Over the last few years, market conditions have changed so dramatically that today, no matter its products or services, every company is also in the environmental business. Prompted by the real-world impacts of climate change, many consumers now demand environmental action from corporations and prefer to buy products marketed as environmentally friendly. Many companies therefore market their products as “net-zero” or “carbon neutral”—and make pledges to be, as a business, “net-zero” by a certain date. In support of these pledges, companies often buy carbon credits from voluntary carbon markets to offset or mitigate their carbon emissions voluntarily.

Voluntary carbon markets present opportunity, but also create financial, regulatory, and litigation risks. Because the voluntary markets are often fragmented, suffer from a lack of transparency and, above all, are not subject to any statutory common standards, there is a lack of trust in the credits issued under these system, which also limits the tradability of the credits.

This quarterly newsletter aggregates the knowledge and experience of Gibson Dunn attorneys around the globe as we help our clients across all sectors navigate the ever-changing landscape of voluntary carbon markets.

* * * *

This Q1 2023 edition of the newsletter explores the question companies must ask when they buy credits on the voluntary carbon market: can we trust that we are getting what we paid for? A recent survey of more than 500 corporate sustainability officers around the world found that 40% of participants did not use carbon offsets because they did trust them, while many companies that do buy carbon credits seek trustworthy credits by only buying from government or certified providers, working with rating agencies, or engaging in their own due diligence.

Read More

The following Gibson Dunn lawyers assisted in the preparation of this alert: Susy Bullock, Abbey Hudson, Brad Roach, Lena Sandberg, Jeffrey Steiner, Jonathan Cockfield, Arthur Halliday, Yannis Ioannidis, Alexandra Jones, Mark Tomaier, and Alwyn Chan.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Environmental, Social and Governance (ESG), Environmental Litigation and Mass Tort, Global Financial Regulatory, or Energy practice groups, or the following authors:

Environmental, Social and Governance (ESG) Group:
Susy Bullock – London (+44 (0) 20 7071 4283, [email protected])

Environmental Litigation and Mass Tort Group:
Abbey Hudson – Los Angeles (+1 213-229-7954, [email protected])

Global Financial Regulatory Group:
Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, [email protected])

Energy, Regulation and Litigation Group:
Lena Sandberg – Brussels (+32 2 554 72 60, [email protected])

Oil and Gas Group:
Brad Roach – Singapore (+65 6507 3685, [email protected])

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

This edition of Gibson Dunn’s Federal Circuit Update summarizes the current status of several petitions pending before the Supreme Court. We also discuss recent Federal Circuit decisions concerning written description, motivation to combine, and requirements for stipulated judgments of non-infringement based on a district court’s claim construction.

Federal Circuit News

Supreme Court:

On March 27, 2023, the United States Supreme Court heard oral argument in Amgen Inc. v. Sanofi (U.S. No. 21-757) on the issue of enablement under 35 U.S.C. § 112. During argument, the Court expressed concern with the breadth of Amgen’s genus claims, which potentially cover millions of antibodies, and repeatedly asked petitioner to clarify what Amgen actually invented. The Court also observed that there appeared to be general agreement between the parties on the enablement legal standard (that a patent must enable a skilled artisan to practice the full scope of the claims without undue experimentation) and questioned what was left for the Court to do. A more detailed summary of the argument may be found on SCOTUSblog here.

Noteworthy Petitions for a Writ of Certiorari:

There are several new potentially impactful petitions pending before the Supreme Court:

Thaler v. Vidal (US No. 22-919): “Does the Patent Act categorically restrict the statutory term ‘inventor’ to human beings alone?” The government waived its right to file a response.

Nike, Inc. v. Adidas AG et al. (US No. 22-927): “Whether, in inter partes review, the Patent Trial and Appeal Board may raise sua sponte a new ground of unpatentability—including prior art that the petitioner neither cited nor relied upon—and whether the Board may rely on that new ground to reject a patent-holder’s substitute claim as unpatentable.” Adidas waived its right to file a response.

Avery Dennison Corp. v. ADASA, Inc. (US No. 22-822): “The question presented is whether [a] claim, by subdividing a serial number into ‘most significant bits’ that are assigned such that they remain identical across RFID tags, constitutes patent-eligible subject matter under 35 U.S.C. § 101.” After ADASA waived its right to file a response, a response was requested by the Court and is due May 2, 2023.

Ingenio, Inc. v. Click-to-Call Technologies, LP (US No. 22-873): “1. Whether 35 U.S.C. § 315(e)’s IPR estoppel provision applies only to claims addressed in the final written decision, even if other claims were or could have been raised in the petition. Whether the Federal Circuit erroneously extended IPR estoppel under 35 U.S.C. § 315(e) to all grounds that reasonably could have been raised in the petition filed before an inter partes review is instituted, even though the text of the statute applies estoppel only to grounds that “reasonably could have [been] raised during that inter partes review.” After Click-to-Call waived its right to file a response, a response was requested by the Court and is due May 26, 2023.

As we summarized in our January 2023 and February 2023 updates, the Court is considering petitions in Novartis Pharmaceuticals Corp. v. HEC Pharm Co., Ltd. (US No. 22-671) and Arthrex, Inc. v. Smith & Nephew, Inc. (US No. 22-639). The response in Arthrex is due April 12, 2023. Novartis will be considered during the Court’s April 14, 2023 conference. Gibson Dunn partners Thomas G. Hungar, Jacob T. Spencer, Jane M. Love, and Robert Trenchard are counsel for Novartis. The petitions in Interactive Wearables, LLC v. Polar Electro Oy (US No. 21-1281) and Tropp v. Travel Sentry, Inc. (US No. 22-22) are still pending the views of the Solicitor General.

Upcoming Oral Argument Calendar

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

Key Case Summaries (March 2023)

Regents of the University of Minnesota v. Gilead Sciences, Inc., No. 21-2168 (Fed. Cir. Mar. 6, 2023): The Patent Trial and Appeal Board (“Board”) determined that UM’s patent directed to phosphoramidate prodrugs of nucleoside derivatives (used to prevent viruses from reproducing or cancerous tumors from growing) was invalid as anticipated by one of Gilead’s patents. The Board concluded that Gilead’s patent was prior art to UM’s patent, because UM’s patent could not claim priority to its parent applications, which failed to provide sufficient written description support for the challenged claims.

The Federal Circuit (Lourie, J., joined by Dyk and Stoll, JJ.) affirmed. The Court explained that written description of a broad genus of chemical compounds requires description not only of the outer limits of the genus but also of either a representative number of members of the genus or structural features common to the members of the genus, both with enough precision for a person of skill in the art to visualize or recognize the members of the genus. The Court reasoned that the various claims in the parent applications created “a maze-like path, each step providing multiple alternative paths” that lead to so many varying options that it is “unclear how many compounds actually fall within the described genera and subgenera.” The Court therefore agreed with the Board that UM’s parent applications failed to provide adequate written description support for the challenged claims, and thus, Gilead’s patent was anticipatory prior art.

Intel Corp. v. PACT XPP Schweiz AG, No. 22-1037 (Fed. Cir. Mar. 13, 2023): The Board determined the challenged claim was not unpatentable as obvious over two prior art references (Kabemoto and Bauman). The Board concluded that prior art did not disclose the recited segment-to-segment limitation in the claim, and that one skilled in the art would not be motivated to combine the two references.

The Federal Circuit (Prost, J., joined by Newman and Hughes, JJ.) reversed and remanded. The Court concluded that Bauman plainly disclosed the segment-to-segment limitation. The Court also reversed the Board’s rejection of Intel’s motivation to combine argument, which was that when a known technique has been used to improve one device, a person of ordinary skill in the art would recognize that it would improve similar devices in the same way. Here, Bauman disclosed that a secondary cache could be used to improve cache coherency, and a person of ordinary skill in the art would have recognized that such a cache would improve similar multiprocessor systems, like the one in Kabemoto, by addressing the same cache coherency problem.

AlterWAN, Inc. v. Amazon.com, Inc., No. 22-1349 (Fed. Cir. Mar. 13, 2023): After the district court construed two disputed terms, the parties stipulated to judgment of non-infringement so that AlterWAN could appeal the constructions.

The Federal Circuit (Dyk, J., joined by Lourie and Stoll, JJ.) vacated the judgment and remanded to the district court for further proceedings on the basis that the stipulation failed to identify which claims remained at issue, and failed to specify whether the construction of both terms must be correct for Amazon to prevail. The Court explained that a stipulated judgment of non-infringement based on a district court’s claim construction must specify which claims remain at issue and which constructions affect the issue of infringement.

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

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

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

Appellate and Constitutional Law Group:
Thomas H. Dupree Jr. – Washington, D.C. (+1 202-955-8547, [email protected])
Allyson N. Ho – Dallas (+1 214-698-3233, [email protected])
Julian W. Poon – Los Angeles (+ 213-229-7758, jpoon@gibsondunn.com)

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

On January 26, 2023, the Delaware Court of Chancery held, for the first time, that corporate officers owe a duty of oversight.[1] Authored by Vice Chancellor J. Travis Laster, the decision denies a motion to dismiss under Rule 12(b)(6) of the Court of Chancery Rules but leaves open the possibility that the case will be dismissed under Rule 23.1 for failure to plead demand futility.[2]

Background

This derivative litigation follows public allegations of misconduct by senior officers at a company and its franchises. Stockholders claim that the company’s directors and officers are liable to the company for failing to oversee it in good faith. As relevant here, they allege that a senior officer responsible for human resources but not a member of the company’s board of directors “exercised inadequate oversight in response to risks of sexual harassment and misconduct at the [c]ompany and its franchises.”[3] They also claim that the same officer “breached his fiduciary duties [of loyalty] by engaging personally” in the same type of misconduct.[4]

The defendants moved to dismiss the complaint under Rule 23.1 for failure to plead demand futility and, in the alternative, under Rule 12(b)(6) for failure to state a claim upon which relief can be granted. The January 26, 2023 decision discussed here addressed only the senior officer’s motion to dismiss under Rule 12(b)(6), leaving unresolved whether the complaint adequately pleaded demand futility—an issue that the court will decide at a later time.

Corporate Officers’ Duty of Oversight

The Delaware Court of Chancery held that officers are subject to the same duty of oversight as directors. Although this is the first time the court has reached that conclusion explicitly, past rulings have suggested that officers owe the same fiduciary duties as directors.[5]

This decision further reasoned that the duty of oversight owed by officers is evaluated under the same two-prong “Caremark” test that applies to directors.[6] First, like directors, officers “must make a good faith effort to ensure that information systems are in place so that the officers receive relevant and timely information that they can provide to the directors.”[7] Second, officers “have a duty to address [red flags they identify] or report upward [to more senior officers or to the board].”[8]

The court observed that oversight liability for officers, however, is more limited than that of directors in at least one important way: officers generally are liable only for overseeing their particular areas of responsibility. This limitation applies under both prongs of the test for oversight liability. The obligation to establish reasonable information systems extends only to the area of an officer’s responsibility.[9] Similarly, “officers generally only will be responsible for addressing or reporting red flags within their areas of responsibility.”[10] The court observed that there might be exceptional circumstances, however, involving “egregious” or “sufficiently prominent” red flags that officers must report up, even outside their area.[11]

Like oversight liability for directors, “oversight liability for officers” arises from the duty of loyalty and thus “requires a showing of bad faith.”[12] Allegations of gross negligence are insufficient.

Breach of Fiduciary Duty as Applied to Sexual Harassment Claims

Applying the above framework, the court went on to hold that plaintiffs had adequately alleged a claim that the company’s senior human resources officer breached his duty of oversight “by consciously ignoring red flags” that indicated a culture of sexual harassment and misconduct in the workplace.[13] The court focused in particular on plaintiffs’ allegations that the senior officer himself engaged in misconduct, finding that in such cases, “it is reasonable to infer that the officer consciously ignored red flags about similar behavior by others.”[14] The court nonetheless recognized “record evidence” in 2019 and onwards that the senior officer was “part of the effort by [c]ompany management to address the problem of sexual harassment and misconduct.”[15]

Finally, the court also separately held that fiduciaries “violate the duty of loyalty when they engage in harassment themselves.”[16] The court reasoned that acts of sexual harassment are in “further[ance of] private interests” rather than “advancing the best interests of the corporation,” and therefore are bad faith conduct that breaches the duty of loyalty.[17] If a fiduciary “personally engages in acts of sexual harassment, and if the entity suffers harm,” then a plaintiff “should be able to assert a claim for breach of fiduciary duty in an effort to shift the loss that the entity suffered to the human actor who caused it.”[18] The court concluded: “Sexual harassment is bad faith conduct. Bad faith conduct is disloyal conduct. Disloyal conduct is actionable.”[19]

Analysis

This decision breaks new legal ground, but is unlikely to change derivative litigation materially, at least at the pleadings stage. Courts have long recognized that officers owe fiduciary duties to the corporation they serve, similar to those that are owed by directors. And plaintiffs have long asserted claims for breach of those duties, including oversight claims, against officers.

From an employment law perspective, however, the decision carries the potential for broader implications. For the first time, the Court of Chancery has held that stockholders may bring suit against directors or officers of a corporation on the theory that sexual harassment constitutes a breach of fiduciary duty. Although there have long been legal remedies for claims of sexual harassment, this decision highlights a potential avenue for derivative claims based on such allegations, providing stockholders with potential recourse to hold corporate officers accountable for actions of sexual misconduct and bringing issues traditionally reserved for employment disputes into the arena of fiduciary duty law.

Significantly, this decision in no way undermines the authority of boards of directors to evaluate whether suing officers is in the best interest of corporations. Therefore, derivative claims for oversight liability against officers should be dismissed under Rule 23.1 absent particularized allegations that it would be futile for the plaintiff to make a pre-suit litigation demand. Notably, Vice Chancellor Morgan T. Zurn recently dismissed derivative claims against officers based on the same reasoning.[20]

Finally, although the decision is most notable for its discussion of officer liability, it also underscores the Court of Chancery’s preference for plaintiffs to seek books and records under Section 220 of the Delaware General Corporation Law before asserting derivative claims. The court recounts its decision to stay the case to allow intervenors to conduct an investigation through Section 220.[21]

Key Takeaways

Although oversight liability for officers has now been expressly acknowledged, this decision is unlikely to have a significant impact on most derivative litigation at the pleadings stage. In many instances, derivative claims are subject to dismissal because the plaintiff did not satisfy the requirement of making a pre-suit litigation demand or pleading that a demand would be futile. The test for pleading demand futility is rigorous, and this decision does not alter it. Nonetheless, the court’s novel findings as to liability for breach of fiduciary duty in the sexual harassment context may incentivize similar claims, at least where a fiduciary is alleged to have personally engaged in acts of sexual harassment.
To preserve their independence, directors should be cautious about close personal or business relationships not only among themselves but also with officers. Plaintiffs can be expected to argue that such relationships, when they exist, impede directors’ ability to render an impartial judgment as to whether it is in the best interest of a corporation to sue its officers.
Corporations should evaluate how they document reporting and control efforts at the officer level. Although the process for documenting board oversight is well established, the documentation of officer oversight is sometimes less formal. Officers are particularly well advised to develop a system for documenting their responses to significant red flags, including in materials provided to the board of directors. Thorough documentation can show that officers discharged their obligations in good faith by addressing red flags.
Oversight liability for officers will usually be confined to their areas of responsibility. For that reason, corporations should evaluate how they document the scope of officers’ responsibilities.
From an employment perspective, corporations should ensure they have appropriate anti-harassment and anti-discrimination policies and practices, including prohibitions of harassment, discrimination and retaliation, along with appropriate training, reporting, investigation, and compliance monitoring.
This decision may renew discussions about whether corporations should utilize recent amendments to Section 102(b)(7) of the Delaware General Corporation Law to exculpate their officers against certain claims for breach of the duty of care. Although corporations should consider amending their certificates of incorporation to add exculpatory clauses for officers, it should be understood that officer exculpation will not protect against oversight claims. As the court made clear, oversight claims against officers (as well as directors) are claims for breach of the duty of loyalty. Exculpatory provisions, however, concern the duty of care and cannot eliminate liability under the duty of loyalty. Exculpatory provisions for officers, moreover, do not apply to derivative litigation, which is the context in which oversight claims are most often litigated.
Plaintiffs’ firms are likely to increase efforts to investigate officer misconduct under Section 220, and these efforts could raise challenging disagreements over the proper scope of Section 220 demands. In many cases, board-level documents will provide information “necessary and essential” to assessing officer misconduct, as well as the board’s ability to act in a corporation’s best interests. Therefore, we do not believe that this decision warrants any expansion of the records that are typically available under Section 220.

____________________________

[1] See In re McDonald’s Corp. S’holder Deriv. Litig., 2023 WL 387292, C.A. No. 2021-0324-JTL, at *1, *9 (Del. Ch. Jan. 26, 2023).

[2] Del. Ch. Ct. R. 12(b)(6); Del. Ch. Ct. R. 23.1.

[3] In re McDonald’s, 2023 WL 387292, at *8.

[4] Id. at *28.

[5] Id. at *13 (citing Gantler v. Stephens, 965 A.2d 695, 709 (Del. 2009)).

[6] See, e.g., id. at *10.

[7] Id. at *11.

[8] Id. at *12.

[9] Id. at *19.

[10] Id.

[11] Id. at *2, *42.

[12] Id. at *22, *24.

[13] Id. at *27.

[14] Id. at *2, *27.

[15] Id. at *28.

[16] Id. at *28.

[17] Id.

[18] Id. at *30.

[19] Id.

[20] See In re Boeing Co. Deriv. Litig., 2021 WL 4059934, C.A. No. 2019-0907-MTZ, at *36 (Del. Ch. Sept. 7, 2021).

[21] In re McDonald’s, 2023 WL 387292, at *8.

The following Gibson Dunn attorneys assisted in preparing this client update: Jason J. Mendro, Mark H. Mixon, Jr., Elizabeth A. Ising, Monica K. Loseman, Brian M. Lutz, Tiffany Phan, Cynthia Chen McTernan, and Minnie Che.

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

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

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

Labor and Employment Group:
Tiffany Phan – Los Angeles (+1 213-229-7522, [email protected])
Jason C. Schwartz – Co-Chair, Labor & Employment Group, Washington, D.C. (+1 202-955-8242, [email protected])
Katherine V.A. Smith – Co-Chair, Labor & Employment Group, Los Angeles (+1 213-229-7107, [email protected])

On August 2, 2022, the Committee on Foreign Investment in the United States (“CFIUS” or the “Committee”) released its annual report covering calendar year 2021 (the “Annual Report”).[1] This report represents the first full calendar year in which the Committee operated pursuant to the new regulations implemented in 2020 under the Foreign Investment Risk Review Modernization Act of 2018 (“FIRRMA”).[2]

Our top observations from the Annual Report are set forth below.

Amidst the Backdrop of a Strong M&A Market, The Committee Reviewed a Record Number of Filings

Parties to a covered transaction may initiate CFIUS’s national security review of the transaction by filing a short-form declaration or a full-length written notice. Consistent with the robust M&A market in 2021, CFIUS reviewed a record number of 436 total filings in 2021, up 39 percent from 2020. 164 (38 percent) of these filings were declarations, and 272 (62 percent) were written notices, both figures representing significant percentage increases from 2020.[3]

	2020	2021 (∆)
Declarations	126	164 (↑30%)
Notices	187	272 (↑45%)
Total Filings	313	436 (↑39%)

1. The Use of Short-Form Declarations and CFIUS Clearance Rates of Such Declarations Have Increased Significantly

Short-form declarations were introduced through the passage of FIRRMA in 2018, as both an optional form of filing and pursuant to mandatory requirements under certain conditions. Although a recent introduction, the statistics noted above indicate that declarations are emerging as a viable alternative to the traditional written notice process in certain situations.

Less than a third of declarations filed in 2021 were subject to mandatory requirements (47 of 164 total declarations), indicating that parties are increasingly seeing value in filing a voluntary declaration, which has fewer requirements and a shorter review timeline. Although, there is always a risk with a declaration that the overall CFIUS timeline and burden could be lengthened should the Committee request the parties to file a written notice or determine it is unable to conclude action on the basis of the declaration after the 30-day declaration review. Thus, deciding whether to file a declaration versus a notice should be based on an overall risk calculus of many factors. As the numbers reflect, the availability of the declaration process does not replace notices as a filing of choice in all instances.

Committee Action	Number of Declarations (164 Total)
Request parties file a written notice	30 (18%)
Unable to conclude action	12 (7%)
Clearance	120 (73%)
Rejected	2 (1%) [4]

To put these numbers into perspective, Committee clearance of declarations increased from less than 10 percent in 2018, to 37 percent in 2019, to 64 percent in 2020, and 73 percent this past year.[5] CFIUS also requested slightly fewer written notices from parties who filed declarations (18 percent, down from 22 percent), and reduced the number of instances in which the parties were informed that CFIUS was unable to conclude action on the basis of the declaration—from 13 percent to 7 percent.[6]

There was a Significant Jump in Withdrawn Notices – But the Percentage of Abandoned Transactions Remained Consistent with 2020

A notable uptick was seen in the number and percentage of withdrawn notices in 2021 – 74 in 2021 (27 percent) versus 29 in 2020 (15.5 percent).[7] Similar to 2020, just under half of all notified transactions proceeded to the subsequent 45-day investigation phase (130).[8] It was during this investigation phase that nearly all (72) of the 74 notices were withdrawn.[9] Most notices were withdrawn after CFIUS informed the parties that the transaction posed a national security risk and proposed mitigation terms.[10] In the vast majority of withdrawn notices in 2021 (85 percent), parties filed a new notice.[11]

Eleven notices, representing four percent of the total number of notices filed in 2021, were withdrawn and the transaction ultimately abandoned either because (i) CFIUS informed the parties that it was unable to identify mitigation measures that would resolve the national security concerns, or the parties rejected mitigation measures proposed by the Committee (nine withdrawals); or (ii) for commercial reasons (two withdrawals).[12] This is relatively consistent with the figures on abandoned transactions in 2020 (just above four percent).[13]

Notably, 2021 was the first year since 2016 in which no Presidential decisions were issued.[14]

Canadian Acquirers Accounted for the Largest Number of Declarations, while Chinese Investors Greatly Preferred and Led in the Number of Notices Submitted

Investors from Canada accounted for the largest number of declarations filed in 2021 (22), representing approximately 13 percent of the total.[15] Other countries commonly characterized by the U.S. government as presenting lower national security risks also topped the list of declarations, with Australia, Germany, Japan, South Korea, Singapore and United Kingdom cumulatively accounting for 62—or approximately 38 percent—of the 164 declarations submitted in 2021. [16] These numbers are generally consistent with previous years’ trends. From 2019 to 2021, Canadian investors submitted 54 declarations, more than any other country. [17] Japanese and United Kingdom investors accounted for the second and third-most declarations filed over the same three-year period. [18]

While Canadian investors may be increasingly utilizing the declaration process, they also still account for a significant number of full-length notices (28, approximately 10 percent of total notices filed, more than any other country except China). The high volume of Canadian declarations and notices is reflective of the significant business activity between the U.S. and Canada, particularly in sectors that may present national security risk, as discussed in insight #5 below.

In contrast to the Canadian utilization of both declarations and notices, Chinese investors largely eschewed the declaration process, filing only one declaration in 2021. [19] Chinese investors filed the highest number of notices last year, with 44 notices, or 16 percent of the total. [20] This represents a 159 percent increase from 2020, and a 76 percent increase from 2019. [21] This increase may not be fully reflective of economic factors in 2021, as this increase comes as CFIUS is intentionally focusing on non-notified historic transactions.

China’s 2021 numbers are also consistent with the last three years, over which Chinese investors submitted 86 notices, but only nine declarations. [22] As noted in our discussion in insight #2, this apparent preference of Chinese investors to forego the short-form declaration in favor of the prima facia lengthier notice process may indicate a calculus that amidst U.S.-China geopolitical tensions, the likelihood of the Committee clearing a transaction involving a Chinese acquiror through the scaled down declaration process is quite low, and therefore a declaration filing may merely result in the Committee requesting after 30 days that the parties submit a notice, thus actually adding time to the process overall.

The low number of declarations also indicates that Chinese investors may be shying away from the more sensitive transactions, such as those involving critical technologies, which would require mandatory declarations.

2021 Figures Confirm Focus on Business Sectors Associated with Critical Technologies and Sensitive Data

Consistent with previous years, a high majority of CFIUS filings in 2021 involved the Finance, Information and Services and Manufacturing sectors, with those two sectors collectively accounting for over 80 percent of CFIUS filings.[23]

Business Sector	Notices
Finance, Information, and Services	55%
Manufacturing	28%
Mining Utilities and Construction	12%
Wholesale Trade, Retail Trade and Transportation	4%

In 2021, CFIUS reviewed 184 covered transactions involving acquisitions of U.S. critical technology companies.[24] In contrast to the 2020 data, the number of critical technologies filings have increased by 51 percent.[25] Consistent with the 2020 data, the largest number of notices filed remained to be the Professional, Scientific, and Technical Services subsector of the Finance, Information and Services sector (35) and Computer / Electronic Product Manufacturing subsector of the Manufacturing sector (31).[26]

Further, consistent with the observations made in insight #4 above, countries seen as traditionally U.S.-allied, such as Germany, United Kingdom, Japan, and South Korea, accounted for the most acquisitions of U.S. critical technology in 2021.[27] These four countries accounted for approximately 33 percent of such transactions. Of note, Canada and China each accounted for approximately five percent of transactions involving the acquisition of U.S. critical technologies.[28]

In light of the new policy mandate, critical technologies is expected to be a continuous focus of the Committee in coming years. Although the Annual Report does not specifically report on covered transactions involving acquisitions of U.S. companies with sensitive data, the sector-specific statistics indicate that this continues to be a focus area.

The Committee Shortened Its Response Times to Respond to Draft Notices and Accept Formal Notices, but Continues to Take Advantage of the Full Time Periods to Complete its Actual Reviews

Parties submitting draft notices to the Committee in 2021 received comments back from the Committee on average in just over six business days, an improvement from the 2020 average of approximately nine days.[29] Similarly, the Committee averaged six business days to accept a formal written notice after submission, which is an improvement from the average of 7.7 business days reported in the 2020 Annual Report.[30]

In terms of the Committee’s turnaround times once a declaration or notice has been filed/accepted, the Committee in 2021 generally utilized the entire available regulatory periods available. With respect to a declaration, the Committee is required to take action [31] within 30 business days after receiving a declaration. Upon acceptance of a formal notice, the Committee has an initial 45 business days to review the filing and may extend the review period into a further investigation period of 45 business days.

Regarding declarations submitted in 2021, it took the Committee, on average, the entire 30-day period to conclude action. [32] Similarly, it took the Committee an average of 46.3 calendar days to close a transaction review during the initial review stage. [33] If the Committee extended the review into the subsequent investigation phase, the Committee completed the investigation, on average, within 65 calendar days. [34] However, this number may be misleading, and in practice parties should expect the Committee to complete investigations closer to the full 90-day deadline because the Annual Report indicates that the median for investigation closures was 89.5 calendar days. [35]

No Significant Changes Regarding Mitigation Measures and Conditions

In 2020, CFIUS adopted mitigation measures and conditions with respect to 23 notices or 12 percent of the total number of 2020 notices. [36] On a percentage basis, 2021 saw a marginal overall decrease in the adoption of mitigation measures and conditions. The Committee adopted mitigation measures and conditions with respect to 31 notices or 11 percent of the total number of 2021 notices. [37] For 26 notices, CFIUS concluded action after adopting mitigation measures. [38] With respect to four notices that were voluntarily withdrawn and abandoned, CFIUS either adopted mitigation measures to address residual national security concerns, or imposed conditions without mitigation agreements.[39] Lastly, as in 2020, measures were imposed to mitigate interim risk for one notice filed in 2021.[40]

It is worth noting that the Committee conducted 29 site visits in 2021 for the purpose of monitoring compliance with mitigation agreements. [41] Where non-compliance was identified, monitoring agencies worked with the parties to achieve remediation. [42]

While CFIUS reviews are highly fact-specific and nuanced, based on historical data points, we can expect the Committee to complete action on a majority of transactions in 2022 without conditions or mitigating measures.

Real Estate Transactions Comprise a Minute Portion of CFIUS Reviews

Despite CFIUS’s expanded authority to review real estate transactions that may present a national security risk, such as proximity to sensitive U.S. military or government facilities, such transactions remain a very small portion of the total transactions reviewed by the Committee. Only five notices and one declaration concerning real estate were reviewed in 2021.[43] While the lack of real estate CFIUS filings could be tied to economic factors, this space remains one to watch in future years.

Requested Filings For Non-Notified/Non-Declared Transactions Decreased

In addition to transaction parties proactively filing with the Committee, the Committee may also identify and initiate unilateral review of a transaction, and may request the parties to submit a filing. The 2020 Annual Report was the first report to contain data relating to the number of non-notified/non-declared transactions identified and put forward to the Committee for consideration.

While CFIUS identified 135 non-notified/non-declared transactions in 2021—compared to 117 in 2020—fewer transactions resulted in a request for filing. [44] Out of 117 identified transactions in 2020, 17 resulted in a request for filing versus just eight requests for filing in 2021.[45]

Given that the number of transactions identified increased, the Committee appears committed to enhancing and utilizing methods for improving the identification of non-notified/non-declared transactions. In fact, in the press release announcing the Annual Report, the Department of Treasury noted as a “key highlight” that CFIUS continues to hire talented staff to support identifying transactions that are not voluntarily filed with the Committee, as well as monitoring and enforcement activities.[46] As such, the trends in the number of non-notified/non-declared transaction will be an important space to watch.

Conclusion

The record increase in CFIUS filings this year reflects the continuing expansion of the Committee’s scope and resources since the enactment of FIRRMA, as well as the recognition by foreign acquirers of the increased risks and sensitivities when it comes to transactions involving U.S. businesses that may pose potential national security risks in the eyes of the Committee. CFIUS has consistently reviewed more covered transactions from year to year, and we see no indication this trend will not continue.

_________________________

[1] Committee on Foreign Investment in the United States, “Annual Report to Congress, Report Period: CY 2021”, available at: https://home.treasury.gov/system/files/206/CFIUS-Public-AnnualReporttoCongressCY2021.pdf.

[2] For further detail on the impact of FIRRMA, see our previous alert “CFIUS Reform: Top Ten Takeaways from the Final FIRRMA Rules,” Feb. 19, 2020, available at: https://www.gibsondunn.com/cfius-reform-top-ten-takeaways-from-the-final-firrma-rules/.

[3] Annual Report at 4, 15.

[4] In one of these instances, the parties re-filed as a notice.

[5] Committee on Foreign Investment in the United States, “Annual Report to Congress, Report Period: CY 2018,” at 31 (the “2018 Annual Report”) available at: https://home.treasury.gov/system/files/206/CFIUS-Public-Annual-Report-CY-2018.pdf; ; Committee on Foreign Investment in the United States, “Annual Report to Congress, Report Period: CY 2019,” at 33 (the “2019 Annual Report”) available at: https://home.treasury.gov/system/files/206/CFIUS-Public-Annual-Report-CY-2019.pdf; Committee on Foreign Investment in the United States, “Annual Report to Congress, Report Period: CY 2020,” at 4 (the “2020 Annual Report”) available at: https://home.treasury.gov/system/files/206/CFIUS-Public-Annual-Report-CY-2020.pdf.

[6] 2020 Annual Report at 4; Annual Report at 4.

[7] 2020 Annual Report at 15; Annual Report at 15.

[8] Annual Report at 15.

[9] Annual Report at 37.

[10] Id.

[11] Id.

[12] Id.

[13] 2020 Annual Report at 15.

[14] Annual Report at 15; 2020 Annual Report at 17.

[15] Annual Report at 11.

[16] Annual Report at 11-12.

[17] Annual Report at 11

[18] Annual Report at 11-12.

[19] Annual Report at 11

[20] Annual Report at 32.

[21] Id.

[22] Annual Report at 11, 32.

[23] Annual Report at 20.

[24] Annual Report at 48.

[25] 2020 Annual Report at 51.

[26] Annual Report at 50.

[27] Annual Report at 49.

[28] Id.

[29] 2020 Annual Report at 18; Annual Report at 18.

[30] 2020 Annual Report at 18; Annual Report at 18.

[31] Upon receiving a declaration, the Committee may request that the parties file a written notice, inform the parties that the Committee is unable to complete action under the initial review phase on the basis of the declaration, initiate a unilateral review, or notify the parties it has completed all action with respect to the transaction. 50 U.S.C. § 4565(b)(1)(C)(v)(III)(aa).

[32] Annual Report at 13.

[33] Annual Report at 18. Considering that the figure of 46.3 days is expressed in calendar days and not business days, we take the view that the time taken by the Committee to close a transaction review is acceptable.

[34] Annual Report at 18.

[35] Id.

[36] 2020 Annual Report at 40.

[37] Annual Report at 38.

[38] Id.

[39] Id.

[40] Id.

[41] Annual Report at 44.

[42] Id.

[43] Annual Report at 4, 22.

[44] Annual Report at 45.

[45] 2020 Annual Report at 48; Annual Report at 45.

[46] “Treasury Releases CFIUS Annual Report for 2021,” (Aug. 2, 2022) available at:
https://home.treasury.gov/news/press-releases/jy0904.

The following Gibson Dunn lawyers prepared this client alert: Stephenie Gosnell Handler, David Wolber, Judith Alison Lee, Adam M. Smith, Annie Motto, and Jane Lu*.

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

United States
Judith Alison Lee – Co-Chair, International Trade Practice, Washington, D.C. (+1 202-887-3591, [email protected])
Ronald Kirk – Co-Chair, International Trade Practice, Dallas (+1 214-698-3295, [email protected])
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, [email protected])
David P. Burns – Washington, D.C. (+1 202-887-3786, [email protected])
Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, [email protected])
Nicola T. Hanna – Los Angeles (+1 213-229-7269, [email protected])
Marcellus A. McRae – Los Angeles (+1 213-229-7675, [email protected])
Adam M. Smith – Washington, D.C. (+1 202-887-3547, [email protected])
Christopher T. Timura – Washington, D.C. (+1 202-887-3690, [email protected])
Laura R. Cole – Washington, D.C. (+1 202-887-3787, [email protected])
Annie Motto – Washington, D.C. (+1 212-351-3803, [email protected])
Chris R. Mullen – Washington, D.C. (+1 202-955-8250, [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])
Shuo (Josh) Zhang – Washington, D.C. (+1 202-955-8270, [email protected])

Asia
Kelly Austin – Hong Kong (+852 2214 3788, [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])

Europe
Attila Borsos – Brussels (+32 2 554 72 10, [email protected])
Nicolas Autet – Paris (+33 1 56 43 13 00, [email protected])
Susy Bullock – London (+44 (0) 20 7071 4283, [email protected])
Patrick Doris – London (+44 (0) 207 071 4276, [email protected])
Sacha Harber-Kelly – London (+44 (0) 20 7071 4205, [email protected])
Penny Madden – London (+44 (0) 20 7071 4226, [email protected])
Benno Schwarz – Munich (+49 89 189 33 110, [email protected])
Michael Walther – Munich (+49 89 189 33 180, [email protected])
Richard W. Roeder – Munich (+49 89 189 33 115, [email protected])

* Jane Lu is a trainee solicitor working in the firm’s Hong Kong office who is not yet admitted to practice law.

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

I. Introduction: Themes and Notable Developments in Rulemaking & Enforcement

A. Heightened Enforcement

In our 2021 Year-End Review, we noted that the Division of Enforcement under this Administration had outlined its vision of aggressive, heightened enforcement through an escalation of existing remedies, including increased penalties, individual bars and admissions. The first half of 2022 reflected the Enforcement Division pursuing the playbook as forecasted.

In the first half of 2022, the Commission filed complaints or settled matters in many of its priority areas, such as digital assets and environmental, social and governance (“ESG”) disclosures, and assessed significantly heightened monetary penalties.[1]

The Commission also brought its first substantive enforcement action involving Regulation Best Interest (“Reg BI”).[2] Reg BI—which establishes a “best interest” standard for investment recommendations by broker-dealers—went into effect on June 20, 2020, and abrogates the prior suitability standard for retail customers. The SEC filed a complaint relating to the sale of allegedly high-risk bonds to a number of retail customers alleging, among other things, that the broker-dealer did not conduct adequate diligence on the bonds, did not adequately advise its brokers of the risks, and did not have adequate policies and procedures for compliance with Reg BI.

The Commission’s Reg BI action is also an example of its continuing emphasis on naming and/or charging individual respondents along with entities. Notwithstanding the alleged institutional shortcomings, the complaint also names five individual brokers who earned as little as $5,400 in commissions from the sale of the bonds. All the defendants are litigating the action.[3] (More details are provided in the Broker-Dealers section below.) The result inevitably increases the litigation burden on the Staff of the Enforcement Division.

B. The Age of Dissent

Also of note is the extent to which the Commission’s heightened enforcement agenda is routinely drawing public dissent from at least one of the Commissioners, Hester Peirce.

Commissioner Peirce has long been critical of the Commission’s approach to regulation of the market for digital assets. In February, she reiterated that same criticism in response to a settled enforcement action against a financial services company to which investors lend crypto assets in exchange for a variable interest rate generated through the use of the crypto assets in lending and investment activities. The settled enforcement action alleged, among other things, violations of the registration provisions of the Securities Act and Investment Company Act. Commissioner Peirce again criticized the Commission’s lack of flexibility in subjecting the respondent to challenging registration requirements of the Investment Company Act without a willingness to structure a workable exemption that would still accomplish the Commission’s regulatory mission. Commissioner Peirce admonished that if the Commission is sincere in its invitation to hear from participants in digital asset markets, then the Commission “need[s] to commit to working with these companies to craft sensible, timely, and achievable regulatory paths.”[4]

In another example, in response to a settled insider trading enforcement action, Commissioner Peirce undertook a granular analysis of the factual findings of the Commission’s order and criticized the sufficiency of the evidence to establish the elements of a violation. The Commission found that the respondent had misappropriated material nonpublic information from a business partner who was on the board of the issuer. In finding that the respondent had become aware of material nonpublic information, the order pointed to public facts that the business partner had joined the board in part to assist with pursuing strategic opportunities combined with the respondent “observing [the insider’s] increased activities” at the issuer. Describing the order’s series of inferences as “a rickety structure at best,” Commissioner Peirce noted that the order appears to endorse an unsupported approach to the standard of materiality in which “the existence of a relationship of trust and confidence somehow transmogrifies non-material, public information into material, non-public information.” Of course, as a settled order, the Commission’s theory of liability is not subject to the test of litigation.[5]

More recently, Commissioner Peirce dissented from a settled enforcement action against a broker-dealer for alleged violations of the suitability, compliance and recordkeeping provisions arising from the sale of certain variable rate structured products. Commissioner Peirce dissented because the settlement order recited that, in accepting the respondent’s offer, the Commission took into consideration the respondent’s remedial acts, which included adopting a policy that prohibits the sale of the securities at issue to retail customers. Commissioner Peirce argued that the “Commission’s orders should not intimate that certain types of investments are never suitable for particular classes of investors.” In particular, Commissioner Peirce noted that the Commission’s acknowledgment of, and reliance on, the remedial step taken by the respondent “may be read either as implying that an absolute prohibition on the sale of a specific product is the only acceptable remedial measure here or as an expectation for other firms dealing with retail clients.”[6]

In another recent example, Commissioner Peirce issued a lengthy public dissent from a settled enforcement action against an accounting firm because the action was based in part on an alleged failure of the respondent to update a response to a voluntary information request from the Staff, notwithstanding that the respondent firm investigated and self-reported the underlying issue to its primary regulator, the PCAOB. Commissioner Peirce sharply criticized the Commission’s position as “lack[ing] sound legal grounding,” “woefully misguided” and “patently unfair.”[7]

These examples are important in that persons and entities subject to investigation have an audience on the Commission, albeit a minority, that provides a potential counterweight to the most aggressive instincts of this Commission, and may be receptive to arguments or positions that are contrary to those advanced by the Enforcement Division. However, make no mistake: the majority of this Commission will continue to pursue an aggressive enforcement agenda for the remainder of this Administration.

C. Litigation Update

In mid-July, the United States Court of Appeals for the Second Circuit issued a decision in SEC v. Rio Tinto plc, definitively limiting the way that the SEC has interpreted the boundaries of scheme liability after the Supreme Court’s decision in Lorenzo v. SEC. The SEC argued in Rio Tinto that alleged misstatements and omissions in annual reports and offering documents could form the basis of a scheme liability claim. The Second Circuit disagreed, holding that Lorenzo did not abrogate prior caselaw that scheme liability requires fraudulent conduct beyond mere misstatements and omissions. Our prior client alert provides additional information regarding the decision.

D. Commissioner and Senior Staffing Update

In the first half of 2022, the Commission experienced a number of changes in its senior staff, as well as the addition of a new Commissioner (with another Commissioner joining in July).

In June, Mark T. Uyeda was sworn into office as a Commissioner, filling the position most recently held by Elad Roisman.[8] He is the first Asian Pacific American to serve as a Commissioner at the SEC. He served on the staff of the SEC for 15 years before his appointment to the Commission, including as a Senior Advisor to various Commissioners and in roles in the Division of Investment Management. Commissioner Uyeda, a Republican, and Jaime Lizárraga, a Democrat, were both confirmed by the Senate earlier that month.[9] Mr. Lizárraga most recently served as a Senior Advisor to House Speaker Nancy Pelosi, and previously worked on the Democratic staff of the House Financial Services Committee.[10] He was sworn in on July 18 to fill the seat of Allison Herren Lee following her departure from the Commission.

At the staff level, the Division of Examinations, in particular, saw significant changes in leadership. Daniel S. Kahl, Acting Director of the Division, left the SEC in March.[11] Following Mr. Kahl’s departure, Richard R. Best left his post as Director of the New York Regional Office to serve as Acting Director and, later, Director of the Division of Examinations.[12] In January, the Division’s Deputy Director since 2018, Kristin Snyder, also left the agency.[13] Ms. Snyder had also led the Investment Adviser/Investment Company (IA/IC) examination program, including the Private Funds unit, since 2016. Following her departure, Joy Thompson has been serving as Acting Deputy Director and Acting Associate Director of the Private Funds Unit, and Natasha Vij Greiner has been serving as Acting Co-National Associate Director of the IA/IC examination program.

There was significant turnover at the regional offices, with five of eleven regional offices experiencing changes in leadership. Those changes, as well as other changes in the senior staffing of the Commission, include:

In February, Lori H. Price was named Acting Director of the Office of Credit Ratings, replacing Ahmed A. Abonamah, who left the agency that month.[14]
Also in February, Kelly L. Gibson, Director of the SEC’s Philadelphia Regional Office since 2020, left the agency.[15] Scott Thompson and Joy Thompson have been serving as Acting Co-Directors of the Philadelphia Regional Office following Ms. Gibson’s departure.
In March, Lara Shalov Mehraban began serving as Acting Director of the New York Regional Office following Richard R. Best’s transition to his new role in the Division of Examinations.[16]
Also in March, Erin E. Schneider, Director of the SEC’s San Francisco Regional Office since 2019, left the agency.[17] Monique C. Winkler has been serving as Acting Regional Director following Ms. Schneider’s departure.
In June, Tracy S. Combs was named Director of the Salt Lake Regional Office.[18] Combs previously served in the agency’s Division of Enforcement, including as counsel to the Director of Enforcement since 2021. Tanya Beard, who served as Acting Director prior to Ms. Comb’s appointment, remains in the Salt Lake Regional Office as Assistant Regional Director of Enforcement.
In July, Kurt. L. Gottschall, Director of the Denver Regional Office since 2018, left the SEC.[19] Jason J. Burt and Thomas M. Piccone have been serving as Co-Acting Regional Directors following Mr. Gottschall’s departure.

E. SPACs

The SEC continued its focus on Special Purpose Acquisition Companies (“SPACs”) in the first half of 2022. While there were no enforcement actions specifically related to SPACs, the SEC, in March, proposed new rules intended to enhance disclosure and investor protection in initial public offerings (“IPOs”) by SPACs and in subsequent business combinations between SPACs and private operating companies (“de-SPAC transactions”).[20] SEC Chair Gary Gensler described these proposed rules as crucial to “help ensure” that “disclosure[,] standards for marketing practices[,] and gatekeeper and issuer obligations” as applied in the traditional IPO context also apply to SPACs.[21] Chair Gensler further observed that “[f]unctionally, the SPAC target IPO is being used as an alternative means to conduct an IPO.”[22]

The proposed rules, which include new rules and amendments to existing rules, involve four key components:

Disclosure and Investor Protection: creating specific disclosure requirements with respect to, among other things, compensation paid to sponsors, potential conflicts of interest, dilution, and the fairness of the business combination, for both the SPAC IPOs and de‑SPAC transactions;
Business Combinations Involving Shell Companies: deeming a business combination transaction involving a reporting shell company and a private operating company as a “sale” of securities under the Securities Act of 1933 (the “Securities Act”) and amending the financial statement requirements applicable to transactions involving shell companies. Furthermore, the rules will amend the current “blank check company” definition to make clear that SPACs cannot rely on the safe harbor provision under the Private Securities Litigation Reform Act of 1995 when marketing a de-SPAC transaction;
Projections: expanding and updating the Commission’s guidance on the presentation of projections in filings with the Commission to address the reliability of such projections; and
New Safe Harbor under the Investment Company Act of 1940: creating a safe harbor that SPACs may rely on to avoid being subject to registration as investment companies under the Investment Company Act of 1940. The safe harbor would (i) require SPACs to hold only assets comprising of cash, government securities, or certain money market funds; (ii) require the surviving entity to be engaged primarily in the business of the target company; and (iii) impose a time limit, from the SPAC IPO, of 18 months for the announcement (and 24 months for the completion) of the de-SPAC transaction.

For a more detailed discussion of these proposed rules, see our prior alert on the subject.

F. Cybersecurity

The SEC continued its history of rulemaking in the area of cybersecurity matters during the first half of 2022.

1. Public Companies

In March, the SEC proposed further amendments to its rules which would require, among other things, current reporting about material cybersecurity incidents and periodic reporting to provide updates about previously reported cybersecurity incidents.[23] The proposal also would require periodic reporting about a public company’s policies and procedures to identify and manage cybersecurity risks; the registrant’s board of directors’ oversight of cybersecurity risk; and management’s role and expertise in assessing and managing cybersecurity risk and implementing cybersecurity policies and procedures. The proposal further would require annual reporting or certain proxy disclosure about the board of directors’ cybersecurity expertise, if any.

For a more detailed discussion of the proposed rule, see our prior alert on the subject.

2. Investment Management

In February, the SEC voted to propose rules related to cybersecurity risk management for registered investment advisers, and registered investment companies and business development companies (funds), as well as amendments to certain rules that govern investment adviser and fund disclosures.[24] The proposed rules would require advisers and funds to adopt and implement written cybersecurity policies and procedures. The proposed rules also would require advisers to report significant cybersecurity incidents affecting the adviser or its fund or private fund clients to the Commission on a new confidential form, and to publicly disclose cybersecurity risks and significant cybersecurity incidents that occurred in the last two fiscal years in their brochures and registration statements. Additionally, the proposal would set forth new recordkeeping requirements for advisers and funds.

For further discussion of the proposed rule, see our prior alert regarding 2022 rule proposals targeting advisers to private funds.

G. ESG

The Division of Enforcement’s Climate and ESG Task Force, led by Sanjay Wadhwa, Deputy Director of the Division of Enforcement, has ramped up its efforts since its founding in May 2021, reportedly using “sophisticated data analysis to mine and assess information” to identify “material gaps or misstatements” in issuer’s disclosures and disclosures relating to investment advisers’ and funds’ ESG strategies.[25] Meanwhile, the Commission is also engaged in a number of rulemaking efforts relating to ESG.

1. Public Companies

In March, the SEC proposed rule changes that would require registrants to include certain climate-related disclosures in their registration statements and periodic reports.[26] The proposed rule changes would require a registrant to disclose information about (i) the issuer’s governance of climate-related risks and relevant risk management processes; (ii) how any climate-related risks identified by the registrant have had or are likely to have a material impact on its business and consolidated financial statements, which may manifest over the short-, medium-, or long-term; (iii) how any identified climate-related risks have affected or are likely to affect the registrant’s strategy, business model, and outlook; and (iv) the impact of climate-related events, and transition activities on the line items of a registrant’s consolidated financial statements, as well as on the financial estimates and assumptions used in the financial statements.

For public companies that already conduct scenario analyses, have developed transition plans, or publicly set climate-related targets or goals, the proposed amendments would require certain disclosures to enable investors to learn about those aspects of the registrants’ climate risk management.

The proposed rules also would require a registrant to disclose information about its direct greenhouse gas (“GHG”) emissions and indirect emissions from purchased electricity or other forms of energy, as well as from upstream and downstream activities in its value chain. The proposed rules provide a safe harbor for liability and an exemption from certain disclosure requirements for smaller reporting companies. Under the proposed rule changes, accelerated filers and large accelerated filers would be required to include an attestation report from an independent attestation service provider, with additional phase-ins over time.

According to Chair Gensler, the SEC has received 14,500 comment letters on the proposal.[27] For a more detailed discussion of the proposal, see our prior alert on the subject.

2. Investment Management

In May, the SEC proposed amendments to rules and reporting forms applying to certain registered investment advisers, advisers exempt from registration, registered investment companies, and business development companies.[28] The proposed amendments seek to categorize certain types of ESG strategies broadly and require funds and advisers to provide more specific disclosures in fund prospectuses, annual reports, and adviser brochures based on the ESG strategies they pursue. Funds focused on the consideration of environmental factors generally would be required to disclose the GHG emissions associated with their portfolio investments. Funds claiming to achieve a specific ESG impact would be required to describe the specific impacts they seek to achieve and summarize their progress on achieving those impacts. Funds that use proxy voting or other engagement with issuers as a significant means of implementing their ESG strategy would be required to disclose information regarding their voting of proxies on particular ESG-related voting matters and information concerning their ESG engagement meetings. Finally, the proposal would require certain ESG reporting on Forms N-CEN and ADV Part 1A.

In May, the SEC also proposed amendments to the Investment Company Act “Names Rule” with the stated goal of “moderniz[ing] the Names Rule for today’s markets,” including for ESG-related funds.[29] The current rule requires registered investment companies whose names suggest a focus in a particular type of investment to adopt a policy to invest at least 80% of the value of their assets in those types of investments. The proposed amendments would extend the requirement to any fund name with terms suggesting that the fund focuses in investments that have (or whose issuers have) particular characteristics, including fund names with terms such as “growth” or “value,” or terms indicating that the fund’s investment decisions incorporate one or more ESG-related factors.

An investment adviser ESG-related disclosure case is described below in III.B.

H. Whistleblower Awards

Coming off a record-breaking year, the pace and size of whistleblower awards has slowed in the first half of 2022. Through June of this year, the SEC’s whistleblower program has awarded approximately $88 million to 22 separate whistleblowers. This is less than half of the payments awarded during the same time period in 2021, which saw nearly $200 million in awards to 45 individuals.

Still, the whistleblower program remains significant for the Commission, with approximately $1.3 billion paid to 273 individuals since the program’s inception in 2012. Further, the SEC remains committed to incentivizing whistleblowers to come forward with information, and to rewarding their efforts. In February, the SEC proposed two amendments to whistleblower program rules aimed at further enticing whistleblowers to come forward.[30] The first proposed change would allow the Commission to pay whistleblower awards, even if the awards might otherwise be paid under another federal agency program.[31] The second change would affirm the SEC’s discretionary authority to consider the dollar amount of potential awards for the sole purpose of increasing any award under Rule 21F-6, which would preclude considering the dollar amount to decrease any award.[32]

Significant whistleblower awards granted during the first half of this year include:

Three awards in January, including a payment of over $13 million to a whistleblower who “promptly” notified the Commission of an ongoing fraud and provided “extensive” assistance thereafter, which led to the opening of an investigation and a successful enforcement action;[33] an award totaling more than $4 million to three whistleblowers in two separate enforcement proceedings, all described as providing “critical” information during the investigation;[34] and awards totaling more than $40 million to four whistleblowers, two of whom received a combined $37 million for providing “key evidence,” while the third received approximately $1.8 million for providing information which prompted a separate related action, and the fourth received a $1.5 million award for providing information that “shaped the staff’s instigative strategy.”[35]
Four awards in March, including a payment of more than $3.5 million to a whistleblower for contributing to the success of two enforcement actions and helping save the SEC staff time and resources;[36] an award of approximately $14 million to a whistleblower whose online report and outreach to staff exposed an ongoing fraud and prompted a successful enforcement action along with restitution to investors;[37] awards totaling approximately $3 million to three whistleblowers who provided information that prompted the SEC staff to open investigations and provided ongoing assistance in three separate actions;[38] and an award of $1.25 million to a whistleblower who provided “high-quality information and exemplary cooperation,” including identifying witnesses and explaining key documents, which led to a successful enforcement action and saved the SEC staff time and resources.[39]
An award in April of $6 million to five whistleblowers in a single enforcement proceeding who each provided ongoing assistance, in the form of either key documents or firsthand accounts of misconduct.[40]
An award in May totaling nearly $3.5 million to four whistleblowers who provided information which led to a successful enforcement action. Three of these whistleblowers provided the SEC with information that led to the opening of a new investigation, while the fourth provided analysis, which “focused the staff’s attention on new allegations.”[41]

II. Public Company Actions

Public company accounting and disclosure cases continued to comprise a significant portion of the SEC’s cases in the first half of 2022, and included a range of financial reporting, disclosure, and professional responsibility enforcement actions.

A. Financial Reporting

In February, the SEC announced settled charges against a healthcare company and two former employees for alleged accounting improprieties stemming from intra-company foreign exchange transactions that resulted in a purported misstatement of the company’s net income.[42] The SEC alleged that, from 1995 to 2019, the company used a non-GAAP convention for converting non-U.S. dollar transactions, assets, and liabilities on its financial statements. The SEC further alleged that, beginning in 2009, the company purposefully used this convention for the purpose of generating foreign exchange accounting gains and avoiding losses of the same. Further, the SEC alleged that one former employee did not take steps to investigate the company’s consistently generated gains. Without admitting or denying the allegations, the company and its former employees agreed to cease and desist from future violations. The company agreed to pay an $18 million fine, and the former employees agreed to pay nearly $315,000 combined in civil penalties and disgorgement.

In April, the SEC announced a settled action against a pest control company and a former executive for allegedly making improper accounting adjustments through reducing accounting reserves without analyzing appropriate criteria under GAAP in order to meet quarterly earnings per share targets.[43] The SEC further alleged that the company and former executive failed to adequately memorialize the basis for these accounting entries and that the company failed to document other quarterly entries from 2016 to 2018. Without admitting or denying the allegations, the company and executive agreed to cease and desist from future violations, and pay penalties of $8 million and $100,000, respectively. The company’s penalty was the highest yet under the SEC’s earnings per share (“EPS”) initiative, which relies on data analytics to uncover hard-to-detect accounting and disclosure violations.

In June, the SEC announced a settled action against a telecommunications-support technology company and several of its senior employees for improper accounting practices, including improperly recognizing revenue on multiple transactions and misleading the company’s auditors.[44] The SEC alleged that, from 2013 to 2017, senior employees of the company improperly accounted for three categories of transactions which resulted in overstating revenue in pursuit of meeting earnings targets: (1) transactions without persuasive evidence of an arrangement; (2) acquisitions and divestitures where revenue was recognized on license agreements instead of netting those amounts against purchase prices; and (3) license and hosting transactions where it recognized revenue upfront, instead of rated over the term of the arrangement. The SEC also alleged that certain employees attempted to conceal that revenue had been improperly recognized upfront when, instead, it was contingent on future events. Without admitting or denying the SEC’s findings, the company agreed to cease and desist from further violations and pay a $12.5 million civil penalty; three former employees and one current employee settled for civil penalties ranging from $15,000 to $90,000; and the company’s former general counsel agreed to pay a $25,000 penalty and to a suspension from appearing or practicing as an attorney before the SEC for 18 months. The company’s founder and former CEO, while not charged with misconduct, agreed to reimburse the company $1.3 million in stock sale profits and bonuses, and return shares of company stock. Additionally, the SEC filed a complaint in the Southern District of New York against both the company’s former CFO and the former Controller, seeking civil penalties, restitution, bars, and permanent injunctions. That litigation remains ongoing.

B. Public Statements and Filing Disclosures

In January, the SEC settled an action—without any monetary penalties—against a private technology company after it made significant remedial efforts in the wake of an internal investigation into misconduct by its now-former CEO.[45] As profiled in our last update, the SEC issued a complaint against the then-CEO of the company, after he allegedly inaccurately claimed the company had achieved strong and consistent revenue and customer growth in order to push it to a “unicorn” valuation of over $1 billion. The company’s Board of Directors conducted an internal investigation leading to the CEO’s removal and a revised valuation down to $300 million. The Board instituted other remedial measures, including the repayment of investors, hiring of new senior management, expansion of its board, and institution of processes and procedures to increase transparency and accuracy of deal reporting. The SEC highlighted these remedial actions and the company’s extensive cooperation in the matter as factors counseling against imposing a penalty. Accordingly, the company settled the complaint for a permanent injunction against further violations without admitting or denying wrongdoing.

In April, the SEC filed a complaint against a former executive of a Brazilian reinsurance company for making allegedly false statements claiming that a large, multi-national conglomerate had recently made a substantial investment in the company.[46] The SEC alleged that, in February 2020, the executive planted misleading stories with the media, created and shared fabricated shareholder lists purporting to show substantial purchases of the company’s stock by the conglomerate, and shared information with analysts and investors purporting to show this investment. The SEC alleged that, as a result of this information, the reinsurance company’s stock price rose by more than 6% during the following 24 hours, and dropped more than 40% after the conglomerate denied the investment. The SEC filed a complaint against the former executive seeking a permanent injunction, officer and director bar, and civil monetary penalties. The Department of Justice also announced criminal charges against the individual.

In May, the SEC announced settled charges against a healthcare supply chain company and a complaint against its former CEO and Chairman of the Board for making allegedly false statements regarding the company’s plan to distribute COVID-19 rapid test kits.[47] The SEC alleged that, in April 2020, the company issued a press release announcing a “committed purchase order” for two million COVID-19 test kits, as well as an ongoing commitment to purchase two million more test kits every week for nearly six months. However, the company allegedly had neither an executed purchase agreement nor a supplier for the tests. The SEC alleged that after the announcement, the company, which was struggling financially at the time, saw a 425% increase in stock price from the prior trading day. Without admitting or denying the allegations, the company agreed to a settlement that included permanent injunctions, a $125,000 penalty, and more than $500,000 in disgorgement. The U.S. Attorney’s Office for the District of New Jersey and the U.S. Department of Justice’s Criminal Division also announced criminal charges against the former CEO.

C. Gatekeepers

In June, the Commission instituted a settled action against a credit rating agency and its CEO for allegedly violating various conflict of interest rules.[48] The SEC’s complaint alleged that the CEO engaged in sales and marketing activities related to a client while, at the same time, determining that client’s credit rating, in violation of Rules 17g-5(c)(8)(i)–(ii) of the Exchange Act. The complaint also alleged that the agency violated Rule 17g-5(c)(1) (the “Ten Percent Rule”) by allegedly continuing to issue and maintain ratings for another client, even though that client had contributed more than 10% of the agency’s revenues in the prior fiscal year. Lastly, the SEC alleged that the agency did not establish, maintain, and enforce sufficient internal controls to manage these conflicts of interest. Without admitting or denying the SEC’s findings, both the agency and its CEO agreed to pay a total of $2 million in civil penalties, as well as over $146,000 in disgorgement.

Also in June, the SEC instituted a settled action against an audit firm and three of its partners for alleged improper professional conduct after failing to investigate two clients’ financial statements despite known concerns about the accuracy of one client’s goodwill impairment calculations and another’s related party transactions.[49] The SEC alleged that, in 2016 and 2017, the audit firm and its partners allegedly improperly accepted its clients’ determination that their goodwill had not been impaired or reduced in value, despite internal beliefs that the goodwill valuation methods employed by the clients were insufficient. The SEC also alleged that the audit firm’s quality control systems led to the failure to adhere to adequate professional auditing standards. Without admitting or denying the allegations, the audit firm agreed to pay a $1.9 million penalty, to be censured, and to retain an independent consultant to review and evaluate certain control policies and procedures. The partners, without admitting or denying the allegations, agreed to each pay penalties ranging from $20,000 to $30,000; two partners additionally agreed to one- and three-year suspensions to practicing before the SEC, and the third partner agreed to a censure. The audit firm’s two clients at issue previously settled with the SEC related to the same financial disclosures, but with different outcomes: one of the audit firm’s clients and the client’s employees agreed to a settlement involving multi-million dollar monetary fines, restitution, and injunctive relief in June 2019;[50] the other client agreed to a no-penalty settlement without admitting or denying wrongdoing.[51]

Also in June, the SEC settled an action with an accounting firm relating to cheating by the firm’s employees on CPA ethics exams over a number of years, which was aggravated by the SEC’s perceived failure by the firm to correct its response to an earlier SEC voluntary request for information regarding the matter.[52] In June 2019, in the wake of a settlement with a different accounting firm regarding a similar issue, the firm received a voluntary information request from the SEC regarding complaints about cheating on CPA ethics exams, and the SEC asked for a response only one day later. The firm complied with the short response timeline, but its response did not include a relevant whistleblower report that was first made the same day the firm received the voluntary information request, and of which the legal department was not aware of its existence at the time of its initial response to the SEC. After becoming aware of this report, the firm conducted an internal investigation into the issue and later reported its results to the PCAOB. However, the SEC reasoned that the firm had violated the PCAOB’s professionalism rules because it did not promptly supplement its initial response to the SEC’s June 2019 voluntary information request with information about the whistleblower’s report. The firm settled the SEC’s allegations, agreeing to pay a $100 million fine, as well as to engage two independent consultants to make recommendations for further internal improvements. As noted above, Commissioner Peirce issued a forceful dissent from the settlement, arguing that the SEC’s “unduly punitive terms” were overly focused on the firm’s “imperfect compliance” with the SEC staff’s request to respond with information the next day, and ignored the “central issue” of cheating by the auditing professionals employed by the firm.[53]

III. Investment Advisers

A. Misuse of Investor Funds

In January, the SEC charged a financial adviser (dual registered representative of a broker-dealer and investment adviser) for allegedly misappropriating nearly $6 million from a client[54] over a six-year period and using the money for personal expenses, and to repay money that he had taken from another client. The SEC alleged the adviser created false account statements, forged signatures on documents, and altered financial records to cover up his actions. The SEC is seeking injunctive relief, disgorgement, and civil penalties. The U.S. Attorney’s Office for the Southern District of Florida filed parallel criminal charges.

In March, the SEC announced fraud charges against an investment adviser for allegedly using investor funds for personal expenses and a Ponzi-like scheme.[55] According to the SEC, the adviser told investors that their pooled money would be invested using a proprietary algorithm. The SEC alleged that, instead, the adviser used investor funds to pay off his own personal expenses and to repay previous investors while misleading current investors about their returns. The same adviser was permanently barred from the securities industry in a 1992 SEC enforcement action.[56] In the current case, the SEC is seeking an injunction, disgorgement, and penalties against the adviser. The U.S. Attorney’s Office for the District of New Jersey brought parallel criminal charges.

In May, the SEC charged a hedge fund and its sole owner for allegedly misappropriating millions of investors’ funds.[57] According to the SEC, over a period of nearly five years, the hedge fund and its owner raised approximately $39 million from more than 100 investors and thereafter made inaccurate statements about the fund’s performance (incurring $27 million in trading losses), falsified investors account documents, misrepresented the fact that the fund did not have an auditor, engaged in a Ponzi-like scheme with new investor funds being paid to earlier investors, and took money from the fund to pay for personal expenses, including jewelry. The SEC sought and obtained emergency relief and an asset freeze against the hedge fund and its owner, and the litigation remains ongoing.

B. Material Misrepresentations

In February, the SEC announced a settled action against a robo-adviser based on allegations that it made misleading statements and failed to comply with its own representations that it was compliant with Shari’ah law.[58] The SEC alleged the robo-adviser promoted its own proprietary funds when no such funds existed, then used investor funds to seed an exchange-traded fund without any disclosure to the investors. In addition, the SEC claimed that the robo-adviser promoted itself as compliant with Shari’ah law, including marketing an income purification process, but then took no actions to ensure this compliance. Without admitting or denying the allegations, the adviser agreed to a cease-and-desist order, to retain an independent compliance consultant, and to pay a $300,000 penalty.

In February, the SEC announced charges against the former Chief Investment Officer and founder of an investment adviser to a mutual fund and a hedge fund, based on allegations that the CIO significant overvalued assets, resulting in his receipt of $26 million of improper profit distributions.[59] According to the SEC, the CIO altered documents describing the funds’ valuation policies and sent forged term sheets to the auditor of the mutual and private funds. The former CIO was removed from his position in February 2021 after the SEC’s Staff showed the firm information suggesting that the CIO had been adjusting the company’s third-party pricing model. Shortly thereafter, at the mutual fund’s request, the SEC issued an order suspending redemptions.[60] The U.S. Attorney’s Office for the Southern District of New York is pursuing parallel criminal charges.

In March, the SEC announced a settled action against an investment adviser for using its discretionary trading authority to invest advisory clients in proprietary mutual funds and failing to disclose the corresponding conflict of interest.[61] Without admitting or denying the allegations, the adviser agreed to a cease-and-desist order, to obtain an independent compliance consultant, and to pay disgorgement and penalties totaling $30 million.

In March, the SEC announced a settled action against a venture capital fund adviser and its CEO for allegedly making misstatements about the adviser’s management fees and otherwise breaching its operating agreement.[62] The SEC alleged that certain promotional material advertised a management fee that was much lower than what the adviser actually assessed. In addition, the SEC claimed that the adviser made cash transfers between various funds that were not authorized by the adviser’s operating agreement. Without admitting or denying the allegations, the adviser agreed to repay $4.7 million to the affected private funds along with a $700,000 penalty; the CEO agreed to pay a $100,000 penalty.

In April, the SEC announced a settled action against an asset manager and its former co-CEOs based on alleged misrepresentations about the asset manager’s prospects for growth.[63] According to the SEC, the asset manager overstated its assets by including amounts provisionally committed by clients who had no obligation to ultimately invest with the manager. The SEC alleged that the inclusion of these investments inflated the asset manager’s value and led investors to vote in favor of a merger for the asset manager that would result in higher paying jobs for the co-CEOs. Without admitting or denying the allegations, the co-CEOs and asset manager agreed to a cease-and-desist order and to pay a $10 million penalty.

In May, the SEC charged an investment firm for alleged misstatements and omissions about ESG considerations in making investment decisions for certain mutual funds that it managed.[64] The SEC’s order alleged that, from July 2018 to September 2021, the firm represented or implied in various statements that all investments in the funds had undergone an ESG quality review. But according to the SEC, numerous investments held by certain funds did not have an ESG quality review score as of the time of investment. Without admitting or denying the SEC’s findings, the firm agreed to a cease-and-desist order, a censure, and to pay a $1.5 million penalty.

Also in May, the SEC announced a settled action against a variable annuities principal underwriter for alleged sales practice misconduct by its wholesalers.[65] The SEC alleged employees of the wholesaler caused exchange offers to be made to customers and clients of its affiliated retail broker-dealer and investment adviser to switch from one variable annuity to another to increase sale commissions Notably, this case represents the first-ever enforcement proceeding under Section 11 of the Investment Company Act of 1940, which, absent an exception, prohibits any principal underwriter from making or causing to be made an offer to exchange the securities of registered unit investment trusts (including variable annuities) unless the terms of the offer have been approved by the SEC. Without admitting or denying the allegations, the respondent agreed to a cease-and-desist order and to pay a $5 million penalty.

Also in May, the SEC announced charges and settlements with an investment adviser and three of the adviser’s former senior portfolio managers for allegedly concealing the downside risks of an options trading strategy from approximately 114 institutional investors who invested approximately $11 billion in the strategy between 2016 and 2020.[66] According to the complaint and consent orders, the lead portfolio manager, with the assistance of two senior managers, manipulated financial reports and other information provided to investors to conceal the magnitude of the strategy’s risk and the strategy’s actual performance. In one instance, the senior portfolio managers allegedly reduced losses in one scenario in a risk report sent to investors from approximately negative 42.15% to negative 4.15%. The SEC alleged that the group took several steps to conceal their conduct, including by providing false testimony to the SEC. In settling the action, the investment adviser, which pleaded guilty to criminal charges, admitted that its conduct violated securities laws and agreed to a cease-and-desist order, a censure, and payment of $349.2 million in disgorgement and prejudgment interest and a fine of $675 million. Two of the three portfolio managers also consented to orders that included associational and penny stock bars as well as monetary relief to be determined in the future. The SEC’s litigation against the lead portfolio manager is ongoing.

In June, the SEC announced a settled action against an investment adviser and two affiliated companies based on allegations that the affiliates did not sufficiently describe in their historical disclosures how allocating a portion of a clients’ funds to cash could affect the performance of their portfolios under certain market conditions.[67] The SEC also alleged that the companies did not adequately disclose an affiliated bank’s ability to earn interest from the cash deposits. The SEC concluded, however, that each of the alleged disclosure deficiencies was fully corrected in November 2018. Without admitting or denying the allegations, the companies agreed to a cease-and-desist order, providing for their payment of approximately $187 million in disgorgement and penalties.

Also in June, the SEC announced a settled action against an investment adviser for allegedly contravening its agreements by allocating certain deal-related expenses across its private equity fund clients in a non-pro rata manner and failing to properly disclose the allocations.[68] According to the SEC, investors in the private equity funds included pension funds, foundations and endowments, other institutional investors, and high net worth individuals. Without admitting or denying the SEC’s allegations, the investment adviser agreed to a cease-and-desist order and to pay a $1 million penalty.

In June, the SEC announced a settled action against an investment adviser based upon allegations that the firm’s financial advisers did not adequately understand the risks associated with an options trading strategy that they recommended to approximately 600 advisory clients between February 2016 and February 2017 clients and thus the recommendations may not have been in the clients’ best interest.[69] Without admitting or denying the SEC’s allegations, the company agreed to a cease-and-desist order and agreed to pay a fine of $17.4 million and disgorgement and prejudgment interest of $7.2 million.

C. New Regulations

In addition to the cybersecurity and ESG-related rule proposals discussed in Section IE above, we note that in February, the SEC proposed a dramatic overhaul to the regulation of private fund advisers.[70] Among other changes, the proposed rules would require private fund advisers to provide investors with quarterly statements regarding fund fees, expenses, and performance. The proposed rule would also prohibit these advisers from giving certain kinds of preferential treatment to investors and would require disclosure to all current and prospective investors in a fund of any preferential rights granted to any investors of the fund.

For a more detailed discussion of the rule proposal, see our prior alert on the subject and the comment letter submitted by the Private Investment Funds Forum, of which GDC was a co-author.

We also note the upcoming November 2022 implementation deadline for the new Marketing Rule, which replaced the former Advertising and Solicitation rules, and caused the SEC to withdraw or modify roughly 200 No Action letters.[71]

IV. Broker-Dealers

A. Misrepresentation

In May, the SEC announced a settled action against a broker-dealer and its co-founder based on allegations that they misled customers as to restricting the purchase of so-called meme stocks in late January 2021.[72] According to the order, the broker-dealer halted purchases of the stocks for about 10 minutes, but after, the broker-dealer and its co-founder stated that it never restricted trading. Without admitting or denying the SEC’s charges, the broker-dealer and co-founder agreed to retain an independent compliance consultant and pay $100,000 and $25,000 fines, respectively.

B. Form-Filling Violations

In February, the SEC announced settled charges against 12 firms, six investment advisers and six broker-dealers, based on allegations that each of the firms failed to timely file and deliver the Form CRS to their existing and/or prospective retail clients and customers.[73] In June 2019, the SEC adopted Form CRS, which SEC-registered investment advisers and broker-dealers that offer services to retail investors are required to file and keep current with the SEC, deliver to existing and prospective clients and customers beginning no later than June/July 2020, and prominently post on their websites the most recently filed version thereof. The SEC alleged that the sanctioned 12 firms missed the regulatory deadlines and, in certain instances, failed to include required information and language in their respective Form CRS. Without admitting or denying the SEC’s findings, the firms each agreed to be censured, to a cease-and-desist order, and to pay civil penalties varying from $10,000 to $97,523.

In May, the SEC announced settled charges against a broker-dealer and investment adviser for allegedly failing to file over 30 suspicious activity reports (“SARs”) between April 2017 and October 2021, which are used to identify and investigate potentially suspicious activity.[74] The SEC’s order alleged that for a nine-month period, the firm failed to file at least 25 SARs as a result of its deficient implementation and testing of a new anti-money laundering (“AML”) transaction monitoring and alert system. The SEC further alleged that the firm failed to file at least nine additional SARs due to its failure to process wire transfer data into its AML transaction monitoring system on dates on which there was a bank holiday without a corresponding brokerage holiday. The order describes the firm’s substantial cooperation and voluntary remedial measures, as well as a thorough internal investigation conducted by the firm, the findings of which were shared with Staff. Notwithstanding, in its press release the SEC characterized the firm as a recidivist, citing to a prior settlement in 2017 relating to an alleged failure to file 50 SARs. Without admitting or denying the SEC’s findings, the firm agreed to a censure, a cease-and-desist order, and to pay a fine of $7 million.

C. Regulation Best Interest (“BI”)

As discussed in the introduction, in June, the SEC charged a broker-dealer and five of its registered representatives for allegedly violating Reg BI when recommending and selling L Bonds to retirees and other retail investors.[75] According to the SEC’s complaint, over a 10-month period, the broker’s registered representatives recommended and sold retail investors approximately $13.3 million in the bonds. According to the SEC, the bond’s issuer described the product as high risk, illiquid, and only suitable for customers with substantial financial resources. In the SEC’s first substantive Reg BI case, the SEC alleges violations of the broker-dealer’s Care Obligation (which requires that the registered representative have a reasonable basis to believe their recommendation is in the best interest of the customer), and Compliance Obligation (which requires that the broker-dealer maintain and enforce written policies and procedures designed to achieve compliance with Reg BI). The SEC is seeking permanent injunctions, disgorgement, and civil penalties.

V. Cryptocurrency and Other Digital Assets

Despite the recent current crypto winter (cryptocurrencies reportedly having lost trillions in value since market highs in 2021), digital assets continue to be a leading-edge asset class and a primary focus for the SEC’s Division of Enforcement, as evidenced by multiple enforcement actions in the first half of 2022, as well as expected rulemaking proposals and dramatic staffing increases in the Commission’s digital asset securities unit.

A. Agency Updates

In May, the SEC announced the allocation of 20 additional positions to the newly renamed Crypto Assets and Cyber Unit (formerly known as the Cyber Unit) in the Division of Enforcement, which will grow to 50 dedicated positions—nearly doubling the size of the unit.[76] According to the SEC, the expanded Crypto Assets and Cyber Unit will focus on investigating securities law violations related to: digital asset offerings; digital asset exchanges; digital asset lending and staking products; decentralized finance (“DeFi”) platforms; non-fungible tokens (“NFTs”); and stablecoins.

B. Fraud

In January, the SEC announced charges against an Australian citizen and two companies he founded for allegedly making false and misleading statements in connection with an unregistered offer and sale of digital asset securities.[77] According to the SEC’s complaint, the Founder claimed to have raised $40.7 million through his companies in an initial coin offering (“ICO”), and allegedly told investors that the ICO proceeds would be used to develop a new technology. Instead, however, he diverted more than $5.8 million in ICO proceeds to gold mining entities. The SEC also alleged that the Founder and his companies did not register their offers and sales of tokens with the Commission, and knowingly sold them to groups of investors without determining whether the underlying investors were accredited. Without admitting or denying the allegations, the Founder and his companies consented to a permanent injunction, and to permanently disable the tokens and remove them from digital asset trading platforms. The Founder further agreed to an officer or director bar, and a penalty of $195,000.

In March, the SEC announced that it charged two individuals with allegedly defrauding retail investors out of more than $124 million through two unregistered offerings of securities involving a digital token.[78] In its complaint, the SEC alleged that the defendants—in roadshows, YouTube videos, and other materials—falsely claimed that its crypto coin was supported by one of the largest crypto mining operations in the world, but that the defendants previously abandoned mining operations after generating less than $3 million in total mining revenue. As alleged, the defendants incorrectly stated that the crypto coin had a $250 million crypto mining operation and was producing $5.4 million to $8 million per month in mining revenues. According to the complaint, the two individuals also arranged for a public website to display a wallet of an unrelated third party showing more than $190 million in assets as of November 2021, even though the coin’s wallets were allegedly worth less than $500,000. Moreover, the complaint alleged that the individuals manipulated the crypto coin’s price and misused investor funds for personal expenses. In a parallel action, the U.S. Attorney’s Office for the Southern District of New York unsealed criminal charges against one of the individuals.

In May, the SEC announced charges against a corporation, its two founders, and two entities controlled by one of its founders.[79] According to the SEC’s complaint, the two founders sold mining packages to investors and promised daily returns of 1%, paid weekly, for a period of up to 52 weeks. The complaint also alleged that, in its early days, investors were promised returns in Bitcoin, but later, defendants required investors to withdraw their investments in the corporation’s own token. The complaint also alleged that investors were required to redeem those tokens on a “fake” crypto asset trading platform created and managed by one of the corporation’s founders, but when investors tried to liquidate their tokens on that asset trading platform, they encountered purported errors and were required to either buy another mining package or forfeit their investments. In April, the United States District Court for the Southern District of Florida issued a temporary restraining order against all of the defendants and an order freezing defendants’ assets, among other relief.

C. Registration and Disclosure

In February, the SEC announced that it charged a company with failing to register the offers and sales of its retail crypto lending product.[80] According to the SEC’s order, the company offered and sold a lending product to the public, through which investors lent crypto assets to the company in exchange for the company’s promise to provide a variable monthly interest payment. The SEC alleged that the lending products were securities, and the company therefore was required to register its offers and sales of the products but failed to do so or to qualify for an exemption from SEC registration. The SEC also alleged that the company operated for more than 18 months as an unregistered investment company because it issued securities and also held more than 40% of its total assets, excluding cash, in investment securities, including loans of crypto assets to institutional borrowers. Finally, the SEC alleged that the company made a false and misleading statement for more than two years on its website concerning the level of risk in its loan portfolio and lending activity. Without admitting or denying the SEC’s allegations, the company agreed to pay a $50 million penalty, cease its unregistered offers and sales of the lending product, and attempt to bring its business within the provisions of the Investment Company Act within 60 days. Finally, in parallel actions, the company agreed to pay an additional $50 million in fines to 32 states to settle similar charges. At the time of the settlement, the company was actively engaged in litigation with multiple states including the New Jersey Attorney General. (Prior to assuming his current role as the Director of the SEC’s Enforcement Division, Gurbir Grewal was the Attorney General for New Jersey.)

In May, the SEC also announced that it settled charges against a technology company for making allegedly inadequate disclosures concerning the impact of cryptomining on the company’s gaming business.[81] The SEC’s order found that, during consecutive quarters in fiscal year 2018, the company failed to disclose that cryptomining was a significant element of its material revenue growth. Specifically, the SEC alleged that the company did not disclose in its Forms 10-Q significant earnings and cash flow fluctuations related to a “volatile business” for investors to ascertain the likelihood that past performance was indicative of future performance. The SEC also alleged that the company’s omissions about the growth of the company’s gaming business were misleading given that the company made statements about how other parts of the company’s business were driven by demand for crypto. Without admitting or denying the SEC’s findings, the company agreed to a cease-and-desist order and to pay a $5.5 million penalty.

VI. Insider Trading

In January, the SEC announced insider trading charges against three Florida residents for allegedly trading in advance of market-moving announcements by three companies.[82] The SEC alleged that one of the individuals obtained non-public information from an insider family member and used it to trade in advance of one company’s earnings announcement, another company’s tender offer, and a third company’s merger announcement, gaining more than $600,000 in personal brokerage profits. The individual allegedly tipped off two friends, who also allegedly traded ahead of these announcements and who were likewise charged by the SEC. According to the SEC’s complaint, one of the tippees used various accounts to trade ahead of all three announcements, resulting in profits of over $4 million; the other tippee allegedly reaped profits of approximately $120,000. The SEC’s complaint seeks permanent injunctions and civil penalties. The U.S. Attorney’s Office of the District of Massachusetts announced criminal charges against the three men for the same conduct.

In March, the SEC filed a complaint against three software engineers of a communications tech company and four of their associates for allegedly trading on confidential information ahead of the company’s positive earnings announcement for the first quarter of 2020.[83] The SEC alleged that the software engineers had learned through their company’s databases that the company’s customers had increased usage of the company’s products and services in response to health measures imposed by the COVID-19 pandemic. The SEC further alleged that the software engineers discussed in a group chat that the company’s stock price would “rise for sure,” after which they tipped off, or used the brokerage accounts of, four of their family members and close friends to trade stock and options in advance of the earnings announcement to generate more than $1 million in profit. The SEC’s action is pending in the Northern District of California. The U.S. Attorney’s Office for the Northern District of California announced criminal charges against one of the tippees.

In April, the SEC announced a settled action against a former accountant of a large multinational restaurant chain for an alleged long-running scheme to trade on confidential information the accountant obtained through his role at the company in advance of the company’s earnings announcements.[84] The SEC alleged that, from 2015 to 2020, the employee engaged in trades across multiple different brokerage accounts tied to himself and family members in advance of earnings announcements, resulting in more than $960,000 in profits. Without admitting or denying the allegations, the accountant consented to an order permanently enjoining him from future violations and to a penalty of over $1.9 million. He also agreed to a suspension from appearing or practicing before the SEC.

In June, the SEC announced settled insider trading charges against a former software engineer of an online gambling company and his longtime friend for allegedly trading on confidential information about the gambling company’s interest in acquiring a mobile sports media company.[85] The SEC alleged that the software engineer purchased 500 out-of-the-money call options on the target mobile sports media company in the weeks and days leading up to the announcement of the acquisition, despite being told not to trade on the information he received. The SEC also alleged that he tipped off his friend about the impending deal through an encrypted messaging application, resulting in approximately $600,000 in combined profits. Without admitting or denying the allegations, the two individuals agreed to a permanent injunction, disgorgement, and civil penalties totaling more than $11,000. The U.S. Attorney’s Office for the Eastern District of Pennsylvania also announced criminal charges against the former software engineer.

VII. Trading and Markets

In March, the SEC commenced an action against five individuals for operating a call center in Colombia that allegedly employed high-pressure sales tactics and made misleading statements to sell the stock of at least 18 small companies trading in U.S. markets.[86] The SEC alleged that the defendants’ call centers employed false personas—including fake names, websites, and phone numbers—to appear as investment management firms. According to the complaint, the call centers then generated over $58 million in trading by making misleading or false statements about the stocks’ prospects for success. The SEC alleged that the defendants received roughly $10 million in exchange for their promotion of these thinly traded stocks. The SEC’s complaint seeks a permanent injunction, disgorgement and civil penalties, and a penny stock bar against the defendants. The complaint also names three additional individuals and one entity as relief defendants and seeks disgorgement from these parties as well.

In April, the SEC brought an action against an individual for making an allegedly false and misleading tender offer announcement.[87] According to the SEC’s complaint, the defendant allegedly placed an advertisement in the New York Times announcing a proposed purchase of all existing stock of a large defense company at a substantial premium. The SEC alleged that this offer was false and misleading because neither the defendant nor his company had the resources necessary to complete the transaction. Moreover, the complaint alleged that the defendant failed to disclose a series of bankruptcies and default judgments and mischaracterized the operations and assets of his company’s corporate parent. The complaint seeks injunctive relief, a monetary penalty, and an officer and director bar against the defendant. In a parallel action, the U.S. Attorney’s Office for the Southern District of New York announced criminal charges against the defendant.

Also in April, the Commission, in three separate complaints, commenced actions against 15 individuals and one entity for engaging in a complex series of allegedly fraudulent microcap operations spanning three continents and generating more than $194 million in illicit proceeds.[88] The SEC alleged that, over many years, various defendants acquired, via offshore companies, majority interests in the penny stocks of at least 17 issuers. Thereafter, the SEC alleged that certain defendants funded promotional campaigns for these stocks to increase demand, at which point some defendants allegedly sold their stocks for significant profits. Two of the three complaints further allege that some defendants used encrypted messaging services and code names to communicate with each other and with offshore trading platforms about the scheme to avoid being detected by regulators. The press release announcing these enforcement actions stated that more than 20 countries’ law enforcement authorities and securities regulators contributed to the SEC’s investigation, which is also associated with parallel criminal actions by the U.S. Attorney’s Office for the Southern District of New York.

Also in April, the SEC filed an action against the owner of an investment firm, as well as the firm’s CFO, head trader, and chief risk officer based on allegations of securities fraud based on misrepresentations and omissions as well as market manipulation, all relating to the trading of certain securities over a seven-month period.[89] The SEC alleged that the owner had purchased, on margin, billions of dollars of total return swaps, resulting in bank counterparties taking on significant positions in the equity securities of the relevant symbols for the purpose of hedging the risk of the swaps. According to the SEC, these swap purchases were intended to drive up the price of the securities. The CFTC also brought a complaint relating to misrepresentations and omissions—but did not allege market manipulation—and the U.S. Attorney’s Office for the Southern District of New York also announced that it is pursuing criminal charges against the individuals involved for the same conduct.

In June, the SEC announced a settled action against an investment adviser based on allegations that on seven occasions between December 2020 and February 2021 the firm violated Rule 105 of Regulation M of the Exchange Act by buying stock shortly after shorting that same stock during a restricted period (i.e., before a covered public offering).[90] The order explains that the firm had relevant policies and procedures and that its systems detected the possible violations both before and after the firm participated in the offerings. In each instance, according to the SEC, the firm’s traders and compliance department bypassed the systematic alerts and exceptions based on their own miscalculations of the restricted period. Thereafter, according to the order, the firm self-identified its errors and the violations, voluntarily and proactively remediated the errors and self-reported the violations to the SEC. Without admitting or denying the SEC’s allegations, the firm agreed to pay a fine of $200,000 and $6.7 million in disgorged profits.

VIII. Municipal Securities

In March, the SEC announced a settled action against a school district and its former CFO, alleging that they misled investors who purchased $20 million in municipal bonds.[91] The SEC also announced settled charges against the district’s auditor for alleged impropriety in connection with an audit of the district’s financial statements. According to the SEC’s complaint and orders, the district and CFO provided investors with misleading financial statements containing inflated general fund reserves and omitted payroll and construction liabilities. The district, without admitting or denying any findings, agreed to settle the SEC’s charges by consenting to a cease-and-desist order. The former CFO, also without admitting or denying the allegations, agreed to pay a $30,000 penalty and not participate in future municipal offerings. The auditor, without admitting or denying any findings, agreed to a suspension of at least three years from appearing or practicing before the SEC as an accountant and from certain auditor roles.

In June, the SEC brought an action against a town, its former mayor, the town’s unregistered municipal adviser, and the adviser’s owner, for allegedly misleading investors who purchased $5.8 million in municipal bonds across two offerings to finance the development of a water system and improvements to a sewer system.[92] According to the SEC’s complaints and order, the town submitted false financial projections, created by the municipal adviser with approval by the then-mayor, overstating the number of sewer customers in order to mislead a state agency commission that needed to approve the offerings. In turn, the town and its then-mayor allegedly failed to disclose to investors that approval of the bonds was based on the allegedly false projections or that the mayor had misused proceeds from prior offerings. Without admitting or denying the findings, the town agreed to settle with the SEC by consenting to a cease-and-desist order, while the municipal adviser and its owner also agreed pay disgorgement and civil penalties in amounts to be determined at a later date.

Also in June, the SEC instituted an action against a city, its former finance director, and its school district’s former CFO, alleging that they misled investors who purchased $119 million in municipal bonds.[93] The SEC also instituted an action against the city’s municipal adviser and its principal for allegedly misleading investors and breaching their fiduciary duty to the city. According to the SEC’s complaint, the defendants provided investors with misleading bond offering documents that failed to disclose the district’s financial distress stemming from spending on teacher salaries. The SEC alleged that the district’s former CFO was aware the district was facing at least a $25 million budget shortfall but misled a credit rating agency regarding the magnitude of the budget shortfall. The school district’s former CFO agreed to settle with the SEC, without admitting or denying any findings, and to pay a $25,000 penalty.

______________________________

[1] See, e.g., SEC Press Release, BlockFi Agrees to Pay $100 Million in Penalties and Pursue Registration of its Crypto Lending Product (Feb. 14, 2022), available at https://www.sec.gov/news/press-release/2022-26; SEC Press Release, Ernst & Young to Pay $100 Million Penalty for Employees Cheating on CPA Ethics Exams and Misleading Investigation (June 28, 2022), available at https://www.sec.gov/news/press-release/2022-114.

[2] SEC Press Release, SEC Charges Firm and Five Brokers with Violations of Reg BI (June 16, 2022), available at https://www.sec.gov/news/press-release/2022-110.

[3] Id.

[4] SEC Statement, Statement on Settlement with BlockFi Lending LLC (Feb. 14, 2022) (Commissioner Hester M. Peirce), available at https://www.sec.gov/news/statement/peirce-blockfi-20220214.

[5] SEC Statement, Statement on In the Matter of Lloyd D. Reed (Apr. 5, 2022) (Commissioner Hester M. Peirce), available at https://www.sec.gov/news/statement/peirce-lloyd-reed-20220405.

[6] SEC Statement, Statement Regarding In the Matter of Aegis Capital Corporation (July 28, 2022) (Commissioner Hester M. Peirce), available at https://www.sec.gov/news/statement/peirce-statement-aegis-capital-corporation-072822.

[7] SEC Statement, When Voluntary Means Mandatory and Forever: Statement on In the Matter of Ernst & Young LLP (June 28, 2022) (Commissioner Hester M. Peirce), available at https://www.sec.gov/news/statement/peirce-statement-ernst-and-young-062822.

[8] SEC Press Release, Mark T. Uyeda Sworn In as SEC Commissioner (June 30, 2022), available at https://www.sec.gov/news/press-release/2022-118.

[9] SEC Statement, Statement on Senate Confirmation of Jaime Lizárraga and Mark Uyeda (June 16, 2022), available at https://www.sec.gov/news/statement/commissioners-statement-confirmation-lizararago-uyeda.

[10] White House Press Release, President Biden Announces Key Nominees (Apr. 6, 2022), available at https://www.whitehouse.gov/briefing-room/statements-releases/2022/04/06/president-biden-announces-key-nominees-10/.

[11] SEC Press Release, SEC Announces New Leadership in Examinations Division and New York Regional Office (Mar. 24, 2022), available at https://www.sec.gov/news/press-release/2022-49.

[12] SEC Press Release, Richard R. Best Named Director of Division of Examinations (May 24, 2022), available at https://www.sec.gov/news/press-release/2022-87.

[13] SEC Press Release, Kristin Snyder, Deputy Director of Division of Examinations, to Leave SEC (Jan. 27, 2022), available at https://www.sec.gov/news/press-release/2022-13.

[14] SEC Press Release, Lori H. Price Named Acting Director of the Office of Credit Ratings; Ahmed Abonamah to Leave SEC (Feb. 1, 2022), available at https://www.sec.gov/news/press-release/2022-16.

[15] SEC Press Release, Kelly L. Gibson, Director of the Philadelphia Regional Office, to Leave the SEC; Scott Thompson and Joy Thompson named Office Acting Co-Heads (Feb. 11, 2022), available at https://www.sec.gov/news/press-release/2022-25.

[16] SEC Press Release, SEC Announces New Leadership in Examinations Division and New York Regional Office (Mar. 24, 2022), available at https://www.sec.gov/news/press-release/2022-49.

[17] SEC Press Release, San Francisco Regional Director Erin E. Schneider to Leave Agency (Mar. 25, 2022), available at https://www.sec.gov/news/press-release/2022-51.

[18] SEC Press Release, Tracy S. Combs Named Director of SEC’s Salt Lake Regional Office (June 29, 2022), available at https://www.sec.gov/news/press-release/2022-115.

[19] SEC Press Release, Denver Regional Director Kurt L. Gottschall to Leave SEC (June 29, 2022), available at https://www.sec.gov/news/press-release/2022-116.

[20] U.S. Securities and Exchange Commission, Proposed Rule (RIN 3235-AM90), Special Purpose Acquisition Companies, Shell Companies, and Projections (Mar. 30, 2022), available at https://www.gibsondunn.com/sec-proposes-rules-to-align-spacs-more-closely-with-ipos/https://www.gibsondunn.com/2022-mid-year-securities-enforcement-update/#_edn1.

[21] SEC Press Release, SEC Proposes Rules to Enhance Disclosure and Investor Protection Relating to Special Purpose Acquisition Companies, Shell Companies, and Projections (Mar. 30, 2022), available at https://www.sec.gov/news/press-release/2022-56.

[22] Id.

[23] SEC Press Release, SEC Proposes Rules on Cybersecurity Risk Management, Strategy, Governance, and Incident Disclosure by Public Companies (Mar. 9, 2022), available at https://www.sec.gov/news/press-release/2022-39.

[24] SEC Press Release, SEC Proposes Cybersecurity Risk Management Rules and Amendments for Registered Investment Advisers and Funds (Feb. 9, 2022), available at https://www.sec.gov/news/press-release/2022-20.

[25] Spotlight on Enforcement Task Force Focused on Climate and ESG Issues, available at https://www.sec.gov/spotlight/enforcement-task-force-focused-climate-esg-issues.

[26] SEC Press Release, SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors (Mar. 21, 2022), available at https://www.sec.gov/news/press-release/2022-46.

[27] SEC Statement, Remarks at Financial Stability Oversight Counsel Meeting (July 28, 2022) (Chair Gary Gensler), available at https://www.sec.gov/news/speech/gensler-statement-financial-stability-oversight-council-meeting-072822.

[28] SEC Press Release, SEC Proposes to Enhance Disclosures by Certain Investment Advisers and Investment Companies About ESG Investment Practices (May 25, 2022), available at https://www.sec.gov/news/press-release/2022-92.

[29] SEC Press Release, SEC Proposes Rule Changes to Prevent Misleading or Deceptive Fund Names (May 25, 2022), available at https://www.sec.gov/news/press-release/2022-91.

[30] SEC Press Release, SEC Proposed Changes to Two Whistleblower Program Rules (Feb. 10, 2022), available at https://www.sec.gov/news/press-release/2022-23.

[31] Id.

[32] Id.

[33] SEC Press Release, SEC Awards Over $13 Million to Whistleblower (Jan. 6, 2022), available at https://www.sec.gov/news/press-release/2022-2.

[34] SEC Press Release, SEC Issues Awards Totaling More Than $4 Million to Whistleblowers (Jan. 10, 2022), available at https://www.sec.gov/news/press-release/2022-5.

[35] SEC Press Release, SEC Issues Awards Totaling More Than $40 Million to Four Whistleblowers (Jan. 21, 2022), available at https://www.sec.gov/news/press-release/2022-7.

[36] SEC Press Release, SEC Awards More Than $3.5 Million to Whistleblower (Mar. 8, 2022), available at https://www.sec.gov/news/press-release/2022-38.

[37] SEC Press Release, SEC Awards Approximately $14 Million to Whistleblower (Mar. 11, 2022), available at https://www.sec.gov/news/press-release/2022-40.

[38] SEC Press Release, SEC Issues Awards Totaling Approximately $3 Million to Three Whistleblowers (Mar. 18, 2022), available at https://www.sec.gov/news/press-release/2022-45.

[39] SEC Press Release, SEC Awards $1.25 Million to Whistleblower (Mar. 25, 2022), available at https://www.sec.gov/news/press-release/2022-52.

[40] SEC Press Release, SEC Issues $6 Million Award to Five Whistleblowers (Apr. 25, 2022), available at https://www.sec.gov/news/press-release/2022-67.

[41] SEC Press Release, SEC Issues Nearly $3.5 Million Award to Four Whistleblowers (May 6, 2022), available at https://www.sec.gov/news/press-release/2022-80.

[42] SEC Press Release, SEC Charges Health Care Co. and Two Former Employees for Accounting Improprieties (Feb. 22, 2022), available at https://www.sec.gov/news/press-release/2022-31.

[43] SEC Press Release, Atlanta-Based Pest Control Company, Former CFO Charged with Improper Earnings Management (Apr. 18, 2022), available at https://www.sec.gov/news/press-release/2022-64.

[44] SEC Press Release, SEC Charges New Jersey Software Company and Senior Employees with Accounting-Related Misconduct (June 7, 2022), available at https://www.sec.gov/news/press-release/2022-101.

[45] SEC Press Release, Remediation Helps Tech Company Avoid Penalties (Jan. 28, 2022), available at https://www.sec.gov/news/press-release/2022-14.

[46] SEC Press Release, SEC Charges Senior Executive of Brazilian Company with Fraud (Apr. 18, 2022), available at https://www.sec.gov/news/press-release/2022-63.

[47] SEC Press Release, SEC Charges Company and Former CEO with Misleading Investors about the Sale of COVID-19 Test Kits (May 31, 2022), available at https://www.sec.gov/news/press-release/2022-94.

[48] SEC Press Release, SEC Charges Egan-Jones Ratings Co. and CEO with Conflict of Interest Violations (June 21, 2022), available at https://www.sec.gov/news/press-release/2022-111.

[49] SEC Press Release, SEC Charges CohnReznick LLP and Three Partners with Improper Professional Conduct (June 8, 2022), available at https://www.sec.gov/news/press-release/2022-102.

[50] SEC Press Release, SEC Adds Fraud Charges Against Purported Cryptocurrency Company Longfin, CEO, and Consultant (June 5, 2019), available at https://www.sec.gov/news/press-release/2019-90.

[51] SEC Press Release, SEC Obtains Final Judgment Against Sequential Brands Group, Inc. for Failing to Timely Impair Goodwill (Dec. 15, 2021), available at https://www.sec.gov/litigation/litreleases/2021/lr25289.htm.

[52] SEC Press Release, Ernst & Young to Pay $100 Million Penalty for Employees Cheating on CPA Ethics Exams and Misleading Investigation (June 28, 2022), available at https://www.sec.gov/news/press-release/2022-114.

[53] SEC Statement, When Voluntary Means Mandatory and Forever: Statement on In the Matter of Ernst & Young LLP (June 28, 2022) (Commissioner Hester M. Peirece), available at https://www.sec.gov/news/statement/peirce-statement-ernst-and-young-062822.

[54] SEC Press Release, Former Financial Advisor Charged with Stealing $5.8 Million from Client (Jan. 24, 2022), available at https://www.sec.gov/news/press-release/2022-8.

[55] SEC Press Release, SEC Charges Previously-Barred Investment Adviser with Fraud (Mar. 7, 2022), available at https://www.sec.gov/news/press-release/2022-35.

[56] SEC News Digest, David Schamens Barred (May 19, 1992), available at https://www.sec.gov/news/digest/1992/dig051992.pdf.

[57] SEC Press Release, SEC Halts Alleged Ongoing $39 Million Fraud by Hedge Fund Adviser (May 25, 2022), available at https://www.sec.gov/news/press-release/2022-90.

[58] SEC Press Release, SEC Charges Robo-Adviser with Misleading Clients (Feb. 10, 2022), available at https://www.sec.gov/news/press-release/2022-24.

[59] SEC Press Release, SEC Charges Infinity Q Founder with Orchestrating Massive Valuation Fraud (Feb. 17, 2022), available at https://www.sec.gov/news/press-release/2022-29.

[60] Investment Company Act Release No. 34198 (Feb. 21, 2021), available at https://www.sec.gov/rules/ic/2021/ic-34198.pdf.

[61] SEC Press Release, City National Rochdale to Pay More Than $30 Million for Undisclosed Conflicts of Interest (Mar. 3, 2022), available at https://www.sec.gov/news/press-release/2022-33.

[62] SEC Press Release, SEC Charges Venture Capital Fund Adviser with Misleading Investors (Mar. 4, 2022), available at https://www.sec.gov/news/press-release/2022-34.

[63] SEC Press Release, Medley Management and Former Co-CEOs to Pay $10 Million Penalty for Misleading Investors and Clients (Apr. 28, 2022), available at https://www.sec.gov/news/press-release/2022-73.

[64] SEC Press Release, SEC Charges BNY Mellon Investment Adviser for Misstatements and Omissions Concerning ESG Considerations (May 23, 2022), available at https://www.sec.gov/news/press-release/2022-86.

[65] SEC Press Release, SEC Charges RiverSource Distributors with Improper Switching of Variable Annuities (May 25, 2022), available at https://www.sec.gov/news/press-release/2022-89.

[66] SEC Press Release, SEC Charges Allianz Global Investors and Three Former Senior Portfolio Managers with Multibillion Dollar Securities Fraud (May 17, 2022), available at https://www.sec.gov/news/press-release/2022-84.

[67] SEC Press Release, Schwab Subsidiaries Misled Robo-Adviser Clients about Absence of Hidden Fees (June 13, 2022), available at https://www.sec.gov/news/press-release/2022-104.

[68] SEC Press Release, SEC Charges Private Equity Adviser for Failing to Disclose Disproportionate Expense Allocations to Fund (June 14, 2022), available at https://www.sec.gov/news/press-release/2022-107.

[69] SEC Press Release, UBS to Pay $25 Million to Settle SEC Fraud Charges Involving Complex Options Trading Strategy (June 29, 2022), available at https://www.sec.gov/news/press-release/2022-117.

[70] SEC Press Release, SEC Proposes to Enhance Private Fund Investor Protection (Feb. 9, 2022), available at https://www.sec.gov/news/press-release/2022-19.

[71] Information Update, Division of Investment Management Staff Statement Regarding Withdrawal and Modification of Staff Letters Related to Rulemaking on Investment Adviser Marketing (Oct. 2021), available at https://www.sec.gov/files/2021-10-information-update.pdf

[72] SEC Press Release, SEC Charges TradeZero America and Co-Founder with Deceiving Customers about Meme Stock Trading Halts (May 24, 2022), available at https://www.sec.gov/news/press-release/2022-88.

[73] SEC Press Release, SEC Charges 12 Additional Financial Firms for Failure to Meet Form CRS Obligations (Feb. 15, 2022), available at https://www.sec.gov/news/press-release/2022-27.

[74] SEC Press Release, SEC Charges Wells Fargo Advisors With Anti-Money Laundering Related Violations (May 20, 2022), available at https://www.sec.gov/news/press-release/2022-85.

[75] SEC Press Release, SEC Charges Firm and Five Brokers with Violations of Reg BI (June 16, 2022), available at https://www.sec.gov/news/press-release/2022-110.

[76] SEC Press Release, SEC Nearly Doubles Size of Enforcement’s Crypto Assets and Cyber Unit (May 3, 2022), available at https://www.sec.gov/news/press-release/2022-78.

[77] SEC Press Release, SEC Charges ICO Issuer and Founder with Defrauding Investors (Jan. 6, 2022), available at https://www.sec.gov/news/press-release/2022-3.

[78] SEC Press Release, SEC Charges Siblings in $124 Million Crypto Fraud Operation that included Misleading Roadshows, YouTube Videos (Mar. 8, 2022), available at https://www.sec.gov/news/press-release/2022-37.

[79] SEC Press Release, SEC Halts Fraudulent Cryptomining and Trading Scheme (May 6, 2022), available at https://www.sec.gov/news/press-release/2022-81.

[80] SEC Press Release, BlockFi Agrees to Pay $100 Million in Penalties and Pursue Registration of its Crypto Lending Product (Feb. 14, 2022), available at https://www.sec.gov/news/press-release/2022-26.

[81] SEC Press Release, SEC Charges NVIDIA Corporation with Inadequate Disclosures about Impact of Cryptomining (May 6, 2022), available at https://www.sec.gov/news/press-release/2022-79.

[82] SEC Press Release, SEC Charges Three Florida Residents in Multi-Million Dollar Insider Trading Scheme (Jan. 6, 2022), available at https://www.sec.gov/news/press-release/2022-4.

[83] SEC Press Release, SEC Charges Seven California Residents in Insider Trading Ring (Mar. 28, 2022), available at https://www.sec.gov/news/press-release/2022-55.

[84] SEC Press Release, Former Domino’s Pizza Accountant to Pay Nearly $2 Million Penalty for Insider Trading (Apr. 21, 2022), available at https://www.sec.gov/news/press-release/2022-66.

[85] SEC Press Release, SEC Charges Former Employee of Online gambling Company with Insider Trading (June 13, 2022), available at https://www.sec.gov/news/press-release/2022-105.

[86] SEC Press Release, SEC Charges Call Center Operators in $58 Million Penny Stock Scheme (Mar. 15, 2022), available at https://www.sec.gov/news/press-release/2022-41.

[87] SEC Press Release, SEC: Takeover Bid of Fortune 500 Company was a Sham (Apr. 5, 2022), available at https://www.sec.gov/news/press-release/2022-58.

[88] SEC Press Release, SEC Uncovers $194 Million Penny Stock Schemes that Spanned Three Continents (Apr. 18, 2022), available at https://www.sec.gov/news/press-release/2022-62.

[89] SEC Press Release, SEC Charges Archegos and its Founder with Massive Market Manipulation Scheme (Apr. 27, 2022), available at https://www.sec.gov/news/press-release/2022-70.

[90] SEC Press Release, SEC Charges Weiss Asset Management with Short Selling Violations (June 14, 2022), available at https://www.sec.gov/news/press-release/2022-106.

[91] SEC Press Release, SEC Charges Texas School District and its Former CFO with Fraud in $20 Million Bond Sale (Mar. 16, 2022), available at https://www.sec.gov/news/press-release/2022-43.

[92] SEC Press Release, SEC Charges Louisiana Town and Former Mayor with Fraud in Two Municipal Bond Deals (June 2, 2022), available at https://www.sec.gov/news/press-release/2022-97.

[93] SEC Press Release, SEC Charges Rochester, NY, and City’s Former Executives and Municipal Advisor with Misleading Investors (June 14, 2022), available at https://www.sec.gov/news/press-release/2022-108.

The following Gibson Dunn lawyers assisted in the preparation of this client update: Mark Schonfeld, Richard Grime, Barry Goldsmith, Tina Samanta, David Ware, Lauren Cook Jackson, Timothy Zimmerman, Luke Dougherty, Zoey Goldnick, Kate Googins, Ben Gibson, Jimmy Pinchak, and Sean Brennan*.

Gibson Dunn is one of the nation’s leading law firms in representing companies and individuals who face enforcement investigations by the Securities and Exchange Commission, the Department of Justice, the Commodities Futures Trading Commission, the New York and other state attorneys general and regulators, the Public Company Accounting Oversight Board (PCAOB), the Financial Industry Regulatory Authority (FINRA), the New York Stock Exchange, and federal and state banking regulators.

Our Securities Enforcement Group offers broad and deep experience. Our partners include the former Director of the SEC’s New York Regional Office, the former head of FINRA’s Department of Enforcement, the former United States Attorneys for the Central and Eastern Districts of California and the District of Maryland, and former Assistant United States Attorneys from federal prosecutors’ offices in New York, Los Angeles, San Francisco and Washington, D.C., including the Securities and Commodities Fraud Task Force.

Securities enforcement investigations are often one aspect of a problem facing our clients. Our securities enforcement lawyers work closely with lawyers from our Securities Regulation and Corporate Governance Group to provide expertise regarding parallel corporate governance, securities regulation, and securities trading issues, our Securities Litigation Group, and our White Collar Defense Group.

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

Securities Enforcement Practice Group Leaders:
Richard W. Grime – Washington, D.C. (+1 202-955-8219, [email protected])
Mark K. Schonfeld – New York (+1 212-351-2433, [email protected])

Please also feel free to contact any of the following practice group members:

New York
Zainab N. Ahmad (+1 212-351-2609, [email protected])
Reed Brodsky (+1 212-351-5334, [email protected])
Joel M. Cohen (+1 212-351-2664, [email protected])
James J. Farrell (+1 212-351-5326, [email protected])
Barry R. Goldsmith (+1 212-351-2440, [email protected])
Mary Beth Maloney (+1 212-351-2315, [email protected])
Alexander H. Southwell (+1 212-351-3981, [email protected])
Lawrence J. Zweifach (+1 212-351-2625, [email protected])
Tina Samanta (+1 212-351-2469, [email protected])

Washington, D.C.
Stephanie L. Brooker (+1 202-887-3502, [email protected])
Daniel P. Chung (+1 202-887-3729, [email protected])
M. Kendall Day (+1 202-955-8220, [email protected])
Jeffrey L. Steiner (+1 202-887-3632, [email protected])
Patrick F. Stokes (+1 202-955-8504, [email protected])
F. Joseph Warin (+1 202-887-3609, [email protected])
Lauren Cook Jackson (+1 202-955-8293, [email protected])
David C. Ware (+1 202-887-3652, [email protected])

San Francisco
Winston Y. Chan (+1 415-393-8362, [email protected])
Thad A. Davis (+1 415-393-8251, [email protected])
Charles J. Stevens (+1 415-393-8391, [email protected])
Michael Li-Ming Wong (+1 415-393-8234, [email protected])

Palo Alto
Michael D. Celio (+1 650-849-5326, [email protected])
Paul J. Collins (+1 650-849-5309, [email protected])
Benjamin B. Wagner (+1 650-849-5395, [email protected])

Denver
Robert C. Blume (+1 303-298-5758, [email protected])
Monica K. Loseman (+1 303-298-5784, [email protected])

Los Angeles
Michael M. Farhang (+1 213-229-7005, [email protected])
Douglas M. Fuchs (+1 213-229-7605, [email protected])
Nicola T. Hanna (+1 213-229-7269, [email protected])
Debra Wong Yang (+1 213-229-7472, [email protected])

* Sean Brennan and Jimmy Pinchak are recent law graduates working in the firm’s Washington, D.C., and New York offices, respectively.

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

Gibson Dunn has surveyed the comment letters submitted by public and private energy companies and related industry associations regarding the proposed rules by the Securities and Exchange Commission (the “SEC” or “Commission”) on climate change disclosure requirements for U.S. public companies and foreign private issuers (the “Proposed Rules”).[1]

Based on our review of these comment letters, we have seen general support for transparent and consistent climate-related disclosures, along with a concern that the Proposed Rules do not reconcile with the SEC’s stated objective “to advance the Commission’s mission to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation, not to address climate-related issues more generally.”[2] Overarching themes included (i) general support for the Commission’s decision to base the Proposed Rules on the Task Force on Climate-Related Financial Disclosures (“TCFD”) framework and Greenhouse Gas Protocol (“GHG Protocol”), (ii) concern with deviation from the long-standing materiality threshold, (iii) concern that the Proposed Rules would overload investors with immaterial, uncomparable, or unreliable data, and (iv) questions as to whether the Proposed Rules would cause an unintended chilling effect on companies to set internal emissions reduction targets or other climate-related goals to avoid additional liability risks in disclosing such goals. The proposed disclosure requirements receiving the most comments from energy industry companies relate to (i) the Greenhouse Gas (“GHG”) emissions reporting (particularly Scope 3 emissions) and (ii) the amendments to financial statement disclosure in Regulation S-X (particularly the 1% materiality threshold). In addition to these higher-level observations, this client alert also provides a more granular review of the energy industry’s comments on specific provisions of the Proposed Rules.

I. Background on the Proposed Rules

The proposed climate change reporting framework laid out in the 500+ page Proposed Rules is extensive and detailed, with disclosure requirements that are mostly prescriptive rather than principles-based. Rather than creating a new stand-alone reporting form, the Commission proposed amending Regulation S-K and Regulation S-X to create a climate change reporting framework within existing registration statements and reports under the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”).

The Proposed Rules would amend (i) Regulation S-K to require a new, separately captioned “Climate-Related Disclosure” section in applicable SEC filings, which would cover a range of climate-related information, and (ii) Regulation S-X to require certain climate-related financial statement metrics and related disclosures in a separate footnote to companies’ annual audited financial statements. While brief summaries of certain of the proposed disclosure requirements are provided in this alert, for a more detailed description of the Proposed Rules, we encourage you to read our prior alert, “Summary of and Considerations Regarding the SEC’s Proposed Rules on Climate Change Disclosure (link),” and view our webcast, “Understanding the SEC Rule Proposal on Climate Change Disclosure (link).”

II. Comment Letter Highlights

To contribute to our understanding of the general reaction of the energy industry to the Proposed Rules, we conducted a survey of what we believe are all comment letters submitted to the SEC through June 17, 2022 (the deadline for comment submissions) by public and private energy and energy services companies and related industry associations. Of the 62 comment letters we reviewed, 31 such comment letters were submitted by U.S. public reporting companies, 10 such comment letters were submitted by non-reporting companies, and the remaining 21 comment letters were submitted by industry associations. The following charts highlight the frequency of comments by the 31 public reporting companies and the 21 industry associations on a particular requirement in the Proposed Rules. The specific comments are described more fully in the sections following the chart. We note that not all comment letters addressed each particular requirement, and we did not assume that the absence of a comment on a proposed requirement by any company or association suggests approval of such proposed disclosure requirement.

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III. Reactions to Proposed Reg. S-K Amendments

We summarize below the most frequent comments on the following proposed Reg. S-K disclosure requirements:

1. GHG Emissions Reporting
2. Climate-related risks
3. Climate-related risk oversight & management
4. Climate-related impacts on strategy, business model & outlook
5. Attestation of GHG Emissions
6. Targets, Goals & Transition Plans

A. GHG Emissions Reporting

Proposed Item 1504 of Reg. S-K would require companies to disclose Scope 1, Scope 2 and, in some cases, Scope 3 “GHG emissions … for [their] most recently completed fiscal year, and for the historical fiscal years included in [their] consolidated financial statements in the filing, to the extent such historical GHG emissions data is reasonably available.” The Commission based the GHG emissions disclosure requirements in the Proposed Rules on the GHG Protocol, which is a leading accounting and reporting standard for GHG emissions.

With respect to Scope 3 emissions, all reporting companies (other than smaller reporting companies) would be required to disclosure Scope 3 emissions, only if material or if the company has set a GHG emissions reduction target or goal that includes its Scope 3 emissions. The Proposed Rules presume that Scope 3 emissions are likely to be material for “oil and gas product manufacturers.”

The Proposed Rules include a limited safe harbor from liability for Scope 3 disclosures, providing that such disclosures will not be deemed fraudulent, “unless it is shown that such statement was made or reaffirmed without a reasonable basis or was disclosed other than in good faith.”

90% of public company letters and 90% of industry association letters commented on the GHG emissions reporting requirements, with particular focus on (i) the disclosure requirements in the Proposed Rule as compared to existing GHG emissions reporting requirements of the Environmental Protection Agency (“EPA”), (ii) the materiality of GHG emissions as defined, particularly with respect to Scope 3 emissions, and (iii) safe harbors for GHG emissions disclosure.

Sample Comments on GHG Emissions Reporting:

“We . . . suggest that the SEC work with the EPA to ensure its standards for Scopes 1 and 2 GHG emissions are sound and consistent. The Proposal acknowledges that the EPA already requires, and makes available to the public, reporting of certain GHG emissions, and we believe the EPA is best positioned to regulate emissions reporting from a scientific standpoint.”
“The SEC should not require GHG intensity disclosures for registrants that are not primarily involved in production activities, as such disclosures could lead to confusion and inaccurately suggest to investors that such data is comparable. Alternatively, the disclosure requirements should provide flexibility to account for differences in underlying business operations, including allowing midstream companies to report GHG intensity on a reasonable and supportable normalized basis of their choosing, or perhaps on a standardized basis developed and adopted by the industry over time (e.g., GHG intensity based on a ratio of emissions relative to throughput).”
“[T]he Proposal would require registrants to report GHG emissions data for certain entities, such as joint ventures, over which they have no operational control. . . . For those [joint ventures] that we do not operate, there is a potential barrier for [us] to obtain required GHG data, as a joint venture partner may (i) not have the necessary information, (ii) be unwilling to provide it, or (iii) calculate it using methodologies or assumptions that conflict with those used by [us]. This will increase the liability for registrants if they are unable to obtain or cannot verify the accuracy of information that is not within their control. The SEC should allow registrants to report GHG emissions on an operated basis (vs. on an equity ownership basis), meaning the registrant would report emissions from assets operated by either the registrant or entities under its direct control.”
“[T]here is an absence of materiality qualifiers applicable to the disclosure of Scope 1 and Scope 2 GHG emissions and, for Scope 3 GHG emissions, the materiality qualifier is ill-defined and somewhat esoteric. Gross emissions data should not be overemphasized, and the [EPA’s Greenhouse Gas Reporting Program (“GHGRP”)] and [California’s Regulation for the Mandatory Reporting of Greenhouse Gas Emissions (“MRR”)] have well-defined and understood reporting thresholds. . . . [R]egistrants who are subject to the GHGRP or MRR [should be allowed] to report GHG emissions in their SEC filings in a manner consistent with those programs.”
“Adopting standards that correspond to the GHG Protocol would provide investors with comparable disclosures to those which companies have made historically and to those made by companies not subject to the Commission’s reporting requirements. However, the standards in the Rule Proposal differ significantly from those in the GHG Protocol. For example, the Rule Proposal requires companies to set organizational boundaries for GHG emissions disclosure using the same scope of entities and holdings as those included in their consolidated financial statements. Conversely, the GHG Protocol allows for an equity share or control boundary. This difference in boundaries could lead to companies reporting significantly different emissions than they have historically. Deviating from the GHG Protocol would only serve to confuse investors with differences from companies’ previous GHG emissions disclosure and unnecessarily increase compliance costs as companies would need to recalculate their emissions disclosure both historically and going forward. We urge the Commission to revise the emission standards in the Rule Proposal to match those of the GHG Protocol.”

Sample Comments on Scope 3 Emissions:

“[T]he materiality of Scope 3 emissions must be evaluated on a case-by-case, registrant-by-registrant basis and does not lend itself to across-the-board presumptions of materiality, such as the Proposal implies for ‘oil and gas product manufacturers’. As a strictly exploration and production company, we are not ‘product manufacturers’ but this vague definition creates more uncertainty and underscores the need for Scope 3 materiality to be assessed at a specific registrant level, not by prescriptive assertions within proposed rulemaking.”
“While midstream companies . . . are not generally oil and gas manufacturers, we are concerned with the risk that this presumption creates. . . . In addition, there is currently no standard or guidance for the midstream sector to define, measure or report on Scope 3 emissions. If pipeline companies are required to report emissions attributable to upstream, downstream and end-use activities that are not within our control and are highly uncertain and unreliable, this would result in significant double or multiple counting of emissions across companies.”
“[R]equiring Scope 3 reporting, which includes all ‘upstream’ and ‘downstream’ emissions, . . . would be incredibly cost prohibitive, even with delayed compliance and ‘good faith’ safe harbor protections, and would limit innovation from companies in our supplier base. . . . Because [we have] thousands of vendors and customers, the variability in terms of their use of different methodologies, assumptions and speculation is self-evident. It would be difficult for us to attest even that the information was made on a ‘reasonable’ basis, since we will not be able to obtain sufficient access to the information required to generate Scope 3 emissions reports.”
“Scope 3 disclosure – upstream and downstream – will remain a challenge for many companies during the next few years, until clear methodologies and estimation tools are put in place for each of the 15 categories defined by the GHG Protocol. Providing accurate and faithful estimates will be subject to a large magnitude of uncertainty. [The company] therefore suggests to allow Scope 3 disclosure with a 5 to 10% uncertainty range.”
“Scope 3 emissions methodology double-counts emissions overall, since ‘the scope 3 emissions for one organization are the scope 1 and 2 emissions of another organization.’ Reporting across all 15 categories of Scope 3 emissions will also count the same emissions multiple times by the same party or by different parties in the value chain from initial production to ultimate sale and use of a product. . . . [T]he Proposal as currently written will likely end up enshrining the current, flawed approach as a feature of regulation, with advancement in reporting methodologies contingent on future SEC rulemaking.”

Sample Comments on Safe Harbors for GHG Emissions:

“At a minimum, the Proposed Rule should include Scope 1 and Scope 2 reporting (the latter of which registrants will necessarily need to rely on other entities to provide), as well as any discussion of scenario analysis, within the safe harbor presently proposed for Scope 3 GHG emissions.”
“Considering the nascent nature of the GHG reporting contemplated by the Proposal compared to traditional SEC reporting requirements, [the company] urges the Commission to provide stronger safe harbor protection from liability for all scopes of GHG emissions disclosures.”
“[W]hile we support the disclosure of Scopes 1 and 2 GHG emissions, to the extent the SEC concludes this information should be included in SEC reports, the data should be furnished, not filed, because these metrics are subject to a significant degree of technical estimation and numerous assumptions.”

B. Climate-Related Risks

Proposed Item 1502 of Reg. S-K would require companies to describe “climate-related risks reasonably likely to have a material impact on the registrant, including on its business or consolidated financial statements, which may manifest over the short, medium, and long term.” Based on the definition of “climate-related risks” in the Proposed Rules, companies would need to consider not only the direct impact of climate change on their financial statements and business, but also the indirect impacts on their “value chains.” These “climate-related risks” would be categorized as either a “physical risk” (i.e., related to physical impacts of climate change) or “transition risk” (i.e., related to the transition to a lower-carbon economy).

48% of public company letters and 43% of industry association letters expressed concern about the climate-related risk disclosure requirements, with particular focus on the definitions of “physical risk” and “transition risk,” the assessment of risks over longer time horizons, and the practicality of assessing risks for a registrant’s value chain.

Sample Comments:

“Risks, to the extent they are material, are currently disclosed in the Risk Factors section of our periodic reports and registration statements filed with the Commission. We believe certain aspects of the Proposal’s climate-related risk disclosures that require prospective disclosures will create compliance challenges and lead to volumes of information immaterial to investors. For example, the requirement to disclose risks over the near-, medium- and long-term presents a particularly tricky challenge given the complexity of modeling scenarios and making materiality determinations over extended periods of time, and such assessments may only serve to obscure material near-term risks.”
“Assessing risk of a registrant’s value chain . . . . is especially onerous for a midstream infrastructure company . . . who provides federally regulated transportation services for shippers without necessarily knowing where the product being shipped originated or where it will go or how it will be used once it leaves the pipeline. Even if [a midstream infrastructure company] could reliably identify companies in its value chain and the myriad of climate-related risks they may face, [such company] does not possess special inside information that would allow it to assess the climate-related risk of its value chain for purposes of assessing materiality.”
“[The] expansive definition of climate-related risks including the impacts on our value chains will require us to expend significant resources to assess and measure potential exposure from an endless list of parties outside of our own operations over which we have no control.”
“We request that the Commission remove the requirement to assess physical risks related to the entities with which a registrant does business, apply a materiality threshold to the assessment of direct physical risks, and provide additional clarification on the definitions of physical climate risks (g., ‘water stress,’ ‘wildfire prone,’) on issues such as frequency and severity to ensure the scope of the analysis required under the Proposed Rule is clear. To the extent that the Commission determines that separate disclosures on physical risks as applied to a registrant’s supply chain will be required, it should create a new definition for ‘supply chain risks.’ Disclosures made pursuant to this new definition should then be limited to the extent that such risks are material and identifiable and should be clarified so as not to require registrants to incur costs associated with collecting data from third parties if the information is not readily available.”
“[I]f the Proposed Rules are passed in their current form, it would be the first time that the Commission has required risk disclosures to be specified over prescribed time frames; this would be a significant departure from past practice. . . . The Proposed Rules do not provide a specific range of years to define short-, medium- and long-term time horizons. Instead, the Commission provides flexibility for registrants to select the time horizons and to describe how they define them. As such, the time horizons selected will vary widely across companies, resulting in information that is not comparable or consistent for investors.”
“The detail required in this proposed disclosure – including, for example, requirements for disclosure of specific locations of properties at physical risk (with location defined as a ZIP code or other similar postal code) – would result in disclosure of extensive information that we do not believe would be decision-useful to investor. At the same time, this level of detail could result in unintended negative consequences, including security concerns, competitive harm and conflicts with contractual obligations for a company.”

C. Climate-Related Risk Oversight & Management

Proposed Item 1501 of Reg. S-K would require companies to describe “the [board’s] oversight of climate-related risks” and “management’s role in assessing and managing climate-related risks.” With respect to the board’s role, disclosure would be required as to whether any directors have “expertise in climate-related risks.” In addition, proposed Item 1503 of Reg S-K would require companies to describe, if applicable, “any process the registrant has for identifying, assessing, and managing climate-related risks.”

39% of public company letters and 29% of industry association letters commented on board and management oversight of climate-related risks, with particular focus on the requirement for a “climate expert” on the board, such board member’s liability as a “climate expert” and the impact such requirement would have on the director selection process.

Sample Comments:

“Elevating particular facets of candidate experience above others, by compelling specific disclosure on those topics, creates a value-laden one-size-fits-all disclosure framework that ignores these important differences between companies and their board needs. Over the long term, this will likely impede the ability of boards and their nominating/governance committees to exercise appropriate judgment in candidate selection based on what they view as the most critical attributes needed for their particular businesses (versus feeling compelled to check certain boxes specified by the Commission).”
“While the disclosure requirements around board and management climate-related expertise and decision-making are dressed up as mere disclosure requirements, the aim and practical effect are clear: By requiring extensive annual disclosures on one particular topic, the Commission is necessarily highlighting it above other issues relevant to good governance and effective operations and ensuring that all public companies will pay particular attention to climate-related issues.”
“[T]here is little incentive for an individual to join a board of directors as a designated expert if there is potential for increased liability, including liability under Section 11 of the Securities Act. While we would urge the Commission to delete this disclosure requirement, if nonetheless adopted, the Proposed Rule should provide a safe harbor clarifying that such an expert designation would not impose any duties, obligations, or liability that is greater than the duties, obligations, and liability imposed on such person as a member of the board of directors in the absence of such designation or identification, similar to the safe harbor proposed in the Commission’s cybersecurity proposal.”
“We have serious concerns that the Proposed Rule will remove or impair the company’s flexibility to select (or maintain) the right board members for the job, potentially elevating climate-related expertise over other business considerations in order to comply with the Proposed Rule. The board of a company is responsible for overseeing all aspects of the business, and the Proposed Rule—focused on climate as it is—ensures the overemphasis on one particular aspect of operations, thereby skewing the focus of boards.”
“We do not believe that an in-depth discussion on climate-related expertise is necessary for investors to be able to understand how the board manages oversight of climate-related risks. However, to the extent that the Commission would require disclosure of such information, we recommend that the proxy disclosure rules be revised to require disclosure about any climate-related experience or expertise of board members.”
“The Commission should provide additional guidance as to whether a director’s expertise in climate-related risks can be demonstrated through Board education or whether such expertise must be demonstrated by prior professional experience, as it does with respect to the Audit Committee Financial Expert designation.”

D. Climate-Related Impacts on Strategy, Business Model & Outlook

Proposed Item 1502 of Reg. S-K would also require companies to describe “the actual and potential impacts of any [identified] climate-related risks … on the registrant’s strategy, business model, and outlook.” Pursuant to this requirement, companies that use scenario analysis would be required to disclose the specific scenarios considered along with parameters, assumptions, analytical choices and projected financial impacts under each scenario. In addition, for companies that have set an internal price on carbon (i.e., an estimate of the cost of carbon emissions for planning purposes), the proposed rules would require detailed disclosure on such carbon pricing.

35% of public company letters and 29% of industry association letters commented on the disclosure requirements for climate-related strategies, business models and outlooks, with particular focus on the unique and competitive nature of a registrant’s climate strategy, as well as the fact that scenario analyses are based on assumptions and forecasts that may change over time.

Sample Comments:

“Certain disclosures required under the Proposal such as internal carbon price and scenario analyses constitute competitive differentiators, the disclosure of which could cause competitive harm. Effective scenario analysis requires business plans and forecasts to assess the company’s exposure to climate-related risks and plan for transition scenarios. Disclosing this information would divulge sensitive information to the public and competitors. We therefore request the Commission consider providing additional safeguards or exclusions for information that a company deems to be competitively sensitive.”
“Unless the SEC provides a detailed framework mandating specific scenarios and a common set of assumptions, this disclosure will inevitably result in a lack of comparability between issuers. Furthermore, it is important to note that these exercises utilize “scenarios,” which reflect potential outcomes over the long term, but these scenarios are not forecasts, and no representation is being made as to the accuracy of the underlying assumptions or the likelihood or occurrence. Including this information in financial reports as required under the Proposed Rule may afford them an undue sense of accuracy.”
“While scenario analysis is a helpful tool, required disclosure of each scenario that a company simulates could result in the disclosure of commercially and strategically sensitive information, to the detriment of that company and its investors, which could penalize and disincentivize companies from taking prudent steps to manage risk through robust and varied scenario analyses. Moreover, disclosure of each scenario that a company simulates could result in disclosure of significant amounts of immaterial information that may only be of interest to competitors, not investors. Furthermore, because a company simulates a range of scenarios that could include those that management believes would have a remote likelihood of occurring, the Commission should not mandate disclosure of all scenario analyses, including input parameters, that a company performs.”
“We believe that the Commission should specify that a registrant is not required to disclose internal carbon prices in any circumstances.”
“We believe that registrants should be required to disclose information about an internal carbon price. Indeed, an internal carbon price is a multifaceted tool that can support companies in assessing climate-related risks and opportunities in the transition to a low-carbon economy. . . . However, there are different approaches both in the definition and application of an internal carbon price. . . . For this reason, we recommend not to mandate a particular carbon pricing methodology.”

E. Attestation of GHG Emissions

Proposed Item 1505 of Reg. S-K would require large accelerated filers and accelerated filers to obtain an attestation report from a GHG emissions attestation provider covering disclosure of Scope 1 and Scope 2 emissions.

35% of public company letters and 29% of industry association letters commented on the attestation requirement for Scope 1 and Scope 2 emissions, with particular focus on the expense and lack of availability of assurance providers.

Sample Comments:

“The attestation requirements will further add to the complexity and cost of compliance. The assurance obligation significantly adds to the time burden by effectively requiring the work to be ‘done again’ (even if just by reviewing the original work) in order for a third-party to provide such assurance. This would be difficult enough for limited assurance, but could become nearly impossible when looking for reasonable assurance. Given the rapidly evolving nature of emissions monitoring and climate data analysis, the methodologies for analyzing this information is still in relatively frequent flux, and achieving reasonable assurance on the time frame in the Proposed Rules may well be impossible; and, if not impossible, prohibitively costly.”
“One challenge that we potentially see with assurance requirements specifically could be availability and cost-effectiveness of qualified independent resources to perform limited reasonable assurance reviews on an annual basis. The supply of available, qualified auditors will be especially limited early on, and the high demand could mean companies are unable to secure and/or afford these resources until further development in this field takes place, which could take several years.”
“[T]he SEC should phase in attestation requirements to allow for a sufficient market of GHG attestation provides to develop, and once phased in, require only limited assurance attestation.”
“The Commission must provide clear guidelines for the accounting and attestation of emissions before reporting companies can be expected to provide results that are verifiable under attestation standards. Current guidelines, including those in the GHG Protocol and GRI, allow degrees of flexibility in interpretations that would be difficult to audit for lack of clear subject matter criteria. . . . The Commission has identified this flexibility as a concern in the Proposed Rule, but we do not believe that it has provided sufficient information to resolve these concerns.”

F. Targets, Goals & Transition Plans

Proposed Item 1506 of Reg. S-K would require detailed disclosures if a company has “set any targets or goals related to the reduction of GHG emissions, or any other climate-related target or goal (e.g., regarding energy usage, water usage, conservation or ecosystem restoration, or revenues from low-carbon products) such as actual or anticipated regulatory requirements, market constraints, or other goals established by a climate-related treaty, law, regulation, policy, or organization.” In addition, registrants would be required to disclose any use of carbon offsets or Renewable Energy Credits (RECs).

29% of public company letters and 33% of industry association letters commented on the disclosure requirements related to climate-related targets, goals and transition plans, with particular focus on the comparability of such disclosure across registrants and the chilling effect such disclosure may have on a registrant’s implementing goals or transition plans.

Sample Comments:

“A registrant should control the timing and extent to which it communicates with investors and other stakeholders about any ‘transition plan’ that it may have adopted. The Proposed Rule may compel companies to disclose potentially sensitive and competitive information earlier than is appropriate. . . . Requiring this disclosure also will likely to have a chilling effect on the progress of goals and sustainability initiatives at companies that are at the early stages of addressing the transition to a low carbon economy.”
“There are no standard methodologies for developing climate-related goals and targets, transition plans, or internal carbon prices. Accordingly, this information would not be comparable across companies and would not be decision-useful to investors.”
“We . . . believe registrants should disclose plans and progress toward meeting material short-term targets and goals only, (i.e., those set within the next five (5) years) where it is possible to make definitive plans. . . . Plans and progress toward meeting long-term targets and goals are inherently less certain and are very likely to evolve over time as circumstances and technologies improve, and we have a number of options to meet these objectives, but have not yet committed to one path. Therefore, we believe that detailed disclosures on medium- and long-term goals and targets would not be material to investors and could potentially be misleading.”
“The Proposal’s requirement to provide detailed disclosures applicable to all climate-related targets and goals that a company has set may have the unintended consequence of significantly limiting a company’s willingness to set new internal and external targets and goals to advance its environmental performance. . . . An alternative that could further the SEC’s goals and not result in these potential negative consequences would be to limit the disclosure requirements related to targets and goals to a company’s material climate-related targets and goals.”
“[T]he Proposal’s requirement for detailed disclosure regarding a company’s use of carbon offsets would result in public disclosure of commercially sensitive, yet likely immaterial information, such as highly negotiated prices associated with different offset-generating projects. To promote comparability of useful information, an alternative to the current provision in the Proposal could require, to the extent material, disclosure of carbon offsets and renewable energy credits inventory volume and annual retirement volume at a summarized level in the same disclosure as GHG emissions and for the same time period. This summarized version of the information would effectively convey comparable information while avoiding competitive harm concerns.”

IV. Reactions to Proposed Reg. S-X Amendments

The Proposed Rules would amend Reg. S-X to require certain climate-related financial information (specifically, financial impact metrics, expenditure/cost metrics and financial estimates and assumptions) and related disclosures in a separate footnote to companies’ annual audited financial statements.

77% of public company letters and 38% of industry association letters commented on the proposed amendments to Reg. S-X, with particular focus on the 1% materiality threshold and the proposed definitions around the required financial metrics. Several commenters requested the Commission forego the amendments to Reg. S-X in their entirety.

Sample Comments:

“[The company] requests that the Commission withdraw its proposed amendments to Regulation S-X. Alternatively, [the company] requests that the Commission bifurcate its rulemaking, deferring the proposed amendments to Regulation S-X until it is better positioned to issue a supplemental notice of proposed rulemaking that provides improved guideposts for assessing potential climate-related financial impacts.”
“At the outset, the premise that climate-related disclosures should be linked to the parameters of a company’s consolidated financial statements is unprecedented and conflicts with existing emissions reporting regimes used by [the company] and others in [the] industry. . . . [I]mposing disclosure requirements that partially overlap others already in place adds to the burdens on companies in preparing required information. At a minimum, registrants should have the flexibility to determine the appropriate parameters for evaluating climate-related information in preparing any required disclosure in order to conform with that company’s operations and other reporting obligations. This would better promote the Commission’s goal of generating reliable disclosure by companies.”
“[W]e believe the inclusion of information about climate events and transition plans through a principles-based framework focused on information most material to investors would align with the recently adopted amendments to modernize, simplify, and enhance certain financial disclosure requirements in Regulation S-K. We recommend that relevant financial impact metrics be included in the Form 10-K in some combination of Item 1 Business, Item 7 MD&A and/or the proposed Item 6 Climate-Related Disclosure under the provisions of Regulation S-K rather than within Item 8 Financial Statements under the provisions of Regulation S-X.”

We summarize below the most frequent comments on the following proposed Reg. S-X amendments:

1. Materiality threshold of 1%
2. Financial impact and expenditure/cost metrics; financial estimates and assumptions
3. Time period covered

A. Materiality Threshold of 1%

The financial metrics under proposed Rules 14-01 and 14-02 of Reg. S-X would require quantified disclosure if the absolute value of all climate-related impacts or expenditures/costs, as applicable, with respect to a corresponding financial statement line item represents at least 1% of that line item.

68% of public company letters and 33% of industry association letters commented on the 1% materiality threshold for the proposed financial metrics, with particular focus on how such a low threshold would likely result in great cost to the registrant and an overload of immaterial information to investors.

Sample Comments:

“One percent has never been, and is not, an appropriate threshold when quantitatively evaluating materiality for a financial statement line item; additionally, any individual line item may not be material for a given company. Applying a one percent threshold to every financial statement line item would require companies to collect data at a threshold much lower than one percent to demonstrate completeness and evaluate whether the threshold is met. This exercise would lead to excessive costs in collecting a substantial amount of data that is immaterial to investors. Furthermore, there is no other financial statement disclosure requirement under Regulation S-X that requires any similar disclosure for any other specific type of risk.”
“The 1% threshold is . . . significantly below the ‘initial step’/rule of thumb of 5% used by some registrants/auditors in assessing materiality. While the SEC Staff openly acknowledges that a purely quantitative threshold is not conclusive, setting the threshold at 1% is very low by any normative standard and by the SEC’s own logic in Staff Accounting Bulletin: No. 99 (‘SAB No. 99’), and not dispositive for purposes of a registrant’s materiality determination.”
“The 1% line-item threshold applicable to the impacts of severe weather or climate transition plan efforts (together, “climate-related impacts”) would not provide investors with consistently decision-useful information. . . . [W]hile materiality includes both qualitative and quantitative assessments, we believe it would be unusual for a climate-related impact to be qualitatively material yet have a quantitative value comprising just 1% of a line item. Indeed, this is even more likely to be the case since the 1% threshold is to be met by aggregating the absolute values of individual climate-related impacts. As a result, this footnote disclosure is unlikely to inform a reasonable shareholder’s investment or voting decision, and would only serve to increase compliance costs.”
“Public companies will need to conduct extensive and costly assessments of potential impacts to determine if they trigger the reporting threshold and revise controls on their financial reporting systems to account for the unprecedented 1% reporting threshold. Thus, notwithstanding if a registrant has to disclose such information, it will still need to engage in data calculation and subsequent calculations to determine whether it falls below the threshold for materiality.”
“[T]he materiality threshold of 1% of an individual line item is significantly lower than other thresholds in Regulation S-X implying that this information is more sensitive than any other measure of financial performance in the financial statements. Since the amount in which to apply this threshold is based on an aggregate number on an absolute basis, processes and controls will need to be in place to capture all transactions to have a complete population to analyze for disclosure, creating a significant burden to preparers.”

B. Financial Impact and Expenditure/Cost Metrics; Financial Estimates & Assumptions

The proposed amendments to Regulation S-X would require companies to disclose, subject to the 1% line-item threshold, (i) the financial impacts of severe weather events, other natural conditions and transition activities on any relevant line items in the company’s financial statements, and (ii) expenditures and capitalized costs to mitigate the risks of severe weather events or other natural conditions and expenditures related to transition activities. In addition, companies would be required to disclose whether estimates and assumptions underlying the amounts reported in the financial statements were impacted by risks and uncertainties associated with, or known impacts from, severe weather events and other natural conditions, the transition to a lower-carbon economy or any disclosed climate-related targets.

61% of public company letters and 19% of industry association letters commented on the disclosure requirements for financial metrics, estimates and assumptions, with particular focus on the definitions of “severe weather events” and “transition activities” and the difficulty in breaking out financial impacts and expenditures from standard business operations.

Sample Comments:

“With respect to our business, one of the largest event-driven impacts to our financial statements is from the movement in commodity prices, which are directly and indirectly impacted in any given period by a multitude of supply, demand and other factors. Thus, it is impossible for us to measure and determine the impact of a single climate or weather-related event on our revenues and certain other financial statement line items or on commodity prices, nor can we bifurcate the impact of macroeconomic events from climate change events. This would be impractical to measure and report even if the Commission were to raise the threshold for reporting from one percent to a higher percentage threshold.”
“Quantifying and providing the proposed financial impact metrics when the impact is the result of a mixture of factors, including events unrelated to climate, may be impractical. In such situations, we believe the Commission should permit a registrant to disclose that it was unable to make the required determination. Moreover, it would be helpful if the Commission could provide examples to illustrate impracticability.”
“[T]he metrics proposed would provide no detail as to the underlying cause for the negative or positive impact from climate-related events or transition activities. The amount disclosed for each line item could be comprised of a number of smaller events that aggregate to an amount requiring disclosure under the Proposed Rules and would not identify which climate-related risks may have driven the amounts disclosed.”
“In particular, we request additional specificity in regards to how, in preparing the proposed climate-related financial statement metrics, registrants should determine the financial impact of transition activities or climate-related physical risks and expenditures related to transition activities and the mitigation of physical risks. As currently drafted, for example, the proposed rules are unclear on how companies should distinguish climate-related impacts and expenditures from those that are part of normal business operations in order to apply the one percent threshold for disclosure.”
“Attempting to assess the financial impact of energy transition risk will require companies to translate predictions about the actions of regulatory bodies, new technologies, changes in market behavior, and a host of other variables, into financial consequences, which, due to the fact that there is no standardized method for making such determinations, means that consistent, comparable, and reliable disclosure is unlikely to be achieved.”

C. Time Period Covered

Proposed Rule 14-01 of Reg. S-X would require the financial statement disclosures discussed above to be provided for a company’s most recently completed fiscal year and for each historical fiscal year included in the financial statements in the applicable filing.

35% of public company letters and 19% of industry association letters commented on the applicable time period for financial statement disclosures, with particular focus on the requirement to provide disclosure for historical periods prior to implementation of any final rule.

Sample Comments:

“The Proposed Rule represents a significant sea change in financial reporting practices, and new processes and controls will have to be put in place to assess and identify relevant data. This will be a daunting task in and of itself, but being required to retroactively apply this requirement to historical financial data with the degree of accuracy that investors expect with respect to financial reporting is unfeasible.”
“Under the Rule Proposal, large accelerated and accelerated filers with calendar year-ends would be required to file the assured GHG emissions metrics by March 1 and March 16, respectively. Under the EPA Rule, those same companies are required to submit unverified metrics by March 31. While we expect that the Rule Proposal’s deadline would be difficult for companies that do not report GHG emissions, even companies that have adopted GHG emissions reporting practices meant to comply with the EPA Rule would incur significant costs to adapt their controls and procedures to meet the Form 10-K reporting deadline. . . . Given the significant burden of completing the GHG emissions reporting and assurance processes within the proposed time frame, the likelihood that disclosures would be undermined by the need to further rely on assumptions and estimates in order to meet such time frame, and the significant cost savings that could be realized with a deadline that occurs after the publication of GHG emissions reports under the EPA Rule, we recommend that the Commission extend the deadline for GHG emissions disclosure.”
“The required historical information will be difficult to obtain for periods prior to the current period when the Proposed Rules first take effect. . . . With the aim to reduce compliance burden, we would welcome a provision that permits the presentation of climate-related financial statement metrics only for the most recently completed fiscal year when the Proposed Rules first take effect and for subsequent years.”
“The proposed rules should not require the retrospective disclosure of historic climate-related information, which would introduce data inherently exposed to a greater risk of inaccuracy and difficulty to assure given, in particular, that registrants would have had no opportunity to implement the systems and processes to collect the required data for those prior years.”
“Compliance with the disclosure timeline contemplated by the Proposed Rule would be extremely onerous for [the association’s] members and other registrants, as it would require the assembly of data for calendar year 2021, which has already passed. For some registrants, systems needed to track the information required under the Proposed Rule were not in place to track all the required info at the time the Proposed Rule was issued, and attempting to retroactively determine that data will be extremely burdensome, if not impossible. For example, without a system to track fuel usage for fleet vehicles, going back and compiling that historical information with any reasonable degree of accuracy would not be possible.”

V. Other Significant Reactions to the Proposed Rules

A. Materiality

Very few items in the Proposed Rules are predicated on materiality. Other than in the context of Form 10-Q updating, only the climate change risk disclosures, the Scope 3 emissions disclosure requirement (i.e., disclosure required either if material or if included in a GHG emissions reduction target or goal), and certain details regarding emissions disclosures are predicated on materiality (and in the case of risk disclosures, the standard is “reasonably likely” to have a material impact).

52% of public company letters and 43% of industry association letters commented in some way that the Proposed Rules deviated from the long-standing, judicially accepted understanding of “materiality” under the federal securities laws.

Sample Comments:

“The Proposed Rules depart from the general, long-standing materiality constraint on required disclosures. While the Commission has previously mandated certain disclosures irrespective of a materiality threshold, that is the exception. The general guidepost for disclosures in federal securities law has been information that a reasonable investor would consider important in deciding how to vote or make an investment decision. However, the Proposed Rules eschew a materiality standard in some areas and apply a modified version in others.”
“We believe that climate-related risks should be disclosed based on the materiality standard that has been used by the Commission for many years and which is consistent with well-established and time-tested Supreme Court precedents. . . . This definition of materiality is foundational to the function of U.S. capital markets. Other frameworks for ESG disclosure have competing and non-aligned definitions of materiality when compared to the SEC’s well-established precedent . . . and we believe disclosures effectively requiring a different materiality framework are likely to create confusion and uncertainty for investors and registrants alike.”
“[The company] believes it is critical for the Commission to maintain the time-tested materiality standard that serves as the cornerstone of the securities disclosure system: information is material if there is a substantial likelihood that a reasonable investor would consider it important or significant in deciding whether to buy or sell a security. . . . The fact that climate-related information is valuable or interesting to many stakeholders does not make it material. We believe that companies are best positioned to determine materiality standards for disclosure of climate-related information, in light of their specific business circumstances, and to engage with their investors to determine what information is most useful to them.”
“The proposed rules, if adopted, would effectively compel all boards and management of public companies (but only of public companies) to subordinate their judgment of materiality to the SEC’s and treat essentially any and all climate-related matters, including any amount of Scope I and Scope II emissions, as material, regardless of whether there is a substantial likelihood that a reasonable shareholder would consider it important.”
“The Proposed Rule substantially deviates from the longstanding conception of materiality under the federal securities laws which is supported by related case law. For decades, the existing concept of materiality has advanced the best interests of investors, encouraged capital formation, and helped ensure the integrity of our capital markets. In contrast, the Proposed Rule calls for the disclosure of granular climate-related information that is often immaterial under the standard of materiality that the United States Supreme Court handed down decades ago.”

B. Implementation Timing

The Proposed Rules provide for a phase-in implementation schedule, assuming that final rules are adopted and effective by the end of 2022. Large accelerated filers would be required to comply with the disclosure requirements (other than Scope 3) beginning with fiscal year-end 2023 (for years 2023, 2022 and 2021), accelerated and non-accelerated filers would be required to comply beginning with fiscal year-end 2024 (for years 2024, 2023 and 2022 if included in the Form 10-K) and smaller reporting companies would be required to comply beginning with fiscal year-end 2025 (for years 2025, 2024 and 2023 if included in the Form 10-K). Disclosure on Scope 3 emissions would be required the succeeding year for large accelerated, accelerated and non-accelerated filers.

52% of public company letters and 29% of industry association letters commented with concerns that the implementation timeline would be too short for registrants to comply with the final rules once adopted.

Sample Comments:

“The timeline for implementing the Proposed Rule is far too aggressive. If adopted as proposed, the compliance date for the proposed disclosures (other than Scope 3 emissions disclosure) in annual reports for large accelerated filers . . . could be as early as the fiscal year 2023. That suggests that the necessary systems for compliance be in place by the end of this year and that we would have already needed to have them in place to the extent necessary for comparison to prior periods. For any adopted rule, there should be a multi-year transition period, even for large accelerated filers.”
“Many companies will not have the necessary expertise or staff to adequately respond to the reporting requirements. As a result, they will need to rely heavily on outside consultants, which will further increase compliance costs. . . . This problem is compounded by the relatively brief phase-in period for compliance with the Rule Proposal. . . . One solution would be to extend the transition period for emissions disclosures by one or two years to allow companies to effectively implement the internal controls and procedures required for emissions disclosures.”
“To enable compliance with the Proposed Rules, companies will need to expend significant effort to enhance data collection (including from third parties in their value chain), validation, reporting, control design, and third-party verification. . . . [The company] strongly recommends that the Commission extend the proposed implementation timeline such that the proposed disclosures, including GHG emission metrics, be required no earlier than for the 2024 fiscal year (filed in 2025), and preferably longer. It is critical to give registrants with sufficient time to ensure that their data is available and reliable in time for filing in the 10-K.”
“As the Commission’s proposed standard would be different than [the EPA’s and other GHG] reporting standards, such difference would create additional burden on the underlying processes and systems for gathering the information. . . . As such, we believe that registrants need time to digest the Commission’s final rule and implement tracking mechanisms and/or system enhancements. . . . We recommend that the Commission provide a transition period of at least one year from the issuance of the final rule until the start of the first reporting period provided the Commission modifies the financial metric disclosure requirements as recommended herein or a transition period of at least two years if the final rule is issued substantially as proposed.”
“We therefore respectfully ask the Commission to review and consider delaying the implementation timeline for all registrants and the phase-in periods for Scopes 1 and 2 emissions disclosure and assurance to at least five (5) years following the adoption of the final rules. This recommendation is consistent with the implementation timeline adopted for major recent changes to financial reporting standards such as the Financial Accounting Standards Board’s (FASB) implementation timeline for each of the revenue recognition and lease accounting standards, each of which provided public companies with significantly longer implementation timelines. . . . And prior to their issuance, the FASB worked for several years with stakeholders, including the financial statement preparer community, to finalize these rules. Neither rule contemplated changes that are as significant as those set forth in the Proposal.”

C. Increased Cost of Being a Public Company

The Commission estimates that annual direct costs to comply with the proposed rules (including both internal and external resources) would range from $490,000 (smaller reporting companies) to $640,000 (non-smaller reporting companies) in the first year and $420,000 to $530,000 in subsequent years.[3]

52% of public company letters and 43% of industry association letters raised concerns about the actual (and economic) cost of the Proposed Rules. Many believe the SEC underestimated the implementation costs, and a handful of companies provided quantitative estimates as to actual cost.

Sample Comments:

“We are . . . concerned about the cost, complexity and practicability of complying with parts of the Proposal (in particular, the proposed amendments to Regulation S-X) that will be borne by registrants of all sizes, and which we believe, will significantly exceed the estimates set forth in the Proposal. Our company expects implementation costs in the $100-500 million range, and annual costs for on-going compliance in the $10-25 million range — costs that will ultimately be borne by investors and the public markets.”
“This additional reporting [on GHG emissions] will come at a high costs: EPA estimated if it lowered its own de minimis reporting thresholds from 25,000 to 1,000 metric tons of CO₂e per year it would cost an additional $266 million (in 2006 dollars). . . . EPA updated the reporting requirements for petroleum and natural gas systems in 2010. In doing so, EPA estimated that the incremental cost to reduce the bright line threshold from 25,000 to 1,000 would cost an additional $54.43 million (2006 dollars). . . . Based on EPA’s figures, the Proposed Rule could mean an additional cost to [the company] of $7,000,000 or more in 2006 dollars just to track and report Scope 1 emissions from additional facilities. These figures also suggest that the Commission has not fully accounted for the cost of this rule.”
“[The company] estimates the cost of voluntarily reporting Scope 3 GHG emissions to be more than $1 million. . . . This does not include accounting personnel to incorporate Scope 3 emissions reporting into our Form 10-K or any commercial efforts needed to amend contracts or attempt to gather and verify Scope 3 emissions data across our value change to the extent it can be identified. Furthermore, [the company] estimates implementing the amendments to Regulation S-X would also be in the millions of dollars.”
“[A small cap public company] estimate[s] that the total annual cost of satisfying the disclosure requirements set forth in the Proposal would be approximately $500,000 to $800,000, which would be significant for a company of our size.”
“We believe the Commission’s cost estimates are significantly understated for large accelerated filers. . . . Currently, [the company’s] climate-related disclosures activities in line with TCFD recommendations require time and several million dollars in costs for data and information collection, IT system solutions, services provided and other related tools, techniques, and expertise. This does not include the significant additional time and cost of assurance of our performance data and disclosures.”
“[W]e believe the SEC has significantly underestimated the costs of compliance, which we believe would be many multiples of the projected $640,000 per year initially and would likely increase over time.”
“The cost of registrants trying to report in alignment with just certain aspects of TCFD for their first time on a voluntarily basis can be around $500,000. This does not account for the level of rigor, financial line items, attestation, and liability costs associated with complying with this Proposed Rule. The actual cost for complete alignment to TCFD could be up to $1,000,000 per registrant over several years. This does not include the annual cost associated with preparing for and conducting attestation.”
“[B]y only considering the costs of compliance to the public companies that are required to file, SEC misses completely the costs to companies that supply SEC filers, the largest being the induced requirement to gather and report their GHG emissions to the filing company as a condition of their supply relationship. . . . [B]ecause filing companies will have to undertake the herculean task of estimating their Scope 3 emissions, they will have no other choice but to require their suppliers to provide their GHGs, even if those suppliers have no regulatory requirement otherwise to report to SEC or EPA.”

D. Timing Deadlines for Reporting

The Proposed Rules would require the new climate-related disclosure to be included annually in the registrant’s Form 10-K (and Form 20-F for foreign private issuers). By requiring disclosures in Form 10-K, large accelerated filers will need to finalize both the traditional year-end financial reporting and the new climate-related disclosure no later than 60 calendar days after the fiscal year end.

45% of public company letters and 24% of industry association letters commented on the reporting timeline for the new climate-related disclosure requirements, with many requesting additional time to prepare the necessary disclosure.

Sample Comments:

“We have experience with reporting GHG emissions data and understand the time commitments and complexities involved to gather, model, analyze and verify the accuracy of such data. In addition to our disclosure of Scope 1 GHG emissions data in our Form 10-K, we also include Scope 2 and Scope 3 emissions data in our Climate Report, which is published significantly later in the year compared to our Form 10-K filing. We recommend that registrants be allowed to provide preliminary emissions data . . . for the most recently completed fiscal year as an estimated amount in the Form 10-K with final emissions data, with the corresponding attestation report on Scope 1 and Scope 2 emissions, provided in a subsequent reporting period (either later in the year on Form 10-Q or the following year Form 10-K).”
“The Proposal’s requirement for all climate-related disclosures to be provided in a registrant’s annual report on Form 10-K will prove challenging. Registrants already face significant pressure to meet existing annual and quarterly reporting deadlines, and the addition of climate-related disclosures, particularly quantitative disclosures that will need to be accompanied by assurance, will only increase such pressures. Moving GHG emissions disclosures and assurance to a separate report, such as furnishing within a specialized disclosure in Form SD with a later reporting deadline in the calendar year, will provide companies with additional time to properly collect GHG emissions data and assurance providers sufficient time to render their opinions. As an alternative, it may also be advisable to report GHG emissions on a one-year lag to ensure sufficient time for reporting and assurance.”
“The SEC financial reporting timelines are not consistent with current regulatory and voluntary reporting timelines. Currently our regulatory and voluntary reporting is based on verified annual data for the prior fiscal year. This means that GHG emissions data are collected and submitted to applicable regulators at the end of the first quarter following the reporting period. Voluntary disclosures such as our annual sustainability report and CDP submission are typically published at the end of the second quarter following the end of the reporting period. Transitioning to a reporting schedule that is consistent with SEC deadlines for Form 10-K will require an additional, parallel reporting process which will incorporate significant estimates (e.g., for the prior 4th quarter), reducing the accuracy of the information and its usefulness to investors and will impose a major burden on our existing reporting systems. A separate mid-year climate disclosure requirement would help ease the transition and avoid the potential need to update these disclosures based on actual data received after the Form 10-K filing deadline.”

E. Liability

The Proposed Rules would treat all climate-related disclosures as “filed” rather than “furnished” (other than those included in a foreign private issuer’s Form 6-K, which generally are “furnished”). This means that, in addition to general anti-fraud liability under Rule 10b-5 under the Exchange Act, such disclosures would be subject to incremental liability under Section 18 of the Exchange Act and, to the extent such disclosures are included or incorporated by reference into Securities Act registration statements, subject to liability under Sections 11 and 12 of the Securities Act.

45% of public company letters and 43% of industry association letters commented on liability concerns, with many requesting the climate-related disclosures be “furnished” rather than “filed” and that safe harbor protections from Sections 11, 12 and 17(a) of the Securities Act and Sections 10(b) and 18 of the Exchange Act be afforded for certain of the proposed disclosure requirements, including any forward-looking information and GHG emissions disclosure.

Sample Comments:

“Due to the long-term and uncertain nature of certain climate-related information, particularly while associated frameworks and standards are still evolving, [the company] believes that climate-related disclosures should be furnished to, rather than filed with the Commission, and not be included as part of any annual or quarterly Sarbanes-Oxley Act certifications.”
“[W]e believe that the new climate report should be treated as “furnished” instead of “filed” for purposes of liability under the Exchange Act, and not automatically incorporated by reference into Securities Act registration statements (where strict liability applies). This approach would appropriately recognize the novel and complex nature of the proposed disclosure requirements – including, among other items, GHG emissions data, scenario planning, targets and goals, and the detailed nature of many of the proposed requirements – which go far beyond information that has been required in SEC filed reports. In these circumstances, treating the information as furnished would provide appropriate liability protection while continuing to make the information widely available via the SEC’s EDGAR system.”
“[I]f climate information is subject to liability under Section 18 of the Securities Exchange Act and the strict liability provisions of Section 11 of the Securities Act, issuers are likely to disclose information in the most limited manner possible, and they may be unwilling to provide additional information that could give investors context. For these reasons, until climate-related estimation, monitoring and measurement methodologies and processes are sufficiently mature to support the more rigorous liability standards, we believe it would be more appropriate to remove the private right of action under 10b-5 with respect to such disclosures, or allow registrants to furnish climate-related disclosures as part of a separate disclosure report, formally furnished to the SEC, or make such disclosures through existing sustainability reports.”
“As climate change views and related rules and interpretations continue to evolve, we would appreciate the ability to furnish rather than file any mandated climate-related disclosures, particularly any disclosure requirements subject to significant interpretation or differences of opinion. Allowing such disclosures to be furnished and strengthening safe harbors around good faith disclosures will encourage greater disclosure transparency while climate and sustainability views evolve into greater uniformity.”
“There should exist a meaningful safe harbor for the entirety of any final rule considering the unique challenges that the SEC itself recognizes registrants must overcome to meet the proposed climate-related disclosure obligations. The SEC should enhance the safe harbor to recognize the evolving nature and inherent uncertainties of assessing climate risks to the level of granularity (e.g., risks to specific locations and assets) required in the Proposed Rule. Registrants should be shielded from liability for forward-looking statements and any inaccuracy in the reporting of the many metrics that necessarily involve uncertainty and subjective or speculative judgment calls.”

F. SEC Authority to Implement Proposed Rules

26% of public company letters and 81% of industry association letters commented on whether the Commission has the authority to implement the Proposed Rules.

Several of these commenters also raised the First Amendment concern noted by Commissioner Hester Peirce in her dissent to the Proposed Rules. Commissioner Peirce expressed a view that the proposal exceeds the Commission’s statutory limits of authority “by using the disclosure framework to achieve objectives that are not [the Commission’s] to pursue and by pursuing those objectives by means of disclosure mandates that may not comport with First Amendment limitations on compelled speech.”[4]

Sample Comments:

“The Proposal, as currently written, suffers from legal flaws that will undermine the validity of any final rule and the Commission’s objectives. Although information regarding climate risks and transition opportunities is important to many investors and companies, as evidenced by the Form 10-Ks and sustainability reports published by [association] members, the Proposal imposes an unprecedented degree of granularity and would require official reporting through the stringent requirements of Regulations S-X and S-K on predictive judgments that fall far outside of what federal securities laws demand. The Proposal also raises serious constitutional questions under the separation of powers. Furthermore, aspects of the Proposal would violate the First Amendment’s prohibition against compelled speech. If the Commission does not significantly alter the Proposal to address these concerns, then the final version of the rule will be vulnerable to invalidation on legal grounds.”
“We agree it is critical for the Commission to adhere to the scope of its authority as established by Congress, to adhere to established precedent regarding materiality and to carefully consider the risks associated with compelled speech. We further agree with the API the Proposal is beyond the scope of the Commission’s authority, violates foundational principles regarding materiality, as that term has been interpreted by the U.S. Supreme Court, and raises significant Constitutional concerns.”
“Congress has not given the SEC unlimited authority over the economy or climate change policy. The use of the [TCFD Framework] and the [GHG Protocol] as the basis of the disclosure framework for the proposal makes it clear that the SEC is attempting to achieve outcomes which are not within the agency’s authority. . . . Congress has yet to issue a specific mandate allowing the SEC to order climate-change disclosures.”
“We share many of the additional concerns articulated by other commenters about the breadth, potential impacts and legal authority to implement the Proposal, including, among others, whether the Proposal is within the scope of authority granted to the SEC by Congress, is enforceable based on application of the major questions doctrine, or exceeds First Amendment limitations on compelled speech.”

VI. Select Remarks from Non-Reporting Companies

Non-reporting energy companies who submitted comment letters focused primarily on concerns with the Proposed Rules’ impact on the energy industry in general and, specifically, on smaller, private companies. Many raised concerns that the Proposed Rules would “operate to limit or deny financing to oil and natural gas companies.” As one sample comment noted, “[t]hese time-intensive, resource-heavy measures will impair the abilities of private companies to pursue their business plans and grow through private capital. Increased costs will create significant burdens even if such private companies ultimately never seek to access the public market.”

Non-reporting companies also raised concerns that the Proposed Rules, and in particular, the GHG emissions reporting requirements, would “undoubtedly demand additional information from . . . privately traded companies not otherwise subject to the SEC’s jurisdiction” and impact the ability of smaller suppliers to public energy companies to compete for business. As noted by a few commenters:

“[b]ecause any one company’s Scope 3 emissions permeate among potentially many hundreds or even thousands of companies and millions of consumers, they are nearly impossible to accurately measure, calculate, or otherwise estimate. SEC would be requiring companies . . . to determine emissions data that are not available from our suppliers, who may-or may not-have SEC reporting obligations. The rule would incentivize SEC filers to favor large suppliers who have the wherewithal to calculate and provide their emissions data while disadvantaging smaller suppliers that cannot.”

One commenter also noted the impact of the Proposed Rules on private companies seeking to go public:

“The Proposed Rule explicitly notes that the climate-related disclosures and data must be included in registration statements but, per the implementation timeline, provides a delayed compliance date for registrants other than large accelerated filers. A smaller private company contemplating an IPO that would, if already public, qualify as an accelerated filer or non-accelerated filer, would be required to comply with the Proposed Rule’s disclosure requirements before an existing accelerated filer or non-accelerated filer, thereby increasing the burden on new entrants to the public markets. Likewise, the Proposed Rule’s amendments to Form S-4 would require a private target company to present all the disclosures required by the Proposed Rule in a Registration Statement on Form S-4 registering the equity securities of the acquiror to be issued in an M&A transaction. For a non-reporting company that has not maintained such records (and which may have been indifferent as to whether its potential acquiror was a reporting company), such a disclosure requirement presents a significant potential barrier to being acquired in an M&A transaction or a SPAC merger.”

VII. Conclusion

The breadth and scope of the Proposed Rules predictably resulted in many comments from the energy industry. These comments are informative as to how the industry is reacting to the Proposed Rules and what steps may be necessary for companies to start taking to be positioned to comply with the Proposed Rules, when adopted. Gibson Dunn’s premier securities regulation and energy lawyers are available to assist companies with preparation and compliance with new disclosure requirements.

___________________________

[1] For purposes of this client alert, we define energy companies to include companies in the oil and gas industry, including those in the exploration and production, midstream, downstream, and oilfield services sectors.

[2] See Release No. 33-11042, p. 9-10.

[3] See Release No. 33-11042, p. 373.

[4] See Commission Hester Peirce, “We are Not the Securities and Environment Commission – At Least Not Yet,” Mar. 21, 2022, https://www.sec.gov/news/statement/peirce-climate-disclosure-20220321.

The following Gibson Dunn lawyers prepared this client update: Hillary Holmes, Justine Robinson, Tull Florey, Brian Lane, Jim Moloney, Gerry Spedale, and Peter Wardle.

Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have about these developments. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work, or any of the following leaders and members of the firm’s Securities Regulation and Corporate Governance, Environmental, Social and Governance (ESG), Capital Markets, and Energy practice groups:

Securities Regulation and Corporate Governance Group:
Elizabeth Ising – Washington, D.C. (+1 202-955-8287, [email protected])
James J. Moloney – Orange County (+1 949-451-4343, [email protected])
Lori Zyskowski – New York (+1 212-351-2309, [email protected])
Brian J. Lane – Washington, D.C. (+1 202-887-3646, [email protected])
Ronald O. Mueller – Washington, D.C. (+1 202-955-8671, [email protected])
Thomas J. Kim – Washington, D.C. (+1 202-887-3550, [email protected])

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

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

Oil and Gas Group:
Michael P. Darden – Houston (+1 346 718 6789, [email protected])
Anna P. Howell – London (+44 (0) 20 7071 4241, [email protected])
Brad Roach – Singapore (+65 6507 3685, [email protected])

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

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

On August 7, 2022, the Senate voted 51-50 to pass the Inflation Reduction Act of 2022 (the “Act”), which broadly addresses climate change, taxes, health care, and inflation. The action sends the measure to the House of Representatives for a vote as early as Friday of this week. The House is expected to pass the $430 billion Act without amendments and send it to the White House for President Biden’s signature. Federal agencies then would implement the law and promulgate rules as to the deployment of the funding.

Our previous alert analyzed proposed changes to U.S. tax law that were in an earlier draft of the legislation that was released on July 27, 2022. Consistent with the prior version of the legislation, the Senate-passed version of the Act includes a 15-percent corporate minimum tax, provides multi-year IRS funding with a dramatic increase in funding for tax enforcement, and extends and expands tax incentives for clean energy.

Notably, the Senate-passed version of the Act differs from the prior draft legislation in certain major respects, including that the Act (1) does not change existing law regarding the tax treatment of carried interests, (2) adds a one-percent excise tax on certain corporate stock buybacks, and (3) eases some of the effects of the new corporate minimum tax by, for example, taking into account certain depreciation and amortization deductions. A change relating to the corporate minimum tax in the draft legislation that may have adversely affected private equity funds was rejected.

Excise Tax on Stock Buybacks

As noted above, the Act introduces a one-percent excise tax on certain corporate stock buybacks. The proposal for the excise tax is identical to the excise tax that was proposed as part of the Build Back Better Act (H.R. 5376) at the end of 2021.

More specifically, the Act would impose a non-deductible one-percent excise tax on the fair market value of certain stock that is “repurchased” during the taxable year by a publicly traded U.S. corporation or acquired by certain of its subsidiaries. The taxable amount is reduced by the fair market value of certain issuances of stock throughout the year. On August 9, 2022, the Joint Committee on Taxation released its revenue estimate projecting that the excise tax will raise more than $73 billion in revenue over ten years.

A special rule would impose the tax on a publicly traded non-U.S. corporation that owns a U.S. entity that expatriated (as determined for U.S. tax purposes) after September 20, 2021. Another special rule would tax certain majority-owned U.S. subsidiaries in connection with certain acquisitions of the stock of their publicly traded non-U.S. parent corporations. (A publicly traded non-U.S. corporation’s non-U.S. subsidiary that undertakes such an acquisition generally would not be subject to the tax, except in the case of a subsidiary non-U.S. partnership with a U.S. entity as a direct or indirect partner.[1])

A “repurchase” includes a “redemption” (generally, any acquisition by a corporation of its stock in exchange for cash or property other than the corporation’s own stock or stock rights) and any other “economically similar” transaction, as determined by the Treasury. Certain repurchases, however, would be specifically excepted from the excise tax. Those include: (1) a repurchase to the extent it is part of a tax-free reorganization and no gain or loss is recognized on the repurchase by the shareholder “by reason of” the reorganization, (2) repurchases followed by a contribution of the repurchased stock (or stock with an equivalent value) to an employee pension plan, employee stock ownership plan, or similar plan, (3) stock repurchases the total value of which does not exceed $1 million during the taxable year, (4) repurchases by a dealer in securities in the ordinary course of business, (5) repurchases by regulated investment companies or real estate investment trusts, and (6) a repurchase that is treated as a dividend for U.S. federal income tax purposes.

The excise tax has a potentially broad reach. For example, certain split-off transactions and leveraged acquisitions that constitute redemptions for U.S. federal income tax purposes may be “repurchases.” Further, the definition of “repurchase” includes transactions that are “economically similar” to redemptions (as determined by the Treasury), so it is possible that a wide range of other corporate transactions that would not constitute stock buybacks in the traditional sense may be subject to the excise tax.

The excise tax would apply to “repurchases” occurring after December 31, 2022.

Revisions to the Corporate Alternative Minimum Tax

In the course of Senate negotiations, one significant change was made to the Act’s 15-percent corporate alternative minimum tax and one potentially significant change was rejected:

In a taxpayer-favorable development, the Act’s calculation of adjusted financial statement income was modified to allow depreciation generally (and amortization deductions for certain wireless spectrum specifically) to be computed using U.S. federal tax accounting methods, conventions, and class lives in lieu of corresponding financial statement principles. This modification will be beneficial to participants in industries that tend to make significant investments in property, plant and equipment (such as manufacturers). We also anticipate it will be a welcome development for sponsors of and investors in clean energy projects (which are further incentivized in the Act as described in our previous alert) because depreciation is one of the key tax attributes that is monetized by a tax equity investor in connection with a clean energy project financing transaction.
A change to the rules for aggregating entities in applying the minimum tax’s $1 billion income threshold (previously proposed as part of the Build Back Better Act and incorporated in a revised draft of the legislation) that would have grouped together additional entities (including, notably, private equity funds) was rejected via an amendment from Senator Thune shortly before passage of the Act.[2] It is hoped that additional clarification or confirmation in the form of committee reports or legislative history will be forthcoming to give guidance and instruction to the IRS and Treasury regarding the import of this aspect of the Act.
The Joint Committee on Taxation has projected that the minimum tax will raise more than $222 billion in revenue over ten years, a decline from the more than $318 billion in revenue that was projected to be raised from a similar provision included in the Build Back Better Act at the end of 2021.

Partnership Issues and Other Guidance Needs

Significant guidance from the IRS and Treasury will be necessary to administer the tax law changes included in the Act, in particular with respect to partnerships. For example, the new 15-percent corporate alternative minimum tax requires a determination of an applicable corporation’s “distributive share” of a partnership’s “adjusted financial statement income” without providing guidance as to how that “share” is to be determined. In addition, the excise tax on corporate stock buybacks applies to stock acquired by a partnership that is majority-owned “directly or indirectly” by the corporation, but the statutory provision itself does not include any further rules for determining such ownership. Further, the new tax credit transfer regime has a rule addressing a transfer of an eligible credit by a partnership, but no rules for the subsequent treatment of an eligible credit transferred to a partnership.

_________________________

[1] The intended interaction of these rules with the “May Company” regulations of Treas. Reg. § 1.337(d)-3 is not entirely clear.

[2] In connection with this amendment, the disallowance of excess of business losses by noncorporate taxpayers under section 461(l) was ultimately extended for two years (through 2028).

This alert was prepared by Josiah J. Bethards, Michael Q. Cannon, Michael J. Desmond, Matthew J. Donnelly, Pamela Lawrence Endreny, Bree Gong, Brian Hamano, Roscoe Jones Jr., Jamie Lassiter, and Eric B. Sloan.

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

Tax Group:
Dora Arash – Los Angeles (+1 213-229-7134, [email protected])
Sandy Bhogal – London (+44 (0) 20 7071 4266, [email protected])
Michael Q. Cannon – Dallas (+1 214-698-3232, [email protected])
Hanna Chalhoub – Dubai (+971 (0) 4 318 4634, [email protected])
Michael J. Desmond – Los Angeles/Washington, D.C. (+1 213-229-7531, [email protected])
Anne Devereaux* – Los Angeles (+1 213-229-7616, [email protected])
Matt Donnelly – Washington, D.C. (+1 202-887-3567, [email protected])
Pamela Lawrence Endreny – New York (+1 212-351-2474, [email protected])
Benjamin Fryer – London (+44 (0) 20 7071 4232, [email protected])
Brian R. Hamano – Los Angeles (+1 310-551-8805, [email protected])
Kathryn A. Kelly – New York (+1 212-351-3876, [email protected])
Brian W. Kniesly – New York (+1 212-351-2379, [email protected])
Loren Lembo – New York (+1 212-351-3986, [email protected])
Jennifer Sabin – New York (+1 212-351-5208, [email protected])
Eric B. Sloan – Co-Chair, New York (+1 212-351-2340, [email protected])
Jeffrey M. Trinklein – London/New York (+44 (0) 20 7071 4224 /+1 212-351-2344), [email protected])
John-Paul Vojtisek – New York (+1 212-351-2320, [email protected])
Edward S. Wei – New York (+1 212-351-3925, [email protected])
Lorna Wilson – Los Angeles (+1 213-229-7547, [email protected])
Daniel A. Zygielbaum – Washington, D.C. (+1 202-887-3768, [email protected])

Global Tax Controversy and Litigation Group:
Michael J. Desmond – Co-Chair, Los Angeles/Washington, D.C. (+1 213-229-7531, [email protected])
Saul Mezei – Washington, D.C. (+1 202-955-8693, [email protected])
Sanford W. Stark – Co-Chair, Washington, D.C. (+1 202-887-3650, [email protected])
C. Terrell Ussing – Washington, D.C. (+1 202-887-3612, [email protected])

Public Policy Group:
Michael D. Bopp – Co-Chair, Washington, D.C. (+1 202-955-8256, [email protected])
Roscoe Jones, Jr. – Co-Chair, Washington, D.C. (+1 202-887-3530, [email protected])

* Anne Devereaux is an of counsel working in the firm’s Los Angeles office who is admitted only in Washington, D.C.; Bree Gong is an associate working in the firm’s Palo Alto office who is admitted only in New York; and Jamie Lassiter is an associate working in the firm’s Los Angeles office who is admitted only in New York and Texas.

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

This Client Alert provides an update on shareholder activism activity involving NYSE- and Nasdaq-listed companies with equity market capitalizations in excess of $1 billion and below $100 billion (as of the last date of trading in 2021) during 2021.

Announced shareholder activist activity increased relative to 2020. The number of public activist actions (76 vs. 63), activist investors taking actions (48 vs. 41), and companies targeted by such actions (69 vs. 55) each increased. Such levels of activism are comparable to those found prior to the market disruption caused by the COVID-19 pandemic, as reflected in public activist actions in 2019 (76 vs. 75), activist investors taking actions (48 vs. 49), and companies targeted by such actions (69 vs. 64). The period spanning January 1, 2021 to December 31, 2021 also saw several campaigns by multiple activists targeting a single company, such as the campaigns involving Kohl’s Corporation that included activity by 4010 Partners, Macellum Advisors, Ancora Advisors and Legion Partners Asset Management; Adtalem Global Education that included activity by Engine Capital and Hawk Ridge Capital; and Bottomline Technologies that included activity by Clearfield Capital Management and Sachem Head Capital Management. In addition, certain activists launched multiple campaigns during 2021, including Carl Icahn, Elliott Investment Management, JANA Partners, Land & Buildings and Starboard Value. Indeed, each of these investors launched four or more campaigns in 2021 and collectively accounted for 20 out of the 76 activist actions reviewed, or 26% in total. Proxy solicitation occurred in 18% of campaigns in 2021, relative to 17% in 2020. These figures represent modest declines relative to 2019, in which proxy materials were filed in approximately 30% of activist campaigns for the entire year.

By the Numbers—2021 Public Activism Trends

*Study covers selected activist campaigns involving NYSE- and Nasdaq-traded companies with equity market capitalizations of greater than $1 billion as of December 31, 2021 (unless company is no longer listed).

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

Notwithstanding the increase in activism levels, the rationales for activist campaigns during 2021 were generally consistent with those undertaken in 2020. Over both periods, board composition and business strategy represented leading rationales animating shareholder activism campaigns, representing 58% of rationales in 2021 and 51% of rationales in 2020. M&A (which includes advocacy for or against spin-offs, acquisitions and sales) remained important as well; the frequency with which M&A animated activist campaigns was 19% in both 2021 and 2020. At the opposite end of the spectrum, management changes, return of capital and control remained the most infrequently cited rationales for activist campaigns, as was also the case in 2020. (Note that the above-referenced percentages total over 100%, as certain activist campaigns had multiple rationales.)

Seventeen settlement agreements pertaining to shareholder activism activity were filed during 2021, which is consistent with pre-pandemic levels of similar activity (22 agreements filed in 2019 and 30 agreements filed in 2018, as compared to eight agreements filed in 2020). Those settlement agreements that were filed had many of the same features noted in prior reviews, including voting agreements and standstill periods as well as non-disparagement covenants and minimum- and/or maximum-share ownership covenants. Expense reimbursement provisions were included in half of those agreements reviewed, which is consistent with historical trends. We delve further into the data and the details in the latter half of this Client Alert.

We hope you find Gibson Dunn’s 2021 Annual Activism Update informative. If you have any questions, please reach out to a member of your Gibson Dunn team.

Read More

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

Barbara L. Becker (+1 212.351.4062, [email protected])
Dennis J. Friedman (+1 212.351.3900, [email protected])
Richard J. Birns (+1 212.351.4032, [email protected])
Andrew Kaplan (+1 212.351.4064, [email protected])
Daniel S. Alterbaum (+1 212.351.4084, [email protected])
Joey Herman (+1 212.351.2402, [email protected])

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

Securities Regulation and Corporate Governance Group:
Elizabeth Ising – Washington, D.C. (+1 202.955.8287, [email protected])
Brian J. Lane – Washington, D.C. (+1 202.887.3646, [email protected])
James J. Moloney – Orange County, CA (+1 949.451.4343, [email protected])
Ronald O. Mueller – Washington, D.C. (+1 202.955.8671, [email protected])
Lori Zyskowski – New York (+1 212.351.2309, [email protected])

© 2022 Gibson, Dunn & Crutcher LLP

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

On July 29, 2022, the New York Department of Financial Services (“DFS”) released Draft Amendments to its Part 500 Cybersecurity Rules; the Draft Amendments would update the Cybersecurity Rules in a manner consistent with the “catalytic” role it took in 2017 as the first state to codify certain cybersecurity best practices and guidance into explicit regulatory requirements for covered entities. The cybersecurity landscape has evolved in the past five years, and the Draft Amendments demonstrate that DFS continues to take a forward-leaning role in strengthening cybersecurity practices. The Draft Amendments propose increased expectations for senior leaders, heightened technology requirements, an expanded set of events covered under the mandatory 72-hour notification requirements, a new 24-hour reporting requirement for ransom payments and a 30-day submission of defenses, significant new requirements for business continuity and disaster recovery, and heightened annual certification and assessment requirements. Notably, the amended regulations propose a new class comprising larger entities which will be subject to increased obligations for their cybersecurity programs. Even the definition of a cybersecurity program has been expanded to include coverage of nonpublic information stored on those information systems—a substantial increase in covered information that will have significant downstream effects on reporting and certification requirements. The cybersecurity regulations by DFS were first released in March 2017 and went into full effect in March 2019, as previewed in our prior alert and subsequently discussed in our agency round-ups (2020 & 2021).

Key provisions of the Draft Amendments are highlighted below.

More Stringent Notification Obligations

The Draft Amendments establish additional requirements on top of DFS’s existing 72-hour notification requirements, including:

Requiring notification to DFS within 72 hours of unauthorized access to privileged accounts or the deployment of ransomware within a material part of the company’s information systems. These are in addition to the existing requirements to notify DFS within 72 hours of any cybersecurity events that require notice to a supervisory body or that have a reasonable likelihood of materially harming a material part of the company’s normal operations. Notably, these newly proposed requirements would significantly lower the notification threshold, as they could be triggered before any sign of actual data compromise or exfiltration.
A new 24-hour notification obligation in the event a ransom payment is made, and a 30-day requirement to provide a written description of why the payment was necessary, alternatives to payment that were considered, and all sanctions diligence conducted.

Heightened Requirements for Larger “Class A” Companies

Adhering to the mantra “with great data comes great responsibility,” the Draft Amendments also increase cybersecurity obligations for a newly defined class of larger entities, which are under DFS’s authority. These “Class A” companies are defined as entities with over 2,000 employees or over $1 billion in gross annual revenue average over the last three years from all business operations of the company and its affiliates. Under the Draft Amendments, Class A companies are required to comply with heightened technical requirements as well as risk assessments and audits. They must:

Conduct weekly systematic scans or reviews reasonably designed to identify publicly known cybersecurity vulnerabilities, and document and report any material gaps in testing to the board and senior management;
Implement an endpoint detection and response solution to monitor anomalous activity and a solution that centralizes logging and security event alerting;
Monitor access activity and implement a password vaulting solution for privileged accounts and an automated method of blocking commonly used passwords;
Conduct an annual, independent audit of their cybersecurity programs; and
Use external experts to conduct a risk assessment at least once every three years.

Increased Obligations on Company Governing Bodies

The original Part 500 regulations imposed a number of new obligations on companies’ governing bodies, including the need for a chief information security officer (“CISO”) or equivalent personnel, detailed cybersecurity reporting to the board, and written policies approved by a senior officer. The Draft Amendments enhance in a very meaningful way many of the Part 500 governance requirements, further indicating how important DFS views strong governance in the quest for effective cybersecurity. The Draft Amendments include obligations:

To ensure the boards of covered entities have sufficient expertise and knowledge, or be advised by persons with sufficient expertise and knowledge, to exercise effective oversight of cyber risk;
To provide the CISO with adequate independence and authority to appropriately manage cyber risks;
That the CISO will provide the board with additional detailed annual reporting on plans for remediating issues and material cybersecurity issues or events;
That the CISO will annually review the feasibility of encryption and the effectiveness of any compensating controls for any unencrypted nonpublic information;
That covered entities’ cybersecurity policies must be approved by the board on an annual basis; and
That add significantly to the annual certification requirements, requiring covered entities to not only certify to their compliance or acknowledge any noncompliance, but also provide sufficient data and documentation to accurately determine and demonstrate compliance, and have such certification or acknowledgment of noncompliance be signed by both the CEO and the CISO.

The Draft Amendments also provide an option for covered entities to submit written acknowledgement that, for the prior calendar year, they did not fully comply with their cybersecurity obligations. Covered entities who submit this acknowledgment will be required to identify all the provisions of the compliance rules that were not followed, describe the nature and extent of the noncompliance, and identify all the areas, systems, and processes that require material improvement, updating, or redesign.

These additional reporting requirements are substantial, and would greatly increase the burden on CEOs, CISOs, and other personnel involved in the preparation of these annual certifications or acknowledgements.

Expanded Requirements for Operational Resilience and Incident Response

The Draft Amendments expand measures directed at “operational resilience” beyond incident response plans, requiring covered entities to also have written plans for business continuity and disaster recovery (“BCDR”). Notably, the original Part 500 cybersecurity regulations were the first of its kind to stipulate detailed requirements for cybersecurity incident response plans. Again, DFS is breaking similar ground with BCDR plans, requiring proactive measures to mitigate disruptive events by, at a minimum:

Identifying business components essential to continued operations (documents, data, facilities, personnel, and competencies) and personnel responsible for implementation of the BCDR plans;
Preparing communications plans to ensure continuity of communications with various stakeholders (leadership, employees, third parties, regulatory authorities, others essential to continuity);
Maintaining procedures for the back-up of infrastructure and data; and
Identifying third parties necessary to continued operations.

Furthermore, DFS has proposed a significant revision to its requirements for incident response plans, requiring that they differentiate based on incident type (e.g., ransomware), while continuing to require that such plans address the previously enumerated areas (e.g., internal response processes; incident response plan goals; definitions of clear roles, responsibilities and levels of decision-making authority; communications and information sharing; identification of remediation requirements; documentation and reporting, etc.) as well as the newly added requirement to address recovery from backups.

Under the Draft Amendments, relevant personnel must receive copies of the incident response plan and BCDR plan, copies must be maintained offsite, and all personnel involved in implementation of the plans must receive appropriate training. In addition, covered entities are required to conduct incident response and BCDR exercises.

Enhanced Technology and Policy Requirements

The Draft Amendments strengthen technical requirements and written policy requirements for covered entities, codifying certain best practices in key cyber risk areas. The Draft Amendments specifically:

Clarify the definition of “privileged accounts” as covering any account that can be used to perform security-relevant functions that ordinary users are not authorized to perform, or affect a material change to technical or business operations. Under the proposals, privileged accounts must:
- Have multi-factor authentication (with exceptions for certain service accounts); and
- Be limited in both number and access functions to only those necessary to perform the user’s job;
- Be limited in use to only when performing functions requiring their use of such access;
Require stricter access management, including periodic review of all user access privileges and removal of accounts and access that are no longer necessary, as well as disabling or securely configuring all protocols that permit remote control of devices;
Require that emails are monitored and filtered to block malicious content from reaching authorized users;
Mandate penetration testing be conducted by an independent party at least annually, and also adjust the required frequency of vulnerability assessments from bi-annually to “regular[ly],” with Class A companies conducting weekly scans as noted above;
Require the use of strong, unique passwords—and Class A companies have additional requirements, as discussed above, relating to passwords and monitoring of access activity;
Require multi-factor authentication for remote access to the network and enterprise and third-party applications that access nonpublic information; and
Mandate that covered entities must maintain backups isolated from network connections.

The Draft Amendments also contain new measures for asset inventory and management, which may cost companies significant time and resources to implement. These measures require all covered entities to:

Implement written policies and procedures to ensure a complete and documented asset inventory for all information systems and their components (e.g., hardware, operating systems, applications, infrastructure devices, APIs, and cloud services); and
Have asset inventory that must, at a minimum, track each asset’s key information (e.g., owner, location, classification or sensitivity, support expiration date, and recovery time requirements).

The Draft Amendments further require additional written cybersecurity policies to include procedures for end of life management, remote access, and vulnerability and patch management. Notably, despite the prominence of recent supply chain cybersecurity attacks, there are not substantive changes to the Part 500 requirements relating to third-party service providers.

Increased Requirements for Risk Assessments, Impact Assessments

The Draft Amendments further expand the requirements for and definition of “risk assessment” to make clear that they must be:

Tailored to consider the “specific circumstances” of the covered entity, including size, staffing, governance, businesses, services, products, operations, customers, counterparties, service providers, vendors, other relations and their locations, as well as the geographies and locations of its operations and business relations; and
Updated at least annually.

While DFS has not changed the core cybersecurity functions that must be covered by the risk assessment per se, covered entities will need to ensure that it covers the broadened scope of “cybersecurity program” under the Draft Amendments (nonpublic information stored on the covered entity’s information systems). Furthermore, another substantial proposal is the requirement that covered entities must conduct impact assessments whenever a change in the business or technology causes a material change to the covered entity’s cyber risk.

Clarified Enforcement Considerations

Finally, the Draft Amendments contain two significant clarifications regarding the enforcement of the Part 500 Cybersecurity Rules:

A violation occurs by committing any act prohibited by the regulations or failing to satisfy a required obligation. This includes the failure to comply for more than 24 hours with any part of the regulations or the failure to prevent unauthorized access to nonpublic information due to noncompliance with the regulations.
DFS may consider certain aggravating and mitigating factors when assessing the severity of penalties, including: cooperation, good faith, intentionality, prior violations, number or pattern of violations, gravity of violation, provision of false or misleading information, harm to customers, accuracy and timeliness of customer disclosures, participation of senior management, penalties by other regulators, and business size.

Next Steps

This report is not an exhaustive list of the changes contained in the Draft Amendments, but it provides a high-level overview of the impact of the Draft Amendments on the Part 500 Cybersecurity Rules, should they be adopted. These recent Draft Amendments will go through a short pre-proposal comments period, which ends on August 18, 2022. After official publication of the proposed amendments, there will be a 60-day comment period. Pending further revisions, most of the amendments would take effect 180 days after adoption, while some requirements—i.e., notification requirements and changes to annual notice of certification—would take effect on an expedited timeframe of 30 days after adoption. Other requirements (e.g., regarding access controls) would take effect a year after adoption.

These amendments signal DFS’s continued focus on ensuring the Part 500 Cybersecurity Rules continue to raise the regulatory bar on covered entities’ cybersecurity programs in an era of a rapidly evolving cyber threat landscape. While many of the Draft Amendments reflect the current state of best practice guidance, covered entities will need to intentionally review the Draft Amendments and ensure they are well-positioned from a governance, technology, and budgetary perspective to ensure compliance.

This alert was prepared by Alexander H. Southwell, Stephenie Gosnell Handler, Terry Wong, and Dustin Stonecipher*.

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

United States
Matthew Benjamin – New York (+1 212-351-4079, [email protected])
Ryan T. Bergsieker – Denver (+1 303-298-5774, [email protected])
S. Ashlie Beringer – Co-Chair, PCDI Practice, Palo Alto (+1 650-849-5327, [email protected])
David P. Burns – Washington, D.C. (+1 202-887-3786, [email protected])
Cassandra L. Gaedt-Sheckter – Palo Alto (+1 650-849-5203, [email protected])
Svetlana S. Gans – Washington, D.C. (+1 202-955-8657, [email protected])
Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, [email protected])
Nicola T. Hanna – Los Angeles (+1 213-229-7269, [email protected])
Howard S. Hogan – Washington, D.C. (+1 202-887-3640, [email protected])
Robert K. Hur – Washington, D.C. (+1 202-887-3674, [email protected])
Kristin A. Linsley – San Francisco (+1 415-393-8395, [email protected])
H. Mark Lyon – Palo Alto (+1 650-849-5307, [email protected])
Vivek Mohan – Palo Alto (+1 650-849-5345, [email protected])
Karl G. Nelson – Dallas (+1 214-698-3203, [email protected])
Ashley Rogers – Dallas (+1 214-698-3316, [email protected])
Alexander H. Southwell – Co-Chair, PCDI Practice, New York (+1 212-351-3981, [email protected])
Deborah L. Stein – Los Angeles (+1 213-229-7164, [email protected])
Eric D. Vandevelde – Los Angeles (+1 213-229-7186, [email protected])
Benjamin B. Wagner – Palo Alto (+1 650-849-5395, [email protected])
Michael Li-Ming Wong – San Francisco/Palo Alto (+1 415-393-8333/+1 650-849-5393, [email protected])
Debra Wong Yang – Los Angeles (+1 213-229-7472, [email protected])

Europe
Ahmed Baladi – Co-Chair, PCDI Practice, Paris (+33 (0) 1 56 43 13 00, [email protected])
James A. Cox – London (+44 (0) 20 7071 4250, [email protected])
Patrick Doris – London (+44 (0) 20 7071 4276, [email protected])
Kai Gesing – Munich (+49 89 189 33-180, [email protected])
Bernard Grinspan – Paris (+33 (0) 1 56 43 13 00, [email protected])
Penny Madden – London (+44 (0) 20 7071 4226, [email protected])
Michael Walther – Munich (+49 89 189 33-180, [email protected])
Vera Lukic – Paris (+33 (0) 1 56 43 13 00, [email protected])

Asia
Kelly Austin – Hong Kong (+852 2214 3788, [email protected])
Connell O’Neill – Hong Kong (+852 2214 3812, [email protected])
Jai S. Pathak – Singapore (+65 6507 3683, [email protected])

* Dustin Stonecipher is an associate working in the firm’s Washington, D.C. office who is admitted only in Maryland.

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

When the COVID 19 pandemic first hit European shores in early spring 2020, the German legislator was quick to introduce wide-reaching legislative reforms to protect the German business world from unwanted consequences of an economy struggling with unprecedented upheaval, the lock-down and the ensuing social strain.[1] One key element of the overall legal reform in March 2020 was the temporary derogation from the regular mandatory German-law requirement to file for insolvency immediately whenever a company is either illiquid (Zahlungsunfähigkeit) or over-indebted (Überschuldung). This derogation has now been extended in time for over-indebted companies, but restricted in scope for illiquid companies.

I. The Temporary Insolvency Law Reform in March 2020

At the time the German Act on the Temporary Suspension of the Insolvency Filing Obligation and Liability Limitation of Corporate Body in cases of Insolvency caused by the COVID-19 Pandemic (“Gesetz zur vorübergehenden Aussetzung der Insolvenzantragspflicht und zur Begrenzung der Organhaftung bei einer durch die COVID-19-Pandemie bedingten Insolvenz” – COVInsAG)[2] was introduced in March 2020, it was felt that the strict insolvency filing requirement that obliges management to file for insolvency without undue delay, but in any event no later than three weeks after such insolvency reason first occurs, would (i) place undue time pressures on companies to file for insolvency in situations where this short time period did not even allow management to canvass its financial or restructuring options or access to newly introduced state funding or other financing sources, (ii) result in a wave of insolvencies of otherwise healthy entities based purely on the traumatic impact of the pandemic and (iii) result in unwanted distortions of the market by failing to differentiate appropriately between businesses facing merely temporary cash-flow problems and genuinely moribund companies with long-standing challenges or issues.

In a nutshell and without going into all details, the interim reform of the German Insolvency Code (Insolvenzordnung, InsO) via the COVInsAG introduced a temporary suspension of the mandatory insolvency filing requirement until September 30, 2020 for both the insolvency reasons of illiquidity (Zahlungsunfähigkeit) and of over-indebtedness (Überschuldung) by way of a strong legal assumption that any such insolvency was caused by the pandemic if (i) the company in question was not yet illiquid on December 31, 2019 and (ii) could show that it would (still or again) be in a position to pay all of its liabilities when due on and after September 30, 2020.

This temporary exemption from having to file for insolvency was flanked by a number of other legislative tweaks to the Insolvency Code that privileged and protected a company’s continued trading during such time window against management liability risks and/or later contestation rights of the insolvency administrator in case the temporary crisis in the spring and summer of 2020 would ultimately result in a later insolvency, after all. Access to new financing was similarly privileged in this time window when the company could show that it traded under the protection of the COVID 19 exemption from the regular insolvency filing requirement.

Finally, the COVInsAG also contained a clause that allowed an extension of this protective time window beyond September 30, 2020 up to the maximum point of March 31, 2021 by way of separate legislative act.

II. The Modified Extension Adopted on September 17, 2020

While an extension of the temporary suspension of the filing requirement was consistently deemed likely by insolvency experts and in political cycles, Germany has since moved beyond the initial lock-down and has mostly opened up the country for trading again. It has also become apparent that, in particular, a continued blanket derogation from the mandatory filing requirement for companies facing severe cash-flow problems to the point of illiquidity (i) would often only delay the inevitable and (ii) create an unwanted cluster of many insolvency proceedings which are ultimately all filed for at the same time when the suspension comes to an end, rather than a steady and progressive cleansing of the market by gradually removing companies that have failed to recover from the pandemic in a reasonably short period of time.

As a consequence, Germany has chosen not simply to extend the current provisions in unchanged form, but rather has significantly modified the wording of the COVInsAG to address the above concerns.

Over-Indebtedness

In particular, as of October 1, 2020 and until December 31, 2020, a continued derogation from the immediate obligation to file for insolvency henceforth only applies to companies which otherwise would only file for insolvency due to over-indebtedness (Überschuldung) but which are not also illiquid. Such companies remain protected from having to file for insolvency based on the above-described rules until December 31, 2020, if (i) they were not already illiquid by December 31, 2019 and will not be illiquid after September 30, 2020 and thereafter.

Unlike illiquid companies, it was felt that companies which are over-indebted, i.e. (i) whose assets based on specific insolvency-driven valuation rules are not sufficient to cover their liabilities and (ii) which do not currently have a positive continuation prognosis (positive Fortführungsprognose), deserve a further grace period during which they may address their underlying structural issues, provided they do not enter illiquidity during this time window.

This extension until year end for over-indebted companies also addresses the often-voiced concerns that the uncertain future effects of the pandemic on a company’s medium-term prospects currently do not allow for a meaningful continuation prognosis which by general consensus has to cover the liquidity situation over the next 12 to 24 months.

Illiquidity

This new restriction of the interim derogation from the filing requirement to over-indebtedness only, in turn, means that companies that cannot pay their liabilities when they fall due on September 30, 2020 (and beyond) and, therefore, are illiquid under German insolvency law terms, may no longer justify such financial distress by claiming it is caused by the pandemic. Instead, they will now be obliged to file for insolvency based on illiquidity once the initial protection accorded to them by the March 2020 rules runs out at the end of September 30, 2020.

With it being mid-September 2020 already, this will give the management of any entity facing serious current cash-flow problems only another two weeks to either remedy such cash flow problems and restore full solvency or file for insolvency on or shortly after October 1, 2020 due to their illiquidity at that point in time.

Consequential Issues

The new, changed wording of the COVInsAG consequently restricts the other privileges connected with the temporary exemption from the filing requirement, i.e. that companies are permitted to keep trading during the extended time-window with certain protections against subsequent insolvency contestation rights, personal liability derogations or privileges and simplified access to new external or internal restructuring financing or loans, only to over-indebted companies. For them, these additional rules, which they may have already become accustomed to in the period between March 2020 and September 30, 2020, are simply extended until December 31, 2020.

III. Immediate Outlook

This law reform is of utmost importance for the management and the shareholders of any German entities that are currently in significant financial distress. The ongoing, periodic monitoring of their own financial position will need to determine in an extremely short time-frame whether or not the respective company is either illiquid or over-indebted as of September 30, 2020. If necessary such analysis should be firmed up by involving external advice or restructuring experts.

If the company is found to be over-indebted but not illiquid, the focus of any future turn-around must be December 31, 2020, i.e. the continued applicability of the COVInsAG rules may continue to provide some respite until then. If the company is found to be illiquid, the remaining time until September 30, 2020 must be used productively to either restore future liquidity via external or internal funding in the shortness of the available time or the filing for insolvency in early October 2020 becomes inevitable and should be prepared.

Managing directors of illiquid companies that do not file for insolvency without undue delay, but continue trading regardless of the insolvency reason, will again face the twin risks of personal civil and criminal liability based on a delayed or omitted filing. They and their trading partners and creditors, furthermore, face the full power of the far-reaching array of insolvency contestation rights (Insolvenzanfechtungsrechte) for a subsequent insolvency administrator of any measures now taken outside of the protective force of the COVInsAG interim rules.

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[1] In this context, see our earlier general COVID 19 alerts under: https://www.gibsondunn.com/whatever-it-takes-german-parliament-passes-far-reaching-legal-measures-in-response-to-the-covid-19-pandemic/ as well as under: https://www.gibsondunn.com/european-and-german-programs-counteracting-liquidity-shortfalls-and-relaxations-in-german-insolvency-law/.

[2] In this context, again see: https://www.gibsondunn.com/whatever-it-takes-german-parliament-passes-far-reaching-legal-measures-in-response-to-the-covid-19-pandemic/, under section II.2, as well as with further analysis in this regard https://www.gibsondunn.com/european-and-german-programs-counteracting-liquidity-shortfalls-and-relaxations-in-german-insolvency-law/.

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The following Gibson Dunn lawyers have prepared this client update: Lutz Englisch, Birgit Friedl, Marcus Geiss.

Gibson Dunn’s lawyers in the two German offices in Munich and Frankfurt are available to assist you in addressing any questions you may have regarding the issues discussed in this update.

For further information, please feel free to contact the Gibson Dunn lawyer with whom you usually work, or the three authors:

Lutz Englisch (+49 89 189 33 150, [email protected])
Birgit Friedl (+49 89 189 33 122, [email protected])
Marcus Geiss (+49 89 189 33 115, [email protected])

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

Introduction

Section 364(e) of the Bankruptcy Code provides important protections to lenders that provide post-bankruptcy financing (known as “DIP Financing”) to companies that are in chapter 11 bankruptcy cases (known as “Debtors”). By its plain terms, Section 364(e) provides a lender with material protections in the event that an order authorizing DIP Financing is later reversed or modified on appeal:

The reversal or modification on appeal of an authorization under this section to obtain credit or incur debt, or of a grant under this section of a priority or a lien, does not affect the validity of any debt so incurred, or any priority or lien so granted, to an entity that extended such credit in good faith … unless such authorization and the incurring of such debt, or the granting of such priority or lien, were stayed pending appeal.[1]

These protections have the practical effect of mooting appeals of orders authorizing DIP Financing where the order contained findings that the lender acted in good faith and the objecting party did not obtain a stay of the order pending appeal.

Many courts have held that Section 364(e)’s protections should be strictly limited to (a) lenders providing DIP Financing (“DIP Lenders”) because Section 364 only applies to DIP Financing and (b) preserving the validity of debt incurred and priorities and liens granted by a Debtor to secure DIP Financing.[2] According to one leading decision, “[t]he questions which arise under this section are: (1) whether the creditor attempting to challenge an authorization of credit obtains a stay pending an appeal; and (2) whether the lender or group of lenders acts in good faith in extending the new credit.”[3] In contrast to these other courts, on June 9, 2020, the Ninth Circuit took a more expansive view of the scope of Section 364(e) by applying that section’s protections to pre-bankruptcy lenders that did not provide any DIP Financing. See Official Committee of Unsecured Creditors of Verity Health System of California v. Verity Health System of California (“Verity”).[4] The Ninth Circuit applied Section 364(e) to moot an appeal seeking to revoke certain rights afforded to pre-bankruptcy lenders, even though (a) those rights were wholly unrelated to the validity of debt or any priority or lien granted to a DIP Lender, and (b) the DIP Financing had been paid in full.

Background

The Debtors in Verity owned hospitals and other healthcare facilities. On August 31, 2018, the Debtors commenced chapter 11 bankruptcy cases in the United States Bankruptcy Court for the Central District of California. To sustain their operations during the chapter 11 cases, the Debtors sought bankruptcy court approval of DIP Financing. If approved, the DIP Lender would receive a “superpriority lien” on the Debtors’ assets pursuant to Section 364(d) of the Bankruptcy Code, giving the DIP Lender priority over the liens and claims held by the Debtors’ pre-bankruptcy lenders (the “Pre-Bankruptcy Lenders”). The DIP Lender was not one of the Pre-Bankruptcy Lenders, and the Pre-Bankruptcy Lenders provided no DIP Financing in the chapter 11 cases.

The DIP Lender conditioned the DIP Financing on the Pre-Bankruptcy Lenders’ agreement to subordinate their pre-bankruptcy liens and claims to the liens and claims that would secure the DIP Financing. The Pre-Bankruptcy Lenders conditioned that agreement upon, among other things, the bankruptcy court’s approval of waivers of (a) the Debtors’ right to surcharge the Pre-Bankruptcy Lenders’ collateral for the costs and expenses of preserving or disposing of such collateral, and (b) the court’s authority to exclude post-petition proceeds of the Debtors’ assets from the Pre-Bankruptcy Lenders’ collateral based on the “equities of the case,” pursuant to Sections 506(c) and 552(b) of the Bankruptcy Code, respectively. The Official Committee of Unsecured Creditors appointed in the Debtors’ chapter 11 cases (the “Committee”) objected on the grounds that the waivers would undermine the unsecured creditors’ prospect for a recovery by precluding their ability to obtain recoveries from the Pre-Bankruptcy Lenders. The bankruptcy court entered an order overruling the objection and approving the DIP Financing, and granted the waivers demanded by the Pre-Bankruptcy Lenders as necessary to induce the DIP Lender to extend DIP Financing. The bankruptcy court further held that the waivers constituted part of the “adequate protection” afforded pre-bankruptcy lenders under Bankruptcy Code Section 361, which is mandated by Section 364(d) to protect against any diminution in value of the Pre-Bankruptcy Lenders’ claims as a result of the DIP Financing.[5]

The Committee appealed the bankruptcy court’s order to the United States District Court for the Central District of California. Following Ninth Circuit precedent in In re Adams Apple, Inc., 829 F.2d 1484 (9th Cir. 1987), the district court explained that “if the court’s order ‘is within the purview of section 364,’ then the protections of § 364(e) apply.”[6] The district court concluded that the waivers were “a condition that was necessary to obtain credit” and the court was “not persuaded that it can cause the modification of a necessary term in the DIP Agreement without implicating § 364(e).”[7]

Having determined that Section 364(e) applied to the appeal, the district court dismissed the appeal as moot because neither of the exceptions to Section 364(e) applied; the Committee had not obtained a stay of the bankruptcy court’s order pending appeal or contended that the DIP Lender failed to act in “good faith.”[8] The Committee timely appealed to the Ninth Circuit.

III. The Ninth Circuit Affirms the Dismissal of the Appeal as Statutorily Moot Pursuant to Section 364(e) of the Bankruptcy Code

On appeal, the Committee argued that Section 364(e) did not cover the waivers because the statute’s plain language is limited to appeals regarding “any priority or lien … granted” to a DIP Lender. The Committee further argued that, whereas the purpose of Section 364(e) is to protect DIP Lenders in order to incentivize them to provide DIP Financing, the appeal could not adversely affect the DIP Lender because it had already been repaid in full and the Committee had stipulated that any ruling in the appeal would not affect the DIP Lender.

The Ninth Circuit affirmed the dismissal of the appeal as moot pursuant to Section 364(e). The court reasoned that, although the waivers were part of the Pre-Bankruptcy Lenders’ adequate protection package that is authorized under Section 361 of the Bankruptcy Code and is “not expressly included in § 364,” “the waivers are included in the Final DIP Order−a postpetition financing arrangement authorized under § 364.”[9] The court also relied on Ninth Circuit precedent holding that Section 364(e) “broadly protects any requirement or obligation that was part of a post-petition creditor’s agreement to finance.”[10] According to the Ninth Circuit, “the waivers were ‘part of a post-petition creditor’s agreement to finance’ and ‘helped to motivate [the DIP Lender’s] extension of credit’”[11] because (a) the DIP Lender conditioned the DIP Financing on the Pre-Bankruptcy Lenders’ consent to subordinate their claims and liens, and (b) the Pre-Bankruptcy Lenders conditioned that required consent on receipt of the waivers at issue in the appeal.

The Ninth Circuit also rejected the Committee’s argument that Section 364(e) was inapplicable because the DIP Lender had been repaid in full and the Committee stipulated that the appeal would not affect the DIP Lender. According to the Ninth Circuit, that argument “does not change the analysis” because “the [Pre-Bankruptcy Lenders] are also entitled to § 364(e)’s protections.”[12]

Conclusion

Verity is noteworthy because it extended Section 364(e) beyond its plain language to bar any appeal regarding waivers that were approved for the benefit of pre-bankruptcy lenders that did not provide DIP Financing. It remains to be seen whether courts will follow Verity and apply the protections of Section 364(e) to non-DIP Lenders or if courts will seek to distinguish Verity by limiting Section 364(e)’s protections to the plain language of the statute.

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[1] 11 U.S.C. § 364(e) (emphasis added).

[2] See, e.g., Kham Nate’s Shoes No. 2, Inc. v. First Bank of Whiting, 908 F.2d 1351, 1355 (7th Cir. 1990) (holding that the purpose of § 364(e) is to assure a post-petition lender that extends credit in good faith reliance upon a financing order that it is entitled to the benefit of the order regardless of whether it is later determined to be legally or factually erroneous); Shapiro v. Saybrook Mfg. Co. (In re Saybrook Mfg. Co.), 963 F.2d 1490, 1493, 1495 (11th Cir. 1992) (held that Section 364(e) did not moot appeal regarding cross-collateralization of pre-petition debt because, “[b]y its own terms, section 364(e) is only applicable if the challenged lien or priority was authorized under section 364(d),” and section 364(d) “appl[ies] only to future—i.e., post-petition—extensions of credit” and “do[es] not authorize the granting of liens to secure pre-petition loans”); In re Joshua Slocum Ltd, 922 F.2d 1081, 1085 n.1 (3rd Cir. 1990) (“Section 364(e) concerns the validity of debts and liens.”); In re Main, Inc., 239 B.R. 59, 72 (Bankr. E.D. Pa. 1999) (held that Section 364(e) did not moot appeal from order permitting payment of debtor’s counsel because Section 364(e) “relates strictly to appeals from orders creating liens with preferential position or authorizing debt against the bankruptcy estate under 11 U.S.C. § 364(d)”).

[3] New York Life Ins. Co. v. Revco D.S., Inc. ( In re Revco D.S., Inc.), 901 F.2d 1359, 1364 (6th Cir. 1990).

[4] Case No. 19-55997 (9th Cir. June 9, 2020). This opinion was not published and, therefore, is not considered precedential even in the Ninth Circuit, though it can be cited to other courts in the circuit. See Ninth Circuit Local Rule 36-3.

[5] Section 361 provides that, “[w]hen adequate protection is required under section … 364 of this title of an interest of an entity in property, such adequate protection may be provided by … (1) requiring the trustee to make a cash payment or periodic cash payments to such entity … (2) providing to such entity an additional or replacement lien … or (3) granting such other relief … as will result in the realization by such entity of the indubitable equivalent of such entity’s interest in such property.” 11 U.S.C. § 361. Section 364(d) provides that the bankruptcy court can approve a senior lien only if it finds that “there is adequate protection of the interest of the holder of the lien on the property of the estate on which such senior or equal lien is proposed to be granted.” 11 U.S.C. § 364(d).

[6] In re Verity Health System of California, Inc., Case No. 2:18-cv-10675-RGK, at 6 (C.D. Cal. Aug. 2, 2019) (quoting Adams Apple, 829 F.2d at 1488) (emphasis added).

[7] Id. at 7−8.

[8] Id. at 7.

[9] Verity at 3.

[10] Id. at 2−3 (quoting Weinstein, Eisen & Weiss, LLP v. Gill (In re Cooper Commons, LLC), 430 F.3d 1215, 1219 (9th Cir. 2005)).

[11] Id. at 3 (quoting Cooper Commons, 430 F.3d at 1219−20) (bracketed material in original).

[12] Id. at 4.

Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues. For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization practice group, or any of the following:

Robert A. Klyman – Los Angeles (+1 213-229-7562, [email protected])
Douglas G. Levin – Orange County, CA (+1 949-451-4196, [email protected])

Please also feel free to contact the following practice group leaders:

Business Restructuring and Reorganization Group:
David M. Feldman – New York (+1 212-351-2366, [email protected])
Scott J. Greenberg – New York (+1 212-351-5298, [email protected])
Robert A. Klyman – Los Angeles (+1 213-229-7562, [email protected])
Jeffrey C. Krause – Los Angeles (+1 213-229-7995, [email protected])
Michael A. Rosenthal – New York (+1 212-351-3969, [email protected])

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

On June 5, 2020, the President signed into law H.R. 7010, the Paycheck Protection Program Flexibility Act of 2020 (“PPP Flexibility Act”), which relaxes a number of requirements of and restrictions on the Paycheck Protection Program (“PPP”) established by the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) and clarified by subsequent guidance from the Small Business Administration (“SBA”) and the U.S. Department of the Treasury.[i] The bill passed the House by a vote of 417-1 and the Senate by voice vote, reflecting the strong bipartisan support behind the legislation. Below is a summary of the major changes to the PPP instituted by the PPP Flexibility Act.

Covered Period

The CARES Act established an eight week “covered period”—beginning on the loan origination date and ending no later than June 30, 2020. The portion of the PPP loan equal to the amount of loan proceeds used during this covered period for certain covered obligations, including payroll costs, mortgage interest payments, rent, and utilities, is eligible for forgiveness.

The PPP Flexibility Act extends the covered period to 24 weeks—ending no later than December 31, 2020. Borrowers who received a PPP loan prior to the PPP Flexibility Act may elect for the covered period to end 8 weeks after the origination of the loan. The PPP Flexibility Act does not address whether new borrowers can apply for forgiveness prior to the end of the 24 week covered period.

Covered Obligations

In the First Interim Final Rule published on April 1, 2020, SBA and the Department of Treasury stated that at least 75 percent of PPP loan proceeds “shall be used for payroll costs.” This ratio of payroll costs to other covered obligations was not in the CARES Act.

The PPP Flexibility Act codifies a new ratio: at least 60 percent of PPP loan proceeds “shall” be used for payroll costs in order to receive full loan forgiveness. Accordingly, up to 40 percent of loan proceeds may go to other covered obligations, including interest on covered mortgage payments, rent, and utilities.

The text of the law appears to create a cutoff precluding loan forgiveness for borrowers that spend less than 60% of PPP loan proceeds on payroll costs—as opposed to a reduction in the amount of forgiveness, as reflected in previous guidance. We expect additional guidance from SBA and the Department of Treasury to prevent this cutoff.

Loan Terms

For all PPP loan funds that are not forgiven, the CARES Act established that the outstanding balance will have a maximum maturity of 10 years and an interest rate not to exceed 4 percent. The First Interim Final Rule instituted a maturity of 2 years and an interest rate of 1 percent.

For new PPP loans originating on or after June 5, 2020, the PPP Flexibility Act extends the minimum maturity for outstanding balances to 5 years. Existing PPP loans are unaffected.

Rehiring Employees

Under the CARES Act, employers who reduced the compensation or number of full-time equivalent employees could eliminate those reductions by June 30, 2020, and avoid any reduction in loan forgiveness.

The PPP Flexibility Act extends the date to eliminate reductions to compensation or number of full-time equivalent employees to December 31, 2020.

Also, SBA and the Department of Treasury Frequently Asked Question No. 40 provided a safe harbor from the reduction in loan forgiveness with respect to laid-off employees who reject a borrower’s offer of re-employment. The FAQ states that the borrower must have made a good faith, written offer of rehire, and the borrower must document the former employee’s rejection of the offer.

The PPP Flexibility Act codifies this safe harbor, stating that loan forgiveness will not be reduced if the borrower can, in good faith, document an inability to rehire former employees or hire similarly qualified employees on or before December 31, 2020. The PPP Flexibility Act also provides a safe harbor for borrowers who cannot return to the same level of business activity at which the business was operating before February 15, 2020, due to compliance with standards for sanitation, social distancing, or any other worker or customer safety requirement related to COVID-19.

The PPP Flexibility Act does not articulate what “business activity” means or how it will be measured. We look forward to additional guidance clarifying this issue.

Loan Deferral Period

Under the CARES Act, borrowers could defer payment of the principal, interest, and fees of their PPP loans for not less than six months and not more than one year.

The PPP Flexibility Act changes this deferral period to end when the PPP loan forgiveness amount is remitted to the lender. Also, if a borrower fails to apply for forgiveness within 10 months after the last day of the covered period, the borrower shall make payments of principal, interest, and fees beginning no earlier than 10 months after the covered period ends.

Payroll Tax Deferral

The CARES Act allowed certain companies to defer paying payroll taxes, excepting companies who had their PPP loans forgiven.

The PPP Flexibility Act eliminates this exception, allowing companies whose PPP loans are forgiven to also defer payroll taxes.

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[i] For additional details about the PPP please refer to Gibson Dunn’s Frequently Asked Questions to Assist Small Businesses and Nonprofits in Navigating the COVID-19 Pandemic and prior Client Alerts about the Program: SBA “Paycheck Protection” Loan Program Under the CARES Act; Small Business Administration and Department of Treasury Publish Paycheck Protection Program Loan Application Form and Instructions to Help Businesses Keep Workforce Employed; Small Business Administration Issues Interim Final Rule and Final Application Form for Paycheck Protection Program; Small Business Administration Issues Interim Final Rule on Affiliation, Summary of Affiliation Tests, Lender Application Form and Agreement, and FAQs for Paycheck Protection Program; Analysis of Small Business Administration Memorandum on Affiliation Rules and FAQs on Paycheck Protection Program; Small Business Administration Publishes Additional Interim Final Rules and New Guidance Related to PPP Loan Eligibility and Accessibility; and Small Business Administration Publishes Loan Forgiveness Application.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For further information, please contact the Gibson Dunn lawyer with whom you usually work, or the following authors:

Michael D. Bopp – Washington, D.C. (+1 202-955-8256, [email protected])
Roscoe Jones, Jr.* – Washington, D.C. (+1 202-887-3530, [email protected])
Alisa Babitz – Washington, D.C. (+1 202-887-3720, [email protected])
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, [email protected])
Alexander Orr – Washington, D.C. (+1 202-887-3565, [email protected])
William Lawrence – Washington, D.C. (+1 202-887-3654, [email protected])
Samantha Ostrom – Washington, D.C. (+1 202-955-8249, [email protected])

* Not admitted to practice in Washington, D.C.; currently practicing under the supervision of Gibson, Dunn & Crutcher LLP.

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

The UK government announces the closure of the Coronavirus Job Retention Scheme from 1 July 2020 to those not previously furloughed on or before 10 June 2020 along with other updates in relation to next and final stages of the Coronavirus Job Retention Scheme and Self-Employment Income Support Scheme.

On 29 May 2020, the Chancellor announced how the Coronavirus Job Retention Scheme (“CJRS”) and Self-Employment Income Support Scheme will operate over the next five months and eventually terminate on 31 October 2020. Further guidance on the flexible furlough and how employers should calculate claims will be published on 12 June and we will accordingly publish further information.

Closure of CJRS to new entrants

A key takeaway from the Chancellor’s announcement is that, from 1 July onwards, employers will only be able to furlough employees that they have previously furloughed for a full three-week period prior to 30 June. Accordingly, any employer who has not already done so but wishes to place an employee on the CJRS must do so by 10 June 2020. Employers will have until 31 July to make any claims in respect of the period to 30 June.

Further, from 1 July claim periods will no longer be able to overlap months: employers who previously had submitted claims which had periods which overlapped calendar months will no longer be able to do this going forwards.

Employer costs going forwards

The level of grant available to employers under CJRS will be slowly tapered to reflect that the fact that people will be returning to work from August 2020.

	July	August	September	October
*Responsibility for Employer NICs and pensions contributions*	Government	Employer	Employer	Employer
*Responsibility for wages[1]*	Government (80% up to £2,500) Employer – N/A	Government (80% up to £2,500) Employer – N/A	Government (70% up to £2,187.50) Employer (10% up to £312.50)	Government (60% up to £1,875) Employer (20% up to £625)
*Employee Receives[2]*	80% up to £2,500 per month	80% up to £2,500 per month	80% up to £2,500 per month	80% up to £2,500 per month

Flexible Furlough in practice

What does ‘flexible furlough’ mean?

At present, employees on furlough are not permitted to do any work for their employer’s business. However, from 1 July 2020 businesses will be given the flexibility to bring furloughed employees back to work part-time. Employers can agree with their employees the hours and shifts their employees will work on their return.

Employers can still claim under the CJRS for the hours the employee is not working. Employees can still continue on full furlough and there is no requirement to provide employees with work, if the employer is not in a position to do so.

What should an employer pay an employee on flexible furlough for the hours they are working?

Employers will be responsible for paying full wages in respect of those hours when the employee is working but will be able to claim under the scheme in respect of that part of their normal working hours on which the employee is not working. Employers will need to submit information on the usual versus actual hours worked by an employee in a claim period. The cap will be proportional to the hours not worked.

Further detailed guidance on how to calculate claims following the introduction of flexible furlough will be released on 12 June.

How should flexible furlough be agreed?

Employers will have to agree any new flexible furloughing arrangement with their employees and confirm that agreement in writing.

A well drafted furlough agreement should currently prohibit employees from carrying out any work for the employer during their furlough period. Hence, it may be necessary for any furlough agreement to be amended by a side letter, or for a fresh furlough agreement to be entered into, which permits an employee to work during the furlough period commencing 1 July.

Amendments to the Self-Employment Income Support Scheme

The self-employed grant, which we reported on previously, is being extended, with applications opening in August for a second and final grant. There will be parity with the reducing furlough scheme, paying 70% (and not 80%) of average earnings in a single instalment covering three months’ worth of profit, and capped at £6,570 in total. The eligibility criteria remains the same for the second grant, as it did for the first with individuals needing to confirm that their business has been adversely affected by COVID-19.

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[1] Capped at 80% of wages, or employers are able to choose to top up employee wages above the CJRS grant at their own expense if they wish.

[2] As above.

Gibson Dunn attorneys regularly counsel clients on the compliance issues raised by this pandemic, and we are working with many of our clients on their response to COVID-19. Please contact the Gibson Dunn attorney with whom you work in the Employment Group, or the following members of the UK employment team:

James Cox – London (+44 (0)20 7071 4250, [email protected])
Sarika Rabheru – London (+44 (0) 20 7071 4267, [email protected])
Heather Gibbons – London (+44 (0)20 7071 4127, [email protected])
Georgia Derbyshire – London (+44 (0)20 7071 4013, [email protected])
Charlotte Fuscone – London (+44 (0)20 7071 4036, [email protected])

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

On 27 May 2020, the UK Financial Conduct Authority (the “FCA”) published Market Watch 63 (“MW63”). MW63 highlights that market participants (including issuers, their advisers and all other market participants) may be subject to new and emerging market conduct risks as a result of the current increase in primary market activity and working from home arrangements widely mandated as a result of public policy to deal with the COVID-19 pandemic. It then sets out the FCA’s expectations on market participants in terms of identifying and mitigating those risks in the current environment.

It is clear that while we have seen some limited regulatory forbearance from the FCA in certain areas in order to alleviate operational burden on market participants and the markets, there is no room for reducing risk appetites or anything other than strict adherence to rules and regulatory expectations in the context of market conduct. The FCA acknowledges the current challenges faced by market participants during the crisis, however the expectation remains that all continue to act in a manner that supports the integrity and orderly functioning of financial markets. As a warning, the FCA also stressed that it will continue to use the tools at its disposal to monitor, investigate and (as necessary) take enforcement action to ensure that requirements relating to market conduct are complied with.

This bulletin outlines the messages of MW63 and provides some practical guidance on the steps that market participants might take in order to ensure they meet the FCA’s expectations in the current environment.

Considerations for all market participants

The market conditions created by COVID-19 are giving rise to new challenges and considerations for all market participants attempting to manage their risks around identifying, handling and disclosing inside information for the purposes of Regulation 596/2014/EU on market abuse (“MAR”). This is a result of several factors, including (i) an increased number of capital raising events leading to greater flows of inside information; and (ii) existing systems and controls to restrict flows of inside information may not address working from home arrangements.

In previous Market Watch newsletters[1], the FCA highlighted the importance of relevant firms undertaking a comprehensive risk assessment to identify the market abuse risks to which they are or may be exposed and the controls necessary to mitigate those risks. Firms are strongly advised to revisit those risk assessments in response to the Coronavirus pandemic and update them to reflect new and emerging risks, and to modify or enhance their systems and controls, including surveillance techniques, to ensure they remain adequate and effective, especially in light of the working from home environment and the heightened risk environment.

The new types of risk which market participants may be exposed to include unlawful disclosure of inside information, as well as manipulative behaviour stemming from short selling activities. The FCA specifically addresses risks arising from short selling activity and makes it clear that the FCA will focus monitoring efforts on short selling activities in the secondary markets as part of its market monitoring. While the FCA does not specifically say so, it is clear when reading between the lines that the FCA is concerned that there is some evidence of abusive behaviour. The FCA will not shy away from bringing appropriate criminal or regulatory action where this is justified.

Some firms are experiencing increased numbers of surveillance alerts as a result of increased market volume and volatility. It is key that firms address this operational challenge by tailoring their response to the risks they are exposed to and ensuring that the response does not diminish the appropriateness and effectiveness of surveillance techniques. Firms may need to consider conducting retrospective reviews concentrating on areas of heightened risk.

Some specific issues raised

Short selling

In terms of compliance by market participants with their obligations under Regulation 236/2012/EU on short selling and certain aspects of credit default swaps (“SSR”), the FCA reminds market participants that they must, at all times, comply with:

the prohibition on “naked” short sales; and
the net short position reporting requirements.

Where market participants engage in short selling activity, it would be prudent for them to confirm that their cover arrangements remain appropriate and that they have adequate documentary evidence of their compliance with the cover requirements.

Market soundings

The MAR market soundings regime was introduced to provide a framework for controlling inside information when market participants undertake wall-crossings. The intent of the regime is to provide protection from allegations of unlawful disclosure of inside information. However, in order for market participants to have the benefit of this protection, the framework set out under MAR must be correctly followed. It is possible that in the current working from home environment firms may find it harder to adhere to the framework rules. It would be prudent for market participants to review their market sounding procedures to ensure they remain adequate and effective in the current environment. In particular, market participants should consider the following:

disclosing market participants should ensure that they are maintaining appropriate records of their interactions, for example, through the use of recorded lines or written minutes (and that those written minutes are approved by the receiving market participant);
receiving market participants should be aware that the purpose of the sounding is for issuers to gauge interest in and views on the proposed transaction. The information relating to the proposed transaction should only be shared internally on a strict need-to-know basis to enable relevant individuals to provide the necessary input to the issuer and for no other purpose; and
the FCA has previously recognised the benefit of the gatekeeper model[2]; receiving market participants should consider whether their chosen method of receiving soundings remains adequate in the current environment and whether instructions to sell-side market participants need to be updated.

Personal account dealing

Given the FCA’s concern around the heightened risks relating to inside information in light of the current market environment, it would be prudent for all firms to revisit their arrangements for personal account dealing to ensure they adequately address the enhanced risks of most staff currently working from home. Market participants should remind their employees of relevant policies and address in particular how the policies apply in the current environment. This is particularly advisable as a result of the concerns expressed by the FCA in its preceding Market Watch newsletter[3] in relation to firms’ controls relating to personal account dealing, as it is highly likely that the FCA will conduct further thematic work in this area in the future. To the extent that firms have not reviewed and enhanced their policies and procedures in this area in response to Market Watch 62, now would be an opportune time to do so.

Considerations for issuers

In the context of increased capital raising activities, the FCA has specifically addressed some of the risks faced by issuers. We have set out a summary of the risks and some of the practical steps that issuers should take in order to mitigate those risks in the current environment.

Types of heightened risks

Practical steps to take

Primary markets activity increases the amount of inside information
Nature of the information that is material to a business’s prospects may have been altered in the context of the pandemic, e.g.:
- ability to resume business, changes in strategy, return-to-work plans, supply chains;
- future financial performance, such as access to finance and funding, including through government schemes, changes to dividends and buy-back schemes
New information may be materially different from previous forecasts, etc. which have previously been publicly announced and may now be misleading to the market, e.g. missing previous forecast earnings, revenue or related KPIs and, if so, announcement of that information is unlikely to be able to be delayed
Working from home may give rise to new risks of unlawful disclosure of inside information
Working from home may give rise to new risks for ensuring confidentiality of inside information when delaying disclosure

Ensure that existing procedures, systems and controls remain adequate to identify items of inside information and enhance them if necessary
Consider whether new information is inside information and whether disclosure is required
Consider refresher training and compliance bulletins for relevant staff on the appropriate handling of inside information, their duties in relation to insider dealing and unlawful disclosure and risk mitigants in the context of working from home
Consider how inside information is securely accessed, stored and communicated especially where disclosure is being delayed
Where financial reporting deadlines are extended, consider whether any additional information needs to be published in the interim to ensure compliance with MAR
Consult with advisers and keep contemporaneous and complete records of decisions taken regarding the disclosure of inside information
Ensure insider lists are maintained and that inside information is only disclosed on a “need to know” basis in accordance with MAR
Only delay disclosure when all the conditions in MAR are met, and only selectively disclose information where disclosure is necessary in the normal exercise of employment, a profession, or duties and is on a confidential basis
When permitted to delay disclosure, ensure a leak announcement is prepared
Be especially vigilant about the possibility of leaks and rumours
Ensure announcements are verified as being complete and accurate and do not contain false or misleading information

________________________

[1] Market Watch 56 and Market Watch 58

[2] Market Watch 58 and Market Watch 51

[3] Market Watch 62

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For additional information, please contact your usual Gibson Dunn contacts or the following authors:

Authors: Michelle Kirschner, Martin Coombes, Chris Hickey, Patrick Doris, Steve Melrose and Chris Haynes

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

Issuers in the United States and their auditors have related, but distinct, obligations to evaluate on a periodic basis whether there is substantial doubt about the issuer’s ability to continue as a going concern.[1] In normal times, this evaluation, conducted with an appropriate level of diligence, results as to almost all major public companies in the conclusion that there is no substantial doubt about the entity’s ability to meet its obligations in the months to come.

But these are not normal times. As the COVID-19 crisis takes an ever-greater toll on the American economy, and as multiple well-known companies declare bankruptcy,[2] the going-concern assessment has taken on new relevance for issuers, auditors, and others in the financial-reporting community. As a result, the number of issuer filings that contain a going-concern disclosure appears to have substantially increased.[3] In this piece, we review some of the significant considerations that apply to the going-concern analysis from both the issuer’s and the auditor’s perspectives.

Summary of Issues

Financial Accounting Standards Board (“FASB”) accounting standards and PCAOB auditing standards both require an assessment of whether there is substantial doubt about the issuer’s ability to continue as a going concern, including evaluating concrete management plans to address the circumstances giving rise to the reasonable doubt. The auditor is required to make an independent assessment, not simply evaluate management’s process.
Important differences between the accounting and auditing standards include that the management assessment occurs quarterly and looks forward one year from the date the financial statements are issued, whereas the auditor annually considers the period one year from the balance sheet date, with different quarterly review procedures.
Both auditors and issuers should anticipate potential exposure to regulatory and private litigation should their forecasts of the effects of the COVID-19 pandemic prove inaccurate.

Background

American Institute of Certified Public Accountants (“AICPA”) and, later, PCAOB auditing standards have for decades required auditors to evaluate on an annual basis whether there is substantial doubt about the ability of the audited entity to continue as a going concern.[4] Under current PCAOB standard AS 2415, an auditor assesses, based on the relevant information obtained during the audit,[5] whether substantial doubt exists about the entity’s ability to meet its obligations as they come due over a reasonable period of time after the balance sheet date (not to exceed one year in the future) without the entity’s having to resort to measures such as disposing of significant assets or restructuring its debt.[6] The relevant information could include evidence such as negative operating trends, loan defaults, loss of key customers or patents, or even natural disasters.[7] If the auditor concludes that substantial doubt does exist, then as a second step it is required to consider management’s plans to address the circumstances giving rise to the substantial doubt, such as selling assets, restructuring debt, or raising capital. Under AS 2415, the auditor’s focus is on whether those plans are feasible and whether the assumptions underlying them are reasonable, such that they represent an adequate plan to address the circumstances.[8] If the auditor concludes even after assessing management’s plans that substantial doubt about the entity’s ability to meet its obligations over the coming year still exists, then the auditor must, among other steps, include an explanatory paragraph to that effect in the audit report.[9]

In addition, if an auditor, during an interim review of an entity’s quarterly financial statements, becomes aware of “the entity’s possible inability to continue as a going concern,” the auditor is required to make certain inquiries of management and assess whether management’s disclosures are adequate.[10]

On top of this established framework, the FASB in 2014 adopted a requirement that companies make their own assessments on a quarterly basis of their ability to continue as a going concern, a requirement codified as ASC Subtopic 205-40.[11] Subtopic 205-40 differs from the PCAOB’s AS 2415 in some important ways. For example, unlike the PCAOB, the FASB defined the concept of “substantial doubt” in connection with its standard: specifically, it stated that substantial doubt exists as to an entity’s ability to continue as a going concern “when conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued.”[12] In other respects, Subtopic 205-40 bears close similarities to AS 2415, including in the circumstances that can indicate that substantial doubt exists and in the requirement to assess management plans to alleviate the substantial doubt.[13]

Even apart from the considerations specific to the COVID-19 crisis, there are two differences between Subtopic 205-40 and AS 2415 that are important to bear in mind:

First, management’s disclosure obligations differ from those of the auditor. While the auditor’s disclosure consists of an explanatory paragraph in the audit report,[14] management’s disclosure of substantial doubt about its ability to continue as a going concern is found in the notes to the financial statements and management typically also includes disclosure of the issue in the liquidity section of management’s discussion and analysis (“MD&A”), as well as in the issuer’s risk factors.[15] Additionally, under Subtopic 205-40, where an issuer that concludes that management’s plans have alleviated the substantial doubt about its ability to meet its obligations, the issuer still must disclose in the notes to the financial statements that substantial doubt existed in the absence of those plans.[16] AS 2415, on the other hand, does not require disclosure by the auditor in situations where management’s plans have alleviated the substantial doubt.
Second, while management’s obligation to evaluate its going-concern status is identical at the annual and quarterly stages,[17] the auditor’s obligations vary considerably between year-end and quarter-end. Unlike many audit procedures, in which the auditor evaluates the reasonableness of management’s accounting or disclosures, the annual going-concern analysis represents a standalone process for the auditor to arrive at a conclusion regarding the entity’s status.[18] In an interim review, by contrast, the procedures are both more limited and more tied to management’s assessment.[19]

Although global pandemics were not included on the list of adverse conditions in either AS 2415 or Subtopic 205-40, the economic shock that COVID-19 has created will provide a basis for many companies and auditors to conduct a more searching going-concern analysis than usual in the months to come. As we address in the next section, this analysis will be especially difficult in a crisis such as COVID-19 whose duration and economic effects are so unpredictable. We will then address some other key considerations for issuers and auditors as they assess the potential for substantial doubt to exist concerning management’s ability to meet upcoming obligations.

Addressing the Significant Uncertainty of the COVID-19 Crisis

The list of adverse events set out in AS 2415 and Subtopic 205-40 that could potentially call a company’s viability into question includes items such as negative operating trends, work stoppages, and loan defaults.[20] In some cases, the ultimate outcome of those events or circumstances will be uncertain at the time of management’s or the auditor’s assessment. The COVID-19 pandemic, however, raises a set of global uncertainties—concerning areas from public health to financial markets—whose complexity is an order of magnitude greater than that of the circumstances that may drive an entity’s going-concern analysis in normal times.

While Subtopic 205-40 requires only that an entity assess its ability to meet its obligations based on “relevant conditions and events that are known and reasonably knowable at the date that the financial statements are issued,”[21] and AS 2415 similarly requires only that the auditor consider “his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor’s report,”[22] both issuers and auditors should be aware that regulators and private plaintiffs will later assess their actions with twenty-twenty hindsight. Plaintiffs, in particular, will have an incentive to ignore that the auditor “is not responsible for predicting future conditions or events,”[23] and likely will seek to claim that the events of the next year were clearly on the horizon at the time that companies and auditors issued their financial statements and reports, based on the progression of the COVID-19 crisis as of that time. In assessing the risk that an entity will be unable to meet its obligations in the coming months, both issuers and auditors should anticipate that they will face potential legal exposure for failing to accurately predict the future.

In the current environment, both management and auditors are likely best served by: (i) making, documenting, and disclosing a good-faith attempt to identify the operational, financial, and economic factors that will affect the company’s ability to meet its obligations in the coming year, including those that are likely to indicate a worse outcome for the company; (ii) comprehensively documenting what they believe is known and reasonably knowable, as of their assessment date, about the implications of each factor for the company’s ability to meet its obligations in the coming months—including, as appropriate, based on consultation with third-party experts such as outside counsel or valuation experts; and (iii) making, and documenting, a good-faith assessment, based on that forecast, of how likely it will be that a point arrives within the relevant timeframe at which, individually or in the aggregate, one or more of those factors causes the company to be unable to meet its obligations as they come due.

Other Key Considerations

In addition to the problem of uncertainty in the progression of the COVID-19 crisis, there are other considerations that issuers and auditors should bear in mind as they conduct their going-concern assessments.

First, if an entity’s management concludes that substantial doubt exists concerning its ability to meet its obligations absent management plans to address the situation, then management should keep in mind the requirements that apply to the plans that it develops. Subtopic 205-40 makes clear that substantial doubt about an entity’s ability to continue as a going concern is alleviated only if two conditions are met: (i) “It is probable that management’s plans will be effectively implemented within one year after the date that the financial statements are issued,” and (ii) “It is probable that management’s plans, when implemented, will mitigate the relevant conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued.”[24]

Concerning the first condition, the standard states that for management’s plans to be considered probable for implementation, they generally must already have been approved by management at the time the financial statements are issued.[25] That is, they should generally not be merely theoretical or even under active consideration. This means that, if management anticipates that its quarter-end analysis may lead to an initial conclusion that substantial doubt exists concerning its ability to continue as a going concern, it should take anticipatory steps during the quarter to plan its response, to help ensure that it has time to approve any alleviating plans that may become necessary.

Concerning the second condition, Subtopic 205-40 states that the magnitude and timing of management’s plans must be measured against “the magnitude and timing of the relevant conditions or events that those plans intend to mitigate.”[26] If, for example, management adopts a plan to address its liquidity needs that will not become effective until after the principal period of its liquidity shortfall has passed, then it may be difficult for it to conclude that the plan is effectively timed to alleviate the substantial doubt concerning its ability to meet its obligations. Issuers should try to ensure, therefore, that they develop plans that will realistically meet their expected liquidity and related needs in terms of both timing and magnitude.

Management should remain aware as to both of these conditions that the probability of execution or success that it assigns to its plans may differ from the probability that its auditor assigns to those same plans; thus, if it hopes to avoid a going-concern explanatory paragraph in the audit report, it will need to communicate early and often with the auditor to understand the auditor’s views as to how it anticipates evaluating management’s plans.

Second, PCAOB standards similarly prescribe particular considerations should an auditor initially conclude that substantial doubt about the entity’s ability to continue as a going concern does exist such that management’s plans become relevant. AS 2415 directs the auditor to focus especially on two points: (i) “those elements that are particularly significant to overcoming the adverse effects of the conditions and events,” and (ii) any “prospective financial information [that] is particularly significant to management’s plans.”[27] The standard requires the auditor to obtain audit evidence specifically to address the most significant aspects of management’s plan, including the evidence that supports management’s assumptions about the prospective financial effects of its plans. This information should be considered with appropriate professional skepticism, and the auditor should keep in mind that the PCAOB would likely conclude that the provisions of auditing standards that require an auditor to consider contrary audit evidence would apply to this exercise.[28]

Third, complications may arise even after the annual audit if the issuer intends to incorporate by reference its financial statements with the Securities and Exchange Commission (“SEC”) as part of a registered offering conducted pursuant to the Securities Act of 1933, as amended. If the issuer does incorporate its financial statements by reference, the issuer is required to obtain the auditor’s consent to include the audit report as part of the registered offering. PCAOB standards require auditors to conduct certain procedures in that situation,[29] and if as a result of those procedures the auditor determines that its audit report would be misleading in the absence of a going-concern explanatory paragraph (even though the conditions giving rise to the substantial doubt occurred after the issuance of the report), then the auditor might re-issue its audit report to include a going-concern explanatory paragraph and require that the issuer update its financial statements to reflected this added disclosure. Depending on the timing, this re-issuance may or may not occur in conjunction with the issuer’s conducting its own quarterly evaluation of its ability to continue as a going concern.

Fourth, there is a slight discrepancy between the time period applicable to an issuer’s going-concern analysis and that applicable to the auditor, but the period during which both parties obtain the evidence that is relevant to their analysis is the same.

AS 2415 states that the auditor’s going-concern evaluation is conducted with reference to the balance-sheet date; meanwhile, Subtopic 205-40 states that management’s evaluation should occur as of the date the financial statements are issued.[30] FASB noted in adopting Subtopic 205-40 that it had received input “from many auditors indicating that, in practice, they already assess over a period of one year from the audit report date instead of one year from the balance sheet date.”[31] More importantly, however, AS 2415 makes clear that the auditor’s consideration of the going-concern question must be “based on his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor’s report.”[32] The fact that the auditor’s balance-sheet date is used as a reference date, then, does not provide the auditor with an excuse to ignore subsequent events that occur prior to the audit report.

A recent SEC case addressing an auditor’s going-concern analysis demonstrated this fact in practice. In the Matter of the Application of Cynthia C. Reinhart, CPA was an appeal to the SEC from sanctions that the PCAOB had ordered be imposed on the engagement partner for an audit of a mortgage lender, Thornburg Mortgage, Inc. (“Thornburg”).[33] The PCAOB charged that Ms. Reinhart had, among other things, failed to properly assess whether there was substantial doubt about Thornburg’s ability to continue as a going concern. Although the SEC recognized that Ms. Reinhart and her team had, consistent with AS 2415, assessed the question of substantial doubt over a period lasting until the following fiscal year end, the SEC’s discussion of the sufficiency of her assessment concentrated in large part on events that occurred between the balance-sheet date and the report date, such as fluctuations in Thornburg’s ability to meet margin calls leading up to the filing of its Form 10-K.[34] The Reinhart case is a useful reminder that the difference between management’s and the auditor’s reference date does not create any distinction between them in terms of the available evidence that may affect their assessment.

Fifth, it has been discussed that auditors may be concerned about issuing going-concern opinions in part because doing so could accelerate the financial decline of the entity being audited, such that the going-concern paragraph becomes a self-fulfilling prophecy.[35] Given the widespread economic dislocations that the COVID-19 crisis has caused, there may be reason to think that the stigma of a going-concern opinion is not as acute as it has been under normal circumstances. In either case, however, audit engagement teams should keep in mind that protecting their own, and their firms’, interests depends on the team ensuring that it considers the relevant evidence with appropriate skepticism and documents that its process was thorough and appropriate.

Sixth, issuers should seek counsel sooner rather than later about their fiduciary obligations when potential going-concern issues exist because it is critical that officers and directors fully understand their fiduciary obligations and how best to comply with them and make reasoned, disinterested, good faith decisions that receive the benefit of the business judgment rule. Members of the Firm’s Business Restructuring and Reorganization Group can assist officers and directors to understand and comply with these obligations.

Conclusion

Hopefully, the period when going-concern analyses occupy a heightened level of attention will pass in the coming months as the COVID-19 health crisis wanes and the U.S. and world economies rebound. Until that time comes, issuers and auditors should ensure that they are approaching the going-concern analysis with the care that it will now warrant.

____________________________

[1] This alert focuses on the considerations applicable to issuers who report their financial statements on the basis of U.S. Generally Accepted Accounting Principles and to audits of those issuers performed pursuant to Public Company Accounting Oversight Board (“PCAOB”) auditing standards. We note, however, that International Financial Reporting Standards (“IFRS”) also contain a requirement that an entity assess its status as a going concern. See IAS 1.25, Presentation of Financial Statements. As a result, many of the observations contained herein may also be relevant to issuers who report using IFRS.

[2] See, e.g., Hertz Global Holdings, Inc., Form 8-K filed May 26, 2020; J. C. Penney Co., Inc., Form 8-K filed May 18, 2020; J.Crew Group, Inc., Form 8-K filed May 4, 2020.

[3] Among the companies that have recently issued going-concern notices are: Chesapeake Energy Corp., see Form 10-Q filed May 11, 2020; and Dave & Buster’s Entertainment, Inc., see Form 10-K filed Apr. 3, 2020. See also SandRidge Energy, Inc., Form 10-Q filed May 19, 2020 (disclosing substantial doubt concerning ability to continue as a going concern alleviated by management plans to sell headquarters).

[4] See AU § 341, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern. AU Section 341 was adopted as an interim standard by the PCAOB pursuant to PCAOB Rule 3200T, see PCAOB Rel. No. 2003-006 (Apr. 18, 2003), and is now codified in PCAOB auditing standards as AS 2415, Consideration of an Entity’s Ability to Continue as a Going Concern.

[5] AS 2415 does not require any procedures to be performed solely for purposes of the going-concern evaluation. Instead, it contemplates that “[t]he results of auditing procedures designed and performed to achieve other audit objectives should be sufficient for that purpose.” AS 2415.05.

[6] AS 2415.01-.03.

[7] AS 2415.06.

[8] AS 2415.07-.09.

[9] AS 2415.12.

[10] AS 4105.21, Reviews of Interim Financial Information.

[11] See Accounting Standards Update No. 2014-15, Disclosure of Uncertainties About an Entity’s Ability to Continue as a Going Concern (Aug. 2014) (“ASU 2014-15”).

[12] ASU 2014-15, Glossary (emphasis in original, other emphasis removed). FASB made clear that the term “probable” as used here has the same meaning as it does in the context of assessing loss contingencies under ASC Topic 450. See id. In the relevant contingencies standard, FASB defined “probable” to mean that “[t]he future event or events are likely to occur.” See Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, ¶ 3(a). Although the standard does not assign percentages to this term, practitioners generally note that “probable” represents approximately a seventy percent chance or greater of occurrence. See, e.g., A Roadmap to Accounting for Contingencies and Loss Recoveries, at 21 (Deloitte 2019).

[13] See ASC 205-40-55-2 (using same list of adverse conditions as that used by PCAOB); ASC 205-40-50-6 (consideration of management plans).

[14] See AS 2415.12.

[15] See ASC 205-40-50-13 (requiring both footnote disclosure and “information that enables users of the financial statements to understand” three points: (i) the “[p]rincipal conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern”; (ii) “[m]anagement’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations”; and (iii) “[m]anagement’s plans that are intended to mitigate the conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern”).

[16] Specifically, management’s disclosures must include (i) the “[p]rincipal conditions or events that raised substantial doubt about the entity’s ability to continue as a going concern (before consideration of management’s plans)”; (ii) “[m]anagement’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations”; and (iii) “[m]anagement’s plans that alleviated substantial doubt about the entity’s ability to continue as a going concern.” ASC 205-40-50-12.

[17] In adopting ASU 2014-15, FASB explicitly stated that it considered limiting the going-concern analysis to an annual exercise but elected to adopt a quarterly requirement instead, “to ensure that uncertainties about an entity’s ability to continue as a going concern were being evaluated comprehensively for each reporting period, and being reported timely in the financial statement footnotes.” ASU 2014-15, ¶ BC23.

[18] In the wake of FASB’s adoption of Subtopic 205-40, the PCAOB staff issued a release emphasizing that an issuer’s “determination that no disclosure is required under [applicable accounting principles] is not conclusive as to whether an explanatory paragraph is required” under PCAOB standards. PCAOB Staff Audit Practice Alert No. 13, Matters Related to the Auditor’s Consideration of a Company’s Ability to Continue as a Going Concern (Sept. 22, 2014). The exception to the principle in AS 2415 that the auditor is in a proactive rather than reactive position in conducting its annual assessment is that, should the entity determine that substantial doubt exists, then the auditor is required to assess the reasonableness of management’s disclosures on that point. See AS 2415.10-.11.

[19] See AS 4105.21.

[20] See ASC 205-40-55-2; AS 2415.06.

[21] ASC 205-40-50-3.

[22] AS 2415.02.

[23] AS 2415.04.

[24] ASC 205-40-50-7.

[25] See ASC 205-40-50-8.

[26] ASC 205-40-50-10.

[27] AS 2415.08-.09.

[28] See AS 1105.29, Audit Evidence (requiring auditor to perform procedures to address any inconsistency or lack of reliability in the audit evidence it obtains). As an example, the SEC in the Reinhart matter (see infra note 33) considered in connection with Ms. Reinhart’s going-concern analysis the predecessor standard to AS 1105, which likewise directs an auditor to “consider relevant evidential matter regardless of whether it appears to corroborate or to contradict the assertions in the financial statements.” AU 326.25, Evidential Matter. In its order, the SEC appeared to assume that Ms. Reinhart was required to consider inconsistent audit evidence as well as confirmatory evidence when assessing the issuer’s ability to continue as a going concern. See, e.g., In the Matter of the Application of Cynthia C. Reinhart, CPA, SEC Rel. No. 85964 at 19 n.38 (May 29, 2019).

[29] See AS 4101, Responsibilities Regarding Filings Under Federal Securities Statutes.

[30] Compare AS 2415.02 (“date of the financial statements being audited”) to ASC 205-40-50-1 (“date that the financial statements are issued”).

[31] ASU 2014-15, ¶ BC28.

[32] AS 2415.02 (emphasis added).

[33] See generally SEC Rel. No. 85964.

[34] See id. at 8 (use of subsequent balance-sheet date for analysis); 8-11 (evidence concerning liquidity arising during subsequent period after balance-sheet date).

[35] See, e.g., John H. Eickemeyer, “The Concerns with Going Concern,” The CPA Journal (Jan. 2016).

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding developments related to the COVID-19 pandemic. For additional information, please contact any member of the firm’s Securities Regulation and Corporate Governance or Business Restructuring and Reorganization practice groups, the Gibson Dunn lawyer with whom you usually work, or the following authors:

Authors: Brian Lane, Michael Scanlon, Michael Rosenthal, Jeffrey Krause, David Ware, and David Korvin

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

On May 21, 2020, the U.S. Copyright Office (the “Office”) released a nearly 200-page report (the “Report”)[1] suggesting changes to the Digital Millennium Copyright Act (17 U.S.C. § 512) (“DMCA”), which governs how online service providers (OSPs) police potential online copyright infringement. The report was the result of a multi-year study of the DMCA—the first comprehensive study by the Office on the DMCA’s operation—and was prepared to analyze whether the DMCA’s safe harbor provisions are successfully balancing the needs of OSPs and copyright holders, “particularly in light of the enormous changes that the internet has undergone in the last twenty-plus years.”[2]

The report concludes that the DMCA does not need “wholesale changes,” but may benefit from fine-tuning to better “balance the rights and responsibilities of OSPs and rightsholders in the creative industries.”[3] In particular, the Office “concluded that Congress’ original intended balance has been tilted askew” and “the scale of online copyright infringement and the lack of effectiveness of section 512 notices to address that situation remain significant problems.”[4]

Among other things, the Office suggested that Congress consider legislation regarding:

What qualifies as “temporary” for 512(c) safe harbor and what activities are appropriately shielded from liability for being “related to” storage;[5]
Whether technology services beyond those providing internet infrastructure should be eligible for the safe harbor provisions;[6]
Whether unwritten policies regarding the account termination of “repeat infringers” serve the intended deterrent purpose and what constitutes “appropriate circumstances” for a user’s termination for repeated infringement;[7]
The distinction between “actual” and “red flag knowledge” and the intended scope of the “willful blindness” doctrine;[8]
Whether rightsholders must submit a unique, file-specific URL for every instance of infringing material on an OSP’s service to properly provide “information reasonably sufficient . . . to locate [infringing material]”:[9]
The impact of the Ninth Circuit’s decision in Lenz v. Universal Music Corp.,[10] which held that copyright holders must consider fair use in good faith before issuing a takedown notice for content posted on the Internet. In particular, the Office recommended that Congress consider the “knowing misrepresentation” requirement for a lawsuit seeking redress for an improper infringement notification, and whether the Lenz decision reflects Congressional intent on this issue;[11]
Appropriate changes to section 512(c)’s notice requirements, given new web-based submission forms and the possibility that some of 512(c)’s current notification standards may become obsolete;[12]
Potential avenues to resolve disputes over whether material should be removed and reinstated that do not require a rightsholder to prepare and file a federal lawsuit in the current statutory timeframe of 10–14 days;[13]
The parameters of a rightsholder’s ability to subpoena an OSP to identify an alleged infringer under section 512(h);[14] and
The possibility and range of injunctive relief available to rightsholders after a takedown;[15]

At present, these remain just proposals for legislative action. And in its report, the Office does not provide non-statutory approaches to alter DMCA provisions or developments involving online intermediary liability in other countries, finding that both issues require further exploration. The Office expressed its intent to explore additional voluntary initiatives to address online infringement and help identify standard technical measures that can be adopted in certain sectors.[16] Additionally, the Senate Judiciary intellectual property subcommittee has announced plans to draft changes to the DMCA by the end of 2020.[17] Whether and to what extend the subcommittee follows the recommendations of this report bears watching for both OSPs and rightsholders.

____________________

[1] United States Copyright Office, Section 512 of Title 17: A Report on the Register of Copyrights (May 2020), https://www.copyright.gov/policy/section512/section-512-full-report.pdf (the “Report”).

[2] Copyright Office Releases Report on Section 512, Issue No. 824, May 21, 2020, https://www.copyright.gov/newsnet/2020/824.html.

[3] Report at 7.

[4] Id. at 197.

[5] Id. at 84–99.

[6] Id.

[7] Id. at 95–110.

[8] Id. at 110–28.

[9] Id. at 138–44.

[10] 801 F.3d 1126, 1154 (9th Cir. 2015).

[11] Section 512 of Title 17 at 145–49.

[12] Id. at 152–59.

[13] Id. at 159–62.

[14] Id. at 163–66

[15] Id. at 167–170.

[16] Id. at 6.

[17] Margaret Harding McGill, Copyright Office: System for pulling content offline isn’t working, Axios (May 21, 2020), https://www.axios.com/copyright-office-system-for-pulling-content-offline-isnt-working-ed78fe62-eec4-44dc-bcdd-1c593e888fb8.html.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please feel free to contact the Gibson Dunn lawyer with whom you usually work in the firm’s Intellectual Property or Media, Entertainment and Technology practice groups, or the following authors:

Howard S. Hogan – Washington, D.C. (+1 202.887.3640,[email protected])
Nathaniel L. Bach – Los Angeles (+1 213-229-7241,[email protected])
Ciara M. Davis – Washington, D.C. (+1 202-887-3783, [email protected])

Please also feel free to contact the following practice leaders:

Intellectual Property Group:
Wayne Barsky – Los Angeles (+1 310-552-8500, [email protected])
Josh Krevitt – New York (+1 212-351-4000, [email protected])
Mark Reiter – Dallas (+1 214-698-3100,[email protected])

Media, Entertainment and Technology Group:
Scott A. Edelman – Los Angeles (+1 310-557-8061, [email protected])
Kevin Masuda – Los Angeles (+1 213-229-7872, [email protected])
Orin Snyder – New York (+1 212-351-2400, [email protected])

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

Since California’s state and local governments began substantively responding to the novel coronavirus (COVID-19) pandemic in mid-March, a complex patchwork of overlapping and sometimes conflicting new regulations, executive orders, and judicial declarations has evolved. For example, on March 27, 2020 Governor Gavin Newsom issued Executive Order N-37-20, which offered several forms of eviction protection for certain residential tenants during the state of emergency, but left it within the discretion of local governments to decide whether to extend the same types of protections to commercial tenants. Some cities and counties, like San Francisco and Los Angeles, immediately enacted ordinances offering similar protections for commercial tenants in their jurisdictions, whereas others like Orange County have generally abstained from imposing new restrictions.

In response, several bills have been introduced before the state legislature that seek to homogenize the complicated legal landscape in California from the top down. These pending measures are summarized below. Certain elements of these legislative proposals could have a significant and adverse impact on landlords’ revenue streams, particularly from multi-family investments, including the ability to fully recover delinquent rents. This update outlines the current state of these measures as they stand in the legislative process, but these bills are constantly changing and will likely continue to evolve in the days and weeks ahead.

SB 939 – Prohibition on Evictions For All Commercial Tenants; Certain Commercial Tenants’ Right to Impose Modification Negotiations

Last Amended: May 13, 2020 (proposed amendments to be introduced by Senator Wiener on May 22, 2020 are discussed below)

Status: From committee with author’s amendments. Read second time and amended. Re-referred to the Senate Judiciary Committee on May 13, 2020. The bill has been set for hearing before the Judiciary Committee on Friday, May 22, 2020.

Introduced by Senators Scott Wiener and Lena Gonzalez, SB 939 would prohibit the eviction of tenants of commercial real property, including businesses and nonprofit organizations, during the pendency of the state of emergency related to COVID-19 proclaimed by the Governor on March 4, 2020. A proposed amendment to be introduced by Senator Weiner on May 22 would extend the duration of this moratorium by another 90 days after the state of emergency is lifted. Additionally, SB 939 would authorize certain qualifying commercial tenants to engage in negotiations with their landlords to modify rent or other economic requirements.

As currently drafted, SB 939 would make it unlawful to (i) terminate a tenancy, (ii) serve notice to terminate a tenancy, (iii) use lockout or utility shutoff actions to terminate a tenancy, or (iv) otherwise endeavor to evict a tenant of commercial real property, including a business or nonprofit organization, during the pendency of the COVID-19 state of emergency, unless the tenant has been found to pose a threat to the property, other tenants, or a person, business, or other entity. By including a prohibition on landlords serving a “notice to terminate,” SB 939 could be read to potentially prevent a landlord from serving a tenant with any notice that would otherwise precede or be a prerequisite to an eviction proceeding, including a three-day notice to quit.[1] The bill further states that if a commercial tenant does not pay rent during the COVID-19 state of emergency, the tenant has a period of twelve (12) months following the date in which the COVID-19 state of emergency ends to repay such amounts. As currently drafted, SB 939 would appear to apply to all commercial tenants, regardless of whether they would qualify for potential lease modification, as more particularly described below, or whether the tenant demonstrates an inability to pay rent due to COVID-19. SB 939 would prohibit Landlords from charging or collecting late fees for rent that became due during the pendency of the COVID-19 state of emergency.[2]

Senator Weiner’s proposed May 22 amendment would invert the structure of the commercial eviction moratorium. Instead of banning all commercial evictions except for those relating to public health and safety, the amended bill would allow all commercial evictions, except those based upon non-payment of rent that accrued during the state of emergency and only where the tenant meets specified criteria indicating that COVID-19 has or will have significant financial impact on the tenant. Relatedly, under the amended bill the only commercial tenants eligible for the twelve-month repayment grace period would be those meeting specified criteria indicating that COVID-19 has or will have significant financial impact on them.

SB 939’s prohibition on evictions would retroactively apply to any eviction or termination of a tenancy that occurs after the COVID-19 state of emergency was first proclaimed on March 4, 2020, but before the effective date of SB 939, by deeming the conduct void, against public policy, and unenforceable. SB 939 also imposes a fine of up to two thousand dollars ($2,000) for any harassment, mistreatment, or retaliation against a tenant aimed at forcing abrogation of the lease. Finally, any eviction or termination of a tenancy in violation of SB 939 is considered an unlawful business practice and an act of unfair competition under the California Business and Professions Code (Cal. Bus. Code § 17200 et seq.)

SB 939 expressly states that it would not “preempt any local ordinance prohibiting the same or similar conduct or imposing a more severe penalty for the same conduct.” It appears that this section intends to set a statewide floor for available tenant protections and establish the minimum punishment for violation of those protections, while allowing localities to set their own standards that are more protective of tenants. However, the current text of SB 939 does not differentiate between more restrictive and less restrictive local eviction moratoria. Thus, it is possible that this provision could actually prevent SB 939 from preempting a local ordinance that offers tenants less protection than the statewide bill itself.

Affirmative Notice Requirement

Landlords are required to provide commercial tenants with written notice of the protections afforded by SB 939 within thirty (30) days of the effective date of the legislation. The required form and content of this required notice is not addressed in the proposed statute as currently drafted.

Lease Modifications for Certain Commercial Tenants

SB 939 authorizes certain commercial tenants to initiate lease modification negotiations with their landlords, which, if unsuccessful, may allow such tenants to terminate their leases under more favorable terms than the law would ordinarily allow.

To qualify for the protections of the lease modification provisions of SB 939, a tenant (“Qualifying Commercial Tenant”) must be (a) a “small business” or an eating or drinking establishment, place of entertainment, or performance venue[3] that is (b) not a publicly traded company or any company owned by or affiliated with a publicly traded company, and which (c) operates primarily in California. Further, the Qualifying Commercial Tenant’s primary business must have (d) experienced a decline of forty percent (40%) or more of monthly revenue, and, if an eating or drinking establishment, place of entertainment, or performance venue, a decline of twenty-five percent (25%) or more in capacity due to a social or physical distancing order or safety concerns. Finally, SB 939 requires that a Qualifying Commercial Tenant be (e) “subject to regulations to prevent the spread of COVID-19 that will financially impair the business when compared to the period before the shelter-in-place order took effect” (requirements (a)-(e), collectively, “Financial Criteria”).

A Qualifying Commercial Tenant would be permitted to take advantage of the lease modification provisions of SB 939 by serving written notice on the premises affirming, under the penalty of perjury, that the commercial tenant meets the Financial Criteria outlined above and stating the modifications the commercial tenant desires to obtain (“Negotiation Notice”). If the tenant and landlord do not reach a mutually satisfactory agreement within thirty (30) days of the date the landlord receives the Negotiation Notice, then within ten (10) days thereafter, the tenant is permitted to terminate the lease without any future liability for future rent, fees, or costs that otherwise may have been due under the lease by providing written notification to the landlord (a “Termination Notice”). Upon service of the Termination Notice, the lease and any third-party guaranties associated with the lease are also terminated and no longer enforceable.

Under this scenario, a landlord’s subsequent ability to collect damages would be limited to the sum of three months’ worth of the past due rent incurred and unpaid during the period of COVID-19 regulations, and all rent incurred and unpaid during a time unrelated to COVID-19 through the date of the termination notice. Even for these limited damages, the tenant has a twelve (12) month grace period to repay the sum owed.

As currently drafted, and including the proposed May 22 amendments, SB 939 raises a number of significant questions, including those highlighted below:

Qualifying Commercial Tenant Criteria:
- SB 939 and its proposed amendment do not establish criteria for defining “eating or drinking establishment, place of entertainment, or performance venue” or categorizing tenants with mixed-use businesses (e.g., tenants with business operations that blend retail and food and beverage services).
- The Financial Criteria do not contemplate whether or not that small business, on a relative basis, has other factors that dictate its revenue (such as seasonality) which are totally unrelated to COVID-19.
- The 25% reduction in capacity may be proven not only by an actual social distancing order, but also by undefined “safety concerns.”
- The Financial Criteria do not contemplate whether the receipt of other forms of aid, such as under the CARES Act or another federal or state stimulus bills, could otherwise disqualify a tenant from the protections of SB 939.
- SB 939 generally does not acknowledge any landlord’s possible mortgage obligations, including, without limitation, whether the landlords have the right to enter into negotiations to modify tenant leases without lender consent, and the economic impact of any such modification on the landlord’s debt service obligations.
Lease Modification Process:
- A Qualifying Commercial Tenant may engage in “good faith” negotiations with its landlord to modify any rent or economic requirement of its lease regardless of the remaining term. This could be read broadly enough to include things like rent escalation or extension that may not be relevant until well after COVID-19 and its impacts are largely resolved.
Landlord Remedies:
- Although a tenant is required to affirm under penalty of perjury that it meets the qualifying criteria outlined above, there is no duty on the tenant to produce any type of corroborating documentation to the landlord. Thus, while a tenant may be incentivized not to falsify this affirmation under the threat of criminal prosecution, there is no statutory remedy for the landlord if post-termination the tenant’s affirmation is ultimately found to be false.
- SB 939 requires a tenant to vacate the premises within fourteen (14) days of delivering a Termination Notice under this statute. However, if the tenant fails to comply with this term, the landlord may lack the judicial remedies to enforce it due to general court closures as well as the provisions of statute.
- The limit on damages that the landlord is permitted to recover under this statute does not specify whether expenses not constituting traditional “rent” would be included, such as reimbursements, expenses, and default interest.
Guarantors: The bill critically leaves out significant details regarding the status of guarantors after the mutual renegotiation of a lease or the issuance of a Termination Notice under its provisions:
- Upon termination, is the payment of outstanding amounts under the grace period of twelve (12) months no longer guaranteed?
- What would happen to a claim under such a guaranty that was already pending before the period affected by COVID-19 regulation?
- What defenses might become available to lease guarantors where a lease modification is imposed, but has not been consented to by such guarantor, and where guarantor is not required under this legislation to consent to it?

Comments on SB 939 can be submitted to Senator Wiener online at https://sd11.senate.ca.gov/contact or by calling (916) 651-4011 and to Senator Gonzalez online at https://sd33.senate.ca.gov/contact/send-e-mail or by calling (916) 651-4033.

AB 828 – Temporary Moratorium on Residential Foreclosures and Unlawful Detainers

Last Amended: May 18, 2020

Status: Re-referred to Rules Committee May 11, 2020.

Introduced by Assembly Members Ting, Gipson, and Kalra, AB 828 would prohibit any action to foreclose on a residential real property, including without limitation, the following:

(a) Causing or conducting the sale of real property pursuant to a power of sale.
(b) Causing recordation of notice of default pursuant to Section 2924.
(c) Causing recordation, posting, or publication of a notice of sale pursuant to Section 2924f.
(d) Recording a trustee’s deed upon sale pursuant to Section 2924h.
(e) Initiating or prosecuting an action to foreclose, including, but not limited to, actions pursuant to Section 725a of the Code of Civil Procedure.
(f) Enforcing a judgment by sale of real property pursuant to Section 680.010.

The foreclosure prohibition of AB 828 would remain in effect during the pendency and for fifteen (15) days after the expiration of the state or local COVID-19 emergency period in the jurisdiction in which the residential real property is located. The bill as currently written does not discuss any potential impact on UCC foreclosures.

Eviction Moratorium

AB 828 would prohibit any state court, county sheriff, or party to an unlawful detainer action from proceeding with any unlawful detainer action, unless on the basis of nuisance or waste under paragraph (3) or (4) of Section 1161 of the Code of Civil Procedure. Actions under these sections may still result in an entry of judgment in favor of the plaintiff; however, rather than proceeding under default for a defendant that does not timely answer the complaint, subsection (b) directs the court to “proceed as though all named defendants had filed an answer denying each and every allegation in the complaint.” To the extent that any defendant otherwise does answer or would have answered timely by denying all allegations, there are no practical differences to the landlord.

The residential eviction prohibition of AB 828 would remain in effect during the pendency and for fifteen (15) days after the expiration of the state or local COVID-19 emergency period in the jurisdiction in which the residential real property is located.

Eviction for Nonpayment of Rent

For any residential eviction based on nonpayment of rent, a residential tenant may, at any time between the filing of the complaint and entry of judgment, notify the court of that defendant’s desire to stipulate to the entry of an order pursuant to this section. Upon receiving notice from the defendant, the court must notify the plaintiff and convene a hearing to determine whether to issue an order (“Order”) under the following guidelines:

(a) At the hearing, the court will determine whether the tenant’s inability to pay resulted from the COVID-19 pandemic. A court will infer a rebuttable presumption of causation for an increased cost or decreased earnings that occurred between March 4 and May 4, 2020. If the causation prong is established, then the landlord may present evidence that rent reduction would cause material economic hardship (not defined by the text of the statute), where if the landlord owns over ten (10) rental units, lack of hardship is presumed, but where a landlord’s ownership interest in just one or two rental units would be sufficient to establish hardship. If the court finds both causation for the tenant and lack of hardship for the landlord, it will issue an Order and dismiss the case with the court retaining jurisdiction to enforce the terms of the Order.

(b) The Order will provide that the tenant retains possession and the tenant shall make monthly payments to the landlord beginning in the next calendar month, in strict compliance with all of the following terms: (i) The payment shall be in the amount of the monthly rent, plus ten percent (10%) of the unpaid rent owing at the time of the Order,[4] excluding late fees, court costs, attorneys’ fees, and any other charge other than rent; (ii) the payment shall be delivered by a fixed day and time to a location that is mutually acceptable to the parties or, in the absence of an agreement between the parties, by no later than 11:59 pm on the fifth (5th) day of each month; and (iii) the payment shall be made in a form that is mutually acceptable to the parties or, in the absence of agreement between the parties, in the form of a cashier’s check or money order made out to the landlord.

(c) If the tenant fails to make a payment in full compliance with the terms of the Order, the landlord may, after forty-eight (48) hours’ notice to the tenant by telephone, text message, or electronic mail, as stipulated by the tenant, file with the court a declaration under penalty of perjury containing all of the following: (i) a recitation of the facts constituting the failure; (ii) a recitation of the actions taken to provide the forty-eight (48) hours’ notice required by this paragraph; (iii) a request for the immediate issuance of a writ of possession in favor of the landlord; and (iv) a request for the issuance of a money judgment in favor of the landlord in the amount of any unpaid balance plus court costs and attorneys’ fees.

Mortgage Notice of Default

For the duration of the state or locally declared emergency and for fifteen (15) days thereafter, a county recorder shall not accept for recordation any instrument, paper, or notice that constitutes a notice of default pursuant to Section 2924 of the Civil Code, a notice of sale pursuant to Section 2924f of the Civil Code, or a trustee’s deed upon sale pursuant to Section 2924h of the Civil Code for any residential real property located in a jurisdiction in which a state or locally declared state of emergency relating to the COVID-19 virus is in effect.

Sale of Tax-Defaulted Residential Real Property

For the duration of the state or locally declared emergency and for fifteen (15) days thereafter, a tax collector shall suspend the sale of tax-defaulted residential real property.

Comments on AB 828 can be submitted to Assemblymember Ting online at https://a19.asmdc.org/ or by calling (916) 319-2019, to Assemblymember Gipson online at https://a64.asmdc.org/2019-2020 or by calling (916) 319-2064, and to Assemblymember Kalra online at https://a27.asmdc.org/ or by calling (916) 319-2027.

SB 1410 – COVID-19 Emergency Rental Assistance Program

Last Amended: May 18, 2020

Status: Set for hearing May 26–27 as of May 14, 2020. Re-referred to Housing Committee May 18, 2020.

Introduced by Senator Lena Gonzalez, SB 1410 would create a “COVID-19 Emergency Rental Assistance Fund” to provide rental assistance payments on behalf of any residential tenants who demonstrate an inability to pay all or any part of the household’s rent due between April 1 and December 31, 2020, as a result of the COVID-19 pandemic, provided that the landlord consents to participation in the program.

Tenants can demonstrate an inability to pay rent by showing any of the following: (a) loss of income due to a COVID-19 related workplace closure; (b) childcare expenditures due to a COVID-19 related school closure; (c) health care expenses related to being ill with COVID-19 or to caring for a member of the household who is ill with COVID-19; and (d) reasonable expenditures that stem from government-ordered emergency measures related to COVID-19. In assessing whether a tenant has the ability to pay rent, any assistance received from unemployment insurance, disability insurance, and federal relief or stimulus payments may be considered.

Landlords who participate in the program receive rental assistance payments covering at least eighty percent (80%) of the amount of unpaid rent owed by a tenant for not more than seven (7) months of a household’s missed or insufficient rent payments. In exchange, the landlord would be required to agree to: (a) not increase rent until after December 31, 2020; (b) not charge or attempt to collect any late fee for any unpaid rent due between April 1 and December 31, 2020; and (c) accept the rental assistance payment as full satisfaction of late or insufficient rent payments covered by the program.

Comments on SB 1410 can be submitted to Senator Gonzalez online at https://sd33.senate.ca.gov/contact/send-e-mail or by calling (916) 651-4033.

AB 2501 – COVID-19 Homeowner, Tenant, and Consumer Relief Law of 2020

Last Amended: May 11, 2020

Status: Re-referred to Committee on Banking and Finance May 11, 2020.

Introduced by Assembly Member Limón, AB 2501 is a comprehensive bill that would provide relief to residential mortgage borrowers, multifamily mortgage borrowers, and vehicle owners by prohibiting creditors and loan servicers from initiating foreclosures during the period of the COVID-19 pandemic and for a one hundred eighty (180)-day period following the end of the COVID-19 state of emergency. As currently drafted, AB 2501 provides different protections for residential mortgage borrowers and multifamily mortgage borrowers which largely mirrors the protections provided to residential and multifamily borrowers of federally backed mortgages under the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). The bill defines a “multifamily mortgage borrower” as a borrower of a residential mortgage loan that is secured by a lien against a property comprising five (5) or more dwelling units.

Multifamily Mortgage Loans

AB 2501 requires multifamily mortgage loan servicers and creditors to grant multifamily borrowers a loan forbearance of one hundred eighty (180) days. Multifamily borrowers have the ability to extend the forbearance period for an additional one hundred eighty (180) day period upon request at least thirty (30) days prior to the end of the initial forbearance period. As currently drafted, AB 2501 seemingly purports to regulate lenders and loan servicers solely through jurisdiction over the California-based property, regardless of whether the lender or servicer which originated the loan is principally based in another state, or merely services a pool of mortgages across multiple states. To qualify, a multifamily mortgage borrower need only submit a request for forbearance to the borrower’s mortgage servicer, either orally or in writing, affirming that the multifamily mortgage borrower is experiencing hardship during the COVID-19 emergency. While mortgage servicers are required to request documentation of a multifamily mortgage borrower’s financial hardship, AB 2501 does not specify what documentation is required to be submitted.

During the term of the forbearance period, the multifamily mortgage borrower would be required to grant rent relief to the residential tenants of the borrower’s property and would be prohibited from evicting a tenant for nonpayment of rent. Additionally, the multifamily mortgage borrower would be prohibited from imposing any late fees or penalties for unpaid rent. As currently drafted, AB 2501 does not expressly define the extent of the rent relief that a multifamily mortgage borrower is required to provided. Further, AB 2501 seemingly prevents a multifamily mortgage borrower from evicting a tenant for unpaid rent or collecting late fees on unpaid rent during the forbearance period regardless of whether the nonpayment first occurs after the end of the COVID-19 emergency period.

Multifamily mortgage borrowers are required to bring a loan placed in forbearance current within the earlier of: (a) twelve (12) months after the conclusion of the forbearance period, effectively allowing a total forbearance period of two (2) years; or (b) within ten (10) days of the receipt by the of multifamily mortgage borrower any business interruption insurance proceeds. As currently drafted, a multifamily mortgage borrower would be required to bring a loan current upon receipt of any business interruption insurance proceeds, regardless of whether such funds would be sufficient to fully satisfy the total amount of delinquent debt service.

Comments on AB 2501 can be submitted to Assemblymember Limón online at https://a37.asmdc.org/ or by calling (916) 319-2037.

AB 2406 – Homeless Accountability and Prevention Act

Last Amended: May 11, 2020

Status: Re-referred to Committee on Housing & Community Development May 12, 2020.

Introduced by Assemblymember Wicks, AB 2406 is aimed at preventing homelessness by providing the public access to information relating to residential rental units within California. In pursuit of this goal, AB 2406 would require any multifamily residential landlord that accepts rental assistance payments from federal or state funds provided in response to the COVID-19 state of emergency to annually submit a rental registry form for any residential dwelling unit as required by Section 50468 of the Health and Safety Code. Until the rental registry form is submitted, landlords would be prohibited from: (a) increasing rents; (b) issuing a notice to terminate a periodic tenancy pursuant to California Civil Code Section 1946.1; or (c) issuing any notice or initiating any unlawful detainer action.

Upon submitting the rental registry form, multifamily residential landlords are further required to annually report comprehensive information pertaining to each residential rental unit. Notably, as currently drafted, multifamily residential landlords would be required to annually report such information as: (i) the legal name of the owner or ownership entity and all limited partners, general partners, limited liability company members, and shareholders with ten percent (10%) or more ownership of the entity; (ii) the occupancy status of each rental unit; (iii) the total number of days each rental unit was vacant; (iv) the effective date of the most recent rent increase for each rental unit and the amount of the increase; and (v) the number of tenants in which the landlord terminated a tenancy and the reason underlying each lease termination.

Comments on AB 2406 can be submitted to Assemblymember Wicks online at https://a15.asmdc.org/letstalk or by calling (916) 319-2015.

California Senate Democratic Caucus’ Budget and Tax Credit Proposal

On May 12, 2020, Senate President Pro Tempore Atkins unveiled the Senate Democratic Caucus’ proposal for the state budget and California’s economic recovery. Part of the proposal includes the creation of a Renter/Landlord Stabilization program that would enable tri-party agreements between renters, landlords, and the State of California to resolve unpaid rents.

Although a draft bill has yet to be introduced, the preliminary proposal indicates that a tri-party agreement would grant a renter immediate rent relief for the full amount of unpaid rent and provide protection against eviction based on the unpaid rent. In exchange, the renter simply provides a commitment to repay past due rents, without interest, to the state over a ten (10)-year period, beginning in 2024. Additionally, the preliminary proposal indicates that a tenant’s obligation to repay past due rents will be based solely on the tenant’s ability to pay and that cases of hardship could lead to full forgiveness of unpaid rent.

As a party to the tri-party agreement, a landlord agrees to relieve the tenant of the obligation to pay past due rent and waives the right to evict the tenant based on the unpaid rent. In exchange, the landlord will receive tax credits from the state equal to the value of the forgiven rent, spread equally over tax years 2024-2033. The tax credits would be fully transferable such that landlords would be permitted to sell the tax credits for immediate cash value.

The preliminary proposal leaves open a number of questions about the program. First, the proposal does not indicate to which tax obligations the credits would apply, nor does the proposal indicate whether the calculation of the value of lost rent will include late fees or interest that would otherwise have accrued on unpaid rent. Second, the proposal requires landlords to wait a four (4) year period before utilizing the value of the tax credit. While a landlord is permitted to immediately sell the tax credit, the delay in the ability of the purchaser to utilize the tax credit will likely require the landlord to sell the tax credit at a discount against the value of the credit, eroding the effectiveness of the tax credit to offset the landlord’s losses. Finally, the proposal seemingly fails to include a mechanism the state can invoke as a remedy should a tenant default on the obligation to repay past due rents to the state. Without a properly crafted remedy, tenant defaults on such decade-long obligations could further deplete the state’s coffers.

Comments on Senator Atkins’ proposal can be submitted online at https://sd39.senate.ca.gov/contact or by calling (916) 651-4939.

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[1] By its terms, SB 939 retroactively renders evictions that would otherwise be disallowed under SB 939, and which occurred after the proclamation of the state of emergency but before the effective date of SB 939, “void” against public policy and unenforceable. Because such “violations” of the section may include improper notices, arguably certain events as simple as a notice of a default, which had previously been issued with the intent of starting the clock for other remedies that were permissible at the time, could be unwound if that action is itself now voided. This distinction between eviction and other available remedies is particularly significant in the commercial context, where it may effectively limit landlord’s other remedies (i.e., limiting tenant improvement allowance draws or draws on letters of credit).

[2] The bill is silent as to the effect it would have on default interest.

[3] The May 22 amendment adjusts this criteria to require that the small business be an eating or drinking establishment, place of entertainment, or performance venue, rather than extending the protections to both small businesses and such venues. Additionally, the amendment adds a definition of “small business” as “a business that is not dominant in its field of operation, the principal office of which is located in California, the officers of which are domiciled in California, and which has 500 or fewer employees.”

[4] An earlier version of this bill would have reduced the amount of rent owed by a tenant by twenty-five percent (25%) for a year following the issuance of an Order under this section, but this provision has been removed in its most recent amendment.

Gibson Dunn’s lawyers are continually monitoring the evolving situation and are available to assist with any questions you may have regarding these developments. For additional information, please contact any member of the firm’s Real Estate or Land Use Group, or the following authors:

Doug Champion – Los Angeles (+1213-229-7128, [email protected]) (Real Estate)
Danielle Katzir – Los Angeles (+1213-229-7630, [email protected]) (Real Estate)
Alayna Monroe – Los Angeles (+1213-229-7969, [email protected]) (Litigation)
Ben Saltsman – Los Angeles (+1213-229-7480, [email protected]) (Real Estate)
Matthew Saria – Los Angeles (+1213-229-7988, [email protected]) (Real Estate)

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

The COVID-19 global pandemic has changed the face of the world for businesses and customers as we know it. Public health mandates and local, state, and national shelter-in-place orders have required events to be canceled, plans to be postponed indefinitely, and facilities closed until further notice. In the wake of these closures and cancellations, consumer frustration has mounted, and scores of class action lawsuits have followed. This Article examines the industries facing these lawsuits, describes the theories that plaintiffs are asserting, and provides some practical considerations and potential defenses for these lawsuits.

Industries Facing COVID-19 Related Refund Class Actions

Plaintiffs’ lawyers have seized on the COVID-19 pandemic to bring class action lawsuits involving the following businesses:

Student Tuition and Fees

As schools have been forced to close their campuses and shift to online learning, students and parents have filed class actions seeking reimbursement of tuition, room and board, and other expenses. The student-plaintiffs allege that the value of their degrees, the quality of their education, and their enjoyment of on-campus facilities have been diminished by switching to online classes. As such, the students allege that they are entitled to refunds on the theory that schools are not fulfilling their alleged contractual obligations to provide an on-campus education. Scores of these lawsuits have been filed against private and public universities.[1] Multiple class actions have been brought that seek not only reimbursement of room and board fees, but also tuition.

Concerts and Sporting Events

Shelter-in-place orders have left no choice but to cancel or postpone concerts and sporting events. In response, ticketholders to these events have filed refund class actions against event sponsors, as well as the websites that facilitate ticket sales, seeking refunds. For example, season ticket holders have sued Major League Baseball for “unfairly” financially burdening customers by withholding refunds after MLB postponed the season.[2] Other class action complaints brought against ticket sellers allege that companies changed their refund policies after consumers had already purchased their tickets.

Season Passes and Memberships

Companies that offer memberships and season passes for access to physical facilities, such as fitness centers, yoga studios, and ski resorts, also find themselves facing class actions seeking refunds following long-term and seasonal closures resulting from COVID-19. For example, one plaintiff claims her gym is not refunding her monthly membership fee while the gym is closed.[3]

Travel Deposits

Consumers have filed a number of class actions against travel companies seeking refunds for canceled flights or cruises. While many travel companies have offered no-fee cancellations and provided a credit for future travel, plaintiffs allege that they should be entitled to refunds of the funds paid, rather than a credit for future travel.[4]

Defenses and Practical Considerations

Businesses that are facing class action lawsuits based on mandatory closures have several defenses that warrant consideration as part of any legal strategy.

Arbitration Agreements and Class Action Waivers

Arbitration agreements are included in many contracts that accompany consumer transactions. Since the Supreme Court’s landmark decision in AT&T Mobility LLC v. Concepcion,[5] these types of agreements are enforceable subject to any generally applicable contract defenses that do not interfere with the fundamental attributes of arbitration (e.g., fraud, duress, and unconscionability).

As a result, one of the first steps a company should take in defending a consumer class action is determining whether the parties have agreed to resolve the dispute outside of court and outside of a class action setting. This also includes looking at whether there are arbitration provisions in third-party contracts, such as contracts between plaintiffs and ticket resellers.

If the case is one in which California law applies, then recent caselaw confirms that a company must also evaluate whether any of plaintiffs’ claims that are the subject of an arbitration agreement seek a public injunction.

Other Contract-Based Defenses

Once a company has determined whether the case should proceed in court or before an arbitrator, it should consider other contract-based defenses, especially those that may excuse a company’s performance or otherwise limit a company’s liability.

A frequently invoked contract defense in the wake of COVID-19 is force majeure. These clauses vary from contract to contract, but as a general matter, the purpose of these clauses is to set forth when a party may terminate or fail to perform without liability due to an unforeseen event. We anticipate that these clauses will be a particular focus of COVID-19 related litigation, especially those based on forced closures and cancellations.

Another possible defense is that there has been no actual breach of contract. If a company is complying with its contractual obligations, there is arguably no liability. For example, a contract may contemplate that an event or season may be cut short due to unforeseen circumstances, and it may assign that risk to the purchaser. Similarly, a purchaser’s entitlement to a refund may turn on his compliance with the contractual procedures for receiving a refund.

Impossibility and frustration of purpose also may excuse performance. “Impossibility” applies where performance is objectively impossible, and “frustration of purpose” is triggered if circumstances make the required performance worthless to the receiving party. Companies may be subject to government orders that make it impossible to host an event or open facilities, and courts have held that impossibility during disasters, based on intervening government restrictions, can excuse performance.[6]

Causation and Reliance-Based Defenses

Depending on a plaintiff’s theory, intervening factors may preclude, or mitigate, a company’s liability. These factors could include state and local orders limiting large gatherings or evidence of a plaintiff’s unwillingness to attend an event even if it were to proceed as scheduled.

A purchaser’s conduct may also defeat his claim. If a purchaser does not mitigate his or her damages, recovery may be limited. For example, a purchaser who fails to accept a voucher may be subject to an offset, and a purchaser who fails to accept a refund offer may not have standing to bring a claim, depending on the circumstances. A purchaser may also waive or negate any claim based on subsequent conduct, such as continuing a membership or using a voucher.

Defenses based on COVID-19 may also exist on bad faith and unjust enrichment claims. Evidence that a company is thoughtfully considering different options for responding to COVID-19 may negate a finding of bad faith. Similarly, companies are still incurring substantial costs due to government orders and closures, even with events canceled and facilities closed. Thus, a company may respond to an unjust enrichment claim by arguing that it is not unjustly retaining benefits due to the excessive costs it is incurring as a result of forced closures.

Class Certification Defenses

As this discussion suggests, putative class members are not going to be similarly situated and/or affected by the pandemic. For example, entitlement to a refund could turn on individualized issues, such as the specific representations to each consumer, and the steps taken to secure a refund. Individualized inquiries may also exist based on customer expectations. A frequent traveler may understand that flights are subject to unforeseen cancellation, but not a less-experienced traveler. In addition, damages may vary and be incapable of a method that allows them to be determined across the class. For example, a class member who uses a gym pass 50 times per year is differently situated than a consumer who historically uses it more infrequently. The presence of arbitration clauses and class action waivers in contracts with at least some of the putative class members can also make a class action lawsuit an inappropriate forum.

Conclusion

Companies that have canceled or postponed events or closed their facilities face many difficult choices based on COVID-19, and the specter of class action lawsuits further complicates these decisions. Regardless of a company’s approach, and even if a company is already subject to a class action lawsuit, there are important considerations that companies should weigh with counsel in order to determine the best path forward.

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[1] See, e.g., Rickenbaker v. Drexel Univ., No. 2:20-cv-1358 (D.S.C. Apr. 8, 2020); Dixon v. Univ. of Miami, No. 2:20-cv-1348 (D.S.C. Apr. 8, 2020); Rosenkrantz v. Ariz. Bd. of Regents, No. 2:20-cv-00613 (D. Ariz. Mar. 27, 2020).

[2] Ajzenman v. Office of the Comm’r of Baseball, No. 2:20-cv-03643 (C.D. Cal. Apr. 20, 2020).

[3] Labib v. 24 Hour Fitness USA Inc., No. 4:20-cv-02134 (N.D. Cal. Mar. 27, 2020); see also Weiler v. Corepower Yoga LLC, No. 2:20-cv-03496 (C.D. Cal. Apr. 15, 2020); Kramer v. Alterra Mountain Co., No. 1:20-cv-01057 (D. Colo. Apr. 14, 2020).

[4] See, e.g., Manchur v. Spirit Airlines Inc., No. 1:20-cv-10771 (D. Mass. Apr. 21, 2020); Alvarez v. Hawaiian Airlines Inc., No. 1:20-cv-00175 (D. Haw. Apr. 20, 2020); Roman v. JetBlue Airways Corp., No. 1:20-cv-01829 (E.D.N.Y. Apr. 16, 2020); Herr v. Allegiant Air LLC, No. 2:20-cv-10938 (E.D. Mich. Apr. 15, 2020); Bombin v. Sw. Airlines Co., No. 5:20-cv-01883 (E.D. Pa. Apr. 13, 2020).

[5] AT&T Mobility LLC v. Concepcion, 563 U.S. 333 (2011).

[6] See, e.g., Bush v. ProTravel Int’l, 192 Misc. 2d 743, 752–53 (N.Y. Civ. Ct. 2002) (recognizing impossibility of performance due to state of emergency following September 11 terrorist attacks).

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For additional information, please contact any member of the firm’s Coronavirus (COVID-19) Response Team or its Class Actions practice group, or the following authors:

AUTHORS: Christopher Chorba, Timothy W. Loose, Daniel Weiss, Jeremy S. Smith, Emily Riff, and Andrew Kasabian.

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

On 10 May 2020, the UK government announced a provisional roadmap for the phased relaxation of the current COVID-19 lockdown restrictions, including those restrictions which have impacted businesses across the UK. While the UK government continues to require those who can work from home to do so, employees who are not able to work from home are now being actively encouraged to return to the workplace provided that their workplace is permitted to open and can be operated within government guidelines. In recent client alerts, we have considered in detail the law regarding: (i) the options for reducing the risk of employee exposure to COVID-19, including (a) instituting work-from-home/telecommuting policies and (b) instructing employees not to work; (ii) what to do if an employee tests positive or needs to care for an ill family member and (iii) the Coronavirus Job Retention Scheme (“CJRS”). Below, we identify some of the key considerations for UK-based businesses when taking steps to comply with their health and safety obligations once certain groups of employees return to the workplace. We also outline key amendments to the CJRS.

The UK government response to the outbreak continues to evolve daily, and we encourage employers in the UK to monitor UK government and National Health Service guidance and legislative developments over the coming weeks.

Return-To-Work, Screening, and Safety

New Government Guidance and Return to Work Plans

On 11 May 2020, the UK government published both new and updated guidance to reflect the focus on getting workers back to work where possible. The guidance has been produced with the aim of helping employers ensure employees work safely during coronavirus, and includes measures to assist employers in making the workplace “COVID-19 secure”. The UK government has produced general guidance comprising of five key points, which we detail below, and eight workplace-specific guidance notes, formulated with the objective of meeting these five key points. We are available to guide clients through the specific guidance applying to their industry.

Five Key Points in the COVID-19 Secure Guidance

Work from home, if you can

Individuals should work from home if they can, and “all reasonable steps” should be taken by employers to enable individuals to work from home. However, the guidance now clearly states that those who cannot work from home and whose workplaces are permitted to operate, should go to work.

To ensure readiness for staff returning to work, employers must devise a return to work plan with employees and those who represent them.

When devising a return to work plan, employers should consult employees, listen to their concerns and be mindful of their personal circumstances including childcare responsibilities. Employers should also think about identifying vulnerable employees and how they will be treated when the workplace reopens. If an employer requires certain roles or numbers of people to return, they should be mindful of how selection will be carried out to avoid any discrimination or other issues of unfairness which could lead to claims.

Carry out a COVID-19 risk assessment, in consultation with workers or trade unions

Employers must carry out COVID-19 risk assessments in consultation with their trade unions or workers in order to establish what guidelines should be put in place, and identify sensible measures to control the risks in the workplace. Employers with over 50 employees should publish their workplace risk assessments on their website, with smaller employers being advised to do so. Employers should share the results of risk assessments with their workforce.

Once a risk assessment has been carried out, an employer should update appropriate policies and procedures accordingly.

Employers should also consider providing appropriate training for managers and employees and deliver this training before or upon their return to the workplace. Communications should be displayed around the workplace in prominent places such as handwashing points, entrances and exits. A downloadable notice is provided in each of the workplace-specific guidance documents. Employers should monitor the effectiveness of their policies and review their plans regularly, ideally each time the government updates its guidance.

Maintain two metres social distancing, wherever possible

Employers may need to consider changing the layout of workspaces to maintain a two metre distance between individuals in compliance with social distancing advice. Employers should consider designating a one way system for entry and exit into the building; limiting the number of people allowed in confined spaces at any one time (e.g. lifts, meeting rooms, toilets); reducing face to face interactions, for example by introducing delivered desk-based lunch orders and restricting or prohibiting the use of communal areas such as kitchens and lunchrooms; encouraging non-public means of getting to work (e.g. bicycles or walking); and reducing non-essential work travel.

Where people cannot be 2 metres apart, manage transmission risk

Employers are also encouraged to change the way work is organised in order to reduce the number of people with whom each employee interacts face to face as well as minimizing those interactions. Employers should consider limiting the number people in the workplace at any one time, by adjusting working hours or dividing employees into groups and rotating their attendance in the office, introducing protective screens into the workplace and encouraging video-conference meetings.

Reinforcing cleaning processes

Workplaces should be cleaned more frequently than usual, focusing on high touch points like door handles or keyboards, ensuring access to hygiene facilities such as hand sanitizer, providing anti-bacterial wipes for equipment and disposing of waste frequently.

Risks of Failing to Implement the COVID-19 Secure Guidance

Employers who fail to comply with the COVID-19 secure guidance may find themselves in breach of health and safety obligations towards workers and visitors to their premises. Such breaches may attract criminal penalties and/or enforcement notices. To encourage compliance with the COVID-19 secure guidance, the Prime Minister has asked employees to report their employers’ failures to implement the guidance to the Health and Safety Executive (“HSE”), the organisation responsible for enforcing health and safety laws in the UK, and the UK government has made available up to an extra £14 million for the HSE for additional compliance-monitoring resources.

Screening Employees for COVID-19

Employers who wish to carry out COVID-19 screening, such as temperature checks, on their employees, workers or visitors will need their consent to do so. The results of any screening would need to be handled appropriately in accordance with the GDPR and Data Protection Act 2018 to the extent that it is stored or processed: a data protection impact assessment is likely to be required and employers will need to ensure any individuals it screens are provided an appropriate privacy notice detailing what personal data will be required, how their personal data will be used, who it will be shared with, the implications of the results and how long it will be kept for. Employers should also ensure any screening is applied consistently across their workforce to mitigate any risk of discrimination claims, which could arise upon the screening of a specific group of employees perceived to be at a higher risk of having contracted the virus. Finally, employers should seek to adopt the least intrusive means of protecting the health and safety of their employees and making the workplace safe.

If Employees Become Ill

Employers must follow government guidelines in respect of COVID-19 related illness. If anyone becomes unwell with a new, continuous cough or a high temperature, they should be advised to follow the stay at home guidance. If these symptoms develop whilst at work, the employee should be sent home immediately and advised not to use public transport if possible. Government policy currently states that it is not necessary to close the business or workplace or send any staff home in these circumstances. Please refer to our alert of 17 March 2020 for sick pay implications.

Employees who require shielding and those at high risk

Employees who have been informed by their GP or an NHS letter that they are clinically extremely vulnerable, because for example they suffer from severe respiratory conditions or are undergoing immunosuppression therapies sufficient to significantly increase risk of infection, are required to shield i.e. stay at home at all times and avoid all non-essential face to face contact. Employers should support members of staff who are clinically extremely vulnerable, as well as individuals with whom they live, as they follow the recommendations set out in the shielding guidance. In particular, they should be supported to stay at home, until UK government guidance suggests otherwise.

Employees who are not clinically extremely vulnerable but have medical conditions which place them at an increased risk of severe illness from COVID-19, such as pregnant women and those with diabetes, have been advised to take particular care to minimise contact with others outside their households, but do not need to be shielded. Employers should listen to such employees’ concerns and be flexible to their needs where practicable.

Employees who are unable to return to the workplace due to childcare commitments

The UK government’s plan for a phased reopening of nurseries and schools is not due to begin until 1 June at the earliest, with only certain year groups eligible to return in the early stages. As such, some employees may be unable to return to the workplace due to childcare commitments. The Prime Minister has encouraged employers to regard childcare commitments as an obvious barrier to an employee’s ability to return to the workplace. Employers should encourage open communication with employees with childcare commitments and endeavour to reach an agreement on flexible working arrangements where possible.

If Employees Hesitate or Refuse to Return to Work

Employees may also be reluctant to return to the workplace if they have to take public transport to get to work, if they do not feel the measures their employer has taken go far enough to ensure their health and safety, or if they live with a vulnerable person who requires shielding. Employers will have the best chance of identifying these issues at an early stage if they are able to engage in early consultation and ongoing communication with their employees.

If employees refuse to return to work, employers will need to consider whether they can be more flexible in the arrangements they have put in place taking into account the employees’ circumstances, or whether ultimately they wish to take further steps to require their employees to comply with the instruction to return to work, or treat a refusal to return to work as an unauthorised absence and consider disciplinary action.

Employers will need to ensure any such steps are taken in a fair, rational and non-discriminatory way to avoid potential liability in this area. It would also be advisable for employers to record their decisions and steps they take to be flexible to the needs of their employees where appropriate or necessary.

Update: Coronavirus Job Retention Scheme

General: We reported on the CJRS when it was first introduced in March 2020. On 12 May 2020, the Chancellor announced that the CJRS will be extended by a further four months until the end of October 2020, with no changes until the end of July 2020. From August 2020: (i) employees will be able to return to work on a part-time basis; (ii) employers will be required to pay a percentage towards the salaries of their furloughed employees and (iii) the employer’s payments will substitute at least part of the government’s contribution under the CJRS, ensuring that any furloughed workers continue to receive 80% of their salary (up to the maximum of £2,500 a month). From August 2020 employers will have to start sharing, with the UK government, the cost of paying people’s furloughed salaries. The UK government has committed to provide further details before the end of May 2020.

Holiday: On 13 May 2020, the UK government published guidance on workers’ entitlement to holiday, holiday pay and the right to carry over of holiday during coronavirus. The guidance confirms that furloughed workers continue to accrue holiday, including any contractual holiday they receive above the statutory minimum of 5.6 weeks (subject to any furlough agreement to the contrary), and may take holiday without it interrupting their period of furlough. It also confirms that a furloughed worker’s entitlement to holiday pay remains unchanged and is to be calculated in the normal way. This means that where the calculated holiday pay rate is above the pay the worker receives whilst on furlough, the employer may continue to claim the 80% CJRS grant, but must pay the worker the difference unless they have agreed that the employee’s pay is to be reduced to the furlough limit for the period of furlough. This applies to bank holidays where they fall within a worker’s furlough period.

As reported in our alert of 27 March 2020, the UK government previously introduced the Working Time (Coronavirus) (Amendment) Regulations 2020 (the “Regulations”) which allow up to 4 weeks of unused holiday to be carried over into the next two leave years if it has not all been taken due to COVID-19. The latest guidance advises that when determining whether it was not reasonably practicable for a worker to take holiday, employers should consider various factors, including: (i) increased demand for the business’ services due to COVID-19 that require the worker to continue working; (ii) the extent to which the business’ workforce is disrupted by COVID-19 and the ability to provide temporary cover of essential activities including the availability of the remaining workforce to cover the worker whilst they are on holiday; (iii) the worker’s health and the speed at which they need a period of rest and relaxation; (iv) the length of time left in the worker’s holiday year to enable them to take holiday later in the year; and (v) the impact of the worker’s holiday on society’s response and recovery from COVID-19.

The guidance states that employers should do everything reasonably practicable to ensure workers take as much of their holiday in the year to which it relates and notes that furloughed workers will be unlikely to need to carry forward their holiday as they can take it during furlough.

As reported in our alert of 27 March 2020, employers have the right to require workers to take or cancel holiday subject to providing a certain amount of notice, a right which continues to apply to furloughed workers under the latest guidance. This tool should assist employers in ensuring holiday is taken within the applicable year and also prevent employers facing unmanageable holiday requests from workers later in the year when restrictions are lifted However, if an employer is unable to fund the difference between furlough pay and holiday pay, this may result it in not being reasonably practicable for the worker to take holiday whilst on furlough and enable them to carry their entitlement forward under the Regulations. Employers should also consider whether a worker’s individual circumstances allow them to enjoy holiday whilst on furlough in the fundamental sense, taking into account any social distance or self-isolation restrictions they may be under which would prevent them from resting and relaxing, before requiring them to take holiday.

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James Cox – London (+44 (0)20 7071 4250, [email protected])
Sarika Rabheru – London (+44 (0) 20 7071 4267, s[email protected])
Heather Gibbons – London (+44 (0)20 7071 4127, [email protected])
Georgia Derbyshire – London (+44 (0)20 7071 4013, [email protected])

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

In a speech on May 12, 2020, Steven Peikin, Co-Director of the U.S. Securities and Exchange Commission’s Division of Enforcement, provided insights on the Division’s enforcement priorities in light of the pandemic, as well as how the Division is managing the investigative process under remote work conditions.[1] The remarks provide helpful guidance on how companies and financial institutions can mitigate risk of investigative scrutiny for financial shocks resulting from the pandemic.

In response to the pandemic, the Enforcement Division has formed a Coronavirus Steering Committee, comprised of leadership from the Home and Regional Offices, the specialized units and the Office of Market Intelligence, to identify areas of potential misconduct and coordinate the Division’s response to COVID-19 related issues. The below areas of regulatory focus provide a helpful roadmap for companies and financial institutions, and reinforce the guidance we provided in our prior alert, to reduce the risk of drawing scrutiny.

Insider Trading and Market Manipulation: The rapid and dramatic impact of the pandemic on the financial performance of companies increases the potential for trading that could be perceived as attributable to material non-public information. The Steering Committee is working with the Division’s Market Abuse Unit to monitor announcements in industries particularly impacted by COVID-19 and to identify potentially suspicious market movements.
Accounting Fraud: As with other financial crises, the pandemic is likely to expose previously undisclosed financial reporting issues, as well as give rise to rapidly evolving financial reporting and disclosure challenges. The Steering Committee is on the lookout for indications of potential disclosure and reporting misconduct. In particular, the Steering Committee is reviewing public filings with an eye toward disclosures that appear out of step to companies in similar industries. The Committee is also looking for accounting that attempts to inaccurately characterize preexisting financial statement issues as coronavirus related.
Asset Management: Asset managers confront unique challenges created by the pandemic, including with respect to valuations, liquidity, disclosures, and the management of potential conflicts among clients and between clients and the manager. The Steering Committee is working with the Division’s Asset Management Unit to monitor these issues, including failures to honor redemption requests, which could reveal other underlying asset management issues.
Complex Financial Instruments: As with prior financial crises, the pandemic may reveal risks inherent in various structured investment products. The Steering Committee is working with the Division’s Complex Financial Instruments Unit to monitor complex structured products and the marketing of those products to investors.
Microcap Fraud: The Steering Committee is working with the Division’s Microcap Fraud Task Force and Office of Market Intelligence, and has suspended trading in the securities of over 30 issuers relating to allegedly false or misleading claims related to the coronavirus.

As we discussed in our prior alert, by understanding the issues that can give rise to regulatory scrutiny, and consulting with counsel on how to navigate the unique challenges, issuers and financial institutions can both lower the risk of being in a regulatory spotlight, as well as resolve regulatory inquiries more efficiently.

Speaking more broadly on the Enforcement Division’s process during the pandemic, Peikin noted that the Division staff continues to remain engaged despite the new challenges of a remote work environment. The Division staff has been directed to work with defense counsel and others to reach reasonable accommodations concerning document production, testimony, interviews and counsel meetings, given the challenges of the pandemic, but also cautioned that the staff will need to protect potential claims and won’t agree to an indefinite hiatus in investigations or litigations. In particular, Peikin noted that in instances where defense counsel would not agree to tolling agreements, the Division will consider recommending that the Commission commence an enforcement action, despite an incomplete investigative record, and will rely on civil discovery to further support its claims.

Predictably, the pandemic has already led to a marked increase in Enforcement investigations and whistleblower tips. Since mid-March, the Division has opened hundreds of new investigations concerning issues related both to COVID-19 as well as traditional areas of investigation. In addition, the Division has triaged more than 4,000 whistleblower tips since mid-March, a 35% increase over the same period last year. Since March 23, the Commission has granted nine whistleblower awards, including one for over $27 million (though these awards were clearly in the pipeline long before the pandemic). Nevertheless, the notable increase in whistleblower complaints further reinforces the guidance in our prior alert on how companies can manage the heightened risks of whistleblowers resulting from the pandemic.

In sum, Peikin noted that while there is uncertainty ahead, the Enforcement Division expects the pandemic will result in increased enforcement activity as the market decline and volatility will lead to investigations of potential past misconduct as well as potential new misconduct.

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[1] See May 12, 2020 Keynote Address: Securities Forum West 2020, available at https://www.sec.gov/news/speech/keynote-securities-enforcement-forum-west-2020.

Gibson Dunn lawyers regularly counsel clients on the issues raised by this pandemic. For additional information, please contact any member of the firm’s Coronavirus (COVID-19) Response Team, the Gibson Dunn lawyer with whom you usually work in the firm’s Securities Enforcement Practice Group, or the following authors:

Mark K. Schonfeld – New York (+1 212-351-2433, [email protected])
Tina Samanta – New York (+1 212-351-2469, [email protected])

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.