Richard Manfredi, Author at Gibson Dunn

Observations and drafting suggestions for CRE terms in merger agreements, licenses, and royalty purchase agreements.

On April 30, 2024, the Delaware Court of Chancery held that the buyer in a life sciences merger and its successor had not breached their contractual obligations under an earn-out provision to use commercially reasonable efforts (“CRE”) to achieve regulatory approvals for a pharmaceutical product. In Himawan, et al. v. Cephalon, Inc., et al., Vice Chancellor Glasscock found that the merger agreement’s definition of CRE for purposes of the earn-out provision, which referred to the efforts of a company with substantially the same resources and expertise as the buyer, required the Court to analyze whether a reasonable actor faced with the circumstances would continue to pursue the development of a drug that had failed to meet one of its co-primary endpoints in an earlier clinical trial.[1] In its reasoning, the Court relied heavily on the merger agreement’s grant to the buyer of “complete discretion with respect to all decisions” over the development activities, subject only to the more general CRE obligation. Although the impact of the decision on CRE clauses granting a buyer less discretion remains to be seen, the Court’s decision provides important guidance on the interpretation and drafting of CRE clauses generally, both in merger agreements and in other contexts, such as license agreements and revenue sharing agreements.

Background

The plaintiffs in the case were representatives of former Ception Therapeutics, Inc. (“Ception”) stockholders. Ception owned the antibody Reslizumb (“RSZ”), which was being developed for treating inflammation in the lungs (eosinophilic asthma, or “EA”) and the esophagus (eosinophilic esophagitis, or “EoE”). Cephalon Inc. (“Cephalon”) acquired Ception in April 2010 with the intent to develop and commercialize RSZ to treat EA and EoE. Two years later, in October 2012, Teva Pharmaceutical Industries Ltd. (“Teva”) acquired Cephalon.

Under the Merger Agreement, Ception stockholders had the right to receive two milestone payments of up to $200 million each for regulatory approval of RSZ for the treatment of EA and EoE (for a total of up to $400 million). In the context of addressing the earn-out consideration, the Merger Agreement provided that the buyer would have “complete discretion with respect to all decisions related to the business of the Surviving Corporation and its subsidiaries, including decisions relating to the research, development, … pricing and distribution of [RSZ], and shall have no obligation to conduct clinical trials related to, or otherwise pursue regulatory approvals of, any indication for [RSZ] … or otherwise take any action to protect, attain or maximize any payment to be received by” stockholders under the earn-out. Notwithstanding the flexibility afforded under this language, the buyer remained subject to an overarching obligation to use “commercially reasonable efforts” to develop and commercialize RSZ in furtherance of the development milestones. “Commercially reasonable efforts” was defined in the merger agreement as requiring “the exercise of such efforts and commitment of such resources by a company with substantially the same resources and expertise as [buyer], with due regard to the nature of efforts and cost required for the undertaking at stake.” Teva assumed this obligation when it acquired Cephalon.

The EA-related regulatory milestone events were achieved and Ception stockholders received the corresponding $200 million milestone payment. However, despite bona fide development efforts and engaging multiple times with the FDA to devise a new clinical path forward, the development of RSZ for the treatment of EoE proved unsuccessful and both Cephalon and Teva abandoned the development of RSZ for this indication. Ception stockholders then sued Cephalon and Teva for breach of the Merger Agreement based on a failure to use CRE to develop and commercialize RSZ for the treatment of EoE.

Ruling

In its ruling, the Court held that Teva and Cephalon did not breach the Merger Agreement and did not breach their obligations to use CRE to develop and commercialize RSZ for the treatment of EoE.

In measuring the efforts of Teva and Cephalon against the CRE yardstick, the Court emphasized that the Merger Agreement gave “complete discretion” to the buyer with respect to all decisions related to the business of the seller, only subject to the restriction that Teva and Cephalon could not avoid the earn-outs in a manner that was commercially unreasonable.[2]

The Court then proceeded to interpret the CRE standard to impose a requirement on the buyer as it found itself situated from an objective standard. Thus, if a reasonable actor faced with the same limitations and risks in the development of a pharmaceutical product would go forward in its own self-interest, then the buyer would be contractually obligated to do the same. Notably, the Court found unworkable the plaintiff’s preferred interpretation that the CRE clause required comparing Cephalon and Teva’s efforts with the efforts of similarly situated pharmaceutical companies and their actions in the real world developing different drugs for EoE on the basis that “no exemplar companies operate under the actual conditions” of Cephalon and Teva.[3]

Rule Application

After establishing the framework for review, the Court separately analyzed Cephalon’s efforts and Teva’s efforts, finding that the actions of both parties were commercially reasonable.

With respect to Cephalon, the Court noted that it had engaged in substantive efforts to develop RSZ for the treatment of EoE even after a failed trial, including hiring former Ception employees, holding a pre-Biologics License Application meeting with the FDA in which it “proposed to submit a pre-Biologics License Application for RSZ under an FDA program for accelerated approval of biological products” and the use of a surrogate endpoint, proposing to amend the Open-Label Study to convert it into an efficacy study, and proposing an enriched, enrollment, randomized withdrawal (“EERW”) study. However, the FDA ultimately rejected those proposals, though it provided a recommendation to gain approval through additional data and analyses. Cephalon conducted the requested analyses and ultimately concluded that it could not identify a “clinical benefit” and would discontinue development. The Court noted that similarly situated competitors also abandoned their EoE development programs after failed clinical trials and studies. While the Court took note of these actions to bolster its finding of commercial reasonableness, such comparisons were not determinative in themselves.

The Court arrived at the same conclusion regarding Teva’s development of RSZ for the treatment of EoE. When Teva acquired Cephalon, Teva did not restart the EoE program, but instead focused on EA from 2011 to 2017. The Court reasoned that Teva’s prioritization of treating EA was objectively reasonable because it was more promising clinically and commercially in comparison with treating EoE, which had already faced numerous regulatory hurdles and clinical setbacks. Teva “hired RxC, a third-party biopharma strategy consulting firm that specializes in pharmaceutical life cycle planning and new product commercialization, to conduct an opportunity assessment of RSZ for EoE.” RxC concluded that the probability of starting a successful new trial was low and that the commercial viability provided limited upside. Teva had determined that it would only be commercially reasonable to develop RSZ for the treatment of EoE if it could obtain a viable subcutaneous route of administration because RSZ was already a challenging commercial product in any indication as it required administration by infusion and the display of a black-box warning label. Teva’s clinical trials of the subcutaneous form of RSZ failed to demonstrate efficacy for the treatment of EA, and so Teva decided it would not pursue the development of RSZ for EoE. Teva had also considered the related milestone payments under the Merger Agreement in concluding that the further development of RSZ for the treatment of EoE was impractical.

Drafting Guidance

The Court’s ruling provides important guidelines for negotiating and drafting CRE definitions in the context of a variety of agreements, including merger agreements, license agreements, and synthetic royalty financing agreements. The Court focused not only on the definition of CRE, but also on surrounding language and the discretion expressly afforded the buyer with regard to the seller’s business. Sellers in future transactions might consider not including any express discretion language with respect to the buyers’ development and commercialization activities in order to bolster the objective measure of the CRE standard. Buyers, on the other hand, might consider including express discretion language in order to bolster the subjective measure of the CRE standard.

The Court’s decision suggests that CRE definitions drafted with reference to the buyer’s specific facts and circumstances will provide buyers with significantly more freedom in the interpretation of commercial reasonableness. While the Court indicated that it was utilizing an “objective” standard to measure CRE, this objectivity was not determined by looking to the efforts of similarly-situated pharmaceutical companies and their actions in the real world with respect to similar drug candidates, but rather by considering whether a reasonable person in the same situation as the buyer (i.e., considering the same opportunities and risks) would go forward in its own self-interest (sometimes referred to as a “subjective objective standard”).

The Court’s ruling notes that applying a purely objective standard is unworkable (or at least challenging to implement), as each set of circumstances around drug development is inherently unique. Simply because other companies had pursued the development of different drugs for the same indication does not provide insight into whether it would be reasonable to require similar efforts in the context of a different drug for the same disease. Rather, the Court applied an objective standard of reasonableness in the context of the buyer’s unique facts and circumstances.

Adopting that interpretative framework, parties in future transactions may consider the following options in drafting CRE terms that accomplish their desired objectives:

M&A Buyer/Licensee Side:[4] The buyer/licensee should define “Commercially Reasonable Efforts” with a subjective standard benchmarked only against itself.

“… shall use those efforts and resources that such Party would typically devote to its owned or exclusively licensed products for the same clinical indication and in the same geographic markets with a similar market potential at a similar stage in development or product life, taking into account intellectual property protection, efficacy, safety, approved labeling, the competitiveness of alternative products in such jurisdiction, pricing/reimbursement for the pharmaceutical product and the profitability of the pharmaceutical product (including with regard to the costs associated with the [earn-out payments]), all as measured by the facts and circumstances in existence at the time such efforts are due.”

M&A Seller/Licensor Side:[5] The seller/licensor should define “Commercially Reasonable Efforts” with an objective standard benchmarked against similarly situated companies as the buyer/licensee, or if possible, an objective standard with specific minimum requirements.

“… shall use those efforts and resources consistent with the usual and customary practices of a similarly situated biopharmaceutical company in the development and exploitation of a drug product owned by or licensed to it, which drug product is at a similar stage of development, is in a similar therapeutic and disease area, and is of similar market potential and without regard to the costs associated with the [earn-out payments] [(provided that, in any event, the number of full time sales representatives of the Company with respect to the Product shall not fall below [___])][6].”

__________

[1] Himawan, et al. v. Cephalon, Inc., et al., C.A. No. 2018-0075-SG (Del. Ch. Apr. 30, 2024).

[2] In coming to this conclusion, the Court distinguished the current context from other cases involving CRE that the plaintiffs cited. In the current context, the buyer had complete discretion over development, cabined only by CRE. On the other hand, in the other cited cases, the merger agreement required the parties to use CRE to achieve one of the milestones as a precursor to consummation of the transaction, and to use reasonable best efforts to consummate the transaction. As a result, if the milestone did not occur and could prevent the completion of the merger, the buyer was affirmatively obligated to take all reasonable steps necessary to achieve the milestone in order to complete the merger.

[3] The plaintiffs had argued that companies with similar resources and expertise (specifically, Shire, Sanofi and Regeneron, Celgene, and GlaxoSmithKline) were pursuing products for treatment of EoE and thus suggesting that Cephalon/Teva was unreasonable in not pursuing approval in the indication. The Court found this to be an apples-to-oranges comparison that was unworkable.

[4] Also aligned with the perspective of the seller of a synthetic royalty interest.

[5] Also aligned with the perspective of the buyer of a synthetic royalty interest.

[6] Where the counterparty expects the expenditure of a minimum level of resources, consider setting an explicit floor for CRE (e.g., with reference to a minimum level of expenditures or minimum number of full-time-equivalent employees working to develop or commercialize the product).

The following Gibson Dunn lawyers prepared this update: Ryan A. Murr, Karen A. Spindler, Todd J. Trattner, Marina Szteinbok, and Artin Au-Yeung.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any leader or member of the firm’s Mergers & Acquisitions or Life Sciences practice groups:

Life Sciences:
Jane M. Love, Ph.D. – New York (+1 212.351.3922, [email protected])
Ryan Murr – San Francisco (+1 415.393.837, [email protected])
Karen Spindler – San Francisco (+1 415.393.8298, [email protected])
Todd Trattner – San Francisco (+1 415.393.8206, [email protected])

Mergers and Acquisitions:
Robert B. Little – Dallas (+1 214.698.3260, [email protected])
Saee Muzumdar – New York (+1 212.351.3966, [email protected])
Marina Szteinbok – New York (+1 212.351.4075, [email protected])

Attorney Advertising: These materials were prepared for general informational purposes only based on information available at the time of publication and are not intended as, do not constitute, and should not be relied upon as, legal advice or a legal opinion on any specific facts or circumstances. Gibson Dunn (and its affiliates, attorneys, and employees) shall not have any liability in connection with any use of these materials. The sharing of these materials does not establish an attorney-client relationship with the recipient and should not be relied upon as an alternative for advice from qualified counsel. Please note that facts and circumstances may vary, and prior results do not guarantee a similar outcome.

Warner Chappell Music, Inc. v. Nealy, No. 22-1078 – Decided May 9, 2024

Today, the Supreme Court held 6-3 that a copyright plaintiff can recover damages for any timely claim of infringement, even if the infringement occurred more than three years before the suit’s filing.

“The Copyright Act entitles a copyright owner to recover damages for any timely claim.”

Justice Kagan, writing for the Court

Background:

The Copyright Act requires that claims for copyright infringement be brought “within three years after the claim accrued.” 17 U.S.C. § 507(b). In 2018, independent record-label owner Sherman Nealy sued Warner Chappell Music, Inc. for alleged copyright infringement roughly a decade after the alleged infringement began, and almost three years after he allegedly discovered the infringement. Warner Chappell accepted that the claim accrued when the alleged infringement was discovered but argued that Nealy could only recover damages or profits for infringement occurring in the last three years, citing Petrella v. Metro-Goldwyn-Mayer, 572 U.S. 663, 672 (2014). The district court agreed with Warner Chappell but certified the question to the Eleventh Circuit, which reversed. The Eleventh Circuit assumed that the discovery rule governed the timeliness of the claim and held that the Copyright Act does not limit the time for collecting damages.

Issue:

Whether, under the discovery accrual rule applied by the circuit courts and the Copyright Act’s statute of limitations for civil actions, 17 U.S.C. § 507(b), a copyright plaintiff can recover damages for acts that allegedly occurred more than three years before the filing of a lawsuit.

Court’s Holding:

Yes. Assuming (without deciding) that a copyright infringement claim is timely if brought within three years after the plaintiff discovered the alleged infringement, the plaintiff may recover damages for any infringement, even if it occurred more than three years before a lawsuit’s filing.

What It Means:

Justice Kagan, writing for a six-Justice majority, based the Court’s holding on the plain text of the Copyright Act. The Court noted that the Copyright Act’s statute of limitations specifies a three-year time limit for filing an infringement claim “after the claim accrued.” 17 U.S.C. § 507(b). By contrast, the Copyright Act’s remedial provisions do not specify any time limit for recovering damages and lost profits. 17 U.S.C. § 504(a)-(c). Therefore, the Court concluded, “a copyright owner possessing a timely claim for infringement is entitled to damages, no matter when the infringement occurred.” Op. 5.
The Court acknowledged that some language in the Court’s decision in Petrella v. Metro-Goldwyn-Mayer, 572 U.S. 663 (2014), could be read out of context to suggest a limit on the time a copyright plaintiff can recover retrospective relief. However, the Court explained that in the context of that case, the plaintiff had sued “only for infringements that occurred in the three years before her suit.” Op. 7.
Importantly, the Court expressly assumed (without deciding) that Nealy’s infringement claims were timely under the discovery rule of accrual. But the Court noted that the Court has “never decided whether that assumption is valid—i.e., whether a copyright claim accrues when a plaintiff discovers or should have discovered an infringement, rather than when the infringement happened.” Op. 4.
Three Justices, in an opinion written by Justice Gorsuch and joined by Justices Thomas and Alito, dissented and would have dismissed the case as improvidently granted. The dissenters disagreed with the assumption that Nealy’s claims were valid under the discovery accrual rule because, in their view, the Copyright Act “almost certainly does not tolerate a discovery rule.” Dissenting Op. 1.
Today’s decision, along with the dissent, likely means that the Court will soon be asked to decide whether claims for copyright infringement are timely under the discovery accrual rule. If they are not—that is, if claims for infringement must be brought within three years of the infringement itself rather than its discovery—then the import of today’s decision may be limited.

The Court’s opinion is available here.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the U.S. Supreme Court. Please feel free to contact the following practice leaders:

Appellate and Constitutional Law Practice

Thomas H. Dupree Jr. +1 202.955.8547 [email protected]	Allyson N. Ho +1 214.698.3233 [email protected]	Julian W. Poon +1 213.229.7758 [email protected]
Lucas C. Townsend +1 202.887.3731 [email protected]	Bradley J. Hamburger +1 213.229.7658 [email protected]	Brad G. Hubbard +1 214.698.3326 [email protected]

Related Practice: Media, Entertainment and Technology

Scott A. Edelman +1 310.557.8061 [email protected]	Kevin Masuda +1 213.229.7872 [email protected]	Benyamin S. Ross +1 213.229.7048 [email protected]
Jillian N. London +1 213.229.7671 [email protected]	Ilissa Samplin +1 213.229.7354 [email protected]	Brian C. Ascher +1 212.351.3989 [email protected]

Related Practice: Intellectual Property

Kate Dominguez +1 212.351.2338 [email protected]	Y. Ernest Hsin +1 415.393.8224 [email protected]	Josh Krevitt +1 212.351.4000 [email protected]
Jane M. Love, Ph.D. +1 212.351.3922 [email protected]	Howard S. Hogan +1 202.887.3640 [email protected]

This alert was prepared by partner Jillian London and associate Branton Nestor.

We are pleased to provide you with Gibson Dunn’s ESG monthly updates for April 2024. This month our update covers the following key developments. Please click on the links below for further details.

I. GLOBAL

Negotiations on global plastics treaty progress in Ottawa

From April 23 to 29, the Intergovernmental Negotiating Committee (INC) assembled in Ottawa, Canada, to progress negotiations regarding an international legally binding instrument on plastic pollution, which is intended to address the full life cycle of plastic, including its production, design, and disposal. The session concluded with an advanced draft text of the instrument and agreement on intersessional work ahead of the fifth session, which takes place in Busan, South Korea, in November.

Automakers and suppliers collaborate to standardize emissions reporting

Global automakers and suppliers have collaborated to release the Automotive Climate Action Questionnaire, aimed at improving consistency in Scope 3 emissions reporting. Participating automakers and suppliers include Ford Motor Company, General Motors, Honda Development & Manufacturing of America, Denso and Toyota Motor North America. The questionnaire provides a standardized template to collect supplier information to measure, manage and reduce carbon emissions within their supply chains.

Basel Committee on Banking Supervision publishes discussion paper on climate scenario analysis

On April 16, the Basel Committee on Banking Supervision issued a discussion paper on how climate scenario analysis can be practically used to help strengthen the management and supervision of climate-related financial risks. This follows the principles for the effective management and supervision of climate-related financial risks which were published in 2022 and intends to harmonize supervisory expectations and comparability of results.

Transition Plan Taskforce publishes latest transition plan

On April 9, the Transition Plan Taskforce (TPT) published its final set of transition plan resources. These include sector-specific transition plan guidance for asset owners, asset managers, banks, electric utilities & power generators, food & beverage, metals & mining and oil & gas, sector summary guidance and guidance on the how to undertake a transition planning cycle and paper on the opportunities and challenges of transition plans in emerging markets and developing economies. The TPT was established by HM Treasury and announced at COP26 in Glasgow in November 2021. (HM Treasury is the UK government’s economic and finance ministry, and the TPT is engaging with many countries to help inform their approaches to transition planning.)

Bloomberg launches government climate tilted bond indices

On April 4, Bloomberg announced the launch of the Bloomberg Government Climate Tilted Bond Indices, a new benchmark family for government bond investors. The indices adjust country weights in Bloomberg Treasury and Sovereign indices based on Bloomberg Government Climate Scores (GOVS), which assess a government’s relative preparedness in the transition to a low-carbon world using transparent, data-driven indicators. The GOVS scores, provided by Bloomberg Sustainable Finance Solutions and informed by Bloomberg’s BloombergNEF (BNEF) data, comprise three equally weighted pillars: Carbon Transition, Power Sector Transition and Climate Policy.

International Sustainability Standards Boards votes to start research on biodiversity and human capital

On April 23, the International Sustainability Standards Board (ISSB) announced it will commence a project to research risk disclosures regarding risks and opportunities associated with biodiversity, ecosystems and ecosystem services and human capital. Focus of the project will be the common information needs of investors in assessing whether and how these risks and opportunities could reasonably be expected to affect a company’s prospects. Through the research projects, the ISSB will assess and define the limitations with current disclosure in these areas, identifying possible solutions and decide whether standard setting is required.

UN Environment Programme Finance Initiative launches new Risk Centre addressing sustainability risks

On April 17, the UN Environment Programme Finance Initiative (UNEP FI) unveiled its new Risk Centre aimed at assisting financial institutions in navigating sustainability risks. The Risk Centre, available exclusively to UNEP FI’s members, will offer access to a centralized platform of resources and guidance tailored specifically for risk professionals. Initially focusing on climate and nature risks, including support for frameworks such as the Taskforce on Climate-Related Financial Disclosures and Taskforce on Nature-Related Financial Disclosures, the Risk Centre will later expand its scope to cover other sustainability risks such as pollution and social issues.

Network for Greening the Financial System publishes reports on transition plans

On April 17, the Network for Greening the Financial System (NGFS) published three reports exploring the role of transition plans in enabling the financial system to mobilise capital, manage climate-related financial risks, and the relevance of transition plans to micro-prudential supervision. In particular, the reports (i) explore the needs and challenges of emerging market and developing economies related to transition plans, (ii) assess the interlinkages between the transition plans of the real economy and of financial institutions and (iii) examine the credibility of financial institutions’ transition plans and processes from a micro-prudential perspective.

Loan Market Association publishes form Sustainability Coordinator Letter

On April 24, the Loan Market Association (LMA) published a form of Sustainability Coordinator Letter intended to provide a starting point for negotiations where a sustainability coordinator is to be appointed on a sustainable lending transaction. The form is available to members on the LMA website.

Institutional Shareholder Services releases ESG Performance Chartbook for the industrials, financials and real estate sectors

On April 30, ISS ESG Solutions, part of Institutional Shareholder Services, released its ESG Performance Chartbook. The goal of the ESG Performance Chartbook series is to provide insights into the distribution of ESG Performance Scores per industry within a sector. The charts are based on the underlying data from ISS ESG Solutions’ ratings methodology.

II. UNITED KINGDOM

British Standards Institute publishes Net Zero Transition Plans Code of Practice

On March 31, the British Standards Institute (BSI) published BSI Flex 3030 – Net Zero Transition Plans – Code of Practice. The BSI Flex is designed to help small and medium-sized enterprises apply high level principles to design and deliver their transition to net zero and link their net zero transition plans with their wider sustainability or ESG reporting.

Financial Conduct Authority launches consultation on extending labels regime to portfolio management

On April 23, the Financial Conduct Authority (FCA) launched a consultation process on extending the Sustainability Disclosure Requirements (SDR) and investment labels regime to portfolio management services. The consultation follows on an earlier consultation paper and corresponding policy statement (published in November 2023) on SDR and investment labels, which introduced a package of measures for fund managers. The process is open for comments until June 14.

UK government announces aviation fuel plans

On April 25, the UK government confirmed new targets to ensure 10% of all jet fuel in flights taking off from the UK comes from sustainable sources by 2030 through its sustainable aviation fuel (SAF) mandate. The SAF mandate will, subject to parliamentary approval, come into force in January 2025.

III. EUROPE

European Parliament approves Corporate Sustainability Due Diligence Directive

On April 24, the European Parliament passed the Corporate Sustainability Due Diligence Directive, meaning the directive has now passed all legislative phases. Once signed into law by the EU Council, EU member states will be given two years to transpose the directive into national laws. Under the directive, companies will need to conduct human rights and environmental due diligence on their own operations, their subsidiaries and their supply chain both within and outside the European Union.

Enforcement is scheduled to begin in 2027 for companies with over 5,000 employees and annual turnover of more than €1.5 billion, in 2028 for companies with more than 3,000 employees and €900 million in turnover, and in 2029 for companies with more than 1,000 employees and €450 million in turnover. Non-EU companies, parent companies and companies with franchising or licensing agreements in the EU reaching the same turnover thresholds in the EU will also be required to comply.

European Parliament adopts new regulation to reduce methane emissions

On April 10, the European Parliament voted to approve a provisional agreement with the EU member countries on a new law aimed at reducing methane emissions from the energy sector. The new regulation covers direct methane emissions from the oil, fossil gas and coal sectors, and from biomethane once it is injected into the gas network. The final act now has to be adopted by the Council of the European Union before being published in the EU Official Journal and entering into force 20 days later.

European Court of Human Rights rules on Swiss climate policies

On April 9, the European Court of Human Rights (ECHR) ruled in favour of a Swiss association which had argued the Swiss government was not taking sufficient action to mitigate the effects of climate change. The ECHR found that the European Convention on Human Rights (Convention) encompasses a right to effective protection by the State authorities from the serious adverse effects of climate change on lives, health, well-being and quality of life and that there had been a violation of the right to respect for private and family life of the Convention. Further, the it held that the Swiss government had failed to comply with its duties (“positive obligations”) under the Convention concerning climate change by failing to comply with its own targets for cutting greenhouse gas emissions and to set a national carbon budget.

European Commission opens two investigations regarding subsidies for solar manufacturers

On April 3, the European Commission announced it had launched two in-depth investigations under the Foreign Subsidies Regulation, relating to the potentially market distortive role of foreign subsidies given to bidders in a public procurement procedure. Focus of the probe are two consortiums bidding for the development of a solar park in Romania, part-financed by EU funds. The European Commission will assess whether the economic operators concerned did benefit from an unfair advantage to win public contracts in the European Union.

According to the Foreign Subsidies Regulation, companies are obliged to notify their public procurement tenders in the European Union when the estimated value of the contract exceeds €250 million, and when the company was granted at least €4 million in foreign financial contributions from at least one third country in the three years prior to notification.

European Parliament votes to leave Energy Charter Treaty

On April 24, the European Parliament voted for the European Union to withdraw from the Energy Charter Treaty (ECT). This vote follows a resolution adopted by the European Parliament in 2022 which called for the European Union to exit the ECT. The Council of the European Union can now adopt the decision by qualified majority.

This resolution follows the departure of a number of EU member states as well as the United Kingdom, as reported on in our February Edition.

European Parliament adopts directive on “right to repair”

On April 23, the European Parliament adopted a new directive on the so-called “right to repair” which intend to clarify the obligations for manufacturers to repair goods. The new rules require manufacturers provide certain repair services and inform consumers about their rights to repair. Goods repaired under the warranty will benefit from an additional one-year extension of the legal guarantee. After the legal guarantee has expired, manufacturer would still be required to repair common household products, such as washing machines, vacuum cleaners, and smartphones. Once the directive is formally approved by Council of the European Union and published in the EU Official Journal, member states will have 24 months to transpose it into national law.

European Commission investigates airlines for misleading greenwashing practices

On April 30, the European Commission announced that it sent letters to 20 airlines identifying several types of potentially misleading green claims and inviting them to bring their practices in line with EU consumer law within 30 days. The letters relate to claims made by airlines that the CO₂ emissions caused by a flight could be offset by climate projects or through the use of sustainable fuels, to which the consumers could contribute by paying additional fees. The European Commission is concerned that the identified practices can be considered as misleading actions/omissions, prohibited under the Unfair Commercial Practices Directive.

IV. NORTH AMERICA

SEC stays implementation of new rules to enhance climate-related disclosures

On April 4, the U.S. Securities and Exchange Commission (SEC) issued an Order pausing implementation of new rules adopted in March 2024 requiring public companies to disclose certain climate change-related information in their SEC filings. The Order follows legal challenges by various parties that have been consolidated for review by the Eighth Circuit. In the Order, the SEC noted: “In issuing a stay, the Commission is not departing from its view that the Final Rules are consistent with applicable law and within the Commission’s long-standing authority to require the disclosure of information important to investors in making investment and voting decisions. Thus, the Commission will continue vigorously defending the Final Rules’ validity in court and looks forward to expeditious resolution of the litigation.”

Reminder for resource extraction issuers

SEC rules that became final in March 2021 (available here) require additional disclosures by public companies that engage in the commercial development of oil, natural gas or minerals. Under the final rule, domestic or foreign “resource extraction issuers” are required to annually disclose information about certain payments made to foreign governments or the U.S. federal government on Form SD.

The final rule allowed for a two-year transition period after the effective date, with initial Form SD filings due no later than 270 calendar days after the end of an issuer’s next completed fiscal year (e.g., September 26, 2024 for issuers with a December 31, 2023 fiscal year end). While the adopting release specifically referred to September 30, 2024 as the due date for a company with a fiscal year end of December 31, 2023 (274 days after year end), we recommend filing the Form SD by September 26, 2024 to ensure timely compliance with the rule’s deadline. More information on these filings is available in our recent client alert.

NYC Comptroller and NYC Public Pension Boards reach agreement on climate finance disclosures

On April 4, New York City Comptroller Brad Lander announced agreements with JPMorgan Chase, Citigroup, and Royal Bank of Canada whereby the banks will regularly disclose their ratio of clean energy supply financing to fossil fuel extraction financing and their underlying methodology. The new agreements follow the submission of shareholder proposals for 2024 annual meetings by three of New York City’s pension funds – the New York City Employees’ Retirement System, the Teachers’ Retirement System, and the Board of Education Retirement System (BERS) – at several banks asking each to disclose the new metric.

Federal civil rights complaint filed against Shake Shack

As reported on in our DEI Task Force Update, on April 25, America First Legal (AFL), the conservative organization founded and run by former Trump policy advisor Stephen Miller, announced that it had filed a federal civil rights complaint with the EEOC against Shake Shack, Inc., alleging race and sex discrimination in violation of Title VII. AFL claims that Shake Shack discriminates on the basis of race and sex by unlawfully considering the protected characteristics of applicants and employees when making employment decisions. In support of these allegations, AFL cites the company’s May 2023 Proxy Statement, in which Shake Shack outlined its “5-Year Diversity Targets” that concentrate on women and people of color. Specifically, Shake Shack set a goal for 50% of its leadership roles to be occupied by people of color by the end of 2025, and also mandated that at least two underrepresented minorities, women, or people of color be interviewed when hiring for leadership positions. AFL highlights Shake Shack’s June 2023 update on its DEI goals, as well, where the company cited a 33% increase in the representation of women and an 18% increase in people of color in leadership positions since establishing its 2025 diversity goals. AFL also sent a cease and desist letter to Shake Shack’s CEO and Board of Directors demanding that the company end its allegedly discriminatory employment practices.

New federal contracts regulations on sustainability

On April 22, the FAR Council (U.S. Department of Defense, General Services Administration, and National Aeronautics and Space Administration) published final rules amending the Federal Acquisition Regulation (FAR) to focus on current environmental and sustainability matters and to implement a requirement for agencies to procure sustainable products and services to the maximum extent practicable. Draft rules had previously been published in August 2023 and the final rules include a number of clarifications to the FAR.

Biden administration announces $20 billion in grants to finance clean energy projects in low income communities

On April 4, the Biden administration announced its selection for $20 billion in grant awards under two competitions within the $27 billion Greenhouse Gas Reduction Fund (GGRF), which was created under the Inflation Reduction Act. The GGRF consists of a series of programs designed to finance clean technology deployment that also includes building the capacity of community lenders to provide financing for clean energy projects. Over 70% of the new awards will be directed to low-income and disadvantaged communities.

V. APAC

Japan releases proposed IFRS based sustainability reporting standards

On April 5, 2024, the Sustainability Standards Board of Japan (SSBJ) announced the release of new drafts for proposed reporting standards regarding sustainability and climate-related information, which are intended to align with the sustainability disclosure standards by the IFRS Foundation’s International Sustainability Standards Board (ISSB).

The SSBJ has released the standards as three exposure drafts, as opposed to the ISSB’s two standards, by dividing IFRS 1 (general sustainability) into two standards. A summary of the differences between its exposure drafts and the ISSB standards has been provided by the SSBJ. The SSBJ is currently soliciting feedback on the exposure drafts.

Singapore Monetary Authority launches sustainable finance jobs transformation map

On April 17, 2024, the Monetary Authority of Singapore (MAS) and Institute of Banking and Finance (IBF), supported by Workforce Singapore (WSG), launched the “sustainable finance jobs transformation map”, which lays out the impact of sustainability trends on jobs in Singapore’s financial services sector and the emerging skills that are predicted to be required to serve sustainable financing demand in the region. The MAS also set aside S$35 million in funds to support upskilling and reskilling, and develop specialists in sustainable finance over the next three years.

Hong Kong Stock Exchange Consultation on Aligning Disclosure Standard with ISSB

On April 19, 2024, the Stock Exchange of Hong Kong (HKEX) published the conclusions of its consultation on the enhancement of climate-related disclosures under its environmental, social and governance (ESG) framework. Following the feedback received, the HKEX will adopt its consultation proposals, modified to reflect IFRS S2 Climate-related Disclosures (IFRS S2) more closely.

The amended listing rules will come into effect on January 1, 2025 and a phased approach for the implementation of the new climate requirements has been laid out by HKEX.

ASEAN Taxonomy Board releases Version 3 of its Sustainable Finance Taxonomy

In March 2024, the ASEAN Taxonomy Board (ATB) released Version 3 of the ASEAN Taxonomy for Sustainable Finance (ASEAN Taxonomy), part of its overarching taxonomy to advance sustainable finance practices across the region. The ASEAN Taxonomy adopts a multi-tiered framework which allows assessment of sustainable activities through either the principles-based Foundation Framework, or the Plus Standard with a more detailed methodology using application of technical screening criteria (TSC). Having published TSC for Electricity, Gas, Steam and Air Conditioning Supply (Energy) sector in ASEAN Taxonomy Version 2, the ASEAN Taxonomy Version 3 introduces TSC for two more focus sectors, namely Transportation & Storage and Construction & Real Estate, which covers activities including construction and renovation of buildings and acquisition and ownership of buildings, as well as urban and freight transport, and infrastructure for land, water, and air transport, among others.

Warmest regards,
Susy Bullock
Elizabeth Ising
Perlette M. Jura
Ronald Kirk
Michael K. Murphy
Selina S. Sagayam

Chairs, Environmental, Social and Governance Practice Group, Gibson Dunn & Crutcher LLP

For further information about any of the topics discussed herein, please contact the ESG Practice Group Chairs or contributors, or the Gibson Dunn attorney with whom you regularly work.

The following Gibson Dunn lawyers prepared this update: Elizabeth Ising, Patricia Tan Openshaw, Selina S. Sagayam, and Theresa Witoszynski.

Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any leader or member of the firm’s Environmental, Social and Governance practice group:

Environmental, Social and Governance (ESG):
Susy Bullock – London (+44 20 7071 4283, [email protected])
Elizabeth Ising – Washington, D.C. (+1 202.955.8287, [email protected])
Perlette M. Jura – Los Angeles (+1 213.229.7121, [email protected])
Ronald Kirk – Dallas (+1 214.698.3295, [email protected])
Michael K. Murphy – Washington, D.C. (+1 202.955.8238, [email protected])
Patricia Tan Openshaw – Hong Kong (+852 2214-3868, [email protected])
Selina S. Sagayam – London (+44 20 7071 4263, [email protected])

The U.S. Food and Drug Administration’s highly anticipated final rule on laboratory-developed tests was officially published in the Federal Register on Monday, May 6, 2024.

On April 29, 2024, the U.S. Food and Drug Administration (FDA) released its highly anticipated final rule on laboratory-developed tests (LDTs) (“LDT Final Rule”), which was officially published in the Federal Register on Monday, May 6, 2024.[1] The LDT Final rule comes roughly six months after FDA published its proposal to assert jurisdiction over LDTs.[2] In the LDT Final Rule, FDA amended its regulations to make explicit that LDTs fall within the definition of “device” under the Federal Food, Drug, and Cosmetic Act (“FDCA”), subjecting these tests to extensive premarket review and postmarket compliance requirements over a four-year phase-in period.

In this update, we summarize four key takeaways from the LDT Final Rule. First, the LDT Final Rule is largely identical in substance to the 2023 proposed rule. Second, there have been significant changes to FDA’s targeted enforcement discretion policies, which are intended, in part, to allocate the agency’s scarce enforcement resources on a risk-benefit basis. Third, the LDT Final Rule has spurred significant opposition from Congress, suggesting a potential revival of congressional efforts to clarify FDA’s authority over LDTs. And fourth, litigation is coming, bringing some uncertainty as to how final, in fact, the Final LDT Rule is.

The LDT Final Rule makes minimal changes to the FDA regulatory text, consistent with the 2023 proposed rule

Last year, we reported on the small wording changes FDA proposed to make to its regulations. As we noted, FDA planned to make a surgical change to its definition of “in vitro diagnostic products” (“IVDs”), which are deemed to be “devices” under the FDCA in the agency’s regulations. The codified amendment to the regulatory language in the LDT Final Rule is the same as in the proposed rule:

In vitro diagnostic products are those reagents, instruments, and systems intended for use in the diagnosis of disease or other conditions, including a determination of the state of health, in order to cure, mitigate, treat, or prevent disease or its sequelae. Such products are intended for use in the collection, preparation, and examination of specimens taken from the human body. These products are devices as defined in section 201(h) of the Federal Food, Drug, and Cosmetic Act (the act), and may also be biological products subject to section 351 of the Public Health Service Act, including when the manufacturer of these products is a laboratory.[3]

The sole change in the LDT Final Rule is to the authorities listed to 21 C.F.R. Part 809, which governs IVDs. In addition to adding various device authorities introduced in the 2023 proposed rule, FDA also added a reference to section 351 of the Public Health Service Act (“PHSA”), which addresses IVDs that are subject to licensure as biological products, rather than the approval or clearance pathways for most medical devices.[4]

The LDT Final Rule expands the scope of FDA’s enforcement discretion policies, which will help appease opponents of the rule

As in the 2023 proposed rule, the preamble of the LDT Final Rule includes enforcement discretion policies in acknowledgement of the significant changes to industry’s compliance obligations. While some of these policies were the same as originally proposed, there are some differences:

Four-year phase-in of medical device regulatory requirements: In the LDT Final Rule, FDA established a slightly modified version of its proposed phase-in schedule for industry to comply with medical device requirements:
- Stage 1 (1 year after the effective date of the LDT Final Rule, July 5, 2024): Compliance with respect to medical device reports (“MDR”) and correction and removal reporting requirements, and complaint file requirements under the Quality System Regulation (“QSR”). Notably, FDA expects manufacturers to comply with these requirements for the LDTs subject to this phaseout policy before it expects compliance with clearance or approval requirements.
- Stage 2 (2 years after the effective date): Compliance with medical device requirements other than MDR, correction and removal reporting, complaint files, and registration and listing.
- Stage 3 (3 years after effective date): Compliance with respect to QSR requirements other than complaint files.
- Stage 4 (3.5 years after effective date of the final rule): Compliance with respect to premarket review for high-risk LDTs. FDA indicates that it will use the existing device classification rubric for LDTs, with “low,” “medium,” and “high” risk corresponding to Class I, II, and III, respectively. FDA notes that it does not intend to take enforcement against high-risk devices with timely-submitted premarket submissions until the agency completes review of its application. The phase-in period for premarket review notably aligns with the timeframe for renewal of the Medical Device User Fee Amendments (“MDUFA”) in 2027.
- Stage 5 (4 years after effective date of the final rule): Compliance with respect to premarket review for moderate- and low-risk LDTs.[5]
Targeted enforcement discretion policies: FDA has also adopted various enforcement discretion policies based on its assessments of the risks and benefits of certain classes of LDTs. These include a number of new policies in the LDT Final Rule in response to comments.
- FDA plans to continue to exempt from all medical device requirements certain categories of tests that it believes are unlikely to pose significant risks, or are conducted in circumstances that will mitigate those risks, such as being subject to other regulatory oversight. These include LDTs of the type on the market at the time of the 1976 Medical Device Amendments to the FDCA; human leukocyte antigen (“HLA”) tests designed, manufactured, and used within a single laboratory appropriately certified under the Clinical Laboratory Improvement Amendments (“CLIA”); and, tests solely for forensic or law enforcement purposes. In the LDT Final Rule, FDA added to this list LDTs manufactured and performed within the U.S. Department of Defense (“DoD”) or the Veterans Health Administration (“VHA”).[6]
- In the final rule, FDA also adopted an enforcement discretion policy with respect to premarket review requirements for LDTs approved by the New York State Department of Health’s Clinical Laboratory Evaluation Program (“NYS CLEP”). The agency acknowledged that NYS CLEP’s review of high and moderate risk LDTs for analytical and clinical validity mitigated risks of inaccurate or unreliable LDTs.[7]
- Lastly, FDA stated that it would not enforce premarket requirements and most QSR requirements for certain classes of LDTs, based on the lower risk associated with those tests, a specific unmet need for those devices, or both factors.
  - These classes include validated LDTs manufactured and performed by a laboratory integrated within a healthcare system to meet an unmet need of patients receiving care within the same healthcare system—a nod to concerns from academic medical centers.
  - Other classes of LDT subject to this enforcement discretion policy include currently marketed IVDs offered as LDTs prior to the issuance of the LDT Final Rule, provided they are not modified in ways that could affect their basic safety and effectiveness profile, and non-molecular antisera LDTs for rare red blood cell (RBC) antigens manufactured and performed by blood establishments, for which there is no alternative IVD available to meet a patient’s need for a compatible blood transfusion.[8]

FDA also indicated that it could adopt additional enforcement discretion policies in the future, similar to the agency’s policies for COVID-19 and mpox tests during the respective public health emergencies.[9] Indeed, on the same day the agency announced the Final LDT Rule, it also released two draft guidance documents related to public health emergencies.[10] The first guidance document outlines an enforcement discretion policy for “immediate response” tests in the absence of an emergency declaration under FDCA section 564, provided certain validation, FDA notification, and transparency measures are taken.[11] The second guidance document describes FDA’s considerations in adopting enforcement policies for unapproved and uncleared tests during a Section 564 public emergency.[12] Notices announcing both policies were published in the Federal Register on May 6, 2024.[13]

Scrutiny of the LDT Final Rule from Capitol Hill is hot—and heating up—with possible legislative action on the horizon

Republican leadership has swiftly rebuked FDA for issuing the LDT Final Rule, indicating a legislative response may be brewing. Echoing his prior comments on the proposed rule,[14] Sen. Bill Cassidy (R – La.), the ranking member of the Senate Health, Education, Labor and Pensions (“HELP”) Committee, stated that “[t]he FDA does not have the authority to unilaterally increase its regulatory jurisdiction,” that “Congress has made clear across multiple statutes that LDTs are not medical devices subject to FDA regulation,” and that the LDT Final Rule “will undermine access to essential laboratory tests, increase health care costs, and ultimately harm patients.”[15] Similarly, Rep. Cathy McMorris (R – Wash.), the chair of the House Energy and Commerce Committee, denounced the LDT Final Rule as “the latest example of executive branch overreach that will have devastating impacts on patients and families across the country.”[16] Her comments followed a hearing of the House Health Subcommittee on the impact of FDA’s proposed rule, in which leadership from laboratory entities and the medical device industry provided their disparate views.[17]

Indeed, the LDT Final Rule could reinvigorate congressional efforts to pass the Verifying Accurate Leading-Edge IVCT Development Act (“VALID Act”), which failed to become law at the end of 2022,[18] and was most recently introduced in the House of Representatives (but not yet the Senate) in 2023.[19] If passed, the VALID Act would provide FDA clear statutory authority to LDTs as a separate category of medical products (in vitro clinical tests, or “IVCTs”) under a more tailored, risk-based approach—an approach favored by a number of comments to the proposed rule.[20] Nonetheless, the VALID Act faces challenging headwinds, particularly from laboratories and academic medical centers opposed to any FDA regulation of LDTs, and may require an external push in order to succeed. Litigation over the LDT Final Rule—and particularly any outcome that forecloses FDA jurisdiction without statutory changes—may very well be the tipping point for legislative efforts at LDT regulation, especially as negotiations begin on policy riders for the next FDA user fee reauthorization legislation in 2027.

Litigation over the Final LDT Rule is coming

Opponents to the LDT Final Rule have been eager to voice concerns about FDA’s authority to regulate LDTs, with more than 25 groups meeting with the Office of Management and Budget during its review and almost 7,000 comments to the docket for the proposed rule.[21] As shown by the 160-page final rule, as published in the Federal Register, the agency can expect legal challenges on multiple fronts, including its statutory authority to regulate LDTs, First and Fifth Amendment constitutional concerns, and compliance with requirements under the Administrative Procedures Act (“APA”) and the Unfunded Mandates Reform Act (“UMRA”). Thus, the future of FDA’s oversight over LDTs remains far from clear, and the LDT Final Rule is likely to engender even more activity in the long-running saga of regulatory attention to the testing space.

__________

[1] 89 Fed. Reg. 37286 (May 6, 2024).

[2] 88 Fed. Reg. 68006 (Oct. 3, 2023). FDA also published a press release accompanying the proposed rule. FDA News Release, “FDA Proposes Rule Aimed at Helping to Ensure Safety and Effectiveness of Laboratory Developed Tests” (Sept. 29, 2023).

[3] 89 Fed. Reg. at 37444-45 (amending 21 C.F.R. § 809.3(a)).

[4] As amended, the authorities for Part 809 now list the following: “21 U.S.C. 321(h)(1), 331, 351, 352, 360, 360c, 360d, 360e, 360h, 360i, 360j, 371, 372, 374, 381, and 42 U.S.C. 262.” Id.

[5] Id. at 37294.

[6] Id. at 37297-28.

[7] Id. at 37299-301.

[8] Id. at 37301-07.

[9] Id. at 37925.

[10] FDA News Release, “FDA Takes Action Aimed at Helping to Ensure the Safety and Effectiveness of Laboratory Developed Tests” (April 29, 2024).

[11] FDA, Draft Guidance for Laboratory Manufacturers and Food and Drug Administration Staff: Enforcement Policy for Certain In Vitro Diagnostic Devices for Immediate Public Health Response in the Absence of a Declaration under Section 564 (May 2024); see 21 U.S.C. § 360bbb-3.

[12] FDA, Draft Guidance for Industry and Food and Drug Administration Staff: Consideration of Enforcement Policies for Tests During a Section 564 Declared Emergency (May 2024).

[13] 89 Fed. Reg. 37158 (May 6, 2024); 89 Fed. Reg. 37232 (May 6, 2024).

[14] U.S. Senate Committee on Health, Education, Labor and Pensions. News Release, “Ranking Member Cassidy Releases Statement on FDA Proposed Laboratory Developed Tests Rule” (Sept. 29, 2023). Earlier this year, Sen. Cassidy also requested information from stakeholders on regulation of clinical tests, observing that “[s]ince 1976, there have been no significant reforms to the regulation of clinical tests, even as new, innovative tests are being used in health care settings.” U.S. Senate Committee on Health, Education, Labor and Pensions News Release, “Ranking Member Cassidy Seeks Information from Stakeholders on Regulation of Clinical Tests” (March 13, 2024).

[15] U.S. Senate Committee on Health, Education, Labor and Pensions, News Release, “Ranking Member Cassidy Rebukes Biden Admin Attempt to Dramatically Increase FDA Authority over Laboratory Developed Tests” (Apr. 29, 2024).

[16] U.S. House Committee on Energy and Commerce Press Release, “Chair Rodgers Statement on FDA LDT Rule” (Apr. 29, 2024).

[17] U.S. House Committee on Energy and Commerce Press Release, “Health Subcommittee Hearing: ‘Evaluating Approaches to Diagnostic Test Regulation and the Impact of the FDA’s Proposed Rule’” (Mar. 21, 2024).

[18] The VALID Act was approved by the Senate HELP Committee in 2022, but ultimately failed to become law. See U.S. Senate Committee on Health, Education, Labor and Pensions. News Release, “Murray Leads HELP Committee in Advancing Historic Bipartisan Bills to Lower Drug Costs, Strengthen Workers’ Retirement Security, More” (June 14, 2022); “Healthcare groups urge Congress to pass diagnostic testing reform before year’s end,” MedTech Dive (Dec. 13, 2022).

[19] See H.R. 2369, 118th Cong. (2023).

[20] See, e.g., 89 Fed. Reg. at 37352-55, 37366-67, 37379-81; see also, e.g., “US lawmakers again propose diagnostics reform bill,” Regulatory Focus (Mar. 30, 2023); “Stakeholders continue push for VALID Act in wake of FDA’s proposed LDT rule,” Regulatory Focus (Oct. 6, 2023).

[21] See Office of Information and Regulatory Affairs, “OIRA Conclusion of EO 12866 Regulatory Review; RIN 0910-AI85.”

The following Gibson Dunn lawyers assisted in preparing this update: Katlin McKelvie and Carlo Felizardo.

Gustav W. Eyler – Washington, D.C. (+1 202.955.8610, [email protected])
Katlin McKelvie – Washington, D.C. (+1 202.955.8526, [email protected])
John D. W. Partridge – Denver (+1 303.298.5931, [email protected])
Jonathan M. Phillips – Washington, D.C. (+1 202.887.3546, [email protected])
Carlo Felizardo – Washington, D.C. (+1 202.955.8278, [email protected])

Gibson Dunn’s Workplace DEI Task Force aims to help our clients develop creative, practical, and lawful approaches to accomplish their DEI objectives following the Supreme Court’s decision in SFFA v. Harvard. Prior issues of our DEI Task Force Update can be found in our DEI Resource Center. Should you have questions about developments in this space or about your own DEI programs, please do not hesitate to reach out to any member of our DEI Task Force or the authors of this Update (listed below).

Key Developments:

On April 24, 2024, the Wisconsin Institute for Law & Liberty (WILL), a conservative non-profit organization, sent a letter to the American Bar Association (ABA) concerning its Judicial Clerkship Program and Judicial Intern Opportunity Program, claiming that these programs unlawfully use race as a criterion for selecting participants. The ABA’s Judicial Clerkship Program consists primarily of a conference that “introduces law students from diverse backgrounds . . . to judges and law clerks” and “informs and educates the students as to life-long benefits of a judicial clerkship.” Participating law schools identify “four to six law students who are from underrepresented communities of color” to send to the conference. The ABA’s Judicial Internship Opportunity Program offers opportunities for students who are members of traditionally underrepresented racial and ethnic groups in the legal profession to work with a judge over the summer. Applicants for this program must indicate how they qualify and may check boxes specifying their race, gender, socioeconomic status, sexual orientation, gender orientation, or disability status. WILL alleges that the criteria for both of these programs constitute unlawful racial quotas. In its letter, WILL cautioned the ABA that it will pursue legal action unless the ABA announces by April 30, 2024 that these programs will no longer consider race as an eligibility factor. As of May 7, 2024, WILL has not reported any subsequent legal action.

On April 25, 2024, the Office for Civil Rights (OCR) for the U.S. Department of Education opened an investigation into Western Kentucky University’s Athletics Minority Fellowship program, which offers four $2,000 undergraduate scholarships to students who are “underrepresented ethnic minorit[ies]” interested in athletic administration careers. The investigation responds to a complaint filed on September 16, 2023 by the Equal Protection Project (EPP) alleging that the program discriminates on the bases of race and national origin because white students are not eligible. The website for the program is no longer active, but EPP states that it “doesn’t matter [if the program is no longer operating] because the discriminatory bell cannot be unrung.” EPP further demands that the university create “a remedial plan to compensate students shut out of this scholarship.” EPP’s complaint also challenges the university’s Distinguished Minority Fellowship program, which provides $15,000 to graduate students who are “African American, American Indian/Alaskan Native, Native Hawaiian/Pacific Islander, two or more races or Hispanic/Latino.” OCR has indicated that there is already an ongoing investigation into that program.

On April 25, 2024, America First Legal (AFL), the conservative organization founded and run by former Trump policy advisor Stephen Miller, announced that it had filed a federal civil rights complaint with the EEOC against Shake Shack, Inc., alleging race and sex discrimination in violation of Title VII. AFL claims that Shake Shack discriminates on the basis of race and sex by unlawfully considering the protected characteristics of applicants and employees when making employment decisions. In support of these allegations, AFL cites the company’s May 2023 Proxy Statement, in which Shake Shack outlined its “5-Year Diversity Targets” that concentrate on women and people of color. Specifically, Shake Shack set a goal for 50% of its leadership roles to be occupied by people of color by the end of 2025, and also mandated that at least two underrepresented minorities, women, or people of color be interviewed when hiring for leadership positions. AFL highlights Shake Shack’s June 2023 update on its DEI goals, as well, where the company cited a 33% increase in the representation of women and an 18% increase in people of color in leadership positions since establishing its 2025 diversity goals. AFL also sent a cease and desist letter to Shake Shack’s CEO and Board of Directors demanding that the company end its allegedly discriminatory employment practices.

As state lawmakers wrap up a busy legislative session, several states have passed bills seeking to promote DEI. On April 17, 2024, Virginia’s legislature enacted House Bill 1404, which establishes the Small SWaM (Small, Women-owned and Minority) Business Procurement Enhancement Program. The program fosters “initiatives to enhance the development of small businesses, microbusinesses, women-owned businesses, [and] minority-owned businesses” by supporting procurement opportunities for SWaM businesses participating in state-funded projects. On March 25, 2024, Washington’s legislature enacted House Bill 1377, which requires continuing education providers to align their content with the state cultural competency and DEI standards. And Maryland’s legislature has enacted two bills: Senate Bill 205, which requires at least one member of the Board of Regents of the University System of Maryland to be a graduate of a historically Black college or university in the state; and House Bill 1212, which establishes a DEI director for the State Retirement and Pension System.

Media Coverage and Commentary:

Below is a selection of recent media coverage and commentary on these issues:

New York Times, “What to Know About State Laws That Limit or Ban D.E.I. Efforts at Colleges” (April 21): The Times’ Anna Betts reports on recent efforts by Republican state lawmakers to roll back college diversity, equity, and inclusion initiatives. Betts explains that proponents of on-campus DEI policies and programs cite their importance in reversing decades of exclusion, but critics argue that DEI programs leave out other groups and perpetuate “reverse racism.” Betts reports that, according to The Chronicle of Higher Education, state lawmakers critical of DEI initiatives have introduced 84 bills targeting publicly funded diversity programs and admissions practices since 2023. Twelve have been enacted into law and 13 are awaiting governors’ signatures. In certain states, including Florida and Texas, these laws have eliminated all DEI-related positions and programs at public universities. But in other states, Betts says, schools are “work[ing] around these laws” by “reintroducing their D.E.I. offices under different names, and rewriting requirements to eliminate words like ‘diversity’ and ‘equity.’”
Forbes, “EEOC And Investors Support Hello Alice’s Grants For Black Entrepreneurs” (April 24): Geri Stengel, president of diverse entrepreneurship consultancy firm Ventureneer, writes about the legal and financial supporters of Hello Alice, a fintech platform providing funding and AI-driven financial tools to small business owners. Some of Hello Alice’s grants are tailored to historically underserved and underfunded groups, including the Black, Latino, Native American, LGBTQ+, rural, urban, and veteran communities. Like Fearless Fund, a venture capital fund providing financing to businesses led by women of color, Hello Alice is currently fighting a lawsuit alleging that these grantmaking policies violate Section 1981, which prohibits consideration of race in contracting. Stengel notes that the EEOC has filed an amicus brief in support of Hello Alice, arguing that SFFA does not prohibit voluntary affirmative action programs in private investment. And although the lawsuit initially cost Hello Alice some investors and grant sponsors, Stengel writes that the organization recently closed its Series C funding round, allowing it to expand its financing offerings for small businesses.
Daily Labor Report, “NYC Settles White Executives’ Demotion Suit Over Diversity Push” (April 25): Three former New York City Department of Education executives have settled their race-discrimination suit against the city, writes Bloomberg’s Ufonobong Umanah. In the suit, Herrera v. New York Department of Education, the white female plaintiffs alleged that they were demoted and replaced with less-qualified Black employees. Previously, Judge Mary Kay Vyskocil of the United States District Court for the Southern District of New York had granted summary judgment to the city on the plaintiffs’ sex discrimination claims, but denied judgment on their race discrimination claims, based in part upon former Mayor Bill de Blasio’s testimony “that it was ‘a policy’ of his administration to consider race in staffing decisions because he wanted the racial composition of his administration to mirror the racial diversity of the City.” The parties settled for an undisclosed amount.
Washington Post, “Can this firm invest in only Black women? This case will decide.” (April 29): The Post’s Julian Mark reports on Fearless Fund’s ongoing work as the venture capital firm awaits the Eleventh Circuit’s decision in American Alliance for Equal Rights v. Fearless Fund Management, LLC. Mark notes that AAER’s lawsuit is seen by some as “an inflection point” for civil rights and racial equity. Mark reports that the lawsuit is taking a toll on Fearless Fund itself—founder Arian Simone said the firm hasn’t had a closing since AAER filed its complaint in August 2023, although its portfolio remains “extremely healthy.” Simone told Mark that the exceptionality of Fearless Fund’s success in an industry dominated by white men only underscores the importance of its mission. “I would love a world that was equitable, where everybody received their fair portion,” Simone said. “If we lived in that world, I’d be fine—I can stop the Fearless Fund. But we don’t live in that world.” (Gibson Dunn represents the Fearless Fund in the litigation.)
Daily Labor Report, “DeSantis Takes Aim Again at Workplace DEI Despite Court Loss” (May 2): Bloomberg’s Chris Marr reports on Florida Governor Ron DeSantis’s May 2 comments about workplace diversity training. During a press conference, Governor DeSantis said that mandatory training sessions on inherent racial and gender bias can create a hostile work environment under existing state law. The governor also indicated that he plans to address the issue with administrative action. These statements come two months after the Eleventh Circuit affirmed a district court’s order preliminarily enjoining operation of Florida’s “Stop W.O.K.E. Act” in Honeyfund.com, Inc. v. DeSantis, — F.4th —, 2024 WL 909379 (11th Cir. Mar. 4, 2024), holding that the law “exceeds the bounds of the First Amendment” by “target[ing] speech based on its content” and thus “penaliz[ing] certain viewpoints.” But, as Marr reports, the governor maintains “that current Florida civil rights laws prohibit[] some of this racist training that is being done and imposed under the rubric of D, E, and I.”
Law360, “EEOC ‘Up For A Fight’ As High Court Title VII Test Takes Shape” (May 2): Law360’s Anne Cullen reports on a recent amicus brief filed by the EEOC in which the Commission argues that courts should apply the Supreme Court’s holding in Muldrow v. St. Louis—that employees alleging discrimination under Title VII need not show they faced significant harm to state a viable claim—to suits under the Americans with Disabilities Act (ADA). The case in which the EEOC filed its brief, Scheer v. Sisters of Charity of Leavenworth Health System, Inc. (No. 24-1055, 10th Cir.), is an appeal of the district court’s grant of summary judgment to the employer. In Scheer, the plaintiff was required to attend mandatory mental health treatment after expressing suicidal ideation but was later terminated after she refused treatment and would not sign a release of liability. The court held that the plaintiff had not shown that mandatory treatment constituted an adverse employment action under the ADA. Now, the Commission is taking the position that Muldrow abrogated the prior adverse-employment-action test in all workplace disputes, not just those under Title VII, and that the new, lower standard would make counseling referrals actionable. Cullen reports that this position “proved divisive internally,” with two of the five Commissioners voting not to file the brief in Scheer. Jason Schwartz, Gibson Dunn partner and co-chair of the firm’s Labor & Employment group, told Cullen that the Commission’s brief is an “overreading” of Muldrow: “It’s like they took the Play-Doh or Silly Putty and tried to stretch it as far as possible. It’s a super broad reading of Muldrow, broader than the Supreme Court intended, and certainly a reading that is going to encourage much more litigation.”

Case Updates:

Below is a list of updates in new and pending cases:

1. Contracting claims under Section 1981, the U.S. Constitution, and other statutes:

Crystal Bolduc v. Amazon.com Inc., No. 4:22-cv-615-ALM (E.D. Tex. Jul. 20, 2022): On July 20, 2022, AFL filed a putative federal class action lawsuit on behalf of a white plaintiff who sought to become an Amazon delivery service provider (DSP), alleging race discrimination in violation of Section 1981 in Amazon’s supplier-diversity initiatives, including a program extending $10,000 grants to Amazon delivery service providers allegedly based in part on race.
- Latest update: On April 25, 2024, the court partially granted Amazon’s motion to dismiss and dismissed the case without prejudice. The court found that Bolduc lacked Article III standing to sue because she never applied to Amazon’s DSP program and thus has suffered no actual or imminent injury. Although Bolduc argued that she was deterred from applying because of the allegedly discriminatory grant, the court explained that a plaintiff must submit to a policy before bringing an action to challenge it. The court concluded that “Bolduc falls outside the class of individuals potentially suffering a direct and personal injury: DSP owners who have been denied any contractual benefit due to their race.” Because the issue of standing was sufficient to dismiss the case, the court did not consider whether Bolduc had failed to state a claim under Section 1981 as Amazon argued in its motion to dismiss. On April 26, 2024, Bolduc filed a notice of appeal.
Poer v. Jefferson Cty. Comm’n , No. 22-11401 (11th Cir. May 1, 2024): In August 2019, Angela Poer filed suit in the Northern District of Alabama alleging that the Jefferson County Commission discriminated against her based on her race in violation of Title VII and Sections 1981 and 1983 by refusing to grant her transfer request and firing her. Poer argued that her boss, a Black woman, created a hostile work environment and denied her transfer request because of her animus against white people. The district court granted the Commission’s motion for summary judgment, finding that no direct evidence supported Poer’s racial discrimination claims and any circumstantial evidence was insufficient to create a reasonable inference that her termination was racially motivated. Poer appealed.
- Latest update: On May 1, 2024, the Eleventh Circuit affirmed the district court’s grant of summary judgment in favor of the Commission. The court found that the Commission offered several legitimate, non-discriminatory explanations for terminating Poer, including multiple performance issues caused by her repeated absences and mishandling of money. The court rejected Poer’s argument that her boss’s alleged racially discriminatory remarks alone were sufficient to preclude summary judgment, finding that Poer failed to tie any discriminatory comments to the decisionmakers who actually fired her.
Valencia AG, LLC v. New York State Off. of Cannabis Mgmt. et al., No. 5:24-cv-116-GTS (N.D.N.Y. Jan. 24, 2024): On January 24, 2024, Valencia AG, a cannabis company owned by white men, sued the New York State Office of Cannabis Management for discrimination, alleging that New York’s Cannabis Law and implementing regulations favored minority-owned and women-owned businesses. The regulations include goals to promote “social & economic equity” (“SEE”) applicants, which the plaintiff claims violate the Fourteenth Amendment’s Equal Protection Clause and Section 1983. On March 13, 2024, the plaintiff’s new counsel, Pacific Legal Foundation, filed an amended complaint, naming only two New York state officials as defendants in their official capacity. The plaintiff sought a permanent injunction against the regulations and a declaration that the use of race and sex in the New York Cannabis Law violates the Fourteenth Amendment.
- Latest update: On April 24, 2024, the defendants moved to dismiss the amended complaint, arguing that the plaintiff lacks standing because no injury or imminent harm warrants such broad relief. The defendants explained that the plaintiff’s “position in the queue [for a New York microbusiness cannabis license] is too low to be considered even if no minority- or women-owned SEE applicants had even applied.” The defendants also argued that the plaintiff failed to state a plausible claim under the Equal Protection Clause. The plaintiff’s response is due May 15, 2024.

2. Employment discrimination and related claims:

Cooper v. The Office of the Commissioner of Baseball et al., No. 1:24-cv-03118 (S.D.N.Y Apr. 24, 2024): On April 24, 2024, a former minor league baseball umpire sued Major League Baseball, alleging that he was fired after he accused a female umpire of harassing him and using homophobic slurs. The complaint alleges that MLB implemented an “illegal diversity quota requiring that women be promoted regardless of merit,” which the plaintiff claims emboldened the female umpire to make statements to him and other male umpires that, “I’m a woman and can get away with anything,” and that “MLB has to hire females, they won’t get rid of me unless I quit.”
- Latest update: The docket does not reflect that MLB has been served.

The following Gibson Dunn attorneys assisted in preparing this client update: Jason Schwartz, Mylan Denerstein, Blaine Evanson, Molly Senger, Zakiyyah Salim-Williams, Matt Gregory, Zoë Klein, Mollie Reiss, Jenna Voronov, Alana Bevan, Marquan Robertson, Janice Jiang, Elizabeth Penava, Skylar Drefcinski, Mary Lindsay Krebs, David Offit, Lauren Meyer, Kameron Mitchell, Maura Carey, and Jayee Malwankar.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Labor and Employment practice group, or the following practice leaders and authors:

Jason C. Schwartz – Partner & Co-Chair, Labor & Employment Group
Washington, D.C. (+1 202-955-8242, [email protected])

Katherine V.A. Smith – Partner & Co-Chair, Labor & Employment Group
Los Angeles (+1 213-229-7107, [email protected])

Mylan L. Denerstein – Partner & Co-Chair, Public Policy Group
New York (+1 212-351-3850, [email protected])

Zakiyyah T. Salim-Williams – Partner & Chief Diversity Officer
Washington, D.C. (+1 202-955-8503, [email protected])

Molly T. Senger – Partner, Labor & Employment Group
Washington, D.C. (+1 202-955-8571, [email protected])

Blaine H. Evanson – Partner, Appellate & Constitutional Law Group
Orange County (+1 949-451-3805, [email protected])

This update summarises the proposed scoping changes, the transitional arrangements and the implications for Excluded Companies and their shareholders and other parties considering a transaction involving an Excluded Company.

EXECUTIVE SUMMARY

On 24 April 2024, the UK Panel on Takeovers and Mergers (the primary regulator in the UK of takeovers of public companies) (the “Panel”) published PCP 2024/1, a Consultation Paper proposing changes to the types of companies to which the City Code on Takeovers and Mergers (the “Takeover Code”) applies.[1]

The proposed changes published by the Code Committee of the Panel (the “Code Committee”) largely narrow the scope of application of the Takeover Code to companies registered in the UK or any of the Crown Dependencies[2] and which currently are UK-listed or listed on a stock exchange of a Crown Dependency (or were so listed at any time in the three years before the company becomes subject of a Takeover Code-regulated offer or event).

The Panel pre-consulted with a number of potentially impacted market participants and industry bodies in devising the proposed changes. It is expected that the changes will be implemented largely as set out in the consultation paper. The likely implementation date will be in Q4 2024.

If the changes are implemented as proposed, a number of companies which are currently subject to the jurisdiction of the Panel and the Takeover Code will fall outside of their jurisdiction (“Excluded Companies”) and consequently companies and shareholders can expect to lose certain protections and benefits currently afforded to target companies under the Takeover Code. The Panel proposes to introduce a three-year transition period from the date of implementation to allow Excluded Companies to consider and implement (if so desired) alternative arrangements to address the loss of protections which will arise as a result of becoming an Excluded Company.

Effective Financial Markets Regulation
1. The key principles for good financial market regulators across the international regulatory landscape would generally expect to include the following: engendering in the regulated community; being robust including having an effective enforcement mechanism in place; being proportionate and fair; ensuring all relevant stakeholders understand the regulator’s approach and having a keen and active understanding of the relevant financial services markets[3].
2. The proposed changes by the Panel is an exemplar of these principles in action and yet another instance where the Panel has demonstrate its pragmatic and agile approach to takeover regulation.
3. The Panel is desirous of ensuring that its jurisdictional rules (being the gateway into the Code and regulation by the Panel – both of which are often seen by those unfamiliar with UK public takeover regulation as being a challenge to navigate – unusually light on black-letter law and heavy on the principles-based approach of regulation) are “clear, certain and objective”.
4. Further, having undertaken a thorough pre-consultation exercise including with the key UK government ministry, financial services regulator, stock exchange and operators of secondary trading and fund-raising platforms, the Panel is mindful of not over-reaching nor imposing regulatory burdens which are not “appropriate or proportionate for pre-listing, growth phase companies”[4] nor being excessively protective in relation to certain companies post-listing.
5. Post-Brexit, the UK has been on a mission to “cement its position as a leader in science, research and innovation[5]“ by supporting and encouraging growth companies and bolstering its position as a global trading centre in particular by making UK’s listing regime more accessible, effective and competitive. The proposed changes of the Panel, which tighten its jurisdictional remit, are aligned with these broader policy objectives.
History … Expansion & Contraction
1. In its 56 years of operation the scope and remit of Code has seen many changes. The Code was originally drafted with quoted companies only in mind but gradually expanded to cover certain unquoted public companies (i.e. entities with or set up with a view to extending offers to large numbers of shareholders) and even certain transactions involving private companies (or those who had been recently quoted or public). The types of transactions which fall within the remit of the Code has also seen an expansion over the years to address new and novel structures that market participants have implemented to secure effective direct or indirect control of Code companies.
2. The Panel however has also been mindful to ensure that its stellar reputation and track record in relation to enforcement is upheld. In making this assessment the Panel has naturally been cognizant of its modest resources comprising a small (but effective) executive team of permanent and seconded staff. Accordingly, a cautious and risk-based approach has been adopted before extending the arm of the Panel/ Code to companies outside of its primary remit (being regulation of UK listed companies) to, for example, companies listed on overseas exchanges and/or whose management is outside of the comfortable (and proportionate) reach of the Panel.
3. As part of the expansionist period, in 2005[6], as a result of implementation of the EU Takeovers Directive in the UK, the Panel was required to take on “shared jurisdiction” of companies which were UK registered but not listed in the EU or were EU registered but listed in the UK. In 2013[7], the Panel changed its rules on the application of the “residency test” (see 4.c, “UK resident: What does it mean” in section 4 below) in determining whether a company was in scope and removed this additional requirement in respect of certain types of companies thus potentially expanding the numbers of companies/ transactions within its regulatory scope.
4. However, in recent years, the Code has seen a narrowing of the scope of companies within the remit of the Panel. In 2018[8], in the light of the UK’s withdrawal from the EU, the Panel took the view that it was appropriate (though not a mandated outcome) to cease to have the so-called “shared jurisdiction” with relevant EU members states. At that time, it was estimated circa x40 companies ceased to be regulated by the Panel.
5. With these latest set of proposed changes, once again, there will be a number of companies which will cease to fall within scope of the Code. It is not practicable to identify the number of Code companies which will cease to be in scope as such but upon review of data between 2017 and 2024 the Code Committee estimates a reduction of the average number of transactions which it regulates from 76 to 72.
Which companies will be in scope?
1. Primary scoping rule – So what type of companies is the Panel proposing to regulate going forward? If the changes are implemented, the Panel would regulate companies which:
  1. are registered in the UK or in any one of the Crown Dependencies (a “Code Jurisdiction”); AND
  2. whose securities are admitted to trading on:
    1. a UK regulated market[9] – for example the Main Market of the London Stock Exchange or the Aquis Stock Exchange (AQSE).
    2. a UK multilateral trading facility[10] – for example the AIM market operated by the London Stock Exchange and the Aquis Growth Market; or
    3. a stock exchange in any one of the Crown Dependencies – for example The International Stock Exchange or “TISE”.
  We refer to companies with securities admitted to trading in any of the categories in 1. – 3. above as “UK-listed”. As currently is the case, the Code will not apply to a company which is incorporated in or has its registered office outside the UK or one of the Crown Dependencies.
2. UK-Listed: What it does not cover – Accordingly, companies with securities trading on:
  (i) a matched bargain facility such as JP Jenkins or Asset Match ;(ii) a multilateral system or a platform such as the proposed new Private Intermittent Securities and Capital Exchange System (PISCES);(iii) a private markets (such as TISE Private Markets ); or(iv) a secondary market of a crowdfunding platform such as Seedrs Secondary Market or Crowdcube,will be outside of scope.
3. Three-year secondary scoping rule – In addition, companies which are registered in a Code Jurisdiction will also be in scope of the Code if they were UK-listed at any time during the three years prior to the date of announcement of an offer or possible offer (or some other Code-relevant transaction) – the “relevant date”. The retention of a “run-off” period is consistent with the current approach under the Code (albeit for a shorter period than the current 10 year run-off period – (see 4.b, ”Private companies” in section 4 below) and is designed to address the situation where for example a company has been subject of a takeover offer, been delisted but there remains a minority which chose not to accept the offer and remain as shareholders – some level of protection is considered appropriate for this cohort.
Which companies currently in scope will become out of scope?
1. Public companies – Currently, the Code also applies to public companies registered in a Code Jurisdiction if they are “UK resident”, regardless of whether the company’s securities are UK-listed or traded on an overseas market (e.g. NASDAQ or NYSE) or traded using a matched bargain facility.
2. Private companies – Currently, the Code also applies to private companies registered in a Code jurisdiction, which are “UK resident” but only if: (a) they were UK-listed at any time during the 10 years prior to the relevant date; (b) dealings in the company’s securities were published on a regular basis for a continuous period of at least six months in the 10 years prior to the relevant date [NB: this would capture for example matched bargain facilities such a JP Jenkins]; (c) any of the company’s securities were subject to a marketing arrangement at any time during the 10 years prior to the relevant date; or (d) the company had filed a prospectus with a relevant authority in any one Code Jurisdiction during the 10 years prior to the relevant date (together the “10 year look-back rules”).
3. “UK resident”: What does it mean? – One of the key drivers behind the proposed changes is the desire by the Code Committee to move away from a jurisdictional test which relies on “UK residency”. For Code purposes, a company will be treated as being “UK resident” if the place of central management and control of a company is in one the Code Jurisdictions. Of note, this is not a tax or other regulatory residency test. The Panel has applied its own test of “central management and control” which it has developed and indeed simplified over time. In the first instance, residency is tested against a quantitative test of where the majority of the board of a company reside but the Panel reserves the discretion to assess more qualitative factors (e.g. giving consideration to the specific roles of the members of the board) depending on the facts and the outcome of the quantitative test. By its nature, the “residency” of a company for Code purposes can change over time depending on where the majority of the board reside and indeed many companies have deliberately ensured that the majority of their board are not “UK resident” in order to avoid falling within the scope of the Code and regulation of the Panel. One of the challenges of the UK residency test (in addition to its more subjective and potentially shifting nature) is that it is “often not possible to ascertain from publicly available information whether at any point in time an unlisted public company [i.e. a non-UK Listed company] or a private company satisfies the residency test”[11]. For example, a UK registered which is listed on an overseas exchange may not be required to disclose and/or update its “UK residency” and relate Code status under applicable exchange and securities law or regulatory requirements. The Panel is no longer comfortable with this position and is desirous of putting in place a regime which allows both companies and market participants to reach an objective determination as to whether a company is or is not a Code company.
4. UK residency test removed – Accordingly, the proposed changes involve the removal of the “UK residency” test scoping limb and also materially modify the 10-year look back rule replacing the latter simply with a three year look-back rule for UK-listed companies only.
5. Excluded Companies – As a result of these changes, the following companies (each being an Excluded Company) will no longer be subject to the jurisdiction of the Code:
  1. a public or private company which was UK-listed more than three years prior to the relevant date;
  2. a public or private company whose securities are, or were previously, traded solely on an overseas market;
  3. a public or private company whose securities are, or were previously, traded using a matched bargain facility such as JP Jenkins or Asset Match;
  4. any other “unlisted” public company; and
  5. a private company which filed a prospectus at any time during the 10 years prior to the relevant date,
  unless the company had been UK-listed at any time during the three years prior to the relevant date.
Transitional arrangements for companies currently in scope which will become Excluded Companies
1. The Code Committee considers that it is appropriate that Excluded Companies – being companies currently within (or potentially within the scope of the Code – to be given a period of time to adjust to the new regime. These will cover public companies referred to in paragraph ‎a above and private companies described in paragraph ‎4.b above.
2. These companies which will be referred to as “transition companies” will remain within the scope of the Code for three years from the date of implementation of the new scoping rules.
3. The Code Committee has summarised out in its consultation paper the proposed transitional arrangements (see Appendix C) and has also provided helpful infographics to identify if a company is a “transition company” on the implementation date (see Appendix D) and if it will be a transition company in respect of a specific transaction (see Appendix E).
4. The Panel expects transition companies to use this period to consider whether it is appropriate to implement alternative arrangements in the light of their pending exclusion from the Code. As noted above, the Code provides a number of protections for companies which find themselves in receipt of a potential takeover offer (target companies) and their shareholders. These include but are not limited to enhanced disclosure of interests and dealings when a company is in play, rules requiring equivalent treatment of all shareholders, the requirement for a person and their “concert parties” who obtains or consolidates control to make a “mandatory offer” on similar terms.
5. Alternative arrangements (which will likely come with cost) may include a transition company:
  1. seeking admission of its securities to trading on a relevant UK market (e.g. a secondary listing) in order to become subject to the jurisdiction of the Panel;
  2. seeking admission of its securities to trading on another market in order to become subject to regulation of a comparable securities regulator;
  3. amending its Articles of Association to incorporate new provisions which are similar to or based upon certain ‘key’ provisions and protections of the Code; and/or
  4. implementing arrangements to facilitate an orderly exit of shareholders who do not wish to remain holders in a company without the protections granted by the Code.
6. If the transition company proposed to entrench new “Code-like” provisions into the contract with its members (i.e. its Articles of Association), it will be for the company to assess (ideally taking into account the views of investors and other relevant stakeholders) which Code provisions they consider appropriate to incorporate. Amended governance documents will however need to be approved by shareholders. Shareholders will need to understand that whilst their new articles of association may include certain Code-like or Code-inspired provisions, the Panel will not have jurisdiction to regulate enforcement of these provisions.
7. Excluded Companies (and companies who have previously publicly disclosed the potential application of the Code depending on whether they satisfy the UK resident test) including those traded on overseas exchanges, will need to consider whether and when to disclose to shareholders that they will no longer become subject to (or potentially subject to) the jurisdiction of the Code and Panel and the protections to shareholders that this affords. This will be dictated in part by reference to the (overseas) exchange and securities regulation applicable to such companies and the nature of any prior disclosures made to shareholders/ the public.
Implications
1. For Excluded Companies
  Directors of these UK registered entities have a duty to promote the success of the company for the benefit of its shareholders taking into account, among other things, the interests of its employees. Companies which will become an Excluded Company should start to give early consideration about what alternative options the company should consider implementing if any in the light of the loss of protections both for the company (in the event it becomes subject of an offer), its shareholders and (to a lesser degree, its employees) when it becomes an Excluded Company. At the least, it should start to prepare to engage with its shareholder based on these issues
2. For Shareholders of Excluded Companies
  Shareholders of companies who will fall outside of scope, as part of their stewardship duties and taking account (where relevant e.g. in the case of institutional investors or sovereigns) their fiduciary duties to their ultimate beneficiaries, they should start to give consideration to what are the key shareholder protections/regulatory expectations they have as a result of their investee company being a Code regulated company and what protections if any they consider critical to preserve going forward. Armed with this analysis and assessment they can then prepare to pro-actively engage at an early stage with investee companies which will fall to become an Excluded Company and/or to actively participate in any outreach and engagement that these companies may have with shareholders going forward during their transition periods. Is the “mandatory offer” concept a key protection from “effective”/ 30%+ controllers? How much comfort is taken from the “rule against frustrating action”?
3. For Parties Interested in an Excluded Company
  Parties engaging with Code companies, whether with a view to carrying out a takeover offer, other Code regulated transaction or indeed even seeking to transact with a Code company which is “in play” (a “Code Transaction”), can find compliance with the Code’s target-company/target-shareholder friendly regime somewhat costly and burdensome in particular, if this is in addition to compliance with overseas exchange and securities law requirements which apply to that company in parallel. The prospect of undertaking a transaction outside of the regime of the Code may indeed be welcome. Whilst we are some years away from the end of the transitional period for Excluded Companies and these companies falling out of scope of the Code, third parties who may be considering a Code Transaction closer to that end date, should be mindful of that date and/or of any alternative arrangements that the Excluded Company may implement when assessing timing (e.g. waiting till post the expiry of the transitional period) and the structure of any possible transaction.
Next Steps & Timing
1. Comments to the Consultation Paper should be sent to the Code Committee in writing or by email[12] by 31 July 2024.
2. The Code Committee intends to publish a response statement to the consultation in Autumn 2024 and the expected implementation date of the changes is circa one month after publication of this response document.
3. As noted above, the transition period for Excluded Companies to prepare for exclusion is three years from the implementation date.

__________

[1] PCP 2024/1 – Companies to which the Takeover Code applies

[2] These are the Isle of Man, Guernsey and Jersey

[3] ICAEW Principles For Good Financial Regulators

[4] Paragraph 2.20 of PCP 2024/1

[5] UK Government Innovation Strategy Statement Nov 2023

[6] See PCP2005/5 – The implementation of the Takeovers Directive.

[7] See PCP2012/3 – Companies subject to the Takeover Code

[8] See PCP 2018/2 – The United Kingdom’s withdrawal from the European Union

[9] As defined in paragraph 13(a) of Article 2(1) of Regulation (EU) No 600/2014 on markets in financial instruments (“UK MiFIR”)

[10] As defined in paragraph (14A) of Article 2(1) of UK MiFIR

[11] Paragraph 2.14 of PCP 2024/1

[12] Email to [email protected]

The following Gibson Dunn lawyer prepared this update: Selina Sagayam.

If you have any questions on the impact of the proposed changes, including application of the transitional arrangements, or are seeking advice on assessing and implementing alternative arrangements for companies which will come out of scope of the Code, we are happy to assist.

For questions about this alert or other UK public M&A or capital market queries, contact the Gibson Dunn lawyer with whom you usually work, the author of this alert or these public listed company and capital markets contacts in London:

Selina S. Sagayam (+44 20 7071 4263, [email protected])

Chris Haynes (+44 20 7071 4238, [email protected])

Steve Thierbach (+44 20 7071 4235, [email protected])

For US securities regulatory queries, including the impact of the proposal on US transition companies, please contact:

James J. Moloney – Orange County, CA (+1 949.451.4343, [email protected])

Public companies have used spin-off transactions for many years to separate a business unit that is no longer a strategic fit with the businesses they wish to retain or when a business unit within the company’s structure would receive a higher valuation as an independent company.

Our presenters explain the basic structure of spin-off transactions and discuss the pros and cons as compared to other separation alternatives, including carve-out IPOs. They examine these issues from various legal perspectives, including corporate, tax and capital markets. The presenters also discuss strategies for avoiding and solving the problems that most frequently arise in spin-off transactions.

PANELISTS:

Hillary Holmes is co-chair of the firm’s Capital Markets practice group and a member of the firm’s Securities Regulation & Corporate Governance, Mergers & Acquisitions, ESG, and Energy & Infrastructure Practice Groups. Hillary also serves as co-partner-in-charge of the Houston office and as a member the firm’s Executive Committee. Hillary advises corporations, investment banks and institutional investors on long-term and strategic capital raising. She regularly counsels companies on securities laws, corporate governance and ESG issues. She also counsels boards of directors, special committees and financial advisors in M&A transactions, take privates and complex situations.

Andrew L. Fabens is a partner in the New York office of Gibson, Dunn & Crutcher. He serves as co-partner in charge of the New York office, co-chair of Gibson Dunn’s Capital Markets Practice Group and is a member of Gibson Dunn’s Securities Regulation and Corporate Governance Practice Group. Mr. Fabens advises companies on long-term and strategic capital planning, disclosure and reporting obligations under U.S. federal securities laws, corporate governance issues and stock exchange listing obligations. He represents issuers and underwriters in public and private corporate finance transactions, both in the United States and internationally. His experience encompasses initial public offerings, follow-on equity offerings, investment grade, high-yield and convertible debt offerings and offerings of preferred, hybrid and derivative securities. In addition, he regularly advises companies and investment banks on corporate and securities law issues, including M&A financing, spinoff transactions and liability management programs.

Saee Muzumdar is a partner in the New York office of Gibson, Dunn & Crutcher and Co-Chair of the firm’s Mergers and Acquisitions Practice Group. Ms. Muzumdar is a corporate transactional lawyer whose practice includes representing both strategic companies and private equity clients (including their portfolio companies) in connection with all aspects of their domestic and cross-border M&A activities and general corporate counseling. She has significant experience with acquisitions and divestitures of public and private entities (including both negotiated transactions and contested takeovers), venture capital investments, proxy contests, tender and exchange offers, recapitalizations, leveraged buyouts, spinoffs, carveouts, joint ventures and other complex corporate transactions. In addition, Ms. Muzumdar has represented a number of major investment banks as financial advisors in M&A transactions and financial institutions in connection with their investment activities.

Pamela Lawrence Endreny is a partner in the New York office of Gibson, Dunn & Crutcher. Ms. Endreny represents clients in a broad range of U.S. and international tax matters. Ms. Endreny’s experience includes mergers and acquisitions, spin-offs, joint ventures, financings, restructurings and capital markets transactions. She has obtained private letter rulings from the Internal Revenue Service on tax-free spin-offs and other corporate transactions. Ms. Endreny is a member of the Executive Committee of the New York State Bar Association Tax Section.

Malakeh Hijazi is an associate in the Houston office of Gibson, Dunn & Crutcher, where she currently practices with the firm’s Capital Markets and Securities Regulation and Corporate Governance practice groups. She represents public and private businesses in a broad range of corporate and securities matters. Malakeh represents issuers and investment banking firms in both equity and debt offerings. Her practice also includes general corporate concerns, including Exchange Act reporting and corporate governance.

MCLE CREDIT INFORMATION:

This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 1.0 credit hour, of which 1.0 credit hour may be applied toward the areas of professional practice requirement. This course is approved for transitional/non-transitional credit.

Attorneys seeking New York credit must obtain an Affirmation Form prior to watching the archived version of this webcast. Please contact [email protected] to request the MCLE form.

Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 1.0 hour.

California attorneys may claim “self-study” credit for viewing the archived version of this webcast. No certificate of attendance is required for California “self-study” credit.

Naranjo v. Spectrum Security Services, Inc., S279397 – Decided May 6, 2024

The California Supreme Court held today that an employer is not subject to statutory penalties for providing incomplete or inaccurate wage statements if it reasonably and in good faith believed the statements were accurate.

“[A]n employer’s objectively reasonable, good faith belief that it has provided employees with adequate wage statements precludes an award of penalties under section 226.”

Justice Kruger, writing for the Court

Background:

California Labor Code section 226 requires employers to provide detailed wage statements to their employees. Employees can seek statutory penalties if they are injured “as a result of a knowing and intentional failure by an employer” to comply with the wage-statement requirement. (Lab. Code, § 226, subd. (e)(1).)

Gustavo Naranjo, a security guard for Spectrum Security Services, brought a putative class action alleging that Spectrum had violated section 226 by failing to report premium amounts due to employees who missed meal breaks. After an initial appeal in which the California Supreme Court clarified that section 226 required wage statements to list premium pay for missed meal periods (Naranjo v. Spectrum Security Services, Inc. (2022) 13 Cal.5th 93), the case was remanded to the Court of Appeal to determine whether Spectrum’s failure to list such premium pay on its wage statement was “knowing and intentional,” such that penalties could be imposed under section 226. The Court of Appeal held that because Spectrum had a reasonable, good-faith belief at the time that its wage statements were accurate (based on uncertainty in the law before the California Supreme Court’s initial decision), the violation was not “knowing and intentional” and could not give rise to section 226 penalties.

The California Supreme Court again granted review, this time to decide whether an employer knowingly and intentionally fails to comply with section 226 when it has a reasonable, good-faith belief that its wage statements complied with the statute.

Issue:

Can an employer be held liable for statutory penalties under Labor Code section 226 if it issues incomplete or inaccurate wage statements with a reasonable and good-faith (but incorrect) belief that the statements were compliant?

Court’s Holding:

No, because “an employer’s objectively reasonable, good faith belief that it has provided employees with adequate wage statements precludes an award of penalties under section 226.”

What It Means:

This decision represents a significant victory for California’s employers, who often face substantial liability for wage-statement violations predicated on other alleged violations of the Labor Code. After today’s decision, an employer will not be liable for penalties under section 226 for wage-statement violations if it had a reasonable and good faith belief that its wage statements complied with the statute.
The Court noted that its holding was consistent with other provisions of the Labor Code that do not allow for statutory penalties where employers reasonably and in good faith believe that they are complying with the law. Reading the Labor Code as a whole to adopt a consistent scheme on the issue of when penalties may be assessed makes sense, the Court reasoned, because claims related to deficient wage statements “are more typically raised as derivative claims of other Labor Code” sections.
Because a good-faith defense based on a misunderstanding of law under section 226 is available only “where the employer’s obligations are genuinely uncertain,” the defense will not be available to companies that do not comply with well-established law. But in cases where the law is unsettled, employers will be able to use that uncertainty as a defense to section 226 penalties.

The Court’s opinion is available here.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the California Supreme Court. Please feel free to contact the following practice leaders:

Appellate and Constitutional Law Practice

Thomas H. Dupree Jr. +1 202.955.8547 [email protected]	Allyson N. Ho +1 214.698.3233 [email protected]	Julian W. Poon +1 213.229.7758 [email protected]
Lucas C. Townsend +1 202.887.3731 [email protected]	Bradley J. Hamburger +1 213.229.7658 [email protected]	Michael J. Holecek +1 213.229.7018 [email protected]

Related Practice: Labor and Employment

Jason C. Schwartz
+1 202.955.8242
[email protected]

Katherine V.A. Smith
+1 213.229.7107
[email protected]

Jesse A. Cripps
+1 213.229.7792
[email protected]

Related Practice: Litigation

Theodore J. Boutrous, Jr.
+1 213.229.7804
[email protected]

Theane Evangelis
+1 213.229.7726
[email protected]

The U.S. Internal Revenue Service and the Treasury Department have released Revenue Procedure 2024-24 providing updated guidelines for requesting private letter rulings regarding transactions intended to qualify under section 355, focusing specifically on “Divisive Reorganizations” and related debt exchanges.

The Internal Revenue Service (the “IRS”) and the Treasury Department (“Treasury”) have released Rev. Proc. 2024-24 (the “Rev. Proc.”) providing updated guidelines for requesting private letter rulings regarding transactions intended to qualify under section 355,[1] with significant focus on “Divisive Reorganizations” and related debt exchanges.[2] The Rev. Proc. modifies Rev. Proc. 2017-52 and supersedes Rev. Proc. 2018-53.[3]

The IRS and Treasury also released Notice 2024-38 (the “Notice”) requesting public comment on select issues addressed by the Rev. Proc. and outlining the IRS and Treasury’s current perspectives and concerns related to those issues.

The Rev. Proc. was highly anticipated and is of critical importance for taxpayers considering a spin-off, particularly for spin-offs that involve debt exchanges. It applies to all ruling requests postmarked or, if not mailed, received by the IRS after May 31, 2024.

I. Background

A. Sections 355 and 361

Section 355 permits a corporation (“Distributing”) to distribute, or “spin off,” a subsidiary corporation (“Controlled”) to its shareholders in a transaction that is tax-free to both shareholders and the corporation (a “Spin-off”). Spin-offs typically occur as part of a larger divisive reorganization (a “Divisive Reorganization”), although sometimes involve the more straightforward distribution of the stock of an existing subsidiary (a “Section 355(c) Distribution”). In either case, the distribution must satisfy numerous requirements to be tax-free to both Distributing and its shareholders, including that Distributing must distribute stock that carries with it at least 80 percent of the voting power of Controlled. Subject to additional requirements, however, Distributing may retain some Controlled stock or securities after the date of the distribution provided the retention does not have a principal purpose of tax avoidance (the “Control Distribution Date”).

In the context of Divisive Reorganizations, but not Section 355(c) Distributions, the Code provides fairly broad flexibility to Distributing to allocate its liabilities between Distributing and Controlled or to retire its liabilities on a tax-free basis. Specifically, Distributing may use Controlled stock and/or securities to retire its obligations to creditors tax-free, and, if Distributing receives money or property other than Controlled stock or securities (commonly known as “boot”) from Controlled, Distributing may use that boot to retire its obligations to creditors, but only to the extent of the net tax basis of the assets transferred to Controlled.[4] These distributions to creditors (including use of Controlled stock to retire debt) may occur on a delayed basis following the Control Distribution Date as part of the spin-off plan.

The exchanges of Controlled stock and/or securities for Distributing debt – so-called debt-for-debt and debt-for-equity exchanges – have a storied history in terms of IRS ruling policy, making this recent guidance particularly important and, inevitably, controversial.

B. Previous Ruling Guidelines Regarding
Retentions of Controlled Stock, Securities or Debt

The IRS has historically issued favorable rulings with respect to delayed distributions after the Control Distribution Date as well as retentions of Controlled stock and securities based on requirements outlined in Appendix B of Rev. Proc. 96-30 (including a sufficient business purpose and no overlapping directors or officers between Distributing and Controlled for the period during which stock and securities are retained (or sufficient business purpose for the overlap)). That is, historically, the IRS has issued rulings that a retention of Controlled stock and securities after the Control Distribution Date will not be in pursuance of a plan having a principal purpose of avoiding federal income tax under section 355(a)(1)(D)(ii) in situations in which a taxpayer indicates a fixed intention to retain shares or securities and sell them in a taxable sale, as well as in situations in which taxpayers otherwise expected to make a delayed distribution of Controlled stock and securities that is “part of the distribution” (within the meaning of section 355(a)(1)(D)) or “in pursuance of the plan of reorganization” (within the meaning of section 361).

C. Previous Ruling Guidelines Regarding Debt Exchanges

The IRS’s approach to debt-for-debt and debt-for-equity exchanges has changed over time, including its approach to debt exchanges involving financial institutions that would acquire Distributing debt in order to engage in a debt exchange with Distributing. Before the issuance of Rev. Proc. 2018-53, taxpayers typically used an “intermediated exchange” model in which the intermediary bank would purchase Distributing debt, hold it for at least five days, and then enter into an exchange agreement with Distributing to exchange that debt for Controlled securities or Controlled stock, with the exchange occurring at least 14 days after the bank’s purchase of the Distributing debt. The issuance of Rev. Proc. 2018-53 modified the types of debt-for-debt and debt-for-equity exchanges on which the IRS would rule. Rev. Proc. 2018-53 contained numerous requirements, continuing the basic theme of permitting Distributing to allocate or retire amounts of its historical debt. Further eschewing the formalism of the IRS’s previous ruling practice, Rev. Proc. 2018-53 permitted new debt to be allocated or retired so long as the total amount of debt allocated or retired was in line with historical debt levels.

II. Rev. Proc. 2024-24 and Notice 2024-38

The Rev. Proc. changes the playing field in a number of areas, including (A) transactions involving delayed distributions and retentions of Controlled stock, securities, or debt and (B) exchanges of Distributing debt for Controlled stock, Controlled securities or other debt obligations, or money or other property (“Section 361 Consideration”). This Update discusses each of these principal topics, as well as related commentary in the Notice. Other topics addressed in the Rev. Proc. are discussed in Exhibit I to this Update.

A. Transactions Involving Delayed Distributions and Retentions of Controlled Stock, Securities, or Debt

The Code contemplates that Distributing will distribute all the Controlled stock and securities it owns but permits taxpayers to make the distributions over time or retain some stock or securities. Consistent with the way the tax bar approaches these matters, the Rev. Proc. and Notice distinguish between “Delayed Distributions” and “Retention” transactions.

1. Delayed Distributions

In a “Delayed Distribution,” the intention and plan is for all Section 361 Consideration to be distributed to Distributing’s stockholders or transferred to Distributing’s creditors as promptly as possible. Toward that end, consistent with prior ruling practice, the Rev. Proc. requires Distributing to represent that it will hold the Controlled stock and securities no longer than is necessary and, in any event, that it will make the final distribution no later than 12 months after the date of the first distribution that was part of the Divisive Reorganization (the “First Distribution Date”)).[5] Taxpayers must submit relevant facts and analysis establishing that the distribution of Controlled stock or securities over a period of time is “part of the distribution” (within the meaning of section 355(a)(1)(D)) or “in pursuance of the plan of reorganization” (within the meaning of section 361).[6] The Rev. Proc. notes that although the length of time between the First Distribution Date and later distributions is not dispositive, it will be the primary factor in determining whether a favorable ruling will be granted.[7]

The Rev. Proc. also requires that, absent “substantial business reasons,” any transfers to creditors must be made within 90 days after the First Distribution Date and, other than as a result of any Post-Distribution Payments (as defined below), all transfers of Section 361 Consideration by Distributing in repayment of its historical debt must be made within 12 months after the First Distribution Date.[8]

2. Retentions

Taxpayers seeking a ruling that a retention of Controlled stock or securities after the Control Distribution Date that does not constitute a Delayed Distribution (a “Retention”) will not be in pursuance of a plan having a principal purpose of avoiding federal income tax must submit several representations that are focused on ensuring that Distributing and Controlled do not maintain a high degree of connection (due to overlapping directors, officers or employees or the closely held nature of Controlled’s stock) and that there is a non-speculative business purpose for the Retention,[9] or that there is an “exigent business circumstance” necessitating the Retention.[10] If Distributing will hold Controlled debt after the distribution, Distributing will be required to represent that the debt will not constitute stock or securities of Controlled. Notably, the Rev. Proc. limits the requirement of an exigent business purpose to circumstances in which there is significant connection between Distributing and Controlled after the distribution (in addition to any retained interest in Controlled).[11]

In a significant shift from prior ruling policy, under the Rev. Proc., the IRS will not entertain simultaneous requests for rulings with respect to both Delayed Distributions and Retentions (“Backstop Retention Rulings”). Backstop Retention Rulings have been important to taxpayers to ensure that Distributing’s continued ownership of Controlled shares (or their disposal in a taxable transaction) will not affect the qualification of the initial distribution under section 355. Taxpayers typically request Backstop Retention Rulings in case, contrary to their expectations, they are not able to pursue a later transaction that qualifies as a Delayed Distribution and want to be sure this inability does not preclude the entire spin-off from qualifying for tax-free treatment under section 355. This new policy therefore will be the source of significant commentary and consternation.

3. Post-Distribution Payments

With respect to any payments made by Controlled to Distributing after the Control Distribution Date that comprise Section 361 Consideration and not, for example, a payment for goods or services (e.g., cash payments made under a transition services agreement) (“Post-Distribution Payments”), the Rev. Proc. requires those payments to be deposited in a segregated account and distributed to Distributing’s shareholders or transferred to Distributing’s creditors within 90 days of receipt. Additionally, taxpayers must submit information and analysis to establish the following: (i) each Post-Distribution Payment is Section 361 Consideration, (ii) as of the date of the earliest distribution effecting the Divisive Reorganization, the fair market value of Distributing’s right to receive the Post-Distribution Payment was not (or will not be) “reasonably ascertainable,” and (iii) whether Distributing will account for its right to receive the Post-Distribution Payment under the installment method (clauses (i) through (iii), the “Post-Distribution Payment Requirements”).

In the Notice, the IRS and Treasury state that they are considering the treatment of Post-Distribution Payments. The Notice explains that Treasury and the IRS believe that a Post-Distribution Payment is considered Section 361 Consideration only if the taxpayer establishes that it satisfies the Post-Distribution Payment Requirements.[13]

4. Solvency and Independence of Distributing and Controlled

The Rev. Proc. requires additional representations relating to the solvency and viability of Distributing and Controlled.[14] According to the Notice, these additional representations are aimed at ensuring that tax-free treatment is not given to “Divisive Reorganizations that burden Controlled with excessive leverage, jeopardizing its ability to continue as a viable going concern.”

Additionally, according to the Notice, the IRS and Treasury are considering the degree to which connections between Distributing and Controlled after a spin-off should prevent a transaction from qualifying under section 355. More specifically, the Notice states that the IRS and Treasury are considering the impact of (i) overlapping key employees, directors, and officers between Distributing and Controlled and (ii) continuing contractual arrangements between Distributing and Controlled that include provisions that are not arm’s length. The IRS and Treasury are concerned that these on-going relationships are inconsistent with the separation envisioned in enacting section 355, particularly if “fit-and-focus” is the stated business purpose for the transaction.

B. Exchanges of Distributing Debt for Section 361 Consideration

1. Direct Issuances and Intermediated Exchanges

One of the most important aspects of the Rev. Proc. is the effective prohibition of “Direct Issuances.” Direct Issuances are transactions in which a third-party financial institution (the “Bank”) makes a short-term loan to Distributing that uses the proceeds of that loan to retire historical Distributing debt. Subsequently, Distributing uses Controlled stock and/or securities to repay the newly incurred short-term debt. In a marked change from prior ruling practice, to qualify under the Rev. Proc., all debt that will be retired in a debt exchange must be incurred before the earliest of the following dates: (i) the date of the first public announcement of the Divisive Reorganization (or a similar transaction), (ii) the date of entry by Distributing into a binding agreement to engage in the Divisive Reorganization (or a similar transaction), and (iii) the date of approval of the Divisive Reorganization (or a similar transaction) by the board of directors of Distributing (the “Earliest Applicable Date”). As a result, under the Rev. Proc., taxpayers will need to use pre-existing debt in a debt exchange or refinance existing debt not later than the Earliest Applicable Date. This will result in a dramatic change in market practice because it will no longer be possible for Distributing to use its newly incurred short-term debt to facilitate a debt-for-debt or debt-for-equity exchange.

Additionally, for both Direct Issuances and “Intermediated Exchanges” (where the Bank purchases historical Distributing debt on the open market and then enters into an exchange agreement in which the Bank agrees to accept Section 361 Consideration as repayment of the debt so acquired), the Rev. Proc. requires taxpayers to make a number of representations (and to provide supporting analysis) to ensure the independence of the Bank (similar to the representations previously contained in Rev. Proc. 2018-53). These representations include that (i) the historical debt acquired by the Bank will not be held for the benefit of Distributing, Controlled, or persons related to either Distributing or Controlled, (ii) each exchange will be effectuated based on arm’s-length terms, (iii) neither Distributing nor Controlled will participate in any profit gained by the Bank upon an exchange of the Section 361 Consideration, and (iv) the Bank will act for its own account and bear the risk of loss with respect to both (x) the acquired Distributing debt and (y) any subsequent sale or other disposition of the Section 361 Consideration transferred to the Bank to satisfy the Distributing debt.[15] It is not clear precisely how the IRS and Treasury envision Intermediated Exchanges occurring in the future.

The Notice expresses concerns that general principles of federal income tax law (including substance over form, agency, and other relevant theories) could cause Direct Issuances to be recast so the Bank is not treated as a “creditor.” In addition, the Notice expresses concerns that, in an Intermediated Exchange, the Bank could be recast as an agent of Distributing, with the result that Distributing likewise would not be treated as exchanging Section 361 Consideration for historical debt of Distributing. Nevertheless, the Notice makes clear that the government “would welcome feedback from intermediaries to help ensure that future guidance is responsive to the business and market-risk considerations that inform the mechanics of intermediated exchanges and direct issuance transactions, as opposed to mere differences in transaction costs.”

2. No Replacement of Distributing Debt

The Rev. Proc. includes a new representation regarding the replacement of Distributing debt in Divisive Reorganizations that mandates that neither Distributing nor any person that is related to Distributing (under either section 267(b) or section 707(b)(1) (a “Related Person”)) will replace any amount of Distributing debt that is satisfied with Section 361 Consideration with borrowing anticipated or committed to before the Control Distribution Date.[16]

The new representation is a significant change from Rev. Proc. 2018-53, where the focus was only on previously committed borrowing. Importantly, the Rev. Proc. accommodates situations in which taxpayers cannot adhere to this representation. It provides that taxpayers may still secure a favorable ruling by substantiating, through detailed information and analysis, that any borrowing—whether existing at the time of the ruling submission or incurred subsequently—is justified under specific conditions. Although not explicit in the Rev. Proc., the implication from the language used is that the guidelines cover all borrowings. Specifically, (i) the borrowing was incurred in the ordinary course of business under financial arrangements such as revolving credit agreements, unrelated to and not anticipated as part of the section 355 transaction or any related transactions, and (ii) the borrowing resulted from unexpected events not related to the section 355 transaction and occurred outside the ordinary business activities of Distributing, directly arising from circumstances that were not anticipated prior to the Control Distribution Date.

3. Limitation to Historical Distributing Debt

In a Divisive Reorganization, the Rev. Proc. requires all historical Distributing debt that is intended to be satisfied with Section 361 Consideration and all liabilities of Distributing that are assumed by Controlled to have been incurred by Distributing before the Earliest Applicable Date.[17] Additionally, with respect to contingent liabilities, the liability must be “economically attributable” to the period ending on the “Contribution Date”[18] or be attributable to the continuation after the Earliest Applicable Date of activities in which Distributing was engaged before the Earliest Applicable Date.[19]

The Rev. Proc. also restricts the amount of Distributing debt satisfied with Section 361 Consideration or assumed by Controlled to the historical average amount of Distributing debt owed to third-party creditors that was outstanding for the prior eight fiscal quarters ending immediately before the Earliest Applicable Date (similar to the standard in effect under Rev. Proc. 2018-53 that covered the eight fiscal quarters that ended immediately before the date of approval of the Divisive Reorganization by the board of directors of Distributing).[20]

EXHIBIT 1

Additional Matters Covered in Rev. Proc 2024-24 and Notice 2024-38

In addition to the topics discussed in the body of the Update, the Rev. Proc. and the Notice provide additional guidance and commentary on a number of other topics relating to Divisive Reorganization that are discussed below.

1. Scope of Plan of Reorganization

The Rev. Proc. requires taxpayers seeking a ruling on a Divisive Reorganization to represent that (i) each step of the proposed transaction will be described clearly in the plan of reorganization, (ii) each step is necessary to effectuate the business purpose and directly a part of the transaction, and (iii) before the first step of the proposed transaction, each party will have adopted the plan of reorganization for the transaction. The Rev. Proc. also requires that the taxpayer submit analysis establishing that each specific step of a proposed transaction is part of the plan of reorganization regarding the transaction, along with a copy of the plan of reorganization as an exhibit to the ruling request.[21]

The Notice discusses confusion and disagreement among practitioners regarding the application of the plan of reorganization requirement under section 361 to Divisive Reorganizations and notes that the representations, information, and analysis in the Rev. Proc. are intended to ensure that plans of reorganization for Divisive Reorganizations provide specificity and clarity that satisfy current Treasury regulation requirements.[22] Specifically, the Notice identifies a concern that some tax advisors incorrectly view the applicability of the plan of reorganization requirement to be limited to situations in which there are certain temporal delays based on the procedures in Rev. Proc. 2018-53 (superseded by the Rev. Proc.).[23] This concern is exacerbated by the fact that case law authority is unclear with respect to what constitutes a plan of reorganization.[24] The Notice indicates that the IRS and Treasury are particularly focused on ensuring that, while a plan of reorganization may incorporate some transactional flexibility, this flexibility should be appropriately constrained based on the relevant Treasury regulation requirements.

2. Distributing as Obligor

The Rev. Proc. also requires that taxpayers seeking a ruling on a Divisive Reorganization submit a representation that Distributing is the obligor of each Distributing debt that will be satisfied with Section 361 Consideration, as well as of any other Distributing liability (including any contingent liability) that will be assumed by Controlled.[25] In connection with this representation, taxpayers must submit information regarding any guarantee, indemnity or similar arrangement provided by any person other than Distributing, as well as analysis establishing that Distributing is the obligor of relevant Distributing debt or other liability (including contingent liability) for federal income tax purposes regardless of the guarantee, indemnity or similar arrangement (if any).[26]

3. Asset Basis Limitations

The Rev. Proc. outlines detailed procedures for taxpayers requesting rulings on sections 357 and 361 in the context of Divisive Reorganizations. This includes adhering to the established procedures detailed in Rev. Proc. 2017-52, except as modified by the Rev. Proc. Taxpayers engaging in Divisive Reorganizations must submit the required representations, information, and analysis to support their requests, ensuring compliance with these guidelines.[27]

The Notice, however, indicates that the IRS and Treasury are seeking public input on the distinct applications of sections 357 and 361, particularly in the context of Divisive Reorganizations. In general, section 357 addresses situations in which Controlled assumes liabilities from Distributing and provides that liability assumptions generally are not considered the receipt of money or other property by Distributing. Additionally, section 357(c) requires gain recognition to the extent that liabilities assumed exceed the aggregate basis of the transferred assets. In contrast, section 361 allows Distributing to transfer assets, including money and other property, to its creditors during a Divisive Reorganization without recognizing gain, treating these transfers as part of the reorganization plan. Similar to section 357(c), section 361(b)(3) requires gain recognition to the extent that boot distributed to Distributing’s creditors exceeds the net tax basis of the transferred assets.

According to the Notice, confusion and disagreement persist among tax advisors regarding the interaction between these sections, especially when Section 361 Consideration is used to satisfy liabilities that do not qualify as debt. The Notice explains that some advisors “mistakenly believe that, in such a situation, the Section 361 Consideration would qualify for nonrecognition treatment under § 361” and further that “some tax advisors also incorrectly contend that Distributing would enjoy nonrecognition treatment under § 361 through the use of Section 361 Consideration to satisfy [contingent liabilities of Distributing], which are not subject to an adjusted basis limitation under § 357(c)(3) (and, therefore, would not be subject to an adjusted basis under § 361(b)(3)).”

In the Notice, the IRS and Treasury state that it is their view that those interpretations are contrary to the plain language and policy intentions of sections 357 and 361, particularly concerning the adjusted basis limitations these sections impose.

4. Holders of Distributing Debt or Other Distributing Liabilities

In general, the Rev. Proc. requires that all of the historical Distributing debt that is repaid with Section 361 Consideration in connection with a Divisive Reorganization be third-party debt. If any of the historical Distributing debt is owed to a Related Person, however, the Rev. Proc. requires that the Section 361 Consideration paid to the Related Person subsequently be paid to a third-party creditor within 12 months after the First Distribution Date. Both the debt owed to the Related Person and the debt owed to the third-party creditor must have existed before the Earliest Applicable Date.

5. Distribution of Qualified Property, Money, and Other Property

The Rev. Proc. requires that all stock and securities of Controlled (“Qualified Property”), money, and other Section 361 Consideration other than Qualified Property (“Other Property”) received by Distributing be distributed by Distributing to its shareholders or transferred to Distributing’s creditors in connection with the Divisive Reorganization. Additionally, money and Other Property (but not Qualified Property) transferred by Controlled to Distributing as part of the plan of reorganization generally must not be distributed to Distributing’s shareholders or transferred to Distributing’s creditors earlier than the First Distribution Date.

The Rev. Proc. does, however, allow for a taxpayer to obtain a ruling even if money or Other Property is distributed or transferred earlier than the First Distribution Date, so long as the taxpayer submits information describing those earlier distributions or transfers along with supporting analysis of the federal income tax consequences of the transfers or distributions. The Rev. Proc. requires the taxpayer to submit (i) a description of the Qualified Property, money, and Other Property to be transferred by Controlled to Distributing, (ii) a description of the transactions in which Distributing will distribute the property to its shareholders or transfer the property to its creditors, and (iii) an analysis establishing that the property will be distributed or transferred in connection with the Divisive Reorganization.

6. Effect of Transaction Related to Divisive Reorganizations on Controlled Securities or Other Qualified Property

The Rev. Proc. sets forth guidelines for handling changes to Controlled securities resulting from Divisive Reorganizations. Taxpayers must submit a representation confirming that no transaction (or series of transactions) directly or indirectly related to the Divisive Reorganization will result in a deemed exchange of any Controlled securities received by Distributing pursuant to the plan of reorganization.[28] Additionally, it must be asserted that Controlled will continue as the obligor of those securities after the transactions. To support these assertions, taxpayers are required to describe any changes in the terms of the Controlled securities or other qualified property received and provide analysis demonstrating that these changes will not constitute a deemed exchange pursuant to Treas. Reg. § 1.1001-3. Moreover, it must be established that Controlled will remain as the obligor after the transactions.

The Notice indicates that the IRS and Treasury are actively considering the implications of modifying, including refinancing, Controlled’s securities or other debt following a Divisive Reorganization, specifically how the modifications impact the qualification of the securities or other debt as Section 361 Consideration.

To assess whether changes in the structure of Controlled’s securities post-distribution could result in a recast of the transaction, the IRS and Treasury are contemplating the application of general principles of federal income tax law, including the doctrine of substance over form and other relevant theories, to these transactions. Without more guidance, this also is likely to be concerning to taxpayers and their advisors.

7. Assumption of Distributing Liabilities

The Rev. Proc. mandates that if a taxpayer requests a ruling on a Divisive Reorganization involving the assumption of Distributing liabilities, including contingent liabilities, comprehensive representations, information, and analysis must be submitted. Taxpayers may seek rulings on whether transactions between Distributing and Controlled constitute the assumption of Distributing liabilities. Taxpayers must provide specific representations to ensure that payments made by Controlled to satisfy these liabilities do not result in any control by Distributing or a Related Person.[29] This includes agreements made before the First Distribution Date, which must demonstrate that the liabilities were incurred in the ordinary course of business associated with Controlled’s assets and operations. In the case of the assumption of a contingent liability of Distributing, an additional representation is required, stating that all payments will be made as soon as practicable after the amounts of those payments are substantially determined.[30]

The Rev. Proc. requires descriptions of each liability assumed, the circumstances under which they were incurred, and any third-party payment arrangements, ensuring Distributing does not retain control over the funds. Failure to comply may lead the IRS to: (i) treat the payment as Section 361 Consideration, (ii) determine that the payment does not align with the plan of reorganization, or (iii) decline to issue a ruling on the transaction.

The Rev. Proc. supersedes the representation requirements from Rev. Proc. 2017-52, which stated that any liabilities assumed by Controlled were incurred in the ordinary course of business and associated with transferred assets.[31] The new procedure adds specificity and clarity to these representations.[32]

Importantly, the Rev. Proc. refines and broadens the definition of ‘liability’ to include debts, contingent liabilities, and other obligations, whether or not they have been previously considered for federal tax purposes. It also clarifies that obligations from business contracts may qualify as liabilities if recorded as liabilities in financial statements, expanding the scope of what can be considered a liability under federal tax law.[33]

8. No Avoidance of Federal Income Tax

The Rev. Proc. includes strict guidelines to ensure that the assumption of Distributing liabilities, including contingent liabilities, within Divisive Reorganizations does not primarily serve to avoid federal income tax and is not devoid of a bona fide business purpose. To this effect, specific representations are required from taxpayers to demonstrate the intent behind these transactions. These include a representation that no assumption by Controlled of any Distributing liability, including Distributing contingent liabilities, is principally aimed at avoiding federal income tax or is driven by any purpose other than a bona fide business purpose, as defined under section 357(b)(1). Additionally, taxpayers must assert that no proposed transaction or series of transactions is principally designed to circumvent any requirements or limitations imposed by either section 357 or section 361.

Alongside these representations, taxpayers are required to submit information and analysis substantiating the accuracy of these representations.

__________

[1] Unless indicated otherwise, all “section” references are to the Internal Revenue Code of 1986, as amended (the “Code”), and all “Treas. Reg. §” references are to the Treasury regulations promulgated under the Code.

[2] The term Divisive Reorganization “means a series of transactions that qualify as a reorganization described in §§ 355(a) and 368(a)(1)(D).” Appendix to Rev. Proc. 2024-24, § 2(21).

[3] Rev. Proc. 2017-52 established a pilot program that specifically addressed the general federal income tax consequences of section 355 transactions (except for certain no-rule issues), marking a pivotal development in formalizing the process for taxpayers to seek IRS guidance on complex corporate divisions. A year later, Rev. Proc. 2018-53 further refined the procedures, focusing on issues related to the assumption or satisfaction of Distributing debt in Divisive Reorganizations.

[4] As used in this Update, the term net tax basis means adjusted tax basis of the assets transferred less liabilities assumed.

[5] Rev. Proc. 2024-24, § 3.03(2).

[6] Taxpayers also are required to submit information regarding the expected percentage of Controlled stock and securities that will not be distributed on the Control Distribution Date, as well as the expected duration of the distribution period. If the distribution period will last longer than 90 days, taxpayers also are required to submit summaries of the expected percentage of Controlled stock and securities that will not be distributed within 90 days and the duration of the distribution period as well as the business reasons for this percentage and duration. Rev. Proc. 2024-24, § 3.03(2).

[7] Id.

[8] Rev. Proc. 2024-24, § 3.05(10). Taxpayers also must submit information and analysis supporting the substantial business reasons for any delayed distributions.

[9] Rev. Proc. 2024-24, § 3.03(3).

[10] Id. To obtain a ruling with respect to a Retention. taxpayers also must submit information regarding (i) the amount and type of stock, securities and options that Distributing will hold after the Control Distribution Date, (ii) an explanation for why the Retention is necessary (including both business and any non-business reasons), (iii) the expected duration of the Retention and timing for dispositions of the retained Controlled stock or securities, and (iv) any federal income tax benefit or advantageous federal income tax treatment that results from the Retention or the disposition of retained Controlled stock or securities.

[11] Id.

[12] Rev. Proc. 2024-24, § 3.03(4).

[13] Notice 2024-38, § 2.02(6).

[14] Rev. Proc. 2024-24, § 3.03(3)

[15] If the Bank’s acquisition of historical Distributing debt is close in time to the exchange of the debt for Section 361 Consideration, the Rev. Proc. requires supporting analysis be provided that establishes that the short amount of time should not cause the form to be recast.

[16] Rev. Proc. 2024-24, § 3.02(3). This representation must be adhered to precisely by the taxpayer unless a satisfactory explanation for deviation is provided by the taxpayer to the Associate Chief Counsel (Corporate).

[17] Rev. Proc. 2024-24, § 3.05(6).

[18] It is an open issue as to what “Contribution Date” means, given that the Rev. Proc. neither defines “Contribution Date” nor uses that term elsewhere.

[19] Rev. Proc. 2024-24, § 3.05(7).

[20] Rev. Proc. 2024-24, § 3.05(8). If any of the Distributing debt satisfied with Section 361 Consideration is owed to a Related Person, then the historical average amount is calculated taking into account the lesser of (i) the total amount of Distributing debt held by the Related Person that holds the Distributing debt to be satisfied with Section 361 Consideration or (ii) the amount of debt held by the third-party creditor to whom the Section 361 Consideration will be transferred within 12 months of the First Distribution Date.

[21] Rev. Proc. 2024-24, § 3.05(1).

[22] Under Treas. Reg. § 1.368-2(g), “the transaction, or series of transactions, embraced in a plan of reorganization must not only come within the specific language of section 368(a), but the readjustments involved in the exchanges or distributions effected in the consummation thereof must be undertaken for reasons germane to the continuance of the business of a corporation a party to the reorganization.”

[23] See Rev. Proc. 2018-53, § 3.04(6) (stating “if satisfaction of any Distributing debt with [Section 361 Consideration] will occur more than 180 days after the date of such first distribution, the taxpayer should submit information and analysis to establish that, based on all the facts and circumstances, the satisfaction will be in connection with the plan of reorganization”). The Notice indicates that the IRS and Treasury are concerned the language above has been misunderstood to require a plan of reorganization only where there is a delayed satisfaction of Distributing debt.

[24] See J.E. Seagram Corp. v. Comm’r, 104 T.C. 75, 96 (1995) (acknowledging that the plan of reorganization concept is “one of substantial elasticity”).

[25] Rev. Proc. 2024-24, § 3.05(2).

[26] Id.

[27] Rev. Proc. 2024-24, § 3.05(3).

[28] Rev. Proc. 2024-24, § 3.05(11)(a), Representation 29.

[29] Rev. Proc. 2024-24, § 3(13)(b), Representations 31, 32, 33, and 34.

[30] Rev. Proc. 2024-24, § 3(13)(b), Representation 35.

[31] Rev Proc. 2017-52, Appendix, § 3, Representation 17.

[32] The Rev. Proc. introduces new representations required for ruling on the assumption of Distributing liability and omits the reference to “any liabilities assumed” by Controlled, and adds a new representation that each Distributing liability—including each Distributing contingent liability—that Controlled assumes will have been incurred in the ordinary course of business and associated with Controlled’s assets and business. See Rev Proc. 2024-24, Appendix, § 3(13)(b), Representation 34.

[33] Appendix to Rev. Proc. 2024-24, § 2(29). Note that, under Rev. Proc. 2017-52, ‘liability’ was defined as “any liability or other obligation without regard to whether it has been taken into account for federal income tax purposes.” See Rev Proc. 2017-52, Appendix, § 2(05).

The following Gibson Dunn lawyers prepared this update: Jennifer L. Sabin, Eric B. Sloan, Pamela Lawrence Endreny, Matt Donnelly, David W. Horton, Yara Mansour, and Galya Savir.

Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Tax and Global Tax Controversy and Litigation practice groups:

Tax:
Dora Arash – Los Angeles (+1 213.229.7134, [email protected])
Sandy Bhogal – Co-Chair, London (+44 20 7071 4266, [email protected])
Michael Q. Cannon – Dallas (+1 214.698.3232, [email protected])
Jérôme Delaurière – Paris (+33 (0) 1 56 43 13 00, [email protected])
Michael J. Desmond – Los Angeles/Washington, D.C. (+1 213.229.7531, [email protected])
Anne Devereaux* – Los Angeles (+1 213.229.7616, [email protected])
Matt Donnelly – Washington, D.C. (+1 202.887.3567, [email protected])
Pamela Lawrence Endreny – New York (+1 212.351.2474, [email protected])
Benjamin Fryer – London (+44 20 7071 4232, [email protected])
Evan M. Gusler – New York (+1 212.351.2445, [email protected])
Kathryn A. Kelly – New York (+1 212.351.3876, [email protected])
Brian W. Kniesly – New York (+1 212.351.2379, [email protected])
Loren Lembo – New York (+1 212.351.3986, [email protected])
Jennifer Sabin – New York (+1 212.351.5208, [email protected])
Eric B. Sloan – Co-Chair, New York/Washington, D.C. (+1 212.351.2340, [email protected])
Edward S. Wei – New York (+1 212.351.3925, [email protected])
Lorna Wilson – Los Angeles (+1 213.229.7547, [email protected])
Daniel A. Zygielbaum – Washington, D.C. (+1 202.887.3768, [email protected])

Global Tax Controversy and Litigation:
Michael J. Desmond – Co-Chair, Los Angeles/Washington, D.C. (+1 213.229.7531, [email protected])
Saul Mezei – Washington, D.C. (+1 202.955.8693, [email protected])
Sanford W. Stark – Co-Chair, Washington, D.C. (+1 202.887.3650, [email protected])
C. Terrell Ussing – Washington, D.C. (+1 202.887.3612, [email protected])

*Anne Devereaux, of counsel in the firm’s Los Angeles office, is admitted to practice in Washington, D.C.

This update provides an overview of key class action-related developments during the first quarter of 2024 (January to March).

Table of Contents

Part I reviews a decision from the Ninth Circuit regarding the enforceability of an arbitration provision in a website’s terms of service;
Part II summarizes a Fourth Circuit decision addressing ascertainability;

Part III covers the Eleventh Circuit’s analysis of how to value injunctive relief in the context of class settlement approval when the named plaintiffs lack Article III standing to seek injunctive relief; and

Part IV highlights a Fourth Circuit opinion on a Rule 23(f) petition that involves the exercise of pendent appellate jurisdiction to review issues that are “interconnected” with class certification.

I. Ninth Circuit Affirms Order Compelling Arbitration Under a Website’s Terms of Service

This past quarter, the Ninth Circuit published an important decision affirming the enforceability of an arbitration provision contained in a website’s terms of service. In Patrick v. Running Warehouse, LLC, 93 F.4th 468 (9th Cir. 2024), the plaintiffs sued the operators of an e-commerce website after hackers allegedly breached the website and accessed customer information. Id. at 475. The defendants moved to compel arbitration because the plaintiffs were bound by the arbitration provision in the website’s Terms of Service, which the plaintiffs acknowledged by checkbox (with a hyperlink to the Terms) when they signed up for an account, and again when they pressed a button to “Submit Order” (which notified them that by submitting an order, they agreed to the hyperlinked Terms). Id. at 474. The district court granted the motion and compelled the plaintiffs to arbitration. Id. The plaintiffs appealed, arguing that they had not assented to the Terms, and that even if they had, the arbitration provision was unenforceable.

The Ninth Circuit affirmed and held that the plaintiffs were bound by the arbitration provision. In so holding, the court addressed several issues that frequently arise in motions to compel arbitration:

Notice of the Arbitration Provision. The court held that the defendants provided sufficient information to at least put the plaintiffs on inquiry notice of the Terms because the notice was explicitly visible on the final order review page, and the webpage was otherwise “uncluttered.” Id. at 477.

Unilateral Modification Clause Not Unconscionable. The court rejected the plaintiffs’ argument that the arbitration provision was unconscionable because of a separate clause allowing the defendants to unilaterally amend the Terms “with no notice to users.” Id. at 480. The court held that this unilateral modification clause alone “does not render a separate arbitration clause at all substantively unconscionable” under California law, since “the implied covenant of good faith and fair dealing prevents a party from exercising its rights under a unilateral modification clause in a way that would make it unconscionable.” Id. (quoting Tomkins v. 23andMe, Inc., 840 F.3d 1016, 1033 (9th Cir. 2016)).

Delegation by Reference to JAMS Rules. The court held that the parties delegated threshold questions of arbitrability to the arbitrator by expressly incorporating the JAMS rules (which, in turn, state that an arbitrator should decide threshold questions of arbitrability) into the arbitration agreement. Id. at 481.

Public Injunctive Relief. The court also rejected the plaintiffs’ argument that the arbitration provision was invalid under the California Supreme Court’s decision McGill v. Citibank, N.A., 2 Cal. 5th 945 (2017), because it supposedly prohibited public injunctive relief. 93 F.4th at 477–88. Although the arbitration provision “prohibit[ed] the consumer from arbitrating as part of a class or representative proceeding,” the court noted that the provision said “nothing about the consumer’s ability to pursue, or the arbitrator’s ability to award, any certain type of relief.” Id. at 478. Nor was there any provision “providing that the arbitrator could grant only individual relief.” Id. Accordingly, the arbitration provision did “not bar the arbitrator from awarding public injunctive relief” and was “not invalid under McGill.” Id.

In a separate opinion, the Ninth Circuit subsequently addressed the contract formation issues for an arbitration agreement presented through a mobile application’s sign-in screen. See Keebaugh v. Warner Bros. Ent. Inc., No. 22-55982, 2024 WL 1819651, – F.4th — (9th Cir. Apr. 26, 2024).

II. Fourth Circuit Affirms Denial of Class Certification for Failure to Satisfy Ascertainability Requirement

While not expressly mentioned in Rule 23, some courts continue to recognize ascertainability as a requirement for class certification. The Fourth Circuit reaffirmed this principle in Career Counseling, Inc. v. AmeriFactors Financial Group, LLC, 91 F.4th 202 (4th Cir. 2024), explaining that it requires members of the proposed class to be “readily identifiable.” Id. at 206 (quoting EQT Prod. Co. v. Adair, 764 F.3d 347, 358 (4th Cir. 2014)).

Career Counseling concerned a putative class action alleging that the defendant sent unsolicited faxes in violation of the Telephone Consumer Protection Act (“TCPA”). Id. at 205. The plaintiffs sought to certify a class comprising the recipients of the unsolicited faxes; however, this class would have included both individuals who used stand-alone telephone fax machines (which are subject to the TCPA), as well as those who used an online fax service (which are not subject to the TCPA). Id. at 207. The district court denied class certification because it would have required individualized inquiries to determine if each recipient used a stand-alone fax machine. Id. at 208.

The Fourth Circuit affirmed the denial of certification, holding that plaintiffs did not meet their burden to prove ascertainability because class members using stand-alone fax machines were not readily identifiable. Id. at 208. The plaintiff’s method of identifying the stand-alone fax machine users—subpoenaing telephone carrier records to determine whether carriers offered each recipient an online fax service—was deficient because one could not assume recipients who were not using online fax services were necessarily using stand-alone fax machines. Id. at 212. Thus, the court agreed with the district court’s determination that it would have had to engage in “extensive and individualized fact-finding or ‘mini-trials’” to identify those class members who used stand-alone fax machines, thereby making class certification inappropriate. Id. at 206 (quoting EQT Prod., 764 F.3d at 358).

III. Eleventh Circuit Vacates Class Settlement, Holding that a District Court Erred in Considering Value of Injunctive Relief that Plaintiffs Lacked Standing to Obtain

Although proposed class settlements often include injunctive relief and value such relief in seeking court approval, the Eleventh Circuit recently clarified that the plaintiffs must have Article III standing to seek this relief in the first place. Smith v. Miorelli, 93 F.4th 1206 (11th Cir. 2024).

Smith involved the settlement of a consumer class action against a sunglass company, which allegedly failed to provide its customers with guaranteed repairs for free or for a nominal fee. Id. at 1209. The plaintiffs had sought monetary damages and injunctive relief; however, none of the named plaintiffs alleged that they were at risk of future harm. Id. at 1210. Even so, the parties reached a proposed class settlement that included monetary relief and injunctive relief that required the company to eliminate the allegedly misleading language from their product packaging and marketing materials. Id. After valuing the injunctive relief at $5 million, the district court approved the settlement as fair, reasonable, and adequate. Id. at 1211. But an objector appealed, arguing the district court erred in considering the value of the injunctive relief because the plaintiffs lacked Article III standing to seek such relief in the first place. Id.

The Eleventh Circuit agreed and held that the district court abused its discretion by considering the value of the injunctive relief when approving the settlement. Id. at 1213. Citing basic principles of Article III standing, the court explained that a plaintiff must demonstrate standing separately for each form of relief sought. Id. at 1212. For injunctive relief, this requires the plaintiffs to establish that they faced a threat of “real and immediate” future injury if the defendant’s alleged misconduct was allowed to continue. Id. However, because the plaintiffs had not demonstrated that they faced any such “real and immediate” threat of future injury (such as by having broken sunglasses that needed to be repaired), they lacked standing to seek injunctive relief. Id. The court thus reversed the settlement approval, explaining that “when a district court lacks the power to grant the requested injunctive relief, its approval of a settlement is based on a legal error, and must be set aside as an abuse of discretion.” Id. at 1213 (cleaned up).

IV. The Fourth Circuit Uses Pendent Appellate Jurisdiction to Review Motion to Dismiss Ruling that Was “Interconnected” with Class Certification Order

Rule 23(f) permits appeals “from an order granting or denying class-action certification.” But as illustrated in a decision from the Fourth Circuit this quarter, a class certification order can be so “interconnected” with a district court’s motion to dismiss rulings so as to authorize review of motion to dismiss rulings under pendent appellate jurisdiction.

In Elegant Massage, LLC v. State Farm Mutual Automobile Insurance Co., 95 F.4th 181 (4th Cir. 2024), a putative class of businesses were allegedly denied insurance coverage when several state executive orders required full or partial closure of those businesses during the COVID-19 pandemic. Id. at 184. The district court denied the defendant’s motion to dismiss and certified a class. Id. at 185–86. The defendant appealed under Rule 23(f). Id. at 186.

Although the Fourth Circuit lacked jurisdiction under Rule 23(f) itself to consider the district court’s ruling on the defendant’s motion to dismiss, the court held that “under the doctrine of pendent appellate jurisdiction, [it] may review an issue not otherwise subject to immediate appeal when the issue is ‘so interconnected’ with an issue properly before [the court] as to ‘warrant concurrent review.’” Id. at 188 (quoting EQT Prod., 764 F.3d at 364). The court highlighted two circumstances that warrant this exercise of pendent appellate jurisdiction: (1) where “an issue is ‘inextricably intertwined’ with a question that is the proper subject of an immediate appeal,” or (2) when “review of a jurisdictionally insufficient issue is ‘necessary to ensure meaningful review’ of an immediately appealable issue.” Id. (citing Scott v. Fam. Dollar Stores, Inc., 733 F.3d 105, 111 (4th Cir. 2013)).

In Elegant Massage, the Fourth Circuit held that the defendant’s appeal fell within the second category because the district court’s motion to dismiss rulings about coverage under the defendant’s insurance policy were essential to its analysis of the class certification order. Id. at 188. Exercising its pendent appellate jurisdiction, the court held the district court erred in its interpretation of the defendant’s insurance policy, and because “the legal error animating the court’s denial of the motion to dismiss directly affects the outcome of the court’s class certification order,” it was appropriate to reverse the class certification order. Id. at 191.

The following Gibson Dunn lawyers contributed to this update: Nasim Khansari, Vannalee Cayabyab, Kyla Osburn, Wesley Sze, Lauren Blas, Bradley Hamburger, Kahn Scolnick, and Christopher Chorba.

Gibson Dunn attorneys are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Class Actions, Litigation, or Appellate and Constitutional Law practice groups, or any of the following lawyers:

Theodore J. Boutrous, Jr. – Los Angeles (+1 213.229.7000, [email protected])
Christopher Chorba – Co-Chair, Class Actions Practice Group – Los Angeles (+1 213.229.7396, [email protected])
Theane Evangelis – Co-Chair, Litigation Practice Group, Los Angeles (+1 213.229.7726, [email protected])
Lauren R. Goldman – New York (+1 212.351.2375, [email protected])
Kahn A. Scolnick – Co-Chair, Class Actions Practice Group – Los Angeles (+1 213.229.7656, [email protected])
Bradley J. Hamburger – Los Angeles (+1 213.229.7658, [email protected])
Michael Holecek – Los Angeles (+1 213.229.7018, [email protected])
Lauren M. Blas – Los Angeles (+1 213.229.7503, [email protected])

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From the Derivatives Practice Group: This week, the CFTC approved final rules amending the capital and financial reporting requirements of swap dealers and major swap participants, and amending the large trading reporting regulations for futures and options.

New Developments

CFTC Chairman Behnam Designates Ted Kaouk as the CFTC’s First Chief Artificial Intelligence Officer. On May 1, CFTC Chairman Rostin Behnam announced the designation of Dr. Ted Kaouk as the agency’s first Chief Artificial Intelligence Officer. Dr. Kaouk currently serves as the CFTC’s Chief Data Officer and Director of the Division of Data. The CFTC stated that in this newly expanded role as the CFTC’s Chief Data & Artificial Intelligence Officer, Dr. Kaouk will be responsible for leading the development of the CFTC’s enterprise data and artificial intelligence strategy to further integrate CFTC’s ongoing efforts to advance its data-driven capabilities. [NEW]
CFTC Approves Final Rule Amending the Capital and Financial Reporting Requirements of Swap Dealers and Major Swap Participants. On April 30, the CFTC announced it has approved a final rule that amends the capital and financial reporting requirements of Swap Dealers (SDs) and Major Swap Participants (MSPs). According to the CFTC, the amendments make changes consistent with CFTC Staff Letter No. 21-15 regarding the tangible net worth capital approach for calculating capital under CFTC Regulation 23.101, as well as CFTC Staff Letter No. 21-18, as further extended by CFTC Staff Letter No. 23-11, regarding the alternate financial reporting requirements for SDs subject to the capital requirements of a prudential regulator. The amendments also revise certain Part 23 regulations regarding the financial reporting requirements of SDs, including the required timing of certain notifications, the process for approval of subordinated debt for capital, and the information requested on financial reporting forms to conform to the rules. The CFTC stated that the amendments are intended to make it easier for SDs and MSPs to comply with the CFTC’s financial reporting obligations and demonstrate compliance with minimum capital requirements. To allow for sufficient time to effectuate the reporting and notification amendments, the final rule has a compliance date of September 30, 2024, and will apply to all financial reports with an “as of” reporting date of September 30, 2024, or later. [NEW]
CFTC Approves Final Rules on Large Trader Reporting for Futures and Options. On April 30, the CFTC announced approval of final rules to amend its large trading reporting regulations for futures and options. These regulations require futures commission merchants, clearing members, foreign brokers, and certain reporting markets (reporting firms) to report to the Commission position information for the largest futures and options traders. The final rules replace the data elements currently enumerated in the CFTC’s regulations with an appendix specifying applicable data elements. The final rules also provide for the publication of a separate Part 17 Guidebook specifying the form and manner for reporting. In addition, the final rules remove the outdated 80-character data submission standard in the CFTC’s regulations. According to the CFTC, that standard will be replaced by a FIXML standard, as set out in the Part 17 Guidebook. [NEW]
CFTC Approves Final Rules on Swap Confirmation Requirements for SEFs. On April 23, the CFTC approved final rules to amend its swap execution facility (SEF) regulations related to uncleared swap confirmations to address issues which have been addressed in CFTC staff no-action letters, including the most recent CFTC No Action Letter No. 17-17, as well as associated conforming and technical changes. In particular, the final rules amend CFTC Regulation 37.6(b) to enable SEFs to incorporate terms of underlying, previously negotiated agreements between the counterparties by reference in an uncleared swap confirmation without being required to obtain such underlying, previously negotiated agreements. Further, the final rules amend CFTC Regulation 37.6(b) to require such confirmation to take place “as soon as technologically practicable” after the execution of the swap transaction on the SEF for both cleared and uncleared swap transactions. The final rules also amend CFTC Regulation 37.6(b) to make clear the SEF-provided confirmation under CFTC Regulation 37.6(b) shall legally supersede any conflicting terms in a previous agreement, rather than the entire agreement. The final rules make conforming amendments to CFTC Regulation 23.501(a)(4)(i) to correspond with the amendments to CFTC Regulation 37.6(b). Finally, the final rules make certain non-substantive amendments to CFTC Regulation 37.6(a)-(b) to enhance clarity.
CFTC Extends Public Comment Period for Proposed Rule for Designated Contract Markets and Swap Execution Facilities Regarding Governance and Conflicts of Interest. On April 22, the CFTC announced it is extending the deadline for public comment period on a proposed rule that makes certain modifications to rules for Swap Execution Facilities and Designated Contract Markets in Part 37 and 38 that would establish governance requirements regarding market regulation functions, as well as related conflicts of interest standards. The deadline is being extended to May 13, 2024.

New Developments Outside the U.S.

ESMA Publishes the Annual Transparency Calculations for Non-Equity Instruments, Bond Liquidity Data and Quarterly SI Calculations. On April 30, ESMA published the results of the annual transparency calculations for non-equity instruments, new quarterly liquidity assessment of bonds and the quarterly systematic internaliser calculations under MiFID II and MiFIR. As indicated in ESMA’s public statement on March 27, the quarterly liquidity assessment of bonds as well as the data for the quarterly systematic internalizers will continue to be published by ESMA. [NEW]
ESAs Issue Spring 2024 Joint Committee Update. On April 30, the three European Supervisory Authorities (EBA, EIOPA and ESMA – the ESAs) issued their Spring 2024 Joint Committee update on risks and vulnerabilities in the EU financial system. The risk update shows that risks remain elevated in a context of slowing growth, an uncertain interest rate environment and ongoing geopolitical tensions. According to the update, in recent months, financial markets have performed strongly in anticipation of potential interest rate cuts in 2024 in both the EU and the US, despite the significant uncertainty surrounding these. The ESAs stated that this strong performance entails elevated risks of market corrections linked to unexpected events. [NEW]
Telbor Committee to Permanently Cease Publication of Telbor. On April 16, the Telbor Committee of the Bank of Israel decided that the publication of all tenor of Telbor will permanently cease following a final publication on June 30, 2025. The announcement constitutes an “Index Cessation Event” under the 2021 ISDA Interest Rate Derivatives Definitions and the November 2022 Benchmark Module of the ISDA 2021 Fallbacks Protocol. In February 2022, the Telbor Committee decided that the SHIR (Shekel overnight Interest Rate) rate would eventually replace the Telbor interest rate in shekel interest rate derivative transactions. The Bank of Israel said that the decision to switch to the SHIR rate is in accordance with the decisions reached in major economies worldwide, according to which IBOR type interest rates will be replaced by risk-free overnight interest rates. ISDA published cessation guidance for parties affected by the announcement.

New Industry-Led Developments

ISDA Launches Outreach Initiative on Proposed Notices Hub. On April 25, ISDA announced major industry outreach initiative to establish support among dealers and buy-side firms for a new online platform that would allow the instantaneous delivery and receipt of critical termination-related notices, reducing the risk exposure and potential losses from a delay. Under the ISDA Master Agreement, termination-related notices must be delivered by certain prescribed methods, using company address details listed in the agreement. However, delays can occur if a company has moved and the documentation hasn’t been updated with the new details or if delivery to a physical location is not possible due to geopolitical shocks. The proposed ISDA Notices Hub would act as a secure central platform for firms to deliver notices, with automatic alerts sent to the receiving entity. Multiple designated people at each firm would be able to access the hub from anywhere in the world, regardless of the situation at its physical location. The platform would also allow market participants to update their physical address details via a single entry, providing a golden source of those details. [NEW]
ISDA, SIFMA, and CCMA Publish T+1 Settlement Cycle Booklet. On April 30, ISDA, the Securities Industry and Financial Markets Association (SIFMA) and the Canadian Capital Markets Association (CCMA) published a T+1 settlement cycle booklet to address queries from market participants on the settlement cycle changes taking place in North America on May 27-28, 2024, and the possible impact to relevant securities and over-the-counter (OTC) derivatives transactions. This booklet may be updated from time to time. [NEW]
ISDA Publishes Sub-Annex A Maintenance Guidelines for the 2005 ISDA Commodity Definitions. On April 30, ISDA published maintenance guidelines for Sub-Annex A of the 2005 ISDA Commodity Definitions. Sub-Annex A contains definitions for various Commodity Reference Prices. [NEW]
ISDA and SIFMA Submit Addendum to Proposed FFIEC Reporting Revisions. On April 23, ISDA and the Securities Industry and Financial Markets Association (SIFMA) submitted an addendum to the joint response to the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency on the proposed reporting revisions of the call report, FFIEC 101 and FFIEC 102, which are designed to reflect the implementation of the Basel III endgame proposal. The addendum contains additional findings in the FFIEC 102 report, including end-of-week Fundamental Review of the Trading Book standardized approach average calculations and reported market risk risk-weighted assets in sub-parts D and E.
ISDA Launches Outreach Initiative on Proposed Notices Hub. On April 25 ISDA announced a major industry outreach initiative to establish support among dealers and buy-side firms for a new online platform that would allow the instantaneous delivery and receipt of critical termination-related notices, reducing the risk exposure and potential losses from a delay. Under the ISDA Master Agreement, termination-related notices must be delivered by certain prescribed methods, using company address details listed in the agreement. However, delays can occur if a company has moved and the documentation hasn’t been updated with the new details or if delivery to a physical location is not possible due to geopolitical shocks. The proposed ISDA Notices Hub would act as a secure central platform for firms to deliver notices, with automatic alerts sent to the receiving entity. Multiple designated people at each firm would be able to access the hub from anywhere in the world, regardless of the situation at its physical location. The platform would also allow market participants to update their physical address details via a single entry, providing a golden source of those details.
Four Directors Join ISDA Board. On April 18, ISDA announced that four directors have joined its Board, three directors were re-appointed, and 10 others have been re-elected at ISDA’s Annual General Meeting in Tokyo. The new directors are: Erik Tim Mueller, Chief Executive Officer, Eurex Clearing AG; Jared Noering, Managing Director, Head of Fixed Income Trading, NatWest Markets; Brad Tully, Managing Director and Global Head of Corporate Derivatives and Private Side Sales for J.P. Morgan; and Jan Mark van Mill, Managing Director of Multi Asset, APG Asset Management.
ISDA Future Leaders in Derivatives Publishes Generative Artificial Intelligence Whitepaper. On April 17, ISDA published a whitepaper from ISDA Future Leaders in Derivatives (IFLD), its professional development program for emerging leaders in the derivatives market. The whitepaper, GenAI in the Derivatives Market: a Future Perspective, was developed by the third cohort of IFLD participants, who began working together in October 2023. According to ISDA, the 38 individuals in the group represent buy- and sell-side institutions, law firms, and service providers from around the world. After being selected for the IFLD program, they were asked to engage with stakeholders, develop positions, and produce a whitepaper on the potential use of generative artificial intelligence (genAI) in the over-the-counter derivatives market. The participants were also given access to ISDA’s training materials, resources, and staff expertise to support the project and their own professional development. ISDA said that, drawing on industry expertise and academic research, the whitepaper identifies a range of potential use cases for genAI in the derivatives market, including document creation, market insight, and risk profiling. ISDA also indicated that it explores regulatory issues in key jurisdictions and addresses the challenges and risks associated with the use of genAI. The paper concludes with a set of recommendations for stakeholders, including investing in talent development, fostering collaboration and knowledge sharing with technology providers, prioritizing ethical AI principles and engaging with policymakers to promote an appropriate regulatory framework.
ISDA Publishes Research Paper on Interest Rate Derivatives, Benchmark Rates and Development Financial Markets in EMDEs. On April 17, ISDA published a research paper in which it outlines the role of interest rate derivatives (IRDs) in supporting the development of financial markets in emerging markets and developing economies (EMDEs). It also examines the significance of reliable, robust interest rate (IR) benchmarks. ISDA indicated that the paper draws valuable lessons from the transition from LIBOR to overnight risk-free rates in advanced economies and applies those insights to the context of EMDEs. Through case studies, ISDA attempts to show how various EMDE jurisdictions have successfully adopted and implemented more robust and transparent IR benchmarks.
ISDA Extends Digital Regulatory Reporting Initiative to New Jurisdictions. On April 17, ISDA announced that it is extending its Digital Regulatory Reporting (DRR) initiative to several additional jurisdictions in an effort to enable firms to implement changes to regulatory reporting requirements. The DRR is being extended to cover rule amendments being implemented under the UK European Market Infrastructure Regulation and by the Australian Securities and Investments Commission and the Monetary Authority of Singapore. Those rule changes are due to be implemented in the UK on September 30, 2024, and October 21, 2024 in Australia and Singapore. The DRR code for all three sets of rules is currently available for market participants to review and test. ISDA said that the DRR will be further extended to cover rule changes in Canada and Hong Kong, both due in 2025, and the DRR for the CFTC rules will also be updated to include further anticipated updates, currently under consultation at the commission. Firms can either use the DRR as the basis for implementation or to validate an independent interpretation of the rules.
ISDA Publishes Margin Survey. On April 16, ISDA published its latest margin survey, which shows that $1.4 trillion of initial margin (IM) and variation margin (VM) was collected by 32 leading derivatives market participants for their non-cleared derivatives exposures at the end of 2023, unchanged from the previous year. The survey also reports the amount of IM posted by all market participants to major central counterparties.
ISDA Establishes Suggested Operational Practices for EMIR Refit. On April 16, through a series of discussions held within the ISDA Data and Reporting EMEA Working Group, market participants established and agreed to Suggested Operational Practices (SOP) for over-the-counter derivative reporting in preparation for the commencement of the EMIR Refit regulatory reporting rules on April 29. ISDA said that the SOP matrix was established based on the EMIR Refit validation table, (as published by ESMA), which contains the Regulatory Technical Standards (RTS), the Implementation Technical Standards (ITS) and validation rules. Additional tabs have been added to supplement to SOPs, including product-level SOPs for several of the underlier fields, and listing names of floating rate options. There are also tabs to reflect updates made to the matrix (‘Updates’) and a tab to track questions raised by the ISDA Data and Reporting EMEA Working Group (‘WG Questions’). ISDA indicated that the document will continue to be reviewed and updated as and when required. While the intention of these SOPs is to provide an agreed and standardized market guide for firms to utilize, no firm is legally bound or compelled in any way to follow any determinations made within these EMIR SOPs.

The following Gibson Dunn attorneys assisted in preparing this update: Jeffrey Steiner, Adam Lapidus, Marc Aaron Takagaki, Hayden McGovern, and Karin Thrasher.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Derivatives practice group, or the following practice leaders and authors:

Jeffrey L. Steiner, Washington, D.C. (202.887.3632, [email protected])

Michael D. Bopp, Washington, D.C. (202.955.8256, [email protected])

Michelle M. Kirschner, London (+44 (0)20 7071.4212, [email protected])

Darius Mehraban, New York (212.351.2428, [email protected])

Jason J. Cabral, New York (212.351.6267, [email protected])

Adam Lapidus – New York (+1 212.351.3869, [email protected])

Stephanie L. Brooker, Washington, D.C. (202.887.3502, [email protected])

Roscoe Jones Jr., Washington, D.C. (202.887.3530, [email protected])

William R. Hallatt, Hong Kong (+852 2214 3836, [email protected])

David P. Burns, Washington, D.C. (202.887.3786, [email protected])

Marc Aaron Takagaki, New York (212.351.4028, [email protected])

Hayden K. McGovern, Dallas (214.698.3142, [email protected])

Karin Thrasher, Washington, D.C. (202.887.3712, [email protected])

On April 23, 2024, the Federal Trade Commission released a new rule outlawing the vast majority of non-compete agreements in the United States. This webinar provides an overview of the rule and its ramifications, discusses recommended next steps for businesses, and discusses legal challenges to the rule.

PANELISTS:

Michael Collins is a partner in Gibson Dunn’s Washington, D.C. office and Co-Chair of the Executive Compensation and Employee Benefits Practice Group. His practice focuses on all aspects of employee benefits and executive compensation. Michael’s practice runs the full gamut of tax, ERISA, accounting, corporate, and securities law aspects of stock option, SAR, restricted stock, and employee stock purchase plans; tax-qualified retirement plans, nonqualified deferred compensation; SERPs; executive employment agreements, golden parachutes and other change in control arrangements; severance, confidentiality, and noncompete contracts; performance bonus and incentive plans; director’s pay; rabbi trusts; split dollar life insurance; excess benefit and top hat plans; and the like. He represents both executives and companies in drafting and negotiating employment arrangements. Michael is a member of the District of Columbia bar.

Andrew Kilberg is a partner in Gibson Dunn’s Washington, D.C. office, where he practices in the firm’s litigation department. A member of the firm’s Labor and Employment, Administrative and Regulatory, and Appellate and Constitutional Law practice groups, Andrew has significant experience challenging onerous federal regulations, advising on regulatory proposals, and defending agency enforcement actions and investigations. He has represented clients in federal district and appellate courts and before the U.S. Supreme Court, as well as before various agencies, authoring dozens of briefs, comment letters, and other submissions. Andrew is a member of the District of Columbia and Virginia bars, and he is admitted to practice before the U.S. Supreme Court, U.S. Courts of Appeals for the Second, Third, Fourth, Fifth, Seventh, Eighth, Ninth, and D.C. Circuits, the U.S. District Court for the District of Columbia, the Supreme Court of Virginia, and the District of Columbia Court of Appeals.

Julian W. Kleinbrodt is a partner in Gibson Dunn’s San Francisco office. He practices in the firm’s Litigation Department and is a member of the firm’s Antitrust and Competition Practice Group as well as the firm’s Labor & Employment Group. Julian has experience handling a wide variety of antitrust matters through trial and appeal. He has particular experience with claims involving price-fixing, monopolization, attempted monopolization, refusals to deal, tying, bundling, exclusive dealing, disparagement, market allocation and division, and no-poach provisions. For example, Julian was part of a team that defended a major technology company in a multi-week bench trial dubbed the “Super Bowl of Antitrust.” Julian has additional experience representing clients in civil and criminal investigations by the U.S. Department of Justice and Federal Trade Commission. He also regularly counsels clients on antitrust compliance and has authored multiple articles on competition issues.

Kristen Limarzi is a partner in the highly acclaimed Antitrust and Competition Practice Group of Gibson Dunn, based in Washington, D.C. Recognized as “Dealmaker of the Year” for 2023 by Global Competition Review, Kristen leverages her experience as a top government enforcer to represent clients in merger and non-merger investigations before the DOJ, the Federal Trade Commission, and foreign antitrust enforcers, as well in as appellate and civil litigation. Prior to joining the firm, she served as a top enforcement official in the U.S. Department of Justice’s Antitrust Division. As Appellate Section Chief, she was responsible for litigating appeals in the Division’s civil and criminal enforcement actions and participating as amicus curiae in private antitrust actions. While serving in the Antitrust Division, Kristen also helped to develop Division policies on a wide range of issues, including the agency’s Antitrust Guidance for Human Resources Professionals in 2016.

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This update reviews the changes introduced by the EU Alternative Investment Fund Managers Directive II and assesses the likely impact of such changes on non-EU sponsors of private investment funds that are marketed in the EU.

On 26 March 2024, AIFMD II was published in the Official Journal of the EU.[1] AIFMD II entered into force on 15 April 2024 and, subject to certain exceptions as noted below, EU member states will have until 16 April 2026 to transpose the new rules into EU member state law.[2] This update reviews the changes introduced by AIFMD II and assesses the likely impact of such changes on non-EU sponsors of private investment funds that are marketed in the EU.

What is AIFMD II?

Following its consultation on the application and scope of the EU Alternative Investment Fund Managers Directive (“AIFMD”)[3], the European Commission concluded that there was a need to harmonise the regulatory framework applicable to alternative investment fund managers (“AIFMs”) managing alternative investment funds (“AIFs”), with a particular focus on those AIFs that originate loans, and to clarify the standards that apply to AIFMs delegating functions to third parties.

What is AIFMD II changing?

AIFMD II does not mark a complete overhaul of the AIFMD. Rather, the Directive adopts targeted amendments to address certain ambiguities identified within the existing regulatory framework. For non-EU sponsors of private investment funds that are marketed in the EU, the key changes relate to: the national private placement regime criteria; the reporting (Annex IV) and disclosure (Article 23) requirements; the delegation of portfolio management to third parties; the creation of a new loan origination regime; and the mandated use of liquidity management tools for open-ended funds.

What is the likely impact on non-EU sponsors?

AIFMD II was the subject of extensive debate among the European supervisory authorities, individual EU member states and the wider fund management industry. In particular, the proposals concerning the delegation of portfolio management and loan origination resulted in intensive negotiations. Fundamental changes to the AIFMD that would have been indicative of a more concerted move to “Fortress Europe”—for example, removing the ability of EU AIFMs to delegate portfolio management to non-EU sponsors—were not realised. That being said, AIFMD II is indicative of the trend towards tightening the avenues through which non-EU sponsors can raise EU capital, which is likely to further narrow over time. As a result of AIFMD II, there will also be a mismatch between requirements that apply to certain non-EU sponsors and those that apply to EU AIFMs, in particular, with respect to the application of the new loan origination provisions. It remains to be seen, however, whether AIFMD II will further push EU investors to prioritize investment in EU-domiciled AIFs.

The impact of AIFMD II on non-EU sponsors will primarily depend on how individual sponsors raise capital from European investors and the investment strategies that they deploy. Non-EU sponsors are currently impacted by AIFMD when they: (a) market AIFs in EU member states via the national private placement regimes (“NPPRs”); and (b) market AIFs in EU members states via the AIFMD marketing passport. With respect to the latter, in order for non-EU sponsors to avail themselves of the AIFMD marketing passport, they need to establish an EU-domiciled AIF (typically, Luxembourg or Ireland) that is managed either by an EU-affiliate of the non-EU sponsor that is licensed as an EU AIFM or by a third party “host-AIFM” located in the EU. For non-EU sponsors utilizing the AIFMD marketing passport (whether via an affiliated EU-AIFM or a “host-AIFM”), the portfolio management function with respect to the AIF is nearly always delegated back to the sponsor’s home jurisdiction (e.g., the United States).

What is the impact for non-EU sponsors accessing European capital via the NPPRs or an EU-affiliated AIFM / “host–AIFM”?

(i) Investor disclosures

Both EU AIFMs and non-EU sponsors that have registered AIFs for marketing via the NPPRs are required to make certain pre-contractual disclosures available to EU investors (i.e., the Article 23 disclosures).[4] Under AIFMD II, the Article 23 disclosures have been enhanced and will require the following information to be made available to investors: (i) the name of the AIF; (ii) a list of all fees, charges and expenses borne by the AIFM which are subsequently directly or indirectly allocated to the AIF or to any of its investments; and (iii) for open-ended funds, a description of the circumstances triggering the use of liquidity management tools. EU AIFMs and non-EU sponsors that have registered AIFs for marketing under the NPPRs will also be required to provide information periodically to investors, including: (i) all fees and charges that were directly or indirectly borne by investors; (ii) any parent undertaking, subsidiary or SPV utilised in relation to the AIF’s investments by or on behalf of the AIFM; and (iii) to the extent applicable, a report on the portfolio composition of any originated loans.

(ii) Annex IV reporting

EU AIFMs and non-EU sponsors that have registered AIFs for marketing in the EU are currently required to submit periodic “Annex IV” reports. The Annex IV reports cover quantitative disclosures in respect of the AIFM and the AIFs it manages, and are due on an annual, biannual or quarterly basis (depending on assets under management, the use of leverage and the investment strategy of the AIFs). AIFMD II introduces additional reporting fields in the Annex IV reports. ESMA has been mandated to publish updated reporting templates by 16 April 2027 and, as a result, compliance with the additional reporting fields will not be required until that date. Currently, an EU AIFM (or a non-EU sponsor marketing an AIF in the EU pursuant to the NPPRs) must report on the “principal” markets and instruments in which it trades and provide information on the “main” instruments in which it is trading and on the “principal” exposures and “most important” concentrations of each of the AIFs it manages. AIFMD II expands the Annex IV reporting obligations by removing the limitations which focus on major trades and exposures or counterparties. AIFMD II also requires the provision of information regarding the total amount of leverage employed by the AIF as well as details on the member states within which the AIF is marketed. Detailed information on portfolio management / risk management delegation (including quantitative data) will also need to be reported. Given the expanded scope of reporting, the revised Annex IV reports are likely to impose additional costs and require additional resources to prepare them.

What is the impact for non-EU sponsors marketing via national private placement regimes?

(i) Changes to accessing the NPPRs

Historically, most non-EU sponsors have accessed EU capital by registering their AIFs under the various EU member state NPPRs. AIFMD II will now prohibit the marketing of non-EU AIFs established in jurisdictions identified as “high risk” under the Fourth Anti-Money Laundering Directive (the “EU AML List”).[5] Similarly, to be eligible for registration under the NPPRs, non-EU AIFs will also need to be formed in jurisdictions that have signed agreements with the EU member state(s) in which they are to be marketed that are compliant with various international tax treaties. Finally, registration under the NPPRs will also be prohibited for any non-EU AIF that is established in a country that is included on the EU’s list of non-cooperative tax jurisdictions.[6]

From the perspective of a non-EU sponsor, these amendments are not expected to be an issue for fund vehicles established in the United States. Any change to the scope of jurisdictions that are contained on the EU’s list of “high risk” and “non-cooperative” jurisdictions is ultimately an EU political decision. That noted, the Cayman Islands was only recently removed from the EU AML List on 7 February 2024. In addition, on 23 April 2024 the European Parliament rejected the European Commission’s proposal to remove the UAE from the EU AML List.[7] Future changes in political headwinds could, therefore, result in other fund domiciles being added to such lists, which would effectively prohibit AIFs established in such jurisdictions from being marketed in the EU. To the extent that a popular fund domicile (e.g., the Cayman Islands) is added to one of the prohibited lists, this would have negative implications for non-EU sponsors seeking to access EU capital.

What is the impact for non-EU sponsors that have an EU-affiliated AIFM or use a “host-AIFM”?

(i) Delegation

The changes introduced by AIFMD II to the AIFMD delegation provisions are not as extensive as the industry originally feared. Importantly, the ability to delegate portfolio management to non-EU countries, such as the United States, remains. However, the changes outlined below indicate: (i) an increased level of scrutiny over delegation arrangements, including the “host-AIFM” model; and (ii) the costs and administrative burden of delegating an EU AIFM’s functions is likely to increase.

AIFMD II expressly provides that an EU AIFM is responsible for ensuring that the performance of functions and the provision of services by a delegate comply with the AIFMD. This requirement applies irrespective of the location or regulatory status of the delegate (i.e., even if the delegate is a non-EU sponsor). The degree to which this obligation results in a greater compliance burden for non-EU sponsors remains to be seen. That noted, EU AIFMs are likely to impose greater initial due diligence and ongoing monitoring requirements in the context of a delegation of functions, which is likely to add to the time and resources that are necessary to put such arrangements in place and to maintain them.[8]

In addition, EU AIFMs will also be required to regularly provide information to their competent authority regarding delegation arrangements that concern portfolio management or risk management functions. For example, this information includes but is not limited to: (i) details of the delegate(s); (ii) the number of full-time equivalent human resources employed by the AIFM for the purposes of performing day-to-day portfolio management or risk management tasks and to monitor the delegation arrangements; (iii) a list and description of the activities concerning risk management and portfolio management functions which are delegated; and (iv) the number and dates of the periodic due diligence reviews carried out by the AIFM to monitor the delegated activity

(ii) Loan origination

The most fundamental changes in AIFMD II concern sponsors that manage AIFs operating loan origination strategies, either through an EU-affiliated AIFM or via the engagement with a “host-AIFM”. Separate requirements are applicable to loan origination activity by “AIFs Which Originate Loans” and “Loan Originating AIFs”. Importantly, the restrictions that apply to AIFs Which Originate Loans and Loan Originating AIFs do not apply to AIFs marketed in the EU by a non-EU sponsor pursuant to the NPPRs.

“AIFs Which Originate Loans”

An “AIF Which Originates Loans” refers to an AIF that: (i) grants loans directly as the original lender; or (ii) grants loans indirectly through a third party or special purpose vehicle, which originates a loan for or on behalf of the AIF, or for or on behalf of an AIFM in respect of the AIF, where the AIF or AIFM is involved in structuring the loan, or defining or pre-agreeing its characteristics, prior to gaining exposure to the loan. With respect to “AIFs Which Originate Loans”, AIFMD II imposes commercial and operational restrictions, including:

Concentration limits – Cannot make loans to a single financial undertaking, a UCITS or other AIF which exceeds, in the aggregate, 20% of the capital of the AIF—except if the AIF is selling assets to meet redemptions or as part of the liquidation of the AIF.

Lending restrictions – Cannot make loans that could give rise to certain conflicts of interest, including to: the EU AIFM (or its staff); any entities within the same group as the EU AIFM; the EU AIFM’s delegate (or its staff); or the AIF’s depositary (or its delegate).

Risk retention – Must retain 5% of each originated loan that is subsequently transferred to a third party.[9]

Originate to distribute – EU AIFMs cannot manage AIFs Which Originate Loans with the sole purpose of selling them to third parties.[10]

Use of proceeds – The proceeds of the loans, minus any allowable fees for the administration of such loans, must be attributed in full to the concerned AIF. Any such costs and expenses must also be included in the Article 23 disclosures.

Policies / Procedures – EU AIFMs of AIFs Which Originate Loans will be required to implement and review policies and procedures relating to the granting of credit.

“Loan Originating AIFs”

A “Loan Originating AIF” refers to an AIF: (i) whose investment strategy is mainly to originate loans; or (ii) where the notional value of the AIF’s originated loans represents at least 50% of its net asset value. In addition to the restrictions applicable to AIFs Which Originate Loans noted above, a Loan Originating AIF is also subject to the following limitations:

Leverage Limit—leverage is limited to no more than: (i) 175% for open-ended Loan Originating AIFs; and (ii) 300% for closed-ended Loan Originating AIFs.[11] The foregoing leverage limits do not apply to Loan Originating AIFs whose loan activity consists solely of originating shareholder loans, provided that such loans do not exceed in aggregate 150% of the capital of the Loan Originating AIF.

Closed-Ended Structure—Must be closed-ended unless the EU AIFM can demonstrate that its liquidity risk management system is compatible with its investment strategy and redemption policy.

“Grandfathering” measures

For the 5-year period from when AIFMD II comes into force (i.e., through 15 April 2029), the leverage limits, concentration limits and the requirement to be closed-ended do not apply to pre-existing AIFs. In addition, if such AIFs do not raise further capital after 15 April 2024, they are exempt indefinitely from these requirements.

However, these grandfathering measures provide limited relief in practice. This is because: (i) if such AIFs are currently in breach of the leverage / concentration limits as at 15 April 2024, they cannot increase leverage or lending during the 5 year grandfathering period; and (ii) such AIFs that are not in breach of these requirements may only increase leverage / concentration to such level that they do not breach these limits.

Pre-existing AIFs also do not need to comply with the other loan origination rules set out above.

(iii) Liquidity management tools for open-ended AIFs

AIFMD II requires EU AIFMs operating open-ended AIFs to select at least two liquidity management tools, which must be appropriate to the investment strategy, the liquidity profile and the redemption policy of the AIF. These include: (i) suspension of redemptions and subscriptions; (ii) redemption gates; (iii) extension of notice periods; (iv) redemption fees; (v) swing pricing; (vi) dual pricing; (vii) anti-dilution levies; (viii) redemptions in kind; and (ix) side pockets. There are circumstances in which certain liquidity management tools can be activated or deactivated, or EU AIFMs may suspend the repurchase or redemption of units in the AIF. The use of liquidity management tools must be documented in policies and procedures and included in the Article 23 disclosures that are made available to investors.

What steps should non-EU sponsors be taking now?

At a high-level, certain aspects of AIFMD II (e.g., the expanded scope of Article 23 disclosures and Annex IV reporting) are consistent with the trajectory of private funds regulation in other jurisdictions, including the United States. Akin to the private fund rules that the U.S. Securities and Exchange Commission (the “SEC”) recently adopted[12] as well as other rules currently proposed by the SEC, AIFMD II is similarly focused on increased transparency with respect to private funds both for investors and for regulators. While some elements of AIFMD II may not have a meaningful impact for many non-EU sponsors, key components of the Directive are likely to impose additional costs and operational burdens. For loan originating funds, AIFMD II goes further by limiting certain commercial flexibilities that were previously negotiated matters among investors, fund sponsors and transaction counterparties.

For now, non-EU sponsors should be undertaking a gap analysis and impact assessment of AIFMD II on their EU operations and fund distribution strategy. Sponsors should also monitor the forthcoming EU Level 2 legislation and implementing legislation in key EU member states where they have a physical presence, engage a “host-AIFM” provider or market their funds. Should you have questions regarding AIFMD II and its potential implications on your business, please do not hesitate to reach out to the authors of this alert.

__________

[1] Directive (EU) 2024/927 of the European Parliament and of the Council of 13 March 2024 amending Directives 2011/61/EU and 2009/65/EC as regards delegation arrangements, liquidity risk management, supervisory reporting, the provision of depositary and custody services and loan origination by alternative investment funds.

[2] References in this client alert to the “EU” should also be deemed to include the three European Economic Area jurisdictions as the context allows (i.e., Iceland, Liechtenstein and Norway).

[3] Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers.

[4] For EU AIFs managed by EU AIFMs, the obligation to make the Article 23 disclosures available to investors lies with the EU AIFM. That noted, the non-EU sponsor will typically prepare the Article 23 disclosures for funds marketed via the marketing passport (irrespective of whether the fund is managed by an affiliated-EU AIFM or a “host-AIFM”).

[5] As at the date of this client alert, the following jurisdictions are on the EU’s AML list: Afghanistan; Barbados; Burkina Faso; Cameroon; Democratic Republic of the Congo; Gibraltar; Haiti; Jamaica; Mali; Mozambique; Myanmar; Nigeria; Panama; Philippines; Senegal; South Africa; South Sudan; Syria; Tanzania; Trinidad and Tobago; Uganda; United Arab Emirates; Vanuatu; Vietnam; and Yemen.

[6] As at the date of this client alert, the following jurisdictions are on the EU list of non-cooperative tax jurisdictions: American Samoa; Anguilla; Antigua and Barbuda; Fiji; Guam; Palau; Panama; Russia; Samoa; Trinidad and Tobago; US Virgin Islands; and Vanuatu.

[7] This decision has created a divergence in the treatment of the UAE, as the Financial Action Task Force removed the UAE from its “grey list” in February 2024.

[8] Notably, there are additional requirements for EU AIFMs managing AIFs on behalf of third parties (i.e., the “host-AIFM” model) to provide additional information to their competent authority with respect to their management of conflicts of interest.

[9] The AIF must retain that percentage of the loan: (i) until maturity for those loans whose maturity is up to eight years, or for loans granted to consumers regardless of their maturity; and (ii) for a period of at least eight years for other loans. Note that there are a number of exemptions including where the EU AIFM seeks to: (a) redeem units or shares as part of the liquidation of the AIF; (b) comply with EU sanctions or product requirements; (c) implement the investment strategy of the AIF, in the best interests of its investors; and/or (d) dispose of the loan due to a deterioration in the risk associated with the loan, detected by the AIFM as part of its due diligence and risk management process and the purchaser is informed of that deterioration when buying the loan.

[10] This is likely to apply to loans that are originated indirectly by an SPV.

[11] Leverage is expressed as the ratio between the exposure of the Loan Originating AIF and its net asset value. For the purposes of calculating this ratio, borrowing arrangements which are fully covered by contractual capital commitments from investors in the Loan Originating AIF do not constitute exposure.

[12] https://www.gibsondunn.com/guide-to-understanding-new-private-funds-rules/

The following Gibson Dunn lawyers prepared this update: Michelle Kirschner, James Hays, and Martin Coombes.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you wish to discuss any of the matters set out above, please contact the Gibson Dunn lawyer with whom you usually work, any member of Gibson Dunn’s Global Financial Regulatory or Investment Funds teams, or the following authors:

Michelle M. Kirschner – London (+44 20 7071 4212, [email protected])
James M. Hays – Houston (+1 346 718 6642, [email protected])
Martin Coombes – London (+44 20 7071 4258, [email protected])

From the Financial Institutions Practice Group: We are pleased to provide you with the April edition of Gibson Dunn’s monthly U.S. bank regulatory update. This update covers recent federal banking agency initiatives and legal news updates on the Community Reinvestment Act final rules and Federal Reserve Bank master accounts.

KEY NEW DEVELOPMENTS

FDIC Board Members Withdraw Proposals to Monitor Asset Managers for Compliance with Change in Bank Control Act

At the Federal Deposit Insurance Corporation’s (FDIC) board meeting on April 25, 2024, FDIC Directors Jonathan McKernan and Rohit Chopra (Director of the Consumer Financial Protection Bureau) each put forth proposals to monitor large asset managers’ compliance with the Change in Bank Control Act with respect to their investments in depository institution holding companies and, indirectly, their insured depository institution subsidiaries. Director McKernan’s proposal would have required the FDIC’s Director of the Division of Risk Management Supervision to submit within 90 days for the review and approval of the FDIC Board a plan to (i) monitor compliance with any passivity commitment or other condition of any FDIC comfort provided to a “covered fund complex” and (ii) annually determine whether any covered fund complex controls, or has controlled, directly or indirectly an FDIC-supervised institution. Director Chopra’s proposal would have removed the exemption from the Change in Bank Control Act’s prior notice requirement for acquisitions of voting securities of a depository institution holding company with an FDIC-supervised subsidiary institution for which the Board of Governors of the Federal Reserve System (Federal Reserve) reviews a notice, thus requiring duplicative notices to be filed with both the Federal Reserve and FDIC.

Insights: Director McKernan’s proposal garnered the support of Vice Chair Travis Hill and Director Chopra’s proposal garnered the support of FDIC Chairman Martin J. Gruenberg. Ultimately, though, neither had the support of Director Michael J. Hsu, Acting Comptroller of the Currency, who pushed for any proposed rulemaking to be done on an interagency basis. Although neither proposal was acted upon, given concerns raised by members of the FDIC Board, continued regulatory scrutiny on passivity commitments and the ownership of shares in financial institutions by large asset managers will undoubtedly remain.

FDIC Releases Comprehensive Report on Orderly Resolution of Global Systemically Important Banks

On April 10, 2024, the Federal Deposit Insurance Corporation (FDIC) released a comprehensive report regarding the orderly resolution of a large, complex financial company under Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The report first outlines the resolution-related provisions of the Dodd-Frank Act before describing key measures for planning and strategy in the event of a bank failure, with a particular eye towards the resolution of global systemically important banks (G-SIBs).

Insights: In issuing the report, the FDIC aims to promote transparency around the G-SIB resolution process, a topic of significant relevance in light of recent regulatory reforms aimed at aligning the regulatory framework across the largest banks, including both G-SIBs and non-G-SIBs. Most notably, the FDIC affirmed its commitment to the Single Point of Entry strategy. By providing such clarity, G-SIBs can continue to better structure their organizations to account for a potential resolution scenario, which may in turn provide opportunities for realizing operational efficiencies. Moreover, the FDIC’s report can serve as a blueprint for those firms that are not G-SIBs but which, over time, may become subject to a regulatory framework that more closely aligns with the framework currently applicable to G-SIBs.

Federal Reserve Board Publishes Financial Stability Report

On April 19, 2024, the Board of Governors of the Federal Reserve System (Federal Reserve) published the its semi-annual Financial Stability Report. According to the Federal Reserve Bank of New York’s industry survey, persistent inflation and monetary policy tightening; policy uncertainty, including trade policy, foreign policy issues related to escalating geopolitical tensions and uncertainty associated with the upcoming elections; and commercial real estate market stress were the three most commonly cited potential risks to financial stability over the next 12 to 18 months. Though commercial real estate concerns and banking sector stress did decrease as financial stability risks compared to the fall 2023 semi-annual survey.

Insights: In a nod to the Financial Stability Oversight Council’s (FSOC) focus on the potential risks to financial stability stemming from the use of leverage by certain hedge funds, the Federal Reserve’s report cites that “measures of hedge fund leverage increased in the third quarter of 2023 to the highest level observed since the beginning of data availability, with the increase driven primarily by the largest hedge funds.” This focus of course follows the FSOC’s easing of its process to designate nonbank financial companies as systemically important financial institutions, subject to any potential legal challenges. It remains to be seen whether in an election year any designations will be made by the FSOC.

Preliminary Injunction Delays Revised CRA Rules

In early February, seven industry and business associations sued the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (collectively, the Agencies) in the Northern District of Texas, seeking to block the Agencies’ final rules interpreting the Community Reinvestment Act of 1977 that were approved on October 24, 2023 and due to take effect beginning on April 1, 2024. According to the industry and business associations’ complaint, the Agencies exceeded their authority because the final rules provided that the Agencies would (1) “begin assessing banks’ activities outside of the locations where they maintain a physical presence and accept deposits, thus ignoring the critical geographic limits that Congress incorporated into the CRA,” and (2) “assess banks’ deposit products rather than the credit products that Congress targeted in the statute.” Finding that the trade associations “demonstrate[d] a substantial likelihood of success on the merits,” the District Court granted a preliminary injunction on March 29, 2024 and enjoined the Agencies from enforcing the final rules against the industry and business associations pending the resolution of the suit, and tolled the effective date and all associated implementation dates while the preliminary injunction remains in place. The Agencies are appealing the decision to the Fifth Circuit.

Insights: Although the District Court prohibited the Agencies from enforcing the new CRA regulations against the specific plaintiffs to the case, those seven trade associations collectively represent a majority of U.S. banks. The Agencies have noticed their intent to challenge the injunction before the Fifth Circuit and also moved to stay further proceedings before the District Court, indicating that both the final rules, and the compliance efforts required to comply with them, may remain on hold for at least the near future.

Federal Reserve Prevails Against Depository Institutions Seeking Master Accounts

In late March, two U.S. District Courts upheld decisions by the Federal Reserve Bank of Kansas City (FRBKC) and the Federal Reserve Bank of San Francisco (FRBSF) to deny master account applications from two depository institutions. In Custodia Bank, Inc. v. Federal Reserve Board of Governors and Federal Reserve Bank of Kansas City, Custodia Bank sued FRBKC challenging the denial of its master account application in 2023. Custodia argued that FRBKC was statutorily required to grant master accounts to all legally eligible depository institutions. The U.S. District Court for the District of Wyoming disagreed, granting summary judgment in favor of FRBKC and finding that FRBKC had discretion to grant or deny master account applications. In a similar case involving the FRBSF, the applicant lost on a similar argument regarding FRBSF’s denial of its master account application in 2023. The applicant brought three claims against FRBSF, each ultimately predicated on the existence of a nondiscretionary duty to make a master account available to the applicant. The U.S. District Court for the District of Idaho found that no such duty exists, and that FRBSF accordingly exercised its lawful discretion in denying the application.

Insights: In denying Custodia Bank’s application for a master account, FRBKC characterized Custodia’s business model as “unprecedented” in that it “proposes to focus almost exclusively on offering products and services related to novel crypto-asset activities and to accept entirely uninsured deposits.” FRBKC concluded that accepting deposits from Custodia into a master account would therefore “introduce undue risk” to the Reserve Bank and the economy at large. Likewise, FRBSF denied the pending application on the grounds that the applicant’s “novel, monoline business model” focusing largely on transactions that are either foreign in nature or involve mostly foreign participants “presents undue risk to the Reserve Bank.” FRBSF also considered the applicant’s risk management framework “insufficient” to address the heightened risks associated with its business model, and cited particular concerns with respect to money laundering, terrorism financing risks, and the potential for the applicant to allow the master account to fund or facilitate such illicit activities. While the District Courts’ decisions are not binding on other courts and are likely to be appealed, they do presently support the conclusion that the Federal Reserve maintains discretion to reject master account applications even in those cases involving eligible applicants. This may be especially true when those applicants are proposing novel business models that the Federal Reserve determines pose undue risk to financial stability or the efforts of the United States in combatting money laundering and the financing of terrorism.

FDIC’s Final Rule on Simplification of Deposit Insurance Rules for Trust and Mortgage Servicing Accounts Goes Effective April 1, 2024

On January 21, 2022, the Federal Deposit Insurance Corporation (FDIC) approved a final rule to amend the deposit insurance regulations for trust accounts and mortgage servicing accounts. The final rule became effective April 1, 2024. Under the final rule, irrevocable and revocable trusts are combined into a single category known as “Trust Accounts” for purposes of the deposit insurance coverage rules. Each Trust Account owner is insured up to $250,000 per eligible primary beneficiary, up to a maximum of five beneficiaries. The FDIC published a presentation highlighting the final here.

Insights: Although insured depository institutions have had more than two years to prepare for changes in coverage, not all Trust Account owners or their beneficiaries may be aware of the changes to the new rule, which could reduce deposit insurance coverage in those cases where Trust Account owners (1) own both revocable and irrevocable trust accounts; and/or (2) have more than five beneficiaries. Clear communication to new and existing customers will be critical in ensuring that customers have an adequate understanding of the impacts, if any, of the new rules on their deposit insurance coverage. In other cases, deposit insurance limits will increase for irrevocable trust owners, which will be calculated in the same manner as revocable trusts, up to a maximum of five beneficiaries.

Speech by Board of Governors of the Federal Reserve System Governor Michelle W. Bowman on Bank Mergers and Acquisitions

On April 2, 2024, Federal Reserve Governor Michelle W. Bowman gave a speech titled “Bank Mergers and Acquisitions, and De Novo Bank Formation: Implications for the Future of the Banking System” in which she was critical of the “broad-based and insufficiently focused reform agenda” of the federal bank regulatory agencies which creates higher barriers to entry for de novo banks, reduces efficiencies in bank M&A, and increases opportunities for “regulation by application” rather than relying on statutes, regulations, and rulemakings.

Insights: Governor Bowman’s speech highlights the obstacles to de novo bank formation and Bowman stressed that the “absence of de novo bank formation over the long run will create a void in the banking system.” She also highlighted her “more immediate concern” with the “dramatically evolving” approach” to bank M&A by prudential regulators. She concluded by reiterating her consistent message of the need to rationalize competing regulatory approaches to ensure the long-term viability of banks.

Federal Reserve Board Governor Bowman Speaks on Bank Liquidity, Regulation and the Federal Reserve’s Role as Lender of Last Resort

On April 3, 2024, Federal Reserve Board Governor Michelle W. Bowman gave a speech titled “Bank Liquidity, Regulation, and the Fed’s Role as Lender of Last Resort.” In her speech, Governor Bowman highlighted the Federal Reserve’s role as a lender of last result, including with respect to potential changes to the liquidity framework supporting the U.S. banking system. Governor Bowman acknowledged that the spring 2023 bank failures have created pressure to pass additional regulations relating to regulatory capital and/or liquidity, but Governor Bowman cautioned that, “…we should think about the response to banking stress more broadly….” In order to do so, Governor Bowman urged the Federal Reserve to analyze the challenges facing, and tools available to, the Federal Reserve’s liquidity and regulatory capital frameworks. With respect to the former, Governor Bowman highlighted the “perception of stigma” associated with utilizing the Federal Reserve discount window. With respect to the latter, Governor Bowman highlighted both available technology and the Federal Reserve’s prudential regulatory authority. Governor Bowman also discussed potential requirements relating to the pre-positioning of collateral with the Federal Reserve in order to access the discount window, reiterating the need to analyze the “important but as yet unanswered questions” associated with such requirements.

Insights: Governor Bowman is clear in her remarks that the “expectation should not be that the Federal Reserve replaces existing sources of market liquidity for banks in normal times” and reiterated the Fed’s discount window as a “source of backup liquidity.” She reiterated her consistent message of the need for the agencies to “focus on improving the targeted approach of supervision, to enhance the ‘prevention’ of banking system stress,” and described the need to consider the liquidity framework in a “broad-based manner” so that “the available tools, resources, and requirements are working in a complementary way.”

New York Fed Announces Participation in Joint International Research Effort on Tokenization and Cross-Border Payments

On April 3, 2024, the Federal Reserve Bank of New York (FRBNY) announced that it will participate in an international technical research project, Project Agorá, that will explore whether the tokenization of central bank money and commercial bank deposits operating on a shared programmable ledger can improve wholesale cross-border payments. Project Agorá, a new effort led by the Bank for International Settlements Innovation Hub in partnership with the Institute of International Finance, will bring together seven central banks and financial institutions from each of their respective jurisdictions to research ways to increase the speed and transparency of international wholesale payments and lower associated costs and risks. The project will focus on overcoming common structural inefficiencies in cross-border payments today related to differing legal, regulatory, and technical requirements, operating hours and time zones, and varying financial integrity controls. Including the FRBNY, the seven participating central banks are the Bank of England, Bank of France, Bank of Japan, Bank of Korea, Bank of Mexico, and the Swiss National Bank.

Insights: Integration of tokenized commercial bank deposits with tokenized wholesale central bank money could lead to improvements in the monetary system’s functionality and offer innovative solutions utilizing smart contracts and programmability, all while preserving its existing two-tier structure. While the FRBNY’s participation in Project Agorá is explicitly limited to research and experimentation, the participation alone marks a significant milestone for cross border Central Bank Digital Currency (CBDC) initiatives. Unlike early adoptions of a CBDC, like the Bahamas’ Sand Dollar or Uruguay’s e-Peso pilot plan, the United States has been hesitant to commit to the development or use of a CBDC. The United States’ involvement in Project Agorá does signify the United States’ further involvement in exploring the cross-border use for a CBDC but should not be read as a commitment to develop a US Dollar CBDC.

OTHER DEVELOPMENTS / RELEVANT LINKS

FDIC Board releases the first semiannual update of 2024 on the Restoration Plan for the agency’s Deposit Insurance Fund (see also Statement by FDIC Chairman Martin J. Gruenberg; Memorandum to the FDIC Board),
Federal Reserve staff publishes FEDS Notes article titled, “Tokenized Assets on Public Blockchains: How Transparent is the Blockchain?”
Federal Reserve Bank of New York publishes a Liberty Street Economics blog post titled, “Can I Speak to Your Supervisors? The Importance of Bank Supervision.”
Federal Reserve Bank of New York publishes a Liberty Street Economics blog post titled, “Internal Liquidity’s Value in a Financial Crisis.”
Federal Reserve Bank of New York publishes a Staff Report titled, “Investor Attention to Bank Risk During the Spring 2023 Bank Run.”

The following Gibson Dunn attorneys contributed to this issue: Jason Cabral, Rachel Jackson, Zach Silvers, Karin Thrasher, Andrew Watson, and Nathan Marak.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Financial Institutions or Global Financial Regulatory practice groups, or the following:

Jason J. Cabral, New York (212.351.6267, [email protected])

Stephanie L. Brooker, Washington, D.C. (202.887.3502, [email protected])

M. Kendall Day, Washington, D.C. (202.955.8220, [email protected])

Jeffrey L. Steiner, Washington, D.C. (202.887.3632, [email protected])

Sara K. Weed, Washington, D.C. (202.955.8507, [email protected])

Ella Capone, Washington, D.C. (202.887.3511, [email protected])

Rachel Jackson, New York (212.351.6260, [email protected])

Chris R. Jones, Los Angeles (212.351.6260, [email protected])

Zack Silvers, Washington, D.C. (202.887.3774, [email protected])

Karin Thrasher, Washington, D.C. (202.887.3712, [email protected])

We are pleased to provide you with the April 2024 edition of Gibson Dunn’s digital assets regular update. This update covers recent legal news regarding all types of digital assets, including cryptocurrencies, stablecoins, CBDCs, and NFTs, as well as other blockchain and Web3 technologies. Thank you for your interest.

ENFORCEMENT ACTIONS

UNITED STATES

Mango Markets Exploitation Jury Finds Avraham Eisenberg Guilty of Fraud and Market Manipulation
On April 18, jurors in the Southern District of New York found Avraham Eisenberg, a cryptocurrency trader, guilty of fraud and market manipulation following a two-week jury trial. In October 2022, Eisenberg executed several purchases on Mango Markets, a decentralized exchange, in an effort to artificially raise the price of the MNGO token relative to the USD Coin, while holding MNGO perpetual futures. Eisenberg then used his perpetual futures as collateral to borrow and withdraw approximately $116 million worth of various crypto assets from Mango Markets, effectively draining all available assets from the platform. Eisenberg claimed he legally obtained the funds, and he returned $67 million in crypto to Mango Markets. He was arrested in Puerto Rico in December 2022. U.S. Attorney Damian Williams said the conviction was the first ever in a cryptocurrency market manipulation case. In addition to these criminal charges, Eisenberg faces civil charges from the SEC and CFTC for violations of the anti-fraud and market manipulation provisions of the securities laws. Reuters; Law360; Cointelegraph; Business Insider; Cointelegraph [2].
SEC Warns of Potential Enforcement Action Against Uniswap Labs
On April 9, Uniswap Labs published a blog post that it had received a Wells notice from the SEC, indicating that the SEC staff would be recommending legal action against Uniswap Labs. The Uniswap Protocol is the largest decentralized trading and automated market making protocol on Ethereum, having reportedly processed over $2 trillion worth of transactions since first launching in 2018. Uniswap Labs builds products to support the Uniswap ecosystem. Uniswap Labs vowed to fight the charges.Uniswap Labs, as with other firms that receive a Wells notice, is permitted to respond in writing concerning why litigation by the SEC would be inappropriate. The SEC has not yet commented on any actions against Uniswap Labs, and no further details on potential litigation were currently available at publishing. Uniswap Labs Blog Post; Reuters; WSJ; Cointelegraph.
DOJ Arrests and Charges Founders and CEO of Bitcoin Mixing Service Samourai Wallet With Money Laundering and Unlicensed Money Transmitting Offenses
On April 24, federal prosecutors charged the founders of Samourai Wallet, a crypto-mixing firm, with conspiracy to commit money laundering and operating an unlicensed money transmitter business. The government alleges that Samourai executed over $2 billion in unlawful transactions and laundered more than $100 million via illegal dark web markets. The government alleges that the founders encouraged and invited users to launder criminal proceeds, citing tweets and private messages; and that the platform was used to wash funds connected to Silk Road and Hydra Market. The DOJ also seized Samourai Wallet, which was hosted in Iceland, and has issued a warrant for its mobile app. The app is still available in Europe. Indictment; DOJ Press Release; Axios; CoinDesk; CoinDesk [2].
Jury Returns Verdict in SEC’s Case against Do Kwon, Terraform Labs
On April 5, a New York jury began deliberations and returned a verdict the same day in the SEC’s case against Terraform Labs and its founder, Do Kwon, finding both liable on civil fraud charges following a two-week trial. The SEC accused the defendants of misleading investors about the stability of Terra USD (USDT), an “algorithmic stablecoin” that was supposed to maintain a peg to the U.S. dollar. In May 2022, USDT unpegged, resulting in a loss of about $40 billion in market value. CoinDesk; CNBC; Reuters.
Federal Court Rejects SEC’s Claim that Coinbase Acted as Unregistered Broker, But Permits Remainder of SEC’s Case Against Coinbase to Proceed; Coinbase Requests Interlocutory Appeal
On March 27, U.S. District Court Judge Katherine Polk Failla (SDNY) granted in part and denied in part Coinbase’s motion for judgment on the pleading in the SEC’s enforcement action against the company. Judge Failla rejected the SEC’s claim that Coinbase acted as an unregistered broker by making its Wallet application available to its customers. Judge Failla also ruled that the rest of the SEC’s claims—including that Coinbase engaged in unregistered sales of securities—could proceed to discovery. On April 12, Coinbase asked the district court to certify an interlocutory appeal that would allow the Second Circuit to immediately consider whether the SEC may regulate as “investment contracts” digital asset transactions that involve no obligation running to the purchaser beyond the point of sale. CNBC; Pymnts; Bitcoin.com; CoinDesk.
Sam Bankman-Fried Files Appeal of Conviction and Sentence
On April 12, less than two weeks after receiving a 25-year prison sentence, Bankman-Fried appealed his conviction and sentence to the Second Circuit. This followed Bankman-Fried’s request to Judge Kaplan to remain at the Metropolitan Detention Center in Brooklyn, rather than transfer to a federal prison in the Bay Area, to pursue the appeal. Bankman-Fried’s lawyers have not indicated the grounds for appeal, though Bankman-Fried noted in emails to ABC News that new evidence existed that was not considered during the trial, that there were procedural flaws, and that there were improper collaborations between FTX’s bankruptcy counsel and federal prosecutors. Notice of Appeal; Forbes; ABC News; Cointelegraph; Daily Coin.
OneCoin’s Legal Boss Gets Four Years in Jail for $4 Billion Crypto Scam
On April 4, the former head of legal and compliance for OneCoin, Irina Dilkinska, was sentenced to four years in jail for her role in the infamous $4 billion crypto Ponzi scheme after admitting she helped launder millions of dollars. Judge Edgardo Ramos (SDNY) also imposed one month of supervised release and a forfeiture of $111 million as restitution. Dilkinska pled guilty to wire fraud and money laundering charges in the Southern District of New York in November 2023. This comes after OneCoin’s co-founder, Karl Sebastian Greenwood, was sentenced to 20 years in prison and ordered to pay $300 million in restitution for his involvement in the scam. The other main co-founder, Ruja Ignatova, remains at large. US Attorneys’ Office Press Release; Reuters; Bloomberg; CoinDesk.

INTERNATIONAL

Filecoin Foundation Investigating Reported Detention of Filecoin Liquid Staking (STFIL) Team Members in China
On April 8, Filecoin Foundation, a nonprofit that promotes the development of Web3 storage protocol Filecoin, reported that core technical members of its STFIL team were detained by Chinese authorities. Filecoin is a decentralized storage protocol that allows PC owners to rent out their hard disk space to users with data storage needs. Filecoin reported that withdrawals from the STFIL protocol stopped working at the same time, after a developer wallet made several unscheduled upgrades, and moved $23 million worth of Filecoin tokens to an address whose owner is unknown. Filecoin noted that it has local counsel in China looking into the incident. The Foundation has been unable to confirm whether authorities have taken possession of the funds, or to determine who is holding the STFIL team in custody. Filecoin is the latest in a set of Web3 platforms that have encountered criminal legal action in China. Cointelegraph; The Block.

REGULATION AND LEGISLATION

UNITED STATES

IRS Releases Draft Form to Report Crypto Gains in 2025
On April 19, the IRS released draft Form 1099-DA, to be used by crypto brokers to report taxable gains or losses regarding crypto trades. The form, which is similar to Form 1099-B, has an array of individual token codes that can be filled in, as well as spaces for wallet addresses and where to find transactions on the relevant blockchain. This version of the form asks the filer to check a box that describes the type of broker they are: kiosk operator, digital asset payment processor, hosted wallet provider, unhosted wallet provider or “other.” The unhosted wallet provider option appears to refer to self-custodial crypto addresses unaffiliated with any third party. Some commentators have suggested that these fields mean that the IRS aims to classify DeFi protocols as brokerage firms, revealing personal information, and potentially undermining the benefits of pseudonymity that the crypto industry offers. Some in the crypto industry have expressed interest in litigating the issue. The form, however, remains in draft, and may change before 2025. As part of the drafting process, the IRS has invited public comment. Draft Form; Reuters; Politico; CoinDesk, DeCrypt.
SEC Calls for Comments on Spot Ether ETF Applications
On April 2, the SEC solicited comments from the public regarding the proposed listing of spot Ether ETF applications on the New York Stock Exchange (“NYSE”). Under the proposed rule, the Ethereum ETF would be listed as a commodity-based trust share on the NYSE. The public had until April 23 to comment. SEC Request; Cointelegraph.
CFPB Flags Risks in Virtual Crypto Economies
On April 4, the CFPB released its report on banking in the gaming and virtual worlds. The report highlighted the growth of crypto-assets in both sectors, and stated that online video games and virtual worlds are becoming akin to traditional banking but lack federal protections. The agency received complaints regarding hacking attempts, account theft, and assets lost within games, with consumers expressing dissatisfaction over the lack of support from gaming companies. This report comes after the CFPB proposed a rule in November 2023 titled “Defining Larger Participants of a Market for General-Use Digital Consumer Payment Applications.” This rule grants the agency oversight over “larger nonbank firms” providing digital wallet and payment app services. Crypto industry insiders suggest that such reports could signal upcoming actions by the CFPB. CFPB Report; CFPB Proposed Rule; Cointelegraph.
SEC Delays Decision on Bitcoin ETF Options
On April 8, the SEC postponed its decision on the NYSE proposed rule change to amend Rule 915 to permit the listing and trading of options on any trust that holds Bitcoin. The proposed rule change was published for comment in the Federal Register on February 29, 2024. Citing the need for more time in order to adequately consider the proposed rule change, the SEC designated May 29, 2024, as the day by which the commission would make a decision on the NYSE’s proposed rule. SEC Filing; Cointelegraph.
Senators Gillibrand and Lummis Introduce Stablecoin Bill
On April 17, Senators Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY) introduced the Lummis-Gillibrand Payment Stablecoin Act, which would prohibit “unbacked, algorithmic stablecoins,” require one-to-one cash reserves for issuers, create state and federal regulatory regimes for firms and prevent illicit uses of stablecoins. Other provisions would permit state non-depository trust companies to issue up to $10 billion in payment stablecoins, with authorized institutions able to issue stablecoins “up to any amount” under a limited-purpose state charter. The bill also aims to uphold the current system of state and federal charters and established rules on custody for non-depository trust companies. Finally, the bill deals with insolvency: should a stablecoin issuer experience insolvency, the FDIC can be granted conservatorship and resolution. Senator Sherrod Brown (D-OH) and Representative Patrick McHenry (R-NC) both expressed cautious optimism regarding advancing the bill. Gillibrand Press Release; Bloomberg; Cointelegraph; The Block; CoinDesk; CoinDesk [2].
Arkansas Senate Passes Two Bills Restricting Cryptocurrency Mining
On April 18, amended legislation aiming to prohibit the establishment of crypto mining facilities and activities involving the creation, preservation, storage, and trade of cryptocurrencies passed the Arkansas Senate. The legislation aims to limit crypto mining operations in the state through a variety of regulations, including through noise limits on mining operations, prohibitions on ownership by foreign entities, grants of authority to local governments to pass ordinances regulating mines, licensing of crypto mining operations by the State Department of Energy and Environment, and special requirements on electricity rates. Arkansas Senate; Arkansas Advocate; Arkansas Democrat Gazette.

INTERNATIONAL

Hong Kong Regulator Approves Bitcoin and Ether ETFs
On April 15, Hong Kong’s Securities and Futures Commission (SFC) approved Bitcoin and Ether exchange traded funds (ETFs), permitting three firms to (conditionally) offer spot Bitcoin and Ether ETFs. The three firms are ChinaAMC, Harvest Global, and Bosera International. While no timeline has been provided for when the batch of approved ETFs can begin trading on regulated exchanges, the conditional approval signals that Hong Kong is becoming a hub for crypto market innovation. CNBC; Reuters; Elliptic.
South African Crypto Exchange VALR Has Received Regulatory Approval from the Country’s Financial Watchdog
On April 15, South African crypto exchange VALR reported that it had obtained a license from the country’s financial regulator. The company, which was valued at $240 million two years ago, is part of the first batch of crypto firms—along with exchange platform Luno and crypto social investment platform Zignaly—to obtain approvals from South Africa’s Financial Sector Conduct Authority (FSCA). VALR now has both Category I and Category II crypto asset service provider (CASP) licenses. A Category I license is the standard financial service provider required for a CASP; a Category II license enables customers to give VALR and other licensed Category II financial service providers (FSPs) a mandate to use its discretion to structure customers’ portfolio, among other things. VALR serves over 1,000 corporate and institutional clients and more than half a million crypto traders worldwide. VALR Blog; CoinDesk; Cointelegraph.
Norwegian Government Introduces Law for Data Centers, to Block Energy-Intensive Crypto Mining
On April 15, a local news outlet in Norway reported that the Norwegian government is attempting to restrict crypto mining in the country by regulating data centers, according to two ministers. Both lawmakers stated that they did not want crypto mining in the country, because of the emissions caused by mining. CoinDesk; Crypto News; VG Norway.
As Markets in Crypto-Assets (MiCA) Regulation to Take Effect, Germany’s Largest Federal Bank to Offer Crypto Custody Services
Banks in Germany are preparing for the European Union’s MiCA regulation that will take full effect in December 2024 as the first comprehensive legal framework for the crypto industry. MiCA will make crypto exchanges fully regulated entities, but the bill is still being finalized. Hand-in-hand with this forthcoming regulation, on April 15,the Landesbank Baden-Wurttemberg announced that it would start offering crypto custody services to institutional clients, in partnership with the Austria-based Bitpanda cryptocurrency exchange, beginning in the second half of 2024. The Landesbank Baden-Württemberg will tap Bitpanda’s institutional custody solution for its offering. Bitpanda Custody is a crypto custody platform with decentralized finance (DeFi) capabilities, registered with the United Kingdom’s Financial Conduct Authority (FCA). Cointelegraph; Coinedition.
Sweden Demands $90 Million in Outstanding Tax from Crypto Miners
On April 18, the Swedish Tax Agency announced that 18 crypto miners filed misleading or incomplete information to benefit from tax incentives. Some businesses provided the government with misleading business descriptions in order to obtain exemptions to paying value added tax on taxable operations. Others found ways to skirt import tax requirements and income tax on mining revenue. The crypto mining companies appealed the tax bill; two companies won on appeal, while the remaining sixteen lost. Law360; Cointelegraph.
Binance Wins Dubai Cryptocurrency Virtual Asset Service Provider License
On April 18, Dubai granted Binance a full regulatory Virtual Asset Service Provider (“VASP”) license. The license will allow Binance to target retail clients, in addition to qualified and institutional clients. This allows the platform to extend its offerings beyond spot trading and fiat services, expanding to margin trading products and staking products. This stage of approval comes almost a year after Binance secured its third-stage license. Bloomberg; Reuters; CoinDesk.This comes while Dubai’s Virtual Asset Regulatory Authority (VARA) is considering alleviating the financial burdens for smaller crypto businesses, by reducing the cost of compliance for smaller entities. Cointelegraph.

CIVIL LITIGATION

UNITED STATES

Consensys Files Suit Against SEC, Seeking Declaration that Ethereum is Not a Security
On April 25, software developer Consensys filed a lawsuit against the SEC in the Northern District of Texas, arguing that the SEC lacks authority to regulate the ether cryptocurrency (ETH) or the MetaMask wallet developed by Consensys, and that any investigation of Consensys based on the idea that ETH is a security would violate the Due Process Clause and the Administrative Procedure Act. Consensys also argued that MetaMask is not a broker and that its staking service does not violate the securities laws. The complaint seeks declaratory relief and injunction preventing the SEC from investigating or bringing an enforcement action premised on ETH transactions being securities or related to MetaMask’s swaps or staking functions. The complaint was filed after Consensys reportedly received a Wells notice from the SEC on April 10, indicating the SEC’s intention to bring an enforcement action against the company. Complaint; Reuters; Bloomberg; CoinDesk.
Blockchain Association and Crypto Freedom Alliance of Texas Challenge SEC’s Dealer Rule
On April 23, the Blockchain Association and the Crypto Freedom Alliance of Texas sued the SEC in the Northern District of Texas, challenging a rule that broadly defines a “dealer” of securities. Under the rule, entities newly deemed to be dealers would face significant new burdens and costs, including capital and registration requirements. The plaintiffs argue that the dealer rule is too broad in scope (affecting participants and traders in DeFi, rather than just dealers), does not properly explain the rule’s impact on crypto market participants, and ignores the feedback the SEC received during the rule’s public comment period. This case joins another challenge to the dealer rule filed in the same court earlier this year by three associations of private fund advisers. Complaint; WSJ; CoinDesk.
SEC Lawyers Forced to Resign After Utah Judge Censures SEC for Abuse of Power in Crypto Case
On March 18 a federal judge in Utah found that the SEC had abused its power in SEC v. Digital Licensing Inc., No. 2:23-cv-00482 (D. Utah, Mar. 18 2024), leading to the resignation of two SEC lawyers, Michael Welsh and Joseph Watkins. The SEC brought a case against Digital Licensing, which operates the blockchain company DEBT Box, accusing the company of defrauding investors of more than $50 million. But Chief District Judge Robert Shelby said that the SEC acted in “bad faith” and was “deliberately perpetuating falsehoods” in order to obtain an asset freeze and a temporary restraining order against the company. The judge also sanctioned the SEC, requiring it to pay attorneys’ fees and costs for DEBT Box. In December, SEC enforcement chief Gurbir Grewal apologized to the court for his department’s conduct. He said that he had appointed new attorneys to the case and mandated training for the agency’s enforcement staff. Opinion; Bloomberg; Reuters.
Former FTX Executives to Settle Class Action Lawsuit for $1.36 Million
On March 27, former FTX and Alameda executives came to a nearly $1.36 million settlement with a class action group of the crypto exchange’s former investors who are seeking compensation for allegedly being defrauded. Zixiao “Gary” Wang, FTX’s co-founder, Nishad Singh and Caroline Ellison each agreed to provide information in connection with the lawsuit to resolve claims against them. Notably, none of the executives admitted fault to any allegations made against them in the lawsuit, but the class group determined that their information would help strengthen its case against others it sued, including celebrities, companies, and venture capitalists. Wang, Singh and Ellison additionally agreed to provide records used in FTX’s bankruptcy case, generally make themselves available for hearings and depositions, and forfeit their assets in their criminal case. Under the settlement agreement, the executives may not oppose a request from FTX investors that their assets be distributed through the class suit rather than through FTX’s bankruptcy or other lawsuits. CoinTelegraph; Yahoo Finance.
Wyoming Federal District Court Upholds Federal Reserve’s Rejection of Custodia Bank’s Master Account Application
On March 29, the Federal District Court of Wyoming rejected Wyoming-based Custodia Bank’s argument that it is entitled to a Federal Reserve master account and membership with the Fed. Custodia Bank is a special purpose depository institution allowing a full suite of financial services both for U.S. dollars and digital assets. In the Opinion, the court held that federal laws do not require the nation’s central bank to give every eligible depository institution access to its master account system, nor did the provided evidence suggest that the Federal Reserve Board of Governors influence a regional branch of the Fed to deny its application for an account. Instead, the court found that the Kansas City Fed likely made the decision, not at the behest of the Board. In 2023, the Fed opined that it had concerns about the sustainability of a crypto-focused bank, despite Custodia’s sufficient capital and resources to launch. The Fed noted that Custodia had significant deficiencies in its ability “to manage the risks of its day-one activities,” and did not think that Custodia could handle basic safety measures or comply with banking laws regarding money laundering. Opinion; CoinDesk; CoinDesk (2023).
Google Files Lawsuit Against Alleged Crypto Scammers
On April 4, Google filed a lawsuit in the Southern District of New York against Yunfeng Sun and Hongnam Cheung for allegedly uploading fraudulent investment apps to Google Play and committing hundreds of acts of wire fraud, harming Google and approximately 100,000 Google users. Google argued that the defendants made numerous misrepresentations to be able to upload their apps to Google Play, including misrepresentations about their identity, location and the nature of the applications. Google alleges that its users were promised high returns for investing in crypto and related products, but that customers who made deposits through the defendants’ apps were unable to withdraw their funds and were required to pay various fees when they attempted to access their funds, which they were still unable to do even after paying such fees. CoinDesk; Blockworks.

SPEAKER’S CORNER

UNITED STATES

Senators Elizabeth Warren and Chuck Grassley Demand that CFTC Chair Explain His Chats with Sam Bankman-Fried
Senator Warren (D-MA) and Senator Chuck Grassley (R-IA) are demanding more information from the CFTC Chair, Rostin Benham, regarding Benham’s contact with Sam Bankman-Fried, the former FTX CEO sentenced to 25 years. Benham has disclosed meetings with Bankman-Fried, but has not provided all the records regarding these meetings. Benham and his team met with Bankman-Fried ten times at the CFTC, and Benham told lawmakers that he’d also exchanged messages with Bankman-Fried. The written communication from the senators demands all written communications, plus minutes and timelines of their interactions. The CFTC has said it will provide the information the senators are asking for. Business Insider.

INTERNATIONAL

New Zealand Minister of Commerce Andrew Bayly Says New Zealand Should Regulate Crypto Sector to Facilitate Growth of Industry
On April 10, 2024, New Zealand Minister of Commerce Andrew Bayly said that the country should support crypto industry growth and take an evidence-based approach to regulating the sector. Bayly noted that doing otherwise might risk New Zealand losing out on the industry, including the financial and technological benefits from the industry’s growth. Advisors to the ministry have proposed a variety of actions for New Zealand to catch up with the global trends towards crypto, including creating supportive policies for blockchain and digital assets, promoting government-industry collaboration, and adopting crypto-friendly measures such as educational initiatives and AML enhancements. Bayly Statement; CoinDesk.
UK Lawmakers Call for the Government to Further Develop Crypto and Blockchain Skills Pipeline
On April 17, UK Parliament’s MP Lisa Cameron called for the government to ensure that digital skills are taught from the early stages of education and in the workplace. Although the government has said it wants to make the country a hub for crypto, Cameron called for more to be done beyond recognizing crypto as a regulated activity. Cameron also noted that there should be greater partnerships with blockchain companies. CoinDesk.
Executive Director for UK’s FCA Emphasizes Crypto-User Protection Over Registration Speed
Despite these pro-crypto calls by UK lawmakers, members of the industry have said that the UK’s Financial Conduct Authority (FCA) takes too long to approve crypto application. Sarah Pritchard, the executive director for markets and international at the FCA, spoke at TheCityUK conference, noting that “[a] simple focus on numbers could undermine trust and reputation” and “[l]ower standards could leave open our market to abuse by those who seek to launder criminally made cash, damaging market integrity and confidence in financial markets,” Pritchard said. “Instead, we take a longer view. Crypto’s success – and the success of any base for crypto firms – relies on trust being built and maintained.” CoinDesk.

OTHER NOTABLE NEWS

Immunefi’s Research Report Shows Crypto Industry Saw 23% Decline in Losses Due to Hacking and Scams in 1Q 2024, Compared to 2023
Immunefi, a leading Web3 bug bounty platform, released its Quarterly Report on March 30, which showed that the amount lost to hacking and fraud incidents in Q1 of 2024 amounted to approximately $336.3 million, down from $437.5 million in Q1 of 2023. The report covers 46 hacking incidents and 15 cases of fraudulent activities. Two projects accounted for the bulk of the losses, totaling $144.5 million, or 43% of the overall amount. The largest attack, causing $81.7 million in loss, targeted the cross-chain bridge protocol Orbit Bridge on New Year’s Eve. The second largest attack was a $62 million exploit on the nonfungible token game Munchables, but the funds were recovered within 24 hours. In total, almost $73.9 million (22%) of the stolen funds from seven exploits in Q1 were recovered. Hacks accounted for 95.6% of losses, with fraud, scams, and rug pulls accounting for the rest. Report; Cointelegraph; CoinDesk.
Shomari Figures, Alabama Democratic Candidate for House, Wins Primary After Receiving $2.7 Million in Outside Support from Digital Asset Industry’s Major Campaign Finance Operation
On April 16, Shomari Figures, a Washington insider, won the Alabama House Democratic Primary runoff with 61% of the vote. The crypto-friendly candidate dominated the field, and received $2.7 million from a political action committee (PAC) backed by the cryptocurrency industry, Protect Progress. CNN; Alabama Political Reporter; CoinDesk.
Security Alliance (SEAL) Has Recovered $50 Million in Assets Since Its Inception in 2023; Launches Threat-Sharing Platform to Support Crypto Space
SEAL, a team of white-hat hackers, said it recovered $50 million in assets since its inception in 2023. On April 17, the alliance announced its threat-sharing platform, SEAL Information Sharing and Analysis Center (ISAC), to support the crypto space. The platform is purpose-built for crypto aiming to protect against cyberattacks and financial crimes, and does so by providing security intelligence and connections to experts. Nearly twenty crypto organizations have joined the initiative. SEAL ISAC Website; Cointelegraph; Business Wire.
Moody’s Says Tokenization Could Boost Liquidity for Alternative Assets
A new Moody’s report found that tokenization could offer a solution to the liquidity issues facing alternative assets, such as natural resources and private equity, by converting them into digital tokens on blockchain networks. That process could lower barriers to entry, increase transparency, and facilitate fractionalized ownership, potentially creating a more liquid secondary markets for these assets. Although tokenization has the potential to reduce costs for investors and distributors, hurdles such as regulatory uncertainty, technical challenges, and interoperability issues need to be addressed in order to achieve widespread adoption. Report; Ledger Insights.

The following Gibson Dunn attorneys contributed to this issue: Jason Cabral, M. Kendall Day, Jeffrey Steiner, Sara Weed, Ella Capone, Grace Chong, Chris Jones, Jay Minga, Nick Harper, Apratim Vidyarthi, and Alexis Levine.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s FinTech and Digital Assets practice group, or the following:

FinTech and Digital Assets Group:

Ashlie Beringer, Palo Alto (650.849.5327, [email protected])

Michael D. Bopp, Washington, D.C. (202.955.8256, [email protected]

Stephanie L. Brooker, Washington, D.C. (202.887.3502, [email protected])

Jason J. Cabral, New York (212.351.6267, [email protected])

Ella Alves Capone, Washington, D.C. (202.887.3511, [email protected])

Grace Chong, Singapore (+65 6507 3608, [email protected])

M. Kendall Day, Washington, D.C. (202.955.8220, [email protected])

Michael J. Desmond, Los Angeles/Washington, D.C. (213.229.7531, [email protected])

Sébastien Evrard, Hong Kong (+852 2214 3798, [email protected])

William R. Hallatt, Hong Kong (+852 2214 3836, [email protected])

Martin A. Hewett, Washington, D.C. (202.955.8207, [email protected])

Michelle M. Kirschner, London (+44 (0)20 7071.4212, [email protected])

Stewart McDowell, San Francisco (415.393.8322, [email protected])

Mark K. Schonfeld, New York (212.351.2433, [email protected])

Orin Snyder, New York (212.351.2400, [email protected])

Jeffrey L. Steiner, Washington, D.C. (202.887.3632, [email protected])

Eric D. Vandevelde, Los Angeles (213.229.7186, [email protected])

Benjamin Wagner, Palo Alto (650.849.5395, [email protected])

Sara K. Weed, Washington, D.C. (202.955.8507, [email protected])

The obligations apply with respect to a company’s own operations and those of its subsidiaries — but also to those carried out by a company’s “business partners” in the company’s “chain of activities”.

On 24 April 2024, the Corporate Sustainability Due Diligence Directive[1] (“CSDDD” or “Directive”) was finally passed by the European Parliament (“Parliament”), marking the end of the key stages of the legislative process, after four years. The CSDDD establishes far-reaching mandatory human rights and environmental obligations on both European Union (“EU”) and non-EU companies meeting certain turnover thresholds, starting from 2027. Those obligations apply with respect to a company’s own operations and those of its subsidiaries—but also to those carried out by a company’s “business partners” in the company’s “chain of activities”.[2] Generally, the CSDDD, one of the most debated pieces of European legislation of recent times, establishes an obligation on in-scope companies to:

identify and assess (due diligence) adverse human rights and environmental impacts;
prevent, mitigate and bring to an end / minimise such adverse impacts; and
adopt and put into effect a transition plan for climate change mitigation which aims to ensure—through best efforts—compatibility of the company’s business model and strategy with limiting global warming to 1.5 °C in line with the Paris Agreement.

The CSDDD also sets out minimum requirements (including the ability for claims to be made by trade unions or civil society organisations) of a liability regime to be implemented by EU Member States for violation of the obligation to prevent, mitigate and bring to an end / minimise adverse impacts.

Key Takeaways

In-scope companies under the Directive include:
- EU companies (on a standalone or consolidated basis) with more than 1,000 employees on average and a net worldwide turnover of more than EUR 450 million; and
- non-EU companies (on a standalone or consolidated basis) generating a net turnover of more than EUR 450 million within the EU.
The human rights and environmental obligations include: (a) integrating due diligence into policies and management systems; (b) identifying and assessing actual and potential adverse human rights and environmental impacts; (c) implementing measures to prevent, cease or minimise such impacts; (d) monitoring and assessing the effectiveness of measures; and (e) providing remediation to those affected by actual adverse impacts.
Obligations are not limited to the company’s own operations and those of their subsidiaries—they extend to a company’s upstream and downstream business partners throughout the company’s “chain of activities”.
Member States are required to impose penalties on companies in breach of the Directive, including pecuniary penalties with a maximum limit of not less than 5% of the in-scope company’s worldwide net turnover.
A breach of certain CSDDD obligations may result in civil liability for damages. However, a company cannot be held liable for any damage caused by its business partners in its chain of activities.
The CSDDD establishes an obligation on companies to adopt a climate change mitigation transition plan to ensure that their business model and strategy are compatible with limiting global warming to 1.5 °C in line with the Paris Agreement.
The Directive will be implemented gradually, applying to larger companies first. From 2027, the Directive will apply to: (a) EU companies with more than 5,000 employees and EUR 1,500 million net worldwide turnover; and (b) non-EU companies with more than EUR 1,500 million net turnover generated in the EU.

1. Legislative History

As reported in our earlier article,[3] in April 2020, the European Commission (“Commission”) proposed the adoption of a directive requiring companies to undertake mandatory human rights and environmental due diligence across their value chains, and a proposal followed in February 2022.[4] At that time, some Member States had already adopted national due diligence laws,[5] and the Commission considered it important to ensure a level playing field for companies operating within the internal market. The Directive was further intended to contribute to the EU’s transition towards a sustainable economy and sustainable development through the prevention and mitigation of adverse human rights and environmental impacts in companies’ supply chains.

After multiple rounds of negotiations and material amendments submitted by all EU institutions, as well as extensive negotiations between Member States, the Permanent Representative Committee of the Council of the European Union (“Council”) endorsed the draft Directive on 15 March 2024, with the Parliament voting in favour on 24 April 2024.[6]

Notably, the CSDDD crystallises into hard law at the EU level certain voluntary international standards on responsible business conduct, such as the UN Guiding Principles on Business and Human Rights (“UNGPs”), the OECD Guidelines for Multinational Enterprises, the OECD Guidance on Responsible Business Conduct, and sectoral direction. Prior to the CSDDD coming into force, these voluntary instruments will continue to offer valuable “best practice” guidance to in-scope companies.

2. Scope of Application and Timing

The Directive will apply to EU companies (i.e., companies formed in accordance with the legislation of a Member State) where a company meets the following thresholds (in each instance measured in the last financial year for which annual financial statements have been or should have been adopted):

has more than 1,000 employees on average (including in certain circumstances, temporary agency workers) and a net worldwide turnover of more than EUR 450 million;[7] or
is the ultimate parent company of a group that collectively reaches the thresholds in (a); or
has entered into or is the ultimate parent company of a group that entered into franchising or licensing agreements in the EU in return for royalties where these royalties amount to more than EUR 22.5 million and provided that the company had or is the ultimate parent company of a group that had a net worldwide turnover of more than EUR 80 million.

The Directive has extra-territorial effect since it also applies to non-EU companies (i.e., companies formed in accordance with the legislation of a non-EU country), if that company:

has generated a net turnover in the EU of more than EUR 450 million; or
is the ultimate parent company of a group that collectively reaches the thresholds under (a); or
has entered into or is the ultimate parent company of a group that entered into franchising or licensing agreements in the EU in return for royalties where these royalties amount to more than EUR 22.5 million in the EU and provided that the company had or is the ultimate parent company of a group that had a net turnover of more than EUR 80 million in the EU.

For the Directive to apply, for both EU and non-EU companies, the threshold conditions must have been satisfied for at least two consecutive financial years. Smaller companies operating in the “chain of activities” of in-scope companies will also be indirectly affected because of contractual requirements imposed on them by companies within the scope of the Directive (discussed further below).

It is notable that the scope of application of the CSDDD is more limited than that of the Corporate Sustainability Reporting Directive (“CSRD”),[8] which (save with respect to franchisors or licensors) applies both lower employee and turnover thresholds. Whilst the CSDDD is expected to apply to around 5,500 companies, the CSRD covers approximately 50,000 companies.

3. Obligations on In-scope Companies

(a) Adopt Human Rights and Environmental Due Diligence

The Directive introduces so-called human rights and environmental “due diligence obligations”. These apply to a company’s own operations, those of its subsidiaries, and those of its direct and indirect business partners throughout their “chain of activities”. The Directive defines “chain of activities” as activities of a company’s:

upstream business partners,[9] relating to the production of goods or the provision of services by the company, including the design, extraction, sourcing, manufacture, transport, storage and supply of raw materials, products or parts of the products and development of the product or the service; and
downstream business partners, relating to the distribution, transport and storage of the product, where the business partners carry out those activities for the company or on behalf of the company.[10]

Companies will be required to:

develop a due diligence policy[11] that ensures risk-based due diligence, and integrate due diligence into their relevant policies and risk management systems;
identify and assess actual or potential adverse human rights and environmental impacts (which are defined by reference to obligations or rights enshrined in international instruments),[12] including mapping operations to identify general areas where adverse impacts are most likely to occur and to be most severe; and
prevent and mitigate potential adverse impacts and bring to an end / minimise the extent of actual adverse impacts. Where it is not feasible to prevent, mitigate, bring to an end or minimise all identified adverse impacts at the same time to their full extent, companies must prioritise the steps they take based on the severity and likelihood of the adverse impacts.

In each instance, companies will be required to take “appropriate measures”; that is, measures that “effectively addres[s] adverse impacts in a manner commensurate to the degree of severity and the likelihood of the adverse impact”.[13] Such measures must take into account the circumstances of the specific case, including the nature and extent of the adverse impact and relevant risk factors.

With regards to the prevention of potential adverse impacts, companies are required (amongst other obligations) to:

develop and implement a prevention action plan, with reasonable and clearly defined timelines for the implementation of appropriate measures and qualitative and quantitative indicators for measuring improvement;
seek contractual assurances from a direct business partner that it will ensure compliance with the company’s code of conduct / prevention action plan, including by establishing corresponding contractual assurances from its partners if their activities are part of the company’s chain of activities;
make necessary financial or non-financial investments, adjustments or upgrades, such as into facilities, production or other operational processes and infrastructures; and
provide targeted and proportionate support for an SME[14] which is a business partner of the company.

Similar obligations are imposed in the context of bringing actual adverse impacts to an end.

Notably, regarding (b), companies must verify compliance. To do so, the CSDDD states that companies “may refer to” independent third-party verification, including through industry or multi-stakeholder initiatives.[15]

The financial sector has more limited obligations. “Regulated financial undertakings” are only subject to due diligence obligations for their own operations, those of their subsidiaries and the upstream part of their chain of activities. Such undertakings are expected to consider adverse impacts and use their “leverage” to influence companies, including through the exercise of shareholders’ rights.

(b) Adopt / Put into Effect a Climate Transition Plan

Companies will also be required to adopt and put into effect a climate change mitigation transition plan (“CTP”), to be updated annually, which aims to ensure that a company’s business model and strategy are compatible with limiting global warming to 1.5°C in line with the Paris Agreement and the objective of achieving climate neutrality, including intermediate and 2050 climate neutrality targets. The CTP should also address, where relevant, the exposure of the company to coal-, oil- and gas-related activities.

The CTP must contain: (a) time-bound targets in five-year steps from 2030 to 2050 including, where appropriate, absolute greenhouse gas emission reduction targets for scope 1, 2 and 3 emissions; (b) description of decarbonisation levers and key actions planned to reach the targets identified in (a); (c) details of the investments and funding supporting the implementation of the CTP; and (d) a description of the role of the administrative, management and supervisory bodies with regard to the CTP.[16]

Companies which report a CTP in accordance with the CSRD or are included in the CTP of their parent undertaking are deemed to have complied with the CSDDD’s CTP obligation. Regulated financial undertakings will also have to adopt a CTP ensuring their business model complies with the Paris Agreement.

(c) Provide Remediation

Consistent with the right to a remedy under the UNGPs, Member States must ensure that where a company has caused or jointly caused an actual adverse impact, it will provide “remediation”.[17] This is defined in the Directive as “restoration of the affected person or persons, communities or environment to a situation equivalent or as close as possible to the situation they would be in had an actual adverse impact not occurred”.[18] Such remediation should be proportionate to the company’s implication in the adverse impact, including financial or non-financial compensation to those affected and, where applicable, reimbursement of any costs incurred by public authorities for necessary remedial measures.

(d) Meaningfully[19] engage with Stakeholders

Companies are required to effectively engage with stakeholders. This includes carrying out consultations at various stages of the due diligence process, during which companies must provide comprehensive information.

(e) Establish a Notification Mechanism and Complaints Procedure

Member States must ensure that companies provide the possibility for persons or organisations with legitimate concerns regarding any adverse impacts to submit complaints.[20] There should then be a fair, publicly available, accessible, predictable and transparent procedure for dealing with complaints, of which relevant workers, trade unions and other workers’ representatives should be informed. Companies should take reasonably available measures to avoid any retaliation.

Notification mechanisms must also be established through which persons and organisations can submit information about adverse impacts.

Companies will be allowed to fulfil these obligations through collaborative complaints procedures and notification mechanisms, including those established jointly by companies, through industry associations, multi-stakeholder initiatives or global framework agreements.

(f) Monitor and Assess Effectiveness

Member States shall ensure that companies carry out periodic assessments of their own operations and measures, those of their subsidiaries and, where related to the chain of activities of the company, those of their business partners. These will assess implementation and monitor the adequacy and effectiveness of the identification, prevention, mitigation, bringing to an end and minimisation of the extent of adverse impacts.

Where appropriate, assessments are to be based on qualitative and quantitative indicators and carried out without undue delay after a significant change occurs, but at least every 12 months and whenever there are reasonable grounds to believe that new risks of the occurrence of those adverse impacts may arise.[21]

(g) Communicate Compliance

Companies will be required to report on CSDDD-matters by publishing an annual statement on their website within 12 months of the end of their financial year, unless they are subject to sustainability reporting obligations under the CSRD. The CSDDD does not introduce any new reporting obligations in addition to those under the CSRD.[22]

The contents of the annual statement will be defined by the Commission through a subsequent implementing act.

4. Enforcement and Sanctions

The Directive requires Member States to designate independent “supervisory authorities” to supervise compliance (“Supervisory Authority”).[23] A Supervisory Authority must have adequate powers and resources, including the power to require companies to provide information and carry out investigations. Investigations may be initiated by the Supervisory Authorities’ own motion or as a result of substantiated concerns raised by third parties.

Supervisory Authorities are to be empowered to “at least”: (a) order the cessation of infringements, the abstention from any repetition of the relevant conduct and the taking of remedial measures; (b) impose penalties; and (c) adopt interim measures in case of imminent risk of severe and irreparable harm.

Sanctions regimes adopted by Member States must be effective, proportionate and dissuasive. This includes pecuniary penalties with a maximum limit of not less than 5% of the in-scope company’s worldwide net turnover.[24] Additionally, the Directive stipulates that any decision of a Supervisory Authority containing penalties is: (a) published, (b) publicly available for at least five years; and (c) sent to the “European Network of Supervisory Authorities” (“naming and shaming”).[25]

Besides these sanctions, compliance with the CSDDD’s obligations can be used as part of the award criteria for public and concession contracts.

5. Civil Liability of Companies

Member States must establish a civil liability regime for companies which intentionally or negligently fail to comply with the CSDDD’s obligations and where damage has been caused to a person’s legal interest (as protected under national law) as a result of that failure.[26] However, a company cannot be held liable if the damage was caused only by its business partners in its chain of activities.

Member States must provide for “reasonable conditions” under which any alleged injured party may authorize a trade union, non-governmental human rights or environmental organization or other NGO or national human rights institution, to bring actions to enforce the rights of the alleged injured party.[27]

The Directive requires a limitation period for bringing actions for damages of at least five years and, in any case, not shorter than the limitation period laid down under general civil liability regimes of Member States.

Regarding compensation, Member States are required to lay down rules that fully compensate victims for the damage they have suffered as a direct result of the company’s failure to comply with the Directive. However, the Directive states that deterrence through damages (i.e., punitive damages) or any other form of overcompensation should be prohibited.

6. Next Steps / Implementation

The Directive must now be formally adopted by the Council and will subsequently come into force on the 20th day following that of its publication in the Official Journal of the EU, which is expected to occur in the first half of 2024. Once the Directive enters into force, Member States will need to transpose it into national law within two years, i.e., by mid-2026.

Depending on their size, companies will have between three to five years from the Directive entering into force to implement its requirements (i.e., likely until between 2027 and 2029):

three years (i.e., likely in 2027) for (a) EU companies with more than 5,000 employees and EUR 1,500 million net worldwide turnover, and (b) non-EU companies with more than EUR 1,500 million net turnover generated in the EU.
four years (i.e., likely in 2028) for: (a) companies with more than 3,000 employees and EUR 900 million net worldwide turnover and (b) non-EU companies with more than EUR 900 million net turnover generated in the EU; and
five years (i.e., likely in 2029) for companies with more than 1,000 employees and EUR 450 million turnover.

7. Relationship between the CSDDD and other EU Laws Protecting Human Rights and the Environment

The Directive is part of a series of EU regulations which aim to protect human rights and the environment through both reporting and due diligence obligations. Such regulations include the CSRD and the Sustainable Finance Disclosure Regulation, which impose mandatory reporting obligations, as well as the Regulation on Deforestation-free Products, the Conflicts Minerals Regulation, the Batteries Regulation and the Forced Labour Ban Regulation (which, coincidentally, was also approved by the European Parliament on 24 April 2024),[28] which impose due diligence requirements on companies in certain sectors / circumstances.

In this context, the CSDDD will become the “default” EU due diligence regime. The Directive expressly provides that its obligations are without prejudice to other, more specific EU regimes, meaning that if a provision of the CSDDD conflicts with another EU regime providing for more extensive or specific obligations, then the latter will prevail.

8. Practical Considerations for In-Scope Companies

Given the significance of expectations and liabilities in the CSDDD, in-scope companies would be well advised to commence preparation now, notwithstanding the implementation timeframe. Indeed, the types of measures that the CSDDD requires to be implemented will take time to operationalise. Functions and entities across multinationals will need to be engaged in that implementation, and it is prudent to involve key internal stakeholders (including legal and compliance functions) in that process from the outset.

The types of next steps in-scope companies should be considering now include:

First, mapping current and potentially future upstream and downstream business relationships to understand where any human rights and environmental risks exist. Any gaps or concerns should be addressed. Additionally, effective systems should be implemented to continually monitor risks within the chain of activities.

Second, putting in place a risk-based due diligence policy containing a description of the company’s approach, as well as supplier codes of conduct, which describe the rules and principles to be followed throughout the company and its subsidiaries. Codes of conduct should apply to all relevant corporate functions and operations, including procurement, employment and purchasing decisions.

Third, considering whether it is appropriate to involve lawyers in the development of internal due diligence systems in order to seek to apply privilege to relevant communications and documentation. This is particularly important given the: (a) matrix of legal regulation which applies in this space; and (b) envisaged regulatory and civil liability regimes.

Fourth, inserting appropriate contractual language into business partner contracts. The CSDDD requires the Commission, in consultation with Member States and stakeholders, to adopt guidance in this regard. However, the Commission has 30 months from the entry into force of the CSDDD to adopt such guidance.

Fifth, training employees—and being cognisant that training should not be limited just to those persons directly involved with sustainability compliance and reporting. Employees should understand how to spot adverse human rights and environmental impacts and understand the actions to be taken when they do.

Sixth, establishing operational level grievance mechanisms for rights holders, their representatives and civil society organisations. Such mechanisms act not only as a tool to remedy and redress but can be harnessed preventively as an early warning system for the identification and analysis of adverse impacts.

Seventh, meaningfully engaging with stakeholders will require identification of who relevant stakeholders are and require companies to design effective engagement processes.

Last, given the overlapping nature of some of the EU directives and regulations in this space (as well as laws at the Member State level), mapping all relevant obligations to ensure consistent compliance and drive efficiencies where practicable. It is notable that the Directive explicitly states that it does not prevent Member States from imposing further, more stringent obligations on companies—so companies will want to keep this under review.

__________

[1] European Parliament legislative resolution of 24 April 2024 on the proposal for a directive of the European Parliament and of the Council on Corporate Sustainability Due Diligence and amending Directive (EU) 2019/1937.

[2] Art. 1(a) of the Directive.

[3] See our previous client alert addressing Mandatory Corporate Human Rights Due Diligence.

[4] See our previous client alert addressing the European Commission’s draft directive on “Corporate Sustainability Due Diligence”.

[5] See for example, France’s “Loi de Vigilance” enacted in 2017, which inserted provisions into the French Commercial Code imposing substantive requirements on companies in relation to human rights and environmental due diligence. Specifically, companies with more than 5,000 employees in France (or 10,000 employees in France or abroad) are required to establish, implement and publish a “vigilance plan” to address risks within their supply chains or which arise from the activities of direct or indirect subsidiaries or subcontractors. Such plans should also include action plans to mitigate those risks and prevent damage, as well as a monitoring system to ensure that the plan is effectively implemented. (See our previous client alert addressing global legislative developments and proposals in the bourgeoning field of mandatory corporate human rights due diligence). Meanwhile in Germany, the Supply Chain Due Diligence Act 2023 (the “SCCDA”) was enacted, imposing due diligence obligations on companies with a statutory seat in Germany and more than 1,000 employees, regardless of revenue. In many instances, the CSDDD and the SCDDA obligations overlap, although there are some differences. For example, whilst the CSDDD extends obligations to the company’s “chain of activities”, the SCDDA focuses primarily on direct suppliers. An in-scope company may also be required to conduct due diligence on its indirect suppliers if the company has substantiated knowledge of grievances or violations of the law. The German legislator is expected to align the obligations under the CSDDD and the SCDDA, as it did in relation to CSRD.

[6] Press Release of the European Parliament, 24 April 2024, “Due diligence: MEPs adopt rules for firms on human rights and environment”.

[7] Turnover of branches of the relevant entity are also to be taken into account when calculating whether a threshold has been reached.

[8] See our previous client alert addressing the CSRD.

[9] See Art. 3(1)(f) of the Directive, which defines “business partner” as “an entity (i) with which the company has a commercial agreement related to the operations, products or services of the company or to which the company provides services pursuant to point (g) (‘direct business partner’), or (ii) which is not a direct business partner but which performs business operations related to the operations, products or services of the company (‘indirect business partner’)”.

[10] See Art. 3(1)(g) of the Directive.

[11] See Art. 5 of the Directive. The company’s risk-based due diligence policy should be developed in consultation with its employees and their representatives and be updated after a significant change or at least every 24 months (Art. 7(3) of the Directive). It shall contain all of the following: (a) a description of the company’s approach, including in the long term, to due diligence; (b) a code of conduct describing rules and principles to be followed throughout the company and its subsidiaries, and the company’s direct or indirect business partners; and (c) a description of the processes put in place to integrate due diligence into the relevant policies and to implement due diligence, including the measures taken to verify compliance with the code of conduct and to extend its application to business partners.

[12] See Art. 3(1)(b) and (c). Adverse environmental impacts are defined as an adverse impact on the environment resulting from the breach of the prohibitions and obligations listed in Part I, Section 1, points 15 and 16 (the prohibition of causing any measurable environmental degradation and the right of individuals, groupings and communities to lands and resources and the right not to be deprived of means of subsistence), and Part II of the Annex to the Directive, which includes, for example, the obligation to avoid or minimise adverse impacts on biological diversity, interpreted in line with the 1992 Convention on Biological Diversity and applicable law in the relevant jurisdiction. Adverse human rights impacts are defined as an adverse impact on one of the human rights listed in Part I, Section 1, of the Annex to the Directive, as those human rights are enshrined in the international instruments listed in Part I, Section 2, of the Annex to the Directive, for example, The Convention on the Rights of the Child and The International Covenant on Civil and Political Rights.

[13] See Art. 3(1)(o) of the Directive.

[14] This is defined in Art. 3(1)(i) of the Directive as “a micro, small or a medium-sized undertaking, irrespective of its legal form, that is not part of a large group…”.

[15] Art. 10(5) of the Directive.

[16] Art. 22 of the Directive.

[17] Art. 12 of the Directive.

[18] Art. 3(1)(t) of the Directive.

[19] Whilst the text of Art. 13(1) of the Directive refers to “effective” engagement with stakeholders, the title of provision refers to “meaningful” engagement, which is also found in the Recitals.

[20] Art. 14 of the Directive.

[21] Ar. 15 of the Directive.

[22] Art. 16 of the Directive.

[23] Art. 24(1) of the Directive. For France and Germany, we expect the “Supervisory Authority” to be the same authority as is currently overseeing compliance with their analogous due diligence regimes.

[24] Art. 27(4) of the Directive.

[25] Art. 27(5) of the Directive.

[26] Art. 29 of the Directive.

[27] Art. 29(3)(d) of the Directive.

[28] See Press Release of the European Parliament on 23 April 2024, “Products made with forced labour to be banned from EU single market”.

The following Gibson Dunn lawyers prepared this update: Selina Sagayam, Susy Bullock, Stephanie Collins, Alexa Romanelli, and Harriet Codd in London; Robert Spano in Paris; and Ferdinand Fromholzer, Markus Rieder, Katharina Humphrey, Julian von Imhoff, Carla Baum, Melina Kronester, Julian Reichert, and Marc Kanzler in Munich.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you wish to discuss any of the matters set out above, please contact the Gibson Dunn lawyer with whom you usually work, any member of Gibson Dunn’s Environmental, Social and Governance (ESG) practice group, or the following authors in London, Paris and Munich:

London:
Selina S. Sagayam – London (+44 20 7071 4263, [email protected])
Susy Bullock – London (+44 20 7071 4283, [email protected])
Stephanie Collins – London (+44 20 7071 4216, [email protected])
Alexa Romanelli – London (+44 20 7071 4269, [email protected])
Harriet Codd (+44 20 7071 4057, [email protected])

Paris:
Robert Spano – Paris/London (+33 1 56 43 14 07, [email protected])

Munich:
Ferdinand Fromholzer (+49 89 189 33-270, [email protected])
Markus Rieder (+49 89 189 33-260, [email protected])
Katharina Humphrey (+49 89 189 33-217, [email protected])
Julian von Imhoff (+49 89 189 33-264, [email protected])
Carla Baum (+49 89 189 33-263, [email protected])
Melina Kronester (+49 89 189 33-225, [email protected])
Julian Reichert (+49 89 189 33-229, [email protected])
Marc Kanzler (+49 89 189 33-269, [email protected])

The Final Regulations modify the “look-through” rule for certain domestic C corporations, and introduce a new ten-year transition rule.

On April 24, 2024, the IRS and Treasury issued final regulations for determining whether a real estate investment trust (a “REIT”)[1] qualifies as a “domestically controlled qualified investment entity” (a “DREIT,” and the final regulations, the “Final DREIT Regulations”). These regulations modify certain provisions of the regulations proposed by the IRS and Treasury in December 2022 (the “Proposed DREIT Regulations”), detailed in our previous Client Alert.

Compared with the Proposed DREIT Regulations, the Final DREIT Regulations:

(1) increase the threshold of foreign ownership required to look through a domestic C corporation that owns a REIT from 25 percent or more to more than 50 percent for purposes of determining whether the REIT qualifies as a DREIT (the “C Corporation Look-Through Rule”);

(2) provide a ten-year transition rule for application of the C Corporation Look-Through Rule to existing REITs, subject to certain restrictions; and

(3) clarify or modify certain rules relating to publicly traded entities, qualified foreign pension funds (“QFPFs”), and withholding taxes.

Background

Subject to certain exceptions discussed below, section 897[2] and related sections added to the Code by the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) require foreign persons that recognize gain from the sale or disposition of a United States real property interest (a “USRPI”) to file U.S. federal income tax returns reporting that gain and pay U.S. federal income tax on that gain at regular graduated rates, even if the gain is not otherwise effectively connected with the conduct of a U.S. trade or business.

The definition of a USRPI is broad. In addition to including a wide array of interests in U.S. real estate (which itself is a very broad term) and interests in disregarded entities and certain partnerships that own U.S. real estate, USRPIs include equity interests in domestic corporations that are United States real property holding corporations (“USRPHCs”). Generally, a USRPHC is any corporation, including a REIT, if the value of its USRPIs represents at least 50 percent of the aggregate value of its real estate (both U.S. and non-U.S.) and business assets.

Even though equity interests in domestic USRPHCs generally are treated as USRPIs, section 897(h)(2) provides that an interest in a DREIT is not a USRPI. Under section 897(h)(4), a REIT is a DREIT if less than 50 percent of the value of its stock is held “directly or indirectly” by “foreign persons” at all times during the shorter of (1) the 5-year period ending on the relevant determination date and (2) the period during which the REIT was in existence (the “Testing Period”). Importantly, gain recognized by a foreign person on the disposition of an interest in a DREIT is not subject to U.S. federal income tax under FIRPTA, even if the DREIT is a USRPHC. Foreign persons often seek to invest in U.S. real estate through DREITs because, in these structures, foreign persons can exit the investment via a sale of DREIT stock without being subject to U.S. tax on the gain or being required to file a U.S. tax return.

Proposed Regulations

Before the promulgation of the Proposed DREIT Regulations, there was relatively little guidance regarding when the stock of a REIT owned by one person was treated as held “indirectly” by another person for purposes of determining DREIT status.[3] The Proposed DREIT Regulations included a broad look-through rule for this purpose that applied to various types of passthrough and quasi-passthrough entities, including REITs, partnerships (other than publicly traded partnerships), S corporations, and RICs (the “Proposed Look-Through Rule”).[4] The Proposed Look-Through Rule would have been implemented by imputing ownership of REIT stock to the owners of such entities pro rata based on the owners’ proportionate interests in such entities.[5]

Diverging from informal IRS guidance that treated domestic C corporations as non-foreign owners of REITs for purposes of determining DREIT status, the Proposed Look-Through Rule also would have applied to “foreign-owned domestic corporations.”[6] Specifically, a “foreign-owned domestic corporation” was defined as any non-publicly traded domestic C corporation if foreign persons held directly or indirectly 25 percent or more of the value of its outstanding stock, applying certain look-through rules.[7] Thus, a “foreign-owned domestic corporation” would not have been treated as a domestic owner of a REIT; rather, ownership of the REIT’s stock would have been imputed to the owners of the “foreign-owned domestic corporation” to determine if the REIT qualified as a DREIT.

Final Regulations

The Final DREIT Regulations generally maintain the provisions of the Proposed Look-Through Rule, with certain changes described below.

Increased Ownership Threshold for Foreign-Controlled Domestic C Corporations

The IRS and Treasury narrowed the scope of the C Corporation Look-Through Rule. Specifically, the IRS and Treasury increased the threshold of foreign ownership required to qualify as a foreign-controlled domestic C Corporation from 25 percent or more to more than 50 percent.[8]

Ten-Year Transition Rule for Existing REITs

Generally, the C Corporation Look-Through Rule and other provisions of the Final DREIT Regulations apply to transactions (e.g., sales of REIT shares) occurring on or after April 25, 2024.[9] Importantly, however, the C Corporation Look-Through Rule does not apply to existing REITs until April 24, 2034, provided certain requirements are satisfied, as discussed below (the “Transition Rule”).[10]

Under the Transition Rule, the C Corporation Look-Through Rule does not apply until April 24, 2034 to a REIT in existence as of April 24, 2024, provided:

(1) the REIT qualifies at all times on and after April 24, 2024 as “domestically controlled”, taking into account all provisions of the Final DREIT Regulations other than the C Corporation Look-Through Rule;

(2) the REIT does not directly or indirectly acquire, on and after April 24, 2024, USRPIs with an aggregate fair market value exceeding 20 percent of the aggregate fair market value of the USRPIs it holds directly or indirectly as of April 24, 2024; and

(3) the percentage of the REIT’s stock held directly or indirectly by one or more “non-look-through persons” does not increase by more than 50 percentage points over the percentage of the REIT’s stock held directly or indirectly by such non-look-through persons as of April 24, 2024.[11]

For purposes of the second requirement, the fair market value of a REIT’s USRPIs as of April 24, 2024 is the value the REIT used for purposes of its REIT asset testing as of March 31, 2024.[12] The fair market value of any USRPI acquired after March 31, 2024 must be determined as of the date the USRPI is acquired “using a reasonable method,” as long as the REIT “consistently” uses the same method with respect to all of its USRPIs for purposes of the Transition Rule.[13]

If a REIT violates any of these requirements, the C Corporation Look-Through Rule will begin to apply to that REIT on the day after the REIT first violates the requirement.[14] Therefore, a REIT that becomes ineligible for the Transition Rule can still apply the Transition Rule to the portion of its Testing Period ending on the day the REIT violates the Transition Rule requirement.

Other Rules

In addition to the rules described above, the Final DREIT Regulations clarify or modify the following rules:

Consistent with the Proposed DREIT Regulations, a QFPF and a “qualified controlled entity” is a foreign person for purposes of determining whether a REIT is domestically controlled.[15]
In a departure from the Proposed DREIT Regulations, subject to the limitation described below, a publicly traded RIC generally is treated as a non-look-through person.[16] This aligns the treatment of publicly traded RICs with the treatment of publicly traded C corporations and publicly traded partnerships.
Under a newly introduced rule, a publicly traded domestic C corporation, publicly traded RIC, or publicly traded partnership will be treated as a look-through person if the REIT being tested for DREIT status has actual knowledge that the public domestic C corporation, publicly traded RIC, or publicly traded partnership is foreign controlled.[17]
A publicly traded REIT is permitted to treat as a U.S. person that is a non-look through person any person holding less than 5 percent of the REIT’s U.S. publicly traded stock (“5 Percent Person”), unless the REIT has actual knowledge that the 5 Percent Person is a non-U.S. Person or is foreign controlled (treating the 5 Percent Person as a non-public domestic C corporation for this purpose).[18]
To avoid section 1445 withholding on the transfer, a transferee of an interest in a DREIT can rely on a statement issued by the DREIT certifying that the interest is not a USRPI.

The IRS and Treasury declined to provide guidance in the Final DREIT Regulations on how a domestic C corporation certifies to a REIT whether it is foreign controlled, or any other guidance on procedures for determining whether a REIT will qualify as a DREIT, including what records a REIT must maintain in this regard.

Takeaways

Sponsors of, and investors in, existing and new REITs intended to qualify as DREITs should consider evaluating whether those REITs qualify as DREITs under the Final DREIT Regulations.

Sponsors also should review the information, representations, and covenants that they request from investors in determining whether a REIT will qualify as a DREIT and should consider what records to maintain with respect to their determination of DREIT status. Further, REIT sponsors should consider any obligations they may have to cause a REIT to qualify as a DREIT.

Sponsors of and investors in existing REITs that seek to rely on the Transition Rule to continue to be classified as DREITs should consider limiting acquisitions of new USRPIs by, and changes of ownership in, these REITs so as not to cause the Transition Rule to cease to apply before April 24, 2034. In particular, sponsors and investors should be aware that seemingly innocuous changes in the indirect ownership of a REIT (e.g., restructurings that do not change the ultimate beneficial ownership of the REIT) could inadvertently cause the Transition Rule to cease to apply to the REIT.

__________

[1] The rules also apply to certain registered investment companies (“RICs”). In our discussion, however, we focus on REITs and DREITs because foreign persons are more likely to invest in U.S. real estate through REITs than through RICs.

[2] Unless indicated otherwise, all “section” references are to the Internal Revenue Code of 1986, as amended (the “Code”), and all “Treas. Reg. §” references are to the Treasury regulations promulgated under the Code.

[3] See our previous Client Alert for a discussion of the available guidance before the promulgation of the Proposed DREIT Regulations.

[4] Prop. Treas. Reg. § 1.897-1(c)(3)(ii)(B).

[5] Id.

[6] Id. See our previous Client Alert for more details.

[7] Prop. Treas. Reg. § 1.897-1(c)(3)(v)(B).

[8] Although the Proposed DREIT Regulations refer to these entities as “foreign-owned domestic corporations,” the Final DREIT Regulations refer to these entities as “foreign-controlled domestic corporations.” 89 F.R. 31621; Treas. Reg. § 1.897-1(c)(3)(v)(B).

[9] Treas. Reg. § 1.897-1(a)(2).

[10] Treas. Reg. § 1.897-1(c)(3)(vi).

[11] Treas. Reg. § 1.897-1(c)(3)(vi)(A). There is an exception for acquisitions of USRPIs or interests in the REIT pursuant to a written agreement that was binding before April 24, 2024. Treas. Reg. § 1.897-1(c)(3)(vi)(E).

[12] Treas. Reg. § 1.897-1(c)(3)(vi)(B)(1), (C).

[13] Treas. Reg. § 1.897-1(c)(3)(vi)(D).

[14] Id.

[15] See our previous Client Alert for further discussion of QFPFs and qualified controlled entities.

[16] For purposes of the Final DREIT Regulations, the term “public RIC” (that is, a publicly traded RIC) excludes a RIC that is also a “qualified investment entity.” Treas. Reg. § 1.897-1(c)(3)(v)(I); I.R.C. § 897(h)(4)(A).

[17] To test whether a RIC is foreign controlled, the Final DREIT Regulations treat the RIC as a non-public domestic C corporation. Treas. Reg. § 1.897-1(c)(3)(v)(I).

[18] Treas. Reg. § 1.897-1(c)(3)(iii)(A). Under the Proposed DREIT Regulations, 5 Percent Persons were considered non-look-through U.S. persons unless the REIT had actual knowledge that the 5 Percent Person was not a U.S. person.

The following Gibson Dunn lawyers prepared this update: Evan M. Gusler, Kathryn A. Kelly, Brian W. Kniesly, Alex Marcellesi, Austin T. Morris, Ray Noonan, Lorna Wilson, and Daniel A. Zygielbaum.

Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Tax and Global Tax Controversy and Litigation practice groups:

Tax:
Dora Arash – Los Angeles (+1 213.229.7134, [email protected])
Sandy Bhogal – Co-Chair, London (+44 20 7071 4266, [email protected])
Michael Q. Cannon – Dallas (+1 214.698.3232, [email protected])
Jérôme Delaurière – Paris (+33 (0) 1 56 43 13 00, [email protected])
Michael J. Desmond – Los Angeles/Washington, D.C. (+1 213.229.7531, [email protected])
Anne Devereaux* – Los Angeles (+1 213.229.7616, [email protected])
Matt Donnelly – Washington, D.C. (+1 202.887.3567, [email protected])
Pamela Lawrence Endreny – New York (+1 212.351.2474, [email protected])
Benjamin Fryer – London (+44 20 7071 4232, [email protected])
Evan M. Gusler – New York (+1 212.351.2445, [email protected])
Kathryn A. Kelly – New York (+1 212.351.3876, [email protected])
Brian W. Kniesly – New York (+1 212.351.2379, [email protected])
Loren Lembo – New York (+1 212.351.3986, [email protected])
Jennifer Sabin – New York (+1 212.351.5208, [email protected])
Eric B. Sloan – Co-Chair, New York/Washington, D.C. (+1 212.351.2340, [email protected])
Edward S. Wei – New York (+1 212.351.3925, [email protected])
Lorna Wilson – Los Angeles (+1 213.229.7547, [email protected])
Daniel A. Zygielbaum – Washington, D.C. (+1 202.887.3768, [email protected])

Global Tax Controversy and Litigation:
Michael J. Desmond – Co-Chair, Los Angeles/Washington, D.C. (+1 213.229.7531, [email protected])
Saul Mezei – Washington, D.C. (+1 202.955.8693, [email protected])
Sanford W. Stark – Co-Chair, Washington, D.C. (+1 202.887.3650, [email protected])
C. Terrell Ussing – Washington, D.C. (+1 202.887.3612, [email protected])

*Anne Devereaux, of counsel in the firm’s Los Angeles office, is admitted to practice in Washington, D.C.

From the Derivatives Practice Group: This week, the CFTC approved final rules to amend its Swap Execution Facility regulations, and extended the deadline for public comment period on a proposed rule that makes certain modifications to rules for Swap Execution Facilities and Designated Contract Markets in Part 37 and 38.

New Developments

“AI Day” To Be Held at May 2 CFTC Technology Advisory Committee Meeting. On April 24, Commissioner Christy Goldsmith Romero, sponsor of the Technology Advisory Committee (TAC), announced “AI Day” is to be held at the CFTC’s Washington, D.C. headquarters on May 2, 2024, during a TAC meeting. AI Day will take place from 1:00 p.m. to 4:00 p.m. (EDT). AI Day is a continuation of the TAC’s study of AI, and the concept of Responsible AI in financial markets. The TAC Subcommittee on Emerging and Evolving Technologies will present on the work and findings of the Subcommittee in its study of AI for financial markets. [NEW]
CFTC Approves Final Rules on Swap Confirmation Requirements for SEFs. On April 23, the CFTC approved final rules to amend its swap execution facility (SEF) regulations related to uncleared swap confirmations to address issues which have been addressed in CFTC staff no-action letters, including the most recent CFTC No Action Letter No. 17-17, as well as associated conforming and technical changes. In particular, the final rules amend CFTC Regulation 37.6(b) to enable SEFs to incorporate terms of underlying, previously negotiated agreements between the counterparties by reference in an uncleared swap confirmation without being required to obtain such underlying, previously negotiated agreements. Further, the final rules amend CFTC Regulation 37.6(b) to require such confirmation to take place “as soon as technologically practicable” after the execution of the swap transaction on the SEF for both cleared and uncleared swap transactions. The final rules also amend CFTC Regulation 37.6(b) to make clear the SEF-provided confirmation under CFTC Regulation 37.6(b) shall legally supersede any conflicting terms in a previous agreement, rather than the entire agreement. The final rules make conforming amendments to CFTC Regulation 23.501(a)(4)(i) to correspond with the amendments to CFTC Regulation 37.6(b). Finally, the final rules make certain non-substantive amendments to CFTC Regulation 37.6(a)-(b) to enhance clarity. [NEW]
CFTC to Hold a Commission Open Meeting April 29. On April 22, Chairman Rostin Behnam announced the Commission will hold an open meeting on Monday, April 29 at 9:30 a.m. (EDT) at the CFTC’s Washington, D.C. headquarters. The Commission will consider Final Rule “Capital and Financial Reporting Requirements for Swap Dealers and Major Swap Participants” and Final Rule “Adopting Amendments to the Large Trader Reporting Rules for Futures and Options.” [NEW]
CFTC Extends Public Comment Period for Proposed Rule for Designated Contract Markets and Swap Execution Facilities Regarding Governance and Conflicts of Interest. On April 22, the CFTC announced it is extending the deadline for public comment period on a proposed rule that makes certain modifications to rules for Swap Execution Facilities and Designated Contract Markets in Part 37 and 38 that would establish governance requirements regarding market regulation functions, as well as related conflicts of interest standards. The deadline is being extended to May 13, 2024. [NEW]
Chairman Behnam Announces CFTC’s First DEIA Strategic Plan. On April 18, CFTC Chairman Rostin Behnam announced the agency’s first Strategic Plan to Advance Diversity, Equity, Inclusion, and Accessibility (DEIA Plan). Chairman Behnam said that the two-year DEIA Plan represents a critical step forward in aligning the CFTC with a collective DEIA vision that not only provides genuine support for team members, but also ensures the CFTC is a source of future leaders. The CFTC designed the DEIA Plan to align with its 2022-2026 Strategic Plan and to focus on the following six goals: Inclusive Workplaces, Partnerships and Recruitment, Paid Internships, Professional Development and Advancement, Data, and Equity in Procurement and Customer Education and Outreach. Each goal includes objectives and strategies/actions to achieve the goal, and identifies the agency division(s)/office(s) that will lead and contribute to the implementation of the goal. The CFTC said that an internal DEIA Executive Council will support and guide the implementation of the DEIA Plan.
CFTC Appoints Christopher Skinner as Inspector General. On April 10, the Commodity Futures Trading Commission announced that Christopher L. Skinner has been appointed CFTC’s Inspector General (IG). The CFTC stated that Mr. Skinner brings 15 years of IG experience, including leading and managing Offices of Inspector’s General (OIG), and conducting investigations, inspections, and audits. Mr. Skinner comes to the CFTC from the Federal Election Commission (FEC) where he served as IG since 2019.

New Developments Outside the U.S.

Telbor Committee to Permanently Cease Publication of Telbor. On April 16, the Telbor Committee of the Bank of Israel decided that the publication of all tenor of Telbor will permanently cease following a final publication on June 30, 2025. The announcement constitutes an “Index Cessation Event” under the 2021 ISDA Interest Rate Derivatives Definitions and the November 2022 Benchmark Module of the ISDA 2021 Fallbacks Protocol. In February 2022, the Telbor Committee decided that the SHIR (Shekel overnight Interest Rate) rate would eventually replace the Telbor interest rate in shekel interest rate derivative transactions. The Bank of Israel said that the decision to switch to the SHIR rate is in accordance with the decisions reached in major economies worldwide, according to which IBOR type interest rates will be replaced by risk-free overnight interest rates. ISDA published cessation guidance for parties affected by the announcement.
New Report Sheds Light on Quality and Use of Regulatory Data Across EU. On April 11, ESMA published the fourth edition of its Report on the Quality and Use of Data aiming to provide transparency on how the data collected under different regulations is used systematically by authorities in the EU, and clarifying the actions taken to ensure data quality. The report provides details on how National Competent Authorities, the European Central Bank, the European Systemic Risk Board and ESMA use the data that is collected through the year from different legislation requirements, including datasets from European Market Infrastructure Regulation, Securities Financing Transactions Regulation, Markets in Financial Instruments Directive, Securitization Regulation, Alternative Investment Fund Managers Directive and Money Market Funds Regulation.

New Industry-Led Developments

ISDA and SIFMA Submit Addendum to Proposed FFIEC Reporting Revisions. On April 23, ISDA and the Securities Industry and Financial Markets Association (SIFMA) submitted an addendum to the joint response to the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency on the proposed reporting revisions of the call report, FFIEC 101 and FFIEC 102, which are designed to reflect the implementation of the Basel III endgame proposal. The addendum contains additional findings in the FFIEC 102 report, including end-of-week Fundamental Review of the Trading Book standardized approach average calculations and reported market risk risk-weighted assets in sub-parts D and E. [NEW]
ISDA Launches Outreach Initiative on Proposed Notices Hub. On April 25 ISDA announced a major industry outreach initiative to establish support among dealers and buy-side firms for a new online platform that would allow the instantaneous delivery and receipt of critical termination-related notices, reducing the risk exposure and potential losses from a delay. Under the ISDA Master Agreement, termination-related notices must be delivered by certain prescribed methods, using company address details listed in the agreement. However, delays can occur if a company has moved and the documentation hasn’t been updated with the new details or if delivery to a physical location is not possible due to geopolitical shocks. The proposed ISDA Notices Hub would act as a secure central platform for firms to deliver notices, with automatic alerts sent to the receiving entity. Multiple designated people at each firm would be able to access the hub from anywhere in the world, regardless of the situation at its physical location. The platform would also allow market participants to update their physical address details via a single entry, providing a golden source of those details. [NEW]
Four Directors Join ISDA Board. On April 18, ISDA announced that four directors have joined its Board, three directors were re-appointed, and 10 others have been re-elected at ISDA’s Annual General Meeting in Tokyo. The new directors are: Erik Tim Mueller, Chief Executive Officer, Eurex Clearing AG; Jared Noering, Managing Director, Head of Fixed Income Trading, NatWest Markets; Brad Tully, Managing Director and Global Head of Corporate Derivatives and Private Side Sales for J.P. Morgan; and Jan Mark van Mill, Managing Director of Multi Asset, APG Asset Management.
ISDA Future Leaders in Derivatives Publishes Generative Artificial Intelligence Whitepaper. On April 17, ISDA published a whitepaper from ISDA Future Leaders in Derivatives (IFLD), its professional development program for emerging leaders in the derivatives market. The whitepaper, GenAI in the Derivatives Market: a Future Perspective, was developed by the third cohort of IFLD participants, who began working together in October 2023. According to ISDA, the 38 individuals in the group represent buy- and sell-side institutions, law firms, and service providers from around the world. After being selected for the IFLD program, they were asked to engage with stakeholders, develop positions, and produce a whitepaper on the potential use of generative artificial intelligence (genAI) in the over-the-counter derivatives market. The participants were also given access to ISDA’s training materials, resources, and staff expertise to support the project and their own professional development. ISDA said that, drawing on industry expertise and academic research, the whitepaper identifies a range of potential use cases for genAI in the derivatives market, including document creation, market insight, and risk profiling. ISDA also indicated that it explores regulatory issues in key jurisdictions and addresses the challenges and risks associated with the use of genAI. The paper concludes with a set of recommendations for stakeholders, including investing in talent development, fostering collaboration and knowledge sharing with technology providers, prioritizing ethical AI principles and engaging with policymakers to promote an appropriate regulatory framework.
ISDA Publishes Research Paper on Interest Rate Derivatives, Benchmark Rates and Development Financial Markets in EMDEs. On April 17, ISDA published a research paper in which it outlines the role of interest rate derivatives (IRDs) in supporting the development of financial markets in emerging markets and developing economies (EMDEs). It also examines the significance of reliable, robust interest rate (IR) benchmarks. ISDA indicated that the paper draws valuable lessons from the transition from LIBOR to overnight risk-free rates in advanced economies and applies those insights to the context of EMDEs. Through case studies, ISDA attempts to show how various EMDE jurisdictions have successfully adopted and implemented more robust and transparent IR benchmarks.
ISDA Extends Digital Regulatory Reporting Initiative to New Jurisdictions. On April 17, ISDA announced that it is extending its Digital Regulatory Reporting (DRR) initiative to several additional jurisdictions in an effort to enable firms to implement changes to regulatory reporting requirements. The DRR is being extended to cover rule amendments being implemented under the UK European Market Infrastructure Regulation and by the Australian Securities and Investments Commission and the Monetary Authority of Singapore. Those rule changes are due to be implemented in the UK on September 30, 2024, and October 21, 2024 in Australia and Singapore. The DRR code for all three sets of rules is currently available for market participants to review and test. ISDA said that the DRR will be further extended to cover rule changes in Canada and Hong Kong, both due in 2025, and the DRR for the CFTC rules will also be updated to include further anticipated updates, currently under consultation at the commission. Firms can either use the DRR as the basis for implementation or to validate an independent interpretation of the rules.
ISDA Publishes Margin Survey. On April 16, ISDA published its latest margin survey, which shows that $1.4 trillion of initial margin (IM) and variation margin (VM) was collected by 32 leading derivatives market participants for their non-cleared derivatives exposures at the end of 2023, unchanged from the previous year. The survey also reports the amount of IM posted by all market participants to major central counterparties.
ISDA Establishes Suggested Operational Practices for EMIR Refit. On April 16, through a series of discussions held within the ISDA Data and Reporting EMEA Working Group, market participants established and agreed to Suggested Operational Practices (SOP) for over-the-counter derivative reporting in preparation for the commencement of the EMIR Refit regulatory reporting rules on April 29. ISDA said that the SOP matrix was established based on the EMIR Refit validation table, (as published by ESMA), which contains the Regulatory Technical Standards (RTS), the Implementation Technical Standards (ITS) and validation rules. Additional tabs have been added to supplement to SOPs, including product-level SOPs for several of the underlier fields, and listing names of floating rate options. There are also tabs to reflect updates made to the matrix (‘Updates’) and a tab to track questions raised by the ISDA Data and Reporting EMEA Working Group (‘WG Questions’). ISDA indicated that the document will continue to be reviewed and updated as and when required. While the intention of these SOPs is to provide an agreed and standardized market guide for firms to utilize, no firm is legally bound or compelled in any way to follow any determinations made within these EMIR SOPs.
ISDA and IIF Respond to BCBS-CPMI-IOSCO Consultation on Margin Transparency. On April 12, ISDA and the Institute of International Finance (IIF) submitted a response to the Basel Committee on Banking Supervision (BCBS), Committee on Payments and Market Infrastructures (CPMI) and International Organization of Securities Commissions (IOSCO) consultation on transparency and responsiveness of initial margin in centrally cleared markets. In their response, the associations expressed support for enhancing transparency on cleared margin for all market participants, which they expect will help with liquidity preparedness and increase resilience of the system, noting it should start with central counterparties (CCPs) making fundamental disclosures about their margin models. In this regard, both associations highlight their support in the response to recommendations one through eight. Regarding recommendation nine, the associations indicated that they are supportive of clients having necessary transparency on clearing member (CM) margin requirements. Regarding recommendation 10, the associations said in the response that they are generally supportive of the principle that CCPs should have visibility into the risk profile of their clearing participants but warned that, in their opinion, the information required under recommendation 10 may raise legal, confidentiality, or competition concerns. Finally, the associations noted that they believe further work should be done on the fundamentals of CCP margin models, for example on the appropriateness of margin periods of risk and the calibration of anti-procyclicality tools, to ensure that margins do not fall too low during low volatility periods.
IOSCO Publishes Updated Workplan. On April 12, IOSCO published its updated 2024 Workplan, which directly supports its overall two-year Work Program published on April 5, 2023. The 2024 Workplan announced new workstreams, reflecting increased focus on AI, tokenization and credit default swaps, and additional work on transition plans and green finance. The 2024 Workplan set out priorities under five themes: Protecting Investors, Address New Risks in Sustainability and Fintech, Strengthening Financial Resilience, Supporting Market Effectiveness and Promoting Regulatory Cooperation and Effectiveness
ISDA, AIMA, GFXD Publish Paper on Transition to UPI. On April 9, ISDA, the Alternative Investment Management Association (AIMA) and the Global Foreign Exchange Division (GFXD) of the Global Financial Markets Association published a paper on the transition to unique product identifiers (UPI) as the basis for over-the-counter (OTC) derivatives identification across the Markets in Financial Instruments Regulation (MIFIR) regimes. The paper has been sent to the European Commission, which is working on legislation to address appropriate identification of OTC derivatives under MiFIR.
ISDA Submits Addendum to US Basel III NPR Comment Letter. On April 8, ISDA submitted an addendum to the joint US Basel III ‘endgame’ notice of proposed rulemaking response along with the Securities Industry and Financial Markets Association. The addendum contains a more developed proposal for the index bucketing approach for equity investment in funds and an update to the Fundamental Review of the Trading Book Standardized Approach Quantitative Impact Study numbers.

The following Gibson Dunn attorneys assisted in preparing this update: Jeffrey Steiner, Adam Lapidus, Marc Aaron Takagaki, Hayden McGovern, and Karin Thrasher.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Derivatives practice group, or the following practice leaders and authors:

Jeffrey L. Steiner, Washington, D.C. (202.887.3632, [email protected])

Michael D. Bopp, Washington, D.C. (202.955.8256, [email protected])

Michelle M. Kirschner, London (+44 (0)20 7071.4212, [email protected])

Darius Mehraban, New York (212.351.2428, [email protected])

Jason J. Cabral, New York (212.351.6267, [email protected])

Adam Lapidus – New York (+1 212.351.3869, [email protected])

Stephanie L. Brooker, Washington, D.C. (202.887.3502, [email protected])

Roscoe Jones Jr., Washington, D.C. (202.887.3530, [email protected])

William R. Hallatt, Hong Kong (+852 2214 3836, [email protected])

David P. Burns, Washington, D.C. (202.887.3786, [email protected])

Marc Aaron Takagaki, New York (212.351.4028, [email protected])

Hayden K. McGovern, Dallas (214.698.3142, [email protected])

Karin Thrasher, Washington, D.C. (202.887.3712, [email protected])

In a sweeping victory for speech rights against overreach by state officials, Gibson Dunn and Elias Law Group convinced a D.C. federal court to enjoin an investigation by Texas Attorney General Ken Paxton into Media Matters, a non-profit research and information center that reports on misinformation and political extremism in the U.S. media. On November 16, 2023, Media Matters published a post reporting that ads for Apple, Bravo, IBM, Oracle, and Xfinity were showing up next to antisemitic content on X (formerly Twitter). In response, X’s owner Elon Musk posted that he would bring a “thermonuclear lawsuit” against Media Matters, filing suit on November 30, 2023 in the Northern District of Texas—despite Media Matters being located in Washington, D.C.

Virtually simultaneously, Texas AG Paxton opened an investigation of Media Matters for potential fraudulent activity in violation of Texas’s Deceptive Trade Practices Act (DTPA). Invoking the DTPA’s authority, Paxton served a broad and intrusive Civil Investigative Demand (CID) upon Media Matters, seeking a broad array of records relating to Media Matters’s reporting, funding, and reporter and editorial communications—despite Media Matters’s lack of any relevant connection to Texas. Gibson Dunn and Elias Law Group sought a preliminary injunction in the D.C. federal court, arguing that Paxton lacked jurisdiction to issue and enforce the CID, that the CID was a retaliatory action for speech in violation of the First Amendment, and that the overbroad document requests violated D.C. and Maryland reporters’ shield laws. Enforcement of the CID had chilled and would further chill Media Matters’s core First Amendment-protected speech, the motion argued, and was a direct assault on its newsgathering function.

The United States District Court for D.C. ruled in favor of Media Matters, issuing a preliminary injunction enjoining Paxton and his office from enforcing the CID. The court ruled that it had personal jurisdiction over Paxton under D.C.’s long-arm statute, that Media Matters had suffered cognizable First Amendment injury, that D.C. was the right venue, and that plaintiffs have proven a likelihood of success on the merits, noting that the threat of administrative intrusion into the newsgathering process would likely deter protected speech and undermine newsgathering and reporting in violation of the First Amendment. The victory sets valuable precedent for journalistic outfits and other entities targeted by overreaching out-of-state AGs, allowing them to fight back without having to submit to the jurisdiction of the AG’s home state.

The Gibson Dunn team includes partners Ted Boutrous (Los Angeles), Amer S. Ahmed (New York), Anne Champion (New York), and Jay Srinivasan (Los Angeles), as well as New York associates Iason Togias and Apratim Vidyarthi.

In this recorded webcast, seasoned practitioners from Gibson Dunn’s Corporate and Antitrust practices discuss best practices and the latest developments in joint venture formation and operation, including:

1. Hot-button operating agreement provisions
2. Navigating transfer and exit considerations
3. Designing antitrust-compliant contractual provisions
4. Analysis and ramifications from recent antitrust enforcement actions

PANELISTS:

Robert B. Little is a partner in Gibson, Dunn & Crutcher’s Dallas office, and he is a Global Co-Chair of the Mergers and Acquisitions Practice Group. Mr. Little has consistently been named among the nation’s top M&A lawyers every year since 2013 by Chambers USA. His practice focuses on corporate transactions, including mergers and acquisitions, securities offerings, joint ventures, investments in public and private entities, and commercial transactions. Mr. Little has represented clients in a variety of industries, including energy, retail, technology, infrastructure, transportation, manufacturing and financial services.

Christopher M. Wilson is a partner in Gibson, Dunn & Crutcher’s Washington, D.C. office and a member of the firm’s Antitrust and Competition Practice Group. Mr. Wilson assists clients in navigating DOJ, FTC, and international competition authority investigations as well as private party litigation involving complex antitrust and consumer protection issues, including matters implicating the Sherman Act, the Clayton Act, the FTC Act, the Hart-Scott-Rodino (HSR) merger review process, as well as international and state competition statutes. His experience crosses multiple industries and his particular areas of focus include merger enforcement, interlocking directorates, joint ventures, compliance programs, and employee “no-poach” agreements.

Taylor Hathaway-Zepeda is a partner in the Los Angeles office of Gibson, Dunn & Crutcher. Her practice focuses on mergers, acquisitions, divestitures, joint ventures, equity investments, restructuring transactions and general corporate governance. She works with companies in a broad array of industries, and has extensive experience working with media, entertainment and technology companies and private equity sponsors. Ms. Hathaway-Zepeda currently serves on the Board of Directors of the California Chamber of Commerce and the Board of Directors of the Los Angeles Area Chamber of Commerce, where she is also Chair of the Governance Committee.

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