Richard Manfredi, Author at Gibson Dunn

Loper Bright Enterprises v. Raimondo, No. 22-451
Relentless, Inc. v. Department of Commerce, No. 22-1219 – Decided June 28, 2024

Today, the Supreme Court overruled Chevron v. Natural Resources Defense Council, a landmark decision that had required courts to defer to agencies’ reasonable interpretations of ambiguous statutory terms.

“Chevron is overruled. Courts must exercise their independent judgment in deciding whether an agency has acted within its statutory authority, as the APA requires.”

Chief Justice Roberts, writing for the Court

Background:

The Supreme Court’s decision in Chevron v. Natural Resources Defense Council, 467 U.S. 837 (1984), instructed courts to apply a two-step framework when reviewing administrative agencies’ interpretations of statutes that they administer. At step one, courts determined whether the statute had an unambiguous meaning using the traditional tools of statutory construction. If not, then courts proceeded to step two, at which they deferred to the agency’s interpretation as long as it was reasonable. This meant that an agency’s reading of the law could control even if it was not the view that a court would otherwise adopt using its independent judgment (and even if the agency’s view had changed over time).

Loper Bright Enterprises and Relentless, Inc. are small businesses engaged in herring fishing off the Atlantic coast. They brought two lawsuits challenging a rule promulgated by the Department of Commerce that required them to pay for government-approved fishing monitors, which can reduce fishers’ returns by up to 20%. The challengers argued that this rule was unauthorized by the governing statute, which did not expressly say who should pay for these monitors. The district courts in both cases granted summary judgment to the Department, and the D.C. Circuit and First Circuit affirmed. Applying Chevron, these courts both held that the agency had reasonably interpreted the statute.

Issue:

Whether the Court should overrule or clarify the Chevron doctrine.

Court’s Holding:

Chevron is overruled. Judicial deference to administrative agencies’ statutory interpretation is contrary to the Administrative Procedure Act (“APA”) and traditional principles of judicial review. Judges must independently interpret statutes without deference to an agency’s reading of the law.

What It Means:

Overruling Chevron will make it more difficult for government agencies to win cases turning on statutory-interpretation questions. Today’s decision continues a trend of Supreme Court decisions reining in administrative agency action, including recent cases curbing the Securities and Exchange Commission’s power to bring enforcement actions in administrative tribunals rather than federal courts (SEC v. Jarkesy) and granting a stay of the Environmental Protection Agency’s “Good Neighbor” emissions-regulation plan for failing to comply with the APA’s requirement of reasoned decisionmaking (Ohio v. EPA). Altogether, this case law signals the Justices’ skepticism of expansive claims of regulatory power by federal agencies, and today’s action is a major resetting of the balance of power between courts and agencies, as well as between agencies and challengers of agency action.
Notably, the Court rested its decision on the plain language of the APA, which provides that a court reviewing agency action “shall decide all relevant questions of law” and “interpret constitutional and statutory provisions.” 5 U.S.C. § 706. Justice Thomas wrote a separate concurrence to explain his view that Chevron also violates the Constitution’s separation of powers by abdicating judges’ duty to exercise independent judgment and impermissibly conferring that judicial power on the Executive Branch.
The effects of Chevron’s demise will likely be most dramatic in the lower federal courts, some of which have continued to apply Chevron in recent years even as the Supreme Court has rarely invoked the doctrine over the past decade. Today’s decision instructs these circuit and district judges to change their practices and abandon deference. Instead, they “must exercise their independent judgment in deciding whether an agency has acted within its statutory authority.”
Going forward, agencies’ interpretation of statutes will still be entitled to a lesser degree of “respect” under Skidmore v. Swift & Co., insofar as the agencies’ views are persuasive. This may depend on factors such as whether the agency adopted the interpretation close in time to the statute’s enactment and how consistently the agency has adhered to that interpretation since.
Today’s decision does not necessarily unsettle prior cases relying on Chevron to interpret statutes. The Court stated that a prior case’s reliance on Chevron to conclude that an agency’s action was lawful is not, standing alone, justification to overrule it.
Even after today’s decision, agencies will likely continue to issue regulations largely as before the overruling of Chevron, particularly in certain areas, though the scope of such regulations may change. For example, taxpayers will continue to seek rules regarding how to report routine business transactions and will want to participate in the rulemaking process through the notice and comment procedure. While today’s decision will have a significant impact on the litigation landscape regarding such tax and other regulations, many of those regulations faced strong judicial headwinds when challenged even under Chevron.

Gibson Dunn represented the Chamber of Commerce of the United States of America as Amicus Supporting Petitioners in Loper Bright.

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 U.S. Supreme Court. Please feel free to contact the following practice group leaders:

Appellate and Constitutional Law Practice

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

Related Practice: Administrative Law and Regulatory Practice

Eugene Scalia +1 202.955.8210 [email protected]	Helgi C. Walker +1 202.887.3599 [email protected]	Stuart F. Delery +1 202.955.8515 [email protected]
Russell Balikian +1 202.955.8535 [email protected]

This alert was prepared by associates Max E. Schulman and Nicholas B. Venable.

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.

From the Derivatives Practice Group: The CFTC had an active week with various approvals and no-action relief.

New Developments

CFTC Staff Issues a No-Action Letter Regarding Certain Reporting Requirements for Swaps Transitioning from CDOR to CORRA. On June 27, the CFTC Division of Market Oversight (“DMO”) and Division of Data (“DOD”) issued a staff no-action letter regarding certain Part 43 and Part 45 swap reporting obligations for swaps transitioning under the ISDA LIBOR fallback provisions from referencing the Canadian Dollar Offered Rate (“CDOR”), to referencing the risk-free Canadian Overnight Repo Rate Average (“CORRA”) following the cessation of CDOR after June 28, 2024. The letter states DMO and DOD will not recommend the CFTC take enforcement action against an entity for failure to timely report under Part 45 the change in a swap’s floating rate. This letter covers those floating rate changes that are made under the ISDA LIBOR fallback provisions from CDOR to CORRA, but only in the event the entity uses its best efforts to report the change by the applicable deadline in Part 45 and in no case reports the required information later than five business days from, but excluding, July 2, 2024. The letter also states DMO and DOD will not recommend the CFTC take enforcement action against an entity for failure to report under Part 43 the change in the floating rate for a swap modified after execution to incorporate the ISDA LIBOR fallback provisions to transition from referencing CDOR to referencing CORRA. [NEW]
CFTC Extends Public Comment Period for Proposed Amendments to Event Contracts Rules. On June 27, the CFTC announced it is extending the deadline for public comment on a proposal to amend its event contract rules. The extended comment period will close on August 8, 2024. The CFTC is providing an extension to allow interested persons additional time to analyze the proposal and prepare their comments. The proposal would amend CFTC Regulation 40.11 to further specify types of event contracts that fall within the scope of Commodity Exchange Act (“CEA”) Section 5c(c)(5)(C) and are contrary to the public interest, such that they may not be listed for trading or accepted for clearing on or through a CFTC-registered entity. [NEW]
CFTC Grants ForecastEx, LLC DCO Registration and DCM Designation. On June 25, the CFTC announced that it has issued ForecastEx, LLC an Order of Registration as a derivatives clearing organization (“DCO”) and an Order of Designation as a designated contract market (“DCM”) under the CEA. DCO registration was granted under Section 5b of the CEA. DCM designation was granted under Section 5a of the CEA. ForecastEx is a limited liability company registered in Delaware and headquartered in Chicago, Illinois. [NEW]
CFTC Approves Final Capital Comparability Determinations for Certain Non-U.S. Nonbank Swap Dealers. On June 25, the CFTC announced it has approved four comparability determinations and related comparability orders granting conditional substituted compliance in connection with the CFTC’s capital and financial reporting requirements to certain CFTC-registered nonbank swap dealers organized and domiciled in Japan, Mexico, the European Union (France and Germany), or the United Kingdom. Pursuant to the orders, non-U.S. nonbank swap dealers subject to prudential regulation by the Financial Services Agency of Japan, the National Banking and Securities Commission of Mexico and the Mexican Central Bank, the European Central Bank, or the United Kingdom Prudential Regulation Authority may satisfy certain CEA capital and financial reporting requirements by being subject to, and complying with, comparable capital and financial reporting requirements under the respective foreign jurisdiction’s laws and regulations, subject to specified conditions. [NEW]
U.S. Department of Treasury Releases Joint Policy Statement and Principles on Voluntary Carbon Markets. On May 28, the Biden-Harris Administration released a Joint Statement of Policy and new Principles for Responsible Participation in Voluntary Carbon Markets (the “Joint Statement”) announcing the U.S. government’s approach to further developing high-integrity voluntary carbon markets (“VCMs”). The Joint Statement announces seven principles, which are not exhaustive, that seek to codify and strengthen concepts and practices already developed market participants, governments and international bodies. The primary aim of these principles is to inform and support the continuing development of VCMs. On June 17, Gibson Dunn published an alert discussing the principles and key takeaways.

New Developments Outside the U.S.

EBA and ESMA Publish Guidelines on Suitability of Management Body Members and Shareholders for Entities Under MiCA. On June 27, EBA and ESMA published joint guidelines on the suitability of members of the management body, and on the assessment of shareholders and members with qualifying holdings for issuers of asset reference tokens (“ARTs”) and crypto-asset service providers (“CASPs”), under the Markets in Crypto Assets regulation (“MiCA”). The first set of guidelines covers the presence of suitable management bodies within issuers of ARTs and CASPs. The second set of guidelines concerns the assessment of the suitability of shareholders or members with direct or indirect qualifying holdings in a supervised entity. [NEW]
ESAs Propose Improvements to the Sustainable Finance Disclosure Regulation. On June 18, the EBA, the European Insurance and Occupational Pensions Authority (“EIOPA”), and ESMA (the three European Supervisory Authorities , i.e., “ESAs”) published a Joint Opinion on the assessment of the Sustainable Finance Disclosure Regulation (“SFDR”). In the joint opinion, the ESAs call for a coherent sustainable finance framework that caters for both the green transition and enhanced consumer protection, considering the lessons learned from the functioning of the SFDR.
ESMA Publishes 2023 Annual Report. On June 14, ESMA announced that it has published its Annual Report for 2023. ESMA stated that the report sets out the key achievements in the first year of implementing ESMA’s new 5-year strategy, delivering on the mission of enhancing investor protection and promoting stable and orderly financial markets in the European Union (EU). According to the report, ESMA’s key accomplishments during 2023 include enhancing supervisory convergence through peer reviews on the supervision of central counterparties (CCPs) and central securities depositories (CSDs), identifying areas for improvement and issuing recommendations to ensure consistent supervision across the EU, and monitoring retail investment markets and reporting on the costs and performance of retail investment products, highlighting cost reductions and variations across products and member states, and recommending that investors carefully evaluate costs and diversify investments. [NEW]

New Industry-Led Developments

ISDA Publishes Framework to Prepare for Close Out of Derivatives Contracts. On June 27, ISDA published the ISDA Close-out Framework that market participants can use to help prepare for potential terminations of collateralized derivatives contracts. ISDA stated that the Llaunch of the ISDA Close-out Framework is in response to the March 2023 failure of Signature Bank and SVB in the US, which, according to ISDA, highlighted the complexities of potentially terminating over-the-counter derivatives trading relationships following various post-crisis regulatory reforms. Specifically, the reforms require that in-scope entities are now required to post margin for non-cleared derivatives transactions, while various jurisdictions have introduced mandatory stays on termination rights and remedies as part of bank resolution regimes. ISDA stated that Tthe ISDA Close-out Framework is intended to be used as a preparatory resource to help firms coordinate internal business functions and stakeholders and internal and external legal, operational, risk management, infrastructure and other relevant service providers to ensure they are adequately prepared for any potential future stress events. [NEW]
ISDA Responds to CCIL on Proposal for USD/INR FX Options. On June 21, ISDA submitted a response to a consultation paper from the Clearing Corporation of India Limited (“CCIL”) on a proposal to introduce an electronic trading platform and clearing and settlement services for USD/INR FX options of up to one year maturity initially. The response sets out the features of the trading platform, the risk management framework and a questionnaire on the parameters of the product. ISDA’s response focuses mainly on the risk management framework aspect, including the margin models and default management framework. It asks for more clarity and transparency on the choice of margin models and encourages the implementation of scheduled variation margin calls and stress-based anti-procyclicality measures. [NEW]
ISDA Responds to FSB Consultation on Liquidity Preparedness for Margin and Collateral Calls. On June 18, ISDA submitted a response to the Financial Stability Board’s (FSB) consultation on liquidity preparedness for margin and collateral calls. The response notes that the recommendations are generally sensible and seek to incorporate a proportionate and risk-based approach. It also highlights a number of considerations relevant to the non-bank financial intermediation (NBFI) sector’s liquidity preparedness for margin and collateral calls.
ISDA Responds to FCA Consultation on Sustainability Disclosure Requirements. On June 14, ISDA responded to the UK Financial Conduct Authority’s (FCA) consultation on sustainability disclosure requirements for portfolio management. ISDA stated that it supports the FCA taking a proportionate approach to the use of derivatives in sustainable investing. ISDA believes that it is important that recommendations on the treatment of derivatives, expected to be proposed by the European Union’s Platform on Sustainable Finance (PSF) by the end of 2024, are implemented consistently by the relevant authorities, including those in the UK. In the response, ISDA highlights several issues related to derivatives and makes recommendations.
ISDA Responds to FCA and BoE on UK EMIR Refit. On June 12, ISDA submitted a response to the joint Bank of England and UK Financial Conduct Authority (FCA) consultation on part two of the UK European Market Infrastructure Regulation (UK EMIR) Refit reporting Q&A and proposed updates to validation rules. In the response, ISDA highlights several topics, including the reporting of equity resets, commodity basis swaps and excess collateral under UK EMIR.
VERMEG Integrates Common Domain Model into COLLINE Collateral Management System. On June 10, ISDA announced that VERMEG, a technology provider for the banking and insurance sector, has integrated the Common Domain Model (CDM) into its COLLINE collateral management system to support the consumption of digitized regulatory initial margin (IM) credit support annexes (CSAs). ISDA stated that VERMEG is the first entity to integrate the CDM to improve the efficiency of collateral processes, with several other firms currently in testing.

The following Gibson Dunn attorneys assisted in preparing this update: Jeffrey Steiner, Adam Lapidus, Marc Aaron Takagaki, Hayden McGovern, and Karin Thrasher.

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 Derivatives practice group, or the following practice leaders and authors:

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

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

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

Darius Mehraban, New York (212.351.2428, [email protected])

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

Adam Lapidus – New York (212.351.3869, [email protected] )

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

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

David P. Burns, Washington, D.C. (202.887.3786, [email protected])

Marc Aaron Takagaki , New York (212.351.4028, [email protected] )

Hayden K. McGovern, Dallas (214.698.3142, [email protected])

Karin Thrasher, Washington, D.C. (202.887.3712, [email protected])

Fischer v. United States, No. 23-5572 – Decided June 28, 2024

Today, the Supreme Court held 6-3 that Section 1512(c) of the Sarbanes-Oxley Act—which prohibits obstructing official proceedings—is limited to acts that impair the availability or integrity of evidence in an official proceeding.

“Although the Government’s all-encompassing interpretation may be literally permissible, it defies the most plausible understanding of why (c)(1) and (c)(2) are conjoined, and it renders an unnerving amount of statutory text mere surplusage.”

Chief Justice Roberts, writing for the Court

Background:

Section 1512(c) of the Sarbanes Oxley Act provides criminal penalties for anyone who corruptly:

(1) alters, destroys, mutilates, or conceals a record, document, or other object, or attempts to do so, with the intent to impair the object’s integrity or availability for use in an official proceeding; or

(2) otherwise obstructs, influences, or impedes any official proceeding, or attempts to do so.

On January 6, 2021, Joseph W. Fischer allegedly forced his way into the Capitol and assaulted members of the Capitol Police. Fischer was arrested and charged with violating Section 1512(c) by obstructing an official proceeding. Fischer moved to dismiss, arguing that the statute prohibits only acts that impair the integrity or availability of evidence in an official congressional proceeding. The district court agreed and dismissed the count. The D.C. Circuit reversed, holding that Section 1512(c)(2) is a catchall provision that reaches beyond the specific examples in subsection (c)(1). Judge Katsas dissented, construing Section 1512(c)(2) as limited to acts that affect the integrity or availability of evidence in an official proceeding.

Issue:

Is 18 U.S.C. § 1512(c)(2) limited to actions pertaining to evidence for official proceedings?

Court’s Holding:

Yes. Section 1512(c)(2) requires the Government to establish that a defendant impaired or attempted to impair the availability or integrity of evidence intended for use in an official proceeding.

What It Means:

The Court’s decision means that the Government cannot use Section 1512(c)(2) to prosecute obstructive conduct that is unrelated to evidence intended for use in an official proceeding. To reach this conclusion, the Court relied on canons of construction that limit generalized statutory terms and phrases—“otherwise” clauses in particular—by reference to more specific neighboring or preceding terms and phrases.
The Court emphasized that Section 1512(c)(2) still has teeth. For example, the Court noted that it is possible to violate Section 1512(c)(2) by creating false evidence, impairing witness testimony, or tampering with intangible information.
Justice Jackson voted with the majority and wrote a concurrence to emphasize that the Court’s holding “follows from” the statute’s “legislative purpose.” Justice Barrett, joined by Justice Sotomayor and Justice Kagan, dissented and would have adopted a broader construction of Section 1512(c)(2) that covered Fischer’s alleged conduct even though it was not related to evidence tampering.
Today’s decision is the latest example of the Court narrowly construing broad criminal law provisions to avoid sweeping in conduct addressed by other statutes. Earlier this week, in Snyder v. United States, the Court narrowly construed the federal bribery statute to exclude after-the-fact gratuities that may be regulated by state law. And in 2015, in Yates v. United States, the Supreme Court construed Sarbanes-Oxley’s criminal spoliation provision, 18 U.S.C. § 1519, to limit the broad phrase “a tangible object” to one used to record or preserve information.

The Court’s opinion is available here.

Appellate and Constitutional Law Practice

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

Related Practice: White Collar Defense and Investigations

Stephanie Brooker +1 202.887.3502 [email protected]	Winston Y. Chan +1 415.393.8362 [email protected]	Nicola T. Hanna +1 213.229.7269 [email protected]
F. Joseph Warin +1 202.887.3609 [email protected]

Related Practice: Public Policy

Michael D. Bopp
+1 202.955.8256
[email protected]

Mylan L. Denerstein
+1 212.351.3850
[email protected]

This alert was prepared by associates Tessa Gellerson and Salah Hawkins.

The groups are seeking a total reversal of the EPA’s decision to grant Louisiana primacy over Class VI wells.

On June 12, 2024, three environmental activist groups—the Deep South Center for Environmental Justice, Healthy Gulf, and the Alliance for Affordable Energy—challenged the United States Environmental Protection Agency’s (the “EPA”) final rule granting Louisiana primary enforcement authority (also known as “primacy”) over Class VI injection wells.[1] The groups filed a petition for review in the United States Court of Appeals for the Fifth Circuit, claiming that the EPA’s final primacy rule was improper and violated the Safe Drinking Water Act (the “SDWA”) and other federal statutes on a number of grounds. The groups are seeking a total reversal of the EPA’s decision to grant Louisiana primacy over Class VI wells, and if the challenge is successful, Louisiana may be forced to resubmit portions of its Class VI primacy application, potentially stranding pending Class VI well permit applications that were transferred to the Louisiana Department of Energy and Natural Resources (the “LDENR”) for review or shifting those applications back to the EPA to undergo its lengthy review process.

Louisiana’s Path to Class VI Primacy

On September 17, 2021, Louisiana submitted an application to the EPA to expand Louisiana’s primacy over underground injection wells to include Class VI injection wells under the state’s existing Underground Injection Control (the “UIC”) program under the SDWA.[2] To gain primacy for a Class VI injection well, a state must demonstrate that it (1) has jurisdiction over underground injection, (2) has implemented UIC laws and regulations that are at least as stringent as the applicable EPA requirements, and (3) has the necessary expertise and administrative, civil, and criminal enforcement mechanisms to enforce its UIC program.[3]

After a year-long review process that included the consideration of over 40,000 public comments, the EPA determined that Louisiana’s Class VI UIC program met all federal requirements, concluding that Louisiana had demonstrated that it has the requisite jurisdiction, stringent UIC provisions, enforcement procedures, and expertise in place to oversee a UIC program.[4] Consequently, on December 28, 2023, the EPA signed a final rule granting primacy over Class VI wells to Louisiana, which became effective on February 5, 2024.[5] We have previously covered Louisiana’s primacy application in greater detail here.

Activist Groups Argue the EPA Violated the Safe Drinking Water Act and the Administrative Procedures Act.

The three activist groups, aided by their counsel at Earthjustice, challenged the EPA’s decision to grant Louisiana primacy over Class VI wells by arguing that the EPA’s decision violated both the SDWA and the Administrative Procedure Act (the “APA”). Two of these claims are described below:

Louisiana’s Waiver of Liability after Site Closure

The activist groups’ primary challenge to Louisiana’s grant of primacy centers on a liability waiver provision in Louisiana’s Class VI regulations governing post-injection site care and closure requirements. These groups argue in their challenge that, even though Louisiana’s post-injection site care and closure regulations appear to meet or exceed the analogous regulations issued by the EPA, these regulations are effectively nullified by a liability release that is given to (1) Class VI storage site operators, (2) the emitters that generated the CO2 that was injected at the applicable site, (3) the owners of the CO2 stored at the applicable site, and (4) other parties.[6] Louisiana’s liability release states:

Upon the issuance of the certificate of completion of injection operations, the storage operator, all generators of any injected carbon dioxide, all owners of carbon dioxide stored in the storage facility, and all owners otherwise having any interest in the storage facility shall be released from any and all future duties or obligations under this Chapter and any and all liability associated with or related to that storage facility which arises after the issuance of the certificate of completion of injection operations.[7]

The activist groups argue that Louisiana’s release of site operators and others from “future duties or obligations” and all liabilities related to the Class VI injection site arising after the site closure certificate is issued by the LDENR means that site operators are released from the state’s post-injection site care and closure requirements and will have no liability if they do not meet such requirements. In addition, the groups point out that under Louisiana’s UIC regulations, upon the state’s issuance of a site closure certificate, the ownership of Class VI wells eventually automatically transfers to the state, but the related liabilities do not. This, they claim, may orphan the responsibility and liability associated with post-injection site care and closure requirements.[8] Consequently, the activist groups argue, “Louisiana’s liability waiver renders the state’s program less stringent [than the EPA’s program] on its face” because the EPA’s Class VI regulations do not include similar liability waiver provisions.[9] Thus, the groups claim in their challenge that Louisiana’s primacy application did not satisfy the necessary requirements and the EPA did not have the authority to grant primacy based on the application.

The EPA appears to have already addressed the arguments made by the activist groups. In its final rule granting Louisiana primacy, the EPA stated that “[t]he EPA disagrees that long term liability provisions are always incompatible with the SDWA and the EPA’s UIC regulatory requirements”.[10] The EPA also pointed out that in its Class VI Rule of 2010 “the EPA did not conclude that states that authorize liability transfer after site closure cannot receive UIC Class VI primacy” and a state may receive primacy if “such state liability transfer provisions [are] appropriately crafted so that the state’s Class VI program meets UIC regulatory requirements”, concluding that Louisiana’s provisions were appropriately crafted and met all federal requirements. [11]

North Dakota and Wyoming, the two other states to have been granted Class VI primacy from the EPA, provide for a possible liability transfer to the state after a Class VI well is closed, after 10 years and 20 years, respectively.[12] Additionally, several other states that are in the process of applying for Class VI primacy have adopted similar liability transfer provisions regarding Class VI wells. Of all these states’ liability transfer provisions, Louisiana’s are the strictest, with a 50-year minimum wait before liability transfer can occur.[13]

Alleged Lack of Expertise at the LDNER

The activist groups further claim that the EPA’s decision to grant Class VI primacy to Louisiana was “arbitrary and capricious” and thus in violation of the APA because, the groups allege, Louisiana failed to demonstrate that the LDENR has the proper staff and expertise necessary to implement its UIC Program.[14] The SWDA and the EPA’s guidelines for making primacy determinations require applicant states to provide a description of the state agency staff that will carry out the UIC program and to demonstrate the technical expertise required to evaluate Class VI projects.

The groups argue that Louisiana “conceded” that the LDENR does not have the requisite expertise because the LDENR plans to utilize third-party contractors to review Class VI well permit applications for factors like site characterization, modeling, risk, and environmental justice analysis.[15] They note that, while the “EPA allows use of contractor support” and states may demonstrate in their primacy applications that “they have in-house staff or access to contractor support” for all requisite areas of expertise,[16] Louisiana’s primacy application did not identify specific contractors or provide details regarding LDENR’s access to contractors. They further argue that access to contractors could prove to be difficult in the future due to either a limited number of contractors or to conflicts of interest.[17] As a result, the groups conclude that the EPA does not have support for the assertion that the LDENR has access to the required expertise, either through in-house staff or through third party contractors.

The activist groups further claim that Louisiana lacks the requisite expertise “in light of the state’s past failures regulating less complicated wells” [18], alleging that performance audits on the state’s oil and gas wells from 2014 through 2020 show a failure to monitor and enforce violations.[19] The groups also allege two instances in which a Class II and Class III well, respectively, caused water contamination in the state, even though Louisiana has primacy over Class II and III wells.[20] The groups claim that, given the state’s alleged lack of expertise and oversight, the EPA failed to reasonably explain why it granted Louisiana Class VI primacy, making the decision to do so arbitrary and capricious.[21]

In its published final rule, the EPA responded to public comments that had expressed similar concerns that Louisiana lacked the requisite staff and expertise to be granted Class VI primacy. The EPA concluded that the LDENR did have the requisite staff and technical expertise to oversee all aspects of its UIC program in accordance with federal standards.[22] The EPA also stated that the previous environmental incidents either were unrelated to UIC program implementation or they did not involve LDENR and thus could not have any bearing on LDENR’s expertise.[23]

Other Claims and Future Developments

The activist groups also challenged Louisiana’s primacy on other grounds, including that (1) the EPA’s adoption of Louisiana’s liability waiver violated federal law by releasing Class VI project participants from liability under the Clean Water Act, CERCLA, and RCRA,[24] and (2) the EPA violated the APA by failing to evaluate certain differences between the EPA’s regulations and Louisiana’s regulations to determine if Louisiana’s regulations are less stringent.[25]

It is not clear if the challenges raised by the activist groups will be successful. The EPA’s responses to public comments appear to show that it was aware of, and not concerned by, these challenges when it issued its final rule granting Louisiana primacy over Class VI wells. While these challenges might delay the development of the carbon capture industry in the United States if successful, the interest in carbon capture projects (and the tax credits that these projects generate) will likely lead to market solutions for any delays that result. Gibson Dunn will continue to monitor this case and other potential challenges to carbon capture projects throughout the United States.

[1] Class VI wells are used by the carbon capture and sequestration industry to permanently sequester captured carbon in underground geological formations.

[2] https://www.epa.gov/uic/primary-enforcement-authority-underground-injection-control-program-0.

[3] 89 Fed. Reg. 703, 704 (Jan. 5, 2024); 40 CFR parts 124, 144, 145, and 146.

[4] 89 Fed. Reg. at 706-10.

[5] 89 Fed. Reg. at 703.

[6] Petitioners’ Brief at 11.

[7] La. Rev. Stat. Section 30:1109(A)(3).

[8] Petitioners’ Brief at 12.

[9] Petitioners’ Brief at 17.

[10] 89 Fed. Reg. at 707.

[11] Id. At 706-07.

[12] N.D. Cent. Code Section 38-22-17; W.S. Section 35-11-319.

[13] La. Rev. Stat. Section 30:1109(A)(1).

[14] Petitioners’ Brief at 1; 49.

[15] Petitioners’ Brief at 46.

[16] Petitioners’ Brief at 46-47.

[17] Petitioners’ Brief at 47.

[18] Petitioners’ Brief at 1.

[19] Petitioners’ Brief at 47-48.

[20] Petitioners’ Brief at 48.

[21] Petitioners’ Brief at 49.

[22] 89 Fed. Reg. at 706-07.

[23] 89 Fed. Reg. at 708-09.

[24] Petitioners’ Brief at 13.

[25] Petitioners’ Brief at 16.

The following Gibson Dunn attorneys prepared this update: Michael P. Darden, Rahul D. Vashi, Zain Hassan, Mariana Lozano, and Graham Valenta.

Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have about these developments. To learn more, please contact the Gibson Dunn lawyer with whom you usually work, any leader or member of the firm’s Oil and Gas, Tax, or Environmental Litigation and Mass Tort practice groups, or the authors:

Oil and Gas:
Michael P. Darden – Houston (+1 346.718.6789, [email protected])
Rahul D. Vashi – Houston (+1 346.718.6659, [email protected])
Graham Valenta – Houston (+1 346.718.6646, [email protected])
Zain Hassan – Houston (+1 346.718.6640, [email protected])
Mariana Lozano – Houston (+1 346.718.6711, [email protected])

Tax:
Michael Q. Cannon – Dallas (+1 214.698.3232, [email protected])
Matt Donnelly – Washington, D.C. (+1 202.887.3567, [email protected])
Josiah Bethards – Dallas (+1 214.698.3354, [email protected])

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

Securities & Exchange Commission v. Jarkesy, No. 22-859 – Decided June 27, 2024

Today, the Supreme Court held 6-3 that the Seventh Amendment to the United States Constitution requires the SEC to sue in federal court, not in the agency’s in-house court, when the SEC seeks civil penalties for fraud.

“[T]he Government has created claims whose causes of action are modeled on common law fraud and that provide a type of remedy available only in law courts. This is a common law suit in all but name. And such suits typically must be adjudicated in Article III courts.”

Chief Justice Roberts, writing for the Court

Background:

In 2013, the SEC brought administrative enforcement proceedings against George Jarkesy and his investment advisor for securities fraud. After an SEC in-house administrative law judge found that Jarkesy committed securities fraud, the SEC ordered Jarkesy to pay hundreds of thousands of dollars in civil penalties and disgorgement.

A divided panel of the Fifth Circuit held unconstitutional parts of the SEC’s in-house adjudication process for three independent reasons: (1) The Seventh Amendment right to a jury trial barred the SEC’s use of administrative proceedings to impose civil penalties; (2) Congress unconstitutionally vested the SEC with the unfettered discretion to decide whether to enforce securities laws in an agency adjudication or in federal court; and (3) Congress unconstitutionally insulated SEC administrative law judges from removal by allowing their firing only upon a finding of “good cause” by the Merit Systems Protection Board, whose members themselves are subject to removal only in certain limited circumstances.

Issue:

Can the SEC require defendants in actions for civil penalties to defend themselves before the agency tribunal rather than before a jury in federal court?

Court’s Holding:

No. The Seventh Amendment entitles defendants to a jury trial in federal court for SEC fraud actions seeking civil penalties.

What It Means:

Today’s decision will have a significant impact on the forum in which the SEC can enforce the statutes it administers—in the agency’s in-house administrative court, or in federal court before an Article III judge and a jury. The Court explained that “if a suit is in the nature of an action at common law, then the matter presumptively concerns private rights, and adjudication by an Article III court is mandatory.” The Court also emphasized that the form of relief the SEC sought in this case—civil penalties—was “all but dispositive” on the issue of whether the Seventh Amendment applied because civil penalties are “a type of remedy at common law that could only be enforced in courts of law.” Thus, going forward, if the SEC seeks civil penalties on a claim that resembles a traditional common-law action, the SEC very likely must proceed only in federal court, not in the administrative court.
The decision will also likely impact how the SEC settles enforcement actions with unregistered parties, including public companies and individual executives, at least for violations that resemble traditional common-law actions. The imposition of penalties in such settlements will likely require a federal court judgment, which in turn will subject settlements to potential scrutiny by a district court prior to endorsement of the judgment.
In the near term, the decision may have little impact on SEC enforcement because the agency hasn’t pursued contested actions seeking penalties in its administrative forum. But long term, requiring the SEC to bring enforcement actions in federal court will afford defendants access to independent judges and juries, the rules of evidence and civil procedure, and other procedural protections.
The Court’s decision could have broader implications for other agencies and other theories of liability. Many agencies have in-house courts that adjudicate alleged violations of the statutes they implement. If an agency seeks monetary penalties on a ground that resembles a traditional action at common law—such as a fraud or negligence claim—the Seventh Amendment presumptively requires the agency to proceed in federal court. The “public rights” exception to this principle will be construed more narrowly than suggested by some prior Court decisions. Defendants facing agency enforcement actions therefore should carefully consider the nature of the agency’s claims and requested penalties and assert their constitutional rights to a jury trial. Similarly, parties to agency investigations should consider asserting those constitutional rights in the event the agency signals it intends to take enforcement action.
Because the Seventh Amendment question resolved the case, the Court declined to reach the other constitutional questions that the petitioner presented. Thus, the Court has yet to decide whether Congress unconstitutionally delegated to the SEC the power to choose the forum in which to proceed or unconstitutionally insulated the administrative law judge from removal.

The Court’s opinion is available here.

Appellate and Constitutional Law Practice

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

Related Practice: Securities Enforcement

Mark K. Schonfeld
+1 212.351.2433
[email protected]

David Woodcock
+1 214.698.3211
[email protected]

Related Practice: Administrative Law and Regulatory Practice

Eugene Scalia +1 202.955.8210 [email protected]	Helgi C. Walker +1 202.887.3599 [email protected]	Stuart F. Delery +1 202.955.8515 [email protected]
Akiva Shapiro +1 212.351.3830 [email protected]	Russell Balikian +1 202.955.8535 [email protected]

Related Practice: Securities Litigation

Reed Brodsky +1 212.351.5334 [email protected]	Monica K. Loseman +1 303.298.5784 [email protected]	Brian M. Lutz +1 415.393.8379 [email protected]
Craig Varnen +1 213.229.7922 [email protected]	Mary Beth Maloney +1 212.351.2315 [email protected]

This alert was prepared by associates Elizabeth Kiernan and Jessica Lee.

Ohio v. EPA, Nos. 23A349, 23A350, 23A351, and 23A384 – Decided June 27, 2024

Today, in a case that further highlights the significance of the Court’s emergency docket for challenging agency rules, the Supreme Court (5-4) granted Ohio and several other applicants a stay that suspends the EPA’s “Good Neighbor” plan regulating some states’ emissions.

“Perhaps there is some explanation why the number and identity of participating States does not affect what measures maximize cost-effective downwind air-quality improvements. But if there is an explanation, it does not appear in the final rule. As a result, the applicants are likely to prevail on their argument….”

Justice Gorsuch, writing for the Court

Background:

The Clean Air Act directs each state to develop plans to implement air-quality standards. If a state’s plan fails to meet the relevant requirements, the EPA can reject that plan and impose a federal plan instead. One requirement in the Act is a “Good Neighbor” provision, which requires upwind states to reduce emissions to account for pollution exported to downwind states. In 2022, the EPA proposed to reject the plans of 23 upwind states whose emissions it said would have an effect on downwind states. The EPA proposed a single, coordinated federal plan for all 23 states. The EPA ultimately disapproved 21 states’ plans. Before the federal plan was final, several courts of appeals held that the EPA had likely violated the Act in disapproving certain states’ plans and granted stays of the disapprovals pending review. In June 2023, the EPA nonetheless finalized the proposed federal plan—the “Good Neighbor” plan. Since then, several other states have obtained stays of the EPA’s state-plan disapprovals. The Good Neighbor plan now applies to only 11 states, regulating far less emissions than the plan’s stated intent.

Ohio and several other states still subject to the federal plan, as well as several industry participants, challenged the plan in the D.C. Circuit and sought a stay pending that court’s review. After the D.C. Circuit declined to stay the federal plan, several of the states and industry participants applied to the Supreme Court for a stay, arguing that the Good Neighbor plan violates the Administrative Procedure Act because the EPA failed to consider how the federal plan would work if it applied to fewer than 23 states.

Issue:

Are applicants entitled to a stay of the Good Neighbor plan?

Court’s Holding:

Yes. The applicants are likely to succeed on the merits because the Good Neighbor plan does not comply with the APA’s requirement that the agency provide a reasoned explanation, and applicants have demonstrated that they face irreparable harm justifying a stay of the plan pending final judicial review.

What It Means:

The Court concluded that the applicants were likely to succeed on the merits. The Court emphasized that the “long-settled standards” of federal rulemaking require the agency to explain its response to all material comments raised during the notice and comment period. While the Court recognized that EPA was aware of the concern that the Good Neighbor plan might not apply to all 23 States, the Court faulted EPA for failing “to explain why it believed its rule would continue to offer cost-effective improvements in downwind air quality with only a subset of the States it originally intended to cover.”
Because the Court concluded that the “harms and equities” relevant to a stay of the enforcement of a federal regulation were “very weighty on both sides,” it held that the propriety of the stay turned on the likelihood of success on the merits. The Court did credit—and the dissent did not dispute—the applicants’ argument that the unrecoverable costs of compliance with the rule during the pendency of the litigation would constitute irreparable harm. This argument would likely extend more broadly to challenges of other agency actions.
Justice Barrett dissented, joined by Justices Sotomayor, Kagan, and Jackson. She did not object to the Court’s analysis of the equities but concluded that the States were unlikely to succeed on the merits. She closed by noting that the Court “should proceed all the more cautiously” when addressing emergency applications “with voluminous, technical records and thorny legal questions.”
The Court’s decision indicates a willingness to grant stays while an agency rule is being challenged in lower courts and even before any lower court has expressed its views on the merits of the rule. This further highlights the importance of the Court’s emergency docket, particularly for challenges to broad federal rules.
Notably, the Court defused criticism over the so-called “shadow docket” by holding oral argument, rather than deciding the stay merely on the briefs.

The Court’s opinion is available here.

Appellate and Constitutional Law Practice

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

Related Practice: Environmental Litigation and Mass Tort

Stacie B. Fletcher
+1 202.887.3627
[email protected]

Daniel W. Nelson
+1 202.887.3687
[email protected]

This alert was prepared by associates Zachary Tyree, Aly Cox, and Aaron Gyde.

Snyder v. United States, No. 23-108 – Decided June 26, 2024

Today, the Supreme Court held 6-3 that a federal bribery statute, 18 U.S.C. § 666(a)(1)(B), does not criminalize after-the-fact “gratuities” paid to state or local government officials in recognition for official acts, where there was no quid pro quo agreement to take those acts.

“The question in this case is whether [federal law] also makes it a crime for state and local officials to accept gratuities—for example, gift cards, lunches, plaques, books, framed photos, or the like—that may be given as a token of appreciation after the official act. The answer is no.”

Justice Kavanaugh, writing for the Court

Background:

Petitioner James Snyder is the former mayor of Portage, Indiana. While Snyder was mayor, Portage contracted with a local truck company to buy garbage trucks worth $1.125 million. Several months later, Snyder solicited and accepted $13,000 from the truck company’s owners, which Snyder contended he received for providing the company with consulting services. It is undisputed that Snyder did not engage in this solicitation until after the city awarded the garbage truck contracts.

Snyder was later indicted for violating 18 U.S.C. § 666, which prohibits state and local officials from “corruptly solicit[ing,] demand[ing,] . . . or accept[ing]” anything of value offered with the intent to “influence[] or reward[]” in connection with certain government business. Snyder moved to dismiss and, after the jury returned a guilty verdict, filed a post-trial motion for acquittal, arguing that Section 666 applies only to acts of quid pro quo bribery and does not criminalize “gratuities” paid in recognition of actions already taken. The district court denied both motions, and the Seventh Circuit affirmed.

Issue:

Does 18 U.S.C. § 666(a)(1)(B) criminalize gratuities, i.e., payments in recognition of actions a state or local official has already taken or committed to take, without any quid pro quo agreement to take those actions?

Court’s Holding:

No. Section 666 applies only to quid pro quoacts of bribery. State and local officials may not be found guilty under this statute unless the prosecution proves that they solicited, demanded, or accepted something of value in exchange for taking an official act.

What It Means:

This decision is the latest in a series of cases in which the Court has rejected novel and expansive readings of federal fraud statutes in state and local public corruption cases.
E.g., Ciminelli v. United States, 143 S.Ct. 1121 (2023); Kelly v. United States, 140 S. Ct. 1565 (2020).

Today’s holding clarifies that providing state and local officials with tokens of appreciation—for example, gift cards, meals, events, or as in this case, a $13,000 payment—does not subject those officials to federal prosecution. At the same time, the Court reiterated that today’s decision does not affect the ability of state and local governments to regulate gratuities: “state and local governments may and often do regulate gratuities to state and local officials.” So before providing state and local officials with gifts or other benefits that might be considered gratuities, you should consult applicable state and local law.
The Court’s holding also should lend confidence to those subject to other federal public corruption statutes that they will not face prosecution for payments that might be seen as after-the-fact “gratuities.” This is especially true for statutes like the Foreign Corrupt Practices Act (FCPA), which prohibits the offer, promise, or payment of anything of value to improperly influence foreign officials. The Court’s ruling today further solidifies the conclusion that the FCPA, which proscribes influencing but not rewarding, does not extend to gratuities.
Justice Gorsuch wrote separately to emphasize that today’s decision is driven by the rule of lenity, which requires construing ambiguous criminal statutes in favor of defendants. Justice Jackson, joined by Justices Sotomayor and Kagan, dissented, contending that the Court’s opinion “elevates nonexistent federalism concerns over the plain text of the statute.”

The Court’s opinion is available here.

Appellate and Constitutional Law Practice

Thomas H. Dupree Jr. +1 202.955.8547 [email protected]	Allyson N. Ho +1 214.698.3233 [email protected]	Julian W. Poon +1 213.229.7758 [email protected]
Lucas C. Townsend +1 202.887.3731 [email protected]	Bradley J. Hamburger +1 213.229.7658 [email protected]	Brad G. Hubbard +1 214.698.3326 [email protected]
Jonathan C. Bond +1 202-887-3704 [email protected]

Related Practice: White Collar Defense and Investigations

Stephanie Brooker +1 202.887.3502 [email protected]	F. Joseph Warin +1 202.887.3609 [email protected]
Charles J. Stevens +1 415.393.8391 [email protected]	Nicola T. Hanna +1 213.229.7269 [email protected]

This alert was prepared by associate Cate McCaffrey and partner Jillian London.

This proposed legislation, if enacted, would constitute the most significant modification of PAGA since it was enacted two decades ago, and would provide employers with significant new options when facing claims brought under PAGA.

After months of negotiations, bills that would substantially reform the California Private Attorneys General Act (PAGA) were introduced in the California Assembly and Senate on June 21, 2024. This proposed legislation, if enacted, would constitute the most significant modification of PAGA since it was enacted two decades ago, and would provide employers with significant new options when facing claims brought under PAGA.

Among other things, the proposed reform would impose new limits on who can bring a PAGA action and the scope of Labor Code violations that a plaintiff can pursue, create caps on penalties for employers who can demonstrate reasonable compliance, reduce penalties for certain types of violations (such as technical defects in wage statements), and provide employers with greater opportunities to cure alleged violations. The law would also for the first time permit injunctive relief in PAGA actions and allocate a greater share of any civil penalties to employees. The bills state that these reforms would apply to PAGA actions brought on or after June 19, 2024, unless the plaintiff submitted a PAGA notice before June 19.

Given the nature of these reforms, and the prevalence of PAGA actions in recent years, we expect significant litigation over the meaning and application of these new provisions if the proposed reform is enacted. California employers should be prepared to leverage these changes in any new PAGA litigation.

I. Background of PAGA Reform

There is currently a ballot measure to repeal PAGA that is set to go to California voters in the November 2024 election. The ballot measure, if enacted, would eliminate private PAGA actions, and replace PAGA with a new law imposing increased penalties but with enforcement limited to state regulators.

Last week, following months of discussions between Governor Newsom, labor advocates, and business groups, Governor Newsom announced a deal on proposed PAGA amendments to “avert [the] contentious ballot measure.” On Friday, Assembly Bill 2288 and Senate Bill 92 were introduced, which memorialize the agreement to reform PAGA. If the legislation is signed into law by June 27, then the PAGA repeal ballot initiative will be withdrawn from the ballot.

II. Key Provisions of the Proposed PAGA Reform

A. Limitations on Standing

The proposed legislation would impose two substantive limitations on standing. First, it would require a plaintiff to have personally suffered each of the Labor Code violations they are seeking to pursue on a representative basis. This change is a response to the Court of Appeal’s decision in Huff v. Securitas Security USA Services, Inc., 23 Cal.App.5th 745 (2018), which has been interpreted to permit a PAGA plaintiff to recover PAGA penalties not only for alleged Labor Code violations that the plaintiff personally suffered, but also other alleged violations that only affected other employees. The proposed legislation makes clear that a plaintiff must prove that they personally suffered the same alleged Labor Code violations they seek to pursue on behalf of other employees. There is an exception to this new requirement for PAGA actions filed by employees represented by certain nonprofit legal aid organizations.

Second, the proposed legislation makes clear that the PAGA plaintiff must have personally suffered each alleged violation within one year of filing a PAGA notice with the Labor & Workforce Development Agency (LWDA). This change is a response to the Court of Appeal’s decision in Johnson v. Maxim Healthcare Services, Inc., 66 Cal.App.5th 924 (2021), which PAGA plaintiffs have used to argue that a PAGA action could be premised on a Labor Code violation regardless of when it occurred. The proposed legislation clarifies that a plaintiff seeking to file a PAGA action must have experienced a Labor Code violation during the one-year limitations period under Section 340 of the Code of Civil Procedure.

B. Courts May “Limit the Scope” of PAGA Claims Prior to Trial

The proposed legislation empowers trial courts to both limit evidence at trial and limit the scope of any PAGA claim to ensure that it can be effectively tried. This is effectively a codification of the California Supreme Court’s decision in Estrada v. Carpet Royalty Mills, Inc., 15 Cal.5th 582 (2024), which held that trial courts cannot strike an entire PAGA claim on manageability grounds, but can and should use their “numerous tools . . . to manage complex cases generally, and PAGA cases in particular.” Id. at 618 (emphasis added). More information about the Estrada decision is available here.

This particular provision will likely be a source of significant litigation, particularly given that the legislation does not describe how or when courts should “limit the scope” of a PAGA action.

C. Reductions in PAGA Penalties

1. Caps When Employer Takes “All Reasonable Steps to Comply”

The proposed legislation expands PAGA’s cure provisions and rewards employers who proactively take “all reasonable steps” to comply with the Labor Code.

First, if an employer cures an alleged violation and takes “all reasonable steps to be prospectively in compliance” either before or within 60 days of receiving a notice of a claimed PAGA violation, then the employer will not be liable for any penalty. The proposed legislation provides examples of “reasonable steps,” including: conducting periodic payroll audits, disseminating lawful written policies, providing trainings on Labor Code and Wage Order compliance, and taking corrective action with regard to supervisors. An employer’s attempts to take reasonable steps shall be evaluated by a “totality of the circumstances and take into consideration the size and resources available to the employer, and the nature, severity and duration of the alleged violation.”

Second, if an employer demonstrates that it “has taken all reasonable steps to be in compliance” with the law prior to receipt of a PAGA notice or a request for personnel records, but does not cure the alleged violation, then the available penalties are capped at 15% of the penalties sought.

Third, if an employer demonstrates that it “has taken all reasonable steps to prospectively be in compliance” with the law within 60 days of receiving a PAGA notice, but does not cure the alleged violations, then penalties would be capped at 30%.

Finally, penalties will be capped at $15 per employee per pay period if an employer cures the alleged violations but does not take “all reasonable steps to prospectively be in compliance” with the law.

These cure provisions, if enacted, will likely become a significant part of responding to PAGA actions given the potential for substantial reductions in PAGA penalties.

2. Reductions for Harmless Violations

Under the proposed legislation, penalties for technical wage statement violations would be capped at $25 per employee per pay period if an employee can easily determine the required information despite the alleged error. In addition, for isolated errors that occur for less than 30 days or four consecutive pay periods, the maximum penalty available is $50.

3. Limits on $200 Penalty for “Subsequent Violations”

PAGA currently allows for a default penalty of $200 per pay period for each “subsequent violation,” rather than the standard $100 penalty for “initial” violations. The proposed legislation limits this higher penalty by making it clear that it will be assessed only after any agency or court “has issued a finding or determination to the employer that its policy or practice giving rise to the violation was unlawful” within the five years preceding the alleged violation, or if the court finds the employer’s conduct was “malicious, fraudulent, or oppressive.”

4. Prohibition on Certain Derivative PAGA Penalties

Currently, PAGA plaintiffs often seek to recover penalties for alleged underpayment of wages and derivative penalties for alleged wage statement violations, failure to timely pay wages during employment, and failure to timely pay wages upon termination based on the same underlying underpayment. The proposed legislation would prohibit an employee from seeking derivative penalties for failure to timely pay wages claims unless the underpayment was willful or intentional, and, for wage statement claims, unless the violation was knowing or intentional.

D. Early Case Resolution Procedures

The proposed legislation also introduces new cure mechanisms for employers wanting early resolution. If an employer has less than 100 total employees during the PAGA period, then the employer can submit a confidential proposal to the LWDA to cure the alleged violations. The LWDA may then arrange a settlement conference with the plaintiff and employer in an attempt to reach an early resolution for the matter. If the LWDA determines that the employer’s proposal is not sufficient, or if the LWDA fails to act, then the employee may proceed to file a PAGA action in court.

For employers with more than 100 employees during the PAGA period, the bill allows the employer to file a request for a stay and an “early evaluation conference” with the court after a PAGA claim is filed, which requires the court stay all discovery and responsive pleading deadlines. Once the conference is set, the employer must submit (and serve plaintiff) a confidential statement to a “neutral evaluator”—which the legislation does not define—that details the allegations the employer disputes, which alleged violations it intends to cure, and the proposed plan to cure the alleged violations. The plaintiff must submit a response statement, including the factual basis for each alleged violation, the amount of penalties claimed for each violation, the total amount of attorney’s fees incurred as of the date of the submission, any settlement demand, and the basis for accepting or rejecting the employer’s cure proposal. If the conference is successful (i.e., the neutral and parties agree to a proposal and the alleged violations are cured), then it is treated as a confidential settlement of that claim. Notably, if the neutral or plaintiff does not agree that the employer has cured the alleged violations, then the employer may file a motion to request the court approve the cure and submit evidence showing correction of the alleged violations.

Unlike the other proposed amendments to PAGA, the early resolution provisions do not become operative until October 1, 2024. But like the other proposed amendments, the early resolution procedures would apply to PAGA actions brought on or after June 19, 2024 (unless the plaintiff submitted a PAGA notice before June 19).

E. Limitations of Potential Penalties for Employers Who Pay Weekly

Because PAGA penalties are based on the number of pay periods in which employees suffered a violation, employers with weekly payroll schedules are penalized twice as much as those employers with bi-weekly payroll schedules. The proposed legislation provides relief to these employers by reducing by 50% the penalties if an employee’s regular pay period is weekly rather than bi-weekly or semi-monthly.

F. Employee-Focused Reforms

Although most of the proposed reforms are designed to address concerns of employers over abuses of PAGA, the proposed legislation does have two changes designed to benefit employees. First, for the first time a PAGA plaintiff would be able to seek injunctive relief. Second, aggrieved employees will now receive a 35% share of any recovery (an increase from 25%).

III. Conclusion

The proposed reform of PAGA would create a new era in California employment litigation, as it would provide employers with significant additional tools to address and defend PAGA claims. Employers should begin preparing now to utilize these tools in future PAGA litigation and should carefully track how courts are applying and interpreting these amendments.

The following Gibson Dunn lawyers prepared this update: Jason Schwartz, Jesse Cripps, Bradley Hamburger, Michael Holecek, Megan Cooney, Amina Mousa, and Tim Kolesk.

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

Jesse A. Cripps – Los Angeles (+1 213.229.7792, [email protected])
Bradley J. Hamburger – Los Angeles (+1 213.229.7658, [email protected])
Michael Holecek – Los Angeles (+1 213.229.7018, [email protected])
Megan Cooney – Orange County (+1 949.451.4087, [email protected])
Jason C. Schwartz – Co-Chair, Washington, D.C. (+1 202.955.8242, [email protected])
Katherine V.A. Smith – Co-Chair, Los Angeles (+1 213.229.7107, [email protected])

The proposed rule would significantly curtail U.S. investments in the People’s Republic of China, Hong Kong, and Macau used to advance the development and production of semiconductors and microelectronics, quantum information technologies, and artificial intelligence systems. Once finalized, this new regulatory framework will implement a notification regime for certain transactions while outright prohibiting others. Additionally, while transactions that occur prior to the effective date of the final rule are excepted, the U.S. Department of the Treasury reserves the right to request information about such transactions as needed. Comments on the proposed rule may be submitted until August 4, 2024.

This alert provides (1) background of the outbound investment rulemaking process; (2) a refresher on the contours of the proposed rule; (3) changes from the August 2023 ANPRM in the June 2024 NPRM; (4) next steps in the regulatory process; and (5) Gibson Dunn’s key takeaways for clients.

I. Background of the Outbound Investment Rule

On June 21, 2024, the U.S. Department of the Treasury (“Treasury”) advanced the Biden Administration’s national security objective of regulating certain outbound investment by issuing a Notice of Proposed Rulemaking (“NPRM”) pursuant to Executive Order (“EO”) 14105, which was issued by President Biden on August 9, 2023. The EO and the NPRM address national security risks posed by certain outbound investment activities involving “covered national security technologies and products” in “countries of concern,” namely the People’s Republic of China (“PRC”), Hong Kong, and Macau. The NPRM follows the Advance Notice of Proposed Rulemaking (“ANPRM”) that was issued concurrently with the EO and was the subject of a previous Gibson Dunn client alert. Note that the NPRM does not itself impose any new requirements, and its proposed requirements are subject to change when Treasury issues the final rule.

An outbound investment regime would become another powerful tool in the U.S. government’s efforts to counter the PRC’s technological and military surge and reflects the Biden Administration’s strategic priority of addressing the PRC as its “pacing challenge” in the global arena, particularly regarding critical technologies, as outlined in its 2022 National Security Strategy.

In line with the ANPRM, the NPRM proposes to prohibit some outbound investment transactions outright, and to require notifications for other investments. The categories of prohibited and notifiable investments address transactions with a “covered foreign person”—that is a person of a “country of concern” who engages in a “covered activity” related to the development or production of “covered national security technologies and products.” The NPRM also provides exceptions and exemptions for certain transactions, outlines the procedures and penalties for compliance and enforcement, and invites further public comments on specific issues. The decision to issue the ANPRM and NPRM—administrative steps not required under the International Emergency Economic Powers Act (“IEEPA”) under which EO 14105 was issued—indicates a concerted effort by Treasury to develop a rule informed by stakeholder input prior to issuing a final rule. The NPRM comment period ends on August 4, 2024, and Treasury is expected to issue a final rule thereafter.

Below, we provide a refresher on the basic contours of the rule, highlight changes introduced by the NPRM, and share key takeaways.

II. Refresher of Basic Contours of the Rule

A. To Whom Does the Rule Apply?

The NPRM adopts the definition of “U.S. person” set out in the EO, which includes “any United States citizen, lawful permanent resident, entity organized under the laws of the United States or any jurisdiction within the United States, including any foreign branches of any such entity, and any person in the United States.”

The proposed rule would also apply to any “controlled foreign entity,” defined as “any entity incorporated in, or otherwise organized under the laws of, a country other than the United States of which a U.S. person is a parent.” The term “parent” would include any person or entity who or which (1) directly or indirectly holds more than 50 percent of the outstanding voting interest or voting power of the board of an entity, (2) is the general partner, managing member, or equivalent of an entity, or (3) is the investment adviser to any entity that is a pooled investment fund. The proposed rule would require such U.S. parents to take “all reasonable steps to prohibit and prevent any transaction by its controlled foreign entity” that would be prohibited or notifiable under the proposed rule. The proposed rule provides a list of examples of “reasonable steps” U.S. parents should take to direct their controlled entities, such as using binding agreements, governance or shareholder rights, internal policies, procedures, or guidelines, periodic training and internal reporting requirements, effective internal controls, and testing and auditing functions.

In addition, the proposed rule would apply to U.S. personnel of foreign entities by prohibiting them from “knowingly directing” transactions that would be prohibited for a U.S. person to conduct itself. This is similar to the standard anti-“facilitation” provisions found in most U.S. sanctions regulations. The proposed rule would not restrict a U.S. person from working at any entity that receives investment, nor would it restrict a U.S. person from working at an entity making such an investment, as long as the U.S. person recuses themselves from the sensitive investment. Developing policies and procedures to ensure compliance with these requirements will be essential for U.S. and non-U.S. companies engaged in transactions that may involve the covered national security technologies and products.

B. What Types of Investments Would Be Restricted?

According to the proposed rule, a “covered transaction” is any transaction that a U.S. person knows (at the time of the transaction) involves a “covered foreign person.” Such transactions include the following:

Acquisition of an equity interest or contingent equity interest;
Certain debt financing that is convertible to an equity interest or that affords certain management or board rights to the lender;
The conversion of a contingent equity interest or equivalent;
A greenfield investment or other corporate expansion;
Entry into a joint venture; and
Acquisition of a limited partner or equivalent interest in a non-U.S. investment fund.

A “covered foreign person” is defined as a person of a “country of concern” that engages in a “covered activity”—and certain parents and majority-owned subsidiaries of such entities. The initial “countries of concern” under the proposed rule are the PRC, Hong Kong, and Macau.

A “covered activity” is any activity related to the development or production of specific “covered national security technologies and products” in three key industries: semiconductors and microelectronics; quantum information technologies, and artificial intelligence (“AI”) systems. As outlined in detail in the table below, certain “covered activities” will require notification to Treasury post-acquisition, while others will be prohibited outright.

Semiconductors and Microelectronics

Proposed Notifiable Transactions

Proposed Prohibited Transactions

Transactions involving “covered foreign persons” engaged in the following “covered activities”:

(1) Integrated Circuit Design: The design of integrated circuits for which transactions involving U.S. persons are not otherwise prohibited.

(2) Integrated Circuit Fabrication: The fabrication of integrated circuits for which transactions involving U.S. persons are not otherwise prohibited.

(3) Integrated Circuit Packaging: The packaging of integrated circuits for which transactions involving U.S. persons are not otherwise prohibited.

Transactions involving “covered foreign persons” engaged in the following “covered activities”:

(1) Technologies that Enable Advanced Integrated Circuits

Software for Electronic Design Automation: The development or production of electronic design automation software for integrated circuits or advanced packaging.
Integrated Circuit Manufacturing Equipment: The development or production of front-end semiconductor fabrication equipment designed for performing the volume fabrication of integrated circuits, including equipment used in the production stages from a blank wafer or substrate to a completed wafer or substrate (i.e., the integrated circuits are processed but they are still on the wafer or substrate).
Equipment for performing volume advanced packaging.
Extreme Ultraviolet Lithography Fabrication Equipment: Commodity, material, software, or technology designed exclusively for use in or with extreme ultraviolet lithography fabrication equipment.

(2) Advanced Circuit Design and Production

Advanced Integrated Circuit Design: The design of integrated circuits that exceed the thresholds in Export Control Classification Number (“ECCN”) 3A090.a, or integrated circuits designed for operation at or below 4.5 Kelvin.
Advanced Integrated Circuit Fabrication: The fabrication of integrated circuits meeting any of the following criteria:
- Logic integrated circuits using a non-planar transistor architecture or with a production technology node of 16/14 nanometers or less, including fully depleted silicon-on-insulator (FDSOI) integrated circuits;
- NOT-AND (NAND) memory integrated circuits with 128 layers or more;
- Dynamic random-access memory (DRAM) integrated circuits using a technology node of 18 nanometer half-pitch or less;
- Integrated circuits manufactured from a gallium-based compound semiconductor;
- Integrated circuits using graphene transistors or carbon nanotubes; or
- Integrated circuits designed for operation at or below 4.5 Kelvin.
Advanced Integrated Circuit Packaging: The packaging of integrated circuits using advanced packaging techniques.

(3) Supercomputers: The development, installation, sale, or production of any supercomputer enabled by advanced integrated circuits that can provide a theoretical compute capacity of 100 or more double-precision (64-bit) petaflops or 200 or more single-precision (32-bit) petaflops of processing power within a 41,600 cubic foot or smaller envelope.

Quantum Information Technologies

Proposed Notifiable Transactions

Proposed Prohibited Transactions

No transactions involving “covered foreign persons” and quantum information technologies are currently contemplated.

Transactions involving “covered foreign persons” engaged in the following “covered activities”:

(1) Quantum Computers and Components: The development of a quantum computer or the production of any of its critical components required to produce a quantum computer such as a dilution refrigerator or two-stage pulse tube cryocooler.

(2) Quantum Sensors: The development or production of any quantum sensing platform designed for, or which the relevant “covered foreign person” intends to be used for military, government intelligence, or mass-surveillance end uses.

(3) Quantum Networking and Quantum Communication Systems: The development or production of any quantum network or quantum communication system designed for, or which the relevant “covered foreign person” intends to be used for: (i) networking to scale up the capabilities of quantum computers, such as for the purposes of breaking or compromising encryption; (ii) secure communications, such as quantum key distribution; or (iii) any other application that has any military, government intelligence, or mass-surveillance end use.

AI Systems

Proposed Notifiable Transactions

Proposed Prohibited Transactions

Transactions involving “covered foreign persons” engaged in the following “covered activities”:

(1) The development of any AI system for which transactions involving U.S. persons are not otherwise prohibited that are:

Designed to be used for any government intelligence or mass-surveillance end use (e.g., through mining text, audio, or video; image recognition; location tracking; or surreptitious listening devices) or military end use (e.g., for weapons targeting, target identification, combat simulation, military vehicle or weapons control, military decision-making, weapons design, or combat system logistics and maintenance);
Intended by the “covered foreign person” to be used for cybersecurity applications, digital forensics tools, and penetration testing tools, or the control of robotic systems; or
Trained using a proposed threshold quantity of computing power based on computational operations. Treasury proposes a potential threshold ranging from greater than 10^23 to greater than 10^25 computational operations (e.g., integer or floating-point operations).

Transactions involving “covered foreign persons” engaged in the following “covered activities”:

(1) Certain AI System Development: The development of any AI system that is designed to be exclusively used for, or which the relevant “covered foreign person” intends to be used for, any:

Military end use (e.g., for weapons targeting, target identification, combat simulation, military vehicle or weapon control, military decision-making, weapons design, or combat system logistics and maintenance); or
Government intelligence or mass surveillance end use (e.g., through mining text, audio, or video; image recognition; location tracking; or surreptitious listening devices).

(2) Certain Training for AI Systems: The development of any AI system that is trained using a proposed threshold quantity of computing power based on computational operations with or without biological sequence data.

Treasury proposes a potential threshold ranging from greater than 10^24 to greater than 10^26 computational operations (e.g., integer or floating-point operations) without biological sequence data and a potential threshold of greater than 10^23 or 10^24 computational operations with biological sequence data.

In addition to the above, transactions involving “covered activities” (even if otherwise merely notifiable) will nevertheless be prohibited if the transaction involves an entity that:

Is included on the Entity List or Military End User List maintained by the U.S. Department of Commerce’s Bureau of Industry and Security;
Meets the definition of a “military intelligence end-user” in 15 C.F.R. § 744.22(f)(2);
Is included on the Specially Designated Nationals and Blocked Person (“SDN”) List maintained by Treasury’s Office of Foreign Assets Control (“OFAC”), or is owned 50 percent or more by one or more individuals or entities included on the SDN List;
Is included on the Treasury’s Non-SDN Chinese Military-Industrial Complex Companie (“NS-CMIC”) List; or
Is designated as a foreign terrorist organization by the Secretary of State under 8 U.S.C. 1189.

C. What Are the Requirements for Notifications?

A U.S. person subject to a notification requirement would have to submit a notification form to Treasury no later than 30 days after (1) a transaction is completed or (2) the U.S. person acquires knowledge (including information a U.S. person had or could have had through a reasonable and diligent inquiry) that the transaction constituted a “covered transaction.” The notification form would include details about the U.S. person, the covered transaction, relevant national security technologies and products, and the covered foreign person.

D. What Are the Exceptions and Exemptions?

Despite its sweeping coverage of many transactions involving the above-identified national security technologies and products, the proposed rule creates several notable exceptions and exclusions.

One prominent exclusion applies to citizens or permanent residents of a country of concern, such as the PRC, Hong Kong, or Macau, who are also either U.S. citizens or permanent residents of the United States. Such individuals are excluded from the definition of “covered foreign persons” and therefore do not on their own trigger the rule’s prohibitions or notification requirements.

Treasury has asked for comments on whether a similar exclusion should apply to U.S. entities that are currently covered under the definition of “person[s] of a country of concern,” such as U.S. subsidiaries of Chinese companies. This alteration to the definition would potentially allow U.S. persons to invest in such entities without being subject to the rule.

In addition to the exclusion for certain individuals, the proposed rule also lists several types of transactions that would be excepted from the rule’s scope, even if the transactions involve a covered foreign person. These include:

Publicly traded securities: An investment by a U.S. person in a publicly traded security (including on non-U.S. exchanges) or a security issued by an investment company, such as an index fund, mutual fund, or exchange-traded fund, unless the investment affords the U.S. person rights beyond standard minority shareholder protections;
Certain LP investments: A U.S. person’s investment made as a limited partner in a pooled investment fund, unless the investment affords the U.S. person rights beyond standard minority shareholder protections; noting, however, that Treasury proposes alternatives which would cap this exclusion to investments which do not exceed (i) $1,000,000, or (ii) 50% of the total assets under management of the fund;
Buyouts of country of concern ownership: A U.S. person’s full buyout of all country of concern ownership of an entity, such that the entity would not constitute a covered foreign person following the transaction;
Intracompany transactions: An intracompany transaction between a U.S. parent and a majority-controlled subsidiary to support ongoing operations or other non-covered activities;
Pre-EO 14105 binding commitments: A transaction fulfilling a binding, uncalled capital commitment entered into prior to August 9, 2023 (though Treasury reserves the right to request information about such transactions as needed);
Certain syndicated debt financings: Where the U.S. person, as a member of a lending syndicate, acquires a voting interest in a covered foreign person upon default and the U.S. person cannot initiate any action vis-à-vis the debtor and does not have a lead role in the syndicate; and
Third country measures: Certain transactions involving a person of a country or territory outside of the United States may be excepted transactions where the Secretary of the Treasury determines that the country or territory is addressing national security concerns posed by outbound investment and the transaction is of a type for which associated national security concerns are likely to be adequately addressed by the actions of that country or territory.

The proposed rule also provides a mechanism for U.S. persons to seek a “national interest” exemption determination for transactions that are in the national interest of the United States. The proposed rule does not specify the criteria or process for obtaining such an exemption, but states that Treasury will issue guidance on this matter in the future.

E. What Are the Penalties for Noncompliance?

The NPRM proposes penalties for violations of the outbound investment restrictions that relate to the nature and severity of the conduct. If a violation is not willful, meaning that the U.S. person did not act with knowledge or intent to violate the rule, the maximum civil penalty is the amount set by Section 206 of IEEPA, which is currently $368,136 per violation (an amount adjusted annually for inflation). If a violation is willful, meaning that the U.S. person acted with knowledge or intent to violate the rule, the maximum civil penalty is $1,000,000 per violation, and if the violator is a natural person, they may also face criminal prosecution and imprisonment of up to 20 years. In addition to monetary penalties and criminal sanctions, the proposed rule authorizes the Secretary of the Treasury to order a U.S. person to divest a covered transaction if the Secretary determines that such divestment is necessary to protect the national security of the United States.

As with other regulatory enforcement regimes, the proposed rule provides a process for U.S. persons to submit a voluntary self-disclosure (“VSD”) of a potential violation to Treasury, which may result in a reduction or mitigation of penalties, depending on the circumstances and the level of cooperation by the U.S. person.

III. Changes From the ANPRM

In response to significant interest and input from regulated industries during the ANPRM’s comment period, which Gibson Dunn previously reviewed, Treasury has continued to refine the exceptions and definitions that will be promulgated in the final outbound investment rule. In particular, the following provisions have been substantially revised from the ANPRM:

The definition and scope of covered transactions involving “AI systems”;
The knowledge standard that would govern when a U.S. person has “reason to know” of a covered transaction’s compliance obligations;
A new exception for the acquisition by a U.S. person of a voting interest in a covered foreign person following its default on a loan made by a syndicate of banks;
A new exception for transactions involving persons of third countries that have similar measures aimed at outbound investments as designated by the Secretary of the Treasury;
A new exception for securities traded on non-U.S. exchanges; and
Scope of the exception for acquisitions of limited partnership interests.

Below, we address each of these new provisions in detail, as well as certain other proposals Treasury notably declined to incorporate.

A. Covered Transactions Involving “AI Systems”

After the ANPRM was published in August 2023, the White House released EO 14110 on “Safe, Secure, and Trustworthy Development and Use of Artificial Intelligence” in October 2023. The new NPRM incorporates EO 14110’s definitions of “artificial intelligence” and “AI systems” in its definition of “AI system,” to include:

A machine-based system that can, for a given set of human-defined objectives, make predictions, recommendations, or decisions influencing real or virtual environments—i.e., a system that uses data inputs to:

Perceive real and virtual environments;
Abstract such perceptions into models through automated or algorithmic statistical analysis; and
Use model inference to make a classification, prediction, recommendation, or decision.

This definition also includes “any data system, software, hardware, application, tool, or utility that operates in whole or in part using” an “AI system.”

Importantly, in response to comments recommending the inclusion of “frontier AI systems,” the new NPRM would also expand the prohibition on transactions developing “AI systems” to include not only those systems designed for military or government intelligence and surveillance end uses, but also any AI system “that is trained using a quantity of computing power greater than” a certain proposed threshold. As noted above, certain lower computing power thresholds are proposed for notifiable transactions. Treasury is seeking comments on the appropriate computational threshold for these provisions.

B. Knowledge Standard

The NPRM proposes a knowledge standard to determine whether a U.S. person knew or reasonably should have known that it was undertaking a covered transaction involving a covered foreign person. Treasury’s proposed definition of knowledge would include any of the following:

Actual knowledge that a fact or circumstance exists or is substantially certain to occur;
An awareness of a high probability of a fact or circumstance’s existence or future occurrence; or
Reason to know of a fact or circumstance’s existence.

In response to commenters’ request for greater clarity on the applicable knowledge standard, section § 850.104 of the NPRM provides that, in assessing whether a U.S. person has undertaken a reasonable and diligent inquiry, Treasury will consider the following factors:

Inquiry conducted by a U.S. person, its legal counsel, or its representatives, including questions asked of the investment target or relevant counterparty, as of the time of the transaction;
The contractual representations or warranties the U.S. person has obtained or attempted to obtain from the counterparty;
Efforts by the U.S. person to obtain available non-public information relevant to the determination of a transaction’s status;
Efforts undertaken by the U.S. person to review public information, and the degree to which other information available to the U.S. person at the time of the transaction is consistent or inconsistent with such publicly available information;
Whether the U.S. person, its legal counsel, or its representatives purposefully avoided learning or sharing relevant information;
Warning signs such as evasive responses or non-responses from an investment target or relevant counterparty to questions or a refusal to provide information, contractual representations, or warranties; and
The use of public and commercial databases to verify relevant information of an investment target or relevant counterparty.

C. Loans Made by a Banking Syndicate to a Defaulting Covered Foreign Person

Signaling its commitment not to disrupt secondary or intermediary financial services such as debt rating, underwriting, or prime brokerage, Treasury has included a new exception from “covered transactions” in § 850.501 of the NPRM for loans made by a banking syndicate that includes U.S. persons to a defaulting covered foreign person, provided that the U.S. person has a passive voting interest but “cannot initiate action vis-à-vis the debtor on its own and does not have a lead role in the syndicate.”

D. Transactions Involving Third Countries with Outbound Investment Rules

As part of Treasury’s continued commitment to engage with allies and partners regarding the national security goals of the proposed rule, Treasury has in § 850.501 of the NPRM excepted certain types of transactions “involving a person of a country or territory outside of the United States designated by the Secretary, after taking into account whether the country or territory is addressing national security concerns posed by outbound investment” in accordance with criteria to be developed. No countries have yet been designated, and Treasury is continuing to solicit feedback on the range of factors it ought to consider in evaluating the adequacy of measures taken by other countries or territories to address the relevant national security concerns.

E. Securities Traded on Non-U.S. Exchanges

After commenters requested that Treasury align its definition of “publicly traded security” in the new regulations with the definition used by OFAC in connection with the NS-CMIC List, Treasury agreed to broaden the definition of an “excepted transaction” in § 850.501 of the NPRM to include “a security traded on a non-U.S. exchange, or a security traded ‘over-the-counter’ in addition to a security traded on a U.S. exchange.” Treasury agreed that this exception aligns with the national security goals undergirding the regulation due to the lower likelihood of the purchase of publicly traded securities resulting in the transfer of intangible benefits to “covered foreign persons” targeted by the proposed regulations.

F. Acquisitions of Limited Partnership Interests

The ANPRM envisioned an exception from the definition of “covered transactions” for a U.S. person’s limited partnership interest in a foreign venture capital fund where the U.S. person’s contribution is solely capital and the U.S. person did not have the ability to “approve, disapprove, or otherwise influence or participate in the investment decisions of the fund.” While the NPRM retains this exception, it contemplates adding one of two alternatives limiting this exception based on the size of the investment. The first alternative would except an acquisition of a limited partner interest only if the “limited partner’s committed capital is not more than 50 percent of the total assets under management of the fund, aggregated across any investment and co-investment vehicles that comprise the fund.” The second alternative would except such an acquisition only if “the limited partner’s committed capital is not more than $1,000,000, aggregated across any investment and co-investment vehicles that comprise the fund.” Treasury acknowledged that the latter $1,000,000 threshold proposal would likely cover a greater number of limited partner investments (along with potentially increasing compliance costs) but stated that such a bright-line approach might make compliance easier for U.S. persons.

G. Treasury Declined Requests for a De Minimis Threshold and Narrower Scoping for AI Systems

Although Treasury made a number of revisions and updates to the proposed rule, some comments were considered and rejected. For example, in response to the ANPRM, Treasury received comments requesting that the definition of covered foreign person include a de minimis threshold to scope out certain covered activities. Treasury considered, but ultimately declined, to propose a de minimis threshold, explaining that any such threshold tied to financial metrics might not sufficiently correlate to the national security significance of a given “covered activity.” This approach aligns with how the U.S. government has treated national security risk in the context of inbound investment, and we would not expect Treasury to reevaluate its stance on this issue in the final rule.

In addition, while some commenters expressed concern that the definition of “AI system” may unnecessarily sweep in civilian uses of AI systems, Treasury expressed that the current broader definition may be necessary to adequately address national security concerns, indicating that it is instead focused on whether the definition of AI system is broad enough, inviting commenters to discuss whether other AI systems not currently contemplated as subject to the notification requirements or prohibitions contained in the NPRM should nevertheless be included. We expect that this topic and the scope of such requirements could be the subject of additional comments.

IV. Next Steps in The Regulatory Process

The current open comment period ends August 4, 2024. Treasury specifically seeks comments regarding the:

Breadth of the rule;
Clarity of the “knowledge” standard;
Compliance and diligence burdens imposed by the rule;
Effect, if any, on the definition of “covered transaction” for the conversion of contingent equity interests or acquisition of limited-partnership interests;
Definitions of “person of a country of concern” and/or “covered foreign person” as applied to U.S. entities;
Scope of “covered activities”; and
Scope of “excepted transactions.”

V. Key Takeaways

Although the rule is likely to be finalized by the end of the year, the NPRM is not a final rule and will likely undergo revisions after the comment period has closed. Treasury is continuing to solicit feedback before the text of the final outbound investment rule is released. Nevertheless, it is important for clients to be aware of the following points at this stage of the rulemaking process:

Congressional action is possible, but less likely. Separate from EO 14105 and proposed rulemaking, Congress came close to legislating its own outbound investment notification protocols in the FY 2024 National Defense Authorization Act signed into law last year. Further attempts to legislate outbound investment provisions are unlikely, at least in the 118th Congress. House Speaker Mike Johnson and House Financial Services Committee Chairman Patrick McHenry blocked last year’s amendment on the grounds that limiting investments would reduce U.S. influence in the PRC and create unnecessary bureaucracy for U.S. business. Given that the Administration is making progress with its own restrictions, congressional supporters of an outbound investment regime likely will not see a need to continue their previous efforts to negotiate with Speaker Johnson and Chairman McHenry to codify restrictions in statute.
The rule implicates not only U.S. but also non-U.S. private equity funds. As described above, Treasury is considering alternatives in how it scopes the rule’s applicability to U.S. limited partner investment through non-U.S. funds, including with the suggestion of a $1 million cap on investment across a fund. The practical result could be to place additional regulatory compliance obligations on the general partners and investment managers of these non-U.S. funds. U.S.- and non-U.S. fund managers alike should follow this rulemaking carefully to better understand any new obligations.
Focus on emerging technologies may result in further updates. As also described above, Treasury updated the NPRM to reflect post-ANPRM developments in how the U.S. government is addressing the rapid development of AI. We expect Treasury may further refine the description of covered activities both during this rulemaking process and after. We may see that a primary use of outbound investment notifications will be to enable Treasury to better track developments and emerging risks in critical technology areas, and to respond by attempting to promulgate refinements and clarifications to rules on more of an ongoing basis, meaning that companies operating in covered areas will need to devote ongoing attention to technological and regulatory developments.
The rule raises potential investor confidentiality concerns. Regulated companies might be particularly interested in Treasury’s request for comments on the confidentiality of submissions regarding notifiable transactions. Some commenters have already highlighted the potential “unintended chilling effect” that the notification requirements may pose. Although Treasury acknowledges that situations may arise where it could disclose confidential corporate information to partner countries and allies—or even to the public when such disclosure would be in the national interest—the NPRM makes clear that such actions would not supersede applicable statutory obligations that restrict the sharing of certain confidential information such as trade secrets. Nevertheless, commenters may wish to provide feedback on the confidentiality of sensitive corporate disclosures more generally for covered transactions, especially given the heightened interest in the conduct of negotiating transactions, evidenced by clarifications in the rule’s “knowledge” standard.
The rule foreshadows outbound investment rulemaking, particularly in the UK/EU. The rule has implications for the U.S. government’s coordination and cooperation with its allies and partners in addressing the challenges posed by the PRC’s investment in critical sectors with the inclusion of a provision that may exempt certain transactions involving third countries that have similar measures to restrict or monitor outbound investment in national security technologies and products. As seen with inbound foreign direct investment rules, we expect to see other countries work to develop and refine their own outbound investment regimes. The fact sheet released by Treasury on the same date at the proposed rule notes that the UK and European Commission are concurrently considering mechanisms to address outbound investment risks in their own jurisdictions.

Gibson Dunn attorneys are monitoring the outbound investment regime developments closely and are available to counsel clients regarding potential or ongoing transactions and other compliance or public policy concerns.

The following Gibson Dunn lawyers prepared this update: Chris Mullen, Mason Gauch, Michelle Weinbaum, Stephenie Gosnell Handler, Amanda Neely, Jayee Malwankar, Adam Smith, and David Wolber.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these issues. For additional information about how we may assist you, please contact the Gibson Dunn lawyer with whom you usually work, the authors, or the following leaders and members of the firm’s International Trade practice group:

United States:
Ronald Kirk – Co-Chair, Dallas (+1 214.698.3295, [email protected])
Adam M. Smith – Co-Chair, Washington, D.C. (+1 202.887.3547, [email protected])
Stephenie Gosnell Handler – Washington, D.C. (+1 202.955.8510, [email protected])
Christopher T. Timura – Washington, D.C. (+1 202.887.3690, [email protected])
David P. Burns – Washington, D.C. (+1 202.887.3786, [email protected])
Nicola T. Hanna – Los Angeles (+1 213.229.7269, [email protected])
Courtney M. Brown – Washington, D.C. (+1 202.955.8685, [email protected])
Amanda H. Neely – Washington, D.C. (+1 202.777.9566, [email protected])
Samantha Sewall – Washington, D.C. (+1 202.887.3509, [email protected])
Michelle A. Weinbaum – Washington, D.C. (+1 202.955.8274, [email protected])
Chris R. Mullen – Washington, D.C. (+1 202.955.8250, [email protected])
Sarah L. Pongrace – New York (+1 212.351.3972, [email protected])
Anna Searcey – Washington, D.C. (+1 202.887.3655, [email protected])
Audi K. Syarief – Washington, D.C. (+1 202.955.8266, [email protected])
Scott R. Toussaint – Washington, D.C. (+1 202.887.3588, [email protected])
Claire Yi – New York (+1 212.351.2603, [email protected])
Shuo (Josh) Zhang – Washington, D.C. (+1 202.955.8270, [email protected])

Asia:
Kelly Austin – Hong Kong/Denver (+1 303.298.5980, [email protected])
David A. Wolber – Hong Kong (+852 2214 3764, [email protected])
Fang Xue – Beijing (+86 10 6502 8687, [email protected])
Qi Yue – Beijing (+86 10 6502 8534, [email protected])
Dharak Bhavsar – Hong Kong (+852 2214 3755, [email protected])
Felicia Chen – Hong Kong (+852 2214 3728, [email protected])
Arnold Pun – Hong Kong (+852 2214 3838, [email protected])

Europe:
Attila Borsos – Brussels (+32 2 554 72 10, [email protected])
Susy Bullock – London (+44 20 7071 4283, [email protected])
Patrick Doris – London (+44 207 071 4276, [email protected])
Sacha Harber-Kelly – London (+44 20 7071 4205, [email protected])
Michelle M. Kirschner – London (+44 20 7071 4212, [email protected])
Penny Madden KC – London (+44 20 7071 4226, [email protected])
Irene Polieri – London (+44 20 7071 4199, [email protected])
Benno Schwarz – Munich (+49 89 189 33 110, [email protected])
Nikita Malevanny – Munich (+49 89 189 33 160, [email protected])

The Corporate Sustainability Due Diligence Directive (CSDDD), one of the most debated pieces of European legislation of recent times, establishes far-reaching mandatory human rights and environmental obligations on companies of a certain size operating in the European Union—obligations that extend to their subsidiaries and even to their suppliers. In our two-episode podcast The ESG Digest: Insights into the European Corporate Sustainability Due Diligence Directive, Gibson Dunn lawyers and clients discuss the impact and implications of the new directive.

In the first episode, partner Robert Spano (London and Paris) and of counsel Selina Sagayam (London) discuss the rationale behind the CSDDD and review key points that led to its establishment. They explain which companies are in scope, the next steps in the directive’s implementation, measures that companies can adopt to ensure compliance, and the potential liabilities for breach of CSDDD’s obligations.

HOSTS:

Selina Sagayam is an English qualified senior of counsel and recent former partner in Gibson, Dunn & Crutcher’s London office and is a leader of the firm’s Environmental, Social and Governance (ESG) Practice and a member of the firm’s corporate group.

Regarded as one of the leading public M&A advisers in the UK, Selina has advised on hostile, competitive and recommended takeovers. Her practice focuses on international corporate finance transactional work, including public and private M&A, joint ventures, international equity capital markets offerings and advisory work focused on corporate governance, shareholder activism and securities law advice. She also focusses on ESG advisory matters.

Robert Spano is a partner in the London and Paris offices and the co-chair of the firm’s Artificial Intelligence Practice Group. He practices in the field of EU litigation, international dispute resolution and advises on regulatory matters. He is a member of the Transnational Litigation, International Arbitration, Environmental, Social and Governance (ESG), Privacy, Cybersecurity and Data Innovation, Technology Regulatory and Litigation, and Public Policy Practice Groups.

He is a leading expert in public international law, business and human rights, EU law and the law of the European Convention on Human Rights, bringing unparalleled experience from senior roles in the judiciary, private practice and academia.

Gibson Dunn’s Workplace DEI Task Force aims to help our clients develop creative, practical, and lawful approaches to accomplish their DEI objectives following the Supreme Court’s decision in SFFA v. Harvard. Prior issues of our DEI Task Force Update can be found in our DEI Resource Center. Should you have questions about developments in this space or about your own DEI programs, please do not hesitate to reach out to any member of our DEI Task Force or the authors of this Update (listed below).

Key Developments

On June 17, America First Legal (AFL) filed complaints with the EEOC and the Virginia Attorney General against Smithfield Foods, Inc., alleging that the pork processor deprives white males of employment opportunities based on sex and race in violation of Title VII and Section 1981. AFL cites several statements from Smithfield’s website and 2023 Sustainability Report, claiming that they demonstrate that Smithfield “uses numerical race and sex-based quotas for hiring, training, and promotion.” AFL asks that the EEOC and the Virginia AG initiate investigations into Smithfield’s employment practices.

On June 6, AFL filed complaints with the EEOC and the New York Department of Labor, requesting that they investigate the office of Manhattan District Attorney Alvin Bragg for race-based employment discrimination in violation of federal and state law. In both letters, AFL points to quotes from the office’s website, including its stated commitment to “the recruitment, hiring, retention, and promotion of a diverse staff,” and notes that the office’s application for a Law Clerk position requires disclosure of race, ethnicity, and gender. Citing statements by EEOC Commissioner Andrea Lucas about the purported illegality of using “race-motivated actions to maintain a demographically ‘balanced’ workforce,” AFL argues that the EEOC should investigate the District Attorney’s office for using race as a motivating factor in its employment practices in violation of Title VII. In its letter to the New York Department of Labor, AFL argued that the office’s practices violate the New York Human Rights Law’s prohibitions on discrimination and publishing discriminatory statements.

On June 4, a former employee sued Ally Financial Inc., asserting violations of Title VII and Section 1981, in Smith v. Ally Financial Inc., 3:24-cv-00529 (W.D.N.C. 2024). The plaintiff claims that Ally did not promote him three times, instead promoting a white woman, a Black woman, and a Black man. The suit claims that Ally executives unlawfully considered race and gender when making promotion and hiring decisions, pointing to the company’s website that describes a goal to achieve “a collective environment of different voices and perspectives.” The plaintiff also alleges that he was treated worse than his colleagues when he disagreed with his boss’s assessment that white supremacy groups who opposed the company’s DEI efforts posed the largest security risk to Ally. The docket does not reflect that Ally has been served with the complaint.

On June 3, twenty-one state attorneys general urged the Council of the American Bar Association (ABA) to revise Standard 206 of the Standards and Rules of Procedure for Approval of Law Schools, citing the SFFA decision. Standard 206 requires law schools to ensure opportunities for “members of underrepresented groups, particularly racial and ethnic minorities.” Law schools must also demonstrate a commitment to having a student body and faculty that is diverse with respect to gender, race, and ethnicity. Led by Tennessee AG Jonathan Skrmetti, the AGs argue that Standard 206 directs law school administrators to violate the Constitution and Title VII by considering race and ethnicity in admissions and hiring. The AGs acknowledge that the ABA recently proposed revisions that would expand the enumerated list of characteristics in the Standard’s text, but argue that the proposed revisions still make unconstitutional demands of administrators and do not adequately clarify how they can comply without violating the law.

On May 29, AFL filed complaints and letters with the Department of Justice’s Immigrant and Employee Rights Section, the EEOC, and the Iowa Civil Rights Commission against Tyson Foods, alleging that the company’s employment and contracting practices constitute potential illegal discrimination on the basis of sex, citizenship, and race. AFL bases its complaints on Tyson’s website and public statements aimed at promoting “a culture of DE&I.” AFL also alleges that Tyson has long favored noncitizen workers over American citizens throughout its labor supply chain, pointing to the fact that more than a third of the company’s workforce is comprised of noncitizens and that the company has joined a program to help connect refugees to work. AFL also sent a cease-and-desist letter to Tyson’s CEO and Board of Directors, demanding compliance with employment, immigration, and civil rights laws.

On May 20, the nonprofit Equal Protection Project filed a civil rights complaint with the U.S. Department of Education’s Office for Civil Rights (OCR) against the Massachusetts Institute of Technology (MIT). The complaint alleges that MIT’s undergraduate “Creative Regal Women of Knowledge” program violates Title VI and Title IX of the 1964 Civil Rights Act. The program is designed to provide academic and professional development assistance to women of color at MIT, including by giving students access to networking and mentoring opportunities as well as financial assistance. The complaint notes that the program’s application form requires applicants to state whether they are “Hispanic or Latino” and specify their race and gender identity. The complaint alleges that MIT violates federal anti-discrimination laws because the program’s eligibility requirements amount to intentional discrimination on the basis of race and sex, and asks that the OCR initiate an investigation and take appropriate enforcement action.

Media Coverage and Commentary:

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

Bloomberg Law, “Conservative Duo Fights Against DEI One Bias Claim at a Time” (June 5): Bloomberg’s Riddhi Setty and Tatyana Monnay profile AFL and American Alliance for Equal Rights (AAER), two organizations at the helm of the anti-DEI legal movement. Setty and Monnay report that AFL, led by former Trump advisor Stephen Miller, has “filed at last 15 lawsuits and sent over 30 letters” to the EEOC, alleging that corporate diversity programs violate Title VII of the 1964 Civil Rights Act. Setty and Monnay say that AFL identifies potential defendants by soliciting tips from insiders and scrutinizing company websites. In an interview with Bloomberg, AFL Vice President Gene Hamilton emphasized that “[t]here is a unique opportunity, given what the Supreme Court said last year in [SFFA v. Harvard], for us to push the accelerator even further down in the fight for more Americans and to bring more cases, more lawsuits, file more complaints.” Setty and Monnay report that AAER, led by legal activist Edward Blum, favors claims brought under Section 1981 of the 1866 Civil Rights Act, and, like AFL, AAER relies on tips to identify potential defendants. Setty and Monnay note that Gibson Dunn “is defending many of the litigation targets of Blum’s group,” including nonprofits Fearless Fund, Hidden Star, and Founders First Community Development Corporation. Mylan Denerstein, Gibson Dunn partner and co-chair of the firm’s Public Policy practice group, told Bloomberg that defending these clients “has been a tremendous part of the firm’s work.”
The Washington Post, “Federal judge halts disaster aid program for minority farmers” (June 10): The Post’s Julian Mark and Aaron Gregg report on a decision by a federal judge in Texas, blocking an Agriculture Department disaster relief program from giving preferences to minority and female farmers, agreeing with plaintiffs who argued that the program illegally discriminates against white male farmers. The Justice Department argued these preferences constitute justified remedial action for “structural biases in federal farm programs,” but the court found that the program lacked justification, was not narrowly tailored to remedy past and ongoing discrimination, and likely violated equal-protection rights. The authors note that this decision follows a line of similar litigation, including a June 2021 decision enjoining a program that provided debt relief to farmers of color (Congress later altered that program to grant relief based on economic need instead of race).
U.S. Law Week, “Workplace DEI Breaks Down Barriers With Flexible Benchmarks” (June 10): EEOC Commissioner Kalpana Kotagal, appointed to the Commission by President Biden in 2023, writes about the importance of maintaining corporate commitment to lawful diversity, equity, inclusion, and accessibility efforts. Although SFFA has caused “a lot of confusion” in corporate circles, writes Kotagal, the decision did not actually “change the law about employer efforts to foster diverse and inclusive workforces or engage the talents of all qualified workers.” Kotagal says that unlike academic affirmative action programs that use protected characteristics as explicit factors in admissions decisions, lawful corporate diversity programs are “forward-looking, proactive ways to remove barriers, reduce risk of discrimination, and create open and inclusive workplaces” but do not involve the consideration of protected characteristics in making employment decisions. Kotagal recommends that corporate leaders focus on examining current practices for bias and barriers and collecting data to identify success and room for growth. Lawful options for improving diversity may include diversifying applicant pools through networking with minority-led institutions, and use of skills-based rather than credential-based hiring. And companies may enhance retention and development of current employees through affinity groups and mentorship opportunities that are open to all with an interest. This “iterative” and “ongoing” work, Kotagal says, will “lay the groundwork for a stronger and more prosperous nation in the long term,” where “all workers have the opportunity to thrive.”
U.S. Law Week, “New Paradigm Shifts DEI From Box-Checking to Mindset-Building” (June 11): New York University School of Law professors Kenji Yoshino and David Glasgow suggest strategies to promote diversity goals despite post-SFFA legal challenges to “cohort-specific” programs—i.e., those that “aim to advance members of some demographic group while excluding others.” Yoshino and Glasgow write that these challenges have caused “understandable frustration in all sorts of organizations, even beyond the lengthy list that have been sued,” as SFFA “has made the most common-sense tools to redress marginalization more perilous.” But the authors encourage “DEI champions” not to give up on realizing their diversity goals, emphasizing three “promising pathways forward”: (1) shift from cohort-based eligibility to content-based eligibility based on individuals’ commitment to DEI-related objectives or missions; (2) select candidates based on individual character and experience rather than membership in a given cohort; and (3) make achievement of DEI goals a priority for all employees. Although the authors “recognize that moving away from cohort-specific programs involves real loss,” Yoshino and Glasgow encourage proponents of diversity programming not to see this as “an era of retreat,” focusing instead on the “opportunities” offered by “a more universalist approach to DEI.”

Case Updates:

Below is a list of updates in new and pending cases:

1. Contracting claims under Section 1981, the U.S. Constitution, and other statutes:

Suhr v. Dietrich, No. 2:23-cv-01697-SCD (E.D. Wis. 2023): On December 19, 2023, a dues-paying member of the Wisconsin State Bar filed a complaint against the Bar over its “Diversity Clerkship Program,” a summer hiring program for first-year law students. The program’s application requirements had previously stated that eligibility was based on membership in a minority group. After the Supreme Court’s decision in SFFA, the eligibility requirements were changed to include students with “backgrounds that have been historically excluded from the legal field.” The plaintiff claims that the Bar’s program is unconstitutional even with the new race-neutral language, because, in practice, the selection process is still based on the applicant’s race or gender. The plaintiff also alleges that the Bar’s diversity program constitutes compelled speech and compelled association in violation of the First Amendment. After reaching a partial settlement agreement with the Bar to make the criteria for the program race-neutral, the plaintiff filed an amended complaint, challenging three mentorship and leadership programs that allegedly discriminate based on race, which are funded by mandatory dues paid to the Bar.
- Latest update: On May 31, the Bar moved to dismiss the amended complaint for failure to state a claim, arguing that (1) facial challenges to the constitutionality of mandatory membership in a state bar had been struck down in numerous previous cases, (2) the Bar is entitled to immunity under the Eleventh Amendment, (3) some of the claims were time-barred, and (4) any Bar activities “not germane to the constitutional purpose” were not funded by compulsory dues.
Do No Harm v. Gianforte, No. 6:24-cv-00024 (D. Mont. 2024): On March 12, 2024, Do No Harm filed a complaint on behalf of “Member A,” a white female dermatologist in Montana, alleging that a Montana law violates the Equal Protection Clause by requiring the governor to “take positive action to attain gender balance and proportional representation of minorities resident in Montana to the greatest extent possible” when making appointments to the twelve-member Medical Board. Do No Harm alleges that since the ten already-filled seats are currently held by six women and four men, Montana law requires that the remaining two seats be filled by men, which would preclude Member A from holding the seat. On May 3, 2024, Governor Gianforte moved to dismiss the complaint for lack of subject matter jurisdiction, arguing that Do No Harm lacks standing because Member A has not applied for or been denied any position. On May 24, 2024, Do No Harm filed an amended complaint, describing additional Members B, C, and D, who are each “qualified, ready, willing, and able to be appointed” to the board.
- Latest update: On June 7, Governor Gianforte moved to dismiss the amended complaint for lack of jurisdiction, arguing that the case is not ripe, and Members A, B, C, and D lack standing because they do not allege a concrete, actual, or imminent harm. Governor Gianforte contended that the Members have not applied for the open seats and some appear currently ineligible, and that compliance with the statute at issue is “aspirational” rather than mandatory. The Governor emphasized that his “sole priority is highly qualified appointees” because he “opposes the ideological tenets of [DEI], quotas, and affirmative action.”
Valencia AG, LLC v. New York State Off. of Cannabis Mgmt. et al., No. 5:24-cv-116-GTS (N.D.N.Y. 2024): On January 24, 2024, Valencia AG, a cannabis company owned by white men, sued the New York State Office of Cannabis Management for discrimination, alleging that New York’s Cannabis Law and regulations favored minority-owned and women-owned businesses. The regulations include goals to promote “social & economic equity” applicants, which the plaintiff claims violate the Fourteenth Amendment’s Equal Protection Clause and Section 1983. On March 13, 2024, the plaintiff’s new counsel, Pacific Legal Foundation, filed an amended complaint, naming only two New York state officials as defendants in their official capacity. The plaintiff sought a permanent injunction against the regulations and a declaration that the use of race and sex in the New York Cannabis Law violates the Fourteenth Amendment. On April 24, 2024, the defendants moved to dismiss the amended complaint for lack of standing and failure to state an Equal Protection Clause claim. The defendants argued that even without the contested policy the plaintiff would not have received the license due to its low “position in the queue.”
- Latest update: On May 29, the plaintiff opposed the defendant’s motion to dismiss, asserting that the categorization of applicants as “priority” or “non-priority,” which will remain in every ensuing application cycle, is unconstitutional. The plaintiff further argues that the Cannabis Law and regulations mandate discrimination by facially categorizing people based on race and sex.

2. Employment discrimination and related claims:

Weitzman v. Fred Hutchinson Cancer Center, No. 2:24-cv-00071-TLF (W.D. Wash. 2024): On January 16, 2024, a white Jewish female former employee sued the medical center where she used to work, alleging that she was terminated for expressing her discomfort with DEI-related content shared in the workplace by coworkers, objecting to DEI-related training, and expressing her political opposition to DEI-aligned ideologies. She also claimed that her employer failed to act when she was allegedly discriminated against because of her religion and race by other coworkers. The plaintiff alleged that her employer’s conduct constituted racial discrimination, a hostile work environment, and retaliation in violation of the Washington Law Against Discrimination and Section 1981; discrimination and retaliation on the basis of political ideology in violation of the Seattle Municipal Code; and intentional infliction of emotional distress and wrongful termination in violation of public policy under common law.
- Latest update: On June 5, the parties notified the court that they had reached a settlement of all claims but requested time to determine the language of stipulations for dismissal. On June 7, the plaintiff and the individual defendants jointly requested voluntary dismissal of the case with prejudice against the individual defendants only, which the court approved on June 10.
Arsenault v. HP Inc., No. 3:24-cv-00943 (D. Conn. May 29, 2024): On May 29, a white former employee of HP Inc. filed suit, alleging that his termination violated Title VII and 42 U.S.C. § 1981. The complaint alleges that during a review meeting in August 2022, the plaintiff voiced agreement with the opinion of another team member that the company was spending too much time on DEI practices, and as a result, his managers accused him of racism. The complaint also alleges that the plaintiff was verbally abused by a co-worker, but the company took no action after he complained. The plaintiff was terminated in March 2023, and while the reason for his termination was a workforce reduction, the complaint alleges that no one else in the plaintiff’s department was laid off, and that the firing was thus pretextual.

3. Challenges to agency rules, laws and regulatory decisions

American Alliance for Equal Rights v. Ivey, No. 2:24-cv-00104-RAH-JTA (M.D. Ala. 2024): On February 13, 2024, AAER filed a complaint against Alabama Governor Kay Ivey, challenging a state law that requires Governor Ivey to ensure there are no fewer than two individuals “of a minority race” on the Alabama Real Estate Appraisers Board. The Board has nine seats, including one for a member of the public with no real estate background (the at-large seat), which has been unfilled for years. Because there was only one minority member among the Board at the time of filing, AAER asserts that state law will require that the open seat go to a minority. AAER states that one of its members applied for this final seat, but was denied purely on the basis of race, in violation of the Equal Protection Clause. On March 29, 2024, Governor Ivey answered the complaint, admitting that the Board quota is unconstitutional and will not be enforced. On May 7, 2024, the court granted a motion to intervene by the Alabama Association of Real Estate Brokers (AAREB), a trade association and civil rights organization for Black real estate professionals, who moved to intervene to “oppos[e] the parties’ position that the race-based provisions are unconstitutional.” On May 14, 2024, AAREB answered the complaint, seeking a declaration that the challenged law is valid and enforceable. On May 20, 2024, AAER moved for judgment on the pleadings, arguing that the racial requirement for appointments to the Board is unconstitutional and there are no unresolved questions of material fact.
- Latest update: On June 10, Governor Ivey responded in support of AAER’s motion for judgment on the pleadings, arguing that it is indisputable that the challenged law cannot survive strict scrutiny because the legislature that enacted it did not “clearly identify discrimination as the basis for [it].” Intervenor AAREB opposed the motion, arguing that there are contested material factual allegations, and the court must examine the facts to determine whether the challenged law withstands strict scrutiny.

4. Actions against educational institutions

Chu, et al. v. Rosa, No. 1:24-cv-75 (N.D.N.Y. 2024): On January 17, 2024, a coalition of education groups sued the Education Commissioner of New York, Dr. Betty A. Rosa, alleging that the state’s free summer program discriminates on the bases of race and ethnicity in violation of the Equal Protection Clause of the Fourteenth Amendment. The Science and Technology Entry Program (STEP) permits students who are Black, Hispanic, Native American, and Alaskan Native to apply regardless of their family income level, but all other students, including Asian and white students, must demonstrate “economically disadvantaged status.” On April 19, 2024, Rosa moved to dismiss the amended complaint for lack of subject-matter jurisdiction, arguing that neither the organizational plaintiffs (groups of parents) nor the named plaintiff, also a parent, have suffered any personal or individual injury, and that the plaintiffs cannot sue for alleged violations of members’ rights as prospective STEP applicants. Plaintiffs opposed the motion, arguing that the plaintiffs do not need to apply for the STEP program as a prerequisite for standing because their “injury is the inability to compete on an equal footing,” not whether they can secure a spot in the STEP program.
- Latest update: On May 31, Rosa filed a reply in support of her motion to dismiss, reiterating the argument that the plaintiffs lacked standing and a cognizable injury. Rosa also contended that, even if the contested clause of STEP were eliminated, the plaintiffs still would not qualify for the program because they cannot demonstrate that they are “economically disadvantaged” and so and cannot show that it is likely that their alleged injury would be “redressed by a favorable decision.”

The following Gibson Dunn attorneys assisted in preparing this client update: Jason Schwartz, Mylan Denerstein, Blaine Evanson, Molly Senger, Zakiyyah Salim-Williams, Matt Gregory, Zoë Klein, Mollie Reiss, Jenna Voronov, Alana Bevan, Marquan Robertson, Janice Jiang, Elizabeth Penava, Skylar Drefcinski, Mary Lindsay Krebs, David Offit, Lauren Meyer, Kameron Mitchell, Maura Carey, and Jayee Malwankar.

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

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

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

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

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

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

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

This update highlights the principal changes announced in the BIS rule and discusses how these expanded export control measures coordinate with and complement additional sanctions targeting Russia announced by OFAC on the same day.

On June 12, 2024, one day before G7 leaders met in Italy to coordinate Ukraine-related policy, and in line with Office of Foreign Asset Controls (“OFAC”)’s latest round of sanctions measures and designations, the Bureau of Industry and Security (“BIS”) released a final rule on the “Implementation of Additional Sanctions Against Russia and Belarus Under the Export Administration Regulations (EAR) and Refinements to Existing Controls” in response to Russia’s continuing invasion of Ukraine. The rule, published to the Federal Register on June 18, 2024, (i) significantly expands the scope of U.S. export controls targeting Russia and Belarus, (ii) creates a single, unified Russian and Belarusian embargo provision in the EAR, (iii) alters the Entity List structure to address unlawful diversion, and (iv) formally primes the private-sector for more aggressive enforcement by BIS and other U.S. government agencies.

All changes in the rule are effective as of June 12, 2024, except for the addition of new controls on certain EAR99-designated software, which are effective September 16, 2024.

We highlight below the principal changes announced in the BIS rule, and we discuss how these expanded export control measures coordinate with and complement additional sanctions targeting Russia announced by OFAC on the same day.

I. Major Changes in the Final Rule

The final rule targets Russian and Belarusian industrial sectors and key technology infrastructure by, among other things, substantially expanding the scope of items subject to industry sector- and software-related restrictions as well as limiting the scope of an available license exception for consumer communication devices (“CCDs”).

Addition of Over 500 Industrial Items to the Russia and Belarus Sanctions Measures

The final rule adds 522 entries to the list of items subject to the Russian and Belarusian industry sector sanctions set forth in Supplement No. 4 to 15 C.F.R. § 746, covering numerous metals, tools, and other items containing technical inputs sought by Russia to advance its war effort in Ukraine (e.g., stoves and related appliances that contain potentially valuable circuitry and/or semiconductors). The expanded list also adds crude oil to the list of covered items. Accordingly, a license is now required to export, reexport, or transfer (in country) these additional items to Russia or Belarus.

The expanded scope of items in Supplement No. 4 now spans an additional 18 complete chapters of the Harmonized Tariff Schedule of the United States (“HTSUS”), in addition to the four chapters completely covered by prior controls.

The rule also restricts additional items considered “chemical riot control agents,” which have been added to Supplement No. 6.

Narrowed Scope of License Exception CCD for Russia and Belarus

The final rule narrows the scope of items eligible for License Exception CCD when commodities and software are being exported to Russia and Belarus. 15 CFR § 740.19(b). Under the revised rule, License Exception CCD will no longer cover a range of consumer electronic devices when destined for Russia that were previously within scope, including consumer disk drives and solid-state storage equipment; graphics accelerators and graphics coprocessors; modems, routers, switches and WiFi access points and drivers, communications and connectivity software for such hardware; network access controls and communications channel controllers; mass market memory devices; digital cameras; webcams, and memory cards; television and radio receivers, set top boxes, video decoders, and antennas; recording devices; integrated circuits described in 3A991.p or computers that incorporate such integrated circuits; or batteries, chargers, carrying cases, and accessories for the such items. License Exception CCD will retain is historic scope for exports of consumer digital communications products to be sold in retail transactions destined for Cuba, and certain government officials in Belarus, Cuba, and Russia will remain ineligible for this license exception.

New Controls on EAR99 Software for Enterprises, effective September 16, 2024

The rule expands software-related controls – which were previously limited to software listed on the Commerce Control List, or for use in quantum computing or advanced manufacturing – to include certain categories of EAR99-designated enterprise management software as well as software updates for previously deployed software. When the software-related measures take effect on September 16, 2024, these controls will extend to the following categories of software classified as EAR99: software for

enterprise resource planning (ERP),
customer relationship management (CRM),
business intelligence (BI),
supply chain management (SCM),
enterprise data warehouse (EDW),
computerized maintenance management system (CMMS),
project and product lifecycle management (PLM),
building information modelling (BIM),
computer aided design (CAD),
computer-aided manufacturing (CAM), and
engineering to order (ETO).

However, BIS will continue to keep available a license exclusion for the export of certain mass market encryption commodities and covered enterprise management software that are provided to civil end-users in Russia that are wholly-owned subsidiaries of companies headquartered in the United States or certain allied and partner nations (see § 746.8(a)(12)(ii)). BIS will also exclude from the new controls the export of covered enterprise management software to entities operating exclusively in the medical or agricultural sectors.

Addition of Addresses to the Entity List

The final rule authorizes BIS to publish addresses to the Entity List without listing a corresponding entity name. BIS explains that this change is aimed at further combating unlawful diversion by targeting addresses which BIS believes are frequently used by multiple shell companies. As such, an export license requirement now applies to all items controlled on the Commerce Control List or listed in Supplement No. 7 to Part 746 when going to any entity using the listed address, even if the entity is not itself specifically named on the Entity List. BIS further notes that a party’s use of the same address as a listed entity is a red flag that requires additional due diligence. Therefore, when confronted with a listed address, exporters, reexporters, and transferors must undertake sufficient due diligence to ensure that the co-located entity is neither the listed entity nor acting on its behalf.

Pursuant to the rule, BIS added eight addresses and five entities in China (which includes Hong Kong under the EAR) and Russia to the Entity List.

Revision, Suspension, or Revocation of License Exceptions

The final rule revises paragraph (b) of 15 C.F.R. § 740.2 (“Restrictions on all License Exceptions”) to clarify that BIS may revise, suspend, or revoke any license exception with or without notice, in whole or in part, and at any time. BIS notes that the revision is designed to “provide transparency” to exporters and notes the risk that license exceptions may be abused by malign actors who make superficial changes to corporate ownership structures to make use of a license exception or who fraudulently claim that a license exception applies to their shipments. BIS reserves the right to react immediately to such scenarios by revoking license exception eligibility for particular persons without advance notice.

Reorganization of Russia- and Belarus-Related Provisions of the EAR

Of interest to compliance professionals, BIS has consolidated Russia- and Belarus-related sanctions measures into a single section, newly expanded 15 C.F.R. § 746.8. BIS notes that the consolidation is intended to enhance clarity and facilitate compliance. Related Supplements will retain their original numbering.

II. Compatibility with OFAC’s IT and Software Services Determination

BIS’s new controls on EAR99 software for enterprises are complemented by OFAC’s June 12 Determination pursuant to E.O. 14071 that comes into effect on September 12, 2024 and will prohibit the supply of certain IT, cloud-based, and software services to any person in Russia. OFAC’s announced prohibition does not extend to any service for software that is licensed by the U.S. Department of Commerce for export to Russia or that is not subject to the EAR but would be within an applicable license exception (or otherwise authorized by the U.S. Department of Commerce) if it was subject to the EAR. Consequently, OFAC’s IT and software services ban works in concert with BIS’s recent controls by excluding certain categories of services that relate to items authorized for export, reexport, or transfer under the EAR pursuant to applicable exclusions and license exceptions. Therefore, software service providers should be mindful of the applicability of the EAR, and its corresponding license exceptions, to underlying software for which they provide related services, even when they do not export the underlying software itself.

III. Policy Analysis, Compliance Considerations, and Key Takeaways

BIS’s June 12 final rule is a substantial escalation of U.S. export controls targeting Russia and Belarus and also harmonizes U.S. measures with those in place in the EU and UK which have maintained substantially broader lists of controlled items than the United States, and – unlike the United States. In an effort to create substantive and structural compatibility with restrictions put into effect by the EU and UK, BIS has maintained the Common High Priority List and is making greater use of large tranches of HTS codes in Russia-related export controls. Furthermore, the rule adds new restrictions on enterprise software that more closely align with measures already in place in the UK and EU, since December of 2022 and 2023, respectively.

However, the rule’s authorization for BIS to utilize address-only entries on the Entity List, in conjunction with evolving enhanced due diligence requirements and expectations, may result in significant difficulties in practice. Restricted party screening based on address-only inputs can be difficult and more error prone – whether automated or not – because address information is often unavailable, inaccurate (and/or misleading), incomplete, or duplicative between multiple tenants in the same building, all of which may lead to more false positives that require additional compliance resources to carefully resolve. Moreover, most companies only use address information today to resolve or corroborate potential hits that are based on name matches as the initial screening hit. Companies may now need to update their policies and screening protocols to include controls that can identify and triage searches and hits based on address information standing alone.

Taken together, these changes represent a significant effort to undermine Russian circumvention and smuggling networks, of which OFAC has already designated dozens, and highlights that a continuing focus of U.S. regulators is on such diversion routing through the greater China region. As BIS uncovers and lists these networks, it will be critical to ensure that it accurately identifies restricted end users.

These changes also complement OFAC’s June 12 designations, which took aim at third-country support to Russia’s military-industrial base. In addition to imposing sanctions on over 300 individuals and entities in and outside of Russia, OFAC expanded the scope of secondary sanctions risk facing foreign financial institutions that continue to engage in significant transactions supporting, or provide services to, Russia’s military-industrial base. As we noted previously, E.O. 14114 of December 22, 2023, introduced new secondary sanctions risk for foreign financial institutions that conduct or facilitate any significant transaction for certain categories of sanctioned persons or that provide any service involving Russia’s military-industrial base. On June 12, OFAC expanded the scope E.O. 14114 by including any significant transaction conducted or facilitated, or any service provided, by a foreign financial institution with any person, regardless of location or industry sector, that is subject to blocking sanctions under E.O. 14024.

The result of this coordinated action is that both U.S. and foreign entities – especially those operating as freight forwarders, shippers, or foreign financial institutions – should consider implementing heightened due diligence policies calibrated to reduce the risk of unlawful diversion to, or for the benefit of, Russia or Belarus, including, for example, by means of routing transactions through less-restricted jurisdictions or by falsifying bills of lading or other transaction documents to circumvent existing compliance processes and procedures.

The following Gibson Dunn lawyers prepared this update: Zach Kosbie, Nicole Martinez*, Samantha Sewall, Chris Timura, Chris Mullen, David Wolber, Stephenie Gosnell Handler, and Adam Smith.

United States:
Ronald Kirk – Co-Chair, Dallas (+1 214.698.3295, [email protected])
Adam M. Smith – Co-Chair, Washington, D.C. (+1 202.887.3547, [email protected])
Stephenie Gosnell Handler – Washington, D.C. (+1 202.955.8510, [email protected])
Christopher T. Timura – Washington, D.C. (+1 202.887.3690, [email protected])
David P. Burns – Washington, D.C. (+1 202.887.3786, [email protected])
Nicola T. Hanna – Los Angeles (+1 213.229.7269, [email protected])
Courtney M. Brown – Washington, D.C. (+1 202.955.8685, [email protected])
Chris R. Mullen – Washington, D.C. (+1 202.955.8250, [email protected])
Sarah L. Pongrace – New York (+1 212.351.3972, [email protected])
Anna Searcey – Washington, D.C. (+1 202.887.3655, [email protected])
Samantha Sewall – Washington, D.C. (+1 202.887.3509, [email protected])
Audi K. Syarief – Washington, D.C. (+1 202.955.8266, [email protected])
Scott R. Toussaint – Washington, D.C. (+1 202.887.3588, [email protected])
Claire Yi – New York (+1 212.351.2603, [email protected])
Shuo (Josh) Zhang – Washington, D.C. (+1 202.955.8270, [email protected])

*Nicole Martinez, an associate in the firm’s New York office, is not admitted in New York.

We are pleased to provide you with the June 2024 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

SEC Closes Ethereum 2.0 Investigation
On June 18, the SEC’s Enforcement Division notified Consensys that it was concluding its investigation into Ethereum 2.0 and that it would not recommend pursuing an enforcement action against Consensys on that basis. Consensys had sought confirmation from the SEC that the agency’s ETH ETF approvals in May meant that it did not view ether as a security. Consensys sued the SEC in April seeking a judicial determination that ether is not a security and that Consensys neither acts as a broker nor issues securities through its software offerings MetaMask Swaps and Staking. Consensys has said that it still intends to pursue its non-ether-related claims. Consensys; Consensys Post on X; CoinDesk; SEC Letter.
Crypto Exchange Gemini Reaches Settlement with New York Attorney General
On June 14, cryptocurrency platform Gemini Trust Company announced that it would be providing final distributions under its Earn program “representing the remaining 3% of the digital assets owed” as of the program’s suspension and had settled a case brought by New York Attorney General Letitia James concerning 230,000 investors who had enrolled in the initiative. Gemini posted on X that it was “excited to deliver this full recovery to you and appreciate your ongoing patience and support throughout this process.” Gemini denied any wrongdoing and agreed to pay $50 million to resolve allegations that investors were misled when invited to participate in the Earn program. Gemini Trust’s X Announcement; NY AG.
Terraform Labs and Former CEO Agree to Pay $4.5 Billion in Civil Penalties to SEC
On June 12, Judge Jed Rakoff of the U.S. District Court for the Southern District of New York approved a $4.5 billion settlement between the SEC, Terraform Labs, and the company’s former CEO, Do Kwon. In addition to disgorgement and civil penalties, the settlement permanently bans both Terraform and Do Kwon from buying and selling crypto asset securities, including those involving Terra ecosystem tokens. The settlement comes after a jury found both Terraform and Do Kwon liable for fraud stemming from the collapse of the Terra ecosystem. At present, Terraform is in Chapter 11 bankruptcy and reportedly has $150 million in assets on hand. CoinDesk; Reuters.
Epoch Times CFO Charged in $67 Million Crypto Money Laundering Scheme
On June 3, the Chief Financial Officer of Epoch Times, a multinational media company, was charged with conspiring to commit money laundering and two counts of bank fraud for his alleged involvement in a “transnational scheme” to launder $67 million of illegally obtained funds using cryptocurrency. According to the indictment, the CFO, Bill Guan, managed a team called “Make Money Online” under the company. The MMO team, along with others, used cryptocurrency to knowingly purchase tens of millions of dollars in crime proceeds, including proceeds of fraudulently obtained unemployment insurance benefits, which had been loaded on to prepaid debit cards. The MMO Team allegedly purchased the proceeds at a discount on an unnamed cryptocurrency exchange, moved the proceeds to bank accounts held by Epoch Times-affiliated entities, and laundered the proceeds through Guan’s personal accounts and cryptocurrency accounts. Guan faces charges that could put him in jail for a maximum of 80 years. DOJ Press Release; Decrypt.
New York Attorney Brings Suit Over Alleged $1 Billion Crypto Scheme
On June 6, New York Attorney General Letitia James filed a civil suit alleging that cryptocurrency firms NovaTech Ltd and AWS Mining Pty Ltd, as well as their promoters, defrauded over $1 billion from hundreds of thousands of victims, primarily from among Haitian and other immigrant communities. The lawsuit alleges that NovaTech received over $1 billion from investors over nearly four years before collapsing in May 2023, and that AWS Mining also allegedly defrauded investors before its 2019 collapse. The defendants, including NovaTech co-founders Cynthia and Eddy Petion, allegedly targeted victims through prayer groups, social media, and a messaging app, exploiting religious faith and community ties. Complaint; Reuters; CoinDesk.
“Evolved Apes” Videogame Developers Face SDNY Indictment
On June 6, the U.S. Attorney’s Office for the Southern District of New York charged three purported videogame developers from the UK with conspiracy to commit wire fraud and money laundering. The charges stem from their alleged involvement in a “rugpull” scheme associated with developing an “Evil Ape” NFT- and videogame-linked project. The defendants supposedly promised to develop a videogame linked to the NFT collection but failed to complete the project and diverted funds for personal gain. DOJ Press Release; CoinDesk.
Founders of Online Marketplace Empire Market Charged by DOJ
On June 14, two men, Thomas Pavey and Raheim Hamilton, were indicted by the U.S. Attorney’s Office for the Northern District of Illinois in federal court in Chicago for owning and operating Empire Market – a dark web online marketplace implicated in illicit transactions – from 2018 to 2020. The DOJ claims that the duo allegedly operated the marketplace using cryptocurrency as the exclusive form of payment and facilitated over $430 million in transactions involving drugs, counterfeit currency, and stolen credit card information. During the course of the investigation, federal law enforcement seized $75 million in cryptocurrency, along with fiat cash and precious metals. Arraignments have not yet been scheduled. The pair now face potential life imprisonment. DOJ Press Release; CoinDesk.
SEC Head of Crypto Assets and Cyber Unit Departs Agency
On June 17, David Hirsch, the head of the Crypto Asset and Cyber Unit for SEC’s Division of Enforcement, announced his departure after almost nine years at the agency and nearly two years as the unit’s chief. As lead of the unit, Hirsch pursued a number of high-profile crypto-related enforcement actions. A successor for Hirsch’s position had not been named as of publication. LinkedIn Post; Law360; Yahoo Finance; CoinDesk.

INTERNATIONAL

Roger Ver Posts Bail in Spain and Faces Extradition to the United States
On May 17, Roger Ver, a prominent Bitcoin investor and advocate widely known by the moniker “Bitcoin Jesus,” was released from jail in Spain after posting €150,000 ($163,000) in bail while awaiting possible extradition to the U.S. to face charges of mail fraud, tax evasion, and filing false tax returns. The U.S. Department of Justice alleges that Ver failed to report capital gains from his sales of Bitcoin and other assets, resulting in a loss of approximately $48 million to the IRS. If convicted, Ver faces up to 20 years in federal prison for each mail fraud count, 5 years for each tax evasion count, and 3 years for each false tax return count. Cointelegraph; Bloomberg; DOJ Press Release.

REGULATION AND LEGISLATION

UNITED STATES

SEC Chair Tells Senators that Ether ETFs Should be Fully Approved by September 2024
On June 13, U.S. Securities and Exchange Commission Chair Gary Gensler informed a subcommittee of the Senate Appropriations Committee in a hearing that full regulatory approval for spot Ether ETFs should be finished this summer. Specifically, Gensler noted that S-1 filings are now being handled at the “staff level” and that the registration process is “working smoothly.” The approval of these Ethereum ETFs should further open the market to these digital assets. Notably, Gensler did not commit to a position at the hearing when asked about whether the Ethereum asset is a commodity subject to the SEC’s jurisdiction. Bloomberg; CNBC.
President Biden Vetoes Resolution Overturning SEC Guidance
On May 31, President Joe Biden vetoed a Congressional bill that would have overturned the SEC’s crypto accounting guidance in Staff Accounting Bulletin 121, saying the measure would “inappropriately constrain” the agency’s ability to address future issues. SAB 121 is an SEC accounting guidance that directs financial institutions holding cryptocurrency for customers to keep the assets on their own balance sheets. Critics of SAB 121 say the guidance makes it difficult for financial institutions to work with crypto companies. The House previously voted 228-182 to pass the measure to repeal SAB 121, with mostly Republicans voting in favor of the measure along with 21 Democrats. The Senate also approved the measure 60-38, with 11 Democrats voting in favor of the repeal, including Majority Leader Chuck Schumer, D.-N.Y. Law360; CoinDesk; TheBlock; Cointelegraph; Decrypt.
Senate Intelligence Committee Approves Bill with Potential Implications for Digital Currencies
On May 22, the Senate intelligence committee unanimously approved The Intelligence Authorization Act for Fiscal Year 2025, a spending package that includes provisions targeting potential ties of terrorism to cryptocurrency. Led by Sen. Mark Warner’s staff, discussions with digital asset industry stakeholders have ensued regarding the provision’s implications. Industry insiders are concerned regarding the Act’s potentially broad impact on crypto businesses, possibly mandating extensive user identity verification to avoid sanctions. Industry stakeholders anticipate significant opposition during the bill’s progression through Senate and House deliberations, particularly given recent bipartisan support for less-restrictive crypto legislation. Legislation; CoinDesk; Politico.
Crypto Trading Firm Nabs NY BitLicense
On June 17, Cumberland DRW, a crypto trading firm and liquidity provider, announced that it had been granted a BitLicense by the New York Department of Financial Services, allowing it to operate a crypto business within the State of New York. The company claims that it is one of the only principal trading firms to have obtained such a crypto license in New York. Law360; Cumberland’s X Announcement; CoinDesk.

INTERNATIONAL

May 31 Deadline to Obtain Hong Kong Crypto Exchanges Licenses Expires
On June 1, the Hong Kong Securities and Futures Commission (“SFC”) non-contravention period for virtual asset trading platforms (“VATPs”) officially ended, meaning that all VATPs operating in Hong Kong must now be either licensed by the SFC or “deemed-to-be-licensed” VATP applicants under Hong Kong’s Anti-Money Laundering and Counter-Terrorist Financing Ordinance. In February 2024, the SFC mandated that all cryptocurrency exchanges must have either submitted operational license applications by February 29 or shut down operations in Hong Kong by May 31. Thus, as of May 31, all unlicensed exchanges, including those with refused or withdrawn license applications, are legally required to cease operations in the region immediately. During the grace period from when the mandate was issued, more than 22 cryptocurrency exchanges applied for licenses, but many of these ultimately decided to withdraw their applications before the deadline. As of May 31, 18 cryptocurrency exchanges had applied for an operational license in Hong Kong, but only two had been approved. SFC Statement; Cointelegraph; TheBlock; DailyCoin.
South Korea Unveils New NFT Regulatory Framework
On June 10, South Korea’s Financial Services Commission (FSC) introduced new guidelines for regulating NFTs to provide clarity on their regulatory status. The FSC will reportedly categorize certain NFTs as cryptocurrencies if they lose their unique characteristics, such as if they are mass-produced, exchangeable, capable of fractionalization, or used for payments. Conversely, NFTs that are non-transferable and of minimal economic value, like proof of transactions or event tickets, will be classified as NFTs. The guidelines aim to establish a framework ahead of South Korea’s broader crypto regulatory law, effective July 19. The Block; Bitcoinist.
UAE Central Bank Updates Stablecoin Regulatory Framework
On June 3, the Central Bank of the United Arab Emirates approved a new system for overseeing and licensing stablecoins, clarifying the issuance, licensing, and supervision of dirham-backed payment tokens. Payment tokens reportedly must be backed by UAE dirhams and cannot be linked to other currencies, digital assets, or algorithms. The move is part of the country’s financial infrastructure transformation program, which aims to boost digital transactions and drive innovation, and may also include the issuance of a central bank digital currency. Emirates News Agency – WAM; Cointelegraph.
Crypto Exchange Crypto.com Registers as Virtual Assets Service Provider in Ireland
On June 7, Crypto.com became listed as a virtual asset service provider (VASP) in Ireland, a member of the European Union. The decision allows the cryptocurrency exchange to offer crypto-to-fiat exchanges and fiat wallets. In addition, the registration allows the company to operate across all twenty-seven member states of the EU. The listing follows a recent trend of cryptocurrency exchanges who have sought licenses and regulatory approvals in multiple countries, including the Netherlands, Spain, the United Arab Emirates, and the United Kingdom. CoinDesk; Yahoo Finance.
Australia Bans Digital Currency for Online Gambling Platforms
On June 11, the Australian government began a push to prohibit digital currency use by online gambling platforms. New rules include a prohibition on using cryptocurrencies, digital wallets, and new forms of credit as payments on these platforms. In an interview, Australia’s Communications Minister explained that the ban is meant to prevent gambling-related issues, stating that “Australians should not be gambling with money they do not have.” Australians who do not comply with these new rules may face fines up to $234,750 Australian dollars (approximately $155,000 USD). NASDAQ; Cointelegraph; Canberra Times.
Zimbabwe Invites Cryptocurrency Service Providers to Comment on Best Regulatory Practices
On June 12, the government of Zimbabwe set up a committee to consult operators in the cryptocurrency space. The move is meant to “assess and understand the cryptocurrency landscape” to be “in line with global trends and best practices.” As a part of the committee’s efforts, the government has invited all cryptocurrency service providers that provide services to people in Zimbabwe to send comments to the committee by June 26. Yahoo Finance; Bloomberg; The Herald Coverage on X.
Taiwan Crypto Industry Association Formally Established After Regulatory Approval
On June 13, the Taiwan Virtual Asset Service Provider Association was formally established with a meeting between twenty-four cryptocurrency-related entities. In March 2024, Taiwan’s Interior Ministry approved the formation of the body, following moves to expand regulation of the crypto industry over the past two years. The Association reportedly aims to bridge the private and public sectors, and its first objective will be to formulate a self-regulation code for the industry. CoinDesk; Yahoo Finance; Taiwan News.

CIVIL LITIGATION

UNITED STATES

Fifth Circuit Vacates SEC’s Funds Rule Interpretation
On June 5, the Fifth Circuit struck down an SEC rule requiring hedge funds and private equity firms to disclose fees and expenses, holding that the SEC exceeded its statutory authority in doing so. The rule, issued in 2023, was challenged by six industry groups who argued that it violated the statute, would increase compliance costs, and would significantly change the sector’s operations. Although the ruling does not bear directly on digital assets, some commentators have suggested that the ruling might signal courts’ willingness to question the SEC’s claimed authority over digital assets as well. Fifth Circuit Opinion; Cointelegraph ; Law360.

INTERNATIONAL

JPEX Sued in Hong Kong
On June 4, two individuals filed a civil suit against digital currency exchange JPEX and other defendants, alleging fraud amounting to $1.6 billion Hong Kong dollars ($208 million USD). The lawsuit, filed in Hong Kong district court, seeks $1.8 million Hong Kong dollars ($236,500 USD) in damages per plaintiff. The case centers on three transactions the plaintiffs made into JPEX wallets totaling $110,500 USD in Tether and $130,000 USD in cash, which were swiftly transferred out of their wallets shortly after deposit. The suit follows a police investigation into JPEX launched in September 2023 for allegedly operating an unlicensed virtual asset trading platform. Over 2,000 complaints from victims reportedly have been received by Chinese authorities as of April 2024. South China Morning Post; Cointelegraph.

SPEAKER’S CORNER

UNITED STATES

RFK Jr. is “Happy” about Trump’s Crypto Commitment
On May 30, at a press conference in Austin, Texas, independent presidential candidate Robert F. Kennedy Jr. said that he is “happy about” Trump’s pro-crypto stance, stating, “I think it’s a good thing for our country. Commitment to crypto is a commitment to freedom and transparency.” RFK Jr. went on to stress the importance of “transactional freedom” in cryptocurrency regulation, saying that, “[w]e need to make sure America remains the hub of blockchain technology. I’m going to make sure cryptocurrency is regulated in a way that protects the consumer from deceptive schemes.” The presidential candidate further remarked that his “objective if elected president is that crypto is a transactional currency. That people can have transactional freedom.” He also noted that he had recently bought 21 bitcoins. RFK Jr. also has said previously that he wants to put the federal budget on the blockchain, and that he believes that Bitcoin is the “way to save the dollar.” CoinDesk; Business Insider; Blockworks.

INTERNATIONAL

Hong Kong Lawmaker Criticizes “Excessively Stringent” Crypto-Licensing Rules
On June 1, Duncan Chiu, a member of Hong Kong’s Legislative Council, raised concerns in an opinion piece published in the Hong Kong Economic Journal over the “excessively stringent” regulations for crypto exchanges to obtain a license, lamenting that these rules have pushed major global exchanges away from entering Hong Kong and have dampened market confidence. Chiu said that license application withdrawals with Hong Kong’s SFC reflected a major drawback in the current licensing system, and that recent license withdrawals of multiple global crypto exchanges have “shaken the confidence of market participants in Hong Kong’s push to develop Web3.” The SFC requires operators to meet standards similar to those for traditional financial institutions, which Chiu criticized as overly restrictive when applied to Web3 finance. TheBlock; Coinspeaker; FastBull.
Hong Kong Securities Commission CEO Speaks to Bitcoin’s Staying Power
On June 5, Julia Leung, CEO of Hong Kong’s SFC, highlighted Bitcoin’s resilience as an alternative asset during a speech at the Greenwich Economic Forum Hong Kong. She emphasized, “Bitcoin has survived multiple cycles of boom and bust, clearly showing its staying power as an alternative asset.” Leung acknowledged the speculative nature of virtual assets and underscored the SFC’s commitment to champion innovation and unlock new opportunities with digital currencies, distributed ledger technology, and fintech. SFC Speech; The Block.

OTHER NOTABLE NEWS

Over $300 Million in Bitcoin Stolen from Japanese Exchange DMM Bitcoin
On May 31, Japanese exchange DMM Bitcoin announced that more than $300 million in Bitcoin had been stolen from its wallets due to a hack of its servers. The exchange said that it would reimburse customers if necessary, saying in an English translation of a press release on its website that deposits “will be fully guaranteed,” but did not offer an immediate timeline. DMM Blog; TheBlock; Cointelegraph; Blockworks.
Project mBridge Reaches Minimum Viable Product Stage with Saudi Participation
On June 5, Project mBridge, a multi-central bank digital currency common platform for cross-border payments and settlements, reached minimum viable product stage, marking a significant milestone in its development aimed at revolutionizing cross-border payments. Launched in 2021 with collaboration between the BIS Innovation Hub and key central banks such as those of Thailand, UAE, China, and Hong Kong, the project now includes Saudi Arabia as a full participant. The platform, based on the mBridge Ledger and utilizing distributed ledger technology, seeks to enhance payment efficiency globally by enabling instant, cost-effective transactions with final settlement. Notable institutions involved include the Federal Reserve Bank of New York, World Bank, Bank of France, and the IMF. BIS Press Release; Reuters; CoinDesk.
Energy Sector Representative Testifies in Texas Senate that State Needs to Double Electrical Grid Capacity to Handle Bitcoin Mining
On June 12, in a Texas State Senate hearing, the CEO of the Electric Reliability Council stated that the state’s grid capacity would need to double in the next decade to handle expected demand from bitcoin mining and AI data centers. Specifically, the CEO stated that bitcoin mining and AI data centers will be responsible for more than half of the growth of Texas’ electricity grid. The testimony comes as the Lieutenant Governor of Texas, Dan Patrick, indicated that the Texas Senate would be taking a closer look at these companies, which he stated “produce very few jobs compared to the incredible demands they place on our grid.” CoinDesk.
European Union’s Innovation Hub for Internal Security Issues Report on Risk of Financial Crimes Using Cryptocurrencies
On June 10, the European Union Innovation Hub for Internal Security published its first report detailing challenges in tracing funds transferred using cryptocurrencies. The report, published as a joint effort by six EU Innovation Hub for Internal Security members, outlined various tools that individuals can use to mask cryptocurrency payments in service of crimes including money laundering. These tools, including privacy coins, mixers, and layer-2 platforms, can make it difficult for law-enforcement agencies to trace funds. CoinDesk; Cointelegraph.

The following Gibson Dunn attorneys contributed to this issue: Jason Cabral, Kendall Day, Jeff Steiner, Sara Weed, Chris Jones, Jay Minga, Nick Harper, Alfie Lim, Jessica Howard, Simon Moskovitz, Sophia Amir, and Narayan Narasimhan.

FinTech and Digital Assets Group Leaders / Members:

Ashlie Beringer, Palo Alto (+1 650.849.5327, [email protected])

Michael D. Bopp, Washington, D.C. (+1 202.955.8256, [email protected]

Stephanie L. Brooker, Washington, D.C. (+1 202.887.3502, [email protected])

Jason J. Cabral, New York (+1 212.351.6267, [email protected])

Ella Alves Capone, Washington, D.C. (+1 202.887.3511, [email protected])

M. Kendall Day, Washington, D.C. (+1 202.955.8220, [email protected])

Michael J. Desmond, Los Angeles/Washington, D.C. (+1 213.229.7531, [email protected])

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

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

Martin A. Hewett, Washington, D.C. (+1 202.955.8207, [email protected])

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

Stewart McDowell, San Francisco (+1 415.393.8322, [email protected])

Mark K. Schonfeld, New York (+1 212.351.2433, [email protected])

Orin Snyder, New York (+1 212.351.2400, [email protected])

Ro Spaziani, New York (+1 212.351.6255, [email protected])

Jeffrey L. Steiner, Washington, D.C. (+1 202.887.3632, [email protected])

Eric D. Vandevelde, Los Angeles (+1 213.229.7186, [email protected])

Benjamin Wagner, Palo Alto (+1 650.849.5395, [email protected])

Sara K. Weed, Washington, D.C. (+1 202.955.8507, [email protected])

From the Derivatives Practice Group: ISDA had an active week, submitting responses to the FSB Consultation on Liquidity Preparedness for Margin and Collateral Calls, the FCA Consultation on Sustainability Disclosure Requirements, and the FCA and BoE on the UK EMIR Refit.

New Developments

CFTC to Hold a Commission Open Meeting June 24. On June 17, CFTC Chairman Rostin Behnam announced the Commission will hold an open meeting on Monday, June 24 at 9:30 a.m. (EDT) at the CFTC’s Washington, D.C. headquarters. The Commission stated that at the meeting, it will consider final capital and financial reporting comparability determinations and orders for certain nonbank swap dealers domiciled in Japan, Mexico, the European Union (limited to France and Germany), and the United Kingdom. [NEW]
CFTC’s Global Markets Advisory Committee Advances Recommendations on Basel III Endgame and Variation Margin Processes. On June 4, the CFTC’s Global Markets Advisory Committee (GMAC) advanced two recommendations to examine the impacts of proposed U.S. bank capital requirements and to improve collateral and liquidity management for non-centrally cleared derivatives. The GMAC approved the two recommendations without objection.
U.S. Department of Treasury Releases Joint Policy Statement and Principles on Voluntary Carbon Markets. On May 28, the Biden-Harris Administration released a Joint Statement of Policy and new Principles for Responsible Participation in Voluntary Carbon Markets (the “Joint Statement”) announcing the U.S. government’s approach to further developing high-integrity voluntary carbon markets (“VCMs”). The Joint Statement announces seven principles, which are not exhaustive, that seek to codify and strengthen concepts and practices already developed market participants, governments and international bodies. The primary aim of these principles is to inform and support the continuing development of VCMs. On June 17, Gibson Dunn published an alert discussing the principles and key takeaways. [NEW]

New Developments Outside the U.S.

ESAs Propose Improvements to the Sustainable Finance Disclosure Regulation. On June 18, the three European Supervisory Authorities (EBA, EIOPA and ESMA – ESAs) published a Joint Opinion on the assessment of the Sustainable Finance Disclosure Regulation (SFDR). In the joint opinion, the ESAs call for a coherent sustainable finance framework that caters for both the green transition and enhanced consumer protection, considering the lessons learned from the functioning of the SFDR. [NEW]
ESAs Board of Appeal Renews its President’s Term and Elects a Vice-President. On June 13, the ESAs renewed the President and elected the Vice-President of the Board of Appeal, for a term of 2.5 years. Michele Siri, Professor of Insurance and Financial Markets Law, University of Genoa, Italy, was renewed as Board of Appeal’s President and Margarida Lima Rego, Associate Professor and Vice-Dean at NOVA School of Law, NOVA University, Portugal, was appointed as Board of Appeal’s Vice-President. [NEW]
ESMA Publishes 2023 Annual Report. On June 14, ESMA announced that it has published its Annual Report for 2023. ESMA stated that the report sets out the key achievements of the authority in the first year of implementing ESMA’s new 5-year strategy, delivering on the mission of enhancing investor protection and promoting stable and orderly financial markets in the European Union (EU). According to the report, ESMA’s key accomplishments during 2023 include enhancing supervisory convergence through peer reviews on the supervision of central counterparties (CCPs) and central securities depositories (CSDs), identifying areas for improvement and issuing recommendations to ensure consistent supervision across the EU, and monitoring retail investment markets and reporting on the costs and performance of retail investment products, highlighting cost reductions and variations across products and member states, and recommending that investors carefully evaluate costs and diversify investments. [NEW]
ESAs publish Joint Annual Report for 2023. On June 7, the Joint Committee of the European Supervisory Authorities (EBA, EIOPA and ESMA – the ESAs) published its 2023 Annual Report, providing an account of the joint work completed over the past year. The Joint Committee continued to play a coordinating role to facilitate discussions and the exchange of information across the three ESAs, the European Commission, and the European Systemic Risk Board (ESRB). The main areas of cross-sectoral focus were joint risk assessment, sustainable finance, digitalization, consumer protection, securitization, financial conglomerates, and central clearing. Among the Joint Committee’s main deliverables were policy products for the implementation of the Digital Operational Resilience Act (DORA) as well as ongoing work related to the Sustainable Finance Disclosure Regulation (SFDR).
ESAs and ENISA Sign a Memorandum of Understanding to Strengthen Cooperation and Information Exchange. On June 5, the ESAs announced that they have concluded a multilateral Memorandum of Understanding (MoU) to strengthen cooperation and information exchange with the European Union Agency for Cybersecurity (ENISA). This multilateral MoU formalizes the ongoing discussions between the ESAs and ENISA to strengthen their already close cooperation as a result of the Directive On Measures For A High Common Level Of Cybersecurity (NIS2 Directive) and the Digital Operational Resilience Act (DORA).
ESAs Call for Enhanced Supervision and Improved Market Practice on Sustainability-related Claims. On June 4, the ESAs published their Final Reports on Greenwashing in the financial sector. In their respective reports the ESAs reiterate the common high-level understanding of greenwashing as a practice whereby sustainability-related statements, declarations, actions, or communications do not clearly and fairly reflect the underlying sustainability profile of an entity, a financial product, or financial services. According to the ESAs, this practice may be misleading to consumers, investors, or other market participants. The ESAs stressed that financial market players have a responsibility to provide sustainability information that is fair, clear, and not misleading. While the ESAs’ reports focus on the EU’s financial sector, they acknowledge that addressing greenwashing requires a global response, involving close cooperation among financial supervisors and the development of interoperable standards for sustainability disclosures.
The EBA and ESMA Invite Comments on the Review of the Investment Firms Prudential Framework. On June 3, ESMA and the European Banking Authority (EBA) published a discussion paper on the potential review of the investment firms’ prudential framework. The discussion paper aims at gathering early stakeholder feedback to inform the response to the European Commission’s call for advice. The consultation runs until August 30, 2024. To assess the impact of the possible changes discussed in the paper, the EBA also launched a data collection exercise on a voluntary basis.

New Industry-Led Developments

ISDA Responds to FSB Consultation on Liquidity Preparedness for Margin and Collateral Calls. On June 18, ISDA submitted a response to the Financial Stability Board’s (FSB) consultation on liquidity preparedness for margin and collateral calls. The response notes that the recommendations are generally sensible and seek to incorporate a proportionate and risk-based approach. It also highlights a number of considerations relevant to the non-bank financial intermediation (NBFI) sector’s liquidity preparedness for margin and collateral calls. [NEW]
ISDA Responds to FCA Consultation on Sustainability Disclosure Requirements. On June 14, ISDA responded to the UK Financial Conduct Authority’s (FCA) consultation on sustainability disclosure requirements for portfolio management. ISDA stated that it supports the FCA taking a proportionate approach to the use of derivatives in sustainable investing. ISDA believes that it is important that recommendations on the treatment of derivatives, expected to be proposed by the European Union’s Platform on Sustainable Finance (PSF) by the end of 2024, are implemented consistently by the relevant authorities, including those in the UK. In the response, ISDA highlights several issues related to derivatives and makes recommendations. [NEW]
ISDA Responds to FCA and BoE on UK EMIR Refit. On June 12, ISDA submitted a response to the joint Bank of England and UK Financial Conduct Authority (FCA) consultation on part two of the UK European Market Infrastructure Regulation (UK EMIR) Refit reporting Q&A and proposed updates to validation rules. In the response, ISDA highlights several topics, including the reporting of equity resets, commodity basis swaps and excess collateral under UK EMIR. [NEW]
VERMEG Integrates Common Domain Model into COLLINE Collateral Management System. On June 10, ISDA announced that VERMEG, a technology provider for the banking and insurance sector, has integrated the Common Domain Model (CDM) into its COLLINE collateral management system to support the consumption of digitized regulatory initial margin (IM) credit support annexes (CSAs). ISDA stated that VERMEG is the first entity to integrate the CDM to improve the efficiency of collateral processes, with several other firms currently in testing.
Joint Response to BCBS G-SIB Window Dressing Consultation. On June 7, ISDA, the Global Financial Markets Association, and the Institute of International Finance submitted a joint response to the Basel Committee on Banking Supervision’s (BCBS) consultation on the revised assessment framework for global systemically important banks (G-SIBs). The associations believe the focus of the consultation – perceived window-dressing behavior – is not founded on robust evidence.
ISDA and SIFMA Submit Additional Proposal for US Basel III NPR Letter. On June 4, ISDA and the Securities Industry and Financial Markets Association (SIFMA) submitted an additional proposal to the US Basel III ‘endgame’ notice of proposed rulemaking (NPR). The proposal covers the look-through approach for equity investments in funds.

The following Gibson Dunn attorneys assisted in preparing this update: Jeffrey Steiner, Adam Lapidus, Marc Aaron Takagaki, Hayden McGovern, and Karin Thrasher.

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

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

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

Darius Mehraban, New York (212.351.2428, [email protected])

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

Adam Lapidus – New York (212.351.3869, [email protected] )

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

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

David P. Burns, Washington, D.C. (202.887.3786, [email protected])

Marc Aaron Takagaki , New York (212.351.4028, [email protected] )

Hayden K. McGovern, Dallas (214.698.3142, [email protected])

Karin Thrasher, Washington, D.C. (202.887.3712, [email protected])

SEC Expands Scope of Internal Accounting Controls to Encompass Companies’ Cybersecurity Practices in Recent Enforcement Action.

In another extension of the internal accounting controls provisions of the securities laws, this week the Securities and Exchange Commission (the “Commission” or “SEC”) announced a settled enforcement action with a public company victimized by a ransomware attack (the “Company”) for violations of Section 13(b)(2)(B) of the Exchange Act and Exchange Rule Rule 13a-15(a). According to the Commission’s order, the Company’s response to the late-2021 cyber incident showed that it had failed to (1) devise and maintain a sufficient “system of cybersecurity-related internal accounting controls” sufficient to provide reasonable assurances that access to its IT systems was only permitted with management’s authorization, in violation of Section 13(b)(2)(B); and (2) design effective disclosure controls and procedures for cybersecurity risks and incidents, in violation of Rule 13a-15(a). As part of the settlement, the Company agreed to pay a $2.125 million civil penalty, an amount which, according to the SEC’s announcement, took into account the Company’s “meaningful cooperation that helped expedite the staff’s investigation” and their voluntary adoption of “new cybersecurity technology and controls.”

The settlement is notable in two key respects:

It departs from the traditional disclosure-related theories that have underpinned previous settlements related to cyber incidents; and
It extends the internal accounting controls provisions of Section 13(b)(2)(B) of the Exchange Act, which the SEC has already used to resolve other financial reporting and disclosure cases, to a company’s IT systems, as well as related policies and procedures relating to cybersecurity.

The order reflects an aggressive stance by the Commission as to the scope of its authority and is an articulation of its belief that it can use authorities relating to internal accounting controls—namely Section 13(b)(2)(B) of the Securities Exchange Act—to regulate public companies’ cyber-related procedures (including vendor management and incident response) even in the absence of unauthorized access to a company’s financial or accounting systems.

The order was accompanied by a strongly-worded dissent from Commissioners Hester Peirce and Mark Uyeda, challenging this expansive interpretation of the SEC’s authority. Commissioners Peirce and Uyeda accused the Commission of “stretch[ing] the law” and “distort[ing]” the internal accounting controls provision to regulate public companies’ cybersecurity practices—including deeming any departure from what the Commission deems appropriate policies to be an internal accounting controls violation.

Background

For a period of approximately four weeks in 2021, the Company was the victim of a ransomware incident during which a threat actor was able to exfiltrate data belonging to 29 of the Company’s clients, including data containing personal identification and financial information. Notably, the investigation into the incident uncovered no evidence that financial systems or corporate financial and accounting data were accessed. The Company’s internal intrusion detection system began issuing alerts on the day the attack commenced, and the third-party managed security services provider (“MSSP”) tasked with reviewing these alerts escalated three of these alerts to the Company. The MSSP also reviewed, but did not escalate, at least 20 other alerts. In its escalation, the MSSP noted that there were indications that similar activity was taking place on multiple computers, that there were connections to a broad phishing campaign, and that the malware appeared capable of facilitating remote execution of arbitrary code. Personnel at the Company reviewed the escalated alerts but, in partial reliance on its MSSP, did not conduct its own investigation of the activity or remove infected instances off the network. The Company did not actively respond to the cyber-attack until it was alerted by another company with shared access to the Company’s network several weeks later. The Company then promptly undertook an extensive response operation, notified government agencies and clients, and issued public disclosures.

A novel and expansive interpretation of internal accounting controls in the cybersecurity context

The Commission’s order for the first time applies an already expansive view of internal accounting controls to the cybersecurity context. Specifically, Section 13(b)(2)(B)(iii) requires issuers to “devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that . . .access to assets is permitted only in accordance with management’s general or specific authorization.” In the order, the Commission found that the Company failed to devise and maintain “a system of cybersecurity-related internal accounting controls” sufficient to provide reasonable assurances that access to its “information technology systems and networks” was only permitted with management’s authorization. Asserting that information technology systems and networks are “assets” is a novel and an expansive interpretation of Section 13(b)(2)(B)(iii).

As noted in the dissent, this interpretation of what constitutes an “asset” “breaks new ground,” and there are arguments that this expansion runs contrary to the statutory language and policy. Commissioners Peirce and Uyeda noted that computer systems do not “fit the category of assets captured by Section 13(b)(2)(B)” because they “are not the subject of corporate transactions,” and that expanding the definition of “assets” in this way “ignores the distinction between internal accounting controls and broader administrative controls.” Notably, the Commission concluded that the computer systems at issue were “assets” despite the fact that the Company’s investigation into the incident “uncovered no evidence that the threat actor accessed the Company’s financial systems and corporate financial and accounting data.”

While the Commission has taken an increasing interest in cybersecurity incidents, the vast majority of its recent cybersecurity enforcement efforts have focused on companies’ disclosures (or lack thereof) of cybersecurity incidents. For example, in 2021, the SEC brought a settled enforcement action against a London-based public company finding that it misled investors about a cyber intrusion involving the theft of millions of student records. That action came on the heels of two similar enforcement actions in 2018 and 2019. Notably, the SEC did not bring any of these enforcement actions under either Section 13(b)(2)(B) of the Exchange Act or Exchange Act Rule 13a-15(a). Rather, all three of these actions alleged violations in line with more established SEC legal enforcement theories, namely that the companies in question had violated provisions of the Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933, which prohibits material misrepresentations in the offer or sale of securities, and Section 13(a) of the Exchange Act, which requires companies to file complete and accurate annual and quarterly reports with the Commission.

This latest action departs from the traditional disclosure-related theories that have underpinned these and other previous settlements related to cyber incidents, and instead extends the internal controls provisions of the Exchange Act to a company’s IT systems, as well as related cybersecurity policies and procedures. This expansive view of “accounting controls” in Section 13(b)(2)(B) represents yet a further extension of the Commission’s use of this provision to resolve financial reporting and disclosure cases (over the objection of Commissioners Peirce and Uyeda):

In a 2023 case, the Commission alleged that a company’s use of Rule 10b5-1 plans that included “accordion” provisions—which gave the company flexibility on when it could buy back stock—reflected that the company had “insufficient accounting controls.” In their dissent, Commissioners Peirce and Uyeda noted that “[w]e do not have the authority to tell companies how to run themselves, but we now routinely use Section 13(b)(2)(B) to do just that” and further noted that the company’s alleged failures had nothing to do with accounting controls as required by the statute.
In 2020, the Commission brought a similar case alleging violations of Section 13(b)(2)(B) in connection with a stock buyback (the allegation was that the company’s process to assess whether it was in possession of material non-public information at the time of the buyback was inadequate). In that case, Commissioner Peirce also issued a strongly worded dissent, noting that “the Order does not articulate any securities law violations.” Commissioner Peirce highlighted “the ease with which a violation of [Section 13(b)(2)(B)] can be alleged,” including “the lack of specific standards” “by which to evaluate the sufficiency of controls,” which mean that “even good faith corporate behavior may be scrutinized with 20/20 hindsight.”

What constitutes “sufficient” controls?

Despite finding fault with several aspects of the Company’s controls, the Commission did not provide guidance to companies seeking to ensure that their cybersecurity controls are sufficient to the Commission. In the settlement, the Commission alleged the following shortcomings:

Failure to escalate alerts to management. The Commission found that the Company’s procedures and controls were not designed to ensure that all relevant information relating to cybersecurity alerts and incidents would be provided to the Company’s disclosure decision-makers in a timely manner, which resulted in it failing to adequately assess the information from a disclosure perspective.
Deficiencies in vendor management. The Commission found several deficiencies in the Company’s management of its MSSP, including that the Company did not:
- reasonably manage their MSSP’s allocation of resources to reviewing intrusion detection alerts;
- “reasonably set out a sufficient prioritization scheme and workflow for review and escalation of the alerts” in its contract with its MSSP; and
- have sufficient oversight over its MSSP to ensure that its review and escalation of the cybersecurity alerts was consistent with the Company’s instructions.
Deficiencies in cyber incident policies and procedures. The Commission found that the Company’s internal incident response policies did not sufficiently identify lines of responsibility, criteria for incident prioritization, or procedures for incident response and reporting, nor did they ensure that relevant information was communicated to decision-makers in a timely manner to allow for potentially required disclosures. Notably, the Commission did not specify what policies would be sufficient in its view. The Commission also found that for alerts that were escalated to the Company, its staff members tasked with review of such alerts did not have sufficient time to dedicate to the escalated alerts because they had significant other responsibilities.

Disclosure controls and procedures

The Commission’s order also found that “[d]espite the importance of data integrity and confidentiality” to the Company, the Company failed to design effective disclosure-related controls and procedures around cybersecurity incidents to “ensure that relevant information was communicated to management to allow timely decisions regarding potentially required disclosure.” According to the order, the Company’s processes did not provide for how cyber-related incidents should be communicated to the Company’s “disclosure decision-makers” in a timely manner. As a result, the cyber incident was not adequately assessed from a disclosure perspective.

Practical implications

The Commission’s use of Section 13(b)(2)(B) of the Exchange Act to regulate public companies’ cyber-related procedures (including vendor management and incident response), even in the absence of unauthorized access to a company’s financial or accounting systems, suggests that public companies who are victims of cyber incidents may face further scrutiny from the Commission in the future.

As a practical matter, the lack of guidance from the SEC as to what they would find to be “reasonable” or “appropriate” presents significant challenges for companies looking to learn from this settlement and respond to the SEC’s expectations. This is perhaps a natural consequence of the SEC’s extension of Section 13(b)(2)(B) to a wholly unrelated area, as the letter of the law does not provide any guidance. Nonetheless, looking at the SEC’s area of focus in this settlement, companies can:

Ensure that policies governing cybersecurity and incident response:
- sufficiently identify lines of responsibility and authority;
- set out clear criteria for alert and incident prioritization; and
- establish clear workflows for cybersecurity alert review, incident response, and internal escalation and reporting, including to disclosure decision-makers.
Ensure that relevant contracts with third-party managed securities services providers set out a prioritization scheme and workflow for review and escalation of cybersecurity alerts.
Establish and maintain robust procedures to audit and oversee third-party managed securities services providers.

The following Gibson Dunn lawyers prepared this update: Sophie Rohnke, Sarah Pongrace, Sarah Scharf, Vivek Mohan, Mark Schonfeld, Stephenie Gosnell Handler, Michael Scanlon, Julia Lapitskaya, David Woodcock, and Tina Samanta.

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

Privacy, Cybersecurity and Data Innovation:
Ahmed Baladi – Paris (+33 (0) 1 56 43 13 00, [email protected])
S. Ashlie Beringer – Palo Alto (+1 650.849.5327, [email protected])
Stephenie Gosnell Handler – Washington, D.C. (+1 202.955.8510, [email protected])
Joel Harrison – London (+44 20 7071 4289, [email protected])
Jane C. Horvath – Washington, D.C. (+1 202.955.8505, [email protected])
Vivek Mohan – Palo Alto (+1 650.849.5345, [email protected])
Rosemarie T. Ring – San Francisco (+1 415.393.8247, [email protected])
Sophie C. Rohnke – Dallas (+1 214.698.3344, [email protected])

Securities Enforcement:
Tina Samanta – New York (+1 212.351.2469, [email protected])
Mark K. Schonfeld – New York (+1 212.351.2433, [email protected])
David Woodcock – Dallas/Washington, D.C. (+1 214.698.3211, [email protected])

Securities Regulation and Corporate Governance:
Elizabeth Ising – Washington, D.C. (+1 202.955.8287, [email protected])
Thomas J. Kim – Washington, D.C. (+1 202.887.3550, [email protected])
Julia Lapitskaya – New York (+1 212.351.2354, [email protected])
James J. Moloney – Orange County (+1 1149.451.4343, [email protected])
Ronald O. Mueller – Washington, D.C. (+1 202.955.8671, [email protected])
Michael Scanlon – Washington, D.C.(+1 202.887.3668, [email protected])
Lori Zyskowski – New York (+1 212.351.2309, [email protected])

Moore v. United States, No. 22-800 – Decided June 20, 2024

Today, in a case widely seen as a test of Congress’s ability to enact wealth taxes, the Supreme Court held narrowly that Congress did not violate the Sixteenth Amendment by requiring U.S. shareholders to pay a one-time tax on undistributed corporate earnings of controlled foreign corporations.

“[T]he precise and narrow question that the Court addresses today is whether Congress may attribute an entity’s realized and undistributed income to the entity’s shareholders or partners, and then tax the shareholders or partners on their portions of that income. This Court’s longstanding precedents, reflected in and reinforced by Congress’s longstanding practice, establish that the answer is yes.”

Justice Kavanaugh, writing for the Court

Background:

The 2017 tax law commonly known as the Tax Cuts and Jobs Act changed the taxation of corporations’ foreign earnings from what was largely a deferral system to what is now largely a current-inclusion system. As part of the transition to the new system, Congress enacted a one-time “mandatory repatriation tax” on U.S. shareholders that owned at least 10% of controlled foreign corporations. The tax deemed the corporations’ retained earnings going back to 1986 as 2017 income for their U.S. shareholders in proportion to the shareholders’ ownership stakes as of 2017. This tax was imposed, at reduced rates, regardless of whether the shareholders themselves had realized any income from the corporation through dividends or other payments.

Charles and Kathleen Moore were minority shareholders in an Indian company. The Moores incurred a $15,000 tax liability under the mandatory repatriation tax, despite having received no dividends or payments from the company. They paid the tax and sued for a refund, claiming that the mandatory repatriation tax violated the Sixteenth Amendment because it was not a tax on income and therefore had to be apportioned among the states according to population to pass constitutional muster. See U.S. Const., art. I, § 2, cl. 3; id. § 9, cl. 4. The District Court and Ninth Circuit disagreed, holding that the mandatory repatriation tax is a tax on income and that the Sixteenth Amendment permits taxing income that has not been realized.

Issue:

Does the mandatory repatriation tax violate the Sixteenth Amendment because it is not a “tax[] on incomes, from whatever source derived,” but instead is a direct tax that must be apportioned?

Court’s Holding:

No. The mandatory repatriation tax does not violate the Sixteenth Amendment because Congress could properly attribute the corporation’s undistributed income to its U.S. shareholders holding a 10% or greater ownership stake.

What It Means:

The Supreme Court emphasized that today’s holding is “narrow.” The Court reasoned that “longstanding precedents” establish that “when dealing with an entity’s undistributed income, Congress may tax either (i) the entity or (ii) its shareholders or partners.” Because the foreign corporation in this case realized the earnings at issue, the Court held only that Congress could properly attribute that income to the Moores based on their holding a 10% or greater ownership stake.
In upholding the mandatory repatriation tax, the Court noted that it “operates in the same basic way as Congress’s longstanding taxation of partnerships, S corporations, and subpart F income.”
Because the corporate income at issue had been realized, albeit by the corporation, not the Moores, the Court declined to decide whether the Sixteenth Amendment requires income or gain to be realized before it may be taxed. The Court further declined to decide whether the Sixteenth Amendment would permit various “wealth taxes” (i.e., taxes on the unrealized appreciation of property, savings accounts, or retirement plans). The Court also did not decide whether Congress could tax “both the entity and the shareholders or partners on the entity’s undistributed income.”
The Court acknowledged that the Due Process Clause limits Congress’s ability to attribute income from one entity or person to another and that Congress may not make “arbitrary” attribution decisions. The Moores did not raise this due process argument at the Supreme Court. It is possible, therefore, that, in future cases, taxpayers may be able to challenge the taxation of attributed income on due process grounds.
Four Justices would have held that the Sixteenth Amendment requires that income be realized before it may be taxed, a conclusion that would bar direct wealth taxes or other similar taxes on unrealized appreciation. Justice Barrett, joined by Justice Alito, concurred in the judgment upholding the tax because, on the question of attribution, she did not find a meaningful distinction between subpart F (which the Moores did not challenge) and the mandatory repatriation tax. Justice Thomas, joined by Justice Gorsuch, dissented and would have struck down the mandatory repatriation tax on the ground that it “is imposed merely based on the ownership of shares in a corporation,” rather than on income.

Gibson Dunn represented the Small Business and Entrepreneurship Council as Amicus Supporting Neither Party.

The Court’s opinion is available here.

Appellate and Constitutional Law Practice

Thomas H. Dupree Jr. +1 202.955.8547 [email protected]	Allyson N. Ho +1 214.698.3233 [email protected]	Julian W. Poon +1 213.229.7758 [email protected]
Lucas C. Townsend +1 202.887.3731 [email protected]	Bradley J. Hamburger +1 213.229.7658 [email protected]	Brad G. Hubbard +1 214.698.3326 [email protected]
Jonathan C. Bond +1 202-887-3704 [email protected]

Tax

Sandy Bhogal
+44 20 7071 4266
[email protected]

Eric B. Sloan
+1 212.351.5220
[email protected]

Global Tax Controversy

Michael J. Desmond +1 213.229.7531 [email protected]	Saul Mezei +1 202.955.8693 [email protected]	Sanford W. Stark +1 202.887.3650 [email protected]
Anne Devereaux* +1 213.229.7616 [email protected]

This alert was prepared by associates Tessa Gellerson and Zachary Tyree.

*Anne Devereaux, of counsel in the firm’s Los Angeles office, is admitted to practice in Washington, D.C.

This disciplinary action serves as a timely reminder regarding the importance of compliance with the Statutory Secrecy Prohibition and as an example of the SFC’s willingness to take decisive action against individuals who breach this provision.

On May 28, 2024, the Hong Kong Securities and Futures Commission (SFC) suspended Mr. Wong Ka Ching (Wong), the former responsible officer (RO) of China On Securities Limited (China On), for four years.[1] The SFC’s disciplinary action against Wong follows the SFC’s investigation into China On over its failures as placing agent in a share placement which took place in 2019. This resulted in a public reprimand and the imposition of a HK$ 6 million fine on China On.[2]

However, while Wong’s suspension is at least partially the result of the SFC’s conclusion that China On’s failures as a placing agent were attributable to Wong as an RO and member of senior management, the SFC also concluded that Wong acted contrary to section 378 of the Securities and Futures Ordinance (SFO) (the Statutory Secrecy Prohibition) by disclosing confidential information regarding the SFC’s investigation to a purported consultant of China On.[3] This disciplinary action serves as a timely reminder regarding the importance of compliance with the Statutory Secrecy Prohibition and as an example of the SFC’s willingness to take decisive action against individuals who breach this provision.

I. Summary of the Disciplinary Action

By way of background, China On acted as the placing agent in late 2019 for the then-majority shareholder (Vendor) of Hon Corporation Limited (Hon Corp) for the procurement of placees to subscribe for shares representing up to 45% of Hon Corp’s total issued share capital (Shares) (the Share Placement). China On and the Vendor agreed that the total placing price for the Shares would be HK$57.24 million (i.e. HK$0.265 per share.)

Following an investigation, the SFC found that China On had failed to a) act within the scope of the Vendor’s authority, and b) adequately safeguard the Vendor’s assets in the course of identifying potential placees for the Share Placement. The SFC found that China On’s failures in this regard occurred with Wong’s consent or connivance, or were attributable to neglect on Wong’s part as an RO and a member of the senior management of China On. The SFC also found that Wong acted negligently or recklessly in handling the Placement, and failed to ensure that China On adhered to appropriate standards of conduct.

However, the SFC also found that Wong had breached the Statutory Secrecy Prohibition by disclosing information about the SFC’s investigation to a ‘dubious consultant’, referred to by the SFC only as “X”.

In its Statement of Disciplinary Action, the SFC noted that Wong had alleged that he had been heavily reliant on X for China On’s compliance and operational matters, and had granted X full access to China On’s front office, back office and accounting systems for this purpose. This was despite the fact that X had no formal agreement with China On and was not a licensed representative or member of senior management of China On. Further, Wong admitted to the SFC that he did not know anything about X’s background or qualifications other than that X had apparently represented to him that he had been licensed by the SFC. According to Wong, X also insisted that his remuneration for his work for China On be paid in cash or through third parties, and switched his phone number and WeChat every one to three months so to avoid detection by regulators.

Despite this, the SFC found that Wong had provided copies of the SFC’s letters and investigation notices to China On to X, and had sought advice and assistance from X in responding to the SFC’s investigation of this matter. Wong did this even though the SFC’s letters and investigation notices include (as a matter of course) prominent warnings to recipients about the consequences of breaching the Statutory Secrecy Prohibition by disclosing this correspondence to others. The SFC concluded that as a result of this, Wong had contravened the Statutory Secrecy Prohibition under section 378(7) of the SFO.

The SFC also concluded that Wong had procured, or at least allowed, China On to represent to the SFC that X had no relationship with China On or its management, and that he had had no involvement in the Share Placement. This was information that was false or misleading in a material particular. As such, its provision to the SFC in the course of the SFC’s investigation was contrary to the requirements under section 384(1) of the SFO.

II. The Statutory Secrecy Prohibition

By way of reminder, the Statutory Secrecy Prohibition is the legal requirement that a person to whom the Statutory Secrecy Prohibition applies must not (unless an exception applies):

disclose any matter coming to their knowledge –
1. by virtue of the person’s appointment under certain specified provisions of the SFO and other related ordinances (Relevant Provisions);[4]
2. in performing any function or exercising any power under any of the Relevant Provisions;
3. in carrying into effect or doing anything required or authorized under any of the Relevant Provisions; or
4. in the course of assisting a person who falls within (b) or (c);
communicate any such matter referred to in 1) to any other person; and
allow any person to have access to any information or document in their possession as a result of 1)a), b), c) or d).

In addition, where information is disclosed under 1)b) or c) above to any person, that person and anyone who receives such information directly or indirectly from him will also be bound by the Statutory Secrecy Prohibition.

Importantly, the persons to whom the Statutory Secrecy Prohibition applies includes not only the SFC and its staff, but also any person assisting the SFC in performing its functions. In an investigations context, the latter category includes any person assisting the SFC in relation to its investigative functions, including by providing a record, document or information required to be produced to the SFC under sections 179 or 181, or providing information and/or attending an interview with the SFC under section 183 of the SFO.

In practice, what this means is that individuals who are the subject of an investigation by the SFC, or who are otherwise assisting the SFC in its investigations (e.g. by cooperating with SFC notices or other requests) must not disclose any information regarding the SFC’s investigation to any person unless an exception to the Statutory Secrecy Prohibition applies.

There are seven exceptions to the Statutory Secrecy Prohibition, which allow for the disclosure of information in the following circumstances:

Disclosure of information already made available to the public;
Disclosure for the purpose of any criminal proceedings in Hong Kong;
Disclosure for the purpose of seeking professional advice from, or giving advice by, a counsel or solicitor, or other professional adviser acting or proposing to act in a professional capacity in relation to any matter arising under any of the Relevant Provisions;
Disclosure in connection with court proceedings to which the person is a party;
Disclosure in accordance with a court order or a law or legal requirement;
Disclosure to the Hong Kong Deposit Protection Board for the purpose of assisting the Board to perform its functions; and
Disclosure by the auditors of a listed corporation to the SFC, the Hong Kong Monetary Authority or the Insurance Authority under section 381 of the SFO.[5]

A breach of the Statutory Secrecy Prohibition is a criminal offence. If convicted, the person who breached the secrecy obligation is liable for a maximum fine of HK$1 million and imprisonment for up to two years upon indictment, and a maximum fine of HK$100,000 and imprisonment for up to six months upon summary conviction. Further, as seen from this case, the SFC may well take into consideration breaches of the Statutory Secrecy Prohibition in imposing disciplinary action on licensed persons.

III. The Importance of Maintaining Secrecy

The Statutory Secrecy Prohibition is one of the key distinguishing factors of the Hong Kong regulatory landscape, and is a key aspect of the SFC’s investigative arsenal. The SFC has stated publicly that it views the Statutory Secrecy Obligation as a safeguard of, relevantly:

the public interest that the SFC should not be compromised in its operations and the pursuit of its regulatory objectives by the leakage of confidential information;
the right of all persons, whether individuals or corporations, to be presumed innocent until proven guilty; and
the reputation of individuals and the goodwill of firms investigated by the SFC or undergoing disciplinary proceedings.[6]

Given these matters, it is unsurprising that the SFC takes breaches and/or suspected breaches of the Statutory Secrecy Prohibition very seriously. The disciplinary action taken against Wong in this case serves as an important reminder of the importance of strictly adhering to the Statutory Secrecy Prohibition and of the SFC’s willingness to discipline individuals for failure to comply with the Statutory Secrecy Prohibition.

Given this, we recommend that SFC licensed firms review their policies and procedures in relation to the handling of information in relation to SFC investigations, and take care to ensure that information flows in relation to investigations comply with the Statutory Secrecy Prohibition. In particular, we recommend reviewing policies and procedures in relation to the reporting of information to parent companies and/or other offshore entities in relation to ongoing SFC investigations to protect against inadvertent breaches of the Statutory Secrecy Prohibition by individuals based in Hong Kong.

__________

[1] “SFC suspends Wong Ka Ching for four years”, published by the SFC on May 28, 2024, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=24PR94.

[2] “SFC reprimands and fines China On Securities Limited $6 million for failures as share placement agent”, published by the SFC on May 18, 2023, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=23PR50.

[3] Section 378, Securities and Futures Ordinance, available at: https://www.elegislation.gov.hk/hk/cap571?xpid=ID_1438403472414_002.

[4] The Relevant Provisions consist of (a) the provisions of the SFO; (b) Parts II and XII of the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap 32) dealing with the performance of functions relating to prospectuses; (c) Part 5 of the Companies Ordinance (Cap 622) dealing with the buy-back by a corporation of its own shares, or a corporation giving financial assistance for the acquisition of its own shares; and (d) Part 2 (except section 6) of the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap 615).

[5] Under section 378(7) of the SFO, notwithstanding the seven exceptions listed above, a person can also disclose information subjected to the Statutory Secrecy Prohibition by seeking the SFC’s consent. Application for the SFC’s consent should be made in writing, stating the full extent of a) the information sought to be disclosed, b) the persons to whom it is proposed to be disclosed and c) the reasons for the proposed disclosure. In particular, the SFC has clarified that the following disclosures can be assumed as permissible, and therefore not a breach of the Statutory Secrecy Prohibition, without the need to make any formal application for the SFC’s consent: 1) the fact that a person is bound by the secrecy obligation; 2) the general nature of the matter which has given rise to the secrecy obligation; 3) the means by which the person came to be bound by the secrecy obligation (e.g., by virtue of receiving an investigator’s notice under section 183 of the SFO); and 4) the date, time and place at which the person is required to provide information or documents to the SFC, or to attend an interview by an SFC investigator. Note that the disclosure under 4) can only be made to an individual’s employer or spouse; or where the individual is a regulated person, his firm’s responsible officer, executive officer, compliance officer or in-house lawyer. Where the person is a corporation, disclosure under 4) is limited to the corporation’s board of directors, its holding company or indemnity insurers. See “Secrecy Provisions”, published by the SFC, available at: https://www.sfc.hk/en/Regulatory-functions/Enforcement/Secrecy-provisions.

[6] “Secrecy Provisions”, published by the SFC, available at: https://www.sfc.hk/en/Regulatory-functions/Enforcement/Secrecy-provisions.

The following Gibson Dunn lawyers prepared this client alert: William Hallatt, Emily Rumble, and Jane Lu.

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

William R. Hallatt (+852 2214 3836, [email protected])
Emily Rumble (+852 2214 3839, [email protected])
Arnold Pun (+852 2214 3838, [email protected])
Becky Chung (+852 2214 3837, [email protected])
Jane Lu (+852 2214 3735, [email protected])

A quarterly update of high-quality education opportunities for Boards of Directors of public and private companies.

Gibson Dunn’s summary of director education opportunities has been updated as of June 2024. A copy is available at this link. Boards of Directors of public and private companies find this a useful resource as they look for high quality education opportunities.

This quarter’s update includes a number of new opportunities as well as updates to the programs offered by organizations that have been included in our prior updates. Some of the new opportunities are available for both public and private companies’ boards.

Read More

The following Gibson Dunn attorneys assisted in preparing this update: Hillary Holmes, Julia Lapitskaya, Lori Zyskowski, Elizabeth Ising, and Ronald Mueller, with assistance from Caroline Bakewell and Ben Blefeld.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. To learn more, please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Securities Regulation and Corporate Governance practice group, or the following authors:

Hillary H. Holmes – Houston (+1 346.718.6602, [email protected])
Elizabeth Ising – Washington, D.C. (+1 202.955.8287, [email protected])
Julia Lapitskaya – New York (+1 212.351.2354, [email protected])
Ronald O. Mueller – Washington, D.C. (+1 202.955.8671, [email protected])
Lori Zyskowski – New York (+1 212.351.2309, [email protected])

Please also view Gibson Dunn’s Securities Regulation and Corporate Governance Monitor.

Gibson Dunn’s ERISA litigation update summarizes key legal opinions and developments during the past year to assist plan sponsors and administrators navigating the rapidly changing ERISA litigation landscape.

This past year was another busy one for Employee Retirement Income Security Act (“ERISA”) litigation, including significant activity at the United States Supreme Court and the federal courts of appeals on issues impacting retirement and healthcare plans, coupled with the promulgation of new regulations affecting ERISA plan sponsors and administrators.

Our Annual ERISA Litigation Review and Outlook summarizes key legal opinions and developments to assist plan sponsors and administrators navigating the rapidly changing ERISA litigation landscape.

Section I highlights two notable cases pending before the United States Supreme Court addressing the scope of the Chevron doctrine and the implications for ERISA plans if Chevron deference is curtailed or eliminated.

Section II provides an update on two decisions from the Third Circuit, and one from the Second Circuit, concerning the enforceability of arbitration provisions and class action waivers in ERISA plans.

Section III then explores other noteworthy legal developments for ERISA-governed retirement plans, including how federal courts are implementing the Supreme Court’s holdings in Hughes v. Northwestern Univ., 595 U.S. 170 (2022), and TransUnion LLC v. Ramirez, 594 U.S. 413 (2021); a growing circuit split on the scope of ERISA’s prohibited transaction provisions; and, an update on the lawsuits challenging the Department of Labor’s environmental, social, and governance (“ESG”) investment rulemaking.

Section IV offers an overview of litigation and rulemaking impacting employer-provided health and welfare plans, such as the Tenth Circuit’s application of Rutledge v. Pharmaceutical Care Management Association, 141 S. Ct. 474 (2020), to hold that ERISA preempts an Oklahoma law regulating pharmacy benefit managers; decisions from the courts of appeal concerning appropriate remedies under ERISA and the scope of the Mental Health Parity and Addiction Equity Act; and, proposed and final regulations implementing the No Surprises Act that are likely to have significant implications for ERISA health plans moving forward.

And finally, Section V looks ahead to key ERISA issues and cases that we expect to see litigated this year.

I. Supreme Court Activity Concerning the Chevron Doctrine

We have been closely monitoring two related pending Supreme Court cases pertaining to the Chevron doctrine—under which courts defer to an agency’s reasonable interpretation of its governing statute if the statute is ambiguous—that carry significant implications for ERISA plans. See Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837, 842–44 (1984). In Loper Bright Enterprises v. Raimondo, No. 22-451, and a companion case, Relentless, Inc. v. Department of Commerce, No. 22-1219, the Supreme Court is deciding whether to overturn or narrow the scope of this long-standing administrative law principle.

The Chevron doctrine has made it easier for agencies to withstand challenges to their legal interpretations, with one study finding that agencies prevail 25% more often when Chevron deference is applied than when it is not, and another concluding that courts that find the statute ambiguous uphold the agency view 89% of the time. Cong. Research Serv., R44954, Chevron Deference: A Primer 15 & n.143 (2023) (collecting sources). By contrast, under a related doctrine called Skidmore deference, courts will accord weight to the agency’s view, but only to the extent the agency’s interpretation is persuasive. Justice Kagan questioned whether Skidmore would have any impact on how cases are actually decided, as it leaves courts free to disregard agency interpretations they find unpersuasive. E.g., Transcript of Oral Argument at 32:17–23, Loper Bright Enters. v. Raimondo, No. 22-451 (U.S. Jan. 17, 2024) (“Tr.”) (Kagan, J.) (“Skidmore, I mean, what does Skidmore mean? Skidmore means, if we think you’re right, we’ll tell you you’re right. So the idea that Skidmore is going to be a backup once you get rid of Chevron, that Skidmore means anything other than nothing, Skidmore has always meant nothing.”).

At argument, the Court also raised questions about how overruling Chevron would affect regulations previously deemed valid. See Tr. at 20–22. One possible outcome is that these regulations will be subject to renewed challenges, which could launch a wave of litigation challenging these regulations under the new framework.

Chevron deference comes into play for ERISA plans because ERISA grants the Secretary of Labor the authority to issue regulations to implement and enforce its provisions. See 29 U.S.C. § 1135. Over the years, the Department of Labor has issued and revised a number of regulations covering a wide range of ERISA issues, including, inter alia, fiduciary responsibilities owed by plan administrators and the minimum requirements for ERISA plans, and the Department’s 2022 rule concerning environmental, social, and governance (ESG) investing that we discussed in our March 2023 review. Moreover, the Pension Benefit Guaranty Corporation “generally receives Chevron deference for its authoritative interpretation of ambiguous provisions of ERISA.” Vanderkam v. Pension Ben. Guar. Corp., 943 F. Supp. 2d 130, 145 (D.D.C. 2013), aff’d sub nom. VanderKam v. VanderKam, 776 F.3d 883 (D.C. Cir. 2015).

For example, in Vanderam, neither side argued that ERISA unambiguously supported a PRBC determination that a different survivor annuity beneficiary could not be substituted pursuant to a domestic relations order, but the court found the determination to be “a reasonable and permissible interpretation of ERISA” and upheld the decision. Id. at 145–46. And in National Association for Fixed Annuities v. Perez, the court upheld new regulations relating to conflicts of interest in retirement investing, finding there was no “affirmative indication” Congress intended to prohibit the interpretation and that the Department of Labor’s interpretation of ERISA provision was reasonable. 217 F. Supp. 3d 1, 27–30 (D.D.C. 2016).

The Loper Bright case is of particular interest in the ERISA context because, in the decision under review, the D.C. Circuit relied in part on the Secretary of Commerce’s general rulemaking authority to promulgate regulations “necessary and appropriate” to further the legislation’s aims relating to Atlantic fishing monitorships to uphold the regulation. See Loper Bright Enterprises, Inc. v. Raimondo, 45 F.4th 359, 363–69 (D.C. Cir. 2022). Because ERISA uses similar language to authorize the Secretary of Labor to implement regulations “necessary or appropriate” to carry out ERISA, see 29 U.S.C. § 1135, a ruling affirming the D.C. Circuit’s reasoning could potentially be used by the Department of Labor in defense of future regulations that impose substantial economic costs on plans and plan sponsors, even if ERISA by its terms does not clearly authorize the agency to impose those costs.

The Supreme Court typically issues opinions for a given term by the end of June, and we are closely monitoring and will report the Court’s opinions on this important issue.

II. An Update on Arbitrability of ERISA Benefits Claims

The arbitrability of ERISA Section 502(a)(2) fiduciary-breach claims continues to be a frequently litigated issue. As we detailed in our 2020 and 2021 year-end updates, the Ninth Circuit’s decision in Dorman v. Charles Schwab Corp., 934 F.3d 1107 (9th Cir. 2019), overturned decades of case law that had held that ERISA fiduciary-breach suits could not be arbitrated. Id. at 1111–12. In response to Dorman, companies have increasingly incorporated arbitration provisions into their ERISA plans. And as we reported in our 2022 update, courts across the country have since faced complicated arbitration issues. This year, two Third Circuit decisions and one Second Circuit decision on ERISA arbitrability are of particular interest.

First, in Henry ex rel. BSC Ventures Holdings, Inc. Employee Stock Ownership Plan v. Wilmington Trust, 72 F.4th 499 (3d Cir. 2023), the Third Circuit found a class action waiver in a plan arbitration clause to be unenforceable because it “purport[ed] to waive plan participants’ rights to seek remedies expressly authorized by” ERISA § 409(a). Id. at 507. The class waiver in Henry “prohibited a claimant from ‘seek[ing] or receiv[ing] any remedy which has the purpose or effect of providing additional benefits or monetary or other relief’ to anyone other than the claimant.” Id. at 503. The court held that this language effectively barred plan participants from pursuing “benefits or monetary relief” on behalf of the plan as a whole, removal of plan fiduciaries, and “such other equitable or remedial relief as the court may deem appropriate,” which are all forms of relief statutorily available under ERISA. Id. at 507 (citing 29 U.S.C. § 1109(a)). Although the Third Circuit recognized that federal law generally favors arbitration, it noted that agreements to arbitrate are not enforceable where they “prohibit[] a litigant from pursuing his statutory rights in the arbitral forum.” Id. at 506. And because the class waiver was not severable from the arbitration provision itself due to a non-severability clause, the court held that “the entire arbitration provision must fall with the class action waiver,” and affirmed the district court’s order declining to enforce the provision. Id. at 508.

Second, in Berkelhammer v. ADP TotalSource Group, Inc., 74 F.4th 115 (3d Cir. 2023), the Third Circuit addressed whether participants must consent to arbitrate claims brought on a plan’s behalf under ERISA § 502(a)(2) and held that the plan (not participants) must consent. Id. at 120. Plaintiffs in Berkelhammer brought claims against a plan fiduciary committee, among others, for fiduciary breach “on behalf of the plan” under ERISA § 502(a)(2), claiming poor investment performance caused monetary losses to their retirement plan. Id. at 117. In response, the committee sought to enforce an arbitration clause in the plan’s service contract with a third-party investment advisor that provided advice on the plan’s investment strategy. Id. Plaintiffs argued that their claims could not be compelled into arbitration because they had not consented to arbitrate. Id. But the district court rejected this argument, concluding that arbitration was required because the plan had already consented to arbitrate. Id. The Third Circuit affirmed, holding that under ERISA § 502(a)(2), which authorizes plan participants to bring claims “on behalf of a plan,” plaintiffs’ claims “belong to the Plan, [so] the Plan’s consent to arbitrate controls.” Id. at 119–20. Notably, because the dispute in Berkelhammer did not implicate any class waiver, the case did not reach the issue that was ultimately dispositive in Henry.

Third, in Cedeno v. Sasson, No. 21-2891, 2024 WL 1895053 (2d Cir. May 1, 2024), the Second Circuit ruled that a plan arbitration provision limiting the relief available in an arbitration proceeding to remedies impacting only the participant’s own account and forbidding any relief that would benefit any other employee, participant, or plan beneficiary was unenforceable. Id. at *1. The plaintiff in Cedeno brought claims “on behalf of the plan” against the company, its trustee, and other defendants under ERISA § 502(a)(2). Id.. Defendants moved to compel arbitration, pointing to the plan’s arbitration provision. Id. at *4. The district court concluded that the arbitration agreement was unenforceable because it prevented participants from pursuing plan-wide remedies under § 502(a)(2). Id. The Second Circuit affirmed, holding that “[b]ecause [plaintiff’s] avenue for relief under ERISA is to seek a plan-wide remedy, and the specific terms of the arbitration agreement seek to prevent [plaintiff] from doing so, the agreement is unenforceable.” Id. at *5. In reaching its conclusion, the Second Circuit pointed to recent decisions from other courts of appeal—including, among others, the Third Circuit’s Henry opinion—as support for its conclusion “that the challenged provisions in the arbitration agreement operate as an impermissible prospective waiver of the plaintiff’s statutory rights.” Id. at *15–*17.

As Henry, Berkelhammer, and Cedeno illustrate, a plan must consent to arbitrate claims brought on its behalf under ERISA § 502(a), but limiting the relief available in arbitration to remedies impacting only a plaintiff’s own account may risk invalidation of the arbitration clause in its entirety absent language making clear that the challenged provisions are severable. Thus, plan administrators should closely evaluate the implications of express severability clauses in plan arbitration provisions.

III. Further Important Developments Concerning ERISA-Governed Retirement Plans

In addition to litigation concerning Chevron deference and arbitrability, other legal and regulatory changes in 2023 had significant impact on ERISA-governed retirement plans.

A. How Courts Interpret the Pleading Standard Post-Hughes

As we addressed in our 2022 update, the Supreme Court reiterated in Hughes v. Northwestern Univ., 595 U.S. 170, 177 (2022) (“Hughes”) that “excessive fees” fiduciary breach suits under ERISA must satisfy the pleading standard set out in Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007) and Ashcroft v. Iqbal, 556 U.S. 662 (2009). The Supreme Court also reiterated that because an ERISA duty of prudence claim “‘turns on the circumstances . . . prevailing at the time the fiduciary acts,’” any inquiry into the sufficiency of the pleadings “‘will necessarily be context specific.’” Id. (quoting Fifth Third Bancorp v. Dudenhoeffer, 573 U.S. 409, 425 (2014)). Recent decisions from the Seventh and Tenth Circuits help to illustrate what “context” a plaintiff must show to survive a Federal Rule 12(b)(6) pleading challenge.

On remand, the Seventh Circuit in Hughes v. Northwestern Univ., 63 F.4th 615 (7th Cir. 2023), held that “to plead a breach of the duty of prudence under ERISA, a plaintiff must plausibly allege fiduciary decisions outside a range of reasonableness.” Id. at 630. This standard, the Seventh Circuit explained, requires plaintiffs to “provide enough facts to show that a prudent alternative action was plausibly available” but not that the prudent alternative action was “actually available.” Id. Applying this standard, the Seventh Circuit found the plaintiffs in Hughes to have adequately pled their imprudence claims by alleging that materially similar but lower cost investment options and recordkeeping services were available in the marketplace but not adopted by plaintiffs’ plan. Id. at 633–34. However, the Court cautioned that the inquiry was context specific and claims “in a future case may or may not survive dismissal based on different pleadings and the specific circumstances facing the ERISA fiduciary.” Id. at 634.

Likewise, in Matney v. Barrick Gold of North America, 80 F.4th 1136 (10th Cir. 2023), the Tenth Circuit relied on the Supreme Court’s guidance in Hughes and held that to establish that investment or recordkeeping fees are plausibly excessive, a “meaningful benchmark” is required, and whether a benchmark is “meaningful” will “depend on context because ‘the content of the duty of prudence’ is necessarily ‘context specific.’” Id. at 1148 (citing Hughes, 595 U.S. at 177). Specifically, in the context of an excessive investment fees claim, the Tenth Circuit explained that a plaintiff must allege that “the alternative investment options have similar investment strategies, . . . objectives, or . . . risk profiles.” Id. In the context of an excessive recordkeeping fees claim, a plaintiff must allege “that the recordkeeping services rendered by the [benchmark plans] are similar to the services offered by the plaintiff’s plan.” Id. Because plaintiffs’ complaint in Matney lacked this level of factual detail, it failed to state a claim, and was therefore properly dismissed. Id. at 1149.

At bottom, the Hughes decision directs courts that there is no ERISA-specific pleading standard for fiduciary-breach claims and plaintiffs must satisfy the plausibility requirements set forth in Twombly and Iqbal. But, as the Hughes and Matney decisions make clear, defendants have a path for challenging the sufficiency of plaintiffs’ pleadings where plaintiffs have failed to allege facts showing meaningfully similar, but lower cost, alternatives were plausibly available in the marketplace.

B. Potential Circuit Split in How Courts Are Applying TransUnion in Assessing Class-Member Standing

In our 2021 update, we addressed how federal courts were implementing the Supreme Court’s decision in TransUnion LLC v. Ramirez, 594 U.S. 413, 431 (2021), which held that “Article III does not give federal courts the power to order relief to any uninjured plaintiff, class action or not.” This year, the Fifth Circuit in Chavez v. Plan Benefits Servs., Inc., 77 F.4th 370 (5th Cir. 2023), identified a potential circuit split regarding how this holding should be applied to class member standing challenges in ERISA fiduciary breach suits.

The issue in Chavez was whether a class could be certified of participants in benefit plans administered by defendant where the named plaintiffs did not participate in some of those plans. Id. at 378. Defendants argued that certification in that context was improper because it allowed the plaintiffs “to challenge fees that they were never subjected to, in plans that they never participated in, relating to services that they never received, from employers for whom they never worked.” Id. at 378. The Fifth Circuit noted that “whether a class representative may seek to litigate harms not precisely analogous to the ones she suffered but harms that were nonetheless suffered by other class members” is a point of disagreement among the circuits and summarized the differing approaches. Id. at 379 (citation omitted).

Under the “class certification approach” adopted by the First, Third, Sixth, and Ninth Circuits, if a “class representative has standing to pursue her own claims,” then the standing inquiry is settled and any remaining concerns regarding disjuncture between the representative and putative class members (including dissimilarity in injuries suffered) are approached “as an issue of class certification”—e.g., as part of the Rule 23(a) commonality analysis. Id. at 380 (citation omitted). In contrast, the Second and Eleventh Circuits have adopted different variations of the “standing approach,” and hold that if a class representative did not “possess the same interest and suffer the same injury as the class members,” then “the class representative lacks standing to pursue [such] claims,” and the claims should be dismissed on Article III grounds. Id. at 380, 383 (citation omitted).

Ultimately, the Fifth Circuit declined to take a position in Chavez because, there, the court concluded that plaintiffs’ claims “wholly implicate the same concerns with respect to each member of the class that [p]laintiffs seek to represent,” so certification could be supported under either of the competing approaches. Id. at 386 (citation omitted).

A recent example of how courts analyze Article III standing in ERISA fiduciary breach suits after TransUnion can be seen in Lucero v. Credit Union Retirement Board, 2024 WL 95327 (W.D. Wisc. Jan 9, 2024), where the court concluded that plaintiffs’ failure to demonstrate concrete injury across the putative class doomed their certification bid. There, plaintiffs brought claims on behalf of their plan under ERISA §§ 502(a)(2) and 409, alleging that they were charged excessive recordkeeping fees. Id. at *1. But the record in the case showed that three of the four named plaintiffs in fact paid recordkeeping fees in a range that plaintiffs themselves alleged was reasonable. Id. at *2. Relying on TransUnion, the court found the three plaintiffs lacked Article III standing, ruling that “‘[o]nly those plaintiffs who have been concretely harmed by a defendant’s statutory violation may sue that private defendant over that violation in federal court.’” Id. (quoting TransUnion, 594 U.S. at 427). Defendants also argued that the remaining plaintiff could not satisfy Rule 23(a)’s adequacy and typicality requirements because she paid different fees than other putative class members. Id. at *3–*4. The court agreed, finding that the class lacked the necessary “congruence between the investments held by the named plaintiff and those held by members of the class[] she wishes to represent.” Id. at *5, *6 (citation omitted).

We will continue to monitor this potential circuit split as the law continues to develop. For now, the Supreme Court’s TransUnion opinion, and the decisions interpreting it, give ERISA defendants paths for challenging Article III standing and class certification where named plaintiffs have not suffered the same injury as the putative class.

C. Growing Split on the Scope of ERISA’s Prohibited Transaction Clause

Late last year, the Ninth and Second Circuits issued published decisions addressing the scope and application of ERISA’s prohibited transaction provisions. As the Second Circuit recognized, there appears to be a growing split between the Third, Seventh, and Tenth Circuits on the one hand, and the Eighth and Ninth Circuits on the other hand, concerning whether a plan fiduciary engages in a prohibited transaction under ERISA § 406(a)(1)(C) simply by entering into a routine, arm’s-length agreement with a third party for plan services such as recordkeeping or investment consulting. Litigants in both cases have filed petitions for writs of certiorari with the Supreme Court. If the Court takes up one or both cases, it will have the opportunity to provide meaningful guidance to plan sponsors and administrators concerning what ERISA requires when a plan contracts with third party service providers.

As background, ERISA § 406(a)(1)(C) prohibits plan fiduciaries from involving plans and assets in certain kinds of business deals, including a prohibition against the “furnishing of goods, services, or facilities” between a plan and a “party in interest.” 29 U.S.C. § 1106(a)(1)(C). A “party in interest” of an employee benefit plan is defined to include “a person providing services to such plan.” 29 U.S.C. § 1002(14)(B). ERISA § 408(b)(2) exempts certain transactions between a plan and a “party in interest” from § 406’s prohibitions if: (1) the contract or arrangement is reasonable, (2) the services are necessary for the establishment or operation of the plan, and (3) no more than reasonable compensation is paid for the services. 29 U.S.C. § 1108(b)(2).

In Bugielski v. AT&T Services, Inc., 76 F.4th 894(9th Cir. 2023), the Ninth Circuit held that contract amendments executed between defendants and a service provider to provide investment advising services and access to a brokerage window were prohibited transactions under section 406(a)(1)(C) because defendants “cause[d] the plan to engage in [] transaction[s]” that constituted “furnishing of goods, services, or facilities between the plan and a party in interest.” Id. at 900–01. In so ruling, the court rejected the reasoning of other courts of appeal—including Sweda v. Univ. of Penn., 923 F.3d 320 (3d Cir. 2019) and Albert v. Oshkosh Corp., 47 F.4th 570 (7th Cir. 2022)—which more narrowly construe the prohibition against “furnishing services” based on concerns that a broad construction of the statute would hinder fiduciaries’ ability to contract with third parties for essential plan services. Id. at 906–07. The Ninth Circuit concluded that remand was necessary for the district court to consider whether the prohibited transactions satisfied the exemption in ERISA § 408(b)(2) that a “party in interest”—here, the third-party service provider—received no more than “reasonable compensation” from all sources for its services to the plan. Id.

Subsequently, in Cunningham v. Cornell University, 86 F.4th 961, 973–74 (2d Cir. 2023), the Second Circuit acknowledged the split that the Ninth Circuit deepened in Bugielski and took a different approach entirely. The Court held that to plead a violation of § 406(a)(1)(C), a “complaint must plausibly allege that a fiduciary has caused the plan to engage in a transaction that constitutes the ‘furnishing of . . . services . . . between the plan and a party in interest’ where that transaction was unnecessary or involved unreasonable compensation.” Id. at 975 (quoting 29 U.S.C. §§ 1106(a)(1)(C), 1108(b)(2)(A)) (original emphasis). The court explained that this interpretation of ERISA’s prohibited transaction provisions as “incorporate[ing]” the exemptions, and “flow[ing] directly from the text and structure of the statute.” Id. The court then affirmed dismissal of plaintiffs’ prohibited transaction claims because plaintiffs had not alleged that the transactions were unnecessary or that the compensation tendered was unreasonable. Id. at 978.

We expect ERISA’s prohibited transaction rules will continue to be a highly litigated area this year, and the developing circuit split may pave the way to a Supreme Court decision in this area. Indeed, plaintiffs filed a petition for certiorari in the Cunningham case, and the Supreme Court requested briefing from defendant, suggesting it may be interested in taking up that case. Defendants also filed a petition in the Bugielski case on April 9, 2024. Should the Court grant either or both of these petitions, it would have the opportunity to further define and clarify ERISA’s requirements for plans contracting with third parties for routine plan services.

D. An Update on the Department of Labor’s ESG Rulemaking

As addressed above in Section I, and as discussed in our 2021 and 2022 updates, the Department of Labor (“DOL”) has been actively engaged in rulemaking concerning environmental, social, and governance (“ESG”) investing for the better part of a decade. Specifically, our update last year focused on the final rule released by the DOL on November 22, 2022 (the “2022 Rule”). Last year’s update also highlighted two lawsuits that challenge the 2022 Rule, Utah v. Walsh and Braun v. Walsh.

In Utah v. Walsh, the 2022 Rule was upheld, and an appeal is now pending. In that case, attorneys general from 25 states filed sued to prevent the 2022 Rule from taking effect. Utah v. Walsh, 2023 WL 6205926, at *1 (N.D. Tex. Sept. 21, 2023). In denying the challenge and ruling for the DOL, the district court applied the two-step framework outlined in Chevron USA Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984),and held that the 2022 Rule did not violate ERISA. The court first analyzed “whether Congress has directly spoken to the precise question at issue,” and found that it had not. 2023 WL 6205926, at *4 (quotation omitted). The court then concluded that the 2022 Rule was a reasonable interpretation of ERISA and “the reasonableness of DOL’s interpretation [wa]s supported by its prior rulemakings.” Id. at *4-*5. The court also held that the 2022 Rule was not arbitrary or capricious under the Administrative Procedure Act because, among other reasons, the DOL reasonably concluded, based on the rulemaking record, that the prior rule could have “a chilling effect on fiduciaries’ consideration of pertinent information when making investment decisions.” Id. at *6. On October 26, 2023, the plaintiffs filed a notice of appeal to the Fifth Circuit, and the appeal is now fully briefed. The Fifth Circuit has tentatively scheduled oral argument for the week of July 8, 2024.

Additionally, as we reported last year, a group of participants in ERISA-regulated retirement plans filed suit in the Eastern district of Wisconsin claiming that the 2022 Rule violates ERISA and exceeds the statutory authority granted to the Secretary of Labor and DOL. See Braun v. Walsh, No. 23-cv-234 (E.D. Wisc.). Since our last report, plaintiffs filed a motion for preliminary injunction and temporary restraining order. No. 23-cv-234, Dkt. 8. As of the time of this publication, the motion is fully briefed and awaiting decision by the court.

We will continue to monitor the legal and regulatory landscape surrounding the 2022 Rule and the changing role of ESG factors in plan sponsor and fiduciary decision making.

IV. Key Developments for Health & Welfare Plans

ERISA-governed health benefit plans remain an active source of litigation. This year, the Tenth Circuit issued a significant decision applying Rutledge v. Pharmaceutical Care Management Association, 141 S. Ct. 474 (2020), to hold that ERISA preempts an Oklahoma law regulating pharmacy benefit managers. The federal courts of appeals also continued to grapple with whether “reprocessing” is an appropriate remedy under ERISA, and whether monetary relief is available for claims brought under ERISA § 502(a)(3). Litigation over the Mental Health Parity and Addiction Equity Act also continued to be active this year, particularly in the Tenth Circuit. And, finally, proposed and final regulations implementing the No Surprises Act are likely to have significant implications for ERISA health plans moving forward.

A. Tenth Circuit Holds That ERISA Preempts Oklahoma Law Regulating Pharmacy Benefit Managers

In recent years, litigation involving pharmacy benefit managers (“PBM”) has become a fertile area for development of case law regarding ERISA preemption. PBMs act as third-party intermediaries between health plans and various entities in the prescription drug supply chain, including manufacturers and pharmacies. As states increasing seek to regulate PBMs, a number of recent decisions involving PBMs have addressed ERISA preemption.

The Supreme Court addressed this issue four years ago in Rutledge v. Pharmaceutical Care Management Association, 141 S. Ct. 474 (2020), holding that ERISA did not preempt a state law regulating the maximum allowable cost (“MAC”) lists that PBMs use to determine the rate at which PBMs reimburse pharmacies for covered prescription drugs. Since then, lower courts have struggled with the implications of Rutledge for other state laws, including other laws regulating PBMs’ interactions with pharmacies.

This year, the Tenth Circuit addressed that issue in Pharmaceutical Care Management Association v. Mulready, 78 F.4th 1183 (10th Cir. 2023), holding that ERISA preempts certain provisions of the Oklahoma Patient’s Right to Pharmacy Choice Act (“the Act”). Enacted in 2019, the Act sought to regulate the network of pharmacies with which PBMs contract by requiring PBMs “to admit every pharmacy that is willing to accept the PBM’s preferred-network terms into that preferred network,” (“network restrictions”), id. at 1183, and by preventing PBMs from denying or terminating “a pharmacy’s contract because one of its pharmacists is on probation with the Oklahoma State Board of Pharmacy” (“probation prohibition”), among other things, id. at 1201–02.

The Pharmaceutical Care Management Association (“PCMA”), a trade association representing PBMs, challenged these provisions, arguing that they were preempted by ERISA because they effectively regulated plans’ decisions about the structure of their coverage networks, and thus effectively prevented plan administrators from administering their plans in a uniform manner. Id. at 1197. The Tenth Circuit agreed, holding that the Act’s network restrictions “have an impermissible connection with ERISA plans”—and are therefore preempted—because they “effectively abolish the two-tiered network structure, eliminate any reason for plans to employ mail-order or specialty pharmacies, and oblige PBMs to embrace every pharmacy into the fold.” Id. at 1196, 1199. The court likewise concluded that ERISA preempted the Act’s probation prohibition because “limiting the accreditation requirements that a PBM may impose on pharmacies as a condition for participation in its network . . . affect[s] the benefits available by increasing the potential providers” and “eliminates the choice of one method of structuring benefits.” Id. at 1203–04. The Tenth Circuit distinguished Rutledge on the grounds that the Arkansas law there—governing MAC pricing—was a “mere cost regulation” and “ERISA does not pre-empt state rate regulations that merely increase costs or alter incentives for ERISA plans without forcing plans to adopt any particular scheme of substantive coverage.” Id. at 1199–00.

In reaching these holdings, the Tenth Circuit also rejected Oklahoma’s argument that the Act is not preempted because “it regulates PBMs, not health plans,” and plans are not required to contract with PBMs. Id. at 1194. Instead, the Tenth Circuit held that a “state law can affect ERISA plans even if it does not nominally regulate them,” and that “state laws can relate to ERISA plans even if they regulate only third parties.” Id. at 1194. The application of ERISA preemption to state laws that nominally regulate plan-affiliated entities such as PBMs and claims administrators is a recurring issue in a variety of settings, so the Tenth Circuit’s holding on this issue is likely to be relevant beyond the PBM context.

Finally, the Tenth Circuit contrasted its holding with the Eighth Circuit’s decision in Pharmaceutical Care Management. Association v. Wehbi, 18 F.4th 956 (8th Cir. 2021), which upheld a North Dakota that “resemble[d]” the probation prohibition in Oklahoma. Mulready, 78 F.4th at 1203. The Tenth Circuit found “Wehbi’s limited reasoning unhelpful” because Wehbi had failed to “assess the law’s effects on the structure of the provider network and connected effect on plan design.” Id. at 1203. In light of the Tenth Circuit’s disagreement with Wehbi, it is reasonably likely that Oklahoma will seek Supreme Court review of the Mulready decision. The deadline for to seek certiorari has now been extended to May 10, 2024.

B. Courts of Appeal Continue to Grapple With Reprocessing as a Remedy

In last year’s update, we reported on the Ninth Circuit’s January 2023 decision in Wit v. United Behavioral Health, 58 F.4th 1080 (9th Cir. 2023), a significant decision of the increasingly litigated topic of “reprocessing” class actions—a strategy that gained steam over the past years as a way to challenge ERISA benefits decisions on a class-wide basis. Since that update, on August 22, 2023, the Ninth Circuit issued an amended decision that preserved the January decision’s bottom-line holding largely reversing the judgment in favor of the class, while providing further nuance regarding the law of reprocessing in the Ninth Circuit. See 79 F.4th 1068 (9th Cir. 2023).

The plaintiffs in Wit were beneficiaries of several ERISA-governed health benefit plans who filed suit on behalf of three putative classes, representing nearly 70,000 coverage determinations under as many as 3,000 different plans. 58 F.4th at 1088. Defendant United Behavioral Health (“UBH”) acted as the claims administrator for these plans, and for a subset of plans, also as the insurer. Id. The plaintiffs had all submitted coverage requests that UBH denied after applying certain “guidelines” that UBH had developed to implement the governing plans’ coverage criteria—including, among other things, a requirement that treatment be consistent with generally accepted standards of care (“GASC”), and that treatment not fall into other exclusions from coverage. See id. at 1088–89. The plaintiffs alleged that UBH breached fiduciary duties and improperly denied benefits by applying guidelines that were more restrictive than GASC. Id. at 1089. To avoid individualized fact questions that otherwise would have precluded class certification, the plaintiffs framed the relevant injury as the use of an unfair “process,” and disclaimed any attempt to prove that the use of that guidelines-based process actually caused the improper denial of benefits—seeking instead only “reprocessing” under new guidelines as relief. See id.

Over the course of several years, the district court certified the plaintiffs’ requested class, held a bench trial, and entered judgment for the plaintiffs. 58 F.4th at 1090–91. The court concluded that UBH had violated ERISA by employing guidelines that impermissibly deviated from GASC, and it ordered prospective injunctive relief for up to ten years—requiring the use of new guidelines going forward—and “reprocessing” of class members’ tens of thousands of past claims under those new guidelines. Id.

As addressed in last year’s publication, the Ninth Circuit reversed in large part in January 2023. It held first that the district court erred in certifying claims seeking “reprocessing” because “reprocessing” is not a remedy available under either of the provisions of ERISA on which the plaintiffs relied—29 U.S.C. §§ 1132(a)(1)(B) and 1132(a)(3). See 58 F.4th at 1094. As the court explained, “[a] plaintiff asserting a claim for denial of benefits must [] show that she may be entitled to a positive benefits determination if outstanding factual determinations were resolved in her favor.” Id. By certifying the class without requiring such a showing, the district court impermissibly used Rule 23 to enlarge or modify the plaintiffs’ substantive rights, in violation of the Rules Enabling Act, 28 U.S.C. § 2072(b). Id. Plaintiffs’ requested “reprocessing” also fell outside the scope of § 502(a)(3), which provides a cause of action for “‘appropriate equitable relief’”—meaning the type of “relief that, traditionally speaking (i.e., prior to the merger of law and equity) were typically available in equity.” Id. (internal citations omitted) (emphasis in original). The panel explained that plaintiffs offered no basis for concluding that reprocessing was relief “typically” available in equity. Id.

Finally, the Ninth Circuit held that, contrary to the district court’s ruling, absent class members cannot be excused from complying with the plans’ administrative exhaustion requirements. 58 F.4th at 1097. The court explained that when an ERISA plan specifies that beneficiaries must exhaust administrative remedies before seeking relief in court, courts are required to enforce those contractual requirements, and cannot create judicial exceptions to compliance. See id. at 1098.

The plaintiffs subsequently sought rehearing, and the Ninth Circuit replaced its January opinion with a new one in August. 79 F.4th at 1086. As it had previously, the court held that the district court abused its discretion by concluding that reprocessing is a remedy available under § 502(a)(3), explaining that reprocessing is not “appropriate equitable relief” for fiduciary breach claims brought under that provision because it was not “typically available in equity.” Id. at 1086.

Moreover, the Ninth Circuit again held that class certification was improper regarding the plaintiffs’ denial of benefits claims because the proposed classes included participants whose claims were denied based on UBH guidelines that the plaintiffs had not challenged or based on reasons other than the UBH guidelines. See id. at 1085–86. As the Ninth Circuit explained, “[a]n individual plaintiff who demonstrated an error in the Guidelines would not be eligible for reprocessing without at least some showing that UBH employed an errant portion of the Guidelines that related to his or her claim.” Id. at 1086.

Applying an abuse of discretion standard, the Ninth Circuit found that UBH’s interpretation that the plans did not require coverage for all care “consistent with GASC” did not conflict with the plans’ language, and thus reversed the district court’s judgment to the extent it relied on the conclusion that the plans required coverage for all care consistent with GASC. Id. at 1088. The court also remanded the case back to the district court regarding whether plaintiffs’ fiduciary duty claim was subject to the plans’ administrative exhaustion requirement and, if so, whether unnamed claim members satisfied that requirement. Id. at 1089.

The implications of Wit for reprocessing class actions remains a live issue even in the Ninth Circuit—and even in Wit itself, where the district court has permitted the plaintiffs to file a renewed motion for class certification in light of the Ninth Circuit’s decision. See No. 3:14-cv-2346, Dkt. 625, at 46-49 (N.D. Cal. Dec. 18, 2023). The plaintiffs have indicated that they intend in that motion to seek certification of a slightly narrow class seeking reprocessing for nearly all of the class that the Ninth Circuit ordered decertified in Wit. See id., Dkt. 617, at 10 (N.D. Cal. Nov. 20, 2023); id., Dkt. 626, at 26 (N.D. Cal. Dec. 15, 2023). In response, UBH has filed a petition for writ of mandamus asking the Ninth Circuit to hold that its August 2023 decision bars the plaintiffs from seeking to revive their reprocessing class action through a renewed motion for class certification. See United Behavioral Health v. U.S. Dist. Ct., No. 24-242, Dkt. 1.1 (9th Cir. Jan. 12, 2024). On April 26, 2024, the same panel that decided UBH’s original appeal (and thus the same panel that issued the August 2023 decision) ordered the plaintiffs to respond to UBH’s mandamus petition by May 17, 2024. See id., Dkt. 12.1 (9th Cir. Apr. 26, 2024). Plaintiffs have filed their response, and UBH filed their reply on May 22, 2024. As of this publication, the Ninth Circuit has not yet ruled on UBH’s mandamus petition.

The Tenth Circuit also weighed in on reprocessing in a pair of decisions last year, ruling on August 15, 2023 that reprocessing was appropriate for an individual plaintiff in David P. v. United Healthcare Insurance Co., 77 F.4th 1293, 1299 (10th Cir. 2023). The Tenth Circuit agreed with the district court that the Defendants’ claims processing procedure was deficient because it failed to “engage with the opinions of” the patient’s treating providers. Id. at 1309–10. But it rejected the Plaintiffs’ argument that in light to this asserted defect, the district court should simply “outright gran[t] Plaintiffs their claimed benefits.” Id. at 1315. Instead, the court agreed with the Defendants that the district court should remand “Plaintiffs’ claims for benefits” to the plan administrator “for proper consideration.” Id.

This decision adds further clarity to the standard articulated by the Tenth Circuit in D.K. v. United Behav. Health, 67 F.4th 1224, 1229 (10th Cir. 2023). In D.K., the court held that it was not an abuse of discretion for a district court to award benefits directly to the plaintiffs instead of remanding the claim decision to the plan administrator for reprocessing. Id. at 1244. The court explained that awarding benefits directly may be appropriate “when the record shows that benefits should clearly have been awarded by the administrator” or when the administrator’s actions were “clearly arbitrary and capricious.” Id. at 1243. Applying that standard, the Tenth Circuit held that remand was unnecessary because the Defendant had committed too many “repeated procedural errors” to warrant “an additional ‘bite at the apple.’” Id. at 1244. In contrast, in David P., the Tenth Circuit held that remand was the appropriate remedy because the record was insufficient to clearly establish that plaintiffs were entitled to the benefits they sought. 77 F.4th at 1315. These cases illustrate the ongoing challenge of determining when remand is appropriate in an individual denial of benefits case.

C. Fourth Circuit Addresses Whether Monetary Relief Is Available Under § 502(a)(3)

Plaintiffs seeking monetary relief following a denial of benefits received a mixed ruling from the Fourth Circuit in Rose v. PSA Airlines, Inc., 80 F.4th 488 (4th Cir. 2023). There, the Fourth Circuit held that an unjust enrichment claim for monetary relief may proceed only if the plaintiff can allege specific traceable profits retained as a result of the wrongful act. In Rose, the administrator of a deceased beneficiary’s estate brought a wrongful denial of benefits claim under ERISA § 502(a)(1)(B) and a breach of fiduciary duty claim under § 502(a)(3), alleging that plan administrators wrongfully refused to cover a heart transplant and seeking monetary relief under both claims. See id. at 492–94. According to the complaint, the plan administrators first denied coverage on the basis that the treatment was experimental and later on the basis that an alcohol-abuse exception precluded coverage, but an external review ultimately determined that the transplant should have been covered. See id. at 493–94. The district court granted the plan administrators’ motion to dismiss, concluding that monetary compensation is not a benefit “due” “under the terms of [the] plan” and ERISA does not provide generally for compensatory, “make-whole” monetary relief under § 502(a)(3). Id. at 493.

On appeal, the Fourth Circuit affirmed the dismissal of the § 502(a)(1)(B) denial of benefits claim, explaining that the only benefit “due” under the plan was the transplant itself. See id. at 495. Therefore, the beneficiary was limited to seeking either an injunction requiring the plan to cover the surgery beforehand or reimbursement for out-of-pocket expenses had he obtained the transplant and paid for it out of pocket, not the “monetary cost of the benefit that was never provided.” See id. (emphasis in original).

The bulk of the court’s analysis focused on the § 502(a)(3) claim, which it remanded. That section allows a beneficiary to seek “other appropriate equitable relief” to “redress” a violation of the plan’s terms. 29 U.S.C. § 1132(a)(3). The court explained that the Supreme Court has construed this provision to only allow for relief that would be “typically available in equity.” Rose, 80 F.4th at 498–500 (emphasis in original) (quoting Montanile v. Bd. of Trustees of Nat. Elevator Indus. Health Benefit Plan, 577 U.S. 136, 142 (2016)). As it pertains to monetary relief, the court determined that equity would allow a plaintiff who can “point[] to specific funds that he rightfully owned but that the defendant possessed as a result of unjust enrichment” to recover, id. at 500, whereas a plaintiff claiming broader “relief that amounts to personal liability paid from the defendant’s general assets” cannot, id. at 502. In reaching that conclusion, the court determined that the Supreme Court’s guidance in CIGNA Corp. v. Amara, 563 U.S. 421 (2011), that ERISA might allow for more general “‘make-whole,’ loss-based, monetary relief under § 502(a)(3),” was mere dicta that had been later disavowed by the Supreme Court, and the court declined to follow prior Fourth Circuit decisions that could potentially permit the broader claim for relief. Rose, 80 F.4th at 502–03 (citing Montanile, 577 U.S. at 148 n.3). Thus, the court held that only a plaintiff who can point to “specifically identified funds that remain in the defendant’s possession or . . . traceable items that the defendant purchased with the funds” can possibly recover those “unjust gains.” Id. at 504. In this case, because the plaintiff had alleged that “the defendants have been unjustly enriched by keeping the money they should have paid [the beneficiary]’s doctors,” id. at 496, the court remanded to the district court to consider whether the plaintiff had plausibly alleged that the “defendant was unjustly enriched by interfering with [the beneficiary]’s rights and (2) that the fruits of that unjust enrichment remain in the defendant’s possession or can be traced to other assets.” Id. at 504–05 (footnote omitted).

Judge Heytens wrote a separate opinion agreeing with the majority’s treatment of the § 502(a)(1)(B) claim and its ruling that the “502(a)(3) claim should be remanded for further proceedings.” Id. at 505 (Heytens, J., concurring in part and dissenting in part). But he disagreed with the majority’s treatment of the law of the circuit, explaining that the Supreme Court’s statements in Montanile did not undermine the dicta in Amara that the Fourth Circuit had previously adopted on the merits. Id. at 507. Thus, he would not have required the beneficiary to “show traceability” in order to obtain relief. Id.

Following this opinion, the plaintiff petitioned for certiorari, which the Supreme Court denied. Minute Entry, Rose v. PSA Airlines Inc., No. 23-734 (U.S. Apr. 15, 2024).

Ultimately, the Fourth Circuit’s ruling suggests a fairly narrow and perhaps difficult path for financial recovery for such claims. We will continue to follow related developments in lower courts following this decision.

D. Courts of Appeal Address the Scope of the Parity Act

The Mental Health Parity and Addiction Equity Act (the “Parity Act”) is a federal law that generally prevents group health plans and health insurance issuers that provide mental health or substance use disorder benefits from imposing less favorable benefit limitations on those benefits than on medical/surgical benefits. Recent litigation regarding the scope of the Parity Act reflects an increased focus by the plaintiffs’ bar on seeking access to behavioral health treatment, mental health treatment, and substance use disorder treatment through Parity Act claims.

In E.W. v. Health Net Life Insurance Co., the Tenth Circuit partially reopened a suit by a plan participant who accused his insurer of wrongfully refusing coverage for his daughter’s in-patient care. 86 F.4th 1265 (10th Cir. 2023). The plaintiff alleged that the insurer unlawfully treated mental health treatment differently from medical and surgical care, in violation of the Parity Act. Id. at 1278–79, 1289. Defendants argued that they did not provide unequal coverage for mental health care in comparison to other types of treatment and instead plaintiffs had failed to identify the medical necessity criteria, dooming their claim. Id. at 1289. The district court agreed, resulting in dismissal of the complaint. Id. at 1280.

The Tenth Circuit reversed, concluding that the plaintiffs stated a claim under the Parity Act. The court reasoned that while a plaintiff must allege a disparity between mental health or substance use disorder benefits and medical/surgical benefits, defendants’ decision to not provide the criteria plaintiffs requested prevented plaintiffs from knowing the criteria used by the insurer when determining coverage sufficed to establish a disparity. Id. at 1290–91. The Tenth Circuit declined to decide whether the Parity Act provides for a private right of action because the issue was not contested by the parties, but nonetheless laid out the elements of a Parity Act claim. Id. at 1281.

Also argued in 2023 was a Ninth Circuit case concerning claims processing under the Parity Act. Ryan S. v. UnitedHealth Grp., Inc. et al., 9th Cir. Case No. 22-5761. In Ryan S., a proposed class of patients accused a health plan administrator of wrongly denying coverage for substance use disorder treatment in violation of ERISA and the Parity Act. On remand from a prior appeal, the district court noted that there is “no clear law on how to state a claim for a Parity Act violation,” dismissed plaintiffs’ Parity Act claim, and concluded that plaintiff had not plausibly alleged that his (or the class’s) injuries stemmed from a breach of ERISA fiduciary duties. Ryan S. v. UnitedHealth Grp., Inc., 2022 WL 2813110, at *2, *5 (C.D. Cal. July 14, 2022).

The Ninth Circuit reversed the dismissal of the Parity Act and fiduciary duty claims. Ryan S. v. UnitedHealth Grp., Inc., 98 F.4th 965 (9th Cir. 2024). The court first reasoned that a plaintiff must allege “the existence of a procedure used in assessing [mental health or substance use disorder benefits claims] that is more restrictive than those used in assessing some other claims under the same classification” to state a Parity Act claim. Id. at 969. When that challenge is to a particular internal process, the plaintiff must “provide some reason to believe that the denial of [mental health or substance use disorder benefits] claims was impacted by a process that does not apply to” analogous medical and surgical claims. Id. at 973. The Ninth Circuit reasoned that the plaintiff met that pleading standard because he alleged that his claims were denied and he cited to a 2018 agency report that concluded that the defendant processed mental health and substance use disorder claims using an algorithmic process that, depending on a patient’s progress, can cause the claim to be referred to peer review that could result in a denial of services. Id. Because there was “no comparable additional review process” for medical and surgical claims, the alleged use “algorithmic process” that could “trigger additional levels of review” and denial of claims was sufficient to allege a violation of the Parity Act. Id. at 973–74. Finally, because plaintiff alleged that a more rigid review process applied to his mental health and substance use disorder benefits claims, the Ninth Circuit reasoned that the fiduciary duty claim survived as well. Id. at 974.

These decisions, particularly the Tenth Circuit’s decision in E.W., still leave open whether a defendant could successfully challenge a Parity Act claim based on a lack of a private right of action. But notwithstanding this open question of law, both E.W. and Ryan S. propose similar elements for such a claim, requiring that plaintiffs prove or allege the relevant plan is subject to the Parity Act; that the plan provides for both medical/surgical benefits and mental health/substance use disorder benefits; that there are medical/surgical benefits that are analogous to the mental health/substance use disorder benefits; and a disparity between those benefits.

E. New Developments Regarding the No Surprises Act

Recent litigation regarding the No Surprises Act (“NSA” or “Act”), 42 U.S.C. § 300gg-111, is also likely to have significant implications for ERISA health plans moving forward. The NSA responds to concerns that patients sometimes face unexpected bills from out-of-network providers. It does so by limiting patients’ cost-sharing payments for most surprise out-of-network services, and establishing an independent dispute resolution (“IDR”) process to resolve payment disputes between providers and insurers. Patients’ cost share is calculated based on the “qualifying payment amount” (“QPA”)—an amount that approximates what the provider would be paid for providing the relevant services in-network. Health care providers and insurers then engage in the IDR process to determine the insurer’s payment either through negotiation or through arbitration before a private entity (the “IDR entity”) certified by the Departments of Health and Human Services, Treasury, and Labor. The IDR entity’s determination of the reimbursement rate is based on the QPA and other factors enumerated in the NSA.

Over the past several years, the Biden Administration has promulgated a series of regulations and guidance establishing the IDR process, the method for calculating the QPA, the administrative fee for IDR disputes, and batching criteria for those disputes. In the past year, however, Judge Kernodle in the Eastern District of Texas—in lawsuits brought by a provider organization, the Texas Medical Association (“TMA”)—has issued three decisions vacating these regulations and guidance.

First, TMA challenged the regulations establishing the IDR process, arguing that they “unlawfully ‘pu[t] a substantial thumb on the scale in favor of the QPA’” and forced the IDR entity to disregard other factors enumerated in the statute that might warrant payment above the QPA amount. Tex. Med. Ass’n v. HHS (“TMA II”), 654 F. Supp. 3d 575, 587 (E.D. Tex. 2023). The regulations purportedly did this by instructing IDR entities to consider the QPA first and to disregard information regarding the other factors if it found that information to be non-credible, irrelevant, or duplicative of information already accounted for by the QPA. The government argued that these aspects of the regulations were supported by its statutory authority to establish the IDR process, see 42 U.S.C. § 300gg-111(c)(2)(A), and to “fil[l] … ’gap[s]’ in the statute ‘concerning how to evaluate the various pieces of information that go into selecting payment amounts,’” TMA II, 654 F. Supp. 3d at 592. But Judge Kernodle disagreed, concluding that “there is no ‘gap’” to fill because the NSA “vests discretion in the arbitrators—not the Departments” to decide how to evaluate this information “based on their expertise as set forth in the statute.” Id. at 591-92. The court thus vacated the regulations in a February 2023 decision. Id. at 595.

The government’s appeal from that decision is fully briefed in the Fifth Circuit, which held oral argument in February 2024 before Judges King, Jones, and Oldham. At the argument, a majority of the panel appeared skeptical of the challenged regulations, with Judge Jones suggesting that the IDR process would have worked “perfectly well” without the challenged regulations, and Judge Oldham suggesting that the approach reflected in the regulations was “not the statute Congress wrote here.” As of this publication, however, the panel has yet to issue its decision.

Second, TMA successfully challenged the regulations establishing the methodology for calculating the QPA. The QPA for a service is calculated by identifying all “contracted rates recognized by the plan or issuer” and taking the median of those rates. 42 U.S.C. § 300gg-111(a)(3)(E)(i). In Texas Medical Ass’n v. HHS (“TMA III”), 2023 WL 5489028 (E.D. Tex. Aug. 24, 2023), Judge Kernodle held that several provisions of the regulations were inconsistent with the statute’s definition of the QPA. That included provisions directing insurers, in calculating the QPA, to: (1) include contracts with an in-network provider that list rates for a service that the provider does not actually provide (so-called “ghost rates”); (2) exclude agreements governing only a single case; (3) exclude incentive and bonus payments; and (4) calculate a single QPA for different specialties when the insurer does not vary its in-network rates by specialty; and that (5) allowed self-funded plans to include contracts with other plans administered by the plan’s third-party administrator. The court also vacated a separate regulation directing insurers to transmit their initial payment or notice of denial of payment to the provider within 30 days after the insurer “receives the information necessary” to make its payment determination, as opposed to 30 days after the provider submits a claim (even if lacking the necessary information). The court nonetheless upheld regulations specifying the information that insurers must disclose to providers about their QPA calculations. Several of these rulings—the rulings on ghost rates, single-case agreements, incentive and bonus payments, timing of payment, and disclosure—have been appealed to the Fifth Circuit. As of this publication, briefing in that appeal is still underway.

Third, Judge Kernodle also vacated regulations and guidance that set the administrative fee for each IDR dispute at $350 and permitted providers to batch IDR disputes together only if they concerned services billed under the same service code. Tex. Med. Ass’n v. HHS (“TMA IV”), 2023 WL 4977746, at *6-15 (E.D. Tex. Aug. 3, 2023). The Biden Administration has since promulgated an amended regulation setting the administrative fee at $115, but has yet to finalize amended batching criteria.

As a result of this litigation, IDR operations were paused several times throughout 2022 and 2023, but the IDR process has been fully reopened since December 15, 2023.

The Second Circuit also recently reaffirmed a decision rejecting a constitutional challenge to the NSA brought by a small group of providers. The providers had argued that the IDR process: (1) violates the Takings Clause by depriving them of their common-law right to payment of the fair value of their services; (2) violates the Seventh Amendment by depriving them of the right to a jury trial that they would otherwise enjoy in suits against patients; and (3) deprives them of due process by allowing insurers to calculate the QPA unilaterally and to thereby dictate the amount of payment. In an August 2022 decision, a district court dismissed the Takings and Seventh Amendment claims on the merits and dismissed the due process claims as premature due to the ongoing litigation regarding the regulations establishing the IDR process. Haller v. HHS, 621 F. Supp. 3d 343, 352-62 (E.D.N.Y. 2022). The providers appealed the rulings on the Takings Clause and Seventh Amendment. But on appeal, they modified their Seventh Amendment theory. Rather than relying on their right to a jury trial in claims against patients, the providers asserted for the first time that they had direct claims against insurers on which they were entitled to a jury trial. The Second Circuit affirmed the dismissal of their original theories, but remanded for the district court to consider their new theory in the first instance. Haller v. HHS, 2024 WL 290440, at *1-2 (2d Cir. Jan. 23, 2024). As of this publication, the providers have indicated that they intend to file an amended complaint in July 2024.

V. ERISA Litigation Issues on the Horizon

The world of ERISA litigation will continue to evolve in 2024 and beyond. Among other emerging trends, fiduciaries should be aware of an uptick in suits challenging (1) actuarial equivalence in pension benefits, (2) how fiduciaries use plan forfeiture accounts, and (3) pension risk transfer transactions.

Growing Prevalence of “Actuarial Equivalence” Suits

We continue to see class actions brought against sponsors of defined benefit pension plans claiming that the plans violate ERISA because they fail to provide joint and survivor annuity (“JSA”) and other forms of benefit that are “actuarially equivalent” to a single life annuity (“SLA”). Relevant here, ERISA requires defined benefit plans to offer married participants a JSA that is the “actuarial equivalent” of a SLA for the life of the participant. 29 U.S.C. § 1055(d); see also 29 U.S.C. § 1054(c)(3). But the statute does not define the phrase “actuarial equivalent,” nor does it dictate what assumptions a plan must use to determine actuarial equivalence. In these lawsuits, plaintiffs challenge under ERISA the reasonableness of the assumptions their plans use to calculate JSA benefits—i.e., the interest rates and mortality tables—arguing that defendants use inapt or out-of-date actuarial assumptions. Plaintiffs seek to reform their plans to require the use of assumptions that would, in their view, result in greater JSA benefits. The issues involved in these cases are complex, and to date, no court of appeals has weighed in on the merits of plaintiffs’ theories. But as the cases proceed through resolution and appeal, the federal courts will have opportunities to provide guidance to plan sponsors concerning ERISA’s requirements for calculating JSA benefits.

Plaintiffs first started bringing claims under this theory in late 2018, and they have thus far had mixed results on the merits. At least two courts recently rejected plaintiffs’ theories as a matter of law on the basis that the text of ERISA does not require that interest rates and mortality tables used to calculate JSA benefits be “reasonable.” See Belknap v. Partners Healthcare Sys., Inc., 588 F. Supp. 3d 161, 175 (D. Mass. 2022); Reichert v. Kellogg Co., No. 2:23-cv-12343 (E.D. Mich Apr. 17, 2024), ECF No. 36. And another court recently held that plaintiffs had failed to plead breach of fiduciary duty claims that the calculation methods used by their plan were unreasonable simply because a different set of assumptions could have yielded higher benefits, but allowed other statutory claims to proceed. Skrtich v. Pinnacle West Capital Corp., No. 2:22-cv-1753 (D. Ariz. Aug. 7, 2023), ECF. No. 29.

A number of other recently filed cases are awaiting decisions on motions to dismiss or are proceeding through discovery and summary judgment. See, e.g., Franklin v. Duke University, No. 1:23-cv-833 (M.D.N.C.) (motion to dismiss denied, pending appeal); Hamrick v. E.I. Du Pont de Nemours and Company, No. 1:23-cv-238 (D. Del.) (motion to dismiss granted in part and denied in part); Whetstone v. Howard University, No. 1:23-cv-2409 (D.D.C.) (motion to dismiss pending); Watt v. FedEx Corp., No. 2:23-cv-2593 (W.D. Tenn.) (motion to dismiss pending); Bennet v. Ecolab, 0:24-cv-546 (D. Minn.) (no response to amended complaint yet filed). We will continue to monitor this rapidly evolving area of law as cases are filed and move toward resolution.

New Wave of Fiduciary-Breach Suits Concerning Plan Forfeiture Accounts

Plan fiduciaries can expect to continue to see an influx of suits alleging claims for breach of fiduciary duty through the use of forfeitures in retirement plans. In these cases, plaintiffs claim that plans violate ERISA by using forfeitures to reduce company contribution costs instead of using the funds to defray plan administrative expenses. The IRS permits plans to use forfeitures to reduce company contributions under certain circumstances, but the Department of Labor has not yet weighed in on whether this is permissible under ERISA.

As one example, in McManus v. Clorox Co., No. 4:23-cv-05325 (N.D. Cal.), the plaintiff alleged that defendant violated ERISA by using 401(k) forfeitures to reduce company contribution costs instead of to pay plan administrative expenses that are otherwise paid from participant accounts. Plaintiffs also separately raised claims under ERISA’s anti-inurement and prohibited transaction provisions. Defendants recently filed a motion to dismiss, which is pending, arguing that the plan permits the fiduciaries to use forfeitures in this way, the fiduciaries properly disclosed how they apply forfeitures, and the fiduciaries did not otherwise violate any duties under ERISA.

The Southern District and Northern District of California have each recently weighed in on this issue. The Southern District of California denied defendants’ motion to dismiss in Perez-Cruet v. Qualcomm Inc., No. 3:23-cv-1890 (S.D. Cal.), allowing plaintiff’s forfeiture claims to proceed. The court reasoned that because the plan sponsor used forfeitures to offset its own future contributions, instead of offsetting administrative expenses that were otherwise paid by plan participants, plaintiff had plausibly alleged a breach of the duty of loyalty under ERISA. The court also held that plaintiff stated a claim for breach of ERISA’s duty of prudence because defendants allegedly “harmed the participants” by “letting the administrative expense charge fall on the participants rather than the employer” despite the plan documents expressly providing that the sponsor could use the forfeitures in this way. Applying similar reasoning, the court concluded that plaintiff had adequately pleaded claims for violations of ERISA’s anti-inurement and prohibited transaction provisions.

However, the Northern District of California recently issued a decision granting defendant’s motion to dismiss in Hutchins v. HP Inc., 5:23-cv-05875 (N.D. Cal.). There, the court reasoned that the plan did not require the sponsor to pay administrative costs, and plaintiff was not otherwise entitled to them under ERISA. Thus, the plan sponsor did not breach any fiduciary duty under ERISA by declining to use forfeited funds to pay administrative costs that would otherwise be paid by participants. The court likewise concluded that plaintiff’s prohibited transaction claims were implausible because they fell outside of “the types of commercial transactions contemplated by Congress.” Thus, the court held that plaintiff’s claims were implausible and must be dismissed, but granted him the opportunity to replead.

Nearly identical complaints have also been filed against other plan sponsors over the past six months. See, e.g., Rodriguez v. Intuit, Inc., No. 5:23-cv-5053 (N.D. Cal.); Barragan v. Honeywell Intl., Inc., No. 2:24-cv-1194 (C.D. Cal.); Prattico v. Mattel, Inc., No. 2:24-cv-2624 (C.D. Cal.). It remains to be seen whether the DOL or other courts will follow the lead of the Southern District of California in Perez-Cruet, or the reasoning of the Northern District of California in Hutchins. We will continue to monitor these cases.

String of New Lawsuits Concerning Pension Risk Transfer Transactions

Early this year, we also saw a series of lawsuits challenging how fiduciaries managed pension risk transfer transactions. In the practice of pension de-risking, a plan sponsor may purchase an annuity contract with an insurer to satisfy benefit obligations under the plan for some or all of the plan participants, thereby shifting pension liability risk to the insurer. While plaintiffs acknowledge that these arrangements are permissible under federal benefits law, they argue that fiduciaries nevertheless breach their duties if they fail to engage in a monitoring process that results in the selection of the safest annuity provider available to assume these obligations. The cases challenging pension risk transfers, which are still in their early stages, are pending in Maryland, Washington, DC, and Massachusetts. See Camire et al v. Alcoa USA Corp., No. 1:24-cv-01062 (D. D.C.); Konya et al v. Lockheed Martin Corp., No. 8:24-cv-750 (D. Md.); Schloss et al. v. AT&T, Inc. et al., No. 1:24-cv-10656 (D. Mass.); Piercy et al. v. AT&T Inc. et al., No. 1:24-cv-10608 (D. Mass.). Pension risk transfers have been growing in popularity in recent years, and these cases warrant a close watch by plan sponsors and fiduciaries considering pension de-risking.

The following Gibson Dunn lawyers prepared this update: Karl Nelson, Geoffrey Sigler, Heather Richardson, Ashley Johnson, Matthew Rozen, Jennafer Tryck, Andrew Kasabian, Becca Smith, Anna Casey, Alex Ogren, Robert Batista, Rachel Iida, Sasha Shapiro, and Spencer Bankhead.

Karl G. Nelson – Dallas (+1 214.698.3203, [email protected])
Geoffrey Sigler – Washington, D.C. (+1 202.887.3752, [email protected])
Katherine V.A. Smith – Los Angeles (+1 213.229.7107, [email protected])
Heather L. Richardson – Los Angeles (+1 213.229.7409,[email protected])
Ashley E. Johnson – Dallas (+1 214.698.3111, [email protected])
Matthew S. Rozen – Washington, D.C. (+1 202.887.3596, [email protected])
Jennafer M. Tryck – Orange County (+1 949.451.4089, [email protected])

Truck Insurance Exchange v. Kaiser Cement & Gypsum Corp., S273179 – Decided June 17, 2024

The California Supreme Court held that the standard language in commercial general liability policies allows an insured to access its excess insurance policy after exhausting its underlying primary insurance for the same policy period, not all primary insurance issued during the continuous period of injury.

“[T]he first-level excess policies do not require the insured to horizontally exhaust primary insurance issued during different policy periods.”

Justice Groban, writing for the Court

Background:

Kaiser Cement and Gypsum Corporation manufactured asbestos-containing products from 1944 through the 1970s. During this period, Kaiser bought primary and excess commercial general liability insurance policies from various insurers. The first-level excess policies included language—standard in commercial excess insurance policies—stating that coverage would not attach until Kaiser exhausted its “other insurance” or “other underlying insurance.”

By 2004, Kaiser faced more than 24,000 suits for bodily injury allegedly resulting from exposure to asbestos. Truck Insurance Exchange, a primary insurer of Kaiser, filed an equitable-contribution claim against several insurers that had issued first-level excess policies to Kaiser. Truck argued that the excess insurers’ indemnity obligations were triggered immediately upon exhaustion of the directly underlying primary policies, and the excess insurers should therefore be required to contribute to Truck’s coverage costs. The excess insurers, in contrast, believed they had no duty to indemnify Kaiser until Kaiser had exhausted every primary policy issued during the decades of continuous asbestos-related damage.

The trial court issued an order denying Truck’s contribution request, agreeing with the excess insurers that the “other insurance” provisions in the excess policies required horizontal exhaustion of all primary insurance before Truck could obtain contribution from any excess insurer. The Court of Appeal affirmed, interpreting the “other insurance” provisions as unambiguously requiring Kaiser to exhaust all primary policies for all policy periods covered by the continuous injury.

The California Supreme Court granted review to determine whether “other insurance” clauses in commercial general liability policies require vertical or horizontal exhaustion.

Issue:

May a primary insurer seek equitable contribution from an excess insurer after the primary policy underlying the excess policy has been exhausted (vertical exhaustion), or must the insured exhaust all primary policies issued during the continuous period of damage first (horizontal exhaustion)?

Court’s Holding:

The language in the first-level excess policies does not require the insured to horizontally exhaust primary insurance issued during different policy periods, but that alone does not resolve whether the primary insurer is entitled to contribution from the excess insurers.

What It Means:

Under standard language found in commercial general liability policies, an excess insurer owes an indemnity obligation to the insured as soon as the directly underlying primary policy has been exhausted—even if primary insurance issued for an earlier or later policy period during which the insured was also harmed remains unexhausted.
The Court clarified that its holding was based on the contractual language. As a result, “[e]xcess insurers . . . remain free to write their future excess policies in a manner that expressly requires horizontal exhaustion.”
The Court’s conclusion does not alter the “well settled [rule] that an excess insurer [generally] has no duty to defend unless the underlying primary insurance is exhausted.” Thus, excess insurers have no indemnity obligations unless and until the insured exhausts the limits of the directly underlying primary policy.
The Court’s decision did not resolve whether the primary insurer was entitled to contribution from the excess insurers because “the terms of the insurers’ policies comprise[d] only one of the factors courts may consider when evaluating whether contribution would ‘accomplish ultimate justice.’” The Court remanded the case to allow the Court of Appeal to analyze the remaining contribution factors.

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 group leaders:

Appellate and Constitutional Law Practice

Thomas H. Dupree Jr. +1 202.955.8547 [email protected]	Allyson N. Ho +1 214.698.3233 [email protected]	Julian W. Poon +1 213.229.7758 [email protected]
Lucas C. Townsend +1 202.887.3731 [email protected]	Bradley J. Hamburger +1 213.229.7658 [email protected]	Michael J. Holecek +1 213.229.7018 [email protected]

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Geoffrey M. Sigler
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Deborah L. Stein
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Matthew A. Hoffman
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Related Practice: Litigation

Theodore J. Boutrous, Jr.
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Theane Evangelis
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This alert was prepared by associates Daniel R. Adler, Ryan Azad, and Dan Willey.