Richard Manfredi, Author at Gibson Dunn

Decided May 11, 2023

National Pork Producers Council v. Ross, No. 21-468

Today, the Supreme Court held in a fractured decision that California’s ban on the sale of pork that comes from pigs that were raised in a “cruel manner,” regardless of where the pigs are raised, does not violate the dormant Commerce Clause.

Background: In 2018, California voters approved Proposition 12, which prohibits selling pork in California if the pigs were housed in a “manner that prevents the animal from lying down, standing up, fully extending [its] limbs, or turning around freely.”

The National Pork Producers Council and the American Farm Bureau Federation sued, alleging that Proposition 12 violates the dormant Commerce Clause, which they argued bars state legislation that (i) discriminates against out-of-state interests, (ii) has impermissible extraterritorial effects, or (iii) imposes a clearly excessive burden on interstate commerce when compared to the putative local benefits. The plaintiffs did not argue that Proposition 12 discriminated against out-of-state interests. Instead, they relied exclusively on its extraterritorial effects and its burden on interstate commerce.

The district court dismissed the complaint and the Ninth Circuit affirmed. The Ninth Circuit held a state law has impermissible extraterritorial effects only if it “dictate[s] the price of a product” or “tie[s] the price of in-state products to out-of-state prices”—which Proposition 12 did not do. Acknowledging that the Supreme Court has “not provided a clear methodology for comparing in-state benefits and out-of-state burdens” to assess a law’s burden on interstate commerce, the Ninth Circuit nevertheless held that Proposition 12’s alleged increase in costs to businesses and consumers was not a constitutionally significant burden on interstate commerce.

Issue: Whether plaintiffs stated a plausible claim that Proposition 12 violates the dormant Commerce Clause because it has impermissible extraterritorial effects or places an undue burden on interstate commerce.

Court’s Holding:

No. The Court’s core dormant Commerce Clause precedents focus on state laws that discriminate against out-of-state commerce, which a law banning the sale in California of pork that was raised in a “cruel manner” does not do, and the plaintiffs failed to allege a plausible claim under Pike v. Bruce Church, Inc., 397 U.S. 137 (1970).

“While the Constitution addresses many weighty issues, the type of pork chops California merchants may sell is not on that list.”

Justice Gorsuch, writing for the Court

What It Means:

The Court’s majority opinion underscores that the focus of the dormant Commerce Clause is on those state laws that discriminate against out-of-state commerce.
The Court’s decision was highly fractured, as parts of Justice Gorsuch’s opinion discussing Pike were joined only by a plurality of the Court, and multiple justices wrote separate opinions. Justice Kavanaugh’s opinion attempts to outline the controlling rule, and suggests “that properly pled dormant Commerce Clause challenges under Pike to laws like California’s Proposition 12 (or even to Proposition 12 itself) could succeed in the future—or at least survive past the motion-to-dismiss stage.”
The Court intimated that several other constitutional provisions may provide a stronger basis for challenging state laws that affect out-of-state commerce, including the Full Faith and Credit Clause, the Import-Export Clause, the Privileges and Immunities Clause, and the “principle inher[ing] in the very structure of the Constitution, which ‘was framed upon the theory that the peoples of the several states must sink or swim together.’”

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

Allyson N. Ho +1 214.698.3233 [email protected]	Thomas H. Dupree Jr. +1 202.955.8547 [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]

We are pleased to provide you with Gibson Dunn’s ESG monthly updates for April 2023. This month our update covers the following key developments. Please click on the blue links below for further details.

I. International

1. ISSB proposing to give relief on Scope 3 emissions and certain other data points in first year of reporting against S1 and S2

The International Sustainability Standards Board (ISSB) is proposing to extend reliefs available to support companies applying the ISSB’s first two Standards—S1 (general requirements) and S2 (climate).

The relief will enable companies to focus initial efforts on ensuring they meet investor information needs around climate change and means companies can prioritise putting in place reporting practices and structures to provide high-quality information about climate-related risks and opportunities in the first year of reporting using the ISSB Standards.

Companies will then need to provide full reporting on sustainability-related risks and opportunities, beyond climate, from the second year. This follows the view from investors that disclosures around climate-related risks and opportunities are the most urgent.

2. Launch of Venture Climate Alliance

The Venture Climate Alliance (VCA), an organization created by leading global venture capital firms to define, facilitate, and realize net zero-aligned pathways for early-stage investments, launched on April 25, 2023 with a goal to build a robust movement within the venture industry to combat climate change. CA members have committed to supporting a rapid, global transition to net zero or negative carbon emissions by 2050 or sooner, and will take specific, near-term steps to achieve this goal, both within their respective firms and in their roles as investors and advisors to their portfolio companies.

As one of the first institutional touchpoints between capital markets and early-stage innovation, venture capital investors have helped thousands of new companies from initial development to commercialization and scale. The VCA provides a forum through which member firms will develop best practices for collecting, interpreting and reporting carbon emissions, and climate impact data, as well as tools and guidance to help to overcome barriers associated with aligning early-stage investments with net zero goals.

3. G7 sets collective targets on renewable energy

The Group of Seven wealthy nations (G7) recently issued a Communique setting out ambitious collective goals to increase their solar power and offshore wind capacity. Their aim is to expedite the development of renewable energy and hasten the phase-out of fossil fuels. However, they did not endorse a 2030 deadline for ending the use of coal, instead leaving room for continued investment in gas. The members committed to boosting offshore wind capacity by 150 gigawatts and solar capacity by more than 1 terawatt by 2030. They also agreed to speed up the phase-out of fossil fuels without capturing CO2 emissions, with a target of achieving net-zero energy systems by 2050 at the latest. The G7 nations also pledged to take practical and timely measures to accelerate the phase-out of unabated coal power generation.

While Canada and some other G7 members support ending the use of unabated coal-fired power by 2030, others are still exploring ways to achieve that goal. The G7 countries acknowledged that renewable energy and energy security are compatible goals and committed to reaching a shared target for 2050. They also pledged to reduce additional plastic pollution to zero by 2040, ten years earlier than previously planned.

II. United Kingdom

1. Northern Ireland faces legal action over new gas storage project

Northern Ireland’s decision to sign off an undersea project that could provide a quarter of the UK’s gas storage capacity will be challenged in the High Court in Belfast over environmental concerns in an action brought by Friends of the Earth Northern Ireland and local campaign group No Gas Caverns. It is believed to be the first case of its kind where the courts have had to grapple with the implications of climate change in the context of government decisions.

A judicial review hearing will start in the week commencing 8 May 2023, where lawyers will argue that the Northern Ireland Department of Agriculture, Environment and Rural Affairs (DAERA) failed to properly consider the environmental implications of the project when granting permission for the Islandmagee Gas Storage development.

2. Financial Conduct Authority to lead first GFIN Greenwashing TechSprint

On 11 April 2023, the UK Financial Conduct Authority (FCA) announced that it would be leading the Global Financial Innovation Network (GFIN)’s first ever virtual Greenwashing TechSprint. The TechSprint will be hosted on the FCA’s Digital Sandbox and aims to bring together international regulators, firms and innovators to address sustainable finance as a collective priority. UK-based firms are invited to apply from 17 April 2023.

The GFIN is a group of over 80 international organisations committed to supporting financial innovation in the interest of consumers. The GFIN’s Co-ordination Group, which sets the overall direction, strategy and annual work programme, is currently chaired by the FCA.

In light of the growing number of investment products marketed as ‘green’ or making wider sustainability claims, the FCA wishes to ensure consumers and firms can trust that products have the sustainability characteristics they claim to have. The objective of the TechSprint is to develop a tool or solution that can help regulators and the market effectively tackle the risks of greenwashing in financial services.

There are currently 13 international regulators that have signed up to participate in the TechSprint. The TechSprint will launch on 5 June 2023 and will run for 3 months, ending with a showcase day in September 2023.

3. The FCA’s view of Green Mortgages

Green mortgages – a mortgage which includes an incentive for people to either purchase an energy efficient property or improve the energy efficiency of an existing property – have a growing role to play in decarbonising the UK’s housing stock by helping borrowers to improve the energy efficiency of their homes. The incentives could be a discount to the fixed rate or a cash rebate after completion of agreed improvements.

In a recent speech by the FCA’s Director of Retail Banking emphasised the role that lenders have in this endeavour and flagged the risk of them missing their decarbonisation targets if they don’t evolve their support for homeowners to enhance energy efficiency. Brokers should see an increase in the availability of green mortgage products and innovation and they have a key role to play in helping borrowers navigate a complex and nuanced landscape in terms of green home finance.

Equally, there are certain risks in requiring lenders to make more green mortgages that could lead to greenwashing if the majority of loans are made to newer, and already efficient, homes or too much innovation such that the number of products available outstrips demand from consumers.

The FCA has also made it clear that lenders need to deliver products that are ethical, socially responsible and green and meet expectations of the consumers based on the advertising or marketing of the products.

III. Europe

1. EBA consultation on benchmarking of diversity practices and policies

On 24 April 2023, the European Banking Authority (EBA) published a consultation paper on draft guidelines on the benchmarking of diversity practices including diversity policies and gender pay gap under the Capital Requirements Directive IV (CRD IV) and the Investment Firms Directive (IFD), addressed to Member State competent authorities (NCAs).

The benchmarking of diversity practices will allow NCAs to monitor diversity trends over time, including the identification of common practices for diversity policies and information on the gender pay gap at the level of the management body. The aspects of diversity that will be analysed concern the gender, age, educational and professional background as well as the geographical provenance of members of the management bodies. The benchmarking of diversity practices should be based on a representative sample of institutions and investment firms.

The EBA will analyse the diversity practices, including diversity policies and the gender pay gap and publish a benchmarking report at the EU level, including a country-by-country analysis every three years. The data is not collected annually as the composition of the management bodies is not expected to change significantly in the short term, but should change in the longer term through taking appropriate measures within institutions and investment firms.

The EBA plans that the first data on the diversity practices under the guidelines should be reported in 2025 with a reference date of 31 December 2024, including in situations where the financial year differs from the calendar year.

2. European Council adopts new rules on pay transparency

The Council has adopted new rules to combat pay discrimination and help close the gender pay gap in the EU. Under the pay transparency directive, EU companies will be required to share information about how much they pay women and men for work of equal value, and take action if their gender pay gap exceeds 5%. Once in the role, workers will be entitled to ask their employers for information about average pay levels, broken down by sex, for categories of employees doing the same work or work of equal value. They will also have access to the criteria used to determine pay and career progression, which must be objective and gender neutral. The new directive also includes provisions on compensation for victims of pay discrimination and penalties, including fines, for employers who break the rules.

3. Parliament adopts new law to fight global deforestation

The European Parliament adopted a new EU law on 19 April 2023 that will ban imports deemed to be driving deforestation. The legislation, which has to get final approval from the European Union’s member countries, would apply to coffee, cocoa, soy, timber, palm oil, cattle, printing paper and rubber, and derived products, coming from countries around the world.

Imports that come from land that was deforested after 31 December 2020 will be prohibited in the EU market. Companies sending such merchandise to Europe will have to show a certificate guaranteeing they do not come from such zones, with checks conducted on a sliding scale according to how high risk the exporting country is ranked. Companies will also have to verify that these products comply with relevant legislation of the country of production, including on human rights, and that the rights of affected indigenous people have been respected.

IV. United States

1. Biden Executive Order – environmental justice

On 21 April 2023, President Biden signed the executive order “Revitalising Our Nation’s Commitment to Environmental Justice for All“, charging all federal agencies with a duty to pursue environmental justice. The executive order directs federal agencies to thoroughly review environmental and health impacts on communities. Under the new requirements, federal agencies must notify communities if toxic substances are released and host public meetings to inform local residents of any resulting health risks.

Increasing concerns about environmental justice come in the wake of the East Palestine train derailment on 4 February 2023, which resulted in the uncontrolled release of hazardous materials into the surrounding area. Following this incident, the Biden-Harris administration has growingly focused on the disproportionate impact of climate change and pollution on lower-income and otherwise disadvantaged communities. This executive order seeks to reduce the burden on such communities by requiring federal agencies to assess the “cumulative impacts” of an area’s environmental and health problems when making decisions on new facilities or projects.

Under the executive order, President Biden has established a new Office of Environmental Justice within the White House Council on Environmental Quality, which will oversee federal agencies’ efforts on environmental justice. In conjunction with this, the White House Council on Environmental Quality will publish an Environmental Justice Scorecard monitoring federal agencies’ progress.

2. Environmental Protection Agency announces proposal on new auto pollution limits

The Environmental Protection Agency (EPA) plans to release its most stringent new emission standards for cars and light trucks. Sources familiar with the matter indicate that the rules are intended to ensure that electric vehicles (EVs) make up 54% to 60% of all new cars sold in the US by 2030, and 64% to 67% by 2032. This aligns with the U.S. President Joe Biden’s goal of EVs accounting for at least 50% of new vehicle sales by 2030.

The EPA’s proposal follows California air regulators’ vote last year to ban the sale of new gasoline-powered cars by 2035 and set interim targets for phasing out these cars. California aims to have 70% of zero-emissions vehicles in all new car sales by 2030, and other states are also planning to adopt California’s rules, driving a shift to EVs. Unlike California’s policy, which directly targets vehicle sales, the EPA intends to implement increasingly stringent greenhouse gas emissions rules for automakers to follow from 2027 to 2032, thus promoting the electrification of the industry. In addition, the US Treasury Department released new rules on April 18 that will provide federal tax credits of up to USD 7,500 to buyers of certain EVs.

3. DOE report on CO2 management in US and steps needed to achieve net zero commitments by 2050

On April 24, the Department of Energy published a new report on carbon management, as part of its ongoing series of Pathways to Commercial Liftoff Reports. In particular, the report indicates the United States will need to rapidly accelerate investment in hydrogen, nuclear and long-duration energy storage in order to meet its commitment to obtaining net-zero emission by 2050, from an approximate USD 40 billion to USD 300 billion by 2030. In addition, the report states that the United States will need to store c.400–1,800 million tonnes of CO2 annually.

V. APAC

1. HKSE consultation paper on enhancements to climate-related disclosures

On 14 April 2023, the Hong Kong Stock Exchange published a consultation paper on enhancements to its climate-related disclosures regime, aiming to achieve closer alignment with the International Sustainability Standards Board Climate Standard, expected to be published before the end of June 2023.

At present, Appendix 27 to the Hong Kong Stock Exchange Listing Rules requires companies to disclose climate-related information on a “comply or explain” basis; the proposed changes would mandate companies to make those disclosures. Listed companies would also be subject to additional climate-related disclosure obligations under the revised Appendix 27. These relate to governance, strategy, risk management, and metrics and targets. Of particular note, an issuer would be required to disclose any climate-related risks and opportunities identified; any strategies prepared in response to those climate-related risks and opportunities; how the business is placed to prepare for and respond to climate-related changes; and any current and anticipated financial effects of climate-related risks.

It is anticipated that the revised HKSE Listing Rules and Appendix 27 will come into effect on 1 January 2024, subject to the responses to the consultation, due by 14 July 2023.

2. New Australian vehicle fuel efficiency standard

Australia is set to introduce fuel efficiency standards as part of its new national electric vehicle (EV) strategy, in a bid to catch up with other developed economies in promoting EV adoption. According to Energy Minister Chris Bowen, the new standards will stipulate the amount of carbon dioxide a car could produce while running. Details of the new EV strategy will be finalized in the coming months The Department of Infrastructure, Transport, Regional Development and Communications published a consultation paper on 19 April 2023 . Australia’s Electric Vehicle Council (EVC) has welcomed the move and stressed the need for strict standards, warning that Australia will “remain the world’s dumping ground for dated high-emission vehicles.”

Australia was the only developed country, aside from Russia, that did not have or was not setting fuel efficiency standards. The lag in environmental rules has made it difficult for EVs and low-emission cars to compete with dirtier and less efficient vehicles in Australia. In 2022, only 3.8% of cars sold in Australia were electric, while the proportion stood at 15% in the UK and 17% in Europe. Bowen acknowledged the need to boost the construction of EV charging facilities. As of December 2022, the country had only 4,900 public chargers at fewer than 2,400 sites. To address this, a policy requiring the installation of one fast charger every 150 kilometers on the highway will soon be implemented, according to Bowen, for the convenience of 83,000 EV drivers on Australian roads.

3. India extends waiver of transmission fees for green hydrogen plants

India will exempt transmission fees for renewable power used in hydrogen manufacturing plants built up before January 2031, extending a waiver previously available for projects set up before July 2025. According to sources familiar with the matter, the move will enable more green hydrogen projects to qualify for the 25-year waiver of transmission charges, thus reducing the manufacturing costs. A government official explained that large-scale hydrogen and ammonia projects will require three to four years to construct, which means that many of them may not come into operation by June 2025.

India aims to become the world’s cheapest producer of green hydrogen – hydrogen produced by splitting water using electricity from renewables. It plans to bring down the manufacturing cost from current levels of USD 4-5 per kg to between USD 1-1.5 per kg. According to industry estimates, renewable energy, including transmission, accounts for 65%-70% of the cost of producing green hydrogen. Therefore, the government official stated that every one rupee decrease in renewable energy costs would result in a 60 Indian rupee (USD 0.73) reduction in the cost of green hydrogen. The inter-state transmission charges range from 1-2 rupees per unit of power transmitted. Besides waiving transmission fees, the Indian government will provide green hydrogen fuel producers with incentives worth at least 10% of their costs, under a USD 2.11bn program called “Strategic Interventions for Green Hydrogen Transition (SIGHT) Program”. The scheme, effective June 2023, is intended to produce affordable green hydrogen and reduce greenhouse gas emissions.

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

Warmest regards,

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

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

The following Gibson Dunn lawyers prepared this client update: Selina Sagayam, Charlie Osborne, Patricia Tan Openshaw, Grace Chong, and Elizabeth Ising.

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

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

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 4 May 2023, the Hong Kong Court of Final Appeal (the “CFA”) handed down its judgment in Guy Kwok-Hung Lam v Tor Asia Credit Master Fund LP [2023] HKCFA 9[1], putting an end to the age-old debate on the effect of an exclusive jurisdiction clause (“EJC”) in the insolvency context.

The CFA upheld the Court of Appeal’s (the “CA”) decision (by majority) to dismiss the bankruptcy petition. The CFA endorsed the approach that in an ordinary case where the underlying dispute of the petition debt was subject to an EJC, the court should dismiss the petition unless there are strong reasons for the court to decide otherwise.

1. Background

The dispute concerned a loan advanced by Tor Asia Credit Master Fund LP (the “Petitioner”), pursuant to a Credit and Guaranty Agreement (the “Agreement”), to a company (the “Borrower”) controlled by Mr. Guy Kwok-Hung Lam (the “Debtor”), whereby the Debtor agreed to provide a guarantee, as primary obligor, to pay in full of all amounts due and owed without any demand or notice. The Agreement contained an EJC in favour of the New York courts in relation to “all proceedings arising out of or in relation to” the Agreement.

The Agreement was subsequently amended and the maturity of the loan was extended. Notwithstanding that, the Borrower was still unable to make repayment. The Petitioner then presented a bankruptcy petition in Hong Kong against the Debtor. The Debtor resisted the petition and argued that there was no event of default and that, pursuant to the EJC, the Petitioner was required to bring proceedings in the New York courts first to establish the Debtor’s liability.

The Court of First Instance (the “CFI”) granted the bankruptcy order, on the basis that the Debtor was unable to demonstrate a bona fide dispute on substantial grounds in relation to the petition debt[2]. The CA allowed the Debtor’s appeal and dismissed the bankruptcy petition[3]. The CA held that if the dispute concerning the underlying debt fell within the scope of an EJC, the bankruptcy petition should not be allowed to proceed without strong reasons.

The Petitioner appealed to the CFA on the proper approach that Hong Kong courts should adopt in a bankruptcy petition where the dispute concerning a debt is subject to an EJC.

2. The CFA’s decision

The CFA unanimously dismissed the appeal and affirmed the decision of the CA.

(i) Jurisdiction and powers of the CFI

The Petitioner contended that parties could not contract out of the insolvency legislation and in these proceedings different considerations were to be taken into account from those involving the upholding of EJCs in private actions. It was argued that to give presumptive weight to EJCs was to erode and undermine the domestic insolvency regime.

Whilst the CFA confirmed that the CFI’s jurisdiction in a bankruptcy matter was conferred by the Bankruptcy Ordinance (Cap. 6), and was not amenable to exclusion by contract, i.e. the parties’ agreement not to invoke the jurisdiction of the CFI had no effect on its jurisdiction, it held that the parties’ agreement to refer their disputes to a foreign court informed the CFI’s discretion as to whether to exercise its jurisdiction.

The CFA observed that the CFI might exercise its discretion to decline jurisdiction in certain classes of cases, such as where the issue of forum non conveniens was raised or where the dispute in a particular action was covered by an arbitration agreement or an EJC.

(ii) The discretion to decline jurisdiction in bankruptcy

Having found that the CFI had the power to decide whether to exercise its jurisdiction, the CFA further held that the determination of whether the debt was bona fide disputed on substantial grounds was a threshold question which might or might not be engaged when the court decided whether to exercise its bankruptcy jurisdiction.

The CFA noted that in the event that the parties had agreed to have all their disputes under an agreement giving rise to the debt determined exclusively in another forum, the CFI had total discretion to choose not to exercise its bankruptcy jurisdiction and refrain from determining such threshold question.

The CFA considered that it was at this stage that the public policy interest in holding parties to their agreements was engaged. Should the CFI proceed with the petition and make a ruling on the threshold question, it assumed jurisdiction to decide a question which the parties had otherwise agreed would be determined in another forum.

The CFA was of the view that parties’ agreement for certain disputes to be resolved in another forum would be highly relevant as to whether the CFI should exercise its bankruptcy jurisdiction at all. In the event that the underlying debt was subject to an EJC, unless the Petitioner could show that there were strong reasons, such as the risk of the debtor’s insolvency impacting third parties, the debtor’s reliance on a frivolous defence, or an occurrence of an abuse of process, the Court should normally dismiss the petition.

3. Comment

This decision crystalises the court’s position on the effect of an EJC in the context of bankruptcy and winding up proceedings. Absent strong reasons, the Hong Kong court will not proceed with the petition before the adjudication of the petition debt by the agreed forum. It also underscores the importance attached by the courts to party autonomy.

The case also serves as an important reminder to parties when entering into agreements with EJCs, they should be aware that such clauses will have significant impact on any insolvency proceedings to be commenced in Hong Kong and they may be required to first have the dispute over the underlying debt adjudicated in the agreed forum before commencing insolvency proceedings in Hong Kong.

__________________________

[1] https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=152321&currpage=T

[2] https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=137308

[3] https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=146843

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, or the following authors in the firm’s Litigation Practice Group in Hong Kong:

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

It is no secret among public companies and their counsel that the US Securities and Exchange Commission has steadily adopted a more aggressive stance on cybersecurity controls and disclosure and incident response recordkeeping. SEC Senior Counsel Arsen Ablaev recently highlighted the Commission’s cybersecurity priorities at the annual Incident Response Forum Masterclass. SEC Chair Gary Gensler also emphasized risks in cyber and information security in the March 29 budget hearing with the House Appropriations Committee, and endorsed U.S. President Joe Biden’s request to earmark a record $2.4 billion in funding for the regulator in 2024. Last month saw yet another example of the SEC’s mounting focus on cyber disclosures as an enforcement priority with the announcement that cloud computing company Blackbaud agreed to pay a $3-million civil penalty to settle administrative charges for alleged “materially misleading disclosures” about a 2020 ransomware attack.

As we foreshadowed in our 2023 U.S. Cybersecurity and Data Privacy Outlook and Review, the increase in SEC enforcement resources (e.g., doubling the size of its Crypto Assets and Cyber Unit Ablaev sits in), in combination with the promulgation of cybersecurity risk management, strategy, governance, and incident disclosure rules Ablaev confirmed will be finalized in coming months, signal that cybersecurity will continue to be an area of heightened enforcement activity for the SEC. In light of these developments, it is critical companies take stock of their cyber hygiene policies and incident response protocols, and not only manage cybersecurity risks and prevent attacks, but also respond to them with proper disclosures.

Read More

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 Privacy, Cybersecurity & Data Innovation practice group, or the authors:

Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, [email protected])

David Woodcock – Dallas (+1 214-698-3211, [email protected])

Vivek Mohan – Palo Alto (+1 650-849-5345, [email protected])

Mashoka Maimona, an associate working in the firm’s San Francisco office who is admitted only in Ontario, Canada, also contributed to this article.

I. Overview

On May 3, 2023, the U.S. Securities and Exchange Commission (the “SEC” or the “Commission”), by a three-to-two vote, adopted significant amendments (the “Amendments”) to Form PF, the confidential reporting form created in 2011 as part of the Dodd-Frank Act that is intended to provide the Commission and the Financial Stability Oversight Council (“FSOC”) with important data and information about private funds. The Commission, citing Form PF’s historical role in allowing both the Commission and FSOC to monitor systemic risk in the private funds industry, stated that the Amendments will provide regulators with “timely and critical information in times of market stress or volatility” as they attempt to “stem the tides on a potential crisis and help prevent investor harm.”[1]

Form PF is required to be completed and filed by entities which are (i) registered or required to register with the SEC as an investment adviser, (ii) manage one or more private funds, and (iii) together with their related persons, collectively, had at least $150 million in private fund assets under management as of the last day of the most recently completed fiscal year.[2] The Amendments, which introduce two new sections to Form PF, apply to three categories of advisers: (1) hedge fund advisers[3] with at least $1.5 billion in hedge fund assets under management (“Large Hedge Fund Advisers”), (2) investment advisers with at least $150 million in private fund assets under management (“Private Equity Advisers”), and (3) investment advisers with at least $2 billion in private equity fund assets under management (“Large Private Equity Advisers”)[4]. The first new section applies to all Private Equity Advisers, and requires that they make filings within 60 days following the end of any fiscal quarter in which a specified trigger event occurred (the “Quarterly Reporting Window”). The other new section applies only to Large Hedge Fund Advisers, and requires that they make filings as soon as practicable, but no later than 72 hours following certain “significant events that have the potential for broad impacts or investor loss” (the “72 hour Reporting Window”).[5] Finally, the Amendments require that Large Private Equity Advisers report additional data in their annual Form PF filings. The below table summarizes the applicable filing requirements, and each of these changes is described in greater detail below.

Triggering Event	Large Hedge Fund Advisers with $1.5bn+ in hedge fund AUM	Private Equity Advisers with $150m+ in private fund AUM	Large Private Equity Advisers with $2bn+ private equity fund AUM
The investment adviser instigates a secondary transaction		File within 60 days of quarter end	File within 60 days of quarter end
Investors elect to remove the general partner (with or without cause)		File within 60 days of quarter end	File within 60 days of quarter end
Investors elect to terminate the fund (for any reason)		File within 60 days of quarter end	File within 60 days of quarter end
Investors elect to terminate the investment period (for any reason)		File within 60 days of quarter end	File within 60 days of quarter end
10-business day holding period return of fund is less than or equal to 20% of aggregate calculated value	File within 72 hours
10 business day change in posted margin, collateral, or equivalent is greater than or equal to 20% of average daily aggregate calculated value during same period	File within 72 hours
Fund is in default on a call for margin, collateral or an equivalent that it cannot cover, or adviser determines that fund will not be able to meet such call	File within 72 hours
A counterparty to a reporting fund (a) does not meet a call for margin, collateral or equivalent or fails to make any other payment on time and in the form contractually required and (b) the amount involved is greater than 5% of aggregate calculated value	File within 72 hours
Termination or material restriction of a reporting fund’s relationship with a prime broker	File within 72 hours
There is a “significant disruption or degradation of the reporting fund’s critical operations”	File within 72 hours
Fund receives cumulative requests for withdrawals or redemptions equal to at least 50% of the most recent net asset value	File within 72 hours
Fund is unable to pay redemption requests	File within 72 hours
Fund has suspended redemptions for at least 5 consecutive business days	File within 72 hours

II. Private Equity Advisers are required to file Form PF on a quarterly basis following the occurrence of certain “trigger” events

The Amendments require that all Private Equity Advisers file Form PF in the Quarterly Reporting Window after the end of a fiscal quarter in which either (1) an adviser-led secondary transaction occurred or (2) a fund’s investors elect to remove the general partner, terminate the fund, or terminate the fund’s investment period.[6] Accordingly, Private Equity Advisers are recommended to institute a process wherein they check on a quarterly basis whether a filing is required as a result of such activity.

A. Adviser-Led Secondary Transactions

Private Equity Advisers will be required to file Form PF within the Quarterly Reporting Window after an adviser-led secondary transaction, which the Amendments define as “any transaction initiated by the adviser or any of its related persons that offers private fund investors the choice to: (1) sell all or a portion of their interests in the private fund; or (2) convert or exchange all or a portion of their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons.”[7] A filing is only required if the transaction is “initiated” by a fund’s Private Equity Adviser (or a related person), which the Commission conceded will require an analysis of the relevant facts and circumstances and noted would generally not include a scenario where the adviser, at the unsolicited request of an investor, participates in a secondary sale of such investor’s fund interest.[8] Importantly, the requirement does not contain exceptions for ordinary-course transactions or situations where the fund’s investors or advisory committee have approved the transaction, as the Commission noted that such approvals, while helpful, “do not always ameliorate investor protection concerns.”[9]

B. Removal of General Partner, Termination of Fund or Termination of Investment Period

Private Equity Advisers will also be required to file Form PF within the Quarterly Reporting Window following: (1) the removal of the adviser or an affiliate thereof as the general partner (or similar control person) of a fund, (2) the election by the fund’s investors to terminate the fund, or (3) the election by the fund’s investors to terminate the fund’s investment period.[10] In each case, the Private Equity Adviser will be required to disclose the effective date of the removal or termination event, as applicable, and a description of such event, and each requirement is triggered upon the adviser receiving notification of the investors’ decision.[11] The Commission noted that only removals or terminations made by the election of the investors would require a filing, but stressed the filing requirement was not limited to “for cause” removals or terminations, noting that such instances are inherently “serious departures from ordinary course operations.”[12]

III. Large Hedge Fund Advisers are required to file Form PF within 72 hours of specified “trigger” events

Under the Amendments, Large Hedge Fund Advisers will be required to file Form PF within the 72 hour Reporting Window following certain triggering events, which are summarized below. As a practical matter, this means that Large Hedge Fund Advisers will need to add a significant number of items to the list of calculations that they run daily in order to determine whether a filing is required.

Extraordinary Investment Losses. Filing required if, as of any business day, the 10-business day holding period return of a reporting fund is less than or equal to 20% of the reporting fund aggregate calculated value.[13]
Significant Margin and Default Events. Filing required if (a) during any 10 business days, the change in a reporting fund’s posted margin, collateral, or equivalent is greater than or equal to 20% of such reporting fund’s average daily aggregate calculated value during the same period or (b) the adviser receives notice that a reporting fund is in default on a call for margin, collateral or an equivalent that it cannot cover with additional funds (or determines that such reporting fund will not be able to meet such call).[14]
Counterparty Default. Filing required if a counterparty to a reporting fund (a) does not meet a call for margin, collateral or equivalent or fails to make any other payment on time and in the form contractually required and (b) the amount involved is greater than 5% of the reporting fund aggregate calculated value.[15]
Prime Broker Relationship Terminated or Materially Restricted. Filing required following the termination or material restriction of a reporting fund’s relationship with a prime broker.[16]
Operations Events. Filing required following an “operations event,” which is defined as a “significant disruption or degradation of the reporting fund’s critical operations” (e.g., operations necessary for the investment, trading, valuation, reporting, and risk management of the reporting fund or the operation of the reporting fund in accordance with federal securities laws and regulations).[17]
Redemptions. Filing required if a reporting fund (a) receives cumulative requests for withdrawals or redemptions equal to at least 50% of the most recent net asset value (after netting against subscriptions or other contributions from investors received and contractually committed), (b) is unable to pay redemption requests, or (c) has suspended redemptions for at least 5 consecutive business days.[18]

The portion of the Amendments covered in sections II and III above will become effective six months after publication of the adopting release in the Federal Register.

IV. Large Private Equity Advisers are required to report additional data as part of their routine Form PF filings

Finally, the Amendments add and amend various questions to Section 4 of Form PF, which is only required to be completed by Large Private Equity Advisers. Most importantly, such advisers will now be required to report whether any reporting fund has effectuated (1) a limited partner clawback (or clawbacks) in excess of an aggregate amount equal to 10% of such fund’s aggregate capital commitments or (2) any general partner clawback, and must provide the reason for such clawback.[19]

The Amendments will also require Large Private Equity Advisers to answer new questions regarding investment strategies of their private equity funds and fund-level borrowing (including with regard to the value of the fund’s borrowings, the types of creditors, and whether the fund can borrow at the fund-level as an alternative or complement to financing of portfolio companies). Additionally, the Amendments will require more granular details regarding certain events of default, bridge financing arrangements (including identifying the institution that provides any bridge loan to a controlled portfolio company), and the geographical breakdown of a fund’s investments (based on a percentage of NAV).[20] Unlike the “trigger” based filing requirements outlined above, changes to Section 4 will become effective one year following publication, and thus should not be relevant for advisers with a December fiscal year end until their annual filings are due in 2025.[21]

V. Analysis

The Amendments will require Private Equity Advisers to add to their quarterly compliance checklists a question as to whether they need to make a filing as a result of a GP-initiated secondary transaction, or a vote of the limited partners to remove the general partner, terminate the fund, or end the investment period early. In addition to paying attention to the other filing requirements described above, Large Hedge Fund Advisers will now need to perform specified calculations on a daily basis (see section III.A. and B. above) and will need to closely monitor redemption requests to determine if they have exceeded 50% of the most recently calculated NAV.

It is not clear what the effect of making a filing under the new requirements will be, but as the Amendments are intended to allow the SEC to monitor systemic risk, such filings will presumably lead to additional questions from the staff, and raise the probability of an SEC inspection.

_____________________________

[1] Press Release, U.S. Securities and Exchange Commission, “Statement on Amendments to Form PF” (May 3, 2023), available at https://www.sec.gov/news/statement/crenshaw-statement-form-pf-050323.

[2] Form PF General Instructions, available at https://www.sec.gov/files/formpf.pdf.

[3] A “hedge fund” generally includes any private fund (other than a securitized asset fund):

(a) with respect to which one or more investment advisers (or related persons of investment advisers) may be paid a performance fee or allocation calculated by taking into account unrealized gains (other than a fee or allocation the calculation of which may take into account unrealized gains solely for the purpose of reducing such fee or allocation to reflect net unrealized losses);

(b) that may borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have gross notional exposure in excess of twice its net asset value (including any committed capital); or

(c) that may sell securities or other assets short or enter into similar transactions (other than for the purpose of hedging currency exposure or managing duration).

Solely for purposes of Form PF, any commodity pool about which you are reporting or required to report on Form PF is categorized as a hedge fund.

For purposes of this definition, long and short positions should not be netted and any borrowings or notional exposure of another person that are guaranteed by the private fund or that the private fund may otherwise be obligated to satisfy should be included.

In general, advisers managing open-ended real asset funds are not considered to be “hedge funds” under Form PF and will not need to make the additional filings included in the Amendments for Large Hedge Fund Advisers. Should you have any questions about the proper filing status of one of your funds, please contact the Gibson Dunn lawyer with whom you usually work, or one of the authors listed herein.

[4] “Regulatory assets under management” corresponds to the same figure reported in the adviser’s Form ADV filing (“RAUM”). “Private fund assets under management” refers to the portion of an adviser’s RAUM attributable to private funds, “private equity fund assets under management” refers to the portion of an adviser’s RAUM attributable to private equity funds, and “hedge fund assets under management” refers to the portion of an adviser’s RAUM attributable to hedge funds.

[5] Press Release, U.S. Securities and Exchange Commission, “Statement on Amendments to Form PF” (May 3, 2023), available at https://www.sec.gov/news/statement/crenshaw-statement-form-pf-050323.

[6] Amendments to Form PF to Require Event Reporting for Large Hedge Fund Advisers and Private Equity Fund Advisers and to Amend Reporting Requirements for Large Private Equity Advisers, SEC Rel. No. IA-6297 (May 3, 2023). Available at https://www.sec.gov/news/press-release/2023-86?utm_medium=email&utm_source=govdelivery.

[7] Id. at 61.

[8] Id.

[9] Id. at 64.

[10] Id. at 64-65.

[11] Id. at 65.

[12] Id. at 67.

[13] Id. at 17. “Reporting fund aggregate calculated value” is defined as follows: Every position in the reporting fund’s portfolio, including cash and cash equivalents, short positions, and any fund-level borrowing, with the most recent price or value applied to the position for purposes of managing the investment portfolio. The reporting fund aggregate calculated value is a signed value calculated on a net basis and not on a gross basis. Where one or more portfolio positions are valued less frequently than daily, the last price used should be carried forward, though a current foreign exchange rate may be applied if the position is not valued in U.S. dollars. It is not necessary to adjust the reporting fund aggregate calculated value for accrued fees or expenses. Reporting fund aggregate calculated value does not need to be subjected to fair valuation procedures. The inclusion of income accruals is recommended but not required; however, the approach should be consistent over time. The reporting fund aggregate calculated value may be calculated using the adviser’s own internal methodologies and conventions of the adviser’s service providers, provided that these are consistent with the information reported internally. “Holding period return” is defined as the cumulative ‘daily rate of return’ over the holding period calculated by geometrically linking the daily rates of return.

[14] Id. at 22-31.

[15] Id. at 31-34.

[16] Id. at 35. Termination events that are set forth in the prime broker (or related) agreement that are isolated to the financial state, activities or other conditions solely of the prime broker do not require a filing.

[17] Id. at 41-48.

[18] Id. at 49-54. While “cumulative” isn’t defined, a filing will be required if, at any time, total withdrawal or redemption requests which have not been granted exceed 50% of NAV.

[19] Id. at 72-78. For purposes of the Amendments, a “limited partner clawback” is defined as “an obligation of a fund’s investors to return all or any portion of a distribution made by the fund to satisfy a liability, obligation, or expense of the fund pursuant to the fund’s governing agreements,” and a “general partner clawback” is defined as “any obligation of the general partner, its related persons, or their respective owners or interest holders to restore or otherwise return performance-based compensation to the fund pursuant to the fund’s governing agreements.”

[20] Id. at 79-83.

[21] Id. at 87-88.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding the issues and considerations discussed above. Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Investment Funds practice group, or the following authors:

Gregory Merz – Washington, D.C. (+1 202-887-3637, [email protected])
Lauren Cook Jackson – Washington, D.C. (+1 202-955-8293, [email protected])
Shannon Errico – New York (+1 212-351-2448, [email protected])
Robert Harrington – New York (+1 212-351-2608, [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])

On May 2, 2023, in a case challenging the fairness of a merger between a cloud security startup and a Boston-based cybersecurity company, the Delaware Court of Chancery denied a motion to dismiss breach of fiduciary duty claims relating to a drag-along merger despite plaintiff-investors’ explicit covenant not to sue over a drag-along sale, including by raising claims of fiduciary duty breach. In a decision by Vice Chancellor J. Travis Laster, the court found that, as a matter of public policy, a covenant not to sue cannot shield defendants from tort liability for intentional harm. This decision follows a March 9, 2023 decision denying a motion to dismiss the same complaint for failure to state a claim. Although the court’s decision may leave directors and controlling stockholders unable to fully protect themselves from bad faith breach of fiduciary duty claims after a drag-along transaction, it does provide some guidance for controllers relying on fiduciary claim waivers.

Background

The plaintiffs in New Enterprise Associates 14, L.P. v. Rich[1] are investment funds managed by venture capital firms, each holding an interest in cloud-security company Fugue, Inc. In early 2021, after an unsuccessful sale process and receiving plaintiffs’ indication of unwillingness to provide additional financial support, the company’s management concluded that a recapitalization led by George Rich was the only viable option for raising necessary capital. As a condition of his investment, Rich required the plaintiffs to enter into a voting agreement that, like typical NVCA-style voting agreements, included a covenant not to sue for a breach of fiduciary duty arising from a drag-along transaction. Notably, the plaintiffs declined an offer to participate in the recapitalization.

Following the recapitalization, Rich and his associates held a controlling interest in the company and controlled the board. In June 2021, the company was contacted by a potential acquirer. Soon after the company’s independent directors resigned in July 2021, the board approved two equity issuances. First, the board issued additional preferred stock to many of the original recapitalization investors at the same distressed price per share as their original investment. According to the plaintiffs, the company both ignored the right of first offer (the “ROFO”) of the plaintiffs found in a side letter signed in connection with the recapitalization and failed to deliver a notice of stockholder action to the plaintiffs under Section 228(e) of the Delaware General Corporation Law. Second, the board approved an issuance of stock options—mostly to themselves—with vesting provisions that accelerated upon a change of control. The plaintiffs allege these transactions were interested and not disclosed.

Shortly after these issuances, the company’s management negotiated a merger with Snyk Limited, a private cybersecurity company. The plaintiffs were asked to join the merger, but refused when Rich and another director refused to attest that they had not communicated with the acquirer regarding a potential transaction before the recapitalization. After the merger closed, the plaintiffs learned of the interested transactions and sued the company, its board of directors, and affiliated entities for breach of fiduciary duty. Because the merger had extinguished the plaintiffs’ standing to bring derivative claims, they instead filed a direct breach of fiduciary duty suit arguing that the merger consideration was inadequate since it did not include the valuable derivative claims that the company had against the defendants for the interested transactions.

In New Enterprise I, the Court of Chancery found that the plaintiffs established standing under Primedia because they had viable underlying derivative claims against the defendants (fiduciary claims regarding the interested transactions as well as disclosure claims), the derivative claims were material (almost 10% of the transaction proceeds), and it was unlikely the acquirer would assert the claims.[2] The court also found that the plaintiffs had adequately stated a claim for breach of fiduciary duty because the defendants were alleged to have a conflict of interest with respect to the merger which extinguished possible derivative causes of action against themselves. The court initially withheld ruling on the defendants’ alternative argument that the drag-along covenant foreclosed the plaintiffs from bringing suit to challenge the merger.

Ruling

On May 2, 2023, in New Enterprise II,[3] the court addressed the defendants’ argument regarding the drag-along covenant. In a detailed discussion of Delaware law, Vice Chancellor Laster clarified that a covenant not to sue for breach of fiduciary duty was not, on its own, facially invalid. Recognizing that Delaware corporate law allows some degree of private fiduciary tailoring, the court noted that “stockholders can agree to more constraints on their ability to exercise stockholder-level rights than corporate planners can impose through the charter or bylaws.” The court also noted that the covenant was clear, specific, and limited to contractually outlined criteria for drag-along sales; it was part of a bargained for-exchange that included the recapitalization; and the parties were sophisticated repeat players who understood its application (one of the plaintiffs also being a member of the NVCA). Nonetheless, the court held that for reasons of Delaware public policy regarding contracts, the covenant could not “insulate the defendants from tort liability based on intentional wrongdoing,” which the court found to be adequately pled.

Uncertain Path Forward

The court’s decision allows for some fiduciary tailoring among stockholders, including through covenants not to sue. The court stated that the covenant could provide protection from claims that “the defendants engaged in self-interested transactions but believed in good faith that the transactions were not contrary to the best interests of the Company” or claims that “the defendants engaged in the self-interested transactions with reckless disregard for the best interests of the Company.”

Moreover, the case at hand presented unique facts, as the plaintiffs agreed to the drag-along in the context of the recapitalization, but allegedly were not informed of subsequent interested transactions that altered their rights. The acts of intentional harm underlying the court’s decision to deny the motion to dismiss did not occur directly as part of the drag-along and became choate only when the plaintiffs learned of the interested transactions and breaches of ROFO protections for which they had negotiated in the original recapitalization. This decision may leave practitioners wary of relying on covenants not to sue in connection with drag-along transactions. It remains to be seen how readily allegations of intentional torts, such as bad faith breach of fiduciary duty, that arise solely from a drag transaction among sophisticated parties (and without incriminating prior conduct similar to the alleged interested transactions) will overcome a similar NVCA-style covenant not to sue.

An immediate and practical takeaway for corporate practitioners is to ensure that contractual and statutory notices (whether preemptive rights notices or Section 228(e) notices) are properly delivered, so that stockholders have access to their negotiated and statutory rights in connection with the lead-up to and execution of the drag transaction.

_________________________

[1] See New Enter. Assocs. 14, L.P. v. Rich (“New Enterprise I”), 2023 WL 2417271 (Del. Ch. Mar. 9, 2023).

[2] Id. at *29–40 (citing In re Primedia, Inc. S’holders Litig., 67 A.3d 455 (Del. Ch. 2013)).

[3] New Enter. Assocs. 14, L.P. v. Rich (“New Enterprise II”), 2023 WL 3195927 (Del. Ch. May 2, 2023).

The following Gibson Dunn lawyers prepared this client alert: Benyamin S. Ross, Marshall R. King, Marina Szteinbok, Mark Goldman, Mark H. Mixon, Jr., Adrian Melendez-Cooper, Sam Shapiro, and Valy Menendez.

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 Emerging Companies, Mergers and Acquisitions, Private Equity, or Securities Litigation practice groups, or the following authors and practice leaders and members:

Benyamin S. Ross – Los Angeles (+1 213-229-7048, [email protected])
Marshall R. King – New York (+1 212-351-3905, [email protected])

Emerging Companies Group:
Chris W. Trester – Palo Alto (+1 650-849-5212, [email protected])

Mergers and Acquisitions Group:
Robert B. Little – Dallas (+1 214-698-3260, [email protected])
Saee Muzumdar – New York (+1 212-351-3966, [email protected])

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

Securities Litigation Group:
Monica K. Loseman – Denver (+1 303-298-5784, [email protected])
Brian M. Lutz – San Francisco/New York (+1 415-393-8379/+1 212-351-3881, [email protected])
Craig Varnen – Los Angeles (+1 213-229-7922, [email protected])

This update provides an overview of key class action-related developments during the first quarter of 2023 (January through March).

Part I discusses noteworthy cases from the Fifth and Ninth Circuits interpreting Rule 23’s predominance requirement—including a decision affirming an order granting a motion to strike class allegations and a decision vacating class certification based on evidence of individual issues related to Article III standing.

Part II discusses a series of cases concerning constructive notice of arbitration agreements and waiver of arbitration.

And Part III addresses a growing circuit split concerning whether lead plaintiffs may be paid service awards from common-fund settlements.

I. The Fifth and Ninth Circuits Interpret Rule 23’s Predominance Requirement as Applied To Motions to Strike Class Allegations and Individual Questions of Article III Injury

This past quarter, the Fifth and Ninth Circuits issued significant decisions analyzing the effects of variations in state law and individualized questions of Article III injury—even as to a small fraction of the putative class—on Rule 23’s predominance requirement.

In Elson v. Black, 56 F.4th 1002 (5th Cir. 2023), the Fifth Circuit affirmed the district court’s order striking the plaintiffs’ class allegations on the grounds that the plaintiffs could not establish predominance as a matter of law. The plaintiffs alleged that the defendants’ advertisements for a massager product said to “virtually eliminate cellulite,” help with weight loss, and relieve pain violated various federal and state false advertising laws. Id. at 1004–05. The district court struck the nationwide class allegations, holding that whether each person justifiably relied on the alleged misrepresentations was “intrinsically an individual determination” that precluded a finding of commonality. Id. at 1005.

Considering the issue as one of predominance, rather than commonality, the Fifth Circuit affirmed, holding that “Plaintiffs are unable to establish predominance as a matter of law for two reasons.” Id. at 1006. First, because “different state laws govern different Plaintiffs’ claims,” the plaintiffs failed “to assure the district court that such differences in state law would not predominate” over individual issues. Id. For example, “the different reliance requirements of the state laws” underscored that “variations in state law here swamp[ed] any common issues and defeat[ed] predominance.” Id. at 1007 (internal quotation marks omitted). Second, “Plaintiffs’ allegations introduce[d] numerous factual differences” because the named plaintiffs and the putative class members did not rely on the same alleged misrepresentations. Id. The court also rejected plaintiffs’ attempt to propose seven state-specific subclasses, explaining that “‘Subclass’ is not a magic word that remedies defects of predominance” because a plaintiff must “demonstrate to the district court how certain proposed subclasses would alleviate existing obstacles to certification,” which the plaintiffs failed to do. Id. at 1007–08.

The Ninth Circuit also ruled that individualized questions can defeat predominance in Van v. LLR, Inc., 61 F.4th 1053 (9th Cir. 2023). In this case, the plaintiff brought suit on behalf of herself and other Alaskans claiming they were improperly charged sales tax by the defendants when making purchases from counties with no sales tax requirement. Id. at 1058–59. Although the defendants had issued refunds for all charges improperly collected as sales tax, they did not refund any interest that might have accrued between the time of the purchase and the time of the refund, and the plaintiff sought recovery for lost interest on the refunded amounts. Id. at 1060–61. The district court certified the class, and the Ninth Circuit granted the defendants’ Rule 23(f) petition. Id.

On appeal, the Ninth Circuit first held that class members who suffered injuries of $0.01 to $0.05 had Article III standing, explaining that “[a]ny monetary loss, even one as small as a fraction of a cent, is sufficient to support standing,” and “the presence of class members who suffered only a fraction of a cent of harm does not create an individualized issue that could predominate over class issues.” Id. at 1064. Even so, the court held that some class members nonetheless lacked Article III standing because they received discounts when making their purchases that offset the improper sales tax. Id. at 1068–69. And because the defendants proffered evidence showing that even a small fraction (18 out of 13,860) of class members received such discounts, the defendants had invoked an individual issue and the district court should have analyzed whether the plaintiff proved predominance by a preponderance of the evidence. Id. at 1069. Because the district court did not conduct this analysis, the Ninth Circuit vacated certification and remanded for further consideration of whether plaintiffs could establish predominance.

II. The Ninth Circuit Issues a Trio of Decisions on Arbitration Issues

The Ninth Circuit issued several noteworthy opinions regarding arbitration issues this quarter. In Armstrong v. Michaels Stores, Inc., 59 F.4th 1011 (9th Cir. 2023), the Ninth Circuit ruled that the defendant had not waived its right to compel arbitration even though it waited almost one year after the lawsuit was filed—and when discovery had been ongoing—before moving to compel arbitration. The Ninth Circuit held that, despite the delay, the defendant’s conduct was consistent with an intention to arbitrate, noting that the parties’ case management statement listed arbitration as a potential legal issue and defendant’s answer reserved arbitration as an affirmative defense. Id. at 1013–14.

In Oberstein v. Live Nation Entertainment, 60 F.4th 505 (9th Cir. 2023), the Ninth Circuit held that website users were on constructive notice of their arbitration agreement in a website’s terms of service, and therefore bound to arbitrate their claims, notwithstanding that the agreement was not a clickwrap agreement. Id. at 515–17. While plaintiffs argued the terms failed to identify the full legal names of the parties to the contract and the interface failed to give constructive notice of the terms, the Ninth Circuit held a “reasonable user” would have understood who the parties to the arbitration agreement were because defendants’ names were identified several times in the terms. Id. at 510–12. The court also concluded the users also had adequate notice of the terms because of the location, font, and color of the terms, as well as the stages in the process where users were informed about the terms, at which point the users would have scrutinized the agreement. Id. at 513–16.

And as discussed in a previous client alert, the Ninth Circuit held in Chamber of Commerce v. Bonta, 62 F.4th 473 (9th Cir. 2023), that the FAA preempts a California statute (AB 51) that sought to criminalize employment arbitration agreements.

III. The Second Circuit Deepens Circuit Split Regarding Service Awards in Class Settlements

Although service awards are a common feature in modern class action settlements, a circuit split has been brewing over whether these awards are permissible in light of Supreme Court decisions dating back to the 1800s. While most circuits have upheld service awards, a few years ago the Eleventh Circuit broke with these decisions, citing a nineteenth-century case holding that such awards are improper. See Johnson v. NPAS Sols., LLC, 975 F.3d 1244, 1260 (11th Cir. 2020) (citing Trustees v. Greenough, 105 U.S. 527, 537 (1881)).

The Second Circuit weighed in this quarter, with at least some judges appearing to agree with Johnson. In Fikes Wholesale, Inc. v. HSBC Bank USA, 62 F.4th 704 (2d Cir. 2023), the Second Circuit panel acknowledged that “service awards to lead plaintiffs” in class actions are “likely impermissible under Supreme Court precedent.” Id. at 721 (citing Greenough, 105 U.S. at 537). The panel noted that “the Supreme Court has held that it was ‘decidedly objectionable’ for cash allowances to be ‘made for the personal services and private expenses’ of a creditor who brought suit on behalf of himself and other similarly situated bondholders.” Id. (quoting Greenough, 105 U.S. at 537). However, the panel concluded that “practice and usage” may have “superseded” this historic precedent (“if that is possible”) and held it “must follow” two recent Second Circuit “precedents” that upheld such awards. Id. (citing Melito v. Experian Mktg. Sols. Inc., 923 F.3d 85, 96 (2019) and Hyland v. Navient Corp., 48 F.34th 110, 123–23 (2d Cir. 2022)).

On April 17, 2023, the Supreme Court declined review of the Eleventh Circuit’s Johnson decision, leaving this issue ripe for further litigation in the lower courts.

The following Gibson Dunn lawyers contributed to this client update: Jennafer Tryck, Andrew Kasabian, Katie Geary, Wesley Sze, Lauren Blas, Bradley Hamburger, Kahn Scolnick, and Christopher Chorba.

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

Theodore J. Boutrous, Jr. – Los Angeles (+1 213-229-7000, [email protected])
Christopher Chorba – Co-Chair, Class Actions Practice Group – Los Angeles (+1 213-229-7396, [email protected])
Theane Evangelis – Co-Chair, Litigation Practice Group, Los Angeles (+1 213-229-7726, [email protected])
Lauren R. Goldman – New York (+1 212-351-2375, [email protected])
Kahn A. Scolnick – Co-Chair, Class Actions Practice Group – Los Angeles (+1 213-229-7656, [email protected])
Bradley J. Hamburger – Los Angeles (+1 213-229-7658, [email protected])
Lauren M. Blas – Los Angeles (+1 213-229-7503, [email protected])

Discrimination and prejudice against Asian American and Pacific Islander (AAPI) communities is not a new phenomenon. However, the COVID-19 pandemic has brought with it a surge in anti-AAPI harassment and hate crimes, with some institutions estimating a 124% increase in hate crimes between 2020 and 2021, followed by an even steeper 339% increase between 2021 and 2022.[1]

This exponential rise in anti-AAPI violence has drawn broader attention to a longstanding problem and an increased urgency to take action. Spearheaded by Debra Wong Yang, former partner Robert Hur, Veronica Moyé, David Lee, Betty Yang, Poonam Kumar, Cynthia Chen McTernan, Nicole Lee and many others, Gibson Dunn has responded through work on various fronts, including the founding of the Alliance for Asian American Justice, leadership of task forces and working groups, and representation of victims of anti-AAPI hate across the country.

Section I of this report examines obstacles that stand in the way of accountability from (a) a prosecutorial perspective and (b) from the perspective of victims. Section II highlights the Firm’s efforts, which are ongoing on multiple fronts, and Section III outlines possible paths forward as we continue to combat anti-AAPI hate.

I. Overview of the Problem

Twenty-four million Asian Americans and 1.59 million Native Hawaiians and Pacific Islanders currently live in the United States, according to 2020 Census data.[2] Although there has been increased media attention surrounding the recent spate of anti-AAPI attacks, this present-day phenomenon is only one part of a broader history.

Upticks in racial violence against Asian Americans historically correlate with periods of economic and social upheaval. In 1871, growing anti-Asian sentiment, fueled by fears that Asian immigrants were depressing wages during an economic downturn, led to a massacre of 18 Chinese residents, including a 15-year-old boy, in Los Angeles’ Chinatown.[3] In January 1930, Filipino men were attacked in race riots in Watsonville, California, purportedly motivated by resentment that Filipino men were taking over agricultural labor and interacting with white women.[4] Southeast Asian refugees faced discrimination and violence in the wake of the Vietnam War, including attacks by Ku Klux Klan members on Vietnamese fishermen in Texas.[5] In 1982, Vincent Chin was beaten to death by two autoworkers in Detroit who believed him to be Japanese, amid a recession that was partially blamed on the rise of Japanese automakers.[6] And in arguably the most recent surge of anti-AAPI violence before the present-day crisis, the terrorist attacks on September 11, 2001 led to a staggering 1,600% increase in the number of anti-Muslim hate crimes reported to the FBI as compared to the year prior.[7]

Today, the COVID-19 pandemic has led to another resurgence of anti-AAPI hate and violence. Reports of anti-AAPI hate crimes increased by over 70% during the pandemic, according to the FBI,[8] while the Center for the Study of Hate and Extremism estimates an even higher increase, from 124% between 2020 and 2021 to 334% between 2021 and 2022.[9] New York City and San Francisco have experienced steeper jumps, 343% and 567% respectively.[10] A 2021 Pew survey revealed that 45% of AAPI adults said they have experienced some sort of offensive incident based on their race.[11] From March 2020 to March 2022, the Stop AAPI Hate reporting center collected 11,467 anti-AAPI incidents nationwide.[12] Most incidents (67%) involved some version of harassment, such as verbal or written hate speech or inappropriate gestures, while 17% of incidents involved physical violence.[13] Additionally, 16% of incidents involved avoidance or shunning, and 12% of incidents included possible civil rights violations, such as discrimination in a business or workplace.[14]

In March 2020, Burmese American Bawi Cung and his six- and two-year-old children were attacked and stabbed in a Texas grocery store because the assailant believed they were Chinese and responsible for causing the pandemic.[15] In early 2021, 84-year-old Thai American Vicha Ratanapakdee was physically assaulted and killed;[16] 65-year-old Filipino American Vilma Kari was kicked in the stomach, knocked to the ground, and kicked in the head repeatedly while her attacker yelled, “You don’t belong here,” and while multiple onlookers watched.[17] And in March 2021, eight people, six of them Asian women, were killed in shootings at several Atlanta spas.[18] A month after the Atlanta killings, a mass shooting at a FedEx facility in Indianapolis left four Sikh Americans dead.[19]

These media reports and statistical data almost certainly fail to capture the full extent of the problem. As discussed in Section II, implicit and institutional biases contribute to underreporting by victims, which is further exacerbated by the lack of a uniform database and widely accessible reporting mechanisms. Some estimate that only about one-tenth or fewer of hate crimes are reported.[20]

II. Obstacles to Accountability and Justice

In Section II, we examine two significant barriers to accountability, both stemming from implicit and institutional biases: (a) challenges in adequate prosecution of hate crimes, and (b) challenges in underreporting and lack of resources on the part of victims of hate crime.

A. Challenges in Prosecution of Hate Crimes

Evidence suggests the physical and verbal attacks unleashed against AAPIs in recent years are not adequately prosecuted as anti-AAPI hate crimes, and that prosecution of these crimes fails to recognize the racial animus and stereotypes driving these acts.

Some of the examples described in Section I are illuminating. In the March 2021 Atlanta spa shootings, six of the eight victims were Asian women. The district attorney in Fulton County, where four of the victims were killed, filed formal notice that she intended to seek hate crime enhancements on the basis that the shooter targeted the victims because they were of Asian descent—yet the prosecutors in Cherokee County, where two of the four victims were Asian, declined to find the shooting racially motivated, determining instead that the perpetrator was motivated by a sex addiction and his religious beliefs. The shooter also claimed his acts were not driven by race.[21]

And in April 2021, nine people (including the gunman) were killed in a mass shooting at a FedEx facility in Indianapolis, Indiana. Four of the eight victims were Sikh Americans, and about 90% of the workers at the facility were as well. Although the shooter had previously visited white supremacist websites, the Justice Department declined to bring charges based on racial motivation or bias.[22]

A report from the Asian American Bar Association of New York found that only seven of the over 230 reported attacks against Asians in New York City through the first three quarters of 2021 led to hate crime convictions.[23] A review of a dozen high-profile criminal cases in San Francisco involving Asian and Asian American victims during 2020 and 2021 similarly found that only two incidents were eventually charged as hate crimes.[24]

The challenges facing adequate prosecution of hate crimes are two-fold. First, hate crimes are by nature difficult to prosecute because they require proof of a perpetrator’s intent. Because no universal symbol of anti-AAPI hate exists, prosecutors typically must rely on a perpetrator’s statements—if any are even made. While some statements may contain racial slurs or similarly obvious epithets, in the absence of such language, prosecutors are left to infer motive from the nature of act itself or must conduct additional investigation to collect evidence. Second, prosecutors may then lack the educational and logistical resources needed to build the rigorous case required for hate-crime prosecution. Prosecutors may not be familiar with the nuances and history behind anti-AAPI sentiment, such that they fail to detect racial animus where it exists, and they may simply lack the time and resources needed to undertake the additional investigation to gather evidence—for example, past Internet activity showing racial hate or evidence of association with various organizations indicating racial motive.

Combined, the difficult legal standard for hate-crime prosecution and a lack of resources needed to meet that standard result in lower rates of charges brought and lower rates of successful prosecutions across the board.

B. Challenges Facing Victims of Anti-AAPI Hate

The difficulties in adequately prosecuting anti-AAPI hate crimes are in turn compounded by the obstacles that face victims of anti-AAPI hate. First, the challenges of prosecuting hate crimes discussed in Section II.A may lead to underreporting by victims who doubt that their complaints will be taken seriously, and who therefore distrust police and the government more generally. Even where victims of anti-AAPI attacks seek to report these incidents, many are unaware of how to do so. Victims, especially those from under-resourced communities, are often unsure of what constitutes a hate crime, and to whom reports of such incidents can made. This is further exacerbated by language and cultural barriers, especially for the elderly.[25] Second, once complaints are made or filed, victims may also lack a sufficient understanding of the legal system to know how to navigate criminal proceedings and may broadly lack access to adequate representation in civil litigation.

As a result of these compounding factors, some estimate that only about one-tenth, or less, of hate crimes against AAPIs are reported. A study from AAPI Data revealed that only 30% of Asian Americans were “very comfortable” reporting a hate crime to law enforcement, compared to 42% for Latino Americans, 45% for Black Americans, and 54% for White Americans.[26] The same study concluded that roughly 10% of Asian Americans had experienced hate crimes or hate incidents, compared to 6% of the general population.[27]

III. Gibson Dunn’s Efforts on Behalf of Victims of Anti-AAPI Hate

A. The Alliance for Asian American Justice

In April 2021, in the wake of the continuing surge in anti-AAPI hate crimes across the country, Gibson Dunn partner Debra Wong Yang and four other prominent attorneys in the AAPI legal community, along with additional Fortune 1000 General Counsels and over 40 law firms, founded the Alliance for Asian American Justice. Recognizing the deep-seated barriers to justice preventing victims of anti-AAPI hate from holding their attackers accountable, Yang and others created the Alliance to stand up for victims and prevent future acts of anti-AAPI hate. In particular, the Alliance connects victims of anti-AAPI hate with law firm resources provided on a pro bono basis in an effort to combat the historical marginalization in the legal system of low-income and under-represented AAPIs.

Through the Alliance, attorneys across the country have provided pro bono legal counsel in civil litigation for victims of anti-AAPI hate, worked with law enforcement to ensure that perpetrators are held accountable, and identified additional specialized services, including social services and other community support, to assist victims in navigating these ordeals. The Alliance is also giving legal representation to families of the March 16 Atlanta spa shooting victims, as well as to the family of Mr. Ratanapakdee. With Gibson Dunn’s involvement, the Alliance is estimated to have provided legal representation in more than 50 cases of anti-AAPI violence, and has grown its network to more than 110 participating law firms.

Although the Alliance connects victims of anti-AAPI hate with law firms across the country, a number of our own Gibson Dunn attorneys have engaged in this important work. Led by partners Veronica Moyé and Betty Yang and of counsel Poonam Kumar, a Gibson Dunn team represents a client in a civil suit filed in Plano, Texas, asserting that a woman attacked our client and her friends, threatened to shoot them, shouted ethnically charged profanities at them, and told them to “stay … in [their] country.” Partner David Lee and associates Cynthia Chen McTernan and Nicole Lee also lead a team in representing an Asian family in southern California in civil litigation alleging that a man trespassed on their property, physically assaulted the family’s father in view of his wife and young daughters, and called them racial slurs. Former partner Robert Hur represented two Korean American women in Baltimore, Maryland, who were beaten by a man with a cinder block as the women tried to close their liquor store. Hur coordinated with law enforcement to hold the perpetrator accountable.

Gibson Dunn’s work extends beyond the Alliance. While partner at Gibson Dunn, Hur also served as chairman of an Asian American Hate Crimes Workgroup formed by Maryland Governor Larry Hogan in April 2021. After extensive consideration and analysis, the workgroup issued a series of recommendations in November 2021 that led to a series of statewide actions by Governor Hogan to combat anti-AAPI hate and bias crimes, including enhanced safety and enforcement measures, more robust community resources, and steps to empower educators and students.

IV. The Path Forward

First, we can and should continue to advocate for the implementation of a formal anti-discrimination framework that will, among other things, aid in combatting prosecutorial bias. To name one example, the Biden administration enacted the COVID-19 Hate Crimes Act in response to the surge in AAPI attacks,[28] intended to make hate crime reporting more accessible at the local and state levels by increasing public outreach, providing grants to law enforcement agencies to train their officers to identify hate crimes, encouraging the creation of state-run hate crimes hotlines, and decreasing language barriers in online reporting resources. Further, the law aims to expedite the Department of Justice’s review of hate crimes and expand reporting channels. Other formal processes to address this issue may include increasing bystander intervention training, increasing and improving data collection, and public education about the diversity within the AAPI community.

Second, we can further combat prosecutorial bias and lower the barriers to accessing justice by increasing awareness of the historical and cultural context in which these anti-AAPI attacks occur. In addition, the focus should not only be on prosecution: Better intelligence about individuals and groups that promote hate-motivated violence can also help. Absent evidence of explicit hate speech during an attack, prosecutors are often reluctant to charge attacks on AAPI victims as hate crimes. In those scenarios, law enforcement must conduct substantial investigation into perpetrators to uncover proof of racial animosity to support a hate crime charge, but resources to do so may not be available.

Third, solutions to addressing the recent rise in AAPI attacks should include education on victims’ rights and opportunities to seek relief through the civil and criminal justice system, as well as targeted outreach to vulnerable segments of the AAPI population, such as women or the elderly, to ensure that they are empowered to exercise the rights available to them. For these reasons, affording victims of anti-AAPI hate competent legal representation—while also ensuring that they have access to the social and mental health services critical to navigate these ordeals—is paramount. Through its work with the Alliance and elsewhere, Gibson Dunn’s work on this front and its representation of victims of AAPI attacks not only help those directly impacted in the cases, but may also inspire other victims of AAPI attacks to speak out and protect their rights. In partnering with organizations like the Alliance and other AAPI groups, Gibson Dunn has helped mobilize legal resources to demonstrate that the AAPI community will not be silent bystanders in the face of unwarranted, hateful attacks.

Moving forward, Gibson Dunn will proudly continue to collaborate with AAPI groups and other legal organizations to assist victims of AAPI attacks and seek justice.

______________________

[1] Kimmy Yam, Anti-Asian hate crimes increased 339 percent nationwide last year, report says, NBC News (Jan. 31, 2022), https://www.nbcnews.com/news/asian-america/anti-asian-hate-crimes-increased-339-percent-nationwide-last-year-repo-rcna14282.

[2] U.S. Census Bureau, 2020 Census Redistricting Data Summary File, Pub. L. 94-171 (2022).

[3] Corina Knoll, Los Angeles to Memorialize 1871 Massacre of Chinese Residents, N.Y. Times (Sept. 14, 2022), https://www.nytimes.com/2022/09/14/us/massacre-chinese-los-angeles-1871.html.

[4] On this day – Jan. 19, 1930: White Mobs Attack Filipino Farmworkers in Watsonville, California, Equal Justice Initiative (last accessed on Jan. 9, 2023), https://calendar.eji.org/racial-injustice/jan/19.

[5] William K. Stevens, Klan Inflames Gulf Fishing Fight Between Whites and Vietnamese, N.Y. Times (Apr. 25, 1981), https://www.nytimes.com/1981/04/25/us/klan-inflames-gulf-fishing-fight-between-whites-and-vietnamese.html.

[6] Wynne Davis, Vincent Chin was killed 40 years ago. Here’s why his case continues to resonate, NPR (June 19, 2022), https://www.npr.org/2022/06/19/1106118117/vincent-chin-aapi-hate-incidents.

[7] Katayoun Kishi, Assaults against Muslims in U.S. surpass 2001 level, Pew Research Center (Nov. 15, 2017), https://www.pewresearch.org/fact-tank/2017/11/15/assaults-against-muslims-in-u-s-surpass-2001-level/.

[8] Raising Awareness of Hate Crimes and Hate Incidents During the COVID-19 Pandemic, U.S. Dep’t of Justice and U.S. Dep’t of Health and Human Servs. (May 20, 2022), https://www.justice.gov/file/1507346/download?_sm_au_= iHV3RFTV1qNV7nVFFcVTvKQkcK8MG.

[9] Yam, supra note 1.

[10] Id.

[11] Neil G. Ruiz, Khadijah Edwards, and Mark Hugo Lopez, One-third of Asian Americans fear threats, physical attacks and most say violence against them is rising, Pew Research Center (Apr. 21, 2021), https://www.pewresearch.org/fact-tank/2021/04/21/one-third-of-asian-americans-fear-threats-physical-attacks-and-most-say-violence-against-them-is-rising/?_sm_au_=iHV3RFTV1qNV7nVFFcVTvKQkcK8MG.

[12] Two Years and Thousands of Voices: What Community-Generated Data Tells Us About Anti-AAPI Hate, Stop AAPI Hate (Jul. 2022), https://stopaapihate.org/wp-content/uploads/2022/07/Stop-AAPI-Hate-Year-2-Report.pdf.

[13] Id.

[14] Id.

[15] Texan pleads guilty to hate-crime attack on Asian family, AP News (Feb. 23, 2022), https://apnews.com/article/ coronavirus-pandemic-business-health-crime-texas-0a2d8913a7d693b911c373d8003dfcba.

[16] Rachel Swan, Man accused in street attack that killed 84-year-old Thai man in San Francisco to face trial, S.F. Chronicle (June 17, 2022), https://www.sfchronicle.com/bayarea/article/Man-accused-in-street-attack-that-killed-17249717.php.

[17] Jessie Yeung, She was attacked in the street for being Asian. Her community still lives in fear, CNN (Jan. 30, 2022), https://www.cnn.com/2022/01/29/us/asian-american-attacks-aftermath-intl-hnk-dst/index.html.

[18] Jenny Jarvie, Police say man charged with killing Asian women and others at spas had ‘sexual addiction’, L.A. Times (Mar. 16, 2021), https://www.latimes.com/world-nation/story/2021-03-16/7-killed-in-shootings-at-3-atlanta-area-massage-parlors.

[19] Casey Smith and Luis Andres Henao, US Sikh community traumatized by yet another mass shooting, AP News (Apr. 20, 2021), https://apnews.com/article/shootings-statutes-violence-hate-crimes-indianapolis-395655b314f1e 57553fbac7b3f1804be.

[20] Catherine Thorbecke, Why anti-Asian hate incidents often go unreported and how to help, ABC News (Mar. 18, 2021), https://abcnews.go.com/US/anti-asian-hate-incidents-unreported/story?id=76509072.

[21] Nicholas Bogel-Burroughs, Atlanta Spa Shootings Were Hate Crimes, Prosecutor Says, N.Y. Times (May 24, 2021), https://www.nytimes.com/2021/05/11/us/atlanta-spa-shootings-hate-crimes.html.

[22] Sakshi Venkatraman, FBI says FedEx shooting not a hate crime; Indianapolis Sikhs still want answers, NBC News (July 29, 2021), https://www.nbcnews.com/news/asian-america/fbi-says-fedex-shooting-not-hate-crime-indianapolis-sikhs-still-n1275430.

[23] Laura Ly, Only 7 of 233 reported attacks against Asian Americans in NYC in 2021 led to hate crime convictions, new report says, CNN (May 31, 2022), https://www.cnn.com/2022/05/31/us/hate-crime-convictions-asian-americans/index.html.

[24] Joe Fitzgerald Rodriguez and Han Li, Why High-Profile Attacks on SF’s Asian Communities Rarely Lead to Hate Crime Charges, KQED (June 2, 2022), https://www.kqed.org/news/11915634/why-high-profile-attacks-on-sfs-asian-communities-rarely-lead-to-hate-crime-charges.

[25] Thorbecke, supra note 20.

[26] Kimmy Yam, Asian Americans are least likely to report hate incidents, new research shows, NBC News (Mar. 31, 2021), https://www.nbcnews.com/news/asian-america/asian-americans-are-least-likely-report-hate-incidents-new-research-n1262607.

[27] Id.

[28] Pub. L. No. 117-13, 131 Stat. 265 (2021).

This update was prepared by Debra Wong Yang, former partner Robert Hur, Poonam Kumar, Cynthia Chen McTernan, Adrienne Liu, and Michelle Lou.

Gibson Dunn lawyers are available to assist in addressing any questions you may have about these developments. Please contact the Gibson Dunn lawyer with whom you usually work or the following:

Debra Wong Yang – Los Angeles (+1 213-229-7472, [email protected])

Zakiyyah T. Salim-Williams – New York (+1 212-351-2326, [email protected])

Katie Marquart – New York (+1 212-351-5261, [email protected])

In no small part owing to the recent momentous economic and political challenges facing Germany, Europe and the world, the past years have seen several ambitious legislative projects come to fruition in Germany that will shape German corporate law and the M&A transactional landscape in 2023 and beyond.

Several of these reforms, but also the jurisprudence of the German courts and decisions of governmental agencies, have repercussions beyond the borders of Germany and are of great interest for international investors and the world-wide M&A community. This is certainly true for the changing regulatory landscape in Germany, where (i) the ongoing drive to re-define and calibrate the German rules on foreign direct investment law (FDI) and (ii) the new directly applicable EU Regulation on foreign subsidies distorting the internal market (Foreign Subsidies Regulation), which will introduce yet another transaction-relevant pre-clearance procedure besides traditional merger clearance proceedings and the existing FDI procedures, will require up-to-date, cutting edge German legal know-how for any investors looking at German inbound investment.

In much the same vein, the details of the traditionally very strict mandatory reason for filing for insolvency in Germany on account of over-indebtedness continues to be tweaked periodically by the law-makers with a view to softening the economic blows to German companies faced with macro-economic volatilities and crises not of their own making.

Finally, both Parliament and the German courts also feel the need to deal more flexibly with the pressing needs of digitalization and globalization of German corporate formalities, in particular as far as the incorporation of new entities or the certification of signatures of parties located outside of Germany or via video conferencing tools is concerned.

Our Munich office (Birgit Friedl, Marcus Geiss, Sonja Ruttmann and Lutz Englisch) have published a German-language article in the “M&A Review” in February 2023, an English translation of which is now available for our international colleagues and client base.

Originally published in the German language by the M&A Review on February 11, 2023, © M&A Media Services GmbH: “Deutsches Gesellschaftsrecht 2023: Ein turbulentes Jahr”

________________________

Table of Contents

Foreign Direct Investment Law in the Focus of Protectionism and Geopolitics
A New Transactional Clearance Requirement – the EU Regulation on Foreign Subsidies distorting the Internal Market
The German Notarial System Caught between Tradition and Digitization
Temporary Adjustments of German Insolvency Law in Response to the Energy Crisis

________________________

1. Foreign Direct Investment Law in the Focus of Protectionism and Geopolitics

The constant changes and steady expansion of the scope of application of foreign direct investment control under the German Foreign Trade and Payments Act (Außenwirtschaftsgesetz, AWG) and the German Foreign Trade and Payments Ordinance (Außenwirtschaftsverordnung, AWV) remain utterly significant for M&A practice. AWV filings have increasingly become an almost regular feature of most cross-border M&A transactions in Germany.

This trend is evidenced by the figures released by the Federal Ministry of Economics and Climate Protection (Bundesministeriums für Wirtschaft und Klimaschutz, BMWK) for the year 2022: Compared to 2020, the number of review cases has increased from 160 to 306.[1] If the cases with purely EU notifications[2] are factored in, the increase is even more marked from 189 to 570 cases. In purely statistical terms, this underlines the considerable importance of EU-wide investment screening, in the main based on the Screening Regulation (EU) 2019/452, which entered into force in 2020. However, measures restricting a proposed acquisition, such as prohibitions, ancillary provisions or public-law contracts and orders, were issued or concluded in only seven[3] of the 306 screened cases under the AWV.[4] Amongst those seven cases are the three recent cases described below in which the BMWK did not grant an unrestricted clearance following a decision by the Federal government (Bundeskabinett):

Initially, the participation of the Chinese (state-owned) group Cosco in the Port of Hamburg’s Tollerort container terminal was only approved in the range of 24.9% of the voting rights, and thus below the 25% of the voting rights considered to be the relevant limit for a blocking minority, instead of the 35% originally sought by Cosco, after intense discussions between the Chancellor’s Office and the BMWK, which were also reflected in public discourse.[5] In addition, the proposed right of Cosco to appoint a member of the management board was prohibited, contrary to the original agreement with the selling terminal operator Hamburger Hafen und Logistik AG (HHLA).

In another case, the acquisition of the wafer production of the semiconductor manufacturer Elmos Semiconductor SE by Silex AB from Sweden, which in turn is held by the Chinese (state-owned) group SAI Micro-Electronics, was even completely prohibited by the Federal government (Bundeskabinett). This, too, was met with criticism because this decision was said to be a strategic one rather than a step taken to protect important technologies in Germany as a business location. After all, the technology for sale was an obsolete technology which Elmos itself no longer used for its products.[6]

The second prohibition related to the planned acquisition of ERS electronic GmbH, a company which develops solutions for thermal wafer tests and is therefore also active in the semiconductor industry, by a Chinese investor. Details of this prohibition are not published.

This is in line with decisions already taken in the first half of 2022, such as the prohibition of the acquisition of Heyer Medical AG, a manufacturer of respiratory equipment, by the Chinese company Aeonmed in January 2022 and the failure to approve the public takeover of the wafer manufacturer Siltronic AG by the Taiwanese competitor GlobalWafers in May 2022 within the offer period which thus led to a de facto prohibition.

These decisions and the criticism voiced against them have been recognized by the German government, which has reportedly received the first draft of a “China strategy paper” that is expected to be adopted by the second half of 2023. This draft (in addition to various other changes) also provides for further amendments to the German foreign trade laws. In future, not only the direct or indirect acquisition of shares in existing German companies will be subject to investment control, but potentially also incorporating a company and, if applicable, venture capital financing by non-EU/non-EFTA investors in Germany.

In addition, the introduction of a law is being considered which would allow the German government to examine so-called “outbound investments”, i.e. investments by German companies abroad, at least in certain countries and industries and, if necessary, to prohibit or restrict them – an approach that would be comparable, for example, to the rights of the government of the United States or China.

With regard to China, in particular, the German government is planning to engage in a closer exchange with the other G7 member states in order to gain a clearer global overview of Chinese investments and thus be able to identify any Chinese acquisition strategies at an early stage and coordinate the handling of (direct) Chinese investments in any G7 member state. This is designed to prevent future dependencies or threats relevant for public security. The focus lies on so-called critical infrastructures, such as transport and smart city infrastructure, data networks (including 5G and, in the future, 6G), cloud computing and electronic payments, as well as electricity and water utilities and hospitals.

A further tightening of the legal reasons that can justify a prohibition is also on the agenda: In addition to the question as to whether a proposed investment is likely to impair the public security or order of the Federal Republic of Germany, another member state of the European Union or regarding projects or programs in the European Union’s interest within the meaning of Article 8 of Regulation (EU) 2019/452, (imminent) risks to European sovereignty in future would also justify the prohibition of an acquisition or clearance subject only to specific conditions.

Even though it remains to be seen which of the measures currently under consideration will find their way into an eventual amendment to the AWG and/or the AWV, we believe that the current strategy paper shows the direction in which the government’s thoughts on foreign investment control are heading. The extension of scope and tighter controls introduced in recent years will probably not be eased or scaled back even after the acute COVID-19 crisis is confined to history. On the contrary, the importance of German and European foreign direct investment control laws in cross-border or global transactions by (especially) non-EU/non-EFTA investors is rather likely to increase further. This is in line with comparable international tendencies, especially in the USA and China, to assess in-bound investments by third countries rather restrictively.

Thus, the M&A practice will need to remain vigilant for the time being. Foreign direct investment law will remain a fast-changing area that needs to be dealt with on a routine basis, taking into account constant further developments and mindful of regular reforms.

Back to Top

2. A New Transactional Clearance Requirement – the EU Regulation on Foreign Subsidies distorting the Internal Market

In the future, it will no longer be sufficient for a number of transactions, even outside the sphere of regulated business activities, to assess only merger control and foreign direct investment law notification requirements at local or EU level. The legal landscape has changed because Regulation (EU) 2022/2560 of the European Parliament and of the Council of December 14, 2022, on foreign subsidies distorting the internal market (Foreign Subsidies Regulation, FSR)[7] has entered into force on January 12, 2023.

While state aid granted by EU member states to companies has for a long time been subject to scrutiny by the European Commission, there has been no equivalent state aid control for subsidies received from third countries. This will change in the future with the FSR, which provides for three components: (i) third-country subsidy control in the case of mergers, (ii) a review process for bids in public procurement procedures, and (iii) a right to conduct ad hoc ex officio investigations if foreign subsidies are at issue which potentially distort the internal market.

In the M&A context this new kind of notification requirement applies to proposed mergers whenever at least one of the merging companies, the acquired company or the joint venture is established in the EU, has an aggregate turnover in the EU of at least EUR 500 million in the prior fiscal year, and (i) in the case of an acquisition, the acquirer or the target company, (ii) in the case of a merger, the merging companies, or (iii) in the case of a joint venture, the companies creating the joint venture and the joint venture have received financial subsidies from third countries (i.e. countries that are not member states of the EU) totaling (on an aggregated basis) more than EUR 50 million within the three fiscal years preceding the notification. However, the European Commission may also impose a notification requirement for mergers before the transaction can be completed even if the thresholds are not met.

Comparable to traditional merger control proceedings, transactions subject to notification requirements are subject to a prohibition to close until due clearance is granted (or the expiry of the relevant deadlines). Mergers carried out in contravention of the prohibition to close are void and, under certain conditions, the unwinding of the transaction may be ordered. In addition, a fine of up to 10% of the worldwide group turnover can be imposed on companies involved in a violation of the prohibition to close. The procedure is otherwise based on the EU merger control procedure, with a Phase I (of 25 working days) and possibly a Phase II (of 90 working days) in place.

In principle, the regulation applies from July 12, 2023. Mergers where the relevant agreement was concluded before this date are expressly not covered. However, the notification requirements for M&A transactions do not apply until October 12, 2023, which means they only cover agreements that (i) are entered into after July 12, 2022, but (ii) have not yet been consummated before October 12, 2023. However, since the Commission may also examine third-country subsidies granted in the (as a rule) last three to a maximum of five years before the entry into force of the FSR, the provisions are de facto relevant as of now, at least for planning purposes.

Beyond an actual obligation to notify any given M&A transaction as such, the FSR is furthermore relevant, in particular, in the context of a due diligence review, because third-country financial subsidies must be notified when bidding in public procurement procedures if (i) the estimated total value of the tender amounts to at least EUR 250 million and (ii) the company participating in such a procurement procedure (as well as, where applicable including its economically dependent subsidiaries, its affiliates and, if applicable, its main subcontractors and main suppliers involved in the same tender under the public procurement procedure) has received financial benefits totaling at least EUR 4 million per third country in the three fiscal years preceding the notification. On the one hand, fines may be imposed for violations of this further notification requirement as well, and the European Commission, on the other hand, may take up and review the measure as if a due notification had been made. Irrespective of this, the Commission can always review any competition-distorting effects of third-country subsidies ex officio and in all market situations, including cases otherwise below the thresholds for mergers and public tenders.

In addition to these formal and procedural requirements to be observed in the future, significant complexity and corresponding uncertainties associated with the FSR are currently caused primarily by the definition of the type of financial contributions that are to be considered relevant third country subsidies and in the assessment of a distortion of competition. In this regard, the text of the FSR itself still leaves some questions unanswered. Corresponding guidelines by the European Commission are to be published by January 12, 2026, at the latest.

In the future, it will be relevant for all three components of the FSR that all financial subsidies received by a group of companies (and received in the last three to five years) are documented comprehensively and in sufficient detail. In the context of structuring due diligence reviews, it will also become important going forward to assess the target’s compliance with FSR requirements, potentially critical subsidies received by the target and whether the seller has in the past acquired the target company in compliance with the FSR’s notification requirement and has thus validly acquired title in the shares or assets, at all.

In addition, the new clearance procedure for mergers must also be duly factored into any proposed timelines, because concrete information on third-country subsidies received will often not be available in the required level of detail on an ad hoc basis, at least during the initial period of application of the FSR. The draft FSR Implementing Regulation including the proposed notification forms suggest that the burden on the parties will be enormous as a vast amount of specific data and numerous documents will have to submitted.

Last but not least, future transaction documents should include appropriate procedural provisions, including a closing condition of due clearance of the transaction (or the expiry of the relevant waiting periods), and specific indemnities or guarantees to safeguard against any past violations should also be considered. In critical cases, the precautionary lodging of clearance proceedings may also be considered if a third-country subsidy granted in the past could be viewed as potentially distorting competition.

Back to Top

3. The German Notarial System Caught between Tradition and Digitization

Especially in an international context, German corporate law and its relatively strict formalities are often perceived as unwieldy and unduly formalistic in M&A circles. In the context of company acquisitions, foreign parties almost inevitably come into contact with German notaries, be it because a notarial recording is a formal requirement of the actual GmbH share purchase and assignment agreement under German law, or because notarial signature certifications are required regarding certain powers of attorney but also for German register applications, for example when appointing foreign managing directors.

3.1 News on the Suitability of Foreign Notarial Certifications for Use in Germany

The notarial certification of signatures executed abroad always requires a certain lead time and careful preparation with the foreign signatories and their local legal advisors. Otherwise, the overall process runs a certain risk of unpredictable adversity with the registry courts and possible interim orders and, therefore, avoidable delays.

In this regard, notarizations under German law concern both (i) the actual identity of the actual signatory and (ii) the authenticity of a signatory’s signature on the document in question. In cross-border cases involving international signatories, these foreign signatories routinely have their signatures notarized by a foreign notary in their home country in order to save them a potentially arduous and expensive trip to Germany or to a German foreign embassy or consulate in their home country that is deemed equivalent to a German notary.

Such foreign notarial certification of signatures for use in Germany is accepted by the German courts and authorities if the foreign notaries – in addition to certifying the signature as such – also confirm their own public authority to act by means of an apostille or a legalization stamp.

In an important decision in 2022, which is also of great interest to foreign investors and their local notaries and advisors, the Berlin Appellate Court (decision of March 3, 2022, case no. 22 W 92/21) further specified the necessary scope and content of the actual certification language used by non-German notaries in this context:

In particular, the court clarified that foreign certification language and procedures – even if they are typical for and legally effective under the local laws of the originating state – are not automatically sufficient, equivalent and acceptable to German register courts or other public authorities under German law, but must be closely aligned with the specifics of German law. The concrete certification language used by the foreign notary must, as a minimum, convey that (i) the signature was issued in the personal presence of the notary public and (ii) that the notary public verified the identity of the signing person.

As a consequence, various typical foreign law short form signature certifications like “vue par legalization” in French-speaking countries or “sworn to before me” in Anglo-Saxon jurisdictions will face a real risk of rejection by German register courts or other authorities as not adequately covering both of the above components which are required for the full equivalence of a foreign notary’s certification language.

Similarly, common practices in some of the Benelux countries where the notary public certifies new signatures provided by the signatory ad hoc by simply comparing them to pre-collected signature samples maintained on the notary’s files are also at risk of being rejected due to the fact that the notary public does not personally witness the actual signature process in person.

This decision of the Berlin Appellate Court is not automatically binding for the whole of Germany, but it is a key precedent that should always guide German lawyers and their foreign clients when preparing signature procedures abroad that require the form of notarial certification. The exact scope of the German formalities should be clearly communicated ahead of signature and a suitable text for the notarial certification language should be drafted and agreed with the foreign notary in advance. Otherwise the client faces the risk of onerous delays and, in a worst case scenario, having to repeat the signature procedure if a certified and apostilled or legalized document ends up being rejected by the German authorities.

Practical experience with German register courts has always shown a certain unpredictability. In this respect, it is unclear how judicial practice will deal with those foreign notaries who are required under local law to use exactly prescribed template texts when certifying documents or signatures. In any event, the decision clearly highlights that the sword of German formalities remains remarkably sharp even in times of increased globalization. The meticulous preparation of documents and precise communication of potential risks involved in the procedure, thus, are and remain indispensable puzzle pieces in the toolkit of the German M&A lawyer who successfully operates in the international arena.

3.2 Digitization of Formalities as Possible Hope for the Future?

However, the clarification of the details and substantive requirements of the existing German formal requirements by court-made case law and in legal practice is not the only area that has recently seen increased movement. The trend towards increased digitization also tends to reach corporate law and its formalities, and has in the past years called the German legislature into action.

Both the Notarization Act (Beurkundungsgesetz) itself and the German Commercial Code (HGB) were fundamentally reformed in 2022 as part of the national implementation of the EU’s Digitalization Directive[8] into German law. With this reform, the possibility of notarial recordings and notarial signature certifications via special notarial video conferencing systems was introduced selectively into the German notarial system and the commercial register procedures, even though the technical requirements for the necessary qualified electronic signatures and proof of identity and the use of such notarial video conferencing systems at present are naturally still in their infancy in practice.

As a general rule, it is currently fair to say that notarial recordings or signature certifications via video conferencing are not generally permissible, but only if they are specifically permitted by law in an individual case. Moreover, access to and use of such online services provided by German notarial offices is not open to everyone without restriction, even if they are permitted by law, but are tied to certain expressly stipulated legal requirements.

On the one hand, the question will arise in the future as to whether the incorporation in cash of new GmbHs in Germany, which is now also theoretically possible online, can develop in the medium term into a practical alternative to the acquisition of inactive shelf companies as a transaction vehicle, which has been the common go-to practice for years.

On the other hand, it will be interesting to see to what extent and for whom the now partially permissible online signature certifications can or will replace the physical visit to the notary, e.g. for filing applications to the commercial register.

Even at first glance, however, the new German law appears to contain some high technical hurdles. The verification of the identity of the parties, which the German notary is obliged to carry out even in the case of measures conducted via video conference, is performed in a two-step procedure, firstly by reading out certain enumerative permissible electronic identification documents to establish the electronic identity (eID) of a person and secondly by means of an additional passport photo comparison using a special notarial app on the smart phone of the relevant signatory.

At the moment, for German citizens, this regularly means the valid ID card along with its ID PIN as well as the passport for individual photo comparison.

Nationals of other EU or EEA member states may access the new procedure if they either hold a German eID card (a so-called Union citizen card) or their local eID meets the “high” security level according to the eiDAS Regulation.[9] This is currently the case for many, but not yet all, member states. In addition, they need their local passport for the individual photo matching by the notary.

Third-country nationals, such as citizens of the United States or the United Kingdom, require a formal German residence title together with a PIN or a comparable identification document of another EU or EEA state that again corresponds to the “high” security level.

All in all, the regulation has a strong local-European focus and will exclude genuine third-country nationals without deeper or longer-term residence status in the EU from participation in the individual case. One of the typical interest groups in the M&A sector, e.g. the newly appointed foreign national and resident managing director of a freshly acquired German target company designated by an investor in the United States, the United Kingdom or the Middle East, will thus continue to be dependent upon the certification of their signatures in their home country before local notaries and the time-consuming apostille or legalization procedure.

For EU citizens and managing directors, it remains to be seen whether and how the new procedural options via video conferencing procedure will become accepted in practice and, in particular, whether they will make it possible to save time and effort in the case of repeated notarizations by the same notary via online notarization.

For the moment – and one would assume until further notice – the use of foreign notaries to certify signatures required in Germany and the acquisition of shelf entities therefore will remain, in our practical experience, the preferred alternative and the path routinely chosen. However, it is undoubtedly a worthwhile exercise to monitor the new regulation and the continuous digitization of legal transactions in the future with open eyes and not to reject them out of hand as new, unwieldy or unfamiliar.

Back to Top

4. Temporary Adjustments of German Insolvency Law in Response to the Energy Crisis

The German legislator had responded to the COVID-19 pandemic by temporarily relaxing Germany’s traditionally strict insolvency filing requirements pursuant to the COVID-19 Insolvency Suspension Act (COVInsAG) for companies that had fallen into financial distress through no fault of their own due to the effects of the pandemic.

In 2022, the next unexpected macroeconomic crisis followed when the impact of Russia’s attack on Ukraine and the effect of the subsequent sanctions against Russia were beginning to be felt. In addition to problems within international energy supply chains, this also led to sharply rising energy prices and an explosion in production costs for numerous companies, which in many cases could not simply be passed on to customers. Not least because of the resulting planning uncertainties, there is a threat of sudden financial difficulties even for otherwise “healthy” companies which are in the process of working on solutions to switch to less scarce energy resources or otherwise reduce costs.

In response to the energy crisis, on October 20, 2022, the German Bundestag passed, among a bundle of other measures, the Act on a Temporary Adjustment of Restructuring and Insolvency Law Provisions to Mitigate the Consequences of the Crisis (Sanierungs und insolvenzrechtliches Krisenfolgenabmilderungsgesetz – SanInsKG), which came into force on November 9, 2022. Key elements of the new law, which relate exclusively to the insolvency reason of over-indebtedness (Überschuldung) under section 19 of the German Insolvency Code (Insolvenzordnung – InsO), are:

Shortening the period for the continuation prognosis under the Insolvency Code as well as for own-administration proceedings and restructuring plans

The reason for filing for insolvency due to over-indebtedness can be excluded if a positive continuation prognosis exists, irrespective of mathematical over-indebtedness on the basis of an over-indebtedness balance sheet. The rolling forecast period was previously twelve months in accordance with section 19 (2) of the InsO. During this period, there had to be an overriding probability that the company would be able to meet its liabilities as they fall due. Under section 4 (2) sentence 1 of the SanInsKG, this forecast period is now reduced to four months on a transitional basis. Thus, if a company found itself in a financial crisis on December 20, 2022, it previously had to establish a positive cash-flow until December 20, 2023 in order to establish a positive continuation prognosis under the general rules. Now, a positive forecast period until April 20, 2023 is sufficient under the new regulation.

The government draft[10] justified this reduction of the forecast period with current uncertainties in forecasts due to price volatilities and the continuation of such uncertainty for the foreseeable future as to the nature, extent and duration of the crisis, which means that forecasts can often only be based on uncertain assumptions. Considering that personal liability and criminal law risks for managing directors of such companies can often only be safely avoided by filing for insolvency, such insolvency filings would also affect companies whose ability to continue its business would be beyond doubt under normal circumstances (without the current price volatilities and uncertainties).

In parallel, the SanInsKG shortens the planning periods for own-administration proceedings (Eigenverwaltungsverfahren) and restructuring plan proceedings (Restrukturierungsplanverfahren) pursuant to section 270a (1) no. 1 of the InsO and section 50 (5) no. 2 of the StaRUG from six to four months. In view of the current forecast uncertainties, this change is intended to facilitate the planning of potential own-administration proceedings and court stabilization orders in cases where out-of-court restructuring measures are no longer sufficient.

The extension of the maximum time limit for an insolvency filing

As a rule, insolvency filings must be lodged immediately after the reason for filing for insolvency has arisen. However, if at the time an insolvency reason first arose, there is a reasonable prospect that such insolvency reason can be overcome, a maximum grace period of six weeks was previously applied in the case of over-indebtedness under section 15a (1) sentence 2 of the InsO. This maximum period has now been increased from six weeks to eight weeks by the SanInsKG. However, as in the past, this maximum grace period may only be exhausted for as long as there is a real and demonstrable prospect that the reason for over-indebtedness can indeed be overcome in the grace period. If this prospect does not (or no longer) exist, the insolvency filing must be lodged immediately, even under the SanInsKG.

No causality requirement

The application of the new rules does not require that the adverse developments on the energy markets and the uncertainty affecting a forecast actually led to the crisis in the individual case. According to the legislator almost all market participants are, at least indirectly, affected by the current conditions and defining a sufficient degree of impact in the individual case would lead to further uncertainties.

Temporary application

The adjustments under section 4 (2) sentence 1 of the SanInsKG only apply for a temporary period until December 31, 2023. However, if these temporary adjustments are not extended beyond December 31, 2023, or are not extended in good time ahead of their expiry, the actual relevant date for examining whether an insolvency filing should be made is likely to be earlier in 2023, namely as early as the beginning of September 2023. If, on September 1, 2023, the management determines that sufficient cash-flow is secured for four months but not for the planning period of twelve months that will again apply from January 1, 2024 going forward, it cannot be ruled out at present that de facto a planning period of twelve months will have to be applied again (and, if necessary, an insolvency filing must be made) as early as the beginning of September 2023 in order to avoid an allegation of a delayed filing at a later point in time.

The new rules have a direct impact on the managers of affected companies. In times of great uncertainty regarding energy and commodity prices, high inflation and difficulties in supply chains, the shortening of the planning period for the continuation prognosis will reduce the liability risk for managers based on a belated insolvency filing due to over-indebtedness. Nevertheless, in view of the fact that the adjustments may only apply for a short period of time and the continuing obligation to identify financial distress at an early stage in accordance with section 1 (1) of the StaRUG, managers must also keep an eye on longer planning periods in parallel and, if necessary, initiate restructuring measures at an early stage.

Also, measures to monitor and ensure full solvency continue to be relevant, as the obligation to file for insolvency due to illiquidity (Zahlungsunfähigkeit) continues to apply unchanged regardless of the SanInsKG. In addition, the adjustments directly affect only the provisions in the Insolvency Code on over-indebtedness as such and the maximum grace period for filing for insolvency on account of over-indebtedness. Other liability risks and criminal law offences, such as deceiving business partners about the possibility of settling future liabilities, are accordingly not excluded.

Business partners could also benefit from the temporary provisions, as they are generally no longer exposed to accusations of aiding and abetting the offence of delaying insolvency during the period in question when dealing with the debtor. However, the next few months will show whether lenders are also prepared to provide “fresh money” to a company that does not have to file for insolvency for the time being merely because of temporary exemptions from the filing obligation. In any case, the risk that new loans granted during the pre-insolvency crisis may be regarded as damages caused contra mores in the event of a subsequent insolvency cannot be eliminated without a sound formal restructuring opinion. The strict requirements for restructuring opinions, in turn, are likely to remain unaffected by the SanInsKG.

However, the shortened forecast period for over-indebtedness offers an opportunity for the scope of application of the stabilization and restructuring framework under the StaRUG. The number of companies that are subject to impending illiquidity (drohende Zahlungsunfähigkeit) but not yet over-indebted and can take advantage of the StaRUG could increase while the SanInsKG is in force. A company that is not fully financed for a period of twenty-four months is facing impending illiquidity. Previously, however, it was already over-indebted (and therefore subject to an obligation to file for insolvency) if the cash-flow was not secured for twelve months. The relevant time window for the use of the StaRUG was therefore twelve months. With the reduction of the planning period for cash-flow forecasts in the case of over-indebtedness to four months, the time window during which there is “only” impending illiquidity is therefore temporarily increased to twenty months.

Even if the adjustment of the forecast period makes sense for essentially healthy companies under the current crisis situation, in practice, the SanInsKG is likely to affect only a small group of companies. The insolvency reason of over-indebtedness without the parallel existence of illiquidity has historically always been the rare exception among the reasons for filing for insolvency. In the current situation, however, companies are often also experiencing an (acute) liquidity crisis due to rising production costs. As mentioned above, the obligation to file for insolvency in the case of illiquidity remains unchanged despite the SanInsKG. However, companies that are already working on effective solutions to counter the energy crisis in the medium term may benefit from the adjustment in the longer term.

Back to Top

______________________

[1] These figures are taken from the BMWK website: www.bmwk.de/Redaktion/DE/Publikationen/Aussenwirtschaft/investitionsprufung-in-deutschland-zahlen-und-fakten.pdf?blob=publicationFile&v=10.

[2] I.e. cases in which there is no national screening procedure (for example because the target company concerned does not have a subsidiary in Germany), but the BMWK has been notified exclusively by one or more other EU member states as part of the EU-wide screening mechanism.

[3] Status as of January 9, 2023, 39 cases filed in 2022 were still pending at that point in time, so the number may increase.

[4] This does not include cases where the acquirer withdrew the application for clearance prior to a decision by the BMWK and abandoned the proposed transaction.

[5] See, for example, www.sueddeutsche.de/politik/hamburger-hafen-cosco-china-1.5682148.

[6] See for example: www.zeit.de/wirtschaft/unternehmen/2022-11/elmos-bund-untersagt-verkauf-von-chipfabrik-an-chinesischen-investor?utm_referrer=https%3A%2F%2Fwww.google.com%2F.

[7] EU Regulation (EU) 2022/2560 of the European Parliament and of the Council of December 14, 2022 on foreign subsidies distorting the internal market; available in English at: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32022R2560&qid=1673254237527.

[8] Directive (EU) 2019/1151 of the European Parliament and of the Council of 20 June 2019 amending Directive (EU) 2017/1132 as regards the use of digital tools and processes in company law, OJ 2019 L 186/80.

[9] Regulation (EU) No. 910/2014 of the European Parliament and of the Council of 23 July 2014 on electronic identification and trust services for electronic transactions in the internal market and repealing Directive 1999/93/EC, OJ 2014, L 257/73.

[10] Amendment by the parliamentary groups of the SPD, Bündnis 90/Die Grünen and the FDP to the bill of the Federal Government – printed matter 20/2730, p. 3.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the developments discussed in this article. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s German corporate practice groups as listed below, or the authors:

Lutz Englisch (+49 89 189 33 150, [email protected])

Birgit Friedl (+49 89 189 33 122, [email protected])

Marcus Geiss (+49 89 189 33 115, [email protected])

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

General Corporate, Corporate Transactions and Capital Markets – Germany

Lutz Englisch (+49 89 189 33 150, [email protected])

Ferdinand Fromholzer (+49 89 189 33 122, [email protected])

Markus Nauheim (+49 89 189 33 122, [email protected])

Dirk Oberbracht (+49 69 247 411 510, [email protected])

Wilhelm Reinhardt (+49 69 247 411 520, [email protected])

Jan Schubert (+49 69 247 411 511, [email protected])

Silke Beiter (+49 89 189 33 170, [email protected])

Aliresa Fatemi (+49 69 247 411 515, [email protected])

Birgit Friedl (+49 89 189 33 122, [email protected])

Annekatrin Pelster (+49 69 247 411 521, [email protected])

On May 3, 2023, the Securities and Exchange Commission (“SEC” or “Commission”), in a 3-to-2 vote, adopted amendments to the disclosure requirements relating to companies’ repurchases of their equity securities. The amendments will require companies to: (i) disclose daily repurchase data in a new table filed as an exhibit to Form 10-Q and Form 10-K, (ii) indicate by a check box whether any executives or directors traded in the company’s equity securities within four business days before or after the public announcement of the repurchase plan or program or the announcement of an increase of an existing share repurchase plan or program, (iii) provide narrative disclosure about the repurchase program, including its objectives and rationale, in the filing, and (iv) provide quarterly disclosure regarding the company’s adoption or termination of any Rule 10b5-1 trading arrangements. The new amendments will invite enhanced scrutiny of companies’ share repurchase practices and rationales.

While reflecting a prescriptive and perhaps quixotic approach to a perceived potential for abuse that the SEC acknowledges is not present in many, or perhaps even most, share repurchases, the final rules reflect a significant paring back from the SEC’s initial proposal, which would have required daily reporting of repurchases on a next-day basis. The SEC also confirmed that companies that rely on recently amended Rule 10b5-1 will not be subject to a cooling-off period, any limitation on the use of multiple overlapping plans, any limitation on the use of single-trade plans or any disclosure regarding so-called “non-10b5-1 trading arrangements.” These changes reflect the SEC’s responsiveness to constructive and pragmatic comments received on its rule proposals, offering a sign of hope for other pending SEC rulemaking initiatives.

The 200+ page adopting release is available here and a Fact Sheet is available here. The final rules will become effective 60 days after publication in the Federal Register. For companies that file on domestic forms, the disclosure requirements will apply to Forms 10-K or 10-Q filed for the first full fiscal quarter beginning on or after October 1, 2023. For calendar year companies, this means that the new disclosures will first appear in their 2023 Form 10-K, showing any repurchases made (and disclosing any related Rule 10b5-1 trading arrangements entered into or terminated) during the fourth quarter. Later effective dates apply for foreign private issuers (“FPIs”) and listed closed-end funds, but there are no delays for other categories such as for smaller reporting companies.

Set forth below is a summary of the amendments and some considerations for companies in connection with these SEC rule amendments.

Summary of Amendments

New Periodic Reporting Requirements for U.S. Companies. The amendments introduce the following new periodic reporting requirements:

Daily Quantitative Transaction Disclosure, Reported Quarterly. Prior to the adoption of these amendments, Item 703(a) of Regulation S-K has required companies to include in their Forms 10-Q and 10-K a table reporting specified information on company repurchases of equity securities during each month of the previous quarter, on an aggregated monthly basis. The new amendments require tabular disclosure of the company’s daily repurchase activity during the prior quarter. The tabular disclosure will be filed as an exhibit to a company’s Form 10-Q or Form 10-K, with FPIs required to report the information quarterly on a new Form F-SR, and listed closed-end funds reporting the information in their semiannual and annual reports on Form N-CSR. There are no exceptions to the reporting requirements, including for smaller reporting companies or for classes of equity securities that are not exchange-traded.A copy of the required format for this table, which will appear as Exhibit 26, is included as an Exhibit to this client alert. The exhibit must be provided in XBRL-tagged format, and must report, for each day on which shares were repurchased:
- the date that the purchase of shares is executed,
- the class of shares repurchased,
- the average price paid per share,
- the total number of shares purchased, including the total number of shares purchased as part of a publicly announced plan,
- the aggregate maximum number of shares (or approximate dollar value) that may yet be purchased under a company’s publicly announced plan,
- the number of shares that were purchased on the open market,
- the number of shares purchased in transactions intended to qualify for the safe harbor in Rule 10b-18, and
- the total number of shares purchased pursuant to a plan that is intended to satisfy the affirmative defense conditions of Rule 10b5-1(c), together with a footnote disclosing the date of adoption or termination of the Rule 10b5-1(c) plan.
Check the Box Disclosure. Companies will be required to include a checkbox preceding the tabular disclosure, indicating whether any Section 16 officer or director purchased or sold shares that are the subject of a publicly announced plan or program within four business days before or after the company’s announcement of the stock repurchase plan or program, or the announcement of an increase in the number or amount of securities to be purchased under an existing plan or program. In response to comments, the SEC confirmed that a company may include additional disclosure to provide context to investors regarding any purchases or sales that trigger the checkbox requirement, and the SEC even noted that such disclosure would be required if material and necessary to prevent the required disclosures from being misleading.
Narrative Disclosure. In addition to requiring tabular disclosures, the new amendments expand upon the existing requirement for narrative disclosures of repurchases in periodic reports. In the section of their Forms 10-Q and 10-K where companies currently report aggregated monthly data on their share repurchases, companies will be required to disclose the following information, and to refer to the particular repurchases in the exhibit table that correspond to the different parts of this narrative:
- the objectives or rationales for each share repurchase plan or program,
- the process or criteria used to determine the amount of repurchases,
- the number of shares purchased other than through a publicly announced plan or program, and the nature of the repurchase transactions, such as whether the purchases were made pursuant to equity compensation arrangements, tender offers, etc., and
- any policies and procedures relating to the purchases and sales of the company’s securities during a repurchase program by its officers and directors, including whether there are any restrictions on such transactions.

As is currently the case, if a company’s repurchase plan or program was publicly announced, the disclosure also must state:

the date each plan or program was announced,

the dollar or share amount approved,

the expiration date, if any, of the plan or program,

each plan or program that has expired in the relevant period, and

each plan or program that the company has determined to terminate prior to expiration, or under which the company does not intend to make further purchases.

Disclosure Requirements for 10b5-1 Plans. In rules adopted last December, the SEC required companies to disclose in their periodic reports whether any executives or directors had entered into or terminated Rule 10b5-1 trading plans (including a modification that is treated as a termination and new plan), and to provide a description of the material terms of any such plans. The issuer repurchase rules adopted by the SEC require substantially similar disclosure regarding any Rule 10b5-1 plan adopted or terminated by the company. As with Rule 10b5-1 trading plans adopted by an executive or director, the company will be required to disclose the date on which it adopted or terminated a Rule 10b5-1 trading plan, the duration of the plan, and the aggregate number of shares to be purchased or sold pursuant to the arrangement. However, in contrast to the disclosure rules applicable to trading plans adopted by executives and directors, companies are not required to disclose whether they entered into an arrangement that meets the SEC’s definition of a “non-Rule 10b5-1 trading arrangement.” As noted above, the SEC also stated that it is not imposing additional conditions on the availability of the Rule 10b5-1 affirmative defense on companies, such as a cooling-off period, limitations on the use of multiple overlapping plans, or limitations on the use of single-trade plans.

New Periodic Reporting Requirements for Foreign Private Issuers and Listed Closed-End Funds. The amendments impose substantially similar requirements on FPI and listed closed-end funds as they do on domestic companies. The requirements that differ for FPIs and listed closed-end funds are described below:

Foreign Private Issuers. FPIs will be required to provide the disclosures described above under the new amendments quarterly in their Forms F-SR beginning with the first full fiscal quarter that begins on or after April 1, 2024. Prior to the adoption of these amendments, FPIs were required to annually disclose any company repurchases, aggregated on a monthly basis. Under the new amendments, any FPI that has a class of equity securities registered pursuant to Section 12 of the Exchange Act and does not file Forms 10-Q and 10-K will be required to file a Form F-SR within 45 days after the end of each quarter disclosing the aggregate stock repurchases made each day during the prior quarter. The narrative disclosures required of U.S. domestic company will be required in FPIs’ future Form 20-F filings. In his remarks dissenting from the adoption of the amendments, Commissioner Uyeda emphasized that the new requirements for FPIs represent a break from the SEC’s traditional deference to home country disclosure standards. Commissioner Uyeda expressed concern that these amendments could signal to international partners that the U.S. no longer respects the principles of mutual recognition and international comity which facilitate streamlined access to international securities markets. As such, Commissioner Uyeda expressed concern that these amendments could lead to a decline in the number of foreign companies listed in the U.S. and increase compliance costs for U.S. companies with international operations, ultimately harming U.S. investors and consumers.
Listed Closed-End Funds. Listed closed-end funds will be required to provide the disclosures described above under the new amendments semi-annually beginning with the Form N-CSR that covers the first six-month period that begins on or after January 1, 2024. Prior to the adoption of these amendments, listed closed-end funds were required to disclose semi-annually any company repurchases, aggregated on a monthly basis.

Considerations and Next Steps

Expect interpretive issues and (hopefully) guidance. The SEC noted that companies can continue to rely on the Commission Staff’s existing “Compliance and Disclosure Interpretations” addressing whether certain transactions are covered by the issuer repurchase disclosure rules. Thus, for example, a company’s acquisition of shares that are tendered to pay the exercise price of an employee stock option will continue to be a reportable repurchase, whereas withholding shares to pay taxes on the option exercise or upon vesting of restricted stock units will not be. Nevertheless, as with any new set of regulations, companies should expect a number of interpretive questions to arise. For example, while the instructions to the checkbox requirement state that companies generally can rely on Section 16 filings in determining whether they need to check the box, it is unclear whether transactions that are exempt from Section 16 reporting, such as dividend reinvestments and 401(k) plan transactions, trigger the checkbox requirement. While the Division of Corporation Finance has continued to express its willingness to address questions arising under its rules, guidance on recently adopted rules has been slow and sparse. Therefore, companies should closely review the new disclosure requirements in the near term and assess whether there are questions on how the rules apply to their own particular repurchase practices, so that the issues can be carefully vetted with in-house and outside counsel.

Companies will need to carefully consider and appropriately revise disclosures regarding the “objectives or rationales” for share repurchases. The SEC emphasized that a company’s discussion of its objective or rationales for repurchases should not be “boilerplate.” Indeed, the rules contemplate that different objectives or rationales could apply to different repurchases reported in the same quarterly report. For example, repurchases under equity compensation plans will have a different rationale than open-market repurchases designed to return excess capital to shareholders. Thus, it will be necessary for companies to tailor and adjust their disclosures from time to time as appropriate. In this regard, the SEC’s adopting release provides some examples of the types of topics that may be included in such disclosures, such as discussing how repurchases fit within the company’s capital allocation plans, whether repurchases were driven by a view that the company’s stock was undervalued, or addressing the source of funds for repurchases (such as whether proceeds from the disposition of a business unit were utilized to fund repurchases). We expect that for many companies with ongoing repurchase programs designed to return excess capital to investors, these “objectives or rationale” disclosures may not vary from quarter-to-quarter. Nevertheless, companies should establish disclosure controls to ensure that such disclosures are reviewed and confirmed or adjusted as appropriate each quarter. In addition, companies will want to ensure that comments by their executives on earnings calls and at other venues regarding the company’s share repurchases are consistent with the disclosures in their Forms 10-Q and 10-K.

Companies should document their processes for implementing share repurchases. The insider trading rule amendments adopted by the SEC in December 2022 require companies to file as exhibits to their Form 10-K any insider trading policies and procedures applicable to purchases and sales of the company’s securities by the company. While the SEC Staff has informally indicated that this insider trading policy exhibit requirement applies to calendar year companies starting with their 2024 Form 10-Ks, the new share repurchase rules require companies to disclose the “process or criteria used to determine the amount of repurchases” starting with calendar year companies’ 2023
Form 10-K. Companies should therefore bear in mind these separate but related disclosure requirements as they prepare to describe their processes around share repurchases.

Companies should consider whether to establish policies or procedures relating to the purchase or sale of shares by officers and directors during the time that a company’s repurchase program is active. Many companies with active and ongoing share repurchase programs do not preclude sales by executives and directors while the companies’ repurchases are ongoing. We believe allowing insider transactions in this context is entirely appropriate, and view the potential for abuse in these situations as largely theoretical. Moreover, compliance with Rule 10b-18, which is a safe harbor designed to prevent issuer repurchases from pushing up a company’s stock price, should provide additional comfort that same-day insider sales and company repurchases are not designed to benefit insiders, as should the use of Rule 10b5-1 trading plans. However, with the advent of trade-day reporting by companies, companies should expect that there will be greater scrutiny by the SEC, shareholders, and the press of insider sales and company repurchases that occur on the same day. Therefore, to the extent they do not already do so, companies should monitor and keep track of their insiders’ open market transactions, whether pursuant to Rule 10b5-1 plans or otherwise, so that they can evaluate the risks of corporate actions or significant announcements that might be viewed as questionable in hindsight. Companies also may want to consider whether to develop policies or procedures addressing potential appearance issues that could arise if they are effecting relatively isolated or unusually large repurchases (other than pursuant to a company’s Rule 10b5-1 buyback plan) on the same day as significant sales by insiders, particularly if those sales are effected by the CEO or by executives who might be expected to be involved in managing the company’s repurchase program, such as the CFO.

Exhibit: Tabular Disclosure Format

ISSUER PURCHASES OF EQUITY SECURITIES

Use the checkbox to indicate if any officer or director reporting pursuant to Section 16(a) of the Exchange Act (15 U.S.C. 78p(a)), or for foreign private issuers as defined by Rule 3b-4(c) (§ 240.3b-4(c) of this chapter), any director or member of senior management who would be identified pursuant to Item 1 of Form 20-F (§ 249.220f of this chapter), purchased or sold shares or other units of the class of the issuer’s equity securities that are registered pursuant to section 12 of the Exchange Act and subject of a publicly announced plan or program within four (4) business days before or after the issuer’s announcement of such repurchase plan or program or the announcement of an increase of an existing share repurchase plan or program.

(a) Execution Date	(b) Class of Shares (or Units)	(c) Total Number of Shares (or Units) Purchased	(d) Average Price per Share (or Unit)	(e) Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs	(f) Aggregate Maximum Number (or Approximate Dollar Value of Shares or Units) that May Yet Be Purchased Under the Publicly Announced Plans or Programs	(g) Total Number of Shares (or Units) Purchased on the Open Market	(h) Total Number of Shares (or Units) Purchased that are Intended to Qualify for the Safe Harbor in Rule 10b-18	(i) Total Number of Shares (or Units) Purchased Pursuant to a Plan that is Intended to Satisfy the Affirmative Defense Conditions of Rule 10b5-1(c)

[insert additional rows as necessary for each day on which a repurchase was executed]

Total:

The following Gibson Dunn attorneys assisted in preparing this update: Ronald O. Mueller, James J. Moloney, Maggie Valachovic, Nicholas Whetstone, and Chris Connelly.

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 of the firm’s Securities Regulation and Corporate Governance or Capital Markets practice groups:

Securities Regulation and Corporate Governance Group:
Elizabeth Ising – Washington, D.C. (+1 202-955-8287, [email protected])
James J. Moloney – Orange County, CA (+1 949-451-4343, [email protected])
Lori Zyskowski – New York, NY (+1 212-351-2309, [email protected])
Brian J. Lane – Washington, D.C. (+1 202-887-3646, [email protected])
Ronald O. Mueller – Washington, D.C. (+1 202-955-8671, [email protected])
Thomas J. Kim – Washington, D.C. (+1 202-887-3550, [email protected])
Michael A. Titera – Orange County, CA (+1 949-451-4365, [email protected])
Aaron Briggs – San Francisco, CA (+1 415-393-8297, [email protected])
Julia Lapitskaya – New York, NY (+1 212-351-2354, [email protected])

Capital Markets Group:
Andrew L. Fabens – New York (+1 212-351-4034, [email protected])
Hillary H. Holmes – Houston (+1 346-718-6602, [email protected])
Stewart L. McDowell – San Francisco (+1 415-393-8322, [email protected])
Peter W. Wardle – Los Angeles (+1 213-229-7242, [email protected])

In 2022, Gibson Dunn lawyers devoted 138,000 hours to a wide range of pro bono projects, from assisting refugees, to defending the right to protest, to advising nonprofits and small business. Our pro bono practice is foundational to who we are as a firm, and we encourage our lawyers to pursue cases and causes that are important to them.

We are proud to share more about the vital work of our pro bono practice in our 2022 Pro Bono Report.

On May 1, 2023, Los Angeles’s single-use plastics ordinance went into effect for most restaurants and food facilities in unincorporated areas of Los Angeles.[1] This ordinance, passed in 2022, requires that all single-use food-service containers, cups, dishes, and cutlery used by restaurants and other food facilities be recyclable or compostable.[2]

The ordinance aims to cut down on single-use plastics in three ways. First, the ordinance bans single-use food service items such as utensils, plates, and cups that are not compostable or recyclable.[3] Second, the ordinance bans the use of “expanded polystyrene” foam (Styrofoam) products.[4] Third, the ordinance requires that sit-down restaurants provide guests with reusable dishes and silverware.[5] Single-use utensils may still be offered in conjunction with food delivery services, but only if a customer affirmatively chooses to request utensils in their order. Third-party delivery platforms are required to establish separate choices related to single-use utensils.[6]

Violations are deemed a public nuisance, and violators may be fined up to a maximum of $100 per day, to a maximum of $1,000 per year; the ordinance also allows for civil actions seeking injunctive relief as well as civil penalties of up to $1,000 for each day of the violation.[7] Given these potential penalties, the ordinance is taking effect in phases. While it goes into effect today for restaurants, it will go into effect for food trucks on November 1, 2023, and it will take effect on May 1, 2024 for temporary food facilities, such as farmers’ markets.[8]

Although this ordinance is limited in scope, clients should be aware that similar local ordinances and state laws are in effect or being contemplated elsewhere. For example, San Mateo and Marin County both passed similar legislation in recent years.[9] Additionally, California passed state-wide legislation last year to reduce single-use plastic. This law requires that 30% of plastic items sold or bought be recyclable by 2028.[10] Earlier this year, England passed a law banning a range of single-use plastics, including plates, cutlery, and food containers. That law will go into effect in October.[11] Clients may want to consider innovations that they can make in light of the increase in ordinances and laws like these.

__________________________

[1] Los Angeles County, Cal. Ordinance 12.86.015(G) (2022).

[2] See generally id. 12.86.

[3] Id. 12.86.015(A).

[4] Id. 12.86.050.

[5] Id. 12.86.040.

[6] Id. 12.86.025.

[7] Id. 12.86.090, 12.86.100.

[8] Id. 12.86.015(G).

[9] San Mateo County, Cal. Ordinance 4.107 (2022); Marin County, Cal. Ordinance 7.25 (2022).

[10] Cal. Pub. Res. Code § 14547.

[11] GOV.UK, Far-reaching ban on single-use plastics in England (Jan. 14, 2023), available at https://www.gov.uk/government/news/far-reaching-ban-on-single-use-plastics-in-england.

The following Gibson Dunn lawyers prepared this client update: Abbey J. Hudson, Perlette M. Jura, Emily Riff, and Al Kelly.

Environmental, Social and Governance (ESG) Group:
Susy Bullock – London (+44 (0) 20 7071 4283, [email protected])
Abbey Hudson – Los Angeles (+1 213-229-7954, [email protected])
Elizabeth Ising – Washington, D.C. (+1 202-955-8287, [email protected])
Perlette M. Jura – Los Angeles (+1 213-229-7121, [email protected])
Ronald Kirk – Dallas (+1 214-698-3295, [email protected])
Michael K. Murphy – Washington, D.C. (+1 202-955-8238, [email protected])
Selina S. Sagayam – London (+44 (0) 20 7071 4263, [email protected])

This edition of Gibson Dunn’s Federal Circuit Update summarizes the current status of several petitions pending before the Supreme Court, addresses a proceeding by the Judicial Council of the Federal Circuit, and summarizes recent Federal Circuit decisions concerning indefiniteness, inherency, obviousness, enablement, and patent-eligibility.

Federal Circuit News

Supreme Court:

As we summarized in our March 2023 update, on March 27, 2023, the United States Supreme Court heard oral argument in Amgen Inc. v. Sanofi (U.S. No. 21-757) on enablement under 35 U.S.C. § 112. A decision in this case is expected by the end of June.

Noteworthy Petitions for a Writ of Certiorari:

This month, there is a new potentially impactful petition pending before the Supreme Court:

NST Global, LLC v. Sig Sauer Inc. (US No. 22-1001): The petition raises questions regarding whether the Patent Trial and Appeal Board’s (“Board’s”) decision to sua sponte construe a patent’s preambles as limiting violates certain statutory and constitutional rights of the patentee, and whether the Federal Circuit’s practice of Federal Circuit Rule 36, which provides for summary affirmance without opinion, violates “constitutional guarantees, statutory protections under 35 U.S.C. § 144, and undermines public trust in the judicial system.” The response is due on May 15, 2023.

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

The Court is considering petitions in Avery Dennison Corp. v. ADASA, Inc. (US No. 22-822), Nike, Inc. v. Adidas AG et al. (US No. 22-927), and Ingenio, Inc. v. Click-to-Call Technologies, LP (US No. 22-873). After the respondents in these cases waived their right to file a response, the Court requested responses in all three cases. The responses are due May 2, 2023, May 18, 2023, and May 26, 2023, respectively.

The petitions in Arthrex, Inc. v. Smith & Nephew, Inc. (US No. 22-639), Interactive Wearables, LLC v. Polar Electro Oy (US No. 21-1281), and Tropp v. Travel Sentry, Inc. (US No. 22-22) are still pending. In Arthrex, a response was filed on April 12, 2023, and a reply was filed on April 28, 2023. The Solicitor General submitted its views in Interactive Wearables and Tropp, and the Court will consider these petitions during its May 11, 2023 conference.

The Court denied the petitions in Thaler v. Vidal (US No. 22-919) and Novartis Pharmaceuticals Corp. v. HEC Pharm Co., Ltd. (US No. 22-671).

Other Federal Circuit News:

Judicial Council of the Federal Circuit Proceeding. On April 14, 2023, the Judicial Council of the Federal Circuit released a statement confirming that a proceeding under the Judicial Conduct and Disability Act and the implementing Rules had been initiated naming Judge Pauline Newman as the subject judge. The full statement may be found here.

Upcoming Oral Argument Calendar

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

Key Case Summaries (April 2023)

Ironburg Inventions Ltd. v. Valve Corp., Nos. 21-2296, 21-2297, 22-1070 (Fed. Cir. Apr. 3, 2023): Ironburg sued Valve for infringing its video game controller patent. The case was tried before a jury over Zoom, and the jury returned a verdict finding that Valve willfully infringed certain claims of Ironburg’s patent. On appeal, Valve argued that the district court erred in concluding that the “elongate member” and “substantially the full distance between the top edge and the bottom edge” were not indefinite.

The majority (Stark, J., joined by Lourie, J.) affirmed on the indefiniteness issues and vacated and remanded on another issue. The majority reasoned that “elongate member,” which means a member that is longer than it is wide, was not indefinite even though it lacked objective guidance as to “how much longer than wider the member must be.” Despite the lack of “numerical precision,” the specification disclosed that the purpose of the elongate shape was to provide users of varying hand sizes the ability to engage the paddles in a comfortable position. The majority therefore concluded that a person of skill in the art could ascertain with reasonable certainty the scope of the claims. For similar reasons, the majority concluded that “substantially the full distance between the top edge and the bottom edge” was not indefinite.

Judge Clevenger dissented. In his view, an ordinary artisan “desiring to produce a non-infringing handheld controller” would need to know “where along the top edge to start the measurement, and where along the bottom edge to complete the measurement” to ascertain the “full distance” as recited in the claims. While the specification provides guidance for the top edge, because that is where the controls are mounted, there is no guidance for the bottom edge.

Arbutus Biopharma Corporation v. Modernatx, Inc., No. 20-1183 (Fed. Cir. Apr. 11, 2023): The Board determined that Arbutus’s U.S. Patent No. 9,404,127 directed to stable nucleic acid-lipid particles (“SNALP”) that have a non-lamellar structure and related methods was anticipated by another Arbutus patent, U.S. Patent No. 8,058,069. In particular, the Board found that the limitation reciting a non-lamellar morphology (the “morphology limitation”) is inherently disclosed by the ‘069 patent as a consequence of the composition of the disclosed SNALP and the method used to produce it.

The Federal Circuit (Reyna, J., joined by Schall and Chen, JJ.) affirmed. Because there was no dispute that the ‘069 patent did not explicitly teach the morphology limitation, the Court focused on whether the limitation was inherently disclosed and found no error in the Board’s conclusion that it was. In doing so, the Court rejected Arbutus’s argument that there is only a “probability” that the morphology limitation would result from controlling several variations of formulations and processes. Instead, it found that there are a “limited number of tools”—five formulations and two processes—that a person skilled in the art would follow that would result in a composition with the “inherent morphological property.”

Sanderling Management Ltd. v. Snap Inc., No. 21-2173 (Fed. Cir. Apr. 12, 2023): Sanderling sued Snap for infringing a patent directed to a method for distribution of dynamic digital promotional content. The district court granted Snap’s motion to dismiss because the patent claimed patent-ineligible subject matter under 35 U.S.C. § 101.

The Federal Circuit (Stark, J., joined by Chen and Cunningham, JJ.) affirmed. The Court concluded that the district court did not err by resolving the motion to dismiss without first undertaking claim construction. “If claims are directed to ineligible (or eligible) subject matter under all plausible constructions, then the court need not engage in claim construction before resolving a Section 101 motion.” The Court agreed with the district court that the claims were directed to the abstract idea “‘of providing information—in this case, a processing function—based on meeting a condition,’ e.g., matching a GPS location indication with a geographic location,” with no inventive concept.

UCB, Inc. v. Actavis Labs. UT, Inc., No. 21-1924 (Fed. Cir. Apr. 12, 2023): UCB developed and marketed Nuepro^®, a transdermal rotigotine patch to treat Parkinson’s. Nuepro^® used a drug-to-stabilizer ratio of 9:2, within the range of 9:1.5 to 9:5 claimed in UCB’s initial Nuepro^® patents. But in commercialization, the 9:2 ratio proved unstable. UCB reformulated to a ratio of 9:4 and was granted U.S. Patent No. 10,130,589, which claimed a range of 9:4 to 9:6. UCB then asserted the ‘589 patent in a Hatch-Waxman action against Actavis. Third Circuit Judge Kent Jordan, sitting as the trial judge by designation, held the asserted claims of the ‘589 patent to be invalid as anticipated and obvious over UCB’s earlier patents, which disclosed an overlapping range.

The Federal Circuit (Stoll, J., joined by Moore, C.J., and Chen, J.) affirmed on obviousness grounds only. The Court noted that UCB’s prior patents did not expressly disclose “a point” within the claimed range of 9:1.5 to 9:5 that fell within the newly claimed range of 9:4 to 9:6. As the Court explained, the disclosure of a range does not disclose points within the range. Nor is it sufficient that a skilled artisan might readily “envisage” points within the range. Instead, an overlapping range anticipates only if it describes the claimed range with “sufficient specificity” such that “there is no reasonable difference in how the invention operates over the ranges.” The Court thus determined that the district court misapplied the law on anticipation. But, as the Court noted, it need not resolve the issue of anticipation because an overlapping range creates a “presumption of obviousness,” and because the patentee failed to rebut that presumption, the Court upheld invalidity on that basis.

FS.com Inc. v. International Trade Commission (No. 22-1228) (Fed. Cir. Apr. 20, 2023): Corning filed a complaint with the International Trade Commission (“ITC”) alleging that FS was violating 19 U.S.C. § 1337 (“Section 337”) by importing high-density fiber optic equipment (commonly used in data centers) that infringed four of Corning’s patents. The administrative law judge (“ALJ”) determined FS violated Section 337 finding, in part, that certain claims were infringed, and rejecting FS’s invalidity challenges, including that certain claims were not enabled. The ITC declined to review the ALJ’s enablement determination and adopted the ALJ’s analysis.

The Federal Circuit (Moore, C.J., joined by Prost and Hughes, JJ.) affirmed. The claims at issue recited a fiber optic density of “at least” 98 or 144 fiber optic connections per U space. FS argued that these open-ended density ranges were not enabled because the specification only enables up to 144 fiber optic connections per U space and that the ITC erred in concluding that some inherent upper limit exists. The Court determined that the ITC properly construed these claims as covering only connection densities up to about 144 connections per U space in light of the specification and expert testimony that densities substantially above that were technologically infeasible.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the Federal Circuit. Please contact the Gibson Dunn lawyer with whom you usually work or the authors of this update:

Blaine H. Evanson – Orange County (+1 949-451-3805, [email protected])
Audrey Yang – Dallas (+1 214-698-3215, [email protected])

Please also feel free to contact any of the following practice group co-chairs or any member of the firm’s Appellate and Constitutional Law or Intellectual Property practice groups:

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, jpoon@gibsondunn.com)

Intellectual Property Group:
Kate Dominguez – New York (+1 212-351-2338, [email protected])
Y. Ernest Hsin – San Francisco (+1 415-393-8224, [email protected])
Josh Krevitt – New York (+1 212-351-4000, [email protected])
Jane M. Love, Ph.D. – New York (+1 212-351-3922, [email protected])

Gibson Dunn’s Public Policy Practice Group is closely monitoring developments regarding the infrastructure permitting debate in Congress. We offer this alert summarizing and analyzing the U.S. Senate Environment and Public Works Committee’s hearing on April 26, 2023 to help our clients prepare for potential changes in infrastructure permitting and environmental authorization laws. We are also available to help our clients arrange meetings on Capitol Hill to discuss permitting reform proposals or to share real-world examples of how the permitting process has affected them.

* * *

On April 26, 2023, the U.S. Senate Committee on Environment and Public Works (the “Committee”) held a hearing addressing the need to improve the federal infrastructure permitting process. During the hearing, witnesses testified on the necessity of various changes to the current permitting process, focusing on energy projects. Witnesses included:

Christy Goldfuss, Chief Policy Impact Officer, National Resource Defense Council (“NRDC”)
Dana Johnson, Senior Director of Strategy and Federal Policy, WE ACT
Christina Hayes, Executive Director, Americans for a Clean Energy Grid
Jay Timmons, President & CEO, National Association of Manufacturers
Marty Durbin, Senior Vice President of Policy, U.S. Chamber of Commerce

The majority of senators who spoke at the hearing expressed interest in finding a bipartisan compromise on permitting reform. Chairman Tom Carper (D-DE) highlighted recent legislation that has increased the need for permitting reform—especially the Infrastructure Investment and Jobs Act (also known as the Bipartisan Infrastructure Law); the Inflation Reduction Act; and the CHIPS and Science for America Act. Those three laws directed billions of taxpayer dollars to developing infrastructure projects across the United States, many of which must obtain federal permits.

We provide a full hearing summary and analysis below. Of particular interest to clients, however:

Chairman Carper set out three main goals he said any bipartisan permitting reform package must meet. It must (1) result in lower emissions and protect bedrock environmental laws; (2) support early and meaningful community engagement, especially for projects that affect historically disadvantaged communities; and (3) provide businesses—in particular, clean energy businesses—with certainty and unlock economic growth across the country.
Ranking Member Shelley Moore Capito (R-WV) emphasized the need for permitting reform to proceed through regular order (i.e., for it to go through the committee process rather than developed by an informal “gang”).
Both Chairman Carper and Ranking Member Capito commented on the importance of real-world examples to convey the need for permitting reform to the American public.
All members agreed that improving front-end community engagement is crucial for any permitting reform package.

Key substantive issues surrounding permitting reform raised in the hearing include: (1) the effectiveness of the FAST-41 permitting reforms; (2) the need for early planning and community engagement; (3) the scope of permitting reform; (4) enforceable timelines and regulatory clarity; (5) litigation; (6) critical minerals and microchip manufacturing; and (7) agency funding.

Effectiveness of FAST-41 Permitting Reforms

In his opening statement, Chairman Carper praised the effectiveness of the FAST-41 program, which created the Federal Permitting Improvement Steering Council (“FPISC” or “Permitting Council”) and provides an agency coordination process for facilitating the permitting process for some of the largest infrastructure projects. He noted that from 2010 to 2018, on average, it took 4.5 years to create a project’s environmental impact statement, but for FAST-41 projects, it took only 2.5 years. Chairman Carper’s support for the FAST-41 framework suggests he may be open to permitting reforms that rely on a similar framework that provide for increased agency communication, coordination, and transparency. Note, too, that Senator Manchin’s 2022 permitting bill heavily drew from the FAST-41 framework.

Similarly, Senator Pete Ricketts (R-NE) suggested that the federal permitting agencies should employ the Lean Six Sigma managerial process, which aims to reduce waste and inefficiencies. He observed that the Lean Six Sigma process cut the timeline for one type of permit in Nebraska from 190 days to 65 days over the course of one year without loosening environmental restrictions. Ms. Goldfuss observed that the FAST-41 process includes some of those same principles, such as the designation of a lead agency to engage with a project proponent and a public, online dashboard that offers transparency into the permitting process for individual projects.

Need for Early Planning and Community Engagement

Senators and witnesses alike agreed that early planning and community engagement is crucial for improving the permitting process. For example, Ms. Goldfuss commented that project sponsors and the government should work together to plan and site development in ways that minimize impact before permitting begins. She also encouraged the federal government to partner with state agencies to share data, mitigation options, and guidance, and she advocated for the federal government to use Inflation Reduction Act funds to help states with planning and permitting.

Likewise, Ms. Johnson advocated for early and ongoing communication during the project planning process. She suggested undertaking community engagement with a neutral party facilitating the conversation and making the comment process more accessible for people who do not have access to computers or who cannot attend public hearings.

Ms. Hayes also endorsed early and meaningful communication with communities and suggested that project sponsors should provide community benefits and revenue sharing. In his opening, Chairman Carper commended a West Virginia project for providing grants for communities surrounding a turbine wind farm and ensuring that construction jobs went to the local labor force.

Senator Ben Cardin (D-MD) expressed concern that rushing permitting processes will prevent community participation. Ms. Johnson responded that Congress cannot prioritize speed over quality and suggested frontloading the engagement process before work on an environmental impact statement or environmental assessment begins.

Scope of Permitting Reform

One of the clear divides between Republicans and Democrats is the scope of permitting reform—both regarding the types of projects such reforms will help and the reforms themselves.

Regarding the types of projects, throughout the hearing, Democrats focused on the need for increased energy transmission and green energy infrastructure. Ranking Member Capito, however, emphasized permitting reform needs to help all infrastructure projects, “not just a small subset that are politically favorable to one group or another.” Other Republicans echoed this sentiment. Mr. Durbin expressed the need for permitting reform to support natural gas development, including interstate pipelines, as well as critical mineral mining and broadband expansion.

Regarding reforms themselves, Ranking Member Capito argued that to make substantive change, Congress will have to amend the underlying environmental statutes, including the Clean Water Act, Clean Air Act, and the National Environment Policy Act (“NEPA”). Senator Kevin Cramer (R-ND) also endorsed amending the environmental statutes.

On the other hand, Ms. Goldfuss contended that “NEPA is not the problem.” She said that instead of focusing on NEPA reforms, agencies should be encouraged to make greater use of programmatic environmental impact statements using a “design one, build many” model. Regarding transmission lines, she argued that the Federal Energy Regulatory Commission and the Department of Energy should move quickly to designate national interest corridors.

Enforceable Timelines and Regulatory Clarity

Ranking Member Capito stated that there need to be “enforceable timelines with clear time limits and predictable schedules for environmental reviews and consequences for when agencies fail to act in a timely fashion.” Mr. Timmons echoed her concern for enforceable timetables in his opening statement, particularly for hydrogen, natural gas, and nuclear infrastructure.

Mr. Timmons also argued that the Environmental Protection Agency and other agencies should refrain from issuing new or shifting regulations and that Congress should hold the federal government accountable for implementing the congressional intent of the One Federal Decision effort, enacted as part of the IIJA.

Litigation

Senator Dan Sullivan (R-AK) expressed concern that litigation is unnecessarily hampering energy projects. Mr. Durbin responded that litigation against natural gas pipelines increases costs for manufacturers and consumers. He emphasized that natural gas is part of the clean energy economy, but litigation affects its reliability and affordability. Mr. Timmons argued that judicial review should be “meaningful and timely.”

In response to questioning from Senator Jeff Merkley (D-OR), Ms. Goldfuss acknowledged that the NRDC opposed Senator Manchin’s permitting proposal last Congress, in part because of the limited timeline for judicial review for certain projects.

Critical Minerals and Microchip Manufacturing

Several senators and witnesses discussed the need to improve the permitting process for mining critical minerals given the national security concerns associated with China manufacturing and processing 80 percent of the critical minerals used in modern technology.

Senator Mark Kelly (D-AZ) expressed his interest in permitting reform to help accelerate microchip manufacturing in the United States. He noted that application of the NEPA process to CHIPS Act funding recipients may unnecessarily delay meeting the national security goal of onshoring chips manufacturing. Mr. Durbin argued that all projects need to have environmental review and community input, but Congress needs to make sure the process is functional and that decisions can be made quickly to advance the CHIPS Act goals.

Agency Funding

Senators Merkley and Ed Markey (D-MA) argued that the real cause of permitting delays is underfunding of federal agencies. Senator Markey suggested that Congress should wait to see the impact of the recently passed Inflation Reduction Act’s allocation of $1 billion to agencies before making any further reforms to the permitting process.

* * *

Senior members of Gibson Dunn’s Public Policy Practice Group have more than 40 years of combined experience on Capitol Hill. Our team includes former congressional staff and Administration officials who have significant experience tracking, developing, and implementing infrastructure permitting reform legislation and regulations. We also have strong working relationships with key members of Congress and Biden administration officials focused on federal permitting reform.

Our team is available to assist clients through strategic counseling; real-time intelligence gathering on federal permitting reform legislation; developing and advancing policy positions; drafting legislative text; shaping messaging; and lobbying Congress. We also work with clients to craft regulatory comment letters; advocate before executive branch agencies; and navigate legislative and regulatory changes to federal infrastructure permitting laws.

The following Gibson Dunn lawyers assisted in preparing this alert: Michael D. Bopp, Roscoe Jones Jr., David Fotouhi, Amanda Neely, Daniel P. Smith, and Miguel Mauricio.*

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 in the firm’s Public Policy or Environmental Litigation and Mass Tort practice groups, or the following authors:

Michael D. Bopp – Co-Chair, Public Policy Group, Washington, D.C. (+1 202-955-8256, [email protected])

Roscoe Jones, Jr. – Co-Chair, Public Policy Group, Washington, D.C. (+1 202-887-3530, [email protected])

David Fotouhi – Washington, D.C. (+1 202-955-8502, [email protected])

Amanda H. Neely – Washington, D.C. (+1 202-777-9566, [email protected])

Daniel P. Smith – Washington, D.C. (+1 202-777-9549, [email protected])

*Miguel Mauricio is a recent law graduate working in the firm’s San Francisco office who is not admitted to practice law.

On April 21, 2023, the Financial Stability Oversight Council (“FSOC”) proposed several changes to how the agency would designate nonbank financial companies as systemically important financial institutions (“SIFIs”), thereby subjecting them to supervision by the Federal Reserve and additional regulations. In the first of two proposed “interpretive guidance“ documents, FSOC would “revise and update” its 2019 Interpretive Guidance on several fronts, with the expressed goal of eliminating “hurdles” to FSOC’s ability to designate nonbank financial companies as systemically important. In the second proposed interpretive guidance document, FSOC sets forth an “analytic framework” that it would employ when assessing a company’s “potential risk or threat to U.S. financial stability,” and accordingly whether to designate the company as systemically important. FSOC has also issued factsheets for the first and second proposed interpretive guidances.

These new documents (together, the “Proposed Guidance”), if finalized, would implement several key changes to FSOC’s current Interpretive Guidance. Under the current Guidance, adopted in 2019, FSOC employed an “activities-based approach” to assess risk and would designate individual entities as SIFIs only as a “last resort.” The Proposed Guidance would eliminate any requirement to use an activities-based approach before designating individual entities. The Proposed Guidance would also remove any obligation that FSOC consider a company’s likelihood of material financial distress before designating that company. Finally, the Proposed Guidance eliminates any requirement that FSOC conduct a cost-benefit analysis before designating companies as SIFIs. These changes would expand FSOC’s ability to designate nonbank financial companies as SIFIs, and thus to subject them to additional regulation.

Below, we provide background information on FSOC’s designation process; Gibson Dunn’s challenge to FSOC’s designation of MetLife; the key changes that the Proposed Guidance would implement; the likely implications of those changes; and, finally, the steps to be taken now by concerned parties.

I. Background of FSOC’s Designation Process

Title I of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) established FSOC and gave it the power to designate a nonbank financial company as a SIFI, meaning that FSOC has determined that material financial distress at the company, or the company’s nature, scope, size, scale, concentration, interconnectedness, or mix of activities, could pose a threat to U.S. financial stability. 12 U.S.C. § 5323(a)(1). This designation imposes on the designated nonbank financial company Federal Reserve examination, supervision, and enforcement authority, as well as enhanced prudential standards—including heightened capital and liquidity requirements, leverage limits, resolution planning, concentration limits, and stress testing and early remediation requirements. Id.

In 2012, FSOC promulgated guidance describing the manner in which the agency would make designation determinations. This guidance provided, for example, that FSOC would assess the company’s vulnerability to material financial distress before addressing the effect of that potential distress, and that the agency would assess the company’s threat to U.S. financial stability. See Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies, 77 Fed. Reg. 21,637, 21,653 (Apr. 11, 2012).

In FSOC’s thirteen years of existence, the agency has designated four nonbank financial companies as SIFIs: American International Group, Inc.; General Electric Capital Corporation; Prudential Financial, Inc.; and MetLife, Inc. Only MetLife challenged its designation.

Represented by Gibson Dunn, MetLife brought suit in federal district court, which court ruled that FSOC’s designation of MetLife was arbitrary and capricious and ordered FSOC to rescind the designation. See MetLife, Inc. v. Fin. Stability Oversight Council, 177 F. Supp. 3d 219 (D.D.C. 2016). The district court first held that FSOC had violated its own rules by failing to consider whether MetLife was vulnerable to material financial distress, and whether hypothetical distress at MetLife would pose a threat to U.S. financial stability. Id. at 233–39. The district court also held that FSOC’s designation decision was arbitrary and capricious because it failed to consider the costs of designating MetLife. Id. at 239–42. FSOC appealed the decision to the D.C. Circuit, but then voluntarily dismissed its appeal. See MetLife, Inc. v. Fin. Stability Oversight Council, No. 16-5086, 2018 WL 1052618, at *1 (D.C. Cir. Jan. 23, 2018). On remand, the district court denied a motion to vacate the portion of its opinion that held FSOC was required to perform a cost-benefit analysis. See Order, MetLife, Inc. v. Fin. Stability Oversight Council, No. 1:15-cv-00045-RMC, Dkt. 129 (D.D.C. Feb. 28, 2018).

By 2018, FSOC had rescinded all of its prior designations. Then, in 2019, FSOC amended its regulations, adopting many of the positions that MetLife had presented in the litigation. See Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies, 84 Fed. Reg. 71,740 (Dec. 30, 2019). In particular, the agency adopted an activities-based approach to assessing potential risks to U.S. financial stability, which focuses on working with other federal and state financial regulators to identify and regulate particularly risky activities, and considers designating individual companies to be a last-resort option. FSOC also committed to performing cost-benefit analyses during its designation decisions, and to assessing the likelihood that the entity would actually experience material financial distress.

II. FSOC’s Proposed Guidance Changes

FSOC’s new Proposed Guidance would disavow many of the changes that FSOC made in its 2019 Interpretive Guidance in response to the MetLife decision. As noted above, three changes in the Proposed Guidance would prove especially important.

First, FSOC’s Proposed Guidance would abandon its activities-based approach to preventing material financial distress in the U.S. economy. Under that approach, FSOC monitors the economy and works with federal and state financial regulators to identify particular activities that could pose a risk to U.S. financial stability in certain contexts. Once they identify a risky activity, FSOC works with those regulatory bodies to address the identified potential risk, and considers designating a particular company to be a last resort. This approach enables regulators to promulgate consistent and predictable rules that govern a particular market as a whole, rather than singling out certain entities for unique treatment. The Proposed Guidance, however, would drop that approach in favor of more aggressively designating individual firms based on “non-exhaustive” risk factors contained in the new “analytic framework,” including leverage, liquidity risk and maturity mismatch, interconnections, operational risks, complexity or opacity, inadequate risk management, concentration, and destabilizing activities.

Second, the Proposed Guidance would eliminate any requirement that FSOC consider a company’s likelihood of material financial distress before designating that company as a SIFI. The Proposed Guidance suggests that inquiring into the likelihood of material financial distress is neither “required [n]or appropriate” because such distress can be difficult to recognize or predict. Accordingly, when evaluating future designations, FSOC would “presuppos[e]” that a company is experiencing material financial distress—irrespective “of the likelihood” of such distress in the real world—and assess the impact that this hypothetical distress might have on the broader economy.

Third, the Proposed Guidance would eliminate any requirement that FSOC conduct a cost-benefit analysis before designating a nonbank financial company as a SIFI, despite the district court’s ruling in MetLife that failure to conduct that analysis was arbitrary and capricious and violated the Supreme Court’s ruling in Michigan v. EPA, 576 U.S. 743 (2015), which had held that when a statute allows an agency to regulate when “appropriate,” the agency must consider the costs of its regulation. The Proposed Guidance posits that weighing the increased costs from regulatory burdens against the potential benefits of designation is not “useful or appropriate,” given difficulties in assessing costs and the “potentially enormous” benefits of designation in averting financial crises. It portrays its loss in the district court as having no legal significance on this point. See FSOC, Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies at 16 n.16 (Apr. 21, 2023).

III. Implications of the Proposed Guidance

The goal of the Proposed Guidance is to broaden—and accelerate—FSOC’s ability to identify and designate certain nonbank financial companies as SIFIs, and thus to subject them to additional and potentially onerous supervision, examination, and regulation. The retreat from an activities-based approach would also limit companies’ ability to know in advance what activities would risk designation, and thus to plan their future behavior. Recent statements by financial regulators suggest that the targets of FSOC’s proposed approach may include traditional nonbank financial companies (for instance, insurers, hedge funds, open-end funds, and money-market funds), along with more recent market entrants (such as stablecoin issuers and other FinTechs engaged in financial activities, including nonbank peer-to-peer payments companies).

The Proposed Guidance may be vulnerable to many of the same objections that prevailed in the MetLife litigation. For example, footnote 16 of the Proposed Guidance asserts that FSOC need not conduct any cost-benefit analysis because MetLife was wrongly decided and has no “preclusive effect.” But, as noted above, the district court rejected the government’s attempt, after it had dismissed its appeal, to vacate the cost-benefit portion of the court’s opinion. Moreover, the district court had explained that its cost-benefit decision was compelled by the Supreme Court’s decision in Michigan v. EPA. See MetLife, 177 F. Supp. 3d at 240 (citing Michigan, 576 U.S. at 752). FSOC remains bound by the Supreme Court’s Michigan decision and any designation that ignores cost-benefits considerations will be vulnerable to the same argument on which Gibson Dunn prevailed in MetLife.

Similarly, the district court held that the text of the Dodd-Frank Act itself mandates an inquiry into a company’s likelihood of material financial distress, see MetLife, 177 F. Supp. 3d at 241 (citing 12 U.S.C. § 5323(a)(2)(K))—the same inquiry that the Proposed Guidance now seeks to discard.

IV. Next Steps

FSOC’s Proposed Guidance is subject to public notice and comment for 60 days following publication of the Proposed Guidance in the Federal Register. Incisive comments may have an effect on the substance of the final documents, and may also form the basis for any future court challenges to FSOC’s final guidance and to any nonbank financial company’s potential designation.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please feel free to contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Administrative Law and Regulatory, Financial Institutions, or FinTech and Digital Assets practice groups, or the following authors:

Eugene Scalia – Washington, D.C. (+1 202-955-8673, [email protected])
Ashlie Beringer – Palo Alto (+1 650-849-5327, [email protected])
M. Kendall Day – Washington, D.C. (+1 202-955-8220, [email protected])
Stephanie L. Brooker – Washington, D.C. (+1 202-887-3502, [email protected])
Amir C. Tayrani – Washington, D.C. (+1 202.887.3692, [email protected])
Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, [email protected])
Jason J. Cabral – New York (+1 212-351-6267, [email protected])
Lochlan F. Shelfer – Washington, D.C. (+1 202-887-3641, [email protected])

On April 6, 2023, President Biden signed an executive order entitled “Modernizing Regulatory Review” (the “Order”). The Order makes a number of significant changes to the process by which the White House Office of Information and Regulatory Affairs (“OIRA”) reviews significant regulatory measures. Under executive orders issued by previous presidents, all “significant regulatory actions” are subject to OIRA review, and agencies must perform a cost-benefit analysis of the action before it is undertaken. President Biden’s new Order narrows the definition of what constitutes a “significant regulatory action,” including by doubling the monetary threshold of annual effects on the national economy (raising it from $100 million to $200 million) and adjusting the threshold based on changes in Gross Domestic Product going forward.

The Order also directs the White House Office of Management and Budget (“OMB”) to propose revisions to OMB Circular A-4, which is the primary guidance document governing how executive branch agencies conduct cost-benefit analyses. On April 6, OMB issued its proposed revisions. They include changes to –

lower discount rates that convert future costs and benefits into current dollars;
provide greater weight to the distributional effects of a regulatory action; and
encourage the assessment of even highly uncertain effects of regulatory action.

If finalized, OMB’s proposed revisions would represent the most significant change to how agencies conduct cost-benefit analysis since Circular A-4 was first issued in 2003. In combination with the changes effected by the Order, OMB’s proposal would likely lead to more and faster regulatory action, by, for instance, reducing OIRA oversight and relieving agencies of their obligation to prepare cost benefit analyses for certain regulatory measures. Similarly, many of OMB’s changes could result in agencies more frequently concluding that a regulatory measure is cost-justified. For example, because the costs of new regulations are often incurred in the near-term, while the benefits often accumulate more gradually over longer periods of time, the lower discount rates OMB proposes may mean that agencies will be more likely to find that the benefits of a regulatory action outweigh its costs. This is particularly true for regulations that address longer term phenomena, such as climate change, which is an example OMB discusses in its proposal.

OMB’s proposed changes could also lead to greater litigation vulnerability for certain regulatory measures. In particular, a court may be more likely to find an action arbitrary and capricious if it is based on highly uncertain benefit assessments that are identified by commenters during the notice and comment process. Some of OMB’s revisions to how costs and benefits are weighed could create opportunities for commenters to challenge agencies’ analyses.

By its terms, the Order only applies to “executive departments and agencies.” Independent agencies, such as the FTC, SEC, and FCC, are apparently not covered. That makes sense because they are not subject to the regulatory review process that President Biden’s Order is modifying. Independent agencies will thus be largely unaffected by many of the changes the Order is introducing. However, in some instances, independent agencies voluntarily follow the guidance set forth in Circular A-4, or otherwise interact with OIRA regarding cost-benefit analyses, as in connection with the Congressional Review Act. To the extent independent agencies follow the guidance in Circular A-4, their regulatory analyses may therefore be affected by the proposed changes.

Interested parties have until June 6 to submit comments on OMB’s proposed changes to Circular A-4.

Gibson Dunn lawyers are available to assist in addressing any questions you may have about these developments. Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Administrative Law and Regulatory Practice or Public Policy groups, or the following authors in Washington, D.C.:

Eugene Scalia (+202-955-8210, [email protected])

Helgi Walker (+202-887-3599, [email protected])

Michael Bopp (+202-955-8256, [email protected])

Blake Lanning (+202-887-3794, [email protected])

We are pleased to provide you with Gibson Dunn’s Accounting Firm Quarterly Update for Q4 2022. The Update is available in .pdf format at the below link, and addresses news on the following topics that we hope are of interest to you:

PCAOB Announces New Enforcement Director
PCAOB Advisory Group Meeting Suggests Topics of Regulatory Interest
PCAOB Releases 2022 Annual Report
PCAOB and U.S. Senators Raise Questions About Crypto “Proof of Reserves” Reports
PCAOB Sued as Unconstitutional by John Doe Plaintiff
SEC Files Petition for Certiorari in SEC v. Jarkesy
CPAB Brings Rare Enforcement Action Against U.S. Firm
House Signals More SEC Oversight
Ninth Circuit and Ohio Supreme Court Issue Rulings of Interest on Employment Arbitration Agreements and Ransomware Attack Insurance
NLRB Issues Decision on Enforceability of Severance Agreement Provisions
SDNY Criminal Motion Alleges Conflict in Representing Both Company and Employee
Other Recent SEC and PCAOB Regulatory Developments

Read More

Accounting Firm Advisory and Defense Group:

James J. Farrell – Co-Chair, New York (+1 212-351-5326, [email protected])

Ron Hauben – Co-Chair, New York (+1 212-351-6293, [email protected])

Monica K. Loseman – Co-Chair, Denver (+1 303-298-5784, [email protected])

Michael Scanlon – Co-Chair, Washington, D.C.(+1 202-887-3668, [email protected])

Mass arbitration is a growing phenomenon in which thousands of plaintiffs—often consumers, employees, or independent contractors—bring arbitration demands against a company at the same time. Pursuing arbitrations in this manner can impose significant, even crippling, costs on companies, particularly in light of the hefty filing fees that many arbitration providers charge. Many companies, however, have deployed successful strategies for deterring and defending against mass arbitrations, primarily through the careful drafting of their arbitration agreements. This webcast describes some of these strategies, as well as recent developments in the law affecting mass arbitrations and the ethical concerns surrounding this issue.

PANELISTS:

Dhananjay (DJ) Manthripragada is a partner in the Los Angeles and Washington, D.C. offices of Gibson, Dunn & Crutcher. He is Chair of the firm’s Government Contracts practice group, and also a member of the Litigation, Class Actions, Labor & Employment, and Aerospace and Related Technologies practice groups. Mr. Manthripragada has a broad complex litigation practice, and has served as lead counsel in precedent setting litigation before several United States Courts of Appeals, District Courts in jurisdictions across the country, California state courts, the Court of Federal Claims, and the Federal Government Boards of Contract Appeals. He has first-chair trial experience and has successfully tried to verdict both jury and bench trials, and has served as lead counsel in arbitration and other alternative dispute resolution forums. His practice spans a wide range of industries, and he has represented some of the world’s leading aerospace and defense, logistics/transportation, high-technology, finance, and pharmaceutical companies in their most significant matters. Mr. Manthripragada is also highly regarded as a trusted advisor to clients regarding significant compliance/enforcement, contract, dispute resolution, and employment issues. He was recognized in The Best Lawyers in America® Ones to Watch in Commercial Litigation in 2021 and 2022.

Michael Holecek is a litigation partner in the Los Angeles office of Gibson, Dunn & Crutcher, where his practice focuses on complex commercial litigation, class actions, labor and employment law, and data privacy—both in the trial court and on appeal. Mr. Holecek has first-chair trial experience and has successfully tried to verdict both jury and bench trials, he has served as lead arbitration counsel, and he has presented oral argument in numerous appeals. Mr. Holecek has also authored articles on appellate procedure, civil discovery, corporate appraisal actions, data privacy, and bad-faith insurance litigation.

Jesenka Mrdjenovic is Of Counsel in Gibson, Dunn & Crutcher’s Washington, D.C. office, where she practices in the firm’s Litigation Department. Ms. Mrdjenovic represents clients in complex litigation and appellate matters, with a particular focus on class action defense. She has represented clients at the trial and appellate levels in matters involving constitutional, employment, intellectual property, consumer protection, and antitrust law. Ms. Mrdjenovic previously served as senior counsel for one of the nation’s largest mortgage lenders and Chief Litigation Officer to a holding company connecting more than 100 portfolio entities in a broad range of industries. In her role as an in-house attorney, Ms. Mrdjenovic managed complex litigation matters and advised senior management on a variety of legal, contract, and regulatory issues.

MCLE CREDIT INFORMATION:

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

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

Gibson, Dunn & Crutcher LLP is authorized by the Solicitors Regulation Authority to provide in-house CPD training. This program is approved for CPD credit in the amount of 1.0 hour. Regulated by the Solicitors Regulation Authority (Number 324652).

Neither the Connecticut Judicial Branch nor the Commission on Minimum Continuing Legal Education approve or accredit CLE providers or activities. It is the opinion of this provider that this activity qualifies for up to 1 hour toward your annual CLE requirement in Connecticut, including 0 hour(s) of ethics/professionalism.

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

The New York City Department of Consumer and Worker Protection, or DCWP, released final rules on April 6 regarding the city’s Local Law 144 and announced that it would begin enforcement on July 5.

Local Law 144 restricts employers and employment agencies from using an automated employment decision tool in hiring and promotion decisions unless it has been the subject of a bias audit by an “independent auditor” no more than one year prior to use. The law also imposes certain posting and notice requirements to applicants and employees subject to the use of AEDTs.

The DCWP is vested with the authority to amend the Rules of the City of New York under the New York City Charter and New York City Administrative Code. As detailed below, the DCWP’s final rules make a number of noteworthy changes and attempt to clarify the law.

1. The rules attempt to clarify the scope of covered AEDTs.

Local Law 144 defines an AEDT as:

Any computational process, derived from machine learning, statistical modeling, data analytics, or artificial intelligence, that issues simplified output, including a score, classification, or recommendation, that is used to substantially assist or replace discretionary decision making for making employment decisions that impact natural persons.

The final rules seek to clarify two of the key phrases within this definition.

The final rules define “machine learning, statistical modeling, data analytics, or artificial intelligence” as a group of mathematical, computer-based techniques:

That generate a prediction, e.g., an assessment of a candidate’s fit or likelihood of success, or a classification, e.g., categorizing applicants based on skill sets or aptitude; and

For which a computer identifies, at least in part, the inputs and their relative importance and, if applicable, other parameters to improve the model’s predictive accuracy.

The phrase “to substantially assist or replace discretionary decision making” is defined as:

To rely solely on a simplified output (score, tag, classification, ranking, etc.), with no other factors considered; or
To use a simplified output as one of a set of criteria where the simplified output is weighted more than any other criterion in the set; or
To use a simplified output to overrule conclusions derived from other factors including human decision-making.

Notably, this definition appears to permit employers to use the AEDT without conducting a bias audit where an AEDT’s output falls outside the specified circumstances.

Local Law 144 provides several examples of tools outside the scope of covered AEDT, i.e., calculators, junk email filters and spreadsheets. The final rules, however, do not provide any further examples.

Read More

Reproduced with permission. Originally published by Law360, New York (April 19, 2023).

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 authors:

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

Danielle J. Moss – New York (+1 212-351-6338, [email protected])

Emily Maxim Lamm – Washington, D.C. (+1 202-955-8255, [email protected])

The Biden administration has been steadily evolving its views of national security risks and priorities—and what measures the executive branch will take to mitigate those risks. Last fall’s National Security Strategy called out critical technology and cybersecurity as key national security concerns. This focus sharpened with the release of the National Cybersecurity Strategy last month. And, most recently, the administration has submitted a $3.1 billion budget request for the Cybersecurity and Infrastructure Security Agency (CISA), a 22 percent increase from its request last year, to implement that strategy and fund other initiatives. While strategy is not policy, and budget proposals are not appropriations, these are strong signals of the shifting winds of the administration regarding the tools and incentives the administration will deploy to mitigate cybersecurity risks.

After years of relying on largely voluntary standards to encourage companies to harden their cybersecurity defenses, interspersed with incentives including funding and grants, the administration has definitively taken the position that it does not think companies have done enough. Accordingly, the new cybersecurity strategy calls for a heavier hand. Should the strategy be implemented, companies can expect to see direct liability, new regulations, and lawsuits from the federal government itself for companies that fail to make secure products, do not adopt minimum security measures, or misrepresent the actions they have taken. These new measures come as the administration is increasingly focused on strategic competition with China.

Below, we highlight the four main tools that companies should know about that the Biden Administration has vowed to use to secure critical infrastructure and industry from cyber threats.

1. Direct liability for software vendors. First, the Biden administration says that software companies and vendors should be directly liable for failing to adopt “reasonable” security measures into the programs used to power critical infrastructure and other areas. The administration said it has been unhappy with voluntary efforts to increase software security, which have made progress but has been inconsistent across industries. And, because the administration believes that software vendors and companies that control data are in the best position to address this liability, it said that they should bear responsibility for failing to adopt those reasonable measures and not their end users and infrastructure providers who will be impacted by those failures directly.

“We’re all walking around with unsafe technology. So we have to change the incentives,” CISA Director Jen Easterly told a House subcommittee recently as she sought funding for the federal government’s efforts. “We may need to look at certain liability for whether manufacturers have duty of care to be able to protect those consumers.”

The legislation the administration is contemplating to implement this liability would prohibit software terms of service from disclaiming all liability for security flaws, even if the flaw is from open-source software that has been integrated into the commercial project, and would also impose higher standards of care in high-risk areas.

2. New rulemaking and legislation to fill in regulatory gaps. Second, in addition to legislation on direct liability, the administration is planning new rulemaking and other legislation to close gaps in existing law that impose minimum security standards in a host of industries. In particular, cloud-based services are not all covered by existing regulations despite being integrated into systems across industries. These new regulations should be “performance-based,” the administration said, and modeled after voluntary frameworks from the National Institute of Standards and Technology (NIST) and CISA.

This comes in the wake of other rulemaking for such standards in the oil and gas pipeline, aviation, rail, and water sectors. And other legislative efforts have also advanced security measures, such as the Cyber Incident Reporting for Critical Infrastructure Act of 2022 (CIRCIA) that requires critical infrastructure providers to notify federal authorities about cybersecurity incidents. The administration is advancing rulemaking to implement CIRCIA as well, with CISA in the lead.

The administration seeks to pair these new requirements with new funding and financial incentives to speed compliance. While some companies can absorb these costs, others have low margins that make this difficult. Thus, in those areas, the administration is encouraging regulators to tilt incentives to reduce these costs, such as through favorable tax and rate-setting arrangements. Such arrangements would be on top of the funding that the government is already pouring into this area through the CHIPS and Science Act, the Inflation Reduction Act, and the Bipartisan Infrastructure Law. Further, the administration said it is exploring a government-backed support for the cyber insurance market to protect it in the event of a catastrophic event.

3. Government to lead the way—including as a plaintiff. Third, in all of these areas, the administration also signaled that it will itself set the bar for private industry to follow, such as by updating its own technology and through procurement processes to test new cybersecurity requirements, and will update its own technology using standards that it wants private industry to adopt as well. For example, the administration is prioritizing cryptography upgrades to public computer networks to be resistant to quantum-based efforts to compromise those networks. This is not just to secure the government’s own networks but also to set the bar that it expects the private sector to follow.

The administration has also signaled it will increase regulatory harmonization, make it easier for companies reporting an incident to connect with the appropriate officials quickly, modernize federal technology, and engage in research and development efforts. Given the increasing patchwork of notification requirements and various government equities in cyber incidents, such harmonization is critical to reducing the regulatory burden on companies—particularly during the high operational tempo of cyber incident response.

The federal government has indicated that it will continue to bring actions to enforce cybersecurity commitments. For example, the Department of Justice has already used the False Claims Act to pursue companies that allegedly misrepresent cybersecurity commitments in their federal contracts. And the Department of Justice has also launched a new nationwide “disruptive technology strike force” with the Commerce Department to coordinate efforts to respond to threats to critical infrastructure.

4. Shifting focus from criminal groups to state actors. Finally, the administration has signaled that the central threat that it has built its strategy around is from state actors. While criminal groups using ransomware to extract groups are still addressed by the administration’s strategy, it is the governments of China, Russia, Iran, and North Korea where the strategy is focused. The administration has highlighted the efforts of those state actors, and in particular China, to carry out cyber attacks and compromise vulnerable infrastructure. In an echo of the National Security Strategy, the cybersecurity strategy highlights that China “now presents the broadest, most active, and most persistent threat.” And also without naming China, the strategy notes that domestic networks should reduce their dependence “on critical foreign products and services from untrusted suppliers,” pointing to the longstanding controversy over China-based companies that supply hardware and equipment for U.S. computer networks.

The administration’s cybersecurity strategy further highlights the administration’s increased cross-border efforts to coordinate cybersecurity efforts with Australia, the United Kingdom and other European countries, India, Japan, and others.

In sum, the key takeaways for private industry in the administration’s cybersecurity strategy, as reinforced by budget priorities, are that companies in an ever-wider set of industries will not only be tempted into compliance with new funding or cajoled from the bully pulpit to increase their cybersecurity measures, but will also have to contend with a more forceful response from government that will expect them to meet security standards and promises—and face liability if they fail to do so. This increased enforcement may also be complicated by multiple agencies pursuing the same actions, resulting in the potential for companies having to deal with overlapping and uncoordinated inquiries. And with the increasing focus on state actors in place of cybercriminals, the strategy shows less of a focus on private ransomware issues and an increasing national security response that may serve as a prioritization filter. While the strategic objectives outlined in the cyber strategy and backed by the budget proposal will require significant executive action prior to coming into effect, companies should prepare now to meet the shifting approach towards increased cybersecurity requirements and liability.

The following Gibson Dunn lawyers assisted in preparing this alert: Alexander Southwell, Stephenie Gosnell Handler, and Eric Hornbeck.

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

United States
S. Ashlie Beringer – Co-Chair, PCDI Practice, Palo Alto (+1 650-849-5327, [email protected])
Jane C. Horvath – Co-Chair, PCDI Practice, Washington, D.C. (+1 202-955-8505, [email protected])
Alexander H. Southwell – Co-Chair, PCDI Practice, New York (+1 212-351-3981, [email protected])
Matthew Benjamin – New York (+1 212-351-4079, [email protected])
Ryan T. Bergsieker – Denver (+1 303-298-5774, [email protected])
David P. Burns – Washington, D.C. (+1 202-887-3786, [email protected])
Gustav W. Eyler – Washington, D.C. (+1 202-955-8610, [email protected])
Cassandra L. Gaedt-Sheckter – Palo Alto (+1 650-849-5203, [email protected])
Svetlana S. Gans – Washington, D.C. (+1 202-955-8657, [email protected])
Lauren R. Goldman – New York (+1 212-351-2375, [email protected])
Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, [email protected])
Nicola T. Hanna – Los Angeles (+1 213-229-7269, [email protected])
Howard S. Hogan – Washington, D.C. (+1 202-887-3640, [email protected])
Kristin A. Linsley – San Francisco (+1 415-393-8395, [email protected])
Vivek Mohan – Palo Alto (+1 650-849-5345, [email protected])
Karl G. Nelson – Dallas (+1 214-698-3203, [email protected])
Rosemarie T. Ring – San Francisco (+1 415-393-8247, [email protected])
Ashley Rogers – Dallas (+1 214-698-3316, [email protected])
Eric D. Vandevelde – Los Angeles (+1 213-229-7186, [email protected])
Benjamin B. Wagner – Palo Alto (+1 650-849-5395, [email protected])
Michael Li-Ming Wong – San Francisco/Palo Alto (+1 415-393-8333/+1 650-849-5393, [email protected])
Debra Wong Yang – Los Angeles (+1 213-229-7472, [email protected])

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

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