it with higher taxes. The problem he's facing is the state government in Albany controls a lot of the city's budget, and Governor Kathy Hochul isn't on board with big income tax hikes. So what is Mamdani doing? Well, he's looking at the things he can control, like property taxes and what they're calling pied-à-terre taxes.}

_{0:04:57.6 AT: Wait, what's a pied-à-terre tax? That's a fancy French term, so I know enough of French to know that that's not English.}

_{0:05:05.0 KK: Yeah. Well, it's really, it is a fancy way of saying a tax on second homes. So picture someone who used to live in Manhattan but moved to Florida and kept their nice, shiny, fancy apartment in New York City so they can come back for Broadway shows and museum openings. The mayor wants to hit those folks with a big tax for having that second home in New York.}

_{0:05:30.6 DS: And that's a clever move politically, right? Because those people can't vote in New York City anymore. They're Florida voters now. It's sort of like the hotel tax we always pay anywhere we go. Yes, we get irritated seeing that on our hotel bill, but what are you gonna do? We don't vote in that city. So the third development, and this has surprised a lot of people, Washington state passed an income tax. Starting January 1st, 2028, if you make over a million dollars in Washington, you're paying state income tax. That's a big deal because Washington was one of the last holdouts alongside Florida, Nevada, Texas, and a few others. Massachusetts also implemented a surtax on millionaires in 2023, Maine did so this year, and Illinois is eyeing something similar for their November ballot. But those have always been high-tax states.}

_{0:06:23.0 AT: So, Doug, what you're saying is that the no-income-tax club is essentially getting smaller.}

_{0:06:28.5 DS: Exactly. And that brings us to the fourth thing. The high-tax states are fighting back. They're not just watching people leave, they're trying to make it harder to go. Governor Hochul in New York has proposed an exit tax. Think about that for a second. A tax for leaving.}

_{0:06:45.2 KK: Yeah. It is really starting to feel like the beginning of a tax war between the states.}

_{0:06:51.3 AT: That's right. Each state is trying to sound like their own country, imposing taxes. Exit taxes is basically what people would think from a federal jurisdiction. So I see what we're saying is that we've got all this pressure building up. Where are you seeing people actually leaving to?}

_{0:07:08.3 DS: Well, the big three destinations are Florida, Nevada, and Texas, the biggest states that still have no income tax. And here's the interesting part. Those states are protective of the people who move there. If California or New York tries to chase someone down in Florida, Governor DeSantis isn't gonna just roll over. Neither is Governor Abbott in Texas. There's real political resistance to letting the high-tax states reach across borders.}

_{0:07:34.9 KK: And California tried something like this many years ago when it tried to tax the pensions of former California residents who had long since left for Florida. And Florida basically told the California agencies to pound sand, and you know there is a lot of sand in California and Florida. And Congress, in response, eventually passed a law saying that states could not do what California was trying to do. The law is basically like a political shield, saying if you move to Texas or Florida, you've suddenly got a whole state government that has your back if California or really any other state—but what other state does this? Comes knocking.}

_{0:08:21.0 AT: So that's really interesting. Okay, let me ask what might be a naive question, but I think one that a lot of listeners are probably asking right now. So we have the Internal Revenue Code for federal taxes. And I know the IRS has specific tests for when someone is a tax resident of the U.S. Don't the states just follow the same rules?}

_{0:08:45.3 DS: You'd hope so, right? But no. The federal tests are actually pretty clear. If you're a non-citizen, you're a tax resident if you have a green card or you spend a certain number of days physically in the U.S. over a three-year period. But states, they do their own thing entirely.}

_{0:09:04.3 KK: And importantly, states like California and New York use this concept called "domicile". And the feds just don't use that concept. And I'm sure we'll get into the concept of domicile later, especially at the end when we talk about the proposed California billionaires tax, but it's a really big deal for understanding how many states think about residency and whether a person is a resident of that state.}

_{0:09:36.6 AT: Okay, so this sounds already much more complicated than I'd hoped and what I'm used to as an Australian. But at least the states are consistent with each other, right? So if you're not a California resident, that means something similar to not being a New York resident, right? I mean, I would assume.}

_{0:09:55.8 DS: Anna, I hate to keep sounding like Debbie Downer here, but also no. There's no agreement between states to make their tests consistent. And honestly, why would there be? Each state's goal is to collect as much revenue as possible, not to make life easier for taxpayers.}

_{0:10:14.4 KK: Yeah, the goal is never easier for taxpayers. Really, as long as a state isn't violating the Constitution, so think big picture, like due process, interstate commerce, the feds will pretty much let states do whatever they want. And that creates real headaches for the real people who have to actually file their taxes. Because you... And you may have saw this coming, but you can literally be claimed as a tax resident by two different states at the exact same time. And guess what? It's on you to figure it out.}

_{0:10:51.0 AT: So let's make this a little bit more relatable to our listeners here. Let's talk about an example of how states approach this. We've discussed quite a bit about New York City and State. How do they determine tax residency?}

_{0:11:04.1 DS: So New York State determines tax residency two ways: domicile in the state, again, that word domicile, or statutory residence. That is, you have a permanent place of abode in New York State, think back to the pied-à-terre that Kimberly discussed earlier, for over 10 months, and you spend 184 days or more there during the year.}

_{0:11:28.4 KK: And New York City has the same rules, which makes sense if you think about it, because otherwise someone could be a tax resident of the city and not the state.}

_{0:11:39.9 AT: All right, so let's turn to California, where all three of us are based, because that's also in the news and it's also where we are. Doug, before we get into the actual residency tests, can you give our listeners a sense of who's involved when there's a residency audit? I mean, what agencies are we dealing with here?}

_{0:11:59.3 DS: Sure. So your first contact is going to be with the Franchise Tax Board. Everyone calls it the FTB. They handle all income taxes in California: individuals, corporations, trusts, everything. When you get that first pay us notice, it's gonna be from the FTB.}

_{0:12:17.4 KK: And I should mention, once the Franchise Tax Board, the FTB, starts an audit, they basically never say, "Oops, our mistake, sorry to bother you." It's just not how it works. And this is really important: the taxpayer bears the burden of proof with the Franchise Tax Board. So you have to show that the FTB is wrong by this standard called preponderance of evidence, which basically means you need to be 51% in the right. And ties, 50%, goes to the Franchise Tax Board.}

_{0:12:56.7 DS: She's not wrong. But here's the good news: if you disagree with the FTB, you can appeal to something called the Office of Tax Appeals, or the OTA. That's an independent panel of tax experts, and I have to say they're pretty fair. They'll rule for the taxpayer when the facts support it, and they'll rule for the FTB when the facts support that. It's a neutral, non-political forum.}

_{0:13:20.7 AT: But what if the OTA rules against you, Doug?}

_{0:13:23.8 DS: Well, then you go to California Superior Court, but there's two catches. Number one, you have to pay the tax, then sue to get it back. Number two, the judge and his or her clerks usually will not have any tax expertise at all.}

_{0:13:39.1 AT: So that all sounds pretty stressful. I'm imagining these audits can get pretty intense.}

_{0:13:46.1 DS: Oh, intense doesn't even begin to cover it. Depending on who you are and how much money is at stake, a residency audit is like a full-body search at airport security, except instead of 20 minutes, it lasts for weeks. The FTB will look at everything. They'll interview your neighbors, they'll interview your veterinarian, they'll pull credit card receipts and phone records. If you claim you weren't in California on a particular day, but you stopped in Barstow on your way to Vegas and bought a Slurpee with your Visa card, trust me, they will find that receipt.}

_{0:14:19.6 KK: Yeah, Anna, Doug's not exaggerating. We have two real stories that will show you sort of just how far the FTB will go. The first is Gilbert Hyatt. He was an inventor and entrepreneur who moved from California to Nevada back in 1991. He was about to get a really big payout from microprocessor patents, and he wanted to avoid California taxes. The Franchise Tax Board came after him saying, "Not so fast, you're still a California resident." And they came after him for millions. And here is where it gets crazy: the Franchise Tax Board agents actually went to his house in Nevada without a warrant, and they dug through his trash. They literally went dumpster diving looking for evidence.}

_{0:15:11.8 AT: That's crazy. I mean, they must be taking their job so, so seriously to be willing to go dumpster diving. I mean, you must be making this up.}

_{0:15:21.1 KK: I wish I were. I don't know that I would go dumpster diving for my job, but the Franchise Tax Board really did. Hyatt ended up suing the Franchise Tax Board for harassment and invasion of privacy, and in 2008, a Las Vegas jury initially awarded him about 388 million in damages. But it took years of more litigation and took multiple trips to the US Supreme Court, the actual Supreme Court of the United States and eventually that award got reduced significantly. But the record confirms what the Franchise Tax Board did, including the dumpster diving. So we're not pulling this from some random anti-tax blog; this is part of the opinion and record of the U.S. Supreme Court.}

_{0:16:15.2 DS: And here's my favorite story. Or maybe favorite isn't the right word. There was a couple who lived in northern New Jersey but loved the Manhattan scene: Broadway, museums, nice restaurants, all that. So they kept a studio apartment in Manhattan. Believe me, it was tiny. They'd drive in the city, do their thing, stay overnight, and drive back the next day. The New York tax authorities claimed they spent enough time in the city, remember, the test is 184 days or more to be taxed as residents.}

_{0:16:46.7 AT: So what was their basis for taking that view?}

_{0:16:52.0 DS: Based on their E-ZPass. They had one of those electronic gizmos on their dashboard so they wouldn't have to stop at the toll booths at the Holland and Lincoln Tunnels. The tax authorities got those records and knew exactly when they entered and left New York City. And here's the kicker: if they went on Saturday evening and they came out Sunday morning, that counted as two days, not one, towards the 184 days, even though less than 24 hours had passed.}

_{0:17:21.9 KK: The lesson there is assume that everything you're doing is being tracked, because it probably is. This was years ago, and GPS on phones and other electronic conveniences have just gotten better and better at tracking people, and this is one of the downsides of that.}

_{0:17:42.1 AT: I want to go back to your New Jersey story. So New Jersey is also a high-tax blue state, right? So why would New York even care about claiming these people?}

_{0:17:53.7 DS: Well, that's a great question, and it shows how irrational this can get. Remember what I said earlier: a state's goal is to squeeze revenue, not to make the system make sense. There are these multi-state metro areas, for example, New York, New Jersey, Connecticut; Pennsylvania, New Jersey; Wisconsin, Illinois, Indiana, where commuters constantly cross borders. Usually the state tax agencies duke it out and figure out who files where, but nobody coordinates to make it easier or fair for the taxpayer.}

_{0:18:26.5 KK: Yeah, and I guess we're a little lucky because California is actually different because our big metro areas aren't near any state borders. The closest thing we have is Incline Village in Lake Tahoe, which is right on that Nevada line, but that's not anywhere near the size or population. And I guess a lot of people who do end up fleeing California try to set up residency in Nevada, but since Nevada has no income tax, there's no competing state agency. So it's just you versus the Franchise Tax Board, and trying to convince them you really live in Nevada even though you are a stone's throw away from California is a little bit difficult.}

_{0:19:12.8 AT: So let's talk about what this means in practice. So what's actually at stake here? So, if you successfully stop being a California resident, what does that actually mean? So, do you just stop paying California taxes entirely?}

_{0:19:26.4 KK: Not exactly. And this is a good question because this distinction is really important. Becoming a non-resident doesn't mean you're totally free of California taxes. You still have to pay California tax on what's called California-sourced income. So things like rent from California property, or gains from selling California real estate, or money from services you perform in California, or business income that flows through partnerships or LLCs based on how much business activity they had in California. I'm hoping you see a pattern.}

_{0:20:06.7 AT: Yeah. So what you're really saying is it's where the money comes from, not necessarily just where you live.}

_{0:20:13.9 DS: Exactly. Let me give you a concrete example. Say someone wants to leave California before a big payday. If it's an asset sale of a California-based business or you're selling California real estate, moving to Texas doesn't help you. That gain is still California-source income and you're still paying California taxes on it.}

_{0:20:34.9 KK: But Doug, and this is where it gets interesting, if the event is something like selling founder's stock in a tech startup, for example, then terminating California residence can actually potentially avoid California taxes. And I know this is a little confusing, but the key is that the move has to be completed and, I'm gonna steal one of your phrases, Doug, old and cold before the sale happens. So if you leave California the week before your startup gets acquired for 500 million, the Franchise Tax Board is absolutely gonna challenge that, especially if the deal terms were already negotiated before you moved. That... Honestly, that's waving a red cape before a bull as far as the Franchise Tax Board is concerned. But you'll have a much better chance of successfully making that argument if your move out of California took place long before that deal was ever thought of.}

_{0:21:35.4 AT: Okay, so this is all really helpful context. Let's move on and dive into the actual legal tests now. So how does California decide if you're a tax resident of California?}

_{0:21:48.6 DS: So there are two ways California can claim you as a resident. And this is where the concept of domicile comes in. Lord knows we talked enough about domicile, so let's try to define it. First, you're a resident if you're in California for other than a temporary or transitory purpose, even if you're technically domiciled somewhere else. So even if your domicile is Nevada, if you're spending all your time in California, they can still get you. Second, you're a resident if you're domiciled in California, even if you happen to be physically outside California for some temporary purpose, like a work assignment abroad.}

_{0:22:27.2 AT: Okay, Doug, you said that you would define domicile, but you didn't do that. I think it's now time to let everyone in on the secret and let us know what it actually means. So I know what it means in plain English, but what does it mean legally for tax purposes?}

_{0:22:41.5 DS: Yes, so let's define it now. Legally, domicile is your fixed home, the place you ultimately return to after trips for business or personal reasons. Think of it as your home base, or think about it as the place you would return if, say, you were on a cruise for several months on the high seas. And here's the critical part: you can only have one domicile at a time. So if you establish a domicile in California, you can't just say, "Now I also have a domicile in Nevada." You have to actually change your domicile from one place to the other.}

_{0:23:17.9 AT: And I'm guessing the FTB doesn't make that change easy.}

_{0:23:22.6 KK: That was a great guess, Anna, 'cause you guessed right. Once you're domiciled in California, the Franchise Tax Board's determination that you're a resident is presumed correct. You have to prove them wrong. The burden is on you. And as I said earlier, ties go to the Franchise Tax Board, so you really have to make your case.}

_{0:23:44.2 DS: And here's the key thing: this is all based on facts and circumstances, not what you say you intended. You can tell the FTB, "I intended to move to Nevada," until your voice is hoarse, but if your actions say otherwise, that's what matters.}

_{0:24:00.4 AT: Okay, so let's say I'm a California resident, which I am, and I want to change my domicile to Nevada or Texas. Kimberly, what do I actually have to do to make that happen?}

_{0:24:13.5 KK: Well, first, and this is big, you do need a new home in the new state. And ideally you own it rather than you rent because that shows commitment. You've put down a down payment, you've taken out a loan, it's a bigger deal. Second, and this one is also pretty big, your California home cannot be available to you. You can't keep it sitting there so that anytime you're in town you can just stop by, take a nap, grab a coffee. You have to either sell it or rent it or just make it unusable for yourself.}

_{0:24:51.9 DS: And it's not just the house. Your stuff has to move too. Clothing, furniture, artwork, personal belongings, they all need to go to the new home. If there's not enough room, put things in storage, but make sure the storage facility is in the new state, not California.}

_{0:25:09.4 KK: And if that doesn't sound like enough of an administrative headache for you, now come the lifestyle stuff, because this can be a long list. Your spouse and kids should move with you because, again, that shows commitment. The kids should be in local schools showing intent that you do not intend to move back. You gotta redirect your mail, get a new driver's license, reregister your cars and boats if you have them in the new state, open bank accounts locally, register to vote in the new state. If you have any spare time and you like to do these things, join local clubs, churches, gyms, whatever makes sense for your life. The big lifestyle things, because the goal is to show that you're actually living a life there and you're building a life there. You're not using it just as a tax address.}

_{0:26:06.1 DS: And get local doctors, dentists, accountants, lawyers, all of that. It sounds like a lot, and it is. But remember, the FTB is going to look at all of this. They want to see a real move, not just a paper move.}

_{0:26:21.7 AT: So you really do have to cut ties and really have to mean it.}

_{0:26:25.2 KK: There's no way around it. You've gotta mean it.}

_{0:26:28.5 AT: All right, so let's say someone does all of this. Moves, sells their California house, registers to vote in, say, Texas, the whole shebang. I'm guessing California still has tricks up its sleeve, right?}

_{0:26:42.1 DS: Oh, yeah. Even if you successfully change your domicile, you still have to be careful about how much time you spend back in California. If the FTB decides you're in California for other than a temporary or transitory purpose, as I said earlier, you're a resident again, even if you're domiciled elsewhere. And here's the magic number. Under FTB regulations, if you're in California for more than nine months in a tax year or calendar year, there's a rebuttable presumption that you're a California resident.}

_{0:27:14.7 AT: Rebuttable. So basically you're on the back foot again. You're the one that has to argue against it.}

_{0:27:20.3 DS: Theoretically, yes, but in practice, that presumption is almost never overcome. So rule number one: don't be in California for more than nine months during the year.}

_{0:27:31.5 KK: But I'll add to that, Anna, staying under nine months doesn't automatically make you safe either. There's no corresponding presumption of non-residence. So the question then comes, what can you do in California without triggering these types of problems or inquiries? Well, coming back as a tourist, visiting friends or family for short periods, that should all be fine. But the key there is that you actually have to act like a visitor. So visitors stay in hotels, they crash with friends for a few days. They definitely don't have a fully furnished house or apartment just waiting for them whenever they feel like it.}

_{0:28:17.7 DS: Yes. Having a vacation home in California after you've gone through all the trouble of moving your domicile, that's asking for trouble. The FTB will look at that and say, "Why'd you keep this place if you're really a Texas resident?"}

_{0:28:31.1 AT: So this raises a practical question. A lot of people who leave California, they will still have business or property here, right? So what if you're a non-resident but you still own, say, an apartment building in LA, or you've got a consulting business with California clients? I mean, just simply saying you've got to cut ties it's not as simple. How do you manage all of that without accidentally becoming a California tax resident again?}

_{0:28:59.2 KK: That is a really great question, Anna. And this is where it gets a little sticky. If you have a California business, you need to find a way to run it without being here constantly, basically, is our response. That might mean delegating to trusted employees or partners who can handle the day-to-day operations so you don't have to visit that apartment building every day and fix the plumbing yourself. But I understand some businesses are harder to do that with. Like if you're a doctor or lawyer or architect who actually does need to be face-to-face with clients, that can be really tough. But if you've got a more turnkey operation, so a store, a manufacturing facility, something like that, it's a lot more doable.}

_{0:29:48.3 DS: And the good news is technology helps a lot here. Video conferencing, email, remote collaboration. Courts have recognized that you can supervise a business virtually without its counting against you for residency purposes. So use Zoom, use Teams, use whatever. If you do have to come back to California for business, keep the trips short and, as Kimberly suggested earlier, stay in hotels, not a company apartment.}

_{0:30:16.7 KK: Yeah. And the same idea applies to investment real estate. Owning apartment buildings in California doesn't automatically make you a resident. So it's about how involved you are. If you're constantly coming back to deal with the tenants and supervise repairs and be hands-on with everything, that looks like you're here for more than a temporary purpose. But if you hire a property manager and you visit occasionally and head out, that's different.}

_{0:30:48.3 AT: So essentially the message that you're trying to convey here is to delegate and keep your distance.}

_{0:30:55.7 DS: Exactly. If someone absolutely insists on being hands-on with California property, they should think about selling the California property and buying something in their new state, maybe even through a 1031 exchange to defer the taxes. That's a whole different subject, but that might be a strategy to cycle out of your California real estate into, let's say, Nevada or Florida real estate.}

_{0:31:19.0 AT: So I think we need to be sensitive about this or realistic about this. So we're talking about flesh and blood human beings with obviously their lives. Are we really saying that to cease to be a California tax resident, they need to pull their kids out of their school, drop all of their trusted doctors and CPAs and other professionals, so the whole shebang? I mean, that's a lot to ask for.}

_{0:31:47.4 DS: Well, Anna, in a word, yeah. This all points to the process not being a paperwork exercise or magic trick. You need to be frank with yourself and your family about whether you really want to move, whether it's worth the tax savings, and whether being angry with the California tax system is enough reason to disrupt you and your family's lives.}

_{0:32:09.4 KK: Of course, on the flip side, sometimes you just can't get to 100%. There just is no such thing as perfect. We're human. So if you, for example, have a doctor that you really like in California for a continuing condition and they know your history and you want to continue using them, you can, and you should be able to. You just have to have a really good explanation to the Franchise Tax Board for why you're continuing to use them despite having moved. And on the flip side of that, you gotta actually be able to prove your other factors even stronger to show the Franchise Tax Board, no, this is my only link. And when you are cutting your other ties to the state, in a lot of cases, it actually is a little more logical to go with local folks. For example, if you're moving to Florida, why wouldn't you, say, get a Florida-based attorney to redo your wills and trusts and other estate planning documents based on local Florida law? So there's a little bit of gray area, there's a little bit of flexibility, but you just have to consider that California is a community property state and Florida isn't, for example.}

_{0:33:28.1 AT: Yeah, I get that. Obviously if you're living in Florida, you want your wills and estate planning documents to be compliant with Florida law as opposed to California law. So that makes sense. I have another practical question. So I'm guessing most people who move out of California, they don't necessarily plan to move on New Year's Day. So what if you leave, say, in the middle of the fiscal year, say June? How does that work in terms of your taxes for that year?}

_{0:33:57.9 DS: Good question. When you move mid-year, you'll file what's called a part-year resident return, a California 540 for part of the year you were a resident and a 540NR for the non-resident portion. But remember the nine-month rule. If you're in California for more than nine months total, they'll treat you as a resident for the whole year. So if you want to establish residency that calendar year, you need to be out by the end of March at the latest.}

_{0:34:24.1 KK: Here's a fun twist to add to that. And by fun, I am being ironic. California doesn't just look at your actual income during your residency period and apply normal tax rates, because of course that would be too easy. No, they annualize your income. Basically, they project it out for a full year and then they apply the highest applicable rate and then they prorate that tax based on how many days you were a resident.}

_{0:34:54.5 AT: Of course. So they're basically squeezing as much tax out of your time as possible.}

_{0:34:59.7 DS: Exactly. California will find a way to hit you with the highest possible rate, which, by the way, tops out at 13.3%. That's among the highest in the country. As we said earlier, a state's goal is to get as much revenue as possible, not to be "fair".}

_{0:35:17.5 AT: Sure does sound that way, Doug. Okay, I think we're running short on time, but I want to make sure we come back to something that we mentioned at the beginning of today's podcast: the proposed California billionaires tax on the November ballot. Kimberly and Doug, can you tell our listeners more about how that would actually work?}

_{0:35:38.9 KK: This is an interesting one. The proposed tax would be considered a one-time 5% levy on the net worth of billionaires who are California residents. And we're, I mean, we're talking total wealth, not just income, but the value of everything you own.}

_{0:36:00.2 DS: And here's the kicker. If the tax passes this November, then it applies retroactively to any billionaire who was a resident of California at the start of 2026. In other words, the sponsors say, "Are you gonna leave California this year to avoid the tax? Forget it." We mentioned earlier that the U.S. Constitution limits a state's tax reach, and there are a host of constitutional issues here in trying to tax someone who has legitimately left California before this thing becomes law. Plus, this brings up the issue we raised earlier about California trying to collect from people who have left. Again, Florida or Texas are not likely to tell California, "Oh, you want to come to collect from our billionaire residents? Come on down." That's not gonna happen.}

_{0:36:49.4 KK: Yeah, and if you think Florida and Texas are not happy about this, you can just bet the billionaires are definitely not thrilled about it either. There's been a real battle of the initiatives, as we sometimes call them. Folks like Sergey Brin from Google are reportedly raising around, I think it's around 80 million right now to push competing ballot measures that would make it harder to create new taxes. Eric Schmidt, Michael Moritz, Chris Larson from the crypto world, also, they're all backing initiatives to put the brakes on this too.}

_{0:37:29.1 AT: And this is all going on the same ballot?}

_{0:37:32.9 DS: That's right. And the initiative with the most yes votes prevails. It's like Thunderdome, but with five fighters, not just two. It's going to be an interesting November. And you can bet that if the wealth tax passes, we're gonna see a whole new wave of residency changes or attempted changes by people who suddenly have a very strong incentive to not be California residents any longer.}

_{0:37:57.4 KK: Honestly, and that's why we might be seeing a lot more aggressive enforcement by California tax agencies coming up. They're, I mean, they are not gonna let billions of dollars walk out the door without a fight. The litigation is going to be endless.}

_{0:38:15.7 AT: Wow, it really does feel like we're just about to enter a new era of state tax competition and all states are fighting it out. Do we have any final thoughts for our listeners?}

_{0:38:27.5 DS: I'd just say don't try to wing this. If you're seriously thinking about changing your residence for tax purposes, work with professionals who know this area. The stakes are high, the rules are complicated, and the FTB is watching.}

_{0:38:42.2 KK: And as we said before, we're all human. So be honest with yourself about whether you're really ready to move or whether your family is able to move. This can't be a paperwork exercise, and it's okay to take a stock of everything going on and make the decision not to do this because it's a huge life change. If you aren't willing or able to build a life somewhere else, don't go through the pretense of trying to build one anyways. The Franchise Tax Board will figure it out, and it will be a very expensive enterprise.}

_{0:39:29.7 AT: So if I'm hearing you guys correctly, the bottom line is this: losing California tax residence isn't a case of Hotel California where you can never leave, but it does require real commitment and real planning. And the tax result has to match your actual life. On that note, I want to thank Doug and Kimberly for joining me today. This was incredibly informative. Thank you. And thank you to all our listeners for tuning in to this episode of Corporate Conversations. For more information on this topic or other corporate matters generally, please visit our website at nossaman.com. Don't forget to subscribe wherever you get your podcasts so you don't miss an episode. Until next time.}

_{0:40:16.7 H: Corporate Conversations is presented by Nossaman LLP and may not be copied or rebroadcast without consent. Content reflects the personal views and opinions of the participants. Statements provided in this podcast are for informational purposes only, are not intended as legal advice, and do not create an attorney-client relationship. Listeners should not act solely upon this information without seeking professional legal counsel}

In this episode, Anna Tang, Nathan Guttman and Kimberly Kamkar tackle one of the most hotly negotiated provisions in M&A: sandbagging – what happens when a buyer closes a deal knowing that a seller’s representation is false, then sues over it. They break down the three competing legal philosophies that courts apply and take listeners on a state-by-state “legal road trip” through Delaware, California, New York, Texas and Nevada to explore how each jurisdiction handles sandbagging. Along the way, the conversation unpacks the critical contract drafting strategies that buyers and sellers should deploy, from defining "knowledge" to choosing governing law, and explains why silence on sandbagging is an invitation to expensive litigation. Whether you are a buyer or seller, negotiate deals, litigate post-closing disputes or simply want to understand the provision that can make or break an M&A transaction, this episode is well worth a listen.

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Transcript for Sandbagging: It's Not Just for Floods

_{0:00:00.6 There's a fine line between fair play and aggressive tactics when it comes to risks, promises, and surprises in mergers and acquisitions. Should a buyer be allowed to close a deal despite knowing a seller's representation is inaccurate and later sue for damages? Or is the buyer effectively waiving recourse by moving forward with eyes wide open? These are the pivotal questions that sandbagging raises, and state laws, differing judicial philosophies, and contract language all impact the answer.}

_{0:00:31.4 Welcome to Nossaman's Corporate Conversations podcast, where our corporate attorneys bring practical insights into the deals, disputes, and legal decisions shaping today's corporate world.}

_{0:00:44.4 Welcome to Corporate Conversations, where we break down the most important and sometimes the most contentious issues in today's corporate landscape. I'm your host, Nathan Guttman, a litigator here at Nossaman, and I'm joined by two of my corporate transactional colleagues. First up is Anna Tang, a leading corporate and M&A lawyer and co-chair of Nossaman's corporate group.}

_{0:01:06.3 Thanks, Nathan. Happy to be here.}

_{0:01:08.8 And Kimberly Kamkar, who specializes in for and nonprofit formation and governance and commercial transactions. Kimberly, great to have you.}

_{0:01:17.5 Thanks, Nathan. Really excited about this one.}

_{0:01:20.6 Okay, so today we're tackling a topic that comes up in virtually every M&A transaction, but it's something that even experienced dealmakers might not fully appreciate until it bites them. We're talking about sandbagging. And no, this has nothing to do with floods.}

_{0:01:35.2 Although, Nathan, there is a certain flood of litigation that can come from getting this wrong. Right?}

_{0:01:40.6 Very true. So, Kimberly, let's start with the basics. What is sandbagging in the M&A context?}

_{0:01:47.4 Sure. So "sandbagging," in M&A, is when a buyer closes a transaction even when they know or have really good reason to think that some of the seller's promises about the business, which we call in legal jargon, reps and warranties, and we'll use that term throughout, aren't accurate. Then after closing, the buyer turns around and sues the seller over those broken promises.}

_{0:02:13.4 So the buyer knows there's a problem, closes the deal anyways, and then sues?}

_{0:02:18.1 Yeah, exactly. Sandbagging gets its name from the idea that the buyer is hiding a weapon, like a giant bag of sand, and really only pulls it out and hits the seller on the head with it after the deal closes.}

_{0:02:31.3 Nathan, I think the best way to make this relatable for our listeners is the termite example, which I really love and I think is very appropriate. So imagine you're buying a house, you do the inspection, and the inspector finds termites. The seller had represented the property was free of termites. But you see the termites, you know that there are termites, and you even have an inspection report noting all the termite damage. But you love the house and you close on it anyway. And then after you have the keys, you turn around and sue the seller over the termites.}

_{0:03:06.0 As a litigator, I can appreciate that dispute. On one hand, the seller's representation was false, but on the other hand, the buyer saw the termites and went ahead anyways. Should the buyer be able to recover? Is the seller being ambushed?}

_{0:03:19.1 Yeah, and that's the million dollar question or billion dollar question, depending on the deal. The answer really depends though, on what approach you take and which state's law governs.}

_{0:03:32.3 Right. I think people sometimes underestimate how much this issue matters. So this is one of the most heavily negotiated provisions in any M&A purchase agreement. Entire deals can swing depending on how this issue gets resolved.}

_{0:03:47.9 Let's get into that. What are the main ways that courts resolve the issue?}

_{0:03:52.5 Nathan, there are essentially three main schools of thought on sandbagging. And to make this a little bit more memorable, we've given some of them fun nicknames. So the first philosophy is the pro-sandbagging philosophy. And if we were to choose an animal mascot for this philosophy, then it would be our friend the shark. So under this view, reps and warranties serve as a risk allocation mechanism between buyer and seller. So the buyer's job in negotiating the deal is to allocate risk, and the seller's job is to stand behind its reps and warranties. If the seller makes a promise and breaks that promise, then the seller pays. End of story. So it doesn't matter whether the buyer knew or relied on that particular promise before closing.}

_{0:04:39.5 So the shark just wants to eat. A deal is a deal?}

_{0:04:42.7 Exactly. The shark says you made a rep, you broke that rep, you pay for it, period.}

_{0:04:50.6 Number two is the anti-sandbagging approach. The animal mascot here would be the big protective mama bear. And this is the complete opposite to the shark that Anna was talking about. Under this approach, the buyer has to show they actually trusted and relied on the seller's promises in order to recover damages. So going back to Anna's example, if the buyer saw those termites and knew the seller's promise wasn't true, then the buyer can't also claim it relied on the rep and recover damages.}

_{0:05:23.7 The mama bear is protecting the seller from a buyer who knew exactly what it was getting into?}

_{0:05:28.6 Yeah, the mama bear says you can't come crying to me about termites when you watched them eat through the floorboards and you still bought the house.}

_{0:05:36.6 And the final philosophy or the third philosophy is the contract-first approach, which, if we were to choose another animal mascot, it would be the wise old owl. So the owl doesn't start with a philosophical presumption. Instead, it looks at the express terms of the purchase agreement to work out whether the buyer's knowledge affects its rights to recover. So if the contract addresses sandbagging, then the owl would follow the contract. If it doesn't, then that's where things get complicated, and we'll talk about that later on in this podcast.}

_{0:06:08.7 So the owl always reads the fine print?}

_{0:06:11.0 Yeah, the owl always reads the fine print.}

_{0:06:15.0 Always. Okay, so we have the shark, the mama bear, and the owl. These different approaches must show up in the language of your contracts, right?}

_{0:06:23.3 Yeah, absolutely. And let's walk through what that looks like.}

_{0:06:28.0 So let's start with a pro-sandbagging provision. I like to call this provision the buyer-wins-all clause.}

_{0:06:33.1 Subtle name.}

_{0:06:38.2 Very subtle, but very apt. So what does this clause do? It does three things. First, it explicitly preserves the buyer's indemnification rights regardless of what is discovered during due diligence. So basically, it says it doesn't matter what you found in the data room or during your investigations, you still get your indemnification rights.}

_{0:07:00.3 So even if the buyer's army of accountants and lawyers found the problem...}

_{0:07:04.6 Doesn't matter. Second thing that the clause establishes is that the reps and warranties in the agreement are all about risk allocation and not reliance. This is key because it takes the reliance argument completely off the table. The final thing that it does is it closes the loophole where a seller could argue that by proceeding with the closing, the buyer waived its right to seek recovery. So a good pro-sandbagging clause says the buyer is not waiving anything by closing on the deal.}

_{0:07:36.5 That does sound like a pretty good day for the buyer. So what about the other side? What does an anti-sandbagging provision look like?}

_{0:07:45.6 An anti-sandbagging provision, which we like to call the buyer-knew-is-the-buyer's-problem clause, this one flat out says the buyer is not entitled to indemnification if the buyer knew at or before closing that one of the seller's promises was inaccurate. It's a straightforward concept, but the drafting is where all the action is.}

_{0:08:10.5 What do you mean?}

_{0:08:12.0 Well, how you define knowledge in the contract is critical. So if you're the seller, you want knowledge to be defined as broadly as possible. You don't just want it to cover what the buyer actually knew. You want it to include what the buyer should have known. So basically, things they would have found or known if they had done their homework during the diligence process.}

_{0:08:35.2 And on the flip side, if you're the buyer, you're gonna fight tooth and nail to narrow that definition. So, Nathan, you want knowledge to mean only what specific named individuals on the buyer's deal team actually knew about, and that's with specificity. So you don't want constructive knowledge anywhere near that provision.}

_{0:08:53.0 So the battle over the sandbagging provision isn't just about whether to include one. It's also about how certain keywords in the provision are defined.}

_{0:09:01.8 Oh, absolutely, 'cause I've seen deals where the sandbagging clause was the last item negotiated that the parties agreed on. So it was after purchase price, after indemnification cap, after literally everything, 'cause that's how heated it can be.}

_{0:09:17.5 All right, so now we understand what these provisions look like on paper, but how are they treated in different jurisdictions? States don't necessarily see eye to eye on this, right?}

_{0:09:28.1 Not even close, Nate. I think the best way to illustrate how far apart some of these states are is to take a legal road trip across America.}

_{0:09:36.1 Great. First stop on our legal road trip: Delaware.}

_{0:09:39.6 Delaware, the first state, the corporate capital of America. And for our purposes, Delaware is the pro-sandbagging capital. Delaware has earned its reputation as Disneyland for corporate lawyers for a reason. And when it comes to sandbagging, the rides are definitely built for the buyer.}

_{0:09:56.5 What makes Delaware so buyer-friendly on this issue?}

_{0:10:00.5 Well, Nate, it really comes down to one core principle, and that's freedom of contract. Delaware courts have consistently taken the view that sophisticated commercial parties can allocate risks and remedies however way they see fit, and the courts respect that bargain. So if the parties agreed that the buyer's knowledge of a breach doesn't preclude recovery, then Delaware will honor that. There's only one major exception, though, and this is very, very important. Delaware will not allow you to contractually limit liability for fraud. So fraud is always off the table when it comes to sandbagging, even in Delaware. But anything short of fraud, the parties can write their own rules, essentially. This is probably best explained using an example. So let's say you are a buyer, and you're buying a medical equipment company. The purchase agreement contains your typical reps and warranties that you would typically see in a medical company deal. So there will be your typical reps and warranties that the company has complied with all applicable healthcare laws. And other than as set out in the seller's disclosure schedules, the company has not received any written notice of any alleged non-compliance from any government authority in, say, the last three years prior to closing.}

_{0:11:20.5 Let's say the seller discloses one notice of non-compliance, but post-closing, the company performs really, really badly. And it comes to your attention, Nate, that there have actually been other notices of non-compliance that the sellers have failed to disclose. And one of those notices actually results in significant expense to you as a buyer. This is exactly what happened in the Delaware case of Akorn v. Fresenius, except it wasn't in the context of a sale, but a merger. So in that case, the buyers sued the sellers for breach of rep. The sellers argued that the buyer's claim should fail because the sellers had told the buyer about the other notices in a conference call during due diligence.}

_{0:12:06.0 So they claimed it was disclosed just informally?}

_{0:12:09.2 Exactly. The Delaware court said, too bad, that doesn't matter. So for purposes of a representation in the merger agreement, whether the sellers disclose the notices outside of the agreement doesn't matter in terms of the legal analysis here. So a breach of contract claim based on misrepresentation doesn't depend on showing any form of reliance. As you recall, in Delaware, the reps serve as a risk allocation function. So effectively the seller is estopped from claiming that information outside of the transaction documents, such as during due diligence, during its employee interviews, in emails or during calls, that really doesn't have any bearing and does not operate to change the seller's reps.}

_{0:12:54.8 And I think what's so powerful about that decision is how clear-cut the reasoning is. The court didn't spend a lot of time agonizing over whether it was "fair." It basically said, this is what you agreed to. You're experienced business people with experienced lawyers. We're gonna hold you to your deal.}

_{0:13:15.9 Which is brutal for the seller's counsel.}

_{0:13:18.8 That's right. And the key takeaway here is that when you're dealing with a matter that's governed by Delaware law, you're essentially swimming in a shark tank. And if the buyer has negotiated a pro-sandbagging clause, then in Delaware, that provision is most certainly going to be enforced by the courts.}

_{0:13:37.7 And even if the agreement doesn't say anything on sandbagging, which we'll get to a little later, Delaware courts are still generally going to side with the buyer. Again, we'll come back to that in a second.}

_{0:13:50.9 All right, let's head west to sunny California. Kimberly, what's the vibe in California?}

_{0:13:56.4 The vibe is anxiety, at least for M&A lawyers trying to draft pro-sandbagging clauses because California takes a more old-school approach, which emphasizes good faith dealing and reliance. The approach to sandbagging in California is more restrictive than Delaware, and it just comes down to state law.}

_{0:14:20.2 And that's a public policy statute?}

_{0:14:22.3 Yeah, correct. There is a California law, California Civil Code Section 1668, which says essentially that you cannot contract away liability for certain types of misconduct. And the kicker is that bar in California is lower than in Delaware, which is fraud. So 1668 covers not just fraud but fraudulent misrepresentation, willful injury, violations of law, all the way down to negligence. So while Delaware says you can contract around almost anything short of fraud, California draws the line a lot earlier.}

_{0:14:57.5 So what does that mean for sandbagging provisions in California?}

_{0:15:01.6 Well, the practical implication is significant here, Nate. It creates a lot of uncertainty. So a California court could look at a pro-sandbagging provision and say, this clause is effectively shielding a seller from liability for fraudulent misrepresentation. And under Section 1668, you can't do that. And so the court will just strike the provision and say that it's unenforceable.}

_{0:15:25.2 So even if you've got this beautifully crafted pro-sandbagging clause, the California court could still take a red pen to it?}

_{0:15:31.9 That's right, Nathan. To be clear, it's not really that pro-sandbagging clauses are automatically unenforceable in California. They just need to be written a lot more carefully because you need to make sure the clause can't be read as protecting someone from the consequences of their own actions, basically if they're making any kinds of fraudulent statements or lying to the buyers.}

_{0:15:58.3 And this is why we chose the mama bear as a mascot for California. The courts are actually pretty protective, so they're looking out for potential abuses, and they're willing to step in if they think that a contract goes too far.}

_{0:16:11.4 So what's the takeaway here for our listeners doing deals that are governed by California law?}

_{0:16:16.1 Draft carefully. Test your provisions against 1668. Don't assume that what works in Delaware will fly in California. It's a different state, different rules, different risk profile. And when the anxiety hits, just remember to go outside and get a little bit of sun, because it will help.}

_{0:16:33.7 All right, let's head back across the country to New York. Anna, how does New York handle sandbagging?}

_{0:16:40.3 Well, Nate, the animal mascot for New York, I would say, is the wise old owl. And this is because New York takes a contract-first approach. So the courts will look at the express language of the purchase agreement to work out what the rights of the parties are and what they intended. New York courts have said that if a buyer closes on a deal knowing that a rep is inaccurate, then the buyer should be prevented from asserting a breach unless the buyer expressly preserves that right in the agreement. So if the agreement contains an express pro-sandbagging clause, then a New York court is likely going to enforce it as it's written.}

_{0:17:20.8 Is there a good example for our listeners?}

_{0:17:23.2 I think the best example is what happened in CBS Inc. v. Ziff-Davis Publishing Co. So this is a New York Court of Appeals case. So as you know, New York Court of Appeals is the highest court in the state. So it's really the cornerstone of New York law on sandbagging. So in that case, CBS acquired publishing assets from Ziff-Davis. Ziff-Davis made reps about the financial condition of the business that was being sold, and CBS learned before closing that some of those reps may not be accurate. And as we've all discussed along, CBS proceeds to close anyway and then brings a claim for breach of warranty.}

_{0:18:06.2 And the court still sided with CBS?}

_{0:18:08.2 Yeah, the court sided with CBS. So the court said that a seller is not estopped from bringing a breach of warranty claim just because the buyer knew prior to closing that the warranty was false. So in that case, the court differentiated between a breach of contract claim from a claim for fraud. And that distinction is critical. So the court said if you're suing for a breach of contract claim, you don't need to prove reliance. So reliance is not an element. But if you're suing for fraud, then you need to prove that you relied on that and incurred damages as a result.}

_{0:18:43.3 Yeah, and that distinction, Nathan, is what makes New York a contract-first jurisdiction, because the court is saying we will enforce the deal as written. If the contract gives you warranty protection, you get warranty protection.}

_{0:18:58.6 Got it. Okay, let's head down to Texas. Kimberly, what's the Texas approach?}

_{0:19:03.8 Texas is straightforward, which is fitting. Texas courts keep it really simple. If you want something, you need to clearly say it in the agreement. And if it's clearly written, the courts will back you up, because the thinking is if you made a deal, you should stick to it. But don't expect a Texas court to rewrite your deal for you.}

_{0:19:24.4 Texas and New York are actually pretty similar in this respect, Nate. Both are saying put it in the contract, make it clear, and we'll respect it. The difference with Texas is it doesn't quite have as much of a developed body of case law on sandbagging as New York does. So there's a little less predictability there.}

_{0:19:45.8 Last stop on the road trip, Nevada. What's the story there?}

_{0:19:50.8 Well, Nevada is a bit of a gamble, pun intended. So here's the thing about Nevada. Everything about Nevada suggests that it should follow Delaware. It's an increasingly business-friendly jurisdiction. The courts believe in freedom of contract. Nevada's statutes are becoming among the most flexible in the country. They let the parties customize pretty much everything. So you'd think Nevada would be solidly in the pro-sandbagging camp.}

_{0:20:22.2 The problem is there's basically no case law in Nevada specifically addressing sandbagging. There's no controlling precedent. And in law, no precedent means no certainty.}

_{0:20:34.2 Exactly, Kimberly. So while we can make educated predictions about how a Nevada court would likely rule, and most lawyers that you speak to would say Nevada should follow the Delaware model, but there's no guarantee. And when you're dealing with a deal that's worth tens or maybe even hundreds of millions of dollars, "probably" isn't the most comforting word in the English dictionary.}

_{0:20:59.2 So Nevada is the jurisdiction where you might win, but you're rolling the dice to find out.}

_{0:21:04.5 And that uncertainty is itself a risk factor both parties need to account for when choosing governing law.}

_{0:21:13.4 Okay, we've talked about what happens when you have an express sandbagging provision, but what happens when the purchase agreement is completely silent on sandbagging and the silence is not deliberate? So let's say you've negotiated a 400-page agreement and nobody thought to address sandbagging. Kimberly, how bad is that?}

_{0:21:32.6 It's not great. Leaving a sandbagging clause out of an agreement is the kind of nightmare that keeps M&A lawyers up at night, because silence on sandbagging is essentially an invitation for a really expensive lawsuit. And again, the outcome is really gonna depend entirely on which state's laws apply.}

_{0:21:56.0 Let's run through the states we've been talking about. Delaware first.}

_{0:22:00.4 So in Delaware, even without an express provision, the buyer likely will prevail. So as we discussed, Delaware's default position is that reps and warranties are risk allocation tools. So if there's no anti-sandbagging clause and if the seller didn't negotiate one expressly, then the court is gonna treat the reps and warranties as what they are: contractual promises that the seller is on the hook for. And that's regardless of buyer's knowledge.}

_{0:22:16.6 How about California?}

_{0:22:32.7 In California, the seller might actually win. California courts are much more likely to read in a requirement that the buyer actually relied on the seller's promises, even if the contract is silent on the matter. 'Cause California's focus is on fairness, and its protective state laws create an environment where courts might be skeptical of a buyer who knew about a breach and closed anyways.}

_{0:22:46.8 New York?}

_{0:23:01.0 New York is a coin toss, and I don't say that lightly. There's genuinely conflicting precedent in New York on what the default rule would be if the contract is silent. So there are some decisions that have supported a pro-sandbagging default, and then there are others where they say that you need to prove a reliance element. So in New York, sandbagging genuinely means uncertainty. So if there's silence, it generally creates uncertainty, and that's not a very good position for either party to be in.}

_{0:23:18.6 What about Texas?}

_{0:23:36.2 I'm gonna steal Anna's phrase. It's also a coin toss, but for slightly different reasons. Similar to Nevada, Texas just doesn't have controlling precedent on this specific issue. So you're asking a judge to figure it out for the first time, and that's always unpredictable.}

_{0:23:54.1 What about Nevada then?}

_{0:23:56.3 Probably the buyer, because Nevada should theoretically follow Delaware. But as we discussed, there's no direct precedent, so it's an educated guess but not a certainty.}

_{0:24:08.6 So to me, the moral of this story is clear: never leave the contract silent on sandbagging.}

_{0:24:14.6 That's exactly it. Even if you're doing a deal governed by Delaware law where the default is favorable to the buyer, you should still include an express provision, because why would you leave anything to chance when you could just address it in the agreement?}

_{0:24:30.8 And Nate, from a seller's perspective, this is much, much more critical. So if you're a seller and you don't negotiate an express anti-sandbagging provision, you could find yourself on the wrong end of an indemnification claim that you thought you were protected against. So silence is not your friend.}

_{0:24:48.4 Right. Silence is not golden. Silence is actually expensive.}

_{0:24:52.7 Exactly. And that might, Nathan, work out for you if they come to you to do the litigating, but silence is very expensive, and we want to avoid that for our clients as much as possible.}

_{0:25:04.1 Yeah. Well, we're done with the theory. We've done the state-by-state tour. Now let's get practical. If you are sitting on a Zoom call negotiating an M&A deal, what should you actually do? Let's start with buyers. Anna, if you're advising a buyer, what's the main playbook?}

_{0:25:24.2 Okay, so if I'm advising the buyer, my number one tip would be to negotiate an express pro-sandbagging provision. So this is non-negotiable, pun intended. So you want a clause that clearly states that your indemnification rights are not affected by any due diligence or anything that you acquired knowledge of before or after closing. So you need to spell it out and you need to make it absolutely clear so that there is no room for ambiguity.}

_{0:25:38.7 What else?}

_{0:25:53.3 Tip number two is to make sure that the clause expressly disclaims any reliance requirement for contract-based claims. So remember the distinction that we talked about between a breach of contract claim versus a fraud claim. So you want the contract to be crystal clear that indemnification claims are contract-based claims and that you do not need to prove reliance as a result.}

_{0:26:18.8 And I'll take tip number three. Think carefully about governing law. We've talked about it a lot today, but if you have the leverage to choose, Delaware and to some extent Nevada are a buyer's best bets. Delaware because the law is well developed and clearly pro-sandbagging, and Nevada because it's business-friendly generally and theoretically should follow Delaware, even though there's a lot less case law.}

_{0:26:46.7 Based on that, some listeners might be wondering, isn't this kind of sneaky? You're deliberately setting up a situation where you can close the deal as a buyer knowing about problems and then sue.}

_{0:26:59.3 That's a really good question, Nate, and I'm glad you raised it because I think there's a misconception here. This is not about being sneaky or acting in bad faith. So this is sophisticated risk allocation, and that is what M&A is all about. So when a buyer negotiates a pro-sandbagging clause, the buyer is essentially saying the seller made specific promises about this business. If those promises are wrong, then the seller has to bear the financial risk of getting that wrong. The buyer's due diligence shouldn't change who bears that risk. So it's a negotiated allocation of risk between sophisticated parties. And look, there's nothing shady about doing that.}

_{0:27:40.0 It's right in the contract. Fair enough. Okay, let's flip to the seller's side. Kimberly, if you're advising a seller, how do you protect your client?}

_{0:27:49.4 Well, tip number one, negotiate an express anti-sandbagging provision. You want a clause that clearly says the buyer cannot seek indemnification for breaches the buyer knew about before closing.}

_{0:28:03.0 And the knowledge definition that we talked about earlier?}

_{0:28:06.3 Exactly. Tip number two. Define knowledge as broadly as you possibly can. You want knowledge to include not just what the buyer's deal team actually knew, but what the buyer should have known if they had done their homework through reasonable due diligence. Because the broader the definition, the more protection the seller has.}

_{0:28:26.7 I can take the last tip, and that's to include a disclosure schedule update mechanism. So this lets the seller cure any breaches of reps and warranties between signing and closing. If the seller discovers that a rep has become inaccurate after signing but before closing, this mechanism will allow the seller to then go back in and update its disclosure schedules to correct that. This gives the opportunity to address the problem before it becomes an indemnification claim.}

_{0:28:57.4 Are there any final tips for sellers?}

_{0:29:00.5 Yeah, I've got one. And just imagine it's a flashing neon sign when I say it. Do not commit fraud. I know that sounds really obvious, but it needs to be said explicitly. Disclose what you need to disclose in your disclosure schedules. Be honest, be thorough, because even in Delaware, which is the most buyer-friendly jurisdiction in the country, the contractual protections we've been talking about only work for honest sellers. You cannot contract away liability for fraud. No state is going to allow that. So an anti-sandbagging provision protects you from a buyer who knew about a legitimate breach. It does not protect you from your own misconduct.}

_{0:29:46.3 Which is a great point to underscore. The entire framework we've been discussing assumes good faith dealing on both sides, and fraud changes all of that.}

_{0:29:51.6 That's absolutely correct.}

_{0:29:56.8 Given the stakes here, I can see why this issue is so heavily litigated. How does it actually play out in practice? Are we seeing more pro-sandbagging provisions or more anti-sandbagging provisions?}

_{0:30:09.2 Actually, there is a growing trend for deliberate silence, which I admit is contrary to what we're saying buyers and sellers should do here. But if you look at recent M&A deal studies, the number of deals with pro-sandbagging provisions is starting to decline. So for example, in 2022, 49% of deals covered in the study included a pro-sandbagging provision. That's down from 52% in 2018, and only 2% included an anti-sandbagging provision. So essentially what's happening is that we're seeing more than half of these deals that are deliberately silent on the issue.}

_{0:30:47.7 That's striking for such a contentious and potentially expensive issue.}

_{0:30:52.0 Yeah, but I think it's worth emphasizing that the silence here is deliberate rather than accidental, like we talked about earlier. And this trend reflects compromise between the parties. So they can't agree whether to include an express pro-sandbagging provision or an anti-sandbagging provision. So they both agree to deliberately omit any sort of sandbagging language and leave it up to the governing law to work out what the buyer's rights are in that situation. And as we discussed, that can be a gamble. And this is why buyers tend to push very hard for a Delaware governing law from the outset of a deal, because they know that if they end up losing the fight to include a pro-sandbagging clause, then they can settle with silence, and the outcome will still essentially be in their favor.}

_{0:31:43.8 All right, we're coming up on time, so let's wrap up with our key takeaways. I'll go around the table and have each of you give us the headlines. Kimberly, kick us off.}

_{0:31:52.7 Takeaway number one. Always address sandbagging expressly in your purchase agreement. I know we've said this multiple times and we've also said contrary, but it bears repeating. Silence is not golden. Silence is an invitation to expensive litigation. Whether you're a buyer or a seller, you are much better off having this conversation during negotiations than having it in front of a judge.}

_{0:32:17.2 Takeaway number two is to choose your governing law wisely. Each state has very different approaches to sandbagging, and so whatever state whose law governs your agreement will have an enormous impact on how these provisions are interpreted and enforced. So Delaware's the most favorable jurisdiction for pro-sandbagging. California has statutory provisions that limit sandbagging enforceability, making it a little bit more seller-friendly. And New York and Texas will enforce the language in the contract so long as it's clear and the contract is not silent on this issue. And as we discussed, Nevada probably leans more towards Delaware, but it's uncertain. So governing law isn't just a boilerplate issue for an M&A deal. It's a strategic decision.}

_{0:33:10.8 And takeaway number three. Define knowledge really carefully. Whether you're drafting a pro or anti-sandbagging provision, the definition of knowledge is where the rubber is going to meet the road. This is as practical as it gets. The distinction between actual knowledge and constructive knowledge is gonna mean the difference between a successful indemnification claim and a dismissed lawsuit. So know which side of the line that you need to be on and draft and negotiate accordingly.}

_{0:33:41.1 Number four is something that we've harped on a lot during this podcast, and that's you can't contract away from fraud liability. And this is the case in every single jurisdiction that we discussed, even in Delaware. So if you're a seller, the best anti-sandbagging provision in the world will not save you from your own dishonesty. And if you're a buyer, you need to know that fraud claims are still open to you regardless of what sandbagging position is taken in the contract.}

_{0:34:11.6 Last but not least, takeaway number five: the sandbagging provision in a purchase agreement reflects bargaining power. So at the end of the day, which provision you end up with pro, anti, or deliberate silence is gonna come down to who has more leverage at the negotiating table.}

_{0:34:29.6 Beautiful summary. Anna, Kimberly, thank you both so much for walking our listeners through this. I think we've taken what can be a pretty dense topic and made it accessible and hopefully a bit fun along the way. I'd also like to thank our listeners for joining us on this episode of Corporate Conversations. For additional information on this topic or other corporate transactional or litigation matters, please visit our website at nossaman.com. And don't forget to subscribe to Corporate Conversations wherever you listen to podcasts so that you don't miss an episode. Until next time.}

_{0:35:02.2 Corporate Conversations is presented by Nossaman LLP and may not be copied or rebroadcast without consent. Content reflects the personal views and opinions of the participants. Statements provided in this podcast are for informational purposes only, are not intended as legal advice, and do not create an attorney-client relationship. Listeners should not act solely upon this information without seeking professional legal counsel.}