Richard Manfredi, Author at Gibson Dunn

On June 13, 2023, in its updated rulemaking agenda for Spring 2023, the Securities and Exchange Commission (“SEC”) indicated a goal of October 2023 for the adoption of proposed cybersecurity rules applicable to public companies and registered investment advisers and funds. The two rule proposals were issued by the SEC at the beginning of 2022 to address cybersecurity governance and cybersecurity incident disclosure, and the SEC had previously targeted adoption by no later than April 2023. Although the “Reg Flex” agenda is not binding and target dates frequently are missed or further delayed, the Spring agenda indicates that cybersecurity rulemakings remain a top, near-term priority for the SEC.

The Proposed Rules

Publicly Traded Companies

In March 2022, the SEC proposed new rules under the Securities Exchange Act of 1934 (the “Exchange Act”), titled Cybersecurity Risk Management, Strategy, Governance, and Incident Disclosure (the “Exchange Act Proposal”). If adopted in its proposed form, the Exchange Act Proposal would require standardized disclosures regarding specific aspects of a company’s cybersecurity risk management, strategy, and governance. The Exchange Act Proposal also would require reporting on material cybersecurity incidents within four business days of a company’s materiality determination and periodic disclosures regarding, among other things, a company’s policies and procedures to identify and manage cybersecurity risk, oversight of cybersecurity by the board of directors and management, and updates to previously disclosed cybersecurity incidents.

Registered Investment Advisers and Funds

In February 2022, the SEC proposed new rules under the Investment Advisers Act of 1940 and the Investment Company Act of 1940, titled “Cybersecurity Risk Management for Investment Advisers, Registered Investment Companies, and Business Development Companies“ (the “RIA Proposal”). If adopted in its proposed form, the RIA Proposal would require both registered investment advisers and investment companies to adopt and implement written cybersecurity policies and procedures to address cybersecurity risk. The RIA Proposal would also require registered investment advisers to report significant cybersecurity incidents affecting the investment adviser or the funds it advises to the SEC, and would impose a new recordkeeping policy and internal review requirements related to cybersecurity.

In addition to the two proposals described above, the SEC has also proposed a cybersecurity rule for broker-dealers, clearing agencies, and other security market participants, but final action on this rule proposal is not expected until April 2024.

As discussed in our prior client alert on the Exchange Act Proposal, the SEC’s proposals were controversial, and many of the comments submitted on the proposals were critical of both the prompt incident reporting standard and prescriptive disclosures on board oversight and director cybersecurity expertise. Since that time, the SEC has adopted a number of rules substantially as proposed, but has significantly revised other rule initiatives in response to commenter concerns, and has also taken varied approaches with respect to new rules’ effective dates. As a result, it is difficult to predict what form the SEC’s final rules will take, and how soon companies will need to adapt their disclosures. Our prior client alert lists a number of actions companies can take in preparation for the final rules, and our recent article offers additional practical guidance given the SEC’s increased enforcement focus on cyber disclosures.

The following Gibson Dunn attorneys assisted in preparing this update: Cody Poplin, Matthew Dolloff, Sheldon Nagesh, Nicholas Whetstone, Stephenie Gosnell Handler, Vivek Mohan, Elizabeth Ising, Ronald Mueller, and Lori Zyskowski.

Gibson Dunn lawyers are available to assist in addressing any questions you may have about these developments. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Privacy, Cybersecurity and Data Innovation or Securities Regulation and Corporate Governance practice groups:

Privacy, Cybersecurity and Data Innovation Group:
S. Ashlie Beringer – Palo Alto (+1 650-849-5327, [email protected])
Jane C. Horvath – Washington, D.C. (+1 202-955-8505, [email protected])
Alexander H. Southwell – New York (+1 212-351-3981, [email protected])
Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, [email protected])
Vivek Mohan – Palo Alto (+1 650-849-5345, [email protected])

Securities Regulation and Corporate Governance Group:
Elizabeth Ising – Washington, D.C. (+1 202-955-8287, [email protected])
James J. Moloney – Orange County (+1 949-451-4343, [email protected])
Ron Mueller – Washington, D.C. (+1 202-955-8671, [email protected])
Lori Zyskowski – New York (+1 212-351-2309, [email protected])

Investment Funds Group:
Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, [email protected])
Shukie Grossman – New York (+1 212-351-2369, [email protected])
Edward D. Sopher – New York (+1 212-351-3918, [email protected])

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice. Please note, prior results do not guarantee a similar outcome.

On June 20, 2023 the Securities and Exchange Commission (the “SEC” or the “Commission”) announced the settlement of an enforcement action against Insight Venture Management LLC (d/b/a Insight Partners) (“Insight”) and published an Order Instituting Administrative and Cease-and-Desist Proceedings, Pursuant to Sections 203(e) and 203(k) of the Investment Advisers Act of 1940 (the “Order”).[1] In the Order, the SEC found that Insight (1) charged excess management fees to its investors through “inaccurate application of its permanent impairment policy” and (2) failed to disclose a conflict of interest to investors concerning the same policy.[2] This action reflects a growing trend we continue to see in our representation of private fund managers in their routine examinations by the SEC–direct and explicit inquiry into the decision by a given fund manager to not permanently impair (i.e., “write-down”) a given fund asset when such impairment would reduce the basis on which management fees are calculated. We view this as a clear indication of the Commission’s focus on scrutinizing the calculation of management fees, in particular after the termination of the commitment period.

I. Calculation of Management Fees

Insight operated multiple funds (the “Funds”) whose respective limited partnership agreements (“LPAs”) required, like many do, that management fees be calculated during the “commitment period” (i.e., the period during which the Funds were permitted to make investments) on the basis of committed capital and during the “post-commitment period” (i.e., the period after the commitment period during which the Funds look to exit investments and realize returns)[3] based on invested capital (i.e., “the acquisition cost of portfolio investments held by the Funds”). Pursuant to the LPAs, when an asset had suffered a “permanent impairment in value” that basis was to be reduced commensurately.[4] The Commission took issue with Insight’s approach to determining whether a permanent impairment had occurred (and whether Insight resultantly calculated management fees on too large a basis).

Specifically, the Commission identified three of Insight’s practices as problematic:

Lack of written criteria in LPA. Insight did not include any language in the Funds’ LPAs indicating how a permanent impairment determination would be made.[5]
Subjective evaluation criteria. In practice, Insight employed a four pronged test to determine whether a permanent impairment was appropriate[6] which included whether: “(a) the valuation of the Fund’s aggregated investments in a portfolio company was currently written down in excess of 50% of the aggregate acquisition cost of the investments; (b) the valuation of the Fund’s aggregated investments in a portfolio company had been written down below its aggregate acquisition cost for six consecutive quarters; (c) the write-down was primarily due to the portfolio company’s weakening operating results, as opposed to market conditions or comparable transactions, or valuations of comparable public companies; and (d) the portfolio company would likely need to raise additional capital within the next twelve months.”[7]
Portfolio Company Level v. Portfolio Investment Level. The Funds’ LPAs included separate definitions for “portfolio company” (i.e., “an entity in which a [p]ortfolio [i]nvestment is made by the [p]artnership directly or through one or more intermediate entities of the [p]artnership”) and “portfolio investment” (i.e., “any debt or equity (or debt with equity) investment made by the [p]artnership”). Further, the LPA provision governing permanent impairments indicated that they were to be assessed on a portfolio investment level rather than a portfolio company level (emphasis added).[8] The Commission took the position that Insight’s aforementioned evaluation criteria failed to honor this distinction and instead only analyzed the need for a permanent impairment at the aggregate portfolio company level.[9]

Taken together, the Commission found that these practices caused Insight to fail to permanently impair certain of their Funds’ assets to the correct extent. As a result, the Commission determined that Insight failed to adequately reduce the basis upon which post-commitment period management fees were calculated, and overcharged their investors.

II. Conflicts of Interest

In addition to the miscalculation of management fees, the Commission also found that the subjective nature of the criteria Insight used to determine whether a permanent impairment had occurred created a conflict of interest between Insight and its investors. Put differently, because Insight was the party ultimately determining whether to find a permanent impairment had occurred, Insight had the right to reverse any permanent impairment it had previously applied, and finding a permanent impairment had occurred would result in Insight collecting fewer management fees, it should have, at the very least, disclosed the existence of this conflict to its investors.[10]

III. Violations and Penalties

As part of its settlement with the SEC, Insight was ordered to reimburse its investors upwards of $4.6 million, corresponding to excess management fees charged and interest thereon, and was required to pay a civil penalty of an additional $1.5 million. It is also notable that although the Commission acknowledged Insight’s prompt remedial efforts (which included mid-exam reimbursement) and cooperation during the course of the investigation, they still decided to proceed with enforcement.

IV. Analysis & Key Takeaways

When determining whether to find a permanent impairment, fund managers should consider listing the criteria they apply in the operative provisions of their LPA(s). Note also that if this practice is adopted, it will be imperative that fund managers adhere closely to the criteria included in the LPA.
Though we expect criteria for finding a permanent impairment will always involve some level of subjectivity, including objective factors to the extent possible and/or involving a third-party valuation professional in the process could provide a meaningful level of enforcement risk mitigation. However, while the Order indicates that Insight did, to the satisfaction of the Commission, subsequently apply more objective criteria when determining the amount of management fees it had overcharged its investors, the Order provides no clear guidance as to what criteria the Commission considers sufficiently objective.
In addition to common valuation related conflicts of interest disclosed in private placement memoranda and similar disclosure documents, fund managers should consider including explicit disclosure around the conflict of interest inherent in the fund manager deciding whether to permanently impair a fund’s assets when such decision would negatively impact the amount of management fees the fund manager would be owed.

V. Conclusion

The SEC’s recent settlement of its enforcement action against Insight reflects the overall trend towards increased scrutiny of the private funds industry generally, including pursuant to its increased rulemaking related to the same. More specifically, this emphasis on valuation and write-down practices is in harmony with the Commission’s 2023 Examination Priorities Report,[11] as well as other recently settled enforcement actions.[12] We expect this trend to continue.

__________________________

[1] Order Instituting Administrative and Cease-and-Desist Proceedings, Pursuant to Sections 203(e) and 203(k) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, Release No. 6332 (June 20, 2023), link.

[2] Id., Paragraph 1

[3] Id., Paragraph 11

[4] Id., Paragraph 11

[5] Id., Paragraph 14

[6] We note that the Order did not make it clear whether this four-pronged test was maintained or recorded by Insight in any formal investment or valuation policy, but the Commission did note that “Insight did not adopt or implement written policies or procedures reasonably designed to prevent violations of the Advisers Act relating to the calculation of management fees…” See Id., Paragraph 18.

[7] Id., Paragraph 15

[8] Id., Paragraph 12

[9] Id., Paragraph 16

[10] Id., Paragraph 17

[11] Securities and Exchange Commission, Division of Examinations, 2023 Examination Priorities, link.

[12] See e.g., Order Instituting Administrative and Cease-and-Desist Proceedings, Pursuant to Sections 203(e) and 203(k) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, Release No. 6104 (Sept. 2, 2022) (Finding that Energy Innovation Capital Management LLC, an exempt reporting adviser, improperly calculated management fees by failing to make adjustments for dispositions of its investments, which included any write-down in value of individual portfolio company securities, when the value of such securities provided the basis on which management fees were calculated, resulting in charging its investors excessive management fees), link; Order Instituting Administrative and Cease-and-Desist Proceedings, Pursuant to Sections 203(e) and 203(k) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, Release No. 5617 (Oct. 22, 2020) (Finding that EDG Management Company, LLC failed to write-down the value of certain of its portfolio securities as required by the applicable LPA, which resulted in overcharging management fees to its investors which were calculated using the value of such portfolio securities as the basis), link.

Should you wish to review how your actual management fee calculations synch up with the mechanics set forth in your limited partnership agreement and disclosure set forth in your private placement memoranda, or if you have any questions about how best to prepare for examination scrutiny related to the same, please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Investment Funds practice group, or the following authors:

Kevin Bettsteller – Los Angeles (+1 310-552-8566, [email protected])
Gregory Merz – Washington, D.C. (+1 202-887-3637, [email protected])
Shannon Errico – New York (+1 212-351-2448, [email protected])
Zane E. Clark – Washington, D.C. (+1 202-955-8228 , [email protected])

Investment Funds Group Contacts:
Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, [email protected])
Albert S. Cho – Hong Kong (+852 2214 3811, [email protected])
Candice S. Choh – Los Angeles (+1 310-552-8658, [email protected])
John Fadely – Singapore/Hong Kong (+65 6507 3688/+852 2214 3810, [email protected])
A.J. Frey – Washington, D.C./New York (+1 202-887-3793, [email protected])
Shukie Grossman – New York (+1 212-351-2369, [email protected])
James M. Hays – Houston (+1 346-718-6642, [email protected])
Kira Idoko – New York (+1 212-351-3951, [email protected])
Eve Mrozek – New York (+1 212-351-4053, [email protected])
Roger D. Singer – New York (+1 212-351-3888, [email protected])
Edward D. Sopher – New York (+1 212-351-3918, [email protected])
William Thomas, Jr. – Washington, D.C. (+1 202-887-3735, [email protected])

Earlier today, the Supreme Court released its much-anticipated decisions in Students for Fair Admissions v. Harvard and Students for Fair Admissions v. University of North Carolina. By a 6–3 vote, the Supreme Court held that Harvard’s and the University of North Carolina’s use of race in their admissions processes violated the Equal Protection Clause and Title VI of the Civil Rights Act. Chief Justice Roberts wrote the majority opinion.

Although the majority opinion does not explicitly modify existing law governing employers’ consideration of the race of their employees (or job applicants), the decisions nevertheless have important strategic and atmospheric ramifications for employers. In particular, the Court’s broad rulings in favor of race neutrality and harsh criticism of affirmative action in the college setting could accelerate the trend of reverse-discrimination claims.

As a formal matter, the Supreme Court’s decision does not change existing law governing employers’ use of race in employment decisions. But existing law already circumscribes employers’ ability to use race-based decision-making, even in pursuit of diversity goals.

I. Background

Students for Fair Admissions (“SFFA”), an organization dedicated to ending the use of race in college admissions, brought two lawsuits that were considered together at the Supreme Court. One lawsuit challenged Harvard’s use of race in admissions on the ground that it violates Title VI, which prohibits race discrimination in programs or activities receiving federal assistance (including private colleges that accept federal funds). SFFA v. Harvard, No. 20-1199. The second lawsuit challenged the University of North Carolina’s use of race in the admissions process on the ground that it violates the Equal Protection Clause, which applies only to state actors (e.g., public universities). SFFA v. University of North Carolina, No. 21-707. The plaintiffs argued, and the defendants did not meaningfully contest, that the law governing the use of race in college admissions under Title VI and the Equal Protection Clause is the same.

Prior to today’s decisions, the law governing colleges’ use of race in admissions was set forth in two Supreme Court cases decided on the same day in 2003: Grutter v. Bollinger, 539 U.S. 306 (2003), and Gratz v. Bollinger, 539 U.S. 244 (2003). In Grutter, the Supreme Court upheld a law school’s consideration of applicants’ race as a “‘plus’ factor . . . in the context of its individualized inquiry into the possible diversity contributions of all applicants.” 539 U.S. at 341. In Gratz, the Supreme Court struck down a university’s consideration of race pursuant to a mechanical formula that “automatically distribute[d] 20 points . . . to every single ‘underrepresented minority’ applicant solely because of race.” 539 U.S. at 271.

SFFA asked the Court to overrule Grutter and adopt a categorical rule that colleges cannot consider applicants’ race in making admissions decisions. It also argued that Harvard’s and North Carolina’s use of race is unlawful even under Grutter because both colleges allegedly engage in racial balancing, discriminate against Asian-American applicants, and reject race-neutral alternatives that would achieve the colleges’ diversity goals.

II. Analysis

A. The Supreme Court’s Opinion

The Supreme Court held that both Harvard and UNC’s affirmative-action programs violated the Fourteenth Amendment’s Equal Protection Clause. In a footnote, the Court explained that the Equal Protection Clause analysis applies to Harvard by way of Title VI, 42 U.S.C. § 2000d, which prohibits “any educational program or activity receiving Federal financial assistance” from discriminating on the basis of race. Because “discrimination that violates the Equal Protection Clause of the Fourteenth Amendment committed by an institution that accepts federal funds also constitutes a violation of Title VI,” the Court “evaluate[d] Harvard’s admissions programs under the standards of the Equal Protection Clause.”

Applying strict scrutiny, the Court asked whether universities could “make admissions decisions that turn on an applicant’s race.” The Court emphasized that Grutter, which was decided in 2003, predicted that “25 years from now, the use of racial preferences will no longer be necessary to further the interest approved today.” The Court explained that college affirmative-action programs “must comply with strict scrutiny, they may never use race as a stereotype or negative, and—at some point—they must end.”

The Court then determined that Harvard and UNC’s admissions programs are unconstitutional for several reasons. First, the Court concluded that universities’ asserted interests in “training future leaders,” “better educating [their] students through diversity,” and “enhancing … cross-racial understanding and breaking down stereotypes” were “not sufficiently coherent for purposes of strict scrutiny.” Second, the Court found no “meaningful connection between the means [the universities] employ and the goals they pursue.” The Court concluded that racial categories were “plainly overbroad” by, for instance, “grouping together all Asian students” or by employing “arbitrary or undefined” terms such as “Hispanic.” Third, the Court held that the universities impermissibly used race as a “negative” and a “stereotype.” Because college admissions “are zero-sum,” the Court held, a racial preference “provided to some applicants but not to others necessarily advantages the former group at the expense of the latter.” Finally, the Court observed that the universities’ use of race lacked a “logical end point.”

The Court’s opinion employs broad language against racial preferences, reasoning that “[e]liminating racial discrimination means eliminating all of it.” As such, universities and colleges can no longer consider race in admissions decisions (subject to a narrow exception for remediating past discrimination). But the Court clarified that “nothing in this opinion should be construed as prohibiting universities from considering an applicant’s discussion of how race affected his or her life, be it through discrimination, inspiration, or otherwise,” as long as the student is “treated based on his or her experiences as an individual—not on the basis of race.” The Court also made clear, however, that “universities may not simply establish through application essays or other means the regime we hold unlawful today.”

The Chief Justice’s opinion for the Court was joined by Justices Thomas, Alito, Gorsuch, Kavanaugh, and Barrett. Justices Kagan, Sotomayor, and Jackson dissented. Justices Thomas, Gorsuch, and Kavanaugh wrote separate opinions concurring in the Court’s decision. Justices Sotomayor and Justice Jackson wrote dissenting opinions.

B. Existing law governing reverse-discrimination claims against employers

Even prior to the SFFA decisions, an employer’s consideration of the race of its employees, contractors, or applicants was already subject to close scrutiny under Title VII and Section 1981. “Without some other justification, . . . race-based decisionmaking violates Title VII’s command that employers cannot take adverse employment actions because of an individual’s race.” Ricci v. DeStefano, 557 U.S. 557, 579 (2009).

Supreme Court precedent allows a defendant to defeat a reverse-discrimination claim under Section 1981 or Title VII by demonstrating that the defendant acted pursuant to a valid affirmative-action plan. See, e.g., Johnson v. Transportation Agency, Santa Clara County, California, 480 U.S. 616, 626–27 (1987); see also, e.g., Doe v. Kamehameha Sch./Bernice Pauahi Bishop Estate, 470 F.3d 827, 836–40 (9th Cir. 2006) (en banc) (applying Johnson in Section 1981 case). If a defendant invokes the affirmative-action defense (under Title VII or Section 1981), then the plaintiff bears the burden of proving that the “justification is pretextual and the plan is invalid.” Johnson, 480 U.S. at 626–27.

“[A] valid affirmative action plan should satisfy two general conditions.” Shea v. Kerry, 796 F.3d 42, 57 (D.C. Cir. 2015). First, the plan must be remedial and rest “on an adequate factual predicate justifying its adoption, such as a ‘manifest imbalance’ in a ‘traditionally segregated job category.’” Id. (quoting Johnson, 480 U.S. at 631) (alteration omitted). “Second, a valid plan refrains from ‘unnecessarily trammeling the rights of white employees.’” Shea, 796 F.3d at 57 (quoting Johnson, 480 U.S. at 637–38 (alterations omitted)). A valid affirmative-action plan “seeks to achieve full representation for the particular purpose of remedying past discrimination,” but cannot seek “proportional diversity for its own sake” or seek to “maintain racial balance.” Id. at 61.

In addition, plaintiffs alleging discrimination under Title VII or Section 1981 must show that they were harmed in some way. For example, Title VII generally requires a plaintiff to show that discrimination affected “his compensation, terms, conditions, or privileges of employment.” 42 U.S.C. § 2000e-2(a)(1). Courts often interpret this to mean a plaintiff must show a concrete and objective “adverse employment action,” e.g., Davis v. Legal Services Alabama, Inc., 19 F.4th 1261, 1265 (11th Cir. 2021) (quotation marks omitted), although other courts have indicated that in some circumstances less tangible harms might be sufficient, see, e.g., Chambers v. District of Columbia, 35 F.4th 870, 874–79 (D.C. Cir. 2022) (en banc). Under these standards, many employers lawfully seek to promote diversity, equity, inclusion, and equal opportunity through certain types of training, outreach, recruitment, pipeline development, and other means.

III. Implications for employers’ diversity programs

The Supreme Court’s decisions in the SFFA case were made in the unique context of college admissions and were based on the Equal Protection Clause, not Title VII or Section 1981, with the assumption, uncontested by the parties, that the analysis would be the same under both the Equal Protection Clause and Title VI. As such, they do not explicitly change existing law governing reverse-discrimination claims in the context of private employment or private employers’ diversity programs for those private employers not subject to Title VI (i.e., those who do not receive qualifying federal funds). Still, courts often interpret Title VI (at issue in the case against Harvard) to be consistent with Title VII and Section 1981, so there is some risk that lower courts will apply the Court’s decision in the employment context. Justice Gorsuch’s concurrence highlights this risk, observing that Title VI and Title VII use “the same terms” and have “the same meaning.”

EEOC Chair Charlotte A. Burrows released an official statement stating that today’s decisions do “not address employer efforts to foster diverse and inclusive workforces.” EEOC Commissioner Andrea Lucas published an article reiterating a view she has previously expressed, which is that race-based decisionmaking is already presumptively illegal for employers, and stating that the Court’s opinion “brings the rules governing higher education into closer parallel with the more restrictive standards of federal employment law.” She recommended that “employers review their compliance with existing limitations on race- and sex-conscious diversity initiatives” and ensure they are not relying on “now outdated” precedent.

Against that backdrop, the Court’s decision could have important strategic and atmospheric consequences for employers’ diversity efforts. The Court’s holdings likely will encourage additional litigation. Plaintiffs’ firms and conservative public-interest groups likely will bring reverse race-discrimination claims against some employers with well-publicized diversity programs. Government authorities such as state attorneys general might also increase enforcement efforts.

The following Gibson Dunn attorneys assisted in preparing this client update: Jason Schwartz, Blaine Evanson, Jessica Brown, Molly Senger, Matt Gregory, and Josh Zuckerman.

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

Labor and Employment Group:

Jason C. Schwartz – Washington, D.C.
(+1 202-955-8242, [email protected])

Katherine V.A. Smith – Los Angeles (+1 213-229-7107, [email protected])

Appellate and Constitutional Law Group:

Thomas H. Dupree Jr. – Washington, D.C. (+1 202-955-8547, [email protected])

Allyson N. Ho – Dallas (+1 214-698-3233, [email protected])

Julian W. Poon – Los Angeles (+ 213-229-7758, [email protected])

Decided June 29, 2023

Groff v. DeJoy, No. 22-174

Today, the Supreme Court clarified the standard employers must satisfy to show that granting a religious accommodation would create an “undue hardship” on the employer’s business. The Court unanimously held that an employer must show “substantial increased costs in relation to the conduct of its particular business” to justify the denial of a religious accommodation under Title VII.

Background: Title VII of the Civil Rights Act of 1964 prohibits employers from discriminating on the basis of “religion” unless the employer can demonstrate that it cannot reasonably accommodate a current or prospective employee’s religious observance or practice “without undue hardship on the conduct of the employer’s business.” 42 U.S.C. § 2000e(j). Relying on Trans World Airlines, Inc. v. Hardison, 432 U.S. 63 (1977), many lower courts interpreted “undue hardship” to mean any accommodation for which the employer must bear more than a “de minimis cost.”

Gerald Groff brought a Title VII claim against his employer, the U.S. Postal Service, after the Postal Service disciplined him for refusing to work on Sunday, when he observed the sabbath. The Postal Service contended that accommodating Groff’s religious observance disrupted workflow and created impositions on his coworkers, to the detriment of workplace morale. The district court granted summary judgment to the USPS, and the Third Circuit affirmed, concluding that accommodating Groff would impose more than de minimis costs on the Postal Service.

Issue: Whether Title VII’s “undue hardship” standard for assessing religious accommodations is satisfied by demonstrating only that the employer would incur costs that are “more than de minimis.”

Court’s Holding:

No. To show that granting a religious accommodation would create an “undue hardship,” an employer must show that the burden of granting an accommodation would result in substantial increased costs in relation to the conduct of its particular business.

“[A]n employer must show that the burden of granting an accommodation would result in substantial increased costs in relation to the conduct of its particular business.”

Justice Alito, writing for the Court

What It Means:

The Court emphasized that context matters in assessing whether a religious accommodation imposes an “undue hardship” on employers. Courts must “apply the test in a manner that takes into account all relevant factors in the case at hand, including the particular accommodations at issue and their practical impact in light of the nature, size and operating cost of an employer.”
One additional issue in the case was whether the effect an accommodation had on the plaintiff’s coworkers could amount to an “undue hardship.” The Court clarified that “coworker impacts” would satisfy that standard only if they affect the conduct of the employer’s business.
The Court advised that its opinion likely would not require the EEOC to revisit much of its guidance on what qualifies as an undue hardship. For example, the EEOC would need to make few, “if any,” changes to its guidance explaining that “no undue hardship is imposed by temporary costs, voluntary shift swapping, occasional shift swapping, or administrative costs.”

The Court’s opinion is available here.

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

Appellate and Constitutional Law Practice

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

Related Practice: Labor and Employment

Jason C. Schwartz
+1 202.955.8242
[email protected]

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

Decided June 29, 2023

Abitron Austria GmbH v. Hetronic Int’l, Inc., No. 21-1043

Today, the Supreme Court held that trademark infringement claims under the Lanham Act apply only where the claimed infringing “use in commerce” occurs in the United States.

Background: The Lanham Act imposes civil liability—potentially including actual, treble, and statutory damages—on anyone who “use[s] in commerce” a trademark in a manner “likely to cause confusion, or to cause mistake, or to deceive.” 15 U.S.C. §§ 1114(1)(a), 1117(a)-(c), 1125(a)(1). Hetronic, a U.S. company, sued Abitron, a group of foreign companies, under the Lanham Act, alleging that Abitron sold products that infringe Hetronic’s trademarks. Less than 0.3 percent of Abitron’s sales were made directly to U.S. buyers. Ninety-seven percent were made in foreign countries, to foreign buyers, for use in foreign countries; and the remainder were made in foreign countries but were designated to and ultimately did enter the United States.

A jury awarded more than $90 million in damages for all of Abitron’s sales, whether inside or outside the United States. The Tenth Circuit affirmed, holding that the Lanham Act applies extraterritorially to foreign sales that have a substantial effect on U.S. commerce. It reasoned that even Abitron’s foreign sales to foreign buyers for foreign use had a domestic effect by depriving a U.S. company of foreign sales that it otherwise would have made.

Issue: Whether the Lanham Act’s provisions that prohibit trademark infringement (15 U.S.C. § 1114(1)(a) and § 1125(a)(1)) apply extraterritorially.

Court’s Holding:

The Court confirmed “that a permissible domestic application” of the Lanham Act “can occur even when some foreign ‘activity is involved in the case,’” but the question of liability reaches only an allegedly infringing “use in commerce” of a trademark that occurs in the United States.

“[W]e hold that § 1114(1)(a) and § 1125(a)(1) are not extraterritorial and that the infringing ‘use in commerce’ of a trademark provides the dividing line between foreign and domestic applications of these provisions.”

Justice Alito, writing for the Court

What It Means:

The Court held 9-0 that the provisions of the Lanham Act that govern infringement claims—§ 1114(1)(a) and § 1125(a)(1)—did not reach Abitron’s foreign sales to foreign buyers for foreign use. But the Court split 5-4 over what counts as a permissible “domestic application” of these provisions. The majority held that the provisions apply only when the allegedly infringing “use in commerce” occurs in U.S. territory.
The majority distinguished the prior controlling case on extraterritorial application of the Lanham Act, Steele v. Bulova Watch Co., 344 U.S. 280 (1952), which looked to the effects of alleged infringement on U.S. commerce, as decided before more recent Supreme Court case law on the extraterritoriality of U.S. statutes and based on facts present in that case that “implicated both domestic conduct and a likelihood of domestic confusion” unlike Abitron’s foreign sales.
Justice Jackson, who offered the fifth vote for the majority, penned a separate concurrence suggesting that a foreign company selling goods in a foreign country could still be engaged in domestic “use in commerce” if the buyer resells the goods in the United States, or if the foreign company engages in other conduct “in the internet age” that would constitute a “use in commerce” in the United States even without a “domestic physical presence.”
Four Justices (Sotomayor, Roberts, Kagan, and Barrett) would have adopted the federal government’s position: foreign sales violate the Lanham Act’s trademark infringement provisions so long as they are likely to cause consumer confusion in the United States. The majority, however, expressly rejected this position, focusing instead on the location of the allegedly infringing “use in commerce” of a trademark.
Because of the decision’s focus on “use in commerce” in the United States, it likely will not affect prior case law that has confirmed the ability of courts to establish personal jurisdiction over trademark infringers and counterfeiters outside the United States that market and sell infringing goods to U.S. consumers. See, e.g., Chloé v. Queen Bee of Beverly Hills, LLC, 616 F.3d 158 (2d Cir. 2010).

The Court’s opinion is available here.

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

Appellate and Constitutional Law Practice

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

Related Practice: Intellectual Property

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

Related Practice: Fashion, Retail and Consumer Products

Howard S. Hogan
+1 202.887.3640
[email protected]

Related Practice: Transnational Litigation

Susy Bullock +44 (0) 20 7071 4283 [email protected]	Perlette Michèle Jura +1 213.229.7121 [email protected]	Andrea E. Neuman +1 212.351.3883 [email protected]
William E. Thomson +1 213.229.7891 [email protected]

On June 21, 2023, the IRS and Treasury published proposed Treasury regulations (the “Proposed Regulations”) that provide eagerly awaited guidance on rules for receiving refund payments in respect of certain credits (more commonly referred to as “direct pay”) under the Inflation Reduction Act of 2022 (the “IRA”).[1] Taxpayers are permitted to rely on the Proposed Regulations until final regulations are published. The IRS and Treasury also released a temporary regulation (the “Temporary Regulation”) that implements a registration system that taxpayers will need to satisfy before any valid direct pay election can be made. (This system is substantially similar to the system that facilitates cash sales of certain credits. We discussed that system in our previous alert, which can be found here.)

This alert begins with some background regarding section 6417 (the statutory provision permitting direct pay) and provides a short summary of some of the most important aspects of the Proposed Regulations and Temporary Regulation,[2] including some observations regarding key implications of the guidance for market participants.

Background

Historically, federal income tax credits associated with the investment in and production of clean energy and carbon capture technologies have been non-refundable,[3] and using non-refundable tax credits has required current tax liability against which the credits could be applied. In our recent client alert on the rules facilitating cash sales of certain credits, we provided background regarding the complicated tax equity arrangements that have been utilized by developers to monetize credits and explained how new rules authorizing the sale of credits could simplify monetization. The “direct pay” rules are expected to serve a similar, albeit more limited, role in reducing the need for complicated tax equity arrangements.

Direct Payment of Credits

The Proposed Regulations and Temporary Regulation provide substantial practical guidance on direct payment of credits, clarifying who may receive direct payments, what a direct payment election covers, how to compute the amount of the direct payment, how (administratively) to elect to receive such payments, how to avoid new excessive payment penalties, and how the rules apply to passthrough entities.[4] The subsections below describe some of the most significant aspects of the guidance on these topics.

Who May Receive Direct Payments

In general, any taxpayer can receive refund payments for the following three credits for five years of the applicable credit period:

the carbon capture and sequestration credit (section 45Q);
the clean hydrogen production credit (section 45V); and
the advanced manufacturing production credit (section 45X).

For the section 45Q and section 45V credits, the election is available for the first five years of the applicable credit period and, for section 45X the election, is available for any consecutive five-year period for which the credit is available, in each case, only for taxable periods that end before January 1, 2033. The Proposed Regulations clarify that, for these three credits, taxpayers are allowed refund payments for only a single five-year period and cannot re-elect to receive refund payments again once the five-year period has expired or the election has been revoked.

Notably, several types of tax-exempt entities are entitled to direct payments for the three credits above for the entire applicable credit period, as well as for eight other energy-related credits (including the production tax credit under section 45 and the investment tax credit under section 48).[5] In response to significant comments from taxpayers, the Proposed Regulations clarify that applicable tax-exempt entities that can receive direct payments include the District of Columbia and agencies and instrumentalities of states, Indian tribal governments, and Alaska Native Corporations.

The Proposed Regulations also clarify that direct payments cannot be received for purchased credits.

Like the rules for cash sales of credits, the Proposed Regulations confirm that, where a disregarded entity owns the property that generates the tax credit, the relevant taxpayer entitled to pursue a refund under the “direct pay” rules is the regarded owner of the disregarded entity. The Proposed Regulations also impose the same ownership requirement as the credit sale rules, denying direct payment to, for example, contractual counterparties that otherwise are allowed the credits under special rules such as section 45Q(f)(3)(B) (election to allow the section 45Q credit to the party that disposes, utilizes, or uses the qualified carbon oxide) or section 50(d)(5) (election to allow lessees to claim the investment tax credit, i.e., inverted leases).

What is Covered by a Direct Pay Election

Similar to the rules for cash sales of credits, the Proposed Regulations provide that an election to benefit from direct payments generally must be made on a property-by-property basis, with an exception for the investment tax credit, which can be elected on a project-wide basis.

Unlike the credit transfer rules, taxpayers cannot elect direct payment for only a portion of a credit. Moreover, unlike a transfer election, which must be made yearly, a direct pay election would apply for entire applicable five-year window (or, for tax-exempt entities, the entire credit period).

How to Compute Direct Payment Amounts

The amounts otherwise determined as eligible for direct payment are subject to several special computation rules.

Reduction for Tax-Exempt Financing. First, all production tax credits (sections 45 and 45Y) and investment tax credits (sections 48 and 48E) are subject to as much as a 15% reduction if the construction of the facility is financed with certain tax-exempt debt, regardless of whether direct payments are sought.

Reduction for Restricted Tax-Exempt Funding. Second, in response to taxpayer concerns, the Proposed Regulations helpfully clarify that, for purposes of receiving direct payments for investment-related credits (i.e., credits that are computed by reference to the entity’s cost basis), exempt income used to fund investments (e.g., certain grants and forgivable loans) in property eligible for credits is generally included in that property’s basis for purposes of computing direct payments, regardless of whether those amounts would have been included in basis under general tax principles. However, this taxpayer-favorable rule comes with a significant exception where the grant, forgivable loan, or other exempt funding was made “for the specific purpose” of purchasing, constructing, reconstructing, erecting, or otherwise acquiring an investment-related credit property. In such a case, if the sum of that restricted exempt funding plus the credit exceeds the cost to acquire or construct the property, then the amount of the credit is reduced so the sum of the credit plus the restricted exempt funding equals the cost of the property.[7]

Reduction for Failing to Satisfy Domestic Content Requirements. Finally, for projects beginning construction in 2024 and after, direct payments for the investment tax credit (sections 48 and 48E) and the production tax credit (sections 45 and 45Y) will be subject to reduction (and will be unavailable entirely beginning in 2026) unless the project also incorporates specified percentages of U.S.-source steel, iron and manufactured components (discussed in our previous client alert, available here).[8]

How (Administratively) to Elect Direct Payments

A direct payment election is made on a taxpayer’s “annual tax return.”[9] For taxpayers that are already required to file an annual tax return, the due date for making a direct pay election is the due date (including extensions) of the taxpayer’s original tax return.[10] For entities that are not otherwise required to file tax returns, the due date is generally the fifteenth day of the fifth month after the end of the entity’s taxable year (or, until further guidance is issued, six months following that date pursuant to an automatic paperless extension).[11] Certain tax-exempt entities that do not otherwise file tax returns (e.g., governmental entities) will need to file IRS Form 990-T to receive direct payments.

The process and rules for making a direct pay election are substantially similar to those applicable to credit transfers. Those requirements include completing a pre-filing registration process and obtaining a registration number for each eligible credit property with respect to which a direct payment election is made and including the relevant registration numbers on the taxpayers tax return for the year of the election. See a summary of those rules here. Like credit transfers, no direct payment election may be made or revised on an amended return or via a partnership administrative adjustment request, and no late filing relief would be available.

When Direct Payments Are Made

When a direct pay election is made, the credit is treated as a payment made against tax, and therefore the cash payment is not made until after the “annual tax return” is filed and processed.

Taxpayers that are required to file a tax return (such as a partnership that is claiming a direct payment of a section 45Q credit or certain section 501(c)(3) organizations) would become eligible for direct payments on the later of their tax return due date (without extensions) and the date on which the return is filed. Entities that are not required to file a tax return would become eligible for a direct payment on the later of the fifteenth day of the fifth month after the end of the taxable year and the date on which that entity submits a claim for refund.

How to Avoid Excessive Payment Penalties

Rules similar to those under the transferability rules (discussed here) apply for purposes of avoiding excessive payment penalties.

Additionally, some of the credits that are eligible for direct pay (e.g., the investment tax credit) are subject to recapture upon the occurrence of certain events. Recapture will operate the same way as with taxpayers that claim credits on their tax returns, i.e., if the credit property ceases to be eligible credit property within the recapture period, the taxpayer’s tax liability for such taxable year will be increased by the recapture amount. Thus, if an applicable entity received a $100,000 direct pay refund in respect of investment tax credit property, and that property is sold 1.5 years after the property was placed in service, the applicable entity’s tax liability will be increased by $80,000 for the year in which the property is sold.

How the Rules Apply to Passthrough Entities

The Proposed Regulations provide additional rules with respect to passthrough entities electing to treat a credit as a payment against tax. The preamble clarifies that passthrough entities can only receive direct payments in respect of credits under sections 45Q, 45V, or 45X. This holds true regardless of how many “applicable entities” are partners in a partnership and even if, for example, all of a partnership’s partners are tax-exempt entities that would be entitled to direct payments if they owned their interests in the project directly. As a result, tax-exempt entities that hold projects through partnerships will be required to sell credits in many instances.[12]

Consistent with the proposed rules for credit transfers, only a passthrough entity – not the owners of the entity – are permitted to make the direct payment election. Also, the passive activity credit rules do not limit direct payments available to a passthrough entity, even if all of the passthrough entity’s owners otherwise would be subject to the passive activity credit rules in their separate capacity. Direct payments made to a passthrough entity are treated as tax-exempt income and each passthrough entity owner’s share of the tax exempt income is equal to its distributive share of the otherwise applicable credit for each taxable year.[13]

Observations

The refund timeline may result in a significant lag (up almost two years) between outlays and receipt of direct payments, which may require sponsors to obtain bridge financing.

The rules for passthrough entities are particularly counter-intuitive because they introduce enormous pitfalls (and sanction planning) in a manner that would otherwise be anathema to the U.S. system of partnership taxation – namely, under these rules, simply interposing a partnership for tax purposes, where there are otherwise no changes to the parties’ economic arrangement, can dramatically alter consequences for direct payments. While these rules will facilitate investments by individuals otherwise subject to the passive activity credit rules, the rules may well discourage investment by tax-exempt entities, which will need to be especially careful to avoid creating unintended tax partnerships with their financial counterparties. In the case of certain credits (e.g., the investment tax credit under sections 48 and 48E), the stakes will be even higher because the IRS has left in place rules that can render partnership projects funded by tax-exempt partners wholly ineligible for such credits, notwithstanding that such tax-exempt partners are effectively treated as taxpayers for all other purposes relevant to such credits.

Effective Date

Taxpayers may rely on these Proposed Regulations for taxable years beginning after December 31, 2022 and before the date the final regulations are published. The Temporary Regulation (i.e., the pre-filing registration regime) is effective for any taxable year ending on or after June 21, 2023.

_______________________

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

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

[3] The investment tax credit for energy property was briefly refundable at its inception (1978-1980) and was effectively payable as a cash grant for projects that began construction in 2009-2011.

[4] For the purposes of this client alert, the term “passthrough” or “passthrough entity” means a partnership or an S corporation, unless otherwise noted.

[5] These entities are (i) any tax-exempt organization exempt from the tax imposed by subtitle A (a) by reason of section 501(a) or (b) because such organization is the government of any U.S. territory or a political subdivision thereof, (ii) any State, the District of Columbia, or political subdivision thereof, (iii) the Tennessee Valley Authority, (iv) an Indian tribal government or subdivision thereof (as defined in section 30D(g)(9)), (v) any Alaska Native Corporation (as defined in section 3 of the Alaska Native Claims Settlement Act (43 U.S.C. 1602(m)), (vi) any corporation operating on a cooperative basis which is engaged in furnishing electric energy to persons in rural areas, or (vii) any agency or instrumentality of any applicable entity described in (i)(b), (ii), or (iv).

[6] These credits include the alternative fuel vehicle refueling property credit (section 30C), the qualified commercial clean vehicle credit (section 45W), the qualifying advanced energy project credit (section 48C), and the investment tax credit (section 48 and 48E).

[7] For example, if a public charity uses $20,000 of its own funds plus a $60,000 tax-exempt grant that it received “for the specific purpose” of building solar energy property, and the energy property would otherwise be entitled to a 50% investment tax credit ($40,000) under the general direct payment rules, the investment tax credit is reduced to $20,000 under this special rule for restricted exempt funding.

[8] Under these rules, a 10-percent haircut applies to projects beginning construction in 2024, a 15-percent haircut applies to projects beginning construction in 2025, and projects beginning construction in 2026 and after are wholly ineligible for refunds, in each case, unless the IRS makes an exception to the applicable domestic content requirements. The IRA authorizes the IRS to provide exceptions to the phaseout if (i) the inclusion of steel, iron, or manufactured products that are produced in the United States either increases the overall costs of construction of projects by more than 25 percent or (ii) there are either insufficient materials of these types produced in the United States or the materials produced in the United States are not of satisfactory quality.

[9] “Annual tax return” is defined in the Proposed Regulations to mean (i) for any taxpayer normally required to file an annual tax return with the IRS, such annual tax return (e.g., IRS Form 1065 for partnerships or IRS Form 990-T for organizations with unrelated business income tax), (ii) for any taxpayer not normally required to file an annual tax return with the IRS (such as taxpayers located in U.S. territories), the return such taxpayer would be required to file if they were located in the U.S., or, if no such return is required (such as for governmental entities), IRS Form 990-T, and (iii) for short tax year filers, the short year tax return.

[10] This date cannot be earlier than February 13, 2023.

[11] For entities located outside the United States, the due date generally is the due date (including extensions) that would apply if the entity were located in the United States.

[12] As noted, passthrough entities can still receive direct payments for credits under sections 45Q, 45V, or 45X.

[13] The Proposed Regulations would also modify the partnership audit rules to specify that direct payments for credits are subject to the partnership audit regime.

This alert was prepared by Mike Cannon, Matt Donnelly, Josiah Bethards, Duncan Hamilton, and Simon Moskovitz.

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

Tax Group:
Michael Q. Cannon – Dallas (+1 214-698-3232, [email protected])
Matt Donnelly – Washington, D.C. (+1 202-887-3567, [email protected])
Josiah Bethards – Dallas (+1 214-698-3354, [email protected])
Duncan Hamilton– Dallas (+1 214-698-3135, [email protected])
Simon Moskovitz – Washington, D.C. (+1 202-777-9532 , [email protected])

Power and Renewables Group:
Gerald P. Farano – Denver (+1 303-298-5732, [email protected])
Peter J. Hanlon – New York (+1 212-351-2425, [email protected])
Nicholas H. Politan, Jr. – New York (+1 212-351-2616, [email protected])

On June 27, 2023, the Federal Trade Commission, with the concurrence of the Antitrust Division of the Department of Justice, announced proposed changes to the Premerger Notification and Report Form (the “HSR Form”) and associated instructions, as well as to the premerger notification rules implementing the Hart-Scott Rodino (“HSR”) Act. The 133-page Notice of Proposed Rulemaking (NPRM) represents the first major overhaul of the HSR premerger notification requirements since the HSR program was established 45 years ago.

The FTC’s sweeping proposal, which we expect to be adopted and become effective within four to six months, would dramatically change the current merger filing process in the United States for HSR-reportable deals. Companies seeking U.S. merger clearance would need to expend considerably more effort preparing their HSR filings, including by collecting a broader set of business documents and financial data. Merging parties would also be required to prepare written responses to questions related to the transaction, bringing the U.S. more into line with filing requirements in certain foreign merger control regimes like the EU. The additional volume and scope of information contained in merging parties’ HSR filings would also allow the antitrust agencies to potentially apply more rigorous scrutiny of proposed transactions at an earlier stage because the information provided likely will take considerable time for the agency to review. As a result, the proposed rules raise the possibility of enhanced, or at least delayed, scrutiny of transactions that may previously have not triggered additional questions given their benign nature, including increases in the number of occasions when parties need to pull-and-refile their HSR forms to provide the agency additional time to review the contents of the HSR forms.

Key changes under the proposal include:

Transaction Details and Draft Item 4(c) Documents. Under the proposed rules, filing companies would be required to make a comprehensive disclosure of the details of their transaction, including submission of a transaction diagram, a projected closing timeline, and a detailed description of the strategic rationale for the transaction. Most significantly, the proposed rules would require the submission of drafts of so-called “Item 4” documents (i.e., documents analyzing the deal as it relates to competition-related issues) where such drafts are provided to an officer, director, or deal team lead or supervisor. The FTC noted that this new requirement is designed to prevent filing companies from submitting only the final, “sanitized” versions of Item 4 documents.
Competition Narratives. The proposed rules would require filing companies to provide narrative responses describing the competitive landscape and the supply chain, as well as certain information pertaining to labor markets and employees. For example, the proposed rules would require disclosing any labor law violations by the filing companies from the past five years. According to the FTC, a history of labor law violations may be indicative of “a concentrated labor market where workers do not have the ability to easily find another job.” This requirement underscores the U.S. antitrust agencies’ current spotlight on labor conditions and use of antitrust law to regulate conditions for employees.
Prior Acquisitions. The proposed rules would create new disclosure requirements related to the parties’ prior acquisitions. Under the proposal, the acquiror and target would be required to identify all prior acquisitions of any size for the previous ten years in any line of business where there is a potential overlap. The FTC noted that this change is aimed to address the antitrust agencies’ competitive concerns about “roll-up strategies.”
Periodic Plans and Reports. The proposed rules would expand the document submission requirements to cover certain strategic documents and reports created in the ordinary course of business, even if they do not relate to the proposed transaction. Documents called for under this new requirement would include semi-annual and quarterly plans that discuss markets and competition and that were shared with certain senior executives, as well as other similar plans or reports if they were shared with one of the filing companies’ Boards of Directors.
Organizational Structure. The proposed rules would require the identification of individuals and entities that may have influence over business decisions or access to confidential business information. On the buyer side, this could include certain minority shareholders and limited partners holding 5% or more of the voting securities or non-corporate interests in the acquiring company or entities controlling or controlled by it.

In light of the significant proposed changes detailed above, firms considering transactions should continue to proactively consult with antitrust counsel to develop appropriate antitrust risk mitigation strategies. Most importantly, merging parties should ensure that they build in considerably more time to prepare their HSR filings, including by not over-committing in Merger Agreements regarding filing deadlines. Currently, it is customary for parties to commit to making HSR filings in Merger Agreements within 7 to 10 business days, a timeframe that likely will be challenging if and when the new filing requirements are adopted. The FTC itself estimates that the proposed new rules could extend the time required to prepare an HSR filing from about 37 hours to 144 hours.

The proposed rules also suggest that firms should pay greater attention to the antitrust risks posed by non-reportable transactions. These transactions, while not reportable at the time they occur, would need to be disclosed in connection with any future HSR-reportable transaction involving a similar line of business. Those prior transactions could come under scrutiny at that time or enhance risk for the larger transaction under review.

Finally, if the proposed rules are adopted, document creation and retention policies – already critical components of any firm’s antitrust compliance program – will become more important than ever. The types of documents that would need to be submitted with the HSR filing would include not just transaction-specific materials but also ordinary course strategic plans and reports related to the relevant businesses. We will continue to keep you posted as developments occur.

The following Gibson Dunn lawyers prepared this client alert: Steve Weissman, Sophia Hansell, Jamie France, Chris Wilson, Steve Pet, and Emma Li.*

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:

Antitrust and Competition Group:
Stephen Weissman – Co-Chair, Washington, D.C. (+1 202-955-8678, [email protected])
Rachel S. Brass – Co-Chair, San Francisco (+1 415-393-8293, [email protected])
Ali Nikpay – Co-Chair, London (+44 (0) 20 7071 4273, [email protected])
Christian Riis-Madsen – Co-Chair, Brussels (+32 2 554 72 05, [email protected])
Sophia A. Hansell – Washington, D.C. (+1 202-887-3625, [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:
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])

*Emma Li is a recent law graduate in the firm’s New York office and not yet admitted to practice law.

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

Topics discussed:

Doug Horowitz discusses current trends in leveraged acquisition finance
Quinton Farrar and Brennan Halloran discusses lessons from the Mindbody litigation
Daniel Alterbaum discusses the implications of the recent McDonald’s decision on officer fiduciary duties for M&A transactions

PANELISTS:

Daniel Alterbaum is a partner in Gibson, Dunn & Crutcher’s New York office and is a member of the firm’s Mergers and Acquisitions and Private Equity Practice Groups. Mr. Alterbaum has been recognized as a “Rising Star” by New York Metro Super Lawyers in the area of mergers and acquisitions from 2015-2022, as well as by The Deal. He represents buyers, sellers and investors in a wide variety of transactions in the private equity, fintech, renewable energy and infrastructure sectors. His experience includes leveraged buyouts, negotiated sales of private companies, carve-out sales and spinoffs of subsidiaries and cross-border asset sales. He also represents issuers and investment funds in connection with venture capital, growth equity and structured preferred equity investments. Mr. Alterbaum is admitted to practice in the states of New York and Connecticut.

Quinton C. Farrar is a partner in Gibson Dunn & Crutcher’s New York office and is a member of the firm’s Mergers and Acquisitions and Private Equity Practice Groups. Mr. Farrar was named “Rising Star” in Private Equity by Euromoney Legal Media Group. He advises public and privately held companies, including private equity sponsors and their portfolio companies, investors, financial advisors, boards of directors and individuals in connection with a wide variety of complex corporate matters, including mergers and acquisitions, asset sales, leveraged buyouts, spin-offs, joint ventures and minority investments and divestitures. He also has substantial experience advising clients on corporate governance issues as well as in advising issuers and underwriters in connection with public and private issuances of debt and equity securities. Mr. Farrar is admitted to practice in the state of New York.

Douglas S. Horowitz is a partner in Gibson, Dunn & Crutcher’s New York office. Mr. Horowitz is the Head of Leveraged and Acquisition Finance, Co-Chair of Gibson Dunn’s Global Finance Practice Group, and an active member of the Capital Markets Practice Group and Securities Regulation and Corporate Governance Practice Group. Mr. Horowitz has been recognized as a leading finance lawyer by Chambers USA, Chambers Global, The Legal 500 and Euromoney’s IFLR 1000: The Guide to the World’s Leading Financial Law Firms. Mr. Horowitz represents leading private equity firms, public and private corporations, leading investment banking firms and commercial banks with a focus on financing transactions involving private credit, syndicated institutional and asset based loans, new issuance of secured and unsecured high-yield debt securities, equity and equity-linked securities, as well as out-of-court restructurings. Mr. Horowitz is admitted to practice in the state of New York.

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

Brennan Halloran is an associate in Gibson, Dunn & Crutcher’s New York office. He is a member of the firm’s Mergers and Acquisitions and Private Equity Practice Groups. Mr. Halloran represents both public and private companies and financial sponsors in connection with mergers, acquisitions, divestitures, joint ventures, minority investments, restructurings and other complex corporate transactions. He also advises clients with respect to governance and general corporate matters. Mr. Halloran is admitted to practice in the state of New York.

MCLE CREDIT INFORMATION:

This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of .50 credit hour, of which .50 credit hour may be applied toward the Ethics & Professionalism. 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 .50 Ethics.

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.

Decided June 27, 2023

Mallory v. Norfolk Southern Railway Co., No. 21-1168

Today, the Supreme Court held in a fractured 5-4 decision that the Due Process Clause does not prohibit Pennsylvania from requiring businesses that register to do business in Pennsylvania to consent to general jurisdiction in the state’s courts, but a majority of the Justices questioned whether other constitutional principles limit states’ power to require such consent.

Background: Robert Mallory sued his former employer, Norfolk Southern, for alleged workplace injuries. Mallory sued in Pennsylvania even though he’s a citizen of Virginia, his injuries allegedly occurred in Ohio and Virginia, and Norfolk Southern was incorporated and had its principal place of business in Virginia. He asserted jurisdiction on the theory that Norfolk Southern registered to do business in Pennsylvania under a statute that requires corporations to submit to general personal jurisdiction in Pennsylvania over all suits.

Norfolk Southern moved to dismiss the suit for lack of personal jurisdiction on the grounds that the suit had no connection to Pennsylvania, and Pennsylvania’s consent-to-jurisdiction statute violates the Due Process Clause. Although the Supreme Court held in Pennsylvania Fire Insurance Co. v. Gold Issue Mining & Milling Co., 243 U.S. 93 (1917), that a similar consent-to-jurisdiction statute did not violate due process, Norfolk Southern argued that Pennsylvania Fire had been implicitly overruled by later cases. The Pennsylvania Supreme Court agreed, holding that the state’s registration statute violated due process by coercing Norfolk Southern to consent to general personal jurisdiction.

Issue: Whether the Due Process Clause prohibits a state from requiring an out-of-state corporation to consent to general personal jurisdiction in that state as a condition of registering to do business there.

Court’s Holding:

No. Due process does not prohibit a state from requiring that businesses consent to general personal jurisdiction as a condition of registering to do business in the state.

“To decide this case, we need not speculate whether any other statutory scheme and set of facts would suffice to establish consent to suit. It is enough to acknowledge that the state law and facts before us fall squarely within Pennsylvania Fire’s rule.”

Justice Gorsuch, writing for the Court

Gibson Dunn submitted an amicus brief on behalf of the Association of American Railroads in support of respondent: Norfolk Southern Railway Co.

What It Means:

The Court’s opinion was fractured, and the only holding joined by a majority of the Justices was narrow, concluding only that Pennsylvania’s consent-by-registration statute did not violate due process under Pennsylvania Fire. The majority made clear that Pennsylvania Fire had not been implicitly overruled by later cases.
Justice Alito concurred, providing the necessary fifth vote to vacate the Pennsylvania Supreme Court’s decision and remand for further consideration. Critically, Justice Alito opined that consent-by-registration statutes might violate other constitutional provisions and principles, including the dormant Commerce Clause.
Justice Barrett dissented, joined by Chief Justice Roberts and Justices Kagan and Kavanaugh, opining that Pennsylvania’s consent-by-registration scheme is inconsistent with both due process and principles of interstate federalism.
Given the Court’s fractured and narrow opinion, and Justice Alito’s concurrence, it is likely that consent-by-registration statutes will continue to face constitutional challenges.

The Court’s opinion is available here.

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

Appellate and Constitutional Law Practice

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

Related Practice: General Litigation

Reed Brodsky +1 212.351.5334 [email protected]	Theane Evangelis +1 213.229.7726 [email protected]	Veronica S. Moyé +1 214.698.3320 [email protected]
Helgi C. Walker +1 202.887.3599 [email protected]

The EU Markets in Cryptoassets Regulation (“MiCA”) was published in the EU’s official journal on 9 June 2023 and will enter into force on 29 June 2023, the 20^th day following the date of its publication. As a result, the provisions on stablecoins (asset-referenced tokens and e-money tokens) will become applicable 12 months after this date, and will apply from 30 June 2024. The other provisions will apply from 30 December 2024.

MiCA establishes a harmonised pan-EU regime for cryptoassets. This new regulatory framework aims to protect investors and preserve financial stability, while allowing innovation and fostering the attractiveness of the cryptoasset sector. It will apply directly across the EU member states replacing the existing domestic laws and harmonising all national legislation in the area of cryptoassets and activities related to them.

MiCA sets out the framework for the regulation of cryptoassets in the EU but certain details will be settled in technical standards and delegated acts. The European Banking Authority (the “EBA”) is required to develop draft regulatory technical standards by 30 June 2024 to establish standard forms, templates and procedures for the cooperation and exchange of information between national competent authorities, as well as issuing guidelines that cryptoasset service providers should consider when conducting assessments and risk mitigation measures. This client alert provides an overview of MiCA, how it impacts on different market participants and what steps cryptoasset firms need to take now to ensure compliance.

Which cryptoassets are in-scope?

MiCA defines a crypto-asset as “a digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology”. Although a limited number of cryptoassets are regulated under existing legislation, MiCA catches previously unregulated cryptoassets that did not fall within the regulatory perimeter. MiCA creates a hierarchy of cryptoassets based on the perceived risks posed by these different tokens.

Cryptoasset	Overview
Utility token	Defined as: “A type of cryptoasset that is intended to provide digital access to a good or service, available on DLT, and is only accepted by the issuer of that token.” Deemed as less risky than stablecoins and, therefore, a lighter touch regime applies to them. While issuers of these tokens do not need to be authorised, they must comply with the obligations set out in Title II of the MiCA.
Stablecoins (being “asset-referenced tokens” and “e-money tokens”)	Asset-referenced tokens Defined as: “A type of cryptoasset that purports to maintain a stable value by referring to the value of several fiat currencies that are legal tender, one or several commodities or one or several cryptoassets, or a combination of such assets.” They are a type of stablecoin. However, the definition excludes algorithmic stablecoins and central bank digital currencies (“CBDCs”). The EU considers that they pose increased risks in terms of consumer protection and market integrity compared to other cryptoassets and so issuers should be subject to more stringent requirements. The requirements that apply relate to: authorisation; governance; conflicts of interests; disclosure of stabilisations mechanism; investment rules; and additional white paper requirements. E-money tokens Defined as: “A type of cryptoasset the main purpose of which is to be used as a means of exchange and that purports to maintain a stable value by referring to the value of a single fiat currency that is legal tender.” Again, as e-money tokens are a type of stablecoin, the EU considers them to be of higher risk than utility tokens. E-money tokens can only be issued by credit institutions (i.e. banks) or authorised electronic money institutions. E-money token issuers must comply with both the Second Electronic Money Directive and MiCA.
Significant asset-referenced tokens or significant e-money tokens	MiCA permits the European Banking Authority to identify tokens as “significant”. A significant token is a type of asset-referenced or e-money token which is considered to pose significant risks for financial stability and consumer protection across the EU. The criteria for determining whether a token is a significant token are set out at Article 43 of MiCA. At least 3 of the criteria must be met, including among others the size of the customer base or the issuer’s reserve, the value of the tokens issued or transactions, the significance of the cross-border activities of the issuer, or the interconnectedness with the financial system. Significant tokens are subject to the strictest requirements in MiCA.

MiCA leaves several components of the digital world outside its scope for now, including CBDCs and cryptoassets that are unique and non-fungible (“NFTs”). MiCA sets out potential areas for future regulation, and an assessment of the necessity and feasibility of regulating NFTs.

Who does MiCA apply to?

MiCA imposes obligations on issuers of in-scope cryptoassets (i.e., those offering cryptoassets to third parties). MiCA also imposes obligations on firms whose business it is to provide certain cryptoasset services to third parties on a professional basis (i.e., cryptoasset service providers or “CASPs”). In particular, the following services are listed and defined in MiCA:

providing advice on cryptoassets;
reception and transmission of orders for cryptoassets;
execution of orders for cryptoassets;
custody and administration of cryptoassets;
operation of a trading platform for cryptoassets;
exchange of cryptoassets for fiat; and
placing of cryptoassets.

Cryptoasset lending is one key service not captured by MiCA. The European Commission is expected to publish a report on the need to regulate this service and, if necessary, a legislative proposal by 30 December 2024.

Non-EU businesses – MiCA applies to those engaged in the aforementioned services “in the Union”. Non-EU businesses wishing to carry on cryptoasset activities within the EU or for EU based customers should consider how the territorial scope of MiCA will impact their current and future business models. MiCA contains provisions which relate to “reverse solicitation” where a third-country firm provides cryptoasset services at the exclusive initiative of an EU customer. However, where a third-country firm solicits clients or potential clients or promotes or advertises crypto-asset services or activities to customers in the EU, the licence requirement will be triggered. Further guidelines will be developed which will specify when a third country firm is deemed to solicit clients within the EU to mitigate against an overreliance on reverse solicitation rules.

Passporting – MiCA provides for passporting across the EU, in line with other EU single market measures. However, as mentioned, there are no provisions on third country equivalence, which may cause issues for service providers seeking to offer services globally.

Impact to existing licensed CASPs – Some EU member states already have in place national regulatory frameworks regulating CASPs. MiCA therefore leaves open a possibility for member states to apply a simplified procedure for applications for authorisation submitted by those entities that are already authorised under national law. In such cases, the national competent authorities will be required to ensure that these applicants comply with key requirements under MiCA. While some firms that are currently operating under national frameworks in some EU member states (i.e. Germany or Malta) will likely be able to leverage their existing internal frameworks to obtain a MiCA licence, non-regulated firms need to be prepared to dedicate a sufficient amount of time, financial and human resources to meet the new regulatory requirements under MiCA.

What areas of MiCA should be key areas of focus for cryptoasset firms?

(1) Offering and marketing of cryptoassets (other than asset-referenced tokens and e-money tokens)

White paper – Subject to certain requirements, issuers may offer such cryptoassets to the public in the EU or apply for admission to a trading platform. Namely, there is a requirement to draw up, notify regulators of, and publish a cryptoasset white paper.
Exemption from the requirement to publish a white paper – In summary, the white paper requirements do not apply where:

(i) the cryptoassets are offered for free, they are created through mining, are unique and not fungible with other cryptoassets;

(ii) are offered to fewer than 150 persons (natural or legal) per member state where such persons are acting on their own account;

(iii) an offer does not exceed EUR 1 million; or

(iv) the offer is solely addressed to qualified investors.

Marketing communications – Marketing communications relating to an offer of cryptoassets to the public or admission to trading must be: (i) clearly identifiable as such; (ii) fair, clear and not misleading; (iii) consistent with the white paper; and (iv) clearly state both that the white paper has been published and an address of the website of the issuer concerned.
Modifications to white paper / marketing communications – The white paper and marketing communications must be updated where there has been a change or new fact that is likely to have a significant influence on the purchase decision of any potential purchaser of the cryptoasset, or on the decision of holders of such cryptoassets to sell or exchange such cryptoassets.

(2) Obligations applying to issuers of asset-referenced tokens

Authorisation procedure – Issuers of asset-referenced tokens will need to be authorised under MiCA and comply with various conduct of business and prudential requirements. Note that issuers must be EU-established legal entities in order to be granted authorisation. Note that there are certain exemptions for small-scale asset-referenced token and where tokens are marketed, distributed and held exclusively by qualified investors.
Enhanced white paper requirements – Issuers of asset-referenced tokens must include additional information in white papers to that described above and the white paper must be pre-approved by national competent authorities. The white paper will need to contain certain mandatory disclosures before it can be issued, offered or marketed while issuers of other tokens need only notify the regulator and provide a copy of their white paper before doing so. The white paper will need to be supported by a legal opinion as to why the asset-referenced token is not an e-money token nor a token excluded from MiCA’s scope.
Prudential and conduct requirements – Issuers must act honestly, fairly and professionally in the best interest of asset-referenced token holders. Requirements also relate to marketing, provision of information, complaints handling, conflicts of interest, governance arrangements, prudential requirements, and maintenance and segregation of reserve assets.
Claims for damages – MiCA contains provisions that allow for asset-referenced token holders with minimum rights to claim damages against an issuer and its management body for certain infringements.
Change in control approval – MiCA contains regulatory change in control approval provisions in advance of acquiring a “qualifying holding in an issuer of asset-referenced tokens”.

(3) Additional requirements relating to significant asset-referenced tokens

Supervision by the EBA – Issuers of significant asset-referenced tokens will be supervised by the EBA given the significant risks they present to financial stability and consumer protection.
Remuneration policy – Issuers must adopt, implement and maintain a remuneration policy that promotes sound and effective risk management and does not create incentives to relax risk standards.
Interoperability – Issuers must ensure that such tokens can be held in custody by different crypto-asset service providers.
Liquidity management policy – Issuers must establish, maintain and implement a liquidity management policy and procedures to ensure that the reserve assets have a resilient liquidity profile that enables issuers of to continue operating normally under scenarios of liquidity stress. Issuers must conduct liquidity stress testing on a regular basis.

(4) Obligations applying to issuers of e-money tokens

Authorisation – Issuers of e-money tokens will need to be authorised as a credit institution or as an e-money institution under the second Electronic Money Directive (2009/110/EC).
White paper requirements – Issuers of e-money tokens must ensure that their white papers contain certain required information as specified in Annex III.
Issuance and redeemability – Upon request by a holder of an e-money token, the issuer must redeem the token, at any time and at par value, by paying in funds, other than electronic money, the monetary value of the e-money token held to the holder of the e-money token. Issuers must prominently state the conditions for redemption in their white paper.
No interest to token holders – Issuers of e-money tokens shall not grant interest to token holders in relation to e-money tokens.
Marketing communications – Marketing communications relating to a public offer or to trading of an e-money token must be (a) clearly identifiable; (b) fair, clear and not misleading; (c) consistent with the white paper, and (d) set out certain information about the white paper and the issuer.
Treatment of funds received – At least 30% of the funds received by issuers in exchange for e-money tokens must be deposited in separate accounts in credit institutions. The remaining funds are to be invested in secure, low-risk assets that qualify as highly liquid financial instruments with minimal market risk, credit risk and concentration risk.

(5) Additional requirements relating to significant e-money tokens

Dual supervision – Issuers of significant e-money tokens will be subject to dual supervision from national competent authorities and the EBA.
New obligations for e-money institutions – E-money institutions issuing significant e-money tokens will not be subject to the own funds and safeguarding requirements under the E-Money Directive (2009/110/EC), but will instead be subject to the requirements specified under MiCA.

(6) Requirements for CASPs

Authorisation procedure – CASPs will need to be authorised under MiCA and have a registered office in the EU. Once authorised in one member state, a CASP will be allowed to provide cryptoasset services throughout the entire EU. Certain institutions which are already authorised under existing financial services legislation do not also need to also be authorised under MiCA to provide cryptoasset services, but must follow certain notification requirements as per Article 60 of MiCA.
Prudential and conduct requirements – CASPs must act honestly, fairly and professionally in the best interest of their clients and prospective clients. Requirements also relate to (among others) marketing, provision of information, prudential requirements, governance arrangements, complaints handling, conflicts of interest, and custody and administration of assets.
Requirements for specific types of CASPs – Chapter 3 of MiCA also sets out specific requirements in respect of different crypto-asset services, including but not limited to: (a) providing custody and administration of cryptoassets; (b) operating a trading platform for cryptoassets; (c) exchanging cryptoassets for funds or other cryptoassets; (d) placing of cryptoassets; and (e) providing advice on, and portfolio management of, cryptoassets.
No new anti-money laundering obligations – MiCA does not include anti-money laundering (AML) provisions with respect to CASPs. However, the Fifth Money Laundering Directive ((EU) 2018/843) (MLD5), which came into force in 2018, contains AML provisions with respect to cryptoasset exchanges and custodian wallet providers. The EU Council also recently agreed its position on a new AML directive (AMLD6), which would extend AML provisions to all CASPs.

(7) Market abuse regime for cryptoassets

Title VI of MiCA establishes a bespoke market abuse regime for cryptoassets. It defines the concept of inside information in relation to cryptoassets and requires the public disclosure of inside information for issuers and offerors seeking admission to trading. It prohibits insider dealing, the unlawful disclosure of inside information, and market manipulation, and expressly imposes requirements relating to systems, procedures and arrangements to monitor and detect market abuse.

When will MiCA enter into force?

MiCA will enter into force 20 days after its publication in the Official Journal of the European Union. The majority of the requirements will apply 18 months after it enters into force. However, the asset-referenced tokens and e-money token requirements will apply 12 months after the entry into force date.

Issuers of asset-referenced tokens other than credit institutions that issued asset-referenced tokens in accordance with applicable law before 12 months after MiCA enters into force may continue to do so until they are granted or refused an authorisation, provided that they apply for authorisation before 13 months after MiCA enters into force. Credit institutions that issued asset-referenced tokens in accordance with applicable law before 12 months after MiCA enters into force may continue to do so until the cryptoasset white paper has been approved or rejected, provided that they notify their competent authority before 13 months after MiCA enters into force.

CASPs already legally providing their services at the date on which MiCA applies may continue to do so until 18 months after the date or they are granted or refused an authorisation, whichever is sooner.

What steps should cryptoasset firms take now?

Firms that are potentially in-scope of MiCA should perform a gap analysis and impact assessment of MiCA on their business models. Ensuring compliance with MiCA is likely to constitute a significant undertaking for firms and firms should not underestimate the time it will take to implement MiCA, including applying for authorisation and implementing MiCA requirements into their systems and processes The first step firm’s should take is consider whether their existing activities fall within scope of MiCA. If so, they will be required to either notify the relevant national regulator or seek authorisation depending on whether they are already authorised financial institutions. Gibson Dunn’s lawyers have a current, substantive and technical understanding of the ever-evolving world of digital assets and would be delighted to assist you with you MiCA implementation projects.

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 following members of Gibson Dunn’s Global Financial Regulatory teams in London and Dubai:

Michelle M. Kirschner – London (+44 (0) 20 7071 4212, [email protected])
Martin Coombes – London (+44 (0) 20 7071 4258, [email protected])
Sameera Kimatrai – Dubai (+971 4 318 4616, [email protected])

Gibson, Dunn & Crutcher LLP is advising Otro Capital and its partner RedBird Capital in their investment in Alpine Racing Ltd., a world class F1 team that finished top 4 in the 2022 F1 World Championship. The investment values the team at approximately $900 million and is being made along with Maximum Effort Investments (led by Ryan Reynolds) and its co-investors Michael B. Jordan and Rob McElhenney, and includes participation from the Huntsman Family and Main Street Advisors.

The Gibson Dunn corporate team is led by partners Stefan dePozsgay and Nick Tomlinson and includes associates Sarah Leiper-Jennings, Sarah Reder and Percy Gao. Partners Sandy Bhogal and Kathryn Kelly and associates Bridget English, Ryan Rott and Isabella Fladée are advising on tax aspects. Partner A.J. Frey and associates Curtis Vella and Fiona Xin are advising on investment funds aspects. Partner Chris Haynes is advising on capital markets aspects. Partner Daniel Angel and associates Jacqueline Malzone and Libby Pica are advising on IP aspects. Partners Michael Collins and James Cox are advising on executive compensation and benefits aspects. Partner Attila Borsos and associate Ben Nunez are advising on competition and foreign investment aspects.

Decided June 23, 2023

Coinbase, Inc. v. Bielski, No. 22-105

Today, the Supreme Court held 5-4 that appealing the denial of a motion to compel arbitration automatically stays district court proceedings pending resolution of that appeal.

Background: The Federal Arbitration Act (“FAA”) authorizes interlocutory appeals from orders refusing to compel arbitration. 9 U.S.C. § 16(a). The FAA does not expressly address stays pending appeal, and a circuit split developed. The majority position, adopted by the Third, Fourth, Seventh, Tenth, Eleventh, and D.C. Circuits, held that stays pending appeal are mandatory. The minority position, adopted by the Second, Fifth, and Ninth Circuits, held that the usual, four-factor standard for discretionary stays pending appeal applies.

Bielski brought putative class-action claims against Coinbase in the Northern District of California. Coinbase moved to compel arbitration under its user agreement. After the district court denied Coinbase’s motion, Coinbase appealed and sought a stay pending appeal. The district court declined to stay its proceedings, holding that under Ninth Circuit precedent a stay pending appeal was not mandatory and that a discretionary stay was not warranted. The Ninth Circuit likewise denied a stay.

Issue: Is a stay pending appeal of the denial of a motion to compel arbitration mandatory?

Court’s Holding:

Yes. Appealing the denial of a motion to compel arbitration automatically stays district court proceedings pending resolution of the appeal.

“The sole question before this Court is whether a district court must stay its proceedings while the interlocutory appeal on arbitrability is ongoing. The answer is yes.”

Justice Kavanaugh, writing for the Court

What It Means:

Today’s decision is a win for defendants who appeal the denial of a motion to compel arbitration. Defendants who appeal the denial of a motion to compel arbitration cannot be forced to continue litigating in the district court during the appeal. In practice, this decision also should stay any district court discovery deadlines. This is a significant change for litigants in the Second, Fifth, and Ninth Circuits, which all previously refused to grant such automatic stays.
In reaching this decision, the Supreme Court applied the general rule that an interlocutory appeal divests a district court of control over the issues on appeal. Because the issue on appeal is whether the case can go forward in the district court, the district court lacks power to require further litigation.
The Court reasoned that “many of the asserted benefits of arbitration (efficiency, less expense, less intrusive discovery, and the like) would be irretrievably lost” without a stay during appeal, even if the court of appeals agrees that arbitration is required. This is especially true in class actions, where “the possibility of colossal liability can lead to . . . blackmail settlements.” Slip op. 5–6.

The Court’s opinion is available here.

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

Appellate and Constitutional Law Practice

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

Related Practice: General Litigation

Reed Brodsky +1 212.351.5334 [email protected]	Theane Evangelis +1 213.229.7726 [email protected]	Veronica S. Moyé +1 214.698.3320 [email protected]
Helgi C. Walker +1 202.887.3599 [email protected]

Related Practice: International Arbitration

Cyrus Benson
+44 (0) 20 7071 4239
[email protected]

Penny Madden QC
+44 (0) 20 7071 4226
[email protected]

Rahim Moloo
+1 212.351.2413
[email protected]

Related Practice: Labor and Employment

Jason C. Schwartz
+1 202.955.8242
[email protected]

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

Related Practice: Class Actions

Christopher Chorba
+1 213.229.7396
[email protected]

Kahn A. Scolnick
+1 213.229.7656
[email protected]

In a major development for employers, New York is poised to ban employee non-competition agreements. Governor Kathy Hochul is currently considering a bill that was fast-tracked through the state legislature that voids “[e]very contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind.” If signed, the bill will amend the New York Labor Law to prohibit New York employers from entering into a non-compete agreement with any individual who is in a position of “economic dependence on, and under an obligation to perform duties” for an employer. Governor Hochul previously expressed support for eliminating non-compete agreements for workers making below the median wage in New York, but the bill she is considering applies to all employees in New York irrespective of compensation. If approved by the Governor, the law will be effective 30 days later.

Below, we outline the noteworthy takeaways from this likely radical change to New York law.

Broad Coverage. The bill broadly defines “non-compete agreement” as “any agreement, or clause contained in any agreement, between an employer and a covered individual that prohibits or restricts such covered individual from obtaining employment, after the conclusion of employment with the employer included as a party to the agreement.”[1] The definition of “covered individual” is similarly broad, defining that term as “any other person who, whether or not employed under a contract of employment, performs work or services for another person on such terms and conditions that they are, in relation to that other person, in a position of economic dependence on, and under an obligation to perform duties for, that other person.”
Limited Express Exceptions. As drafted, the bill expressly states that it does not impact an employer’s ability to enter into a “fixed-term of service” with any covered individual. It also states that employers may continue to enter into agreements that protect trade secrets, confidential and proprietary client information and prohibit solicitation of clients of the employer that the covered individual learned about during employment, “provided that such agreement does not otherwise restrict competition in violation of this section.”
No Retroactivity. The bill only applies to non-compete agreements entered into on or after its effective date, which is 30 days after the Governor’s approval.
Private Right of Action. Covered individuals would have a private cause of action against employers violating the law. Such individuals would be permitted to bring lawsuits seeking to void any non-compete that violates the law, obtain injunctive relief against enforcement of the non-compete, and recover for lost compensation, damages, and reasonable attorneys’ fees and costs. The bill also provides that “the court shall award liquidated damages to every covered individual affected under this section.” Liquidated damages are capped at $10,000.
Two-Year Statute of Limitations. The bill provides a two-year statute of limitations, but employers should be aware that litigation could arise long after entering into the offending agreement. This is because the two-year period runs from the latest of: (i) when the prohibited non-compete agreement was signed; (ii) when the covered individual learns of the prohibited non-compete agreement; (iii) when the employment or contractual relationship is terminated; or (iv) when the employer takes any step to enforce the non-compete agreement.
Significant Unresolved Questions. The bill is redundant in places and contains numerous ambiguities. For example, it does not address whether it applies to independent contractors or whether paid garden leave and equity forfeiture arrangements are permissible. The bill also does not define a “fixed term of service” agreement, and it is silent about the permissibility of post-employment agreements not to solicit or hire a former employer’s employees. The bill also does not expressly address non-competition agreements arising from the sale of a business, which are common.

If enacted, this is undoubtedly a dramatic change for New York employers. New York will join several other states that have essentially banned post-employment non-compete agreements, including California, Minnesota, North Dakota, and Oklahoma. In recent years, other jurisdictions such as Colorado, Illinois, Maine, Maryland, Nevada, New Hampshire, Oregon, Rhode Island, Virginia, Washington, and Washington, D.C. have also limited the validity of non-compete provisions based on specific factors like compensation and employee classification. Additionally, there has been increased scrutiny on non-competes at the federal level with the Federal Trade Commission’s proposed new rule seeking to ban non-compete clauses[2] and the National Labor Relations Board General Counsel’s memorandum expressing her view that certain non-compete provisions in employment and severance agreements could violate the National Labor Relations Act.[3]

____________________________

[1] N.Y. A01278B § 191-d(a) (emphasis added), https://nyassembly.gov/leg/?default_fld=&leg_video=&bn=A01278&term=&Summary=Y&Actions=Y&Text=Y.

[2] FTC Proposes Rule to Ban Noncompete Clauses, Which Hurt Workers and Harm Competition (Jan. 5, 2023), https://www.ftc.gov/news-events/news/press-releases/2023/01/ftc-proposes-rule-ban-noncompete-clauses-which-hurt-workers-harm-competition.

[3] NLRB General Counsel Issues Memo on Non-competes Violating the National Labor Relations Act (May 30, 2023), https://www.nlrb.gov/news-outreach/news-story/nlrb-general-counsel-issues-memo-on-non-competes-violating-the-national.

The following Gibson Dunn attorneys assisted in preparing this client update: Jason Schwartz, Harris Mufson, Tiffany Phan, and Emily Lamm.

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

Harris M. Mufson – New York (+1 212-351-3805, [email protected])

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

The Pro Bono Committee is thrilled to announce the winners of this year’s Frank Wheat Memorial Awards. This year’s winners demonstrated an unfailing dedication to pro bono, a commitment to excellence, and a passion for service, exemplifying the very best of Gibson Dunn. As in previous years, this year’s winners and nominees worked on a wide variety of matters—including both high-stakes individual pro bono representations and large-scale projects with far-reaching impacts—that reflect the breadth of Gibson Dunn’s pro bono practice.

Frank Wheat, a former Los Angeles partner, was a superb transactional lawyer, SEC commissioner, and president of the Los Angeles County Bar. He was also a giant in the nonprofit community, having founded the Alliance for Children’s Rights in addition to serving as a leader of the Sierra Club and as a founding director of the Center for Law in the Public Interest. He exemplified the commitment to the community and to pro bono service that has always been a core tenet of the Gibson Dunn culture. The Frank Wheat Award is given annually to individual lawyers and teams that have demonstrated leadership and initiative in their pro bono work, obtained significant results for their pro bono clients, and served as a source of inspiration to others. Recipients of the Frank Wheat Memorial Award each receive a $2,500 prize to be donated to pro bono organizations designated by the recipients.

In 2021, a year that presented countless challenges, Gibson Dunn remained committed to pro bono work, devoting more than 140,000 pro bono hours valued at approximately $128 million to hundreds of projects firmwide. Our attorneys averaged more than 90 pro bono hours per attorney in the United States and more than 80 pro bono hours per attorney worldwide.

View the Full Announcement

Decided June 22, 2023

Yegiazaryan v. Smagin, No. 22-381

Today, the Supreme Court in a 6-3 decision rejected a bright-line rule that would have precluded foreign plaintiffs from pursuing civil RICO claims, and instead held that foreign plaintiffs can satisfy civil RICO’s domestic-injury requirement if their injuries arose in the United States.

Background: The Racketeer Influenced and Corrupt Organizations Act (RICO) provides a private right of action that authorizes “[a]ny person injured in his business or property by reason of” a substantive RICO violation to sue for treble damages. 18 U.S.C. § 1964(c). In RJR Nabisco, Inc. v. European Community, 579 U.S. 325 (2016), the Supreme Court held that this private right of action extended only to domestic injuries, but did not address what constitutes a “domestic” injury.

In 2003, Russian businessmen Ashot Yegiazaryan and Vitaly Smagin partnered on a Moscow real estate project that collapsed in 2009. Yegiazaryan subsequently fled to Beverly Hills to avoid a Russian indictment. Smagin, who remained in Russia, then won an arbitration award against Yegiazaryan in London.

Smagin sued Yegiazaryan in California federal court to enforce the arbitration award. After Yegiazaryan engaged in a number of complex and fraudulent transactions to prevent Smagin from collecting on the California court’s judgment in his favor, Smagin brought a civil RICO claim against Yegiazaryan, alleging that his actions to hide assets and avoid paying the California court’s judgment on the arbitral award constituted a pattern of racketeering activities.

The district court dismissed Smagin’s civil RICO claim, holding that he failed to satisfy RICO’s domestic-injury requirement. The Ninth Circuit reversed, noting that Smagin confirmed the arbitral award in California and that Yegiazaryan’s alleged misconduct to evade the California court’s judgment occurred in California.

Issue: Whether foreign plaintiffs can suffer domestic injuries that would permit them to pursue a civil RICO claim.

Court’s Holding:

Yes. Foreign plaintiffs can suffer an injury that is domestic depending on the facts and circumstances of the alleged RICO violation, as there is no rule that any injury suffered by a foreign plaintiff necessarily arises outside the United States.

“[I]n assessing whether there is a domestic injury, courts should engage in a case-specific analysis that looks to the circumstances surrounding the injury. If those circumstances sufficiently ground the injury in the United States, such that it is clear the injury arose domestically, then the plaintiff has alleged a domestic injury.”

Justice Sotomayor, writing for the Court

What It Means:

In holding that RICO’s domestic-injury requirement can be satisfied based on the facts and circumstances surrounding the alleged injury, the Court rejected a bright-line rule that would look only to the plaintiff’s place of residence as the place where the economic injury is experienced.
Today’s decision creates opportunities for judgment creditors to use RICO to pursue assets based on domestic conduct that allegedly injures property rights, including unlawful efforts to frustrate the enforcement of foreign judgments within the United States. In this case, the Court relied on allegations that the foreign plaintiff was “injured in his ability to enforce a California judgment, against a California resident, through racketeering acts that were largely ‘designed and carried out in California’ and were ‘targeted at California.’” Slip.
op. 8.
The Court reaffirmed its longstanding requirement that a plaintiff’s injury must be proximately caused by the defendant’s substantive RICO violation. Slip op. 3 n.3.

The Court’s opinion is available here.

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

Appellate and Constitutional Law Practice

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

Related Practice: Judgment and Arbitral Award Enforcement

Matthew D. McGill
+1 202.887.3680
[email protected]

Robert L. Weigel
+1 212.351.3845
[email protected]

Since the European Commission first published its highly anticipated proposal for an AI regulation in April 2021,[1] EU institutions and lawmakers have been making significant strides towards passing what would be the first comprehensive legislative framework for AI, the EU Artificial Intelligence Act (“AI Act”). The AI Act seeks to deliver on EU institutions’ promises to put forward a coordinated European regulatory approach on the human and ethical implications of AI, and once in force would be binding on all 27 EU Member States.[2]

Following on the heels of the European Commission’s 2021 proposal, the Council of the European Union adopted its common position (“general approach”) on the AI Act in December 2022.[3] Most notably, in its general approach the Council narrowed the definition of ‘AI system’ covered by the AI Act to focus on a measure of autonomy i.e., to ensure that simpler software systems were not inadvertently captured.

On June 14, 2023, the European Parliament voted to adopt its own negotiating position on the AI Act,[4] triggering discussions between the three branches of the European Union—the European Commission, the Council and the Parliament—to reconcile the three different versions of the AI Act, the so-called “trilogue” procedure. The Parliament’s position expands the scope and reach of the AI Act in a number of ways, and press reports suggest contentious reconciliation meetings and further revisions to the draft AI Act lay ahead. In this client alert, we offer some key takeaways from the Parliament’s negotiating position.

The AI Act Resonates Beyond the EU’s Borders

The current draft regulation provides that businesses placing AI systems on the market or putting them into service in the EU will be subject to the AI Act, irrespective of whether those providers are established within the EU or in a third country. Given its status as the first comprehensive attempt to regulate AI systems and its extraterritorial effect, the AI Act has the potential to become the key international benchmark for regulating the fast-evolving AI space, much like the General Data Protection Regulation (“GDPR”) in the realm of data privacy.

The regulation is intended to strike a much-debated balance between regulation and safety, citizens’ rights, economic interests, and innovation. Reflecting concerns that an overly restrictive law would stifle AI innovation in the EU market, the Parliament has proposed exemptions for research activities and open-source AI components and promoted the use of so-called “regulatory sandboxes,” or controlled environments, created by public authorities to test AI before its deployment.[5] Establishing harmonized standards for the implementation of the AI Act’s provisions will be critical to ensure companies can prepare for the new regulatory requirements by, for example, building appropriate guardrails and governance processes into product development and deployment early in the design lifecycle.

The Definition of AI Is Aligned with OECD and NIST

The AI Act’s definition of AI has consistently been a key threshold issue in defining the scope of the draft regulation and has undergone numerous changes over the past several years. Initially, the European Commission defined AI based on a series of techniques listed in the annex to the regulation, so that it could be updated as the technology developed. In the face of concerns that a broader definition could sweep in traditional computational processes or software, the EU Council and Parliament opted to move the definition to the body of the text and narrowed the language to focus on machine-learning capabilities, in alignment with the definition of the Organisation for Economic Co-operation and Development (OECD) and the U.S. National Institute of Standards and Technology (“NIST”):[6]

“a machine-based system that is designed to operate with varying levels of autonomy and that can, for explicit or implicit objectives, generate outputs such as predictions, recommendations, or decisions that influence physical or virtual environments.”

In doing so, the Parliament is seeking to balance the need for uniformity and legal certainty against the “rapid technological developments in this field.”[7] The draft text also indicates that AI systems “can be used as stand-alone software system, integrated into a physical product (embedded), used to serve the functionality of a physical product without being integrated therein (non-embedded) or used as an AI component of a larger system,” in which case the entire larger system should be considered as one single AI system if it would not function without the AI component in question.[8]

The AI Act Generally Classifies Use Cases, Not Models or Tools

Like the Commission and Council, the Parliament has adopted a risk-based approach rather than a blanket technology ban. The AI Act classifies AI use by risk level (unacceptable, high, limited, and minimal or no risk) and imposes documentation, auditing, and process requirements on providers (a developer of an AI system with a view to placing it on the market or putting it into service) and deployers (a user of an AI system “under its authority,” except where such use is in a “personal non-professional activity”)[9] of AI systems.

The AI Act prohibits certain “unacceptable” AI use cases and contains some very onerous provisions targeting high-risk AI systems, which are subject to compliance requirements throughout their lifecycle, including pre-deployment conformity assessments, technical and auditing requirements, and monitoring requirements. Limited risk systems include those use cases where humans may interact directly with an AI system (such as chatbots), or that generate deepfakes, which trigger transparency and disclosure obligations.[10] Most other use cases will fall into the “minimal or no risk” category: companies must keep an inventory of such use cases, but these are not subject to any restrictions under the AI Act. Companies developing or deploying AI systems will therefore need to document and review use cases to identify the appropriate risk classification.

The AI Act Prohibits “Unacceptable” Risk AI Systems, Including Facial Recognition in Public Spaces, with Very Limited Exceptions

Under the AI Act, AI systems that carry “unacceptable risk” are per se prohibited. The Parliament’s compromise text bans certain use cases entirely, notably real-time remote biometric identification in publicly accessible spaces, which is intended to include facial recognition tools and biometric categorization systems using sensitive characteristics, such as gender or ethnicity; predictive policing systems; AI systems that deploy subliminal techniques impacting individual or group decisions; emotion recognition systems in law enforcement, border management, the workplace and educational institutions; and scraping biometric data from CCTV footage or social media to create facial recognition databases. There is a limited exception for the use of “post” remote biometric identification systems (where identification occurs via pre-recorded footage after a significant delay) by law enforcement and subject to court approval.

Parliament’s negotiating position on real-time biometric identification is likely to be a point of contention in forthcoming talks with member states in the Council of the EU, many of which want to allow law enforcement use of real-time facial recognition, as did the European Commission in its original legislative proposal.

The Scope of High-Risk AI Systems Subject to Onerous Pre-Deployment and Ongoing Compliance Requirements Is Expanded

High risk AI systems are subject to the most stringent compliance requirements under the AI Act and the designation of high risk systems has been extensively debated during Parliamentary debates. Under the Commission’s proposal, an AI system is considered high risk if it falls within an enumerated critical area or use listed in Annex III to the AI Act. AI systems listed in Annex III include those used for biometrics; management of critical infrastructure; educational and vocational training; employment, workers management and access to self-employment tools; access to essential public and private services (such as life and health insurance); law enforcement; migration, asylum and border control management tools; and the administration of justice and democratic processes.

The Parliament’s proposal clarifies the scope of high-risk systems by adding a requirement that an AI system listed in Annex III shall be considered high-risk if it poses a “significant risk” to an individual’s health, safety, or fundamental rights. The Parliament also proposed additional AI systems to the high risk category, including AI systems intended to be used for influencing elections, and recommendation engines of social media platforms that have been designated as Very Large Online Platforms (VLOPs), as defined by the Digital Services Act (“DSA”).

High-risk AI systems would be subject to pre-deployment conformity assessments, informed by guidance to be prepared by the Commission with a view to certifying that the AI system is premised on an adequate risk assessment, proper guardrails and mitigation processes, and high-quality datasets. Conformity assessment would also be required to confirm the availability of appropriate compliance documentation, traceability of results, transparency, human oversight, accuracy and security.

A key challenge companies should anticipate when implementing the underlying governance structures for high risk AI systems is accounting for and tracking model changes that may necessitate a re-evaluation of risk, particularly for unsupervised or partially unsupervised models. In certain cases, independent third-party assessments may be necessary to obtain a certification that verifies the AI system’s compliance with regulatory standards.

The Parliament’s proposal also includes redress mechanisms to ensure harms are resolved promptly and adequately, and adds a new requirement for conducting “Fundamental Rights Impact Assessments” for high-risk systems to consider the potential negative impacts of an AI system on marginalized groups and the environment.

“General Purpose AI” and Generative AI Will Be Regulated

Due to the increasing availability of large language models (LLMs) and generative AI tools, recent discussions in Parliament focused on whether the AI Act should include specific rules for GPAI, foundation models, and generative AI.

The regulation of GPAI—an AI system that is adaptable to a wide range of applications for which it was not intentionally and specifically designed—posed a fundamental issue for EU lawmakers because of the prior focus on AI systems developed and deployed for specific use cases. As such, the Council’s approach had contemplated excluding GPAI from the scope of the AI Act, subject to a public consultation and impact assessment and future regulations proposed by the European Commission. Under the Parliament’s approach, GPAI systems are outside the AI Act’s classification methodology, but will be subject to certain separate testing and transparency requirements, with most of the obligations falling on any deployer that substantially modifies a GPAI system for a specific use case.

Parliament also proposed a regime for regulating foundation models, consisting of models that “are trained on broad data at scale, are designed for generality of output, and can be adapted to a wide range of distinctive tasks,” such as GPT-4.[11] The regime governing foundation models is similar to the one for high-risk AI applications and directs providers to integrate design, testing, data governance, cybersecurity, performance, and risk mitigation safeguards in their products before placing them on the market, mitigating foreseeable risks to health, safety, human rights, and democracy, and registering their applications in a database, which will be managed by the European Commission.

Even stricter transparency obligations are proposed for generative AI, a subcategory of foundation models, requiring that providers of such systems inform users when content is AI-generated, deploy adequate training and design safeguards, ensure that synthetic content generated is lawful, and publicly disclose a “sufficiently detailed summary” of copyrighted data used to train their models.[12]

The AI Act Has Teeth

The Parliament’s proposal increases the potential penalties for violating the AI Act. Breaching a prohibited practice would be subject to penalties of up to €40 million, or 7% of a company’s annual global revenue, whichever is higher, up from €30 million, or 6% of global annual revenue. This considerably exceeds the GDPR’s fining range of up to 4% of a company’s global revenue. Penalties for foundation model providers who breach the AI Act could amount to €‎10 million or 2% annual revenue, whichever is higher.

What Happens Next?

Spain will take over the rotating presidency of the Council in July 2023 and has given every indication that finalizing the AI Act is a priority. Nonetheless, it remains unclear when the AI Act will come into force, given anticipated debate over a number of contentious issues, including biometrics and foundation models. If an agreement can be reached in the trilogues later this year on a consensus version to pass into law—likely buoyed by political momentum and seemingly omnipresent concerns about AI risks—the AI Act will be subject to a two-year implementation period during which its governance structures, e.g., the European Artificial Intelligence Office, would be set up before ultimately becoming applicable to all AI providers and deployers in late 2025, at the earliest.

In the meantime, other EU regulatory efforts could hold the fort until the AI Act comes into force. One example is the DSA, which comes fully into effect on February 17, 2024 and regulates content on online platforms, establishing specific obligations for platforms that have been designated as VLOPs and Very Large Online Search Engines (VLOSEs). Underscoring EU lawmakers’ intent to establish a multi-pronged governance regime for generative models, the Commission also included generative AI in its recent draft rules on auditing algorithms under the DSA.[13] In particular, the draft rules reference a need to audit algorithmic systems’ methodologies, including by mandating pre-deployment assessments, disclosure requirements, and comprehensive risk assessments.

Separately, Margrethe Vestager, Executive Vice-President of the European Commission for a Europe fit for the Digital Age, at the recent meeting of the US-EU Trade and Technology Council (TTC) promoted a voluntary “Code of Conduct” for generative AI products and raised expectations that such a code could be drafted “within weeks.”[14]

We are closely monitoring the ongoing negotiations and developments regarding the AI Act and the fast-evolving EU legal regulatory regime for AI systems, and stand ready to assist our clients in their compliance efforts. As drafted, the proposed law is complex and promises to be challenging for companies deploying or operating AI tools, products and services in the EU to navigate—particularly alongside parallel legal obligations under the GDPR and the DSA.”

_________________________

[1] EC, Proposal for a Regulation of the European Parliament and of the Council laying down Harmonised Rules on Artificial Intelligence and amending certain Union Legislative Acts (Artificial Intelligence Act), COM(2021) 206 (April 21, 2021), available at https://digital-strategy.ec.europa.eu/en/library/proposal-regulation-european-approach-artificial-intelligence. For more details, please see Gibson Dunn, Artificial Intelligence and Automated Systems Legal Update (1Q21), https://www.gibsondunn.com/artificial-intelligence-and-automated-systems-legal-update-1q21/#_EC_Publishes_Draft.

[2] If an agreement can be reached in the trilogues, the AI Act will be subject to a two-year implementation period before becoming applicable to companies. The AI Act would establish a distinct EU agency independent of the European Commission called the “European Artificial Intelligence Office.” Moreover, while the AI Act requires each member state to have a single overarching supervisory authority for the AI Act, there is no limit on the number of national authorities that could be involved in certifying AI systems.

[3] For more details, please see Gibson Dunn, Artificial Intelligence and Automated Systems 2022 Legal Review, https://www.gibsondunn.com/artificial-intelligence-and-automated-systems-2022-legal-review/

[4] European Parliament, Draft European Parliament Legislative Resolution on the Proposal For a Regulation of the European Parliament and of the Council on Laying Down Harmonised Rules on Artificial Intelligence (Artificial Intelligence Act) and Amending Certain Union Legislative Acts (COM(2021)0206 – C9‑0146/2021 – 2021/0106(COD)) (June 14, 2023), https://www.europarl.europa.eu/doceo/document/A-9-2023-0188_EN.html#_section1; see also the DRAFT Compromise Amendments on the Draft Report Proposal for a regulation of the European Parliament and of the Council on harmonised rules on Artificial Intelligence (Artificial Intelligence Act) and amending certain Union Legislative Acts (COM(2021)0206 – C9 0146/2021 – 2021/0106(COD)) (May 9, 2023), https://www.europarl.europa.eu/news/en/press-room/20230505IPR84904/ai-act-a-step-closer-to-the-first-rules-on-artificial-intelligence („Draft Compromise Agreement”).

[5] See, e.g., Open Loop, Open Loop Report “Artificial Intelligence Act: A Policy Prototyping Experiment” EU AI Regulatory Sandboxes (April 2023), https://openloop.org/programs/open-loop-eu-ai-act-program/.

[6] See NIST, AI Risk Management Framework 1.0 (Jan. 2023), https://www.nist.gov/itl/ai-risk-management-framework (defining an AI system as “an engineered or machine-based system that can, for a given set of objectives, generate outputs such as predictions, recommendations, or decisions influencing real or virtual environments [and that] are designed to operate with varying levels of autonomy”). For more details, please see our client alert NIST Releases First Version of AI Risk Management Framework (Jan. 27, 2023), https://www.gibsondunn.com/nist-releases-first-version-of-ai-risk-management-framework/.

[7] Draft Compromise Agreement, https://www.europarl.europa.eu/news/en/press-room/20230505IPR84904/ai-act-a-step-closer-to-the-first-rules-on-artificial-intelligence, Art. 3(1)(6)-(6b).

[8] Id., Art. 3(1)(6(b).

[9] Id., Art 3(2)-(4).

[10] Id., Art. 52.

[11] Id., Art. 3(1c), Art. 28(b).

[12] Id., Art. 28(b)(4)(c).

[13] European Commission, Digital Services Act – conducting independent audits, Commission Delegated Regulation supplementing Regulation (EU) 2022/2065 (May 6, 2023), https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/13626-Digital-Services-Act-conducting-independent-audits_en.

[14] Philip Blenkinsop, EU tech chief sees draft voluntary AI code within weeks, Reuters (May 31, 2023), https://www.reuters.com/technology/eu-tech-chief-calls-voluntary-ai-code-conduct-within-months-2023-05-31/.

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

Kai Gesing – Munich (+49 89 189 33 180, [email protected])
Joel Harrison – London (+44 (0) 20 7071 4289, [email protected])
Vivek Mohan – Palo Alto (+1 650-849-5345, [email protected])
Robert Spano – London (+44 (0) 20 7071 4902, [email protected])
Frances A. Waldmann – Los Angeles (+1 213-229-7914, [email protected])
Christoph Jacob – Munich (+49 89 1893 3281, [email protected])
Yannick Oberacker – Munich (+49 89 189 33-282, [email protected])
Hayley Smith – London (+852 2214 3734, [email protected])

Artificial Intelligence Group:
Cassandra L. Gaedt-Sheckter – Co-Chair, Palo Alto (+1 650-849-5203, [email protected])
Vivek Mohan – Co-Chair, Palo Alto (+1 650-849-5345, [email protected])
Eric D. Vandevelde – Co-Chair, Los Angeles (+1 213-229-7186, [email protected])

On June 14, 2023, the IRS and Treasury issued proposed Treasury regulations (the “Proposed Regulations”) that provide eagerly awaited guidance on the rules for selling certain tax credits pursuant to a new regime introduced in the Inflation Reduction Act of 2022 (the “IRA”).[1] Taxpayers are permitted to rely on the Proposed Regulations until final regulations are published. In a separate regulatory package issued on the same date, the IRS and Treasury released a Temporary regulation (the “Temporary Regulation”) that implements a registration system (discussed below) with the IRS that parties will need to satisfy before any valid sale of credits; the Temporary Regulations will be effective as of June 21, 2023.[2]

On the same day, the IRS and Treasury also issued proposed and temporary Treasury regulations addressing rules under the IRA that make certain credits refundable under certain circumstances (so-called “direct pay”). We will address the proposed and temporary “direct pay” regulations in a subsequent alert.

The Proposed Regulations and Temporary Regulation are detailed, and a comprehensive discussion of them is beyond the scope of this alert. Instead, this alert begins with some background regarding section 6418[3] (the statutory provision permitting credit transfers), provides a short summary of some of the most important aspects of the Proposed Regulations and Temporary Regulation, and concludes with some observations regarding key implications of the guidance for market participants. The IRS and Treasury received hundreds of taxpayer requests for guidance on these issues, and the regulatory package is commendable for its breadth. As discussed below, some aspects of the guidance are very taxpayer-friendly, including clear guidance that a transferee who acquires a credit at a discount will not be subject to tax based upon that discount. By contrast, there are other aspects that are less taxpayer-friendly, such as a burdensome requirement that each individual energy property must be pre-registered with the IRS on an annual basis in order to transfer credits. We expect market participants will push for adjustments to these less taxpayer-friendly aspects of the Proposed Regulations before they are finalized.

Background

Historically, federal income tax credits associated with the investment in and production of clean energy and carbon capture technologies have been non-refundable,[4] and using non-refundable tax credits has required tax liability against which the credits could be applied. Because developers of clean energy (e.g., wind, solar) and carbon capture projects often earn credits in excess of their tax liability, these developers frequently enter into complex arrangements with third-party investors that have consistent and significant federal income tax liabilities (referred to as tax equity investors), such as banks, to shift entitlement to the project’s tax attributes (typically, credits and accelerated tax depreciation) to the tax equity investor. These arrangements require significant and costly structuring. Section 6418 is expected to reduce the need for complicated tax equity arrangements because it authorizes a number of eligible credits[5] to be simply sold by an eligible taxpayer to an unrelated third-party for cash.[6]

Transferring a Credit

The Proposed Regulations provide substantial practical guidance on transferability, clarifying who is eligible to transfer, who is effectively able to purchase, what can be transferred, what can be paid for a transfer, how the transfer is treated for income tax purposes by the transferor and transferee, how (administratively) to transfer the credits, which taxpayer is subject to recapture, how excessive credit transfer penalties can be avoided, and how these rules apply to passthrough entities that are transferors or transferees. The subsections below describe some of the most significant aspects of the guidance on these topics.

Who May Transfer Credits

Only “eligible taxpayers” are authorized to transfer eligible tax credits. The IRA broadly defines “eligible taxpayers” to include most U.S. taxpayers,[7] including passthrough entities, but excludes certain “applicable entities” for which the IRA makes credits refundable.[8] The Proposed Regulations confirm that, where a disregarded entity owns the property that generates the tax credit, the “eligible taxpayer” is the regarded owner of the disregarded entity. The Proposed Regulations also impose a strict ownership requirement on transferors that denies transferability in the case of, for example, contractual counterparties who otherwise are allowed the credits under special rules such as section 45Q(f)(3)(B) (election to allow the section 45Q credit to the party that disposes, utilizes, or uses the qualified carbon oxide) or section 50(d)(5) (election to allow lessees to claim the investment tax credit, i.e., inverted leases).

Further, a credit may be transferred only once. The preamble clarifies that any arrangement in which the ownership of an eligible credit transfers first from an eligible taxpayer to a dealer or intermediary and then to a transferee taxpayer would violate the single transfer limitation.[9] However, an arrangement using a broker to match eligible taxpayers and transferee taxpayers should not violate this limitation, assuming the arrangement at no time transfers the ownership of the eligible credit to the broker or any taxpayer other than the transferee taxpayer.

Who May Purchase Credits

Taxable C corporations seem likely to make up most of the buy-side market for transferrable credits.[10] The Proposed Regulations will effectively prevent most individuals, trusts, and estates from purchasing credits because the Proposed Regulations provide that, for purposes of the passive activity credit rules (section 469), the transferee taxpayer will be considered to earn eligible credits through the conduct of a trade or business related to the eligible credit but will not materially participate in that trade or business.[11] As a result, individuals would be required to treat the credits as passive activity credits, which (other than in certain limited circumstances) cannot offset tax liabilities attributable to wage income or portfolio income.

What Can be Transferred

As previously noted, the credits that may be transferred include those credits enumerated in section 6418, and the Proposed Regulations make clear that part or all of the credit that otherwise would be available to the transferor (including any “bonus” adder) may be transferred to one or more buyers. Circumscribing this flexible rule, however, is a “vertical slice” restriction, which provides that a taxpayer has to transfer an undivided portion (including all bonus amounts) of the credit generated with respect to a particular energy property (e.g., 1 percent of the total credit).

In addition, the Proposed Regulations make clear that the credit transferred is determined on an energy-property-by-energy-property basis, meaning taxpayers can choose to transfer credits with respect to one property but not with respect to another property, even if that other property is of the same class (or, apparently, even if the properties are part of the same project).[12]

What Can be Paid for a Credit

Section 6418 states that any amounts paid by a transferee taxpayer in connection with the transfer of an eligible credit must be paid in cash. The Proposed Regulations define “cash” and clarify when a payment needs to be made. A “cash” payment is one made in United States dollars by cash, check, cashier’s check, money order, wire transfer, automated clearing house (ACH) transfer, or other bank transfer of immediately available funds. Prepayments had raised several issues (e.g., that time value was invalid consideration for the credits), and the Proposed Regulations include a rule that blesses any payment made within the period beginning on the first day of the taxable year during which the credit is determined and ending on the due date (including extensions) for the transferor’s tax return for that year.[13] Moreover, a transferee is permitted to make a contractual commitment to purchase eligible credits in advance of the date the credit is transferred to such transferee taxpayer, as long as all payments comply with the timing rules described in the preceding sentence. If any consideration provided by a transferor to a transferee does not satisfy these requirements, the entire payment fails the test, and the credit transfer fails and is invalid for federal income tax purposes.

How the Transferor is Treated for Income Tax Purposes

Section 6418 provides that payments received by a transferor in exchange for a transfer of eligible credits is not included in the transferor’s gross income, as long as those amounts are received “in connection with” a transfer election. The Proposed Regulations clarify that an amount paid is “in connection” with a transfer election of an eligible credit (or portion thereof) if: (i) it is paid in cash, (ii) it directly relates to the specified credit portion (discussed below), and (iii) is not related to an excessive credit transfer. Thus, under the Proposed Regulations, it is clear that if a transfer election is ineffective for some reason, or if the actual amount of the credit is less than anticipated, the excess cash paid does not qualify for the gross income exclusion.

How the Transferee is Treated for Income Tax Purposes

Payments made by a transferee “in connection with” a transfer election (under the rules discussed above) are not deductible by the transferee taxpayer. In addition, the Proposed Regulations clarify that the transferee does not recognize gross income if it buys an eligible credit at a discount. The Proposed Regulations make specific note of not yet addressing the income tax treatment of transaction costs (for the transferor or the transferee), or the deductibility of losses incurred by a transferee who ultimately (i.e., after an audit) is determined to have overpaid for a credit, but the Treasury and the IRS note that they are currently developing rules on these general issues and are seeking taxpayer comments.

From a timing standpoint, the transferee takes the transferred credit into account in the first taxable year of the transferee ending with, or after, the taxable year of the transferor in which the credit was generated. If the taxable years of a transferor and transferee end on the same date, the transferee will take the eligible credit into account in that taxable year. If, however, their taxable years end on different dates, the transferee will take the eligible credit into account in the transferee’s first taxable year that ends after the taxable year of the transferor in which the credit was determined. Importantly, under the Proposed Regulations, a transferee may take into account a credit that it has purchased, or intends to purchase, when calculating its estimated tax payments.

How (Administratively) to Transfer Credits

The Temporary Regulation prescribes several detailed requirements that must be complied with in order to file an election to transfer credits. In addition to prescribing the information that transferors and transferees must include on their tax returns in order to make the transfer election,[14] there are several other significant administrative requirements under the Temporary Regulation.

Pre-Filing Registration Process. Would-be transferors must complete a pre-filing registration process and obtain a registration number for each eligible credit property with respect to which a transfer election is expected to be made. A substantial amount of information is required to be submitted to obtain a registration number, and a registration number must be obtained for each energy property. An eligible taxpayer who does not obtain a registration number and report the registration number on its return with respect to an eligible credit property is ineligible to make a transfer election. This registration number is valid only for the taxable year in which the credit is determined for the eligible credit property for which the registration is completed, and, in the case of transferees, for a transferee’s taxable year in which the eligible credit is taken into account.[15]

Transfer Election Statement. The transferor and transferee must agree to a “transfer election statement,” which is a written document that describes the transfer of the eligible credit entered into between a transferor and transferee. The detailed statement must be completed before the transferor files the tax return for which the eligible credit is determined and before the transferee files a tax return for the year in which the eligible credit is taken into account, and is required to comply with a substantial number of requirements laid out in the Temporary Regulations.[16]

How to Avoid Excessive Credit Transfer Penalties

Under the IRA, a tax is imposed on credit transferees equal to any “excessive credit transfer” (generally, a redetermination of the initial credit amount not arising from a post-determination recapture event). In addition, a 20-percent penalty tax will apply unless the transferee shows “reasonable cause” for the excessive credit transfer.

The Proposed Regulations state that reasonable cause will be determined based on the relevant facts and circumstances, but that generally the most important factor is the extent of the transferee’s efforts to determine that the amount of the credit to be transferred is not excessive and has not already been transferred to another taxpayer by the transferor. These efforts may be shown by reviewing records and reasonably relying on third-party expert reports and representations by the transferor that the credit is not excessive and has not been transferred to another taxpayer.

Which Taxpayer Is Subject to Recapture

Some of the credits that are eligible to be transferred (e.g., the investment tax credit) are subject to recapture upon the occurrence of certain events. The Proposed Regulations clarify that, in general, regular credit recapture rules apply to the transferee, even in a circumstance in which the recapture is caused solely by an action of the transferor. An exception applies to recapture resulting from certain actions that occur at the partner or shareholder level with respect to partnership or S corporation transferors (discussed below). The preamble makes clear that taxpayers can contract for indemnities for recapture events, without jeopardizing a transfer.

How the Rules Apply to Passthrough Entities

The Proposed Regulations provide detailed and extensive rules with respect to passthrough entities that are transferors or transferees. Although the Proposed Regulations confirm that passthrough entities may be both transferors and transferees, they also clarify that any partner or S corporation shareholder is prohibited from further transferring any credits allocated to it by a partnership or S corporation, as applicable, that directly holds (including via a disregarded entity) the credit-generating property. Consistent with the single transfer requirement, partners and shareholders in a transferee passthrough entity are not permitted to transfer credits that are allocated to them; importantly, however, the Proposed Regulations make clear that an allocation of credits by a transferee passthrough entity to its partners or shareholders does not constitute a transfer that runs afoul of the single transfer requirement. The Proposed Regulations contain additional rules (discussed below) designed to prevent partnerships, including tiered partnerships, from being used to avoid the single transfer requirement.

Notably, the rules clarify that certain characteristics of a transferor passthrough entity’s owners do not limit the amount of credits that a transferor passthrough entity is able to transfer. Most importantly, passthrough entity transferors will not be limited by the application of the passive activity credit rules (which apply at the partner or shareholder level).[17] There are, however, several exceptions to this general proposition. First, passthrough entities are required to apply the “at-risk” rules of section 49 based on how those rules would apply to the passthrough entities’ partners or shareholders, as applicable. Second, in the case of partnerships transferring certain credits (e.g., investment tax credits), the tax-exempt use property limitations will continue to reduce the amount of credits that can be transferred by certain partnerships with tax-exempt partners.

The Proposed Regulations provide that income received as consideration for transferred credits is treated as tax exempt and generally is allocated to each passthrough entity owner based on the amount of the underlying credit that would have been allocated to that passthrough entity owner in the absence of a transfer. This rule applies through tiers of partnerships. Thus, if a partnership (a lower-tier partnership) allocates tax-exempt income to a partner that is itself a partnership (an upper-tier partnership), the upper-tier partnership must allocate the tax-exempt income to its partners in the same manner that the credit would have been allocated to its partners absent the transfer election.

With respect to transferor partnerships that transfer less than all of their transfer-eligible credits, the Proposed Regulations allow income to be allocated to those partners that wished to transfer their share of the credits so long as (1) the amount of credits allocated to any partner does not exceed the amount of credits such partner would have received if no transfer were made and (2) the amount of tax-exempt income allocated to any partner does not exceed the partner’s “proportionate share of tax-exempt income.” A partner’s proportionate share of tax-exempt income is determined based on the amount of credits a partner would have received if the entire credit was transferred, adjusted for any credits actually allocated to the partner. The Proposed Regulations provide an example illustrating this rule and calculating the amount of credits and tax-exempt income allocated to each partner.

On the transferee partnership side, the rules clarify that purchased credits will be treated as “extraordinary items” within the meaning of Treas. Reg. § 1.706-4(e)(2). This treatment generally will prevent the allocation of purchased credits to partners who are not partners in a partnership on the first day that the transferee partnership makes a cash payment for the credit.[18] Purchased credits will be allocated among a partnership’s partners in proportion to their shares of the nondeductible expenses used to fund the purchase of the credits that year.

The Proposed Regulations also provide specific recapture guidance for passthrough entities. Under those rules, a transfer of an interest in a transferor partnership or S corporation (that, in the absence of a credit transfer, would have caused recapture of tax credits allocated to the transferring partner or shareholder, as applicable) will trigger recapture for the transferring partner or shareholder. However, the transfer will not trigger recapture for the transferee if the transfer of the interest in the transferor partnership or S corporation did not cause the property in the hands of the transferor partnership to cease to be eligible property (e.g., depending on the terms of the transferor’s partnership agreement, the transferee may still suffer recapture on the sale by a partner of its interest in the transferor partnership if the buyer is a tax-exempt entity).[19]

Commentary

Many aspects of the Proposed Regulations are taxpayer friendly and will help facilitate credit transfer transactions, but other aspects of the guidance are less taxpayer friendly and could be adjusted to better promote Congressionally intended transfer transactions. Numerous new rules with the potential for complete “cliff effect” disqualification of intended transfers will require great care in structuring unless those rules are modified when the Proposed Regulations are finalized.

No Inverted Lessee Transferors. The rule allowing only the actual owner of the underlying property to transfer credits will prevent lessees in “inverted lease” structures from transferring credits. In an inverted lease structure (which dates to the 1962 origins of the investment tax credit), the lessor and the lessee elect for investment tax credit purposes to treat the lessee as having acquired the energy property for its fair market value. Market participants had been hopeful that the transferability rules would allow these lessees to transfer the investment tax credit, but the Proposed Regulations do not allow this. That said, the IRS and Treasury’s stated rationale for denying transferability in inverted lease structures is likely to meet meaningful criticism.
Partnership Syndications. The Proposed Regulations make clear that a partnership can be a transferee, which should make it feasible to functionally transfer the credits broadly with a single transfer election. However, the “extraordinary item” rules impose a significant limitation that will require careful consideration in structuring payments for credits.
No Selling Bonus Credits Separately. The Proposed Regulations authorize transferors to transfer some or all of their eligible credits, authorize transfers to an unlimited number of transferees, and make it feasible to transfer on an energy-property-by-energy-property basis. While these rules combine to provide substantial flexibility, they do not permit a transferor to transfer anything other than a vertical slice of a credit. Many tax credits that are eligible to be transferred include both a base credit amount and various bonus adders (g., energy community bonus, domestic content bonus). Taxpayers had requested to be able to transfer some or all of these bonus adders (which may bear more risk because of ongoing eligibility issues) separately from the base amount, but the Proposed Regulations make clear that this is not feasible.
Cash Consideration Requirement – Some Flexibility, with Limits.
- The Proposed Regulations make clear that the only consideration that may be paid to a transferor is cash consideration. A peppercorn of noncash consideration will invalidate the entire transfer—a huge trap for the unwary.
- The Proposed Regulations provide some limited flexibility in terms of when payments may be made, but essentially limit payments so they are quasi-contemporaneous with the generation of the credits. The Proposed Regulations do authorize advance contractual commitments to purchase eligible credits, as long as actual payments are made in the prescribed regulatory window (which could be as long as 21-1/2 months). This advance contractual commitment authorization will be essential to securing bridge financing and to the orderly functioning of the burgeoning brokerage market, but still will impose some potentially significant limitations on sponsors seeking to monetize a stream of tax credits (g., production tax credits under section 45) over time, likely putting the transferability rules at a further disadvantage to traditional tax equity financing (which allows for a significant up-front payment based on both anticipated depreciation and tax credits). Additional authorization for advance commitments coupled with substantial prepayments would help close this gap between traditional tax equity and transferability.
Tax-Free Discount Purchases. Market participants had been concerned about whether a purchase by a transferee at a discount to the face amount of the credit would result in the transferee recognizing taxable income on the difference. The Proposed Regulations follow the position previously articulated by the Joint Committee on Taxation and make clear that this discount is not income.[20] This rule is favorable to all stakeholders and will avoid transferees “grossing down” credit prices.
Burdensome Transfer Requirements. Various aspects of the transfer regime in the Proposed Regulations likely will prove administratively burdensome, making it more challenging for taxpayers to avail themselves of the rules.
- For example, a separate transfer election must be made for each property (with a potential exception for the transfer of the investment tax credit, which may be able to be made on a project-wide basis). This requirement could be construed to require, for example, a separate election for each wind turbine comprising a wind facility. Adding to this complexity is the fact that, for a production tax credit-eligible project, transfers must be made on a yearly basis. And where there are multiple buyers, separate transfer elections must be made for each of them. Taken together, the specificity of these requirements could mean that a large number of elections may need to be made with respect to a single project. We appreciate and support the government’s efforts to eliminate fraud or other duplication of credits, but we think these objectives could be achieved with rules that allow for a smaller number of transfer elections (g., allowing aggregation of all facilities in a wind farm using “single project” factors similar to those that have been used in earlier “begun construction” guidance).
- In addition to potentially having to make numerous transfer elections with respect to a single project, the Proposed Regulations also impose a requirement for potential transferors to register the credits they intend to transfer before transferring them, prescribing a process that will require the submission of substantial information to obtain pre-registration. The rules also require that transferors and transferees agree upon a transfer election statement with detailed requirements and further prescribe a host of other tax return requirements, mandating yearly transfer elections. These requirements will serve as a barrier for all but the most sophisticated and well-financed taxpayers, limiting the reach and benefit of the transfer rules. In light of the fact that the rules in section 6418 were intended to eliminate the complexity and cost inherent in tax equity financing transactions, we are hopeful that the IRS and Treasury will consider ways to reduce the administrative complexity for would-be transferors in order to maximize the reach of the tax credit transfer rules.
Recapture Risk. A number of market participants had been hopeful that recapture risk for credit transferees would be substantially limited, but the Proposed Regulations make clear that buyers generally bear recapture risk, although buyers are authorized to obtain contractual protection to reallocate this risk. The Proposed Regulations do provide, however, that where the tax credit transferor is a partnership, transfers by the partners of interests in that partnership generally do not cause recapture to a credit transferee as long as the transfer of the partnership interest does not cause the partnership’s property to cease to be credit eligible (g., as long as transferee of the partnership interest does not cause tax-exempt use property issues). As time goes on, the continued application of the tax-exempt use rules to transferor partnerships is likely to serve as a trap for the unwary because their application is counterintuitive (and even counter-policy) after the enactment of IRA. That is, the tax-exempt use rules were designed to prohibit tax-exempt entities from monetizing their tax-exempt status; those rules serve an uncertain (at best) role in this IRA credit regime in which tax-exempt entities are effectively treated as taxpayers for all purposes relevant to such credits.
Useful Allocation Rules for Transferor Partnerships. The Proposed Regulations provide taxpayer-friendly rules that will be particularly useful for sponsors wishing to transfer the credits that are allocated to them in tax equity partnerships. Under a typical tax equity partnership, the bulk of the tax credits (usually 99 percent) are allocated to the tax equity investor until it achieves its “flip yield,” with the remaining 1 percent of the credits being allocated to the sponsor, who may not be able to use those credits. The Proposed Regulations authorize a tax equity partnership to transfer a single partner’s share of the otherwise applicable credits and specially allocate the income from that transfer (this income is tax exempt) to that partner. This should allow for more efficient credit monetization by sponsors, particularly given that the regulations make clear that the cash generated by a tax credit sale by a partnership can be used in whatever manner the partners decide.

Effective Date

___________________________

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

[2] The text of the Temporary Regulation was also included in the Proposed Regulations.

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

[4] The investment tax credit for energy property was briefly refundable at its inception (1978-1980) and was effectively payable as a cash grant for projects that began construction in 2009-2011.

[5] “Eligible credit” means the alternative fuel vehicle refueling property credit determined under section 30C to the extent treated as a credit listed in section 38(b), the renewable electricity production credit under section 45(a), the credit for carbon oxide sequestration under section 45Q(a), the zero-emission nuclear power production credit under section 45U(a), the clean hydrogen production credit under section 45V(a), the advanced manufacturing production credit under section 45X(a), the clean electricity production credit under section 45Y(a), the clean fuel production credit under section 45Z(a), the energy credit under section 48, the qualifying advanced energy project credit under section 48C, and the clean electricity investment credit under section 48E. Credit carryforwards and carrybacks are not eligible credits.

[6] The terms “transferee,” “transferees,” and “transferee taxpayer” mean any taxpayer that is not related (within the meaning of sections 267(b) or 707(b)(1)) to the eligible taxpayer making the transfer election to which an eligible taxpayer transfers a specified credit portion of an eligible credit.

[7] U.S. taxpayers include those with employment or excise tax liability, not just those with income tax liability.

[8] The term “applicable entity” means (i) any tax-exempt organization exempt from the tax imposed by subtitle A (a) by reason of section 501(a) or (b) because such organization is the government of any U.S. territory or a political subdivision thereof, (ii) any State, the District of Columbia, or political subdivision thereof, (iii) the Tennessee Valley Authority, (iv) an Indian tribal government or subdivision thereof (as defined in section 30D(g)(9)), (v) any Alaska Native Corporation (as defined in section 3 of the Alaska Native Claims Settlement Act (43 U.S.C. 1602(m)), (vi) any corporation operating on a cooperative basis which is engaged in furnishing electric energy to persons in rural areas, or (vii) any agency or instrumentality of any applicable entity described in (i)(b), (ii), or (iv). For the purposes of this client alert, the term “passthrough” or “passthrough entity” means a partnership or an S corporation, unless otherwise noted.

[9] Unless otherwise stated, all references to the “preamble” are to the preamble to the Proposed Regulations.

[10] Importantly, the new federal corporate alternative minimum tax (commonly referred to as “CAMT”), also enacted by the IRA, can be wholly offset by transferrable credits.

[11] The rule also will limit the utility of credit purchases by certain closely held personal service corporations.

[12] This approach deviates from the general class-by-class approach that applies for purposes of electing out of “bonus” depreciation under section 168(k).

[13] This rule is described in the preamble as safe harbor but operates as a requirement.

[14] Note that the transferor must make the election on its original return, including extensions (no late-election relief is available), and no transfer election may be made or revised on an amended return or on a partnership administrative adjustment request.

[15] Transferees are also required to report the registration number received from a transferor taxpayer on Form 3800 as part of the return for the taxable year with respect to which the transferee taxpayer takes the transferred specified credit portion into account.

[16] For example, an eligible taxpayer that determines eligible credits with respect to two properties would need to make a separate election with respect to each property. For production-based credits that are available over a 10- or 12-year period, the election would need to be made each taxable year that the transferor elects to transfer credits.

[17] As discussed above, the passive activity credit rules will apply to credit transferees.

[18] If the transferee partnership and the transferor have different taxable years, the credit will be allocated only to partners in the transferee partnership as of the date that is the later of (i) the first day that the transferee partnership makes a cash payment for the credit and (ii) the first date the transferee partnership takes the credit into account under section 6418(d).

[19] The passthrough transferor is not required to provide notice of such transfers to the transferee.

[20] Joint Committee on Taxation, Description of Energy Tax Changes Made by Public Law 117-169, JCX-5-23, 97 (April 17, 2023).

This alert was prepared by Mike Cannon, Matt Donnelly, Emily Brooks, Alissa Fromkin Freltz*, Duncan Hamilton, and Simon Moskovitz.

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

Tax Group:
Michael Q. Cannon – Dallas (+1 214-698-3232, [email protected])
Matt Donnelly – Washington, D.C. (+1 202-887-3567, [email protected])
Kathryn A. Kelly – New York (+1 212-351-3876, [email protected])
Josiah Bethards – Dallas (+1 214-698-3354, [email protected])
Emily Risher Brooks – Dallas (+1 214-698-3104, [email protected])
Duncan Hamilton– Dallas (+1 214-698-3135, [email protected])
Simon Moskovitz – Washington, D.C. (+1 202-777-9532 , [email protected])

*Alissa Fromkin Freltz is an associate working in the firm’s Washington, D.C. office who currently is admitted to practice only in Illinois and New York.

Decided June 16, 2023

United States, ex rel. Polansky v. Executive Health Resources, Inc., No. 21-1052

Today, the Supreme Court held 8-1 that the federal government may move at any time to dismiss a False Claims Act lawsuit over the objection of a relator, so long as it first intervenes in the action.

Background: The False Claims Act (FCA) allows private individuals, known as relators, to bring claims on behalf of the government against parties who have allegedly defrauded the federal government. When a relator files a complaint based on an alleged violation of the FCA, the government has the opportunity to intervene and litigate the action itself, or it can decline to intervene and allow the relator to litigate the action on its behalf. The statute provides that the Government “may dismiss the action”—notwithstanding the objections of the relator—if “the court has provided the [relator] with an opportunity for a hearing on the motion.” 31 U.S.C. § 3730(c)(2)(A).

Jesse Polansky brought an FCA claim against Executive Health Resources. The government initially declined to intervene. After Polansky spent five years litigating the case, the government moved to dismiss the case, citing discovery costs, the low likelihood that the lawsuit would succeed, and concerns about Polansky’s credibility. The district court granted the government’s motion and the Third Circuit affirmed, rejecting Polansky’s argument that the government lacks authority to seek dismissal under § 3730(c)(2)(A) after declining to intervene at the outset of the case.

Issue: Whether the government can seek dismissal of an FCA suit despite initially declining to intervene and, if so, what standard applies.

Court’s Holding:

The government may seek to dismiss an FCA lawsuit even after initially declining to intervene, as long as it intervenes before moving to dismiss. Federal Rule of Civil Procedure 41(a)’s generally applicable standards—which permit voluntary dismissals “on terms that the court considers proper”—govern the government’s dismissal motion, but courts applying those standards should grant the government’s views substantial deference.

“[W]e hold that the Government may seek dismissal of an FCA action over a relator’s objection so long as it intervened sometime in the litigation, whether at the outset or afterward.”

Justice Kagan, writing for the Court

Gibson Dunn submitted an amicus brief on behalf of Pharmaceutical Research and Manufacturers of America in support of the winning respondent: Executive Health Resources, Inc.

What It Means:

Today’s decision confirms what lower courts have widely held for years: the government should be given wide latitude to dismiss an FCA suit when litigation of the suit is not in the government’s interest, including because it imposes discovery costs on federal employees and agencies that exceed any potential benefits or because it interferes with federal policy priorities. The decision also could present additional opportunities for defendants facing abusive FCA litigation to enlist support from the government even at advanced stages of the litigation.
The Court’s decision is consistent with the Department of Justice’s 2018 “Granston” memo, which required department lawyers to consider pursuing dismissal of cases brought by relators that are shown to be frivolous, parasitic or opportunistic, or otherwise contrary to the government’s policies and programs. Michael D. Granston, U.S. Dep’t of Justice, Factors for Evaluating Dismissal Pursuant to 31 U.S.C. 3730(c)(2)(A) (Jan. 10, 2018). The Department has, even after the Granston memo, exercised its authority to dismiss FCA lawsuits very sparingly, but may have more confidence to seek dismissal of FCA lawsuits now that the Court has confirmed its authority to do so at any stage.
Justice Thomas questioned the constitutionality of the FCA’s provisions allowing private relators to bring False Claims Act actions on behalf of the federal government. Justices Kavanaugh and Barrett, concurring in the Court’s decision, agreed with Justice Thomas’s view that there are “substantial arguments” that permitting private relators to represent the government is “inconsistent” with Article II and stated that the Court should address this “Article II issue” in a future case. These arguments have previously failed in lower courts, but these separate opinions will draw new attention to the issue, which is of significant importance given the enormous growth of qui tam FCA litigation in recent decades.

The Court’s opinion is available here.

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

Appellate and Constitutional Law Practice

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

False Claims Act / Qui Tam Defense & FDA and Health Care Practices

John D.W. Partridge +1 303.298.5931 [email protected]	Jonathan M. Phillips +1 202.887.3546 [email protected]	Winston Y. Chan +1 415.393.8362 [email protected]
Gustav W. Eyler +1 202.955.8610 [email protected]

How do you win cases in the highest court in the U.S.? Ted Olson and Ted Boutrous are back to discuss the strategies that helped them win landmark cases before the U.S. Supreme Court. This insider’s look also examines what it takes to craft and deliver legal arguments to secure success in the highest court in the land. Understanding your audience, knowing your arguments and keeping your cool are all essential, they say.

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All episodes of The Two Teds are available on GibsonDunn.com and wherever you listen to podcasts. You can also subscribe to be notified of new episodes via e-mail.

HOSTS:

Ted Boutrous – Theodore J. Boutrous, Jr., a partner in the Los Angeles office of Gibson, Dunn & Crutcher LLP, is global Co-Chair of the firm’s Litigation Group and previously led the firm’s Appellate, Crisis Management, Transnational Litigation and Media groups. He also is a member of the firm’s Executive and Management Committees. Recognized for a decade of excellence in the legal profession, the Daily Journal in 2021 named Mr. Boutrous as a Top Lawyer of the Decade for his victories. As a tireless advocate and leader for high-stakes and high-profile cases, Mr. Boutrous was also named the 2019 “Litigator of the Year, Grand Prize Winner” by The American Lawyer.

Ted Olson – Theodore B. Olson is a Partner in Gibson, Dunn & Crutcher’s Washington, D.C. office; a founder of the Firm’s Crisis Management, Sports Law, and Appellate and Constitutional Law Practice Groups. Mr. Olson was Solicitor General of the United States during the period 2001-2004. From 1981-1984, he was Assistant Attorney General in charge of the Office of Legal Counsel in the U.S. Department of Justice. Except for those two intervals, he has been a lawyer with Gibson, Dunn & Crutcher in Los Angeles and Washington, D.C. since 1965.

The New York Court of Appeals, the highest court in New York, recently issued a decision regarding several elements of New York’s defamation law, including what plaintiffs qualify as “public figures” for purposes of determining their burden of proof for defamation claims, the applicability of New York privileges against defamation liability, and the scope of certain of the 2020 amendments to New York’s anti-SLAPP law. Those amendments to sections 70-a and 76-a of the New York Civil Rights Law strengthened the protections for defendants in so-called SLAPP suits (“strategic lawsuits against public participation”) that seek to punish and chill the exercise of the rights of petition and free speech. Notably, this appears to be the first decision from New York’s highest court regarding the amendments New York adopted to its anti-SLAPP law in 2020.

Background

In Gottwald v. Sebert,* the New York Court of Appeals considered a dispute between the singer/songwriter Kesha Rose Sebert, known as “Kesha,” and the music producer Lukasz Gottwald, known as “Dr. Luke.”[1] In 2014, Kesha, who had been under contract with Gottwald in connection her recording career, sued Gottwald in California alleging that Gottwald had sexually assaulted her and seeking to void her contractual arrangements with him.[2] The same day, Gottwald sued Kesha in New York, alleging that Kesha and her attorneys had defamed him.[3]

While Gottwald’s defamation action was pending, New York amended its existing anti-SLAPP law in a number of ways.[4] New York’s previous anti-SLAPP law, enacted in 2008, was limited to litigation arising from a public application or permit, “usually in a real estate development situation.”[5] Among other things, as relevant here, the 2020 amendments “substantially expanded” the definition of “an action involving public petition and participation” to which the anti-SLAPP law would apply.[6] The anti-SLAPP law already required a plaintiff in any action to which the anti-SLAPP law applied to meet the “actual malice” standard, so expanding the scope of actions to which the anti-SLAPP law applies also expanded the actions in which plaintiffs were required to show actual malice.[7] Similarly, the anti-SLAPP law already allowed defendants to file a counterclaim to seek compensatory and punitive damages; expanding the scope of the anti-SLAPP law also expanded the set of actions in which defendants could seek that relief. And the 2020 amendments also created a mandatory fee-shifting provision, meaning that courts are required to award attorneys’ fees to defendants who defeat actions to which the anti-SLAPP law applies.[8]

After New York amended its anti-SLAPP law, Kesha sought leave to assert a counterclaim under the amended anti-SLAPP law for attorneys’ fees, damages for emotional distress, and punitive damages, as the amended law permits.[9]

After initial rulings at the trial court, the First Department intermediate appellate court issued two separate rulings on Kesha’s defenses, ruling that Gottwald was not a public figure; that whether Kesha’s statements were protected by New York privileges against defamation liability was a fact question that only the jury could resolve; and that the amended anti-SLAPP law did not apply to Gottwald’s claims because he had filed his claims before the amendments to the anti-SLAPP law were adopted.[10]

Kesha appealed both those rulings to the New York Court of Appeals, New York’s highest court. On June 13, 2023, the New York Court of Appeals reversed the appellate court in whole or in part on each issue.[11]

Public Figure Status

Under governing precedent from the United States Supreme Court, as a matter of federal constitutional law, a defamation plaintiff found to qualify as a “public figure” can only establish defamation liability if he proves by clear and convincing evidence that defamatory statements were made about him with “actual malice,” meaning with knowledge that the statement was false or with reckless disregard as to whether the statement was false.[12] Public figures come in two varieties. A general or “all-purpose public figure” is so prominent as to qualify as a public figure for all purposes, regardless of what defamatory statements are made or what subject matter those statements address.[13] Alternatively, plaintiffs will qualify as a “limited-purpose public figure” even if they do not have such broad notoriety if they nonetheless have invited and achieved public attention with respect to the subject matter the defamatory statements address.[14]

In the Gottwald case, the First Department intermediate appellate court held that Gottwald was not a general-purpose public figure because he was not a “celebrity” or a “household word.”[15] And the court held he was not a limited-purpose public figure with respect to Kesha’s allegedly defamatory statements about him because those statements accused him of sexual assault and Gottwald had done nothing to achieve public prominence with respect to the “specific public dispute . . . [of] sexual assault and the abuse of artists in the entertainment industry.”[16] Therefore, the court found, Gottwald’s acknowledged fame as a music producer and the notoriety he had achieved for his relationships with the artists he represented was irrelevant.[17]

A dissent at the First Department intermediate appellate court authored by Justice Saliann Scarpulla argued that the majority had misapplied the standard to determine when a plaintiff qualifies as a public figure.[18] The dissent argued that Gottwald probably qualified even as a general-purpose public figure because, though not a “household name” everywhere, he was “a household name to those that matter.”[19] But even if not, the dissent argued that Gottwald was at minimum a limited-purpose public figure “in connection with the dynamics of his relationship to the artists with whom he works and upon which he has built his well-known professional reputation.”[20] The dissent argued that the panel’s application of the public-figure analysis was too narrow: “That Dr. Luke has not spoken publicly about Kesha’s allegations of sexual assault is not surprising, is not relevant, and does not preclude a finding that he is a limited purpose public figure. The definition of limited purpose public figure is not so cramped as to only include individuals and entities that purposefully speak about the specific, narrow topic (in this case a protégé’s sexual assault) upon which the defamation claim is based.”[21]

The New York Court of Appeals reversed, “agree[ing] with the dissent below” that Gottwald met the standard to qualify as a limited-purpose public figure, because he had “purposefully sought media attention for himself, his businesses, and for the artists he represented, including Sebert, to advance those business interests.”[22] Therefore, Gottwald will be required to prove that Kesha made statements about him with “actual malice” to establish her liability.[23]

Privileges Against Defamation Liability

Kesha also argued that certain statements identified in Gottwald’s complaint were protected by certain of New York privileges against defamation liability: New York’s absolute common-law privilege for statements made in connection with judicial proceedings; its qualified common-law privilege for statements made in anticipation of litigation; and its statutory privilege codified at Civil Rights Law Section 74 for “fair and true reports” of judicial proceedings.[24]

Absolute Common-Law Privilege For Statements Made In Connection With Judicial Proceedings

New York courts have held that statements made in connection with judicial proceedings are absolutely privileged against defamation liability if they are pertinent to that proceeding.[25] Since 1986,[26] lower New York courts, beginning with the First Department intermediate appellate court, have identified an exception to that doctrine termed the “sham” exception, holding that the absolute privilege “will not be conferred where the underlying lawsuit was a sham action brought solely to defame the defendant.”[27] The First Department intermediate appellate court reaffirmed this exception as recently as 2015, when it expressly rejected a trial court’s conclusion that the First Department’s “sham” exception had “waned” in value.[28]

In Gottwald, the First Department intermediate appellate court held that whether the “sham” exception applied was a fact question that turned on whether Kesha sued Gottwald in good faith or as a sham.[29] Therefore, Kesha could not obtain summary judgment on the basis of that privilege; only the jury could decide whether Kesha could benefit from the absolute privilege for statements made in connection with judicial proceedings.[30]

The New York Court of Appeals reversed, holding that it was “error” to apply a “sham exception” to New York’s common-law absolute privilege for statements made in connection with judicial proceedings.[31] It was “inconsistent” with the Court of Appeals’ prior decisions regarding the absolute privilege for a court to examine the motive of the speaker.[32] Instead, if a statement was made in connection with a judicial proceeding and was pertinent to that proceeding, the absolute privilege applies.[33] The New York Court of Appeals therefore held that the absolute privilege applied to statements Kesha and her attorneys made in connection with her litigation against Gottwald.[34]

Qualified Common-Law Privilege For Statements Made In Anticipation Of Litigation

New York courts have also recognized a qualified privilege for statements made in good-faith anticipation of litigation.[35] However, unlike the absolute privilege for statements made in connection with a judicial proceeding, New York’s qualified privilege can be “lost . . . where a defendant proves that the statements were not pertinent to a good faith anticipated litigation.”[36] And because Gottwald had argued there is a factual dispute as to whether Kesha actually had a good-faith anticipation of litigation at the time she made some challenged statements, the Court of Appeals agreed with the lower courts that the jury would have to determine whether the qualified privilege applied only after determining whether Kesha actually had a good-faith anticipation of litigation at the time that she and her agents made the relevant statements.[37]

Civil Rights Law Section 74 Fair Report Privilege

Finally, New York has adopted a statutory privilege immunizing statements that publish a “fair and true report of any judicial proceeding” where the statement is “substantially accurate.”[38] The New York Court of Appeals has previously held that, unlike the common-law absolute privilege for statements made in connection with judicial proceedings, the statutory “fair report” privilege does include an exception for statements made by a plaintiff who “maliciously institute[s] a judicial proceeding” in order to make defamatory statements in connection with that proceeding.[39] In Gottwald, the New York Court of Appeals agreed with the lower courts that whether the fair report privilege applied was a question for the jury after determining whether Kesha’s claims against Gottwald “were brought . . . in good faith or maliciously to defame Gottwald.”[40]

Applicability Of Amended Anti-SLAPP Law

Finally, the New York Court of Appeals considered whether the amendments to the anti-SLAPP law applied “retroactively” and applied to Gottwald’s claims even though he filed them before the New York anti-SLAPP law was amended.[41] If the amendments applied “retroactively,” they would apply to Gottwald’s claims in their entirety throughout the entire course of the litigation, including over the six years the matter was litigated before the amendments were adopted in 2020.

Kesha primarily argued that two separate elements of the 2020 amendments to New York’s anti-SLAPP law should apply retroactively in Gottwald. First, Kesha argued that Gottwald should be required to meet the “actual malice” standard, regardless of whether he qualified as a public figure.[42] Second, Kesha argued that she should be entitled to file a counterclaim under the amended anti-SLAPP law that would entitle her to recover attorneys’ fees, damages for emotional distress, and punitive damages if she ultimately prevailed in the litigation.[43]

Until the Gottwald case was decided by the First Department intermediate appellate court, a significant number of state and federal courts had held that the 2020 amendments to the anti-SLAPP law did apply retroactively to any matter pending at the time they were adopted.[44] The First Department intermediate appellate court in Gottwald was the first court to hold otherwise, holding instead that the amendments did not apply retroactively and applied only to claims filed after the amendments were adopted.[45] The First Department intermediate appellate court reached that decision as to both the question of whether Gottwald was required under the amended anti-SLAPP law to meet the “actual malice” standard and as to the question of whether Kesha could file a counterclaim under that law for attorneys’ fees and damages—answering both questions in the negative.[46]

Because the New York Court of Appeals had already held that Gottwald did qualify as a public figure and therefore was required to meet the “actual malice” standard, it did not consider the question of whether the 2020 amendments to the anti-SLAPP law also independently required him to do so.[47]

The New York Court of Appeals held that the provisions of New York’s amended anti-SLAPP law authorizing a defendant to counterclaim for attorneys’ fees and damages did not apply retroactively.[48] The Court held that the legislature did not expressly provide that the amendments should apply retroactively.[49] In particular, the Court held that because the amendments that allowed a defendant to bring a counterclaim for attorneys’ fees and damages constituted a “statute imposing damages,” they should not “presumptively apply in pending cases.”[50]

Instead, the Court held that because the amendments to the anti-SLAPP law provided that defendants could recover attorneys’ fees and damages for an action “commenced or continued” improperly, the amendments could apply to Gottwald’s claims, but only with respect to events that occurred after the amendments were adopted.[51] This did not constitute “retroactive” application, the Court held, because “these provisions are applied, according to their terms, to the continuation of the action beyond the effective date of the amendments.”[52] In other words, the Court held that Kesha may bring a counterclaim under New York’s amended anti-SLAPP law to recover attorneys’ fees and damages, but only for attorneys’ fees and damages that arose after the amendments were enacted, and not before: “Because Gottwald’s liability [under the amended anti-SLAPP law] attached, if at all, when he chose to continue the defamation suit after the effective date of the statute, any potential calculation of attorneys’ fees or other damages begins at the statute’s effective date.”[53]

Dissent

Judge Jenny Rivera of the New York Court of Appeals dissented in part.[54]

Judge Rivera argued in dissent that the majority had erred regarding the scope of New York’s qualified privilege for statements made in anticipation of litigation.[55] Judge Rivera would have held that on the undisputed record, the statements in question were clearly made in anticipation of litigation because they were made while pre-suit settlement negotiations were ongoing, shortly before Kesha filed suit in California against Gottwald, and were made either in connection with settlement negotiations or as part of sharing information with the press under pre-suit embargo.[56] Judge Rivera argued that requiring a jury to decide whether Kesha had a good-faith anticipation of litigation on that record “severely limits settlement efforts” by allowing potential defamation liability to attach.[57]

Judge Rivera also argued in dissent that the majority had erred regarding the scope of New York’s statutory “fair report” privilege.[58] Judge Rivera would have held that the statements of Kesha and her attorneys about litigation with Gottwald qualified as a “fair report” without examining her motives in bringing the litigation.[59] Judge Rivera argued that the Gottwald majority had “extend[ed]” the “sham” exception to the New York statutory “fair report” privilege in a way that “risk[ed] eroding the privilege altogether.”[60]

Finally, Judge Rivera argued in dissent that the majority had erred regarding the retroactivity of the 2020 amendments to the New York anti-SLAPP law.[61] Judge Rivera would have held that those amendments were retroactive and applied to Gottwald’s suit in its entirety, dating to the day it was commenced.[62] In particular, Judge Rivera argued that the majority was wrong to treat the amendments that allowed defendants to assert a counterclaim for attorneys’ fees and damages as a new law that “introduced damages liability” for the first time.[63] Judge Rivera argued that the 2020 amendments instead articulated a specific version of a remedy that always existed—the availability of sanctions, including attorneys’ fees and damages, for filing a frivolous lawsuit—and so should not be treated as a statute imposing liability on past conduct that had not been a basis for liability at the time that conduct occurred.[64] Judge Rivera disagreed with the majority’s interpretation of the statutory phrase “commenced or continued,” which she would have found was a reason to hold the amendments applied retroactively, rather than applying only as of the date the amendments were adopted. In Judge Rivera’s view, “[t]he majority’s prospective-only construction of the ‘commenced or continued’ language . . . is an overly narrow construction of that phrase. The fact that any action continued at the time of the effective date of the amendments falls within the scope of the statute means just that; it does not necessarily or by implication mean that monetary relief is measured from the effective date. Despite the majority’s effort to complicate straightforward language, the meaning and effect of the word ‘commenced’ in the phrase ‘commenced or continued’ tracks to the person who commenced the prohibited legal action.”[65]

Conclusion

This decision from the highest court of New York provides additional precedent regarding the categories of plaintiffs who will qualify as public figures under New York law, the availability of New York common-law and statutory privileges against defamation liability, the retroactivity of New York’s amended anti-SLAPP law, and the analysis New York courts should apply to evaluate whether newly enacted laws should have retroactive effect. The New York Court of Appeals expressly left open the question of whether other provisions of New York’s amended anti-SLAPP statute will have retroactive effect as to cases pending at the time those amendments were adopted.

* Gibson, Dunn & Crutcher LLP represents Sony Music Entertainment with respect to third-party discovery in the trial court in Gottwald v. Sebert, No. 653118/2014 (Sup. Ct. N.Y. Cty.); claims against Sony Music Entertainment in the trial court have been dismissed.

________________________

[1] Gottwald v. Sebert (“Gottwald III”), No. 32, 2023 WL 3959051 (N.Y. June 13, 2023).

[2] Id. at *1.

[3] Id.

[4] Id. at *2.

[5] 2020 N.Y. Senate Bill No. 52-A/Assembly Bill No. 5991A (July 22, 2020), https://www.nysenate.gov/legislation/bills/2019/s52/amendment/a.

[6] Gottwald III, 2023 WL 3959051 at *5.

[7] Palin v. New York Times Co., 510 F. Supp. 3d 21, 28–29 (S.D.N.Y. 2020)(citing New York Times v. Sullivan, 376 U.S. 254 (1964) and N.Y. Civil Rights Law § 76-a(2)).

[8] Gottwald III, 2023 WL 3959051 at *5.

[9] Gottwald III, 2023 WL 3959051 at *2.

[10] Gottwald v. Sebert (“Gottwald II”), 165 N.Y.S.3d 38 (App. Div. 1st Dept. 2022); Gottwald v. Sebert (“Gottwald I”), 148 N.Y.S.3d 37 (App. Div. 1st Dept. 2021).

[11] Gottwald III, 2023 WL 3959051.

[12] Huggins v. Moore, 94 N.Y.2d 296, 301 (1999); New York Times Co. v. Sullivan, 376 U.S. 254, 279–80 (1964).

[13] Gottwald III, 2023 WL 3959051, at *2, *14 n.8.

[14] Gottwald III, 2023 WL 3959051, at *2.

[15] Gottwald I, 148 N.Y.S.3d at 43.

[16] Id. at 43–45.

[17] Id. at 44–45.

[18] Id. at 47–51 (Scarpulla, J., dissenting).

[19] Id. at 48–49 (Scarpulla, J., dissenting).

[20] Id. at 49–51 (Scarpulla, J., dissenting).

[21] Id. at 50 (Scarpulla, J., dissenting).

[22] Gottwald III, 2023 WL 3959051, at *2–3.

[23] Id. at *3.

[24] Id. at *3–4.

[25] Front, Inc. v. Khalil, 24 N.Y.3d 713, 718 (2015).

[26] Halperin v. Salvan, 117 A.D.2d 544, 548 (1st Dept. 1986).

[27] Gottwald I, 148 N.Y.S. at 46.

[28] Flomenhaft v. Finkelstein, 127 A.D.3d 634, 638 (1st Dep’t 2015).

[29] Gottwald I, 148 N.Y.S.3d at 46.

[30] Id.

[31] Gottwald III, 2023 WL 3959051, at *3.

[32] Id.

[33] Id.

[34] Id.

[35] Id. at *4.

[36] Id.

[37] Id.

[38] Id. (citing Civil Rights Law § 74, Holy Spirit Assn. for Unification of World Christianity v. New York, 49 N.Y.2d 63, 67 (1979)).

[39] Williams v. Williams, 23 N.Y.2d 592, 599 (1969).

[40] Gottwald III, 2023 WL 3959051, at *4.

[41] Id. at *5–7.

[42] Id. at *5.

[43] Id. at *6.

[44] Memorandum of Law in Support of Motion of Defendant-Respondent for Reargument or, in the Alternative, Leave to Appeal, Gottwald v. Sebert, No. 2021-03036, Dkt. 20 at 15 n.1 (N.Y. App. Div. 1st Dep’t Apr. 11, 2022).

[45] Gottwald II, 165 N.Y.S.3d at 39–40.

[46] Id.

[47] Gottwald III¸ 2023 WL 3959051, at *5.

[48] Id. at *6–8.

[49] Id. at *6.

[50] Id. at *7.

[51] Id. at *6.

[52] Id.

[53] Id.

[54] Gottwald III, 2023 WL 3959051, at *8–17 (Rivera, J., dissenting).

[55] Id. at *14–15 (Rivera, J., dissenting).

[56] Id.

[57] Id. at *14 (Rivera, J., dissenting).

[58] Id. at *15–16 (Rivera, J., dissenting).

[59] Id.

[60] Id. at *16 (Rivera, J., dissenting).

[61] Id. at *9–13 (Rivera, J., dissenting).

[62] Id. at *10–11 (Rivera, J., dissenting).

[63] Id. at *10 n.4, *12–13 (Rivera, J., dissenting).

[64] Id.

[65] Id.

The following Gibson Dunn lawyers assisted in the preparation of this client update: Theodore Boutrous, Annie Champion, Connor Sullivan, Alexandra Perloff-Giles, and Angela Coco.

Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or the following leaders and members of the firm’s Media, Entertainment & Technology Practice Group:

Scott A. Edelman – Co-Chair, Los Angeles (+1 310-557-8061, [email protected])
Kevin Masuda – Co-Chair, Los Angeles (+1 213-229-7872, [email protected])
Benyamin S. Ross – Co-Chair, Los Angeles (+1 213-229-7048, [email protected])
Theodore J. Boutrous, Jr. – Los Angeles (+1 213-229-7000, [email protected])
Orin Snyder – New York (+1 212-351-2400, [email protected])
Brian C. Ascher – New York (+1 212-351-3989, [email protected])
Anne M. Champion – New York (+1 212-351-5361, [email protected])
Michael H. Dore – Los Angeles (+1 213-229-7652, [email protected])
Ilissa Samplin – Los Angeles (+1 213-229-7354, [email protected])
Angela A. Coco – New York (+1 332-253-7657, [email protected])
Alexandra Perloff-Giles – New York (+1 212-351-6307, [email protected])
Connor Sullivan – New York (+1 212-351-2459, [email protected])