Richard Manfredi, Author at Gibson Dunn

An Expert Analysis of FCPA Liability and Avoiding the Third Party Pitfall

Gibson, Dunn & Crutcher LLP is pleased to announce with Global Legal Group the release of Global Legal Insights – Bribery & Corruption 2024. Gibson Dunn partner Michael Diamant and partner-elect Melissa Farrar, with assistance from associates Allison Lewis and Kelly Skowera, were contributing editors to the publication’s Expert Analysis chapter, “Bribery & Corruption Laws and Regulations 2024 | FCPA liability: avoiding the thirdparty pitfall,” which addresses FCPA liability for actions of third parties and related compliance strategies. The Guide, comprising 21 jurisdictions, is live and FREE to access.

Please view this informative and comprehensive chapter via the links below:

CLICK HERE to view “Bribery & Corruption Laws and Regulations 2024 | FCPA liability: avoiding the thirdparty pitfall.”

CLICK HERE to view, download or print a PDF version.

The following Gibson Dunn lawyers prepared this publication: Michael Diamant and Melissa Farrar, with assistance from Allison Lewis and Kelly Skowera.

Gibson Dunn lawyers are available to assist in addressing any questions you may have about these issues. Please contact the Gibson Dunn lawyer with whom you usually work, any leader or member of the firm’s Anti-Corruption & FCPA practice group, or the following authors:

Michael S. Diamant – Washington, D.C. (+1 202.887.3604, [email protected])

Melissa Farrar – Washington, D.C. (+1 202.887.3579, [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.

Join us for a 30-minute briefing covering several M&A practice topics. The program is the fourth in a series of quarterly webcasts designed to provide quick insights into emerging issues and practical advice on how to manage common M&A problems. Stephen Glover, co-chair of the firm’s Global Mergers and Acquisitions Practice, acts as moderator.

Topics discussed:

Branden Berns and Pamela Endreny discuss some of the key corporate, securities law and tax issues that arise in connection with the use of contingent value rights to bridge valuation gaps in M&A transactions.
Lora Elizabeth MacDonald describes the Department of Justice’s plan to provide guidance regarding corporate self-disclosure tailored to M&A transactions.
Andrew Kaplan provides an update on recent trends in shareholder activism.

PANELISTS:

Stephen Glover is a partner in the Washington, D.C. office of Gibson, Dunn & Crutcher who has served as Co-Chair of the firm’s Global Mergers and Acquisitions Practice. Mr. Glover has an extensive practice representing public and private companies in complex mergers and acquisitions, joint ventures, equity and debt offerings and corporate governance matters. His clients include large public corporations, emerging growth companies and middle market companies in a wide range of industries. He also advises private equity firms, individual investors and others. Mr. Glover has been ranked in the top tier of corporate transactions attorneys in Washington, D.C. for the past seventeen years (2005 – 2023) by Chambers USA America’s Leading Business Lawyers. He has also been selected by Chambers Global for the past five years as a top lawyer for USA Corporate/M&A. Chambers has singled out Mr. Glover as the only “Star” corporate lawyer in the District of Columbia.

Branden Berns is a partner in the San Francisco office of Gibson, Dunn & Crutcher, where he practices in the firm’s Corporate Transactions Practice Group, with a practice focused on representing leading life sciences companies and investors. Mr. Berns advises clients in connection with a variety of financing transactions, including initial public offerings, secondary equity offerings and venture and growth equity financings, as well as complex corporate transactions, including mergers and acquisitions, asset sales, spin-offs, joint ventures, PIPEs and leveraged buyouts. Mr. Berns regularly serves as principal outside counsel for publicly-traded companies and advises management and boards of directors on corporate law matters, SEC reporting and corporate governance.

Pamela Lawrence Endreny is a partner in the New York office of Gibson, Dunn & Crutcher. Ms. Endreny represents clients in a broad range of U.S. and international tax matters. Ms. Endreny’s experience includes mergers and acquisitions, spin-offs, joint ventures, financings, restructurings and capital markets transactions. She has obtained private letter rulings from the Internal Revenue Service on tax-free spin-offs and other corporate transactions. She has been repeatedly selected for inclusion in Chambers USA: America’s Leading Lawyers for Business, and was also named a Tax “MVP” by Law360. Ms. Endreny is a member of the Executive Committee of the New York State Bar Association Tax Section. She is also a member of the Tax Forum and Private Investment Fund Tax Forum.

Andrew Kaplan is a partner in the New York office of Gibson, Dunn & Crutcher, where his practice focuses on mergers and acquisitions, and corporate governance matters. Mr. Kaplan represents both public and private acquirors and targets in connection with mergers, acquisitions and takeovers, both negotiated and contested. Mr. Kaplan also advises corporations and their boards of directors in connection with corporate governance and compliance matters, shareholder activism, takeover preparedness and other corporate matters. He also represents various major investment banks as financial advisors in M&A transactions, and hedge funds in their M&A and investment activities. Mr. Kaplan also has represented both issuers and underwriters in a variety of securities transactions.

Lora Elizabeth MacDonald is of counsel in the Washington, D.C. office of Gibson, Dunn & Crutcher. She practices in the Firm’s Litigation Department, focusing on white collar criminal defense, internal investigations, and corporate compliance.Lora has extensive experience representing multinational corporations as well as individuals in connection with internal investigations related to potential violations of the U.S. Foreign Corrupt Practices Act (“FCPA”) and U.S. antitrust laws. As part of her practice, she regularly interacts with attorneys at the U.S. Department of Justice and the U.S. Securities and Exchange Commission. Lora has particular experience guiding companies towards the resolution of DOJ and SEC investigations, as well as prophylactic and post-resolution corporate compliance. Lora regularly advises on anti-corruption aspects of proposed mergers and acquisitions, and conducts related due diligence as well as compliance program reviews and pre- and post-acquisition due diligence.

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 0.5 credit hour, of which 0.5 credit hour may be applied toward the areas of professional practice requirement. This course is approved for transitional/non-transitional credit.

Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 0.5 hour.

Neither the Connecticut Judicial Branch nor the Commission on Minimum Continuing Legal Education approve or accredit CLE providers or activities. It is the opinion of this provider that this activity qualifies for up to 30 minutes toward your annual CLE requirement in Connecticut, including 0 hour(s) of ethics/professionalism.

Application for approval is pending with the Texas, Virginia and Washington State Bars.

The Proposed Guidelines set out for the first time the specific regulatory requirements and the SFC’s regulatory expectations in respect of market soundings in Hong Kong.

On October 11, 2023, Hong Kong’s Securities and Futures Commission (“SFC”) published a consultation paper (the “Consultation Paper”) on the proposed guidelines for market soundings (the “Proposed Guidelines”).[1] The Proposed Guidelines are noteworthy since it sets out for the first time the specific regulatory requirements and the SFC’s regulatory expectations in respect of market soundings in Hong Kong. This client alert will explore the SFC’s proposals in greater detail.

I. Why introduce the Proposed Guidelines?

To understand the rationale of the requirements in the Proposed Guidelines, it is helpful to understand why the SFC has decided that it is the appropriate time to introduce the Proposed Guidelines.

Firstly, the SFC observed an increasing number of persons trading ahead of placings and block trades, which suggested that some intermediaries may have unfairly taken advantage of non-public information received during market soundings to make unjustified profits. This led the SFC’s thematic review of market sounding practices and controls adopted by intermediaries in 2022, where the SFC noted a divergence of practices among intermediaries in designing their risk controls over market soundings, which suggested that more clarity on the SFC’s regulatory expectations was required to deter substandard conduct and to assist intermediaries in upholding market integrity during market soundings.

Secondly, in light of the determination of the Securities and Futures Appeals Tribunal (“SFAT”) on September 27, 2022 (the “SFAT Determination”) in the Aarons case,[2] the SFC considered it appropriate to provide both sell-side and buy-side market participants with additional clarity on complying with the general principles in the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the “Code of Conduct”) during market soundings. In summary, the case involved a hedge fund manager who entered into short swaps (which can be used for short selling) after the manager received non-public information about an intended block sale (a large, privately negotiated sale of securities) of shares in a listed Korean company from one of the underwriters of the block sale. The communication was made by the underwriter (a sell-side broker) to the hedge fund manager (a buy-side participant) as part of a market sounding to see if the manager would be interested in participating as a buyer on the block sale. After news of the block sale became public, there was a material drop in the share price of the listed Korean company, and the short swaps entered into by the hedge fund manager generated a profit for the fund he managed.

The SFAT upheld the finding by the SFC that the hedge fund manager’s conduct was such that he was not a fit and proper person to continue to be licensed, having regard to General Principles 1 (Honesty and fairness) and 7 (Compliance) of the Code of Conduct. In doing so, the SFAT determined that a two years suspension of the hedge fund manager’s licence was the most appropriate sanction.

It is relevant to note that the hedge fund manager was not charged with the offence of insider dealing under the Securities and Futures Ordinance (Cap. 571) (“SFO”). The reason is likely because the civil and criminal insider dealing regimes[3] under the SFO have a regulatory lacuna with respect to insider dealing committed in Hong Kong with respect to overseas listed securities. This regulatory lacuna will be addressed when amendments to the insider dealing provisions under the SFO are introduced (please see our earlier client alert [4] for further details). As such, in hearing the appeal, it was not necessary for the SFAT to determine whether or not the communication made to the hedge fund manager constituted “inside information” as defined in the SFO. Rather, the issue to be determined by the SFAT was whether the hedge fund manager’s conduct breached the Code of Conduct (namely, General Principles 1 and 7).[5] The SFAT ultimately agreed with the SFC’s findings that the hedge fund manager’s deceitful conduct after receiving “material non-public information” about an impending block sale meant that he failed to adhere to principles of honest and fair conduct, and hence failed to act with the integrity that the market required, and in conclusion failed to comply with General Principles 1 and 7 of the Code of Conduct.

II. What communications are subject to the Proposed Guidelines?

The Proposed Guidelines would apply to the communication of non-public information – irrespective of whether or not it is price-sensitive “inside information”[6] – with potential investors prior to the announcement of a securities transaction, to gauge their interest in a potential transaction or assist in determining the specifications related to a potential transaction (such as private placements and large block trades) (“Market Sounding”), by intermediaries who:

Disclose non-public information during the course of a Market Sounding (“Disclosing Person”), such as a sell-side broker acting on behalf of an issuer or an existing shareholder selling in the secondary market (“Market Sounding Beneficiary”) in a potential securities transaction; and
Receive non-public information during the course of a Market Sounding, such as a buy-side firm that is sounded out by a Disclosing Person as a potential investor in a potential securities transaction(collectively, a “Market Sounding Intermediary”).[7]

It is important to highlight that the Proposed Guidelines apply to communications on all “non-public information”, irrespective of whether the same information constitutes “inside information” under the SFO. It is also noticeable that, despite referring to the SFAT Determination, the Proposed Guidelines do not use the potentially narrower term “material” non-public information, as found in the SFAT Determination, and instead adopt the much broader term “non-public information”. This appears to be intentional, as the Consultation Paper explains that one of the SFC’s concerns was that intermediaries may run the risk of potential misconduct from an inaccurate determination of what constitutes “inside information”, as it often involved complex judgment and interpretations and that it was not uncommon for parties to arrive at different conclusions)[8] – and presumably similar concerns apply to the determination of whether or not non-public information is “material” or not. Adopting the broader term “non-public information” therefore reduces the risk of inaccurate determinations.

III. What communications are not subject to the Proposed Guidelines?

According to the Consultation Paper, the Proposed Guidelines will not apply to communications regarding:

Speculative transactions or trade ideas shared by a Disclosing Person without consulting with the potential Market Sounding Beneficiary or without any “level of certainty” of such transactions materialising. The Proposed Guidelines provides guidance on the factors to consider in determining whether there is some “level of certainty”, such as the extent to which the Market Sounding Beneficiary has expressed an interest with the Disclosing Person in proceeding with a possible transaction, among other factors[9];
Transaction in such size, value, structure or selling method, that are commensurate with “ordinary day-to-day trade execution”, such as a sell-side broker sourcing potential buy-side participants to execute an ordinary size trade (in relation to the average trading volume or market capitalisation) after receiving an actual order instruction placed by the sell-side broker’s client with a genuine intention for execution; and
Public offering of securities.

The above carve-outs will be important in light of the wide range of Market Sounding communications that are likely to contain some form of “non-public information”. However, internal procedures and controls will need to be carefully designed and implemented, or else intermediaries run the risk of potential misconduct from an inaccurate determination of whether a particular communication falls within the above carve-outs, and therefore failing to comply with the regulatory requirements in the Proposed Guidelines.

The Proposed Guidelines also make clear that they may apply even before a formal mandate from the Market Sounding Beneficiary is received, i.e. as soon as the Disclosing Person starts to conduct any form of market sounding (soft or otherwise) on behalf of a Market Sounding Beneficiary.

IV. Core Principles of Market Sounding

The Proposed Guidelines contain a set of Core Principles (“CP”), which all Market Sounding Intermediaries should comply with in conducting Market Soundings. The CPs are briefly summarised below[10]:

CP 1. Market Integrity: Market Sounding Intermediaries should maintain confidentiality and not trade on or use non-public information passed or received during Market Soundings for the benefit of themselves or others until the information ceases to be non-public.
CP 2. Governance: Market Sounding Intermediaries should implement robust governance and oversight arrangements over its Market Sounding activities. This includes: (i) senior management are responsible for oversight of Market Soundings; (ii) establish governance arrangements for Marketing Soundings; (iii) designate a committee or person(s) independent from the “front-office” to monitor Market Soundings in support of senior management oversight; and (iv) develop and implement appropriate reporting lines and escalation processes to ensure any Market Sounding issues are promptly reported to senior management and the designated committee or person(s) for review and follow-up action.
CP 3. Policies and Procedures: Market Sounding Intermediaries should establish and maintain effective policies and procedures specifying the manner and expectations in which its Market Soundings should be conducted. The written polices and procedures should cover, among other matters: (i) when they become applicable and the timing and procedures of Market Soundings; (ii) allocation of roles and responsibilities among staff involved in Market Soundings, taking into account the “three lines of defence” and ensuring proper staff training; (iii) personal dealing restrictions; (iv) escalation protocols; (v) consequences for non-compliance with the Market Sounding requirements; (vi) categorisation, identification and handling of information during the course of Market Soundings; and (vii) record-keeping requirements.
CP 4. Information Barrier Controls: Market Sounding Intermediaries should implement adequate and effective physical and electronic information barrier controls to prevent inappropriate disclosure, misuse or leakage of non-public information during the course of Market Soundings. This includes, but is not limited to: (i) physical segregation; (ii) system user access controls; (iii) information sharing policies and procedures (e.g. Market Sounding information should be restricted to authorised personnel on a “need-to-know” basis and disclosed only through authorised communication channels); and (iv) maintaining a list of internal and external recipients of non-public information as well as “Restricted List” to prohibit trading on non-public information.
CP 5. Review and Monitoring Controls: Market Sounding Intermediaries should establish effective procedures and controls to monitor and detect suspicious behaviour, unauthorised disclosure, or misuse of information from Market Soundings. This includes periodic reviews of trading and communication surveillance controls, voice and electronic communications, and unauthorised access to information.
CP 6. Authorised Communication Channels: Market Sounding Intermediaries should only use recorded and firm-authorised communication channels to conduct Market Soundings, until the information ceases to be non-public.

Market Sounding Intermediaries are expected to periodically review and update their governance and oversight arrangements, policies and procedures, and internal systems and controls, to ensure that they remain robust and effective.

V. Specific requirements for Disclosing Persons

As the party that initiates Market Soundings, Disclosing Persons bear the initial responsibility to ensure that any non-public information associated with Market Soundings is properly safeguarded and disclosed in accordance with the standards of conduct set out in the Proposed Guidelines. To this end, the specific requirements applicable to the Disclosing Persons are more extensive than for the Recipient Persons, and are summarised below.[11]

Stage of Market Sounding	Specific Requirements
Pre-Market Sounding procedures	Before the initial contact with Recipient Persons or other potential investors to conduct a Market Sounding, a Disclosing Person should: Conduct assessments to determine whether the information disclosed during the Market Sounding would constitute non-public information; Obtain consent from the Market Sounding Beneficiary to engage in the Market Sounding; and Determine in advance, on a case-by-case basis taking into account the requirements in the Proposed Guidelines: (i) a standard set of information to be disclosed to Recipient Persons, (ii) an appropriate timing to conduct the Market Soundings, and (iii) a suitable number of Recipient Persons to contact for the Market Sounding.
During the Market Sounding communications process	A Disclosing Persons should adopt a standardised pre-approved script that is reviewed by senior management or independent functions, such as Legal and Compliance, during initial and subsequent Marketing Sounding communications. In summary, the script should at a minimum include: A statement that the communication is for the purpose of a Market Sounding and that the Recipient Person shall keep confidential the non-public information, and not trade or use such information for its own or others’ benefit until the information ceases to be non-public; A statement that the conversation is recorded and to request the Recipient Person’s consent for recording; Confirm that the individual is the person designated by the Recipient Person to receive Market Soundings; A statement that the Recipient Person will receive information which the Disclosing Person considers to non-public and a request for their consent to receive such information; and An estimate of when the information will cease to be non-public, where possible. After obtaining the above consents, a Disclosing Person should provide a written confirmation to the Recipient Person as soon as possible, summarising the contents covered in its Market Sounding communications. Prior to receiving the Recipient Person’s consent (as explained above), a Disclosing Person should ensure that any preliminary information shared with the Recipient Person is sufficiently broad, limited, vague and anonymised to minimise the change of the Recipient Person guessing the name of the security involved. Greater caution should be exercised in determining the amount of non-public information to be shared where the subject security may be identified even with the provision of only limited information (e.g. for narrow industry sectors) – for example the situation in the SFAT Determination as discussed above.
Cleansing	After non-public information has been disclosed during a Market Sounding, a Disclosing Person should: (i) conduct assessments to determine whether the information has ceased to be non-public (e.g. following the announcement of the transaction, or if the transaction was called off); and (ii) inform the Recipient Person(s) as soon as possible in writing when the information ceases to be non-public according to the Disclosing Person’s assessment.
Record keeping	A Disclosing Person should keep the records in relation to its Market Soundings for a period of not less than seven years. These records must include: Consents obtained from Market Sounding Beneficiaries to engage in Market Soundings; A list of Recipient Persons who informed the Disclosing Person that they do not wish to receive any Market Soundings; Audio, video or text recordings of Market Soundings conducted; The Disclosing Person’s assessment considerations, rationales, and discussions with the Market Sounding Beneficiary (if any), in determining whether the information disclosed would constitute non-public information, and whether non-public information disclosed during Market Soundings has ceased to be non-public; A list of all internal and external persons(s) who possess non-public information as a result of Market Soundings, including details such as the date and time of the Marketing Sounds, information and materials disclosed, etc.; Notifications to inform Recipient Persons when the information ceases to be non-public.

VI. Specific requirements for Recipient Persons

The specific requirements for Recipient Persons are relatively lighter when compared with the Disclosing Person, and are summarised below.[12]

Stages of Market Sounding

Requirements

Handling of Market Sounding requests

A Recipient Person should:

Designate a properly trained specified person(s) to receive Market Soundings, and inform the Disclosing Persons of such arrangement upon being contacted by the Disclosing Persons for Market Soundings; and
Inform the Disclosing persons whether it wishes to, or not to, receive Market Soundings from the Disclosing Persons.

Record keeping

A Recipient Person should keep the records in relation to its Market Soundings for a period of not less than seven years. These records must include:

Any notifications given to the Disclosing Person of its wish to, or not to, receive Market Soundings;
Audio, video or text recordings of Market Sounding received; and
A list of all internal and external persons(s) who possess non-public information as a result of Market Soundings, including details such as the date and time of the Marketing Sounds, information and materials disclosed, etc.

VII. Conclusion

The Consultation Paper containing the Proposed Guidelines is currently undergoing a public consultation. The SFC has indicated that it currently plans to provide a six-month transition period for the industry to update their internal procedures and controls after the Proposed Guidelines are finalised. Even prior to the finalisation of the Proposed Guidelines, intermediaries may still find it helpful to compare their existing internal procedures and controls with the requirements in the Proposed Guidelines, as it provides useful guidance on the SFC’s regulatory expectations and areas which an intermediary may wish to consider updating. As demonstrated by the SFAT Determination, the SFC can still find an intermediary to be in breach of the General Principles in the existing Code of Conduct if the intermediary engages in substandard conduct in respect of market soundings.

__________

[1] “Consultation Paper on the Proposed Guidelines for Market Soundings”, published by the SFC on October 11, 2023, available at: https://apps.sfc.hk/edistributionWeb/api/consultation/openFile?lang=EN&refNo=23CP6

[2] Christopher James Aarons v. Securities and Futures Commission, SFAT Application No. 1 of 2021, Determination, September 27, 2022, available at: https://www.sfat.gov.hk/files/SFAT%202021-1%20determination.pdf

[3] SFO, sections 270 and 291.

[4] “Hong Kong SFC Places Key Reforms to SFO Enforcement Provisions on Hold Following Industry Feedback”, published by Gibson Dunn on August 11, 2023, available at: https://www.gibsondunn.com/hong-kong-sfc-places-key-reforms-to-sfo-enforcement-provisions-on-hold-following-industry-feedback/.

[5] SFAT Determination, paragraph 192.

[6] “Inside information” is defined in sections 245 and 285 of the Securities and Futures Ordinance as “specific information that (a) is about (i) the corporation; (ii) a shareholder or officer of the corporation; or (iii) the listed securities of the corporation or their derivatives; and (b) is not generally known to the persons who are accustomed or would be likely to deal in the listed securities of the corporation but would if generally known to them be likely to materially affect the price of the listed securities.

[7] The Consultation Paper, paragraph 24; and the Proposed Guidelines, paragraph 1.2.

[8] The Consultation Paper, paragraphs 20 to 21.

[9] According to the Proposed Guidelines, a case-by-case consideration of the facts and circumstances is needed to determine whether there is some “level of certainty” of a corresponding potential transaction materialising. The examples of factors to take into account when making such determination include the extent to which the Market Sounding Beneficiary has orally or in writing: (i) expressed an interested with the Disclosing Person in proceeding with a possible transaction; (ii) shared any particulars with the Disclosing Person in relation to the possible transaction (such as the timing, size, pricing or structure of the transaction); or (iii) mandated, requested or consented to the gauging of investor appetite by the Disclosing Person. It is important to note that these are only examples of some factors to take into account, and are not intended to be exhaustive.

[10] The Consultation Paper, paragraphs 27 to 41; the Proposed Guidelines, paragraph 2.

[11] The Proposed Guidelines, paragraph 3.

[12] The Proposed Guidelines, paragraph 4.

The following Gibson Dunn lawyers prepared this client alert: William Hallatt, Arnold Pun, and Jane Lu*.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you wish to discuss any of the matters set out above, please contact any member of Gibson Dunn’s Global Financial Regulatory team, including the following members in Hong Kong:

William R. Hallatt – Hong Kong (+852 2214 3836, [email protected])
Emily Rumble – Hong Kong (+852 2214 3839, [email protected])
Arnold Pun – Hong Kong (+852 2214 3838, [email protected])
Becky Chung – Hong Kong (+852 2214 3837, [email protected])

*Jane Lu is a paralegal (pending admission) working in the firm’s Hong Kong office who is not yet admitted to practice law.

An overview of key technical provisions and practical takeaways for regulated parties from EPA’s final methane rule.

On December 2, 2023, the U.S. Environmental Protection Agency (EPA) announced its finalized rule targeting methane emissions from the oil and gas sector. In this regulatory action, EPA enacted (i) new source performance standards (NSPS) for methane and volatile organic compounds (VOCs) from new or modified oil and gas sources and (ii) emissions guidelines for states to follow in designing and executing implementation plans to cover existing sources.

This final rule is one of the Biden Administration’s signature actions to address climate change. In finalizing the rule, EPA included measures designed to decrease flaring and fugitive emissions from oil and gas production facilities and also moved forward with its novel “Super Emitter” program that allows third parties to track large emissions events. But the final rule also included additional flexibility for industry and states compared to EPA’s proposal, such as more time for states to submit compliance plans for existing facilities, more time for certain requirements, and flexibility for industry to use advanced monitoring technologies to detect methane leaks.

This client alert summarizes the key technical provisions for oil and gas production and practical takeaways for regulated parties.[1]

Who is subject to the rule? The rulemaking applies to new and existing oil and gas facilities involved in (i) production and processing, including equipment and processes at well sites, storage tank batteries, gathering and boosting compressor stations, and natural gas processing plants, and (ii) natural gas transmission and storage, including compressor stations and storage tank batteries.

What are the key takeaways? Leveraging EPA’s existing VOC rules governing oil and gas production, EPA’s new rule requires frequent monitoring and repair of methane leaks at well sites, centralized production facilities, and compressor stations using established inspection technologies or, at an operator’s election, novel advanced detection technologies. Similarly, storage vessels at production facilities are regulated in largely the same manner under this final rule as existing VOC requirements. However, storage vessels that previously were unaffected by regulation, including both new and existing facilities, may now be subject to NSPS based upon updated definitions and the addition of a new applicability trigger. Finally, the rule aims to phase out venting and flaring of gas coming from oil wells. Agency officials said the most significant emissions reductions created by the final rule come from this directive for new oil wells to eliminate routine gas flaring as well as requiring continuous operation of flares on storage tanks.

Unique to this rule is EPA’s creation of the “Super Emitter” program for identifying and addressing significant methane leaks from production facilities, including an avenue for qualified third parties to alert EPA of owners and operators exceeding the emissions standards and for EPA, in turn, to require owners/operators to investigate such alerts.

In addition, the rule imposes a number of new requirements on reciprocating compressors, centrifugal compressors, pneumatic pumps and controllers (even prohibiting using natural gas in all but a few circumstances) and sweetening units, as well as the completion process and liquids unloading process.

How has EPA structured the legal framework?[2] The new rule establishes a role for both federal and state standards. First, new federal NSPS, added at 40 C.F.R. part 60, subpart OOOOb, apply to sources that commenced construction, modification, or reconstruction after December 6, 2022.

Second, existing sources will be regulated by emissions guidelines implemented as part of state programs that are equivalent to federal NSPS. These emissions guidelines – which essentially serve as model rules for states to implement – are set forth in a new subpart, OOOOc. States can either adopt presumptive standards set forth in the OOOOc emissions guidelines for existing sources or develop their own standards that are as strict as the federal standards, and they must conduct meaningful public engagement during their development of these standards.

EPA must approve all state emissions standards, and if a state’s standards are not as strict as the federal standards, EPA can then promulgate a rule for that state.[3]

What is the applicability date? The final rule’s “applicability date” is December 6, 2022. Sources constructed, modified or reconstructed after December 6, 2022 will need to comply with the new source performance standards in OOOOb.

Sources constructed prior to December 6, 2022 will be considered existing sources and will have later compliance dates under state plans. For this category of existing sources, states have two years to propose these standards, and operators have three years after that submission deadline to comply. For that reason, the deadline for compliance for existing sources will vary based on location, but could be up to five years.

What are the key differences in obligations for new and existing sources? Both subpart OOOOb and subpart OOOOc include new requirements to address methane emissions from oil and gas operations using the “best system of emission reduction” (BSER) as summarized below. With the exception of requirements governing new wells and well completions (and particularly the flaring requirements), the final NSPS subpart OOOOb requirements for new affected facilities and the presumptive standards for existing facilities under subpart OOOOc are largely the same as it relates to methane. The key differences between the two programs are (i) the timeframe for compliance, (ii) the additional requirements for new wells, particularly as it relates to flaring, and well completions, and (iii) the additional requirements for VOC control for new sources.[4]

What are the key elements of the new requirements?

Eliminating Routine Flaring From Oil Wells. EPA’s new rule phases out flaring of gas coming from new oil wells under subpart OOOOb. It phases in flaring restrictions by dividing wells into three categories based on construction date. For new wells constructed after future dates set by the rule, routine flaring will be prohibited after the phase-in period; ultimately, absent a safety concern or defined malfunctions, gas from these wells must be routed to a sales line, used as an onsite fuel source or another useful purpose that a purchased fuel, chemical feedstock, or raw material would serve, or reinjected into the well or into another well upon start-up.

Under subpart OOOOc, for preexisting wells with documented methane emissions of 40 tons per year or less, flaring is permitted provided that the gas is routed to a flare or control device that achieves 95.0 percent reduction in methane. For existing wells with documented methane emissions of 40 tons per year or more, flaring is prohibited absent a showing of technical infeasibility with alternative options. These alternatives include routing the gas to a sales line, using it as an onsite fuel source or for another useful purpose, or injecting it back into the same well or another well. If all of these options are technically infeasible, then these existing wells (producing associated gas with more than 40 tpy of methane) can route associated gas to a flare or control device that achieves 95.0 percent reduction in methane.

Third-Party Monitoring of Super Emitters. EPA’s rule establishes the Super Emitter Program. Under this program, certain third-parties can seek agency authorization to detect “super emitter” events at operators’ sites and report those events to EPA. A super emitter event is defined by the rule as emissions of 100 kilograms (220.5 pounds) of methane per hour or larger.

To qualify, these third parties must be credentialed by EPA. Third parties must submit any super emitter detections to EPA, which then verifies them and notifies the operator. Upon receiving such a notification, an operator is required to investigate the alleged super emitter event within five days and report the results of the investigation to EPA within 15 days of the notification. Additionally, incidents that trigger this program may also trigger the Department of Transportation’s upcoming Pipeline and Hazardous Materials Safety Administration rule, which will likely impose reporting and remediation requirements in the event of a major leak (a term that has yet to be defined).

In response to industry comments, the final rule takes a different approach from the proposed rule in that EPA, and not third parties, will notify an identified owner or operator after reviewing third-party notifications of the presence of a super emitter event at or near its oil and gas. Also, in response to comments, the final rule provides that certified third parties only will be authorized to use remote sensing technologies such as satellites or aerial surveys—the program does not authorize third parties to enter well sites or other oil and gas facilities.

Storage Vessel Applicability Changes. In the regulation, EPA has retained the preexisting control and operational requirements governing storage tanks used in oil and gas production under NSPS Subparts OOOO and OOOOa, including the requirement to reduce emissions by 95 percent, but it has added methane into the VOC framework, changed the trigger governing when the federal requirements apply, and added requirements for determining when state permit limits are legally and practicably enforceable limits. These applicability changes potentially impact both new and existing operations.

For purposes of the NSPS applicability trigger governing new or modified facilities, EPA’s rule adds storage tank batteries (i.e. groups of tanks that are adjacent and receive fluids from the same source) to the existing definition of storage vessel. A tank battery is an affected facility under the rule if the aggregate potential methane emissions from the group of storage vessels is greater than or equal to 20 tons per year. This is a change from EPA’s preexisting approach under NSPS Subpart OOOO and OOOOa, which evaluates applicability based on emissions from individual storage tanks (as opposed to batteries). If owners or operators of new or modified facilities trigger NSPS Subpart OOOOb applicability under this new criteria, then the owners/operators of tanks or batteries qualifying as affected facilities must reduce VOC and methane emissions by 95 percent (as previously required by NSPS Subpart OOOO and OOOOa).

The NSPS rule also updates the definition of “modification” to cover the occurrence of an increase in potential emissions of a tank battery such that its potential to emit (PTE) exceeds the 6 tons of VOC per year or 20 tons of methane per year thresholds following any of these four specified physical or operational changes: (i) adding a storage vessel to an existing battery; (ii) increasing the cumulative storage capacity of the battery by replacing one or more storage vessels; (iii) for well sites or centralized production facilities: an existing battery receives additional crude oil, condensate, intermediate hydrocarbons, or produced water throughput (e.g. as a result of hydraulic fracturing or hydraulic refracturing); (iv) for compressor stations or onshore natural gas processing plants: an existing battery receives additional fluids which cumulatively exceed the throughput used in the most recent determination of the potential for VOC or methane emissions.

Owners/operators of existing tanks or tank batteries also will need to evaluate a new applicability trigger under the emissions guidelines set forth in Subpart OOOOc (as incorporated into state plans). Under the presumptive standard, for existing storage tanks or tank batteries with a PTE of 20 tons of methane per year or greater, owners/operators will have to reduce their emissions by 95 percent. In other words, under the rule, existing tank systems can now trigger NSPS requirements if their potential methane emissions exceed 20 tons per year.

Finally, EPA finalized criteria that must be met for a permit limit or other requirement to qualify as a legally and practicably enforceable limit for purposes of determining whether a tank battery is an affected facility or designated facility under NSPS OOOOb. A legally and practicably enforceable limit must include a quantitative production limit and quantitative operational limit(s) for the equipment, or quantitative operational limits for the equipment; an averaging time period for the production limit, if a production-based limit is used, that is equal to or less than 30 days; established parametric limits for the production and/or operational limit(s), and where a control device is used to achieve an operational limit, an initial compliance demonstration (i.e., performance test) for the control device that establishes the parametric limits; ongoing monitoring of the parametric limits that demonstrates continuous compliance with the production and/or operational limit(s); recordkeeping by the owner or operator that demonstrates continuous compliance with the limit(s) in; and periodic reporting that demonstrates continuous compliance.

New Methane Leaks Requirements. EPA’s new rule restructures leak detection and repair (LDAR) requirements based upon the type of facility involved in order to address methane and VOC leaks. In general, affected facilities are well sites, centralized production facilities, and compressor stations where components with the potential to emit fugitive emissions of methane or VOC are present.

Well sites are broken into several regulatory categories.

Single wellhead only well sites require quarterly audible, visual, and olfactory (AVO) inspections. Owners and operators have 15 days from detecting a leak to initiate repairs and must complete those repairs within 15 days after the first repair.
Multi-wellhead only well sites require semiannual optical gas imaging (OGI) inspections (or optional EPA Method 21 inspections) and quarterly AVO inspections. Repairs of any leaks must commence within 30 days of detection and be completed 30 days after the first repair attempt.
Well sites with major production and processing equipment, including one or more controlled storage vessels or tank batteries, control devices, or natural gas-driven process controllers or pumps, and centralized production facilities require quarterly OGI inspections (or optional EPA Method 21 alternative inspections) and bimonthly AVO inspections. Leak repairs must commence within 30 days and be completed 30 days after the first repair attempt.

At compressor stations, the rule requires quarterly OGI inspections (or EPA Method 21 alternative inspections) and monthly AVO inspections. Leaks detected using AVO inspections must be repaired within 15 days after detection and concluded within 15 days after that, while leaks detected using OGI or EPA Method 21 inspections must be repaired beginning 30 days after detection and finalized 30 days later.

The rule provides the opportunity for regulated parties to replace traditional leak detection programs (i.e. using Method 21 and OGI) with advanced measurement technologies such as on-site sensor networks and aerial flyovers using remote sensing technology. These technologies need to be approved by EPA in advance when an owner or operator submits a monitoring plan. The frequency at which these alternative technologies must be used in order to satisfy the traditional OGI/Method 21 requirements varies depending upon the capabilities of the technology itself. For example, if the technology has an aggregate detection threshold of 15 kilograms per hour, periodic screenings must be conducted monthly.

Well Closure. The rule requires that fugitive emissions monitoring continue until the closure of any well pursuant to a well closure plan. Once a well is closed, a final OGI survey must be performed. If any emissions are detected in this final survey, they must be eliminated. Then, the results of the OGI survey, along with other details of the well closure, must be submitted to EPA.

Pneumatic Pump And Controller Requirements. The new rule requires that all pneumatic pump affected facilities in the oil and gas industry have zero emissions. In other words, the rule prohibits natural gas-driven pumps except at facilities with fewer than three natural gas-driven diaphragm pumps in areas where other power sources are inaccessible. EPA’s new rule also requires pneumatic controllers (now called process controllers) outside of Alaska to have zero methane and VOC emissions. The rule provides a one-year period for operators and owners to come into compliance.

Well Liquids Unloading. The rule requires that affected gas wells that unload liquids minimize or eliminate venting of emissions during liquids unloading events to the maximum extent possible using best management practices. Alternatively, such wells can comply by reducing methane and VOC emissions from gas well liquids unloading events by 95 percent using a closed vent system (CVS) to route emissions to a control device.

Well Completions. The rule also regulates well completion of hydraulically fractured or refractured wells. During completion of most non-wildcat and non-delineation wells, owners or operators must route all flowback to a storage or completion vessel and separator. They must then utilize any salable gas (for example, as fuel on-site) and route all liquid to a storage or well completion vessel, a collection system, or another well. During completion of wildcat and delineation wells (and non-wildcat and non-delineation low pressure wells), owners or operators must either route all flowback to a completion combustion device or well completion vessels and use a separator.

Centrifugal Compressors. Centrifugal compressors with wet seals at new affected facilities other than well sites must reduce methane and VOC emissions from their fluid degassing systems by 95 percent by routing emissions to a control device or process. Some new centrifugal compressors such as centrifugal compressors with dry seals must instead meet work practice performance-based volumetric flow rate standards. At existing facilities located at non-well sites, the requirement will be monitoring and repair to maintain volumetric flow rate at or below 3 standard cubic feet per minute per seal.

Reciprocating Compressors. Reciprocating compressors must meet a performance-based emissions standard of 2 standard cubic feet per minute per cylinder.

Covers, Closed Vent Systems and Combustion Control Devices. Similar to the existing VOC rules, covers and CVSs must demonstrate their ability to comply with the no identifiable emissions standard through OGI or EPA Method 21 monitoring and AVO inspections conducted at the same frequency as the fugitive emissions monitoring for the type of site where the cover and CVS are located. Combustion control devices being used to meet a 95 percent emission reduction standard must demonstrate a continuous level of control of emissions through performance tests every 5 years.

Equipment Leaks at Natural Gas Processing Plants. Equipment located at onshore natural gas processing plants, defined as pumps, pressure relief devices, open-ended valves, and flanges and other connectors, must be inspected either (i) bimonthly using OGI monitoring or (ii) according to EPA Method 21 monitoring at the corresponding frequencies of each type of equipment. The rule also includes specific requirements for each piece of equipment. For example, open-ended valves must all be equipped with closure devices.

Sweetening Units. Affected facilities with a sulfur production rate of at least 5 long tons per day must reduce sulfur dioxide emissions by 99.9 percent. For affected facilities with a design capacity of less than 2 long tons per day of hydrogen sulfide in acid gas, recordkeeping and reporting are required but emissions controls are not. These rules only apply to new and modified sources.

How Does the Rule Intersect with Other Climate Change Laws and Programs? EPA’s final methane rule is part of a larger effort by the Biden Administration to address climate change. Related laws and proposals include:

In August 2022, Congress passed the Inflation Reduction Act (IRA) creating a phase-in schedule for a methane fee that commences in 2024. In 2024, the fee will be levied on methane emissions in excess of the allowance at a rate of $900 per metric ton. That rate will rise to $1200 in 2025, and it will remain at $1500 from 2026 on. Importantly, this fee applies only to facilities that are out of compliance with EPA’s methane emissions requirements and do not fall under another exemption.
In July 2023, EPA proposed key changes to the greenhouse gas emissions reporting requirements for the oil and gas sector. If finalized, most of the proposed changes would be reflected in reports for Reporting Year 2025, due by March 31, 2026.This proposed regulatory action would (i) newly require reporting for emissions from maintenance or other abnormal emission events (including planned releases from maintenance activities), (ii) revise existing calculation methodologies, (iii) expand reporting requirements for certain emissions sources, and (iv) clarify ownership transfer rules and reporting responsibility for assets sold or purchased during the reporting year.

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[1] To see a chart explaining how the 2023 rule compares to the 2012 and 2016 emissions rules with regard to specific facilities, go to https://www.epa.gov/system/files/documents/2023-12/epas-oil-and-natural-gas-final-rule-.table-of-covered-sources.pdf.

[2] In order to buoy the rule against potential legal challenges by states and other actors, the rule is self-described as severable with regard to each of its categories of actions and with regard to each emissions source it regulates.

[3] Two additional categories in the regulatory framework are edits to reconcile inconsistencies created by Congress’s repeal of 2020 methane rules and an appendix, appendix K, that establishes a protocol for the use of optical gas imaging inspections.

[4] A table summarizing the translation of BSER into concrete requirements for new and existing regulated sources can be found at https://www.epa.gov/system/files/documents/2023-12/summary-of-key-requirements-table.pdf.

The following Gibson Dunn attorneys assisted in preparing this update: Stacie Fletcher, Rachel Levick, Veronica J.T. Goodson, Monica Murphy, Samantha Yi*, and Dominic Solari.

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, the authors, or any of the following leaders and members of the firm’s Environmental Litigation and Mass Tort, Environmental, Social and Governance, Oil and Gas or Cleantech practice groups:

Environmental Litigation and Mass Tort:
Stacie B. Fletcher – Washington, D.C. (+1 202.887.3627, [email protected])
David Fotouhi – Washington, D.C. (+1 202.955.8502, [email protected])
Rachel Levick – Washington, D.C. (+1 202.887.3574, [email protected])
Veronica J.T. Goodson – Washington, D.C. (+1 202.887.3719, [email protected])

Environmental, Social and Governance (ESG):
Hillary H. Holmes – Houston (+1 346.718.6602, [email protected])
Elizabeth Ising – Washington, D.C. (+1 202.955.8287, [email protected])
Perlette M. Jura – Los Angeles (+1 213.229.7121, [email protected])
Ronald Kirk – Dallas (+1 214.698.3295, [email protected])
Michael K. Murphy – Washington, D.C. (+1 202.955.8238, [email protected])

Oil and Gas:
Michael P. Darden – Houston (+1 346.718.6789, [email protected])
Anna P. Howell – London (+44 20 7071 4241, [email protected])
Rahul D. Vashi – Houston (+1 346.718.6659, [email protected])

Cleantech:
John T. Gaffney – New York (+1 212.351.2626, [email protected])

*Samantha Yi is an associate working in the firm’s Washington, D.C. office who currently is admitted to practice in Maryland.

The steps will further strengthen London’s position as a leading centre for resolution of cross-border commercial disputes.

The UK Government has recently taken two steps that will further strengthen London’s position as a leading centre for the resolution of cross-border commercial disputes: (1) introducing legislation updating the UK Arbitration Act 1996 (the “1996 Act”); and (2) confirming that the UK will join the Hague Convention on the Recognition and Enforcement of Foreign Judgments in Civil or Commercial Matters (the “Hague Convention”) as soon as practicable. This client alert highlights some key takeaways from each development.

I. Updates to the 1996 Act

(a) Status

Arbitration in England and Wales is regulated by the 1996 Act – a framework that has helped contribute to London’s global ranking as the most preferred seat for international commercial arbitration.[1] In 2021, the UK Government asked the Law Commission to review the 1996 Act, to determine “whether there might be any amendments to be made in order to ensure that it is fit for purpose…”.[2]

The results of this consultation process were published in September 2023, together with proposed draft legislation to implement the reforms proposed (the “Arbitration Bill”). The consultation concluded that wholesale reform was not needed or wanted; and the list of recommendations were confined to “a few major initiatives”, and “a very small number of minor corrections”.[3]

On 21 November 2023, the Arbitration Bill began its progress through the UK Parliament.[4] It is expected that the legislative process will be straightforward, and that the amended act will become law in 2024.

(b) What are the key changes?

Although the Arbitration Bill does not seek to reform the 1996 Act wholesale, there are some important changes:

A new express provision for summary disposal. The Arbitration Bill provides that a party will be able to apply for a claim, defence or issue to be dismissed “on a summary basis” if it has “no real prospect of succeeding” (thus aligning the test with that of summary judgment in the English courts). Whilst the power to dismiss summarily exists implicitly under the 1996 Act, the lack of express provision has meant that arbitral tribunals have been reluctant to exercise this power in practice. The proposed standard for dismissal is lower than most arbitral institutional rules provide (“manifestly without merit”).[5] Parties may nevertheless agree to those higher standards, however, as the new provision of the 1996 Act will be ‘opt out’.

The law governing an arbitration agreement is the law of the seat of the arbitration, absent express party agreement otherwise. This reverses the UK Supreme Court’s decision in Enka v Chubb [2020] UKSC 38,[6] where the court held, in short, that where parties have not expressly chosen a law to govern an agreement to arbitrate, but they have made an express choice of law to govern the wider (or “matrix”) contract in which the arbitration agreement sits, the law governing the matrix contract is likely to be considered the implied choice of law of the arbitration agreement. This is an important change for parties negotiating arbitration agreements: the law that governs that arbitration agreement should be express if different to the law of the seat, otherwise it will be deemed to be the law of the seat.

The process for challenging an award for lack of substantive jurisdiction has changed. Under s. 67 of the 1996 Act, a party may challenge an award as to its substantive jurisdiction, and this will involve a full re-hearing before court. The Arbitration Bill expressly limits the new arguments that may be heard in that context as follows:
- a ground for objection that was not raised before the arbitral tribunal must not be raised before the court unless the applicant shows that, at the time of the arbitration proceedings, the applicant did not know and could not with reasonable diligence have discovered the ground;
- evidence that was not heard by the tribunal must not be heard by the court unless the applicant shows that, at the time of the arbitration proceedings, the applicant could not with reasonable diligence have put the evidence before the tribunal; and
- evidence that was heard by the tribunal must not be re-heard by the court, unless the court considers it necessary “in the interests of justice”.

The court’s supportive powers of arbitration proceedings have been clarified. The Arbitration Bill: (i) clarifies that orders under s. 44 of the 1996 Act (including in relation to the preservation of evidence, and for injunctive relief) can be made against third parties;[7] and (ii) provides for the enforcement of emergency arbitrator decisions.[8]

Codifies an arbitrator’s duty of disclosure, introducing a statutory duty on an arbitrator to disclose “circumstances that might reasonably give rise to justifiable doubts as to [their] impartiality”.[9]

II. UK to join the Hague Convention

The second notable development is the UK Government’s confirmation that the UK will join the Hague Convention “as soon as practicable”, following a consultation period.[10]

The Hague Convention is a multilateral convention, which entered into force on 1 September 2023. The Hague Convention provides a set of common rules for the recognition and enforcement of judgments given in civil and commercial matters, between Contracting Parties. The merits of a judgment cannot be reviewed, and recognition and enforcement can only be refused on the grounds specified therein. While most national laws provide for the enforcement of foreign judgments (subject to certain conditions), such laws differ as between jurisdictions. This can make the enforcement of foreign judgments unpredictable, lengthy and costly. By establishing common rules, however, the Hague Convention provides greater certainty and reduces complexity (and cost) of that process.

The UK Government is expected to sign and ratify the Hague Convention without delay, and it will enter into force 12 months from the date on which the UK deposits its instrument of ratification.

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[1] Queen Mary University of London, 2021 International Arbitration Survey: Adapting arbitration to a changing world, available here: https://arbitration.qmul.ac.uk/research/2021-international-arbitration-survey/.

[2] Law Commission, Review of the Arbitration Act 1996, Current project status, available here: https://lawcom.gov.uk/project/review-of-the-arbitration-act-1996/.

[3] Law Commission, Review of the Arbitration Act 1996: Final report and Bill, paragraph 1.22, available here: https://lawcom.gov.uk/project/review-of-the-arbitration-act-1996/.

[4] https://bills.parliament.uk/publications/53038/documents/4022.

[5] See, for example, LCIA Arbitration Rules 2020, Article 22.1(viii); ICSID Convention Arbitration Rules 2022, Article 41; ICC Rules of Arbitration, Article 22 and Note to Parties and Arbitral Tribunals on the Conduct of the Arbitration under the ICC Rules of Arbitration, Section C.

[6] Enka v Chubb [2020] UKSC 38, available here: https://www.supremecourt.uk/cases/docs/uksc-2020-0091-judgment.pdf.

[7] Section 9 of the Arbitration Bill.

[8] Section 8 of the Arbitration Bill.

[9] Section 2(2) of the Arbitration Bill.

[10] Government response to the Hague Convention of July 2019 on the Recognition and Enforcement of Foreign Judgements in Civil or Commercial Matters (Hague 2019), 23 November 2023, available here: https://www.gov.uk/government/consultations/hague-convention-of-2-july-2019-on-the-recognition-and-enforcement-of-foreign-judgments-in-civil-or-commercial-matters-hague-2019/outcome/government-response-to-the-hague-convention-of-july-2019-on-the-recognition-and-enforcement-of-foreign-judgements-in-civil-or-commercial-matters-hagu.

The following Gibson Dunn attorneys assisted in preparing this update: Piers Plumptre, Stephanie Collins, Theo Tyrrell and Harriet Codd.

Gibson Dunn’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 member of the firm’s International Arbitration, Judgment and Arbitral Award Enforcement, or Transnational Litigation practice groups, or any of the following in London:

Penny Madden KC (+44 20 7071 4226, [email protected])
Piers Plumptre (+44 20 7071 4271, [email protected])
Stephanie Collins (+44 20 7071 4216, [email protected])
Theo Tyrrell (+44 20 7071 4016, [email protected])
Harriet Codd (+44 20 7071 4057, [email protected])

The Co-Chairs of our Privacy, Cybersecurity and Data Innovation Practice Group, Ahmed Baladi (Paris) and Alexander Southwell (New York), and partner Cassandra Gaedt-Sheckter (Palo Alto), discuss how GDPR has impacted U.S. laws and companies. They examine the contrasts between U.S. privacy laws and GDPR in Europe, provide an overview of enforcement actions in the U.S., particularly California, and review the challenges companies face when dealing with global data privacy laws.

Previous Episode | Next Episode

HOSTS:

Ahmed Baladi is a partner in the Paris office of Gibson, Dunn & Crutcher, where he is co-chair of the firm’s Privacy, Cybersecurity and Data Innovation practice and a member of the Artificial Intelligence practice. Ahmed has developed renowned experience in a wide range of privacy and cybersecurity matters including compliance and governance programs in light of the GDPR. He regularly represents companies and corporate executives on investigations and procedures before Data Protection Authorities. He also advises a variety of clients on data breach and national security matters including handling investigations, enforcement defense and crisis management.

Alexander Southwell is one of the nation’s leading technology-focused litigators and investigations lawyers and is regularly called upon by numerous leading global companies to counsel on — as well as handle investigations, enforcement defense, and litigation related to — a wide array of privacy, data breach, information technology and governance, theft of trade secrets, computer fraud, advertising and marketing practices, and network and data security issues. A partner in Gibson, Dunn & Crutcher’s New York office, Mr. Southwell founded and co-chairs the Firm’s Chambers-ranked Privacy, Cybersecurity, and Data Innovation Practice Group and is a member of the White Collar Defense and Investigation, Litigation, Crisis Management, and Artificial Intelligence Practice Groups. Mr. Southwell is a Certified Information Privacy Professional (CIPP/US) through the International Association of Privacy Professionals.

Cassandra Gaedt-Sheckter is a partner in Gibson, Dunn & Crutcher’s Palo Alto office, where she co-chairs the global Artificial Intelligence (AI) practice, and is a key member of the Privacy, Cybersecurity and Data Innovation practice, including as the leader of the firm’s State Privacy Law Task Force. With extensive experience advising companies on AI, data privacy, and cybersecurity issues, Cassandra focuses on regulatory compliance counseling and privacy and AI program development, regulatory enforcement matters, and transactional representations. Cassandra advises clients in various industries, from leading tech companies and luxury fashion companies, to shipping giants.

The proposed regulations address, on a comprehensive basis for the first time in over 40 years, the determination of the investment tax credit for energy property under section 48.

On November 17, 2023, the IRS and Treasury issued proposed regulations (the “Proposed Regulations”) addressing, on a comprehensive basis for the first time in more than 40 years, the determination of the investment tax credit for energy property under section 48 (the “ITC”).[1] The Proposed Regulations also revisit more recent guidance on the prevailing wage and apprenticeship requirements (the “PWA Requirements”)[2] and provide guidance on other changes resulting from the Inflation Reduction Act of 2022 (the “IRA”), which made substantial adjustments to the ITC.[3] Taxpayers are permitted to rely on the Proposed Regulations until final regulations are published.

This alert briefly provides background on the ITC, summarizes the primary substantive content of the Proposed Regulations, and concludes with some observations regarding key implications for taxpayers.

Background

ITC-eligible property includes certain solar energy property, qualified biogas property, energy storage technology, and certain other properties. Although an ITC has been available for the placement in service of qualifying energy property since 1978, the IRS and Treasury have not issued comprehensive guidance relating to the determination of energy property ITC since 1981, despite significant technological developments and material changes to section 48 in the interim. Most recently, the IRA significantly increased the types of property that are eligible for the ITC, introduced the PWA Requirements, and added ITC “adder” or “bonus” amounts for projects that meet additional requirements (e.g., “energy community” siting and domestic content).[4] As a result, the ITC provisions are among the more frequently revised provisions in the Code, and the IRS and Treasury staff faced a heavy task in attempting to capture a lifetime (literally) of legal developments.

The Proposed Regulations provide long-sought updates to the ITC regulations and additional guidance with respect to critical IRA provisions.

Requirements for Energy Property

The Proposed Regulations touch nearly every aspect of ITC determination and computation; in some instances, the Proposed Regulations appear to represent a significant departure from existing law.

Units of Energy Property and Integral Parts

The Proposed Regulations provide that ITC-eligible property includes both (1) energy property (defined to “include” a “unit of energy property,” which is further defined as “all functionally interdependent components”) and (2) integral parts.[5] A component of energy property is “functionally interdependent” if placing the component in service, along with the other components, is necessary to generate or store electricity, thermal energy, or hydrogen, or otherwise perform a required function. “Integral part” is defined using long-standing ITC principles (and notably would include subsea export cables to an onshore substation).

Retrofitted Property

Generally speaking, under the IRS’s “80/20 rule” (which has appeared in various forms of IRS guidance), property may be treated as originally placed in service even if it contains some items of used property as long as the fair market value of the used property is not more than 20 percent of the total value of the relevant property. The Proposed Regulations make explicit the application of the 80/20 rule to ITC property, but compute the 80/20 rule by reference to the “unit of energy property” under the definition described above and take into account costs paid or incurred with respect to “integral parts” for ITC purposes only if the 80/20 rule is satisfied with respect to the “unit of energy property.” Importantly, subject to limited exceptions, the Proposed Regulations make clear that modifications or improvements to existing energy property are not eligible for the ITC unless the 80/20 rule is satisfied.

Fractional Interest / Multiple Owners Rule

The Proposed Regulations introduce a new rule providing that a taxpayer must own at least a fractional interest in an entire “unit of energy property” to claim the ITC in respect of any component of that energy property. Put differently, the ITC is disallowed if, for example, a taxpayer owns only one or more components (but less than all) of a “unit of energy property.” For purposes of this rule, “related taxpayers” (i.e., members of a group of trades or businesses that are under common control under Treas. Reg. § 1.52–1(b)) are treated as a single taxpayer.[6]

Dual Use Property

Under the existing regulations, if property uses energy from both qualifying sources and nonqualifying sources, the eligibility of the property for the ITC depends on the annual percentage of energy used from qualifying sources. Above a threshold percentage (computed with respect to each applicable year), the ITC is determined on a proportionate basis; below the cliff threshold percentage, the ITC is disallowed. In response to numerous taxpayer requests, the Proposed Regulations lower the cliff threshold percentage for ITC eligibility from 75 percent to 50 percent. Before the IRA, the dual use property rule was particularly onerous for determining the ITC eligibility of energy storage technologies, but the Proposed Regulations confirm that the IRA effectively overrode the dual use property rule for energy storage technologies.

Categories of Energy Property

In addition to simply updating the existing regulations for changes to the Code, the Proposed Regulations provide new guidance defining both new and existing categories of energy property. Certain of these categories are discussed below.

Energy storage technology. The Proposed Regulations would provide several critical clarifications regarding ITC-eligible energy storage technology:

Ammonia, methanol, and other hydrogen carriers: The preamble indicates that ITC-eligible hydrogen energy storage property includes storage via a “material based” medium (which may include forms of ammonia and methanol) or a “physical based” storage medium, provided that the storage is used solely for the production of energy (including the production of heat, the generation of electricity, or the use in a fuel cell vehicle) and not for the production of end products, such as fertilizer

Rechargeable electrochemical batteries and “second life” batteries: Rechargeable electrochemical batteries of all types would be ITC eligible. “Second life” battery components would be counted in determining whether an improvement to energy storage technology is ITC eligible, but, as is required by the Code, only if the modifications to the energy storage technology satisfy the statutory threshold applicable to that modified energy storage technology.[7] The IRS and Treasury separately are continuing to consider whether “second life” batteries should be considered new components for purposes of the 80/20 rule (discussed above).

Qualified biogas property. ITC-eligible qualified biogas property is defined in the Code as property comprising a system that converts biomass into a gas that is not less than 52 percent methane and captures the gas for sale or productive use (rather than for disposal by combustion), including any cleaning and conditioning property that is part of such a system. Notwithstanding the statutory reference to cleaning and conditioning property, however, the definition in the Proposed Regulations expressly excludes gas upgrading equipment, which generally concentrates the biogas (through removal of other gases such as carbon dioxide, nitrogen, or oxygen) into a mixture for injection into a pipeline.[8]

Geothermal property. The Proposed Regulations would clarify that ITC-eligible geothermal energy property includes production wells, injection wells, monitoring wells, and certain electricity generating equipment (for those projects that convert geothermal energy to electricity).[9] Consistent with the existing ITC regulations, distribution equipment also would be included as geothermal property under the Proposed Regulations.[10]

Electrochromic glass. The Proposed Regulations confirm statements in the legislative record that ITC-eligible electrochromic glass includes the full controls package, the electrochromic glass coating, as well as window and installation components (including glass, flashing, framing, and sealants). The Proposed Regulations add that windows incorporating electrochromic glass must be rated in accordance with the National Fenestration Rating Council (NFRC) and that secondary glazing systems must be rated in accordance with the Attachments Energy Rating Council (AERC) Rating and Certification Process.

Co-located property. The Proposed Regulations, like the Code, make clear that no ITC may be claimed in respect of any property that is part of a qualified facility generating section 45 production tax credits (“PTCs”). This prohibition makes delineating between an energy property (on which ITC is claimed) and a qualified facility (on which PTCs are claimed) of critical importance. Nevertheless, the Proposed Regulations provide that property that is shared by a PTC facility and an ITC property and that is an integral part of the ITC property will not be excluded from ITC qualification under this rule. An example in the Proposed Regulations illustrates the rule (or, perhaps, the exception to the rule) in the case of a PTC-eligible wind generation facility and an ITC-eligible energy storage property that share power conditioning and transfer equipment (which is integral to the energy storage property). The example explains how to allocate the cost of the power conditioning and transfer equipment between the wind generation facility and the energy storage property (for purposes of determining eligible ITC basis) and concludes that the shared integral equipment is ITC eligible (to the extent of the eligible basis) and that, because the shared equipment is not considered part of the PTC facility, the wind facility is eligible for PTCs.

Apprenticeship Requirements for Alteration and Repair

The Proposed Regulations would withdraw and re-propose portions of the proposed regulations issued with respect to the PWA Requirements in August 2023.

Under the IRA, other than certain grandfathered and statutorily excepted projects, a taxpayer seeking to claim the full (i.e., 30 percent, before adders) ITC generally must satisfy the PWA Requirements, including with respect to any alteration or repair of the ITC property during the five-year period beginning after the property is placed in service. Statutory cure provisions are available in the case of certain PWA Requirement failures, and if a taxpayer fails to cure a prevailing wage requirement failure during the recapture period, the unvested portion of the ITC would be subject to recapture. (Generally, 20 percent of the ITC fully vests every year, including the ITC “increase” for satisfying the PWA Requirements.) The Proposed Regulations would eliminate the recapture requirements for failing to satisfy the apprenticeship rules with respect to alteration and repair during the recapture period.[11]

“Energy Project” for PWA Requirements, Domestic Content, and Energy Community Rules

The PWA Requirements, the “domestic content” adder, and the “energy community” adder are applied with respect to an “energy project,” which is defined by the IRA as one or more energy properties that are operated as part of a single energy project. The Proposed Regulation would provide that multiple energy properties will be treated as an “energy project” if, at any time during the construction of the multiple energy properties, they are owned by a single taxpayer (together with any “related taxpayers”) and any two or more of the following factors are present:

The energy properties are constructed on contiguous pieces of land;
The energy properties are described in a common power purchase, thermal energy, or other off-take agreement or agreements;
The energy properties have a common intertie;
The energy properties share a common substation or thermal energy offtake point;
The energy properties are described in one or more common environmental or other regulatory permits;
The energy properties are constructed pursuant to a single master construction contract; or
The construction of the energy properties are financed pursuant to the same loan agreement.[12]

The Proposed Regulations also provide that, if multiple energy properties are treated as a single energy project under the begun construction rules (described in the preceding footnote), the multiple energy properties also will be treated as a single energy project for purposes of the PWA Requirements, the “domestic content” adder, and the “energy community” adder.

Commentary

The Proposed Regulations are a welcome development, but the guidance they provide is incomplete, especially without corresponding, fulsome recapture guidance (which, in its current form, is even more outdated than the existing ITC regulations). For example, the Proposed Regulations’ definition of a “unit of energy property” applies for purposes of (1) defining ITC-eligible property that does not need to separately satisfy the “integral” requirement, (2) applying the 80/20 rule, and (3) applying the new “fractional interest” rule. However, unlike the Code’s other “unit of property” rules (g., under sections 168 and 263A), this “unit of energy property” confusingly may not be the same unit of property with respect to which the ITC is actually determined or, critically, subjected to recapture.[13] Recapture guidance for circumstances in which damaged property is replaced is especially needed (in particular, in light of revisions to the 80/20 rule discussed below).

The Proposed Regulations state that “buildings (also referred to as structures) are generally not integral parts of an energy property because they are not integral to the activity of the energy property,” and then import part of a pre-1986 regular investment tax credit rule to define potentially “integral” buildings that are ITC-eligible.[14] However, any generalization against energy ITC-eligibility for buildings is not supported by the Code; buildings (and structural components) have been explicitly eligible (without qualification) for the energy ITC since it was enacted in 1978 (a point reiterated in the regulations since 1981), an effort by Congress to save taxpayers seeking the energy credit for building components from having to satisfy the exact rules to which the Proposed Regulations would subject them.[15] Indeed, several ITC-eligible properties are themselves building components.

Applying the 80/20 rule with respect to the ITC on a “unit of energy property” basis may represent a potentially significant change from present law, although its full effect is unclear without additional recapture guidance.[16] For example, although not as well developed as guidance under sections 168 or 263A, existing ITC guidance and rulings generally have analyzed the ITC qualification (and recapture) of replacement parts and improvements on a separate property-by-property basis.

The Proposed Regulations include welcome clarification that has been sought for several years by the offshore wind industry, making clear that ITC eligible property includes all property from the turbine downstream to onshore transformer and switchgear, including clarification that subsea export cables would qualify for the ITC.

The new fractional interest / multiple owners rule creates a massive new cliff-effect trap that will require taxpayers to be certain they own at least a fractional interest in the entire “unit of energy property” or otherwise risk total disallowance. The rule directly conflicts with the Tax Court’s decision in Cooper v. Commissioner;[17] it may be that the “unit of energy property” rules (described above) are intended to overrule that decision, although there is no mention of this intent in the preamble. This rule is likely to have an outsized impact on certain types of projects, including landfill gas projects, that are more likely to have different components of the project owned by different owners.

Although an example in the Proposed Regulations shows the ITC being claimed in respect of a battery that is co-located with a PTC facility, given the high stakes, further clarification would be helpful. For example, is a battery that is co-located with a PTC facility eligible for ITC even where the battery is not connected to the grid and is charged solely from the PTC facility (e., is arguably “integral” to the PTC facility)? Given the “integral part” framework of the Proposed Regulations and that a battery and a co-located PTC facility may represent separate projects, we believe it would be appropriate to adopt a bright-line rule specifying that energy storage property is eligible for the ITC even where the “unit of energy property” is integral to a co-located PTC facility.

Under the revised definition of “energy project,” which expressly excludes a facility on which PTC is claimed, it is curious that the decision about whether to claim PTC or ITC on a generation facility could have a material impact on the availability of certain credit adders, such as the domestic content adder, even for identical project configurations. (In particular, if PTC is claimed on the generation facility, then the generation facility and battery are independently tested. If, on the other hand, ITC is claimed on the generation facility, then the generation and battery are jointly tested.) A rule allowing for independent assessment of whether each particularly type of energy property is eligible for an adder would provide a more cohesive set of rules.

Application of the expansive “energy project” rules to the PWA Requirements, the “domestic content” adder, and the “energy community” adder (and, in particular, the “related taxpayer” rule) will make satisfaction of these requirements more challenging and will introduce new diligence and documentation hurdles.

The exclusion of gas upgrading equipment from the definition of qualified biogas property surprised many market participants (as it is arguably at odds with both the text of section 48 and analogous guidance) and is uncertain in scope. The preamble states that gas upgrading equipment is not a “functionally interdependent” component of qualified biogas property (and, therefore, implicitly not a “unit of [qualified biogas] energy property”). Unfortunately, the Proposed Regulations do not address whether gas upgrading equipment could be an “integral part” of qualified biogas property, e. whether gas upgrading equipment is used directly in the intended function of qualified biogas property and is essential to the completeness of the intended function.[18] Under this framework, gas upgrading equipment would seem to be an integral part of a single process to prepare biogas for sale or productive use; if the IRS and Treasury intended to signal that gas upgrading equipment needed to satisfy the “integral part” analysis (as it did with other equipment), would be helpful if they make that intent clearer.

Effective Date

The Proposed Regulations generally apply with respect to property placed in service during a taxable year beginning after the regulations are final, although (1) taxpayers may rely on these Proposed Regulations for taxable years beginning after December 31, 2022 and (2) the Proposed Regulations relating to the PWA Requirements apply to projects that begin construction after the date final regulations are published (except that the “energy project” rule applies to projects on which construction begins after November 22, 2023).

__________

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

[2] Please see our previous alert on the proposed regulations addressing the PWA Requirements, which is found here.

[3] 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.”

[4] Please see our previous client alerts on these adders, which can be found here and here.

[5] “Integral parts” of energy property have been ITC-eligible since the energy credit was enacted in 1978, although the “integral part” language was not included in section 48 when the ITC statute was amended in 1990 for the gradual elimination of the regular investment tax credit that began in 1986. A reference to “integral parts” was included in section 48(a)(5) (election to claim the ITC for PTC facilities) when it was later enacted, and the statutory gap will be filled entirely when the ITC transitions to the technology neutral tax credit under section 48E in 2025.

[6] The preamble observes that “related taxpayer” is neither defined in section 48 nor did the IRS or Treasury receive comments regarding the “related taxpayer” rule in response to Notice 2015–70. Some further explanation may help clear up the confusion (and give an indication of the drafting task facing the IRS and Treasury): “Related taxpayer” is not defined in section 48 because it is not used in section 48; the language was removed, along with the rule to which it related, in 1990. The IRS and Treasury did not receive comments regarding the “related taxpayer” rule in response to Notice 2015–70 for that reason (and also because the IRS and Treasury did not ask for any such comments).

[7] Although improvements are generally not ITC eligible unless the modified property satisfies the 80/20 rule under the Proposed Regulations, modifications to energy storage technologies are subject to special statutory rules.

[8] In addition, the Proposed Regulations state that methane measurement would occur at the point at which gas exits the biogas production system, but likely before the biogas enters the gas upgrading equipment.

[9] Under the Proposed Regulations production equipment does not include equipment used for exploration and development of geothermal deposits.

[10] Distribution equipment generally is defined as equipment that transports geothermal energy from a geothermal deposit to the site of ultimate use. As is the case with the existing ITC regulations, however, geothermal property would not include any electrical transmission equipment.

[11] The cross-references in Prop. Treas. Reg. § 1.6418-5(f)(2) and Prop. Treas. Reg. § 1.6418-5(f)(3) to Prop. Treas. Reg. § 1.48-13(c)(3)(D) and to Prop. Treas. Reg. § 1.48-13(c)(3)(B), respectively, appear to have been intended as cross-references to Prop. Treas. Reg. § 1.48-13(c)(4) and to Prop. Treas. Reg. § 1.48-13(c)(3)(ii), respectively.

[12] Notice 2018-59 included a similar list of “single project” factors for purposes of determining whether construction had begun on a project, but did not contain the same numerical, two-factor threshold.

[13] Perhaps the single most persistent complaint we hear from clients involved in energy transition activities is the Code’s and Regulations’ inconsistent use of the critical IRA terms “project,” “facility,” “property,” and “component.” The Proposed Regulations may add “unit” to the list.

[14] Like the “unit of energy property” rule, this aspect of the Proposed Regulations appears to have its origins in Notice 2018-59, which is taxpayer-friendly guidance that addresses when construction began on ITC-eligible property but does not provide guidance as to what constitutes ITC-eligible property.

[15] This rule changes beginning in 2025, when buildings and their structural components become ineligible for the ITC under section 48E.

[16] Once again, this aspect of the Proposed Regulations appears to have been based on Notice 2018-59, which did not provide guidance for ITC eligibility.

[17] 88 T.C. 84 (1987).

[18] In contrast, the Proposed Regulations regarding electricity-generating property would treat analogous “power conditioning” and “transfer equipment” as integral.

The following Gibson Dunn attorneys prepared this update: Mike Cannon, Matt Donnelly, Josiah Bethards, Blake Hoerster, Alissa Fromkin Freltz, Duncan Hamilton, and Austin Morris.

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 following authors:

Tax:
Michael Q. Cannon – Dallas (+1 214.698.3232, [email protected])
Matt Donnelly – Washington, D.C. (+1 202.887.3567, [email protected])
Josiah Bethards – Dallas (+1 214.698.3354, [email protected])
Alissa Fromkin Freltz – Washington, D.C. (+1 202.777.9572, [email protected])
Duncan Hamilton– Dallas (+1 214.698.3135, [email protected])
Blake Hoerster – Dallas (+1 214.698.3180, [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])

An annual update of observations on new developments and highlights of considerations for calendar-year filers preparing Annual Reports on Form 10-K.

Each year we offer our observations on new developments and highlight select considerations for calendar-year filers as they prepare their Annual Reports on Form 10-K. This alert touches upon recent rulemaking from the U.S. Securities and Exchange Commission (“SEC”), comment letters issued by the staff of the SEC’s Division of Corporation Finance (the “Staff”), and trends among reporting companies that have emerged throughout the last year.

An index of the topics described in this alert is provided below.

I. New Disclosure Requirements for 2023
A. Update on Repurchase Rule
B. Cybersecurity Risk Management, Strategy, and Governance Disclosures
1. Risk Management and Strategy
2. Governance
C. Rule 10b5-1 Plan Disclosures for Section 16 Officers and Directors
D. Compensation Clawback Disclosures
II. Disclosure Trends and Considerations
A. Climate Change
B. Human Capital
C. Generative Artificial Intelligence
D. Geopolitical Conflict
E. Potential Government Shutdown
F. Inflation and Interest Rate Concerns
III. SEC Comment Letter Trends
IV. Other Reminders and Considerations
A. Disclosure Controls and Procedures
B. Characterization of Legal Proceedings
C. EDGAR Next
D. Filing Requirement for “Glossy” Annual Report
E. Cover Page XBRL Disclosures

I. New Disclosure Requirements for 2023

Throughout 2023, the SEC has maintained the rapid pace of rulemaking we have seen since Chair Gary Gensler took office in 2021. New disclosure requirements that, for calendar year-end companies, will begin to apply for the first time with the 2023 Form 10-K consist of:

Cybersecurity risk management, strategy, and governance disclosures, which will be included under “Item 1C. Cybersecurity,” a new caption under Part I; and
Compensation clawback-related disclosures, which involve a new Exhibit 97, two new checkbox disclosures on the Form 10-K cover page, and disclosure in Part III, “Item 11. Executive Compensation,” which most companies will forward-incorporate by reference to their upcoming proxy statements.

Beginning with the 2024 Form 10-K next year, all of the new cybersecurity disclosure requirements will need to be tagged in Inline XBRL (“iXBRL”).

Rules that would have required new disclosures around company share repurchases and company Rule 10b5-1 plans were challenged in litigation and therefore appear unlikely to apply to companies’ 2023 Forms 10-K.

Set forth below are discussions of each of the new disclosure requirements.

A. Update on Repurchase Rule

On November 22, 2023, the SEC announced [1] that it had issued an order indefinitely postponing the effectiveness of the Share Repurchase Disclosure Modernization rule (the “Repurchase Rule”), pending further SEC action. At the same time, the SEC asked the Fifth Circuit for additional time to respond to the court’s order, discussed below, requiring the SEC to correct deficiencies in the Repurchase Rule by November 30, 2023. The petitioners in the lawsuit that had challenged the Repurchase Rule opposed the SEC’s motion and requested instead vacatur of the Repurchase Rule. The court denied the SEC’s motion on November 26, 2023. We will provide further updates on the Repurchase Rule in the Gibson Dunn Securities Regulation Monitor.[2]

The Repurchase Rule, discussed in our client alert here[3], requires companies to: (i) disclose daily company share repurchase data in a new table filed as an exhibit to reports on Form 10-Q and Form 10-K, (ii) provide narrative disclosure in those filings about the company’s share repurchase program, including its objectives and rationale, and referencing the particular repurchases that correspond to that narrative, (iii) indicate by a checkbox whether any executives or directors traded in the company’s equity securities within four business days before or after the public announcement of the repurchase plan or program or the announcement of an increase of an existing share repurchase plan or program, and (iv) provide quarterly disclosure regarding the company’s adoption or termination of any Rule 10b5-1 trading arrangements. The Repurchase Rule was scheduled to go into effect beginning with the Form 10‑K or Form 10-Q filed for the first full fiscal quarter beginning on or after October 1, 2023, meaning that for calendar year-end companies, these disclosure requirements would have applied to the 2023 Form 10-K. While the Repurchase Rule is stayed, the pre-existing share repurchase disclosure rules, requiring information on share repurchase programs and quarterly repurchase disclosures presented on an aggregated, monthly basis, remain in effect. In addition, as discussed in Section I.C below, companies must continue to satisfy the Rule 10b5-1 plan disclosure requirements for Section 16 officers and directors.

B. Cybersecurity Risk Management, Strategy, and Governance Disclosures

On July 26, 2023, the SEC adopted a suite of new cybersecurity disclosure requirements, which we discussed in our client alert available here.[4] In addition to the incident disclosure requirements on Form 8-K, the final rule includes a number of new disclosure items on Form 10-K regarding cybersecurity risk management, strategy, and governance under new Item 106 of Regulation S-K. Companies are required to comply with these disclosure requirements beginning with the Form 10-K for the first fiscal year ending on or after December 15, 2023, which for calendar year-end companies is the 2023 Form 10-K.

1. Risk Management and Strategy

Under new Item 106, companies are required to describe their processes, if any, for assessing, identifying, and managing material risks from cybersecurity threats in sufficient detail for a reasonable investor to understand those processes. The definitions of cybersecurity incident and cybersecurity threat extend to all information systems a company uses, not just those the company itself owns. In providing such disclosure, a company should address, as applicable, the following non-exclusive list of disclosure items:

Whether and how any such processes have been integrated into the company’s overall risk management system or processes;
Whether the company engages assessors, consultants, auditors, or other third parties in connection with any such processes; and
Whether the company has processes to oversee and identify such risks from cybersecurity threats associated with its use of any third-party service provider.

Companies must also describe whether any risks from cybersecurity threats, including as a result of any previous cybersecurity incidents, have materially affected or are reasonably likely to materially affect the company, including its business strategy, results of operations, or financial condition and if so, how.

While discussing the board’s role in company-wide risk oversight is familiar for public companies, this new requirement goes further and requires that companies delve more deeply into the company’s efforts to assess, identify and manage this one particular area of risk. As such, compliance with the rules will require coordination with personnel responsible for day-to-day cybersecurity risk management.

2. Governance

Companies must describe the board of directors’ oversight of risks from cybersecurity threats. If applicable, companies must identify any board committee or subcommittee responsible for the oversight of risks from cybersecurity threats and describe the processes by which the board or such committee is informed about such risks. In addition, companies must describe management’s role in assessing and managing the company’s material risks from cybersecurity threats, with such disclosure addressing, as applicable, the following non-exclusive list of disclosure items:

Whether and which management positions or committees are responsible for assessing and managing such risks, and the relevant expertise of such persons or members in such detail as necessary to fully describe the nature of the expertise;
The processes by which such persons or committees are informed about and monitor the prevention, detection, mitigation, and remediation of cybersecurity incidents; and
Whether such persons or committees report information about such risks to the board of directors or a committee or subcommittee of the board of directors.

With respect to management’s expertise, the instructions to Item 106 provide that it may include “[p]rior work experience in cybersecurity; any relevant degrees or certifications; any knowledge, skills, or other background in cybersecurity.” Interestingly, with this requirement, the SEC is seeking a level of detail regarding cybersecurity executives’ backgrounds that is not even required for chief executive officers or chief financial officers. Companies will need to think through how much detail is “necessary to fully describe the nature of the expertise” of its chief information security officer or other cybersecurity personnel.

As noted by the SEC, many companies currently address cybersecurity risks and incidents in the risk factor sections of their filings, and risk oversight and governance are often addressed in companies’ proxy statements. However, the new rule requires disclosures to appear in a newly designated Item 1C in Part I of the Form 10-K and does not allow the disclosures to be incorporated from the proxy statement. Companies should review their risk factor and proxy statement disclosures when drafting the new discussions of cybersecurity risk management, strategy, and governance in order to maintain consistency with the company’s past public statements regarding its cybersecurity risks governance and processes and to assess how those disclosures may be conformed or enhanced going forward. We expect companies will continue to include disclosure of cybersecurity governance in their proxy statements, and therefore should confirm that they are using terminology consistently across the documents and should consider whether any details disclosed under the new requirements should be repeated in the proxy statement disclosure.

Companies should note that, beginning with the Form 10-K next year (2024 for calendar year-end companies), all of the new disclosure requirements will need to be tagged in iXBRL (block text tagging for narrative disclosures and detail tagging for quantitative amounts).

C. Rule 10b5-1 Plan Disclosures for Section 16 Officers and Directors

On December 14, 2022, the SEC adopted a final rule introducing disclosure requirements with respect to the adoption or termination of Rule 10b5-1 plans by Section 16 officers and directors, which we discussed in more detail in our client alert available here.[6] In Form 10-K and Form 10-Q, companies must disclose whether any Section 16 officer or director adopted or terminated a Rule 10b5-1 plan or a “non-Rule 10b5-1 trading arrangement” during the prior quarter. Amended Rule 10b5-1 now specifically states that any modification or amendment to an existing trading plan to change the amount, price, or timing of the purchase or sale of the securities underlying the plan would be deemed termination of a plan and entry into a new plan, and would therefore trigger disclosure in the Form 10-K or Form 10-Q covering the quarter in which the plan was modified or amended. For all companies but smaller reporting companies (“SRCs”), the requirement became effective with the filing covering the first full fiscal quarter that began on or after April 1, 2023. SRCs are required to comply with the requirement beginning with the filing covering the first full fiscal quarter beginning on or after October 1, 2023, which for calendar year-end SRCs is the 2023 Form 10‑K. As noted above, the Repurchase Rule would have required disclosure of the same type of information regarding companies’ adoption or termination of Rule 10b5-1 plans, but the requirement has not taken effect.

For each trading arrangement that is adopted or terminated, the disclosure must identify whether the trading arrangement is a Rule 10b5-1 plan or a non-Rule 10b5-1 trading arrangement, and provide a brief description of the material terms (other than price), including (i) the name and title of the director or officer; (ii) the date of adoption or termination of the trading arrangement; (iii) the duration of the trading arrangement; and (iv) the aggregate number of securities to be sold or purchased under the trading arrangement (including pursuant to the exercise of any options).

As discussed in our previous post, the form of this disclosure is not prescribed by the final rule.[7] While the vast majority of companies we surveyed have provided narrative disclosure in response to the requirement, a minority have provided tabular disclosure instead. For an example of this narrative disclosure, please see our prior post regarding the new insider trading rules.[8]

While companies have taken a varied approach to this disclosure when no Section 16 officers or directors have adopted or terminated Rule 10b5-1 plans during the quarter, we note that the majority of companies we surveyed have chosen to include narrative disclosure that states there have been no such adoptions or terminations (e.g., “During the quarter ended [date], no director or officer (as defined in Rule 16a-1(f) under the Exchange Act) of the Company adopted or terminated any Rule 10b5-1 trading arrangements or non-Rule 10b5-1 trading arrangements (in each case, as defined in Item 408(a) of Regulation S-K).”). Another approach some companies have taken is to simply state “None” under the applicable Item, and a small minority of the companies elected to make no disclosure and to omit the relevant Item from the periodic filing altogether (which is permissible under the instructions to Part II of Form 10-Q, but not permissible in the Form 10-K).

D. Compensation Clawback Disclosures

On October 26, 2022, the SEC adopted final rules that require listed companies to implement policies for recovery (i.e., “clawback”) of erroneously awarded incentive compensation.[9] In addition to disclosures related to the application of the clawback policies, which for most companies will be included in the proxy statement,[10] there are two disclosure components specific to the Form 10-K that companies must comply with beginning with any Form 10-K filed on or after December 1, 2023, the date by which companies must have adopted the clawback policies. The first component is the addition of two new checkboxes to the Form 10-K cover page, which requires companies to indicate whether (i) the financial statements included in the filing reflect the correction of an error to previously issued financial statements and (ii) any such corrections are restatements that required a recovery analysis pursuant to Rule 10D-1(b). We expect a number of interpretive questions to arise with respect to the applicability of the checkboxes in various contexts. For example, the Staff has informally confirmed that the first checkbox would not need to be checked if the annual financial statements included in the Form 10-K reflect the correction of a material error to interim financial statements and where that error only affected the interim periods (but not any annual periods).[11]However, the first box may need to be checked if the 10-K reflects even an immaterial correction to previously issued annual financial statements. The second checkbox only needs to be checked for material error corrections (i.e., a “little r” restatement or “Big R” restatement) that triggered a clawback recovery analysis. The second component is the requirement for companies to file their clawback policy as Exhibit 97 to the Form 10-K.

II. Disclosure Trends and Considerations

A. Climate Change

The landscape of climate change disclosure requirements continues to evolve with the adoption of the Corporate Sustainability Reporting Directive (“CSRD”) by the European Council in November 2022, which impacts both EU and U.S. companies, and three new laws in California, which impact both public and private companies doing business or operating in California.[12] Final SEC rules on climate-related disclosure are still pending,[13] but the SEC has continued to issue Form 10-K comment letters regarding companies’ climate-related disclosures under existing requirements.

For companies reviewing their existing climate-related disclosures in their Form 10-K, a few items to consider in light of Staff comments made since the issuance of the SEC’s sample comment letter related to climate change disclosure that it issued in 2021[14] include:

Tailor climate-related disclosures to the company’s business and financial condition, rather than generic discussions on climate change. For example, the Staff may ask a company to provide specific disclosure, if material, as to the impact on the company’s business of climate change risks disclosed in the risk factor section. Overly broad statements may also inadvertently create future reporting obligations as legislation, such as California’s Assembly Bill No. 1305, begins to tie disclosure requirements to the making of certain sustainability-related claims.
Consider whether certain climate-related matters should be disclosed not only qualitatively, but also quantitatively. For example, if climate-related capital projects have become a significant portion of overall capital expenditures spending, the comment letters indicate that quantitative disclosure may be warranted.
For any climate-related disclosure included in the Form 10-K, take steps to adequately substantiate those disclosures. This involves, among other things, assessing the methodology and assumptions underlying climate-related disclosures. Companies should be mindful that disclosures made today can carry liability for years to come and give sufficient attention to these disclosures now to avoid liability down the road. Frameworks such as COSO’s “Achieving Effective Internal Control Over Sustainability Reporting” and related guidance can be helpful when building or expanding ESG-related internal controls.
As part of the disclosure controls and procedures for the 2023 Form 10-K filing, review the company’s publicly disclosed ESG materials, such as the company’s sustainability report, to determine whether any of the information is or may become material under federal securities laws. Based on Staff comments, the Staff has gone outside a company’s SEC filings to review ESG-related statements made elsewhere and ask what consideration was given to including such disclosures in the Form 10-K. To the extent information disclosed in sustainability reports is not material for purposes of SEC rules (often, it is not), appropriate disclaimers to that effect should be provided as we previously advised in our prior client alert, “Considerations for Climate Change Disclosures in SEC Reports.”[15]

B. Human Capital

Since 2021, companies have been required to include in their Form 10-K[16] a description of the company’s human capital resources, to the extent material to an understanding of the business taken as a whole, including the number of persons employed by the company and any human capital measures or objectives that the company focuses on in managing the business (such as, depending on the nature of the company’s business and workforce, measures or objectives that address the development, attraction and retention of personnel).

The rule adopted by the SEC did not define “human capital” or elaborate on the expected content of the disclosures beyond the few examples provided in the rule text. This principles-based approach has resulted in significant variation among companies’ disclosures. With three years of human capital disclosure now available, we recently conducted a survey of the substance and form of human capital disclosures made by the S&P 100 in their Forms 10-K for their three most recently completed fiscal years. While company disclosures continued to vary widely, we saw companies continuing to tailor the length of their disclosure and the range of topics covered and also noted a slight increase in the amount of quantitative information provided in some areas. For a more detailed summary of our findings from this survey, which looked at eight primary categories of human capital disclosure, please see our prior client alert, “Form 10-K Human Capital Disclosures Continue to Evolve.”[17]

While we anticipate that human capital disclosure will continue to evolve under the existing principles-based requirements, the SEC is expected to propose more prescriptive rules that could significantly change the landscape. At its meeting on September 21, 2023, the SEC’s Investor Advisory Committee approved subcommittee recommendations to expand required human capital management disclosures, which include prescriptive disclosure requirements (such as headcount of full-time versus part-time and contingent workers, turnover metrics, the total cost of the issuer’s workforce broken down into components of compensation, and demographic data of diversity across gender, race/ethnicity, age, disability, and/or other categories) as well as narrative disclosure in management’s discussion and analysis of how the company’s “labor practices, compensation incentives, and staffing fit within the broader firm strategy.”[18]

C. Generative Artificial Intelligence

Recent developments in artificial intelligence (“AI”), including generative AI, may accelerate or exacerbate potential risks related to technological developments. Companies should consider ways in which the company’s strategy, productivity, market competition and demand for the company’s products, investments and the company’s reputation, as well as legal and regulatory risks could be affected by AI. Companies should also consider any impacts related to cybersecurity and social or ethical challenges. These updates may affect existing risk factors or merit a new standalone risk factor or mention in the forward-looking statement disclaimer, depending on the importance of AI to the company’s business. Further consideration should be given to discussing AI in the business section and trends section of the MD&A, as applicable.

D. Geopolitical Conflict

Public companies need to consider the recent and evolving developments in the Middle East in their Form 10-K, including as to whether risks associated with these developments are adequately discussed in the risk factors, as well as their direct and indirect impacts on their operations and financial condition. While the SEC has not published specific disclosure guidance related to the Middle East, the Staff’s “Sample Comment Letter Regarding Disclosures Pertaining to Russia’s Invasion of Ukraine and Related Supply Chain Issues”[19] may provide guidance as to the types of disclosure that may be necessary. Companies should consider whether disclosure should be provided, to the extent material, regarding any material impacts or risks related to (i) direct or indirect exposure due to operations or investments in affected countries, securities trading in affected countries, sanctions imposed or legal or regulatory uncertainty associated with operating in or existing in the Middle East, (ii) direct or indirect reliance on goods or services sourced in the Middle East, (iii) actual or potential disruptions in the company’s supply chain, or (iv) business relationships, connections to, or assets in the Middle East.

Companies should undertake similar disclosure analyses to determine whether direct or indirect impacts of or material risks from the continued conflict between Russia and Ukraine or emerging geopolitical conflicts, such as rising tensions between China and Taiwan and China and the United States, should be discussed in any sections of the upcoming Form 10-K. Companies with operations in the People’s Republic of China should review the Division of Corporation Finance’s recent sample comment letter[20] highlighting three focus areas for periodic disclosures related to China-specific matters, including those arising from the Holding Foreign Companies Accountable Act (the “HFCAA”), the Uyghur Forced Labor Prevention Act, and specific government-related operational risks. In addition to posing questions regarding HFCAA disclosures, the sample letter includes comments directed at risk factors and MD&A disclosure.

E. Potential Government Shutdown

Companies should continue to monitor the potential for a shutdown of the U.S. federal government and consider whether any looming prospect of a shutdown poses new risks for the business. In particular, companies trading in U.S. government securities or other securities with values derived from U.S. government securities should revisit any risk factors or other disclosures related to potential default by the federal government, including discussing any material losses in MD&A or elsewhere. As noted in the SEC Division of Corporation Finance’s announcement in September regarding the anticipated impacts of a potential government shutdown, EDGAR will continue to accept filings during a shutdown, so filing Forms 10-K should not be affected.[21]

F. Inflation and Interest Rate Concerns

With the rise of inflation and relatively high interest rates, companies should consider whether their disclosures regarding inflation impacts and risks as well as recent rate increases and uncertainty regarding future rate changes are adequately discussed. Depending on the effect on a company’s operations and financial condition, additional disclosure of risk factors, MD&A, or the financial statements may be necessary.

In recent comment letters relating to inflation, the Staff has focused on how current inflationary pressures have materially impacted a company’s operations, including by pointing to statements regarding inflation made in a company’s earnings materials, and sought disclosure on any mitigation efforts implemented with respect to inflation. If inflation is identified as a significant risk, the Staff asked companies to quantify, where possible, the principal factors contributing to inflationary pressures and the extent to which revenues, expenses, profits, and capital resources were impacted by inflation.

In recent comment letters relating to interest rates, the Staff has asked companies to expand their discussion of rising interest rates in the Risk Factors and MD&A sections to specifically identify the actual impact of recent rate increases on the business’s operations and how the business has been affected.

It is also critical that companies confirm that their disclosures in “Item 7A. Quantitative and Qualitative Disclosures About Market Risk” are up-to-date and responsive to the requirements of Item 305 of Regulation S-K.

III. SEC Comment Letter Trends

In 2023, comment letters from the SEC Staff continued an emphasis on addressing disclosures in management’s discussion and analysis (“MD&A”) as well as the use of non-GAAP measures. In addition, although the SEC’s proposed climate change rules are still in flux, in 2023, the Staff continued to issue comment letters regarding companies’ climate-related disclosures under the current disclosure regime, continuing the trend that started in the fall of 2021.

A. Management’s Discussion and Analysis

Many of the comment letters addressing MD&A focused on disclosures relating to results of operations, with the Staff often requesting that registrants explain related disclosures with more specificity. The Staff has focused on disclosures regarding material period-to-period changes in quantitative and qualitative terms as prescribed by Item 303(b) of Regulation S-K. For example, the Staff has commented on disclosures about factors contributing to gross profit and revenue, to request that registrants provide both quantitative detail regarding the extent to which certain factors have impacted gross profit, as well as qualitative factors like which factors contribute to certain business sectors having a greater effect on gross product. The Staff has also requested that registrants make disclosures about known trends and uncertainties affecting their results of operations. Another area that the Staff has focused on is ensuring that key performance indicators (“KPIs”) are properly contextualized so that they are not misleading. The Staff has, in certain circumstances, requested that registrants provide additional disclosures about why KPIs are useful to investors, how they are used by management, and if there are any estimates or assumptions being used to calculate the various metrics. The Staff has also often asked registrants to quantify and provide additional disclosure regarding significant components of financial condition and results of operations that have affected segment results. Two other key areas of MD&A that the Staff focused on were critical accounting estimates and liquidity and capital resources. The Staff frequently noted that registrants’ disclosures regarding critical accounting estimates were too general, and requested that registrants provide a more robust analysis, consistent with the requirement now set forth in Item 303(b)(3) of Reg S-K. The Staff indicated that these disclosures should supplement, not duplicate, the disclosures in footnotes to financial statements.

B. Non-GAAP Financial Measures

The Staff expressed concerns regarding the improper use of non-GAAP measures in filings and issued several comments aligned with the Compliance and Disclosure Interpretations (“C&DIs”) released last December. Comments related to the latest C&DIs included a focus on whether operating expenses are “normal” or “recurring” (and therefore, whether exclusion from non-GAAP financial measures might be misleading). The Staff has also asked registrants about whether certain non-GAAP adjustments to revenue or expenses have made the adjustments “individually tailored.” In addition to a focus on the topics covered under the C&DIs, the Staff focused on a number of other matters relating to compliance with Item 10(e) of Regulation S-K, including prominence of non-GAAP measures, reconciliations, usefulness and purpose of particular measures, the exclusion of normal, recurring cash operating expenses (Non-GAAP C&DI 100.01), and the use of individually tailored accounting principles (Non-GAAP C&DI 100.04).

C. Segment Reporting

The Staff has also commented on a number of segment reporting disclosures. Examples of common comments include whether a registrant’s operating segments are properly categorized and the reasoning behind the aggregation of similar segments (and the factors used to identify different segments). Of particular note, the SEC has taken issue with registrations disclosing multiple measures of segment profit or loss in the notes to the financial statements and has indicated that registrants should not attempt to circumvent non-GAAP requirements when taking this approach.

D. Climate-Related Disclosures

As discussed in Part II.A above, climate-related disclosures continue to be a focus of the Staff. The Staff has often issued multiple rounds of letters on these types of disclosures, particularly when the initial response asserts that a category of climate-related disclosures is not material to its business (with the Staff frequently requesting the registrant to quantify the effects or costs or provide a materiality analysis).

IV. Other Reminders and Considerations

A. Disclosure Controls and Procedures

In light of the new cybersecurity disclosure rules and the end of the year for calendar companies, now is a good time for companies to take an opportunity to review their disclosure controls and procedures, which are intended to help companies collect pertinent information for review for purposes of their public disclosure obligations. The SEC has demonstrated a willingness to bring enforcement action on disclosure controls as they relate to issues it sees as priorities, including recent hot-button topics such as cybersecurity and workplace misconduct.

SolarWinds (Cybersecurity)

In October 2023, the SEC brought charges against SolarWinds Corporation, a software company, and its Chief Information Security Officer (the “CISO”) in connection with the cyberattack more commonly known as “SUNBURST,” which occurred in December 2020. Notably, this is the first time the SEC has brought a cybersecurity enforcement action against an individual. The SEC alleged that SolarWinds and the CISO made materially misleading statements and omissions about the company’s cybersecurity practices and risks in disclosures made on the company’s website and in public filings, which the SEC claims ultimately led to a drop in the company’s stock price following the subsequent disclosure of the SUNBURST cyberattack. Specifically, the complaint alleges that SolarWinds made a number of false statements relating to: (1) compliance with the National Institute of Standards and Technology (NIST) Cybersecurity Framework; (2) using a secure development lifecycle when creating software for customers; (3) having strong password protection; and (4) maintaining good access controls.

The SEC’s complaint also states that SolarWinds had deficient disclosure controls, alleging that at the time the company was touting its cybersecurity practices in its public disclosures, the CISO and other employees knew that the company had serious cybersecurity deficiencies, with internal documents “describ[ing] numerous known material cybersecurity risks, control issues, and vulnerabilities.” In doing so, the company was concealing from the public known poor cybersecurity practices that were ultimately exploited during the SUNBURST cyberattack. The complaint seeks permanent injunctive relief, disgorgement of profits, civil penalties, and an officer and director bar against the CISO.

The SEC’s actions in SolarWinds should be viewed in light of the new incident disclosure requirements on Form 8-K and recent prior enforcement cases (Pearson PLC 2021 and First American Financial Corporation in 2019). In these recent enforcement cases, the SEC focused on the importance of carefully assessing the materiality of a cyber incident and found incidents to be material even when there was not an adverse impact on the companies’ businesses.

Activision Blizzard (Workplace Misconduct)

Early in 2023, the SEC charged Activision Blizzard Inc., a video game development and publishing company (recently acquired by Microsoft Corporation) (“Activision Blizzard”), with a failure to maintain disclosure controls. Specifically, the SEC alleged that Activision Blizzard “lacked controls and procedures designed to ensure that information related to employee complaints of workplace misconduct would be communicated to [company] disclosure personnel to allow for timely assessment on its disclosures.” The SEC’s order stated that management “lack[ed] sufficient information to understand the volume and substance of employee complaints of workplace misconduct,” and therefore “management was unable to assess related risks to the company’s business, whether material issues existed that warranted disclosure to investors, or whether the disclosures it made to investors in connection with these risks were fulsome and accurate.” Activision Blizzard agreed to a cease-and-desist order and to pay a $35 million penalty to settle the charges.

DXC Technology (Non-GAAP Financial Measures)

In March 2023, the SEC settled charges against DXC Technology Company, an IT services company, for making misleading disclosures about its non-GAAP financial performance in multiple reporting periods from 2018 until 2020. Specifically, the SEC alleged that the company materially increased its non-GAAP earnings by negligently misclassifying tens of millions of dollars of expenses as transaction, separation and integration-related (“TSI”) costs and improperly excluding these expenses as non-GAAP adjustments. The SEC noted that “[t]he absence of a non-GAAP policy and specific disclosure controls and procedures caused employees within the [company] to make subjective determinations about whether expenses were related to an actual or contemplated transaction, regardless of whether the costs were actually consistent with the description of the adjustment included in the company’s public disclosures.” The order went on to explain that the company’s controller group and disclosure committee “negligently failed to evaluate the company’s non-GAAP disclosures adequately” and even failed to recognize that for years the company did not have a non-GAAP policy and adequate disclosure controls and procedures in place. Ultimately, the company’s negligence led to misstating the nature and scope of its TSI costs resulting in materially misleading statements. The company agreed to pay an $8 million penalty and to undertake to develop and implement appropriate non-GAAP policies and disclosure controls and procedures.

Charter Communications Inc. (Internal Accounting Controls)

In November 2023, the SEC charged Charter Communications Inc., a telecommunications company, for failure to establish internal accounting controls to provide reasonable assurances that its trading plans were conducted in accordance with the board of directors’ authorization, which required the use of trading plans in conformity with Rule 10b5-1. Under Rule 10b5-1, a trading plan intended to satisfy the rule may not permit the person who entered into the plan to exercise any subsequent influence over how, when, or whether to effect transactions under the plan. According to the SEC order in Charter Communications, many of the company’s trading plans contained “accordion” provisions allowing for increases to the amount of share repurchases if the company opted to conduct certain debt offerings. The SEC asserted that, since these debt offerings were available at the company’s discretion, this feature effectively gave the company the ability to increase trading activity after adoption of its trading plans—in violation of Rule 10b5-1 and, as a result, inconsistent with the board’s authorization. The SEC order explained that “the company did not have reasonably designed controls to analyze whether the discretionary element of the accordion provisions was consistent with the [b]oard’s authorizations” and Charter ultimately paid $25 million to settle the claims.[22]

In light of these recent enforcement actions, it is important for companies to regularly review their disclosure controls and procedures to identify and stay apprised of key risks that are relevant to the company.

B. Characterization of Legal Proceedings

Public companies often characterize legal proceedings in their securities filings as “without merit.” However, companies may want to reconsider relying on this boilerplate phrase in their legal proceedings disclosures following a decision in the fall of 2023 from the United States District Court for the District of Massachusetts.

In City of Fort Lauderdale Police and Firefighters’ Retirement System v. Pegasystems Inc.,[23] plaintiff shareholders initiated a class action against Pegasystems Inc. (“Pegasystems”) after it was ordered to pay over $2 billion in damages in a prior lawsuit regarding trade secret misappropriation. Although it did not initially disclose the trade secret matter in its securities filings when the lawsuit was first initiated in May 2020, Pegasystems eventually disclosed the matter in its Form 10-K in February 2022 stating its belief that “the claims brought against the defendants are without merit,” it had “strong defenses to these claims,” and “any alleged damages claimed by Appian are not supported by the necessary legal standard.” Pegasystems’ stock price dropped by about 16% the following day and, in May 2022, the jury returned a unanimous verdict in favor of the plaintiff in the trade secret matter.

In the subsequent class action, plaintiff shareholders alleged that Pegasystems made a number of false statements and falsely reassured investors that the claims in the trade secret matter were “without merit,” in light of the fact that its CEO was allegedly aware of the corporate espionage campaign. The court found that this was an actionable opinion statement explaining that “a reasonable investor could justifiably have understood [the CEO]’s message that [the trade secret] claims were ‘without merit’ as a denial of the facts underlying [the] claims—as opposed to a mere statement that Pega[systems] had legal defenses against those claims.” The court went on to say that Pegasystems was not required to admit any wrongdoing in its disclosure and that “[a]n issuer may legitimately oppose a claim against it, even when it possesses subjective knowledge that the facts underlying the claims against it are true. When it decides to do so, however, it must do so with exceptional care, so as not to mislead investors. For example, an issuer may validly assert its intention to oppose the lawsuit. . . . It also may state that it has ‘substantial defenses’ against it, if it reasonably believes that to be true. . . . An issuer may not, however, ‘make misleading substantive declarations regarding its beliefs about the merits of the litigation.’”

The court’s decision provides a cautionary tale against using boilerplate disclosure language when describing a company’s litigation matters, particularly where those disclosures are contradictory to the actual prospect of an adverse result. Going forward, companies should avoid relying on boilerplate language such as “without merit” to describe claims in a lawsuit; often times, there is at least some merit to litigation even if a defendant has a strong legal defense. Instead, statements like “we intend to contest this matter vigorously” or “we have substantial defenses” (if supportable) might be appropriate alternatives. Counsel for companies should carefully evaluate their legal proceedings disclosures—even for those matters that have previously been disclosed—and consider seeking input from management in assessing any allegations asserted against the company.

C. EDGAR Next

On September 13, 2023, the SEC proposed amendments to Rules 10 and 11 of Regulation S-T and Form ID regarding potential technical changes to EDGAR filer access and account management (referred to by the SEC as “EDGAR Next”). EDGAR Next would require filers to authorize designated account administrators to manage the filers’ accounts and make filings on the filers’ behalf and would require these account administrators and any other authorized users to have their own individual account credentials to access EDGAR Next. For details on the proposed amendments, see our prior post on this topic.[24]

In connection with the proposed amendments, the SEC opened a public beta environment that is available until March 15, 2024 for filers to test and provide feedback on the technical functionality of the changes contemplated by EDGAR Next. Details regarding how to access the EDGAR Next beta environment and related resources are available at the SEC’s dedicated EDGAR Next website.[25]

D. Filing Requirement for “Glossy” Annual Report

As discussed in last year’s alert, in June 2022 the SEC adopted amendments requiring that annual reports sent to shareholders pursuant to Exchange Act Rule 14a-3(c), otherwise known as “glossy” annual reports, must also be submitted to the SEC in the electronic format in accordance with the EDGAR Filer Manual. These annual reports will be in PDF format, and filed using EDGAR Form Type ARS. In its final rule, the SEC noted that electronic submissions in PDF format of the glossy annual report should capture the graphics, styles of presentation, and prominence of disclosures (including text size, placement, color, and offset, as applicable) contained in the reports. As noted in our report last year, this may cause technical concerns with file sizes when filing through EDGAR, and companies should be mindful of the file size of their glossy annual report and conduct test runs in advance of filing.

E. Cover Page XBRL Disclosures

On September 7, 2023, the SEC published a sample comment letter regarding XBRL disclosures.[26] Contained in this sample comment letter was a comment regarding how common shares outstanding are reported on the cover page as compared to on the company’s balance sheet. The sample comment addresses instances in which companies “present the same data using different scales (presenting the whole amount in one instance and the same amount in thousands in the second).” Companies thus should consider presenting their outstanding share data consistently throughout their Form 10-K.

* * * * *

The 2023 Form 10-K will require a number of new disclosures for the first time. Companies should start drafting their disclosures earlier rather than later, particularly where disclosures will require coordination with a number of teams, such as with the new cybersecurity disclosure requirements.

Looking ahead, there are several rules the SEC is expected to enact that have the potential to significantly impact future filings, including the highly anticipated climate disclosure rules, which have been pending since March 2022 and may require public companies to disclose their greenhouse gas emissions, those of their suppliers, and their downstream emissions. The latest Reg Flex agenda suggested that these rules would be finalized in October 2023, though this target has moved several times.

Additionally, the Financial Accounting Standards Board (FASB) has finalized rules related to enhanced tax disclosures and segment reporting that apply starting with the 2024 10-K[27],[28] and is considering rules regarding the disaggregation of expenses[29], each of which may require a significant amount of preparation.

__________

[1] See “Announcement Regarding Share Repurchase Disclosure Modernization Rule” (Nov. 22, 2023), available at https://www.sec.gov/corpfin/announcement/announcement-repurchase-disclosure-modernization-112223

[2] Gibson Dunn’s Securities Regulation Monitor is a blog site that provides frequent updates on securities law and corporate governance developments and is available at https://securitiesregulationmonitor.com/default.aspx

[3] For a further discussion on the share repurchase requirements, please see our prior client alert “SEC Adopts Amendments to Enhance Company Stock Repurchase Disclosure Requirements” (May 5, 2023), available at https://www.gibsondunn.com/sec-adopts-amendments-to-enhance-company-stock-repurchase-disclosure-requirements/.

[4] See “SEC Adopts Rules on Cybersecurity Risk Management, Strategy, Governance, and Incident Disclosure by Public Companies” (July 26, 2023), available at https://www.sec.gov/news/press-release/2023-139.

[6] See “SEC Adopts Amendments to Modernize Rule 10b5-1 Insider Trading Plans and Related Disclosures” (Dec. 14, 2023), available at https://www.sec.gov/news/press-release/2022-222.

[7] Available at https://www.securitiesregulationmonitor.com/Lists/Posts/Post.aspx?ID=480.

[8] Available at https://www.securitiesregulationmonitor.com/Lists/Posts/Post.aspx?ID=480.

[9] See “SEC Adopts Compensation Recovery Listing Standards and Disclosure Rules” (Oct. 26, 2022), available at https://www.sec.gov/news/press-release/2022-192.

[10] Item 402 of Regulation S-K now requires companies to disclose how they have applied their recovery policies. If, during its last completed fiscal year, the company either completed a restatement that required recovery or there was an outstanding balance of excess incentive-based compensation relating to a prior restatement, the company must disclose (i) the date which the company was required to prepare each accounting restatement, the aggregate dollar amount of excess, and an analysis of how it was calculated; (ii) if the compensation is related to a stock price or TSR metric, the estimates used to determine the amount of erroneously awarded compensation; (iii) the aggregate dollar amount of excess incentive-based compensation that remained outstanding at the end of the company’s last completed fiscal year; (iv) the amount of recovery foregone under any impracticability exception used; and (v) for each current and former named executive officer, the amounts of incentive-based compensation that are subject to a clawback but remain outstanding for more than 180 days since the date the company determined the amount owed.

[11] Center for Audit Quality SEC Regulations Committee Highlights, Joint Meeting with SEC Staff (June 15, 2023), available at https://www.thecaq.org/wp-content/uploads/2023/09/June-15-2023-Joint-Meeting-HLs-FINAL-for-Posting-9-5-23.pdf (Section III.D.).

[12] For background on the CSRD, see “European Union’s Corporate Sustainability Reporting Directive—What Non-EU Companies with Operations in the EU Need to Know,” Gibson Dunn (Nov. 2022), available at https://www.gibsondunn.com/european-union-corporate-sustainability-reporting-directive-what-non-eu-companies-with-operations-in-the-eu-need-to-know/, and “European Corporate Sustainability Reporting Directive (CSRD): Key Takeaways from Adoption of the European Sustainability Reporting Standards,” Gibson Dunn (Aug. 2023), available at https://www.gibsondunn.com/european-corporate-sustainability-reporting-directive-key-takeaways-from-adoption-of-european-sustainability-reporting-standards/.

For background on California’s recently enacted climate disclosure laws, see “California Passes Climate Disclosure Legislation,” Gibson Dunn (Sept. 2023), available at https://www.gibsondunn.com/california-passes-climate-disclosure-legislation/, and “UPDATE: California Governor Signs Climate Legislation Into Law, Bug Signals Changes to Come,” Gibson Dunn (Oct. 2023), available at https://www.securitiesregulationmonitor.com/Lists/Posts/Post.aspx?ID=487.

[13] For more information on the SEC’s proposed rules on climate-related disclosure, see “The Enhancement and Standardization of Climate-Related Disclosures for Investors,” SEC (Apr. 2022), available at https://www.sec.gov/files/rules/proposed/2022/33-11042.pdf, and “Summary of and Considerations Regarding the SEC’s Proposed Rules on Climate Change Disclosure,” Gibson Dunn (Apr. 2022), available at https://www.gibsondunn.com/summary-of-and-considerations-regarding-the-sec-proposed-rules-on-climate-change-disclosure/.

[14] For a discussion of the 2021 and 2022 comment letters, see “SEC Staff Scrutiny of Climate Change Disclosures Has Arrived: What to Expect And How to Respond,” Gibson Dunn (Sept. 2021), available at https://www.securitiesregulationmonitor.com/Lists/Posts/Post.aspx?ID=446 and “Considerations for Preparing Your 2022 Form 10-K,” Gibson Dunn (Jan. 2023), available at https://www.gibsondunn.com/wp-content/uploads/2023/01/considerations-for-preparing-your-2022-form-10-k.pdf.

[15] Available at https://www.gibsondunn.com/considerations-for-climate-change-disclosures-in-sec-reports/.

[16] See “Modernization of Regulation S-K Items 101, 103, and 105, Release No. 33-10825” (Aug. 26, 2020), available at https://www.sec.gov/rules/final/2020/33-10825.pdf.

[17] Available at https://www.gibsondunn.com/form-10-k-human-capital-disclosures-continue-to-evolve/.

[18] Available at https://www.sec.gov/files/spotlight/iac/20230921-recommendation-regarding-hcm.pdf.

[19] See “Sample Letter to Companies Regarding Disclosures Pertaining to Russia’s Invasion of Ukraine and Related Supply Chain Issues” (May 3, 2021), available at https://www.sec.gov/corpfin/sample-letter-companies-pertaining-to-ukraine.

[20] Available at https://www.sec.gov/corpfin/sample-letter-companies-regarding-china-specific-disclosures.

[21] Available at https://www.sec.gov/corpfin/announcement/announcement-cf-pre-shutdown-communication-092723.

[22] SEC Commissioners Hester Peirce and Mark Uyeda dissented from this decision. Commissioners Peirce and Uyeda argued that this application of the rule went too far by using Section 13(b)(2)(B)(i)’s requirement that companies “devise and maintain a system of internal accounting tools” to require that Charter Communications had sufficient systems in place to answer the legal question of whether its trading plans were in compliance with Rule 10b5-1.

[23] No. CV 22-11220-WGY, 2023 WL 4706741 (D. Mass. July 24, 2023).

[24] Available at https://securitiesregulationmonitor.com/Lists/Posts/Post.aspx?ID=483.

[25] Available at https://www.sec.gov/edgar/filer-information/edgar-next.

[26] Available at https://www.sec.gov/corpfin/sample-letter-companies-regarding-their-xbrl-disclosures.

[27] Available at https://www.fasb.org/Page/ProjectPage?metadata=fasb-Targeted%20Improvements%20to%20Income%20Tax%20Disclosures

[28] Available at https://www.fasb.org/page/getarticle?uid=fasb_Media_Advisory_11-27-23.

[29] Available at https://www.fasb.org/Page/ShowPdf?path=Proposed+ASU%E2%80%94Income+Statement%E2%80%94Reporting+Comprehensive+Income%E2%80%94Expense+Disaggregation+Disclosures+%28Subtopic+220-40%29%E2%80%94Disaggregation+of+Income+Statement+Expenses.pdf&title=Proposed+Accounting+Standards+Update%E2%80%94Income+Statement%E2%80%94Reporting+Comprehensive+Income%E2%80%94Expense+Disaggregation+Disclosures+%28Subtopic+220-40%29%E2%80%94Disaggregation+of+Income+Statement+Expenses&acceptedDisclaimer=true&IsIOS=false&Submit.

The following Gibson Dunn attorneys assisted in preparing this update: Ron Mueller, Elizabeth Ising, Mike Scanlon, Mike Titera, Julia Lapitskaya, Matthew Dolloff, David Korvin, Meghan Sherley, Victor Twu, Maggie Valachovic, and Nathan Marak.

Gibson Dunn’s lawyers are available to assist with 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 in the firm’s Securities Regulation and Corporate Governance or Capital Markets practice groups, or any of the following practice leaders and members:

Securities Regulation and Corporate Governance:
Elizabeth Ising – Co-Chair, Washington, D.C. (+1 202.955.8287, [email protected])
James J. Moloney – Co-Chair, Orange County (+1 949.451.4343, [email protected])
Lori Zyskowski – Co-Chair, New York (+1 212.351.2309, [email protected])
Brian J. Lane – Washington, D.C. (+1 202.887.3646, [email protected])
Ronald O. Mueller – Washington, D.C. (+1 202.955.8671, [email protected])
Thomas J. Kim – Washington, D.C. (+1 202.887.3550, [email protected])
Michael A. Titera – Orange County (+1 949.451.4365, [email protected])
Aaron Briggs – San Francisco (+1 415.393.8297, [email protected])
Julia Lapitskaya – New York (+1 212.351.2354, [email protected])

Capital Markets:
Andrew L. Fabens – New York, NY (+1 212.351.4034, [email protected])
Hillary H. Holmes – Houston, TX (+1 346.718.6602, [email protected])
Stewart L. McDowell – San Francisco, CA (+1 415.393.8322, [email protected])
Peter W. Wardle – Los Angeles, CA (+1 213.229.7242, [email protected])

Please join us for this 60-minute program. The panel covers key developments to be aware of headed into the 2023 Form 10-K reporting season, including recent SEC rulemaking and comment letters, disclosure trends and other developments such as:

New Cybersecurity Risk Management, Strategy, and Governance Disclosures
New Share Repurchase and Rule 10b5-1 Plan Disclosures
SEC Comment Letter and Company Disclosure Trends

PANELISTS:

Mike Titera is a partner in the Orange County office and a member of the Firm’s Securities Regulation and Corporate Governance Practice Group. His practice focuses on advising public companies regarding securities disclosure and compliance matters, financial reporting, and corporate governance. Mr. Titera often advises clients on accounting and auditing matters and the use of non-GAAP financial measures. He also has represented clients in investigations conducted by the Securities and Exchange Commission and the Financial Industry Regulatory Authority. Mr. Titera’s clients range from large-cap companies with global operations to small-cap companies in the pre-revenue phase. His clients operate in a range of sectors, including the retail, technology, pharmaceutical, hospitality, and financial services sectors. Mr. Titera is a frequent author on a range of securities law issues. His recent publications include articles in Insights and Deal Lawyers. Mr. Titera also co-authors a chapter regarding audit committees in the treatise “A Practical Guide to SEC Proxy and Compensation Rules” and contributed to a chapter about accounting-related matters in “Director’s Handbook: A Field Guide to 101 Situations Commonly Encountered in the Boardroom,” a recent publication of the American Bar Association.

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.

David Korvin is a corporate associate in the Washington, D.C. office of Gibson, Dunn & Crutcher, where he currently practices in the firm’s Securities Regulation and Corporate Governance Practice Group. He advises public companies and their boards with respect to corporate governance, federal securities, financial reporting and accounting, insider trading, stock exchange, shareholder engagement, ESG and executive compensation matters. Prior to joining Gibson Dunn, David was an attorney at the Securities and Exchange Commission in the Division of Corporation Finance, where he handled the legal review of Securities Act and Exchange Act filings and served as a member of the Shareholder Proposal Taskforce.

Meghan Sherley is a corporate associate in the Orange County office of Gibson, Dunn & Crutcher, where she currently practices in the firm’s corporate department. Her practice is focused on securities regulation and corporate governance, including matters relating to ESG, compliance, and other general corporate matters. She writes and presents on these topics, including on trends and developments in human capital management disclosures. Meghan’s pro bono engagements include advising nonprofit entities on a variety of compliance and transactional matters.

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 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:

In California, new challenges have emerged to DEI-related programs in the state’s community college system. In April 2023, the California Community College system adopted new regulations, requiring faculty to “employ teaching, learning, and professional practices that incorporate DEIA . . . principles” and directing community colleges to “consider[] an employee’s demonstrated, or progress toward, proficiency in diversity, equity, inclusion, and accessibility [ ] competencies” in employee evaluations. Cal. Code Regs. tit. 5, §§ 53602, 53605. Two groups of professors, represented by the nonprofit organization Foundation for Individual Rights and Expression (FIRE), sued the California Community College system in June and August 2023 in the Eastern District of California. Both suits seek to enjoin the application of the new evaluation standards. The professors argue that the system’s new regulations compel speech in violation of the First and Fourteenth Amendments by requiring faculty to either parrot the state’s stance on DEI or be punished. On November 14, 2023, a magistrate judge in the June lawsuit (Johnson v. Watkin) recommended granting an injunction, writing that “California’s goal of promoting diversity, equity, inclusion, and accessibility in public universities does not give it the authority to invalidate protected expressions of speech.” The district court has not yet ruled on this recommendation. More details on these cases can be found in the case updates section below.

On November 21, 2023, America First Legal Foundation (“AFL”) sent a letter to the EEOC, calling for the Commission to initiate an investigation into Macy’s, Inc.’s DEI initiatives. The letter to the Commission, as well as a letter AFL sent to Macy’s Board of Directors, alleges violations of Title VII and Section 1981 based on the company’s 2022 Diversity & Inclusion Annual Report. The stated goals of the Report include achieving ethnic and gender diversity of 50% for the company’s models, 30% for its senior-level management, and 5% for its supplier relationships.

On November 8, 2023, United States Senator Eric Schmitt (R – Missouri) introduced Senate Bill 3252, proposing to terminate the authorities of certain DEI offices and officers of the Federal Government. The Bill, short-titled the “Abolish Government DEI Act,” lists a total of 40 executive offices and officer positions that would be terminated on the date of the Bill’s enactment. The Bill targets the DEI and Civil Rights offices of numerous executive departments and agencies, including—among others—the Department of State, the Department of the Interior, the Department of the Treasury, the Department of Energy, the Department of Health and Human Services, and the Equal Employment Opportunity Commission. The Bill, if enacted, would abolish a number of DEI officer positions in these agencies and would prohibit the head of a covered agency from carrying out “any plan relating to diversity, equity, and inclusion.” The Administrator of the United States Agency for International Development would also lose the ability to implement the agency’s Diversity, Equity, Inclusion, and Accessibility strategy. The Bill has been read twice and referred to the Committee on Homeland Security and Governmental Affairs.

Media Coverage and Commentary:

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

New York Law Journal, “‘Affirmative Recruiting’ Under Title VII” (November 15): New York University School of Law Professor Samuel Estreicher and employment attorneys Erin Connell and Alexandria Elliott explore courts’ historical treatment of race- and diversity-conscious recruiting under Title VII. The authors survey EEOC guidance and decisions from federal courts of appeals and find that, although Title VII does not explicitly prohibit consideration of race or other protected characteristics in recruiting, diversity-focused recruiting violates Title VII when it results in a disparate impact in hiring. Estreicher, Connell, and Elliott advise that employers should focus on diversifying talent pools while maintaining merits-focused hiring practices to mitigate risk in the current landscape.
Law360, “10th Cir. Keeps Cards Close To Vest In DEI Bias Suit” (November 17): Law 360’s Grace Elleston reports on the recent oral argument heard by a three-judge panel of the Tenth Circuit in Young v. Colorado Department of Corrections. Joshua Young, a white ex-corrections officer, is appealing the dismissal of his Title VII suit that claims a Colorado Department of Corrections DEI training session created a hostile work environment by implying that white people are inherently racist. Elleston notes that Judge Timothy M. Tymkovich seemed skeptical that a single training session could meet the severe and pervasive standard necessary to create a hostile work environment for white employees, and queried whether a training session perceived by the plaintiff to cause offense based on his race could alter the conditions of his employment. Elleston concludes that the panel’s questioning shed little light on how it will rule.
Inc., “How Firms Are Winning Anti-DEI Lawsuits” (November 22): According to Brit Morse, Associate Editor at Inc., the recent wave of litigation challenging law firm diversity programs has only strengthened those firms’ commitment to promoting diversity in the legal profession. Those firms’ strategy of adjusting diversity program criteria seems to be working, writes Morse, and may also work for companies in other industries seeking to mitigate risk while maintaining a strong commitment to diversity. But Morse emphasizes that those hardest hit by recent litigation may be nonprofits and minority business owners reliant on diversity-focused funding, which is increasingly becoming the target of advocacy groups challenging diversity initiatives in court.
Paradigm, “New Data: 2023 DEI Trends & 2024 Opportunities” (November 19): Paradigm Co-Founder and CEO (and former civil rights attorney) Joelle Emerson highlights Paradigm’s new report on corporate DEI trends. The report aggregates data from 148 companies using Paradigm’s strategy and analytics platform. Emerson identifies four areas of opportunity for DEI in 2024, recommending that companies increase reliance on data to identify areas for improvement and to track progress, use DEI training to “reset the narrative” about diversity goals, focus on increasing (and measuring) inclusion, and assess hiring plans to ensure access to a wider pool of diverse candidates.
Bloomberg News, “Corporate America Is Rethinking Diversity Hiring” (November 22): Bloomberg’s Jeff Green and Kelsey Butler report on the corporate response to the recent wave of lawsuits targeting diversity programs. Interviews with employment lawyers, consultants, and diversity executives suggest that “[t]he biggest companies that were already committed to diversity initiatives prior to 2020 are more likely to be sticking with their programs,” while “[e]mployers that are newer to DEI or haven’t really started are more likely to pull back.” But the authors indicate that, despite these different approaches, the majority of private employers are changing the language they use to discuss diversity initiatives and reducing public communications about DEI efforts.
The Charlotte Post, “Affirmative action backlash hits maternal health program” (November 26): Freelance journalist Ronnie Cohen reports on the lawsuit filed in May 2023 by the Californians for Equal Rights Foundation—represented by the American Civil Rights Project—against the city of San Francisco and the state of California over the “Abundant Birth Project,” which provides monthly stipends to pregnant San Franciscans who are Black or of Pacific Island heritage. According to its website, the Project aims to address higher-than-average rates of maternal mortality and preterm births among members of these communities. But the plaintiffs argue that the Project, along with other city programs providing financial support to Black and transgender residents, violates Title VI and the equal protection clauses of the Fourteenth Amendment and the California Constitution.

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. Fearless Fund Mgmt., LLC, No. 1:23-cv-03424-TWT (N.D. Ga. 2023), on appeal at No. 23-13138 (11th Cir. 2023): Advocacy group American Alliance for Equal Rights (“AAER”) sued a Black women-owned venture capital firm with a charitable grant program that provides $20,000 grants to Black female entrepreneurs; AAER alleged that the program violates Section 1981 and sought a preliminary injunction. Fearless Fund is represented by Gibson Dunn.
- Latest update: On November 13, 2023, the Eleventh Circuit granted the parties’ motion to expedite oral argument and tentatively scheduled argument for the week of January 29, 2024.
Landscape Consultants of Texas, Inc. v. City of Houston, No. 4:23-cv-3516 (S.D. Tex. 2023): Plaintiff landscaping companies owned by white individuals challenged Houston’s government contracting set-aside program for “minority business enterprises” that are owned by members of racial and ethnic minority groups. The companies claim the program violates the Fourteenth Amendment and Section 1981.
- Latest update: On November 13, 2023, the City of Houston filed its motion to dismiss, arguing that the plaintiffs failed to state claims for disparate treatment under the Equal Protection clause and contracting discrimination under Section 1981. In particular, the City argued that one plaintiff, as a company owned 51% by a woman, might have been treated identically to a minority business enterprise, and that all plaintiffs failed to allege that they were “actually prevented, and not merely deterred” from contracting with the City. The City also argued that since the plaintiffs never actually submitted a bid to contract with Houston, they could not make out a Section 1981 claim.
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. The firm had previously announced that it would continue the program in response to a threat letter from AAER.
- Latest update: On October 30, 2023, AAER moved for a preliminary injunction seeking to bar the firm from considering race as a factor for its diversity fellowship program, to require it to use race-neutral language for program eligibility, and if necessary, to require the firm to restructure its hiring process. On November 14, 2023, the district court entered a briefing schedule; Winston & Strawn’s response is due on December 11, 2023.

2. Employment discrimination under Title VII and other statutory law:

Netzel v. American Express Company, No. 2:22-cv-01423 (D. Ariz. 2022), on appeal at No. 23-16083 (9th Cir. 2023): On August 23, 2022, a group of former American Express employees alleged that the company’s diversity initiatives discriminated against white workers and that the company retaliated against the same workers after they complained, in violation of Title VII and Section 1981.
- Latest update: After the district court granted American Express’s motion to compel arbitration, the plaintiffs appealed to the Ninth Circuit, filing their opening brief on November 9, 2023. The plaintiffs argue in part that they should not be compelled to arbitrate because they seek “public injunctive relief” against alleged “racial discrimination . . . that specifically harms the general public,” a right they claim is not waivable under California law. American Express’s response is due January 10, 2024.

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

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 14, 2023, a magistrate judge issued a recommendation and proposed order to grant a preliminary injunction. The judge recommended enjoining the colleges from investigating or disciplining the plaintiff based on his proposed political speech in the classroom. The judge also recommended denying the defendant’s motion to dismiss. The parties have until November 29, 2023 to file their objections to the magistrate judge’s findings.
Palsgaard v. Christian, No. 1:23-cv-01228-SAB (E.D. Cal. 2023): On August 17, 2023, community college professors in California filed suit, challenging the adoption of the state’s new DEI-related evaluation competencies and corresponding language in their faculty union contract, which they allege requires them to endorse the state’s views on DEI concepts. The plaintiffs challenge the regulations and contract language as compelled speech in violation of the First and Fourteenth Amendments.
- Latest update: On August 23, 2023, the plaintiffs moved for a preliminary injunction, which is fully briefed. The court has not yet ruled on the motion. The defendants’ current deadline to respond to the initial complaint is December 15, 2023.

The following Gibson Dunn attorneys assisted in preparing this client update: Jason Schwartz, Mylan Denerstein, Blaine H. 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])

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 amendments impact settlement agreements entered into on or after November 17, 2023. The expanded statute of limitations applies to claims arising on or after February 15, 2024.

New York recently passed two noteworthy employment laws. First, it expanded restrictions on the use of non-disclosure and non-disparagement provisions in agreements settling claims of discrimination, harassment, or retaliation. These expanded restrictions impact settlement agreements entered into on or after November 17, 2023. Second, effective February 15, 2024, New York extended the statute of limitations from one to three years for all claims resulting from unlawful discriminatory practices under the New York State Human Rights Law (NYSHRL).

Expanded Restrictions on Non-Disclosure and Non-Disparagement Provisions in Settlement Agreements: Calculating damages arising from a breach of a confidentiality/non-disparagement restriction can often be challenging for employers. As a result, settlement agreements frequently include a liquidated damages provision whereby the complainant agrees to pay a specified amount of damages to an employer (including some or all of the settlement payment) in the event of a breach. Such provisions are no longer permissible in New York as the newly enacted amendments to New York General Obligations Law § 5-336 state that in any agreement settling claims involving discrimination, harassment, or retaliation, a release is unenforceable if the agreement requires the complainant to pay liquidated damages or forfeit all or part of the consideration for the agreement for violation of a non-disclosure or non-disparagement provision. The newly enacted amendments also invalidate a release in a covered settlement agreement if it contains or requires any affirmative statement, assertion, or disclaimer that the complainant was not in fact subject to unlawful discrimination, harassment, or retaliation.

Changes Regarding the Procedure to Memorialize a Complainant’s Preference for Confidentiality: NY General Obligations Law § 5-336(1) sets out a particular process and timeframe for employers to memorialize a complainant’s preference for confidentiality in a settlement agreement where the factual foundation of the settlement involves claims of discrimination, harassment, or retaliation. Specifically, employers must ensure: (i) the non-disclosure provision is the complainant’s preference; (ii) the non-disclosure provision is set forth in writing; and (iii) the complainant has up to 21 days to consider such terms and 7 days to revoke their acceptance.

New York law previously required that complainants be given a non-waivable 21-day consideration period for covered settlement agreements. Now, for pre-litigation settlements, the amendments allow a complainant to waive the 21-day consideration period and sign the agreement before that period expires. Still, the agreement cannot be effective until after the expiration of the 7-day revocation period.

Employers should take note that NY CPLR § 5003-B—which applies to settlements reached after a lawsuit has been filed in New York state court—requires plaintiffs to wait the full 21-day consideration period before signing a settlement agreement that would prevent the disclosure of the underlying facts and circumstances of any discrimination claim. Accordingly, the 21-day consideration period is still not waivable in agreements settling a discrimination claim that has been filed in court.

Independent Contractors Covered: The recent amendments state that NY General Obligations Law § 5-336 now applies to independent contractors, in addition to employees and potential employees. Accordingly, any covered settlement agreement with an independent contractor is now subject to § 5-336.

Communications with Attorney General Added to Protected Activity: Since § 5-336’s passage in 2018, New York employers have been required to notify complainants that provisions in any agreement (not just settlement agreements) that prevent the disclosure of factual information related to any future claim of discrimination do not prohibit the complainant from speaking with law enforcement, the EEOC, the New York State Division of Human Rights, a local commission of human rights, and attorneys. The amendments further require that complainants be notified that they are not prohibited from speaking with the New York Attorney General. Accordingly, employers should review and update their agreements to include the requisite carve-outs.

Expanded Statute of Limitations: As previewed above, in addition to amending § 5-336, New York enacted a separate law extending the statute of limitations for all claims resulting from unlawful discriminatory practices under the NYSHRL from one to three years. The new statute of limitations applies to claims arising on or after February 15, 2024.

Takeaway

Employers in New York State should review relevant agreements to ensure compliance with these amendments and be prepared to face a potential uptick in lawsuits over time in light of the impending extended statute of limitations under the NYSHRL.

The following Gibson Dunn attorneys assisted in preparing this update: Harris Mufson, Danielle Moss, Hayley Fritchie, and Tia Kerkhof.

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:

Harris M. Mufson – Partner, New York (+1 212.351.3805, [email protected])

Danielle J. Moss – Partner, New York (+1 212.351.6338, [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])

The Court’s decision also distinguishes the ADGM and DIFC’s approaches to English law.

A unique feature of the ADGM—certainly within the region—is that the English common law, as it stands from time to time, not only applies and has legal force in the jurisdiction, but also forms part of the ADGM’s laws. This is enshrined in Article 1(1) of the Application of English Law Regulations 2015 (“Regulations”).

On 17 November 2023, the ADGM Court of Appeal published an important decision in AC Network Holding Ltd. v. Polymath Ekar SPV1, confirming, among other things, that whilst ADGM judges “are not sitting as English law judges”, “they are bound to apply the rule laid down by the [Regulations]”. Lord Hope contrasted this with the position in the Dubai International Financial Center (“DIFC”): “The position in the Dubai International Financial Centre is different. Common law rules in various areas have been codified, and it is only if those rules or the laws of other relevant legal systems do not provide an answer that the laws of England and Wales are applied.”

This decision provides clarity to parties contracted to resolve disputes before the ADGM courts, and emphasises the unique position of English law in the ADGM, which the Court of Appeal observed “lies at the heart of the system of law that was created for the ADGM”.

Context and Factual Background

With the adoption of the Regulations in 2015, the ADGM opted to fully transplant English law as its applicable private law.[1] The result is that the entire, constantly updated, corpus of English common law applies in the ADGM. However, as the AC case demonstrates, there remained some doubts as to the full effect of this legal transplant.

AC concerned the sale of shares in a car-sharing company operating in Dubai, Abu Dhabi and Saudi Arabia. In 2020, the company’s minority shareholders were compelled, pursuant to a “Drag Along Notice” (“Notice”) issued by the majority shareholders, to sell their shareholding to a third party.

The minority shareholders challenged the validity of the Notice on the ground that the third party purchaser was not a ‘bona fide purchaser’ as required by the Shareholders’ Agreement (“Agreement”). Rather, they claimed that the purchaser was actually the majority shareholder himself, merely acting through a corporate veil. The minority shareholders sued the majority for the economic torts of intentionally procuring a breach of the Agreement as well as of conspiracy to use unlawful means to breach the Agreement. The Agreement was governed by English Law and any disputes arising under the Agreement were subject to the exclusive jurisdiction of the ADGM courts.

Court of First Instance

The ADGM Court of First Instance agreed with the minority shareholders that the Notice was invalid, insofar as the majority shareholder, by standing on “both sides of the fence,” had effectively expropriated the company’s shares in bad faith. However, the Court did not find that this breach was intentional, with the majority shareholder having received assurance from its legal counsel that the transfer was lawful.[2] In considering the unlawful means conspiracy claim, the Court was faced with a question of English law: did this claim also require knowledge of the unlawfulness of the conduct?

In answering this question, the minority shareholders pointed to a 2021 decision of the English Court of Appeal in Racing Partnership, where a majority of judges held that such knowledge was not required.[3] However, the ADGM Court of First Instance declined to follow this decision, holding that while Article 1(1) of the Regulations made English court decisions and precedent “highly relevant,” it did not bind ADGM courts.[4] Instead, it was the ADGM Court of First Instance’s duty to ascertain the “correct position” in English law, which may not be reflected in the latest case law.[5]

In this analysis, the ADGM Court of First Instance found that Racing Partnership confused rather than settled English law, with the correct position being that knowledge was, in fact, a requirement to establish the tort of conspiracy by unlawful means. Having already found that the majority shareholder lacked knowledge that his conduct was unlawful, the minority shareholders’ claims were dismissed.[6]

Court of Appeal

On appeal, the minority shareholders claimed that the Court of First Instance had erred in its application of English law, and consequently, the Regulations. They argued that Article 1(1) of the Regulations required that the ADGM courts apply English law including respecting the doctrine of precedent, the principle that within a single legal system, lower courts are bound by the prior decisions of higher courts.

The ADGM Court of Appeal agreed. In its reading, Article 1(1) of the Regulations required ADGM courts to apply English law principles, which would necessarily include the bedrock doctrine of precedent.[7] With some exceptions, a lower court would thus be required to apply decisions of higher courts even if they felt that the decision was faultily reasoned or had an unjust result.[8] In this context, the ADGM Court of Appeal found that the English Court of Appeal’s decision Racing Partnership was binding authority in the ADGM.[9] With knowledge of the illegality of its conduct no longer required, the ADGM Court of Appeal found the majority shareholder was liable for conspiracy to use unlawful means to breach the Agreement.[10]

Implications

The ADGM Court of Appeal’s decision in AC has profound implications in the ADGM. As the decision recognises, respect for the doctrine of precedent injects predictability into the ADGM’s application of English law, which was the primary reason for the Regulations in the first place. No longer will ADGM judges be encouraged (or permitted) to depart from latest English case law to undertake novel (and potentially complex) analyses of the ‘correct’ position under English law. Instead, the practice before the ADGM courts will be greatly synthesised with that before English courts, providing relief to clients and lawyers already familiar with these courts and their rulings.

AC also has the notable effect of further entrenching the ADGM’s wholesale adoption of English common law, which stands in contrast to other special economic zones and financial zones in the region (including in the UAE). For example, the DIFC explicitly codified various common law rules as DIFC law with adjustments, with English common law only applied to fill gaps in these existing DIFC codes.[11] The merit of the ADGM model—evidenced by the ADGM’s growing attractiveness to foreign investors worldwide—is its immediate familiarity to clients and lawyers well-versed with English law. The AC decision is another welcome step in the right direction.

__________

[1] Application of English Law Regulations 2015, art. 1(1) (“The common law of England (including the principles and rules of equity), as it stands from time to time, shall apply and have legal force in, and form part of the law of the Abu Dhabi Global Market”.)

[2] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 16.

[3] Racing Partnership v. Done Bros Ltd. [2021] Ch 233

[4] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 18.

[5] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 19.

[6] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 19.

[7] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 25.

[8] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶¶ 32-33.

[9] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 45.

[10] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 46.

[11] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 2.

The following Gibson Dunn attorneys assisted in preparing this update: Nooree Moola and Praharsh Johorey.

Gibson Dunn’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, the authors, or any of the following leaders and members of the firm’s global Litigation, International Arbitration, or Mergers and Acquisitions practice groups:

Renad Younes – Abu Dhabi (+971 2 234 2602, [email protected])
Marwan Elaraby – Dubai/Abu Dhabi (+971 4 318 4611, [email protected])
Nooree Moola – Dubai (+971 4 318 4643, [email protected])
Praharsh Johorey – Dubai (+1 212.351.3911, [email protected])
Cyrus Benson – London (+44 20 7071 4239, [email protected])
Penny Madden KC – London (+44 20 7071 4226, [email protected])

The Court’s decision raises important considerations for asset managers, non-U.S. funds, and other non-U.S. persons that invest in the United States.

On November 15, 2023, the Tax Court released its opinion in YA Global v. Commissioner,[1] holding, among other things, that YA Global — a Cayman Islands fund with a U.S. investment manager — was engaged in a U.S. trade or business and therefore was correctly assessed U.S. federal withholding tax liability with respect to its non-U.S. partners. YA Global had been closely followed ever since the IRS first released its analysis of the case in 2015.[2] Although YA Global’s activities and arrangements with its investment manager, based on the facts as described by the Court, were unusual as compared with those of a typical non-U.S. fund that makes U.S. investments, the case raises several important considerations for asset managers, non-U.S. funds, and other non-U.S. persons that invest in the United States.

I. Background

U.S. federal income tax law requires non-U.S. persons to pay tax on income effectively connected with a U.S. trade or business (“ECI”).[3] Section 1446(a) requires a partnership to withhold and pay tax on the portion of any ECI allocable to a non-U.S. partner. Neither the Code nor the Treasury Regulations define a U.S. trade or business for this purpose.[4] Instead, whether a taxpayer is engaged in a U.S. trade or business depends on the particular facts and circumstances.[5]

To be considered engaged in a U.S. trade or business, a non-U.S. person must conduct continuous and regular activity in the United States for profit.[6] Importantly, mere management of investments does not give rise to a trade or business regardless of the amount of time and effort devoted to the activity.[7] In addition, the Code provides a safe harbor that prevents a non-U.S. person from being treated as engaged in a U.S. trade or business if the non-U.S. person’s activities are limited to (i) trading in stocks or securities through an independent agent, or (ii) if the non-U.S. person is not a “dealer,” trading in stocks or securities for its own account or through a broker or other agent (collectively, the “Trading Safe Harbor”).[8] For this purpose, the Treasury regulations define “securities” and the act of trading in securities quite broadly.[9] And, notably, the regulations provide that the volume of stock or security transactions effected during the taxable year is not taken into account in determining whether the taxpayer is engaged in a U.S. trade or business.[10]

In 2015, the IRS Office of Associate Chief Counsel (International) released a legal memorandum (the “CCA”) discussing the facts of YA Global.[11] The CCA concluded that (a) YA Global was engaged in “lending” and “underwriting” activities that were so extensive that they rose to the level of a U.S. trade or business, (b) the “lending” and “underwriting” activities did not constitute “trading in stocks or securities” for purposes of the Trading Safe Harbor, and (c) even if YA Global’s activities otherwise constituted “trading in stocks or securities” for this purpose, YA Global would not have qualified for the Trading Safe Harbor because YA Global was a dealer acting through a non-independent agent.

Now, eight years later, the Tax Court has also concluded that YA Global’s activities constituted a U.S. trade or business, albeit based on a somewhat different analysis from that of the CCA.

The Tax Court’s decision in YA Global is the most significant development regarding this issue since the CCA was published. Non-U.S. funds that invest in the United States should take particular note of this decision, especially given the IRS’s current campaign entitled Financial Service Entities engaged in a U.S. Trade or Business,[12] which is intended to address whether non-U.S. credit funds are engaged in a U.S. trade or business.

II. Facts

The following summarizes the facts as described by the Court in its opinion. In its briefs and responses, however, YA Global disputed certain of these characterizations of its activities and investments.

1. The Main Parties

YA Global Investments, LP, a Cayman Islands limited partnership (“YA Global”), was the flagship fund of Yorkville Advisors, LLC, a U.S.-based fund sponsor (“Yorkville Advisors”). YA Global had no employees and took the position that it was not engaged in a U.S. trade or business during the tax years at issue (2006, 2007, and 2008).

Yorkville Advisors served as YA Global’s general partner until 2007 and as its investment manager under a 2005 investment management agreement (the “Management Agreement”).[13] The Management Agreement appointed Yorkville Advisors as YA Global’s “Agent” and granted Yorkville Advisors a power of attorney, though YA Global could provide notice of specific investment restrictions, and, under a 2007 amendment, Yorkville Advisors’ actions were subject to the “policies and control” of YA Global’s general partner. In return for its management services, Yorkville Advisors received a management fee equal to a specified percentage of YA Global’s assets. Yorkville Advisors (presumably in its role as general partner) also received a 20 percent incentive fee based on YA Global’s profits. During each year at issue, YA Global’s assets constituted at least 72 percent of Yorkville Advisors’ total assets under management, and, for most of the relevant period, YA Global was the only fund Yorkville Advisors managed.

YA Offshore Global Investments, Ltd., a Cayman Islands limited company (“YA Offshore”), was a limited partner in YA Global. YA Offshore took the position that it was not engaged in a U.S. trade or business, either directly or through YA Global.

2. Activities of YA Global and Yorkville Advisors

During the tax years at issue, YA Global invested primarily in convertible debentures, standby equity distribution agreements (“SEDAs”), and other securities of microcap and low-priced public companies trading on the over-the-counter public markets (investments like these sometimes are described as private investments in public securities.)

SEDAs. In a typical SEDA, YA Global committed to purchase a maximum dollar value of a company’s stock over a fixed period (typically two years). The purchase price for the stock generally was discounted to 95 to 97 percent of the stock’s market price at the time of purchase. YA Global entered into 25 SEDA transactions in 2006, 19 in 2007, and 9 in 2008.

Convertible Debentures. YA Global acquired convertible debentures from companies, some of which included a fixed conversion price, while others set the conversion price at a discount to the market price of the company’s stock at the time of conversion. YA Global generally exercised a conversion feature when it was ready to sell the stock it would receive on conversion. YA Global acquired 202 convertible debentures in 2006, 116 in 2007, and 111 in 2008.

Fees. The companies in which YA Global invested typically paid “fees” to Yorkville Advisors and/or YA Global in connection with the SEDAs and convertible debentures. The CEOs of two of Yorkville Advisors’ portfolio companies stated they viewed the fees as part of their overall cost of capital, not fees for services. According to the Court, in some cases, Yorkville Advisors used the fees it received from portfolio companies to pay its expenses and then remitted the excess to YA Global. In other cases, according to the Court, Yorkville Advisors remitted all of the fees to YA Global. Finally, in some cases, Yorkville Advisors kept the fees but reduced the management fees YA Global paid to Yorkville Advisors by a corresponding amount.[14]

Marketing. The Court found that YA Global held itself out in its marketing materials as being willing and able to provide capital to portfolio companies. The founder and president of Yorkville Advisors stated that its strong reputation led many companies seeking funding to contact them directly, and that employees attended conferences seeking to make connections at portfolio companies. Marketing materials referred to introductions provided by investment bankers, law firms, and accounting firms.

Tax Returns. YA Global filed a partnership information return on Form 1065 for each of the years at issue but did not file Form 8804 (reporting withholding tax liability under section 1446), because YA Global took the position that it was not engaged in a U.S. trade or business. The parties executed Forms 872-P, extending the assessment period to March 31, 2015, and the IRS asserted deficiencies on March 6, 2015.

III. Analysis and Key Holdings

1. YA Global Was Engaged in a U.S. Trade or Business

As a preliminary matter, the Court held that Yorkville Advisors was an agent of YA Global because the Management Agreement named Yorkville Advisors as YA Global’s agent and required Yorkville Advisors to comply with ongoing directions from YA Global. The Court contrasted this arrangement with that of a service provider where directions and guidelines are established as an initial matter and generally are not subject to change. As a result, the Court determined that all of the activities of Yorkville Advisors in the United States were attributable to YA Global.

The Court then held that YA Global was engaged in a U.S. trade or business based on a three-part analysis: (i) Yorkville Advisors’ activities conducted on behalf of YA Global were continuous, regular, and engaged in for the primary purpose of producing income or profit (i.e., constituted a trade or business) (according to the Court, YA Global did not dispute this point); (ii) in the Court’s view, the activities were not limited to the management of investments but included the performance of services and, thus, did not fall within the judicial exception set out in Higgins;[15] and (iii) because the Court characterized YA Global’s activities as including the provision of services, the activities were not covered by the Trading Safe Harbor.

The majority of the Court’s discussion focuses on the second part of this analysis—the judicial exception for the management of investments. In the Court’s view, whether YA Global, and Yorkville Advisors on its behalf, were simply managing YA Global’s investments turned on whether YA Global earned income from the companies in which it invested beyond just a return on the capital invested in those companies. In that regard, the Court found that the fees or discounts the companies provided to YA Global, or to Yorkville Advisors as YA Global’s agent, were given in respect of services provided by Yorkville Advisors in negotiating and structuring the investments. The Court rejected YA Global’s arguments that YA Global and Yorkville Advisors provided no services to the portfolio companies and that the fees or discounts were merely part of the companies’ cost of capital (even though that is how the companies viewed them) or that certain of the fees should instead be viewed as put option premiums.[16] In the Court’s view, the companies “received something of value from Yorkville Advisors above and beyond the capital they received from YA Global.” According to the Court, that “something of value” was Yorkville Advisors’ work in sourcing, negotiating, conducting due diligence, structuring, and managing the transactions on behalf of YA Global.[17] Thus, the Court determined that YA Global was not merely an investor managing its investments.

The Court applied essentially the same test to determine that YA Global did not qualify for the Trading Safe Harbor. Noting that “[t]raders, like investors, simply earn returns on the capital they invest,” the Court held that because it viewed YA Global as earning income from fees that went beyond returns for the use of capital, YA Global was not a trader for purposes of the Trading Safe Harbor.[18]

2. YA Global Was a Dealer for Purposes of Section 475

After concluding that YA Global was engaged in a U.S. trade or business for the years at issue, the Court held that, to calculate the amount of YA Global’s ECI allocable to non-U.S. partners for those years, YA Global’s annual income should have been determined under section 475(a)’s mark-to-market rules for dealers.

Section 475(a) requires dealers in securities to recognize ordinary gain or loss each taxable year as if they sold all their securities on the last day of the year, at fair market value (the “mark-to-market” requirement).[19] For this purpose, a “dealer in securities” is any taxpayer that (i) “regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business,” or (ii) “regularly offers to enter into, assume, offset, assign or otherwise terminate positions in securities with customers in the ordinary course of a trade or business.”[20]

Securities held for investment (i.e., not inventory) and debt acquired or originated by the taxpayer in the ordinary course of a trade or business of the taxpayer but not held for sale are both exempt from the mark-to-market requirement so long as the taxpayer properly identifies them as such.[21]

The Court found that YA Global was a “dealer in securities” for purposes of section 475 because it regularly purchased securities from the portfolio companies in which it invested, and, according to the Court, those portfolio companies were its customers.[22] The Court also found that YA Global did not meet the identification requirements under section 475(b)(2) and therefore did not establish that any securities it held met the “held for investment” exception. As a result, the Court held that YA Global was subject to the mark-to-market requirement for the tax years at issue.

3. All of YA Global’s Income Was ECI

Under section 1446, partnerships are required to withhold and pay tax on ECI allocable to a non-U.S. partner.[23] For section 1446 withholding purposes, income from sales of personal property is U.S.-source when attributable to an office or other fixed place of business in the United States, even if, for example, the personal property is securities of a non-U.S. company.[24] And U.S.-source income from the sale of personal property, other than capital assets, is ECI for a non-U.S. person that is engaged in a U.S. trade or business.[25] Because the Court held that Yorkville Advisors was a non-independent agent of YA Global, the Court attributed Yorkville Advisors’ U.S. office to YA Global. Further, because the Court held that YA Global was a dealer under section 475, all of YA Global’s stocks and securities were personal property other than capital assets, with the result that all gain or loss resulting from their sale and all mark-to-market gains or losses were ECI. Therefore, the Court held that all of YA Global’s income allocable to non-U.S. partners during the tax years at issue was ECI subject to withholding under section 1446.

4. YA Offshore’s Nonpartnership Deductions Did Not Reduce Withholding
Tax Liability

Generally, a non-U.S. partner’s distributive share of partnership deductions may reduce its allocable share of the partnership’s ECI and, thus, the partnership’s section 1446 withholding tax liability with respect to that partner. Nonpartnership deductions (i.e., those that are only deductible by a partner rather than by the partnership) reduce a non-U.S. partner’s share of the partnership’s section 1446 withholding tax liability if the partner provides a certification to the partnership of the nonpartnership deductions available to reduce the non-U.S. partner’s ECI.[26] The Court held that, because YA Offshore did not timely file U.S. federal income tax returns and therefore could not provide any withholding certificates to YA Global, YA Offshore’s nonpartnership deductions did not reduce YA Global’s liability for section 1446 withholding tax.

5. Statute of Limitations Did Not Begin Running When Form 1065 Was Filed

Generally, a taxpayer does not start the statute of limitation running by filing one return when a different return is required, unless the return filed is sufficient to advise the IRS that liability exists for the tax that should have been disclosed on the other return.[27] The Court found that YA Global was liable for section 1446 withholding tax in respect of its ECI. Therefore, YA Global was required to file Form 8804 for each applicable year in addition to its Form 1065. YA Global did not file a Form 8804 for any of the years at issue, and the Court found that its Forms 1065 were insufficient to advise the IRS of its liability under section 1446. Therefore, the Court held that the statute of limitations for the relevant taxable years had not begun running (and therefore had not expired).

IV. Key Takeaways

Non-U.S. funds and other non-U.S. persons that invest in the United States should carefully review their activities (and the related documentation) in light of the decision in YA Global. As noted above, the IRS currently is engaged in a campaign to determine whether certain non-U.S. funds are engaged in a U.S. trade or business. The Court’s decision in YA Global may provide added support for this campaign, as well as motivation for the IRS to challenge taxpayers on this issue.
Most non-U.S. funds, particularly credit funds, follow strict guidelines to ensure that their activities do not rise to the level of a U.S. trade or business. To be conservative, these guidelines typically assume that the fund manager’s activities on behalf of the fund will be attributed to the fund under the IRS’s broad view of agency attribution. Many of these funds have management agreements similar to the agreement between YA Global and Yorkville Advisors. The Court’s determination that Yorkville Advisors’ activities were attributable to YA Global strongly supports the continued use of these strict guidelines and, in particular, their application to the U.S.-based fund manager’s activities on behalf of the non-U.S. fund.
The Court’s determination that the receipt of fees caused YA Global to be engaged in a U.S. trade or business suggests that non-U.S. funds should be very careful in structuring fee arrangements. Fortunately, typical fund fee arrangements are distinguishable from the Court’s description of the fee arrangements entered into by Yorkville Advisors. Most funds do not receive structuring, diligence, and other fees—either directly or as a passthrough from their fund manager. Instead, if the fund’s manager or its affiliate receives fees from a portfolio company, the fund may receive a corresponding offset against future management fees equal to a pro rata amount (based on the fund’s ownership percentage of the portfolio company) of the fees paid to the manager. As a result, the manager or its affiliate profits from fees received on its own account, and the fund receives the offset simply to avoid a double payment.
Some funds receive commitment fees or purchase price discounts attributable to their agreement to invest a specified amount of capital and/or their role as seed investor. Typically, funds do not provide any services in exchange for these discounts. In the case of debt investments, these amounts are often treated as a reduction of the issue price and result in original issue discount (which is taxed as interest); alternatively, both the Tax Court and the IRS have determined that in some cases commitment fees are properly viewed as put option premiums.[28] Although the Court in YA Global acknowledged that in many cases the portfolio companies viewed the fees they paid as part of the economic cost of gaining “access to” capital, the Court distinguished paying for access to capital from paying for capital and held that the former constituted fees for services even though, economically, it is difficult to understand the distinction. The Court also rejected YA Global’s argument that certain of the fees should be viewed as put option premiums, notwithstanding the case law and Revenue Ruling in support of YA Global’s argument. Presumably the Court’s conclusion with respect to the fees and discounts reflected the unusual facts of the YA Global case, as described in the opinion. The Court did not reach a conclusion on the IRS’s arguments that the fund was engaged in loan origination and underwriting activities, but these points may have been what propelled the Court to view Yorkville Advisors (and YA Global) as having provided “services” to the portfolio companies in which the fund invested.
Most U.S.-managed funds that actively buy and sell stocks and securities rely on the Trading Safe Harbor. If a fund is considered a dealer, however, it cannot qualify for the Trading Safe Harbor unless it acts through an independent agent. Although the Court did not decide whether YA Global was acting as a dealer under section 864, the Court’s holding that YA Global was a dealer for purposes of section 475, including its broad and, to date, unprecedented view of the meaning of “customers,” strikes a cautionary note.[29] Again though, it was likely the unique nature of YA Global’s activities and investments (according to the facts described in the case) that caused the Court to conclude that YA Global was a dealer. In particular, despite YA Global’s arguments to the contrary, the Court appeared to view YA Global’s role in the SEDA and convertible note transactions as locking in a discount or spread similar to a dealer (in contrast to funds that are simply active traders for their own account that make their profits from market price fluctuations).
As a procedural matter, the case highlights the importance of filing protective U.S. tax returns, including Form 8804, to preserve the ability to claim deductions and to start the statute of limitations running.

__________

[1] 161 T.C. No. 11 (2023).

[2] Chief Counsel Advice 201501013 (Sept. 5, 2014).

[3] Sections 871(b) and 882 of the Internal Revenue Code of 1986, as amended (the “Code”). All section references in this publication are to the Code or the Treasury Regulations issued thereunder. Non-U.S. persons also are required to file a U.S. federal income tax return if they are engaged in a U.S. trade or business, including if they are a partner in a partnership that is engaged in a U.S. trade or business. Treas. Reg. §§ 1.6012-1(b) and -2(g); section 875.

[4] Section 864(b) provides that the performance of personal services within the United States constitutes a U.S. trade or business, subject to certain exceptions, and also provides several exemptions from being engaged in a U.S. trade or business, as discussed further in this publication.

[5] Treas. Reg. § 1.864-2(e); Groetzinger v. Comm’r, 480 U.S. 23 (1987); Higgins v. Comm’r, 312 U.A. 212 (1941).

[6] See, e.g., Pinchot v. Comm’r, 113 F.2d 718 (2d Cir. 1940)(taxpayer’s activity “required regular and continuous activity of the kind which is commonly concerned with the employment of labor; the purchase of materials; the making of contracts; and the many other things which come within the definition of business.”); de Amodio v. Comm’r, 34 TC 894 (1960), aff’d, 299 F.2d 623 (3d Cir. 1962); Spermacet Whaling & Shipping Co. v. Comm’r, 30 TC 618 (1958), aff’d, 281 F.2d 646 (6th Cir. 1960); Groetzinger v. Comm’r, 480 U.S. 23 (1987); Lewenhaupt v. Comm’r, 20 T.C. 151 (1953), aff’d, 221 F.2d 227 (9th Cir. 1955); Rev. Rul. 88-3, 1988-1 C.B. 268. Section 864(b).

[7] See, e.g., Higgins v. Comm’r, 312 U.S. 212 (1941) (active management of investments and collection of rents, interest and dividends by a non-U.S. person in the U.S. did not result in a U.S. trade or business); Treas. Reg. § 1.864-3(b), Ex. 2 (supervising investments does not constitute a trade or business).

[8] Section 864(b)(2)(A)(i) contains the exemption for trading done through an independent agent in the United States, and section 864(b)(2)(A)(ii) contains the exemption for non-dealers trading for their own accounts.

[9] Treas. Reg. § 1.864-2(c)(2)(i)(c) provides: “…the term ‘securities’ means any note, bond, debenture or other evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing.”

[10] Treas. Reg. § 1.864-2(c)(2)(i)(c) provides: “…the effecting of transactions in stocks or securities includes buying, selling (whether or not by entering into short sales), or trading in stocks, securities, or contracts or options to buy or sell stocks or securities, on margin or otherwise, for the account and risk of the taxpayer, and any other activity closely related thereto (such as obtaining credit for the purpose of effectuating such buying, selling, or trading).”

[11] Chief Counsel Advice 201501013 (Sept. 5, 2014).

[12] Financial Service Entities engaged in a U.S. Trade or Business, IRS Large Business and International Division (June 10, 2021).

[13] Yorkville Advisors GP, LLC was the general partner for the other years at issue.

[14] This management fee reduction mechanism is quite common in the fund industry. YA Global’s other fee arrangements described by the Court, where portfolio companies paid fees directly to YA Global or where Yorkville Advisors remitted fees to YA Global, are not typical, although the taxpayer disputed the Court’s characterization of some of these arrangements. It appears that some of the “fees” discussed by the Court were actually additional shares of stock, warrants, or purchase price discounts received by YA Global in connection with its investment commitment.

[15] Higgins v. Comm’r, 312 U.A. 212 (1941).

[16] According to the Court, it rejected the put option characterization because, in the Court’s view, the writer of a put option receives the premium for taking the risk that it will be called upon to purchase stocks or securities in the future for more than their fair market value, and it did not view YA Global as taking that risk.

[17] Because the Court concluded YA Global was engaged in the performance of services, it did not decide whether YA Global was engaged in a lending or underwriting trade or business (as the IRS had argued in the CCA and in certain of its briefs). YA Global v. Comm’r, 161 T.C. No. 11, 22 n.21 (2023).

[18] The Court seemingly rejected any notion that the activities for which Yorkville Advisors received compensation on behalf of YA Global were closely related to its trading in stocks and securities and thus within the Trading Safe Harbor under Treas. Reg. § 1.864-2(c)(2)(i)(c), quoting the IRS’s broad statement in its submissions that “‘[t]axpayers engaged merely in trading and investment simply do not earn income designated as fees.’” YA Global v. Comm’r, 161 T.C. No. 11, 36 n.33 (2023).

[19] Section 475(d)(3)(A)(i).

[20] Section 475(c)(i). A “security” for this purpose includes any share of stock in a corporation, note, bond, debenture, or other evidence of indebtedness, or warrant to acquire stock. Sections 475(c)(2)(A), 475(c)(2)(C), and 475(c)(2)(E).

[21] Section 475(b)(1)-(2); Treas. Reg. § 1.475(b)-1(a); see also Rev. Rul. 97-39, 1997-2 C.B. 62, 62.

[22] Although it is difficult to understand how the portfolio companies were customers, the Court pointed to Treas. Reg. § 1.475(c)-1(a)(2), which, “in contrast to the statute it interprets, does not use the term ‘customers.’ In place of that term, the regulation refers to the taxpayer’s ‘regularly hold[ing] itself out as being willing and able to enter into’ specified positions.” The Court concluded “[t]he regulation thus establishes that a taxpayer’s ‘customers,’ for purposes of section 475(c)(1)(B), are those with whom the taxpayer does what it ‘regularly holds itself out’ to do.”

[23] Treas. Reg. § 1.1446-2.

[24] Section 865(e)(2)(A).

[25] Section 864(c)(3).

[26] Treas. Reg. § 1.1446-6(c).

[27] Commissioner v. Lane-Wells Co., 321 U.S. 219 (1944).

[28] Federal Home Loan Mortgage Corp. v. Comr., 125 T.C. 248 (2005); Rev. Rul. 81-160; 1981-1 C.B. 312

[29] Treas. Reg. § 1.864-2(c)(iv) defines a dealer in stocks or securities as “[a] merchant of stocks or securities, with an established place of business, regularly engaged as a merchant in purchasing stocks or securities and selling them to customers with a view to the gains and profits that may be derived therefrom. Persons who buy and sell, or hold, stocks or securities for investment or speculation, irrespective of whether such buying or selling constitute the carrying on of a trade or business… are not dealers in stocks or securities….”

The following Gibson Dunn attorneys assisted in preparing this update: Jennifer Fitzgerald, Pamela Lawrence Endreny, Emily Leduc Gagné*, Eric Sloan, Hayden Theis, Daniel Zygielbaum, Anne Devereaux*, James Jennings, and Loren Lembo.

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 practice group:

Dora Arash – Los Angeles (+1 213.229.7134, [email protected])
Sandy Bhogal – Co-Chair, London (+44 (0) 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])

*Anne Devereaux is of counsel working in the firm’s Los Angeles office who is admitted to practice in Washington, D.C.; Emily Leduc Gagné is an associate working in the firm’s New York office who is admitted to practice in Ontario, Canada.

A Survey of Disclosures from the S&P 100 During the Three Years Following Adoption of the Securities and Exchange Commission Rule

Human capital resource disclosures by public companies have continued to be a focus since the U.S. Securities and Exchange Commission (the “Commission”) adopted the new rules in 2020; not only for companies making the disclosures, but employees, investors, and other stakeholders reading them. This alert updates the alert we issued in January 2023, “Evolving Human Capital Disclosures: A Survey of Disclosures from the S&P 100 During the Two Years Following Adoption of the Securities and Exchange Commission Rule,” available here, and reviews disclosure trends among S&P 100 companies, each of which has now included human capital disclosure in their past three annual reports on Form 10-K. This alert also provides practical considerations for companies as we head into 2024.

The overall takeaway from our survey, which categorized disclosures into 27 topic areas, was that companies are generally tailoring the length of their disclosures and the topics covered and including slightly more quantitative information in some areas.[1] We note the following trends regarding the S&P 100 companies’ disclosures compared to the previous year:

Length of disclosure. Forty-eight percent of companies increased the length of their disclosures, four percent of companies’ disclosures remained the same, and the remaining 48% of companies decreased the length of their disclosures (with the decreases generally attributable to the removal of discussion related to COVID-19).
Number of topics covered. Twenty-two percent of companies increased the number of topics covered (with the categories seeing the most increases being diversity statistics by race/ethnicity and gender, employee mental health, monitoring culture, talent attraction and retention, and talent development), while 34% decreased the number of topics covered (the majority of which were attributable to the removal of disclosures related to COVID-19), and the remaining 46% covered the same number of topics.
Breadth of topics covered. The prevalence of 16 topics increased, seven decreased, and four remained the same.
- The most significant year-over-year increases in frequency involved the following topics: quantitative diversity statistics on gender (60% to 65%), employee mental health (46% to 50%), culture initiatives (22% to 26%), efforts to monitor culture (60% to 64%), and talent attraction and retention (90% to 94%).
- The most significant year-over-year decrease involved COVID-19 disclosures, which declined in frequency from 69% to 34%. Other year-over-year decreases involved discussion of governance and organizational practices (56% to 51%) and diversity targets and goals (23% to 19%).
Most common topics covered. The topics most commonly discussed this most recent year generally remained consistent with the previous two years. For example, diversity and inclusion, talent development, talent attraction and retention, and employee compensation and benefits remained four of the five most frequently discussed topics, while quantitative talent development statistics, supplier diversity, community investment, and quantitative statistics on new hire diversity remained four of the five least frequently covered topics.
Industry trends. Within the technology, finance, and energy industries, the trends that we saw in the previous year regarding the frequency of topics disclosed generally remained the same.

I. Background on the Requirements

On August 26, 2020, the Commission voted three to two to approve amendments to Items 101, 103, and 105 of Regulation S-K, including the principles-based requirement to discuss a registrant’s human capital resources to the extent material to an understanding of the registrant’s business taken as a whole.[2] Specifically, public companies’ human capital disclosure must include “the number of persons employed by the registrant, and any human capital measures or objectives that the registrant focuses on in managing the business (such as, depending on the nature of the registrant’s business and workforce, measures or objectives that address the development, attraction, and retention of personnel).”

Notably, the Commission’s agenda list includes new human capital disclosure rules that are expected to be more prescriptive than the current rules, in part,[3] because one of the main criticisms of the existing human capital rules is lack of comparability across companies. Based on our survey, while company disclosures under the existing principles-based rules vary—which is expected under the principles-based regime—our survey was able to introduce some comparability. The next four sections show the relevant data from our survey.[4]

II. Disclosure Topics

Our survey classifies human capital disclosures into 27 topics, each of which is listed in the following chart, along with the number of companies that discussed the topic in each of 2021, 2022, and 2023. Each topic is described more fully in the sections following the chart.

A. Workforce Composition

Among S&P 100 companies, 58% included disclosures relating to workforce composition in one or more of the following categories:

Full-time/part-time employee split. While most companies provided the total number of full-time employees, only 16% of the companies surveyed included a quantitative breakdown of the number of full-time versus part-time employees, compared to the same percentage in the previous year and up slightly from 14% in 2021. Similarly, 67% of companies provided statistics on the number of seasonal employees and/or independent contractors or a breakdown of employees by business segment, job function, or geographical location, up from 65% in 2022 and 61% in 2021.
Unionized employee relations. Of the companies surveyed, 37% stated that some portion of their workforce was part of a union, works council, or similar collective bargaining agreement, compared to 38% the previous year and 33% in 2021.[5] These disclosures generally included a statement providing the company’s opinion on the quality of labor relations, and in many cases, disclosed the number of unionized employees.
Quantitative workforce turnover rates. Although a majority of companies discussed employee turnover and the related topics of talent attraction and retention in a qualitative way (as discussed in Section II.B. below), only 20% of companies surveyed provided specific employee turnover rates (whether voluntary or involuntary), compared to the same percentage in the previous year and 17% in 2021.

B. Diversity

Among S&P 100 companies, 97% included disclosures relating to diversity in one or more of the following categories:

Diversity and inclusion. This was the most common type of disclosure, with 96% of companies including a qualitative discussion regarding the company’s commitment to diversity, equity, and inclusion (“DEI”), compared to the same percentage the previous year and up from 90% in 2021. The depth of these disclosures varied, ranging from generic statements expressing the company’s support of diversity in the workforce to detailed examples of actions taken to recruit and support underrepresented groups and increase the diversity of the company’s workforce.
Priorities within diversity. Companies disclosed different areas of focus for diversity efforts and programming within the organization. The most common disclosure was diversity in the retention or development of the company’s current workforce (45% of companies surveyed in 2023, compared to 45% in 2022 and 41% in 2021), followed by diversity in the company’s hiring practices (42% in 2023, compared to 42% in 2022 and 35% in 2021), followed by diversity in the company’s promotion practices (24% in 2023, compared to 26% in 2022 and 23% in 2021), and then diversity in the company’s suppliers (11% in 2023, compared to 10% in 2022 and 9% in 2021).
Quantitative diversity statistics. Many companies also included a quantitative breakdown of the gender or racial representation of the company’s workforce: 65% included statistics on gender and 60% included statistics on race or ethnicity (compared to 60% and 57% in 2022, respectively, and 48% and 43% in 2021, respectively). Companies provided gender statistics on both a global and U.S. basis, whereas nearly all companies provided race or ethnicity statistics for their U.S. workforce only. Most companies provided these statistics in relation to their workforce generally, regardless of position; however, an increased subset (40% in 2023, compared to 37% in 2022 and 26% in 2021) included separate statistics for different classes of employees (g., managerial, vice president and above, etc.). Similarly, 10% of companies also provided separate statistics for their boards of directors (compared to 10% in 2022 and 4% in 2021). Some companies also included numerical goals for gender or racial representation, either in terms of overall representation, promotions, or hiring; 19% of companies included these diversity goals or targets (compared to 23% in 2022 and 18% in 2021).

C. Recruiting, Training, Succession

Among S&P 100 companies, 98% included disclosures relating to talent and succession planning in one or more of the following categories:

Talent attraction and retention. These disclosures were generally qualitative and focused on efforts to recruit and retain qualified individuals. While providing general statements regarding recruiting and retaining talent were common, with 94% of companies including this type of disclosure (compared to 90% in 2022 and 65% in 2021), quantitative measures of retention, like workforce turnover rate, were uncommon, with only 20% of companies disclosing such statistics (as noted above).
Talent development. Disclosures related to talent development were tied with talent attraction and retention as the most common category, with 96% of companies including a qualitative discussion regarding employee training, learning, and development opportunities, up from 93% the previous year and 82% in 2021. This disclosure tended to focus on the workforce as a whole rather than specifically on senior management. Companies generally discussed training programs such as in-person and online courses, leadership development programs, mentoring opportunities, tuition assistance, and conferences, and a minority also disclosed the number of hours employees spent on learning and development. Some companies discussed quantitative figures related to talent development, such as dollars or hours spent on training, with 14% of companies including this type of disclosure (compared to 11% in both 2022 and 2021).
Succession planning. Only 21% of companies surveyed addressed their succession planning efforts (compared to 19% in 2022 and 18% in 2021), which may be a function of succession being a focus area primarily for executives rather than the human capital resources of a company more broadly.

D. Employee Compensation[6]

Among S&P 100 companies, 88% included disclosures relating to employee compensation, up from 86% the previous year and 74% in 2021. All of those companies included a qualitative description of the compensation and/or benefits program offered to employees. Of the companies surveyed, 42% addressed pay equity practices or assessments (up from 41% in 2022 and 31% in 2021), and substantially fewer companies included quantitative measures of the pay gap between racially or ethnically diverse and nondiverse employees or male and female employees (17% of companies surveyed in 2023, 14% in 2022 and 12% in 2021) or quantitative measures such as a minimum wage or investment in benefits (17% of companies surveyed in 2023, 14% in 2022, and 14% in 2021).

E. Health and Safety

Among S&P 100 companies, 76% included disclosures relating to health and safety in one or both of the following categories:

Workplace health and safety. Of the companies surveyed, 61% included qualitative disclosures relating to workplace health and safety, down from 64% in the previous year but up from 51% in 2021, typically consisting of statements about the company’s commitment to safety in the workplace generally and compliance with applicable regulatory and legal requirements. However, 8% of companies surveyed provided quantitative disclosures in this category (up from 7% in 2022 and 6% in 2021), generally focusing on historical and/or target incident or safety rates or investments in safety programs. These quantitative disclosures tended to be more prevalent among industrial, energy, and manufacturing companies. While many companies continued to provide disclosures on safety initiatives undertaken in connection with COVID-19, the decrease in safety disclosures in 2022 is largely due to the substantial decline in COVID-19 disclosures generally, which is discussed separately below.
Employee mental health. In connection with disclosures about standard benefits provided to employees, or additional benefits provided as a result of the pandemic, 50% of companies disclosed initiatives taken to support employees’ mental or emotional health and wellbeing, up from 46% the prior year and 36% in 2021.

F. Culture and Engagement

In addition to the many instances where companies mentioned a general commitment to culture and values, 70% of S&P 100 companies discussed specific initiatives they were taking related to culture and engagement in one or more of the following categories:

Culture and engagement initiatives. Of the companies surveyed, 26% included specific disclosures relating to practices and initiatives undertaken to build and maintain their culture and values, up from 22% in the previous year and 15% in 2021. These companies most commonly discussed efforts to communicate with employees (g., through town halls, CEO outreach, trainings, or conferences and presentations) and to recognize employee contributions (e.g., awards programs and individualized feedback). Many companies also discussed culture in the context of diversity-related initiatives to help foster an inclusive culture.
Community investment. Some companies disclose information about community investment, donations, or volunteer programs sponsored by the company, with 10% of companies surveyed providing such disclosure in 2023, compared to 9% in 2022 and 7% in 2021.
Monitoring culture. Disclosures about the ways that companies monitor culture and employee engagement were much more common, with 64% of companies providing such disclosure, up from 60% the previous year and 52% in 2021. Companies generally disclosed the frequency of employee surveys used to track employee engagement and satisfaction, with some reporting on the results of these surveys, sometimes measured against prior year results or industry benchmarks.

G. COVID-19

The number of S&P 100 companies that included information regarding COVID-19 and its impact on company policies and procedures or on employees generally declined sharply, with 34% of companies making such disclosure, compared to 69% in 2022 and 67% in 2021. COVID-19-related topics addressed ranged from work-from-home arrangements and safety protocols taken for employees who worked in person to additional benefits and compensation paid to employees as a result of the pandemic and contributions made to organizations supporting those affected by the pandemic. This sharp decline in COVID-19 disclosures is consistent with a more general trend of companies discussing COVID-19 less frequently as a result of its decreasing significance and illustrates the expected evolution of disclosure resulting from a principles-based framework.

H. Human Capital Management Governance and Organizational Practices

Over half of S&P 100 companies (51% of those surveyed, compared to 56% in 2022 and 40% in 2021) addressed their governance and organizational practices (such as oversight by the board of directors or a committee and the organization of the human resources function).

III. Industry Trends

One of the main rationales underlying the adoption of principles-based—rather than prescriptive—requirements for human capital disclosures is that the relative significance of various human capital measures and objectives varies by industry. This is reflected in the following industry trends that we observed:[7]

Technology Industries (E-Commerce, Internet Media & Services, Hardware, Software & IT Services, and Semiconductors). For the 21 companies in the Technology Industries, at least 85% discussed each of talent development and training opportunities, talent attraction, recruitment and retention, employee compensation, and diversity. Compared to the S&P 100 as a whole, relatively uncommon disclosures among this group included part-time and full-time employee statistics (5%), succession planning (10%), COVID-19 (24%), supplier diversity (5%), and unionized employee relations (19%). However, these industries saw increased rates of disclosure compared to the S&P 100 for quantitative turnover rates (43%) and qualitative pay equity (57%).
Finance Industries (Asset Management & Custody Activities, Consumer Finance, Commercial Banks, and Investment Banking & Brokerage). For the 13 companies in the Finance Industries, a large majority included quantitative diversity statistics regarding race (85%) and gender (92%) and qualitative disclosures regarding employee compensation (92%), and, compared to other industries, a relatively higher number discussed pay equity (62%) and quantified their pay gap (38%). Relatively uncommon disclosures among this group included part-time and full-time employee statistics, unionized employee relations, quantitative workforce turnover rates, and succession planning (in each case less than 16%).
Energy Industries (Oil & Gas Exploration & Production and Electric Utilities & Power). For the seven companies in the Energy Industries, a large majority included quantitative diversity statistics regarding race (71%) and gender (86%), qualitative disclosures regarding employee compensation (86%), and governance and organizational practices (71%), and, compared to other industries, a relatively higher number discussed unionized employee relations (57%) and quantified their workforce turnover rates (57%). Relatively uncommon disclosures among this group included part-time and full-time employee statistics, diversity in promotion, diversity targets or goals, culture initiatives, quantitative employee compensation statistics, pay equity, and quantitative pay gap (in each case less than 15%).

IV. Disclosure Format

The format of human capital disclosures in S&P 100 companies’ annual reports on Form 10‑K continued to vary greatly.

Word Count. The length of the disclosures ranged from 106 to 2,094 words, with the following statistical trends in the past three years:

	2023	2022	2021
Minimum word count	106	109	105
Maximum word count	2,094	1,995	1,931
Median	1,025	949	818
Mean	987	964	828

Metrics. The disclosure requirement specifically asks for a description of “any human capital measures or objectives that the registrant focuses on in managing the business” (emphasis added). Our survey revealed that companies are increasingly providing quantitative metrics, with 85% of companies providing disclosure in at least one of the quantitative categories we discuss above (up from 82% in 2022 and 68% in 2021) and only 5% electing not to include any type of quantitative metrics beyond headcount numbers (down from 8% in 2022 and 12% in 2021). The group of companies that identify important objectives they focus on but omit quantitative measures related to those objectives has been shrinking as more companies choose to include metrics. For example, 96% of companies discussed their commitment to diversity, equity, and inclusion (compared to 96% in 2022 and 89% in 2021), and 65% and 61% of companies disclosed quantitative metrics regarding gender and racial diversity, respectively (compared to 60% and 58%, respectively, in 2022 and 47% and 43%, respectively, in 2021).

Graphics. Although the minority practice, 27% of companies surveyed also included tables, charts, graphics or similar formatting used to draw attention to particular elements, up from 24% the previous year and 21% in 2021, which were generally used to present statistical data, such as diversity statistics or breakdowns of the number of employees by geographic location.

Categories. Most companies organized their disclosures by categories similar to those discussed above and included headings to define the types of disclosures presented.

V. Upcoming Rulemaking and Investor Advisory Committee Recommendations

At its meeting on September 21, 2023, the Commission’s Investor Advisory Committee (“IAC”) approved subcommittee recommendations (the “IAC Recommendations”) to expand required human capital management disclosures.[8] The Commission must now decide whether to incorporate the IAC Recommendations into its anticipated human capital management rule proposal, which according to the most recent Regulatory Flexibility agenda, which is admittedly aspirational, was expected to be issued in October.[9]

The IAC Recommendations contain prescriptive disclosure requirements—many of which have been previously considered as part of the 2020 rulemaking—for various quantitative metrics in the business description of Form 10-K under Item 101(c) of Regulation S-K as well as narrative disclosure in Management Discussion and Analysis. The recommended changes to Item 101(c) would require disclosure of the following metrics:

Headcount Metrics. Companies would be required to disclose “[t]he number of people employed by the issuer, broken down by whether those people are full-time, part-time, or contingent workers.” This disclosure would include “reporting on all similarly situated persons whose work contributes to a material level of revenue or income.”
Turnover Metrics. Companies would be required to disclose “turnover or comparable workforce stability metrics.” The IAC Recommendations do not address whether the calculation of turnover would be determined by the SEC or by companies individually.
Components of Compensation. The IAC Recommendations also require disclosure of “[t]he total cost of the issuer’s workforce, broken down into major components of compensation.” This would require companies to break out each component of labor costs (g., salary, equity, etc.), rather than aggregating labor costs with other line-item expenses, such as cost of goods sold or selling, general, and administrative costs, on the companies’ income statements.
Demographic Data. Companies would also be required to disclose “[w]orkforce demographic data sufficient to allow investors to understand the company’s efforts to access and develop new sources of talent, and to evaluate the effectiveness of these efforts.” This disclosure would include “diversity across gender, race/ethnicity, age, disability, and/or other categories viewed as important to investors and relevant to the business” and “diversity at senior levels.” The IAC Recommendations includes a brief reference in a footnote that any new rules could provide a “limited exception for disclosure of workforce composition outside the United States to consider laws and regulations in non-U.S. jurisdictions” without providing any additional guidance.

The recommended narrative disclosure in MD&A would discuss how the company’s “labor practices, compensation incentives, and staffing fit within the broader firm strategy. Such a discussion would address what portion of labor costs management views as an investment and why, including how labor is allocated across areas designed to promote firm growth (e.g., R&D) and those necessary to maintain current operations rather than increase sales revenue (e.g., compliance).”

While one of the key criticisms of the current rule appears to be lack of standardized disclosure that would allow for greater comparability among companies, it is not clear that human capital disclosures that are material to each company can be truly standardized given the different industries, sizes, geographic reach, and other qualities of public companies. As shown by the data discussed above, in response to the 2020 principles-based rules, public companies are providing more robust human capital disclosures in their SEC filings and are continuing to evolve these disclosures with each filing.

VI. Comment Letter Correspondence

Comment letter correspondence from the staff of the Division of Corporation Finance (the “Staff”), which often helps put a finer point on principles-based disclosure requirements like this one, has shed relatively little light on how the Staff believes the new requirements should be interpreted. Consistent with what we found at this time last year and the year before, the comment letters, all of which involved reviews of registration statements, were generally issued to companies whose disclosures about employees were limited to the bare-bones items companies have discussed historically, such as the number of persons employed and the quality of employee relations. From these companies, the Staff simply sought a more detailed discussion of the company’s human capital resources, including any human capital measures or objectives upon which the company focuses in managing its business. There were also a few comment letters where the Staff asked companies to clarify statements in their human capital disclosures. Based on our review of the responses to those comment letters, we have not seen a company take the position that a discussion of human capital resources was immaterial and therefore unnecessary.

VII. Implications of Recent U.S. Supreme Court Decisions

On June 29, 2023, the United States Supreme Court released its opinion in Students for Fair Admissions v. Harvard, in which the Court held that Harvard’s and the University of North Carolina’s use of race in their admissions policies was unlawful. Although the Supreme Court’s holding addressed only college and university admissions and not private-sector employers, the increased scrutiny on affirmative action programs in the workplace in the wake of SFFA has heightened the risk that employers with robust DEI initiatives may face litigation from employees, potential contracting partners, advocacy groups, and government agencies. Since the SFFA opinion was released, advocacy groups have sent dozens of letters to companies claiming that their DEI programs violate federal antidiscrimination law, including Title VII (discrimination in employment) and Section 1981 (discrimination in contracting), and arguing that the legal risk associated with DEI programs threatens stockholders’ value, and a number of lawsuits have been filed. Many companies are carefully reviewing their DEI programs and related public disclosures in light of these risks. For more information on the latest DEI developments, please see our DEI Task Force newsletter here.

VIII. Conclusion

Based on our survey, companies continue to be thoughtful about their human capital disclosures—expanding their disclosures in some areas (e.g., quantitative diversity statistics on gender) and reducing them in others (e.g., COVID-19)—in response to ever-changing circumstances. That is precisely what principles-based disclosure rules are designed to elicit.

To that end, as companies prepare for the upcoming Form 10-K reporting season, they should consider the following:

Confirming (or reconfirming) that the company’s disclosure controls and procedures support the statements made in human capital disclosures and that the human capital disclosures included in the Form 10-K remain appropriate and relevant. In this regard, companies may want to compare their own disclosures against what their industry peers did these past three years, including specifically any notable additional disclosures made in the past year.
Reviewing disclosures in light of the IAC Recommendations to assess whether any of the human capital measures or objectives may be material to the company.
Setting expectations internally that these disclosures likely will evolve. As shown by the measurable increase in disclosure in the third year of reporting, companies should expect to develop their disclosure over the course of the next couple of annual reports in response to peer practices, regulatory changes, and investor expectations, as appropriate. The types of disclosures that are material to each company may also change in response to current events, as was shown by the sharp decrease in COVID-19 related disclosures this past year.
Addressing in the upcoming disclosure, if not already disclosed, the progress that management has made with respect to any significant objectives it has set regarding its human capital resources as investors are likely to focus on year-over-year changes and the company’s performance versus stated goals.
Addressing significant areas of focus highlighted in engagement meetings with investors and other stakeholders. In a 2021 survey, 64% of institutional investors surveyed cited human capital management as a key issue when engaging with boards (second only to climate change at 85%).^{^[10]}
Revalidating the methodology for calculating quantitative metrics and assessing consistency with the prior year. Former Chairman Clayton commented that he would expect companies to “maintain metric definitions constant from period to period or to disclose prominently any changes to the metrics.”

_________________

[1] Data provided is as of November 3, 2023. The categorization data necessarily involves subjective assessment and should be considered approximate.

[2] See 17 C.F.R. § 229.101(c)(2)(ii).

[3] Agency Rule List – Spring 2023 Securities and Exchange Commission, Office of Information and Regulatory Affairs (2023), available here.

[4] Note that companies often include additional human capital management-related disclosures in their ESG/sustainability/social responsibility reports, on their websites, and in their proxy statements, but these disclosures are outside the scope of the survey, which is focused on disclosures included in Part I, Item 1 of annual reports on Form 10-K.

[5] While never expressly required by Regulation S-K, as a result of disclosure review comments issued by the Division of Corporation Finance over the years and a decades-old and since-deleted requirement in Form 1-A, it has been a relatively common practice to discuss collective bargaining and employee relations in the Form 10-K or in an IPO Form S-1, particularly since the threat of a workforce strike could be material.

[6] Our survey reviewed the employee compensation disclosures contained in Part I, Item 1 of each company’s Form 10-K and did not separately review any employee compensation information included in companies’ financial statements or the notes thereto.

[7] For purposes of our survey, we grouped companies in similar industries based on both their four-digit Standard Industrial Classification code and their designated industry within the Sustainable Industry Classification System. The industry groups discussed in this section cover 41% of the companies included in our survey.

[8] Available at https://www.sec.gov/files/spotlight/iac/20230921-recommendation-regarding-hcm.pdf.

[9] Agency Rule List – Spring 2023 Securities and Exchange Commission, Office of Information and Regulatory Affairs (2023), available here.

[10] See Morrow Sodali 2021 Institutional Investor Survey, available at https://morrowsodali.com/insights/institutional-investor-survey-2021.

The following Gibson Dunn attorneys assisted in preparing this update: Elizabeth Ising, Mike Titera, Julia Lapitskaya, Lauren Firestone, Zoë Klein, and Meghan Sherley.

Gibson Dunn’s lawyers are available to assist with 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 in the firm’s Securities Regulation and Corporate Governance or Labor and Employment practice groups, or any of the following practice leaders and members:

Labor and Employment:
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])

An Expert Analysis of National Security Deference Given in the US and EU Foreign Direct Investment Regimes

Gibson, Dunn & Crutcher LLP is pleased to announce with Global Legal Group the release of the International Comparative Legal Guide – Foreign Direct Investment Regimes 2024. Gibson Dunn partners Stephenie Gosnell Handler and Robert Spano were contributing editors to the publication, which covers issues including foreign investment policy, law and scope of application, jurisdiction and procedure and substantive assessment. The Guide, comprised of 30 jurisdictions, is live and FREE to access HERE.

Ms. Handler, Mr. Spano, and associates Sonja Ruttmann, Alexa Romanelli, and Hugh Danilack co-authored the Expert Analysis Chapter, “National Security Deference Given in the US and EU Foreign Direct Investment Regimes.”

Please view this informative and comprehensive chapter via the links below:

CLICK HERE to view “National Security Deference Given in the US and EU Foreign Direct Investment Regimes.”

CLICK HERE to view, download or print a PDF version.

The following Gibson Dunn lawyers assisted in preparing this publication: Stephenie Gosnell Handler, Robert Spano, Sonja Ruttmann, Alexa Romanelli, Hugh Danilack, and Mason Gauch.

Stephenie Gosnell Handler – Washington, D.C. (+1 202.955.8510, [email protected])

Robert Spano – London/Paris (+44 20 7071 4902, [email protected])

Sonja Ruttmann – Munich (+49 89 189 33 150, [email protected])

Alexa Romanelli – London (+44 20 7071 4269, [email protected])

Hugh N. Danilack – Washington, D.C. (+1 202.777.9536, [email protected])

Mason Gauch – Houston (+1 346.718.6723, [email protected])

The decision could effectively blunt the SEC’s ability to seek disgorgement for a wide range of alleged regulatory violations that do not result in financial harm to any investors.

In a case with potentially far-reaching implications for the SEC’s enforcement program, the Second Circuit recently held that the SEC is not entitled to disgorgement unless it can show the allegedly defrauded investors suffered pecuniary harm. The case, Securities and Exchange Commission v. Govil,[1] provides important limitations on the SEC’s ability to seek disgorgement, especially in circumstances where the allegedly violative conduct does not result in obvious “victims.” The case provides defense counsel with persuasive authority to oppose an SEC claim for disgorgement absent proof of any harm to investors especially if all the SEC alleges is a benefit to the defendant. The decision could effectively blunt the SEC’s ability to seek disgorgement for a wide range of alleged regulatory violations that do not result in financial harm to any investors.

Factual Background

Aron Govil founded and served as CEO of Cemtrex, Inc., an industrial and manufacturing technology company. In 2016 and 2017 Govil caused Cemtrex to issue new securities based on misrepresentations concerning the expected use of the funds that were raised, which Govil then transferred to his own accounts to pay for unrelated personal expenses. After he was caught, Govil entered into a settlement agreement with Cemtrex, which he no longer ran, and agreed to repay $7.1 million to the company by returning $5.6 million of Cemtrex securities and issuing a promissory note for $1.5 million. In addition, Govil also entered into a consent agreement with the SEC in which he agreed not to contest a civil enforcement action that would be brought by the SEC but which left the remedy unresolved.

After bringing an enforcement action, the Commission asked the district court to order disgorgement of approximately $7.3 million.[2] The district court did so over Govil’s objections, concluding that disgorgement was appropriate because Cemtrex’s defrauded investors were Govil’s “real victims” rather than Cemtrex itself, and that the $5.6 million in securities that Govil returned to Cemtrex would not offset what he owed as “Cemtrex shareholders received nothing” from that transfer.[3] Critically, however, the SEC offered no proof—and the district court made no findings—that Cemtrex’s shareholders suffered any pecuniary harm resulting from Govil’s fraud. Govil was ordered to disgorge approximately $6 million, from which he appealed.

The Second Circuit’s Decision

On appeal, the Second Circuit vacated the relief ordered by the district court and remanded the matter for further fact-finding. Applying the Supreme Court’s teachings in Liu that disgorgement “is permissible” as equitable relief only where it “is awarded for victims,”[4] the Second Circuit held that disgorgement under both 15 U.S. §§ 78u(d)(5) and 78u(d)(7) requires a finding that there were victims who suffered some financial loss. Noting that Liu “did not explain straightforwardly what a ‘victim’ is for the purpose of awarding ‘equitable relief,’” the Second Circuit held that “a ‘victim’” is “one who suffers pecuniary harm from the securities fraud” because allowing disgorgement to benefit investors who had not suffered any damages “would be conferring a windfall on those who received the benefit of the[ir] bargain” rather than “restoring the status quo for those investors.”[5] In doing so, the Court expressly rejected a presumption that investors have “suffered economic harm by definition when capital they invested in the company for corporate purposes [is] looted,” explaining that determining whether investors “actually suffered pecuniary harm” requires an analysis of “the type of securities held, the terms of those securities, and when those securities were sold” because defrauded investors might earn a profit on their investment notwithstanding a defendant’s wrongdoing.[6] As the Second Circuit reasoned, Liu “emphasized” that disgorgement as “an equitable remedy is about ‘returning the funds to victims,’” which necessarily “presupposes pecuniary harm” as funds “cannot be returned if there was no deprivation in the first place.”[7]

In reaching this conclusion, the Second Circuit also drew an important analogy between SEC enforcement actions and securities fraud actions brought by private plaintiffs. Although the SEC need not show loss causation or economic loss to prevail in litigation, the Court noted that private plaintiffs bringing securities fraud claims under Rule 10b-5 must prove that they “have suffered ‘economic loss’” and, similarly, that “pecuniary harm is an element” of common-law fraud claims.[8] Accordingly, the Court rejected the notion that investors who have not been shown to have suffered pecuniary harm should be allowed to receive “proceeds of disgorgement,” which otherwise “would allow the SEC to . . . circumvent the limitations on private claims under § 10(b) and the common law.”[9] Because there was no showing that Govil had caused any such pecuniary harm to Cemtrex’s investors, that relief was vacated to allow the district court to determine in the first instance if there was any such harm, a necessary prerequisite for disgorgement to be available.

In addition, the Second Circuit also held that the district court erred in not offsetting its disgorgement award by the value of the Cemtrex shares surrendered by Govil. Rejecting the SEC’s arguments, the Second Circuit reasoned that “a wrongdoer returns ‘value’ for the purpose of disgorgement whenever he returns property that holds value in his own hands” and that “a defendant need not return more than the amount by which he was unjustly enriched” because disgorgement is intended “‘to prevent wrongdoers from unjustly enriching themselves’” rather than “‘to compensate victims.’”[10]

Implications of Govil

Going forward, by limiting disgorgement and more closely aligning it with the relief available in private securities fraud actions in which economic loss and loss causation must be proven, the SEC will be forced to more clearly identify and prove the harm suffered by alleged “victims” in many of its enforcement actions. Although this analysis is relatively straightforward in more traditional securities fraud cases, Govil will likely result in serious questions being raised concerning the SEC’s ability to seek disgorgement in other aspects of its enforcement agenda. As the SEC moves ahead, both the SEC and those against whom disgorgement is sought will need to wrestle with Govil in areas where it is more difficult to identify victims who have suffered pecuniary harm resulting from the alleged securities law violations.

There is a wide range of regulatory enforcement actions in which the SEC has sought disgorgement despite the absence of identifiable victims who incurred a financial loss. Govil puts the SEC’s ability to seek disgorgement in such cases in serious question. Consider, for example, enforcement actions alleging the offering of securities without registration. In such cases, the SEC does not even allege that investors have been defrauded, let alone harmed. Going forward, it would seem that Govil precludes a claim for disgorgement. In Foreign Corrupt Practices Act cases, the SEC has historically sought disgorgement of profits allegedly earned by a company through business obtained or retained by virtue of an improper payment to a foreign official. After Govil, the SEC likewise would be challenged to identify a victim who has suffered a financial harm. In insider trading matters, the SEC routinely seeks disgorgement of imputed profits or avoided losses from defendants based on a differential between a trade price and a post-disclosure market price. However, the SEC has never undertaken, nor been required, to prove that there was an identifiable victim in the sense of a defrauded counterparty to the allegedly offending trade. And if required to meet such a burden of proof after Govil, one doubts that it could. Suffice it to say that the SEC likely did not foresee that the aggressive pursuit of disgorgement in a case in which Aron Govil had stipulated to liability would lead to such a potentially significant adverse impact on its broader enforcement program.

____________________________

[1] — F.4th —, 2023 WL 7137291 (2d Cir. 2023).

[2] The SEC sought disgorgement pursuant to 15 U.S.C. § 78u(d)(5) and § 78u(d)(7). Although the equitable remedy of disgorgement has been used by the SEC since the 1970s, see, e.g., SEC v. Manor Nursing Ctrs., Inc., 458 F.2d 1082 (2d Cir. 1972), it was not until 2002 that Congress expressly authorized the SEC to “seek . . . any equitable relief that may be appropriate for the benefit of investors” in § 78u(d)(5). The Supreme Court then clarified in Liu v. SEC that “a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims is equitable relief permissible under § 78u(d)(5).” 140 S.Ct. 1934, 1940 (2020). Congress enacted 15 U.S.C. § 78u(d)(7) six months after Liu narrowed the circumstances in which disgorgement is permissible, expressly authorizing the SEC to “seek . . . disgorgement” without reference to any limitations that might otherwise apply to relief already available under § 78u(d)(5). Although others courts have disagreed, the Second Circuit has previously held that the enactment of § 78u(d)(7) did not serve to undo the limitations that Liu imposed on the SEC’s disgorgement remedy. See SEC v. Ahmed, 72 F.4th 379 (2d Cir. 2023) (“We read ‘disgorgement’ in § 78(u)(d)(7) to refer to equitable disgorgement as recognized in Liu.”)

[3] SEC v. Govil, 2022 WL 1639467, at *3 (S.D.N.Y. May 24, 2022).

[4] 140 S.Ct. at 1940.

[5] 2023 WL 7137291, at *9.

[6] Id. at *10 n.16.

[7] Id. at *10 (quoting Liu, 140 S.Ct. at 1948, cleaned up).

[8] Id. at *11.

[9] Id.

[10] Id. at *12-13 (quoting SEC v. Cavanagh, 445 F.3d 105, 117 (2d Cir. 2006)).

The following Gibson Dunn lawyers assisted in preparing this alert: Reed Brodsky, Richard Grime, Mark Schonfeld, David Woodcock, Michael Nadler, and Peter Jacobs*.

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, any leader or member of the firm’s Securities Enforcement practice group, or the following authors:

Reed Brodsky – New York (+1 212.351.5334, [email protected])
Richard W. Grime – Washington, D.C. (+1 202.955.8219, [email protected])
Mark K. Schonfeld – New York (+1 212.351.2433, [email protected])
David Woodcock – Dallas (+1 214.698.3211, [email protected])
Michael Nadler – New York (+1 212.351.2306, [email protected])

*Peter Jacobs is an associate working in the firm’s New York office who is not yet admitted to practice law.

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. This is our second DEI Task Force Update (the first, issued on November 1, 2023, can be found here) and we will continue to circulate similar updates bi-monthly moving forward. 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 November 1, 2023, America First Legal Foundation (“AFL”) sent letters to the EEOC calling for the Commission to initiate investigations into the DEI initiatives of American Airlines, United Airlines, and Southwest Airlines. AFL also sent letters to each airline, alleging violations of both Title VII and Section 1981, and primarily referenced each company’s published DEI reports, which detail the companies’ efforts to hire and retain diverse talent through various hiring goals, affinity retreats, and training programs focused on diverse employees.

On November 2, 2023, AFL also sent the EEOC a letter calling for the agency to investigate NASCAR and a privately owned affiliate, Rev Racing, for violating Title VII through its “Drive for Diversity” and “Diversity Pit Crew Development” programs. The programs are part of NASCAR’s ongoing efforts to increase the diversity of its drivers and pit crew members by providing additional coaching, training, and apprenticeship to historically underrepresented demographics within its ranks. Before the SFFA decision, the selection criteria limited eligibility for these programs to women, Black or African Americans, Asians, and Hispanics. Following SFFA, NASCAR and Rev Racing expanded the programs to include all individuals from any “diverse background” or possessing “diverse experiences.” AFL’s letter questions whether the companies’ rebranding efforts led to an actual change in selection criteria.

At a press event on November 7, 2023, Kalpana Kotagal, the newest EEOC commissioner, said that she plans to collaborate with her two Democratic colleagues to encourage lawful diversity, equity, inclusion, and accessibility practices in the workplace. Kotagal was previously a civil rights and employment attorney, has represented workers in discrimination class actions, and is the co-author of the “Inclusion Rider,” a sample provision for actors’ or filmmakers’ contracts to ensure equity and inclusion at every level in a production. EEOC Chair Charlotte Burrows and Commissioner Kotagal also held a DEI listening session with corporate leaders on November 7.

On October 8, 2023, California governor Gavin Newsom signed into law Senate Bill 54 (“SB 54”), under which covered entities in the venture capital industry will be required to annually report certain diversity statistics to the California Civil Rights Department (“CRD”) if their portfolio companies or investors have a covered connection to California. The demographic data, which includes race, ethnic identity, individuals who identify as LGBTQ+, gender identity, disability status, veteran status, and California resident status, must be reported on an aggregated and anonymized basis. Investments made in the prior calendar year in portfolio companies with diverse founding teams must also be reported as a percentage of the covered entity’s aggregate venture capital investments. SB 54 allows the CRD to publish this anonymized information online and conceivably to sue funds on the basis of discrimination. SB 54 also delegates to the CRD the power to investigate and prosecute complaints of discrimination. SB 54 is scheduled to go into effect on March 1, 2025.

Gibson Dunn published a Client Alert on November 7, 2023, discussing in more depth the scope, consequences, and uncertainties of SB 54’s implementation.

Media Coverage and Commentary:

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

Bloomberg Law, “Nasdaq’s Board Diversity Win Invigorates SEC Disclosure Plans” (November 9): Bloomberg Law’s Andrew Ramonas and Clara Hudson report on the recent decision by the United States Court of Appeals for the Fifth Circuit upholding Nasdaq’s rules requiring companies listed on Nasdaq’s exchange to disclose certain information about their board members’ diversity characteristics. (Gibson Dunn represented Nasdaq in this matter.) Ramonas and Hudson report that the SEC is considering proposing regulations to enhance board-diversity disclosures. Although DEI remains a priority for many companies, a recent Spencer Stuart report on board appointments indicates that the proportion of new directors appointed between May 2022 and April 2023 who identified as female or underrepresented minorities is down from the prior year.
US Law Week, “Throw Out the Diversity Playbook and Reimagine Inclusive Hiring” (November 7): William & Mary Law School Dean A. Benjamin Spencer argues that traditional law-firm diversity programs were flawed because they “signaled—unfairly—that ‘diverse’ candidates mostly couldn’t cut it in the regular hiring process.” He advocates for an “inclusive excellence” approach, including identifying larger pools of prospective hires through regional and specialty group career fairs and junior lateral hiring.
The Brookings Institution, “Admissions at most colleges will be unaffected by Supreme Court ruling on affirmative action” (November 7): According to Sarah Reber, Gabriela Goodman, and Rina Nagashima of Brookings, new data based on public reporting confirm prior findings that affirmative action is primarily used by highly selective, private four-year colleges. The data further show that most students from historically excluded racial groups do not attend colleges using affirmative action. Reber and her colleagues write that it is unlikely that the SFFA ruling will have a significant effect on college enrollment of historically marginalized racial and ethnic groups overall, although enrollment at highly selective institutions is likely to decline.
The Washington Post, “A law that helped end slavery is now a weapon to end affirmative action” (November 6): According to the Post’s Julian Mark, more than a dozen lawsuits filed over the last three years attempt to use the Civil Rights Act of 1866 (42 U.S.C. § 1981), which Congress passed to provide newly emancipated slaves with equal rights of citizenship, to assert claims of reverse discrimination. Plaintiffs in these suits argue that Section 1981 prohibits race-conscious programs, even those designed to remedy historic underrepresentation of certain groups. But critics of these suits say plaintiffs “have distorted the law’s intent.” The article highlights Gibson Dunn’s representation of the Fearless Fund: “This is a seminal civil rights statute, passed right after the Civil War, to ensure that the newly freed people who were slaves have the same rights as everybody else,” Jason Schwartz, a lawyer with Gibson Dunn, a law firm defending the Fearless Fund, said in a recent interview. “And to try to use that statute as a weapon against Black people . . . is outrageous.”
Forbes, “Balancing Diversity And Meritocracy: The Gannett DEI Lawsuit” (November 6): Arizona State University professor Susan Harmeling summarizes a putative class-action complaint filed in August against Gannett, one of the country’s largest newspaper publishers. The plaintiffs allege that Gannett terminated and denied promotion to white employees while favoring less-qualified underrepresented minorities. Harmeling predicts that the case signals a new era in the DEI landscape as companies attempt to pursue broad diversity goals “while ensuring that meritocracy remains at the forefront of their employment practices.”
National Law Journal, “How Employers Can Embrace DEI Without Inviting Lawsuits” (November 2): NLJ’s Chris O’Malley provides an overview of recent DEI-related litigation and risk reduction strategies. He highlights Gibson Dunn’s defense of the Fearless Fund:Arguing for the fund, Jason Schwartz, of Gibson Dunn & Crutcher, cited the irony of using Section 1981 to attempt to end the grant program. “Here, the irony would be even worse to take Section 1981, passed in the wake of the Civil War, to make freedom real for Black citizens, and use it to shut down the charitable endeavor of my clients supporting other Black women who face discrimination.”O’Malley notes that one of the “unusual” ways plaintiffs might challenge DEI initiatives is through the form of antitrust suits, citing a New York State Bar Association report highlighting that impermissible information sharing about “competitive conduct” may be interpreted broadly “to include any metrics used to compete for business or talent, including DEI commitments.”
Wall Street Journal, “Small Business Gets Caught in DEI Crossfire” (October 12): WSJ’s Ruth Simon and Theo Francis write that reverse-discrimination lawsuits targeting programs providing grants and other support to minority-owned small businesses are having a negative effect on small-business funding more generally. The Small Business Administration has also been ordered by federal judges to adjust its distribution of certain grant funds meant for socially and economically disadvantaged individuals and groups. For one SBA program that provided grants to restaurants, a court ordered the SBA to stop giving priority to restaurants owned by minorities, women, and other disadvantaged groups, and to instead allocate the grants on a first-come, first-served basis.

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:

Alexandre v. Amazon.com, Inc., No. 3:22-cv-1459 (S.D. Cal. Sept. 29, 2022): White, Asian, and Native Hawaiian entrepreneur plaintiffs, on behalf of a putative class of past and future Amazon “delivery service partner” program applicants, challenged a DEI program that provides a $10,000 grant to qualifying delivery service providers who are “Black, Latinx, and Native American entrepreneurs.” Plaintiffs alleged violations of California state civil rights laws prohibiting discrimination.
- Latest update: The court dismissed the plaintiffs’ initial complaint for lack of standing and failure to state a claim on September 9, 2023, but granted leave to amend. Plaintiffs filed an amended complaint on September 22. Defendants’ deadline to respond is December 6, 2023.
Am. Alliance for Equal Rights v. Fearless Fund Mgmt., LLC, No. 1:23-cv-03424-TWT (N.D. Ga. 2023), on appeal at No. 23-13138 (11th Cir. 2023): AAER sued a Black women-owned venture capital firm with a charitable grant program that provides $20,000 grants to Black female entrepreneurs; AAER alleged that the program violates Section 1981 and sought a preliminary injunction. Fearless Fund is represented by Gibson Dunn.
- Latest update: On November 6, 2023, AAER filed its merits brief in the Eleventh Circuit in support of a preliminary injunction. AAER argued that Fearless Fund’s grant program is not protected by the First Amendment because it is “conduct, not speech,” and is not “inherently expressive.” AAER also argued that Section 1981 prohibits discrimination against whites as well as other racial groups and that AAER’s failure to disclose the names of the putatively harmed non-black non-female business owners did not defeat its standing to bring suit.
Mid-America Milling Company v. U.S. Dep’t of Transportation, No. 3:23-cv-00072-GFVT (E.D. Ky. 2023): Two plaintiffs, construction companies, sued the Department of Transportation, requesting the court enjoin the DOT’s Disadvantaged Business Enterprise Program, an affirmative action program that awards contracts to minority-owned and women‑owned small businesses in DOT-funded construction projects with the statutory aim of having such business comprise 10% of certain DOT-funded contracts nationally. Plaintiffs allege that the program constitutes unconstitutional race discrimination in violation of the Fifth Amendment.
- Latest update: DOT’s deadline to respond to the complaint is December 30, 2023.

2. Employment discrimination under Title VII and other statutory law:

Harker v. Meta Platforms, Inc., No. 23-cv-7865 (S.D.N.Y. 2023): A lighting technician who worked on a set where a Meta commercial was produced sued Meta and a film producers association, alleging that Meta and the association violated Title VII, Sections 1981 and 1985 and New York law through a diversity initiative called Double the Line. Plaintiff also claims that he was retaliated against after raising questions about the qualifications of a coworker hired under the program.
- Latest update: On November 3, 2023, the defendants filed their motions to dismiss, arguing the plaintiff lacked standing and failed to state plausible discrimination claims because he did not actually apply for a Double the Line position, nor did he meet the non-racial eligibility qualifications had he applied. The plaintiff’s deadline to respond is December 5, 2023.

3. Board of Director or Stockholder Actions:

Craig v. Target Corp., No. 2:23-cv-00599-JLB-KCD (M.D. Fl. 2023): America First Legal sued Target and certain of its officers on behalf of a stockholder, claiming the board falsely represented that it monitored social and political risk, when it allegedly focused only on risks associated with not achieving ESG and DEI goals. Craig claims that this focus depressed Target’s stock price, alleging violations of Sections 10(b) and 14(a) of the Securities Exchange Act of 1934.
- Latest update: On November 7, 2023, Target filed a motion to dismiss for lack of standing and failure to state a claim. Target argued that the plaintiff’s case alleged only a policy disagreement, not fraud. On the plaintiff’s claim of misrepresentation, Target pointed out that it has never hidden its commitment to DEI or potential risks of its approach and that plaintiff purchased his stock before Target made any of the allegedly fraudulent statements, meaning he could not have relied on them.

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

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

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

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

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

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

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

*Teddy Rube is an associate working in the firm’s Washington, D.C. office who is not yet admitted to practice law.

An overview of global privacy and cybersecurity considerations and red flags in M&A transactions

In today’s business environment, data privacy and cybersecurity are bedrocks of trust and confidence—for customers, partners, and other businesses alike. As personal information becomes increasingly digitized, bad actors have augmented cyber-attacks and phishing scams to penetrate business servers and systems. To protect the public, legislators and agencies across the world have passed data privacy and cybersecurity laws to set standards and measures for data privacy and cybersecurity compliance, leading to regulatory, compliance, public relations, and litigation risks. Managing data privacy and cybersecurity risks has become critical to M&A transactions, not only due to the significant exposure to potential legal liability, financial and reputational harm, but also the potential material impact on the company’s ability to conduct its operations (especially for data or technology driven companies).

The importance of data privacy and cybersecurity is evident from the keen interest of company management in technology, as highlighted by Accenture Research’s 2022 Technology in M&A survey, which found that 74% of CEOs view technology integration in M&A as “a source of competitive advantage or growth enabler, rather than the cost of doing business.” Furthermore, according to the same survey, 96% of CIOs reported that technology due diligence uncovered “issues or opportunities that had material impact on certain deals.”

Below, we highlight several privacy and cybersecurity considerations and red flags in M&A transactions, regardless of which side of the table you sit.

Applicability of U.S. State Privacy Laws

Applicability of the California Consumer Privacy Act, as amended by the California Privacy Rights Act (the “CCPA”), is a critical part of the due diligence process, as the CCPA is enforced by active regulators (both the California Attorney General and the new California Consumer Privacy Agency), and provides a private right of action in the event of certain security incidents. Statutory damages can reach up to $750 per consumer per incident, and CCPA regulatory penalties can be as high as $7,500 per each intentional violation (or $2,500 for unintentional violation).

Outside of California, state privacy laws are developing in other jurisdictions as well—13 states have passed laws, with laws in Virginia, Colorado, Utah, and Connecticut taking effect just this year. Closely assessing the applicability of, and compliance with, these various state privacy laws is essential to identifying the legal risks involved for businesses operating and catering to customers in the U.S. As a first step acquirors should review the state-specific threshold requirements for applicability, which may include the target company’s gross annual revenue and/or the number of state residents’ information processed. For example, the breadth of the CCPA’s applicability is particularly broad—any business that has over $25M in revenue a year, and processes personal information of a California resident, will be subject to the law. Notably, any business that says they do not collect personal information—a refrain not uncommon in this area—is likely wrong, if they do business in California or outside the U.S. Indeed, unique amongst the state laws, but more similar to the GDPR, the CCPA applies to information collected from B2B partners, employees, and others not traditionally seen as “consumers,” making these laws relevant to nearly every transaction.

Applicability of E.U. / UK GDPR and Other International Laws

Acquirors should assess whether the target company (i) has any establishment in the E.U. or UK, (ii) even in the absence of an establishment in the E.U. or UK offers goods or services to individuals in the E.U. or UK, or (iii) monitors the behavior of individuals in the E.U. or UK. If the General Data Protection Regulation, including as incorporated into UK law pursuant to the European Union (Withdrawal) Act 2018 (together, the “GDPR”), applies to the company, an acquiror should review the safeguards instituted to ensure safe transfer of personal information outside the European Economic Area (“EEA”). The GDPR also has complex and demanding compliance requirements including, but not limited to, (1) a requirement for controllers to notify supervisory authorities of security incidents within 72 hours, (2) enlistment of processors, by controllers, who contractually agree to implement safeguard required by the GDPR, and (3) stringent restrictions concerning cross-border data transfers to countries outside of the EEA and UK.

With increasingly high fines from public enforcement, and growing private enforcement through privacy litigation, the potential consequences of failing to comply with the GDPR are growing. Non-compliance with the GDPR can result in fines up to 20 million Euros, or up to 4% of the total worldwide annual turnover of the company’s preceding financial year. Since the GDPR entered into application in May 2018 until October 2023, more than 1,878 fines were imposed amounting to more than EUR 4.4 billion in total.

The competent supervisory authorities may also impose other sanctions, such as a temporary or definitive limitation (including a ban) on processing. In addition to civil penalties, there can also be potential criminal liability in some E.U. member states.

The legal landscape in the E.U. and UK also continues to evolve, particularly as new laws continue to go into effect in furtherance of the EU Commission’s European Data Strategy. The GDPR is also influencing new data privacy laws in other parts of the world, including the Middle-East and APAC regions. Australia, New Zealand, and Singapore have enacted GDPR-like enhancements, and other APAC countries are exhibiting a clear trend towards GDPR-like extra-territoriality and revenue-based fines.

Applicability of Sector-Specific Privacy and Cybersecurity Laws

Businesses can be regulated by sector-specific or information-specific privacy laws, such as the Health Insurance Portability and Accountability Act (“HIPAA”), the Fair Credit Reporting Act (“FCRA”), the Gramm-Leach-Bliley-Act (“GLBA”), the Cyber Incident Reporting for Critical Infrastructure Act (“CIRCIA”), the Children’s Online Privacy Protection Act (“COPPA”), the Biometric Information Privacy Act (“BIPA”), the CAN-SPAM Act, and the Telephone Consumer Protection Act (“TCPA”). It is important to assess if any of these sector-specific laws are applicable in light of the nature and activities of the target company. Failure to comply with requirements of such laws can be important red flags, as non-compliance can result in statutory damages, which are assessed on a per-incident basis, including exposing companies to class action suits, under certain laws. While some of these laws are very sector-specific, some (such as CAN-SPAM), may be a reasonable line of inquiry in nearly every transaction.

Outdated Privacy Notices or No Privacy Notice

Today, it is uncommon to find a brick-and-mortar company with no online presence, and no requirements or best practices to have transparent notices around the collection, processing, transfer, disclosure, sharing, storage, security, and use of personal information. Common red flags for privacy notices include having (1) no policy, (2) an outdated policy, (3) only an online policy (e.g., regarding collection of information online, but not relating to other parts of their business), (4) an online policy that does not match the data collection and processing practices of the target company, or (5) a policy that does not outline consumers’ rights related to their personal information.

Storage of Sensitive Personal Information

A target company may house important and sensitive personal information regarding its employees, customers, suppliers, and counterparties—if not end-consumers. Assessing how such sensitive data is stored, including whether it is stored in-house or through a third-party vendor, is an important initial step to assess risk. Acquirors should also inquire what security mechanisms are employed by the company, such as whether data at rest and in transit is encrypted using industry-grade mechanisms. If privacy laws are likely to apply, then there may be additional obligations relating to sensitive information (including under U.S. state privacy laws, the GDPR, HIPAA, the GLBA, and others) that should be analyzed.

Cybersecurity Protocols, Policies and Procedures, and Insurance

Companies are increasingly expected to establish cybersecurity protocols, policies, and procedures, and to conduct security trainings, audits, penetration tests, or other reviews of the company’s privacy and cybersecurity protections, and to address any material issues, vulnerabilities, or other risks in a timely manner.

The target company’s cyber liability insurance policies, and whether any claims have been made against such policies, are also relevant. As acquirors draft representation and indemnification protections concerning cybersecurity matters, it is necessary to review the insurance coverage cap and the categories of attacks covered by the policies.

AI Solutions

As companies are increasingly relying on AI solutions, acquirors should review whether the target company uses any AI products to assist the business, the type of AI products used, and analyze the scope and types of personal information stored and used by such AI products. Use and/or development of such tools can unveil a gamut of potential risks, including relating to privacy, IP, antitrust, and employment.

Security Incidents, Reports, Investigations, or Litigations

A crucial aspect of data privacy and cybersecurity diligence is the discovery and disclosure of details regarding past or present security incidents, inquiries, complaints, investigations, or litigation related to personal information. These issues are ubiquitous and important considerations that can affect negotiations for representations and warranties insurance and deal prices. As such, an acquiror should scrutinize, and the target company should disclose:

Any data privacy or security incidents, which can include (1) the nature of the information affected, including whether any personal information was affected, (2) whether the target company was required to notify individuals or regulators, (3) the extent of any impacts on the target company’s operations and revenue, (4) any remediation steps taken to prevent similar incidents from occurring, and (5) whether such incidents have led to any complaints by customers, or inquiries or investigations from relevant governmental authorities. Any risk monitoring mechanisms and practices to prevent these incidents and resultant legal issues. Even if the target company has not experienced any security incidents, an acquiror must review the target company’s risk monitoring mechanisms and practices, to ensure the company has measures in place to detect security incidents, and IT and cybersecurity policies and procedures to ensure preparedness, including whether a written information security policy, incident response plan, and business continuity and disaster recovery plan have been developed and implemented. These are all important indicators of a target company’s capacity to identify and respond to security incidents and other material system outages or instances of unauthorized access.

Acquirors should also be prepared to review data privacy or cybersecurity-related lawsuits or regulatory inquiries, settlements, and claims. These may arise in the context of the target company’s session replay litigation, regulatory inquiries in relation to BIPA, CCPA, and the FTC. More specifically, acquirors should be aware of target company’s data privacy practices because issues, such as lack of consent from customers, can lead to post-acquisition claims and inquiries concerning the absence of proper compliance measures for processing personal information.

Integrating the Diligence

Privacy and cybersecurity diligence can often reveal issues that are not readily apparent to an acquiror, some of which may be material, and some which may not be. Notwithstanding a target company’s disclosure of significant breaches and incidents in the disclosure schedule, other material red flags, including insufficient privacy policies or non-compliance with international, domestic, or local privacy and cybersecurity laws, can heavily influence the negotiations involved in draft agreements. Privacy and cybersecurity diligence may influence not only the price associated with the representations and warranties insurance, but also the price of the acquisition or merger itself. If a target company fails to adhere to relevant data privacy laws, post-closing remediation may be necessary to address any existing compliance gaps—for which an acquiror will have an early advantage in constructing adequate compliance measures, if diligence is performed well.

Our attorneys are leading industry experts, and we regularly advise on privacy and cybersecurity matters on behalf of the world’s largest companies. We efficiently identify the costs and resources needed to implement post-acquisition remediation, and assist in integrating the privacy and cybersecurity practices of target companies into acquirers’ global organizations. We also help manage target companies’ pre-existing security incidents and claims, and provide holistic assessments on the impacts of such events on the transaction or the acquiror’s business.

The following Gibson Dunn lawyers assisted in preparing this alert: Alexander Southwell, Ahmed Baladi, Cassandra Gaedt-Sheckter, Robert Little, Saee Muzumdar, Peter Moon, Amanda Estep, 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, any member of the firm’s Mergers and Acquisitions, Private Equity, or Privacy, Cybersecurity & Data Innovation practice groups, the authors, or the following practice leaders:

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 (0) 20 7071 4279, [email protected])
Federico Fruhbeck – London (+44 (0) 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])

Privacy, Cybersecurity & Data Innovation:
Ahmed Baladi – Paris (+33 (0) 1 56 43 1300, [email protected])
S. Ashlie Beringer – Palo Alto (+1 650-849-5327, [email protected])
Jane C. Horvath – Washington, D.C. (+1 202-955-8505, [email protected])
Alexander H. Southwell – New York (+1 212-351-3981, [email protected])

© 2023 Gibson, Dunn & Crutcher LLP. All rights reserved. For contact and other information, please visit us at www.gibsondunn.com.Our lawyers provide an overview of global data privacy and cybersecurity considerations and red flags in M&A transactions.

A summary and commentary on the recent decision of the Hong Kong Court of Final Appeal regarding service of originating process by the Securities and Futures Commission

On 30 October 2023, the Hong Kong Court of Final Appeal (the “CFA”) handed down its reasons for dismissing the appeal in Securities and Futures Commission v Isidor Subotic and Others [2023] HKCFA 32[1]. The CFA confirmed that leave is not required for the Securities and Futures Commission (the “SFC”) to serve proceedings out of jurisdiction as the relevant provisions in the Securities and Futures Ordinance (the “SFO”) has empowered the Court of First Instance (the “CFI”) to hear and determine a claim made against persons who are not within the jurisdiction.

Background

In July 2019, the SFC commenced the present proceedings against various individuals and companies under sections 213 and 274 of the SFO. It was alleged that these parties were operating a false trading scheme involving artificially inflating the price of the share of a Hong Kong listed company before “dumping” them and causing loss to market participants and lenders. The SFC sought, amongst other relief, a restoration order in favour of the market participants involved and an injunction to freeze certain assets.

As six of the defendants in this case were located outside of Hong Kong (the “Foreign Defendants”), the SFC applied for and was granted leave to serve a concurrent writ on them outside of Hong Kong. The Foreign Defendants applied to set aside the order granting leave and sought a declaration that the CFI lacks jurisdiction over them, arguing that leave was wrongly granted as the SFC’s claims did not come within any of the “gateways” specified in Order 11, rule 1(1) of the Rules of the High Court (the “RHC”) (i.e., the types of claims for which leave to effect service outside of Hong Kong could be obtained).

The CFI[2] and the Court of Appeal[3] both upheld the decision granting leave to effect service out of the jurisdiction on the basis that claims of the SFC were either a claim founded on tort and damage was sustained or resulted from an act committed within the jurisdiction (“Gateway F”) or a claim for an injunction restraining a conduct within the jurisdiction. The Foreign Defendants then appealed to the CFA on grounds that the relief sought by the SFC under Section 213 of the SFO cannot be properly characterized as a claim and even if it is a claim, it is not founded on tort for the purpose of invoking Gateway F.

Before the CFA hearing, the CFA directed the parties to make submissions on whether leave was in fact necessary in the circumstances because under Order 11, rule 1(2) of the RHC, if a legislative provision already confers the CFI with jurisdiction in respect of a claim over a defendant outside of Hong Kong or in respect of a wrongful act committed outside Hong Kong, leave from the court is not required for effecting service of a writ out of the jurisdiction.

CFA’s Decision

The CFA unanimously dismissed the appeal and held that, according to Order 11, rule 1(2) of RHC, it was not necessary for the SFC to seek leave from the CFI to serve its claim on the Foreign Defendants.

In coming to such conclusion, the CFA looked into three questions in particular, namely (1) what are the claims that the SFC is making; (2) whether the CFI is empowered to hear and determine the claims made by the SFC by virtual of any written law; and (3) whether the CFI is so empowered notwithstanding that the person against whom the claim is made is not within the jurisdiction of the court or that the wrongful act giving rise to the claim did not take place within the jurisdiction.

On the first question, it was observed that the writ which the SFC served upon the Foreign Defendants seeks declarations that they are persons within section 213 of the SFO who have engaged in false trading activities in contravention of sections 274 and/or 295 of the SFO.

On the second question, having identified the claims of the SFC, the CFA then considered the effect of sections 213 and 274 of the SFO. The CFA held that these provisions are intended to operate in combination and must be read together. Whilst section 274 of the SFO defines the prohibited acts of false trading, section 213 of the SFO provides for the orders that the CFI may impose against the contraveners. It is clear that by virtue of the written law, CFI is empowered to hear and determine the claims put forwarded by the SFC under sections 213 and 274 of the SFO.

On the last question, the CFA found in the affirmative because upon contravention of section 274 of the SFO, the CFI is empowered under section 213 of the SFO to grant relief against a person “in Hong Kong or elsewhere” where such person does anything that constitutes false trading affecting the Hong Kong market. It was noted that the policy to confer the CFI with extraterritorial jurisdiction over persons outside of Hong Kong is justified considering that trading on the Hong Kong Stock Exchange is global and therefore it would be necessary to make sanctions legally available against overseas fraudulent parties who cause disruption to the local market and losses to other investors.

Notwithstanding the above, the CFA also made clear that the application of Order 11 rule 1(2) of the RHC is limited to cases where the written law in question clearly contemplates proceedings being brought against persons outside of jurisdiction or where the wrongful act did not take place within the jurisdiction. It is not sufficient if the written law is of general application and may be invoked against persons within or outside the jurisdiction.

Comment

This decision confirms that no leave is required for the SFC to serve a writ seeking reliefs such as restoration orders, damages and compensation orders or restraint orders under section 213 of the SFO on foreign defendants out of jurisdiction.

Such decision is consistent with the intent of the SFO to seek redress in relation to wrongful acts damaging to market participants whether such acts took place within or outside Hong Kong and to provide appropriate legal recourse against the wrongdoers. In light of the decision, it is expected that the SFC may take more aggressive enforcement actions against parties who have engaged in cross-border market misconduct and pursue them regardless of their physical location.

____________________________

[1] https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=155879

[2]https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=137397&currpage=T

[3]https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=149666

The following Gibson Dunn lawyers assisted in preparing this alert: Brian Gilchrist, Elaine Chen, Alex Wong, and Cleo Chau.

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, or the following authors in the firm’s Litigation Practice Group in Hong Kong:

Brian W. Gilchrist OBE (+852 2214 3820, [email protected])
Elaine Chen (+852 2214 3821, [email protected])
Alex Wong (+852 2214 3822, [email protected])
Cleo Chau (+852 2214 3827, [email protected])

We are pleased to provide you with Gibson Dunn’s ESG monthly update for October 2023. This month, our update covers the following key developments.

I. INTERNATIONAL

UN Global Compact issues new guidance on sustainable infrastructure under China’s Belt and Road Initiative

During an event in Beijing on October 18, 2023 attended by high-level representatives from governments, business and academia, the UN Global Compact unveiled new guidance and assessment tools for companies to advance sustainable infrastructure under the Chinese government’s Belt and Road Initiative (BRI) — a global infrastructure development strategy adopted in 2013 to invest and cooperate with over 150 countries and international organisations. The guidance includes A Practical Guide for Private Sector Players on the Human Rights and Labour Principles, the Environment Principles, and the Anti-Corruption Principle, designed to promote application of the UN Global Compact’s Ten Principles in the infrastructure sector, and a Guidance and Assessment Tool for Companies on Maximizing Impact towards the SDGs, which aims to engage private sector players participating in infrastructure projects under the BRI to align their operations with the UN’s Sustainable Development Goals.

Network for Greening the Financial System publishes conceptual note on short-term climate scenarios

On October 3, 2023, the Network for Greening the Financial System — a group of central banks and financial supervisors working to help develop environment and climate risk management in the financial sector, and mobilise finance to support the transition toward a sustainable economy—released a Conceptual Note on Short-term Climate Scenarios. This note follows a public feedback survey conducted in February 2023 which identified short-term scenarios as a key priority. The note explains that short-term scenarios covering a three-to-five-year period enable better understanding of the near-term macro-financial impact of transitioning to a net zero economy upon the real economy, individual financial institutions, and the broader financial system—which is of particular importance against the backdrop of heightened uncertainties resulting from fossil energy supply and mounting scientific evidence that the world might exceed global temperatures increases of 1.5 °C within the next five years.

The note proposes five short-term climate scenario narratives (‘Highway to Paris’ (implementation of an ambitious mitigation pathway), ‘Green Bubble’ (glut of green private investment), ‘Sudden wake-up call’ (sudden change in public opinion and accelerated transition), ‘Low Policy Ambition and Disasters’ (severe acute physical disasters and higher risk premia), and ‘Diverging Realities’ (severe natural disasters, lack of external financing, disruption of transition-critical mineral supply chains hampering global transition)), all driven by different geopolitical, economic and technological factors to result in a range of plausible futures, and designed to provide the basis for climate stress testing related to central banks’ prudential and supervisory responsibilities.

The International Capital Markets Association releases paper on market integrity and greenwashing risks in sustainable finance

On October 10, 2023, The International Capital Markets Association (ICMA) released a new paper on market integrity and greenwashing risks in sustainable finance, which expands on its response in January 2023 to the European Supervisory Agencies’ Call for Evidence on greenwashing on November 15, 2022.

In the paper, ICMA sets out its concerns regarding proposals for a definition of greenwashing for regulatory purposes flagging that exhaustive definitions of greenwashing are problematic as they risk market paralysis or regression due to excessive reputational or litigation concerns, and that a broad catch-all definition of greenwashing would not distinguish between intentional and unintentional behaviour, having the unintended consequence of exacerbating “greenhushing”.

ICMA instead proposes a focussed definition of greenwashing for consideration by regulators, but suggests that unpacking greenwashing into areas of actual concern is a more effective approach than expanding the current definitions. The proposed definition for consideration reads as follows: “For financial regulatory purposes, greenwashing is a misrepresentation of the sustainability characteristics of a financial product and/or of the sustainable commitments and/or achievements of an issuer that is either intentional or due to gross negligence”.

ICMA also finds that, while ambition and materiality in the early development of the new sustainability-linked bond market may have been insufficient, there is a positive trend in the last 12 months, and that greenwashing is not prevalent in the green and sustainable bond market.

Financial Stability Board publishes annual progress report on climate-related disclosures

On October 12, 2023, the Financial Stability Board (FSB)—an international body that promotes the stability of the global financial system by coordinating national financial authorities and international standard-setting bodies—published its annual progress report on climate-related disclosures, which was delivered to G20 Finance Ministers and Central Bank Governors.

The report finds that significant further progress has been achieved on climate disclosures in the past years, including the publication of the International Sustainability Standards Board (ISSB) Standards in June 2023, which will serve as a global framework for climate-related and sustainability disclosures. It further finds that all FSB member jurisdictions have either requirements, guidance, or expectations in respect of climate-related disclosures currently in place or have taken steps to do so.

The report also references the findings of the Task Force on Climate-Related Financial Disclosures (TCFD) in its 2023 Status Report, which utilised artificial intelligence technology to analyse reporting by more than 1,350 public companies, highlighting that while the percentage of companies making TCFD-recommended disclosures continues to grow, more progress is needed.

Principles for Responsible Investment seeks support for Spring initiative addressing nature loss

The Principles for Responsible Investment (PRI)—a UN-supported international network of financial institutions—invited endorsers (asset owners, investment managers and service providers) on October 3, 2023 to publicly sign up to its Spring investor expectation statement.

The statement sets out the PRI’s stewardship initiative (“Spring”) to urge target companies to take action addressing deforestation and biodiversity loss either directly through their own engagement with policy makers or indirectly through engagement with investees with regards to their responsible political engagement practices given the importance of strong public policy design and implementation in this area. Investors endorsing the statement are not obligated to engage with the target companies but can choose simply to signal their support for the effort.

A list of the target companies is due to be published in early 2024 and the PRI are encouraging investors to sign up by 19 January 2024 to be included the first list of endorsers.

Institutional Shareholder Services announces results of annual global benchmark policy survey

On October 31, 2023, Institutional Shareholder Services (ISS) published the results of its 2023 Global Benchmark Policy Survey to inform its proxy development for the 2024 proxy season. The report sets out key findings related to: increased investor scrutiny of non-GAAP adjustments in US companies’ incentive pay program metrics; the ISS Japan benchmark policy of recommending votes against the re-election of top executives of companies based on return on equity performance; the ISS policy for Korea on director accountability and material governance failures; ISS director independence classification for directors who provide professional services; ISS policy on Foreign Private Issuers and companies listed on US markets; and investor preference regarding ISS approach (globally consistent versus market-specific) to policy guidelines relating to various Environmental and Social topics.

The Society for Corporate Governance submitted a comment letter on September 21, 2023, drawing attention to the “survey bias” observed by its members in the survey questions. The letter observes that given the “increased politicisation of ESG” there is a lack of consensus among the general public and investors regarding ESG generally. It questions the appropriateness of the ISS assuming the role of a quasi-regulator on the issue of Environmental and Social disclosure, and urges the ISS to avoid adopting benchmark policies that are prescriptive or standardised.

II. UNITED KINGDOM

UK Energy Act 2023: Landmark legislation becomes law

The UK Energy Act 2023 (EA 2023) Energy Bill, which originated as the Energy Bill in the House of Lords in July 2022, received royal assent on October 26, 2023. The Department for Energy Security and Net Zero’s announcement describes it as the “biggest piece of energy legislation in the UK’s history”.

The EA 2023 sets out measures to promote investment in low-carbon industries, protect consumers from unfair energy pricing and safeguard the country’s security of energy supply, including:

introduction of business models for the transport and storage elements of carbon capture usage and storage and hydrogen projects, industrial carbon capture and low-carbon hydrogen;
creation of a specific merger regime for energy networks under the Competition and Markets Authority;
introduction of a low-carbon heat scheme;
support for an increase in investment in the consumer market for electric heat pumps (as an alternative to domestic gas boilers) by providing for a new market standard and trading scheme;
facilitate the first large-scale hydrogen heating trial;
creation of a new regulatory environment for fusion energy; and
speeding up the deployment of offshore wind, while maintaining environmental protection.

Global First – UK’s Transition Plan Taskforce launches ‘first of its kind’ globally applicable Transition Plan Disclosure Framework

The Transition Plan Taskforce was launched by HM Treasury in April 2022 to develop a “gold standard” disclosure framework (the Disclosure Framework) for best practice climate transition plans, representing a key step in the UK’s efforts towards becoming the world’s first net-zero aligned financial centre.

The Disclosure Framework, published in October 2023 together with a one-page summary, sets out good practice for robust and credible transition plan disclosures, recognising that listed firms and investors need clear guidance on how best to comply with developing voluntary and mandatory corporate reporting rules, which in the UK will require large firms in the UK to produce transition plans that detail how they intend to deliver on net zero emission goals and respond to climate-related risks.

The UK’s Financial Conduct Authority has welcomed the launch of the Disclosure Framework and has already signalled its intention to consult on transition plan disclosures by UK listed companies in line with the Disclosure Framework.

The Disclosure Framework is designed to be available for voluntary and mandatory use internationally. Of particular note, the framework was designed to be consistent with and build on the final Climate-Related Disclosures standards (IFRS S2) issued by the International Sustainability Standards Board and has also drawn upon the Glasgow Financial Alliance for Net Zero framework for transition planning.

The Disclosure Framework applies three guiding principles of Ambition, Action and Accountability and is organised across five elements (foundations, implementation strategy, engagement strategy, metrics & targets and governance) and 10 disclosure sub-elements.

The final version of the Disclosure Framework is based on the draft launched for consultation in November 2022, the key findings of which can be found here.

Loan Market Association and the European Leveraged Finance Association publish updated best practice guide to sustainability-linked leveraged loans

The Loan Market Association (LMA) and the European Leveraged Finance Association have worked with their respective committees to jointly update the Best Practice Guide to Sustainability-Linked Leveraged Loans (the Guide), in response to the growing appetite in the leveraged loan market for engagement with sustainability-linked financings.

The Guide was published on October 5, 2023 and seeks to provide practical guidance on the application of the ‘Sustainability-Linked Loan Principles’ to leveraged loans, setting out what borrowers, finance parties and their respective advisers ought to consider when integrating sustainability factors into their facility agreements. It observes that the participants in leveraged loan markets are uniquely placed to lead sustainability efforts given that the asset class can lend itself to close relationships between borrowers and lenders, and that investors are already used to conducting “deep dives” into borrowers’ businesses.

In addition to the publication of the Guide, on October 12, 2023, the LMA published a Term Sheet for Draft Provisions for Sustainability-Linked Loans (SLL), prepared by a working group of financial institutions and law firms. The term sheet can be accessed by LMA members on its website.

The Law Society of England & Wales publishes guide to climate risk governance and greenwashing risks for in-house and private practice lawyers

On October 13, 2023, the Law Society of England and Wales published a guide providing information to in-house and private practice lawyers who advise companies on climate risk governance and greenwashing risks, and how these risks might impact solicitors’ and directors’ duties.

The guide intends to inform lawyers as to their duty to advise companies on their duties under the UK Companies Act 2006 and climate-related disclosures. It also addresses what is meant by “good climate governance” and includes certain definitions such as “Greenwashing”, “Climate risks” and “Net Zero”. The guide also includes certain useful resources to learn more about UK directors’ duties and climate risk and governance.

UK Government launches a review of emissions reporting under the UK’s existing streamlined energy and carbon reporting regime

The UK Government is seeking views on the streamlined energy and carbon reporting regime (SECR). The SECR started to apply for financial years starting on or after 1 April 2019 to most UK publicly traded companies, as well as large non-traded companies and large limited liability partnerships. It requires in-scope entities to disclose Scope 1 and Scope 2 greenhouse gas (GHG) emissions in their annual reports, while disclosures of Scope 3 emissions (which are indirect emissions that occur in a company’s value chain) are mostly voluntary. The SECR also requires disclosure of energy usage and energy efficiency measures. The UK Government is asking for feedback as to whether ‘Scope 3 emissions’ should be within the scope of SECR. The UK Government is seeking views on, among other things, the costs, benefits and practicalities of Scope 3 GHG reporting.

The UK Government has asked for feedback by December 14, 2023.

III. EUROPE

The Council of the European Council adopts the new Renewables Energy Directive

On October 9, 2023, the Council of the European Union formally adopted the amended Renewable Energy Directive (RED III). RED III raises the 2030 target for the share of renewable energy in the EU’s overall energy consumption from 32% to 42.5%, with a further indicative target of 2.5%, as well as introducing specific sub-targets for Member States in the industry, transport and building (district heating and cooling) sectors with a view to speeding up the integration of renewables in sectors where uptake has been slower. Member States now have 18 months to adjust national legislation accordingly.

RED III is part of the broader ‘Fit for 55’ package, aligning the EU’s energy and climate goals with the objective of reducing greenhouse gas emissions by at least 55% by 2030.

The European Parliament and the Council of the European Union adopt the European Green Bonds Regulation, the new voluntary standard to fight greenwashing

On October 5, 2023, the European Parliament formally adopted the regulation on European Green Bonds and optional disclosures for bonds marketed as environmentally sustainable and for sustainability-linked bonds (the EuGB Regulation), which was published on October 11, 2023. On October 24, 2023, the Council of the European Union has similarly announced its adoption of the EuGB Regulation.

The EuGB Regulation set out a framework that bond issuers, whether within or outside the EU, must follow if they wish to use the “European Green Bond” (EuGB) designation. It also includes voluntary disclosure guidelines for other environmentally sustainable bonds and sustainability-linked bonds issued in the EU.

The key aspects of this new standard are:

the link between the use of proceeds and the EU Taxonomy Framework;
increased transparency, through the required completion of a pre-issuance green bond factsheet and EU Prospectus Regulation compliant prospectus, post-issuance allocation report(s) and post-allocation impact report;
the voluntary “lite” disclosure regime applicable to bonds marketed as environmentally sustainable and sustainability-linked bonds;
the introduction of a supervised external reviewer regime; and
the introduction of supervisory and sanctioning powers to “national competent authorities”.

European Parliament’s Committee on Economic and Monetary Affairs has published a draft report on the proposal for a regulation of the European Parliament and of the Council on the transparency and integrity of Environmental, Social and Governance rating activities

On October 6, 2023, the European Parliament’s Committee on Economic and Monetary Affairs published a draft report on the European Commission’s proposal for a regulation of the European Parliament and of the Council on the transparency and integrity of environmental, social and governance (ESG) rating activities. The draft report was prepared by Rapporteur Aurore Lalucq, who submitted 97 amendments to the text proposed by the European Commission.

In the explanatory statement to the report, the Rapporteur outlines her views on the proposed regulation, including the following:

the disclosure requirements should be more stringent and instructive;
entities seeking multiple ratings should prioritise at least one provider with a market share below 5% to ensure diversity and competitiveness in the marketplace;
the reliability and transparency of ESG rating activities needs to be improved;
ESG rating providers should actively incorporate standardized ESG data into their assessments; and
the objectives of the rating providers need to be clarified.

The European Securities and Markets Authority has published a report on the climate-related matters in the financial statements

On October 25, 2023, the European Securities and Markets Authority (ESMA) published a report on disclosures of climate-related matters in the financial statements, which aims to assist and enhance the ability of issuers to provide more robust disclosures and create more consistency in how climate-related matters are accounted for in the financial statements drawn up in accordance with International Financial Reporting Standards. The report does not, however, set out best practices or prescribe the way in which the disclosure of climate-related matters should be made in the financial statements.

The report focuses on the following key topics, for which ESMA has deemed climate-related matters to likely have a higher impact: significant judgements, major source of estimation uncertainty and accounting policies; impairment of non-financial assets; useful lives of tangible and intangible assets; and provisions and other accounting topics.

IV. UNITED STATES

Federal banking regulators finalize guidance for large financial institutions on managing physical and transition risks associated with climate change

On October 24, 2023, the Office of the Comptroller of the Currency, Treasury, Board of Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation collectively finalized principles for climate-related financial risk management for large financial institutions (i.e., those with more than $100 billion in assets). Federal Reserve Chair Jerome H. Powell stressed in a same day statement that the principles are “squarely focused on prudent and appropriate risk management,” not making policy decisions addressing climate change, and that banks must understand and manage their material risks.

Financial officers of 21 states continue dialogue with proxy advisory firms on ESG proposals

State treasurers, auditors, and other financial officers from 21 states sent a follow-up letter on October 24, 2023 to proxy advisory firms Institutional Shareholder Services (ISS) and Glass Lewis that continued to express their concern regarding political, ideological, and personal bias in the firms’ voting recommendations made on ESG-related Rule 14a-8 shareholder proposals. In particular, the letter raised the potential for unfair treatment of proposals submitted by conservative proponents. It also focused primarily on proposals related to “debanking” risks as an area for the firms “to demonstrate [their] commitment to avoiding political bias” in the upcoming proxy season. This correspondence continued dialogue among the parties that began in May 2023. Prior responses from ISS and Glass Lewis are available here and here, respectively.

U.S. Department of Energy announces selection of seven sites to establish clean hydrogen hubs with a $7 billion investment

On October 13, 2023, the U.S. Department of Energy’s (DOE) Office of Clean Energy Demonstrations announced a $7 billion investment from the Bipartisan Infrastructure Law to launch seven Regional Clean Hydrogen Hubs (H2Hubs) across the country. The investment aims to foster “a national network of clean hydrogen producers, consumers, and connective infrastructure,” aligning with the DOE’s U.S. National Clean Hydrogen Strategy and Roadmap and Pathways to Commercial Liftoff: Clean Hydrogen. If the H2Hubs proceed as planned, the DOE expects them to annually reduce 25 million metric tons of carbon dioxide emissions from end-use and produce three million metric tons of hydrogen, in addition to substantial job creation.

California adopts legislation requiring diversity disclosure for private equity and venture capital funds, mandating climate-related disclosure, and regulating “green” claims

On October 8, 2023, California enacted Senate Bill 54, “Venture Capital Companies: Reporting,” which will be effective on March 1, 2025. The bill will require venture capital companies with certain connections to California to annually disclose to the California Civil Rights Department demographic data regarding portfolio company founding teams, including race, ethnic identity, disability status, gender identity, and veteran status, among other characteristics. More information on this development is available in our recent client alert here.

In early October, California also enacted three bills that will impose significant climate-related reporting obligations on public and private companies with connections to the State. For further detail, see our September update, client alert, and blog post.

New York Stock Exchange proposes new listing standards for securities of “Natural Asset” companies

The New York Stock Exchange (NYSE) proposed new listing standards in late September for a category of public companies called “Natural Asset Companies” (NACs). The NYSE defines these companies as corporations “whose primary purpose is to actively manage, maintain, restore (as applicable), and grow the value of natural assets and their production of ecosystem services.” Such companies may also “seek to conduct sustainable revenue-generating operations,” if certain conditions are satisfied. The proposed listing rules include governance and reporting requirements related to corporate charters, license agreements, mandatory written policies (e.g., environmental and social, biodiversity, human rights, etc.), and a mandatory pre-listing “Ecological Performance Report.” NACs would otherwise be subject to the Section 303A.00 corporate governance requirements, with specific responsibilities for their audit committees. The Intrinsic Exchange Group partnered with the NYSE for the proposal.

V. APAC

Australian Accounting Standards Board publishes draft sustainability reporting standards

In October 2023, the Australian Accounting Standards Board published a draft of the country’s sustainability reporting standards, out for consultation until March 1, 2024. The draft Australian Sustainability Reporting Standards (ASRS) – Disclosure of Climate-related Financial Information (ED SR1) have been developed using the International Sustainability Standards Board’s two sustainability disclosure standards, released in June 2023, and include ASRS 1 for general requirements for disclosure of climate-related financial information (developed using IFRS S1 as the baseline) and ASRS 2 for climate-related financial disclosures (developed using IFRS S2). A third standard (ASRS 101, References in Australian Sustainability Reporting Standards) has been developed as a service standard that lists the relevant versions of any non-legislative documents published in Australia and foreign documents that are referenced in ASRS standards.

Hong Kong’s Securities and Futures Commission announces plans to sponsor the development of a voluntary code of conduct for ESG ratings and data product providers

On October 31, 2023 the Hong Kong’s Securities and Futures Commission (HKSFC) announced plans to support and sponsor the development of a voluntary code of conduct (VCoC) for ESG ratings and data product providers. The VCoC will be developed via an industry-led working group, namely the Hong Kong ESG Ratings and Data Products Providers VCoC Working Group (VCWG).

The HKSFC has noted that the VCoC will align with international best practices as recommended by the International Organization of Securities Commissions. Further details of the VCWG are included in its terms of reference and a participation list has also been published by the HKSFC.

Japan announces issue of new government transition bonds and efforts to improve regional alignment on transition finance in Asia through the “Asia GX Consortium”

At the PRI in Person in Japan, on October 3, 2023, Prime Minister Fumio Kishida explained that the Japanese Government will work to improve regional alignment on transition finance in Asia. The Prime Minister outlined that the Japanese Government’s efforts will be based on its “GX” or “green transformation” plan and will encourage specific implementation of transition finance across Asian countries, launching an “Asia GX consortium” by the middle of 2024. The consortium will aim to drive GX investment in Asia, across both the public and private sectors. Prime Minister Kishida also announced that the Japanese Government will issue new government transition bonds titled “Climate Transition Bonds” this fiscal year and these will be the “world’s first government-issued transition bonds aligned with global standards”.

Monetary Authority of Singapore backs the use of carbon credits to finance the early retirement of coal-fired plants

The Monetary Authority of Singapore and McKinsey & Company published a working paper setting out how high-integrity carbon credits can be utilised as a complementary financing instrument to accelerate and scale the early retirement of coal-fired plants (CFPPs).

The paper explains that the phase-out of CFPPs is key to Asia’s energy transition and should be accompanied by the further development of clean energy. The paper explores the role that high-integrity carbon credits can play in this process and considers what is required to further development in a market for high-integrity carbon credits.

Please let us know if there are other topics that you would be interested in seeing covered in future editions of the monthly update.

Warmest regards,

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

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

The following Gibson Dunn lawyers prepared this client update: Lauren Assaf-Holmes, Grace Chong, Sophy Helgesen, Elizabeth Ising, Tamas Lorinczy, Cynthia Mabry, Shannon McAvoy, Patricia Tan Openshaw, Selina S. Sagayam and David Woodcock.

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

Environmental, Social and Governance (ESG):
Susy Bullock – London (+44 (0) 20 7071 4283, [email protected])
Elizabeth Ising – Washington, D.C. (+1 202-955-8287, [email protected])
Perlette M. Jura – Los Angeles (+1 213-229-7121, [email protected])
Ronald Kirk – Dallas (+1 214-698-3295, [email protected])
Michael K. Murphy – Washington, D.C. (+1 202-955-8238, [email protected])
Patricia Tan Openshaw – Hong Kong (+852 2214-3868, [email protected])
Selina S. Sagayam – London (+44 (0) 20 7071 4263, [email protected])