Richard Manfredi, Author at Gibson Dunn

Lawdragon named 44 Gibson Dunn partners to its 500 Leading Litigators in America 2024 guide, featuring the “advisors you want to send into battle.” The partners named as Leading Litigators are: Trey Cox and Veronica Moyé in Dallas; Monica Loseman in Denver; Gregg Costa and Collin Cox in Houston; Lauren Blas, Theodore Boutrous Jr., Christopher Chorba, Scott Edelman, Theane Evangelis, Perlette Michèle Jura, Sam Liversidge, Marcellus McRae, Ilissa Samplin, Julian Poon, Deborah Stein, Daniel Swanson, and Debra Wong Yang in Los Angeles; Reed Brodsky, Anne Champion, Lauren Goldman, Benjamin Hershkowitz, Charlotte Jacobsen, Josh Krevitt, Adam Offenhartz, Orin Snyder, Eric Stock, and Lawrence Zweifach in New York; Ashlie Beringer in Palo Alto; Rachel Brass, Kristin Linsley, and Rosemarie Ring in San Francisco; and Svetlana Gans, Scott Hammond, Joshua Lipshutz, Joshua Lipton, Matthew McGill, Ted Olson, Elizabeth Papez, Michael Perry, Cynthia Richman, Helgi Walker, F. Joseph Warin, and Stephen Weissman in Washington, D.C. The list was published September 8, 2023.

The National Law Journal named Gibson Dunn to its 2023 Appellate Hot List, which “highlights law firms that have handled exemplary appellate matters.” The list was published on August 31, 2023.

The Gibson Dunn Appellate and Constitutional Law Practice Group’s lawyers participate in appeals in all 13 federal courts of appeals and state appellate courts throughout the United States and have presented arguments in front of the Supreme Court of the United States nearly 160 times. The group has broad experience in complex appellate litigation at all levels of the U.S. federal and state court systems and has been involved in matters that cover a wide array of constitutional, statutory, regulatory and common-law issues.

The Los Angeles Superior Court has granted a two-year domestic violence restraining order in favor of Gibson Dunn’s pro bono client, a low-income mother of a developmentally delayed child, who suffered years of physical, psychological and financial abuse from her husband. Before Gibson Dunn joined the case, our client’s temporary restraining order did not include a move-out order against her husband or an order for possession of her vehicle, leaving our client without stable housing or reliable transportation. Our team successfully amended the request for a temporary restraining order to seek the additional relief.

At the evidentiary hearing, our lawyers presented compelling evidence that our client suffered abuse from her husband throughout their 11-year marriage. After the hearing, including cross-examination of the husband—who testified that he had never physically or otherwise abused our client, and attempted to argue that our client was the abuser—the court sided with our client, concluding that she was more credible than her husband. In addition to the restraining order against her husband, the court awarded our client sole legal and physical custody of their child, exclusive use of the residence and immediate return of her vehicle. The court also ordered limited professionally monitored child visitation with the husband.

Los Angeles associate Summer Wall led the team and conducted the examinations, with valuable assistance from associates Camille Houle and Chelsea D’Olivo (Washington, D.C.), and supervision from partner Michael Holecek and senior associate Patrick Murray. The team received outstanding support from our pro bono partners at the Los Angeles Center for Law and Justice and from Gibson Dunn support staff, including Austin Kang.

Originally published by PLI Chronicle

Much ink has been spilled about the role of artificial intelligence (AI) in employment, especially in light of the developing menagerie of laws seeking to govern automated decision tools in the workplace. And rightly so—this is a burgeoning area with daily developments that must be carefully monitored. From enforcement of New York City’s AI employment law beginning on July 5, 2023 to a barrage of proposed bills like U.S. Senator Casey’s No Robot Bosses Act, there has seldom been a dull moment in 2023. However, amidst all of the buzz around automation in the workplace, privacy regulations have emerged as yet another piece of the employment puzzle.

Where Does Privacy Come In?

Privacy regulations play a key role in the effective governance of AI in the workplace. AI systems are increasingly processing personal data—ranging from demographic data to biometric data—by using algorithms to analyze and extract insights from various types of information to make predictions, recommendations, or even decisions for an employer. By implementing an AI system that collects and processes this personal data, the employer may be responsible for ensuring compliance with the evolving patchwork of laws governing the use of AI in employment decision making but also with many existing data protection laws, depending on their geographical scope and use.

Read More

Reproduced with permission. Originally published in PLI Chronicle: Insights and Perspectives for the Legal Community (August 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 Artificial Intelligence, Labor & Employment, or Privacy, Cybersecurity & Data Innovation practice groups, or the authors:

Cassandra L. Gaedt-Sheckter – Palo Alto (+1 650-849-5203, cgaedt-sheckter@gibsondunn.com)

Emily Maxim Lamm – Washington, D.C. (+1 202-955-8255, elamm@gibsondunn.com)

Attorney Advertising: These materials were prepared for general informational purposes only based on information available at the time of publication and are not intended as, do not constitute, and should not be relied upon as, legal advice or a legal opinion on any specific facts or circumstances. Gibson Dunn (and its affiliates, attorneys, and employees) shall not have any liability in connection with any use of these materials. The sharing of these materials does not establish an attorney-client relationship with the recipient and should not be relied upon as an alternative for advice from qualified counsel. Please note that facts and circumstances may vary, and prior results do not guarantee a similar outcome.

Ms. X fled to the U.S. from El Salvador in 2016 to escape targeted gang violence. Her family staunchly and vocally opposed the gang’s control of their community and reported the gang’s activities to the police. In retaliation, the gang threatened the family with death. One of Ms. X’s cousins was murdered and dismembered by gang members, and Ms. X herself was directly threatened. After being assaulted by the gang’s local leader, Ms. X fled to the U.S.

Over the next seven years, Gibson Dunn represented Ms. X in partnership with Kids In Need of Defense (KIND). Her case was shuffled among three different judges at three different immigration courts.

Gibson Dunn faced difficult strategic choices along the way. In particular, the team learned that neither of Ms. X’s primary persecutors remained in El Salvador: one had been killed by the police, and one had traveled to the U.S. The team disclosed this information to the Court and burnished Ms. X’s asylum application with the testimony of two expert witnesses who detailed the risk of persecution Ms. X would still face at the hands of gang members who remained in El Salvador.

El Salvador’s recent Régimen de Excepción (State of Exception) also raised unexpected challenges. Under the State of Exception, the Salvadoran military has arrested and detained more than 68,000 purported gang members, often solely on the basis of anonymous tips. In the wake of these mass arrests, the Department of Homeland Security (DHS) has begun arguing that El Salvador no longer has a gang problem and that asylum seekers who fled gang-based violence, like Ms. X, should be returned to El Salvador. In fact, the opposite is true: individuals like Ms. X now face two separate persecutors—the gangs, and the Salvadoran government itself, which has been arresting deportees and individuals previously targeted by gangs for so-called “association” or “collaboration” with the very gangs that persecuted them.

On the day of the hearing, Ms. X provided powerful direct-examination and cross-examination testimony, and Gibson Dunn secured DHS’s stipulation to refrain from challenging her experts’ testimony and, notably, her application for asylum. The court entered an oral grant of asylum from the bench, and DHS waived its right to appeal.

Washington, D.C. associate Tessa Gellerson was the lead attorney during the individual merits hearing, with Joseph West as supervising partner. The team, which included former associates Ariel Fishman, Nicholas Fuenzalida, Haley Morrisson, Alison Friberg, and Nanding Chen, received outstanding support from its pro bono partners at KIND and several members of the Gibson Dunn support staff, including Ileana Rivera and Sandra Andrade, who provided invaluable assistance with translation, and the D.C. Copy Center team, who saved the day more than once with monumental printing requests.

On August 30, 2023, the IRS and Treasury published proposed Treasury regulations (the “Proposed Regulations”) providing expansive guidance on the prevailing wage and apprenticeship requirements (the “PWA Requirements”) that taxpayers must[1] satisfy to receive the full credit amount[2] available under various revised and new tax credits provided for in the Inflation Reduction Act of 2022 (the “IRA”).[3] Taxpayers are permitted to rely on the Proposed Regulations with respect to a facility[4] on which construction began on or after January 29, 2023 but before final regulations are published.[5]

The Proposed Regulations are detailed, and a comprehensive discussion of them is beyond the scope of this alert. Instead, this alert begins with some background regarding these requirements, then provides a short summary of the Prevailing Wage Requirement and the Apprentice Requirements (including, with respect to each requirement, a short description of the consequences of noncompliance, remediation opportunities, and recordkeeping obligations), and concludes with observations regarding key implications of the guidance for market participants.

Background

The IRA introduced the PWA Requirements with the intent of “creating good-paying union jobs” in the clean energy, manufacturing, and construction sectors.[6] At a high level, the “Prevailing Wage Requirement” requires that all laborers and mechanics employed by a taxpayer (or a contractor or subcontractor of such taxpayer) claiming an applicable credit[7] are paid wages for construction, alteration, or repair of the applicable facility that are not less that the “prevailing” wage for that type of work. The Apprenticeship Requirements (as defined below) are focused on making sure that project developers make on-the-job training opportunities available to the next generation of skilled tradesmen.

Key Prevailing Wage Requirements

The Proposed Regulations provide substantial practical guidance on compliance with the Prevailing Wage Requirement. The Proposed Regulations clarify which workers must be paid prevailing wages, describe the types of work that constitutes construction, alteration, or repair of a facility, and explain how to determine and pay prevailing wages. The subsections below describe some of the most significant aspects of the guidance on these topics.

Workers Subject to the Prevailing Wage Requirement

Workers engaging in construction, alteration, or repair of a facility (described below) must be paid at or above the prevailing wage if they are laborers or mechanics employed by the taxpayer or its contractor or subcontractor. The Proposed Regulations provide clarity on the meaning of these terms.

A laborer or mechanic is any worker whose duties are manual or physical in nature and includes apprentices and helpers. Generally, this definition excludes individuals with roles that are primarily administrative, executive, or clerical. The IRS and Treasury are seeking comments regarding the treatment of persons whose roles are not primarily physical in nature, such as a foreperson, owner, or administrator, but who perform certain duties that are physical in nature.[8]

A person is employed if the person performs the duties of a laborer, mechanic, contractor, or subcontractor. The term “employed” is intended to be significantly broader in the prevailing wage context than in the employment tax context.[9] Accordingly, workers, regardless of whether they would be viewed as employees or independent contractors for other purposes of the Code, may be “employed” by the taxpayer, its contractor, or its subcontractor.

The taxpayer[10] can be any person subject to taxation under the Internal Revenue Code (including a partnership and an entity that is permitted to make a “direct pay” election under section 6417[11]).

A contractor is any person that enters into a contract with the taxpayer for construction, alteration, or repair of a qualified facility and a subcontractor is any person that agrees to perform or be responsible for any part of such a contract.

Scope of Construction, Alteration, or Repair of the Facility

The Proposed Regulations clarify that “construction, alteration, or repair” (i.e., the types of work covered by the Prevailing Wage Requirement) should be construed expansively, but do clarify that ordinary maintenance work (i.e., work that is intended to sustain the existing functionality of the facility) is not covered by the Prevailing Wage Requirement.[12] In addition, work that would fit within the broad definition of “construction, alteration, or repair” is subject to the Prevailing Wage Requirement only if the physical work occurs at the physical site of the facility (including any adjacent or virtually adjacent dedicated support site) or at a secondary site that is established specifically for or dedicated exclusively to the construction of such facility for a meaningful time.[13]

For example, if a taxpayer builds a wind farm, the construction at the site where the wind farm will be located would be subject to the Prevailing Wage Requirement. If a significant portion of the facility is constructed at an off-site warehouse that was established specifically to assist with, or dedicated exclusively for a specific period of time to, the construction of the wind farm, work completed at the off-site warehouse also would be subject to the Prevailing Wage Requirement. However, if the step-up transformer is constructed at an off-site location that (during the transformer’s construction) is building transformers for other wind farms, the labor performed on the transformer at that location is generally not subject to the Prevailing Wage Requirement, at least with respect to the construction of the taxpayer’s wind farm.

How to Determine Prevailing Wages

The Wage and Hour Division of the Department of Labor is responsible for making prevailing wage determinations. The prevailing wage is based on the type of construction, the type of labor performed, and the geographic area in which the labor is performed. The Proposed Regulations indicate that, when a taxpayer plans to construct, alter, or repair a facility, the taxpayer (and its contractors or subcontractors) will be able to find the prevailing wage for the applicable type of construction and location for each type of labor they expect to require on a website approved by the Department of Labor (currently www.sam.gov), rather than being required to seek an individualized, project-specific ruling.

In general, taxpayers can pay registered apprentices less than the prevailing wage rate that would need to be paid to a journeyworker[14] performing the same type of work, but not less than the rate (and fringe benefits) specified by the registered apprenticeship program.[15] For any hours worked by an apprentice in excess of the ratio permitted by the Ratio Requirement (a requirement described below requiring an appropriate ratio of apprentices to more experienced workers), the Proposed Regulations provide that the apprentice must be paid not less than the wage rate that would need to be paid to a journeyworker for the same type of work.

As noted above, the IRS and Treasury expect that prevailing wages will be available from the website approved by the Department of Labor. The Proposed Regulations make clear, however, that a supplemental, facility-specific wage determination can be requested from the Department of Labor if (i) the facility spans more than one geographic area,[16] (ii) there is no general wage determination currently available for a particular geographic area or type of work, or (iii) the wages for certain labor classifications are not listed on the generalized Department of Labor website.[17] If a taxpayer only discovers that it has not paid prevailing wages when the Department of Labor subsequently makes a determination of the prevailing wage rate, the taxpayer has 30 days from the date of determination to remediate the failure by making “catch-up” payments to the laborers and mechanics who have received insufficient wages.

The Proposed Regulations helpfully clarify that, in general, applicable prevailing wages are required to be determined only at the outset of the work, although wage rates must be refreshed if a contract is expanded to cover additional work not within its original scope. In addition, for any alteration or repair work on a facility that occurs after the facility is placed in service, taxpayers must use the prevailing wage in effect at the time the alteration or repair work begins.

How to Pay and How Long to Pay the Prevailing Wage

After determining both which workers are subject to the Prevailing Wage Requirement and the prevailing wage rates applicable to those workers, employers must pay workers prevailing wages through regular payroll practices, without subsequent deduction or rebate of any kind (except as required by law or permitted by regulations issued by the Secretary of Labor). For production tax credit facilities, the Prevailing Wage Requirement generally applies during the life of the production tax credit, whereas for an investment tax credit facility the relevant period is, in general, five years (i.e., the recapture period).

Apprenticeship Requirements

In addition to the Prevailing Wage Requirement, taxpayers must abide by three apprenticeship requirements (the “Apprenticeship Requirements”) in connection with construction, alteration, or repair of a facility to receive full tax amounts for certain tax credits.[18] First, the “Labor Hours Requirement” specifies the required percentage of labor hours that must be performed by qualified apprentices.[19] Second, the “Ratio Requirement” mandates that the taxpayer abide by the applicable apprentice-to-journeyworker ratio, as determined by the Department of Labor or applicable state apprenticeship agency. Third, under the “Participation Requirement,” each taxpayer, contractor, or subcontractor that employs four or more individuals to perform construction, alteration, or repair work with respect to the construction of the qualified facility must employ one or more qualified apprentices to perform that work. The Proposed Regulations clarify the relationship among the Apprenticeship Requirements and provide further explanation and rules that generally tighten the requirements.

Labor Hours Requirement

The Proposed Regulations reiterate that, under the Labor Hours Requirement, the “applicable percentage”[20] of total labor hours must be performed by qualified apprentices.[21] The Proposed Regulations make clear that the Labor Hours Requirement is subject to the Ratio Requirement, meaning that hours worked by a qualified apprentice that do not comply with the Ratio Requirement will not be counted as labor hours by a qualified apprentice for purposes of meeting the Labor Hours Requirement.

Ratio Requirement

The Ratio Requirement is intended to ensure there are sufficient supervising journeyworkers onsite.[22] The applicable apprentice-to-journeyworker ratio for a particular apprentice will be determined by the registered apprenticeship program in which that apprentice is participating, and also would be subject to the requirements of the Department of Labor and applicable state apprenticeship agencies. The Proposed Regulations clarify that the Ratio Requirement applies on a daily basis.

Participation Requirement

The Participation Requirement requires that each taxpayer, contractor, or subcontractor who employs four or more individuals to perform construction, alteration, or repair work with respect to the construction of a qualified facility must employ one or more qualified apprentices to perform such work. The Proposed Regulations clarify that the Participation Requirement is not a daily requirement. Because the Participation Requirement is designed to prevent taxpayers from satisfying the Labor Hours Requirement by only hiring apprentices to perform one type of work, the Proposed Regulations provide that the Participation Requirement must be satisfied separately by the taxpayer and each contractor and subcontractor (if any such person has four or more employees who perform relevant work on the facility); however, the taxpayer ultimately must ensure that each of its contractors and subcontractors (if applicable) has satisfied the Participation Requirement.

Noncompliance Rules and Remedies

Prevailing Wage Requirement – Penalties and Correction Payments

Under the Proposed Regulations, if a taxpayer fails to satisfy the Prevailing Wage Requirement, the taxpayer may cure that failure and retain the credit by making a correction payment to all impacted laborers and mechanics, as well as paying any applicable penalties.

For any period during which a laborer or mechanic was paid wages that failed to satisfy the Prevailing Wage Requirement, the correction payment is calculated as the difference between the wages that should have been paid under the Prevailing Wage Requirement and all wages paid to that laborer or mechanic for the period, plus interest.[23] The Proposed Regulations require that a correction payment must be made even if the taxpayer is not able to locate one or more of the impacted laborers or mechanics, requiring taxpayers to comply with, for example, state-administered unclaimed wage programs.

In addition to any back wages and interest, taxpayers are required to pay a $5,000 penalty for each laborer or mechanic who was underpaid for each applicable year. Helpfully, the Proposed Regulations provided that this penalty is waived automatically in certain quickly discovered and corrected situations. The automatic waiver has two conditions:

The taxpayer makes the correction payment not later than the earlier of (i) 30 days after the date taxpayer becomes aware of the error and (ii) the date on which the tax return claiming the credit is filed; and

Either (i) the laborer or mechanic was underpaid for not more than 10 percent of all relevant periods or (ii) the underpayment was not greater than 2.5 percent of what the laborer or mechanic should have been paid under the Prevailing Wage Requirements.

If the IRS determines that any failure to satisfy the Prevailing Wage Requirements was due to intentional disregard, the required correction payment amount is increased by a multiple of three and the penalty rate is increased from $5,000 to $10,000.[24] The Proposed Regulations provide a non-exclusive list of facts that might be considered in the determination of whether a failure to meet the Prevailing Wage Requirements is due to intentional disregard, including whether (i) the failure to pay prevailing wages by the taxpayer is part of a pattern of conduct, (ii) the taxpayer promptly cured any failures to pay prevailing wages, (iii) the taxpayer included (and caused to be included) provisions in contracts with contractors and subcontractors ensuring compliance with the Prevailing Wage Requirement, and (iv) the taxpayer provided notice to laborers and mechanics of the Prevailing Wage Requirement (such as by posting information prominently at the site of work). Notably, the Proposed Regulations provide a rebuttable presumption that a failure was not intentional with respect to the Prevailing Wage Requirements if the taxpayer makes all correction and penalty payments before receiving a notice from the IRS, giving taxpayers a meaningful incentive to take steps proactively to monitor compliance with the Prevailing Wage Requirement.[25]

The Proposed Regulations also clarify that, for credits sold pursuant to section 6418, credit sellers would be responsible for any correction payments and penalties with respect to the Prevailing Wage Requirements, although credit buyers would still remain liable for any resulting excessive credit transfer tax resulting from the failure to meet the Prevailing Wage Requirements.

Apprenticeship Requirements – Penalties

If a taxpayer does not satisfy the Apprenticeship Requirements or the Good Faith Effort Exception (discussed below), the taxpayer may still receive the full tax credit amount if the taxpayer pays a $50 penalty ($500 for intentional disregard) for each labor hour for which the taxpayer failed to meet the Labor Hours Requirement or the Participation Requirement. For the Labor Hours Requirement, the penalty is applied to the shortfall by which the “applicable percentage” of labor hours exceeded the hours actually worked by qualified apprentices (a single aggregate computation). For the Participation Requirement, the penalty is computed separately for the taxpayer and each of its contractor(s) and subcontractor(s) (but the penalty is payable only by the taxpayer) and is applied to the quotient of the total number of relevant labor hours worked by all individuals employed by the non-compliant employer divided by the total number of such individuals employed by such non-compliant employer.

Similar to the Prevailing Wage Requirement, the Proposed Regulations provide a non-exclusive list of facts that might be considered in the determination of whether a failure to meet the Apprenticeship Requirements is due to intentional disregard, including whether (i) the failure was part of a pattern of conduct by the taxpayer, (ii) the taxpayer promptly cured the failure, (iii) the taxpayer included (and caused to be included) provisions in contracts with contractors and subcontractors ensuring compliance with the Apprenticeship Requirements, and (iv) the taxpayer had been required to make a penalty payment in respect of the Apprenticeship Requirements in prior tax years. As with the Prevailing Wage Requirements, the Proposed Regulations also provide a rebuttable presumption that a failure was not intentional if the taxpayer makes all penalty payments before receiving a notice from the IRS.

As is the case for the Prevailing Wage Requirements, credit sellers under section 6418 would be responsible for any penalties with respect to the Apprenticeship Requirement, but credit buyers would still remain liable for any resulting excessive credit transfer tax resulting from the failure to meet the Apprenticeship Requirements.

Qualifying Project Labor Agreement

The Proposed Regulations would provide that penalty payments will not be required if there is a Qualifying Project Labor Agreement in place and if a correction payment is paid to a laborer or mechanic on or prior to the date on which the tax credit is claimed. In general, a Qualifying Project Labor Agreement is a pre-hire collective bargaining agreement with one or more labor organizations for a specific construction project that meets criteria detailed in the Proposed Regulations.[26]

Good Faith Effort Exception

The Code excuses taxpayers from complying with the Apprenticeship Requirements if they have requested qualified apprentices from a registered apprenticeship program and either the request is denied for a reason other than noncompliance with the standards or requirements of the program or the program does not acknowledge receipt of the request or otherwise respond to the taxpayer within five business days after receiving a request (the “Good Faith Effort Exception”).[27]

Generally, the Proposed Regulations would require additional effort by a taxpayer to satisfy the Good Faith Effort Exception. One key modification is that the Proposed Regulations would require a written request be made to at least one registered apprenticeship program that trains apprentices in the necessary occupation(s) and has a customary business practice of entering into agreements with employers to place apprentices in their trained occupation.[28] In addition, the registered apprenticeship program to which the taxpayer submits the written request either must (i) operate within the geographic area that includes the location of the facility or (ii) reasonably be expected to be able to provide apprentices to the facility’s location. The IRS expects that taxpayers may need to submit requests to multiple apprenticeship programs, depending on the number of occupations involved in the project and the anticipated number of required apprentice labor hours.

Under the Proposed Regulations, a denial of a written request from a registered apprenticeship program, or a non-response to such a written request, will permit a taxpayer to rely on the Good Faith Effort Exception only for 120 days after the date on which the request was submitted. Thereafter, the taxpayer would be required to submit an additional request to continue to rely on the Good Faith Effort Exception. As a result, to continue to rely on the Good Faith Effort Exception, a taxpayer would have to submit requests to a registered apprenticeship program and have those requests be denied by the registered apprenticeship program on a rolling 120-day basis. Further, a partially denied request is to be treated as a denial solely with respect to that part of the request that is denied.

Recordkeeping and Reporting Requirements

The Proposed Regulations specify certain records that taxpayers must maintain to substantiate that the Prevailing Wage Requirement and Apprenticeship Requirements have been satisfied, including (at a minimum) payroll records that reflect the wages paid to laborers, mechanics and qualified apprentices engaged in the construction, alteration, or repair of the facility, regardless of whether the laborers and mechanics are employed by the taxpayer, a contractor, or a subcontractor.

For the Prevailing Wage Requirement, sufficient records “may include” the labor classification(s) used for determining the prevailing wage rate (and documentation supporting the applicable classification), the hourly rate(s) of wages paid for each applicable labor classification, records supporting fringe benefit calculations (detailed in the Proposed Regulations), the total number of labor hours worked and wages paid per pay period, records to support wages paid to any apprentices (including records reflecting the registration of the apprentices, the applicable wage rates and apprentice-to-journeyworker ratios), and the amount and timing of any correction payments (and documentation reflecting their calculation).

For the Apprenticeship Requirements, records sufficient to establish compliance may include copies of any written requests for apprentices, any agreements with a registered apprenticeship program, documents verifying participation in a registered apprenticeship program by each apprentice, and the payroll records for any work performed by apprentices. Like the Prevailing Wage Requirement, the Proposed Regulations would provide that it is the responsibility of the taxpayer to maintain the relevant records for each apprentice, regardless of whether the apprentice is employed by the taxpayer, a contractor, or a subcontractor.

The Proposed Regulations do not include detailed reporting requirements, but the preamble indicates that the IRS and Treasury expect that taxpayers will be required to report, at the time of filing a return: (i) the location and type of qualified facility; (ii) the applicable wage determinations for the type and location of the facility; (iii) the wages paid (including any correction payments) and hours worked for each of the laborer or mechanic classifications engaged in the construction, alteration, or repair of the facility; (iv) the number of workers who received correction payments; (v) the wages paid and hours worked by qualified apprentices for each of the laborer or mechanic classifications engaged in the construction, alteration, or repair of the facility; (vi) the total labor hours for the construction, alteration, or repair of the facility by any laborer or mechanic employed by the taxpayer or any contractor or subcontractor; and (vii) the total credit claimed.[29]

Commentary

Many aspects of the Proposed Regulations will facilitate efficient administration of the IRA, though other aspects of the guidance could be clarified further to provide taxpayers with greater guidance as to their obligations under the PWA Requirements.

Allocation of Legal Responsibility for PWA Requirements. The Proposed Regulations make clear that the taxpayers who claim or transfer tax credits (and not the contractors or subcontractors of those taxpayers) are ultimately responsible for complying with the PWA Requirements. Thus, the onus is on the taxpayer to carefully monitor compliance with the PWA Requirements, ensure its contractors and subcontractors comply with the PWA Requirements, and maintain adequate records demonstrating compliance with the PWA Requirements. Well-advised taxpayers likely will seek to include provisions in their agreements with contractors to ensure that the PWA Requirements are satisfied and that necessary records and information substantiating the satisfaction of those requirements is maintained.

Incentives for Self-Policing. The Proposed Regulations encourage taxpayers to carefully monitor failures to meet the PWA Requirements, proactively report these failures to the IRS, and then affirmatively and timely make correction payments. If taxpayers take these steps, as long as the noncompliance is relatively minor, then the Proposed Regulations generally allow taxpayers to avoid the application of penalties. Given these benefits, taxpayers will want to put in place procedures for monitoring compliance, including compliance by contractors and their subcontractors.

Useful Begun Construction Rule, with Limits. Under the Proposed Regulations, prevailing wage determinations generally have to be made only once, in connection with the commencement of construction. This rule does not apply, however, if there is a change in the scope of work originally envisioned. Given that scope changes are relatively common in the course of constructing a facility, this exception could apply relatively frequently. It would be useful if the exception were adjusted to apply in more limited circumstances (g., to major changes that result in a more than 10 percent adjustment to the contract price).[30]

Enhanced Apprenticeship Requirements. The Proposed Regulations would tighten significantly the rules applicable to the Apprenticeship Requirements, including by limiting the scope of the Good Faith Effort Exception by providing that denial of a request for qualified apprentices lasts only 120 days after the submission of the request. This rule will make it necessary for developers to approach registered apprenticeship programs repeatedly. The IRS and Treasury’s further clarification that it may be necessary to make inquiries to multiple registered apprenticeship programs suggests that the IRS and Treasury are very focused on making sure that apprentices receive training opportunities, even if doing so imposes incremental compliance burdens.

Incentives for Entering into Qualifying Project Labor Agreement. Under the Proposed Regulations, if a Qualifying Project Labor Agreement (e.g., collective bargaining agreement meeting certain criteria) is entered into, various penalties can be eliminated as long as any needed correction payment is made before the credit is claimed. This rule will provide some level of incentive for developers to pursue these types of agreements.

Helpful Rule for Offshore Wind Projects. The Proposed Regulations include a helpful convention for offshore wind projects. Rather than requiring that each offshore wind project make a request for an individualized supplemental wage determination (given that general Department of Labor data is unlikely to cover offshore sites), the Proposed Regulations allow use of the generalized information prepared by the Department of Labor for the closest geographical area.

Scope of Apprenticeship Requirements. The Code contains an ambiguity concerning whether the Labor Hours Requirement and Participation Requirements apply only to the “construction” of a facility (as opposed to the Prevailing Wage Requirements, which apply to both the construction phase of a facility and alteration and repair work performed after the construction phase with respect to the facility). Interestingly, the Proposed Regulations suggest that the Participation Requirement would apply only to the construction phase of a facility (but would apply to all alteration and repair work, if any, occurring during that construction phase). In contrast, the Proposed Regulations suggest that the Labor Hours Requirement would apply to both the construction of the facility and alteration and repair work performed after the construction phase with respect to the facility. It would be helpful for the IRS and Treasury to state its interpretation explicitly and to clarify this apparent discrepancy in the preamble to the final regulations. Further, more examples of the application of these and other rules that are more fact-intensive in application (including, for example, the secondary site rule) would be especially helpful.

____________________________

[1] Compliance with the prevailing wage and apprenticeship requirements is not required for facilities (i) that have a maximum net output or storage capacity of less than one megawatt or (ii) the construction of which began before January 29, 2023.

[2] Technically, the baseline tax credit is multiplied by five if the PWA Requirements are met, resulting in a tax credit amount that traditionally has been considered the full amount of the federal income tax credits that may be claimed in respect of clean energy technologies. This full credit amount also can be increased by so-called adders, such as the domestic content adder and the energy community adder. Please see our prior client alerts on these adders, which can be found here and here, respectively.

[3] As was the case with the so-called Tax Cuts and Jobs Act, the Senate’s reconciliation rules prevented Senators from changing the Act’s name, and the formal name of the so-called Inflation Reduction Act is actually “An Act to provide for reconciliation pursuant to title II of S. Con. Res. 14.” In addition to tax credit guidance, the proposed regulations also include guidance regarding the PWA Requirements under section 179D, which provides a deduction for the cost of energy efficient commercial building property placed in service during the taxable year.

[4] Depending on the type of credit at issue, the applicable facility may be a qualified facility, property, project, or certain other equipment or facilities. For the purposes of this alert, we use the term “facility” to refer generally to those assets in respect of which a taxpayer is permitted to claim an applicable credit.

[5] Unless indicated otherwise, all section references are to the Internal Revenue Code of 1986, as amended (the “Code”).

[6] See Fact Sheet: One Year In, President Biden’s Inflation Reduction Act is Driving Historic Climate Action and Investing in America to Create Good Paying Jobs and Reduce Costs, The White House, Aug. 16, 2023, here.

[7] Tax credits with a prevailing wage or apprenticeship requirement include those credits provided for under sections 30C, 45, 45L, 45Q, 45U, 45V, 45Y, 45Z, 48, 48C, and 48E.

[8] Under the Proposed Regulations, working forepersons who devote more than 20 percent of their time during a workweek to laborer or mechanic duties, and who do not meet the criteria for exemption of 29 CFR part 541, would be considered laborers and mechanics for the time spent conducting laborer and mechanic duties.

[9] The preamble to the Proposed Regulations expressly provides that the term “employed,” as used in connection with the PWA Requirements, is not intended to apply for other purposes of the Code.

[10] In the case of any credits that were transferred pursuant to section 6418, the “taxpayer” is the credit transferor, not the transferee. Please see our prior alert on the proposed regulations on credit transferability, which is found here.

[11] Please see our prior client alert on the proposed regulations on direct pay, found here.

[12] The Proposed Regulations provide that maintenance expressly does not include work that improves a facility, adapts it for a different use, or restores functionality as a result of inoperability.

[13] The Proposed Regulations clarify that the work performed by a manufacturer that focuses on constructing components for a particular facility for some limited period of time (measured in hours or days) in order to meet a deadline is not subjected to the Prevailing Wage Requirement. A longer period of exclusive dedication (measured in weeks or months) to the preparation of products made to specifications would potentially subject this type of work to the Prevailing Wage Requirement.

[14] For these purposes, a journeyworker is an individual who has attained a level of skill, abilities, and competencies recognized within an industry as having mastered the skills and competencies required for the occupation (regardless as to whether such skills are acquired through formal apprenticeship or through practical on-the-job experience and formal training).

[15] Registered apprentices are those employed pursuant to an apprenticeship program registered with the Department of Labor’s Office of Apprenticeship (or with a state apprenticeship agency recognized by that office). If the apprenticeship program does not require the payment of bona fide fringe benefits, then the Proposed Regulations would require that apprentices be paid the full amount of bona fide fringe benefits listed on the applicable wage determination.

[16] If, however, construction, alteration, or repair of a facility occurs in more than one geographic area, then the Proposed Regulations generally would require that the applicable wage determination for the work performed in each geographic area be used for the work performed in that area, though the preamble to the Proposed Regulations suggests that taxpayers can ensure compliance with the Prevailing Wage Requirement by paying the highest rate for each classification in both geographic areas. The Proposed Regulations also include an important rule that benefits developers of offshore wind projects, providing that taxpayers may rely on the general wage determination for the relevant category of construction that is applicable in the geographic area closest to the location of the facility.

[17] The IRS and Treasury generally expect that supplemental wage determinations would be requested no more than 90 days before the beginning of construction, alteration, or repair of a facility.

[18] Section 45L (new energy efficient home credit) and section 45U (zero-emission nuclear power production credit) do not have apprenticeship requirements.

[19] Under the Proposed Regulations, a “qualified apprentice” is “an individual who is employed by the taxpayer or by any contractor or subcontractor and who is participating in a registered apprenticeship program.” The preamble to the Proposed Regulations indicate that participants in pre-apprenticeship programs would not be considered “qualified apprentices.”

[20] For a facility on which construction begins during 2023, the applicable percentage is 12.5 percent. For a facility on which construction begins in 2024 or later, the applicable percentage is 15 percent.

[21] Under the Proposed Regulations, “labor hours” means the total number of hours devoted to the performance of construction, alteration, or repair work by any individual employed by the taxpayer or by any contractor or subcontractor. Labor hours would not include hours worked by foremen, superintendents, owners, or persons employed in bona fide executive, administrative, or professional capacities.

[22] Under the Proposed Regulations, a journeyworker is any laborer or mechanic that has mastered the skills and competencies required for the applicable occupation. A journeyworker can acquire these skills and competencies either through experience or through a formal apprenticeship.

[23] Interest is imposed at the federal short-term rate as determined under section 6621, but substituting “6 percentage points” for “3 percentage points” in section 6621(a)(2).

[24] The Proposed Regulations do not address specifically whether an automatic waiver of the penalty would potentially be available in the case of intentional disregard, although in practice we do not anticipate automatic waiver relief would be available in that case.

[25] A taxpayer generally is not be permitted to cure non-compliance with the Prevailing Wage Requirement if the taxpayer does not make the penalty payment on or prior to the date that is 180 days after the IRS makes a final determination that a penalty is due.

[26] The agreement needs (i) to be a collective bargaining agreement with a labor organization (i.e., a union), (ii) to include provisions obligating taxpayers to pay prevailing wages and to use qualified apprentices to perform work, and (iii) to provide guarantees against strikes, lockouts, and other similar job disruptions.

[27] Under the Proposed Regulations, a “registered apprenticeship program” is defined as “a program that has been registered by the U.S. Department of Labor’s Office of Apprenticeship or a recognized State apprenticeship agency, pursuant to the National Apprenticeship Act and its implementing regulations for registered apprenticeship at 29 CFR parts 29 and 30, as meeting the basic standards and requirements of the Department of Labor for approval of such program for Federal purposes.”

[28] The Proposed Regulations also provide additional specificity as to what the contents of such a written request would need to be.

[29] The IRS and Treasury affirmatively decided not to require certified weekly reporting of payroll records.

[30] There is precedent for using a ten percent standard in determining whether a contract modification is significant. See, e.g., PLR 8930013 (concluding that a taxpayer was eligible for transitional relief provisions in the Tax Reform Act of 1986 that exempted property from new depreciation and investment tax credit rules if that property was constructed, reconstructed, or acquired pursuant to a written contract binding on March 1, 1986, notwithstanding later adjustments to the contract that increased its cost by 10.02 percent, relying on legislative history suggesting design changes made for reasons of technical or economic efficiencies of operation that caused an insignificant increase in cost nevertheless were treated as insignificant).

This alert was prepared by Mike Cannon, Matt Donnelly, Josiah Bethards, Alissa Fromkin Freltz, Blake Hoerster, and Hayden Theis.

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

Tax Group:
Michael Q. Cannon – Dallas (+1 214-698-3232, mcannon@gibsondunn.com)
Matt Donnelly – Washington, D.C. (+1 202-887-3567, mjdonnelly@gibsondunn.com)
Josiah Bethards – Dallas (+1 214-698-3354, jbethards@gibsondunn.com)
Alissa Fromkin Freltz – Washington, D.C. (+1 202-777-9572, afreltz@gibsondunn.com)
Blake Hoerster – Dallas (+1 214-698-3180, bhoerster@gibsondunn.com)
Hayden Theis – Houston (+1 346-718-6695, htheis@gibsondunn.com)

Power and Renewables Group:
Peter J. Hanlon – New York (+1 212-351-2425, phanlon@gibsondunn.com)
Nicholas H. Politan, Jr. – New York (+1 212-351-2616, npolitan@gibsondunn.com)

This edition of Gibson Dunn’s Federal Circuit Update summarizes the current status of several petitions pending before the Supreme Court, additional materials released from the ongoing investigation by the Judicial Council of the Federal Circuit, and recent Federal Circuit decisions concerning claim construction, secondary considerations, and obviousness-type double patenting.

Federal Circuit News

Noteworthy Petitions for a Writ of Certiorari:

A couple potentially impactful petitions were filed before the Supreme Court in August 2023:

Intel Corp. v. Vidal (US No. 23-135): “The question presented is whether 35 U.S.C. § 314(d), which bars judicial review of “[t]he determination … whether to institute an inter partes review,” applies even when no institution decision is challenged to preclude review of [the United States Patent & Trademark Office] rules setting standards governing institution decisions.”

HIP, Inc. v. Hormel Foods Corp. (US No. 23-185): The questions presented are: “1. Whether joint inventorship requires anything more than a contribution to conception that is stated in a patent claim. Whether, under Section 116(a), a claimed and enabled contribution to conception can be deemed insignificant in quality based on the quantity of disclosure in the specification.” The Federal Circuit opinion being petitioned was summarized in our May 2023 update.

As we summarized in our July 2023 update, the Court will consider Killian v. Vidal (US No. 22-1220) and Ingenio, Inc. v. Click-to-Call Technologies, LP (US No. 22-873) during its September 26, 2023 conference. In CareDx Inc. v. Natera, Inc. (US No. 22-1066), after the respondents waived their right to file a response, retired Federal Circuit Judge Paul R. Michel and Professor John F. Duffy filed an amici curiae brief in support of Petitioners. The Court thereafter requested a response, which was filed on August 9, 2023. The Court will also consider this petition during its September 26, 2023 conference.

Other Federal Circuit News:

Report and Recommendation in Judicial Investigation. As we summarized in our July 2023 update, there is an ongoing proceeding by the Judicial Council of the Federal Circuit under the Judicial Conduct and Disability Act and the implementing Rules involving Judge Pauline Newman. On August 16, 2023, the Special Committee released additional materials in the investigation. The materials may be accessed here.

Upcoming Oral Argument Calendar

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

Key Case Summaries (August 2023)

Axonics, Inc. v. Medtronic, Inc., Nos. 22-1532, 22-1533 (Fed. Cir. Aug. 7, 2023): Axonics filed petitions for inter partes review (“IPR”) challenging Medtronic’s patents directed to transcutaneous (through the skin) charging of implanted medical devices through inductive coupling. After institution, Medtronic advanced for the first time a construction of a claim term in its Patent Owner Response, which Axonics disagreed with, and argued in reply that the claims would be unpatentable even under Medtronic’s construction. Medtronic then argued in its sur-reply that it would be prejudicial for the Board to consider Axonics’s new reply arguments. The Board agreed with Medtronic and refused to consider Axonics’s new reply arguments, because these arguments had not been made in its petition.

The Federal Circuit (Dyk, J., joined by Lourie and Taranto, JJ.) vacated and remanded. The Court explained that, under the Board’s rules and the Supreme Court’s decision in SAS Inst., Inc. v. Iancu, 138 S. Ct. 1348, 1345 (2018), a petitioner is entitled to respond to new arguments made in a patent owner response. Additionally, under the Administrative Procedure Act (“APA”), the Board may adopt a new construction after institution, if it gives the petitioner an opportunity to respond to constructions that are not sufficiently similar to one disputed by the parties. Consistent with this precedent, the Court held that the petitioner must have adequate notice and an opportunity to respond to post-institution claim constructions, including a reasonable opportunity in reply to present argument and evidence under that new construction.

Rembrandt Diagnostics, LP v. Alere, Inc., No. 21-1796 (Fed. Cir. Aug. 11, 2023): Alere sought an IPR challenging Rembrandt’s patent directed to test assay devices and methods for testing biological fluids. Alere initially identified “efficiency” as a reason that a relevant artisan would have been motivated to combine the asserted prior art. In response, Rembrandt challenged Alere’s motivation arguments, but did not submit expert testimony. In reply, Alere submitted an expert declaration and argued that combining the prior art references would save cost and time, and that there was thus a motivation to combine them, as well as a reasonable expectation of success. The Board found all the claims unpatentable, relying on Alere’s cost and time savings arguments and unrebutted expert testimony.

The Federal Circuit (Reyna, J., joined by Moore, C.J., and Dyk, J.) affirmed. Rembrandt argued that Alere improperly raised the benefit of cost and time savings for the first time in its reply. However, the Court determined that Rembrandt had forfeited this argument by only lodging a “generic objection” to Alere’s reply generally and not to that specific benefit argument, which was insufficient to constitute a proper objection. The Court also held that Alere’s cost and time savings arguments were not new arguments raised for the first time in its reply, but arguments that responded to Rembrandt’s opposition and also properly expands on and is a fair extension of its efficiency arguments raised in the petition.

Volvo Penta of the Americas, LLC v. Brunswick Corp., No. 22-1765 (Fed. Cir. Aug. 24, 2023): In 2015, Volvo launched the Forward Drive embodying its patent directed to a tractor-type stern drive for a boat. In 2020, Brunswick launched a similar product called the Bravo Four S, and on the same day as its launch, filed an IPR petition challenging Volvo’s patent. The Board determined that the challenged claims would have been obvious over the asserted prior art. The Board also found a lack of nexus with the embodying products, but determined that even if there had been nexus, Brunswick’s strong evidence of obviousness outweighed Volvo’s evidence of nonobviousness.

The Federal Circuit (Lourie, J., joined by Moore, C.J. and Cunningham, J.) vacated and remanded. The Court explained that there were two ways to prove nexus: (1) via a presumption of nexus or (2) via a showing that the evidence is a direct result of the unique characteristics of the claimed invention. While the Court agreed that Volvo’s arguments regarding presumption were insufficient, the Court determined that Volvo had put forth evidence that Brunswick recognized the success of Forward Drive was directly tied to the unique characteristics of the claimed tractor-type stern drive. Indeed, the Court noted that the Board found that boat manufacturers strongly desired Volvo’s Forward Drive and urged Brunswick to bring a similar product to market. The Court therefore concluded that there was a nexus between the unique features of the claimed invention and the evidence of secondary considerations.

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, bevanson@gibsondunn.com)
Audrey Yang – Dallas (+1 214-698-3215, ayang@gibsondunn.com)

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, tdupree@gibsondunn.com)
Allyson N. Ho – Dallas (+1 214-698-3233, aho@gibsondunn.com)
Julian W. Poon – Los Angeles (+ 213-229-7758, jpoon@gibsondunn.com)

Intellectual Property Group:
Kate Dominguez – New York (+1 212-351-2338, kdominguez@gibsondunn.com)
Y. Ernest Hsin – San Francisco (+1 415-393-8224, ehsin@gibsondunn.com)
Josh Krevitt – New York (+1 212-351-4000, jkrevitt@gibsondunn.com)
Jane M. Love, Ph.D. – New York (+1 212-351-3922, jlove@gibsondunn.com)

On August 29, 2023, the federal banking agencies (the Board of Governors of the Federal Reserve System (“Federal Reserve”), the Federal Deposit Insurance Corporation (“FDIC”) and the Office of the Comptroller of the Currency (“OCC”)) issued a joint notice of proposed rulemaking that would require certain large banking organizations to issue and maintain minimum amounts of long-term debt (“LTD”).[1] The Proposed Rule represents another major step in the federal banking agencies’ continued efforts to impose heightened enhanced prudential standards on banking organizations with $100 billion or more in total consolidated assets and align those enhanced prudential standards with those currently applicable to global systemically important banking organizations (“GSIBs”).

As anticipated, the Proposed Rule would require Category II, III and IV bank holding companies (“BHCs”), savings and loan holding companies (“SLHCs”) and U.S. intermediate holding companies (“IHCs”) of foreign banking organizations (“FBOs”) that are not GSIBs (collectively, “covered entities”) to issue and maintain minimum amounts of LTD that satisfies certain requirements.[2]

The Proposed Rule also would require four categories of insured depository institutions (“IDIs”) that are not consolidated subsidiaries of U.S. GSIBs to issue and maintain minimum amounts of LTD. Those “covered IDIs” are:

any IDI that has at least $100 billion in total consolidated assets and that is a consolidated subsidiary of a covered entity or a U.S. IHC of a foreign GSIB;
any IDI that has at least $100 billion in total consolidated assets and is not controlled by a parent entity;
any IDI that has at least $100 billion in total consolidated assets and (i) is a consolidated subsidiary of a company that is not a covered entity, a U.S. GSIB or a foreign GSIB subject to the Federal Reserve’s total loss-absorbing capacity (“TLAC”) rule or (ii) is controlled but not consolidated by another company; and
any IDI (regardless of size) that is affiliated with an IDI in one of the foregoing three categories.[3]

IDIs that are consolidated subsidiaries of U.S. GSIBs would not be subject to the Proposed Rule because their parent holding companies are subject to LTD requirements under the Federal Reserve’s TLAC rule and the most stringent capital, liquidity and other enhanced prudential standards.[4] However, covered IDIs that are consolidated subsidiaries of U.S. IHCs controlled by foreign GSIBs would be subject to the Proposed Rule and would be required to issue and maintain minimum amounts of LTD.

The Proposed Rule follows closely the federal banking agencies’ release of the Basel III endgame reforms in July 2023 (see our prior Client Alert). The Basel III endgame proposal would significantly reduce the differences that apply across the four categories established by the federal banking agencies in 2019 for determining the applicability and stringency of regulatory capital requirements for large banking organizations. Like the Basel III endgame proposal, the Proposed Rule would align LTD requirements applicable to large banking organizations with total assets of $100 billion or more in a similar manner across the four categories—although, as noted above, IDIs that are consolidated subsidiaries of U.S. GSIBs would not be subject to the Proposed Rule.

Unlike the Basel III endgame proposal, the Proposed Rule was adopted unanimously. However, Federal Reserve Governors Bowman and Waller raised concerns with the Proposed Rule, including concerns that the Proposed Rule, like the Basel III endgame proposal, would not comply with the tailoring requirements of Section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), as amended by the 2018 Economic Growth, Regulatory Relief, and Consumer Protection Act (“EGRRCPA”).[5]

As with prior rulemakings, the Proposed Rule, if finalized, would include a three-year transition period and the LTD requirements under any final rule would be fully phased in over that three-year period. Entities that become subject to the Proposed Rule after the effective date also would benefit from a three-year transition period. The Proposed Rule also would allow banking organizations to include, as part of the required minimum amounts, certain “grandfathered” existing LTD.

Comments on the Proposed Rule are due by November 30, 2023 – the same date that comments to the Basel III endgame proposal are due.[6] The agencies have included 67 questions as prompts (almost all of which include multiple related sub-prompts) to solicit comments on all aspects of the Proposed Rule.

I. Key Aspects of the Proposed Rule

Scope of Application. The Proposed Rule would apply to all non-U.S. GSIBs with $100 billion or more in total consolidated assets. Large banking organizations subject to the Proposed Rule would be required to comply with LTD requirements at both the holding company level and IDI level. U.S. GSIBs would not be subject to the LTD requirements at the IDI level, though IDI subsidiaries of U.S. IHCs controlled by foreign GSIBs would be subject to the Proposed Rule.

Application of the Proposed Rule
U.S. GSIBs and their IDI subsidiaries	Category II, III and IV BHCs and SLHCs and their IDI subsidiaries	Category II, III and IV U.S. IHCs and their IDI subsidiaries
U.S. GSIBs are already subject to LTD requirements under the TLAC rule.	Category II, III and IV BHCs and SLHCs would be subject to the LTD requirements.	Category II, III and IV U.S. IHCs of FBOs would be subject to the LTD requirements. U.S. IHCs controlled by foreign GSIBs are already subject to LTD requirements under the TLAC rule.
IDIs that are consolidated subsidiaries of U.S. GSIBs would not be subject to the LTD requirements.	IDIs with at least $100 billion in total consolidated assets and their affiliated IDIs would be subject to the LTD requirements. IDI subsidiaries of U.S. IHCs controlled by foreign GSIBs would be subject to the LTD requirements.

Minimum LTD Levels. Under the Proposed Rule, covered entities and covered IDIs would be subject to the same minimum LTD levels as U.S. IHCs of foreign GSIBs under the TLAC rule:

Minimum LTD Levels

U.S. GSIBs under TLAC Rule

U.S. IHCs of foreign GSIBs under TLAC Rule

Covered Entities and Covered IDIs under Proposed Rule

Outstanding eligible external LTD in an amount not less than the greater of:

– 6% of total risk-weighted assets plus the surcharge applicable under the GSIB surcharge rule; and

– 4.5% of total leverage exposure.

Outstanding eligible external LTD in an amount not less than the greater of:

– 6% of total risk-weighted assets;

– 3.5% of average total consolidated assets; and

– 2.5% of total leverage exposure if subject to the supplementary leverage ratio (“SLR”).

Outstanding eligible LTD in an amount not less than the greater of:

– 6% of total risk-weighted assets;

– 3.5% of average total consolidated assets; and

– 2.5% of total leverage exposure if subject to the SLR.

As with the LTD requirements applicable to U.S. GSIBs and the U.S. IHCs of foreign GSIBs, the Proposed Rule’s eligible LTD requirement was calibrated primarily on the basis of a “capital refill” framework. The Proposed Rule would not tailor the LTD requirements for Category II, III or IV banking organizations or their IDI subsidiaries.

The Proposed Rule would prohibit a covered entity from redeeming or repurchasing any outstanding eligible LTD without the prior approval of the Federal Reserve if after the redemption or repurchase the covered entity would not meet its minimum LTD requirement. Additionally, the Proposed Rule would authorize the agencies, after providing an external LTD issuer with notice and an opportunity to respond, to order the external issuer to exclude from its outstanding eligible LTD amount any otherwise eligible debt securities “with features that would significantly impair the ability of such debt securities to absorb losses in resolution.”[7]

Externally/Internally Issued LTD. Under the Proposed Rule, certain covered entities and covered IDIs would be required or permitted to issue eligible LTD externally, while others would be required or permitted to issue eligible LTD internally.

Externally/Internally Issued LTD
Covered U.S. Holding Companies	May only issue eligible “external” LTD
Covered IHCs of FBOs	“Resolution IHCs”[8] may issue eligible “internal” or “external” LTD “Non-resolution IHCs”[9] may only issue eligible “internal” LTD
Covered IDIs	Covered IDIs that are consolidated subsidiaries of covered entities or a foreign GSIB IHC may only issue eligible “internal” LTD Covered IDIs that are not controlled subsidiaries of a parent entity may only issue eligible “external” LTD Covered IDIs that are consolidated subsidiaries of a parent entity that is not a covered entity or that are controlled but not consolidated by a covered entity or foreign GSIB IHC entity may issue eligible “internal” or “external” LTD

Eligible External and Internal LTD. The Proposed Rule would generally align the requirements for externally issued LTD with the requirements for eligible LTD under the Federal Reserve’s TLAC rule.

Eligible External LTD
Category II, III and IV BHCs and SLHCs, covered IDIs required or permitted to issue external LTD and “resolution IHCs”
Paid in and issued directly by the external issuer (debt instruments issued by a subsidiary of a covered entity or covered IDI would not qualify as eligible external LTD) Held by a non-affiliate (except that a covered IDI may issue eligible external LTD to an affiliate that controls but does not consolidate the covered IDI)[10] Unsecured, not guaranteed by the issuer or a subsidiary or an affiliate of the issuer, and not subject to any other arrangement that legally or economically enhances the seniority of the instrument (such as a credit enhancement provided by an affiliate) Maturity of greater than or equal to one year from the date of issuance “Plain vanilla” features Excluded from treatment as eligible external LTD if instruments are: (i) structured notes, (ii) have a credit-sensitive feature, (iii) include a contractual provision for conversion into or exchange for equity in the issuer, or (iv) include a provision that gives the holder a contractual right to accelerate payment (including automatic acceleration) Permissible acceleration rights include rights exercisable: (i) on one or more dates specified in the instrument, (ii) in the event of the issuer entering into insolvency or resolution proceedings, or (iii) upon the issuer’s failure to pay principal or interest on the instrument and which remains uncured for 30 days or more[11] In the case of eligible external LTD issued by a covered IDI, instrument must be contractually subordinated so that the claim represented by the LTD in the receivership of the IDI would be junior to deposit and general unsecured claims Issued in a minimum principal denomination of $400,000 Governed by U.S. law or the laws of any state

Principal due to be paid on eligible external LTD in one year or more and less than two years would be subject to a 50% haircut for purposes of the external LTD requirement and principal due to be paid on eligible external LTD in less than one year would not count toward the external LTD requirement.

Eligible Internal LTD
Covered IDIs required or permitted to issue internal LTD and “non-resolution IHCs”
The requirements for eligible internal LTD are generally the same as those for eligible external LTD, with two principal differences: eligible internal LTD issued by a covered IDI must be issued to and remain held by a company that consolidates the covered IDI, generally an upstream parent; and no minimum principal denomination requirement Eligible internal LTD issued by a covered IHC would be required to include a contractual conversion trigger approved by the Federal Reserve pursuant to which the Federal Reserve could require the covered IHC, under certain circumstances, to convert or exchange some or all of the internal LTD into common equity tier 1 capital of the covered IHC without the covered IHC’s entry into a resolution proceeding and would not include a prohibition against credit sensitive features[12] Non-resolution IHCs would be required to issue eligible internal LTD to a foreign company that directly or indirectly controls the covered IHC, or to a wholly owned subsidiary of a controlling foreign company For a covered IDI that is a consolidated subsidiary of a covered IHC, the Proposed Rule would require that eligible internal LTD of the covered IDI be issued to the covered IHC, or a subsidiary of the covered IHC that consolidates the IDI (the LTD could not be directly issued to a foreign affiliate that controls the IDI)

Grandfathering of Legacy External LTD. The Proposed Rule would permit some legacy external LTD to count towards the minimum LTD requirements, even where such legacy external LTD does not meet certain eligibility requirements:

instruments that contain impermissible acceleration clauses;
instruments issued with principal denominations that are less than the proposed $400,000 minimum amount; and
in the case of legacy instruments issued externally by a covered IDI, are not contractually subordinated to general unsecured creditors (collectively, “eligible legacy external LTD”).

Notably, eligible legacy external LTD issued by a consolidated subsidiary IDI of a covered entity may be used to satisfy the minimum external LTD requirement applicable to both its covered parent holding company or covered resolution IHC and any internal LTD requirement applicable to the subsidiary IDI itself. However, eligible legacy external LTD cannot be used to satisfy the internal LTD requirement for non-resolution covered IHCs. To qualify as “eligible legacy external LTD,” an instrument must be issued prior to the date that notice of the final rule is published in the Federal Register. The Proposed Rule would authorize the federal banking agencies, after providing a covered entity or covered IDI with notice and an opportunity to respond, to order the covered entity or covered IDI to exclude from its outstanding eligible LTD amount any eligible legacy external LTD.[13]

Transition Period. The Proposed Rule would provide a transition period for covered entities and covered IDIs that would be subject to the rule upon its effectiveness, and a transition period for covered entities and covered IDIs that become subject to the rule after it becomes effective. Over that three-year period, covered entities and covered IDIs would need to meet:

25% of their LTD requirements by one year after the effective date of the final rule (or one year after becoming subject to the rule);
50% after two years of the effective date of the final rule (or two years after becoming subject to the rule); and
100% after three years of the effective date of the final rule (or three years after becoming subject to the rule).

The federal banking agencies would be authorized to accelerate or extend the transition period. The transition period would not re-start for a covered IDI that converts its charter or any holding company thereof. Finally, covered entities that transition from being subject to the final rule to the Federal Reserve’s TLAC rule would have three years to comply with the requirements imposed under the TLAC rule.[14]

Clean Holding Company Requirements. The Proposed Rule also would include “clean holding company” requirements like those that apply to U.S. GSIBs and U.S. IHCs of foreign GSIBs subject to the Federal Reserve’s TLAC rule. In particular, the Proposed Rule would prohibit covered entities from:

externally issuing short-term debt instruments (i.e., instruments with an original maturity of less than one year);
entering into qualified financial contracts, or “QFCs”, with third parties;[15]
guaranteeing (including by providing credit support for) a subsidiary’s liabilities with an external counterparty if the covered entity’s insolvency or entry into a resolution proceeding (other than resolution under Title II of the Dodd-Frank Act) would create default rights for a counterparty of the subsidiary; and
having outstanding liabilities that are guaranteed by a subsidiary of the covered entity or that are subject to rights that would allow a third party to offset its debt to a subsidiary upon the covered entity’s default on an obligation owed to the third party.

The Proposed Rule would amend the QFC prohibition of the clean holding company requirements so that holding companies subject to the TLAC rule may enter into underwriting agreements, fully paid structured share repurchase agreements and employee and director compensation agreements. These changes also would be applied to the clean holding company requirements proposed for covered BHCs and SLHCs (not covered IHCs) under the Proposed Rule. The Proposed Rule would authorize the Federal Reserve to determine that additional agreements would not be subject to the QFC prohibition.

Capital Deduction Framework. Under the current capital rule, U.S. GSIBs, their subsidiary depository institutions and Category II banking organizations are required to deduct investments in LTD issued by banking organizations that are required to issue LTD to the extent that aggregate investments by the investing banking organization in the capital and LTD of other financial institutions exceed a specified threshold. The Proposed Rule would expand the existing capital deduction framework for LTD issued by U.S. GSIBs and the IHCs of foreign GSIBs to include external LTD issued by covered entities and external LTD issued by covered IDIs by amending the capital rule’s definition of “covered debt instrument.” The Proposed Rule would not otherwise amend the capital rule’s deduction framework.

Notably, the Basel III endgame proposal would subject Category III and IV banking organizations to the LTD deduction framework that currently only applies to U.S. GSIBs, their subsidiary depository institutions and Category II banking organizations and would apply a heightened risk weight to investments in LTD that are not deducted.

Changes to the Existing TLAC Rule. The Proposed Rule would make conforming and certain other changes to the TLAC rule, including:

conforming changes to require minimum denominations for eligible LTD;[16]
changes to the haircuts that are applied to eligible LTD for purposes of compliance with the TLAC requirement to conform to haircuts that apply for purposes of the LTD requirement – accordingly, the Proposed Rule would allow only 50% of the amount of eligible LTD with a maturity of one year or more but less than two years to count towards the TLAC requirement;
clarifications to the clean holding company requirements so that U.S. GSIBs and U.S. IHCs of foreign GSIBs may enter into underwriting agreements, fully paid structured share repurchase agreements and employee and director compensation agreements; and
enhanced disclosure requirements.

Finally, the Proposed Rule would authorize the Federal Reserve to require LTD and TLAC levels greater than or less than the minimum requirement currently required under the TLAC rule.[17]

II. Issues with the Proposed Rule

As they did with the Basel III endgame proposal, each of Federal Reserve Governors Bowman and Waller—although voting in support of the Proposed Rule—raised concerns with the authority for the Proposed Rule being in conflict with the tailoring requirements under Section 165 of the Dodd-Frank Act, as amended by EGRRCPA, and the federal banking agencies’ tailoring rules implementing Section 165. These statements raise the prospects that the Proposed Rule could be subject to challenge if adopted substantially as proposed.

Governor Bowman: “Today’s proposal would weaken the current risk-based, tailored approach to regulation by applying the same regulatory requirements to firms from $100 billion to $1 trillion regardless of their activities and potential risks to the financial system. I am concerned that collapsing Categories II, III, and IV into a single prudential category may call into question whether the Federal Reserve is complying with the statutory requirements to tailor prudential requirements for large firms.[2] … In 2017, when the rules addressing total loss-absorbing capacity and long-term debt for GSIBs and the U.S. intermediate holding companies of foreign GSIBs were adopted, the [Federal Reserve] expressly noted that the application of the rules were limited, ‘in keeping with the Dodd-Frank Act’s mandate that more stringent prudential standards be applied to the most systemically important bank holding companies.’[3] In my view, there is a legitimate question about whether the proposal meets the statutory bar for tailoring the stringency of enhanced prudential standards, and applying such standards to banks with $100 billion to $250 billion in assets. I look forward to receiving feedback from commenters on this issue.”[18]
Governor Waller: “More importantly, I am concerned that our regulatory framework for large banks is moving in a direction that does not tailor requirements in a manner consistent with the spirit of the Dodd-Frank Act, as amended by Congress in 2018.”[19]

Governor Bowman also focused on the potential impacts of the Proposed Rule on competition and highlighted that the joint implementation of the Basel III endgame proposal and LTD requirements would have unclear effects. On competition, she noted:

In my view, as the differences between the regulatory requirements for GSIBs and firms with more than $100 billion in assets continue to be eroded, it will become less economically rational for firms to remain in Category IV and creates an even steeper “cliff” effect for regional banks that seek to grow into this category. Ultimately, the cumulative effect of these proposals and others to be considered in the coming months could exacerbate the pressure on banks to grow larger through acquisition resulting in harmful effects on competition, the reduction of banking options in some geographic or product markets, and rendering some institutions competitively unviable.[20]

Governor Bowman has long stressed that enhanced supervision should be the federal banking agencies’ focus, consistently highlighting that the Dodd-Frank Act provides regulators the toolkit they need to supervise banking organizations through the cycle, and that as banks grow, those tools are in place for supervision and regulation to become more stringent. In her statement accompanying the release of the Proposed Rule, she again reiterated the need for enhanced supervision, rather than a “belt, suspenders, and elastic waistband approach” to regulatory reform.[21]

Finally, as the federal banking agencies acknowledge in the preamble to the Proposed Rule, “there is a risk that efforts by covered entities and covered IDIs to issue a large volume of LTD over a limited period could strain the market capacity to absorb the full amount of such issuance if issuance volume exceeds debt market appetite for LTD instruments,” particularly in periods of adverse funding market conditions.[22] In recent years, a number of large banking organizations have been issuing LTD instruments in the market in anticipation of LTD requirements similar to those imposed on U.S. GSIBs under the TLAC rule being imposed on firms with $100 billion in more in total assets. It will be important for organizations that could become subject to the Proposed Rule to contemplate further LTD issuances in anticipation of the Proposed Rule being adopted substantially as proposed and taking advantage of the grandfathering provisions for eligible legacy external LTD and the Proposed Rule’s three-year transition period to satisfy expected LTD requirements going forward.

III. Conclusions

As with the Basel III endgame proposal, it is imperative that all stakeholders actively engage in the rulemaking process with the federal banking agencies and other policymakers to facilitate a thoughtful approach to the final rule. The comment process will play a critical role in shaping the substance of the final rule and the federal banking agencies’ consideration of the myriad issues raised by the Proposed Rule, its interaction with the Basel III endgame proposal, its potentially broader unintended consequences, including impacts on competition, and may also form the basis for any future legal challenges to the federal banking agencies’ final rule.

________________________

[1] Federal Reserve, FDIC, OCC, Long-term Debt Requirements for Large Bank Holding Companies, Certain Intermediate Holding Companies of Foreign Banking Organizations, and Large Insured Depository Institutions (July 27, 2023), available at: https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20230829a1.pdf (the “Proposed Rule”). The Proposed Rule follows an advance notice of proposed rulemaking issued in October 2022 by the Federal Reserve and FDIC seeking input on a long-term debt requirement for certain large banking organizations that are not GSIBs. See Federal Reserve, FDIC, Resolution-Related Resource Requirements for Large Banking Organizations, 87 Fed. Reg. 64170 (Oct. 24, 2022).

[2] Proposed Rule, p. 9. This part of the Proposed Rule is issued by the Federal Reserve.

[3] Proposed Rule, p. 10. This part of the Proposed Rule is issued by the Federal Reserve, FDIC and OCC.

[4] Proposed Rule, p. 9, n. 2.

[5] See 12 U.S.C. § 5365(a)(1), (2)(A), (2)(C). As it relates to covered IDIs, Director Chopra argued in his statement in support of the Proposed Rule that the proposal “for an [IDI] to issue minimum amounts of long-term debt is not a Dodd-Frank Act Section 165 ‘enhanced prudential standard,’ and is therefore not tied to the [EGRRCPA’s] $100 billion asset threshold.” Statement of CFPB Director Rohit Chopra Member, FDIC Board of Directors Regarding Proposals to Improve the FDIC’s Options for Managing Large Bank Failures (Aug. 29, 2023), available at: https://www.consumerfinance.gov/about-us/newsroom/statement-of-cfpb-director-rohit-chopra-member-fdic-board-of-directors-regarding-proposals-to-improve-the-fdics-options-for-managing-large-bank-failures/#6 (“Director Chopra Statement”).

[6] The Basel III endgame proposal provided for a 126-day comment period; the Proposed Rule provides for a 93-day comment period.

[7] See Proposed Rule, p. 42.

[8] “Resolution IHCs” are “covered IHCs of FBOs with a top-tier group-level resolution plan that contemplates their covered IHCs or subsidiaries of their covered IHCs entering into resolution, receivership, insolvency, or similar proceedings in the United States.” Proposed Rule, p. 60.

[9] “Non-resolution IHCs” are “covered IHCs of FBOs with top-tier group-level resolution plans that do not contemplate their covered IHCs or the subsidiaries of their covered IHCs entering into resolution, receivership, insolvency, or similar proceedings.” Proposed Rule, p. 60.

[10] See Proposed Rule, pp. 43-44.

[11] Eligible external LTD instruments would be permitted to give the holder a put right as of a future date certain (such an instrument would be treated as if it were due to be paid on the day on which it first became subject to the put right, regardless of whether the put right would be exercisable on that date only if another event occurred (e.g., a credit rating downgrade)). See Proposed Rule, p. 52, n. 48.

[12] The conversion provision may be triggered if both (a) the Federal Reserve determines that the covered IHC is “in default or in danger of default,” and (b) any of the following circumstances apply: (i) the top-tier FBO or any subsidiary of the top-tier FBO has been placed into resolution proceedings in its home country; (ii) the home country supervisory authority consents to the conversion or exchange or does not object to the conversion or exchange following 24 hours’ notice; or (iii) the Federal Reserve makes a written recommendation to the Secretary of the Treasury that the FDIC should be appointed as receiver of the covered IHC under the “orderly liquidation authority” under Title II of the Dodd-Frank Act. The terms of the contractual conversion provision in the debt instrument would have to be approved by the Federal Reserve. See Proposed Rule, p. 63.

[13] See Proposed Rule, pp. 65-66.

[14] See Proposed Rule, pp. 83-85.

[15] The proposed requirement would only apply prospectively to new agreements entered into after the post-transition period effective date of a final rule. See Proposed Rule, p. 73.

[16] Question 59 asks: “Should the [Federal Reserve] impose a higher minimum denomination for TLAC companies subject to the TLAC rule? Should the minimum denomination be higher (e.g., $1 million) for companies subject to the TLAC rule than for covered entities subject to the newly proposed LTD requirement?” Proposed Rule, p. 90.

[17] See Proposed Rule, pp. 86-97.

[18] Statement by Federal Reserve Governor by Michelle W. Bowman (August 29, 2023), available at: https://www.federalreserve.gov/newsevents/pressreleases/bowman-statement-20230829.htm. (citing to 12 U.S.C. § 5365(a)(1), (2)(C) and 82 Fed. Reg. 8266, 8288 (Jan. 24, 2017), respectively) (“Governor Bowman Statement”).

[19] Statement by Federal Reserve Governor Christopher J. Waller (August 29, 2023), available at: https://www.federalreserve.gov/newsevents/pressreleases/waller-statement-20230829.htm. In contrast, Director Chopra proposed whether “we should determine whether institutions below $100 billion, such as those with high levels of ‘uninsured’ deposits or those that have grown very rapidly, should also be subjected to a similar requirement.” Director Chopra Statement.

[20] Governor Bowman Statement.

[21] See id.

[22] See Proposed Rule, p. 114.

Gibson Dunn’s Distressed Banks Resource Center provides resources and regular updates to our clients. Please check the Resource Center for the latest developments.

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 Gibson Dunn’s Global Financial Regulatory, Financial Institutions, Capital Markets, Securities Regulation and Corporate Governance, Public Policy or Administrative Law and Regulatory practice groups, or the following authors:

Jason J. Cabral – New York (+1 212-351-6267, jcabral@gibsondunn.com)
Zach Silvers – Washington, D.C. (+1 202-887-3774, zsilvers@gibsondunn.com)

On August 30, 2023, the U.S. Department of Labor issued a proposed rule to revise its regulations implementing minimum wage and overtime exemptions for executive, administrative, and professional employees, among others, under the Fair Labor Standards Act (“FLSA”). The proposal, if finalized, would revise the minimum wage and overtime exemptions issued by the Trump Administration in 2019, which have been in effect since January 1, 2020.

Among other things, the proposal would increase the compensation thresholds that are used when determining whether an employee qualifies for the executive, administrative, or professional exemptions. Under the Department’s existing regulations an employee qualifies for an exemption if: (1) she is paid a predetermined and fixed salary that is not subject to reduction because of variations in the quality or quantity of work performed; (2) the amount of salary paid meets a minimum specified amount; and (3) her job duties are primarily executive, administrative, or professional. The Department has periodically revised the minimum salary component of the test, most recently in 2019, when it set the minimum salary at $684 per week ($35,568 on an annual basis).

The Department’s proposal would increase the salary threshold substantially. The Department proposes to increase the threshold to at least $1,059 per week, which is approximately $55,000 per year, representing a nearly 55 percent increase over the current threshold. The proposal also leaves open the possibility that the Department might use more recent wage data when it finalizes the rule, which means the compensation thresholds could easily be as high as $1,140 or $1,158 per week, or approximately $60,000 per year. (A higher threshold applies under state law in only a handful of states, such as California which requires that exempt employees earn at least $1,240 per week.) These increases are the result of the Department’s proposal to tie the compensation thresholds to the 35th percentile of wage survey data of full-time salaried workers in the lowest-wage Census Region—as opposed to 20th percentile of wage survey data of full-time salaried workers in the lowest-wage Census Region and of retail workers nationally.

The proposal would also increase the compensation threshold for the highly compensated employees exemption. Employees earning at least $107,432 annually currently qualify for this exemption if they regularly perform at least one executive, administrative, or professional duty. The Department proposes to increase the compensation threshold to $143,988, an increase of approximately 34 percent.

These changes to the Department’s compensation thresholds would, if implemented, have significant consequences for many employers. It is estimated that the changes will expand the number of workers who would be eligible for overtime wages by at least 3.6 million.

The Department also proposes to automatically increase the compensation thresholds every three years to account for changes in wage survey data collected by the Bureau of Labor Statistics. If implemented, the automatic increase mechanism would likely result in significantly higher compensation thresholds in the coming years.

Increases to the compensation threshold, including automatic increases, were included in the Obama Administration’s 2016 rule. That rule, which would have increased the compensation threshold to $913 per week ($47,476 on an annual basis), was enjoined before it took effect. It was later struck down by the U.S. District Court for the Eastern District of Texas on the grounds that the Department’s reliance on salary thresholds to the exclusion of an analysis of employees’ job duties exceeded the Department’s authority under the statute. A similar challenge should be expected to any final rule resulting from the Department’s new rulemaking, particularly in light of Justice Kavanaugh’s dissent in Helix Energy Solutions Group, Inc. v. Hewitt, 598 U.S. 39 (2023), which suggested that the Department’s compensation threshold test may be inconsistent with the FLSA.

Interested parties will have 60 days to submit comments on the proposed rule after it is published in the Federal Register. The Department may issue a final rule as soon as early-to-mid 2024. As noted, legal challenges are possible once a final rule is adopted.

The following Gibson Dunn attorneys assisted in preparing this client update: Eugene Scalia, Jason Schwartz, Katherine Smith, Andrew Kilberg, and Blake Lanning.

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

Eugene Scalia – Co-Chair, Administrative Law & Regulatory Group, Washington, D.C.
(+1 202-955-8210, escalia@gibsondunn.com)

Jason C. Schwartz – Co-Chair, Labor & Employment Group, Washington, D.C.
(+1 202-955-8242, jschwartz@gibsondunn.com)

Katherine V.A. Smith – Co-Chair, Labor & Employment Group, Los Angeles
(+1 213-229-7107, ksmith@gibsondunn.com)

Helgi C. Walker – Co-Chair, Administrative Law & Regulatory Group, Washington, D.C.
(+1 202-887-3599, hwalker@gibsondunn.com)

Gibson Dunn has secured a six-figure settlement awarding attorneys’ fees for its representation of the New Jersey Chapter of the American Immigration Lawyers Association (AILA-NJ) against the federal Executive Office for Immigration Review (EOIR) in the District of New Jersey.

The settlement follows a February 2023 ruling that held that immigration judges at the Newark Immigration Court violated a stipulation by failing to timely adjudicate motions made by immigration attorneys to appear remotely and neglecting to provide adequate reasoning when denying those motions. The judge dismissed EOIR’s explanation that “bandwidth issues” compelled the Newark Immigration Court’s sudden switch to default in-person hearings or justified denying motions for WebEx hearings, finding that it was unsupported by the evidence.

After stipulating in February 2021 to timely adjudicate requests to appear remotely, EOIR abruptly changed course in August 2022, citing “bandwidth issues” at the court. The Gibson Dunn team filed an Emergency Motion to Enforce the Stipulation in October 2022, alleging that the policy change was a violation of EOIR’s commitment. At a two-day evidentiary hearing, the Gibson Dunn team presented two witnesses, AILA-NJ’s Chapter President and a Department of Homeland Security attorney and union representative. Both testified that their members faced an impossible choice between representing their clients in person or risking their or their immunocompromised loved ones’ safety. The Gibson Dunn team also cross-examined the government’s IT expert, who conceded that there was no factual basis for EOIR’s “bandwidth issues” rationale.

In its March 2023 Final Order, the Court granted AILA-NJ permission to file a motion for attorneys’ fees as the prevailing party. Following negotiations, EOIR then agreed to a substantial settlement.

The Gibson Dunn team included partner Akiva Shapiro and associates Seton Hartnett O’Brien, Salah Hawkins, Dasha Dubinsky, Tawkir Chowdhury, and Edmund Bannister.

Because of an expiring transition rule, a partner that currently relies on a “bottom dollar guarantee” to support an allocation of liabilities may be required to recognize gain under section 731(a) unless that partner takes action before October 4, 2023.[1] After a brief overview and discussion of the applicable Treasury regulations, we describe the action that should be taken.

I. Overview

In October 2019, the IRS and Treasury issued final regulations (the “2019 Regulations”) that provide that “bottom dollar payment obligations” (commonly referred to as “bottom dollar guarantees”) do not cause a partnership’s liabilities to be treated as recourse with respect to the partner providing the guarantee. The result of this rule is that a bottom dollar guarantee does not cause the guaranteed liability to be allocated to the partner providing the guarantee.[2] The absence of such an allocation may cause the partner providing the guarantee to recognize gain in an amount up to the amount of the liabilities. The 2019 Regulations are effective for partnership liabilities incurred and guarantees entered into on or after October 5, 2016.

The 2019 Regulations include a seven-year transition rule for a partner that had a “negative tax capital account” immediately before October 5, 2016 and was relying on an allocation of recourse liabilities to avoid gain recognition. In general, a partner would have a “negative tax capital account” to the extent that the partner has previously been allocated losses or deductions or received distributions from the partnership in excess of the partner’s capital investment in the partnership (i.e., capital contributions to the partnership and previous allocations of income or gain by the partnership to the partner). The transition rule also applies to liabilities incurred and payment obligations entered into before October 5, 2016 that were subsequently refinanced or modified.

When the transition rule expires on October 4, 2023, bottom dollar guarantees will no longer be effective to cause partnership liabilities to be treated as recourse with respect to the partner providing the guarantee. As a result, absent other action, the partner may recognize gain under section 731(a) to the extent of the partner’s remaining “negative tax capital account.”

II. Discussion

A. Background on the Allocation of Partnership Liabilities

An entity that is classified as a partnership for U.S. federal income tax purposes allocates its liabilities among its partners in accordance with section 752 and the regulations interpreting section 752. Any liability that is allocated to a partner increases that partner’s basis in its partnership interest. A partner with a share of liabilities may, therefore, be able to receive greater distributions of money from the partnership without recognizing gain under section 731(a) or claim deductions for a greater amount of partnership deductions than would be possible without the share of liabilities.

When a partner’s share of a liability decreases—whether because the liability is repaid or because it is allocated to a different partner—the partner whose share decreases is treated as receiving a distribution of money in an amount equal to the reduction. If the amount of the reduction exceeds the partner’s basis in its interest, the partner recognizes taxable gain under section 731(a).

Whether a partnership liability is allocated to a particular partner depends, in the first instance, on whether the liability is “recourse” or “nonrecourse.” A liability that is “recourse” to a particular partner is allocated to that partner. A liability that is not recourse to any particular partner is considered “nonrecourse” and generally is allocated among all partners (though, in many cases, there is substantial flexibility with respect to the allocation of nonrecourse liabilities under Treas. Reg. § 1.752-3).

For this purpose, a liability is a recourse liability when a partner or related person bears the “economic risk of loss” with respect to that liability. To determine whether any partner or related person bears the economic risk of loss with respect to a liability, the Treasury regulations require the partnership to determine whether any partner would have a “payment obligation” if all of the assets of the partnership (including cash) became worthless and the liabilities became due (this is sometimes referred to as the “atom bomb test”).[3]

B. Use of Guarantees to Cause Allocations of Liabilities

A partner that wishes to be allocated a share of partnership liabilities in excess of its share of nonrecourse liabilities sometimes will guarantee repayment of some or all of the partnership’s liabilities. For example, if a partner with a $0 basis in its interest is entitled to a distribution of money from the partnership, and the partner does not want to recognize taxable gain on the distribution, the partner might guarantee a partnership liability before the distribution. If the amount of the guarantee is at least equal to the amount of money to be distributed, the distribution does not cause the partner to recognize gain under section 731(a) because the liability “supports” the distribution by providing additional basis.

This well-understood and perfectly acceptable planning technique, of course, is not without economic risk; a partner that guarantees a liability may be called upon to satisfy that guarantee. With lower-leverage partnerships, this can be relatively low risk. In a higher-leverage partnership—for example, certain real estate joint ventures—however, the risk can be more significant.

Before the issuance of temporary Treasury regulations in October 2016, a partner that sought to be allocated a share of liabilities while reducing the associated economic exposure sometimes entered into a so-called “bottom dollar guarantee.” Unlike other guarantees (in which the guarantor is liable for the amount guaranteed beginning with the first dollar of the unsatisfied outstanding principal balance), a bottom dollar guarantee requires the guarantor to make a payment only to the extent that the lender ultimately collects less than the amount guaranteed. That is, a bottom dollar guarantee exposes the guarantor to the last dollars of loss rather than the first. A bottom dollar guarantee thus caused a liability to be a recourse liability that exposed the guarantor to lower risk while still constituting sufficient risk exposure to support an allocation of liabilities (in an amount equal to the guarantee). This allowed the partner providing the guarantee to avoid gain recognition to the extent of the associated liabilities.

C. IRS and Treasury Response to Bottom Dollar Guarantees

The IRS and Treasury perceived bottom dollar guarantees as lacking commercial substance and, in January 2014, proposed an initial set of regulations seeking to curb their use. Under the final 2019 Regulations, “bottom dollar payment obligations” are not recognized (i.e., a bottom dollar guarantee does not result in the guarantor partner being treated as having the economic risk of loss with respect to the liability). Under the regulations, a bottom dollar payment obligation generally includes any payment obligation under a guarantee or similar arrangement with respect to which the partner (or a related person) is not liable for up to the full amount of the payment obligation in the event of non-payment by the partnership. In other words, the lender must be able to recover from the guarantor beginning with the lender’s first dollar of loss. In determining whether a guarantee meets the definition of a bottom dollar payment obligation, and, relatedly, whether the partner (or a related person) bears the economic risk of loss, every aspect of the guarantee must be considered, including whether, by reason of contract, state law, or common law, the partner has a reimbursement or contribution right (for example, by claiming reimbursement or contribution from the joint venture on a priority basis relative to the other partners, from the other partners, or from third parties).

The determination of whether a particular guarantee meets the definition of “bottom dollar payment obligation” is, therefore, a mixed issue of law and transaction-specific facts.

D. Special Rule for “Vertical Slice” Guarantees

One important clarification of the bottom dollar guarantee rules is the rule for so-called “vertical slice” guarantees. The 2019 Regulations provide that a guarantee is not a bottom dollar guarantee if the guaranteed obligation equates to a fixed percentage of every dollar of the guaranteed partnership liability. That is, a partner does not need to guarantee the entire liability but rather can guarantee a “vertical slice” of the entire liability. For example, suppose a partner agrees to guarantee ten percent of a $100 million partnership liability, which would be $10 million. In a typical guarantee, the partner would be liable for the first $10 million of the lender’s losses—that is, if the lender recovers less than $100 million, the guarantor is liable for up to $10 million. If, however, the partner enters into a “vertical slice guarantee” for ten percent of the lender’s loss up to the same $10 million amount, the partner would be liable for ten percent of each dollar of the lender’s loss, thus reducing its effective economic exposure in the event of a loss. That is, if the lender recovered only $60 million from the partnership, the guarantor would be liable for $4 million (ten percent of the $40 million loss). Unlike a bottom dollar guarantee (which, in the example, would not have resulted in a payment obligation because the lender recovered in excess of the $10 million guaranteed amount), a “vertical slice guarantee” exposes a guarantor partner to liability from the first dollar of loss.

Accordingly, a partner seeking to provide a guarantee of only a portion of a partnership liability may be able to use a “vertical slice guarantee” to accomplish this goal while reducing economic exposure in the event of a loss.

E. Anti-Abuse Rule

The 2019 Regulations contain an anti-abuse rule pursuant to which a payment obligation is disregarded if the facts and circumstances indicate a plan to circumvent or avoid the obligation. Factors cited by the regulations as evidence of such a plan include the partner (or a related person) not being subject to commercially reasonable contractual restrictions that protect the likelihood of payment and that the terms of the partnership liability would be substantially the same had the partner (or related person) not agreed to provide the guarantee. These rules should be considered if entering into a guarantee or other payment obligation.

III. How May The Expiration Of The Transition Rule Impact You?

If you:

are a partner in an entity classified as a partnership for U.S. federal income tax purposes;
guaranteed one or more partnership liabilities before October 5, 2016; and
your share of partnership liabilities exceeded your basis in your partnership interest at that time;

then you should consult your tax lawyers to determine whether the guarantee is a bottom dollar payment obligation. If it is, the transition rule described above will expire on October 4, 2023, and you should consider whether to take any action before that date. Actions that can be taken include entering into a replacement guarantee that complies with the 2019 Regulations before October 4, 2023. If you do not, you may recognize gain equal to all or a portion of your current “negative tax capital account,” either in 2023 or later.

____________________________

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

[2] The 2019 Regulations finalized temporary regulations promulgated in T.D. 9788 on October 5, 2016.

[3] There is a special rule for liabilities with respect to which the lender may look only to specific partnership assets. In that case, the liability is treated as satisfied by transferring the property to the lender.

This alert was prepared by Emily Leduc Gagné,* Evan M. Gusler, James Jennings, Andrew Lance, and Eric B. Sloan.

Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Tax or Real Estate practice groups:

Tax Group:
Dora Arash – Los Angeles (+1 213-229-7134, darash@gibsondunn.com)
Sandy Bhogal – Co-Chair, London (+44 (0) 20 7071 4266, sbhogal@gibsondunn.com)
Michael Q. Cannon – Dallas (+1 214-698-3232, mcannon@gibsondunn.com)
Jérôme Delaurière – Paris (+33 (0) 1 56 43 13 00, jdelauriere@gibsondunn.com)
Michael J. Desmond – Los Angeles/Washington, D.C. (+1 213-229-7531, mdesmond@gibsondunn.com)
Anne Devereaux* – Los Angeles (+1 213-229-7616, adevereaux@gibsondunn.com)
Matt Donnelly – Washington, D.C. (+1 202-887-3567, mjdonnelly@gibsondunn.com)
Pamela Lawrence Endreny – New York (+1 212-351-2474, pendreny@gibsondunn.com)
Benjamin Fryer – London (+44 (0) 20 7071 4232, bfryer@gibsondunn.com)
Kathryn A. Kelly – New York (+1 212-351-3876, kkelly@gibsondunn.com)
Brian W. Kniesly – New York (+1 212-351-2379, bkniesly@gibsondunn.com)
Loren Lembo – New York (+1 212-351-3986, llembo@gibsondunn.com)
Jennifer Sabin – New York (+1 212-351-5208, jsabin@gibsondunn.com)
Hans Martin Schmid – Munich (+49 89 189 33 110, mschmid@gibsondunn.com)
Eric B. Sloan – Co-Chair, New York (+1 212-351-2340, esloan@gibsondunn.com)
Jeffrey M. Trinklein – London/New York (+44 (0) 20 7071 4224 /+1 212-351-2344), jtrinklein@gibsondunn.com)
Edward S. Wei – New York (+1 212-351-3925, ewei@gibsondunn.com)
Lorna Wilson – Los Angeles (+1 213-229-7547, lwilson@gibsondunn.com)
Daniel A. Zygielbaum – Washington, D.C. (+1 202-887-3768, dzygielbaum@gibsondunn.com)
Emily Leduc Gagné* – New York (+1 212-351-6387, eleducgagne@gibsondunn.com)
Evan M. Gusler – New York (+1 212-351-2445, egusler@gibsondunn.com)
James Jennings – New York (+1 212-351-3967, jjennings@gibsondunn.com)

Real Estate Group:
Andrew Lance – New York (+1 212-351-3871, alance@gibsondunn.com)

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

On August 23, 2023, the U.S. Securities and Exchange Commission (the “SEC”) by a 3-2 vote adopted final rules (the “Final Rules”) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), which modify certain aspects of the rules initially proposed on February 9, 2022 (the “Proposed Rules”) and adopt others largely as proposed. The Final Rules reflect the SEC’s asserted goal of bringing “transparency” to the inner workings of private funds and their sponsors by restricting or requiring extensive disclosure of preferential treatment granted in side letters, as well as imposing numerous additional reporting and other compliance requirements.[1] While several of the Final Rules require further clarification, and industry practice will undoubtedly evolve as the Final Rules are further analyzed and, to the extent possible, implemented, the following table sets forth a high-level overview of key requirements and restrictions reflected in the Final Rules. Following the table is a Q&A addressing some of the most frequently asked questions sponsors and other industry participants have asked us. These materials are a general, initial summary and do not assess the legality of the Final Rules, which remain subject to potential challenge.

Private Funds Rules – Overview of Key Requirements and Restrictions

Requirement or Restriction	High-Level Observations	Compliance Date[2] / Grandfathering of existing funds[3]
Preferential Treatment Rule (Disclosure Requirements): An adviser may not admit an investor into a fund unless it has provided advance disclosure of material economic terms granted preferentially to other investors, and must disclose all other preferential treatment “as soon as reasonably practicable” after the end of the fundraising period (for illiquid funds) or the investor’s investment (for liquid funds) and at least annually thereafter (if new preferential terms are granted since the last notice).	As set forth below, this requirement fundamentally changes the rules of the game with respect to a fund’s typical MFN process and requires advance disclosure of material economic terms, including to those investors who are not entitled to elect them, and to those who would not typically see them (e.g., smaller investors who do not have side letters).Because the disclosure requirements apply to existing funds, older funds will need to disclose preferential treatment previously granted but not yet disclosed.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers) Existing funds grandfathered? No.
Quarterly Statement Rule: Registered advisers must issue quarterly statements detailing information regarding fund-level performance; the costs of investing in the fund, including itemized fund fees and expenses; the impact of any offsets or fee waivers; and an itemized accounting of all amounts paid to the adviser or its related persons by each portfolio company.	As set forth below, the requirement to show performance metrics for illiquid funds, both with and without the impact of fund-level subscription facilities, and to spell out clearly all fund-level and portfolio company-level special fees and expenses (e.g., monitoring fees) and provide a cross-reference to the section of the private fund’s organizational and offering documents setting forth the applicable calculation methodology with respect to each is extremely burdensome and could provide another basis for the SEC staff to review performance calculations and fee and expense allocations during exams. We also expect the timing deadlines for the quarter- and year-end statements to present significant operational challenges for sponsors.	Compliance Date: 18 months (Larger and Smaller Advisers) Existing funds grandfathered? No
Private Fund Audit Rule: Registered advisers must obtain an annual audit for each private fund that meets the requirements of the audit provision in the Advisers Act custody rule (Rule 206(4)-2), and will no longer be able to opt out of the requirement using surprise examinations.	Many private fund sponsors are already providing audited financial statements in compliance with the custody rule. Sponsors who opt out of this requirement in favor of surprise examinations will be affected. We note that the SEC has re-opened its comment period with respect to its proposal regarding safeguarding client assets to allow commenters to assess its interplay with the Private Fund Audit Rule.	Compliance Date: 18 months (Larger and Smaller Advisers) Existing funds grandfathered? No
Adviser-Led Secondaries Rule: Registered advisers must obtain and distribute an independent fairness opinion or valuation opinion in connection with an adviser-led secondary transaction, and disclose material business relationships the adviser has had in the last two years with the opinion provider.	We believe that a U.S. market norm has likely developed in recent years where many sponsors are already providing fairness opinions or valuation opinions as a best practice in GP-led secondaries. This requirement will, however, increase expenses for transactions that have not historically relied on such opinions (such as where a third-party bid establishes the price), and ultimately such expenses will be passed onto investors.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? No
Books and Records Rule Amendments: Requirement to maintain certain books and records demonstrating compliance with the Final Rules.	We believe that the books and records amendments generally clarify that sponsors must maintain specific records of compliance with the new rules. We anticipate the SEC staff will focus on this requirement in considering possible deficiencies related to the new rules as part of routine exams.	Compliance Date: Based on the compliance date of the underlying rule for which records are required Existing funds grandfathered? No
Restricted Activities Rule (Investigation Costs): An adviser may not allocate to the private fund any fees or expenses associated with an investigation of the adviser without disclosing as much and receiving consent from a majority in interest of fund investors (excluding the adviser and its related persons), and is prohibited from charging the fund for fees and expenses for an investigation that results or has resulted in a sanction for a violation of the Advisers Act or the rules thereunder.	We believe this rule will adversely affect and burden sponsors.[4] Sponsors will no longer be able to allocate costs of an investigation to a fund unless a majority in interest of unaffiliated investors consent. The adopting release makes clear that the SEC intends that sponsors seek separate consents for each investigation, which would suggest that the practice of describing such costs with generality in the fund’s governing document would not be sufficient. Even if sponsors obtain consent to allocate costs related to an investigation to a fund, they will not be able to do so if the investigation results in sanctions for violations of the Advisers Act.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? Yes, if disclosed.[5]
Restricted Activities Rule (Regulatory/Compliance Costs): Advisers may not charge or allocate to the private fund regulatory, examination, or compliance fees or expenses unless they are disclosed to investors within 45 days after the end of the fiscal quarter in which such charges occur.	The adopting release makes clear that the SEC continues to view advisers charging to the fund “manager-level” expenses that it feels should more appropriately be borne by the adviser as “contrary to the public interest and the protection of investors.” As is currently the case, an adviser that allocates its regulatory, compliance and examination costs to a fund should ensure that this practice is clearly permitted under the fund’s governing documents. However, even with such authority, the level of granular disclosure regarding such costs that the Final Rule seemingly requires could have a chilling effect on the practice (where applicable) and discourage investment in compliance.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? Disclosure requirement generally applies
Restricted Activities Rule (After-tax Clawback): Advisers may not reduce the amount of a GP clawback by amounts due for certain taxes unless the pre-tax and post-tax amounts of the clawback are disclosed to investors within 45 days after the end of the fiscal quarter in which the clawback occurs.	Advisers who wish to reduce their GP clawback amount by their actual or hypothetical taxes (the latter being a common practice permitted by most fund governing documents) will need to provide investors with notice of having done so and disclosure of specific dollar amounts.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? Yes, with disclosure
*Restricted Activities Rule (Non-pro rata* investment-level allocations):** Advisers may not charge or allocate fees or expenses related to a portfolio investment on a non-pro rata basis when multiple funds and other clients are invested, unless the allocation is “fair and equitable” and the adviser distributes advance notice describing the charge and justifying its fairness and equitability.	We believe that this requirement will put additional pressure on advisers to determine, at the outset of a fundraise, whether certain costs, such as those related to AIVs or feeder funds set up to accommodate particular investors’ unique tax or regulatory profiles, will be allocated across the fund or instead allocated exclusively to such investors. Increased disclosure will likely lead to more allocation of these costs across the fund. This rule also places additional pressure on the practice of disproportionately allocating broken deal expenses to the fund as opposed to investors who were proposed to have invested alongside the fund, which is a longstanding focus of the SEC.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? Disclosure requirement generally applies
Restricted Activities Rule (Borrowing from the fund): Advisers may not borrow or receive an extension of credit from a private fund without disclosure to and consent from fund investors.	This rule does not apply to the more typical practice of sponsors lending money to the fund. In light of the clarification that disclosure and consent are required, a minority of sponsors may seek to include the ability to borrow from the fund on certain pre-defined terms in the fund’s governing documents.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? Yes.[6]
Preferential Treatment Rule (Redemption Rights): An adviser may not offer preferential treatment to investors regarding their ability to redeem if the adviser reasonably expects such terms to have a material, negative effect on other investors, unless such ability is required by law or offered to all other investors in the fund without qualification.	State pension funds and sovereign wealth funds, in particular, often negotiate special redemption rights. Sponsors are being placed in the difficult position of determining whether such rights have a material, negative effect on other investors, when they are not driven by laws, rules or regulations applicable to the investor. The SEC has provided little guidance to assist in this determination, which must be examined on a case-by-case basis.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? Yes.[7]
Preferential Treatment Rule (Portfolio Holdings Information): An adviser may not provide preferential information about portfolio holdings or exposures if the adviser reasonably expects that providing the information would have a material, negative effect on other investors, unless such preferential information is offered to all investors.	Attention should be given to information required by bespoke reporting templates to determine whether this provision applies.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? Yes.[8]
Compliance Rule Amendment: All registered advisers (including those without private fund clients) must document in writing the required annual review of their compliance policies and procedures.	We believe this codifies an informal position that the SEC examinations staff has already imposed on advisers.	Compliance Date: 60 days after publication of the Final Rules in the Federal Register Existing funds grandfathered? N/A

Frequently Asked Questions:

The following Q&A sets forth our answers to questions to frequently asked questions:

Question: Which of the Final Rules apply to various types of sponsors?

- Registered investment advisers to private funds are subject to all of the rules and restrictions set forth in the table above.
- Exempt reporting advisers and other unregistered advisers are not affected by the Quarterly Statement Rule, the Private Fund Audit Rule, the Adviser-Led Secondaries Rule or the Compliance Rule Amendment.
- Offshore advisers whose principal place of business is outside the U.S., whether registered or unregistered, are technically subject to the Final Rules, but the SEC has indicated that it will not extend the requirements of these rules to the adviser’s activities with respect to their offshore private fund clients, even if the offshore funds have U.S. investors.
- The Final Rule states that Quarterly Statement Rule, Private Fund Audit Rule, Adviser-Led Secondaries Rule, Restricted Activities Rule and Preferential Treatment Rules do not apply to investment advisers with respect to securitized asset funds they advise; real estate funds relying on Section 3(c)(5)(C), and other collective investment vehicles that are not “private funds”[9] are also outside the technical scope of those rules.
- Real estate fund managers that are not registered with the SEC (or filing reports as an exempt reporting adviser) on the basis that they are not advising on “securities” are not subject to the Advisers Act or the Final Rules.

Question: What do sponsors have to disclose before and after admitting investors, and how will the current MFN process change?

Sponsors will now have to disclose (i) fee and carry breaks or other material economic arrangements preferentially granted to other investors ahead of admitting new investors into their private funds, and (ii) all preferential treatment as soon as reasonably practicable after the final closing of a closed end fund or the admission of the new investor in an open-end fund, and at least annually thereafter if preferential terms are provided that were not previously disclosed. This disclosure requirement applies to existing funds, even if they have held a final closing prior to the compliance date.

In a statement released concurrently with the release of the Final Rule, Commissioner Caroline A. Crenshaw stated that “collective action problems appear to prevent coordination among investors to bargain for uniform baseline terms.”[10] The SEC’s decision to require disclosure of material economic terms ahead of admitting investors to the fund and disclosure of all preferential treatment post-final closing takes aim at that purported collective action problem.

Notably, the SEC seemingly narrowed its original proposal by opting to require advance written disclosure of “any preferential treatment related to any material economic terms,” as opposed to advance disclosure of all preferential treatment, as originally proposed.[11] Notwithstanding that concession, all preferential treatment (notably, without the materiality qualifier) must invariably be disclosed as soon “as reasonably practicable” following the end of the private fund’s fundraising period (for illiquid funds) or the investor’s investment in the private fund (for liquid funds).[12]

The SEC notes that “as soon as reasonably practicable” will be a facts and circumstances analysis, but suggests that it believes that “it would generally be appropriate for advisers to distribute the notices within four weeks.”[13] We find this proposed timeline ambitious and, in the absence of a hard deadline, would predict that many sponsors will continue take additional time to complete their MFN process. The “as soon as reasonably practicable” requirement would, however, cut against conducting an MFN process an excessive number of months after the final closing, as sometimes happens at present.

Material economic terms that require prior disclosure include, without limitation, “the cost of investing, liquidity rights, fee breaks, and co-investment rights.”[14] The SEC cited excuse rights as an example of non-economic preferential terms which must be disclosed post-closing. Providing a summary of preferential treatment provisions with sufficient specificity to convey its relevance will satisfy this requirement, as will providing the actual provisions granted, and in each case this may be done on an anonymized basis.[15]

In our experience, most investors in private funds with commitments in excess of a certain threshold negotiate side letters with sponsors that contain a “most favored nations” (“MFN”) clause entitling them to view all or part of the side letters granted to other investors and, most frequently, to opt into those more favorable terms negotiated by other investors who make commitments that are equal to or lesser than their capital commitment (and are not otherwise inapplicable to them). This process (the “MFN Process”) typically happens after the fund’s final closing in the closed-end fund context. Accordingly, the Final Rules essentially require sponsors to conduct a portion of their MFN Process in piecemeal fashion, with part of the process conducted prior to the final closing and the rest conducted post final closing, and to do so with respect to each investor regardless of whether such investor negotiated a side letter with an MFN clause or is entitled to elect any of the disclosed provisions. This will curtail the common practice of only showing other investors’ side letter provisions to those investors with MFN provisions and of only showing investors those provisions which they are eligible to elect. Due to the ongoing disclosure requirements, those sponsors of closed-end funds which already held their final closings and ran a more limited MFN process will now be required to disclose any preferential treatment granted to other investors, regardless of size, that had not been previously disclosed. There is no requirement to offer the election of such provisions to the investors who receive the disclosure.

While, as a technical matter, only disclosure of the key terms is required (and not an opportunity to elect such terms), the natural consequence of disclosure is that investors may ask sponsors at the time they are informed of key terms (regardless of whether they have a side letter with an MFN provision) to be granted the same terms as other similarly situated investors.

We expect that these disclosure requirements will present a substantial logistical challenge and may affect previously negotiated commercial arrangements. The SEC has not prescribed a method of delivery for electronic notices, so sponsors will be able to choose whether to do so in the private placement memorandum (the “PPM”), as a standalone disclosure document in an electronic data room, via email or otherwise. PPM supplements may be a natural place to make this disclosure, since private funds typically accept investors across multiple closings over the course of a fundraising and already provide supplements to PPMs, although virtual data rooms may also be an attractive alternative delivery method.

Sponsors will face the issue of how to handle their first closing and how to handle disclosure of terms that are being negotiated concurrently in the final hours before a later closing. In a typical fund closing, multiple side letters are negotiated concurrently with investors in the days leading up to the closing date. Time will tell where the industry lands on this point, but one potential reading of the Final Rules suggests that a sponsor concerned about managing these closing dynamics could take the position that any preferential terms granted as of the same date and at a given closing can be deemed not to have been granted prior to the capital commitments made by any other investor in that closing, and therefore may be disclosed later. It remains to be seen, however, whether this approach is consistent with the intent of the Final Rules and whether, alternatively, the Final Rules would effectively obligate sponsors to communicate two dates to their prospective investors for their closings: one being the “drop dead” date when all side letter terms need to be agreed to, and the second being a later date when commitments will be accepted and the closing will occur. This approach would give the fund, and legal counsel, time to disclose any additional material economic terms to all investors and make any last-minute updates to their side letters in response to any requests to opt into those terms that they are eligible for. In any event, we expect that the Preferential Treatment Rule’s disclosure requirement, assuming it can be practically implemented, will increase organizational expense costs for sponsors. Many sponsors agree to organizational expense caps with their investors, and some are able to negotiate that the MFN Process falls outside of those caps. If at least a portion of the MFN Process, which can be lengthy and expensive, must take place ahead of closing investors, then sponsors are likely to seek increases to their organizational expense caps to accommodate these added costs. The Final Rules will also allow smaller investors, including those that did not themselves negotiate a “most favored nations” clause (or even have a side letter), to view the provisions negotiated by larger investors. This may result in more protracted negotiations with investors who are making capital commitments at sizes which, in the view of sponsors, do not typically entitle them to a side letter arrangement, or to propose in the fund’s PPM fee breakpoints and other means of giving preference based on size, timing and other pre-determined criteria instead of doing so through the side letter process.

Question: How will sponsors’ quarterly and annual reports be affected?

Under the Final Rules, registered investment advisers are required to prepare quarterly statements for each of their private funds that include (A) a table with a detailed accounting of all fees, compensation and other amounts paid to the adviser or any of its related persons by the fund as well as all other fees and expenses paid by the fund during the relevant reporting period, (B) a table with a detailed accounting of all fees and compensation paid to the adviser or any of its related persons by the fund’s covered portfolio investments and (C) performance measures of the fund for the relevant reporting period.[16] Advisers must comply with the quarterly statement requirement for a new fund once it has had two full fiscal quarters of operating results. The Final Rule goes into granular detail about what information needs to be clearly and prominently disclosed in the quarterly statements, including the methodologies used and assumptions relied upon in the quarterly statement, as further described below.

(A) Quarterly Statement: Fund-Level Fee, Compensation and Expense Disclosure

The Quarterly Statement Rule requires registered investment advisers to disclose on a quarterly basis (1) a detailed accounting of all compensation, fees, and other amounts allocated or paid to the adviser or any of its related persons by the private fund during the reporting period, including, but not limited to, management, advisory, sub-advisory, or similar fees or payments, and performance-based compensation (e.g., carried interest), (2) a detailed accounting of all fees and expenses allocated to or paid by the private fund during the reporting period other than those listed in (1), including, but not limited to, organizational, accounting, legal, administration, audit, tax, due diligence, and travel fees and expenses, and (3) the amount of any offsets or rebates carried forward during the reporting period to subsequent quarterly periods to reduce future payments or allocations to the adviser or its related persons.

The SEC emphasizes in several places throughout its commentary to the Final Rules that there should be separate line items for each category of compensation, fee or expense and that the exclusion of de minimis expenses, the grouping of smaller expenses into broad categories or the labeling of any expenses as miscellaneous is prohibited, which will require significant effort on the part of advisers. Additionally, they advise that to the extent a certain expense could be categorized as either adviser compensation or a fund expense, the Final Rule requires that such payment or allocation be categorized as adviser compensation. For example, if an adviser or its related persons provide consulting, legal or back-office services to a private fund as a permitted expense under the private fund’s governing documents, such amounts should be categorized as compensation as opposed to an expense. This highlights the technicalities that the Final Rule imposes upon advisers and the potential pitfalls that may arise in compliance.

The SEC also noted in its commentary that the definitions of “related person” and “control” adopted under the Final Rules are consistent with the definitions used on Form ADV and Form PF, which registered investment advisers are familiar with.

This set of disclosure must be done before and after the application of any offsets, rebates or waivers to fees or compensation received by the adviser, including, but not limited to, any fees an adviser or its related person receives for management services provided to a fund’s portfolio company.

(B) Quarterly Statement: Portfolio Investment-Level Fee and Compensation Disclosure

Similar to the above, the Quarterly Statement Rule requires registered investment advisers to disclose a detailed accounting of all portfolio investment compensation allocated or paid by each covered portfolio investment during the reporting period in a single, separate table from the disclosure table noted above.

The definition of a portfolio investment is broad and is intended to cover any entity through which a private fund holds an investment, including through holding vehicles, subsidiaries, acquisition vehicles, special purpose vehicles or the like. In its commentary to the Final Rules, the SEC recognizes that this may impose challenges specifically for funds of funds, as it may be difficult to determine portfolio investment compensation arrangements at the underlying fund level.

This prong of the Final Rule also similarly requires a detailed line-by-line itemization of all portfolio investment compensation. Additionally, the SEC also notes in its commentary to the Final Rules that advisers are required to list the portfolio investment compensation allocated or paid with respect to each covered portfolio investment both before and after the application of any offsets, rebates or waivers. However, it is not clear how this is intended to apply at this level, as such offsets are taken into account at the fund level, not the portfolio company level.

“Portfolio investment compensation” includes any compensation, fees, and other amounts allocated or paid to the adviser or any of its related persons by the portfolio investment attributable to the private fund’s interest in the portfolio investment, including, but not limited to, origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees or similar fees or payments. Notably, this requirement could cause some sponsors to consider transitioning in-house or affiliated operating groups to unaffiliated entities (e.g., owned by the operating advisors themselves).

(C) Quarterly Statement: Performance Disclosure

Under the Final Rule, registered investment advisers are required to provide standardized fund performance information in each quarterly statement. The performance metrics shown will depend on whether a private fund is classified as a liquid fund or an illiquid fund. An “illiquid fund” is defined as a private fund that does not have investor redemption mechanisms and that has limited opportunities for investor withdrawal other than in exceptional circumstances. A “liquid fund” is defined as a private fund that is not an illiquid fund.

(1) Liquid Funds

For liquid funds, registered investment advisers are required to show performance based on (A) annual net total return for each fiscal year for the 10 fiscal years prior to the quarterly statement or since inception (whichever is shorter), (B) average annual net total returns over one-, five-, and 10-fiscal year periods, and (C) cumulative net total return for the current fiscal year as of the end of the most recent fiscal quarter. It is anticipated that estimations may need to be made for liquid funds that have been operating for lengthy periods of time that did not keep adequate records of the earlier years.

(2) Illiquid Funds

For illiquid funds, registered investment advisers of illiquid funds are required to (i) show performance based on internal rates of return and multiples of invested capital (both gross and net metrics shown with equal prominence) (A) since inception and (B) for the realized and unrealized portions of the illiquid fund’s portfolio, with the realized and unrealized performance shown separately and (ii) present a statement of contributions and distributions. The Final Rule defines the terms “internal rate of return” and “multiple of invested capital”, on both a gross and net basis, and provides color on what is expected to be included in the statement of contributions and distributions.[17] This illustrates the granular and prescriptive nature of the Final Rule, which will require concerted effort on behalf of fund sponsors to ensure compliance.

Advisers are required to consider the impact of fund-level subscription facilities on returns and disclose such performance information for illiquid funds on both a levered and an unlevered basis. In its commentary to the Final Rules, the SEC is repeatedly focused on standardizing information across private funds as much as possible, and as such has provided no room for exclusions to this rule, such as possibly exempting advisers from providing unlevered returns on short-term subscription facilities or excluding subscription line fees and expenses from the calculation of net performance figures.

The SEC notes in its commentary to the Final Rules that to the extent that certain funds rely on information from portfolio investments to generate the required performance data and such information is not available prior to the distribution of the quarterly statement, an adviser would be expected to use the performance measures “through the most recent practicable date”, which is likely the end of the immediately preceding quarter.

An additional prong to the quarterly statement rule is to include clear and prominent disclosure of the methodologies and assumptions made in calculating performance information. This includes, but is not limited to, whether dividends were reinvested in a liquid fund, or whether any fee rates or fee discounts were assumed in the calculation of net performance measures.

This Final Rule also requires the quarterly statement to include cross-references to the sections of the private fund’s organizational and offering documents that set forth the applicable calculation methodology for all expenses, payments, allocations, rebates, waivers, and offsets. This will likely result in significant changes to how private placement memoranda and the operating agreements of private funds are drafted going forward. Furthermore, to the extent that the allocation and methodology provisions in existing operating agreements are not adequately detailed, this requirement under the Final Rule may prompt future LPA amendments that require limited partner consent.

This consequence of the Final Rules is in tension with the legacy status (i.e. grandfathering) that the Final Rules afford governing agreements entered into prior to the date that the Final Rules take effect. The cross-reference requirement of the Quarterly Statement Rule may effectively eliminate the protections provided by the legacy status concept if sponsors will be required to amend their governing agreements to include sufficient allocation and methodology provisions according to the SEC’s new standards. Notwithstanding the fact that many sponsors may already disclose some of the information required under the Quarterly Statement Rule to their investors, it is anticipated that compliance with the Quarterly Statement Rule will result in significant increased cost to advisers and funds, especially at the outset in establishing compliant quarterly statement templates and disclosures.

Such disclosures must be included in the quarterly statement itself as opposed to in a separate document. The SEC noted that while advisers are not required to provide all supporting calculations in quarterly statements, such information should be made available to investors upon request.

With regards to timing, the Final Rule mandates that registered investment advisers must distribute the quarterly statements to the private fund’s investors within 45 days after the end of the first three fiscal quarters of each fiscal year and within 90 days after the end of each fiscal year, and in the case of fund of funds, within 75 days after the end of the first three fiscal quarters of each fiscal year and within 120 days after the end of each fiscal year.

Question: Which of the Proposed Rules were not adopted or were modified by the Final Rules?

While the Final Rules will require sponsors to provide investors with significantly more “transparency” regarding preferential economic arrangements granted in side letters (notably, with respect to material economic terms, before closing new investors into their funds) and fees received by the adviser and related persons, as well as providing new rules on quarterly statements, fund audits, adviser-led secondaries, books and records, annual compliance reviews and certain restricted activities, and some of the “disclose and consent” requirements may operate in practical effect as prohibitions on the relevant conduct, it is worth noting that the Final Rules do not specifically adopt the following items which had been set forth in the Proposed Rules.

In particular, the Final Rules do not:

(i) require all preferential rights granted by side letter to be disclosed prior to investment (only material economic terms must be disclosed prior, the rest must be disclosed later);

(ii) eliminate sponsors’ ability to be indemnified, or limit liability, for simple negligence (preserving the “gross negligence” standard for indemnification);

(iii) prohibit clawbacks of carried interest net of taxes (as noted above, this was replaced by a disclosure requirement);

(iv) expressly prohibit allocating portfolio investment fees and expenses to funds on a non-pro rata basis, subject to disclosure requirements; or

(v) prohibit borrowing from a fund (which may done with disclosure and consent).

Further, the Final Rules also do not provide the specific prohibition against charging accelerated monitoring fees that was noted in the Proposed Rules; although members of the SEC staff clarified during the open meeting held on the Final Rules on August 23, 2023 (the “Open Meeting”) that they did not feel specific language on accelerated monitoring fees was necessary because they believe such fees are already prohibited under applicable guidance. The Final Rules also do not expressly prohibit charging an adviser’s regulatory, compliance, examination and certain investigation costs to the fund (except, in some cases, with consent and disclosure and excluding those investigations that result from a violation of the Advisers Act). Our view, however, is that the SEC’s consistent messaging on the impropriety of such charges, combined with burdensome disclosure requirements, could function as a de-facto prohibition of such charges.

___________________________

[1] Resources:

– Link to the Final Rule and the Adopting Release (Release No. IA-6383; File No. S7-03-22 , RIN 3235-AN07, 17 CFR Part 275, Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews: Final Rule)

– Link to the SEC’s Fact Sheet concerning Final Rules

[2] For purposes of the compliance date, the SEC recognized that smaller advisers will require more time to implement certain rules and provided size-based deadlines for implementation, which will be staggered starting from the publication of the Final Rule in the Federal Register. “Larger Advisers” means advisers with assets under management attributable to private funds (“Private Funds AUM”) of $1.5 billion or more. “Smaller Advisers” means advisers with Private Funds AUM of less than $1.5 billion.

[3] The Final Rules grandfather in certain existing arrangements if the private fund has “commenced operations” and has made contractual arrangements related to the provision that were entered into prior to the compliance date, and if the Final Rules would require amending such agreements.

[4] Note that the term “investigation” does not appear to include examinations of the adviser, which are addressed in the row immediately below.

[5] Except that costs associated with investigations resulting in Advisers Act sanctions may not be allocated to new or existing funds even with disclosure and consent.

[6] For loan agreements entered into prior to the compliance date if compliance would require an amendment to such agreements

[7] With respect to contractual obligations entered into prior to the compliance date.

[8] With respect to contractual obligations entered into prior to the compliance date.

[9] Issuers that would be investment companies but for the exclusions contained in Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940.

[10] “Statement Regarding Private Fund Adviser Rulemaking”, Aug. 23, 2023, Commissioner Caroline A. Crenshaw (https://www.sec.gov/news/statement/crenshaw-statement-private-fund-advisers-082323?utm_medium=email&utm_source=govdelivery)

[11] Release, page 292.

[12] Release, page 294.

[13] Release, page 299.

[14] Id.

[15] Id at 297.

[16] 17 C.F.R. § 275.211(h)(1)-2(b)-(c).

[17] See 17 C.F.R. § 275.211(h)(1)-1. “Multiple of invested capital” means (i) the sum of: (A) the unrealized value of the illiquid fund; and (B) the value of distributions made by the illiquid fund; (ii) divided by the total capital contributed to the illiquid fund by its investors. “Internal rate of return” means the discount rate that causes the net present value of all cash flows throughout the life of the private fund to be equal to zero. Gross metrics are calculated gross of all fees, expenses and performance-based compensation borne by the private fund, whereas net metrics are calculated net of all fees, expenses and performance-based compensation borne by the private fund.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding the issues and considerations discussed above, and we will continue to monitor developments in the coming months. Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Investment Funds practice group, or any of the individuals listed below:

Investment Funds Group:
Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, jbellah@gibsondunn.com)
Kevin Bettsteller – Los Angeles (+1 310-552-8566, kbettsteller@gibsondunn.com)
Albert S. Cho – Hong Kong (+852 2214 3811, acho@gibsondunn.com)
Candice S. Choh – Los Angeles (+1 310-552-8658, cchoh@gibsondunn.com)
John Fadely – Singapore/Hong Kong (+65 6507 3688/+852 2214 3810, jfadely@gibsondunn.com)
A.J. Frey – Washington, D.C./New York (+1 202-887-3793, afrey@gibsondunn.com)
Shukie Grossman – New York (+1 212-351-2369, sgrossman@gibsondunn.com)
James M. Hays – Houston (+1 346-718-6642, jhays@gibsondunn.com)
Kira Idoko – New York (+1 212-351-3951, kidoko@gibsondunn.com)
Gregory Merz – Washington, D.C. (+1 202-887-3637, gmerz@gibsondunn.com)
Eve Mrozek – New York (+1 212-351-4053, emrozek@gibsondunn.com)
Roger D. Singer – New York (+1 212-351-3888, rsinger@gibsondunn.com)
Edward D. Sopher – New York (+1 212-351-3918, esopher@gibsondunn.com)
William Thomas, Jr. – Washington, D.C. (+1 202-887-3735, wthomas@gibsondunn.com)

Tax Group:
Pamela Lawrence Endreny – New York (+1 212-351-2474, pendreny@gibsondunn.com)
Brian W. Kniesly – New York (+1 212-351-2379, bkniesly@gibsondunn.com)
Daniel A. Zygielbaum – Washington, D.C. (+1 202-887-3768, dzygielbaum@gibsondunn.com)

The following Gibson Dunn attorneys assisted in preparing this client update: Kevin Bettsteller, Shannon Errico, Greg Merz, and Rachel Spinka.

This Client Alert provides an update on shareholder activism activity involving NYSE- and Nasdaq-listed companies with equity market capitalizations in excess of $1 billion and below $100 billion (as of the last date of trading in 2022) during 2022.

Announced shareholder activist activity increased relative to 2021. The number of public activist actions (82 vs. 76), activist investors taking actions (54 vs. 48) and companies targeted by such actions (72 vs. 69) each increased. The period spanning January 1, 2022 to December 31, 2022 also saw several campaigns by multiple activists targeting a single company, such as the campaigns involving: Alphabet Inc. that included activity by NorthStar Asset Management and Trillium Asset Management; C.H. Robinson Worldwide, Inc. that included Ancora Advisors and Pacific Point Wealth Management; and SpartanNash Company that included Ancora Advisors and Macellum Advisors. In addition, certain activists launched multiple campaigns during 2022, including Ancora Advisors, Carl Icahn, Elliott Investment Management, Engine Capital, JANA Partners, Land & Buildings, Starboard Value and Third Point Partners, which each launched three or more campaigns in 2022 and collectively accounted for 32 out of the 82 activist actions reviewed, or 39% in total. Proxy solicitation occurred in 17% of campaigns in 2022—a slight decrease from the amount of solicitations in 2021 (18%).

By the Numbers—2022 Public Activism Trends

2022 Annual Activism Update Chart

*Study covers selected activist campaigns involving NYSE- and Nasdaq-listed companies with equity market capitalizations of greater than $1 billion as of December 31, 2022 (unless company is no longer listed), and all information is derived from publicly available sources

**Ownership is highest reported ownership since the public action date and includes economic exposure to derivatives where applicable.

Additional statistical analyses may be found in the complete Activism Update linked below.

Notwithstanding the increase in activism levels, the rationales for activist campaigns during 2022 were generally consistent with those undertaken in 2021. Over both periods, board composition and business strategy represented leading rationales animating shareholder activism campaigns, representing 63% and 39% of rationales in 2022 and 58% and 34% of rationales in 2021, respectively. M&A (which includes advocacy for or against spin-offs, acquisitions and sales) increased in importance relative to 2021, as the frequency with which M&A animated activist campaigns was 40% in 2022 and 33% in 2021. At the opposite end of the spectrum, management changes, return of capital and control remained the most infrequently cited rationales for activist campaigns, as was also the case in 2021. (Note that the above-referenced percentages total over 100%, as certain activist campaigns had multiple rationales.)

23 settlement agreements pertaining to shareholder activism activity were filed during 2022, which is an increase from the 17 filed in 2021. Those settlement agreements that were filed had many of the same features noted in prior reviews, including voting agreements and standstill periods as well as non-disparagement covenants and minimum-share ownership and/or maximum-share ownership covenants. Expense reimbursement provisions were included in less than half of those agreements reviewed, which is a decrease from previous years. We delve further into the data and the details in the latter half of this Client Alert.

We hope you find Gibson Dunn’s 2022 Annual Activism Update informative. If you have any questions, please reach out to a member of your Gibson Dunn team.

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The following Gibson Dunn lawyers prepared this client alert: Barbara Becker, Richard Birns, Dennis Friedman, Andrew Kaplan, Saee Muzumdar, Kristen Poole, Daniel Alterbaum, and Joey Herman.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this publication. For further information, please contact the Gibson Dunn lawyer with whom you usually work, or any of the following practice leaders, members, and authors:

Barbara L. Becker (+1 212.351.4062, bbecker@gibsondunn.com)
Dennis J. Friedman (+1 212.351.3900, dfriedman@gibsondunn.com)
Richard J. Birns (+1 212.351.4032, rbirns@gibsondunn.com)
Andrew Kaplan (+1 212.351.4064, akaplan@gibsondunn.com)
Daniel S. Alterbaum (+1 212.351.4084, dalterbaum@gibsondunn.com)
Kristen P. Poole (+1 212.351.2614, kpoole@gibsondunn.com)
Joey Herman (+1 212.351.2402, jherman@gibsondunn.com)

Mergers and Acquisitions Group:
Robert B. Little – Dallas (+1 214-698-3260, rlittle@gibsondunn.com)
Saee Muzumdar – New York (+1 212-351-3966, smuzumdar@gibsondunn.com)

Securities Regulation and Corporate Governance Group:
Elizabeth Ising – Washington, D.C. (+1 202.955.8287, eising@gibsondunn.com)
Brian J. Lane – Washington, D.C. (+1 202.887.3646, blane@gibsondunn.com)
James J. Moloney – Orange County, CA (+1 949.451.4343, jmoloney@gibsondunn.com)
Ronald O. Mueller – Washington, D.C. (+1 202.955.8671, rmueller@gibsondunn.com)
Lori Zyskowski – New York (+1 212.351.2309, lzyskowski@gibsondunn.com)

Gibson Dunn’s Public Policy Practice Group is closely monitoring the debate in Congress over potential oversight of artificial intelligence (AI). We have previously summarized major federal legislative efforts and White House initiatives regarding AI in our May 19, 2023 alert Federal Policymakers’ Recent Actions Seek to Regulate AI. We have also covered two U.S. Senate hearings that focused on AI in our June 6, 2023 alert “Oversight of AI: Rules for Artificial Intelligence” and “Artificial Intelligence in Government” Hearings.

On July 25, 2023, the Senate Judiciary Committee’s Subcommittee on Privacy, Technology, and the Law held the second in a series of “Oversight of AI” hearings, following its May 16, 2023 hearing on “Rules for Artificial Intelligence,” with a focus on “Principles for Regulation.”[1] A bipartisan group of Senators, led by Chair Richard Blumenthal (D-CT) and Ranking Member Josh Hawley (R-MO), emphasized the urgent need for AI legislation in the face of rapidly advancing AI technology, including generative algorithms and large language models (LLMs).

Witnesses included:

Stuart Russell, Professor of Computer Science, The University of California – Berkeley;
Yoshua Bengio, Founder and Scientific Director, Mila – Québec AI Institute; and
Dario Amodei, Chief Executive Officer, Anthropic.

I. Points of Particular Interest from July 25, 2023 Hearing

We provide a full hearing summary and analysis below. Of particular note, however:

Chair Blumenthal opened the hearing by noting that, when speaking to constituents about AI, the word he heard most often was “scary.” He pointed to the hearing’s witnesses as “provid[ing] objective, fact-based views to reinforce those fears.” Although he recognized these fears as existential threats, Chair Blumenthal continued to emphasize AI’s enormous potential for good and reiterated the need not to stifle innovation and to maintain U.S. leadership in the AI sector.
Both Chair Blumenthal and Ranking Member Hawley extolled the rare bipartisan support for AI regulation. In particular, Chair Blumenthal and Ranking Member Hawley highlighted their recent introduction of a bill to waive immunity under Section 230 of the Communications Act of 1934 for claims related to generative AI, following the Subcommittee’s May 19 discussion of whether such immunity should apply to actors in the AI sector.[2]
Senator Amy Klobuchar (D-MN) emphasized the need to act quickly to capitalize on this bipartisan appetite for AI regulation and avoid “decay[ing] into partisanship and inaction.”
Ranking Member Hawley emphasized AI’s potential impact, questioning whether it will be an innovation more like the Internet or the atom bomb. Ranking Member Hawley thought the question facing society, and Congress specifically, is whether Congress will “strike that balance between technological innovation and our ethical and moral responsibility to humanity, to liberty, to the freedom of this country.”
The subcommittee and its witnesses invoked recent efforts by the White House to secure voluntary commitments from leading AI companies—including Mr. Amodeo’s company, Anthropic—to safeguard against key risks.[3] However, Chair Blumenthal stated that many of these commitments are non-enforceable and relatively unspecific. Chair Blumenthal emphasized that this hearing, in contrast, sought to develop legislation and regulations that would create specific, enforceable obligations on actors in the AI sector.

II. Alleged Risks of Particular Concern

In his opening statement, Ranking Member Hawley commented that he had no doubt that AI will be good for large companies, but that he was less confident that AI would be good for the American people. Much of the hearing, therefore, discussed key areas of risks or alleged harms posed by unregulated AI.

The witnesses testifying before the subcommittee typically divided these risks between immediate or short-term risks that may currently exist in AI—such as privacy concerns, copyright issues, alleged bias in algorithms, and possible misinformation—and more medium-term or long-term risks that may present themselves as AI technology advances. The witnesses emphasized the need for Congress to act urgently to prevent these longer term risks from materializing. Professor Bengio drove home this need, explaining that many AI experts had previously “placed a plausible timeframe for [the] achievement of [human-level AI] somewhere between a few decades and a century” but now considered “a few years to a couple of decades” to be the appropriate estimate.

Throughout the hearing, senators focused on a number of short-term and longer term risks, primarily relating to: (i) misinformation and political influence, (ii) national security, (iii) privacy, and (iv) intellectual property.

a. Misinformation and Political Influence

As in the subcommittee’s previous hearing, concerns about misinformation—particularly in the context of elections—took center stage, with Chair Blumenthal noting that “[i]f there’s nothing else that focuses the attention of Congress, it’s an election.” Both the lawmakers and witnesses highlighted risks associated with “deep fakes” and other forms of misinformation or external influence campaigns using AI.

While Mr. Amadeo noted that his company, Anthropic, trains its AI not to generate misinformation or politically biased content, Ranking Member Hawley pushed back on the idea that AI companies can be trusted to police these lines in the face of business pressures commenting that certain decisions about ethics may be “in the eye of the beholder.” Ranking Member Hawley expressed that, in his view, the control that a relatively small number of companies exercise over the AI sector creates a “serious structural issue” regarding who makes decisions about ethics and misinformation.

Other lawmakers and witnesses echoed Ranking Member Hawley’s concerns about the difficulty of policing AI-generated misinformation, with Senator Klobuchar noting the need to comply with the First Amendment’s protections for free speech and Professor Russell invoking the Orwellian specter of “Ministry of Truth.” Professor Russell proposed, however, that Congress could look to other highly regulated industries like banks and credit cards for guidance on how to balance effective and truthful disclosure requirements with free speech concerns.

b. National Security

Concerns about AI’s implications for national security permeated the hearing, with Ranking Member Hawley listing this issue as one of his top four priorities.

Some of these alleged national security risks related to the use of lethal weapons. For example, Chair Blumenthal noted agreement between the U.S. and China that on limiting certain uses of AI in connection to nuclear weapons, and Professor Russell echoed the popular position against the creation of lethal autonomous weapons systems (LAWS) with the ability to kill in the absence of direction or input from a human actor.

Mr. Amodei specifically addressed concerns that AI could enable malicious actors to develop sophisticated biological weapons. His company had, he explained, conducted a six month study that found that current AI systems are capable of filling in some, but not all, steps in the highly technical process of developing biological weapons. This study extrapolated, however, that AI systems may be able to fill in all steps of these processes within two to three years, allowing malicious actors that lack specialized expertise to weaponize biology.

Ranking Member Hawley and Mr. Amodei also discussed national security risks that could arise if the U.S. fails to secure the AI supply chain, with Mr. Amodei noting the significant number of bottle necks that currently exist in the semiconductor manufacturing process. (For more detailed discussion of U.S. efforts to secure the semiconductor supply chain, see our previous client alerts on the implementation of the CHIPS Act, here and here.) Ranking Member Hawley expressed particular concern about the U.S.’s reliance on Taiwan-origin chips, in light of the possibility of a Chinese invasion of Taiwan.

Some witnesses, however, provided comfort by emphasizing the leadership of the U.S. and its allies in the AI sector. When asked about the AI capabilities of U.S. adversaries, Professor Russell indicated that the U.S., the UK, and Canada currently have the most advanced AI technology in the world whereas, in his view, China’s capabilities have been “slightly overstated.” While he acknowledged China’s extensive investments in AI and its strength in voice and face recognition technology, he suggested that numerical publication requirements on China’s academic sector have limited the country’s ability to produce technological breakthroughs.

c. Privacy

Several senators raised the potential privacy risks that could result from the deployment of AI, often invoking Congress’s perceived failure to address the privacy implications of social media proactively to emphasize an urgent need for AI guardrails. Ranking Member Hawley pointed out that these privacy concerns, if left unchecked, could exacerbate other alleged risks if, for example, an AI program gained access to voter files and used them to target certain voters with misinformation.

Senator Marsha Blackburn (R-TN) stressed her view that the U.S. is “behind” its allies on issues of online consumer privacy, pointing to the digital privacy regimes of the EU, UK, New Zealand, Australia, and Canada as examples. Specifically, she expressed concern that consumers’ personal data was being used to train AI systems, often without their knowledge. Senator Blackburn queried whether a federal privacy standard would help address this concern without interfering with the U.S.’s position as a global leader in generative AI. Professor Russell supported a federal standard, including an absolute requirement to disclose whether systems are harvesting data from users’ conversations.

Mr. Amodei pointed to his own company as an example of how to navigate these concerns, explaining that it relies primarily on publicly available information to train its AI and that the program is trained not to produce results containing certain types of private information.

d. Intellectual Property

Senator Blackburn emphasized the profound impact that unregulated AI could have on the creative sector, suggesting that AI is “robbing [authors, actors, and musicians] of their ability to make a living off of their creative work.” Senator Blackburn queried whether artists whose artistic creations are used to train algorithms are or will be compensated for the use of their work. Professor Russell agreed that existing intellectual property laws may not always be sufficient to address these concerns.

III. Key Regulatory Proposals

As indicated by the hearing’s title, “Principles for Regulation,” the lawmakers and witnesses focused not just on potential risks associated with AI but also with concrete policy measures that could mitigate these risks.

At the end of the hearing, Ranking Member Hawley asked each witness for “one or two recommendations for what Congress should do right now” to regulate the AI industry.

Professor Russell would establish a federal agency tasked with regulating the AI sector. He would also remove from the market any AI systems that violate a designated set of “unacceptable” behaviors associated with the risks and alleged harms discussed above. Professor Russell described this latter recommendation as creating not just positive effects for consumer protection but also as incentivizing companies to conduct rigorous research and testing to ensure their products are effective and controllable before putting them on the market.
Professor Bengio would invest in the safety of AI systems, both at the levels or hardware and cybersecurity measures, through a mix of direct investments and incentives for companies. Professor Bengio emphasized that U.S. investment in AI safety should be “at or above the level of investment” that goes into developing AI programs.
Mr. Amodei would develop rigorous testing and auditing regimes for the AI sector, stressing that “without such testing, we’re blind” to the capabilities and future risks that AI may pose. He also reiterated the importance of an enforcement mechanism for these measures, although he was agnostic on whether that should come from a new federal agency or from existing authorities.

Beyond these high-level recommendations, the subcommittee and witnesses discussed the following regulatory and legislative measures: (a) a potential AI federal agency and auditing regime, (b) labeling and watermarking requirements for information generated by AI, (c) limitations on the release of pre-trained, open source AI models, and (d) the creation of private rights of action authorizing lawsuits against AI companies.

e. AI Federal Agency

Building on conversations from the subcommittee’s May 19, 2023 hearing, the lawmakers and witnesses discussed the possibility of a new federal agency focused on regulating AI, with Chair Blumenthal stating that he had “come to the conclusion that we need some kind of regulatory agency” focused on AI. Chair Blumenthal stressed that this should not be a “passive body” and should instead invest proactively in research to develop countermeasures that can effectively address potential AI risks.

While Chair Blumenthal was the only subcommittee member whose questions focused expressly on the creation of a new federal agency, the witnesses voiced support for the idea throughout the hearing. Noting the rapid development of new AI technology, Professor Bengio observed that legislation alone will be insufficient to mitigate against future AI risks. “We don’t know yet” what regulations might be necessary in one, two, or three years, Professor Bengio commented, and “having an agency is a tool toward [the] goal” of responding agilely to evolving technology. Mr. Amodei also agreed with Chair Blumenthal that this new agency should play a proactive role in researching countermeasures, rather than simply responding to new risks. Mr. Amodei stressed that centralizing research efforts in a new agency, or even through the Department of Commerce’s National Institute of Standards and Technology (NIST) would allow the U.S. to create consistent standards against which to measure risks and benefits associated with AI.

The witnesses believed that one centralized agency focused on AI would provide benefits beyond streamlined domestic implementation of AI regulation. For example, Professor Bengio was of the view that a single agency could better coordinate with the U.S.’s international allies, allowing the U.S. to speak with a single voice while advocating for global standards.

The witnesses emphasized, however, that a federal agency will not, by itself, be sufficient to tackle AI-related risk. Professor Russell observed that “no government agency” will be able to match the tremendous resources—which he estimated at more than $10 billion—that the private sector invests in the creation of AI systems. He suggested that his proposal for involuntary recall provisions could bridge this gap by incentivizing robust testing of AI models by the private sector before these models are released commercially.

f. Labeling and Watermarking Requirements

One of the most frequently mentioned methods of tackling AI-generated misinformation was a regime of labeling and watermarking materials produced by an AI system. As Mr. Amodei and Professor Russell explained, labeling requirements would require as a matter of policy that AI outputs be clearly labeled as produced by AI wherever they are published; watermarking, on the other hand, is a technical measure by which the provenance of both original and AI-generated content can be established. Professor Russell emphasized the need for international coordination to avoid fragmented enforcement, suggesting the creation of an encrypted global escrow system capable of verifying the provenance of any piece of media uploaded to the system.

Chair Blumenthal noted a growing bipartisan consensus on this issue and stressed that labeling and watermarking would be necessary to address election-related misinformation. Senator Klobuchar likewise pointed out that her recently introduced REAL Political Advertisement Act would require election materials produced by AI to be labeled as such.[4]

g. Limitations on Open-Source Model Releases

All three witnesses raised concerns related to the availability to the public of pre-trained open source AI models, because, as Mr. Amodei observed, “when a model is released in an uncontrolled manner, there is no ability to [control it.] It is entirely out of your hands.” This prompted discussion of whether open source AI should be restricted in any way.

Despite the tremendous benefit open source programs may offer in scientific fields, Professor Bengio warned that these could open the door for exploitation by malicious actors who would not otherwise have the technical expertise and computing power necessary to create their own models. He observed that many of these open source systems were being developed at universities and proposed the creation of ethics review boards for university AI programs that could ensure future releases are carefully evaluated for potential risks before they are released. Professor Russell also suggested that “the open source community” may need to face some form of liability “for putting stuff out there that is ripe for misuse.”

h. Private Rights of Action Against AI Companies

The subcommittee and its witnesses focused not just on the legal frameworks necessary to protect against AI-related risk but also on mechanisms for enforcing these laws.

One key enforcement mechanism highlighted by Ranking Member Hawley was the private right of action authorized by the “No Section 230 Immunity for AI Act” that he recently introduced alongside Chair Blumenthal.[5] Ranking Member Hawley described this as an important mechanism to allow Americans to vindicate their privacy rights in court. Specifically, the bill would allow civil actions—as well as criminal prosecutions—“if the conduct underlying the claim or charge involves the use or provision of generative artificial intelligence.”[6]

IV. How Gibson Dunn Can Assist

Gibson Dunn’s Public Policy, Artificial Intelligence, and Privacy, Cybersecurity and Data Innovation Practice Groups are closely monitoring legislative and regulatory actions in this space and are available to assist clients through strategic counseling; real-time intelligence gathering; developing and advancing policy positions; drafting legislative text; shaping messaging; and lobbying Congress. Gibson Dunn also offers holistic support representing our clients in, and ensuring our clients are prepared to respond effectively to, any civil, criminal, or congressional investigations or litigation relating to the development and/or deployment of AI systems.

___________________________

[1] Oversight of A.I.: Principles for Regulation: Hearing Before the Subcomm. on Privacy, Tech., and the Law of the S. Comm. on the Judiciary, 118th Cong. (2023), https://www.judiciary.senate.gov/committee-activity/hearings/oversight-of-ai-principles-for-regulation.

[2] No Section 230 Immunity for AI Act, S. 1993, 118th Cong. (2023).

[3] See Press Release, Fact Sheet: Biden-Harris Administration Secures Voluntary Commitments from Leading Artificial Intelligence Companies to Manage the Risks Posed by AI, The White House (Jul. 21, 2023), https://www.whitehouse.gov/briefing-room/statements-releases/2023/07/21/fact-sheet-biden-harris-administration-secures-voluntary-commitments-from-leading-artificial-intelligence-companies-to-manage-the-risks-posed-by-ai/.

[4] Real Political Advertisements Act, S. 1596, 118th Cong. (2023).

[5] No Section 230 Immunity for AI Act, S. 1993, 118th Cong. (2023).

[6] Id.

The following Gibson Dunn lawyers prepared this client alert: Michael Bopp, Roscoe Jones, Jr., Vivek Mohan, Cassandra Gaedt-Sheckter, Amanda Neely, Daniel Smith, and Sean Brennan.

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, the authors, or any of the following in the firm’s Public Policy, Artificial Intelligence, or Privacy, Cybersecurity & Data Innovation practice groups:

Public Policy Group:
Michael D. Bopp – Co-Chair, Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com)
Roscoe Jones, Jr. – Co-Chair, Washington, D.C. (+1 202-887-3530, rjones@gibsondunn.com)
Amanda H. Neely – Washington, D.C. (+1 202-777-9566, aneely@gibsondunn.com)
Daniel P. Smith – Washington, D.C. (+1 202-777-9549, dpsmith@gibsondunn.com)

Artificial Intelligence Group:
Cassandra L. Gaedt-Sheckter – Co-Chair, Palo Alto (+1 650-849-5203, cgaedt-sheckter@gibsondunn.com)
Vivek Mohan – Co-Chair, Palo Alto (+1 650-849-5345, vmohan@gibsondunn.com)
Eric D. Vandevelde – Co-Chair, Los Angeles (+1 213-229-7186, evandevelde@gibsondunn.com)
Frances A. Waldmann – Los Angeles (+1 213-229-7914, fwaldmann@gibsondunn.com)

Privacy, Cybersecurity and Data Innovation Group:
S. Ashlie Beringer – Co-Chair, Palo Alto (+1 650-849-5327, aberinger@gibsondunn.com)
Jane C. Horvath – Co-Chair, Washington, D.C. (+1 202-955-8505, jhorvath@gibsondunn.com)
Alexander H. Southwell – Co-Chair, New York (+1 212-351-3981, asouthwell@gibsondunn.com)

On July 31, 2023, the European Commission (the “Commission”) adopted the first set[1] of European Sustainability Reporting Standards (the “ESRSs”)[2] for use by all entities subject to the Corporate Sustainability Reporting Directive (the “CSRD”)[3]. The ESRSs are now subject to a two month scrutiny period (extendable by up to two months), during which the European Parliament and the Council of the European Union (“EU”) may approve (in its entirety) or reject the ESRSs. If approved, the ESRSs will apply, in the first instance, to companies that are already subject to the EU’s non-financial reporting framework (based on the Non-Financial Reporting Directive (the “NFRD”)[4]) for reporting periods beginning January 1, 2024: namely, so-called “large” EU undertakings exceeding an average of 500 employees during the financial year that either have securities admitted to an EU-regulated market or are regulated financial entities (e.g., banks or insurance companies). The CSRD and the ESRSs will be phased-in for other categories of entities, including companies outside the EU, over the next five years.

The ESRSs now provide a detailed basis for in-scope entities to begin to assess their potential reporting obligations, including assessing which aspects are material under the new, broad “double materiality” standard of the CSRD, looking both at the impact of the company (inside-out) as well as the financial impact on the company (outside-in). Such analysis will allow companies to undertake the requisite due diligence on material topics and integrate changes to their reporting process. Effective implementation will require substantial resources and a thorough analysis of the ESRSs and the CSRD reporting obligations resulting thereof.

In this alert, we provide context and an overview of the 12 standards in the first set of ESRSs, along with a review of key changes as compared to earlier ESRSs drafts.

Background

The CSRD came into force on January 5, 2023, and the Commission mandates that each EU member state implement the CSRD into national law by July 6, 2024. The CSRD extends the scope of non-financial reporting under the NFRD to include sustainability reporting and requires such disclosures from an expanded range of entities, including large companies, listed small and medium-sized companies (“SMEs”) and even non-EU parent companies of such in-scope companies, and certain branches. The NFRD’s requirements remain in force until companies have to comply with the national laws implementing the CSRD. More detailed discussions of the CSRD, including its impact for non-EU entities with a significant presence in the EU, can be found in our client alert available here.

The CSRD, as a directive, requires the Commission to develop standards for what a reporting entity must disclose about its material impacts, risks and opportunities in relation to certain environmental, social and governance (“ESG”) matters. In accordance with the CSRD, the ESRSs are based on draft standards developed by EFRAG (previously known as the European Financial Reporting Advisory Group), a non-profit organization dedicated to the advancement and advocacy of European perspectives in financial and sustainability reporting.

EFRAG submitted its first draft ESRSs to the Commission on November 22, 2022 (the “Draft ESRSs”).[5] The Draft ESRSs were developed based on input that EFRAG had received from public consultation on exposure drafts of the ESRSs developed from April to August 2022.[6] Following EFRAG’s submission of the Draft ESRSs, the Commission carried out further consultations leading to the publication for consultation of the first set of Draft ESRSs for a four-week public feedback period from June 9 to July 7, 2023.

The consultation process confirmed that the Draft ESRSs broadly met the CSRD’s mandate. However, various stakeholders drew attention to potential issues with the Draft ESRSs, including the challenging nature of disclosure requirements against a backdrop of limited primary source data and the lack of coherence between disclosures under the ESRSs and the disclosure obligations under other European regulations including the Sustainable Finance Disclosure Regulation or ‘SFDR,’ the Benchmarks Regulation and the Capital Requirements Regulation (cumulatively, the “Financial Regulations”).[7]

The Commission made a number of modifications to the Draft ESRSs in response to this feedback. The Commission published and adopted their final version of the ESRSs on July 31, 2023.

Overview of First Set of ESRSs

The first 12 standards in the ESRSs include two “cross-cutting” standards that apply across all ESG topics and 10 topical standards divided across ESG matters. Compared to the Draft ESRSs, the final set of ESRSs reflect a reduction in both the number of disclosure requirements (from 136 to 84) and the number of qualitative and quantitative data points (from 2,161 to 1,144).

“Cross-Cutting” Standards

ESRS 1 General Requirements

ESRS 2 General Disclosure

Environmental Standards

ESRS E1 Climate Change

ESRS E2 Pollution

ESRS E3 Water and Marine Resources

ESRS E4 Biodiversity and Ecosystems

ESRS E5 Resource Use and Circular Economy

Social Standards

ESRS S1 Own Workforce

ESRS S2 Workers in the Value Chain

ESRS S3 Affected Communities

ESRS S4 Consumers and End-Users

Governance Standards

ESRS G1 Business conduct

The ESRSs include descriptions of the disclosure requirements under each standard. For example, for the disclosure requirement related to ESRS 2’s integration of sustainability-related performance in incentive schemes, the ESRSs state that reporting entities shall disclose whether and how climate-related considerations are factored into the renumeration of members of the administrative, management and supervisory bodies, including any assessment against GHG emissions reductions targets.

Another example includes the disclosure requirements under ESRS E1’s transition plan for climate change mitigation. The ESRSs instruct reporting entities to disclose their transition plans, including explanations of how it’s targets are compatible with the limiting of global warming to 1.5°C in line with the Paris Agreement and explanations of the decarbonization levers identified, and key actions planned, including changes in the reporting entity’s product and service portfolio and the adoption of new technologies in its own operations, or the upstream and/or downstream value chain.

Key Changes from the Draft ESRSs

The Commission received 604 comments and pieces of feedback on the Draft ESRSs. The top five categories of respondents were companies (26.66%), business associations (24.17%), non-governmental organizations (“NGOs”) (14.07%), EU citizens (13.25%) and others (10.60%) and the top five countries where respondents provided feedback were Germany (18%), Belgium (17%), Netherlands (13%), France (10%) and the United Kingdom (5%).[8]

The Commission responded to stakeholder feedback with the following modifications in the ESRSs:[9]

Most Disclosures Limited by Materiality (But Double Materiality Standard Retained)

The Draft ESRSs would have required companies to report on the following standards regardless of whether they were material to their business: the “Climate Change” standard (ESRS E1), certain data points under the “Own Workforce” standard (ESRS S1) for companies with more than 250 employees, and certain data points that correspond to information required by the Financial Regulations.

The ESRSs will now only mandate that all reporting companies to address the “General Disclosure” standard (ESRS 2). Otherwise, all other standards, disclosure requirements and data points must only be disclosed if they are assessed to be material[10] to the company.

The Commission expects these changes will lessen the burden of implementing and complying with the ESRSs by requiring companies to focus on those ESG impacts, risks and opportunities that are material.[11] However, companies should not underestimate the potential reporting burden and compliance costs presented by this approach. The ESRSs’ “double materiality” standard for assessing materiality (taken from the CSRD) represents for many reporting entities, a significant departure from the investment-decision-based or financial materiality tests under U.S. securities law and other reporting standards.

Double materiality assesses matters from two perspectives: (1) an ‘inside-out’ impact perspective, meaning a company’s actual or potential impact on people or the environment; and (2) an ‘outside-in’ financial perspective, meaning how social and environmental issues create financial risks and opportunities for the company. Matters that are material under one or both of these standards must be disclosed. Notably, companies will not be making these determinations in a vacuum, as materiality assessments are subject to external, third-party assurance in accordance with the CSRD.[12] When certain matters are determined to be immaterial, the company must also affirmatively state that determination and its analysis in its reports.

For example, a reporting entity is required to provide a thorough explanation if it concludes that the “Climate Change” standard (ESRS E1) is not a material topic for its business. In a similar vein, if a reporting entity concludes that a certain data point corresponding to information required by the Financial Regulations is not material, it must explicitly state that the data point is “not material.” The ESRSs also indicate that reporting entities should include a table in their disclosures with all such data points, with either the location of the data point in the report or stating it is “not material,” as applicable.

The Commission asked EFRAG to prepare additional guidance on the ESRSs for reporting entities, including on the materiality assessment.[13] During its August 23, 2023 public session, EFRAG will provide an update on the first draft “EFRAG Implementation Guidance and FAQ” regarding the materiality assessment and value chain. In addition, EFRAG will consider responses from the Commission’s four-week public feedback period on the Draft ESRSs to identify priority areas for further guidance. EFRAG will also soon have a place on its website for stakeholders to submit ESRSs application questions.[14]

Additional Phase-In Requirements

The Commission included further phase-ins, in addition to those provided in the Draft ESRSs, to support applicable reporting entities in transitioning from existing methodologies or frameworks to the ESRSs. Under these phase-ins:

Reporting entities with fewer than 750 employees may omit:
- for its first year of applying the ESRSs – Scope 3 GHG emissions data (included in ESRS E1) and the disclosure requirements specified in the “Own Workforce” standard (ESRS S1), and
- for its first two years of applying the ESRSs – the requirements in the standards on Biodiversity and Ecosystems (ESRS E4), Workers in the Value Chain (ESRS S2), Affected Communities (ESRS S3) and Consumers and End-Users (ESRS S4).
All reporting entities (regardless of the number of employees) may omit, for the first year of applying the ESRSs:
- financial effects related to non-climate environmental issues, such as Pollution (ESRS E2), Water (ESRS E2), Biodiversity (ESRS E4) and Resource Use (ESRS E5), and
- certain data points related to their own workforce (ESRS S1) (social protection, persons with disabilities, work-related ill-health, and work-life balance).

Desired Interoperability with Global Standard Setting Initiatives

Comments to the Draft ESRSs raised concerns that the standards would not be consistent with the EU’s sustainability ambitions and other pieces of sustainability legislation, and did not ensure the interoperability of global standards such that companies could use the same sustainability-related information for multiple legislations or standards. The Commission noted that it worked to ensure a “very high degree of interoperability” among the ESRSs, the global reporting framework under development by the International Sustainability Standards Board (the “ISSB”) and the Global Reporting Initiative (“GRI”). The ESRSs were also created in parallel with the first two standards under the ISSB, IFRS S1 and IFRS S2, which were published on June 26, 2023. The Commission, EFRAG and the ISSB discussed the standards at length in an effort to provide a high degree of alignment where the standards overlap. For example, companies that are required to disclose under the requirements of the “Climate Change” standard (ESRS E1) of the ESRSs are expected, to a large degree, to be able to report the same information under the ISSB climate-related disclosures (IFRS S1).

While the ESRSs and the ISSB standards are built on existing reporting frameworks, including the Task Force on Climate-Related Financial Disclosures (“TCFD”)[15], it is important to note that the ESRSs and the ISSB requirements are not interchangeable, so if and when the ISSB Sustainability Standards come to be adopted by national regulators, reporting entities will need to review each set of standards to confirm that all requirements are being applied and met.

The ESRSs’ anticipated adoption of the CSRD’s double materiality standard[16] is a principal area of divergence from the ISSB’s financial materiality standard. While the ESRSs use the broad double materiality standard discussed above, the ISSB standard is modeled on the financial materiality standard used by the IFRS international accounting standards: that information is material if its omission, obfuscation or misstatement could be reasonably expected to impact investor decisions. This reflects in part the purpose of each standard. ISSB intends to address the needs of financial stakeholders (e.g., investors and lenders) for a global ESG reporting framework while the CSRD and ESRSs intend to address the needs of a broader range of stakeholders, including investors, NGOs, trade unions, civil society organizations, consumers, community and value chain and indeed when undertaking their materiality assessment for CSRD purposes, reporting entities are required to consult with their broader base of stakeholders.

EFRAG has created a TCFD recommendations and Draft ESRSs reconciliation table and they are working on a mapping table that includes requirements for each of the ESRSs and the ISSB standards. The TCFD/ESRSs reconciliation table and the draft version of the ESRSs/ISSB table are available on their website.

Expanded Voluntary Disclosures and Further Reporting Options

Although the Draft ESRSs included several voluntary data points, the Commission included even more in the ESRSs by converting a limited number of reporting requirements from mandatory to voluntary. These modifications included, for example, biodiversity transition plans, specific indicators related to “non-employees” in the reporting entity’s own workforce and an explanation as to why a particular sustainability topic is not material.

The Commission also introduced certain flexibilities for disclosure against some mandatory data points instead of converting them to voluntary data points. For example, there are additional flexibilities in the disclosure requirements on the financial effects stemming from sustainability risks and engagement with stakeholders, as well as in the methodology used for the materiality assessment process.[17] Furthermore, the Commission modified the data points concerning corruption and bribery, as well as the protection of whistle-blowers, which the Commission was concerned could be perceived as impairing the right to refrain from self-incrimination.[18]

Final Approval Pending

In the second half of August 2023, the ESRSs will be formally transmitted to the European Parliament and to the Council of the EU for a two month scrutiny period (extendable by up to two months). The European Parliament and the Council of the EU may approve (in its entirety) or reject the ESRSs, but neither can amend it. If approved by the European Parliament and the Council of the EU, the ESRSs may apply for some companies as early as January 1, 2024 (for reporting in 2025).

Reporting obligations for in scope companies begin as early as the 2024 reporting period. Companies or reporting entities that fall within the scope of the CSRD need to review these standards to begin assessing potential reporting obligations and compliance costs.

What’s Next

In the ESRSs, the Commission responded to feedback and reduced the weight of the reporting burden by allowing reporting entities to focus more on meaningful materiality assessments and the quality of disclosures. However, the ESRSs have received a mix reception from the market. Various stakeholder groups, including some groups of investors[19], have bemoaned the dilution introduced by the Commission in the ESRSs. Despite these complaints, it is expected that stakeholders will benefit in the mid-longer term if material reliable disclosures are made by reporting entities.

In addition to developing guidance to support companies disclosing against the standards, EFRAG has been tasked with developing sector-specific standards. First drafts of standards for eight sectors are already up and running. The CSRD requires the Commission to adopt additional sets of ESRSs by June 2024, including at least eight sector-specific standards, proportionate standards for listed SMEs and standards for non-EU companies. EFRAG is currently developing draft sector-specific standards from the following sectors: (1) Oil and Gas, (2) Coal, Quarries and Mining, (3) Road Transport, (4) Agriculture Farming and Fisheries, (5) Motor Vehicles, (6) Energy Production and Utilities, (7) Good and Beverages and (8) Textiles, Accessories, Footwear and Jewelry. Any decisions taken to start new sector work will be published on EFRAG’s website.[20] The final work stream in relation to the development of standards will be the formation of specific standards for reporting at the level of non-EU company parent companies, which will commence for financial year 2028 (for reporting in 2029).

_________________________

[1] The CSRD requires the Commission to adopt a second set of sustainability reporting standards by June 30, 2024, specifying sector-specific standards, standards for small and medium sized enterprises and to take account of the development of international standards.

[2] Commission Delegated Regulation supplementing Directive 2013/34/EU as regards sustainability reporting standards (available here), including Annex 1 (available here) and Annex 2 (available here).

[3] Directive (EU) 2022/2464 of the European Parliament and of the Council of 14 December 2022 amending Regulation (EU) No 537/2014, Directive 2004/109/EC, available here.

[4] Accounting Directive by Directive 2014/95/EU of the European Parliament and of the Council of 22 October 2014 amending Directive 2013/34/EU as regards disclosure of non-financial and diversity information by certain large undertakings and groups, available here.

[5] Draft Commission Delegated Regulation supplementing Directive 2013/34/EU as regards sustainability reporting standards (available here), including Draft Annex 1 and Draft Annex 2.

[6] Exposure drafts of the ESRSs are published on EFRAG’s website, available here.

[7] All comments and feedback on the Draft ESRSs are published on the European Commission website, available here.

[8] The European Commission, Total of valid feedback instances received: 604, available at https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/13765-European-sustainability-reporting-standards-first-set/feedback_en?p_id=32180832.

[9] Additional information can be found in our client alert “European Union’s Corporate Sustainability Reporting Directive — What Non-EU Companies with Operations in the EU Need to Know,” accessible at the following link.

[10] EFRAG is developing additional guidance on the materiality assessment, the process to determine material matters and material information. Additional information is below.

[11] Commission Delegated Regulation (EU) of 31.7.2023 supplementing Directive 2013/34/EU of the European Parliament and of the Council as regards sustainability reporting standards, Article 2, available at http://ec.europa.eu/finance/docs/level-2-measures/csrd-delegated-act-2023-5303_en.pdf.

[12] Under the CSRD, the Commission must adopt legislation requiring independent assurance of sustainability reports and metrics by a third-party auditor. This has the goal of raising the quality of sustainability reporting to the same level as financial reporting. See Directive (EU) 2022/2464 of the European Parliament and of the Council of 14 December 2022 amending Regulation (EU) No 537/2014, Directive 2004/109/EC, starting at point sixty (60) of Article 1, available here.

[13] Commission Delegated Regulation (EU) of 31.7.2023 supplementing Directive 2013/34/EU of the European Parliament and of the Council as regards sustainability reporting standards, Article 2, available at http://ec.europa.eu/finance/docs/level-2-measures/csrd-delegated-act-2023-5303_en.pdf.

[14] EFRAG, Press Release, EFRAG Welcomes the Adoption of the Delegated Act on the First Set of European Sustainability Reporting Standards (ESRS) by the European Commission(July 31, 2023), available at efrag.org/News/Public-439/EFRAG-welcomes-the-adoption-of-the-Delegated-Act-on-the-first-set-of-E.

Sustainability Reporting Standards, EFRAG Sector Specific ESRS, available at https://www.efrag.org/lab5.

[15] In addition to the TCFD, the ESRSs and ISSB standards are built on existing frameworks from the Sustainability Accounting Standards Board (SASB) and Climate Disclosure Standards Board (CDSB).

[16] Directive (EU) 2022/2464 of the European Parliament and of the Council of 14 December 2022 amending Regulation (EU) No 537/2014, Directive 2004/109/EC, at point twenty-nine (29) of Article 1, available here.

[17] An example of the additional flexibilities is included in General Disclosure (ESRS 2): disclosure of “the undertaking’s understanding of the interests and views of its key stakeholders” –”key” added.

[18] Commission Delegated Regulation (EU) of 31.7.2023 supplementing Directive 2013/34/EU of the European Parliament and of the Council as regards sustainability reporting standards, Article 2, available at http://ec.europa.eu/finance/docs/level-2-measures/csrd-delegated-act-2023-5303_en.pdf.

[19] See, Better Finance (The European Federation of Investors and Financial Services Users), Diluted European Sustainability Reporting Standards Raise Greenwashing Concerns (August 7, 2023), available here; World Wildlife Fund for Nature (WWF), EU Commission undermines standards for sustainability reporting (July 31, 2023), available here; Reuters, EU confirms watering down of corporate sustainability disclosures (August 1, 2023), available here.

[20] EFRAG Sustainability Reporting Standards, EFRAG Sector Specific ESRS, available at https://www.efrag.org/lab5.

The following Gibson Dunn lawyers prepared this client update: Elizabeth Ising, Cynthia Mabry, Sarah Phillips, Selina S. Sagayam, Ferdinand M. Fromholzer, David Woodcock, Robert Spano, Judith Raoul-Bardy, and Lauren M. Assaf-Holmes.

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 leaders and members of the firm’s Environmental, Social and Governance (ESG) or Securities Regulation and Corporate Governance practice groups:

Environmental, Social and Governance (ESG) Group:
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Michael Titera – Orange County (+1 949-451-4365, mtitera@gibsondunn.com)
Lori Zyskowski – New York (+1 212-351-2309, lzyskowski@gibsondunn.com)

Decided August 21, 2023

Raines v. U.S. Healthworks Medical Group, S273630

This week, the California Supreme Court held that a business entity acting as an agent of an employer may be held directly liable as an “employer” for alleged violations of California’s Fair Employment and Housing Act.

Background: Plaintiffs Kristina Raines and Darrick Figg were job applicants who received offers of employment contingent upon passing a medical screening. The screening included a detailed health history questionnaire that the applicants were required to complete.

These pre-employment screenings were not conducted by the plaintiffs’ prospective employers, but instead by third-party occupational health services providers. Plaintiffs sued these providers on behalf of a putative class, alleging that the questions were intrusive and overbroad in violation of California’s Fair Employment and Housing Act, or the FEHA. Plaintiffs sued in state court, and the providers removed the case to federal court.

The FEHA generally precludes “any employer or employment agency” from “requir[ing] a medical or physical examination” of a job applicant. Cal. Gov’t Code § 12940(e)(1). It does, however, allow employers to require such examinations of a “job applicant after an employment offer has been made,” so long as the examination is “job related and consistent with business necessity.” Id. § 12940(e)(3). The statute elsewhere defines “employer” as “any person regularly employing five or more persons, or any person acting as an agent of an employer, directly or indirectly.” Id. § 12926(d).

The providers argued that even if they were “agents” of the plaintiffs’ prospective employers, agents could not be held directly liable for FEHA violations separately from their employer-principals. The district court agreed. On appeal, the Ninth Circuit observed the significance of the issue on employment litigation throughout the state, and that the California Supreme Court had previously reserved judgment on the issue in Reno v. Baird, 18 Cal. 4th 640 (1998). The Ninth Circuit accordingly certified the question of an agent’s direct liability under the FEHA to the California Supreme Court.

Issue: California’s Fair Employment and Housing Act defines “employer” as “any person regularly employing five or more persons, or any person acting as an agent of an employer.” Can a business acting as an agent of an employer be held directly liable for employment discrimination?

Court’s Holding:

Yes. Businesses with at least five employees that carry out FEHA-regulated activities as an agent of an employer may be held directly liable for employment discrimination under the FEHA.

“[W]e conclude that legislative history, analogous federal court decisions, and legislative policy considerations all support the natural reading of [the FEHA] advanced here, which permits business-entity agents to be held directly liable for FEHA violations in appropriate circumstances.”

Justice Jenkins, writing for the Court

What It Means:

By interpreting the FEHA’s definition of “employer” to include an employer’s agents in a manner beyond simply incorporating the ordinary principles of respondeat superior, the opinion opens up businesses acting as agents to potential FEHA litigation that was otherwise not clearly available to employees under the statute.
Still, the California Supreme Court clarified that its decision was limited to answering the specific question posed by the Ninth Circuit: “whether a business-entity agent may ever be held directly liable under the FEHA.” The court therefore declined to “identify the specific scenarios” in which a business-entity agent could face direct liability under the statute. And it stated that it was not ruling on the “significance, if any,” of the degree of employer control over the agent’s acts on the ultimate question of liability.
The court observed that a large business acting as an agent, like the screening providers, may have the bargaining power either “to avoid contractual obligations that will force it to violate the FEHA” or to secure agreements from employers to indemnify it for any FEHA liability. But the court left open the question whether businesses acting as agents and having fewer than five employees could be held directly liable for FEHA violations.

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 California Supreme Court. Please feel free to contact the following practice leaders:

Appellate and Constitutional Law Practice

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

Enforcement Actions

United States

Ripple Secures Landmark Win Against SEC, SEC Seeks To Appeal

On July 13, U.S. District Judge Analisa Torres ruled that the SEC could not establish as a matter of law that a crypto token was a security in and of itself, delivering a landmark legal victory for the cryptocurrency industry. The ruling provided a win for a cryptocurrency company in a case brought by the SEC, while also giving the SEC a partial victory. The judge determined that Ripple’s XRP sales on public exchanges were not offers of securities, but sales to sophisticated investors amounted to unregistered sales of securities. The case has significant implications for the broader crypto industry and has triggered calls for Congress to provide clear rules and legislation for digital assets. Following the ruling, both Coinbase and Kraken, large U.S. crypto exchanges, announced they will allow trading of XRP on their platforms again. On August 9, the SEC stated in a letter to the court that it plans to seek an interlocutory appeal, which is a generally disfavored procedural step that would require Judge Torres’s approval. On August 17, Judge Torres permitted the SEC to file a motion to file an interlocutory appeal by the following day. Ripple will have until September 1 to file its response to the motion, and the SEC will have until September 8 to file a reply. Only if Judge Torres grants the motion will the SEC then be allowed to seek permission for an interlocutory appeal also from the Second Circuit. The Block; Blockworks; Client Alert; CoinDesk; Reuters; Order

Landmark Ripple Determination Endorsed, But Split Arises In Rejection Of Do Kwon And Terraform Labs’ Motion To Dismiss

On July 31, U.S. District Court Judge Jed Rakoff denied Terraform Labs and founder Do Kwon’s motion to dismiss the SEC’s lawsuit against them alleging fraud involving various cryptocurrencies. Terraform and Do Kwon argued that the above Ripple decision invalidated the SEC’s case against them. Significantly, Judge Rakoff agreed with Judge Torres’ Ripple ruling that the SEC could not establish as a matter of law that a crypto token was a security in and of itself. However, Judge Rakoff rejected the Ripple opinion’s distinction between institutional versus retail purchasers for whether a token was offered as a security. The case is currently headed for trial. Bloomberg; The Block; Client Alert; Financial Times; Reuters; Order

Bankman-Fried Jailed Pending Trial, Campaign Contribution Charge Still Possible

FTX founder Sam Bankman-Fried was ordered to jail when Judge Lewis A. Kaplan of the Manhattan Federal District Court revoked his bail, concluding that Bankman-Fried’s communications with the media and an attempt to contact a former FTX employee constituted attempts “to tamper with witnesses at least twice” in the lead-up to his trial, which is scheduled to start on October 2. The presiding judge had imposed a temporary gag order in the case while considering prosecutors’ request to jail Bankman-Fried. Bankman-Fried had been under house arrest at his parents’ home since December, released on a $250 million bond. The U.S. government sought modifications to Bankman-Fried’s bail agreement after he showed a reporter private writings of Caroline Ellison, the former head of the crypto hedge fund he founded and his former girlfriend, who is a key witness for the prosecution. Bankman-Fried also had phone calls with journalists and was in contact with an author who is writing a book about his rise and fall that is set for publication the week before the trial begins.Meanwhile, U.S. prosecutors announced they intend to file a superseding indictment that will incorporate Bankman-Fried’s alleged campaign finance charge into existing charges, reversing a reported late-July decision to drop the campaign contribution charge from their fraud case against Bankman-Fried, after he argued it was not part of his extradition agreement. Bankman-Fried also faces fraud and conspiracy charges that could lead to decades in prison if convicted. ABC News; Bloomberg; CoinDesk; CoinTelegraph; DOJ; NPR; NYTimes

Judge Appears To Side With Coinbase Against SEC In Pre-Motion Conference; Coinbase Files Motion For Judgment On Pleadings; Scholars File Amicus Brief In Support of Coinbase

On July 13, 2023, Judge Katherine Polk Faila of the U.S. District Court for the Southern District of New York held a pre-motion conference in the SEC’s suit filed in June against Coinbase. The SEC alleges that Coinbase violated securities laws by listing on its platform digital assets that the SEC considers securities. At the conference, Judge Faila expressed “skepticism” with the SEC’s position, that the Court “would have thought the [SEC] was doing diligence” when it approved Coinbase’s Form S-1 to commence trading, and that the SEC failed to warn Coinbase that “maybe some day there could be a problem” and sued two years later. The Court also voiced concerns over the breadth of the SEC’s definition of securities, its ability to communicate this definition to the public, and the vagueness of the Howey test, the SEC’s criteria for whether a digital asset qualifies as a security.

On August 4, Coinbase filed its motion for judgment on the pleadings, maintaining that the SEC’s claims fall outside the agency’s Congressionally delegated authority because the platform does not trade securities. The motion contends that the SEC’s claims must be dismissed because (i) the SEC fails to allege a contractual undertaking beyond the point of sale, (ii) the alleged transactions lack expectation in income, profits, or assets of a business, (iii) the major questions doctrine prohibits the SEC’s interpretation of “investment contract,” (iv) the SEC fails to allege Coinbase acts as a “broker” by making Wallet software available, and (v) Coinbase’s alleged staking services do not involve relinquishment of property creating risk of loss or profits generated by managerial efforts. The case is closely watched for its potential impact on cryptocurrency trading and exchange listings.

On August 11, a group of six securities law scholars filed an amicus brief in support of Coinbase. The law professors argue that the tokens traded on Coinbase are not “investment contracts” under the settled meaning of the term in that they lack a contractual undertaking and an expectation in income, profits, or assets of a business, and, therefore, are not securities.

U.S. Senator Cynthia Lummis (R-WY) and the Blockchain Association, a pro-crypto lobbying group, also filed amicus briefs in support of Coinbase’s motion, arguing in part that Congress has not granted the SEC authority to regulate crypto assets. Axios; Bitcoinist; Decrypt; Hearing Transcript; Motion; The Verge; Professors’ Amicus Brief; CoinTelegraph; Sen. Lummis Amicus Brief; Blockchain Association Amicus Brief

SEC Sues Crypto Founder Richard Heart Alleging Fraud

On July 31, the SEC sued Richard Heart, also known as Richard Schueler, and three entities under his control (Hex, PulseChain, and PulseX) for conducting unregistered offerings of crypto asset securities that raised over $1 billion from investors. The SEC also accused Heart and PulseChain of fraud by misappropriating at least $12 million of proceeds from the offerings to buy luxury items, including sports cars and a 555-carat black diamond. Heart allegedly promoted Hex as a high-yield “blockchain certificate of deposit,” and claimed returns as high as 38% for a “staking” feature for Hex tokens, misleading investors with promises of wealth. The SEC’s complaint seeks injunctive relief, disgorgement of ill-gotten gains, penalties, and other equitable relief. SEC Press Release; CoinDesk; Bloomberg; The Block

DOJ Consolidates Crypto Enforcement Team

The U.S. Department of Justice (DOJ) announced the merging of the Computer Crime and Intellectual Property Section (CCIPS) with the National Cryptocurrency Enforcement Team (NCET) to strengthen efforts to combat cybercrime. The merger will double the Criminal Division attorneys available for digital currency-related cases, elevate the status of cryptocurrency work within the DOJ, enhance tracing and seizure of cryptocurrency assets, and multiply the entire DOJ’s capacity to charge digital assets cases. The announcement emphasizes that “every modern prosecutor needs to be able to trace and seize cryptocurrency.” The DOJ aims to tackle cyber threats, such as ransomware, by leveraging the expertise of the newly combined CCIPS and NCET teams and promoting collaboration with the DOJ’s National Security Division. DOJ Announcement; Coin Geek

Bitfinex Hacker “Crypto Couple” Pleads Guilty To Money Laundering

A New York couple, Ilya Lichtenstein and Heather Morgan, pleaded guilty to money laundering conspiracy after hacking into cryptocurrency exchange Bitfinex and stealing assets now worth over $4.5 billion. According to the DOJ, Lichtenstein used advanced hacking techniques to fraudulently authorize over 2,000 transactions transferring bitcoin to his crypto wallet. At the time of their arrest, the DOJ had seized around 120,000 bitcoin (then worth approximately $3.6 billion) that the couple allegedly had conspired to steal, and subsequently recovered an additional $475 million related to the hack. Reuters; Law360

Celsius Founder Alex Mashinsky Arrested, Faces Suits By Four Agencies

On July 13, Alex Mashinsky, founder and former CEO of bankrupt crypto-lender Celsius Network, LLC, was arrested and charged with seven counts of fraud by the DOJ under an indictment that also names Celsius’s Chief Revenue Officer, Roni Cohen-Pavon. The CFTC, FTC, and SEC simultaneously filed civil suits alleging similar claims against Mashinsky. The FTC’s complaint also names Celsius officers Shlomi Daniel Leon and Hanoch “Nuke” Goldstein. Mashinsky is accused of having schemed to defraud customers about the security of the Celsius platform, and made false or misleading statements about profits and Mashinsky’s purchases and sales of Celsius’s token to inflate the token’s value and to attract customer deposits of digital assets to the platform. Mashinsky is further accused of misappropriating deposits, unregistered offers and sales of securities, using false statements to obtain customer information of a financial institution, consumer harm, acting as an unregistered commodity pool operator (CPO) and associated person (AP) of a CPO, and failing to make commodity pool disclosures. Mashinsky faces up to 115 years in prison if found guilty on all criminal counts. Mashinsky pleaded not guilty and was released from custody on a $40 million bond. CoinDesk; CFTC; CFTC Complaint; Decrypt; DOJ Indictment; FTC Complaint; SEC Complaint; Wired

New York U.S. Attorney Announces Indictment For Decentralized Exchange Smart Contract Exploit

On July 11, the U.S. Attorney for the Southern District of New York announced the unsealing of an indictment and arrest of New Yorker Shakeeb Ahmed, a senior security engineer for an international tech company, for using his expertise to reverse engineer smart contracts and blockchain audits to exploit a vulnerability in a crypto exchange’s smart contract and inject fake pricing data, causing it to generate fraudulent fees worth approximately $9 million. After withdrawing the fees as cryptocurrency, Ahmed communicated with the crypto exchange, offering to return most of the stolen funds on the condition that he avoid referral to law enforcement. Ahmed then laundered the proceeds of the exploit through various transactions, including swapping tokens, bridging blockchains, exchanging into Monero for anonymity, and using overseas cryptocurrency exchanges. Ahmed subsequently conducted online searches related to the exploit, his criminal liability, fleeing the U.S., and avoiding extradition. Ahmed, aged 34, pleaded not guilty to charges of wire fraud and money laundering, each carrying a maximum sentence of 20 years in prison. Ahmed was released on bond and reportedly will be permitted to live at his Manhattan apartment pending trial. DOJ; CoinTelegraph; Decrypt; Forbes; Blocking.net; Yahoo Finance; International Business Times; TechNext; CyberNews; Blockworks; Gizmodo

Bittrex Inc. And Founder Settle Unregistered Exchange Charges With SEC

Crypto trading platform Bittrex Inc. and its co-founder William Shihara have agreed to settle SEC charges of operating an unregistered national securities exchange, brokerage, and clearing agency. Bittrex Inc.’s foreign affiliate, Bittrex Global GmbH, also agreed to settle charges that it failed to register as a national securities exchange. The SEC’s complaint, filed in April 2023, also alleged that Bittrex provided services to U.S. investors with crypto assets that were considered securities and that Shihara, the company’s former CEO, directed issuers to remove from public channels certain statements that would alert regulators to investigate whether the crypto asset was offered and sold as a security. As part of the settlement, Bittrex and Shihara neither admit nor deny the allegations and will pay $24 million in disgorgement, prejudgment interest, and civil penalties, pending court approval. SEC Press Release; CoinTelegraph

U.S. Treasury Defeats Tornado Cash Suit, District Court Upholds OFAC Sanctions

On August 17, a federal judge in Texas sided with the U.S. Department of the Treasury against a group of plaintiff developers and investors who sued in September last year, seeking to invalidate the Office of Foreign Assets Control’s (OFAC’s) addition of Tornado Cash to the Specially Designated National and Blocked Persons (SDN) List. The U.S. District Court for the Western District of Texas, Judge Robert Pitman, found that Tornado Cash qualified as an association, composed of its founders, its developers, and its DAO, with the common purpose of developing, promoting, and governing Tornado Cash, and thus could be designated under OFAC regulations, despite arguments that Tornado Cash was autonomous software. The court then held that it would defer to OFAC’s determination that smart contracts constitute property. Specifically, the court found whereas contracts are property under the regulations, smart contracts are a “code-enabled species of unilateral contracts,” “like a vending machine.” Judge Pitman further found that Tornado Cash had a beneficial interest in the smart contracts, stemming from an expectation that they would generate revenue in the form of tokens. The court additionally rejected plaintiffs’ First Amendment arguments, holding (among other things) that the Amendment does not protect a right to make political donations through any bank or service of their choosing. Lastly, the court held the plaintiffs’ Fifth Amendment Takings Claim was waived as the plaintiffs failed to pursue it against the government’s motion. The plaintiffs may appeal. CoinDesk; Order; CoinTelegraph

International

Worldcoin Token And Protocol Launch; French Investigators Reinforce Worldcoin Investigation; Kenya Temporarily Bans Worldcoin Operations, Police Raid Warehouse

Following a July 24 launch of Worldcoin’s token (WLD) and blockchain protocol, French and Argentine data protection regulators CNIL and AAIP, respectively, announced investigations of Worldcoin due to concerns over data collection and retention practices. Worldcoin requires that users provide an iris scan in exchange for a digital World ID and in certain countries pays a user 25 tokens for a scan. Operators of Worldcoin’s iris-scanning Orbs receive tokens as incentives as well. WLD tokens currently trade for around $2. Worldcoin reportedly has collected over 2.2 million individuals’ iris scans to date. CNIL’s investigations support the ongoing and previously reported work on the project of Bavarian privacy regulators, who bear primary responsibility under EU law. The project has reiterated its compliance with EU’s law on biometric data under the General Data Protection Regulation (GDPR). Worldcoin also faces concerns from the UK’s Information Commissioner’s Office regarding the sufficiency and ability to withdraw consent consistent with data processing rights.

On August 2, the Kenyan minister of internal security announced a temporary ban on Worldcoin from operating in the country until authorities had the opportunity to assess any risk to residents. On August 7, Kenyan police reportedly raided a Worldcoin warehouse in Nairobi and seized machines believed to store Worldcoin data. The Kenyan Data Commissioner alleged that Worldcoin’s parent company, Tools for Humanity, had misrepresented its intentions when registering and the Kenyan Interior Cabinet Secretary stated that Worldcoin was not a registered legal entity. Worldcoin stated it plans to cooperate with the government before resuming operations. Bloomberg; CoinDesk; CoinTelegraph; KahawaTungu; Reuters; Semafor

Crypto Bridge MultiChain CEO And Sister Arrested In China, Operations Shuttered Following $130M Hack

MultiChain, a cryptocurrency project facilitating cross-blockchain connectivity, announced its closure following news that its founder and CEO, known as Zhaojun, was apprehended by Chinese authorities on May 21. In a Twitter statement, MultiChain explained that Zhaojun’s unexplained absence since late May prompted the decision. As a crypto bridge, MultiChain enabled users to exchange digital tokens across different blockchains they operated on. CoinDesk; Decrypt; Economic Times; DLNews

Regulation and Legislation

United States

Coinbase Wins Approval To Sell Crypto Futures In U.S.

On August 16, Coinbase announced that it had gained approval to sell cryptocurrency derivatives directly to retail consumers in the U.S. The approval comes from the National Futures Association (NFA), a CFTC-designated self-regulatory organization, and permits Coinbase to operate as a Futures Commission Merchant (FCM) as well as eligible U.S. customers to access derivatives products alongside Coinbase’s spot market. According to the announcement, the global crypto derivatives market comprises approximately 75% of worldwide crypto trading volume. Coinbase previously acquired FairX in 2022, now known as the Coinbase Derivatives Exchange, which is open to third-party brokers, FCMs, and market makers, and which offers retail-investor-sized nano BTC and ETH futures as well as BTC and ETH futures trading for institutional investors. Coinbase also launched a derivatives exchange in Bermuda in May. Bloomberg; Coinbase; CoinTelegraph; Forbes

Federal Reserve Establishes Program To Enhance Supervision Of Banks’ Crypto Activity

On August 8, the Federal Reserve introduced the Novel Activities Supervision Program (Program). The Program will primarily focus on four types of activities: (1) complex, technology-driven partnerships with non-bank entities to offer banking services to end customers, including through application programming interfaces (APIs) with automated bank infrastructure access; (2) crypto-asset-related activities, including custodial services, crypto-collateralized lending, facilitation of crypto trading, and issuance or distribution stablecoins/dollar tokens; (3) projects utilizing distributed ledger technology (DLT) with “potential for significant impact on the financial system,” which the supervision and regulation letter to Federal Reserve officers recognizes as including dollar token issuance, as well as tokenization of securities and other assets; and (4) banking organizations concentrating in offering traditional banking services like deposits, payments, and lending to crypto-asset-related entities and fintechs. The Program is designed to work in partnership with existing Federal Reserve supervisory teams to monitor and examine novel activities, and banks engaged in such novel activities will not be moved to a separate supervisory portfolio. The Federal Reserve will notify institutions in writing whose novel activities will be subject to examination through the Program. CoinDesk; CoinTelegraph; CryptoSlate; Federal Reserve SR 23-7

Federal Reserve Issues Guidance On Bank Preapprovals For Stablecoin/Dollar Token Activity

Also on August 8, the Federal Reserve outlined the supervisory nonobjection process for state member banks seeking to use DLT or similar technologies to conduct payments activities as principal, including by issuing, holding, or transacting in stablecoins, which the Federal Reserve refers to as “dollar tokens.” The guidance provides that a state member bank will be required to show, to the satisfaction of its Federal Reserve supervisors, that it has established appropriate safe and sound controls and to obtain a written notification of supervisory nonobjection from the Federal Reserve prior to engaging in the proposed activities. Assessment by Federal Reserve staff will focus on various factors, including operational, cybersecurity, liquidity, illicit finance, and consumer compliance risks tied to dollar tokens, as well as compliance with applicable laws. The two Federal Reserve supervisory letters were released in conjunction with the previously announced interagency crypto-asset policy sprint. CoinDesk; CoinTelegraph; CryptoSlate; Federal Reserve SR 23-8; Interagency Joint Statement on Crypto-Asset Policy Sprint

GAO Releases Crypto Oversight Report Commissioned By Former House Financial Services Committee

On July 24, the GAO released a report concluding that there is a significant regulatory gap as to digital assets among federal agencies and recommending that the CFPB, CFTC, FDIC, NCUA, OCC, and SEC adopt an enhanced coordination mechanism going forward. Commissioned by the last House Financial Services Committee, the report found that no single regulator had authority over digital assets that are not “securities” and further noted that no uniform rules existed for requiring stablecoins to disclose reserve assets and risk profiles. CoinDesk; Report

House Republicans Introduce Updated Digital Asset Oversight Bill

On July 20, House Republicans introduced an updated version of proposed legislation first released in June that would clarify the regulatory responsibilities of the SEC and CFTC over digital assets. The new draft defines “digital assets” more broadly to include an additional range of decentralized finance tokens, leading some critics to argue that the SEC and other regulatory agencies could stretch the language to continue enforcement actions the legislation is intended to forestall. CoinDesk; Bill

SEC Chair Requests Additional Funding To Combat Digital Asset “Noncompliance”

On July 19, SEC Chair Gary Gensler asked the Senate Appropriations Committee for an additional $72 million in funding to combat “noncompliance” in the digital assets industry, which he described as the “Wild West.” The request, which would represent an approximately 3% increase in the agency’s current draft budget, would go toward hiring dozens of additional full-time staff members to conduct additional enforcement activities. CoinDesk

Senate Considers Bill To Regulate Digital Asset Providers Like Banks

On July 18, a group of U.S. senators introduced the Crypto-Asset National Security Enhancement Act of 2023, a bipartisan bill that would require decentralized finance (DeFi) providers to impose know-your-customer and identity verification requirements akin to those currently required of regulated banks. Subject entities would be required to vet and collect information on customers, run anti-money laundering programs, report suspicious activity to the government, and block sanctioned individuals from protocols. The bill would apply to anyone who controls, makes available, or invests more than $25 million in developing a DeFi protocol. CoinDesk; Bill

U.S. Stablecoin Bill Meets House Opposition, Bipartisan Negotiations Lose Steam

Negotiations toward a potential bipartisan compromise over stablecoin legislation in the House of Representatives appear to have hit an impasse. According to House Financial Services Committee Chair Patrick McHenry (R-NC), the White House encouraged minority committee members to stall over concerns that the legislation did not go far enough to regulate anonymous payments and embraced an overly decentralized licensing regime. Meanwhile, Rep. Maxine Waters (D-CA), the Committee’s ranking Democrat, noted that neither the Federal Reserve nor the U.S. Treasury support the current version of the bill, identifying limited licensing oversight and potential state and federal regulatory conflicts as problematic. Nevertheless, the House bill was successfully voted out of committee by a 34-16 vote last week and introduced by McHenry (R-NC) as the Clarity for Payment Stablecoins Act. CoinDesk; CoinDesk; CoinTelegraph; Decrypt

Federal Reserve’s Instant-Payment System Raises Concerns About National Digital Currency

On July 20, the Federal Reserve officially launched FedNow, a new instant-payment service that replaces the existing hour- or day-long bank-to-bank payment system with just-in-time payments. The service will operate around the clock and brings the U.S. banking system in line with many other countries including the EU, UK, India, and Brazil where similar services have existed for years. Although the Fed emphasized that FedNow does not signal a shift toward a central bank digital currency, critics have pointed out that FedNow adopts many of the same speed and efficiency goals as the digital asset industry and paves the way for issuance of a national, and centrally monitored, digital currency. CoinDesk; CoinDesk; Federal Reserve; Forbes; Reuters

Nasdaq Halts Plan For Crypto Custody Solution Due To Changing Regulatory Ecosystem

On July 18, Nasdaq announced that it is halting plans for the launch of a crypto custody solution in light of “the shifting business and regulatory environment in the U.S.” with respect to cryptocurrencies. The exchange had first revealed its intention to develop the custody service in September alongside the establishment of its crypto business, Nasdaq Digital Assets. Nasdaq will continue to list cryptocurrency exchanges and services, to provide technology for crypto custody, and to partner with crypto ETF-issuers to enable tradable exchange-listed products. Bloomberg; CNBC; CoinDesk; CryptoNews; Financial Times

Crypto Miners Establish Lobbying Group

On August 15, the Digital Energy Council (DEC) officially launched as the first member association focused solely on digital asset mining and energy security, aiming to drive policies that enhance grid resilience, sustainable energy practices, U.S. competitiveness, and national security. Founder Tom Mapes has emphasized the need to foster collaboration between the digital asset mining and energy sectors to fortify energy infrastructure during a pivotal moment of energy modernization. The DEC will facilitate productive discussions among members, regulators, and policymakers to dispel misconceptions and promote economic development, notably engaging with figures like U.S. Senators Lisa Murkowski and Cynthia Lummis to pioneer collaboration and responsible practices in these domains. Bitcoin Magazine; CoinDesk

International

EU Regulators Prepare Draft MiCA Regulations For Crypto Asset Providers

European securities and banking regulators have released draft regulations implementing the EU’s Markets in Crypto Assets (MiCA) law, which was approved last year and establishes a uniform licensing regime for crypto asset service providers across the bloc’s 27 member nations. Member states and interested parties are invited to comment on the proposals. Further proposals are expected to issue later this year and submission to the European Commission is slated for June 2024.

On July 12, the European Securities and Markets Authority (ESMA) issued its first of three consultation packages, in this first tranche seeking input on proposed rules that would impose additional disclosure and conflict-of-interest requirements, boost know-your-customer and money laundering protections, require the segregation of customer assets, and introduce standards for handling customer complaints. The ESMA has invited comments from stakeholders on this first package by September 20, 2023 and intends to publish a second in October 2023.

On July 24, media outlets reported that the European Banking Authority (EBA) will release proposed regulations that would subject “significant” cryptocurrencies to centralized EU, rather than member state, control, including by imposing uniform stress test and reserve requirements. Those proposals would be in line with earlier statements from the EBA on implementation of the MiCA. CoinDesk; CoinDesk; ESMA

Abu Dhabi Licenses Rain As First Retail Cryptocurrency Exchange In UAE

On July 25, Abu Dhabi’s Financial Services Regulatory Authority approved the UAE’s first retail virtual-asset exchange after a five-year inquiry process. The license went to Rain, a Bahrain-based digital assets company backed by crypto exchange Coinbase. Rain’s Abu Dhabi unit is now authorized to open a bank account in the UAE, enable clients to fund their own accounts, and provide services to institutional and certain retail customers in the Abu Dhabi Global Market financial free zone, an economic hub located off the coast of the emirate. The Block; CoinDesk; Reuters

Dubai Grants Binance License To Operate As Virtual Asset Exchange

On July 31, Binance announced that its Dubai-based subsidiary, Binance FZE, obtained a license to operate as a virtual asset exchange in Dubai. The crypto exchange won an Operational Minimum Viable Product license after meeting the pre-conditions since receiving a preparatory license in September 2022 from Dubai’s Virtual Assets Regulatory Authority (VARA). The license allows Binance FZE to offer crypto services to institutional and qualified retail investors in the emirate subject to Dubai’s know-your-customer and due-diligence requirements. Specifically, the license allows the exchange to open a domestic bank account to hold clients’ funds locally, operate a crypto exchange and offer payments and custody services. “We are honored to be the first exchange to be granted an operational Minimum Viable Product License by VARA,” said Richard Teng, head of regional markets of Binance. Teng went on to say the company’s priority is to “operate this first fully regulated exchange [in Dubai] . . . setting the stage for global scalability.” The Operational Minimum Viable Product license is step three of four to becoming fully regulated in the jurisdiction. The fourth step, a Full Market Product license, is expected after demonstration of compliance with all rules of Dubai’s licensing process. Binance Blog; CoinDesk; CoinTelegraph; The Block

Russia Adopts Legal Framework For Central Banking Token

On July 24, Russian President Vladimir Putin signed legislation authorizing the Russian central bank to issue a digital ruble. The Bank of Russia has been working toward the central bank digital currency since 2020, when the Bank published its first analysis on the project, and may begin testing the electronic currency in August. The cryptocurrency has been the subject of a pilot program with several Russian banks since February 2022, and has been viewed by the Bank of Russia as a method to circumvent financial sanctions imposed by the U.S. and Europe and to allow Russian authorities better control over money allocated for domestic projects. Bloomberg; CoinDesk

UK Economic Secretary Rejects Proposal To Regulate Crypto As Gambling

On July 20, the UK’s Economic Secretary rejected a proposal issued by the House of Commons Treasury Committee to regulate cryptocurrencies more harshly by relying on the country’s gambling laws. According to the Secretary’s response, the UK Government remains committed to establishing a new regulatory regime for digital assets that protects customers without departing from international norms, which would risk driving digital asset providers out of the country and redirecting interested customers to foreign markets. CoinDesk; Report

Indonesia Launches National Cryptocurrency Exchange

On July 20, officials with the Indonesian commodities regulator confirmed that the nation’s cryptocurrency exchange and clearinghouse had been operational since July 17 after a number of significant delays. The exchange is managed by the nation’s central bank and financial regulators and operates much like a traditional securities market with built-in fairness and consumer-protection requirements. CoinDesk

Hong Kong Approves First Retail Cryptocurrency Exchanges, Positions Itself As Crypto Hub

HashKey Exchange and OSL have become the first cryptocurrency exchanges in Hong Kong to secure licenses enabling retail investors to trade on their platforms. The milestone comes two months after the local regulatory authority announced permitting for companies to offer such services. The licenses mark the establishment of Hong Kong as a crypto hub, an especially notable development against the backdrop of some relatively cautious markets following the collapse of FTX. With this opening of HashKey Exchange’s and OSL’s services to everyday retail investors, the platforms aim to boost crypto adoption and engagement within the region. Nikkei; CoinDesk; Bloomberg; Yahoo Finance; CoinTelegraph

Singapore Grants Crypto Exchange Blockchain.com Major Payment Institution License

On August 1, Blockchain.com was granted a major payment institution (MPI) license from the Monetary Authority of Singapore (MAS) that will allow it to expand its services to institutional and accredited investors. The MPI license enables it to offer payment services, including digital payment token services and cross-border transfers. Blockchain.com’s approval follows an in-principle approval that MAS first issued to Blockchain.com in September 2022. The Singapore headquarters of the global crypto exchange Crypto.com and stablecoin issuer Circle recently received licenses to provide digital payment token services in June 2023. Blockworks; CoinDesk; CoinTelegraph; Press Release; The Straits Times

Civil Litigation

United States

FTX And Genesis Reach Agreement Regarding Bankruptcy Dispute

Bankrupt crypto firms FTX and Genesis have reached an agreement in principle to settle their ongoing dispute. Genesis emerged as the largest unsecured creditor of FTX, owed $226.3 million, while FTX claimed that Genesis owed FTX nearly $4 billion, later reduced to $2 billion, which Genesis denied. The agreement, detailed in a letter filed with the U.S. Bankruptcy Court for the Southern District of New York in the Genesis Chapter 11 proceedings, stated that the settlement would resolve the claims made by both parties, but did not include specific details about the agreement. Genesis Global Capital had temporarily halted redemptions and new loans following the collapse and Chapter 11 filing of FTX in November due to market dislocation and loss of industry confidence. Genesis in turn filed for bankruptcy protection in January, already weakened by losses from the collapse of Three Arrows Capital. Bloomberg; CoinDesk

FTX Estate Sues Bankman-Fried And Former Executives In Bid To Recoup $1 Billion

On July 20, the bankruptcy estate for crypto firm FTX filed a complaint against its founder Bankman-Fried and three of its former executives, Caroline Ellison, Gary Wang, and Nishad Singh, in an attempt to claw back over $1 billion in allegedly misappropriated value to the company. The estate claims that the former executives breached their fiduciary duties by misusing customer funds on luxury condominiums, political and charitable donations, and speculative investments, as well as abused their control over the exchange and its related companies. Further, the executives allegedly issued hundreds of millions of dollars of equity to themselves without value to the estate, and cash to make investments unrelated to the estate. CoinTelegraph; Reuters; The Guardian

Winklevoss’ Gemini Sues Digital Currency Group And Founder Barry Silbert For Alleged Fraud

Crypto trust firm Gemini has filed a lawsuit against Digital Currency Group (DCG), claiming fraud by DCG subsidiary Genesis, and its founder Barry Silbert. The suit aims to recover funds from DCG that assertedly were tied to Gemini’s Earn program and managed by Genesis. Gemini alleges that Genesis falsely presented robust risk management practices and thorough vetting processes. The suit accuses Silbert of urging Gemini to continue the Earn program despite knowing of Genesis’s insolvency and attempting to conceal its financial issues. DCG countered the claims as defamatory and called the lawsuit a “publicity stunt.” Bloomberg; CoinDesk

Crypto Custodian Prime Trust Files For Chapter 11 Bankruptcy

Crypto custodian Prime Trust filed for Chapter 11 bankruptcy protection in Delaware on August 14. The filing comes after confronting a shortfall in customer funds—the company has between 25,000 and 50,000 creditors and estimated liabilities between $100 million and $500 million versus $50 million to $100 million worth of estimated assets. The firm’s top five unsecured creditors assert claims of roughly $105 million, with the largest claim for $55 million. The bankruptcy also follows a June 21 cease and desist order against Prime Trust issued by Nevada’s business regulator, saying the firm’s financial condition was “critically deficient” and unable to honor customer withdrawals. On June 26, the Nevada regulator petitioned a court to place the firm into receivership, which the court approved on July 18. At the time of the regulator’s petition, Prime Trust owed over $85 million in fiat to its clients but only had around $2.9 million. Its digital asset liabilities were smaller, with Prime Trust owing about $69.5 million in crypto while holding approximately $68.6 million. Bankruptcy Filing; The Block; Cease & Desist Order; CoinTelegraph; Receivership Petition

Speaker’s Corner

United States

SEC Chief Accountant Warns Accounting Firms About Legal Liability For Crypto ‘Audits’

In a public statement on July 27, SEC Chief Accountant Paul Munter warned accounting firms of the potential pitfalls of purported crypto “assurance” work. In particular, Munter highlighted accounting firms’ potential legal liability for statements made by their clients and responsibilities with respect to auditor independence. Reflecting on a renewed focus on accounting firms following recent developments and insolvency in the industry, as well as a recent trend involving crypto platforms and others engaging accounting firms to perform reviews and marketing these as “audits” to investors, Munter cautioned that accounting firms could face legal liability under antifraud laws for statements made by their clients, if the clients mislead about the extent of a financial review or the “scope of work” done by the accounting firm. As part of their public responsibilities, the SEC Chief Accountant insisted, accounting firms must ensure that accountants’ names or services are not used to convey a false sense of legitimacy or to mislead investors. Thus, where an accounting firm learns that a client has made misleading statements to the public about the nature of its non-audit work, the Office of the Chief Accountant staff view that best practice is for the firm to consider making a noisy withdrawal to disassociate from the client. SEC Statement

Gensler Raises Concerns About Fraud And Manipulation For Bitcoin ETFs

SEC Chair Gary Gensler expressed skepticism about the crypto marketplace when asked about pending applications for spot bitcoin ETF applications in a televised interview on July 27. Though Gensler did not make a direct statement regarding the recent wave of filings spurred by BlackRock in the interview, he did raise concerns about general fraud and potential manipulation in the crypto industry. “The platforms themselves, where trading is occurring of various crypto tokens, though some of it comes under the securities laws, currently they’re not necessarily compliant with those time-tested protections against fraud and manipulation,” Gensler said. The Block; Bloomberg

International

South Korea Urges Crypto Platforms To “Strengthen Compliance Capacity”

On July 27, the Korean Financial Intelligence Unit (KoFIU)—a government agency dedicated to tackling money laundering and terrorist financing—held a consultative body meeting to “strengthen the compliance capacity of virtual asset service providers.” At the meeting, KoFIU Commissioner Rhee Yunsu said that the agency “will operate a strategic analysis team on virtual assets to more systematically analyze criminal activities involving virtual assets” to provide data to investigative authorities. The purpose of the initiative is to support virtual asset service providers’ compliance efforts and to combat relevant crime as the country awaits proper legislation to address illegal activities in the market. Five domestic crypto services providers attended the meeting and reported their measures for dealing with potential crime. The Block

Japan’s Prime Minister Says Web3 Can Transform Internet

During the WebX web3 conference in Tokyo on July 25, Japan’s Prime Minister Fumio Kishida said that web3 has the capacity to transform the traditional internet and contribute to social change in Japan. Kishida said the government was dedicated to creating an ecosystem amenable to the promotion of web3 as part of his administration’s “new capitalism” economic platform designed to address social issues through growth and innovation. “Web3 is part of the new form of capitalism,” the Prime Minister declared. The Block

Other Notable News

Cboe Amends Five Spot Bitcoin ETFs To Enter “Surveillance Sharing Agreements” With Coinbase Following Refiling Of Blackrock Spot Bitcoin ETF

On July 11, exchange operator Cboe Global Markets submitted amendments to the SEC for five proposed spot bitcoin ETF applications to include a surveillance-sharing agreement (SSA) with Coinbase. The amended filings include ETFs from Invesco, VanEck, WisdomTree, Fidelity, and the joint fund ARK Invest and 21Shares. Cboe stated that it “reached an agreement on terms” with Coinbase for the SSAs. Coinbase’s shares surged as much as 11% on June 11 following the announcement. Cboe’s filings follow on the heels of Nasdaq’s refiling for BlackRock’s ETF in July, which also listed Coinbase as a surveillance sharing partner. The SSAs are intended to meet the SEC’s standards for preventing fraud and protecting investors, as outlined by the regulator earlier this year. If approved, the filings would mark the first spot bitcoin ETFs. The Block; CoinTelegraph

Two Major Crypto VC Funds Announce New Fundraisings, Buck “Crypto Winter”

Polychain Capital, one of the most prominent venture capital firms in the crypto space, has raised around $200 million in the “first close” of its fourth crypto venture capital fund. The firm further plans to raise around $400 million total for this fund. Polychain has around $2.6 billion in assets under management. Coinfund, a New York-based crypto venture capital firm, also announced that it raised $158 million in its latest funding round and is focusing on crypto infrastructure projects that enable greater decentralization, a trend that has emerged after the implosion of FTX last year. Both successful raises come in the midst of an extended crypto winter that has seen a broad retreat from crypto-related investments following a series of failures throughout 2022, further complicated by higher interest rates that have increased the cost of borrowing. But Alex Felix, Coinfund’s co-founder and chief investment officer, has pointed out that this slower-paced environment raises the quality of entrepreneurs competing for more limited funds. CoinDesk; Fortune; Decrypt

Ethereum DeFi Spooked By Hacks And Curve Finance Liquidation Threat; Risks Mitigated

On July 30, around $70 million was stolen in a string of attacks on several key DeFi platforms, including Curve Finance, one of the most popular decentralized exchanges. The attacks also targeted lending protocol Alchemix, yield platform Pendle, synthetic asset tool Metronome, and decentralized NFT protocol JPEG. Spooked traders withdrew roughly $1.5 billion worth of digital assets after hackers stole around $62 million from Curve. The price of the Curve DAO (CRV) declined 20.91% on the day of the hack, and continued to decline the next day to a seven-month low. By the morning of August 1, the market valuation of CRV had plummeted 46%. This drop in turn triggered wider market fear as Curve Finance founder, Michael Egorov, had loans worth roughly $100 million secured against CRV, collateral that was at risk of liquidation if the price of CRV dipped below a certain threshold. Several actions were taken to mitigate any risk of a liquidation crisis for Curve—and to avoid any systemic risk for DeFi more broadly. On August 1, Egorov sold 39.25 million CRV tokens for stablecoins to a number of notable decentralized finance investors, including Justin Sun, the founder of Tron blockchain, for a total of $15.8 million. Egorov also made partial repayment on certain of his loans, reducing liquidation risk. Further, the DAO that governs one of the lending platforms that Egorov had borrowed from, Abracadabra, approved an emergency measure to change how it tracks those tokens’ prices to prevent inadvertent selling of CRV tokens. As of August 11, Curve Finance had recovered 70% of funds worth about $50 million lost in the hacking incident. The Block; CoinDesk; CoinTelegraph; Forbes; NewsBTC; TechCrunch; Yahoo Finance

PayPal Launches U.S. Dollar Stablecoin

On August 7, PayPal launched a U.S. dollar-denominated stablecoin called PayPal USD (PYUSD), aimed at leveraging the potential of stablecoins for web3 payments and digital environments. The stablecoin will be an Ethereum-based token fully backed by U.S. dollar deposits, short-term U.S. Treasuries, and similar cash equivalents, and will be redeemable 1:1 for U.S. dollars. It will enable eligible U.S. PayPal customers to transfer funds, send person-to-person payments, fund purchases, and convert cryptocurrencies within the PayPal ecosystem. The stablecoin’s issuance is managed by Paxos Trust Company and is designed to bridge the gap between fiat and digital currencies, while promoting transparency through public monthly reserve reports and third-party attestations of value. CoinDesk; PayPal Press Release

Binance Japan To Begin Onboarding Users

Binance Japan, a subsidiary of Binance, announced that it is set to begin onboarding users to its new platform, with existing Binance customers able to migrate to the Japanese subsidiary as soon as mid-August. The Japanese subsidiary will enable users to spot trade, earn products, and participate in an NFT marketplace. It will also feature 34 tokens available for trading, including Binance Smart Chain’s BNB, which will be available in Japan for the first time. CoinDesk

Pro-Bitcoin Argentine Presidential Candidate, Javier Milei, Wins Presidential Primary

Javier Milei, a libertarian candidate, unexpectedly won Argentina’s open presidential primary election with over 30% of the vote, positioning him as a front-runner for the fall general election. Milei has called for abolition of Argentina’s central bank as a “scam” and spoken favorably of Bitcoin, remarking that it “represents the return of money to its original creator, the private sector.” Milei’s party, La Libertad Avanza, also has tweeted positively of El Salvador’s use of Bitcoin as legal tender. Milei, however, advocates for dollarization of the Argentine economy as triple-digit inflation afflicts the nation. The general election is set for October, with a potential runoff in November. CoinDesk; Finbold; NYTimes

The following Gibson Dunn lawyers prepared this client alert: Ashlie Beringer, Stephanie Brooker, Jason Cabral, M. Kendall Day, Jeffrey Steiner, Sara Weed, Ella Capone, Grace Chong, Chris Jones, Jay Minga, Nick Harper, Jessica Howard, Nathaniel Tisa, and Simon Moskovitz.

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

FinTech and Digital Assets Group:

Ashlie Beringer, Palo Alto (650.849.5327, aberinger@gibsondunn.com)

Michael D. Bopp, Washington, D.C. (202.955.8256, mbopp@gibsondunn.com

Stephanie L. Brooker, Washington, D.C. (202.887.3502, sbrooker@gibsondunn.com)

Jason J. Cabral, New York (212.351.6267, jcabral@gibsondunn.com)

Ella Alves Capone, Washington, D.C. (202.887.3511, ecapone@gibsondunn.com)

M. Kendall Day, Washington, D.C. (202.955.8220, kday@gibsondunn.com)

Michael J. Desmond, Los Angeles/Washington, D.C. (213.229.7531, mdesmond@gibsondunn.com)

Sébastien Evrard, Hong Kong (+852 2214 3798, sevrard@gibsondunn.com)

William R. Hallatt, Hong Kong (+852 2214 3836, whallatt@gibsondunn.com)

Martin A. Hewett, Washington, D.C. (202.955.8207, mhewett@gibsondunn.com)

Michelle M. Kirschner, London (+44 (0)20 7071.4212, mkirschner@gibsondunn.com)

Stewart McDowell, San Francisco (415.393.8322, smcdowell@gibsondunn.com)

Mark K. Schonfeld, New York (212.351.2433, mschonfeld@gibsondunn.com)

Orin Snyder, New York (212.351.2400, osnyder@gibsondunn.com)

Jeffrey L. Steiner, Washington, D.C. (202.887.3632, jsteiner@gibsondunn.com)

Eric D. Vandevelde, Los Angeles (213.229.7186, evandevelde@gibsondunn.com)

Benjamin Wagner, Palo Alto (650.849.5395, bwagner@gibsondunn.com)

Sara K. Weed, Washington, D.C. (202.955.8507, sweed@gibsondunn.com)

On July 12, 2023, United States Senators Cynthia Lummis (R-WY), a member of the Senate Banking Committee, and Kirsten Gillibrand (D-NY), a member of the Senate Agriculture Committee, reintroduced the Lummis-Gillibrand Responsible Financial Innovation Act (the “RFIA”).[1] Although it is unclear whether the RFIA will pass the Senate in its current form, certain consumer protection provisions were modified from the prior 2022 version to pick up more votes. Regardless of the RFIA’s future viability, the RFIA is driving a broader conversation within Congress. For example, shortly after reintroduction, provisions of the RFIA addressing crypto asset anti-money laundering examination standards and anonymous crypto asset transactions were added to the 2024 National Defense Authorization Act (“NDAA”).[2]

As such, the RFIA’s “enhanced” approach sheds light on the priorities of the U.S. Congress and, in turn, makes clear those areas that warrant attention. The RFIA addresses industry uncertainty surrounding the role of federal regulators; the classification of, and subsequent restrictions to, certain assets; and the interaction of these assets with the existing anti-money laundering and tax regimes.

Compared to the initial 2022 version of the RFIA,[3] the 2023 version reflects revisions to adjust to the changing cryptocurrency market, particularly in light of the string of 2022 cryptocurrency exchange bankruptcies. In particular, for purposes of this client alert, we focus on the following provisions of the RFIA that represent significant departures from the initial 2022 version:[4]

Draws a clear division between Securities and Exchange Commission (“SEC”) and Commodity Futures Trading Commission (“CFTC”) jurisdiction over cryptocurrencies, and creates the Consumer Protection and Market Integrity Authority;
Provides substantive regulations rooted in consumer protection principles for both Crypto Asset Intermediaries and Payment Stablecoin Issuers (each as defined below);
Prioritizes combating illicit finance; and
Revises the federal tax code to more precisely reflect crypto asset and securities transactions.

We review each of these developments in turn below, highlighting the provisions of the RFIA that represent significant updates from 2022. Following this review, we provide our thoughts on the potential implications to covered entities should the RFIA, or other similar bills, be enacted.

1. Altered Federal Regulatory Framework

As currently drafted, the RFIA proposes a new federal framework for the regulation of crypto assets[5] and crypto asset intermediaries.[6] The framework strives to clarify and differentiate the governing role of the CFTC and SEC by providing the necessary statutory authority, directing the agencies to engage in rulemaking while also introducing the concept of a Customer Protection and Market Integrity Authority. These provisions will have a notable impact on these agencies, as determining whether a certain asset is a security will dictate the regulator, restrictions and obligations of the crypto asset and the related entity.

1a. Enhanced CFTC Authority

The CFTC’s existing statutory authority over spot market commodities, including cryptocurrencies, is limited to enforcement authority over fraud and manipulation in those markets; however, the CFTC’s regulatory authority is limited to the derivatives markets (e.g., futures and swaps). As currently drafted, the RFIA provides the CFTC the statutory authority to regulate the spot crypto asset markets, including crypto issuers, crypto assets and other aspects of the crypto asset markets, leaving the SEC a defined, but more limited role.

Spot Market Jurisdiction

The RFIA grants the CFTC spot market jurisdiction over all commercially fungible crypto assets that are not defined as securities, including endogenously referenced crypto assets (colloquially known as “algorithmic stablecoins,” though these assets are prohibited from referring to themselves as stablecoins; notably, the CFTC does not regulate stablecoins, as further discussed below).[7] This would mark the first time that the CFTC would have broad jurisdiction over a class of spot market commodities. In particular, the RFIA provides the CFTC with exclusive jurisdiction over any agreement, contract, or transaction involving a sale of a crypto asset, including ancillary assets.[8] Notably, in addition to limiting the CFTC’s jurisdiction to crypto assets that are not securities and that are commercially fungible, the RFIA excludes from the CFTC’s jurisdiction digital collectibles and other unique crypto assets.[9] Accordingly, the RFIA would carve many non-fungible tokens (“NFTs”) outside the scope of the CFTC’s jurisdiction. Nonetheless, this expansive jurisdiction marks the CFTC as the primary crypto asset regulator.

Crypto Asset Exchanges

The RFIA defines “crypto asset exchange” as a trading facility that lists for trading at least one crypto asset.[10] Any trading facility that seeks to offer a market in crypto assets or payment stablecoins must register with the CFTC, except truly decentralized protocols.[11] The RFIA tasks each crypto asset exchange with establishing and enforcing its own rules, ensuring only assets that are not readily susceptible to manipulation, and protecting the safety of customer assets.[12] Additionally, each crypto asset exchange must segregate customer assets from exchange assets.[13]

Under the RFIA, the CFTC has new regulatory oversight over registered crypto asset exchanges. Although crypto asset exchanges are banned from conducting proprietary trading, the CFTC may engage in rulemaking to establish standards for permissible market making.[14] Further, any change of control of a crypto asset exchange resulting in an individual or entity gaining ownership of greater than 25 percent must first receive approval from the CFTC.[15]

Covered Affiliates

Under the RFIA, “covered affiliate” means, based on the totality of the facts and circumstances as determined by the CFTC, a person with substantial legal or financial relationship to an entity registered under the Commodity Exchange Act that is primarily engaged in crypto asset activities.[16] The RFIA empowers the CFTC to order the examination of a covered affiliate and to limit covered affiliates from providing services to a registered entity or entering into legal relationships or specified transactions with a registered entity.[17]

Risk Management Standards for Self-Hosted Wallets

The RFIA also tasks the CFTC with promulgating rules to adopt risk management standards relating to money laundering, customer identification, and sanctions for self-hosted wallets that conduct transactions with a futures commission merchant. The term “self-hosted wallet” means a digital interface used to secure and transfer crypto assets, in which the owner of the assets retains independent control in a manner that is secured by that interface.[18]

1b. The Role of the SEC

Although the RFIA establishes the CFTC as the primary federal regulator of most crypto assets, the SEC would have jurisdiction over digital assets that are securities. To the extent that the digital asset in question provides the holder of the asset with a debt or equity interest, liquidation rights, a right to a dividend payment, or other financial interest in a business entity, the asset would not be treated as a “crypto asset” or an “ancillary asset” subject to the CFTC’s jurisdiction and, instead, would be subject to the SEC’s jurisdiction.[19]

Notably, should conflict arise as to whether a digital asset should be treated as a crypto asset, the RFIA grants the U.S. Court of Appeals for the D.C. Circuit authority to resolve the conflict by determining whether the asset represents a financial interest in a business entity and thus is a security.[20] The RFIA is silent on which party must bring the conflict to the U.S. Court of Appeals for the D.C. Circuit.

These provisions represent a major change from the status quo and are an attempt to provide a clearer regulatory regime than the previous version of the RFIA. As currently drafted, the SEC would not have the role of the primary digital asset regulator, but would still have the authority to treat certain assets as securities and challenge the CFTC’s claimed jurisdiction over other assets. An aggressive SEC, such as the current one, could use that authority to maintain a prominent role in crypto regulation.

1c. Customer Protection and Market Integrity Authority

As currently drafted, the RFIA creates a Customer Protection and Market Integrity Authority (“Authority”), which is a self-regulatory organization (“SRO”) for crypto asset intermediaries that is jointly chartered by the SEC and the CFTC.[21] Membership in the Authority is limited to only crypto asset intermediaries. The Authority is tasked with regulating, supervising, and disciplining crypto asset intermediaries,[22] essentially serving as a Self-Regulatory Organization, though the RFIA does not define it as such.

Under the RFIA, the Authority must have the following allocation of a 13-member board of directors: three governmental directors (the Director of the Office of Financial Innovation of the CFTC, the Director of the Office of Financial Innovation of the SEC, and the Director of FinCEN), four independent directors appointed by the President, and six directors appointed by the members of the Authority.[23]

SROs are nothing new in the financial industry—the National Futures Association oversees aspects of the derivatives industry, and the Financial Industry Regulatory Authority (“FINRA”) oversees aspects of the securities industry. Indeed, an intermediary of a crypto commodity or a crypto security would already be required to join one of those SROs. The establishment of a special SRO for crypto not only imposes unique costs on crypto intermediaries, but also risks unnecessary overlap between the requirements of the new SRO and the old ones.

2. Substantive Regulation of Crypto Asset Intermediaries and Stablecoin Issuers

Beyond proposing a new federal statutory framework under which agencies would engage in rulemaking, the RFIA proposes concrete restrictions and obligations. In particular, these substantive requirements trend toward consumer protection ideals and particularly target Crypto Asset Intermediaries and Stablecoin Issuers.

2a. Consumer Protection

The new stated purpose of the RFIA is “to provide for consumer protection and responsible financial innovation to bring crypto assets within the regulatory perimeter.”[24] This new focus on consumer protection is found throughout provisions in the RFIA and is likely influenced by the aftermath of the 2022 cryptocurrency exchange bankruptcies.

Proof of Reserve Requirement

The RFIA provides that all crypto asset intermediaries must maintain a system to demonstrate cryptographically verifiable possession or control of all crypto assets under custody or otherwise provided for safekeeping by a customer to the intermediary.[25] The system must be protected against disclosure of customer data, proprietary information, and other data that may lead to operational or cybersecurity risk.[26] The crypto asset intermediary must retain an independent public accountant to verify possession or control of all crypto assets under custody.[27] This verification must include an examination of the system and shall take place at a time chosen by the independent public accountant without prior notice.[28] Should the accountant identify any material discrepancies, they must inform the appropriate regulator and the Authority within one day.[29]

Permissible Transactions

The RFIA provides that each crypto asset intermediary must ensure that it clearly discloses the scope of permissible transactions that the intermediary may undertake involving crypto assets belonging to a customer in a customer agreement.[30] Further, each crypto asset intermediary must provide clear notice to each customer and require acknowledgement of the following: (i) whether customer crypto assets are segregated from other customer assets and the manner of the segregation; (ii) how the crypto assets of the customer would be treated in a bankruptcy or insolvency scenario and the risk of loss; (iii) the time period and manner in which the intermediary is obligated to return the crypto asset of the customer upon request; (iv) applicable fees imposed on a customer; and (v) the dispute resolution process of the intermediary.[31]

Lending

The RFIA provides that a crypto asset intermediary must disclose any lending arrangement to customers before any lending services take place, including the potential bankruptcy treatment of customer assets in the case of insolvency.[32] In any lending arrangement, the crypto asset intermediary must also disclose whether the intermediary permits failures to deliver customer crypto assets or other collateral, and in the event of a failure to deliver, the period of time in which the failure must be cured.[33] Notably, the RFIA expressly prohibits the rehypothecation of crypto assets by a crypto asset intermediary.[34] This last provision originates from the collapse of FTX, which rehypothecated customers’ crypto assets without informing those customers.[35] Such a ban would disadvantage crypto intermediaries vis-à-vis traditional lenders. In traditional finance, lenders use rehypothecation to access credit for their own use, thereby pursuing their own goals. A ban for crypto intermediaries will limit their ability to take similar risks for their own purposes.

2b. Stablecoins

Under the RFIA as currently drafted, no entity other than a depository institution[36], or a subsidiary thereof, may issue a payment stablecoin.[37] This has the potential to affect current stablecoin issuers, many of which are not depository institutions. The term “payment stablecoin” means a claim represented on a distributed ledger that is: redeemable, on demand, on a one-to-one basis for instruments denominated in United States dollars; issued by a business entity; accompanied by a statement from the issuer that the asset is redeemable from the issuer or another person; backed by one or more financial assets, excluding other crypto assets; and intended to be used as a medium of exchange.[38]

Depository institutions need to apply to issue stablecoins by filing an application to the appropriate Federal banking agency or State bank supervisor. The Federal banking agency or State bank supervisor must approve the application unless the payment stablecoins are not likely to be conducted in a safe and sound manner; the depository institution lacks resources and expertise to manage the stablecoin; or the depository institution does not have required policies and procedures related to the stablecoin.[39]

Should a current stablecoin issuer hold a non-depository trust company charter or a State license that only persons engaged in crypto activities may obtain, the stablecoin issuer may in effect “skip the line” upon application to receive a charter as a depository institution and issue payment stablecoins.[40] These applications, while still reviewed, will be reviewed before applications from other entities.

Once approved, the issuing depository institution must clearly disclose to customers that a payment stablecoin is neither guaranteed by the U.S. government nor subject to deposit insurance by the Federal Deposit Insurance Corporation.[41] Though payment stablecoins are not guaranteed or insured, in the event of the receivership of the issuing depository institution, a person who has a valid claim on a payment stablecoin is entitled to priority over all other claims on the institution with respect to any required payment stablecoin assets, including claims with respect to incurred deposits.[42]

Restrictions

The RFIA provides that stablecoins may only be used in permissible transactions. They may not be pledged, rehypothecated, or reused, except for the purpose of creating liquidity to meet reasonable expectations of requests to redeem payment stablecoins.[43]

Further, the RFIA restricts which assets may properly use the term “payment stablecoin” or “stablecoin.” Endogenously referenced crypto assets cannot use the terms payment stablecoin or stablecoin in advertising marketing materials.[44] Endogenously referenced crypto assets are assets that will be converted, redeemed, or repurchased for a fixed amount of monetary value, or assets for which a mechanism exists to achieve such conversion, redemption, or repurchase, and assets that either rely solely on another crypto asset to maintain the fixed amount of monetary value or rely on algorithmic means to maintain the fixed amount of monetary value.[45]

3. Combatting Illicit Finance

As currently drafted, the RFIA includes new provisions to combat illicit finance risks, ranging from enhanced oversight of cryptocurrency ATMs to increasing efforts to combat illicit finance across government agencies.

Cryptocurrency ATMs

The RFIA provides a refreshed regime for combatting illicit finance. Notably, the RFIA directs the Financial Crimes Enforcement Network (“FinCEN”) to require crypto asset kiosk owners to submit and update the physical addresses of the kiosks owned or operated.[46] Further, FinCEN must require crypto asset kiosk owners and administrators to verify the identity of each kiosk customer by using government issued identification.[47] These provisions are similar to those in another bill sponsored by Senator Elizabeth Warren (D-MA), which has been heavily criticized by the crypto industry.[48]

Financial Technology Working Group

Additionally, the RFIA establishes the Independent Financial Technology Working Group to Combat Terrorism and Illicit Financing, consisting of the Secretary of the Treasury, senior-level representatives from FinCEN, the Internal Revenue Service, the Office of Foreign Assets Control, the Federal Bureau of Investigation, the Drug Enforcement Administration, the Department of Homeland Security and the United States Secret Service, the Department of State, and five individuals to represent financial technology companies, distributed ledger intelligence companies, financial institutions, and institutions engaged in research.[49]

The Independent Financial Technology Working Group has a broad mandate and is tasked with conducting independent research on terrorists and illicit use of new financial technologies; analyzing how crypto assets and emerging technologies may bolster the national security and economic competitiveness of the United States in financial innovation; and developing legislative and regulatory proposals to improve anti-money laundering, counter-terrorist, and other illicit financing efforts in the United States.[50]

4. Tax Implications

As currently drafted, the RFIA proposes an alternate tax treatment of crypto assets. Gross income does not include gain from the sale or exchange of any crypto asset, unless the sale or exchange is for cash or cash equivalent; property used by the taxpayer in the active conduct of a trade or business; or any property held by the taxpayer for the production of income.[51] Notably, this exclusion does not apply if the value of such sale or exchange exceeds $200 or if the total gain exceeds $300.[52] At bottom, this exclusion will ensure that consumers who transact in small amounts of crypto do not face the same type of tax liability as those who transact in large sums.

The RFIA also disallows loss deductions from wash sales. No deduction is allowed with respect to any loss claimed to have been sustained from any sale or other disposition of specified assets where it appears that, within a period beginning 30 days before the date of such sale or other disposition and ending 30 days after such date, the taxpayer has acquired substantially identical specified assets, or entered into a contract or option to acquire, or long notional principal contract in respect of, substantially identical specified assets.[53] Under current law, these restrictions apply to securities transactions. Thus, even if a crypto asset is a commodity under the rest of the RFIA’s provisions, it would still be treated like a security in this instance.

Concluding Thoughts

As discussed at the onset of this alert, the RFIA aims to solve for certain industry pain points surrounding the regulations, restrictions, and protections applicable to the cryptocurrency industry. However, the effectiveness of the updated provisions within the RFIA remain to be tested and could present some glaring issues for the industry to address. In particular, we note a few provisions:

The obligation to become a depository institution in order to issue a payment stablecoin would represent a significant—and perhaps insurmountable—burden for many Fintech industry participants. There is not presently a single stablecoin issuer in the United States that is a depository institution. The provisions in the RFIA could render existing stablecoins impermissible overnight and subject all issuers to the regulation, supervision, and enforcement authority of federal and state banking regulators. Further, fiat-backed stablecoins inherently require 100% reserves, while banks operate on a business model that is predicated on fractional reserves. These distinctly different business models and use cases raise questions surrounding whether stablecoins will even be palatable to banks. These points certainly merit further discussion among all industry stakeholders and policymakers through the legislative process.
The RFIA, in effect, deems the CFTC the primary federal regulator of nearly all crypto assets, crypto asset exchanges, and affiliates. While the industry may welcome this provision as the preferred regulatory regime, we do not anticipate a seamless transition of regulatory authority from an aggressive SEC, which still retains jurisdiction, albeit more limited jurisdiction, over digital assets that are securities. The competing agencies may create friction in the industry, as entities work towards figuring out their proper classification under the RFIA and adjust to a potentially new regulator.

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[1] Lummis-Gillibrand Responsible Financial Innovation Act, S. _, 118th Cong. (2023).

[2] S. Amdt. 1000, 118th Cong. (2023).

[3] Lummis-Gillibrand Responsible Financial Innovation Act, S. 4356, 117th Cong. (2022).

[4] This client alert focuses on provisions of the RFIA that are completely new, or represent major changes from the 2022 version of the bill. For a section by section summary of the RFIA, including new and legacy provisions alike, see Cynthia Lummis & Kirsten Gillibrand, Lummis-Gillibrand Responsible Financial Innovation Act of 2023: Section-by-Section Overview, https://www.lummis.senate.gov/wp-content/uploads/Lummis-Gillibrand-2023-Section-by-Section-Final.pdf

[5] The term “crypto asset” means a natively electronic asset that (1) confers economic, proprietary, or access rights or powers; (2) is recorded using cryptographically secured distributed ledger technology or any similar analogue and (3) does not represent, derive value from, or maintain backing by, a financial asset (except other crypto asset). Crypto assets do not include payment stablecoins or other interests in financial assets represented on a distributed ledger or any similar analogue. RFIA, § 101(a). “Crypto asset” also excludes an asset that provides the holder of the asset with any of the following rights in a business entity: (1) a debt or equity interest in that entity; (2) liquidation rights with respect to that entity; (3) an entitlement to an interest or dividend payment from that entity; and (4) any other financial interest in that entity. RFIA, § 401.

[6] Crypto asset intermediary is defined by the Bill as a person who holds or is required to hold a license, registration, or any other similar authorization that conducts market activities relating to crypto assets and is not a depository institution. RFIA, § 101(a).

[7] RFIA, § 403(a).

[8] Id. The term “ancillary asset” means an intangible, fungible asset that is offered, sold, or otherwise provided to a person in connection with the purchase and sale of a security. Ancillary assets benefit from entrepreneurial and managerial efforts that determine the value of the assets, but do not represent securities because they are not debt or equity or do not create rights to profits, liquidation preferences, or other financial interests in a business entity. RFIA, § 301(a)(1).

[9] RFIA § 403(a).

[10] RFIA, § 401(a). We note a potential inconsistency: the RFIA limits the definition of crypto asset exchanges to those exchanges which trade crypto assets. Payment stablecoins are expressly exempt from the definition of crypto assets. However, the RFIA requires those offering a market in payment stablecoins to register as a crypto asset exchange.

[11] Id. The RFIA creates a definition of “decentralized crypto asset exchange”: (i) software that comprises predetermined and publicly disclosed code deployed to a public distributed ledger; (ii) permits a user or group of users to create a pool or group of pools for crypto assets; (iii) enables a user or group of users to conduct crypto asset transactions from a pool or group of pools, with such transactions occurring pursuant to the code described in clause (i), and; (iv) no person, or group of persons, known to one another who have entered into an agreement (implied or otherwise) to act in concert, can unilaterally control or cause to control the software protocol through altering transactions, functions, or actions on the protocol, or blocking or approving transactions on the protocol.

[12] RFIA, § 404(a).

[13] RFIA, § 705(c).

[14] RFIA, § 404(a).

[15] Id.

[16] RFIA, § 405(a).

[17] Id.

[18] RFIA, § 403(a).

[19] RFIA, § 501.

[20] Id.

[21] RFIA, § 601(a).

[22] Id.

[23] Id.

[24] RFIA, § 101.

[25] RFIA, § 203(a).

[26] Id.

[27] Id.

[28] Id.

[29] Id.

[30]RFIA, § 205. The Bill also advises the Consumer Financial Protection Bureau to issue guidance setting forth best practices for standard crypto asset intermediary customer agreements, in consultation with the SEC and CFTC.

[31] Id.

[32] RFIA, § 205.

[33] RFIA, § 206(a).

[34] Id.

[35] See Jonathan Chiu & Russell Wong, What is a Crypto Conglomerate Like FTX? Economics and Regulations, No. 23-09 (March 2023). https://www.richmondfed.org/publications/research/economic_brief/2023/eb_23-09.

[36] The term depository institution includes: an insured bank or any bank which is eligible to make application to become an insured bank, any mutual savings bank, any savings bank, any insured credit union or any credit union which is eligible to make application to become an insured credit union, or any savings association which is an insured depository institution.

[37] RFIA, § 701. Note that the Bill neither defines “stablecoin issuer” nor considers what activities are considered issuance.

[38] RFIA, § 101(a).

[39] RFIA, § 701.

[40] RFIA, § 706(a).

[41] RFIA, § 701.

[42] Id.

[43] Id.

[44] RFIA, § 702(c).

[45] RFIA, § 702(a).

[46] RFIA, § 303(b).

[47] RFIA, § 303(c).

[48] Digital Asset Anti-Money Laundering Act of 2023, S. _, 118th Cong. (2023).

[49] RFIA, § 304(b)(1)-(3).

[50] RFIA, § 304(c)(1)-(3).

[51] RFIA, § 801(a).

[52] Id.

[53] RFIA, § 805(a).

The following Gibson Dunn lawyers prepared this client alert: Sara Weed, Jason Cabral, Jeffrey Steiner, Karin Thrasher, Alexis Levine, Roscoe Jones Jr., Amanda Neely, and Christian Dibblee.

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 Gibson Dunn’s FinTech and Digital Assets, Financial Institutions, or Public Policy practice groups, or the following authors:

Financial Institutions Group:
Jason J. Cabral – New York (+1 212-351-6267, jcabral@gibsondunn.com)

FinTech and Digital Assets Group:
Jeffrey L. Steiner – Co-Chair, Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com)
Sara K. Weed – Washington, D.C. (+1 202-955-8507, sweed@gibsondunn.com)

Public Policy Group:
Roscoe Jones, Jr. – Co-Chair, Washington, D.C. (+1 202-887-3530, rjones@gibsondunn.com)
Amanda H. Neely – Washington, D.C. (+1 202-777-9566, aneely@gibsondunn.com)

In the recent decision of Re Shandong Chenming Paper Holdings Ltd [2023] HKCFI 2065[1] (“Re Shandong”), the Court of First Instance (the “CFI”) held that the principle in Guy Kwok-Hung Lam v Tor Asia Credit Master Fund LP [2023] HKCFA 9[2] (“Guy Lam”) (namely, that the Court will generally dismiss a bankruptcy petition where the debt under dispute was subject to an exclusive jurisdiction clause (“EJC”)) was equally applicable where the debtor had raised a cross-claim, in an amount exceeding the petitioning debt, which was subject to an arbitration agreement.

1. Background

On 15 June 2017, Arjowiggins HKK 2 Limited (the “Petitioner”) issued a petition (the “Petition”) seeking the winding up of Shandong Chenming Paper Holdings Limited (the “Company”) on the grounds of insolvency arising from non-payment of an arbitration award (the “Award”).

On 20 June 2022, the Company commenced an arbitration against the Petitioner (the “2nd Arbitration”) advancing claims under the same agreement which had given rise to the arbitration that resulted in the Award (the “Cross-Claim”). The amount of the Cross-Claim exceeds the debt established by the Award. The substantive hearing of the 2nd Arbitration is due to take place in May 2024.

On 25 October 2022, the Company issued an application seeking the dismissal or adjournment of the Petition. The Company argued that, as the amount of the Cross-Claim exceeds the debt established by the Award and such Cross-Claim will be determined in an arbitration, the Petition should be dismissed or stayed.

2. The CFI’s Decision

As noted in our previous article, the Court of Final Appeal (the “CFA”) in Guy Lam held that where the underlying dispute of the petition debt was subject to an EJC, the court should generally dismiss the petition absent countervailing factors and 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; in such circumstances, the debtor is not required to demonstrate a bona fide defence on substantial grounds in order to defeat the petition.

The issue in Re Shandong was whether the same principle applies in the context of an arbitrable cross-claim raised by the debtor against the petitioner.

The CFI held that the same principle applies in these circumstances – the Court should therefore dismiss or stay a petition where the debtor has raised a cross-claim that is subject to an arbitration clause which exceeds the amount of the petition debt. The CFI examined the relevant authorities and observed that:

As a general principle of insolvency law, in examining whether the debtor can establish a defence to a winding-up petition, no distinction is drawn between a claim and a cross-claim.
The Singapore Court of Appeal in AnAn Group (Singapore) Pte Ltd v VTB Bank (Public Joint Stock Co) [2020] SGCA 33 had examined this issue and held that “when a court is faced with either a disputed debt or a cross-claim that is subject to an arbitration agreement, the prima facie standard should apply, such that the winding-up proceedings will be stayed or dismissed as long as (a) there is a valid arbitration agreement between the parties; and (b) the dispute falls within the scope of the arbitration agreement, provided that the dispute is not being raised by the debtor in abuse of the court’s process”. Such a decision is consistent with the established principles.
Even though the Petitioner argued that there is no merit in the Cross-Claim, it did not go so far as to suggest that the Cross-Claim obviously constituted an abuse of process such that the Court should disregard the Company’s objection. Merits of and delay in bringing the Cross-Claim are not of themselves capable of bringing a case within that category.
Nothing in the CFA’s judgment in Guy Lam suggested that a defence and a cross-claim should be treated differently or should engage different principles. The CFI should not be invited to strain to find ambiguities in appellate judgments.

Whilst the Court would normally dismiss the Petition in these circumstances, given the lengthy and torrid history of this particular case, the CFI considered it appropriate to stay the Petition so as to preserve the current date of presentation of the Petition in case it becomes relevant in the future.

3. Comments

The CFI’s decision in Re Shandong provides welcomed clarity to the application of the approach in Guy Lam. In addition to clarifying that the Guy Lam approach extends to cross-claims raised by a debtor, the CFI helpfully confirmed that such approach applies to arbitration clauses (and not just EJCs).

As such, when entering into commercial agreements, parties should bear in mind that the existence of EJCs or arbitration clauses may have a material bearing on the conduct of winding-up or bankruptcy proceedings in Hong Kong.

__________________________

[1] Available here.

[2] See our article on this judgment at: https://www.gibsondunn.com/hong-kong-court-of-final-appeal-upholds-dismissal-of-bankruptcy-petition-debt-under-dispute-was-subject-to-exclusive-jurisdiction-clause/.

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, bgilchrist@gibsondunn.com)
Elaine Chen (+852 2214 3821, echen@gibsondunn.com)
Alex Wong (+852 2214 3822, awong@gibsondunn.com)
Andrew Cheng (+852 2214 3826, aocheng@gibsondunn.com)

Carmelo [not his real name] fled his home country to escape persecution from local authorities and gang members. Since coming to the U.S., he has persevered through years of immigration detention—including prolonged isolation and even deportation in the midst of his appeal. But Carmelo and his Gibson Dunn pro bono legal team have been leaders in seeking justice not only in his case but for others like him who face persecution and torture abroad and are subject to lengthy detention during their search for protection in the U.S.

Now their work has led to an important precedent from a federal appeals court that will apply in all immigration cases within its jurisdiction. The Fourth Circuit’s opinion reaffirmed that people who fear returning to their countries of origin because they will be persecuted due to their family ties are eligible for asylum and other protections. It also acknowledged that immigration judges must meaningfully review all the evidence of the risk of torture before them, including people’s past experiences of torture by police and “country conditions evidence” that shows the likelihood of gang and government-sponsored violence in other countries.

In addition to the federal court appeal, our pro bono team worked alongside Carmelo through a trial, three agency appeals, and other proceedings seeking mandamus, habeas, and bond. The Fourth Circuit praised the team’s dedication and determination in its opinion: “In his administrative proceedings and on appeal, [the asylum seeker] has been ably represented pro bono by lawyers with the firm of Gibson, Dunn & Crutcher. [C]ounsel have performed admirably, and we are appreciative of their fine service.”

Our Washington, D.C. pro bono team included partners David Debold and Naima Farrell and associates Jessica Wagner, Tommy McCormac, Cate McCaffrey, Sam Whipple, and Austin Donohue.

This narrative courtesy of the Capital Area Immigrants’ Rights (CAIR) Coalition, which asked Gibson Dunn to take on Carmelo’s case.