The U.S. Food and Drug Administration (FDA) recently published a draft guidance document proposing to regulate end-user output of prescription drug use-related software (PDURS) as labeling.[1] The draft guidance sets forth review pathways that could benefit prescription drug application sponsors, including by allowing sponsors to incorporate information about PDURS in the FDA-approved labeling and to seek premarket review for certain PDURS functions that meet the definition of a medical device. But by proposing to regulate PDURS-related information as labeling, the draft guidance poses potential enforcement risks for sponsors under the Federal Food, Drug, and Cosmetic Act (FDCA), the False Claims Act (FCA), and other laws, including through possible off-label promotion claims. Interested parties should consider submitting comments to FDA on the draft guidance. FDA has invited comments through December 18, 2023.

Introduction

On September 19, 2023, FDA published a new draft guidance document outlining the agency’s planned approach for regulating PDURS.[2] Sponsors of new drug applications for prescription drugs have developed PDURS as tools to connect with patients and healthcare providers in various ways, such as providing more information about drugs or their potential side effects and aiding in dosing and medication adherence. For example, sponsors have developed tablets, autoinjectors, and inhalers with integrated sensors that can allow providers to monitor when patients take the drug.[3] They have also created patient diary apps that allow patients to document symptoms they experience, and apps that help patients calculate appropriate doses of products such as insulin.[4]

The PDURS Draft Guidance marks a further step in the agency’s evaluation of novel technologies, like mobile apps, that are intended for use with FDA-regulated products. The agency previously has addressed when and how it intends to assert jurisdiction over certain software functions intended for use with medical devices as product components.[5] FDA also has described the types of mobile app functions it views as components of new tobacco products, including those that monitor where a product is located, activated, or used.[6]

FDA first proposed a framework for oversight and review of PDURS in a 2018 Federal Register notice.[7] FDA developed the PDURS Draft Guidance in response to comments it received on that 2018 notice.[8]

Under the PDURS Draft Guidance, end-user output produced by PDURS would be considered labeling. End-user output is defined by FDA to include any content that PDURS presents to the end user, including static or dynamic screen displays, sounds, or audio messages created by the software.[9] FDA  recommends the inclusion of a description of the end-user output produced by PDURS in the prescribing information (PI) if evidence shows a meaningful effect on clinical outcomes or validated surrogate endpoints. In the PDURS Draft Guidance, FDA also outlines proposed oversight processes for device-connected PDURS, including premarket review for software functions regulated as medical devices.

The framework in the PDURS Draft Guidance presents both possibilities and risks for prescription drug sponsors. Sponsors that are able to provide supporting data for the clinical impact of PDURS they develop can utilize FDA’s regulatory pathways to augment their FDA-approved labeling and enable additional claims about their products. On the other hand, FDA’s regulation of PDURS end-user output as labeling would create another area of enforcement risk under FDCA requirements for prescription drug labeling. Moreover, sponsors might also face potential liability under the FCA if end-user output is not consistent with the FDA-approved label.

FDA Proposed Regulation of PDURS Output as Labeling:

• FDA defines PDURS as software “that (1) is disseminated by or on behalf of a drug sponsor and (2) produces an end-user output that supplements, explains, or is otherwise textually related to one or more of the sponsor’s drug products.”[10] Accordingly, the PDURS Draft Guidance would not apply to third-party software that is not generated on behalf of a drug sponsor, even if the third-party developer’s “intention is for the software to be used with one or more drugs or combination products.”[11]

• The PDURS Draft Guidance also makes clear that FDA views the software’s end-user output as labeling.[12] Under the FDCA, “labeling” refers to “all labels and other written, printed, or graphic matter (1) upon any article or any of its containers or wrappers, or (2) accompanying such article.”[13] Under the PDURS Draft Guidance, “end-user output” is broadly defined as “[a]ny material (content) that the [PDURS] presents to the end user (a patient, caregiver, or health care practitioner).”[14] These include static or dynamic screen displays, sounds, or audio messages created by PDURS.[15]

• FDA recognizes two categories of labeling: the FDA-required labeling, which includes the PI and other labeling reviewed and approved by FDA in applications, and promotional labeling.[16] In the PDURS Draft Guidance, FDA views the end-user output associated with a software function as FDA-required labeling if a sponsor of a new drug application submits data from one or more adequate and well-controlled studies demonstrating that use of the software function results in a meaningful improvement on a clinical outcome or validated surrogate endpoint.[17] FDA also recommends that the PI describe such software functions and their end-user output.[18] Under the PDURS Draft Guidance, certain post-approval changes to the end-user output from such a software function would need to be submitted to FDA for review and approval, similar to other changes to the FDA-required labeling.[19]

• In contrast, FDA views all other end-user output from PDURS as promotional labeling.[20] Under the PDURS Draft Guidance, end-user output that constitutes promotional labeling would need to be submitted to FDA on an FDA Form 2253 at the time of initial dissemination. Software updates that do not change the end-user output, such as security patches, would not require submission of an FDA Form 2253.[21] FDA also reminds sponsors in the PDURS Draft Guidance that, in accordance with the FDCA and FDA regulations, promotional labeling must be truthful and non-misleading, convey balanced information about a drug’s efficacy and risks, and reveal material facts about the drug, including facts about consequences that can result from use of a drug as suggested in a promotional piece.[22]

FDA Oversight for Device-Connected PDURS Functions

• Under the PDURS Draft Guidance, additional considerations also would apply to certain PDURS functions that are “device-connected,” in that they receive input data from a device constituent that is part of a combination product.[23] Examples of such functions in the PDURS Draft Guidance include software that connects an app and an inhaler or autoinjector to capture and display data about the patient’s usage, and software that supplies information about a patient’s ingestion of a drug from embedded sensors in the tablet.[24]

• FDA recommends that sponsors briefly describe device-connected software functions in the appropriate section of the FDA-approved labeling for the prescription drug, such as the “How Supplied/Storage and Handling” section.[25] In contrast, FDA does not generally expect the approved labeling to describe end-user output from PDURS that does not include device-connected software functions, unless the PDURS is considered essential to a safe and effective use of the drug, or the sponsor has submitted evidence that use of the PDURS leads to a clinically meaningful benefit.[26]

• According to the PDURS Draft Guidance, device-connected functions could meet the definition of “medical device” under the FDCA and be subject to regulation by the Center for Devices and Radiological Health (CDRH). They also may require premarket device submissions, such as a 510(k) notification, de novo classification request, or premarket application (PMA).[27] When it reviews a premarket submission for a device-connected function, CDRH would consult with the Center for Drug Evaluation and Research (CDER) or the Center for Biologics Evaluation and Research (CBER), as applicable, to evaluate any considerations related to representations within the PDURS function. For PDURS functions that are medical devices cleared or approved by FDA, changes may require a new premarket submission or supplement.[28]

• Postmarket changes to end-user output of PDURS functions that constitute promotional labeling and do not require a CDRH marketing submission should be submitted to FDA at the time of initial dissemination on Form FDA 2253.[29]

• Consistent with FDA’s enforcement approach to device software functions, FDA intends to focus its device regulatory oversight on PDURS functions which are devices and whose functionality could pose a risk to patient safety if they fail to function as intended.[30]

FDA encourages interested parties to submit comments on the PDURS Draft Guidance to Docket No. FDA-2023-D-2482.[31] FDA requests the submission of comments by December 18, 2023, to allow for agency review before it begins work on the final version of the draft guidance.

Sponsors who currently use, or are considering using or developing, PDURS should consider submitting comments on the PDURS Draft Guidance to help shape the FDA’s development of final guidance. In particular, sponsors should seek to identify costs and complications not identified as considerations by FDA, such as those related to delays in development and FDA clearance or approval of PDURS, where required; challenges that may stem from necessary updates to end-user output from PDURS associated with the FDA-approved labeling; the discrepancy between the approaches in the PDURS Draft Guidance to sponsor-developed PDURS and to third-party-developed PDURS; and potential alternatives or modifications to the PDURS Draft Guidance’s approach that FDA should consider. Sponsors should also consider whether FDA’s proposed framework and review processes, particularly for PDURS described in the FDA-approved labeling, could impact their ability to timely develop and update software to help patients who use their products. Sponsors also should consider potential enforcement and compliance risks and costs that would stem from implementation of the PDURS Draft Guidance, including expansion of possible off-label promotion liability, which remains an active enforcement area for FDA and the U.S. Department of Justice[32] and a frequent claim in class actions.

Gibson Dunn is prepared to help sponsors and other interested entities consider potential effects of the PDURS Draft Guidance and submit comments to FDA recommending modifications to the PDURS Draft Guidance.

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[1] 88 Fed. Reg. 64443 (Sept. 19, 2023); FDA, Draft Guidance for Industry: Regulatory Considerations for Prescription Drug Use-Related Software (Sept. 2023) (“PDURS Draft Guidance”).

[2] PDURS Draft Guidance.

[3] See, e.g., id. at 11; Office of Inspector Gen., Dep’t of Health & Hum. Serv. (“HHS OIG”), Advisory Opinion No. 19-02 (Jan. 24, 2019).

[4] See, e.g., PDURS Draft Guidance at 11-12, 14.

[5] See, e.g., FDA, Guidance for Industry and Food and Drug Administration Staff: Policy for Device Software Functions and Mobile Medical Applications (Sept. 2022) (“Device Software Functions Guidance”).

[6] 21 C.F.R. § 1114.7(i)(1)(i); see also 86 Fed. Reg. 55300, 55332 (Oct. 5, 2021).

[7] 83 Fed. Reg. 58574 (Nov. 20, 2018).

[8] PDURS Draft Guidance at 1; see Docket No. FDA-2018-N-3017.

[9] PDURS Draft Guidance at 6, 16.

[10] Id. at 16.

[11] Id. at 2.

[12] Id.

[13] 21 U.S.C. § 321(m).

[14] PDURS Draft Guidance at 16.

[15] Id. at 6.

[16] Id. at 2.

[17] Id. at 7.

[18] Id. at 7-8.

[19] Id.; see, e.g., 21 C.F.R. §§ 314.70, 601.12.

[20] PDURS Draft Guidance at 2.

[21] Id. at 9.

[22] Id. at 4-5; see, e.g., 21 U.S.C. §§ 321(n), 352(a)(1), (f)(1); 21 C.F.R. §§ 201.5, 201.6, 202.1.

[23] PDURS Draft Guidance at 5.

[24] Id. at 8, 11

[25] Id. at 8-9.

[26] Id. at 9.

[27] Id. at 3.

[28] Id. at 9-10.

[29] Id. at 9, 14-15.

[30] Id. at 3.

[31] See Docket No. FDA-2023-D-2482.

[32] See, e.g. U.S. Dep’t of Justice, Press Release, “Jet Medical and Related Companies Agree to Pay More Than $700,000 to Resolve Medical Device Allegations” (Jan. 4, 2023).

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

Gustav W. Eyler – Washington, D.C. (+1 202-955-8610, [email protected])
John D. W. Partridge – Denver (+1 303-298-5931, [email protected])
Jonathan M. Phillips – Washington, D.C. (+1 202-887-3546, [email protected])
Jonathan C. Bond – Washington, D.C. (+1 202-887-3704, [email protected])
Carlo Felizardo – Washington, D.C. (+1 202-955-8278, [email protected])

© 2023 Gibson, Dunn & Crutcher LLP.  All rights reserved.  For contact and other information, please visit us at www.gibsondunn.com.

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.

Gibson, Dunn & Crutcher LLP advised investor and active manager of core infrastructure assets John Laing on its acquisition of a portfolio of five UK assets from HICL Infrastructure PLC.

The portfolio of assets consists of Hornsea II offshore transmission assets, the Oxford John Radcliffe Hospital PFI Project, the Queen’s Hospital PFI Project in Romford, the South Ayrshire Schools PFI Project, and the Priority Schools Building Programme North East Batch.

The portfolio will help John Laing build on its extensive education, health and renewable energy experience, and marks its entry into the growing transmission sector.

The Gibson Dunn team representing John Laing was led by co-head of private equity in Europe Federico Fruhbeck and private equity partner Alice Brogi, with support from counsels Cason Moore and Manjinder Tiwana, and associates Dominic Kinsky and Magdalena Augé.

The team was also supported by co-chair of the firm’s antitrust and competition group Ali Nikpay, antitrust and competition partner Attila Borsos, and associates Alana Tinkler and Robert Albertson Kill.

The False Claims Act (FCA) is one of the most powerful tools in the government’s arsenal to combat fraud, waste, and abuse involving government funds. Nearly two years ago, the Department of Justice announced the establishment of the Civil Cyber-Fraud Initiative to utilize the False Claims Act to pursue cybersecurity related fraud by government contractors and grant recipients. Since the announcement of the Civil Cyber-Fraud Initiative, the government has continued to promulgate new cybersecurity requirements and reporting obligations in government contracts and funding agreements—which may bring yet more vigorous efforts by DOJ to pursue fraud, waste, and abuse in government spending under the False Claims Act. As we approach the second anniversary of the Civil Cyber-Fraud Initiative, as much as ever, any company that receives government funds—especially technology companies operating in the government contracting sector—needs to understand how the government and private whistleblowers alike are wielding the FCA to enforce required cybersecurity standards, and how they can defend themselves.

Please join us to discuss developments in the FCA, including:

1. The latest trends in FCA enforcement actions and associated litigation affecting government contractors, including technology companies;
2. Updates on enforcement actions arising under the DOJ Civil Cyber-Fraud Initiative;
3. New proposed amendments to the FCA introduced by Senator Grassley;
4. The latest trends in FCA jurisprudence, including developments in particular FCA legal theories affecting your cybersecurity compliance and reporting obligations; and
5. Updates to the cybersecurity regulations and contractual obligations underlying enforcement actions by DOJ’s Civil Cyber-Fraud Initiative.

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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.

On September 21, 2023, the Federal Trade Commission (“FTC”), delivering on recent agency promises to increase scrutiny of private equity-backed transactions and strategies, released a complaint filed against private equity sponsor Welsh, Carson, Anderson, and Stowe (“Welsh Carson”) and U.S. Anesthesia Partners (“USAP”), a Texas-based provider of anesthesia services and Welsh Carson portfolio company. With this slate of claims, the FTC takes aim at Welsh Carson and USAP’s serial acquisitions over a decade, post-merger conduct, and the “roll-up” strategy employed by USAP and Welsh Carson.

The complaint alleges numerous violations of Sections 1 and 2 of the Sherman Act, asserting defendants monopolized, conspired to monopolize, and entered into agreements to fix prices and allocate markets with respect to commercially insured hospital-only anesthesiology services. The complaint also claims defendants violated Clayton Act Section 7 and Section 5 of the FTC Act through a string of serial acquisitions which allegedly lessened competition in Texas. The complaint asserts that defendants’ “roll-up” strategy represented an “unfair method of competition.” Finally, the complaint alleges that Welsh Carson’s acquisitions, pricing actions, and horizontal agreements together represent a “scheme to reduce competition in Texas” under Section 5 of the FTC Act. The FTC has asserted in this complaint a novel test for “unfair methods of competition” that forms the basis for separate and standalone claims under Section 5.

Roll-Up Strategy

Private equity firms look for opportunities to use their deal-making, operational, and financial expertise, along with their significant equity funding resources, to create more efficient companies in competitively fragmented landscapes. One strategy, the “roll-up” or (also often referred to as a “buy and build” strategy”), entails combining numerous, smaller companies in a particular industry. Private equity firms typically start with an initial, larger “platform” company acquisition, which then makes often numerous additional acquisitions to create a significantly larger organization that can achieve efficiencies and develop new or greater service offerings through scale, scope, and integration. These strategies can lower prices for consumers and provide other procompetitive benefits by reducing costs through centralizing common support functions or infrastructure costs, using size and scale to increase utilization and often obtain more favorable financing (driving down costs of debt), enhancing purchasing power to produce lower operating costs, and spreading costs across a larger buyer base to allow for innovation and growth into new products and services in ways that would be too expensive for independent smaller businesses.

The FTC’s Theories of Harm

Over the past several years, there has been a marked increase in rhetoric from enforcers related to antitrust scrutiny of private equity firms. Although the FTC has discussed leveraging new tools to police private equity[1], much of the FTC’s complaint against Welsh Carson and USAP relies on traditional antitrust theories of anticompetitive conduct and harm. The complaint defines a relevant product market (“commercially-insured hospital-only anesthesia services”) and several relevant geographic markets (metropolitan statistical areas, respectively, of Austin, Dallas, and Houston). It alleges that the serial acquisitions resulted in monopoly level market shares for USAP of 60-70% in each geographic area. The complaint asserts that high switching costs for hospitals, high barriers for entry, and horizontal agreements (both related to prices and territories) with other providers contributed to higher prices for consumers and an inability by hospitals to constrain prices for anesthesia services.

The more novel aspects of the FTC’s complaint include the joint Section 7 Clayton Act and Section 5 FTC Act claims, attacking the parties’ acquisitions and general roll-up strategy, the complaint takes aim simultaneously at multiple acquisitions over the course of years. Count 2 alleges a roll-up of the Houston market via 3 acquisitions over a period of 3 years, and Count 5 alleges a roll-up of the Dallas market via 6 acquisitions over a period of 3 years. This complaint continues a recent trend of U.S. agency review of consummated and long-past transactions under Section 7 of the Clayton Act, where historically such transactions rarely received oversight or enforcement so long after consummation. With the “roll-up” cause of action envisioned in the complaint, however, the FTC seems to open the door to challenging transactions well after closing, and with the benefit of hindsight assessment of the resulting impact of a multi-deal, multi-year M&A strategy, as part of an alleged broader conspiracy.

The complaint also includes a novel standalone Section 5 claim (Count 8), broadly challenging defendants’ alleged “scheme to reduce anesthesia competition in Texas.” This claim is unusual in that the FTC has refrained from asserting Section 5 where “enforcement of the Sherman or Clayton Act is sufficient to address the competitive harm arising from the act or practice.”[2] This divergence from past practice seems driven by an interest in developing an independent (and perhaps more flexible) framework for prosecuting “unfair methods of competition” in line with policy statements by the FTC issued over the last several years. The complaint’s allegation of a scheme to lessen competition through acquisitions and agreements with other providers across Texas rests solely on Section 5 authority. It alleges harms to consumers in the form of increased prices through mechanisms suitably addressable by Clayton Act Section 7 and Sherman Act Sections 1 and 2 (and are addressed through these laws in the other counts). Where the Section 5 count differs is that it alleges a scheme across the state of Texas, and utilizes Section 5 to claim “unfair methods of competition” without defining a relevant product or geographic market as they did with the local metropolitan region claims. If judicially recognized, this would allow the FTC to pursue claims against consolidation and pricing actions with fewer requirements and lower burdens of proof via effects-driven analysis over econometric analysis through established and defined  relevant markets. Use of Section 5 as standalone authority may also attempt to circumvent the four-year statute of limitations restrictions on antitrust claims, as many of the contested transactions date farther back than four years.

Implications and Takeaways

All businesses, not just private equity sponsors, whose growth strategy includes significant M&A activity should remain mindful of the context in which it engages customers in price negotiation and competitors in collaborative agreements. As market shares increase, so too does the possibility of broader antitrust scrutiny. Although the complaint identifies the serial acquisitions as one cause of antitrust harm, the alleged pricing actions and agreements with competitors by a growing market participant may have precipitated the investigation and litigation.

Businesses that engage in mergers and acquisitions as part of their growth strategy should consider future M&A plans in light of past acquisitions. Businesses, particularly private equity firms, engaged in multiple acquisitions as part of a “consolidation” strategy (especially transactions where consequent price adjustments are expected) should prepare for increased scrutiny at the investigation stage regardless of the outcome of this lawsuit.

In this shifting and aggressive enforcement landscape, it is important to consult with counsel early and consider potential antitrust risks in M&A strategy broadly, and not just with respect to individual transactions. While roll-ups can be effective in enhancing competition in many different markets, private equity sponsors and their portfolio companies should be mindful that as an M&A-driven growth strategy produces market share increases, their strategy and overall conduct may attract increased agency scrutiny. Counsel can help advise proactively on risks in strategic initiatives and pipeline acquisitions, as well as assess the potential risk of enforcement involving past M&A-focused growth strategies and post-acquisition market conduct.

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[1] See, e.g. Draft Merger Guidelines, U.S. Department of Justice and Federal Trade Commission (July 19, 2023) (available here);  Statement of Commissioner Rohit Chopra Regarding Private Equity Roll-ups and the Hart-Scott-Rodino Annual Report to Congress Commission, File No. P110014 (July 8, 2020) (available here); Statement of Chair Lina M. Khan, Joined by Commissioner Rebecca Kelly Slaughter and Commissioner Alvaro M. Bedoya Regarding JAB Consumer Fund/SAGE Veterinary Partners (June 13, 2022) (available here).

[2] Statement of Enforcement Principles Regarding “Unfair Methods of Competition” Under Section 5 of the FTC Act (August 13, 2015) (available here).

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The following Gibson Dunn lawyers prepared this client alert: Rachel Brass, Mark Director, Sophie Hansell, Cynthia Richman, Dan Swanson, Chris Wilson, Jamie France, and Zoë Hutchinson.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Antitrust and Competition, Mergers and Acquisitions, or Private Equity practice groups, or the following authors and practice leaders:

Antitrust and Competition Group:
Rachel S. Brass – Co-Chair, San Francisco (+1 415-393-8293, [email protected])
Sophia A. Hansell – Washington, D.C. (+1 202-887-3625, [email protected])
Cynthia Richman – Washington, D.C. (+1 202-955-8234, [email protected])
Daniel G. Swanson – Los Angeles (+1 213-229-7430, [email protected])
Stephen Weissman – Co-Chair, Washington, D.C. (+1 202-955-8678, [email protected])
Chris Wilson – Washington, D.C. (+1 202-955-8520, [email protected])
Jamie E. France – Washington, D.C. (+1 202-955-8218, [email protected])

Mergers and Acquisitions Group:
Mark D. Director – Washington, D.C./New York (+1 202-955-8508, [email protected])
Robert B. Little – Co-Chair, Dallas (+1 214-698-3260, [email protected])
Saee Muzumdar – Co-Chair, New York (+1 212-351-3966, [email protected])

Private Equity Group:
Richard J. Birns – Co-Chair, New York (+1 212-351-4032, [email protected])
Ari Lanin – Co-Chair, Los Angeles (+1 310-552-8581, [email protected])
Michael Piazza – Co-Chair, Houston (+1 346-718-6670, [email protected])

© 2023 Gibson, Dunn & Crutcher LLP.  All rights reserved.  For contact and other information, please visit us at www.gibsondunn.com.

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.

Privacy, Cybersecurity and Data Innovation co-chair Ahmed Baladi discusses GDPR enforcement actions in Europe with practice partners Vera Lukic (Paris) and Joel Harrison (London). They review enforcement actions over the past five years and anticipate future trends, look at Brexit’s impact on the GDPR and on its application in the UK, and examine issues arising from the enforcement of the e-privacy directive, with its lack of a one-stop-shop mechanism.

Previous Episode | Next Episode

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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.

Joel Harrison is a partner in the London office of Gibson, Dunn & Crutcher and a member of the firm’s Privacy, Cybersecurity and Data Innovation and Technology Transactions Practice Groups. Joel advises on everything technology-related, including transactions, disputes and renegotiations, as well as regulatory issues. He also specializes in data protection and cybersecurity, advising on the full range of regulatory, transactional and contentious matters. Joel’s clients include some of the world’s leading corporations and financial institutions.

Vera Lukic is a partner in the Paris office of Gibson, Dunn & Crutcher, where she serves as a member of the Privacy, Cybersecurity and Data Innovation Practice Group. She is also a member of the Strategic Sourcing and Commercial Contracts Practice Group. She focuses on information technology, digital transactions, cybersecurity, and data privacy.

On July 27, 2023, Hong Kong’s Securities and Futures Commission (“SFC”) published a “Circular on Licensing and Registration of Depositaries of SFC-authorised Collective Investment Schemes and Related Transitional Arrangements” (the “Circular”).[1] Trustees and custodians of SFC-authorised collective investment schemes (the “relevant CIS”) will have to be licensed or registered with the SFC for the new Type 13 regulated activity (“RA 13”) from October 2, 2024.

The Circular should be read in tandem with the soon to be enacted Schedule 11 to the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (“Schedule 11”).[2] Together, the Circular and Schedule 11 provide guidance on the SFC’s expectations regarding RA 13 licensing arrangements.

The new RA 13 regulatory regime intends to remedy what the SFC has previously described as a “patchy” approach to the regulation of depositories, whereby the SFC was unable to directly supervise depositaries. Instead, the SFC could only exercise indirect oversight through the requirements under the Product Codes.[3]  The RA 13 regulatory framework was proposed by the SFC in September 2019 to fill this void left by a lack of specific, direct supervision mechanism over trustees and custodians of public funds.[4] In doing so, the new RA 13 regulatory regime will also align Hong Kong’s fund custody framework with international standards; most major jurisdictions (such as the United Kingdom and Singapore) have some form of direct regulatory powers over entities providing trustee, custodian or depositary services for public funds (at a minimum). Viewed broadly, the introduction of RA 13 is also consistent with the SFC’s focus on regulating entities providing custody services – for instance, its recent decision to regulate virtual assets custody under its new virtual assets trading platform (“VATP”) regime by requiring custody be undertaken by a wholly owned subsidiary of a licensed VATP operator.

I. Who needs a RA 13 license?

The amendments made to the Securities and Futures Ordinance (“SFO”) to introduce RA 13 define it as “providing depositary services for relevant CISs”.[5] In essence, what this means is that trustees and custodians (i.e. depositaries as defined under the amendments to the SFO) of a relevant CIS at the “top level” of the custodian chain will be required to be licensed or registered for RA 13 in order to provide the following services:

• the custody and safekeeping of the CIS property, including property held on trust by the relevant CIS (“CIS Property”); and
• the oversight of the CIS to ensure that it is operated according to scheme documents.[6]

In practice, many of these depositaries were not previously supervised by the SFC until the introduction of the new RA 13 regime. This suggests that individuals who will now be required to be licensed to undertake RA 13 activities will be subjected to direct SFC supervision for the first time, and may not be accustomed to being licensed.

II. What are the RA 13 regulatory requirements?

In the table below, we highlight the key regulatory requirements applicable to depositaries licensed for RA 13 (“RA 13 Depositaries”):

Capital thresholds	RA 13 Depositaries are required to maintain a paid-up share capital of not less than $10,000,000 and a liquid capital of not less than $3,000,000.[7]
Treatment of Scheme Money	RA 13 Depositaries that hold or receive scheme money under a relevant CIS (“Scheme Money”) must deposit such Scheme Money into segregated and designated trust accounts or client accounts within three business days after receipt. Each segregated account must be established and maintained for one relevant CIS only.[8] RA 13 Depositaries must not pay Scheme Money out of the segregated account unless such payment is (i) instructed in writing, or (ii) for the purpose of meeting payment, distribution, redemption settlement, or margin requirements, or (iii) to settle any charges or liabilities on behalf of the relevant CIS, as per the scheme documents.[9]
Treatment of Scheme Securities	Similarly, an RA 13 Depositary must deposit client securities which it holds or receives when providing depositary services (“Scheme Securities”) into a segregated and designated trust account or client account. Alternatively, the RA 13 Depositary can register the Scheme Securities in the name of the relevant CIS.[10] An RA 13 Depositary can only deal with Scheme Securities in accordance with written instructions or scheme documents. It must take reasonable steps to ensure that Scheme Securities are not otherwise deposited, transferred, lent or pledged.[11]
Record keeping obligations	In line with the record keeping requirements generally applicable to licensed intermediaries, RA 13 Depositaries are required to keep accounting, custody and other records to sufficiently explain and reflect the financial position and operation of the business, and support accurate profits and loss or income statements.  Specifically, RA 13 Depositaries must also account for all relevant CIS Property, and make sure that its accounting systems can trace all movements of relevant CIS Property.[12]
OTCD reporting	RA 13 Depositaries are exempted from reporting specified over-the-counter (“OTC”) derivative transactions to the Hong Kong Monetary Authority (“HKMA”) when acting as a counterparty to the OTC derivative transaction.[13] Similarly, authorized institutions need not report the OTC derivative transaction to the HKMA if the counterparty of the transaction is an RA 13 Depositary acting in its capacity as a trustee of the relevant CIS.[14]

Further, the SFC has previously clarified that the Managers-In-Charge (“MIC”) requirements under the current licensing framework extend to RA 13 licensees.[15]

III. Are there any additional requirements applicable to specific classes of RA 13 Depositaries?

Schedule 11 sets out additional requirements applicable to specific classes of RA 13 Depositaries. In the table below, we summarize the key requirements applicable to RA 13 Depositaries authorized under the Code on Unit Trusts and Mutual Funds[16] and Code on Pooled Retirement Funds (“UT/RF RA 13 Depositaries”).[17] These are mostly RA 13 Depositaries operating Chapter 7 Funds (i.e. plain vanilla funds investing in equity and/or bunds), specialized schemes (such as hedge funds, listed open-ended funds), and pooled retirement funds.

Appointment and oversight of delegates or third parties	UT/RF RA 13 Depositaries should establish internal control policies and procedures to oversee appointed delegates or third parties. These internal control policies and procedures should cover the following: the selection of a delegate or third party, including assessment procedures and criteria on the delegate or third party’s competence, regulatory and financial status, capabilities and the effectiveness of their internal controls and systems; ongoing and regular monitoring of the delegate or third party to ensure compliance with regulatory requirements and maintenance of effective internal controls and systems; and management of actual or potential conflicts of interests arising from the appointment and oversight of delegates or third parties (where applicable). UT/RF RA 13 Depositaries should also establish appropriate contingency plans to cater for instances of breaches or insolvency of these delegates or third parties.[18]
Oversight of the relevant CIS	UT/RF RA 13 Depositaries should have oversight over the operations of the relevant CIS, and ensure that the CIS is operated or administered in accordance with the relevant constitutive documents.[19]
Subscription and redemption	UT/RF RA 13 Depositaries should monitor the relevant operators of each CIS to ensure (among other things): timely processing of subscription and redemption transactions; execution of subscription and redemption orders in accordance with the constitutive documents of the relevant CIS; timely deposits of subscription and redemption proceeds into a segregated bank account designated as a trust account or client account holding relevant CIS Property; reconciliation of subscription and redemption, and that the frequency of such reconciliation is consistent across subscription and redemption; and proper documentation of reasons for (i) suspension of dealing of unit or shares of the relevant CIS, and (ii) suspension of valuation, price or net asset value calculations of the relevant CIS.[20]
Distribution payments	UT/RF RA 13 Depositaries should supervise the relevant operators of each CIS to ensure that: distributions are calculated in accordance with the constitutive documents of the relevant CIS; and complete and accurate distribution payments are made on a timely basis. With respect to each relevant CIS, UT/RF RA 13 Depositaries should ensure that distribution proceeds are transferred according to the operator’s instruction on a timely basis into a designated and segregated or omnibus bank account.[21]
Custody and safekeeping of CIS Property	UT/RF RA 13 Depositaries can adopt the safeguards to ensure the safekeeping of CIS Property: assess and manage custody risk by making adequate organisational arrangements to minimise the risks of loss of the CIS Property; register the CIS Property in the name of the UT/RF RA 13 Depositary; verify ownership of the CIS Property using reliable sources; maintain updated and comprehensive records of the CIS Property; and ensure reconciliation is carried out daily for CIS Property in cash form.[22]

Notwithstanding the above, there are specific requirements applicable to RA 13 Depositaries authorized under the Code on Real Estate Investment Trusts (“REIT RA 13 Depositaries”).[23] These are RA 13 Depositaries operating closed-ended funds primarily investing in real estate. REIT RA 13 Depositaries are under a fiduciary duty to hold assets of Real Estate Investment Trusts (“REIT”) on trust for the benefit of the unitholders of the REIT. While the requirements applicable to UT/RF RA 13 Depositaries summarized above are generally applicable to REIT RA 13 Depositaries, Schedule 11 tailors some of these requirements to account for the unique features and product structure of REITs. The key modifications are summarized as follows:

Cash flow monitoring and cash reconciliation

Under the Code on Real Estate Investment Trusts (“REIT Code”), the management company of a REIT bears the obligation to manage cash flows. Schedule 11 modifies the custody requirements – which require UT/RF RA 13 Depositaries to carry out cash reconciliation of CIS Property daily – to instead require REIT RA 13 Depositaries to ensure that the management company has put in place proper cash flow management policies and controls, and supervise the implementation of such policies and controls.

Custody and safekeeping of CIS Property

REIT RA 13 Depositaries should ensure that all REIT assets (including the title documents of REIT-owned real estate) are properly segregated and held for the benefit of the unitholders in accordance with the REIT Code and the constitutive document of the REIT. Where the REIT RA 13 Depositary considers it in the interests of the REIT for certain assets of the REIT to be held by the management company on behalf of the REIT, the REIT RA 13 Depositary should make sure that the management company has established proper safeguards and controls to properly segregate REIT assets. Additionally, the REIT RA 13 Depositary must maintain on-going oversight and control over the relevant assets.

IV. What are the next steps?

The SFC has begun accepting licensing applications for RA 13 since July 27, 2023. Depositaries are reminded to submit RA 13 applications on or before November 30, 2023. The RA 13 regime will take effect on October 2, 2024.

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[1] “Circular on Licensing and Registration of Depositaries of SFC-authorised Collective Investment Schemes and Related Transitional Arrangements” (July 27, 2023), published by the SFC, available at https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC32

[2] The final text of Schedule 11 can currently be found at Appendix C, “Consultation Conclusions on Proposed Amendments to Subsidiary Legislation and SFC Codes and Guidelines to Implement the Regulatory Regime for Depositaries of SFC-authorised Collective Investment Schemes” (March 24, 2023), published by the SFC, available at https://apps.sfc.hk/edistributionWeb/api/consultation/conclusion?lang=EN&refNo=22CP1

[3] Namely, the Code on Unit Trusts and Mutual Funds, the Code on Open-Ended Fund Companies, the Code on Real Estate Investment Trusts, and the Code on Pooled Retirement Funds.

[4] “Consultation Paper on the Proposed Regulatory Regime for Depositaries of SFC-authorised Collective Investment Schemes” (September 27, 2019) (“2019 Consultation Paper”), published by the SFC, available at https://apps.sfc.hk/edistributionWeb/api/consultation/openFile?lang=EN&refNo=19CP3

[5] Section 3, “Securities and Futures Ordinance (Amendment of Schedule 5) Notice 2023” (March 20, 2023), available at https://www.gld.gov.hk/egazette/pdf/20232712/es22023271262.pdf

[6] “Scheme document” refers to (i) the trust deed constituting or governing the relevant CIS if the CIS is constituted in the form of a trust, (ii) the documents governing the formation or constitution of the relevant CIS if the CIS is constituted in any other form other than a trust, or (iii) other documents setting out the requirements relating to (a) the custody and safekeeping of any CIS Property, or (b) the oversight of the operations of the relevant CIS.

[7] Amended Schedule 1 of the Securities and Futures (Financial Resources) Rules, set out under section 10 of the “Securities and Futures (Financial Resources) (Amendment) Rules 2023” (March 20, 2023), available at https://www.gld.gov.hk/egazette/pdf/20232712/es22023271256.pdf

[8] Amended rule 10B of the Securities and Futures (Client Money) Rules, set out under section 7 of the “Securities and Futures (Client Money) (Amendment) Rules 2023” (“CMR Amendment Rules”) (March 20, 2023), available at https://www.legco.gov.hk/yr2023/english/subleg/negative/2023ln055-e.pdf

[9] Amended rule 10C of the of the Securities and Futures (Client Money) Rules, set out under section 7 of the CMR Amendment Rules

[10] Amended rule 9B of the Securities and Futures (Client Securities) Rules, set out under section 6 of the “Securities and Futures (Client Securities) (Amendment) Rules 2023” (“CSR Amendment Rules”) (March 20, 2023), available at https://www.legco.gov.hk/yr2023/english/subleg/negative/2023ln054-e.pdf

[11] Amended rules 9C and 10A of the Securities and Futures (Client Securities) Rules, set out under sections 6 and 7 of the CSR Amendment Rules respectively

[12] Amended rule 3A of the Securities and Futures (Keeping of Records) Rules, set out under section 5 of the “Securities and Futures (Keeping of Records) (Amendment) Rules 2023” (“KKR Amendment Rules) (March 20, 2023), available at https://www.legco.gov.hk/yr2023/english/subleg/negative/2023ln057-e.pdf

[13] Amended rule 10 of the Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) Rules, set out under section 4 of the “Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) (Amendment) Rules 2023” (“OTCD Amendment Rules”) (March 20, 2023), available at https://www.legco.gov.hk/yr2023/english/subleg/negative/2023ln061-e.pdf

[14] Amended rule 11 of the Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) Rules, set out under section 5 of the OTCD Amendment Rules

[15] Paragraph 26, 2019 Consultation Paper. The SFC’s MIC requirements are listed in the “Circular to Licensed Corporations Regarding Measures for Augmenting the Accountability of Senior Management” (December 16, 2016), available at https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=16EC68, and the related Frequently Asked Questions published by the SFC (last updated on January 26, 2022), available at https://www.sfc.hk/en/faqs/intermediaries/licensing/Measures-for-augmenting-senior-management-accountability-in-licensed-corporations

[16] “Code on Unit Trusts and Mutual Funds” (January 1, 2019), published by the SFC, available at https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/codes/section-ii-code-on-unit-trusts-and-mutual-funds/section-ii-code-on-unit-trusts-and-mutual-funds.pdf

[17] “Code on Pooled Retirement Funds” (December 2021), published by the SFC, available at https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/codes/code-on-pooled-retirement-funds/code-on-pooled-retirement-funds.pdf?rev=9badf81950734ee08c799832be6ff92b

[18] Section 6, Schedule 11

[19] Section 8, Schedule 11

[20] Section 9, Schedule 11

[21] Section 11, Schedule 11

[22] See section 14, Schedule 11 for the full list of safeguards.

[23] “Code on Real Estate Investment Trusts” (August 2022), published by the SFC, available at https://www.sfc.hk/-/media/EN/files/COM/Reports-and-surveys/REIT-Code_Aug2022_en.pdf?rev=572cff969fc344fe8c375bcaab427f3b

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The following Gibson Dunn lawyers prepared this client alert: William Hallatt, Emily Rumble, 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 (+852 2214 3836, [email protected])
Emily Rumble (+852 2214 3839, [email protected])
Arnold Pun (+852 2214 3838, [email protected])
Becky Chung (+852 2214 3837, [email protected])

© 2023 Gibson, Dunn & Crutcher LLP.  All rights reserved.  For contact and other information, please visit us at www.gibsondunn.com.

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.

The Financial Times recognized Gibson Dunn at the Europe Innovative Lawyer Awards 2023. The firm was selected as overall winner in the Responsible Business category for our work securing the release of Nazanin Zaghari-Ratcliffe from illegal detention in Iran. The firm was also recommended in the Private Capital category for our work advising KKR on its purchase of a minority stake in the fiber network spin-off of Telenor, and in connection with our work on behalf of a German client that was seeking to sell to a private equity buyer, in which our lawyers cut the time required to draft the legal “fact book” from weeks to three days. In addition, the firm was also recognized in the Supporting Refugees and Migrants category as part of the Afghan Pro Bono Initiative. The awards were presented on September 21, 2023.

The German weekly FOCUS recognized Gibson Dunn’s Frankfurt and Munich offices in its annual special issue, “Law and Advice.” The firm is recommended as “Top-Wirtschaftskanzlei 2023″ (top commercial law firm) in the Compliance, Corporate Law, and Mergers & Acquisitions categories. The feature was published on September 16, 2023.

Los Angeles partner Tiaunia Henry was honored at CenterForce’s 2023 Diversity, Equity & Inclusion Impact Awards with the DEI Leadership Award. CenterForce’s Driving Diversity in Law & Leadership Summit and Awards program took place on September 21, 2023 and recognized exceptional leaders throughout Los Angeles for their unwavering commitment to championing diversity, equity and inclusion. Tiaunia was also featured in a panel titled “Pulse Check: Benchmarking DEI Post Pandemic and What Does Success Look Like.”

Tiaunia has been an active member of the LA Area Diversity Committee since joining the firm in 2007. She has served as Co-Chair of Gibson’s LA Area Diversity Committee since 2012 and as Chair of the Affinity Groups for Black attorneys and Women of Color in Los Angeles as well as being actively involved in the Los Angeles Parenting Group. Tiaunia is also responsible for one of the Firm’s most successful diversity programs. She worked closely with Gibson’s Global Diversity Team to spearhead and launch the Diverse Perspectives in the Law Speaker Series, a firmwide program that explores our diverse attorneys’ experiences in navigating issues around race and inclusion throughout their lives and how it has shaped their careers in the legal profession.

Gibson Dunn antitrust practitioners discuss the proposed changes to the DOJ-FTC Merger Guidelines, along with potential implications for the HSR merger review process. The speakers also share practical advice and considerations for M&A going forward.

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The National Law Journal named Theane Evangelis as an Employment Law Trailblazer​ for her work on “the first and only successful challenge to California’s AB5.” The report was published on September 5, 2023.

Theane Evangelis is Co-Chair of the firm’s global Litigation Practice Group. She has served as lead counsel in a wide range of bet-the-company appellate, constitutional, class action, labor and employment, media and entertainment, and crisis management matters in trial and appellate courts across the country.

Starting January 1, 2024, California will be broadening its already expansive prohibitions on employee non-compete agreements.  Senate Bill (SB) 699, signed into law on September 1, 2023, added Section 16600.5 to the Business & Professions Code, which expands California’s existing restrictions on non-competes to agreements created out-of-state and creates new enforcement rights for employees to challenge non-compete clauses.

California’s Business and Professions Code section 16600 currently voids contracts that restrain an employee from engaging in a lawful profession, trade, or business of any kind.  State courts have historically applied Section 16600 to bar agreements made in California restricting post-employment competition, with limited exceptions.[1]

Section 16600.5 will prohibit enforcement of any contract previously forbidden under Section 16600 “regardless of where and when the contract was signed.”  Plaintiffs may capitalize on this broad phrasing to argue that the new law should apply retroactively to any contract with non-compete provisions, and courts will likely have to clarify whether California’s presumption against retroactivity applies.[2]  The new law will further bar “an employer or former employer from attempting to enforce a contract that is void regardless of whether the contract was signed and the employment was maintained outside of California.”[3]  Employers that enter into a contract that is void or attempt to enforce a contract forbidden by Section 16600 will have committed a civil violation.  The expanded restrictions are intended to (i) respond to an increasingly remote talent market, in which “California employers increasingly face the challenge of employers outside of California attempting to prevent the hiring of former employees”; and (ii) to preserve the state’s “competitive business interests” by “protecting the freedom of movement of persons whom California-based employers wish to employ to provide services in California, regardless of the person’s state of residence.”[4]

It remains to be seen how broadly Section 16600.5 will apply in practice, and whether jurisdictional challenges may limit its effect within and outside California.  For example, employees who recently moved to California may cite Section 16600.5 in California courts to try to invalidate non-competes that they previously agreed to, even if such clauses were legally negotiated out-of-state with a non-California employer.  Alternatively, remote workers employed in other states by California employers may try to invoke the provision in their local jurisdictions to invalidate non-competes formed outside of California, even if the employee never set foot in California.  Of course, this raises the question of whether a non-California court will find Section 16600.5 to apply to an employee outside California.  Section 16600.5 also raises the question of whether a California court has the authority to rule a non-compete is unenforceable even if the agreement complies with the law of the state in which it was made or has already been held enforceable by a non-California court.  Employers should monitor whether and to what extent courts apply judicial principles of comity and extraterritoriality in adjudicating these types of cases.[5]

Employers should also be aware that the law authorizes employees, former employees, and prospective employees to seek injunctive relief, actual damages, or both, and entitles a prevailing plaintiff to recover reasonable attorneys’ fees and costs.  But employers who prevail in litigation over restrictive covenants are not entitled under the new law to recover their fees against the losing individuals.  Employers with ties to California are encouraged to review their employee agreements in light of this new law.

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[1] Statutory exceptions to Section 16600 include restrictive covenants in the sale or dissolution of corporations, partnerships, and limited liability corporations.  See Cal. Bus. & Prof. Code §§ 16601, 16602, 16602.5.

[2] Cal. Civ. Code, § 3; Evangelatos v. Super. Ct., 44 Cal. 3d 1188, 1208 (1988) (holding that a statute will not be applied retroactively unless it contains “an express retroactivity provision” or it is “very clear from extrinsic sources that the Legislature . . . must have intended a retroactive application”).

[3] 2023 Cal. S.B. No. 699 (2023-2024 Regular Session).

[4] Id. §§ 1 (d) & (f).

[5] See, e.g., Advanced Bionics Corp. v. Medtronic, Inc., 29 Cal. 4th 697, 706–07 (2002), as modified (Mar. 5, 2003) (applying the comity principle to reason that while “California has a strong interest in protecting its employees from noncompetition agreements” under section 16600, “[a] parallel action in a different state presents sovereignty concerns that compel California courts to use judicial restraint when determining whether they may properly issue a TRO against parties pursuing an action in a foreign jurisdiction.”); Ward v. United Airlines, Inc., 986 F.3d 1234, 1240 (9th Cir. 2021) (discussing the breadth of the extraterritoriality principle).

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The following Gibson Dunn lawyers prepared this client alert: Tiffany Phan, Joseph Rose, Jason C. Schwartz, Katherine V. A. Smith, Stephen Weissman, and Yekaterina Reyzis.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Antitrust and Competition or Labor and Employment practice groups, or the following authors and practice leaders:

Tiffany Phan – Los Angeles (+1 213-229-7522, [email protected])

Joseph R. Rose – San Francisco (+1 415-393-8277, [email protected])

Rachel S. Brass – Co-Chair, Antitrust & Competition, San Francisco (+1 415-393-8293, [email protected])

Stephen Weissman – Co-Chair, Antitrust & Competition, Washington, D.C. (+1 202-955-8678, [email protected])

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

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

© 2023 Gibson, Dunn & Crutcher LLP.  All rights reserved.  For contact and other information, please visit us at www.gibsondunn.com.

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.

Gibson Dunn has advised Zensho Holdings Co., Ltd., Japan’s premier food service company based on sales, on its acquisition of The Snowfox Group, a multi-channel international Japanese food service platform, for $621 million. The Snowfox Group’s global brands include Snowfox, Bento, Taiko and YO! in North America and the United Kingdom.

The Gibson Dunn M&A team was led by Scott Jalowayski, Till Lefranc, and Michelle Gourley. Rachel Brass, Sébastien Evrard, and Steve Pet advised on competition aspects, Carrie LeRoy advised on intellectual property, and Sandy Bhogal advised on tax. Joanne Hughes, Jordan Rex, Dominic Kinsky, and Luisa de Belgique advised on corporate aspects.

New York partner Mylan Denerstein and associate Lee Crain are authors of “Accessing the Courts: Why New York Should Eliminate the Dreaded, Needless and Unduly Complex ‘Certificate of Conformity” [PDF] published by the New York Law Journal on September 6, 2023.

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

Enforcement Actions

United States

1. Feds Charge Tornado Cash Developers Facilitated $1 Billion in Money Laundering

On August 23, the Manhattan U.S. Attorney’s Office brought charges in the Southern District of New York against two developers of Tornado Cash, Roman Storm and Roman Semenov. Tornado Cash is a crypto application that obscures the source of assets transferred through it. Prosecutors allege that more than $1 billion was laundered through Tornado Cash, including hundreds of millions by North Korea’s Lazarus Group. Charges include conspiracy to engage in money laundering, conspiracy to violate U.S. sanctions targeting North Korea, and conspiracy to operate an unlicensed money transmitting business. Storm was arrested and released after posting bond. Also on August 23, the Office of Foreign Asset Control (OFAC) sanctioned Semenov and eight Ethereum addresses allegedly controlled by Semenov. Law360; Forbes; Indictment

2. SEC Brings First Enforcement Actions Alleging NFTs Are Securities

On August 28, the U.S. Securities and Exchange Commission (SEC) issued an order simultaneously filing and settling charges against Impact Theory, LLC, a Los Angeles-based media company, related to its sales of non-fungible tokens (NFTs). Applying the Howey test, the SEC concluded that Impact Theory’s KeyNFTs were investment contracts primarily because Impact Theory’s marketing statements promised “tremendous value” and “massive” appreciation. As part of a settlement of the charges, the SEC ordered Impact Theory to disgorge over $5 million. SEC Commissioners Hester Pierce and Mark Uyeda issued a joint dissent from the order, arguing in part that the tokens were not investment contracts because they were not shares of the company and did not generate any type of dividend for purchasers. Order; Law360; CoinWire

Weeks later, on September 13, the SEC issued an order simultaneously filing and settling charges against Stoner Cats 2 LLC (SC2), alleging an unregistered securities offering in the form of profile-picture NFTs. The order states that SC2 raised approximately $8 million from the sale of around 10,000 NFTs to finance the animated web series Stoner Cats, starring Mila Kunis and Ashton Kutcher. In an accompanying press release, the SEC stated that the offering led “investors to expect profits because a successful web series could cause the resale value of the Stoner Cats NFTs in the secondary market to rise.” SC2 agreed to pay a $1 million fine and destroy all remaining NFTs in its possession. Commissioners Pierce and Uyeda dissented from this order as well, arguing that “the Stoner Cats NFTs are not that different from Star Wars collectibles sold in the 1970s” and that the order “carries implications for creators of all kinds.” Order; Press Release; CoinDesk

3. CFTC Charges DeFi Platforms Over Crypto Derivatives

On September 7, the Commodity Futures Trading Commission (CFTC) issued orders simultaneously filing and settling charges against three decentralized finance (DeFi) trading platforms—Opyn, Inc., ZeroEx (0x), Inc., and Deridex, Inc.—for offering digital asset derivatives trading. The orders require Opyn, ZeroEx, and Deridex to pay civil penalties of $250,000, $200,000, and $100,000, respectively, and “cease and desist from violating the Commodity Exchange Act (CEA) and CFTC regulations.” The companies were all said by the CFTC to have cooperated in the investigation, getting a reduced penalty as a result. “The DeFi space may be novel, complex, and evolving, but the Division of Enforcement will continue to evolve with it and aggressively pursue those who operate unregistered platforms that allow U.S. persons to trade digital asset derivatives,” said Director of Enforcement Ian McGinley. Release; CoinDesk

4. LBRY to Appeal Ruling That It Violated U.S. Securities Law

On September 7, crypto file-sharing protocol LBRY filed a notice of appeal of a New Hampshire federal court’s decision that it failed to register the sale of its native LBRY tokens (LBC) with the SEC. The court’s final judgment ordered LBRY to pay a $111,614 civil penalty and barred it from participating in any unregistered crypto securities offerings in the future. “LBRY is appealing the [court’s] decision because it is unjust and incorrect,” said CEO Jeremy Kauffman. LBRY previously indicated that it would shut down following the July 11 ruling. Notice of Appeal; CoinDesk; CoinTelegraph

5. Former FTX Executive Ryan Salame Pleads Guilty Ahead of Bankman-Fried Trial

On September 7, former top FTX executive Ryan Salame pleaded guilty to one count of conspiracy to operate an unlicensed money transmitting business and one count of conspiracy to make unlawful political contributions and defraud the Federal Election Commission. Salame faces a maximum of 10 years in prison. He also has agreed to forfeit up to $1.5 billion and make restitution of $5.6 million to FTX debtors. His sentencing is set for March 6, 2024. This plea comes less than one month before Sam Bankman-Fried, co-founder of FTX, is set to go to trial on October 2. Salame’s attorney previously told prosecutors he would invoke his Fifth Amendment rights against self-incrimination if called as a witness against Bankman-Fried at trial. CNN; Reuters; New York Times

6. Former OpenSea Head of Product Receives Three-Month Prison Sentence for NFT Insider Trading

On August 23, Nate Chastain, the former Head of Product at OpenSea, the NFT trading platform, was sentenced to three months in prison for making around $50,000 by trading NFTs that he knew would be featured on the OpenSea homepage. In May, he was convicted by a jury of wire fraud and money laundering in what is considered the first insider-trading case involving digital assets. Prosecutors had sought a two-year prison sentence, but U.S. District Judge Jesse Furman imposed a shorter sentence based on Chastain’s limited profits. Judge Furman also sentenced Chastain to 200 hours of community service following his imprisonment, a $50,000 fine, and forfeiture of 15.98 ether. Reuters; Crypto News

Regulation and Legislation

United States

7. Treasury and IRS Propose Tax-Reporting Rules for Crypto Industry

On August 25, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) released controversial proposed regulations governing tax-reporting requirements for the crypto industry. The long-awaited regulations would broaden the definition of “broker” to encompass digital asset trading platforms, payment processors, wallet providers, and “some” DeFi platforms. Under the proposed regulations, starting on January 1, 2025, these entities would be subject to similar tax reporting rules as brokers for securities and other financial instruments. The proposal exempts crypto miners from these requirements. The proposed regulations are open for public comment until October 30. The proposed regulations were criticized by Chairman Patrick McHenry (R-NC) of the House Financial Services Committee as “an attack on the digital asset ecosystem.” Treasury; IRS; Axios; WSJ

8. FASB Announces New Bitcoin Accounting Rules

On September 6, the Financial Accounting Standards Board (FASB) announced forthcoming accounting rules under which companies that hold or invest in cryptocurrencies will be required to report their holdings at fair value. This would allow companies to recognize gains and losses in cryptocurrencies immediately, as they would with other financial assets. This change is widely seen as an improvement over the current practice of treating cryptocurrencies as indefinite-lived intangible assets. The forthcoming rules include other requirements as well, including that companies must make a separate entry in their financial statements for cryptocurrencies. The accounting rules will be mandatory for all companies—public and private—for fiscal years beginning after December 15, 2024, including interim periods within those years. WSJ; Bloomberg

International

9. UK Crypto Firms Can Apply for Extra Time to Comply with New Restrictions on Crypto Promotions

On September 7, the UK’s Financial Conduct Authority (FCA) announced that UK crypto firms could be given an extra three months to implement new restrictions on crypto promotions. The “[t]ough new rules designed to make the marketing of cryptoasset products clearer and more accurate” are set to take effect on October 8, but can be delayed until January 2024 for otherwise compliant firms to develop the right technical setup. The FCA said that it still intends to take enforcement action against overseas or unregulated firms that continue to unlawfully market to UK consumers starting October 8. Release; CoinDesk

10. Travel Rule Regulation Goes into Force in the UK for Crypto Asset Firms

On September 1, a new rule requiring crypto firms in the UK to comply with the Financial Action Task Force’s Travel Rule went into effect. The UK Travel Rule requires UK-based Virtual Asset Service Providers (VASPs) to collect, verify, and share information on domestic and cross-jurisdictional transactions. According to an FCA statement, crypto businesses domiciled in the UK are required to “comply with the rule when sending or receiving a cryptoasset transfer to a firm that is in the UK, or any jurisdiction that has implemented the Travel Rule.” If information is missing or incomplete, businesses must make a risk-based assessment before releasing the cryptoassets to the beneficiary. FCA Statement; The Block

Civil Litigation

United States

11. D.C. Circuit Vacates SEC Denial of Grayscale Bitcoin ETF as Arbitrary and Capricious

On August 29, the U.S. Court of Appeals for the D.C. Circuit ruled that the SEC will have to take another look at Grayscale Investments’ application to list a bitcoin exchange-traded product (ETP), because the SEC’s rejection of the submission was “arbitrary and capricious” and thus violated the Administrative Procedure Act. The three-judge panel’s unanimous ruling was authored by Judge Neomi Rao (a President Trump appointee) and was joined by Judges Edwards and Srinivasan (President Carter and Obama appointees, respectively). The court concluded that the SEC “failed to adequately explain why it approved the listing of two bitcoin futures ETPs but not Grayscale’s” proposed spot product, and rejected every rationale offered by the SEC for treating bitcoin spot ETPs differently than comparable bitcoin futures products. “In the absence of a coherent explanation,” the court concluded, “this unlike regulatory treatment of like products is unlawful.” The court’s ruling requires the SEC to reconsider Grayscale’s application, but it does not require the SEC to approve the application. Opinion; Law360; Barron’s

12. Federal Court Dismisses Uniswap Class Action

On August 30, U.S. District Court Judge Katherine Polk Failla dismissed a class action suit brought against Uniswap and its developers and investors by users claiming that they lost money on scam tokens sold on the Uniswap platform. In dismissing the claims, Judge Failla reasoned in part that “the identities of the Scam Token issuers are basically unknown and unknowable” due to Ethereum’s “decentralized nature,” and that the plaintiffs’ claims therefore were akin to “attempting to hold an application like Venmo or Zelle liable for a drug deal that used the platform to facilitate a fund transfer.” Judge Failla also rejected the plaintiffs’ claims that Uniswap was liable for the losses under the Securities Exchange Act of 1934, refusing to “stretch the federal securities laws to cover the conduct alleged.” In rejecting the securities-law claims, Judge Failla stated in passing that ether and bitcoin are “crypto commodities,” potentially suggesting that she believes those assets are not subject to the securities laws at all. Judge Failla also is presiding over the SEC’s enforcement action against Coinbase. Opinion; Fortune; Bitcoinist

13. New York Federal Court Holds that Electronic Fund Transfer Act Does Not Apply to Certain Crypto Transactions

On August 11, Judge Lewis J. Liman dismissed a claim asserting that the Electronic Fund Transfer Act (EFTA) applies to cryptocurrency transactions. In Yuille v. Uphold HQ, Inc., No. 1:22-cv-07453 (S.D.N.Y. Aug. 11, 2023 ), a Michigan retiree sued Uphold HQ, a crypto trading platform and wallet provider, after a hacker drained $5 million from his account. The plaintiff argued in part that Uphold HQ failed to meet the requirements of the EFTA, which imposes obligations on financial institutions to expeditiously investigate and correct errors related to electronic fund transfers. Earlier this year, a different judge in separate suit against Uphold held that the term “electronic funds transfer” in the EFTA was capacious enough to include crypto transactions. Rider v. Uphold HQ Inc., 2023 WL 2163208 (S.D.N.Y. Feb. 22, 2023) (Cote, J.). Instead of resolving that issue, Judge Liman held that the plaintiff’s transactions fell outside the EFTA because his crypto wallet was not an “account,” which is defined under the Act to include only accounts “established primarily for personal, family, or household purposes.” Judge Liman held that the plaintiff’s crypto wallet account was instead established primarily for profit-making purposes. Opinion; Law360

14. Gemini Earn Customers Could Recover All Funds in New Proposed Renumeration Scheme

On September 13, bankrupt crypto lender Genesis and its parent company Digital Currency Group (DCG) filed a new proposed remuneration plan. Genesis and DCG stated that, under the proposal, over 230,000 creditors who used Gemini’s Earn program “are estimated to recover approximately 95-110% of their claims.” Gemini Earn was an investment program implemented by crypto exchange Gemini with financing from Genesis. Gemini Earn customers were affected when Genesis was forced to freeze withdrawals and its lending arm—Genesis Global Holdco LLC—filed for bankruptcy in January 2023. DCG hopes to file an amended version of the proposed plan by October 6, and solicit votes by December 5. On September 15, Gemini issued a statement criticizing the proposed plan as “misleading at best and deceptive at worst.” Gemini stated that “[r]eceiving a fractional share of interest and principal payments over seven years from an incredibly risky counterparty . . . is not even remotely equivalent to receiving the actual cash and digital assets owed today by Genesis to the Gemini Lenders.” Proposed Agreement; CoinTelegraph; CoinDesk; Gemini Filing

Speaker’s Corner

United States

15. Former SEC Chair Says Spot Bitcoin ETF Approval Is ‘Inevitable’

On September 1, former SEC chair Jay Clayton appeared on CNBC Television to discuss the SEC’s deferral of bitcoin ETP applications: “It is clear that bitcoin is not a security. It is clear that bitcoin is something that retail investors want access to, institutional investors want access to, and, importantly, some of our most trusted providers who are fiduciaries or have duties of best interest want to provide this product to the retail public. So I think [spot bitcoin ETP] approval is inevitable,” Clayton told CNBC. Clayton’s comments follow a federal court’s ruling in Grayscale v. SEC (discussed above) that there was no justification for the SEC to allow bitcoin futures-based ETPs but deny spot bitcoin ETPs. CNBC; The Block; Grayscale Opinion

16. SEC Chair Gary Gensler Testifies Before Senate Banking Committee

On September 12, SEC Chair Gary Gensler testified before the Senate Banking Committee in an SEC oversight hearing. In his prepared testimony, Gensler maintained his stance that most cryptocurrencies qualify as securities that should be regulated by the SEC: “As I’ve previously said, without prejudging any one token, the vast majority of crypto tokens likely meet the investment contract test.” Gensler also reiterated his strong criticism of the crypto industry: “I’ve never seen a field that’s so rife with misconduct,” said Gensler. “It’s daunting.” The most substantive discussion on digital assets came during questioning from Senator Cynthia Lummis (R-WY), who expressed concerns over Gensler issuing an SEC staff bulletin that would require companies to report customer crypto assets on their balance sheets. Also during the hearing, Chairman Sherrod Brown (D-OH) was highly critical of the crypto industry. “The problems we saw at FTX are everywhere in crypto—the failure to provide real disclosure, the conflicts of interest, the risky bets with customer money that was supposed to be safe,” said Brown. Brown also praised the SEC’s approach to regulating crypto: “I’m glad the SEC is using its tools to crack down on abuse and enforce the law.”

Gensler is scheduled to testify next before the House Financial Services Committee on September 27. These scheduled appearances follow mounting criticism from lawmakers over the SEC’s approach to regulating crypto, which they argue prioritizes enforcement over providing clear guidance. Sept. 12 Prepared Testimony; Sept. 12 Hearing; CryptoSlate; CryptoNews

International

17. Chinese Central Bank Official Says China’s Digital Yuan Must Be Available in All Retail Scenarios

During a trade forum in Beijing on September 3, Changchun Mu, the head of the digital currency research institute at the People’s Bank of China, said that an essential step for the development of China’s digital yuan “is to use digital yuan as the payment tool for all retail scenarios.” Although the digital yuan is being tested in pilot regions across China, it remains far from achieving widespread adoption. “In the short term, we can start by unifying QR code standards on a technical level to achieve barcode interoperability,” Mu added. Mu’s comments follow the Chinese central bank’s pledge last year to push for universal QR payment codes. The use of QR code payment systems, dominated by WeChat Pay and Alipay, is already widespread in China. The Block; CoinTelegraph

Other Notable News

18. SEC Defers Decisions on All Bitcoin ETFs

On August 31, the SEC delayed until October its decisions on all pending applications for a spot bitcoin exchange-traded product, which have been filed by BlackRock, Grayscale Investments, and others. The SEC’s decisions come days after Grayscale won a key victory over the SEC (discussed above), which many have viewed as clearing a path for the long-awaited product. Bloomberg; CoinDesk; PiOnline

19. Visa to Use Solana and USDC Stablecoin to Boost Cross-Border Payments

On September 5, Visa announced that it has expanded its stablecoin settlement capabilities with Circle’s USDC stablecoin to the Solana (SOL) blockchain. According to its statement, Visa is one of the first major financial institutions to use the Solana network at scale for settlements. “By leveraging stablecoins like USDC and global blockchain networks like Solana and Ethereum, we’re helping to improve the speed of cross-border settlement and providing a modern option for our clients to easily send or receive funds from Visa’s treasury,” said Cuy Sheffield, head of crypto at Visa, in a statement. CoinDesk; The Block

20. Vitalik Buterin Co-Authors Paper on Regulation-Friendly Tornado Cash Alternative

On September 9, Ethereum co-founder Vitalik Buterin published a research paper that he co-authored with Ethereum core developer Ameen Soleimani, researcher Jacob Illum from blockchain analytics firm Chainalysis, and academics Matthias Nadler and Fabian Schar. The paper proposes a privacy protocol called Privacy Pools. The core idea of the proposal is to allow users to publish a zero-knowledge proof, demonstrating that their funds do not originate from unlawful sources, without publicly revealing their entire transaction graph. The authors argue that this proposal, if implemented, could allow financial privacy and regulation to co-exist. SSRN; The Block

21. FTX, BlockFi, and Genesis Claimant Data Breached in Cyberattack

On August 25, Kroll LLC, announced that cybercriminals exposed data belonging to claimants in the FTX, BlockFi, and Genesis Global Holdco bankruptcies following a sophisticated cyberattack directed against Kroll employees. Kroll stated that a cybercriminal targeted a cell phone account belonging to one of its employees “in a highly sophisticated ‘SIM swapping’ attack.” Law360; CoinDesk

22. Ant Group Launches Overseas Blockchain Brand ZAN

On September 8, Ant Group—the owner of the world’s largest mobile payment platform, Alipay—launched ZAN, a new blockchain service aimed at Hong Kong and overseas markets. According to the official press release, ZAN “comprises of a full suite of blockchain application development products and services for both institutional and individual Web3 developers.” ZAN will also provide “a series of technical products, including electronic Know-Your-Customer (eKYC), Anti-Money Laundering (AML) and Know-Your-Transactions (KYT), to help Web3 businesses build up their capabilities in customer identity authentication, security protection and risk management.” Press Release; CoinTelegraph; The Block

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The following Gibson Dunn lawyers prepared this client alert:  Ashlie Beringer, Stephanie Brooker, Jason Cabral, M. Kendall Day, Jeffrey Steiner, Sara Weed, Ella Capone, Grace Chong, Chris Jones, Jay Minga, Nick Harper, Apratim Vidyarthi, Alexis Levine, Zachary Montgomery, and Tin Le.

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

FinTech and Digital Assets Group:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

© 2023 Gibson, Dunn & Crutcher LLP.  All rights reserved.  For contact and other information, please visit us at www.gibsondunn.com.

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.

Asian Legal Business named Gibson Dunn the “Tax and Trusts Firm of the Year” at the ALB Hong Kong Law Awards 2023. The awards recognize the exceptional performance of private practitioners and in-house counsel in Hong Kong. The awards were presented on September 15, 2023.

Gibson, Dunn & Crutcher’s Hong Kong office provides an extensive range of U.S., Hong Kong and English legal advice to global and Asia-based clients. We offer our clients all the advantages of deep local expertise combined with the strengths of a global firm. Our lawyers handle some of the most challenging and complex transactions, regulatory matters and disputes across Asia. Lawyers in the office have lived and worked in the region for many years and possess an in-depth understanding of Hong Kong’s legal and business culture. The Hong Kong team works closely with our Beijing and Singapore offices to provide complete and seamless legal services throughout Asia.

Gibson, Dunn & Crutcher LLP is pleased to announce that Kavita Davis has joined its Global Finance Practice Group as a partner in the London office.

Kavita focuses on cross-border debt finance matters, and has significant experience in advising on leveraged buyouts representing sponsors, including sponsors focusing on infrastructure transactions. She received her B.A., LL.B. (Hons) from the W.B. National University of Juridical Sciences in India, and is admitted as a solicitor in England and Wales.

Federico Fruhbeck, Co-Chair of Gibson Dunn’s Projects and Infrastructure Practice Group and Head of Private Equity in Europe, said: “Our lawyers know Kavita well, having worked closely with her on complex cross-border deals. Her practice has a great number of synergies with groups around the firm, as is evident, for example, with her significant experience representing sponsor clients in private equity acquisitions in the infrastructure, industrial and real assets space.” Doug Horowitz, Co-Chair of Gibson Dunn’s Global Finance Practice Group added: “Beyond being especially well known in the global infrastructure finance world, Kavita’s broad finance skill set allows her to be immediately impactful to our clients around the globe with English law finance needs.”

Penny Madden, Co-partner in charge of Gibson Dunn’s London office, said: “We are excited to welcome Kavita to the firm and to the London office. Over the last few years we have attracted fantastic talent to join our growing transactional practices in London, and her arrival strengthens our finance bench, allowing us to expand our offering to clients around the globe.”

Kavita noted: “It is a fantastic time to be joining Gibson Dunn’s growing finance practice and the firm’s focus on infrastructure transactions was a particular draw.”

Kavita’s hire follows a period of growth for Gibson Dunn’s Finance Practice Group over the past year, including with the arrivals of partners Doug Horowitz and Jin Hee Kim in New York; Frederick Lee in Dallas; Chad Nichols in Houston/New York; Ben Shorten and Trinh Chubbock in London; and Darko Adamovic in Paris. Her arrival also complements the strategic build out of the Projects and Infrastructure Practice Group, with high profile hires including Federico Fruhbeck, Alice Brogi, Rob Dixon, Wim De Vlieger, Till Lefranc and Isabel Berger in London; and Marwan Elaraby, Renad Younes, Laleh Shahabi, Jade Chu and Samuel Ogunlaja in the UAE.

Over the last two weeks, both the House of Commons and the House of Lords have considered the Economic Crime and Corporate Transparency Bill (“the Bill”). The government has described the Bill as the most significant reform of the identification doctrine in more than 50 years and the proposals have been welcomed by the UK’s Serious Fraud Office.

Although there is an outstanding point of contention for corporate criminal liability reform relating to the scope of the failure to prevent fraud offence, and in particular, whether it should be limited to large organisations, or expanded to non-micro organisations, the Bill is now in the final stages of its passage through Parliament and some commentators have indicated it could receive royal assent before the end of this year.

Key Takeaways The Bill proposes a number of changes to the current law including an expansion of the identification principle and a new offence of failure to prevent fraud. Organisations can be held liable for actions of “senior managers” for the purposes of prosecuting relevant economic crimes.  Organisations should identify and train individuals who fall within this definition. In anticipation of the new offence of failure to prevent fraud coming into force, organisations must ensure reasonable procedures are in place to prevent fraud.  This could include: carrying out a fraud risk assessment; updating existing policies to identify and mitigate fraud risk; ensuring staff are properly trained and retaining training records; and ongoing monitoring of risk and compliance with policies.

The identification principle – the current position

With the exception of a small number of specific offences, including the existing failure to prevent offences under the Bribery Act 2010 and the Criminal Finances Act 2017, in order for a corporate entity to be held criminally liable for the actions of an individual, that individual must be the “directing mind and will” of the corporate entity. This is called the “identification principle”.

The leading case on the identification principle is Tesco Supermarkets Ltd v Nattrass,[1] which states that one has to identify “those natural persons who by the memorandum and articles of association or as a result of action taken by the directors, or by the company in general meeting pursuant to the articles, are entrusted with the exercise of the powers of the company”, also referred to as the primary rule of attribution.

The principle has been narrowly applied and prosecutors have had difficulty satisfying the test in a number of high profile cases including The Serious Fraud Office v Barclays PLC and Barclays Bank PLC.[2] In that case, Davis LJ found that despite the defendants being senior executive directors and two of those defendants being on the board, their actions could not be attributed to Barclays because they had not been delegated entire authority to complete the relevant acts. Davis LJ noted that the “status” of an individual is a relevant consideration, but the focus should be on the particular authority bestowed by the company for the performance of the particular function in question.

The Barclays case and others like it have triggered debate about whether the identification principle, now over fifty years old, is fit for purpose when dealing with large multinational companies with complex management structures. As it stands, smaller companies with simpler structures are more exposed to criminal prosecution given the relative ease in demonstrating which individuals control and direct the company’s actions. This has prompted concern that larger companies are not being held to account for criminal wrongdoing carried out on their behalf. The proposals to reform corporate criminal liability laws, discussed below, seek to address these difficulties.

Proposed reforms

1. New approach to “attributing criminal liability for economic crimes to certain bodies”

Rather than relying on the identification principle, under the new legislation, the corporate entity will be liable for actions committed by a “senior manager” acting within the actual or apparent scope of their authority.

“Senior manager” is defined as an individual who plays a significant role in:

• the making of decisions about how the whole or a substantial part of the activities of the body corporate or partnership are to be managed or organised, or
• the actual managing or organising of the whole or a substantial part of those activities.[3]

This definition is adopted from the Corporate Manslaughter and Corporate Homicide Act 2007. The Explanatory Notes to the Corporate Manslaughter and Corporate Homicide Act 2007 state that this covers both individuals in the direct chain of management, and those in, for example, strategic or regulatory compliance roles.[4] The practical impact is that the pool of potential employees whose criminal conduct could be attributed to a corporate body is widened potentially very substantially.

At this stage, the reforms to the way in which liability is attributed to an organisation will only apply to economic crimes specified in the Bill, such as offences relating to fraud, bribery, theft, false accounting and concealing criminal property.[5] However, whilst the current focus is on economic crimes (which reportedly make up over 40% of crime in the UK[6]), the government has “committed in the Economic Crime Plan 2 and the Fraud Strategy to introduce reform of the identification principle to all criminal offences in due course”.[7]

The explanatory notes to amendments made by the House of Lords following the third reading in July 2023 state that the Bill “ensures that criminal liability will not attach to an organisation based and operating overseas for conduct carried out wholly overseas, simply because the senior manager concerned was subject to the UK’s extraterritorial jurisdiction: for instance, because that manager is a British citizen […] However, certain offences, regardless of where they are committed, can be prosecuted against individuals or organisations who have certain close connections to the UK. Any such test will still apply to organisations when the new rule applies”.[8]

The reform of the identification principle is intended to make it easier for authorities to pursue corporates for primary fraud and bribery offences rather than just failure to prevent offences. Although “senior manager” is now defined, it will still be subject to judicial interpretation and the courts may favour a narrow interpretation, as in The Serious Fraud Office v Barclays PLC and Barclays Bank PLC.[9] The government has also concluded in its Impact Assessment that whilst the reforms to the identification principle are expected to increase the number of corporate prosecutions, the number of additional cases is expected to be low.[10]

2. Failure to prevent fraud

In addition to broadening the general scope for corporate criminal liability, a new corporate offence of failure to prevent fraud will also be introduced. This new offence borrows from both the existing offences of failure to prevent bribery under the Bribery Act 2010 and failure to prevent the facilitation of tax evasion under the Criminal Finances Act 2017.

Under the new offence, if they meet specific criteria, large corporates and partnerships will be held criminally liable where:

• a specified fraud offence is committed by an employee or agent (such as fraud by false representation, fraud by abuse of position or fraud by failing to disclose information); and
• the offence benefits the organisation.

The prosecution must establish both limbs of the offence set out above. However the company will have a defence if it can show it either had “reasonable procedures” in place to prevent the fraud, or that it was not reasonable to have relevant procedures at all. This is said to place a lesser burden on organisations than the requirement to have “adequate procedures” under the Bribery Act 2010.[11] As with the Bribery Act and the Criminal Finances Act there is a requirement for the government to issue “guidance about procedures that relevant bodies can put in place to prevent persons associated with them from committing fraud offences”.[12] This has not yet been issued but it is likely to include detailed policies, procedures and training.

The House of Lords disagreed with the House of Commons that the failure to prevent fraud offence should only apply to large organisations. They voted to amend the Bill so that the offence applies to “non-micro organisations” which satisfy two or more of the following conditions in a financial year: (i) turnover of more than £632,000 and less than £36 million; (ii) a balance sheet total of more than £316,000 and less than £18 million; and (iii) more than 10 but less than 250 employees.[13] In support of this amendment, Lord Garnier referred to the fact there is no exemption for small and medium enterprises for the offence of failure to prevent bribery and proposed that only the very smallest and newest commercial organisations should be exempted from the failure to prevent regime.[14] The Commons rejected these amendments on Wednesday 13 September and the Bill has been returned to the Lords for further consideration.

Extraterritorial reach

The failure to prevent fraud offence has wide extraterritorial effect, applying to a body corporate or a partnership wherever they are incorporated or formed.[15] The government factsheet summarising the failure to prevent fraud offence explains that: “if an employee commits fraud under UK law, or targeting UK victims, their employer could be prosecuted, even if the organisation (and the employee) are based overseas”.[16]

Impact

The failure to prevent fraud offence is making headlines and will inevitably need to be given serious consideration by large organisations. The new legislation is designed to close “loopholes that have allowed organisations to avoid prosecution in the past”.[17]

The government believes that the changes will “result in a deterrent effect where increased awareness and corporate liability may deter would-be fraudsters”. [18] Perhaps most compellingly, the government intends that the legislation will create cultural change and encourage the development of an anti-fraud culture within organisations.[19]

Post-legislative scrutiny of the Bribery Act 2010 identified a changing and improved corporate anti-bribery culture following the introduction of the failure to prevent bribery offence. The government hopes that the proposed changes will have a similar impact for fraud and will promote a corporate culture in which fraud detection and prevention are encouraged.[20]

It is not clear how many prosecutions the failure to prevent fraud offence will give rise to – the Serious Fraud Office (“SFO”) has only prosecuted two corporations for failure to prevent bribery since the Bribery Act came into force in 2011.[21] On the other hand, the offence of failure to prevent bribery has featured in nine of the twelve deferred prosecution agreements (“DPAs”) entered into since DPAs were introduced in February 2014.  The SFO is likely to take a similar approach to prosecuting failure to prevent fraud offences.

Practical steps

In anticipation of the Economic Crime and Corporate Transparency Act coming into force, we have set out some practical steps to be considered:

• Risk assessments: carry out and document appropriate risk assessments, identifying relevant fraud risks.
• Reasonable policies and procedures: identify and update relevant existing policies or introduce new policies to ensure the new offences are taken into account and to mitigate the fraud risks identified in the risk assessment.
• Reporting: ensure appropriate channels are in place for reporting suspicions of fraud.
• Identification of potential senior managers: identify which individuals and roles may fall into the definition of “senior manager”. Ensure those individuals receive adequate training on fraud risk and applicable policies and procedures and are appropriately monitored.
• Raising awareness within the company: provide adequate training to employees to embed fraud policies and procedures and ensure that employees are aware of appropriate channels for reporting suspicions of fraud. Records of this training should be retained.
• Ongoing monitoring: procedures should be put in place for the ongoing monitoring of fraud risk, compliance with relevant policies and procedures (including the effectiveness of fraud detection processes), and the conduct of individuals. Companies should monitor and review their effectiveness on a regular basis to ensure that necessary improvements are made when required.

Whilst the timeline for the Bill receiving royal assent and being implemented is uncertain, it is important to understand the proposed changes and how to prepare for their implementation. The reforms demonstrate a cultural change and appetite for greater scrutiny of corporate entities. It will be interesting to see how they are used by law enforcement authorities once the Bill is passed.

Irrespective of the final content of the Bill, there is no doubt that it is a significant change for the corporate criminal liability landscape within the UK.
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[1] [1972] AC 153.

[2] [2018] EWHC 3055 (QB).

[3] https://bills.parliament.uk/publications/51963/documents/3729.

[4] https://www.legislation.gov.uk/ukpga/2007/19/section/1/notes?view=plain.

[5] https://bills.parliament.uk/publications/51963/documents/3729.

[6] https://www.gov.uk/government/publications/fraud-strategy/fraud-strategy-stopping-scams-and-protecting-the-public.

[7] https://www.gov.uk/government/publications/economic-crime-and-corporate-transparency-bill-2022-factsheets/factsheet-identification-principle-for-economic-crime-offences.

[8] https://hansard.parliament.uk/lords/2023-06-27/debates/EF8264AF-6478-470E-8B37-018C4B278F6E/EconomicCrimeAndCorporateTransparencyBill.

[9] [2018] EWHC 3055 (QB).

[10] See attachment here.

[11] See attachment here.

[12] Section 203 of the Bill https://bills.parliament.uk/publications/51963/documents/3729.

[13] https://publications.parliament.uk/pa/bills/cbill/58-03/0363/220363.pdf.

[14] https://hansard.parliament.uk/Lords/2023-09-11/debates/181F85C9-5619-4DAF-BD42-327C0DAF036F/EconomicCrimeAndCorporateTransparencyBill.

[15] https://bills.parliament.uk/publications/52462/documents/3896.

[16] https://www.gov.uk/government/publications/economic-crime-and-corporate-transparency-bill-2022-factsheets/factsheet-failure-to-prevent-fraud-offence.

[17] https://www.gov.uk/government/publications/economic-crime-and-corporate-transparency-bill-2022-factsheets/factsheet-failure-to-prevent-fraud-offence.

[18] See attachment here.

[19] https://bills.parliament.uk/publications/50688/documents/3279.

[20] https://bills.parliament.uk/publications/50688/documents/3279.

[21] https://bills.parliament.uk/publications/50688/documents/3279.

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Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you wish to discuss any of the matters set out above, please contact the Gibson Dunn lawyer with whom you usually work, any member of Gibson Dunn’s White Collar Defense and Investigations practice group, or the following authors in London:

Michelle M. Kirschner (+44 20 7071 4212, [email protected])
Matthew Nunan (+44 20 7071 4201, [email protected])
Allan Neil (+44 20 7071 4296, [email protected])
Patrick Doris (+44 20 7071 4276, [email protected])
Maria Bračković (+44 20 7071 4143 [email protected])
Amy Cooke (+44 20 7071 4041, [email protected])
Rebecca Barry (+44 20 7071 4086, [email protected])

We have seen many notable developments in securities law during the first half of 2023 across a number of different areas.  This update provides an overview of those major developments in federal and state securities litigation since our 2022 Year-End Securities Litigation Update:

• We discuss major Supreme Court decisions from October Term 2022, and preview several significant grants of certiorari. In addition, we examine circuit court-level developments that may end up before the Supreme Court.
• We review significant developments in Delaware corporate law, including a number of decisions concerning fiduciary duties in the context of a merger or acquisition, and the intersection of Unocal, Schnell, and Blasius when board action implicates the stockholder franchise.
• We examine developments in federal securities litigation involving special purpose acquisition companies (“SPACs”). As fewer SPAC IPOs and de-SPAC transactions occur, relative to the peak in 2021, we have also seen fewer new SPAC-related cases filed.  Earlier SPAC-related litigation continues to proceed through courts—we discuss a proposed class action settlement and two recent decisions on statutory standing.
• We examine developments in securities litigation involving environmental, social, and corporate governance (“ESG”) allegations.
• We survey litigation in the cryptocurrency space as courts continue to grapple with the application of securities laws to cryptocurrencies.
• We discuss the shareholder activism landscape, including recent proxy battles and new SEC regulations related to shareholder proposals and proxy elections that could potentially encourage shareholder activists going forward.
• We continue to monitor the emergence of a potential circuit split regarding the Supreme Court’s 2019 decision in Lorenzo, which allows scheme liability under Rule 10b-5(a) and (c) even if the disseminator did not “make” the statement within the meaning of Rule 10b-5(b). As discussed in our 2022 Mid-Year Securities Litigation Update, a number of courts have grappled with the effects of Lorenzo.  In particular, the Second Circuit in SEC v. Rio Tinto provided some clarity for district courts within the Circuit by finding that “something extra” is required beyond misstatements for there to be scheme liability.  A recent district court opinion in California, however, acknowledged that the Ninth Circuit has not adopted Rio Tinto.
• Finally, we discuss the Second Circuit’s long-awaited decision in Arkansas Teacher Retirement System v. Goldman Sachs Group, Inc., and a district court’s application of Goldman Sachs Group, Inc. v. Arkansas Teacher Retirement System in denying class certification in part.

I. Filing and Settlement Trends

With thanks to analysis from Cornerstone Research, new filings have increased from 93 total securities class action filings in the first half of 2022 to 114 filings in the first half of 2023.  Although the median value of settlements has increased compared to the same period in 2022, the number and total value of settlements are lower than any year since 2017.  SPAC-, COVID-19-, and cryptocurrency-related filings continue to be a focus, even as the nature of such suits continues to evolve.

A. Filing Trends

Figure 1 below reflects the semiannual filing rates dating back to 2014 (all charts courtesy of Cornerstone Research).  For the fourth six-month period in a row, new filings remained at or below the historical semiannual average.  Notably, at 114, filings in the first half of 2023 barely top 50% of the average semi-annual filing rates seen between 2017 and 2019, though this deficit is largely driven by a substantial decrease in M&A-related filings.  The 110 total new “core” cases—i.e., securities cases without M&A allegations—filed in the first half of 2023 represent a modest increase from the semi-annual periods since the first half of 2021.

Figure 1:

Semiannual Number of Class Action Filings (CAF Index®)
January 2014 – June 2023

As illustrated in Figure 2 below, cryptocurrency-related actions are nearly on pace to match the record high set in 2022.  The annualized number of COVID-19 and SPAC-related filings are markedly lower than prior years.  Cybersecurity-related actions are on pace to be in line with historical averages.

Figure 2:

Summary of Trend Cases—Core Federal Filings
2019 – June 2023

B. Settlement Trends

The first half of 2023 has seen fewer settlements and less total settlement value than any semi-annual period since 2017.  Just 32 settlements have been approved through June 2023.  Similarly, as reflected in Figure 3, the total settlement value in the first half of 2023 is just $700 million, down from a high of $4.4 billion in the first half of 2018 and $2.3 billion in the previous semi-annual period.  The low total settlement value is largely a product of fewer settlements and fewer large settlements (there has only been one settlement greater than or equal to $100 million through June 2023).  The median value of settlements approved in the first half of 2023 is nonetheless $16.3 million, however, an increase of over 25% from the median value for the same period in 2022.

Figure 3:

II. What to Watch for in the Supreme Court

A. Recent Supreme Court Decisions

1. Slack Prevails at the Supreme Court

On June 1, 2023, the Supreme Court unanimously held that in a direct listing (as in traditional initial public offerings), a plaintiff who claims that a company’s registration statement is misleading and who sues under Section 11 of the Securities Act of 1933 must plead and prove that they bought shares registered under that registration statement.  Slack Techs., LLC v. Pirani, 143 S. Ct. 1433 (2023).  See our 2022 Year-End Securities Litigation Update for additional background on the case.

The Court’s opinion adopted the longstanding “tracing” requirement, noting that although “direct listings are new, the question how far § 11(a) liability extends is not,” and that “every court of appeals to consider the issue . . . reached the . . . conclusion”—like the Court—that “[t]o bring a claim under § 11, the securities held by the plaintiff must be traceable to the particular registration statement alleged to be false or misleading.”  Slack Techs, 143 S. Ct. at 1440–41.  In so concluding, the Court rejected Pirani’s textual argument—that the key phrase, “such security,” “should [be] read . . . to include other securities that bear some sort of minimal relationship to a defective registration statement”—and his arguments “from policy and purpose.”  Id. at 1441.  And in rejecting Pirani’s view of Section 11, the Court avoided an interpretation that could have unsettled the scope of liability under that section in cases beyond direct listings, including traditional IPOs and follow-on offerings.  The Court’s holding thus protects reasonable expectations and avoids a potentially massive increase in litigation for companies that recently went public.

The Court, however, declined to resolve whether Section 12 of the ‘33 Act, which enforces the Act’s prospectus requirement and permits anyone who buys “such security” from the defendant to sue, 15 U.S.C. § 77l(a)(1), likewise requires proof of purchase of registered shares.  It “express[ed] no views” about that question and remanded the matter to the lower courts to decide that question in the first instance.  Id. at 1442 n.3.  Gibson Dunn will provide further updates on this case and related issues as they arise.

Gibson Dunn represented Slack Technologies, LLC in the case.  Thomas Hungar, a Gibson Dunn partner in the Washington, D.C. office, argued the case on its behalf.

2. Axon and Cochran Prevail at the Supreme Court

As detailed in our 2022 Year-End Securities Litigation Update, the Supreme Court heard oral argument in Securities and Exchange Commission v. Cochran, No. 21-1239, and a companion case, Axon Enterprise, Inc. v. Federal Trade Commission, No. 21-86, on November 7, 2022.

On April 14, 2023, the Supreme Court issued its decision and determined that “the review schemes set out in the Exchange Act and the FTC Act do not displace district court jurisdiction over Axon’s and Cochran’s far-reaching constitutional claims.”  Axon Enter., Inc. v. Fed. Trade Comm’n, 143 S. Ct. 890, 900 (2023).  In reaching its conclusion, the Court considered the three factors set forth in Thunder Basin Coal Co. v. Reich, 510 U.S. 200 (1994):  (1) whether precluding district court jurisdiction could “foreclose all meaningful judicial review” of the claim, (2) whether the claim is “wholly collateral” to the statute’s review provisions, and (3) whether the claim is “outside the agency’s expertise,” Axon, 143 S. Ct. at 900.

In an opinion authored by Justice Kagan, the Court found all three factors weighed in favor of federal court jurisdiction.  First, relying on internal administrative review would “foreclose all meaningful judicial review” because Cochran and Axon would lose their “rights not to undergo the complained-of agency proceedings if they cannot assert those rights until the proceedings are over.”  Id. at 904.  Second, Axon’s and Cochran’s claims had “nothing to do with either the enforcement-related matters the Commissions regularly adjudicate or those they would adjudicate in assessing the charges against Axon and Cochran,” and were thus wholly collateral.  Id. at 904–05.  Finally, Axon’s and Cochran’s constitutional assertions were “outside the agency’s expertise.”  Id. at 905.

B. Grants of Certiorari

1. Murray v. UBS Securities, LLC – Retaliation Under Sarbanes-Oxley

On May 1, 2023, the Supreme Court granted certiorari in Murray v. UBS Securities LLC, et al., a case arising from the Second Circuit that could impact the ability of whistleblowers to bring claims of retaliation under 18 U.S.C. § 1514A of the Sarbanes-Oxley Act (“SOX”).  See 143 S. Ct. 2429 (2023).  The case is scheduled to be argued on October 10, 2023.

The case concerns a SOX retaliation claim by former UBS employee Trevor Murray.  See Murray v. UBS Securities LLC, et al., 43 F.4th 254, 256 (2d Cir. 2022).  UBS had hired Murray as a strategist supporting its commercial mortgage-backed securities business.  Id.  After “a shift in strategy prompted by financial difficulties,” which resulted in a “series of reductions in force,” UBS terminated his employment.  Id. at 257.  Murray alleged that he was terminated because he had reported being pressured “to skew his research and to publish reports to support their business strategies.”  Id. at 256–57.

In 2014, Murray sued UBS, and a jury returned a verdict in his favor.  Id. at 258.  UBS appealed, arguing the district court committed reversible error when it failed to instruct the jury that a SOX whistleblower claim requires a showing of the employer’s retaliatory intent.  Id. at 256.  The Second Circuit agreed with UBS, finding “retaliatory intent is an element of a section 1514A claim,” a conclusion that “flow[ed] from the plain meaning of the statutory language and [wa]s supported by [the Second Circuit’s] interpretation of nearly identical language in the [Federal Railroad Safety Act].”  Id. at 262–63.  The Second Circuit thus vacated the district court’s judgment and remanded for a new trial.  Id. at 263.

The Supreme Court subsequently granted review.  In his opening brief filed on June 27, 2023, Murray argued that a plaintiff under the burden-allocation regime applicable to SOX retaliation claims need not prove “retaliatory intent.”  In response, in its brief filed on August 8, 2023, UBS argued that SOX’s statutory language—which prohibits “discrimination … because of” protected activity—requires a plaintiff to show discriminatory intent and that the burden-allocation framework does not alter that requirement.

Gibson Dunn attorneys Eugene Scalia, Thomas Hungar, and Gabrielle Levin represent UBS Securities LLC and UBS AG.

2. SEC v. Jarkesy – Constitutional Challenges to the SEC’s Enforcement Powers

On June 30, 2023, the Supreme Court granted the SEC’s petition for writ of certiorari in Securities and Exchange Commission v. Jarkesy, 2023 WL 4278448, at *1 (U.S. June 30, 2023).  The case presents three questions:  (1) “Whether statutory provisions that empower the Securities and Exchange Commission (SEC) to initiate and adjudicate administrative enforcement proceedings seeking civil penalties violate the Seventh Amendment”; (2) “Whether statutory provisions that authorize the SEC to choose to enforce the securities laws through an agency adjudication instead of filing a district court action violate the nondelegation doctrine”; and (3) “Whether Congress violated Article II by granting for-cause removal protection to administrative law judges in agencies whose heads enjoy for-cause removal protection.”  See Petition for a Writ of Certiorari, Securities and Exchange Commission v. Jarkesy, No. 22-859, at (ii) (Mar. 8, 2023).

On May 18, 2022, the Fifth Circuit issued an opinion holding that (1) the Jarkesy parties were deprived of their Seventh Amendment right to a jury trial, (2) Congress “unconstitutionally delegated legislative power to the SEC by failing to provide it with an intelligible principle by which to exercise the delegated power,” and (3) the “statutory removal restrictions on SEC ALJs violate Article II.”  Jarkesy v. SEC, 34 F.4th 446, 451 (5th Cir. 2022).  As to the first, the court reasoned that because the right to a jury trial attaches to “traditional actions at law,” and enforcement proceedings carrying civil penalties are “akin” to those “traditional actions,” parties to such enforcement proceedings have a jury trial right.  Id. at 451.  In addition, the Court rejected the SEC’s argument that “the action [it] brought . . . [wa]s . . . the sort that may be properly assigned to agency adjudication under the public-rights doctrine.”  Id. at 455–57.  As to the second, the Fifth Circuit explained that because “Congress . . . delegated to the SEC what would be legislative power absent a guiding intelligible principle”—i.e., the power to bring securities fraud actions for monetary penalties within the agency instead of in an Article III court—and Congress failed to “provide the SEC with an intelligible principle by which to exercise that power,” “Congress unconstitutionally delegated legislative power to the SEC.”  Id. at 460–62.  Finally, the Court reasoned that because ALJs “perform substantial executive functions,” the two layers of for-cause removal restrictions are an unconstitutional impediment to the Article II requirement that the President “take Care that the Laws be faithfully executed.”  Id. at 463.

In its petition for certiorari, the SEC argued that all three of these “highly consequential” conclusions warrant the Court’s review, as they “call[] into question longstanding practices at the SEC and many other agencies.”  Petition for a Writ of Certiorari, at 9.  Among other things, the SEC argued that “[u]nder [a] long line of precedent, SEC administrative adjudications seeking civil penalties qualify as matters involving public rights,” id. at 11; “[t]he Commission’s decision whether to pursue an administrative or judicial remedy in a particular case is a core executive function” rather than an “exercise of legislative power,” id. at 13; ALJs are not improperly insulated because, inter alia, they “perform adjudicative rather than enforcement or policymaking functions,” id. at 18 (quoting Free Enter. Fund v. PCAOB, 561 U.S. 477, 507 n.10 (2010)), and the standard for their removal is “less stringent than the removal standard . . . held invalid in Free Enterprise Fund;” and the Merit Systems Protection Board’s “involvement in reviewing the removal of ALJs” does not “contribute[] to the violation of Article II,” id. at 18–19.

3. Loper Bright Enterprises v. Raimondo – Chevron’s Vitality

On May 1, 2023, the Supreme Court granted certiorari in Loper Bright Enterprises v. Raimondo.  It presents the question of whether the Supreme Court should overrule Chevron v. Natural Resources Defense Council, 467 U.S. 837 (1984), “or at least clarify that statutory silence concerning controversial powers expressly but narrowly granted elsewhere in the statute does not constitute an ambiguity requiring deference to the agency.”  Petition for Writ of Certiorari, Loper Bright Enters. v. Raimondo, No. 22-451 (Nov. 10, 2022); Loper Bright Enters. v. Raimondo, 143 S. Ct. 2429 (2023).

The case involves a group of commercial fishing companies and certain actions taken by the National Marine Fisheries Service (“the Service”).  Loper Bright Enters., Inc. v. Raimondo, 45 F.4th 359, 363 (D.C. Cir. 2022).  Specifically, “[i]n implementing an Omnibus Amendment that establishes industry-funded monitoring programs in New England fishery management plans, [the Service] promulgated a rule that required industry to fund at-sea monitoring programs.”  Id.  The group of commercial fishing companies then sued, “contend[ing] that the [Magnuson-Stevens Fishery Conservation and Management Act of 1976 (the “Act”)] does not specify that industry may be required to bear such costs and that the process by which the Service approved the Omnibus Amendment and promulgated the Final Rule was improper.”  Id.

The district court ruled in favor of the Government, and the D.C. Circuit, relying partly on the limited scope of review permitted by Chevron, 467 U.S. 837, affirmed.  Chevron requires courts to evaluate the Government’s interpretation of certain statutes by asking first “whether Congress has spoken clearly,” and if not, then, second, “whether the implementing agency’s interpretation is reasonable.”  Loper Bright, 45 F.4th at 365.  Here, the D.C. Circuit concluded that “[a]lthough the Act may not unambiguously resolve whether the Service can require industry-funded monitoring, the Service’s interpretation of the Act as allowing it to do so [wa]s reasonable.”  Id.; see also id. at 370.

C. Circuit-Level Developments

1. Lee v. Fisher – Potential Circuit Split on Forum Selection Clauses and Section 14

On June 1, 2023, an en banc panel of the Ninth Circuit issued its opinion in Lee v. Fisher, thereby furthering a potential split with the Seventh Circuit.  70 F.4th 1129 (9th Cir. 2023).  As discussed in our 2022 Year-End Securities Litigation Update, Lee concerns whether investors can file derivative suits in federal court when a company’s bylaws contain a forum-selection clause that mandates such cases be filed in Delaware state court.  In Seafarers Pension Plan v. Bradway, the Seventh Circuit held that a forum-selection clause similar to the one at issue in Lee was not enforceable.  23 F.4th 714, 724 (7th Cir. 2022).

In contrast to the Seventh Circuit, the Ninth Circuit held that the at-issue forum selection clause contained in the company’s bylaws, which required “any derivative action or proceeding brought on behalf of the Corporation” to be adjudicated in the Delaware Court of Chancery, was enforceable.  Lee, 70 F.4th at 1138.  First, the Court held that the forum selection clause did not waive substantive compliance with the Exchange Act, i.e., compliance with the obligation not to make false or misleading statements in a proxy statement.  The court explained that Lee could enforce substantive compliance through direct claims that are outside the ambit of the forum selection clause.  See Lee, 70 F.4th at 1139; see also id. at 1139 n.5 (“Lee can also enforce the substantive obligation to refrain from making false or misleading statements in a proxy statement under Delaware law.”).  It also rejected Lee’s argument that “the forum selection clause conflicts with § 29(a)’s antiwaiver provision” because it forecloses the “right to bring a derivative § 14(a) action,” explaining, among other things, that § 29(a) does not “forbid . . . waiver of a particular procedure for enforcing such duties.”  Id. at 1141.  Next, the court rejected Lee’s argument—which relied largely on J.I. Case Co. v. Borak, 337 U.S. 426 (1964)—that there is a strong public policy “of allowing shareholders to bring a § 14(a) derivative action.”  Id. at 1143.  The court observed, among other things, that “the [Supreme] Court now looks to state law rather than federal common law to fill in gaps relating to federal securities claims, and under Delaware law, a § 14(a) action is direct, not derivative.”  Id. at 1149.  The court further noted that the Supreme Court “now views implied private rights of action with disapproval, construing them narrowly, and casting doubt on the viability of a corporation’s standing to bring a § 14(a) action.”  Id.  The court also rejected Lee’s argument that enforcement of the forum selection clause would conflict with “the federal forum’s strong public policy of giving federal courts exclusive jurisdiction over Exchange Act claims under § 27(a).”  Id. at 1150–51.  Last, the court held that because “the Delaware Supreme Court has indicated that federal claims like Lee’s derivative § 14(a) action are not ‘internal corporate claims’ as defined in Section 115, and because no language in [Delaware precedent], Section 115, or the official synopsis operates to the limit the scope of what constitutes a permissible forum-selection bylaw under Section 109(b),” the forum-selection clause was valid under Delaware law.  Id. at 1156.

Some had criticized the original Lee opinion for potentially foreclosing federal courts as a forum to hear federal derivative suits.  Under the en banc court’s reasoning, however, that criticism rests on a mistaken premise.  Whereas Seafarers concluded that “Section 14(a) may be enforced . . . in derivative actions asserting rights of a corporation harmed by a violation,” 23 F.4th at 719 (citing Borak, 337 U.S. at 431–32), the en banc panel all but held that federal derivative actions are outside the scope of the Exchange Act, see, e.g., Lee, 70 F.4th at 1147 (“[T]he injury caused by a violation of § 14(a) gives rise to a direct action under Delaware law, not a derivative action.”); id. at 1149 (“Virginia Bankshares casts grave doubt on whether a shareholder can bring a derivative § 14(a) action on behalf of a corporation. . . .  [T]he [Supreme] Court now views implied private rights of action with disapproval, construing them narrowly, and casting doubt on the viability of a corporation’s standing to bring a § 14(a) action.”); id. at 1158 (“The Seventh Circuit . . . misread Borak.”).

2. Chamber of Commerce v. SEC – Challenges to the SEC’s Share-Repurchase Final Rule

On May 12, 2023, the U.S. Chamber of Commerce filed a Petition for Review challenging the SEC’s recently announced share-repurchase rule.  Petition For Review, Chamber of Com. of the United States v. SEC, No. 23-60255 (May 16, 2023).  As detailed in a recent Client Update, it requires companies to:  (1) disclose daily repurchase data in a new table filed as an exhibit to Form 10-Q and Form 10-K, (2) indicate by a check box 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, (3) provide narrative disclosure about the repurchase program, including its objectives and rationale, in the filing, and (4) provide quarterly disclosure regarding the company’s adoption or termination of any Rule 10b5-1 trading arrangements.  Share Repurchase Disclosure Modernization, Release Nos. 34-97424; IC-34906; File No. S7-21-21.  The Chamber of Commerce contends that the rule disincentivizes companies from using stock buybacks and violates both the Administrative Procedure Act and the First Amendment.  Press Release, U.S. Chamber of Commerce, U.S. Chamber Sues the Securities and Exchange Commission Over Stock Buyback Rule (May 12, 2023).

3. Update on Goldman Sachs Group v. Arkansas Teacher Retirement System

On August 9, 2023, the Second Circuit issued its long-awaited decision in Arkansas Teacher Retirement System v. Goldman Sachs Group Inc., No. 22-484.  As noted in our 2022 Year-End Securities Litigation Update, oral argument was held on September 21, 2022, before a panel consisting of Judges Richard Sullivan, Denny Chen, and Richard Wesley.  In an opinion by Judge Wesley, the Second Circuit concluded that Goldman successfully rebutted Basic’s presumption of reliance and decertified the class.  For a detailed discussion of the case, see the Market Efficiency and “Price Impact” Cases section in Part IX, infra.  We will report on any future developments.

III. Delaware Developments

The Delaware Supreme Court has said that Delaware’s “corporate law is not static,” Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 957 (Del. 1985), and that was certainly true in the last half-year.  In some areas, Delaware courts held steady, affirming, for example, that controllers who distance themselves from conflicted transactions can win court approval, that transactions that are fair to minority stockholders can withstand scrutiny under the entire fairness standard, and that backchanneled mergers may fail to pass muster.  In other areas, Delaware law marched forward with trends that began last year.  For example, the Court of Chancery continued its developing trend of applying entire fairness to SPAC deals.  And still elsewhere, Delaware courts broke new ground, raising the bar for merger-disclosure strike suits and reshaping the standards for board measures in control contests.

A. Delaware Carves Path for Conflicted Controllers in Oracle

In May 2023, the Delaware Court of Chancery ruled in favor of Oracle founder Larry Ellison in a lawsuit arising from Oracle’s $9.3 billion acquisition of NetSuite.  In re Oracle Corp. Derivative Litig., 2023 WL 3408772 (Del. Ch. May 12, 2023).  The court held that Ellison was not a controlling stockholder and therefore the transaction was governed by the business judgment rule.  Id. at *27.

In January 2016, Oracle’s board of directors created a special committee to assess a potential takeover of NetSuite, a company co-founded and partly owned by Ellison.  Id. at *4, *6.  Oracle announced a tender offer for NetSuite in July 2016 for $109 per share.  Id. at *14–15.  After the purchase, Oracle stockholders sued, alleging that, in spite of the independent committee, Ellison’s status as Oracle’s controller meant the board lacked independence and that Ellison had forced the company to overpay for NetSuite for his personal benefit.  Id. at *18.  In 2018, the court denied Ellison’s motion to dismiss.  Id. at *16.

After trial, the court issued a decision holding that even though “[p]laintiff-friendly presumptions” that Ellison’s roughly 25% holdings in Oracle and control over its actions meant the board was conflicted “were sufficient to carry this matter to trial,” the post-trial evidence did not support this theory.  Id. at *2.  The court distinguished earlier cases holding that minority stockholders caused a conflict because of a “combination of [their] stock holdings” and “affirmative actions taken to control the transaction.”  Id. at *26.  It noted that Ellison “neither possessed voting control, nor ran the company de facto,” and emphasized that even though he “had the potential to control the transaction at issue . . . he scrupulously avoided influencing the transaction.”  Id. at *27.  Accordingly, the business judgment rule applied.  Id. 

Oracle demonstrates that although Delaware courts may find that a minority holder is a controller and entire fairness applies for pleading-stage purposes, it is still possible for a putative controller to avoid application of that exacting standard at trial where he or she actively removes him or herself from the transaction at issue.

B. Mixed Verdict for Drag-Along Covenants Not to Sue

In May 2023, the Delaware Court of Chancery refused to enforce an explicit covenant not to sue over a drag-along sale.  New Enter. Assocs. 14, L.P. v. Rich, 295 A.3d 520 (Del. Ch. 2023).  The court explained that as a matter of public policy, a covenant not to sue cannot insulate defendants from tort liability based on intentional wrongdoing.  Id. at 536.  The court clarified that covenants not to sue for fiduciary-duty breaches are not facially invalid and signaled a continued receptiveness to some tailoring of fiduciary duties, despite the outcome of this decision.  Id. at 530–31.  We discussed the decision and its implications in more detail in our May 8, 2023 M&A Report.

C. Court Finds Merger Backchannelling Caused Conflict

In April 2023, Chancellor McCormick held that the CEO of software company Mindbody Inc. violated his fiduciary duties by tilting the company’s sales process in favor of a private-equity buyer.  In re Mindbody, Inc. S’holder Litig., 2023 WL 2518149 (Del. Ch. Mar. 15, 2023).  The suit followed Mindbody’s 2019 take-private transaction by Vista Equity Partners.  Id.  According to the court, the CEO was motivated by a personal need for liquidity and had been partial to Vista throughout the process.  Id. at *2, *35.  His backchanneling with Vista as the company’s formal sale process continued was, the court concluded, a breach of fiduciary duties.  Id. at *35–38.  He also breached his duty of disclosure by failing to disclose several meetings he had with Vista, including attending a private summit that it hosted.  Id. at *1, *9, *12, *36.  This case is discussed further in our April 10, 2023 M&A Report.

D. Supreme Court Affirms Tesla’s Acquisition of SolarCity Was Entirely Fair

The Delaware Supreme Court recently affirmed the Delaware Court of Chancery’s holding that Tesla’s 2016 acquisition of SolarCity was entirely fair to Tesla’s stockholders.  In re Tesla Motors, Inc. S’holder Litig., — A.3d —, 2023 WL 3854008 (Del. June 6, 2023) (Tesla II).  In 2016, Tesla stockholders accused Elon Musk of forcing Tesla’s board to overpay for SolarCity, a producer of solar panels that the plaintiffs claimed was insolvent at the time.  Id. at *1.  In addition to his Tesla leadership role, Musk was the chairman of SolarCity and the company’s largest stockholder.  Id. at *2.  The Court of Chancery had held, after trial, that the transaction process and price were ultimately fair despite Musk’s participation.  In re Tesla Motors, Inc. S’holder Litig., 2022 WL 1237185, at *2 (Del. Ch. Apr. 27, 2022) (Tesla I).  The high court’s June opinion in Tesla II affirmed that finding.  2023 WL 3854008, at *2.

The Delaware Supreme Court’s opinion reaffirms and clarifies several aspects of the entire fairness analysis.  The plaintiffs had made a number of arguments on appeal as to why the trial court erred in applying that standard, but the court rejected each in turn.  See Tesla II, 2023 WL 3854008, at *24, *33, *44.  First, the court affirmed that a conflicted board’s decision not to utilize a special committee to negotiate a merger “does not automatically result in a finding of liability.”  Id. at *26.  A board may choose to subject itself to the “expensive, risky, and ‘heavy lift’” of satisfying entire fairness for a number of strategic reasons, including to avoid “transaction execution risk,” to maintain flexibility, and “to access the technical expertise and strategic vision and perspectives of the controller.”  Id. at *27.

Second, the Supreme Court held that although the Court of Chancery’s analysis placed too much weight on Tesla’s pre-merger stock price—which, the Supreme Court concluded, failed to factor in material nonpublic information—the court’s overall focus on the merger price was not misplaced, and there was sufficient evidence establishing that the price was fair.  Tesla II, 2023 WL 3854008, at *34.  The plaintiffs had argued that the trial court “applied a bifurcated entire fairness test, concluding that its separate fair price analysis alone satisfied entire fairness.”  Id.  The Supreme Court disagreed, pointing out that the trial court had, in fact, made “extensive fact and credibility findings relating to the Acquisition’s process.”  Id.  The Supreme Court further concluded that the trial court was correct to put great weight on price because although a fair price “is not a safe-harbor that permits controllers to extract barely fair transactions,” it is “the paramount consideration” in deciding whether the merger as a whole was fair.  Id. (citations omitted).

The Supreme Court, however, departed from the Court of Chancery in how the price analysis should be conducted, agreeing with the plaintiffs that the trial court should not have relied on a pre-merger stock price that did not factor in later-revealed nonpublic information.  Id. at *44.  Indeed, the court “cautioned against reliance on a stock price that did not account for material, nonpublic information” and “sole reliance on the unaffected market price.”  Id. at *46 (citation omitted).  Nonetheless, the Supreme Court found that other evidence “amply supports the [trial] court’s finding that the price was fair”; in addition to the stock price, the trial court had relied on “an array of valuation and fair price evidence,” such as its financial advisor’s analysis and evidence of SolarCity’s financial performance.  Id.

E. Court of Chancery Again Holds Entire Fairness Governs De-SPAC Transactions

The Delaware Court of Chancery again affirmed that de-SPAC mergers are subject to the entire fairness standard of review.  In Laidlaw v. GigAcquisitions2, LLC, stockholders brought fiduciary duty claims against the directors and controlling stockholder of GigCapital2, Inc., a special purpose acquisition company (“SPAC”).  2023 WL 2292488, at *1 (Del. Ch. Mar. 1, 2023).  SPACs are publicly traded corporations created with the sole purpose of merging with a private business before a set deadline, which allows the private business to go public.  When the merger takes place, the investors of the SPAC can choose to redeem their investments or invest in the post-merger company.  In Laidlaw, the stockholders alleged that the defendants had issued a false and misleading proxy statement that prevented the stockholders from making an informed decision about whether to redeem their investments in the SPAC.  Id.

The opinion by Vice Chancellor Will followed her earlier decisions in In re MultiPlan Corporation Stockholders Litigation, 268 A.3d 784 (Del. Ch. 2022) and Delman v. GigAcquisitions3, LLC, 288 A.3d 692 (Del. Ch. Jan 4, 2023).  These earlier cases held that mergers between SPACs and their targets, also referred to as de-SPAC transactions, were inherently conflicted because the sponsors of the SPACs would lose their investments if they did not consummate the mergers before the given deadlines.  Each of the earlier decisions held that the at-issue de-SPAC transaction was subject to the entire fairness standard.  In re Multiplan, 268 A.3d at 813; Delman, 288 A.3d at 709.

In her recent decision, Vice Chancellor Will noted that the legal questions presented in Laidlaw were “largely indistinguishable” from those in Delman.  Laidlaw, 2023 WL 2292488, at *1.  The court held that the sponsors were conflicted because of the way the de-SPAC was structured:  the sponsors allegedly preferred a bad merger to no merger because they would lose their Founder Shares and Private Placement Units if the SPAC did not merge with another company, while public stockholders would prefer no deal to a bad one because they would still receive their full investment plus liquidation interest if there were no merger.  Id. at *8.  And even after the merger agreements were signed, the sponsor had an interest in minimizing redemptions by stockholders because the deals required the SPAC to have $150 million in cash.  Id.  The court further noted that it was reasonably conceivable that the de-SPAC transaction was conflicted because a majority of the board members lacked independence from the owner and controller of the sponsor.  Id. at *9.

As a result, the court rejected the defendant’s motion to dismiss and the plaintiffs’ claims that the defendant issued a false and misleading proxy statement were allowed to proceed.  Id. at *14.

F. Supreme Court Clarifies Standard for Voting Control Measures

In Coster v. UIP Companies, Inc., the Delaware Supreme Court clarified the standards applicable to board action in a contest for corporate control that interferes with stockholders’ voting rights.  ‌— A.3d —, 2023 WL 4239581 (Del. June 28, 2023) (Coster IV).  As we wrote in our 2022 Year-End Securities Litigation Update, this case arose when the plaintiff became a 50% stockholder in UIP and deadlocked with the company’s other half-owner regarding UIP’s board composition.  Coster v. UIP Companies, Inc., 2022 WL 1299127, at *1 (Del. Ch. May 2, 2022) (Coster III).  The plaintiff brought an action to appoint a custodian with full control over the company, and the board responded by issuing one-third of the total outstanding shares to an “essential” employee who broke the deadlock.  Id. at *3.  After unsuccessfully challenging the stock issuance in the Court of Chancery, the plaintiff appealed to the Delaware Supreme Court, which remanded with instructions to apply the standards laid out in Blasius Industries, Inc. v. Atlas Corporation, 564 A.2d 651 (Del. Ch. 1988), and Schnell v. Chris-Craft Industries, Inc., 285 A.2d 437 (Del. 1971).  Coster IV, 2023 WL 4239581, at *4.  The trial court again ruled for the defendants, and she again appealed.  Id. at *5.

On June 28, 2023, the Supreme Court reconciled the various applicable standards:  Schnell for board-entrenchment measures, Blasius for interference with the stockholder franchise, and Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985), for antitakeover strategies.  Where the board “interferes with the election of directors or a shareholder vote in a contest for corporate control”—that is, where both entrenchment or antitakeover measures and the stockholder franchise are at issue—courts should apply “Unocal . . . with the sensitivity Blasius review brings.”  Coster IV, 2023 WL 4239581, at *12.  First, courts should judge whether there was a threat to “an important corporate interest” that was “real and not pretextual,” such that the board’s motivation was “proper and not . . . disloyal.”  Id.  Per Blasius, boards cannot rely on the justification that they know what is best for stockholders.  Id.  Second, courts should review, per Unocal, whether the board’s response was “reasonable in relation to the threat” and “not preclusive or coercive to the stockholder franchise.”  Id.  Applied in this fashion, the standard also “subsume[s] the question of loyalty” and “thus address[es] issues of good faith such as were at stake in Schnell.”  Id. at *11.

Judged by this standard, the court affirmed the Court of Chancery’s decision, finding the company’s actions passed muster.  Id. at *17.  As the trial court held, the plaintiff’s broad request for a custodian posed significant risks to the company, and even though the trial court found that “some of the board’s reasons for approving the Stock Sale were problematic, on balance[,] . . . the board was properly motivated in responding to the threat.”  Id. at *14.

G. Delaware Raises the Bar for Merger Plaintiffs’ Fees

The Delaware Court of Chancery raised the bar for attorneys’ fees in cases where a plaintiff’s suit over allegedly inadequate merger disclosures causes the defendant to supplement those disclosures.  Anderson v. Magellan Health, Inc., 298 A.3d 734 (Del. Ch. 2023).  In Anderson, a stockholder sued the selling company in a merger saying that its proxy materials were inadequate and its deal protections stood in the way of getting the best price; in response, the company loosened the deal protections and made new disclosures.  Id.  In July 2023, the court held that the loosened deal protections, as a practical matter, did not create a “corporate benefit” allowing the plaintiff to collect attorneys’ fees because they had no effect on the ultimate deal price.  Id. at *741–45.  And the court changed the standard for when supplemental disclosures justify a fee award—previously, these only had to be “helpful,” whereas the Court of Chancery held that fees are justified “only when the information is material.”  Id. at *747–51.  We discussed this decision in greater detail in our August 2, 2023 Client Alert.

IV. Federal SPAC Litigation

The number of SPAC IPOs and the value of de-SPAC transactions have decreased significantly since their peak in 2021, as noted in our 2022 Mid-Year Securities Litigation Update.  De-SPAC transactions, however, have given rise to significantly more securities class actions than other IPOs, and plaintiffs have generally had more success in surviving the motion to dismiss stage.

A. Clover Health: Settlement Offer Proposed in Fraud-on-the-Market SPAC Litigation

Our 2022 Mid-Year Securities Litigation Update highlighted Bond v. Clover Health Investments, Corp., 587 F. Supp. 2d 641 (M.D. Tenn. Feb. 28, 2022), as a prototypical example of the Section 10(b) class actions that survived the motion-to-dismiss stage after the 2021 SPAC boom.  We also noted that, in denying the motion to dismiss in that case, the district court for the Middle District of Tennessee expressly credited a fraud-on-the-market theory, see id. at 664–66, and was apparently the first federal court to do so in the context of claims arising from a SPAC-related offering.  In April 2023, less than three months after the court granted the plaintiffs’ motion for class certification, Bond v. Clover Health Invs., Corp., 2023 WL 1999859 (M.D. Tenn. Feb. 14, 2023), Clover Health announced that the parties had agreed to a proposed settlement.  Under the parties’ agreement, which is subject to final court approval, the class will receive $22 million and the defendants will receive customary releases.  Press Release, Clover Health, Clover Health Announces Agreement to Settle Securities Class Action Litigation (Apr. 24, 2023), https://investors.cloverhealth.com/news-releases/news-release-details/clover-health-announces-agreement-settle-securities-class-action.  In May, the court preliminarily approved the agreement and scheduled a settlement hearing for October 2, 2023.  Bond v. Clover Health Invs., Corp., 3:21-CV-00096 (M.D. Tenn. May 26, 2023), Dkt. No. 132.

B. Statutory Standing in the SPAC Context

Our 2022 Year-End Securities Litigation Update highlighted a decision, In re CCIV/Lucid Motors Securities Litigation, 2023 WL 325251 (N.D. Cal. Jan. 11, 2023), addressing the standing requirements for bringing a Section 10(b) action in the SPAC context.  In two recent cases, lower courts continued to examine how statutory standing requirements apply in the context of SPAC litigation.

In March 2023, a SPAC-related class action in the Southern District of New York, In re CarLotz, Inc. Securities Litigation, 2023 WL 2744064 (S.D.N.Y. Mar. 31, 2023), was dismissed on standing grounds, based on the fact that the plaintiffs did not own shares of the privately held, pre-merger target, id. at *1, *5.  The de-SPAC transaction in CarLotz concerned Acamar, a SPAC that went public and then identified CarLotz, a used vehicle marketplace, as a target company.  Id. at *1.  The plaintiffs alleged that officers of pre-merger CarLotz made materially false and misleading statements, and that the falsity of those statements was revealed in disclosures that were made after the merger.  Id. at *2.  In dismissing the case, the CarLotz court followed Second Circuit precedent that the CCIV court had considered, Menora Mivtachim Insurance Ltd. v. Frutarom Industries Ltd., 54 F.4th 82 (2d. Cir. 2022), but was not “compell[ed]” to follow, 2023 WL 2744064, at *4–5; see also In re CCIV/Lucid Motors, 2023 WL 325251, at *7–8.

The court applied the rule from an earlier Second Circuit decision that did not directly concern SPACs, Menora Mivtachim, 54 F.4th 82, which held that shareholders of an acquiring company could not sue the target company for alleged misstatements that had been made prior to the merger between the two companies, id. at 86.

The plaintiffs argued that applying Menora to companies acquired by SPACs would create a “loophole” that shields from liability the pre-merger statements of parties to SPAC transactions.  CarLotz, 2023 WL 2744064, at *5.  Although the court acknowledged this policy concern, it stated that it was bound by the Menora precedent.  Id.  The court also noted alternative means of accountability for pre-merger actions taken by a target company, such as SEC enforcement actions, shareholder derivative suits, or actions brought under state law.  Id.

CarLotz and another case, Mehedi v. View, Inc., 2023 WL 3592098 (N.D. Cal. May 22, 2023), also addressed requirements for standing under Section 11 of the Securities Act, which imposes strict liability for any materially misleading statements or omissions in a registration statement, see CarLotz, 2023 WL 2744064, at *5–8; Mehedi, 2023 WL 3592098, at *5–7.  Section 11 requires each plaintiff to demonstrate that he or she can trace the shares he or she purchased to the offering related to the allegedly misleading document or statement, rather than from some other source.  Mehedi, 2023 WL 3592098, at *5.

In Mehedi, the plaintiffs did not allege that they had purchased securities that were directly traceable to the relevant registration statement.  Id. at *5–7.  In CarLotz, the plaintiffs conceded that one named plaintiff had purchased shares in Acamar, the public company, even before the de-SPAC registration statement and prospectus were effective, but argued that his shares were still traceable to the registration statement because the merger itself “functionally transformed” his Acamar shares into shares of the new public company, CarLotz.  2023 WL 2744064, at *7.  The court acknowledged this theory was “creative,” but found it foreclosed by Second Circuit precedent on Section 11 traceability, which requires the plaintiff to have purchased shares “under” “the same registration statement” being challenged.  Id.  The plaintiffs again identified policy reasons for loosening these standing requirements in the context of SPAC transactions, including a proposed SEC regulation that, “if promulgated, would subject registration statements for de-SPAC transactions to Section 11 liability.”  Id. at *8.  But the court found that proposed non-final rule and other policy considerations insufficient to overcome the current binding precedent.  Id.

V. ESG Civil Litigation

For the past several years, a number of lawsuits have been filed against public companies or their boards related to the companies’ environmental, social, and governance (“ESG”) disclosures and policies.  The following section surveys notable developments in pending cases that involve ESG allegations.

A. Environmental Litigation

Fagen v. Enviva Inc., No. 8:22-CV-02844 (D. Md. Nov. 3, 2022):  We first reported on this case in our 2022 Year-End Securities Litigation Update.  After the court appointed a lead plaintiff in January 2023, an amended complaint was filed in April 2023. ECF No. 34. In the amended complaint, the plaintiff alleges that Enviva made false or misleading statements in offering documents and other communications to investors that exaggerated the sustainability of Enviva’s wood pellet production and procurement methods.  Id. at 1–4.  The amended complaint claims Enviva’s stock price dropped after various third parties published reports challenging Enviva’s environmental claims.  Id. at 3.  The defendants have filed motions to dismiss the amended complaint.  ECF Nos. 62, 63.  In those motions, the defendants argue that the alleged “misrepresentations” are merely part of “an ongoing public debate about the environmental benefits of using wood pellets—rather than fossil fuels—to generate heat and electricity,” which cannot give rise to securities fraud.  ECF No. 62-1 at 1.  The motions to dismiss are fully briefed and pending before the court.

Wong v. New York City Emp. Ret. Sys., No. 652297/2023 (N.Y. Sup. Ct., N.Y. Cnty. May 11, 2023):  In Wong, the plaintiffs have brought breach of fiduciary duty claims against three New York City pension funds that divested approximately $4 billion in fossil fuel investments.  NYSCEF No. 2.  The plaintiffs allege that the retirement boards impermissibly prioritized political goals unrelated to the financial health of the plans over their obligation to pursue the best financial returns for plan participants, declaring the pension fund’s actions an “utter abandonment of fiduciary responsibilities.”  Id. at 2–3.  The divestment allegedly caused the pension fund to lose out on the energy’s sector significant growth, and therefore lucrative returns, over the past few years.  Id. at 18.  The plaintiffs sought an injunction, requiring the pension fund to cease the ongoing divestment and make decisions regarding fuel-related and other potential investments “exclusively on relevant risk-return factors” going forward.  Id. at 24.  The defendants filed a motion to dismiss the complaint on August 7, 2023.  NYSCEF No. 20 at 1.  Gibson Dunn is representing Plaintiffs in this case.

B. Social Litigation

City of St. Clair Shores Police and Fire Ret. Sys. v. Unilever PLC, No. 22-CV-05011 (S.D.N.Y. June 15, 2022): As reported in our 2022 Year-End Securities Litigation Update, in at least one action, investors challenged corporate commitments on ESG-related topics.  The allegations in Unilever arose from a Ben & Jerry’s board resolution purporting to end the sale of Ben & Jerry’s products in areas deemed “to be Palestinian territories illegally occupied by Israel.”  ECF No. 1 at 6.  The plaintiffs alleged that Ben & Jerry’s parent company made misleading statements to investors by failing to adequately disclose the business risks associated with the resolution.  Id. at 10–18.  The defendants filed a motion to dismiss in late 2022, arguing, among other things, that the plaintiffs failed to plead an actionable misstatement or omission and failed to plead scienter.  See, e.g., ECF No. 31 at 3.  The motion to dismiss is now fully briefed and pending before the court.

C. Diversity and Inclusion

Ardalan v. Wells Fargo & Co., No. 22-CV-03811 (N.D. Cal. July 28, 2022):  In this putative class action, the plaintiffs alleged that Wells Fargo announced an initiative which required that 50 percent of interviewees be diverse for most roles above a certain salary threshold, and then purported to meet that requirement by conducting interviews for positions that had already been filled.  ECF No. 1 at 2–4.  These practices, the plaintiffs allege, made the bank’s statements about its diversity initiatives materially misleading.  Id.  The plaintiffs alleged that the bank’s stock price fell by more than ten percent after the New York Times published an article purporting to reveal that certain of the bank’s employees were holding interviews for filled positions.  Id.  In April 2023, the defendants filed a motion to dismiss the complaint.  In that motion, the defendants argued that the plaintiffs’ allegations of isolated incidents of employee misconduct cannot render the bank’s general statements about its diversity program false or misleading.  ECF No. 100 at 2–3.  The district court agreed.  In an August 18, 2023 opinion granting the defendants’ motion to dismiss, the district court held that the PSLRA “requires particularized allegations sufficient to infer that sham interviews took place during the Class Period and that they were widespread.”  ECF No. 112 at 8.  The district court dismissed the complaint without prejudice.  Id. at 15.

* * * * *

Gibson Dunn will continue to monitor developments in ESG-related securities litigation.  Additional resources relating to ESG issues can be found on Gibson Dunn’s ESG practice group page.

VI. Cryptocurrency Litigation

A growing number of both class action and regulatory lawsuits are being filed against cryptocurrency platforms and their operators.  Many of these lawsuits seek to classify cryptocurrencies as “securities” under existing federal securities law, and courts continue to grapple with the application of securities laws to cryptocurrency.  Defendants have crafted multiple arguments in favor of dismissing these actions, with varying levels of success.

A. Class Actions

Underwood v. Coinbase Glob., Inc., 2023 WL 1431965 (S.D.N.Y. Feb. 1, 2023):  A putative class of users of Coinbase’s trading platform, a platform which facilitates cryptocurrency transactions, brought claims under Sections 12(a)(1) and 15 of the Securities Act, Section 29(b) of the Exchange Act, and state law, alleging that they suffered damages in connection with the defendants’ sale and solicitation of allegedly unregistered securities.  2023 WL 1431965 at *1.  The defendants filed a motion to dismiss arguing that under the terms of Section 12, Coinbase was not the “statutory seller” of the tokens sold to the plaintiffs.  Id. at *1, 6.  The court concluded in ruling on a motion to dismiss the Section 12 claims that Coinbase did not directly sell tokens to the plaintiffs because the company did not hold title to the cryptocurrency traded on its platform during the transaction.  Id. at *6–8.  The court also reasoned that Coinbase did not “solicit” transactions because it did not partake in the “direct and active participation in the solicitation of the immediate sale.”  Id. at *9.  Based on this reasoning, the court dismissed the plaintiffs’ Section 12 claim as Coinbase was not the “statutory seller” of the tokens.  The court also dismissed the plaintiffs’ control-person claim, which was predicated on the Section 12 violation.  Id. at *10.  The court likewise dismissed the plaintiffs’ claim under Section 29(b) of the Exchange Act, holding that the plaintiffs failed to demonstrate that their user agreements with Coinbase’s platform involved a “prohibited transaction” under Section 29(b).  Id. at *11–12.  The court declined to exercise supplemental jurisdiction over the plaintiffs’ state law claims.  Id. at *12–13.  The plaintiffs are currently appealing the district court’s decision to the Second Circuit.  See Underwood v. Coinbase Glob., Inc., 2023 WL 1431965 (S.D.N.Y. Feb. 1, 2023), appeal docketed, No. 23-184 (2d Cir. Feb. 9, 2023).

De Ford v. Koutoulas, 2023 WL 2709816 (M.D. Fla. Mar. 30, 2023), reconsideration denied, 2023 WL 3584077 (M.D. Fla. May 22, 2023):  The plaintiffs represent a group of individuals who purchased the token “LGBCoin.”  The plaintiffs brought a putative class action asserting multiple claims, including a claim under Section 12 of the Securities Act.  2023 WL 2709816 at *13–16.  Section 12(a)(1) of the Securities Act provides a private right of action against any person who offers or sells a security in violation of Section 5 of the Securities Act.  The plaintiffs allege in their complaint that LGBCoin is a security, and that the defendants created, marketed, and offered the tokens for sale to customers in the United States.  See ECF No. 1 at ¶¶ 173–83.  Two defendants filed motions to dismiss the Section 12 claims for failure to state a claim.  ECF Nos. 101, 104.  While ruling on the motions to dismiss, the court held that, when drawing “all reasonable inferences in Plaintiffs’ favor . . . it is at least plausible that LGBCoin is a security.”  2023 WL 2709816, at *13–15.  The court then concluded that the plaintiffs had plausibly alleged that one of the defendants, an executive at LGBCoin who made social media posts promoting the token, could be held liable as a “seller” of a security under Section 12.  Id. at *15.  The court reasoned that because of this defendant’s “extensively documented alleged promotion of LGBCoin in-person or online in videos, on social media, and on podcasts,” he was a seller and was “plausibly alleged to have made the[] solicitations to serve his own financial interests.”  Id.  The court found, however, that a separate defendant-executive of the company who was not alleged to have made similar public solicitations for his own financial interest, was not a seller.  Id.  The court thus denied the former executive’s motion to dismiss the securities fraud claim, while granting the latter executive’s motion to dismiss.  Id. at *16–17.  On April 14, 2023, the plaintiffs filed a third amended complaint.  ECF No. 245.

B. Regulatory Lawsuits

SEC v. Arbitrade Ltd., 2023 WL 2785015 (S.D. Fla. Apr. 5, 2023):  The SEC brought claims under Sections 5 and 17 of the Securities Act and under Section 10b of the Exchange Act, alleging that Arbitrade Ltd., Cryptobontix Inc., SION Trading FZE, and their respective control persons were operating “a classic pump and dump scheme” involving the crypto asset “Dignity” (“DIG”).  2023 WL 2785015 at *1–2.  Specifically, the SEC alleged that defendants generated artificial demand for DIG tokens by claiming that they had received title to $10 billion in gold bullion that they would use to back the tokens.  Id.  The defendants then sold their DIG tokens and converted the proceeds to cash.  DIG tokens reached a zero dollar valuation soon after.  Id. at *2.  On April 5, 2023, the court denied two separate motions to dismiss brought by individual defendants.  Id. at *11.  In doing so, the court held that the SEC had jurisdiction over the case because, based on the facts alleged in the complaint, DIG tokens could be considered securities from which investors expected to derive profits.  Id. at *3–6.

SEC v. Payward Ventures, No. 23-CV-0588 (N.D. Cal. Feb. 9, 2023):  The SEC charged Payward Ventures, Inc. and Payward Trading, Ltd., both commonly known as “Kraken,” for their crypto staking service.  ECF No. 1 at 1–2.  Crypto staking is a process that crypto networks use to process and validate transactions.  Id. at 2.  The SEC alleged that Kraken’s staking service, which launched in 2019, caused investors to lose control of their assets and assume the risk of the staking platform.  Id. at 3, 9.  The SEC alleged that Kraken did not provide sufficient information to substantiate the staking program’s representations of certain program features.  See id. at 10–17.  The complaint further claimed that because crypto investors entrust money to the staking service with expectations of profit, Kraken’s staking program was marketed as an investment opportunity, and that the service was offered and sold as a security.  Id. at 16, 19–22.  The SEC complaint concluded that Kraken needed to register the offers and sales on the platform with the SEC and make adequate disclosures under the Securities Act because it used interstate commerce to offer investment contracts in exchange for investors’ cryptocurrency.  Id. at 22.  Kraken settled the case by ceasing the offering and selling of alleged securities through its staking program, and by agreeing to pay $30 million in disgorgement, prejudgment interest, and civil penalties.  See Press Release, Kraken to Discontinue Unregistered Offer and Sale of Crypto Asset Staking-As-A-Service Program and Pay $30 Million to Settle SEC Charges (Feb. 9, 2023), https://www.sec.gov/news/press-release/2023-25.

SEC v. Binance Holdings Ltd., No. 23-CV-01599 (D.D.C. June 5, 2023):  On June 5, 2023, the SEC filed a 13-claim complaint against Binance Holdings Limited, BAM Trading Services Inc., BAM Management Holdings Inc. and Changpeng Zhao in D.C. federal court, alleging they engaged in unregistered offers and sales of crypto asset securities.  ECF No. 1.  The SEC claims Binance Holdings Limited and BAM were both acting as exchanges, broker-dealers, and clearing agencies, and that they intentionally chose not to register with the SEC.  Id. at 2.  A day after filing the complaint, the SEC filed a motion for a TRO, seeking to freeze BAM’s assets.  ECF No. 4.  On June 13, 2023, consistent with the arguments set forth in the defendants’ briefing, the government admitted that it had no evidence that customer assets have been misused or dissipated and, as a result, the defendants successfully prevented the SEC from obtaining the extensive relief it sought.  Instead, at the court’s direction, Binance, the SEC, and the other defendants in the action negotiated a consent order that will remain in place while the action is pending.  ECF No. 71.  Gibson Dunn is representing Binance Holdings Limited.

SEC v. Coinbase, Inc., No. 23-CV-4738 (S.D.N.Y. June 6, 2023):  On June 6, 2023 the SEC filed a 5-count complaint against Coinbase and its parent company Coinbase Global.  ECF No. 1.  The SEC alleges that Coinbase has violated the securities laws since 2019 by failing to register as an exchange, broker, or clearing agency despite facilitating trading and settlement of several digital assets that the SEC alleges are securities, including ADA, SOL, MATIC, and others.  Id. at 1, 33.  The SEC also alleges that Coinbase has operated as an unregistered broker by offering its Coinbase Prime and Coinbase Wallet services, and that Coinbase’s staking service for several digital assets, including Ethereum, constitutes unregistered securities offerings.  Id. at 2.  On June 28, 2023, Coinbase filed a 177-page answer to the SEC’s complaint, calling the suit an “extraordinary abuse of process” that “offends due process and the constitutional separation of powers.”  ECF No. 22. at 2.  On August 4, 2023, Coinbase filed its motion for judgment on the pleadings claiming both that in bringing the action the “SEC has violated due process, abused its discretion, and abandoned its own earlier interpretations of the securities laws” and that “[t]he subject matter falls outside the agency’s delegated authority” because none of the digital assets identified in the complaint qualify as securities under the Securities Act.  ECF No. 36 at 1.

SEC v. Ripple Labs, Inc., 2023 WL 4507900 (S.D.N.Y. July 13, 2023):  In 2020, the SEC sued Ripple in the Southern District of New York for the unregistered offer and sale of securities in violation of Section 5 of the Securities Act related to Ripple’s offer and sale of XRP, a crypto token.  2023 WL 4507900 at *1–4.  In September 2022, the parties filed cross-motions for summary judgment.  Id.  at *4.  On July 13, U.S. District Judge Analisa Torres ruled that the SEC could not establish as a matter of law that a crypto token was a security in and of itself.  In a partial victory for Ripple, the court determined that Ripple’s XRP sales on public exchanges were not offers of securities.  In a partial victory for the SEC, the ruling also found that sales to sophisticated investors did amount to unregistered sales of securities.  On August 17, 2023, the court permitted the SEC to file a motion for leave to file an interlocutory appeal.  ECF No. 891.  Briefing on the motion is set to conclude on September 8, 2023.  ECF No. 892.

SEC v. Terraform Labs Pte. Ltd., 2023 WL 4858299 (S.D.N.Y. July 31, 2023):  The SEC brought an enforcement action in February of this year alleging that Terraform Labs and its founder, Do Hyeong Kwon, perpetrated a multi-billion dollar crypto asset securities fraud scheme by offering and selling crypto asset securities in unregistered transactions and misleading investors about the Terraform blockchain and its crypto assets.  ECF No. 1.  The complaint alleges violations of the anti-fraud provisions of the Securities Act and Exchange Act and the securities-offering-registration and security-based swap provisions of the federal securities laws.  Id. at 4.  On July 31, 2023, Judge Rakoff denied the defendants’ motion to dismiss, finding that the court had personal jurisdiction over the defendants and that the complaint plausibly alleged that “the defendants used false and materially misleading statements to entice U.S. investors to purchase and hold on to the defendants’ products;” the products being “unregistered investment-contract securities that enabled investors to profit from the supposed investment activities of the defendants and others.”  2023 WL 4858299 at 1–2.  Notably, Judge Rakoff agreed with the Ripple ruling’s holding that the SEC could not establish as a matter of law that a crypto token was a security in and of itself.  But Judge Rakoff rejected Judge Torres’s distinction between institutional and retail purchasers as to whether a token was offered as a security.  Id. at *15.  Instead, Judge Rakoff found that “secondary-market purchasers had every bit as good a reason to believe that the defendants would take their capital contributions and use it to generate profits on their behalf,” and thus held that “the SEC’s assertion that the crypto assets at issue here are securities . . . survives the defendants’ motion to dismiss.”  Id.

VII. Shareholder Activism

Activists have continued targeting large U.S. companies in the first half of 2023, and recent changes to SEC regulations related to shareholder proposals and proxy elections could potentially encourage shareholder activists going forward.

A. Activist Campaigns Persist, with Companies Responding Swiftly

Four out of the six largest activist campaigns by volume in the first half of 2023 were resolved prior to formal proxy fights.  The remaining contests have had different outcomes: one activist investor successfully replaced an incumbent director, and the final campaign has litigation in progress.

Salesforce, Inc.:  In January 2023, Elliott Management announced a multibillion-dollar stake in Salesforce and nominated a slate of directors pushing for changes in corporate governance in light of Elliott Management’s view of the company’s performance.  See Lauren Thomas and Laura Cooper, Elliott Management Takes Big Stake in Salesforce, Wall Street Journal (Jan. 23, 2023).  The activists dropped the campaign in light of the company’s “announced ‘New Day’ multi-year profitable growth framework, strong fiscal year 2023 results, fiscal year 2024 transformation initiatives, Board and management actions and clear focus on value creation.”  Salesforce and Elliott Issue Joint Statement, Salesforce (Mar. 27, 2023).

The Walt Disney Company:  In January 2023, Trian Partners, led by activist investor Nelson Peltz, announced a $900 million position in Disney and released a detailed press release describing its intention to nominate Peltz to the Disney board of directors.  Trian Nominates Nelson Pretz for Election to Disney Board, Trian Partners (Jan. 11, 2023).  In the press release, Trian described examples of what it viewed as poor corporate governance, strategic decisions, and capital allocation decisions that had caused Disney to underperform its peers.  A week after the launch of the proxy fight, Disney replaced its then-CEO, Bob Chapek, with former CEO Bob Iger, whom Trian said it would not oppose.  Trian Applauds Recent Initiatives Announced by Disney as a Win for All Shareholders and Concludes Proxy Campaign, Trian Partners (Feb. 9, 2023).  Trian abandoned Peltz’s board nomination after Disney announced corporate restructuring and cost-cutting plans.  Id.

Fleetcor Technologies, Inc.:  In March 2023, Fleetcor Technologies, Inc., a business payments company operating in the fuel, corporate payments, toll and lodging spaces, reached a cooperation agreement with its longstanding shareholder D. E. Shaw to add two new directors and form an ad hoc strategic review committee to explore possible divestiture.  See Fleetcor Technologies, Inc., Cooperation Agreement (Mar. 15, 2023).  Following the agreement, the ad hoc strategic review committee will assess alternatives for Fleetcor’s portfolio, including a possible separation of one or more of its businesses.  See FLEETCOR Enters into Cooperation Agreement with the D. E. Shaw Group, FleetCor (Mar. 20, 2023).

Bath & Body Works, Inc.:  In March 2023, Bath & Body Works avoided a proxy fight with the hedge fund Third Point, led by Third Point’s founder and CEO, Dan Loeb.  At Third Point’s request, Bath & Body Works agreed to appoint Lucy Brady as a director and hire a technology services firm, and agreed with Third Point’s feedback that the Board would benefit from additional financial and capital allocation expertise.  See Bath & Body Works Board of Directors Sends Letter to Shareholders Highlighting Transformative Value-Creating Actions and Responding to Third Point’s Potential Proxy Contest, Bath & Body Works (Feb. 27, 2023).  Bath & Body Works also agreed to appoint Thomas J. Kuhn to the board in exchange for Third Point’s promise not to nominate other candidates at the 2023 annual shareholder meeting.  See Bath & Body Works Announces Appointment of Thomas J. Kuhn to Board of Directors, Bath & Body Works (Mar. 6, 2023).  Third Point ultimately opted to abandon its proxy contest.

Illumina, Inc.:  In May 2023, gene sequencing company Illumina faced a proxy fight led by activist investor Carl Icahn.  Icahn protested Illumina’s decision to acquire a cancer test developer company, Grail, Inc., without informing the shareholders of European and U.S. regulatory opposition.  See Carl Icahn, Carl C. Icahn Issues Open Letter to Shareholders of Illumina, Inc. (Mar. 13, 2023).  Icahn nominated three new director candidates to prevent the current board from further pursuing the deal.  Id.  The European Commission ultimately blocked the acquisition due to antitrust concerns last year, a result Illumina has now appealed.  Annika Kim Constantino, Biotech Company Illumina Pushes Back against Carl Icahn’s Proxy Fight over $7.1 Billion Grail Deal, CNBC (Mar. 20, 2023).  An unsuccessful appeal could result in a fine of up to 10% of Illumina’s annual revenues.  Id.  Illumina set aside $453 million in case of an EU fine.  See Foo Yun Chee, Exclusive: Illumina to face EU fine of 10% of turnover over Grail deal-sources, Reuters (Jan. 11, 2023).  The two-month proxy contest resulted in the board appointment of Andrew Teno, portfolio manager at Icahn Capital LP.  See Illumina Announces Preliminary Results of Annual Meeting, Illumina (May 25, 2023).

Freshpet, Inc.:  In May and June 2023, JANA Partners (the largest shareholder of Freshpet, Inc.) and James Panek (a putative stockholder of Freshpet) filed two separate actions against Fresphet, Inc. and its directors for allegedly interfering with Freshpet, Inc.’s shareholders’ right to nominate directors for the upcoming election, and thereby entrenching the incumbent directors.  See Compl. ¶¶ 12, 19, 102, 120, JANA Partners LLC v. Norris, 2023 WL 3764931 (Del. Ch. June 1, 2023); and Compl. ¶¶ 4, 9, 32, 40, 44, Panek v. Cyr, 2023 WL 3738885 (Del. Ch. May 30, 2023).  JANA Partners intended to nominate four candidates for election at Freshpet’s 2023 annual meeting.  See Compl. ¶¶ 1, 81, JANA Partners LLC v. Norris, 2023 WL 3764931 (Del. Ch. June 1, 2023).  Amid settlement discussions regarding board composition, Freshpet accelerated the 2023 annual meeting to an earlier date and reduced the number of directors up for election from four to three.  Id. ¶ 1.  JANA subsequently filed a lawsuit alleging a breach of the duty of loyalty, and seeking declaratory relief that (1) JANA has an opportunity to nominate, and the shareholders have an opportunity to elect, four directors at the 2023 annual meeting; and (2) the Freshpet directors breached their fiduciary duties.  See id. at Prayer for Relief.  Freshpet has postponed the 2023 annual meeting to October.  Freshpet Provides Update on 2023 Annual Meeting of Stockholders, Freshpet (June 6, 2023).  Gibson Dunn will continue to monitor developments on the two ongoing cases.

B. Two Regulatory Changes over SEC Proxy Rules Could Potentially Embolden Activist Investors

A new SEC rule and proposed amendments to Rule 14a-8 of the Securities Exchange Act of 1934 could potentially encourage activist campaigns to nominate new board members or submit shareholder proposals ahead of upcoming shareholder meetings.  The SEC’s new “Universal Proxy” rule provides activist campaigns with potential support in efforts to elect new board members and bring provisions to a vote at corporate meetings.  And proposed SEC amendments to Rule 14a-8, which could take effect in October 2023, would require companies to include with greater specificity why shareholder proposals should be excluded on implementation, duplication, or resubmission grounds.

The “Universal Proxy” rule that went into effect in January 2022 requires the issuer of a proxy card to list all candidates rather than the slate of candidates they support only.  Universal Proxy, 86 Fed. Reg. 68330 (Dec. 1, 2021).  The use of a  “universal proxy card” is required in all non-exempt solicitations involving director election contests.  Id.  With universal proxies, shareholders can more easily vote for nominees from a combination of two slates, potentially increasing the chance for activist investors to have at least one of their dissident nominees elected.  SEC Adopts Rules Mandating Use of Universal Proxy Card, Gibson Dunn (Nov. 18, 2021).

Among other things, incumbent boards have responded to the Universal Proxy rule by implementing advance notice bylaw provisions that include additional disclosure requirements.  For example, medical device maker Masimo enacted and subsequently withdrew a bylaw amendment in 2022 that required “any person (including any hedge fund) seeking to nominate a candidate for election to the board to disclose,” among other things, “the identity of . . . any limited partner or other investor who owned 5% or more of the hedge fund, as well as all investors in any sidecar vehicle.”  John C. Coffee, Jr., Proxy Tactics Are Changing: Can Advance Notice Bylaws Do What Poison Pills Cannot?, The CLS Blue Sky Blog (Oct. 19, 2022); see Masimo Corp., Current Report (Form 8-K) (Feb. 5, 2023).  The case law in this area is still developing.  See Coffee, supra; see also Jorgl v. AIM ImmunoTech Inc., 2022 WL 16543834 at *11 (Del. Ch. Oct. 28, 2022); Rosenbaum v. CytoDyn Inc., 2021 WL 4775140, at *12 (Del. Ch. Oct. 13, 2021).

The SEC is poised to finalize its proposed amendments to SEC Rule 14a-8 in October 2023.  Substantial Implementation, Duplication, and Resubmission of Shareholder Proposals Under Exchange Act Rule 14a-8, Release No. 34-95267, SEC (July 13, 2022); Office of Information and Regulatory Affairs, Agency Rule List – Spring 2023, RIN: 3235-AM91 .  The new amendments, if enacted, would heighten the bar for a company to exclude shareholder proposals on substantial implementation, duplication, and resubmission grounds.  Id.  The amendments could potentially build on the recent rise in shareholder proposals reaching a shareholder vote.  From 2021 to 2023, there was an 18% increase in shareholder proposals and a 40% increase on proposals that were voted on.  Mark T. Uyeda, Commissioner, SEC, Remarks at the Society for Corporate Governance 2023 National Conference (June 21, 2023).

VIII. Lorenzo Disseminator Liability

As discussed in our 2019 Mid-Year Securities Litigation Update, in Lorenzo v. Securities and Exchange Commission, the Supreme Court expanded scheme liability to encompass “those who do not ‘make’ statements” but nevertheless “disseminate false or misleading statements to potential investors with the intent to defraud.”  139 S. Ct. 1094, 1099 (2019).  In the wake of Lorenzo, secondary actors—such as financial advisors and lawyers—face potential scheme liability under SEC Rules 10b-5(a) and 10b-5(c) for disseminating the alleged misstatement of another if a plaintiff can show that the secondary actor knew the alleged misstatement contained false or misleading information.

In 2022, the Second Circuit, interpreting Lorenzo, held in Securities and Exchange Commission v. Rio Tinto plc, that the defendants must do “something extra” beyond making material misstatements or omissions to be subject to scheme liability under SEC Rule 10b-5(a) and (c).  41 F.4th 47, 54 (2d Cir. 2022); see Client Alert (Gibson Dunn represents Rio Tinto in this litigation.) Although the Supreme Court and other circuit courts have not directly addressed the requirements for scheme liability after Lorenzo, several recent district court decisions have added to the debate.  Specifically, one California district court has explicitly refused to apply Rio Tinto’s “something extra” requirement, another California district court has adopted a less onerous standard for plaintiffs than the Rio Tinto court, and one district court in Massachusetts engaged in an analysis similar to the Rio Tinto decision without specifically adopting the Second Circuit’s analysis.

In Securities and Exchange Commission v. Earle, a California district court declined to adopt Rio Tinto and noted that the Ninth Circuit “has not adopted” the “something extra” requirement, while denying an individual defendant’s motion to dismiss the SEC’s scheme liability claims.  2023 WL 2899529, at *7 (S.D. Cal. Apr. 11, 2023).  In Earle, the defendant, citing Rio Tinto, moved to dismiss the SEC’s 10b-5(a) and (c) claims on the grounds that the SEC had not alleged “something extra” beyond a “recitation of allegations of a violation of Rule 10b-5(b).”  Id.  The court disagreed with the defendant.  The court reasoned that the Supreme Court in Lorenzo had “recognized the ‘considerable overlap’ between the subsections of Rule 10b-5,” and that the Ninth Circuit made “clear that the argument that Rule 10b-5(a) and (c) claims cannot overlap with Rule 10b-5(b) statement liability claims is foreclosed by Lorenzo.”  Id. (citation and quotation marks omitted).  The court also found that the SEC alleged that the defendant disseminated misstatements, which the Supreme Court in Lorenzo held was enough to establish scheme liability.  Id. 

In another recent order rejecting defendants’ motion to dismiss 10b-5(a) and (c) claims, a different district court in California also emphasized the “‘considerable overlap’ between the subsections of Rule 10b-5.”  In re Vaxart, Inc. Sec. Litig., 2023 WL 3637093, at *3 (N.D. Cal. May 25, 2023).  The court stated that, although Lorenzo established that the dissemination of material misstatements can serve as the basis of 10b-5 scheme liability, “Rule 10b-5(a) and (c) prohibit more than just the dissemination of misleading statements; the language of these provisions is ‘expansive.’”  Id. (quoting Lorenzo, 139 S. Ct. at 1102).  Although the court did not mention Rio Tinto in its order, the court found that the defendants had allegedly committed many acts beyond misstatements and omissions—acts that were potentially sufficient to establish a claim for scheme liability even under a “something extra” requirement.  Id.

In Securities and Exchange Commission v. Wilcox, the district court denied an individual defendant’s motion to dismiss, concluding that “the allegation that [the defendant] provided false support to an external audit firm constitute[d] a deceptive act that, even if related to the making of a false statement by another, may establish her liability under . . . Rule 10b-5(a) and (c).”  2023 WL 2617348, at *9 (D. Mass. Mar. 23, 2023).  The defendant, citing Rio Tinto, had moved to dismiss the SEC’s Rule 10b-5(a) and (c) claims, arguing that the SEC alleged only that she prepared and provided support for misstatements.  Id. at *8.  The defendant claimed that these actions could not operate as the basis for scheme liability because they were not distinct, or “something extra,” from the misstatements themselves.  Id.  The court disagreed.  Although the court did not explicitly address the Rio Tinto “something extra” requirement, it mirrored Rio Tinto’s analysis in denying the motion to dismiss by holding that the alleged corruption of an auditing process, in conjunction with alleged misstatements, “may form the basis for scheme liability.”  Id.

These cases indicate that the landscape of Rule 10b-5 scheme liability remains dynamic in the wake of Lorenzo, with many circuits yet to address the issue.

IX. Market Efficiency and “Price Impact” Cases

As we explained in our recent Client Alert, the Second Circuit recently decertified a class of investors in Arkansas Teacher Retirement System v. Goldman Sachs Group, Inc., No. 22-484, — F.4th —, 2023 WL 5112157 (2d Cir. 2023), in the highly awaited decision following the fourth time this long-running class certification dispute has reached that court.

Two years ago, the Supreme Court considered questions regarding price-impact analysis for the first time since its 2014 decision preserving the “fraud-on-the-market” theory which enables a presumption of classwide reliance in Rule 10b-5 cases, but also permits defendants to rebut that presumption with evidence that the challenged statements did not impact the issuer’s stock price.  In that 2021 decision, which we detailed in our 2021 Mid-Year Securities Litigation Update, the Supreme Court confirmed that the generic nature of statements should be a part of the pre-certification price impact analysis, even though the same evidence may also be relevant to the merits question of materiality.  Goldman Sachs Grp., Inc. v. Ark. Tchr. Ret. Sys., 141 S. Ct. 1951, 1960–61 (2021).  The Supreme Court also observed that where the plaintiffs’ price impact theory is based on “inflation maintenance”—i.e., the alleged misstatement did not cause the stock price to increase but instead merely prevented it from dropping—any mismatch between generic challenged statements and specific alleged corrective disclosures will be a key consideration.  Id. at 1961.  After the Supreme Court’s decision, the Second Circuit remanded the case to the district court, which certified the proposed class again.  With this latest decision, the Second Circuit reversed the class certification order and remanded with instructions to decertify the class.

The plaintiffs in this long-running dispute alleged that the defendants’ general statements about Goldman’s business principles and conflict-of-interest management procedures were false and misleading, which artificially maintained Goldman’s stock price, and that the “truth” was “revealed” through announcements about regulatory enforcement actions and investigations into certain transactions.  At class certification, the plaintiffs relied on the Basic presumption of reliance, arguing that because Goldman’s stock trades in an efficient market, anyone purchasing the stock implicitly relied on all public, material information incorporated into the current price, including defendants’ alleged misstatements.  The defendants argued that the statements about Goldman Sachs’s business principles and conflict-of-interest management procedures—which included statements such as “[i]ntegrity and honesty are at the heart of our business” and “[w]e have extensive procedures and controls that are designed to identify and address conflicts of interest”—were so generic that they could not have affected Goldman’s stock price.

In this most recent decision, the Second Circuit decertified the class, holding that there was “an insufficient link between the corrective disclosures and the alleged misrepresentations” and that “Defendants have demonstrated, by a preponderance of the evidence, that the misrepresentations did not impact Goldman Sachs’ stock price, and, by doing so, rebutted Basic’s presumption of reliance.”  Ark. Tchr. Ret. Sys. v. Goldman Sachs Grp., Inc., 2023 WL 5112157, at *24.  The Second Circuit concluded that when plaintiffs rely on inflation maintenance theory, they cannot just “identify a specific back-end, price-dropping event,” “find a front-end disclosure bearing on the same subject,” and then “assert securities fraud, unless the front-end disclosure is sufficiently detailed in the first place.”  Id. at *21.  The specificity of the statement and alleged correction must “stand on equal footing.”  Id.

The Second Circuit is not the only court to apply the Supreme Court’s guidance from Goldman and find a mismatch between generic alleged misrepresentations and specific corrective disclosures sufficient to defeat the presumption of reliance.  In In re Qualcomm Inc. Securities Litigation, 2023 WL 2583306 (S.D. Cal. Mar 20, 2023), the plaintiffs alleged that Qualcomm, a company that sells computer chips and licenses its patents to device manufacturers, made misrepresentations about its licensing and bundling practices.  Id. at *1–2.  In denying class certification regarding the licensing-related statements, the court credited Qualcomm’s argument that statements describing its licensing practices as “broad,” “fair,” and “nondiscriminatory” were too generic to be “corrected” by disclosures confirming Qualcomm licensed only at the device level.  Id. at *11–12.  The court explained “the generic nature of the alleged misrepresentations makes it less likely that those misrepresentations deceived the market in the way Plaintiffs theorize, and therefore, less likely that they caused ‘front-end price inflation.’”  Id.  The court was also persuaded by Qualcomm’s argument that the alleged corrective disclosure amounted to information that was already publicly available and known in the market.  Id. at *12–13.  Taken together, the court concluded that Qualcomm successfully rebutted the Basic presumption of reliance and established a lack of price impact by a preponderance of the evidence.  Id.  The court, however, certified the class as to the bundling-related statements.  Id. at *14.

These two cases suggest that courts are following the Supreme Court’s approach in Goldman and conducting holistic analyses taking into account all evidence presented and applying “common sense” about the generic nature of statements when assessing whether defendants have rebutted the Basic presumption of reliance.  We will continue to monitor this developing line of caselaw.

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The following Gibson Dunn attorneys assisted in preparing this client update: Monica K. Loseman, Brian M. Lutz, Craig Varnen, Jefferson E. Bell, Christopher D. Belelieu, Michael D. Celio, Johnathan D. Fortney, Mary Beth Maloney, Jessica Valenzuela, Allison Kostecka, Lissa Percopo, H. Chase Weidner, Luke A. Dougherty, Trevor Gopnik, Tim Kolesk, Mark H. Mixon, Jr., Megan R. Murphy, Kevin Reilly, Marc Aaron Takagaki, Dillon M. Westfall, Kevin J. White, Eitan Arom, Angela A. Coco, Dasha Dubinsky, Graham Ellis, Mason Gauch, Nathalie Gunasekera, Amir Heidari, Tin Le, Lydia Lulkin, Michelle Lou, and Nicholas Whetstone.

Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding the developments in the Delaware Court of Chancery. 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 Securities Litigation practice group:

Securities Litigation Group:
Christopher D. Belelieu – New York (+1 212-351-3801, [email protected])
Jefferson Bell – New York (+1 212-351-2395, [email protected])
Michael D. Celio – Palo Alto (+1 650-849-5326, [email protected])
Jonathan D. Fortney – New York (+1 212-351-2386, [email protected])
Monica K. Loseman – Co-Chair, Denver (+1 303-298-5784, [email protected])
Brian M. Lutz – Co-Chair, San Francisco/New York (+1 415-393-8379/+1 212-351-3881, [email protected])
Mary Beth Maloney – New York (+1 212-351-2315, [email protected])
Jason J. Mendro – Washington, D.C. (+1 202-887-3726, [email protected])
Alex Mircheff – Los Angeles (+1 213-229-7307, [email protected])
Jessica Valenzuela – Palo Alto (+1 650-849-5282, [email protected])
Craig Varnen – Co-Chair, Los Angeles (+1 213-229-7922, [email protected])
Mark H. Mixon, Jr. – New York (+1 212-351-2394, [email protected])

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Gibson Dunn & Crutcher team was led by European Co-Chair of Private Equity Federico Fruhbeck, M&A and Private Equity partners Alice Brogi, Ariel Harroch and Judith Raoul-Bardy, as well as Labor & Employment partner Nataline Fleury.

The firm acted alongside Spanish firm Perez-Llorca on this transaction.