Richard Manfredi, Author at Gibson Dunn

New Colorado laws impose sweeping changes to employment practices, such as pay transparency, paid family and medical leave benefits, sick leave, nondisclosure provisions, and more.

On January 1, 2024, a flurry of new employment laws, regulations, and programs will go into effect in Colorado. The laws affect a broad range of employment issues, from job posting requirements to the launch of benefits for the State’s family-leave insurance program. Read together, these laws and regulations continue to add to Colorado’s reputation as one of the most employee-friendly jurisdictions in the United States.

In light of these new laws, employers may wish to review their employment policies and practices as they move into 2024. Additional detail about the most notable aspects of these laws is provided below, including steps employers could consider taking to ensure compliance.

I. Ensure Equal Pay for Equal Work Act (EEPEWA) – Effective January 1, 2024

Signed into law on June 5, 2023, the Ensure Equal Pay for Equal Work Act (“EEPEWA”) – which amends Colorado’s pay transparency law, the Equal Pay for Equal Work Act (“EPEWA”) – goes into effect on January 1, 2024. The EEPEWA, together with the Equal Pay Transparency (“EPT”) Rules issued by the Colorado Department of Labor and Employment (“CDLE”), create significant, new disclosure and notice requirements for employers with even one employee in Colorado.

Steps to consider: Most notably, to comply with the amended requirements, covered employers may consider undertaking the following:

provide notice of each “job opportunity” to employees;
disclose how to apply and the application deadline, in addition to information about compensation and benefits, in both external and internal covered job postings;
disclose certain information about selected candidates to employees with whom the candidate will likely work, and about how employees can express interest in similar jobs in the future;
provide notice to eligible employees of career-progression positions, including the requirements to progress, compensation, benefits, responsibilities, further advancement, and full-time or part-time status; and
continue to preserve records of wages and job descriptions.

Additional detail about the amendments to Colorado’s pay transparency law is provided below.

A. The EEPEWA Requires Employers to Announce “Job Opportunities.”

Under the EEPEWA, employers are required to take reasonable steps to ensure that every “job opportunity” is announced, posted, or made known to all Colorado employees on the same day and before any selection decisions are made. But employers physically outside Colorado that have fewer than 15 remote employees in Colorado need only provide notice of remote job opportunities through July 1, 2029.

The EEPEWA defines a “job opportunity” as a “current or anticipated vacancy” for which an employer is considering or interviewing candidates, or that an employer has posted publicly. Notably, a “job opportunity” does not encompass either “career development” or a “career progression.” “Career development,” as defined in the statute, refers to changes in an employee’s terms of “compensation, benefits, full-time or part-time status,” or job title that recognize an employee’s performance or contributions. And “career progression” means a “regular or automatic” movement from one position to another based on objective metrics, such as time spent in a role.

B. The EEPEWA Requires Disclosing Information About Job Opportunities, Career Progression, and Selected Candidates.

The EPT Rules provide that employers should include in both external job postings and internal job-opportunity notices the application deadline and information about how to apply, in addition to the already-required information about compensation and benefits for any job that can be performed in or from Colorado.

Furthermore, within 30 days of selecting a candidate for a job opportunity, the EEPEWA requires the employer to make reasonable efforts internally to disclose certain information about the selected candidate – at a minimum, to employees who will work with the new hire. This includes (a) the candidate’s name, (b) their former job title (if the candidate was an internal hire), (c) their new job title, and (d) information on how employees can express interest in similar job opportunities in the future. The regulations provide a limited exception to some of these requirements where disclosure would pose risks to a selected candidate’s health or safety.

For positions that constitute “career progression,” moreover, the EEPEWA requires employers to make available to “eligible employees” information about the requirements for such progression, in addition to information about each position’s compensation, benefits, full-time or part-time status, responsibilities, and further advancement. In new regulations issued by the CDLE, “eligible employees” are defined as “those in the position that, when the requirements in the notice are satisfied, would move from their position to another position listed in the notice.” Career progression notices should be made available to eligible employees shortly after beginning any position within a career progression, though employers retain discretion in how to provide these notices (e.g., in an employee’s new hire packet, on a company intranet page accessible by all eligible employees, etc.).

C. The EEPEWA Requires the CDLE to Take Further Protective and Investigative Measures.

Finally, the EEPEWA requires the CDLE to create and implement systems to accept and mediate complaints regarding violations of the sex-based wage equity provision of the EPEWA and create new rules as necessary to accomplish this purpose. Previously, the EPEWA simply permitted the CDLE to take these measures, but did not make them mandatory.

Furthermore, the EEPEWA requires the CDLE to investigate complaints or leads related to sex-based wage inequity (employing fact-finding procedures from the EPEWA), promulgate rules as needed, and order compliance and relief if a violation is found. However, these enforcement actions will “not affect or prevent the right of an aggrieved person from commencing a civil action.” Moreover, the EEPEWA allows plaintiffs bringing sex-based wage discrimination claims to seek back pay going back twice as long as they could previously: up to six years instead of three.

II. Family and Medical Leave Insurance Program (FAMLI) – Benefits Begin January 1, 2024

In November 2020, Colorado voters approved Proposition 118, which required the establishment of a state-run paid Family and Medical Leave Insurance (“FAMLI”) program. The program is mandatory for most employers with one or more employees working in Colorado. While most Colorado employers and employees began paying into the program in 2023, the program will begin providing paid leave benefits to employees starting on January 1, 2024.

Under the FAMLI program, workers generally can take off up to twelve weeks in a one-year period to: (1) care for a new child during the first year after their birth, adoption, or foster care placement; (2) care for a family member with a serious health condition; (3) care for an employee’s own serious health condition; (4) make arrangements for a family member’s military deployment; and/or (5) obtain safe housing, care, and/or legal assistance in response to domestic violence, stalking, sexual assault, or sexual abuse. Individuals with serious health conditions caused by pregnancy or childbirth complications are entitled to up to four additional weeks of FAMLI leave.

Under the law, employees can take the leave continuously, intermittently, or in the form of a reduced schedule, and there is no minimum amount of time the employee must work with a company to be eligible for leave. Employers are required to preserve the employee’s job (or a similar job) for them upon their return if they have worked at the company for at least 180 days. Employees may also choose to use sick leave or other paid time off prior to accessing FAMLI benefits, but cannot be required to do so. In addition, an employer and an employee may mutually agree (in writing) that the employee may use any accrued PTO or other employer-provided leave as a supplement to FAMLI benefits, in an amount not to exceed the difference between the employee’s FAMLI wage replacement benefits and the employee’s average weekly wage. Finally, employees enrolled in the state-run program apply for leave directly to the FAMLI Division, meaning that employers will receive a notice from the FAMLI Division that an employee has applied for FAMLI leave, then whether that period of leave has been approved, without employer discretion to approve or reject such requests.

Steps to consider: Going into 2024, employers should continue to file their premium payments and wage reports, as was already required in 2023. Employers also can update their total employee headcounts by January 31, 2024, to ensure they are charged the correct premiums each quarter. In addition, employers may want to designate on the “My FAMLI+Employer” portal a dedicated point of contact at the company to receive the relevant documentation from the FAMLI Division when an employee files a claim. Employers also can consider training HR employees and managers who handle leave requests from Colorado employees regarding the employer’s obligations and policies pursuant to the FAMLI Act.

Further, employers should update their FAMLI notices with the most updated version, available here. And employers may wish to update their leave policies to address the FAMLI program, with an eye toward ensuring compliance with the FAMLI Act’s notice and non-retaliation requirements, as well as explaining how FAMLI benefits can be used in coordination with other leave benefits the employer may offer, including those under the federal Family and Medical Leave Act. Employers also may want to consider whether to opt into a private plan instead, now that such plans are available.

III. Colorado Overtime and Minimum Pay Standards Order (COMPS Order) – Changes Effective January 1, 2024

The CDLE adopted the 39th edition of Colorado’s wage-and-hour regulations – the Colorado Overtime and Minimum Pay Standards Order (“COMPS” Order) – on November 9, 2023, which will take effect on January 1, 2024.

The new Order is mostly consistent with COMPS Order #38, but there are a few significant changes. Most notably, the COMPS Order purports to expand the definition of “time worked” (i.e., time that employers must compensate employees for) to include even an activity (or combination of multiple activities consecutively) of less than one minute, depending “on the balance of the following factors, as shown by the employer: (A) the difficulty of recording the time, or alternatively of reasonably estimating the time; (B) the aggregate amount of compensable time, for each employee as well as for all employees combined; and (C) whether the activity was performed on a regular basis.” The Order also clarifies rules around tip sharing, among other updates.

Steps to consider: Importantly, the Division also published the 2024 version of Colorado’s wage-and-hour poster and notice, which most employers are required to post and otherwise provide to employees. So employers should update their existing posters/notices with the new poster/notice, which is available here. In addition, employers may wish to consider whether they need to update any of their policies and/or train any employees in connection with the changes created by COMPS Order #39.

IV. Job Application Fairness Act (JAFA) – Effective July 1, 2024

In June 2023, Governor Polis signed into law the Job Application Fairness Act (JAFA), which restricts employers’ ability to inquire initially about applicants’ age. The law covers all public and private employers in Colorado, regardless of company size or industry. It also covers individuals who are “an agent, a representative, or a designee of the employer.”

Under the law, employers cannot ask applicants on an initial application to disclose their date of birth, dates of attendance at an educational institution, dates of graduation from an educational institution, or other similar inquiries that would disclose age (e.g., asking which election they first voted in). Employers may still request additional application materials, such as school transcripts, but are required to notify applicants that they may redact age-related information prior to submission.

The JAFA includes limited exceptions to allow employer compliance with age requirements imposed by or pursuant to: (1) a bona fide occupational qualification related to public or occupational safety, (2) a federal statute or regulation, or (3) a state or local statute or regulation based on a bona fide occupational qualification. However, CDLE guidance makes clear that an employer verifying compliance in an initial application still cannot ask an individual’s specific age.

For example, federal and state law prohibits minors from selling or serving alcoholic beverages. For an initial application for such a position, the employer could ask whether the applicant would be at least 18 when starting work. Only after a job offer was extended could the employer ask the applicant to provide evidence of their specific age without redacting age information.

Steps to consider: In light of this new law, employers may wish to review their job application materials to ensure they do not include any prohibited age-related inquiries. Employers also could consider training hiring managers and interviewers regarding when they may and may not make age-related inquiries.

V. Sick Leave, Nondisclosure Limitations, and Other Changes – Already in Effect Since August 7, 2023

A number of other Colorado employment laws passed in 2023 already went into effect on August 7, 2023. We’ve briefly summarized the most notable of these laws below, with additional detail available in our prior client alert about these laws.

A. New Limits on Nondisclosure Provisions and Other Changes

Wide-ranging amendments to Colorado’s anti-discrimination law took effect on August 7. The amendments void nondisclosure provisions that limit an employee’s ability to disclose or discuss alleged discriminatory or unfair employment practices, unless the nondisclosure provision satisfies certain conditions. Employers who violate this law face a potential $5,000 penalty for each instance in which they include in an agreement a noncompliant nondisclosure provision, as well as potential liability for actual damages, costs, and attorneys’ fees.

The amendments also modified the definition of harassment and replaced the “severe or pervasive” standard for such claims. In addition, the amendments impose limitations on the circumstances under which an employer may assert an Ellerth/Faragher-type affirmative defense (providing employers a safe harbor from vicarious liability resulting from sexual harassment claims against a supervisory employee), including requiring that the employer communicated to supervisors and non-supervisors the existence and details of its complaint and investigation/remediation process.

In addition, the amendments made “marital status” a protected class in Colorado. The amendments also imposed new recordkeeping mandates, requiring employers to maintain personnel and employment records for a minimum of five years, and to “maintain an accurate, designated repository of all written or oral complaints of discriminatory or unfair employment practices.”

Steps to consider: Employers may wish to review any agreements that include nondisclosure provisions, such as separation agreements, settlement agreements, and so on, to ensure those agreements comply with Colorado’s new requirements. Employers also could consider taking steps to ensure they are complying with Colorado’s expanded recordkeeping obligations. In addition, employers may wish to consider whether to update their handbooks and other EEO-related materials to include information about Colorado’s revised definition of harassment, the company’s anti-harassment investigation/remediation process, and the inclusion of marital status as a protected class. Employers also could consider training managers and HR employees on these issues.

B. Expansion of Paid Sick Leave

Since August 7, Colorado employees are allowed to take paid “sick” leave for qualifying bereavement- and disaster-related needs, in addition to the other uses of paid sick leave already required under the prior version of Colorado’s sick leave statute. The CDLE consequently updated the required paid sick leave poster/notice, which is available here.

Steps to consider: Employers may wish to (1) incorporate Colorado’s updated paid sick leave notice into their onboarding documents for Colorado employees and (2) post and provide the updated paid sick leave notice to current Colorado employees by the end of 2023. While not expressly required, it may also make sense to inform or remind HR employees and managers who handle leave requests from Colorado employees that the State has expanded the uses for which employees may use paid sick leave. Employers also could consider whether to update their sick leave and/or PTO policies to address Colorado’s expansion of paid sick leave.

The following Gibson Dunn attorneys prepared this update: Jessica Brown, Marie Zoglo, and Ming Lee Newcomb.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. To learn more about these issues, 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 partners:

Jessica Brown – Partner, Denver (+1 303.298.5944, [email protected])

Jason C. Schwartz – Co-Chair, Washington, D.C. (+1 202.955.8242, [email protected])

Katherine V.A. Smith – Co-Chair, Los Angeles (+1 213.229.7107, [email protected])

Class action filings continue to rise and present substantial exposure to companies. This article previews several issues that will impact these cases in the year ahead, including significant circuit splits and procedural disputes.

I. Three Circuit Splits to Watch …

There are several emerging circuit splits that may be ripe for Supreme Court review, including on ascertainability, “fail-safe” classes, and personal jurisdiction.

A. Ascertainability—What Good Is a Class If You Can’t Tell Who’s In It?

For years, courts have grappled with whether a Rule 23(b)(3) class can be certified if it’s not ascertainable. After all, what good does it do to certify a class if there’s no easy way to tell who is part of it? Most circuits agree that at a minimum, Rule 23 requires that a class be defined using objective criteria. Many practical-minded judges have further recognized that the text, structure, and purpose of Rule 23 also require a reliable and administratively feasible way to determine who is, and who is not, part of a certified class. The Third Circuit recently joined the First and Fourth Circuits in adopting this heightened ascertainability requirement as a formal Rule 23(b)(3) prerequisite. In re Niaspan Antitrust Litig., 67 F.4th 118, 133–34 (3d Cir. 2023); In re Nexium Antitrust Litig., 777 F.3d 9, 19 (1st Cir. 2015); EQT Prod. Co. v. Adair, 764 F.3d 347, 358 (4th Cir. 2014).

But not all courts agree, with some holding that there is no heightened requirement to “ascertain” class members before certification. For example, in Cherry v. Dometic Corp., 986 F.3d 1296, 1304 (11th Cir. 2021), the Eleventh Circuit reasoned that “administrative feasibility” is just one of many factors that courts can consider when assessing certification. In this decision, the Eleventh Circuit joined the Second, Sixth, Seventh, Eighth, and Ninth Circuits in rejecting a strict “ascertainability” requirement in Rule 23(b)(3). See id. at 1302. In the Eleventh Circuit’s view, “administrative difficulties … do not alone doom a motion for certification,” and “manageability problems will rarely, if ever, be in themselves sufficient to prevent certification.” Id. at 1304 (cleaned up).

But is the Eleventh Circuit right? As the Third Circuit observed, if “members of a Rule 23(b)(3) class cannot be identified in an economical and administratively feasible manner, the very purpose of the rule is thwarted.” Niaspan, 67 F.4th at 132. Ascertainability thus goes part in parcel with the objectives that rule makers had in mind when drafting Rule 23. Being able to actually identify class members protects absent class members by ensuring a way to disseminate the “best notice practicable” under Rule 23(c)(2) and helping them understand who is, and is not, bound by a class judgment. See id. at 132 (citing Marcus v. BMW of N. Am., LLC, 687 F.3d 583, 593 (3d Cir. 2012)).

The purpose of the class device is to “save[] the resources of both the courts and the parties by permitting an issue potentially affecting every [class member] to be litigated in an economical fashion under Rule 23.” Califano v. Yamasaki, 442 U.S. 682, 701 (1979). Even in circuits that may not recognize formal ascertainability as a prerequisite to certification, defendants should continue to raise these issues because the Supreme Court may eventually weigh in.

B. Fail-Safe Classes—Do They Fail Rule 23?

Can a class be defined based on the merits of the claim? One problem with a “fail-safe” class is that it creates a “heads I win, tails you lose” proposition for defendants: by defining a class as including only those entitled to relief, such a class would “shield[] the putative class members from receiving an adverse judgment,” because “[e]ither the class members win or, by virtue of losing, they are not in the class and, therefore, not bound by the judgment.” Randleman v. Fidelity Nat’l Title Ins. Co., 646 F.3d 347, 352 (6th Cir. 2011).

Several circuits—including the First, Third, Sixth, Seventh, and Eighth—have adopted a bright-line rule prohibiting fail-safe classes. See Orduno v. Pietrzak, 932 F.3d 710, 716 (8th Cir. 2019); McCaster v. Darden Rests., Inc., 845 F.3d 794, 799 (7th Cir. 2017); Byrd v. Aaron’s Inc., 784 F.3d 154, 167 (3d Cir. 2015); In re Nexium Antitrust Litig., 777 F.3d 9, 22 (1st Cir. 2015); Young v. Nationwide Mut. Ins. Co., 693 F.3d 532, 538 (6th Cir. 2012). Other circuits stop short of a per se prohibition, but have recognized that such classes are inherently suspect. See Olean Wholesale Grocery Coop., Inc. v. Bumble Bee Foods LLC, 31 F.4th 651, 669 n.14 (9th Cir. 2022) (en banc); Cordoba v. DIRECTV, LLC, 942 F.3d 1259, 1276–77 (11th Cir. 2019); EQT Prod. Co. v. Adair, 764 F.3d 347, 360 n.9 (4th Cir. 2014).

But a minority of circuits have rejected such a prohibition. See In re Rodriguez, 695 F.3d 360, 370 (5th Cir. 2012). Earlier this year, the D.C. Circuit declined to impose a prohibition against fail-safe classes. In re White, 64 F.4th 302 (D.C. Cir. 2023). Although it recognized the majority of circuits forbid (or at the very least, strongly discourage) “fail-safe” classes, the D.C. Circuit reasoned that the existing Rule 23 framework adequately addresses these problems. Id. at 312. However, the court did recognize that the issue “is an important, recurring, and unsettled question of class action law.” Id. at 310. The Supreme Court denied a petition for writ of certiorari from this decision, but it may be only a matter of time before this issue reaches the High Court.

C. Personal Jurisdiction in Class Actions—Does the Bristol-Myers Squibb Rule Apply to Nationwide Classes?

Bristol-Myers Squibb Co. v. Superior Court, 582 U.S. 255 (2017), ruled that a California state court could not assert jurisdiction over the tort claims of non-California plaintiffs against a non-California defendant. Since that decision, lower courts have considered whether this “mass tort” rule applies in class actions. In recent years, the Third, Sixth, and Seventh Circuits have held that Bristol-Myers Squibb does not apply in this context, because defendants litigate only against named plaintiffs and not absent class members. See Fischer v. Fed. Express Corp., 42 F.4th 366 (3d Cir. 2022); Lyngaas v. Curaden AG, 992 F.3d 412 (6th Cir. 2021); Mussat v. IQVIA, Inc., 953 F.3d 441 (7th Cir. 2020). These courts reason that “the named representatives must be able to demonstrate either general or specific personal jurisdiction, but the unnamed class members are not required to do so.” Mussatt, 953 F.3d at 447.

These holdings have drawn dissents. In Lyngaas, Judge Thapar argued that courts “cannot just assume that jurisdiction over the class representative’s claims confers jurisdiction over the claims of the class” because, under Bristol-Myers, courts “lack[] the power to decide the absent class members’ claims if they arise from wholly out-of-state activity.” 992 F.3d at 441 (Thapar, J., concurring in part and dissenting in part). Likewise, Judge Silberman dissented from a D.C. Circuit decision holding that this question was not ripe at the pleadings stage: “the class action mechanism … is not a license for courts to enter judgments over claims which they have no power.” Molock v. Whole Foods Mkt. Grp. Inc., 952 F.3d 293, 307 (D.C. Cir. 2020) (Silberman J., dissenting).

Although no court has held that Bristol-Myers expressly applies in the class action context, some courts have applied it to FLSA claims. See, e.g., Fischer, 42 F.4th at 380; Canaday v. Anthem Cos., 9 F.4th 392 (6th Cir. 2021); Vallone v. CJS Sols. Grp., LLC, 9 F.4th 861 (8th Cir. 2021); but see Waters v. Day & Zimmermann NPS, Inc., 23 F.4th 84 (1st Cir. 2022) (holding that Bristol-Myers does not apply to collective actions). In March, the Supreme Court declined a cert petition raising the FLSA issue. Fischer v. Fed. Express Corp., 143 S. Ct. 1001 (2023).

II. … and Four Trends We’re Watching

The following issues involving Article III, “mass” arbitrations, arbitration waiver, and class settlements also continue to percolate in the courts.

A. Article III Injury and Standing in Class Actions

While the Supreme Court has provided guidance on the interplay between class actions and Article III standing, lower courts continue to delineate the metes and bounds of standing for statutory violations—as we have discussed in prior quarterly updates here, here, and here. This question of statutory standing dovetails with another trend we have observed in recent years, which is the continued prevalence of privacy class actions (e.g., class actions alleging data breach, data collection/tracking, statutory privacy claims).

TransUnion LLC v. Ramirez, 594 U.S. 413 (2021), has proved to be a significant decision. In that case, the Supreme Court held that every member of a class certified under Rule 23 must establish Article III standing to be awarded individual damages. It further explained that “an injury in law is not an injury in fact,” and “[o]nly those plaintiffs who have been concretely harmed by a defendant’s statutory violation” have standing. Id. at 427. Although all class members had suffered a statutory violation (for inaccurate information on their credit reports and the company’s failure to disclose information required under the Fair Credit Reporting Act), most did not experience a “physical, monetary, or cognizable intangible harm” necessary to establish a concrete injury under Article III (because the inaccurate credit information was not disclosed to third parties). Id.

While TransUnion requires absent class members demonstrate standing to receive monetary damages, that case involved a jury verdict awarding each class member (including those who were not concretely harmed) both statutory and punitive damages. The Supreme Court did not address how courts should treat motions to certify where the class contains some number of uninjured absent class members, but instead stated that “[p]laintiffs must maintain their personal interest in the dispute at all stages of litigation” and a plaintiff “must demonstrate standing ‘with the manner and degree of evidence required at the successive stages of the litigation.’” TransUnion, 592 U.S. at 431. Courts have disagreed on whether a class may be certified when a single absent class member cannot prove Article III standing.

The majority of courts have held that classes with absent class members who lack standing may be certified, but only if the number of uninjured class members is “de minimis”—though the precise limits remain unsettled. While these cases generally predate TransUnion, they are currently still seen as good law, though TransUnion’s impact is still uncertain. For example, the D.C. Circuit acknowledged that the few decisions involving uninjured class members “suggest that 5% to 6% constitutes the outer limits of a de minimis number” of class members who are uninjured. In re Rail Freight Fuel Surcharge Antitrust Litig.- MDL No. 1869, 934 F.3d 619, 625 (D.C. Cir. 2019). Other courts have similarly held that a class may be certified when the class includes a small number of uninjured class members, but not when the number is so large to defeat predominance.[1]

The Ninth Circuit, on the other hand, rejected the D.C. and First Circuits’ categorical rule precluding certification of a class that includes more than a de minimis number of uninjured class members. Olean Wholesale Grocery Coop., Inc. v. Bumble Bee Foods LLC, 31 F.4th 651, 669 (9th Cir. 2022) (en banc) (“[W]e reject the dissent’s argument that Rule 23 does not permit the certification of a class that potentially includes more than a de minimis number of uninjured class members.”). The en banc court reversed a panel decision adopting the “de minimis” requirement, though it emphasized that individual questions of class members’ injury—both as an element of the underlying claim and as a requirement of Article III—can sometimes predominate over common questions, precluding certification under Rule 23(b)(3). Id.

Similarly, courts have applied the standing requirement inconsistently in the settlement context. In Drazen v. Pinto, the Eleventh Circuit held that every settlement class member must have standing before settlement class can be certified. 41 F.4th 1354, 1359 (11th Cir. 2022), rev’d on other grounds, 74 F.4th 1336 (11th Cir. 2023) (en banc); id. at 1362 (“when a class seeks certification for the sole purpose of a damages settlement under Rule 23(e), the class definition must be limited to those individuals who have Article III standing”). The Second Circuit, on the other hand, certified a Rule 23(b)(2) class where absent class members lacked standing, reasoning that “[s]tanding is satisfied so long as at least one named plaintiff can demonstrate the requisite injury.” Hyland v. Navient Corp., 48 F.4th 110, 117 (2d Cir. 2022).

B. The Continued Rise in “Mass” Arbitrations

In recent years, the Supreme Court has repeatedly recognized that arbitration clauses and class action waivers must be enforced according to their terms. See, e.g., AT&T Mobility LLC v. Concepcion, 563 U.S. 333, 339-344 (2011); Lamps Plus, Inc. v. Varela, 139 S. Ct. 1407, 1415 (2019); Epic Systems Corp. v. Lewis, 138 S. Ct. 1612, 1630-32 (2018). Many plaintiffs’ lawyers have responded to these decisions by filing “mass” arbitrations, often on behalf of claimants who have had no business dealings with the respondents. The strategy is to rack up thousands or millions of dollars in filing fees (which typically are borne solely by the respondents), and to extort a windfall settlement from a company.

This issue recently came to a head in an Illinois case now on appeal, Wallrich v. Samsung Electronics America Inc., No. 22-C-5506, 2023 WL 5935024 (N.D. Ill. Sept. 12, 2023). The plaintiffs filed petitions to compel arbitration on behalf of nearly 50,000 consumers, resulting in an assessment of $4.125 million in initial filing fees by the American Arbitration Association (AAA). Id. at *3. When the defendant declined to pay, plaintiffs filed an action to compel the defendant to arbitration and pay the fees. After dismissing the portion of claimants who failed to properly allege venue, the district court ordered Samsung to pay the filing fees for the 35,000 remaining claimants. Id. at *13. This ruling disregarded evidence that the claimants were leveraging the court and arbitration proceedings to extract a windfall settlement, as well as the fact that compelling arbitration was improper, given that the claimants could either pursue their claims in court or proceed in arbitration by fronting the filing fees. See Mot. to Dismiss Petition to Compel Arbitration, Wallrich v. Samsung Electronics America Inc., No. 22-C-5506 (N.D. Ill.). The court also refused to engage with the question of whether claimants’ filing of mass arbitration was inconsistent with the arbitration agreement’s prohibition on collective actions. Wallrich, 2023 WL 5935024 at *9. This case is now on appeal and is one to watch in 2024.

Wallrich demonstrates that mass arbitration can sometimes impose significant costs on defendants. The risk on both sides of the coin seems to have led to a somewhat slower rise in mass arbitrations than some expected. One survey—the 2023 Carlton Fields Class Action Survey—found that only 3.9% of companies had experienced mass arbitrations in the prior 12 months. See Carlton Fields, 2023 Carlton Fields Class Action Survey, at 29, https://www.carltonfields.com/getmedia/d71bff8d-56f9-4448-89e1-2d7ee3f8fe6a/2023-carlton-fields-class-action-survey.pdf. Nevertheless, practitioners have observed a growth of mass arbitrations, particularly in the consumer and privacy areas, and it is important for defendants to carefully consider how their arbitration agreements may be implemented in the mass arbitration context.

C. Arbitration Waivers After Morgan v. Sundance

Courts continue to grapple with the question of when defendants waive their right to arbitration following the Supreme Court’s 2022 decision in Morgan v. Sundance, 142 S. Ct. 1708, 1714 (2022), which eliminated the longstanding requirement that a party opposing arbitration on the grounds of waiver needed to demonstrate prejudice. Since that decision, while the waiver analysis remains highly fact specific, we have seen that courts are more willing to find waiver. For example, in Hill v. Xerox Business Servs., 59 F.4th 457 (9th Cir. 2023), the Ninth Circuit in a 2-1 decision found that the defendant waived its right to arbitration against absent class members by not moving to compel at outset of the case—even though those absent class members were not yet parties to the proceeding, as no class had been certified. Other circuits have also been more inclined to find waiver. See, e.g., White v. Samsung, 61 F.4th 334 (3d Cir. 2023).

Other circuits are less so willing to find waiver, particularly as to absent class members. For example, the Eighth Circuit concluded that defendant did not waive its right to compel arbitration against absent class members because there were no arbitration agreements with the named plaintiffs, and the defendant moved to compel arbitration promptly after the class was certified. See H&T Fair Hills, Ltd. v. Alliance Pipeline L.P., 76 F.4th 1093 (8th Cir. 2023). The issue of waiver, particularly as to absent class members, thus remains an issue we are actively monitoring going into the next year.

D. Continued Judicial Scrutiny of Class Settlements

Many class actions are ultimately resolved through settlement. Perhaps sparked by vocal objectors—and fueled by high-profile class settlements that are larger than ever—we have continued to see courts taking on active roles in scrutinizing class settlements. See, e.g., Kim v. Allison, 87 F.4th 994 (9th Cir. 2023) (scrutinizing adequacy of named plaintiff). Some of the more frequently litigated issues concern the scope of releases in class settlement agreements; potential conflicts of interest between the lead plaintiffs, counsel, and absent settlement class members; and plans of distribution. See, e.g., In re Blue Cross Blue Shield Antitrust Litig., 85 F.4th 1070 (11th Cir. 2023) (analyzing class releases, adequacy of representation, and fairness of distribution plan). Awards of attorney fees in connection with class settlements also continue to draw objections, with courts keeping a close eye on whether such awards are justified and reasonable. See, e.g., In re Broiler Chicken Antitrust Litig., 80 F.4th 797 (7th Cir. 2023) (vacating fee award and remanding for “greater explanation” to justify award); Lowery v. Rhapsody Int’l, Inc., 75 F.4th 985 (9th Cir. 2023) (holding fees should be based on actual, not theoretical, recovery by class). Because parties should expect potential objectors to scour settlements for potential weaknesses, settling parties review settlement terms carefully to ensure they withstand the watchful eye of objectors and judges alike. Defects in class settlements can result in increased administrative expenses, undermine the certainty and finality that class settlements afford to all parties, and delay the distribution of settlement benefits to the class.

Another issue receiving attention is the practice of awarding incentive awards to named plaintiffs in class settlements. These awards arose several decades ago, and have been increasingly common in class settlements. The theory is that the named plaintiff and class representative should be compensated above and beyond the class recovery, to “incentivize” people to serve as class representatives and to recognize the time and effort spent in discovery and for lending their names to the lawsuit. These awards had been largely non-controversial until a few years ago, when the Eleventh Circuit held that such incentive awards are impermissible under a century-old Supreme Court case prohibiting payment of salaries or expenses for a plaintiff that initiated litigation to preserve securities owed to himself and other creditors. See Johnson v. NPAS Solutions, LLC, 975 F.3d 1244 (11th Cir. 2020) (citing Trustees v. Greenough, 105 U.S. 527 (1882), and Cent. R.R. & Banking Co. v. Pettus, 113 U.S. 116 (1885)). So far, it does not appear there’s much appetite for other circuits to follow the Eleventh Circuit’s approach, and incentive awards remain permissible in all other circuits. The Supreme Court also denied a petition for review of the Eleventh Circuit’s Johnson decision, suggesting that the Eleventh Circuit will remain the outlier for the foreseeable future.

One final issue that bears watching is the rise of fraud in class settlement administration. In recent years, there have been reports of fraudulent claims activity in connection with some class settlements, including the use of automated “bots” to submit fraudulent claims en masse from suspicious IP addresses or email domains. These efforts have picked up considerably over the last year. This type of sophisticated fraud jeopardizes settlement approval, harms legitimate class members, and undermines trust in the process. While these criminals are using increasingly sophisticated technology to perpetrate fraud, settlement administrators are developing new tools to detect and weed out fraud during settlement administration. Parties should ensure that administrators are capable to handle these sophisticated fraud efforts.

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[1] See, e.g., In re Asacol Antitrust Litig., 907 F.3d 42, 47, 51-58 (1st Cir. 2018) (denying class certification when thousands of class members suffered no injury); see also Krakauer v. Dish Network, L.L.C., 925 F.3d 643, 657–59 (4th Cir. 2019) (rejecting argument that uninjured class members should preclude certification because “there is simply not a large number of uninjured persons”); Messner v. Northshore Univ. HealthSystem, 669 F.3d 802, 825 (7th Cir. 2012) (recognizing “‘a class should not be certified if it is apparent that it contains a great many persons who have suffered no injury at the hands of the defendant,’” but acknowledging “[t]here is no precise measure for ‘a great many’”); Cordoba v. DIRECTV, LLC, 942 F.3d 1259, 1277 (11th Cir. 2019) (stating that when a large portion of the class does not have standing, individualized issues may predominate).

The following Gibson Dunn lawyers contributed to this update: Christopher Chorba, Kahn Scolnick, Michael Holecek, Wesley Sze, Emily Riff, and Lena Cohen.

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])

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.

Any taxpayer seeking to transfer or receive a direct payment in respect of credits must complete a registration process and obtain a registration number for each eligible credit property before claiming the credit or refund.

On December 22, 2023, the IRS and Treasury unveiled their new pre-filing registration portal (available here) for transferrable and refundable tax credits under the Inflation Reduction Act of 2022 (the “IRA”)[1] and the CHIPS and Science Act of 2022 (the “CHIPS Act”). As discussed in greater detail in our earlier alerts about the transferability of IRA tax credits (available here) and the direct payment rules related to these credits (available here), any taxpayer seeking to transfer or receive a direct payment in respect of credits must complete a registration process and obtain a registration number for each eligible credit property before claiming the credit or refund. Without a registration number, no tax credit transfer or direct payment is permitted, so understanding the process for obtaining a registration number will be critical to taxpayers seeing to take advantage of IRA and CHIPS Act incentives.

In connection with rolling out the new pre-filing registration portal, the IRS provided detailed (64 pages, plus appendices) instructions (available here). These instructions explain how to access and use the pre-filing registration portal,[2] describe the information that must be submitted (including both general information applicable to all taxpayers using the portal and credit-specific information),[3] explain the process that taxpayers with multiple qualifying projects or facilities should use (including specifying procedures for bulk registrations),[4] describe the process that the IRS will utilize if it requires additional information from a taxpayer,[5] clarify which person is required to submit a registration (including addressing consolidated groups and disregarded entities),[6] and clarify the process that should be followed if facts change after a registration number is obtained.[7]

Although a comprehensive discussion of the portal and its explanatory instructions is beyond the scope of this alert, we have included ten, important observations below:

Lengthy Waiting Period Required – The instructions recommend that taxpayers make sure to budget 120 days for receipt of a registration number after submission, assuming no comments. This recommendation suggests that the IRS review period for submissions may be lengthy.

Get in Line Quickly – The instructions note that applications for registration numbers will be processed in the order in which the applications are received. Taxpayers seeking to transfer credits will want to move as quickly as possible to get in line.

Don’t Lose Your Spot in Line – If the IRS makes a follow-up request to an applicant before providing a registration number, but the applicant fails to respond that request in a timely fashion, the applicant will be pushed to the back of the line. For this reason, applicants should put in place processes to make sure they are carefully monitoring the IRS portal after submitting a request for a registration number.

One Registration Package Per Year – The portal allows only one registration package per taxable year per applicant. So, for example, even if an applicant has multiple facilities for which registration numbers are needed, that applicant can submit only one registration package. Once a package is submitted, no adjustments are allowed until the IRS has responded to the package. (An amended submission can be made, but only after the IRS has provided its response.)

Advisors May Not be Welcome – The portal requires the person applying for a registration for an entity transferor to certify that the person is “a corporate officer, partner, guardian, executor, receiver, administrator, trustee, or individual other than the taxpayer” and that they “have the legal authority to execute [the] authorization on behalf of the taxpayer.” The instructions go on to state that information submitted will be compared to information in IRS records and that errors in creating a portal account for a business result in a 24 hour lockout. Based on these statements, it is not clear whether an advisor can complete the registration on behalf of a taxpayer. It would be useful for the IRS to clarify whether representatives may assist in obtaining registration numbers.

Know Which EIN to Use – The instructions for the portal include detailed directions regarding employer identification numbers (“EINs”), including rules related to the EIN to use in the case of a disregarded entity (for disregarded entities owned by trusts/individuals, the disregarded entity’s name and EIN is used, and for disregarded entities owned by other taxpayers, the EIN and name of the regarded owner is to be used), and rules that apply to consolidated groups (the EIN for the consolidated parent must be utilized).

Collect Necessary Information and Documents in Advance – Applicants are required to submit detailed information, both about themselves and about the projects for which registration numbers are being sought. In addition, for many of the credits, various documents (or summaries of documents) are required. While this information (e.g., longitude and latitude coordinates that pinpoint a project location precisely (within inches)) and these documents will undoubtedly help guard against fraud, it is reasonable to anticipate that the burden on taxpayers will not be insignificant, and it will be important for applicants to collect all needed materials in order to make sure the submission process goes smoothly.

Bulk Submissions – The online application portal allows applicants to submit requests for registration numbers related to multiple facilities in bulk (using a spreadsheet that can be downloaded from the portal). This will be particularly useful for applicants that have many projects with many facilities (e.g., a wind farm), given that a separate registration number is required for each facility. As mentioned, however, each taxpayer is not allowed to have more than one application process outstanding at a particular time.

In-Service Dates Are Key. No pre-filing registration is allowed for a facility before the date on which the facility is placed in service. For tax credit transferees that demand that a registration number be obtained before the payment for tax credits, this feature may affect transactions or financings related to credits.

Watch Out for Traps – The pre-filing registration process prioritizes fraud prevention over flexibility. Thus, it is important to remember that a registration number is specific to a type of election (i.e., transfer vs. direct pay), type of credit, facility/property, tax period for the election, and the owner of the facility/property. If any of these changes, a new registration number will be required. For corporations, if a corporation has obtained a registration number and subsequently joins or leaves a consolidated group, a new registration number will be needed.

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[1] As was the case with the so-called Tax Cuts and Jobs Act, the Senate’s reconciliation rules prevented Senators from changing the Act’s name, and the formal name of the so-called Inflation Reduction Act is actually “An Act to provide for reconciliation pursuant to title II of S. Con. Res. 14.”

[2] The IRS and Treasury have partnered with ID.me, a third-party technology provider, to provide identity verification and sign-in services. The portal requires each taxpayer to create an account, and, if the person submitting the filing is not the taxpayer (e.g., in the case of transferors that are entities), mandates an authorization process, which requires submission of information about both the taxpayer and the person acting on behalf of the taxpayer

[3] All taxpayers must submit their name, address, entity type, bank account information (required for verification), tax period to which the election relates, types of tax returns filed by the taxpayer, and (if applicable) information about consolidated subsidiaries. In addition, information about the type of election being made (i.e., direct pay vs. transfer), key dates (including beginning of construction and placement in service) and facility/property location is required for many credits. Moreover, many credits require the submission of unique, credit-specific information or attestations. For example, for a taxpayer seeking to register production tax credits, an attestation is required that no investment tax credit under section 48 will be claimed for the facility/property.

[4] The portal requires that each taxpayer have no more than a single submission outstanding at a given time. The portal allows taxpayers who require numerous registration numbers to make a bulk submission using a specific format.

[5] Once a submission has been made, the IRS will utilize the portal to communicate with the taxpayer, although it is possible for taxpayers to opt into email alerts.

[6] The relevant rules are very specific, and not always intuitive, particularly the rules that apply to disregarded entities and consolidated groups. These rules are discussed in greater detail below.

[7] At a high level, and as discussed in greater detail later on in this alert, a new submission is generally required.

The following Gibson Dunn attorneys prepared this update: Mike Cannon and Matt Donnelly.

Gibson Dunn lawyers are available to assist in addressing any questions you may have about these developments. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Tax or Power and Renewables practice groups, or the authors:

Tax:
Michael Q. Cannon – Dallas (+1 214.698.3232, [email protected])
Matt Donnelly – Washington, D.C. (+1 202.887.3567, [email protected])

Power and Renewables:
Peter J. Hanlon – New York (+1 212.351.2425, [email protected])
Nicholas H. Politan, Jr. – New York (+1 212.351.2616, [email protected])

The case is an example in which the UK Competition and Markets Authority focused on innovation theories of harm in its assessment. It also is notable in that the proposed remedies would effectively amount to a prohibition of the proposed merger.

On 18 December 2023, Adobe and Figma (together, the “Parties”) mutually agreed to terminate their $20 billion merger deal (the “Proposed Merger”), after they concluded that there was “no clear path” to get clearance from EU and UK antitrust regulators. This case is an example in which the UK Competition and Markets Authority (“CMA”) focused on innovation theories of harm in its assessment, and is further notable in that the CMA’s proposed remedies would effectively amount to a prohibition of the Proposed Merger.

Background

On 13 July 2023, the CMA announced that it had decided to refer the Proposed Merger for an in-depth Phase 2 investigation under the Enterprise Act 2002. In its Phase 1 investigation, the CMA found that the Parties compete in the supply of: (i) screen design software (where Figma has established a substantial share of the market and Adobe has been continually making investments), and (ii) creative design software (where Adobe is the industry standard and Figma is an emerging competitive threat).

The CMA provisionally concluded that the merger may be expected to result in a substantial lessening of competition (“SLC”) in the global markets for: (i) all-in-one product design software for professional users, and (ii) certain creative design software (vector and raster editing software).

Theories of harm considered by the CMA focused on innovation and potential competition

SLC in all-in-one product design software

In its assessment of the potential SLC in all-in-one product design software, the CMA noted that Figma accounts for over 80% of the relevant market by revenue, and that Adobe’s competing product, Adobe XD, has a market share of 5-10%. Also, Adobe had significantly reduced investment in Adobe XD prior to the Proposed Merger, and had also cancelled the development of a new product design software (Project Spice) which would compete more strongly with Figma in product design. The CMA provisionally found that, absent the Proposed Merger, Adobe would have continued to be a close competitor of Figma through its innovation efforts in an all-in-one product design software.

SLC in vector and raster editing software

The competitive harm identified by the CMA in the market for vector and raster editing software was expansive in that the Parties do not currently compete in this market; rather, Figma is a potential competitor of Adobe. The CMA’s provisional conclusion was rooted in the premises that Figma has the ability and incentive to develop vector and raster editing functionality, and Adobe perceived Figma to pose a competitive threat, and undertook actions to mitigate this threat, for example through product development.

Notably, the CMA considered that the markets for vector and raster editing software on the one hand and product design software on the other are adjacent. Particularly, Adobe and Figma’s platforms are characterised by network effects, which cause the value of their respective platforms to increase with the number of users, and, importantly, operate across markets. This means, for example, that the value of Figma’s vector and raster editing offerings is greater the more Figma is used for product design, and vice versa. This consideration of network effects is indicative of the new focus by competition regulators on mergers that involve several linked markets (or “ecosystems”), a theory of harm that was central in the European Commission’s prohibition of the Bookings / eTraveli merger.

Remedies proposed by the CMA

In response to its provisional findings, the CMA only presented two possible structural remedies, in keeping with its preferred stance, in its notice to the Parties:

Prohibition of the merger (being regarded by the CMA as a “feasible remedy” that provides a “comprehensive solution”); and
Divestiture of overlapping operations to eliminate the SLC in each of the markets in which the CMA provisionally identified an SLC.

Despite presenting these two options, the CMA acknowledged that, as substantially all of Figma’s business is carried out in the all-in-one product software market, which includes its leading product, Figma Design, this would effectively mean that any ‘partial’ divestiture involving Figma operations would in reality be substantially similar to prohibition of the Proposed Merger.[1]

Likewise, as the CMA remained of the belief that, absent the Proposed Merger, Adobe would have continued to compete with Figma in all-in-one product design and has a strong position in an adjacent market, any partial divestiture involving Adobe assets may not be sufficient to restore the conditions of competition that would have prevailed absent the Proposed Merger.[2]

The CMA also considered, given the nature of the relevant products in the digital design sector, there may be an unacceptably high level of composition risk relating to identification, allocation and transfer of assets arising from the carve-out of any divestiture package; for example, Adobe’s businesses are closely integrated with its operations in creative design.[3]

Increased reliance by CMA on parties’ internal documents

The CMA’s provisional findings in Adobe / Figma also demonstrate its continued reliance on the internal documents of parties when considering evidence for a proposed merger, despite the Parties’ submission in this case that such evidence had been “mischaracterised and misunderstood” by the CMA. Importantly, the CMA considered that some documents evidenced concerns by Adobe’s management over the competitive threat from Figma weeks before the Proposed Merger was announced. The CMA’s approach in this case is reflective of a wider trend of the CMA increasingly relying on internal documents in merger investigations.

Parallel European Commission investigation also focused on innovation and potential competition

In parallel to the CMA’s probe, the European Commission (“EC”) opened a Phase 2 investigation into the Proposed Merger on 7 August 2022, citing similar competition concerns to the CMA in the markets for the supply of product design and digital asset creation tools. In its statement of objections, the EC set out the provisional view that the Proposed Merger may significantly reduce competition in both of these markets, with reasoning that was substantially similar to the CMA’s. Following the abandonment of the Proposed Merger, Executive Vice-President Vestager commented that the Proposed Merger “would have terminated all current and prevented all future competition between [the Parties]”, emblematic of the EC’s continued focus on innovation and the safeguarding of potential future competition.

Conclusion

The approach of the CMA and EC in the Adobe / Figma case indicates an intention on the part of the agencies to continue to be seen as strong enforcers, particularly in the tech space and anywhere innovation or future competition could be seen to be put at risk through merger activity. It serves as a warning that it is important for legal teams to acknowledge the scale of risks that a deal may pose and to address those risks upfront and early.

Key steps for companies contemplating deals that may raise these kinds of risks include building in sufficient time at the outset for thorough internal document review to pick up potential sources of concern, stress-testing of efficiencies and pro-competitive arguments, and early consideration of possible remedy packages. Early substantive engagement with the agencies’ possible theories of harm and potential remedies will also be key. In this respect, the proposed amendments to the CMA’s Phase 2 processes are intended to encourage exactly this kind of engagement.

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[1] CMA Notice of possible remedies (28 November 2023), paragraph 27.

[2] CMA Notice of possible remedies (28 November 2023), paragraphs 28 – 29.

[3] CMA Notice of possible remedies (28 November 2023), paragraph 31.

The following Gibson Dunn attorneys prepared this update: Deirdre Taylor, Attila Borsos, Molly Heslop, and Konstantinos Flogaitis.

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 Antitrust and Competition, Mergers and Acquisitions, or Private Equity practice groups, or the following authors and practice leaders:

Antitrust and Competition:
Attila Borsos – Brussels (+32 2 554 72 11, [email protected])
Rachel S. Brass – San Francisco (+1 415.393.8293, [email protected])
Ali Nikpay – London (+44 20 7071 4273, [email protected])
Cynthia Richman – Washington, D.C. (+1 202.955.8234, [email protected])
Christian Riis-Madsen – Brussels (+32 2 554 72 05, [email protected])
Deirdre Taylor – London (+44 20 7071 4274, [email protected])
Stephen Weissman – Washington, D.C. (+1 202.955.8678, [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])

Private Equity:
Richard J. Birns – New York (+1 212.351.4032, [email protected])
Wim De Vlieger – London (+44 20 7071 4279, [email protected])
Federico Fruhbeck – London (+44 20 7071 4230, [email protected])
Scott Jalowayski – Hong Kong (+852 2214 3727, [email protected])
Ari Lanin – Los Angeles (+1 310.552.8581, [email protected])
Michael Piazza – Houston (+1 346.718.6670, [email protected])
John M. Pollack – New York (+1 212.351.3903, [email protected])

The VCC Proposal enumerates certain factors that a CFTC-regulated exchange, such as a designated contract market or a swap execution facility, should consider.

On December 4, 2023, the Commodity Futures Trading Commission (the “CFTC” or the “Commission”) approved proposed guidance and a request for public comment regarding the listing for trading of voluntary carbon credit (“VCC”) derivative contracts (the “VCC Proposal”).[1] The VCC Proposal enumerates certain factors that a CFTC-regulated exchange, such as a designated contract market (“DCM”) or a swap execution facility (“SEF”)[2] should consider in connection with the relevant Commodity Exchange Act (“CEA”) requirements and CFTC regulations applicable to the design and listing of contracts. Comments on the VCC Proposal are due on or before February 16, 2024.

This alert provides a high-level summary of the VCC Proposal and related considerations for participants in the voluntary carbon markets.

Overview

The VCC Proposal represents the most recent development in the CFTC’s interest in the voluntary carbon markets and explains how the statutory “Core Principles”[3] apply to VCC[4] derivatives. In particular:

Recognizing that VCC derivatives are a relatively new set of products that continue to receive an increasing amount of attention, the CFTC issued the VCC Proposal as guidance for DCMs and SEFs to consider in the context of product design and listing.
The CFTC builds on private sector initiatives that are designed to foster the standardization of VCC derivatives and promote transparent and liquid markets. The CFTC specifically requested comment on whether it should require DCMs to incorporate any VCC standards set by the private sector into the terms and conditions of a VCC derivative contract.[5]
The CFTC referenced its regulatory authority over environmental commodity derivatives, as established in a joint product definition rulemaking with the Securities Exchange Commission following the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act.[6]
Critically, the CFTC does not have regulatory authority over the spot trading of VCCs. However, the CFTC does have enforcement authority over fraud and manipulation in the spot VCC market.[7] The VCC Proposal is an effort by the CFTC to promote integrity in the voluntary carbon markets by requiring more diligence on VCC derivatives, which can indirectly influence behavior in the spot market.[8]
DCM Core Principle 3 (a requirement that a DCM only list for trading contracts that are not readily susceptible to manipulation) and DCM Core Principle 4 (a requirement that a DCM prevent manipulation, price distortion, and disruptions of the physical delivery or cash-settlement process through market surveillance, compliance, and enforcement practices and procedures) form the foundation of the VCC Proposal.
The VCC Proposal addresses the product submission requirements under Part 40 of the CFTC’s regulations and CEA section 5c(c), as such requirements relate to VCC derivatives.
The VCC Proposal is limited in scope. As Commissioner Johnson stated, the CFTC “provides much-needed direction to DCMs (and SEFs) to facilitate their compliance with core principles when they list futures contracts (and swaps contracts) on VCCs. However, the Commission is only addressing one small aspect of the market for derivatives on these underlying assets. There is also a segment of the swaps market that is not traded on a SEF for which VCCs are underliers and an even more significant volume of environmental forwards that are not considered to be swaps. The VCC Proposal suggests the potential for a broader and more comprehensive regulatory framework… there may be several interventions that may bring similar needed reforms to over-the-counter traded environmental commodities—material risk disclosures, good faith and fair dealing, and clearing.”[9]

The CFTC and Voluntary Carbon Markets

The VCC Proposal states that there are now more than 150 derivative contracts on mandatory emissions program instruments listed on DCMs.[10] Eighteen futures contracts on voluntary carbon market products have been submitted to the CFTC by DCMs as of November 2023. Three of those eighteen contracts currently have open interest.[11]

Chairman Benham has increased the CFTC’s attention on carbon markets and environmental aspects of the derivatives and commodities markets in recent years.[12] For example:

In June 2022, Chairman Behnam held the first-ever Voluntary Carbon Markets Convening to address product standardization, integrity, and other matters related to the supply of and demand for high quality carbon credits.
Also in June 2022, the CFTC issued for public comment a request for information regarding the CFTC’s ability to regulate climate-related financial risk relevant to the derivatives markets and underlying commodities markets.
In July 2023, Chairman Behnam held the Second Voluntary Carbon Markets Convening to discuss private sector efforts on developing high quality carbon credits, market trends and developments, public sector initiatives, and to hear market participants’ concerns.

CFTC Guidance for DCMs Regarding the Listing of VCC Derivative Contracts

The VCC Proposal is not meant to modify or supersede the existing regulatory framework regarding the listing of derivative products by CFTC-regulated exchanges. The VCC Proposal focuses mainly on physically-settled VCC derivative contracts because, to date, all listed VCC derivative contracts are physically-settled. However, the CFTC noted that it “continues to believe that, with respect to cash-settled derivative contracts, an acceptable specification of the cash settlement price would include rules that fully describe the essential economic characteristics of the underlying commodity.”[13]

1. A DCM Shall Only List Derivative Contracts That Are Not Readily Susceptible to Manipulation.

The requirement that a DCM only list derivative contracts that are not readily susceptible to manipulation follows DCM Core Principle 3.[14] While the Commission acknowledges that “standardization and accountability mechanisms for VCCs are currently still being developed,” it has identified certain criteria, present in both mandatory and voluntary carbon markets, as critical to assessing the integrity of carbon credits. The VCC Proposal explains that the Commission “preliminarily believes” that a DCM should take into consideration quality standards, delivery points and facilities, and inspection provisions (which the CFTC refers to as “VCC commodity characteristics”) when designing a VCC derivative contract.

(A) Quality Standards

A DCM should consider transparency, additionality, permanence and risk of reversal, and robust quantification when addressing quality standards in the development of the terms and conditions of a VCC derivative contract.[15]

Transparency. The contract terms and conditions should include information that readily specifies the crediting program(s)[16] – and, as applicable, the specific types of projects or activities – from which VCCs that are eligible for delivery under the contract may be issued. Whether the crediting program(s) make such information publicly available is an important consideration.
Additionality. It is critical that the greenhouse gas emission reductions or removals of the underlying VCC would not have occurred but for the monetary incentive created by the sale of carbon credits. Information on the crediting program(s) assessment and testing of additionality may constitute an economically significant attribute of the underlying VCCs, which should be described or defined in the terms and conditions of a VCC derivative contract.
Permanence and Risk of Reversal.
- The crediting program(s) should be able to demonstrate that it has measures in place to adequately address the risk that VCCs issued for a project or activity may have to be recalled or cancelled due to carbon removed by the project or activity being released back into the atmosphere, or due to a reevaluation of the amount of carbon reduced or removed from the atmosphere by the project or activity.
- A DCM should consider whether the crediting program for a VCC has measures in place, such as “buffer reserves” or other mechanisms, that provide reasonable assurance that, in the event of a reversal, the VCC will be replaced by a VCC of comparably high quality that meets the contemplated specifications of the contract. (The risk of reversal may impact the risk management needs of VCC derivative market participants.)
Robust Quantification.
- A DCM should consider the methodology or protocol used by a crediting program to calculate the level of greenhouse gas emission reductions or removals associated with credited projects or activities.
- Given the current absence of a standardized methodology or protocol to quantify greenhouse gas emission reduction or removal levels (both across crediting programs and within a particular crediting program) with respect to different types of projects or activities, the Commission believes that a DCM that lists a VCC derivative contract should consider whether the crediting program for the underlying VCCs can demonstrate that the quantification methodology or protocol that it uses to calculate greenhouse gas emission reductions or removals for the underlying VCCs is robust, conservative, and transparent.
- A quantitative estimate of the deliverable supplies can be used as the basis for effectively setting the DCM’s exchange-set speculative position limits.

(B) Delivery Points and Facilities

Delivery procedures for a physically-settled derivative contract should, among other things, seek to minimize or eliminate any impediments to making or taking delivery by both deliverers and takers of delivery, to help ensure convergence of cash and derivative contract prices at the expiration of the derivative contract.[17]

With respect to a physically-settled VCC derivative contract, the CFTC “preliminarily believes” that a DCM should consider the governance framework and tracking mechanisms of the crediting program for the underlying VCCs, as well as the crediting program’s measures to prevent double-counting. In particular:

Governance. The CFTC stated that it may be appropriate for a DCM to include information about the crediting program’s governance framework in the terms and conditions of a physically-settled VCC derivative contract. Accordingly, in reviewing a crediting program’s governance mechanisms, a DCM should assess, at a minimum:
- Who is responsible for administration of the program and how the independence of key functions is ensured;
- Reporting and disclosure procedures;
- Public and stakeholder engagement processes;
- Risk management policies (including financial resources/reserves, cyber-security, and anti-money laundering policies); and
- Whether information regarding such procedures and policies is made publicly available.
Tracking.
- A DCM should ensure that the crediting program for the underlying VCCs can demonstrate that it has processes and procedures in place to help ensure clarity and certainty with respect to the issuance, transfer, and retirement of VCCs.
- A DCM should consider whether the crediting program operates or makes use of a registry that has measures in place to effectively track the issuance, transfer, and retirement of VCCs; to identify who owns or retires a VCC; and to make sure that each VCC is uniquely and securely identified. The CFTC suggested additional considerations would apply in the event that the registry also serves as the delivery point.
No Double Counting. The CFTC preliminarily believes that a DCM should consider whether the crediting program for the underlying VCCs can demonstrate that it has effective measures in place that provide reasonable assurance that credited emission reductions or removals are not double counted (i.e., VCCs cannot be issued to more than one registry and cannot be used after retirement or cancelation).
- Effective measures to ensure that emission reductions or removals are not double counted may include, among other things, procedures for conducting cross-checks across multiple carbon credit registries.

(C) Inspection Provisions – Third Party Validation and Verification

Any inspection or certification procedures for verifying compliance with quality requirements or any other related delivery requirements for physically-settled VCC derivative contracts should be specified in the contract’s terms and conditions and should be consistent with the latest procedures in the voluntary carbon markets.

A DCM should consider, among other things, how the crediting program for the underlying VCCs requires validation and verification that credited mitigation projects or activities meet the crediting program’s rules and standards.
Additionally, in designing a VCC derivative contract, a DCM should consider whether the crediting program has up-to-date, robust and transparent validation and verification procedures, including whether those procedures contemplate validation and verification by a reputable, disinterested party or body, and – more broadly – whether they reflect best practices.

2. A DCM Shall Monitor a Derivative Contract’s Terms and Conditions as They Relate to the Underlying Commodity Market.

DCM Core Principle 4 requires a DCM to prevent manipulation, price distortion, and disruptions of the physical delivery or cash-settlement process through market surveillance, compliance, and enforcement practices and procedures. With respect to a DCM’s monitoring of the terms and conditions of a physically-settled VCC, the CFTC preliminarily believes that such monitoring would include, at a minimum:

Ensuring that the underlying VCC reflects the latest certification standard applicable for that VCC by, among other things, amending the contract’s terms to correspond to any such update and monitoring the available deliverable supply in connection with the developments regarding new standards or certifications and
Maintaining rules that require their market participants to (i) keep records of their trading, including records of their activity in the underlying commodity and related derivatives market, and, importantly, (ii) make such records available to the DCM upon request.

3. A DCM Must Satisfy the Product Submission Requirements Under Part 40 of the CFTC’s Regulations and CEA section 5c(c).

The VCC Proposal highlights three submission requirements in connection with the listing of VCC derivative contracts.

The contract submission must include an explanation and analysis of the contract and its compliance with applicable provisions of the CEA, including the DCM Core Principles and CFTC regulations.
The explanation and analysis of the contract must “either be accompanied by the documentation relied upon to establish the basis for compliance with applicable law, or incorporate information contained in such documentation, with appropriate citations to data sources.”[18]
A DCM must provide any “additional evidence, information or data that demonstrates that the contract meets, initially or on a continuing basis, the requirements” of the CEA or the CFTC’s regulations or policies thereunder.[19]

The information provided to the CFTC in connection with the above may include qualitative explanations and analysis and is expected to be “complete and thorough.”

Conclusion

While the VCC Proposal’s scope is limited to exchange-traded VCC derivatives, it suggests implications for the over-the-counter VCC derivatives markets, as well as the VCC spot markets, including by providing DCMs and the CFTC greater insight into trading activity in the VCC spot markets. Accordingly, the comment process and the Commission’s guidance should play an important role in shaping the future of the voluntary carbon markets.

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[1] The VCC Proposal and statements by the Chairman and Commissioners are available at: https://www.cftc.gov/PressRoom/PressReleases/8829-23.

[2] As discussed in the body of the alert, the CFTC focuses on physically-settled VCC derivative contracts but “preliminarily believes that the [VCC Proposal] also should be considered by any SEF that may seek to permit trading in swap contracts that settle to the price of a VCC, or in physically-settled VCC swap contracts.” VCC Proposal at 20.

[3] See, generally, CEA Section 5(d), 7 U.S.C. 7(d).

[4] In footnote 31 of the VCC Proposal, the CFTC clarifies its use of the term “voluntary carbon credits” rather than “verified carbon credits.” The VCC Proposal concerns itself with “the quality and other attributes of the intangible commodity underlying a derivative,” while recognizing that the cash and secondary markets for voluntary carbon credits may avail themselves of the standard terms and templates published by the International Swaps and Derivatives Association (ISDA) for the trading and retirement of “verified carbon credits,”. See 2022 ISDA Verified Carbon Credit Transactions Definitions (“VCC Definitions”) Frequently Asked Questions, available at https://www.isda.org/a/jBXgE/2022-ISDA-Verified-Carbon-Credit-Transactions-Definitions-FAQs-061323.pdf.

[5] VCC Proposal at 38.

[6] Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping; Final Rule, 77 Fed Reg 48208, 48233-48235 (August 13, 2012). (“An agreement, contract or transaction in an environmental commodity may qualify for the forward exclusion from the “swap” definition set forth in section 1a(47) of the CEA, 7 U.S.C. 1a(47), if the agreement, contract or transaction is intended to be physically settled.”)

However, the VCC Proposal “does not address the regulatory treatment of any underlying VCC or associated offset project or activity, including whether any such product, project or activity may qualify as a swap or be eligible for the forward contract exclusion….” See VCC Proposal at footnote 68.

[7] See 7 U.S.C. § 9; 17 CFR § 180.1.

[8] This approach – providing guidance to DCMs for the listing of new or novel products – is similar to the CFTC’s approach to regulating Bitcoin futures and other digital assets. See e.g., “CFTC Backgrounder on Self-Certified Contracts for Bitcoin Products” (2017), available here.

[9] We note that swap dealers are subject to CFTC Regulation 23.600(c)(3)’s “New Product Policy” requirement and the external business conduct standards applicable to swap dealers (17 CFR Part 23 Subpart H).

[10] The CFTC explains that derivative contracts on mandatory emissions products have been trading since 2005, with greenhouse gas emissions-related products first listed in 2007. See VCC Proposal at 14.

[11] See VCC Proposal at footnote 51. (“The NYMEX CBL Global Emissions Offset (GEO) futures contract; the NYMEX CBL Nature-Based Global Emissions Offset (N-GEO) futures contract; and the NYMEX CBL Core Global Emission Offset (C-GEO) futures contract are currently the only listed futures contacts with open interest and trading volume. Information is available at: https://www.cmegroup.com/markets/energy/emissions/cbl-global-emissions-offset.volume.html.”)

[12] In his statement accompanying the VCC Proposal, Commissioner Benham stated that “The publication of this [VCC Proposal] and request for public comment marks the culmination of years of work with stakeholders such as farmers, foresters, end users, energy traders and associations, emission-trading focused entities, carbon-credit rating agencies, crediting programs, CFTC-registered exchanges and clearinghouses, and derivatives trade associations.”

[13] VCC Proposal at 19.

[14] CEA section 5(d)(3), 7 U.S.C. 7(d)(3). See also 17 CFR §§ 38.200-201.

[15] The VCC Proposal should be considered in light of recent issues involving the verification of carbon credits. For more detail on one issue, involving Verra, please refer to Gibson Dunn’s Carbon Markets Update – Q2 2023 at page 1, available here: https://www.gibsondunn.com/wp-content/uploads/2023/07/carbon-markets-update-q2-2023.pdf.

[16] Commissioner Goldsmith Romero focused on the role of crediting programs in her remarks, asking commenters to address “whether market integrity can be improved by exchanges relying on a crediting program’s processes and diligence, as assumed in the [VCC Proposal], or if there is a benefit to exchanges conducting additional due diligence into specific categories, protocols, or projects.”

[17] See Appendix C to Part 38 of the CFTC’s regulations, paragraph (b)(2)(i)(B)

[18] 17 CFR §§ 40.2(a)(3)(v) (for self-certification) and 40.3(a)(4) (for Commission approval).

[19] 17 CFR §§ 40.2(b) (for self-certification) and 40.3(a)(10) (for Commission approval).

The following Gibson Dunn attorneys prepared this update: Jeffrey Steiner, Adam Lapidus, and Hayden McGovern.

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 Derivatives practice group, or the following authors:

Jeffrey L. Steiner – Washington, D.C. (+1 202.887.3632, [email protected])

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

The Guidelines include some shifts from prior Agency guidance, although in practice they reflect many developments already seen at the Agencies under the Biden Administration’s leadership.

On December 18, 2023, the U.S. Federal Trade Commission (FTC) and Department of Justice (DOJ) (collectively, the Agencies) jointly released the final version of the 2023 Merger Guidelines following a public comment period on an earlier draft version released in July 2023. The Guidelines reflect the Biden Administration’s competition policy and provide guidance on the Agencies’ enforcement priorities. The Guidelines are now effective, and although they include some shifts from prior Agency guidance, in practice the Guidelines reflect many developments already seen at the Agencies under the Biden Administration’s leadership.

The final revised Guidelines include several notable changes from the July draft, including:

An expanded discussion of a transaction’s potential to harm competition by eliminating potential entrants or nascent competitive threats, making clear that the Agencies view their burden to prove the loss of potential competition is materially lower than that of parties to prove that third-party potential entrants will preserve competition;
A modified discussion of vertical merger enforcement that softens the prior draft’s presumption of harm, but expands the discussion of potential foreclosure risks associated with vertical deals; and
A reframing of “trends toward consolidation” as a framework for analyzing mergers in the broader context of developments in their industry rather than as an independent theory of harm.

Overall, the final Guidelines continue to reflect the Agencies’ increased skepticism of merger and acquisition activity, especially in concentrated markets, and attempt to revive seldom-used and novel theories of competitive harm, including some based on case law from many decades ago. While they reflect current enforcement guidance, the new Guidelines are not binding on the federal courts, and it remains to be seen whether courts in the future will find them persuasive as courts have done with the 2010 Merger Guidelines. Likewise, if there is an Administration change in 2025, we expect that there will be a significant, if not wholesale, “dialing back” of these revised Guidelines.

Potential Future Competition

The final Guidelines signal Agency intent to challenge more acquisitions where no immediate competitive overlaps exist between the merging parties under the theory that parties may nevertheless be potential future competitors or important partial constraints as part of a broader “ecosystem” of competitive industry participants. While courts have historically required the Agencies to show, at least by reasonable probability (noticeably greater than 50%), that merging parties will be future competitors,[1] the 2023 Guidelines generally articulate a lower burden for the Agencies to show harm to future competition.

The theme of preventing mergers from eliminating potential and nascent competitive threats reaches across multiple sections of the final Guidelines. In addressing vertical mergers, the Guidelines focus on mergers’ potential to prevent the entry of competitors in the relevant markets under investigation as well as related markets. And in addressing horizontal mergers, the Guidelines carefully distinguish between harm to competition from a merger’s elimination of a potential entrant and rebuttal claims by merging parties that likely or potential entry of new competitors will offset competitive effects. Notably, the Guidelines articulate two different standards for establishing the likelihood of potential entry: a lower standard for Agency claims that effects on a merging party’s potential entry can harm competition because the Agencies “seek to prevent threats at their incipiency,” and a higher standard for merging parties to show that potential entry by a third party can offset competitive harms because potential entrants only offer an attenuated effect on competition compared to active participants. It remains to be seen how courts will address the inconsistency in standards (and the Guidelines cite no case law to support the bifurcated proposition).

The final Guidelines also add new language addressing the effects of “ecosystem” competition in mergers where one or both parties offer a “wide array of products or services.” The Guidelines state that large incumbent firms who acquire small niche players offering non-competing services to the acquirer may nevertheless harm competition by reducing the “ecosystem” of services and products offered by multiple competitors that in concert may constrain larger incumbent firms. The final Guidelines single out markets undergoing “technological transitions” where new technological developments can create competitive threats to incumbent firms. Under this framework, the Agencies may recontextualize smaller acquired parties as “nascent threats” who offer “partial constraints” to large incumbent acquirers.

Vertical Mergers

The final Guidelines’ treatment of vertical mergers is markedly different from the July 2023 draft, reducing the draft version’s focus on categorical presumptions but expanding the discussion of potential harms.

While the draft Guidelines articulated a presumption of illegality when a merged firm has a “foreclosure share” above 50 percent, the final version notes in a footnote that this threshold is sufficient for a general inference of harm “in the absence of countervailing evidence.” In most regards, however, the Guidelines expand categories of potential harms resulting from vertical consolidation. For example, the Guidelines contain an expanded discussion of foreclosure concerns stemming from a vertical merger, including foreclosure of “routes to market,” referring to limiting market participants’ means of access to trading partners, distribution channels, or customers. The final Guidelines also expand on vertical mergers’ potential creation of barriers to entry by requiring potential entrants to invest in related products as well as the relevant product at issue in an investigation. Finally, the Guidelines expound on foreclosure incentives, articulating a low Agency burden of proof that the existence of close competition between merging parties alone signifies an incentive to foreclose rivals through direct or indirect downstream means.

Trends Toward Consolidation

The final Guidelines significantly alter and expand Guideline 7 (formerly Guideline 8 in the draft Guidelines) regarding industry trends towards consolidation. The draft Guidelines appeared to articulate an independent theory of harm that mergers could lessen competition by “contribut[ing] to a trend towards consolidation,” relying on language from the Supreme Court in General Dynamics “allow[ing] the Government to rest its case on a showing of even small increases of market share or market concentration in those industries or markets where concentration is already great or has been recently increasing.”[2]

By contrast, the final Guidelines now note that a trend towards consolidation is a “highly relevant factor” that may “heighten the competition concerns identified in Guidelines 1-6.” Rather than serve as an independent theory of harm on which the Agencies may challenge a merger, however, the Guidelines now articulate that mergers will be reviewed in the context of other industry consolidation activity, and the Agencies will analyze proposed transactions’ potential effect on potential future consolidation activity. The Guidelines discuss an “arms race” concern that consolidation can create leverage against participants in upstream, downstream, or other related markets that encourage further consolidation and generally reduce competition. Vertical mergers, while generally considered inherently procompetitive by courts due to synergies such as elimination of double-marginalization, are particularly susceptible to scrutiny where other market participants may move to vertically integrate to achieve similar efficiencies. Additionally, the Guidelines note that multiple mergers by different players in the same industry may be examined in context of one another, though the Guidelines do not expound further on how this may affect concentration calculations and to what extent trends towards consolidation could serve as a factor in enforcement action claims. The final Guidelines make clear, however, that merging parties must remain cognizant of wider industry merger and acquisition trends in analyzing risk of investigation in planned transactions.

Conclusions and Takeaways

The 2023 Merger Guidelines provide a window into the expanded and more aggressive antitrust enforcement characterizing Agency review of mergers under the Biden Administration.[3] Importantly, as noted, the Guidelines neither reflect nor create binding authority on merging parties. Rather, the Guidelines provide guidance on how and under what circumstances the Agencies will consider enforcement actions and the theories under which they may bring such actions. Actions brought under the enforcement policies articulated and expanded upon in the final Guidelines are subject to review by federal courts, assuming the parties decide to litigate. To prevail on the novel and expanded theories of harm in the Guidelines, the Agencies will ultimately need to persuade federal courts that these theories are supported by legal precedent. Nevertheless, merging parties should expect aggressive enforcement action by the Agencies that seek abandonment of mergers through lengthy investigations, procedural delay, and more frequent court challenges.

Firms considering transactions should continue to proactively consult with antitrust counsel early in the transaction consideration process to identify and mitigate risk. Gibson Dunn attorneys are closely monitoring these developments and are available to discuss these issues as applied to your particular business.

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[1] See, e.g., FTC v. Meta Platforms Inc., ___ F.3d __, 2023 WL 2346238, at *22 (N.D. Cal. 2023) (requiring a probability of entry “noticeably greater than fifty percent”). Other courts have imposed an even stricter standard, requiring the government to establish the likelihood of future entry with “clear proof.” FTC v. Atl. Richfield Co., 549 F.2d 289, 295 (4th Cir. 1977).

[2] United States v. General Dynamics Corp., 415 U.S. 486 (1974).

[3] See Gibson Dunn Client Alerts: U.S. Antitrust Agencies Release Updated Merger Guidelines (July 20, 2023); DOJ Signals Increased Scrutiny on Information Sharing (Feb. 10, 2023); FTC Proposes Rule to Ban Non-Compete Clauses (Jan. 5, 2023); FTC Announces Broader Vision of Its Section 5 Authority to Address Unfair Methods of Competition (Nov. 14, 2023); DOJ Antitrust Secures Conviction for Criminal Monopolization (Nov. 9, 2022); DOJ Antitrust Division Head Promises Litigation to Break Up Director Interlocks (May 2, 2022).

The following Gibson Dunn attorneys prepared this update: Kristen Limarzi, Stephen Weissman, Chris Wilson, Jamie France, Zoë Hutchinson, Logan Billman, and Kyla Osburn*.

Antitrust and Competition:
Rachel S. Brass – San Francisco (+1 415.393.8293, [email protected])
Kristen C. Limarzi – Washington, D.C. (+1 202.887.3518, [email protected])
Ali Nikpay – London (+44 20 7071 4273, [email protected])
Cynthia Richman – Washington, D.C. (+1 202.955.8234, [email protected])
Christian Riis-Madsen – Brussels (+32 2 554 72 05, [email protected])
Stephen Weissman – Washington, D.C. (+1 202.955.8678, [email protected])
Chris Wilson – Washington, D.C. (+1 202.955.8520, [email protected])
Jamie E. France – Washington, D.C. (+1 202.955.8218, [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])

*Kyla Osburn is an associate working in the firm’s Palo Alto office who is not yet admitted to practice law.

Gibson Dunn’s Pro Bono Committee is thrilled to announce the winners of this year’s Frank Wheat Memorial Awards. As in past years, this year’s winners (and nominees) all exemplify excellence and serve as an inspiration to us all. The nominees this year are as diverse as they are impressive, hailing from offices around the world and representing a wide variety of clients and interests. The common thread among these efforts and attorneys is unfailing determination to use their unique and privileged power as lawyers to make a difference in the lives of their clients and their broader global community.

Frank Wheat was a former Los Angeles partner, a superb transactional lawyer, SEC commissioner, and president of the Los Angeles County Bar. He was also a giant in the nonprofit community, having founded the Alliance for Children’s Rights in addition to serving as a leader of the Sierra Club and as a founding director of the Center for Law in the Public Interest. He exemplified the commitment to the community and to pro bono service that has always been a core tenet of the Gibson Dunn culture. Recipients of the Frank Wheat Memorial Award each receive a $2,500 prize to be donated to pro bono organizations designated by the recipients.

This year’s Frank Wheat Award winners showcase important aspects of the Firm’s diverse and vibrant pro bono practice, which includes advising small businesses and nonprofits, appellate litigation, immigration, racial justice and criminal justice reform, veterans advocacy, and many other important initiatives. In 2023, more than 1,700 Gibson Dunn attorneys around the world have devoted more than 150,000 hours to pro bono work. In total, these matters were valued at approximately $168 million.

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The case is particularly significant for limited partners in private equity and hedge fund managers organized as limited partnerships.

On November 28, 2023, the U.S. Tax Court (the “Tax Court” or the “Court”) issued its opinion in Soroban Capital Partners LP v. Commissioner,[1] holding that a “functional analysis test” must be applied in determining whether the “limited partner exception” to the imposition of Self-Employed Contributions Act (“SECA”) tax under section 1402(a)(13)[2] applies to limited partners in a limited partnership.[3] The case is particularly significant for limited partners in private equity and hedge fund managers organized as limited partnerships. Since the launch of its SECA tax compliance campaign in 2018,[4] the Internal Revenue Service (the “IRS”) has been pursuing self-employment tax audits of limited partnerships, limited liability companies, and limited liability limited partnerships. The campaign seeks to address the IRS’s contention that certain taxpayers have been improperly claiming to be “limited partners” for purposes of the “limited partner exception” from SECA tax.

The decision in Soroban Capital Partners LP (“Soroban”), amidst the IRS’s SECA tax compliance campaign, represents a meaningful victory for the IRS that, if sustained on appeal, could significantly limit the ability of many limited partners to assert that they are not subject to self-employment tax.

I. Background

SECA, enacted into law in 1954,[5] requires self-employed individuals to contribute to Social Security and Medicare by imposing a tax on their net earnings from self-employment. The SECA tax applies to “self-employment income,” defined – somewhat tautologically – in section 1402(b) as “net earnings from self-employment” (“NESE”). The SECA tax currently comprises two component parts: a 12.4 percent Social Security tax on the first $160,200 (for 2023) of NESE and 3.8 percent Medicare tax on all NESE.[6] The SECA tax applies to a partner’s distributive share of the partnership’s business income, unless an exception applies, and also applies to a partner’s guaranteed payments for services.

Section 1402(a)(13), enacted as part of the Social Security Amendments of 1977,[7] carves out an exception from NESE (the “Limited Partner Exception”) for “limited partners” that excludes “the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.” (Emphasis added). In enacting this exception, Congress was concerned that individuals were investing as limited partners in investment-related business ventures, paying a small amount of SECA tax, and thereby qualifying for future Social Security benefits. The Limited Partner Exception was intended to curb this perceived abuse.[8]

The scope of the Limited Partner Exception has been subject to some debate because the term “limited partner” is not defined in section 1402 or in the Treasury regulations and, in general, is not a term elsewhere defined in the U.S. federal tax law or commonly understood to have a particular meaning for U.S. federal tax purposes.[9] The emergence – in the 1990s and the first decade of this century – of so-called “hybrid entities,” such as limited liability companies (“LLCs”), limited liability partnerships (“LLPs”), and limited liability limited partnerships (“LLLPs”), which often are classified as partnerships for U.S. federal income tax law purposes, has given rise to questions as to the scope of interpreting and applying the Limited Partner Exception.

In 1994, the Treasury Department and the IRS issued proposed regulations defining “limited partner” for purposes of the Limited Partner Exception.[10] Those regulations were re-proposed in 1997.[11] The proposed regulations also applied to owners of entities other than limited partnerships, such as LLCs. These proposed regulations would have disqualified individuals from being considered limited partners if they bore personal liability for partnership debts, had authority to contract for the partnership, or participated in the partnership’s trade or business for over 500 hours during the partnership’s taxable year.[12] In response to negative reaction from parts of the U.S. media, Congress subsequently enacted a one-year moratorium preventing the finalization of the proposed regulations, due to a concern that the proposed change in the treatment of individuals who are limited partners under applicable state law would have exceeded Treasury’s regulatory authority.[13] In the twenty-five years that have passed since the expiration of the moratorium, neither the IRS nor Congress has clarified the definition of a “limited partner.”[14]

Although several cases have interpreted the Limited Partner Exception in the context of LLPs and LLCs,[15] until Soroban no case had interpreted the Limited Partner Exception in the context of a limited partner who owns a limited partner interest in a limited partnership. Somewhat ironically, Judge Buch wrote the only opinion in this area of the law holding that a member of an LLC classified as a partnership for tax purposes should be treated as a limited partner for purposes of the Limited Partnership Exception.[16]

II. Background to Soroban Capital Partners LP

Soroban, a Delaware limited partnership, is a hedge fund manager located in New York City. During 2016 and 2017, Soroban had four partners: three individual limited partners, each of whom was a limited partner, and Soroban Capital Partners GP LLC, a Delaware limited liability company, as the general partner. The general partner was owned indirectly by the three individual limited partners.

According to the limited partnership agreement, the general partner was to carry on the business and affairs of the limited partnership and had the ultimate authority to make decisions on behalf of the limited partnership. One of the limited partners served as the Managing Partner and Chief Investment Officer, another limited partner served as the Co-Managing Partner, and the third limited partner served as the Head of Trading and Risk Management of Soroban. Two of the limited partners had negative consent rights over certain enumerated actions of a fundamental nature. Each of the three individual limited partners devoted his full-time efforts to the activities of Soroban and its affiliates.

During the years at issue, Soroban made guaranteed payments for services to each of the three individual limited partners and allocated the remaining ordinary business income among all of its partners. Soroban reported the guaranteed payments, as well as the general partner’s share of ordinary business income, but not the limited partners’ shares of ordinary business income, as subject to SECA tax.

The IRS challenged Soroban’s position that the limited partners’ shares of ordinary business income were not subject to SECA tax and issued Notices of Final Partnership Administrative Adjustment (“FPAAs”) making adjustments to Soroban’s NESE for the years in issue. Soroban’s tax matters partner filed a petition in Tax Court challenging the FPAAs and then filed a motion for summary judgment requesting that the Court find as a matter of law that the Limited Partner Exception precludes the limited partners’ shares of ordinary business income from being subject to SECA tax.

III. The Court’s Analysis

Addressing the merits of the case,[17] the Court held that the “limited partner exception does not apply to a partner who, is limited in name only,”[18] even when that person is a limited partner in a limited partnership. The Court turned to principles of statutory construction to ascertain Congress’s intent, as neither section 1402(a)(13) nor applicable regulations define the term “limited partner.” The Court focused on the phrase “limited partner, as such.” In the Court’s view, if Congress had intended for limited partners to be per se excluded from the SECA tax, Congress could have simply used the term “limited partner” without “as such.” In support of its interpretation, the Court reviewed legislative history, stating that “Congress enacted section 1402(a)(13) to exclude earnings from a mere investment. It [Congress] intended for the phrase ‘limited partners, as such’ used in section 1402(a)(13) to refer to passive investors.”[19] The Court held that it must apply a “functional analysis test” to determine whether a limited partner in a limited partnership is a “limited partner, as such.”

In other words, the Court effectively concluded that there is no legally relevant distinction between limited partners in a limited partnership and the partners or members of the other entities (e.g., LLCs and LLPs) addressed under the Court’s prior precedent. This is a surprising expansion of the prior precedent given the very clear language of the Code and the much more obvious meaning of the words “as such,” reflecting a distinction between the distributive share of income received by an individual who is both a limited partner and a general partner in the limited partnership. As stated in the legislative history, “if a person is both a limited partner and a general partner in the same partnership, the distributive share received as a general partner would continue to be covered ….”[20] Thus, “as such” was a necessary clarification that only the distributive share of income attributable to the limited partnership interest is excepted from NESE.

IV. Implications

Because the Soroban opinion addressed only the legal question on summary judgment of whether a partner in a limited partnership is per se excluded from SECA tax, the Tax Court has not yet addressed whether the limited partners in Soroban satisfy the “functional analysis test,” which will depend on the specific facts and circumstances. Resolution of that issue will require further proceedings, including potentially a trial, for the Tax Court to hear evidence on and apply the functional analysis test.

We expect that, if, in applying that test, the Soroban limited partners are found not to be “limited partner[s], as such,” Soroban will appeal the Tax Court’s decision to the U.S. Court of Appeals for the Second Circuit. It is also possible that, to avoid a potentially unnecessary trial, Soroban could pursue an interlocutory appeal of the Tax Court’s summary judgment order, which would require approval of both the Tax Court and the Second Circuit to proceed. There has yet to be a circuit court review of section 1402(a)(13), and now appears to be an opportune time for such a review given both the legal history of this provision and the broad effects on taxpayers. A decision by the Second Circuit in the Soroban case, however, would only control Tax Court cases appealable to the Second Circuit. As a result, in cases appealable to other circuits, taxpayers or the IRS could be expected to continue to litigate the issue.

Currently, there are two other pending Tax Court cases relating to fund managers which raise the same arguments as Soroban, and the IRS is still actively auditing numerous partnerships as part of its SECA tax compliance campaign.

Please reach out to your Gibson Dunn lawyers for assistance with any IRS examinations on this topic or to determine how this case may influence your compliance with SECA tax obligations going forward.

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[1] 161 T.C. No. 12 (2023).

[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] Judge Buch authored the Soroban opinion, which is the second opinion he has written for the Tax Court applying section 1402(a)(13). See Hardy v. Commissioner, 113 T.C.M (CCH) 1070 (2017) (holding that a plastic surgeon’s distributive share of income from a surgical center organized as an LLC (classified as a partnership) was exempt from SECA tax under section 1402(a)(13) because he was a mere investor in the LLC).

[4] IRS Announces Rollout of Five Large Business and International Compliance Campaigns (March 13, 2018), available at https://www.irs.gov/businesses/irs-lbi-compliance-campaigns-mar-13-2018.

[5] Self Employment Contributions Act of 1954, c. 736, 68A Stat. 353.

[6] Section 1401(a), (b). The base Medicare tax is 2.9 percent, but it increases to 3.8 percent on NESE in excess of certain thresholds.

[7] Pub. L. No. 95-216, Title III, § 313(b), 91 Stat. 1536.

[8] H.R. Rep. No. 95-702, pt. 1, at 40-41 (1977).

[9] In 2011, the IRS issued proposed regulations under section 892 defining a “limited partner interest” as an interest held by a partner who does not have rights to participate in the management and conduct of the partnership’s business at any time during the partnership’s taxable year under the law of the jurisdiction in which the partnership is organized or under the governing agreement. REG-146537–06, 76 Fed. Reg. 68119 (Nov. 3, 2011). In addition, in 2011, the IRS proposed regulations under section 469(h)(2) that was intended to clarify the definition and tax treatment of “limited partners” for purposes of defining material participation in partnership activities. REG-109369-10, 76 Fed. Reg. 72367 (Nov. 23, 2011). Neither of these proposed regulations addressed the definition of a limited partner for purposes of section 1402.

[10] 59 Fed. Reg. 67253 (Dec. 29, 1994).

[11] REG-209824096, 62 Fed. Reg. 1701 (Jan. 13, 1997).

[12] Id., Prop. Treas. Reg. § 1.1402(a)-2(h)(2)(i)-(iii).

[13] Taxpayer Relief Act of 1997, Pub. L. No. 105-34, Title IX, § 935, 111 Stat. 882.

[14] Just weeks before issuance of the Tax Court’s decision in Soroban, the IRS and Treasury Department released the 2023-2024 Priority Guidance Plan, adding “[g]uidance under section 1402(a)(13)” and indicating a renewed interest in addressing the Limited Partner Exception through regulations or other published guidance. 2023-2024 Priority Guidance Plan, available at https://www.irs.gov/pub/irs-utl/2023-2024-priority-guidance-plan-initial-version.pdf.

[15] See, e.g., Renkemeyer, Campbell & Weaver LLP v. Commissioner, 136 T.C. No. 137 (2011). In Renkemeyer, the Court analyzed the legislative history of section 1402(a)(13) and concluded that its intent “was to ensure that individuals who merely invested in a partnership and who were not actively participating in the partnership’s business operations … would not receive credits towards Social Security coverage.” Id. at 150. The Court held that partners in a law firm organized as a limited liability partnership were not limited partners for purposes of section 1402(a)(13) because their “distributive shares arose from legal services … performed on behalf of the law firm” and not “as a return on the partners’ investments.” Id.

[16] See Hardy v. Commissioner, 113 T.C.M (CCH) 1070 (2017).

[17] The Court also held that, under the now-repealed TEFRA partnership audit rules, SECA tax adjustments constituted “partnership items” within the meaning of former section 6231(a)(3), giving it jurisdiction to decide the case. Soroban, 161 T.C. No. 12, slip. op. at 13-15. Under partnership audit rules enacted by the Bipartisan Budget Act (the “BBA”), which generally are effective beginning with the 2018 tax year, the treatment would be different as the BBA is limited to Subtitle A, Chapter I Income Tax and does not include the SECA tax under Subtitle A, Chapter 2.

[18] Soroban, 161 T.C. No. 12, slip. op at 11.

[19] Id.

[20] H.R. Rep. No. 95-702, pt. 1, at 40 (1977).

The following Gibson Dunn attorneys prepared this update: Michael Benison, Michael Desmond, Evan Gusler, Galya Savir, and Terrell Ussing.

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 (0) 20 7071 4232, [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])
Jeffrey M. Trinklein – London/New York (+44 (0) 20 7071 4224), [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 is of counsel working in the firm’s Los Angeles office who is admitted to practice in Washington, D.C.

In this article, originally published by Law360, we distill the array of major global AI developments to spotlight a narrow but vitally important area — practical insights for employers using AI in the workplace.

We have been witnessing an absolute whirlwind of artificial intelligence policy developments around the globe.

On Dec. 8, European Union policymakers reached a historic agreement on the AI Act — the world’s most comprehensive risk-based framework governing AI systems. Although details will be finalized in the coming weeks, the AI Act’s full set of requirements is expected to go into effect in approximately the next two years.

This is just the latest significant development in AI regulation and governance — following the release of the risk-based AI international code of conduct by G7 leaders, 18 countries signing onto international guidelines on safe AI development and deployment, and the UK’s AI Safety Summit.

Additionally, in the U.S., the White House recently issued its AI executive order. At the same time, AI-related developments have been continuing at the state level, including the California Privacy Protection Agency, or CPPA, publishing discussion draft regulations relating to automated decision-making technology.

Each of these developments shows keen interest in AI regulation and is a road map to the potential requirements and guardrails for those developing and deploying AI tools.

There is a recognition that AI has the potential to transform a range of industries, and that we are merely at the beginning of this technological journey.

In this article, we will seek to move past AI buzzwords and amorphous definitions to distill the array of major AI developments to spotlight a narrow — but vitally important area — practical insights for employers using AI in the workplace.

In particular, we will address how:

- The now officially forthcoming EU AI Act may impose compliance obligations on U.S. employers deploying AI systems;
- The U.S. Department of Labor’s new role as articulated under the AI executive order and recent coordinating efforts with two federal agencies is likely to result in increased AI enforcement actions and influence how AI in the workplace is regulated;
- The recently released draft AI guidance from the White House’s Office of Management and Budget — while not directly applicable to most companies, other than government contractors — is likely to be an instructive guide as to expectations at the federal level; and
- California’s recently published automated decision-making prerulemaking efforts might shape regulation at the state level.

Read More

Reproduced with permission. Originally published by Law360, New York (December 14, 2023).

The following Gibson Dunn attorneys prepared this article: Vivek Mohan and Emily M. Lamm.

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 in the firm’s Artificial Intelligence or Labor and Employment practice groups, or the authors:

Vivek Mohan – Palo Alto (+1 650.849.5345, [email protected])

Emily Maxim Lamm – Washington, D.C. (+1 202.955.8255, [email protected])

On November 1, 2023, the New York Department of Financial Services (“NYDFS” or “the Department”) finalized the amendments to its Part 500 Cybersecurity Regulation (the “Second Amended Cybersecurity Regulation”) and cemented its status as a proactive regulatory leader in the effort to protect consumer data, promote cybersecurity governance best practices, and keep pace with new cybersecurity threats and emerging technology.

In line with NYDFS’s risk-based approach to cybersecurity, and as previewed in its previous drafts, the Second Amended Cybersecurity Regulation introduces several notable changes, including expanded responsibility for senior governing bodies, obligations to implement additional safeguards, new requirements for larger companies, new and increased obligations related to written policies and procedures, heightened requirements around audits and risk assessments, and additional reporting requirements for cybersecurity incidents.

NYDFS’s cybersecurity regulation, 23 NYCRR Part 500 (the “Cybersecurity Regulation”), was first released in March 2017 and went into full effect in March 2019. A minor, ministerial amendment changing the date of the required annual certification was made in 2020 (the “First Amended Cybersecurity Regulation”). In July of 2022, NYDFS began the process of a thorough review and update to the regulation. Since then, NYDFS has issued three draft amendments—the initial Draft Proposed Second Amendment (published July 29, 2022), the Proposed Second Amendment (published November 9, 2022), and the Revised Proposed Second Amendment (published June 28, 2023)—and held two notice and comment periods with active stakeholder participation.

Key updates to the Cybersecurity Regulation, as reflected in the Second Amended Cybersecurity Regulation, are highlighted below:

Heightened Obligations for Senior Leadership and Governing Bodies

Under the Second Amended Cybersecurity Regulation, the “senior governing body” of a covered entity joins the Chief Information Security Officer (“CISO”) at the helm of the company’s cybersecurity apparatus. “Senior governing body” is broadly defined to account for the varied sizes, corporate structures, business models, and industries under NYDFS’s purview. A covered entity’s board of directors or equivalent governing body, a board committee, or senior officer(s) responsible for the entity’s cybersecurity program would all qualify as senior governing bodies under the updated regulation.

The senior governing body of a covered entity is required to exercise oversight of the covered entity’s cybersecurity risk management. At a minimum, this entails (i) having a sufficient understanding of cybersecurity-related matters; (ii) requiring management to develop, implement, and maintain the covered entity’s cybersecurity program; (iii) regularly receiving and reviewing management reports on cybersecurity; and (iv) confirming that sufficient resources are allocated in order to implement and maintain the cybersecurity program. Previously, a covered entity’s CISO was charged with ensuring sufficient allocation of resources to develop and maintain an effective cybersecurity system; in recognition of the fact that senior governing bodies, not CISOs, tend to make enterprise-wide resource allocation decisions, NYDFS shifted that responsibility to the senior governing body.

The Second Amended Cybersecurity Regulation also expands reporting obligations on the CISO, requiring the timely reporting of material cybersecurity issues to the senior governing body or senior officer(s), such as significant cybersecurity events and significant changes to the cybersecurity program.

Increased Investment in Cybersecurity Programs

The Second Amended Cybersecurity Regulation requires covered entities assess the adequacy of their governance practices and their investments in technology and personnel. In addition to significantly expanding the breadth of covered entities’ cybersecurity efforts by including “nonpublic information stored on the covered entity’s information systems” in its definition of “cybersecurity program,” NYDFS established additional requirements related to written policies and procedures.

Companies must have written incident response plans, business continuity and disaster recovery plans, and plans for investigating and mitigating cybersecurity events. As it did in the original Cybersecurity Regulation in 2017 for the then-novel incident response plans, NYDFS took care to enumerate a number of proactive measures intended to help covered entities formulate effective business continuity plans. The draft amendments related to business continuity and incident response plans remained largely the same throughout the process of reviewing and updating the regulation, though the Department did make a few practical and logistical changes.

Each covered entity must also implement written policies and procedures that are designed to produce and maintain a complete, accurate, and documented asset inventory of its information systems. NYDFS made a subtle adjustment to this provision from the June 2023 Revised Proposed Second Amendment, requiring covered entities to “produce and maintain” an asset inventory rather than “ensure” it exists—this is one of many instances where the Department made revisions geared toward providing covered entities with concrete guidance on how to navigate the cybersecurity landscape.

Separate Requirements for Larger “Class A” Companies

NYDFS codified heightened cybersecurity requirements for a newly defined class of larger entities, termed “Class A” companies. Throughout its drafting process, NYDFS iterated upon the scope and scale of Class A companies, and ultimately chose a relatively limited definition. Class A companies are those with an in-state gross annual revenue over $20 million in each of the last two fiscal years, and have had either (i) an average of more than 2,000 employees, or (ii) over $1 billion in gross annual revenue in each of the last two fiscal years. When calculating these figures, entities should include any affiliates that it shares information systems, cybersecurity resources, or a cybersecurity program with.

The Department has imposed several obligations on Class A companies, including to design and conduct independent audits of their cybersecurity programs based upon their respective risk assessments; monitor privileged access activity and implement privileged use management solutions; and implement security precautions such as centralized logging and notifications for security alerts, automatic rejection of common or simple passwords, and endpoint detection and response solutions for anomalous activity.

While the Revised Proposed Second Amendment published on June 28, 2023 would have required audits of Class A cybersecurity programs on an annual basis, the final Second Amended Cybersecurity Regulation introduces some flexibility by requiring audits at a frequency determined by the results of the entity’s risk assessments. This change reflects the Department’s understanding that designing and conducting annual audits may be a particularly burdensome, time-consuming, and resource-heavy endeavor given the size of Class A companies and the complexity of their cybersecurity programs. NYDFS did, however, add that Class A companies should design their audits, in addition to conducting them, which demonstrates NYDFS’s desire for covered entities to be engaged, comprehensive, and diligent about their cybersecurity efforts.

Additional Requirements for Audits and Risk Assessments

In earlier draft amendments, NYDFS had proposed strict requirements related to audits, risk assessments, and penetration tests, such as prohibiting the use of internal auditors and requiring covered entities retain external auditors. Many public commenters took issue with these proposals; in response, the Department expanded the pool of eligible auditors and experts to include internal personnel and reduced the rigidity of timetables for certain obligations. Under the Second Amended Cybersecurity Regulation:

An “independent” audit is one conducted by internal or external auditors, who are free to make their own decisions and are not influenced by the covered entity or its owners, managers, or employees;
Class A companies must re-review and update their risk assessments at least annually, and whenever changes to their business or technology result in a “material change” to the cyber risk they face;[1] and
Penetration testing of information systems must be performed annually by qualified internal or external “parties” (not necessarily by “experts,” as contemplated in the Proposed Second Amendment).

In addition, the Second Amended Cybersecurity Regulation includes a new requirement that risk assessments must “inform the design” of the cybersecurity program and enable adjustments in controls to address evolving cybersecurity and privacy risks. This includes general risks and those particular to the covered entity’s business operations.

Incident Notification Obligations

Covered entities should take note of the growing number and increased sophistication of cybersecurity events in recent years. In an effort to combat these threats, NYDFS established a new 24-hour notification obligation in the event a covered entity makes a ransom payment, and a 30-day window for covered entities to provide a written description of why the payment was necessary, alternatives to payment that were considered, and all diligence conducted to ensure compliance with applicable rules and regulations.

NYDFS narrowed the circumstances for which covered entities would have to provide NYDFS with notice by differentiating between “cybersecurity events” and “cybersecurity incidents.” Under the Second Amended Cybersecurity Regulation, entities must notify NYDFS only where the covered entity has determined that there is an incident at the covered entity, its affiliate, or a third-party service provider that: (i) impacts the covered entity and has triggered the notification requirement of another governmental body, self-regulatory agency, or other supervisory body; (ii) has a reasonable likelihood of materially harming normal operations of the covered entity; or (iii) results in the deployment of ransomware within a material part of the covered entity’s information systems.

NYDFS considered, but did not adopt, a requirement that entities notify the Department of any incident involving unauthorized access to a “privileged account,”[2] acknowledging that such an overbroad requirement would likely lead to overreporting and the inefficient use of resources.

Compliance Timeline

In general, entities have 180 days, or until April 29, 2024, to comply with the Second Amended Cybersecurity Regulation. However, several provisions have different specified transitional periods that override this general timeline:

Incident reporting requirements take effect 30 days after the effective date of the Second Amended Cybersecurity Regulation, or December 1, 2023.
Governance, encryption, incident response plan and business continuity management, and the limited exemption provisions take effect one year after the effective date of the Second Amended Cybersecurity Regulation, or November 1, 2024.
Vulnerability scanning, access privileges and management, and monitoring and training provisions take effect 18 months after the effective date of the Second Amended Cybersecurity Regulation, or May 1, 2025.
Multifactor authentication and asset management and data retention provisions take effect two years after the effective date of the Second Amended Cybersecurity Regulation, or November 1, 2025.

Looking Ahead

The proliferation of artificial intelligence (“AI”), generative AI, and large language models is on NYDFS’s radar[3] and may receive attention in a forthcoming round of amendments. Although NYDFS declined to dedicate a section of the Cybersecurity Regulation to these rapidly expanding technologies, it cautioned covered entities that cybersecurity risks associated with AI are “concerning” and should be taken into account in risk assessments and addressed in cybersecurity programs.[4]

The Second Amended Cybersecurity Regulation signals a significant shift in the cybersecurity regulatory landscape, reflecting NYDFS’s proactive efforts to empower covered entities to protect themselves against escalating threats of sophisticated and frequent cyber events. Organizations should assess their cybersecurity policies and practices to ensure that adequate controls, resources, and personnel are in place to comply with NYDFS’s regulatory changes.

__________

[1] NYDFS did not adopt its proposed requirement that external experts conduct risk assessments at least once every three years.

[2] Privileged account means “any authorized user account or service account that can be used to perform security-relevant functions that ordinary users are not authorized to perform, including but not limited to the ability to add, change or remove other accounts, or make configuration changes to information systems.” Section 500.1(n).

[3] Assessment of Public Comments on the Revised Proposed Second Amendment to 23 NYCRR Part 500, here.

[4] Assessment of Public Comments on the Revised Proposed Second Amendment to 23 NYCRR Part 500, here.

The following Gibson Dunn lawyers assisted in preparing this alert: Alexander Southwell, Stephenie Gosnell Handler, Vivek Mohan, Sara Weed, Cassarah Chu, Anne Lonowski, and Ruby Lang.

Gibson Dunn lawyers are available to assist in addressing any questions you may have about these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any member of the firm’s Privacy, Cybersecurity & Data Innovation practice group:

United States
S. Ashlie Beringer – Co-Chair, Palo Alto (+1 650.849.5327, [email protected])
Jane C. Horvath – Co-Chair, Washington, D.C. (+1 202.955.8505, [email protected])
Alexander H. Southwell – Co-Chair, New York (+1 212.351.3981, [email protected])
Matthew Benjamin – New York (+1 212.351.4079, [email protected])
Ryan T. Bergsieker – Denver (+1 303.298.5774, [email protected])
David P. Burns – Washington, D.C. (+1 202.887.3786, [email protected])
Gustav W. Eyler – Washington, D.C. (+1 202.955.8610, [email protected])
Cassandra L. Gaedt-Sheckter – Palo Alto (+1 650.849.5203, [email protected])
Svetlana S. Gans – Washington, D.C. (+1 202.955.8657, [email protected])
Lauren R. Goldman – New York (+1 212.351.2375, [email protected])
Stephenie Gosnell Handler – Washington, D.C. (+1 202.955.8510, [email protected])
Nicola T. Hanna – Los Angeles (+1 213.229.7269, [email protected])
Howard S. Hogan – Washington, D.C. (+1 202.887.3640, [email protected])
Kristin A. Linsley – San Francisco (+1 415.393.8395, [email protected])
Vivek Mohan – Palo Alto (+1 650.849.5345, [email protected])
Karl G. Nelson – Dallas (+1 214.698.3203, [email protected])
Rosemarie T. Ring – San Francisco (+1 415.393.8247, [email protected])
Ashley Rogers – Dallas (+1 214.698.3316, [email protected])
Eric D. Vandevelde – Los Angeles (+1 213.229.7186, [email protected])
Benjamin B. Wagner – Palo Alto (+1 650.849.5395, [email protected])
Sara K. Weed – Washington, D.C. (+1 202.955.8507, [email protected])
Michael Li-Ming Wong – San Francisco/Palo Alto (+1 415.393.8333, [email protected])
Debra Wong Yang – Los Angeles (+1 213.229.7472, [email protected])

Europe
Ahmed Baladi – Co-Chair, Paris (+33 (0) 1 56 43 13 00, [email protected])
Kai Gesing – Munich (+49 89 189 33-180, [email protected])
Joel Harrison – London (+44 20 7071 4289, [email protected])
Vera Lukic – Paris (+33 (0) 1 56 43 13 00, [email protected])

Asia
Connell O’Neill – Hong Kong (+852 2214 3812, [email protected])
Jai S. Pathak – Singapore (+65 6507 3683, [email protected])

This 60-minute webcast covers key developments to be aware of as you prepare your 2024 proxy statement, including:

Proxy season trends
Recent and upcoming SEC rulemaking
Investor and proxy advisor updates

Please join us for a discussion of these topics and questions provided by the audience.

PANELISTS:

Aaron K. Briggs is a partner in Gibson Dunn’s San Francisco, CA office, where he works in the firm’s securities regulation and corporate governance and ESG practice groups. Mr. Briggs’ practice focuses on advising public companies, with a focus on technology and life sciences companies, on a wide range of corporate governance, securities and ESG matters, including in going-public transactions. Before rejoining Gibson Dunn, Mr. Briggs served as Executive Counsel at General Electric Company. His in-house experience— which included responsibility for SEC reporting and compliance, board governance, proxy and annual meeting, investor outreach and executive compensation matters, and included driving GE’s redesign of its full suite of investor communications provides a unique insight and practical perspective on the issues that his clients face every day. Mr. Briggs is a frequent speaker on securities and ESG matters.

Julia Lapitskaya is a partner in Gibson Dunn’s New York office. She is a member of the firm’s Securities Regulation and Corporate Governance and its ESG (Environmental, Social & Governance) practices. Ms. Lapitskaya’s practice focuses on SEC, NYSE/Nasdaq and Securities Exchange Act of 1934 compliance, securities and corporate governance disclosure issues, corporate governance best practices, state corporate laws, the Dodd-Frank Act of 2010, SEC regulations, shareholder activism matters, ESG and sustainability matters and executive compensation disclosure issues, including as part of initial public offerings and spin-off transactions. Ms. Lapitskaya is a frequent author and speaker on securities law and ESG issues and is a member of the Society for Corporate Governance.

Based in Gibson Dunn’s Orange County office, Lauren Assaf-Holmes advises public companies across industries on a variety of ESG, compliance and related corporate law matters as a member of the firm’s Securities Regulation and Corporate Governance Practice Group. Lauren advises clients throughout the year on financial reporting and compliance matters in connection with Securities and Exchange Act reporting (including Section 16 and Schedule 13G/D reports), as well as beginning or expanding ESG-related reporting. She has contributed to the publication Legal Risks and ESG Disclosures: What Corporate Secretaries Should Know and presents on these and related topics.

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.

Gibson Dunn represented JPMorgan as dealer manager in connection with Perrigo’s tender offer for up to $300 million of its outstanding 3.9% senior notes due 2024. Gibson Dunn also represented JPMorgan as Administrative Agent and as a lead arranger in connection with Perrigo’s $300 million incremental term loan, the proceeds of which were used to finance the tender offer.

The Gibson Dunn team was led by Doug Horowitz, with Alex Plaia and Melody Karmana on the incremental term loan and Harris Quraishi on the tender offer.

Gibson, Dunn & Crutcher LLP acted for The Kingdom of Saudi Arabia in connection with a US$ 11,000,000,000 Senior Unsecured Term Loan Credit Facility coordinated and arranged by Industrial and Commercial Bank of China Limited, Dubai (DIFC) Branch. It is the largest loan in EMEA in 2023.

The Gibson Dunn team was comprised of partners Mahmoud Abdel-Baky, Laleh Shahabi and associate attorney, Galadia Constantinou.

Last month, Gibson Dunn announced the opening of its Riyadh office with a team that included seven partners, each of whom has extensive experience working with clients in Saudi Arabia. The firm has significantly expanded its presence in the Gulf in the last 12 months, adding 14 new partners and 19 new associates, the largest investment made in the region by any international firm during this time.

With ongoing volatility due to the conflict in the Middle East, the Russia-Ukraine conflict, and other global developments and trends, companies have been navigating a complex 2023 capital raising market. Join partners of Gibson Dunn’s Capital Markets and Securities Regulation and Corporate Governance practice groups, as they provide an overview of market activity in 2023 and how companies have reacted to the market impact of these developments. This webcast also discusses thoughts on 2024 capital raising and the key issues and opportunities that may impact companies considering capital raise transactions in the next year.

PANELISTS:

Andrew L. Fabens is a partner and 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.

Robert D. Giannattasio is a partner (effective January 1, 2024) in the New York office of Gibson, Dunn & Crutcher and practices in Gibson Dunn’s Capital Markets Practice Group, Securities Regulation and Corporate Governance Practice Group and Global Finance Practice Group. He has a broad corporate and capital markets practice representing issuers and underwriters on a variety of public and private debt and equity offerings, including acquisition financings, investment-grade and high-yield debt offerings, IPOs and follow-on equity offerings and liability management transactions. Robert has led a number of complex cross-border transactions and regularly advises companies on securities law and corporate governance matters, SEC reporting and disclosure issues.

Thomas J. Kim is a partner in the Washington D.C. office of Gibson, Dunn & Crutcher, LLP, where he is a member of the firm’s Securities Regulation and Corporate Governance Practice Group. Mr. Kim focuses his practice on a broad range of SEC disclosure and regulatory matters, including capital raising and tender offer transactions and shareholder activist situations, as well as corporate governance, environmental social governance and compliance issues. He also advises clients on SEC enforcement investigations – as well as boards of directors and independent board committees on internal investigations – involving disclosure, registration, corporate governance and auditor independence issues. Mr. Kim has extensive experience handling regulatory matters for companies with the SEC, including obtaining no-action and exemptive relief, interpretive guidance and waivers, and responding to disclosures and financial statement reviews by the Division of Corporation Finance. Mr. Kim served at the SEC for six years as the Chief Counsel and Associate Director of the Division of Corporation Finance, and for one year as Counsel to the Chairman.

Ben McNulty is an Executive Director in J.P. Morgan’s Debt Capital Markets group. His clients primarily include investment grade public companies in the TMT industry. He has advised on complex debt offerings, liability management exercises, loan syndications and general capital structure advisory.

Alice Takhtajan is a Managing Director in J.P. Morgan’s Equity Capital Markets group.

We are pleased to provide you with the next 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

DOJ, CFTC, Treasury, and Binance, CZ Reach Settlement
On November 21, Binance, the largest cryptocurrency exchange in the world, reached a settlement with the U.S. Department of Justice (DOJ), the Commodity Futures Trading Commission (CFTC), the U.S. Department of Treasury’s Office of Foreign Asset Control (OFAC) and Financial Crimes Enforcement Network (FinCEN), to resolve a multi-year investigation by the agencies and a civil suit brought by the CFTC. Attorney General Merrick Garland, Treasury Secretary Janet Yellen, and CFTC Commissioner Rostin Benham announced the multi-agency resolutions in a press conference. As part of the settlement, Binance agreed to pay $4.3 billion across the four agencies and pleaded guilty to conspiracy to conduct an unlicensed money transmitting business and violation of the International Emergency Economic Powers Act. The plea agreement requires Binance to engage in remedial compliance measures over a three-year probationary term and imposes an Independent Compliance Monitor, in addition to requiring the payment of fines and forfeitures. Concurrent with the company’s settlement, Binance’s founder Changpeng Zhao also pleaded guilty to one count of failing to maintain an effective AML program. NBC; CNN; ABC; Law360; CNBC; C-SPAN.
SEC Sues Kraken Cryptocurrency Exchange
On November 20, the SEC sued Kraken, the world’s third-largest crypto asset exchange, alleging that it operates as an unregistered securities exchange, broker, dealer, and clearing agency. The complaint’s allegations track those made in complaints against other crypto exchanges. The SEC’s complaint, filed in federal district court in San Francisco, seeks injunctive relief, disgorgement of ill-gotten gains plus interest, and penalties. SEC; Reuters; Fortune.
DOJ Seizes Millions of Dollars of Tether
On November 21, the Department of Justice seized $9 million worth of Tether (USDT), a U.S. dollar stablecoin, from accounts associated with “pig butchering” scams. These schemes involve scammers developing fake romantic relationships with victims, convincing them to transfer digital assets into fake exchanges before stealing the assets. Tether Limited, which manages Tether, had earlier frozen $225 million worth of USDT in accounts connected to these scams, from which the $9 million was seized. The operation was a collaboration between the Department of Justice, the U.S. Secret Service, and Tether Limited. CryptoNews; DOJ; Law360; CNBC.
SEC’s Crypto Enforcement Increases in 2023
The SEC announced their enforcement results for fiscal year 2023 which marked the third consecutive year that enforcement activity had increased since Chair Gary Gensler became head of the agency. While investment adviser cases, insider trading, and individual accountability cases saw a decrease in the 2023 fiscal year, cryptocurrency cases increased from 18 in fiscal year 2022 to 44 in fiscal year 2023. The SEC said it will continue to prioritize violations involving crypto in 2024. Law360.

INTERNATIONAL

Feds Seize and Sanction Sinbad, a North Korean-Linked Crypto Mixer
On November 29, Sinbad, a company that makes crypto transactions anonymous, was sanctioned by the U.S. Department of Treasury. Authorities have alleged that Sinbad washed millions of dollars of stolen cryptocurrency for North Korean state-backed hackers the Lazarus Group following high-profile digital heists. Sinbad is the third crypto mixer to face U.S. sanctions since 2022. Last month, the Financial Crimes Enforcement Network proposed rules to reclassify companies like Sinbad to bring them under its jurisdiction, which could require mixers to report some transactions to the federal government. Law360.
Montenegro Court Approves Extradition of “Cryptocurrency King” Do Kwon
On November 24, 2023, the High Court in Podgorica, Montenegro approved the extradition of Terraform Labs co-founder Do Hyeong Kwon to the United States or South Korea to face charges related to the collapse of stablecoin Terra USD. In February of this year, the U.S. Securities and Exchange Commission charged Kwon with orchestrating a multi-billion dollar crypto asset securities fraud. This followed South Korea’s issuance of a warrant for Kwon’s arrest in September of last year. Kwon agreed to be extradited to South Korea after serving a four-month sentence in Montenegro for document forgery. Montenegro’s justice minister will issue a final decision approving or denying extradition at the expiration of Kwon’s sentence. Reuters; Financial Times.

REGULATION AND LEGISLATION

UNITED STATES

New York State Announces New Crypto Regulations
On November 15, the New York State Department of Financial Services (NYDFS) unveiled new restrictions on crypto companies under the New York Financial Services Law. The restrictions require companies to submit for pre-approval policies regarding the listing and delisting of cryptocurrency coins. The submitted policies must include provisions on governance, risk assessment, monitoring, de-listing process, and execution. The new restrictions apply to digital currency businesses licensed under New York law and to limited purpose trusts under New York banking law. Covered businesses must meet with NYDFS by December 8 to discuss draft policies, and must submit final policies by January 31, 2024. Cointelegraph; N.Y. Dep’t Fin. Servs.
CFPB Proposes Rule to Supervise Nonbank Companies Offering Digital Wallets and Payment Apps
On November 7, the Consumer Financial Protection Bureau (CFPB) issued a proposed rule to supervise certain nonbank companies that offer services such as digital wallets and payment apps. The proposed rule would apply to nonbank payments companies providing general-use digital consumer payment applications that process more than five million consumer payment transactions per year and are not a “small business concern” as defined under the Small Business Act. The proposed rule defines “consumer payment transactions” as “the transfer of funds by or on behalf of a consumer physically located in a State to another person primarily for personal, family, or household purposes,” though it excludes certain transactions (including international money transfers). And it further asserts that “funds” include cryptocurrencies. The comment period for the proposed rule closes on January 8, 2024. CFPB.
Officials’ Questions at Hearing Suggest Further Tax Proposal Revisions to Come Following Crypto Industry’s Criticism
The IRS held a hearing on November 13 regarding its proposed crypto tax reporting rule, which has been heavily criticized by the crypto industry. The proposed rule would set forth reporting requirements and applicable definitions for digital asset brokers. At the hearing, IRS officials asked questions to clarify the criticism regarding the proposal’s wide definition of “brokers,” which as of now includes decentralized finance (DeFi) projects and wallet software. Industry representatives explained that there is no specific person that controls software used in DeFi and that it is therefore impractical to collect the information that would be required to be reported under the IRS’s proposal. In addition, the IRS asked questions relating to potentially excluding the stablecoin-reporting requirement. The industry has argued that the government should not track these transactions as taxable exchanges of assets. Furthermore, the IRS inquired about data privacy risks for consumers as a result of the proposed regulations. CoinDesk; Reuters.
Key Cryptocurrency Legislation Likely Delayed to 2024, Lawmakers Say
In recent months, legislators in Congress have introduced a series of bills to modernize the legal framework governing cryptocurrencies. These include the Financial Innovation and Technology for the 21st Century Act, introduced by Congressman French Hill (R-Ark.), Congressman Dusty Johnson (R-S.D.) and Congressman Glenn G.T. Thompson (R-Pa.) and the Clarity for Payment Stablecoins Act of 2023, introduced by Congressman Patrick McHenry (R-N.C.). Efforts to advance those bills had been sidelined as a leadership dispute roiled the House of Representatives following the ouster of Congressman Kevin McCarthy (R-CA) as Speaker of the House. Key proponents of the legislation have indicated that further progress on the bills is unlikely until at least early-2024. CoinDesk; CNBC.
FASB Says Cryptocurrencies to Be Measured at Fair Value
On December 13, 2023, the Financial Accounting Standards Board (FASB) promulgated new standards governing accounting for digital assets. Under the new standards, companies that hold bitcoin or ether will be required to record their holdings at fair value. The standards do not cover non-fungible tokens, stablecoins, and issuer-created tokens. Previous rules had required companies to record assets at their low values, which some had criticized as artificially depressing the reported value of cryptocurrency holdings due to temporary downturns in price. The FASB accounting standards will take effect after December 15, 2024, but companies may voluntarily adopt them sooner. Bloomberg; CoinDesk.

INTERNATIONAL

Hong Kong’s SFC Updates Guidance on Tokenized Securities-Related ActivitiesOn November 2, Hong Kong’s Securities and Futures Commission (SFC) published two circulars providing updated guidance to intermediaries engaging in tokenized securities-related activities and on the tokenization of SFC-authorized investment products. The SFC now considers tokenized securities to be traditional financial instruments that are securities which utilize blockchain (or similar) technology in their security lifecycle. This updated characterization supersedes the SFC’s previous March 2019 statement characterizing tokenized securities as complex products requiring extra investment protection measures and restricting their offering to professional investors. A detailed breakdown of the circulars is available in Gibson Dunn’s November 10, 2023 Client Alert. Gibson Dunn.
European Banking Authority Launches Public Consultation on Crypto Money Laundering
On November 24, the European Banking Authority initiated a public consultation program to gather opinions on “new Guidelines on preventing the abuse of funds and certain crypto-assets transfers for money laundering and terrorist financing purposes.” The proposed Guidelines set out procedures that payment service providers and crypto asset service provides must follow to “detect missing or incomplete information that accompanies a transfer of funds or crypto-assets” and to manage transfers ordered with less than complete information. The Authority will take comments on its published consultation paper until February 26, 2024, and will hold a virtual public hearing on the Guidelines on January 17, 2024. EBA 1; EBA 2.
Monetary Authority of Singapore Finalizes New Crypto Regulations
On November 23, the Monetary Authority of Singapore (MAS) issued a response to feedback on its proposed regulation of crypto service providers. In an effort to combat the encouragement of crypto speculation, with regard to retail persons, the regulation prohibits crypto service providers from financing crypto transactions, permitting margin transactions, or providing incentives to trade. Providers are barred from accepting locally issued credit card payments, and must assess customers’ risk awareness before permitting trading. The regulation also relaxes requirements for qualifying as an accredited investor by allowing a certain quantity of crypto assets to count toward the net-worth calculation. The MAS previously issued responses to feedback in July when it promulgated regulations requiring providers to deposit customer assets in a statutory trust for safekeeping and restricting providers from lending and staking cryptocurrency to retail investors. The rules will take effect in phases, beginning in mid-2024. CoinDesk; MAS 1; MAS 2; MAS 3.
Countries Announce Intent to Implement the OECD’s Crypto Reporting Framework
The Organization for Economic Cooperation and Development (OECD) released the Crypto-Asset Reporting Framework (CARF) in October 2022, which focused on ensuring crypto-assets are not used for illicit purposes such as tax evasion. This month, 48 jurisdictions, including the U.S., U.K., France, Spain, Germany, Canada, and Japan, announced their intent to implement the CARF by 2027. Erika Nijenhuis, a U.S. Department of Treasury official, said earlier that regulations to implement the CARF were in process and that the Treasury can require reporting for much of what the CARF covers. Law360.
U.K.’s Financial Conduct Authority Licenses Crypto.com As Electronic Money Institution
On December 4, the U.K.’s Financial Conduct Authority granted crypto exchange Crypto.com a license to operate in the country as an Electronic Money Institution. Crypto.com plans to use the license to “offer a suite of UK-localised e-money products,” according to a press release. Since August 2022, the firm has held the status of a registered crypto-asset business in the U.K., but the new license will enable it to provide cash placements and withdrawals from payment accounts; to execute payment transactions; to issue payment instruments; to remit money; and to issue electronic money. Conversely, the license restricts Crypto.com from hiring agents or using distributors and from providing payment services unrelated to those licensed. Other crypto exchanges hold similar licenses in the U.K. CoinDesk; Crypto.com; Financial Conduct Authority; Crypto.news.
South Korea Proposes New Consumer Protection Rules for Cryptocurrency
In June of this year, South Korea’s lawmakers approved the Virtual Asset User Protection Act, which defined digital assets and imposes penalties for trading such assets on nonpublic information, manipulating markets, or otherwise engaging in unfair trading practices. The legislation also gave South Korea’s Financial Services Commission power to oversee cryptocurrency firms and asset custodians. On December 11, 2023, the country’s Financial Services Commission promulgated comprehensive regulations to effectuate the new law. The proposed rules (a) broaden the range of covered tokens, (b) prescribe standards for custodying digital assets, (c) require virtual asset service providers (VASPs) to store 80% or more of customer assets in cold wallets, (d) mandate certain insurance and reserve baselines to prevent catastrophic losses in the event of hacking or technological failures, (e) specify when nonpublic information becomes public, (f) limit when VASPs may block customer deposits and withdrawals, and (g) require VASPs to monitor abnormal transaction activity. Bloomberg; CoinDesk; S.K. Financial Services Commission.
Regulators Approve El Salvador’s “Bitcoin Bonds”
In January 2023, El Salvador’s lawmakers approved a bill authorizing the issuance of sovereign “Bitcoin bonds.” El Salvador’s National Bitcoin Office (ONBTC) announced on Monday that the country’s Digital Assets Commission had approved issuing the bonds, known colloquially as the “Volcano Bond” – a reference to geo-thermal energy sources used to support the country’s mining operations. According to ONBTC, the bonds are expected to issue in the first quarter of 2024 on the Bitfinex Securities Platform, a registered trading site for blockchain-based assets in El Salvador. Cointelegraph; Yahoo.

CIVIL LITIGATION

UNITED STATES

Celsius Network Faces Roadblock in Pivot to Bitcoin Mining After Winning Initial Ch. 11 Plan Approval
On November 30, Chief Judge Martin Glenn of the U.S. Bankruptcy Court for the Southern District of New York said that Celsius Network, the bankrupt cryptocurrency investment platform, may have to seek a new creditor vote on its proposed transformation into a bitcoin mining business. This development comes just days after Judge Glenn signed an order confirming the initial Chapter 11 plan of Celsius. Under that plan, crypto consortium Fahrenheit LLC would acquire Celsius’ assets and focus on mining new bitcoin and on earning “staking” fees by validating blockchain transactions. Customers who had Celsius accounts at the time of the bankruptcy would receive pro rata distributions of the company’s remaining cryptocurrency and preserve their right to pursue claims against parties accused of manipulating the price of Celsius’ tokens prior to the bankruptcy.However, Celsius scaled back its post-bankruptcy business plans to focus only on bitcoin mining after receiving feedback from the SEC. Although the SEC did not explicitly oppose Celsius’ bankruptcy plan before it was approved, Celsius claims that the SEC is unwilling to approve crypto lending and staking activity. Judge Glenn expressed frustration with the late pivot, saying that he had been a “broken record” about Celsius’ need to reach agreement with the SEC. Law360; Reuters.
Genesis, Digital Currency Group Reach Agreement on New Settlement Plan
A recent bankruptcy filing revealed that Genesis Global and its parent company, Digital Currency Group (DCG), have agreed on a repayment plan to settle their lawsuit. In September 2023, Genesis sued DCG seeking repayment of over $600 million in loans. The settlement plan shows that DCG has already settled roughly $227.3 million of its debt to Genesis and lays out a plan for an additional $275 million to be paid by April 2024 using a combination of U.S. dollars and bitcoin. The settlement also includes other consideration. CryptoSlate.
Genesis Sues Gemini to Recover ‘Preferential Transfers’ Worth $689M
On November 21, Genesis Global, a crypto lender, sued cryptocurrency exchange Gemini Trust Co, for allegedly making preferential transfers of approximately $689 million. Genesis filed for bankruptcy in January 2023. Genesis alleges that, before the bankruptcy filing, Gemini made “unprecedented withdrawals” that contributed to a “run on the bank.” Gemini has stated that the claims are “baseless and inflammatory.” Reuters; CoinDesk.
FTX Says IRS Tax Estimate Is $24 Billion Too High
On November 29, FTX asked a Delaware bankruptcy judge to set its tax bill at $0 claiming that the IRS is estimating $24 billion in claims without evidence. Given its collapse in November 2022, FTX is arguing that it has no tax liability. FTX expects to seek votes for its Chapter 11 plan in March and asked for a hearing with the IRS in February to resolve this issue beforehand as it has the potential to derail these Chapter 11 cases. After the IRS began an audit of FTX’s taxes, it had originally estimated claims at $44 billion before being revised in November to $24 billion. FTX is concerned that these claims could halt plan confirmation and indefinitely delay distributions on allowed claims to customers and creditors. Law360.

INTERNATIONAL

FTX Investors Sue MLB, F1 Team Over Crypto Promotions
On November 27, FTX investors filed three class action suits in Florida federal court against Major League Baseball, Mercedes-Benz’s Formula One race team, and media companies Wasserman Media Group LLC and Dentsu McGarry Bowen LLC for promoting FTX. The investors claim that all the organizations failed to conduct adequate due diligence on FTX and “aided and abetted FTX’s deceptive marketing practices.” Further, the suits allege that the organizations had a pivotal role in deceiving the public through their promotion of FTX. Law360.

SPEAKER’S CORNER

UNITED STATES

Presidential Candidate Vivek Ramaswamy Shares Crypto Plan
On November 16, Republican presidential candidate Vivek Ramaswamy shared his plan for regulating digital assets. Ramaswamy advocated for classifying most cryptocurrencies as commodities rather than securities, and has been critical of SEC Chair Gary Gensler’s unwillingness to share how he thinks ether should be classified. Ramaswamy also shared that his administration would not target software developers just for writing code and would leave unhosted wallets unregulated. Fellow GOP candidate Ron DeSantis also has pledged to “defend the right of Americans to hold digital assets without government interference.” CoinDesk; Washington Examiner.

INTERNATIONAL

Singapore to Pilot Use of Wholesale Central Bank Digital Currencies in 2024
On November 16, Ravi Menon, Managing Director of the Monetary Authority of Singapore (MAS), announced Singapore’s plan to pilot the live issuance and use of wholesale central bank digital currencies (CBDCs) in 2024. Previously, the MAS had only simulated the issuance of wholesale CBDCs within test environments. The MAS will soon partner with local banks to pilot the use of wholesale CBDCs as a common settlement asset in domestic payments. Banks will have the ability to issue tokenized bank liabilities that represent claims on their balance sheets. Retail customers can utilize these tokenized bank liabilities in transactions with merchants who, in turn, can credit these liabilities with their respective banks. MAS; CNBC.
IMF Says Central Bank Digital Currencies Can Replace Cash
On November 15, Kristalina Georgieva, Managing Director of the International Monetary Fund (IMF), said that central bank digital currencies (CBDCs) have the potential to replace cash in island economies where the distribution of physical currency is costly. Georgieva encouraged the public sector to prepare for the deployment of CBDCs and related payment platforms in the future, noting that such technologies could potentially improve financial inclusion and financial literacy. Georgieva noted that the success of CBDCs will ultimately rely on policy decisions, how technologies evolve, personal privacy and data security, and how the private sector responds. The IMF has said that more than 100 countries are exploring CBDCs, with countries such as Jamaica, Nigeria, and the Bahamas having already issued retail CBDCs. CNBC.

OTHER NOTABLE NEWS

Gibson Dunn Debuts Fintech and Digital Assets Practice
On November 13, Gibson, Dunn & Crutcher LLP announced its fintech and digital assets practice group. The practice group consists of 40 attorneys and is co-chaired by three Washington, D.C. partners, M. Kendall Day, Jeffrey Steiner, and Sara Weed. These attorneys will “advise traditional and emerging companies on the most complex investigations and enforcement actions brought by regulators in critical markets in the United States, Europe, and Asia.” Working alongside their colleagues in other practice areas like artificial intelligence, financial institutions, data innovation, public policy, privacy and cybersecurity and many others, the fintech and digital assets practice group aims to handle a broad range of “regulatory, policy and supervision and enforcement situations involving fintech, digital assets and blockchain technology” that will enable their clients to seamlessly accelerate their growth worldwide. Gibson Dunn.
Argentina Elects Pro-Bitcoin President Javier Milei
On November 19, Argentina elected Javier Milei as its new president. Milei is known for his anti-central banking stance, criticizing the central bank for “cheating” Argentinians through inflationary tax and even proposing the elimination of the Central Bank of Argentina. As Argentina struggles with triple-digit rates of inflation, Milei sees bitcoin as “the natural reaction against central bank scammers; to make money private again.” While Milei has not proposed making bitcoin legal tender in Argentina, as it is in El Salvador, he plans to dollarize the Argentine economy to combat the country’s inflation issues. Despite his strong views on bitcoin and cryptocurrency, it remains unclear how Milei’s administration will integrate crypto into national economic policies. Blockworks

The following Gibson Dunn attorneys contributed to this issue: Jason Cabral, M. Kendall Day, Chris Jones, Jay Minga, Nick Harper, Grace Feitshans, Justin Fishman, Kameron Mitchell, Michelle Lou, and Edward Ferguson.

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 agreement marks a watershed moment for AI regulation and is the most significant endorsement of so-called “comprehensive” AI regulation from a major political actor on the world stage.

I. Introduction

After almost 6 months of negotiations, in the late night and early morning hours of December 8-9, 2023, the European Commission, the Council and the Parliament reached political agreement on the provisional rules that will comprise the European Union’s Artificial Intelligence Act (the “AI Act”).[1] This agreement marks a watershed moment for AI regulation, and is the most significant endorsement of so-called “comprehensive” AI regulation from a major political actor on the world stage. The provisional agreement on the AI Act would:

Establish a broad and extraterritorial scope of application,
Prohibit certain uses of AI entirely, and
Define a broad range of other uses as “high-risk” and subject to stringent requirements.

A number of procedural steps remain before the AI Act is finalized (as summarized in more detail in Section III); however, the staggered – and relatively rapid – planned enforcement of certain provisions bears note. Provisions related to prohibited AI systems are set to become enforceable six months after the Act is finalized; and provisions related to so-called General Purpose AI (“GPAI”) become enforceable 12 months after this date. The rest of the AI Act is expected to become enforceable in 2026.

The “long arm” of the AI Act will impact a broad range of business – including, but not limited to, those that intend to provide or deploy AI systems within the EU.[2] The distinct posture of the AI Act – based in part on fundamental and human rights jurisprudence – requires companies to think differently when preparing compliance strategies:

Proactive engagement with novel regulatory measures, such as a fundamental rights impact assessment for certain AI systems, and
Reimagining and documenting strategic decision-making related to internal governance and compliance in the face of unpredictable and uncertain go-forward risks.

This alert builds on our previous alerts which analyzed the European Commission’s 2021 proposal on the AI Act, the European Council’s common position (December 2022) and European Parliament’s negotiating position (June 2023). This alert takes a closer look at some of the key areas of debate in the trilogue procedure and the political agreement that was reached.

Negotiations on the final text of the AI Act remain underway, and the final wording of the provisional agreement is not yet public. The analysis below is based on public reports and our understanding of the substance of the agreement, but this may change based on a variety of factors. Keen followers of artificial intelligence would no doubt agree a lack of forward-looking certainty is the one guarantee in this area, and that applies equally to the AI Act’s journey from initial gestation to “political agreement.”

II. From negotiation to agreement: Outcome of the trilogue procedure

a) Scope of Application

The AI Act will provide for an extra-territorial scope of application that includes obligations for providers and deployers of AI systems. This has significant consequences for businesses not established in the EU, if they place an AI system on the market or put it into service in the EU. Furthermore, the regulations apply when “outputs” produced by an AI system are (or are intended to be) used in the EU. A key issue yet to be determined relates to the scope of the “output” provisions and the extent to which the AI Act regulates activities across the AI supply chain. One example could be AI-assisted R&D that is outsourced outside Europe such that only the final product (e.g., products designed using AI that do not themselves fall within the definition of an AI system and are not, technically, “outputs” of an AI system) are marketed in the EU.

b) Definition of AI

The definition of AI, a key threshold for applicability of the AI Act, has been subject to significant change throughout the legislative process. As noted in our previous alert, what started out as an overly broad definition has been reportedly narrowed over time with the goal of ensuring that traditional computational processes and software are not inadvertently captured. While the final text of the AI Act has not yet been released, the language reportedly aligns with the definition of AI recently adopted by the OECD[3] and reflects the need to preserve the ability to adjust the definition as necessary to account for future developments in the fast-moving AI landscape. While the definition in the final text does not reflect the OECD’s definition verbatim, it reflects its main elements, i.e., objective-based output generation that is able to influence its environment with varying degrees of autonomy.[4]

c) Prohibited AI systems

The AI Act classifies AI systems by risk level (unacceptable, high, limited, and minimal or no risk). AI systems that carry “unacceptable risk” are per se prohibited. In other words, the Act adopts bright line rules as to some uses of AI systems, based on fundamental rights concerns, differently from some other flagship regulations in the EU which usually allow for exceptions based on general rules. This framework will require particular diligence on behalf of businesses when classifying their AI systems for the purposes of the Act’s risk-based approach.

While the European Commission and Council advocated for a narrower list of prohibited AI systems, the Parliament’s mandate included a longer list of prohibited AI systems, banning certain use cases entirely. The agreed AI Act prohibits, inter alia:[5]

Manipulation of human behavior to circumvent end-users’ free will;
Social scoring;
Certain applications of predictive policing;
Emotion recognition systems used in the workplace; and
Real time remote biometric identification for law enforcement purposes in publicly accessible spaces (with narrow exceptions).

The European Council resisted the full ban on real-time remote biometric identification in publicly accessible spaces proposed by the European Parliament. Instead, real-time remote biometric identification for law enforcement purposes is prohibited unless it fits within narrow exceptions, such as for uses tied to the prevention of terrorist attacks or to locate victims or suspects in connection with serious offences, such as terrorism. Under the agreed version of the AI Act, other forms of biometric identification that fall outside the scope of the prohibition (i.e., ex-post biometric identification) are considered “High-Risk” (for which, see below).

d) High-risk AI systems

High-risk AI systems, while permitted, are subject to the most stringent obligations. AI systems may fall into this category if they pose a “significant risk” to an individual’s health, safety, or fundamental rights, and are used, or intended to be used, for inter alia education, employment, critical infrastructure, public services, law enforcement, border control, and administration of justice. One new obligation for companies imposed by the AI Act will be to prepare fundamental rights impact assessments (‘FRIAs’). Determining when and how to conduct an FRIA will raise many strategic and compliance-focused questions, taking account of the nature and scope of the AI system in question. Businesses will need to take steps to engage with this obligation as soon as possible.

In response to concerns that the high-risk category may be over-inclusive, the agreed version of the AI Act adds the concept of a filter system, which provides a series of exemptions that would allow providers of AI systems to avoid the high-risk category based on self-assessments.

The European Commission is expected to develop guidelines on the application of these filters. Currently, it has been reported that the filters exempt AI systems that are (i) intended to perform a narrow procedural task; (ii) intended to review or improve the result of a previously completed human activity; (iii) purely intended to detect decision-making patterns or deviations from prior decision-making patterns to flag potential inconsistencies; or (iv) used to perform preparatory tasks for an assessment relevant to critical use cases. It is not unlikely that the operation of this filter system may cause some problems in practice and lack of legal certainty as to the scope of the exemptions.

Providers that make an assessment that their systems fall outside of the high-risk category may be obliged to provide, upon request, the results of their prior assessment as to classification to the respective national market surveillance authorities. The agreed AI Act also contemplates allowing these market surveillance authorities to carry out evaluations of AI systems where they have sufficient reason to believe they should be considered high-risk, and to impose fines where they have sufficient evidence that the AI system provider misclassified their system to avoid a high-risk classification.[6]

e) General Purpose AI (Foundation Models)

As explained in our previous alert, the Parliament’s negotiating position introduced a regime for regulating GPAI models – or foundation models – consisting of models that “are trained on broad data at scale, are designed for generality of output, and can be adapted to a wide range of distinctive tasks”.[7] Parliament also introduced certain separate testing and transparency requirements, with most of the obligations falling on any deployer that substantially modifies a GPAI system for a specific use case.

The regulation of GPAI models was heavily debated during the trilogue procedure. The final text features a tiered approach (initially proposed by the European Commission) which places more onerous obligations on GPAI models that could pose “systemic” risks. The AI Act contains a presumption categorizing models as carrying a “systemic risk” where the model was trained using computing power greater than 10^25 floating point operations (FLOPs), indicating their capabilities and amount of underlying data. The European Commission has commented that “these new obligations will be operationalized through codes of practices developed by industry, the scientific community, civil society and other stakeholders together with the Commission.”[8] The tiered approach represents a compromise between the stark opposition to any regulation of foundation models in the AI Act by some Member States, including France, Germany and Italy, and the European Parliament’s preferred approach of establishing horizontal obligations which would apply equally to all foundation models.[9]

While certain obligations will apply to GPAI models, e.g., transparency obligations relating to the training data as well as copyright safeguards or making AI-generated content recognizable, providers of foundation models that meet the “systemic risks” threshold will need to notify the Commission of their status and comply with the relevant obligations in the AI Act (similar to the notification mechanism in the EU Digital Services Act). The regime places onerous obligations on providers of foundation models that are similar to those that apply to high-risk AI systems, e.g., requirements to assess and mitigate the risks their models entail, comply with certain design, information and environmental requirements and register such models in an EU database.

f) Enforcement

The AI Act envisions a strict enforcement regime set to be overseen by national authorities designated by each EU Member State to supervise compliance within its territory as well as a centralized European Artificial Intelligence Office tasked with coordinating enforcement efforts. Notably, the AI Act does not contemplate a de-centralized system of enforcement or a “one-stop shop” as under the GDPR. However, the competent national authorities will be gathered in the European Artificial Intelligence Board to ensure consistent application of the law. The maximum fines for non-compliance with the AI Act can reach up to EUR 35 million or, if the offender is a company, up to 7% of its total worldwide annual turnover for the preceding financial year, whichever is higher.[10] Certain proportionate caps on fines will apply for small and medium-sized enterprises (SMEs) and start-ups.

III. Next Steps

The AI Act is an extensive and complicated piece of legislation, and its impact will be far-reaching. After the conclusion of the trilogue process, the AI Act is now subject to formal adoption by the European Parliament and the Council. Once adopted, the AI Act will be published in the Official Journal and will enter into force 20 days following publication. However, the AI Act will not become fully enforceable until two years after its entry into force—likely in 2026—with some exceptions for specific provisions such as prohibited AI systems and AI systems classified as GPAI, which will be applicable after 6 and 12 months, respectively.

Now that political agreement has been reached, companies should be proactively engaging with the provisions of the AI Act and making preparations to ensure compliance by the applicable deadlines.

__________

[1] Council of the EU, Artificial intelligence act: Council and Parliament strike a deal on the first rules for AI in the world, press release of 9 December 2023, available here.

[2] The scope of some of the broadest jurisdictional hooks, including governing companies that are responsible for generating output from AI tools that have effect in the Union, remains to be seen.

[3] See, Luca Bertuzzi, Euractiv, OECD updates definition of Artificial Intelligence ‘to inform EU’s AI Act’, Article of 9 November 2023, available here.

[4] See, Luca Bertuzzi, Euractiv, AI Act: EU policymakers nail down rules on AI models, butt heads on law enforcement, Article of 9 December 2023, available here.

[5] European Commission, Commission welcomes political agreement on Artificial Intelligence Act, Article of 9 December 2023, available here.

[6] See, Luca Bertuzzi, Euractiv, AI Act: Leading MEPs revise high-risk classification, ignoring negative legal opinion, Article of 10 November 2023, available here.

[7] European Parliament’s compromise proposal, Art. 3(1c), available here.

[8] European Commission, Commission welcomes political agreement on Artificial Intelligence Act, Article of 9 December 2023, available here.

[9] See, Luca Bertuzzi, Euractiv, EU’s AI Act negotiations hit the brakes over foundation models, Article of 10 November 2023, available here.

[10] European Commission, Commission welcomes political agreement on Artificial Intelligence Act, Article of 9 December 2023, available here.

The following Gibson Dunn attorneys assisted in preparing this update: Vivek Mohan, Robert Spano, Kai Gesing, Joel Harrison, Christian Riis-Madsen, Nicholas Banasevic, Stéphane Frank, Frances Waldmann, Leon Freyermuth, Christoph Jacob, Jonas Jousma, Yannick Oberacker, Ciara O’Gara, Tine Rasmussen, and Hayley Smith.

Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you usually work, any of the leaders and members of the firm’s Artificial Intelligence or Privacy, Cybersecurity & Data Innovation practice groups, or the following authors:

Stéphane Frank – Brussels (+32 2 554 72 07, [email protected])
Kai Gesing – Munich (+49 89 189 33 180, [email protected])
Joel Harrison – London (+44 20 7071 4289, [email protected])
Vivek Mohan – Palo Alto (+1 650.849.5345, [email protected])
Christian Riis-Madsen – Brussels (+32 2 554 72 05, [email protected])
Robert Spano – London/Paris (+44 20 7071 4902, [email protected])
Frances A. Waldmann – Los Angeles (+1 213.229.7914, [email protected])

Artificial Intelligence:
Cassandra L. Gaedt-Sheckter – Co-Chair, Palo Alto (+1 650.849.5203, [email protected])
Vivek Mohan – Co-Chair, Palo Alto (+1 650.849.5345, [email protected])
Robert Spano – Co-Chair, London/Paris (+44 20 7071 4902, [email protected])
Eric D. Vandevelde – Co-Chair, Los Angeles (+1 213.229.7186, [email protected])

Privacy, Cybersecurity and Data Innovation:
Ahmed Baladi – Co-Chair, Paris (+33 (0) 1 56 43 13 00, [email protected])
S. Ashlie Beringer – Co-Chair, Palo Alto (+1 650.849.5327, [email protected])
Jane C. Horvath – Co-Chair, Washington, D.C. (+1 202.955.8505, [email protected])
Alexander H. Southwell – Co-Chair, New York (+1 212.351.3981, [email protected])

Gibson Dunn has formed a Workplace DEI Task Force, bringing to bear the Firm’s experience in employment, appellate and Constitutional law, DEI programs, securities and corporate governance, and government contracts 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 December 6, 2023, Fearless Fund (represented by Gibson Dunn) filed its merits brief in Am. Alliance for Equal Rights v. Fearless Fund Mgmt., LLC, No. 23-13138 (11th Cir. 2023). The brief is available here. Fearless Fund is a Black women-owned venture capital firm with a “Fearless Strivers” charitable grant program that provides $20,000 grants to Black female entrepreneurs as part of its mission to raise awareness about inequities in access to capital. AAER sued Fearless Fund in August 2023, claiming the program violates Section 1981 and seeking a preliminary injunction preventing Fearless Fund from awarding the grants. The district court denied the plaintiff’s motion for a preliminary injunction, but on September 30, 2023, the Eleventh Circuit temporarily enjoined the program pending appeal. AAER filed its merits brief on November 6, 2023. Its reply brief is due on January 3, 2024. Oral argument is scheduled for January 31, 2024.

On December 6, 2023, the U.S. Supreme Court heard oral arguments in Muldrow v. City of St. Louis, a case that presents potentially sweeping implications for workplace discrimination claims. The question before the Court is whether Title VII prohibits discrimination in transfer decisions if the transfer did not create a significant disadvantage for the employee, such as diminished earnings, benefits, or future career prospects. The plaintiff argued that all job-transfer decisions based on a protected characteristic violate Title VII regardless of whether an employee suffers any additional harm, an argument to which a number of Justices appeared sympathetic. The defendant argued that an employee must experience a materially adverse employment action—beyond the transfer decision itself—for the action to be cognizable under Title VII. Depending on its scope, a finding by the Court that the lateral transfer in this case was an actionable change in the “terms, conditions and privileges of employment” could significantly expand the range of employment actions subject to Title VII. An expanded definition of “terms, conditions and privileges of employment” could raise questions, for example, about whether workplace DEI programs that do not constitute tangible employment actions like promotions could nevertheless be actionable under Title VII if they provide differential treatment based on race or gender.

On November 28, 2023, America First Legal (“AFL”), on behalf of Target shareholders, filed an amended complaint in its lawsuit against Target Corporation and certain of its officers. Plaintiffs allege that the Target board depressed Target’s stock price by falsely representing that it was monitoring social and political risks to the company, when it was, in fact, only focused on risks associated with not achieving ESG and DEI goals. The original complaint alleged violations of Sections 10(b) and 14(a) of the Securities Exchange Act of 1934. The amended complaint adds a claim under Section 20(a) of the Exchange Act based on the company’s 2023 Pride Month collection. The amended complaint also adds four new plaintiffs. Responsive pleadings are due on January 26, 2024.

On December 4, 2023, the Sixth Circuit issued a decision in Ames v. Ohio Department of Youth Services, No. 23-3341 (6th Cir. Dec. 4, 2023), calling attention to a circuit split relating to a plaintiff’s burden of proof in Title VII “reverse-discrimination” cases. In affirming the district court’s decision granting summary judgment for the Department, the court relied on Sixth Circuit precedent that requires plaintiffs in reverse-discrimination cases to make an additional showing that “background circumstances . . . support the suspicion that the defendant is that unusual employer who discriminates against the majority.” In a concurring opinion, Judge Raymond M. Kethledge took issue with the background circumstances rule, noting that the rule goes against the express language of Title VII because it imposes different burdens on different plaintiffs based on their membership in different demographic groups. The Sixth, Seventh, Eighth, Tenth, and D.C. Circuits have adopted the background circumstances rule, while the Third and Eleventh Circuits have expressly rejected it. Judge Kethledge predicted that the Supreme Court will resolve the circuit split and review the validity of the background circumstances rule.

With the 2024 proxy season approaching for many publicly traded companies, special interest investors with viewpoints that span the political spectrum continue to use the shareholder proposal process set forth in Securities and Exchange Commission (SEC) Rule 14a-8 to advance their particular pro- or anti-DEI agendas. As we reported on here, shareholder proposals focused on nondiscrimination and diversity issues were the fourth most popular proposals submitted during the 2023 proxy season. These proposals largely focused on requesting racial equity or civil rights audits, reports on DEI efforts, and analyses of gender and racial pay equity. Companies also received shareholder proposals from ESG skeptics like the National Legal and Policy Center and the National Center for Public Policy Research. These proposals asked that companies roll back plans to undertake a racial equity audit, conduct a cost/benefit analysis of DEI programs and conduct a “return to merit” audit where the supporting statements focused on concerns about potential discrimination against “non-diverse” employees or discrimination based on religious and political views. DEI-related shareholder proposals submitted for 2024 annual meetings to date are similar, including shareholder proposals requesting reports on corporate DEI programs and on any risks associated with potential discrimination against conservative viewpoints or ideologies.

Media Coverage and Commentary:

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

The Washington Post, “Conservatives are suing law firms over diversity efforts. It’s working.” (December 9): The Post’s Julian Mark and Taylor Telford summarize the efforts of Edward Blum’s conservative advocacy group American Alliance for Equal Rights, which has sued or sent threat letters to at least seven law firms challenging their diversity recruitment programs. At least three of these firms changed their diversity fellowship eligibility criteria. Blum noted that “it is likely that other corporate entities with similar racially discriminatory policies will be sued in the coming weeks.” Professor Kenji Yoshino was quoted extensively and offered alternative paths to achieving DEI goals in this new legal landscape.
Bloomberg Law, “Blum Says He’s Done Suing Law Firms as Winston Yields on DEI.” (December 6, 2023): Bloomberg Law’s Tatyana Monnay reports that AAER has no further plans to sue law firms, however, Edward Blum noted that his team still “combs websites of hundreds of firms looking for any evidence of programs he views as illegal.”
Law360, “Commerce Dept. Wants Feedback on Draft DEI Principles” (November 27): Law360’s Sarah Jarvis reports on a recent request by the U.S. Department of Commerce for comments on a proposed set of DEIA principles that set out best practices for DEI in the private sector. According to the Department’s Federal Register notice, the Initiative is intended to be the first step in a long-term effort to “convene private sector business diversity leaders, amplify existing efforts, and inspire additional, voluntary business diversity efforts.” The draft principles are focused on executive leadership, organizational strategy, workforce development, human resources, business opportunities, and community investment. Comments are due January 5, 2024.
Bloomberg Law, “Nasdaq’s Board Diversity Court Win Draws New Conservative Appeal” (November 28): Bloomberg Law’s Andrew Ramonas reports that the National Center for Public Policy Research (“NCPPR”) has filed a petition for en banc review of the Fifth Circuit’s October decision in Alliance for Fair Board Recruitment v. SEC, upholding Nasdaq’s Board Diversity Rules. The Alliance for Fair Board Recruitment, the other petitioner in the case, previously filed a petition for rehearing in October. Among other things, NCPPR contends that the rules exceed the scope of the Exchange Act. Gibson Dunn represents Nasdaq as an intervenor in the case.
Law360 California Pulse, “Diversity In Management Linked To Higher Long-Term Growth” (November 30): Law360’s Aaron West summarizes a new study by corporate social responsibility and workplace equity nonprofit As You Sow, which found that, in certain industries, companies with more racial diversity in management are more likely to demonstrate increases in average long-term financial growth, income after tax, and other financial metrics. According to the report, these positive correlations were evident in the “communication services, consumer discretionary, consumer staples, financials, health care, and information technology sectors.” West notes that the study also identified that the most statistically significant positive financial gains occurred among companies with the largest market capitalization.
Law360, “4th Circ. Reluctant To Reverse White Exec’s Race Bias Verdict” (December 7): Law360’s Hayley Fowler reports on the oral argument before a panel of the Fourth Circuit in Duvall v. Novant Health Inc., a case in which a white executive was awarded nearly $4.6 million after a jury trial on his claim that he was fired as a result of a North Carolina hospital’s diversity initiative, in violation of Title VII. Oral argument on Novant Health’s appeal included an extended discussion of the efforts white collar workers must make to find new employment, in order to mitigate damages. According to Fowler, the panel “seemed dubious” overall of undoing the jury verdict in favor of the plaintiff.

Current Litigation:

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

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

Am. Alliance for Equal Rights v. Winston & Strawn LLP, No. 4:23-cv-04113 (S.D. Tex. 2023): AAER sued law firm Winston & Strawn, challenging its 1L diversity fellowship program as racially discriminatory in violation of Section 1981.
- Latest update: On December 6, 2023, AAER dismissed the case after Winston & Strawn changed its fellowship program eligibility language to be race-neutral.
Phillips v. Starbucks Corp., No. 19-cv-19432 (D.N.J. 2019): On October 28, 2019, a white former Starbucks regional director sued the company for firing her based on her race, allegedly to protect its image after the company suffered bad press when two Black men were arrested in a store for which the plaintiff oversaw operations. The plaintiff alleged discrimination and retaliation in violation of Title VII, Section 1981, and New Jersey state law. On June 12, 2023, a New Jersey federal jury awarded $25.6 million in compensatory and punitive damages to the plaintiff. On July 13, 2023, Starbucks filed a number of post-trial motions, including a motion to vacate and a motion for judgment as a matter of law.
- Latest update: The court heard oral argument on the post-trial motions on November 30, 2023.
Correll v. Amazon.com, Inc., No. 3:21-cv-1833 (S.D. Cal. 2022): On October 28, 2021, a white male businessman sued Amazon, alleging that by having a feature within its website that allows consumers to identify products sold by non-white, non-male sellers, the company violated Section 1981 and separately California Civil Code §§ 51 and 51.5, which prohibit racial discrimination by businesses.
- Latest update: On November 28, 2023, the parties filed a joint motion to dismiss, stipulating to the plaintiff’s dismissal of the action against Amazon with prejudice. The court granted the motion on November 30, 2023.
Bradley, et al. v. Gannett Co. Inc., 1:23-cv-01100 (E.D.V.A. 2023): On August 18, 2023, white plaintiffs sued Gannett over its alleged “Reverse Race Discrimination Policy,” in response to Gannett’s expressed commitment to having its staff demographics reflect the communities it covers, alleging violations of Section 1981.
- Latest update: On November 24, Gannett moved to dismiss, arguing that the plaintiffs failed to state Section 1981 claims because they did not plead specific facts connecting the allegedly discriminatory policy with their own differential treatment on the basis of race. Gannett also argued that many of the actions that the plaintiffs challenged, including performance evaluations and reassignments, did not rise to actionable adverse employment actions. A hearing on the motion to dismiss has been scheduled for January 10, 2024.

2. Challenges to agency rules, laws, and regulatory decisions:

Alliance for Fair Board Recruitment v. SEC, No. 21-60626 (5th Cir. 2021): On October 18, 2023, a unanimous Fifth Circuit panel rejected challenges to Nasdaq’s Board Diversity Rules and the SEC’s approval of those rules. Petitioners Alliance for Fair Board Recruitment and National Center for Public Policy Research sought review of the SEC’s approval of Nasdaq’s Board Diversity Rules, which require companies that have contracted to list their shares on Nasdaq’s exchange to (1) disclose aggregated information about their board members’ voluntarily self-identified diversity characteristics (including race, gender, and sexual orientation), and (2) provide an explanation if fewer than two board members are diverse. The SEC approved the rules after determining that they were consistent with the Exchange Act. Petitioners challenged the rules on constitutional and statutory grounds. Gibson Dunn represents Nasdaq, which intervened to defend its rules.
- Latest update: On October 25, 2023, AFBR petitioned for a rehearing en banc. On November 27, 2023, NCPPR also petitioned for rehearing en banc, and the court ordered the SEC and Nasdaq to respond to the petitions. On November 28, Republican Attorneys General from Utah and 18 other states filed an amicus brief in support of the petitions. Responses to these petitions are due December 18, 2023.
Johnson v. Watkin, No. 1:23-cv-00848-ADA-CDB (E.D. Cal. 2023): On June 1, 2023, a community college professor in California sued to challenge new “Diversity, Equity and Inclusion Competencies and Criteria Recommendations” enacted by the California Community Colleges Chancellor’s Office, claiming the regulations violated the First and Fourteenth Amendments. The plaintiff alleged that the adoption of the new competency standards, which require professors to be evaluated in part on their success in integrating DEI-related concepts in the classroom, will require him to espouse DEI principles with which he disagrees, or be punished. The plaintiff moved to enjoin the policy.
- Latest update: On November 29, 2023, both plaintiff and defendant filed objections to the magistrate judge’s recommendation and proposed order granting a preliminary injunction to prevent the college from disciplining or investigating the plaintiff based on his political speech. The plaintiff argued that the court should enjoin the new DEI rules in their entirety. The defendants argued that the proposed injunction is overbroad and forecloses all DEI policies (including those not yet written), and is factually inaccurate as to how disciplinary procedures work. The defendants further argued that the plaintiff lacks standing and that the rules are constitutionally permissible standards for job-related conduct rather than restrictions of the plaintiff’s personal views.

3. Educational Institutions and Admissions (Fifth Amendment, Fourteenth Amendment, Title VI, Title IX):

Students for Fair Admissions, Inc. v. University of Texas at Austin, 1:20-cv-00763-RP (W.D. Tex. 2020): On July 20, 2020, SFFA sued the University of Texas, alleging that UT Austin’s methods of considering race in undergraduate admissions violated the Equal Protection Clause of the Fourteenth Amendment, Sections 1981, Title VII, the Texas Constitution, and Texas state law.
- Latest update: On October 27, 2023, the defendants moved to dismiss the action as moot, claiming UT Austin made its admissions process race-neutral following the Supreme Court’s decision in SFFA v. Harvard. On November 27, SFFA opposed dismissal, arguing the case is still live because UT Austin has allegedly failed to implement safeguards to ensure its admissions officers comply with the new policy and because SFFA is still seeking an injunction to prohibit UT from reinstituting its prior policy. The defendants’ reply is due on January 11, 2024.
Students for Fair Admissions v. United States Naval Academy, No. 1:23-cv-02699-ABA (D. Md. 2023): On October 5, 2023, SFFA sued the U.S. Naval Academy, arguing that consideration of race in its admissions process violates the Fifth Amendment.
- Latest update: On November 27, 2023, the court set a hearing on the plaintiffs’ motion for a preliminary injunction for December 14, 2023. On December 1, 2023, the Naval Academy and other federal defendants filed their response to the preliminary injunction motion, arguing that SFFA did not demonstrate that it had standing because it submitted only anonymous declarations on behalf of its members, and that it did not demonstrate irreparable harm because there had been a substantial delay in bringing the action. On the merits, the Academy argued that the military has a compelling national security interest in a diverse officer corps, and that its admissions process was narrowly tailored.
Students for Fair Admissions v. U.S. Military Academy at West Point, No. 7:23-cv-08262 (S.D.N.Y. 2023): On September 19, 2023, SFFA sued West Point, arguing that affirmative action in its admissions process, including alleged racial “benchmarks” of “desired percentages” of minority representation, violates the Fifth Amendment of the U.S. Constitution by taking applicants’ race into account.
- Latest update: On November 22, 2023, West Point and other federal officials filed their opposition to the motion for a preliminary injunction. They argued that SFFA has not demonstrated it has standing because it has not pled facts to show its members, who are described anonymously in the complaint, have a stake in the controversy. They also argued that SFFA did not demonstrate irreparable harm, in part because its members have not actually applied for admission to West Point. On the merits, West Point argued that its admissions process is constitutional because the military has a compelling national security interest in a diverse officer corps distinct from academic interests in student diversity, and its admissions process is narrowly tailored.

The following Gibson Dunn attorneys assisted in preparing this client update: Jason Schwartz, Mylan Denerstein, Elizabeth Ising, Blaine Evanson, Molly Senger, Zakiyyah Salim-Williams, Matt Gregory, Zoë Klein, Mollie Reiss, Teddy Rube*, Alana Bevan, Janice Jiang*, and Marquan Robertson*.

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])

Elizabeth A. Ising – Partner & Co-Chair, Securities Regulation and Corporate Governance
Washington, D.C. (+1 202-955-8287, [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])

*Teddy Rube, Janice Jiang, and Marquan Robertson are associates working in the firm’s Washington, D.C. office who are not yet admitted to practice law.

The role of ESG in capital markets transactions has evolved significantly over the last five years. Please join us for a discussion of these topics and questions provided by the audience.

What opportunities does ESG present to access capital?
What risks does leveraging ESG present for issuers and underwriters?
How does ESG impact marketing, disclosure and diligence?
What are current ESG market trends?
How can we expect ESG to impact capital markets in the future?

PANELISTS:

Crystal Simpson is a managing director and head of energy equity capital markets at Evercore, which includes sustainable energy & clean technology, oil & gas, power, mining and chemicals. Ms. Simpson has led more than 550 bookrun energy equity offerings. Since 2012, she has raised over $120 billion for energy companies, including Altus Power, Antero, Crescent Energy, EVgo, Gulfport, Lithium Americas, Plains All American, Piedmont Lithium, QuantumScape, Shell Midstream, Rice Energy, RSP Permian, Targa, Viper and Williams. She has deep experience leading initial public offerings, follow-ons, equity-linked offerings, private investments in public equities (PIPEs) and pre-IPO capital. She graduated summa cum laude from Washington & Lee University with a B.S. in business administration and accounting alongside a double-major in broadcast journalism.

Oscar Sloterbeck is a senior managing director and leads Evercore ISI’s Company Surveys Team. Mr. Sloterbeck was ranked No. 3 for economics in the 2023 Institutional Investor All-America Research Team survey, a position he has held since 2019. As head of Company Surveys, he oversees proprietary surveys of companies, investors and U.S. states, as well as teens and young adults. These surveys provide unique insights into the economy and market sentiment. Prior to joining Evercore, Mr. Sloterbeck spent three years at JPMorgan Investment Management on the macroeconomics team. He is a chartered financial analyst and earned his B.A. from the College of William & Mary.

Hillary Holmes is Co-Chair of Gibson Dunn’s Capital Markets practice group. Hillary advises corporations, investment banks and institutional investors on all forms of long-term and strategic capital raising, including sustainability-linked financings and IPOs. She regularly advises companies on obligations under federal securities laws, corporate governance and ESG issues. Chambers ranks her amongst the top lawyers for energy capital markets, energy transactions and corporate counseling, and Law 360 has twice named her an Energy MVP. Hillary earned her JD from University of Pennsylvania Law School and her BA from Duke University, cum laude.

Jason Meltzer is a partner in Gibson Dunn’s Litigation Department and has experience in a wide range of complex commercial litigation, with an emphasis on securities and consumer products class action defense. Jason has defended several cases challenging ESG statements as false or misleading, and authored several publications on minimizing risks in connection with ESG statements. Jason also frequently consults for companies about how to minimize litigation risks in connection with their ESG statements and reports. The National Law Journal, Super Lawyers, and The Washington Post Magazine have all recognized Jason as a class actions and civil litigation “Rising Star,” and Jason was recently recognized as one of The Best Lawyers in America in the Commercial Litigation category. Jason received his B.A., magna cum laude, from the University of Pennsylvania, and his J.D. from the University of Pennsylvania Law School.

Marie Kwon is of counsel in the New York office of Gibson, Dunn & Crutcher. She is a member of the firm’s Capital Markets and Securities and Regulation and Corporate Governance Groups. Marie’s practice focuses on counseling corporations and financial institutions on a wide variety of capital markets transactions, including initial public offerings, secondary offerings, debt offerings and ESG financing. In addition, she has advised public companies on reporting obligations under the Exchange Act. Marie received her Juris Doctor from Columbia University. She graduated magna cum laude from Brown University with a Bachelor of Arts degree in International Relations and was a member of Phi Beta Kappa.

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This edition of Gibson Dunn’s Federal Circuit Update summarizes the current status of several petitions pending before the Supreme Court, and recent Federal Circuit decisions concerning attorneys’ fees under 35 U.S.C. § 285, Article III standing, and the Board’s authority to issue a final written decision past the statutory deadline.

Federal Circuit News

Noteworthy Petitions for a Writ of Certiorari:

As we summarized in our October 2023 update, there are a few petitions pending before the Supreme Court. We provide an update below:

In VirnetX Inc. v. Mangrove Partners Master Fund, Ltd. (US No. 23-315), the Court granted an extension for the response, which is now due December 27, 2023. An amicus curiae brief has been filed by the Cato Institute.
In Intel Corp. v. Vidal (US No. 23-135), a response was filed on November 9, 2023. Three amici curiae briefs have been filed. The petition will be considered during the Court’s January 5, 2024 conference.
The Court denied the petition in HIP, Inc. v. Hormel Foods Corp. (US No. 23-185).

Other Federal Circuit News:

New Federal Circuit Rules. The December 1, 2023 amendments to the Federal Circuit Rules are now in effect. The Federal Circuit has also approved increases to its local fees effective December 1, 2023. Details can be found here.

Upcoming Oral Argument Calendar

The list of upcoming arguments at the Federal Circuit is available on the court’s website.

Key Case Summaries (November 2023)

In re PersonalWeb Technologies LLC, Nos. 21-1858, 21-1859, 21-1860 (Fed. Cir. Nov. 3, 2023): This was the third appeal from a multidistrict litigation involving PersonalWeb. In 2011, PersonalWeb sued Amazon for patent infringement. After claim construction, PersonalWeb dismissed with prejudice its claims against Amazon. Then, in 2018, PersonalWeb brought claims against Amazon’s customers on the same patents. Amazon intervened and filed a motion for declaratory judgment barring PersonalWeb’s infringement actions against Amazon and its customers. The cases were consolidated. The district court ultimately entered judgment of non-infringement in favor of Amazon. Amazon then moved for attorneys’ fees and costs under 35 U.S.C. § 285. The district court granted that motion and awarded over $5 million in fees and costs.

The majority (Reyna, J., joined by Lourie, J.) affirmed, holding that the district court did not abuse its discretion in awarding fees and costs. In particular, the majority concluded that the district court did not abuse its discretion when it determined that PersonalWeb’s claims were objectively baseless because it required only a “straightforward application of Kessler,” which precludes follow-up suits against a company’s customers over the same allegedly infringing products that had already been adjudicated. The majority reasoned that a dismissal with prejudice operates as an adverse adjudication on the merits.

Judge Dyk dissented, reasoning that PersonalWeb’s claims against Amazon’s customers were not objectively baseless in light of unsettled case law surrounding the Kessler doctrine, and specifically whether the Kessler doctrine applies to a stipulated dismissal with prejudice or only to a litigated determination of non-infringement. Indeed, PersonalWeb sought certiorari on that very issue from its 2018 litigation, and the Solicitor General filed an amicus brief agreeing with PersonalWeb that its claims should not have been barred under Kessler. Thus, Judge Dyk would have remanded because, in his view, the district court abused its discretion in awarding fees based on PersonalWeb’s Kessler argument.

Actelion Pharmaceuticals Ltd. v. Mylan Pharmaceuticals Inc., No. 22-1889 (Fed. Cir. Nov. 6, 2023): Actelion sued Mylan for infringing two of Actelion’s patents directed to epoprostenol formulations. The parties disputed the meaning of a limitation in the patents requiring “a pH of 13 or higher.” The district court construed the phrase to encompass “values that round up or down to 13, 12.5 and 13.4,” relying exclusively on the intrinsic evidence. Mylan stipulated to infringement of Actelion’s patents under the district court’s construction, and appealed.

The Federal Circuit (Stoll, J., joined by Reyna and Stark, J.J.) vacated and remanded. The Court concluded that the intrinsic evidence was not sufficiently clear as to the level of precision required by a “pH of 13 or higher” and that the district court should have considered the extrinsic evidence the parties presented to ascertain the ordinary meaning of the phrase. Accordingly, the Court vacated the district court’s construction and remanded for the district court to consider the extrinsic evidence in the first instance.

Allgenesis Biotherapeutics Inc. v. Cloudbreak Therapeutics, LLC, No. 22-1706 (Fed. Cir. Nov. 7, 2023): Allgenesis filed a petition for inter partes review (“IPR”) challenging Cloudbreak’s patent directed to the use of multikinase inhibitors, including nintedanib, for treating pterygium, an eye condition involving tumorous growths. During the proceeding, Cloudbreak disclaimed the genus claims, leaving only the claims that more narrowly claimed the use of nintedanib. The Board issued a final written decision finding that Allgenesis failed to show that the remaining nintedanib claims were unpatentable. Specifically, the Board found that the nintedanbi claims were sufficiently described by the specification of a provisional application from which the Cloudbreak patent claimed priority and therefore predated the alleged prior art reference.

The Federal Circuit (Moore, C.J., joined by Stoll and Cunningham, JJ.) dismissed the appeal because it determined that Allgenesis lacked Article III standing. The Court determined that Allgenesis failed to establish an injury-in-fact from potential infringement liability or that the Board’s priority analysis would have a preclusive effect, impacting Allgenesis’s patent rights in issued or still-pending continuation applications. Specifically, the Court held that collateral estoppel would not attach to the Board’s non-appealable priority determination. Instead, if an examiner were to reach the same priority determination during prosecution of Allgenesis’s pending application, “Allgenesis can challenge that determination in a separate appeal.”

Purdue Pharma L.P. v. Collegium Pharmaceutical, Inc., No. 22-1482 (Fed. Cir. Nov. 21, 2023): Purdue sued Collegium for infringement of Purdue’s patent directed to a formulation containing a gelling agent that “prevent[s] or deter[s] the abuse of opioid analgesics by the inclusion of at least one aversive agent in the dosage form.” Collegium filed a petition for post-grant review (“PGR”) of the patent. Purdue subsequently filed for bankruptcy and requested a stay of all proceedings, including the PGR. After the statutory deadline for the Board to issue a final written decision had passed, Purdue asked for the stay to be lifted for the district court proceedings only, but the bankruptcy court lifted the stay for both the district court and PGR proceedings. Purdue then moved to terminate the PGR proceeding, arguing that the Board no longer had the authority to issue a final written decision. The Board denied the motion and issued its final written decision, finding the challenged claims unpatentable for lack of written description and anticipation.

The Federal Circuit (Dyk, J., joined by Hughes and Stoll, JJ.) affirmed. The Court determined that the Board’s failure to meet the statutory deadline did not deprive the Board of authority to issue a final written decision. The Court noted that the statutory language required that the Board issue a final written decision by a certain deadline, but found no congressional intent to “deprive the agency of power” to act after the deadline passed.

The following Gibson Dunn attorneys assisted in preparing this update: Blaine Evanson, Jaysen Chung, Audrey Yang, Al Suarez, Julia Tabat*, and Vivian Lu.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the Federal Circuit. Please contact the Gibson Dunn lawyer with whom you usually work, any leader or member of the firm’s Appellate and Constitutional Law or Intellectual Property practice groups, or the following authors:

Blaine H. Evanson – Orange County (+1 949.451.3805, [email protected])
Audrey Yang – Dallas (+1 214.698.3215, [email protected])

Appellate and Constitutional Law:
Thomas H. Dupree Jr. – Washington, D.C. (+1 202.955.8547, [email protected])
Allyson N. Ho – Dallas (+1 214.698.3233, [email protected])
Julian W. Poon – Los Angeles (+ 213.229.7758, [email protected])

Intellectual Property:
Kate Dominguez – New York (+1 212.351.2338, [email protected])
Y. Ernest Hsin – San Francisco (+1 415.393.8224, [email protected])
Josh Krevitt – New York (+1 212.351.4000, [email protected])
Jane M. Love, Ph.D. – New York (+1 212.351.3922, [email protected])

*Julia Tabat is an associate working in the firm’s Dallas office who currently is admitted to practice in Illinois.