From the Derivatives Practice Group: ISDA and ESMA were particularly active this week, releasing several global reports.

New Developments

CFTC’s Energy and Environmental Markets Advisory Committee to Meet February 13. On January 30, 2024, CFTC Commissioner Summer K. Mersinger, sponsor of the Energy and Environmental Markets Advisory Committee (EEMAC) announced the EEMAC will hold a public meeting from 9:00 a.m. to 11:30 a.m. (MST) on Tuesday, February 13 at the Colorado School of Mines in Golden, Colorado. The CFTC stated that at this meeting, the EEMAC will explore the role of rare earth minerals in transitional energy and electrification, including the potential development of derivatives products to offer price discovery and hedging opportunities in these markets. Additionally, the meeting will include a presentation and discussion on the federal prudential financial regulators proposed rules implementing Basel III and the implications for and impact on the derivatives market. Finally, the two EEMAC subcommittees will offer an update on their continued work related to traditional energy infrastructure and metals markets. [NEW]
CFTC Cautions the Public to Beware of Artificial Intelligence Scams. On January 25, the CFTC’s Office of Customer Education and Outreach issued a customer advisory warning the public about Artificial Intelligence (AI) scams. Customer Advisory: AI Won’t Turn Trading Bots into Money Machines explains how the scams use the potential of AI technology to defraud investors with false claims that entice them to hand over their money or other assets to fraudsters who misappropriate the funds and deceive investors. The advisory warns investors that claims of high or guaranteed returns are red flags of fraud and that strangers promoting these claims online should be ignored. The CFTC stated that the advisory is intended to help investors identify and avoid potential scams and includes a reminder that AI technology cannot predict the future. It also lists four items investors may consider to avoid such scams: researching the background of a company or trader, researching the history of the trading website, getting a second opinion, and knowing the risks associated with the underlying assets.
CFTC Staff Releases Request for Comment on the Use of Artificial Intelligence in CFTC-Regulated Markets. On January 25, the CFTC’s Divisions of Market Oversight, Clearing and Risk, Market Participants, and Data and the Office of Technology Innovation issued a request for comment (RFC) in an effort to better inform them on the current and potential uses and risks of AI in the derivatives markets that the CFTC regulates. The RFC seeks comment on the definition of AI and its applications, including its use in trading, risk management, compliance, cybersecurity, recordkeeping, data processing and analytics, and customer interactions. The RFC also seeks comment on the risks of AI, including risks related to market manipulation and fraud, governance, explainability, data quality, concentration, bias, privacy and confidentiality and customer protection. The CFTC indicated that staff will consider the responses to the RFC in analyzing possible future actions by the CFTC, such as new or amended guidance, interpretations, policy statements, or regulations. Comments will be accepted until April 24, 2024.
CFTC Seeks Public Comment on Proposed Capital Comparability Determination for Swap Dealers Subject to Supervision by the UK Prudential Regulation Authority. On January 24, the CFTC solicited public comment on a substituted compliance application requesting that the CFTC determine that certain CFTC-registered nonbank swap dealers located in the United Kingdom may satisfy certain Commodity Exchange Act capital and financial reporting requirements by being subject to, and complying with, comparable capital and financial reporting requirements under UK laws and regulations. The Institute of International Bankers, the International Swaps and Derivatives Association, and the Securities Industry and Financial Markets Association submitted the application. In connection with the application, the CFTC also solicited public comment on a proposed comparability determination and related order providing for the conditional availability of substituted compliance to CFTC-registered nonbank swap dealers under the UK Prudential Regulation Authority’s prudential supervision. The comment period will be open until March 24, 2024.
BGC Group Announces Approval for FMX Futures Exchange. On January 22, BGC Group, Inc. (BGC) announced that its FMX Futures Exchange (FMX) received approval from the CFTC to operate an exchange for U.S. Treasury and SOFR futures. BGC will combine their Fenics UST cash Treasury platform and FMX to work across the CME’s U.S. interest rate complex. FMX is party to a clearing agreement with LCH SwapClear, a holder of interest rate collateral, which it indicated will allow for portfolio margining across rates of risk and provide for margin efficiencies and effective risk management.
CFTC Cancels Open Meeting. On January 20, the CFTC cancelled its open meeting scheduled for January 22. According to the CFTC, Tthe following matters will be resolved through the CFTC’s seriatim process:
- Notice of Proposed Order and Request for Comment on an Application for a Capital Comparability Determination Submitted on behalf of Nonbank Swap Dealers subject to Capital and Financial Reporting Requirements of the United Kingdom and Regulated by the United Kingdom Prudential Regulation Authority,
- Proposed Rule: Requirements for Designated Contract Markets and Swap Execution Facilities Regarding Governance and the Mitigation of Conflicts of Interest Impacting Market Regulation Functions.
CFTC Designates IMX Health, LLC as a Contract Market. On January 18, the CFTC announced it has issued an Order of Designation to IMX Health, LLC, granting it designation as a contract market (DCM). IMX Health is a limited liability company registered in Delaware and headquartered in Chicago, Illinois. The CFTC issued the order under Section 5a of the Commodity Exchange Act (CEA) and CFTC Regulation 38.3(a). The CFTC determined IMX Health demonstrated its ability to comply with the CEA provisions and CFTC regulations applicable to DCMs. With the addition of IMX Health, there will be 17 DCMs.
CFTC Issues Staff Letter No. 24-01. On January 16, the CFTC issued Staff Letter No. 24-01, granting an exemption to LCH SA from the requirements of Regulation 1.49(d) to permit LCH SA to hold customer funds at the Banque du France. Additionally, the CFTC confirmed that it would not recommend enforcement action against LCH SA for failing to obtain, or provide the Commission with, an executed version of the template acknowledgment letter set forth in Appendix B to Regulation 1.20 , as required by Regulations 1.20(g)(4) and 22.5, for customer accounts maintained at the Banque de France.

New Developments Outside the U.S.

ESAs Recommend Steps to Enhance the Monitoring of BigTechs’ Financial Services Activities. On February 1, the European Supervisory Authorities (ESAs) published a Report setting out the results of a stock take of BigTech direct financial services provision in the EU. The Report identifies the types of financial services currently carried out by BigTechs in the EU pursuant to EU licenses and highlights inherent opportunities, risks, regulatory and supervisory challenges. The stock take showed that BigTech subsidiary companies currently licensed to provide financial services pursuant to EU law mainly provide services in the payments, e-money and insurance sectors and, in limited cases, the banking sector. However, the ESAs have yet to observe their presence in the market for securities services. To further strengthen the cross-sectoral mapping of BigTechs’ presence and relevance to the EU’s financial sector, the ESAs propose to set-up a data mapping tool. The ESAs explained that this tool is intended to provide a framework that supervisors from the National Competent Authorities would be able to use to monitor on an ongoing and dynamic basis the BigTech companies’ direct and indirect relevance to the EU financial sector. [NEW]
ESMA Publishes Risk Monitoring Report. On January 31, the European Securities and Markets Authority (ESMA) published its first risk monitoring report of 2024, where it sets out the key risk drivers currently facing financial markets. Beyond the risk drivers, ESMA’s report provides an update on structural developments and the status of key sectors of financial markets, during the second half of 2023. The report considers structural developments in various areas, including market-based finance, sustainable finance, securities markets, and asset management. [NEW]
ESMA Consults on Reverse Solicitation and Classification of Crypto Assets as Financial Instruments Under MiCA. On January 29, ESMA, published two Consultations Papers on guidelines under Markets in Crypto Assets Regulation (MiCA), one on reverse solicitation and one on the classification of crypto-assets as financial instruments. ESMA is seeking input on proposed guidance relating to the conditions of application of the reverse solicitation exemption and the supervision practices that National Competent Authorities may take to prevent its circumvention. ESMA is also seeking input on establishing clear conditions and criteria for the qualification of crypto-assets as financial instruments. [NEW]
EC Publishes Amendments to Clearing Obligation Scope in Light of Benchmark Reform. On January 22, the delegated regulation amending the regulatory technical standards (RTS) defining the scope of the clearing obligation (CO) was published in the EU Official Journal, with the amended requirements due to enter into force 20 days after publication. The European Commission (EC) stated that the amendments were introduced in light of the transition to the TONA and SOFR benchmarks referenced in certain over-the-counter derivatives contracts. The amendment to the scope of the CO consists of introducing TONA overnight indexed swaps (OIS) with maturities up to 30 years and extending the SOFR OIS class subject to the CO to maturities up to 50 years. The adoption follows the publication by ESMA, on February 1, 2023, of its final report on changes to the scope of the CO and the derivatives trading obligations (DTO) in light of the benchmark transition, following a consultation last year, to which ISDA responded on September 30, 2022. This ESMA report included two draft amending RTS: one draft RTS amending the scope of the CO and one draft RTS amending the scope of the DTO. The delegated regulation containing the RTS amending the scope of the CO has now been published. The RTS on the DTO has not yet been adopted.

New Industry-Led Developments

ISDA Response on Anti-Greenwashing Rules. On January 26, ISDA submitted a response to the UK Financial Conduct Authority’s consultation on xGC23/3: Guidance on the Anti-Greenwashing Rule. In the response, ISDA highlights that actual or perceived misrepresentation of sustainability features may have a detrimental impact on investor and consumer perceptions of sustainable finance products, and ISDA supports efforts to enhance trust in the market. ISDA considers that sustainability-linked derivatives, environmental, social and governance derivatives and voluntary carbon credits fall within the scope of the rule. [NEW]
Joint Response to EC on BMR. On January 23, ISDA, the Global Financial Markets Association and the Futures Industry Association (FIA) submitted a joint response to the EC call for feedback on the review of the scope and regime for non-EU benchmarks. The response sets out the associations’ comments on the EC’s proposal, along with potential draft amendments and additional revisions that were considered to support the EC’s aims. In the response, the associations welcome the EC’s recognition of the problems caused by the current drafting of the Benchmark Regulation (BMR). The associations support the aim of establishing a third-country regime that is sustainable in the long term once the current transitional regime expires, and overall consider that the proposal will result in a more proportionate regime for users and administrators of benchmarks. [NEW]
ISDA, FIA Respond to MAS Consultation on Amendments to the Capital Framework for Approved Exchanges and Clearing Houses. On January 22, ISDA and the FIA jointly responded to the consultation from the Monetary Authority of Singapore (MAS) on proposed amendments to the capital framework for approved exchanges and approved clearing houses. The scope of the response is limited to the capital framework for approved clearing houses. The associations stated that they welcomed the introduction of a separate liquidity requirement and proposed that MAS consider a more conservative minimum threshold of at least 12 months of operating expenses. They also agreed with the proposed amendments that capital components should only include equity instruments and exclude an approved clearing house’s skin-in-the-game. For total risk requirement, the response suggests the alignment of the operational risk component with the liquidity risk requirement and the inclusion of some clarifications on the investment risk and general counterparty risk components.
ISDA Launches Digital Version of 2002 ISDA Equity Derivatives Definitions. On January 18, ISDA launched a fully digital edition of the 2002 ISDA Equity Derivatives Definitions on the ISDA MyLibrary platform, enabling new versions to be released more efficiently as products and market practices evolve in the future. Following consultation with buy- and sell-side market participants, ISDA identified support to move the definitions to a digital format, develop new product provisions and streamline certain components over time. Publication of the 2002 ISDA Equity Derivatives Definitions in digital form is a first step and enables further changes to be made in future versions.
BCBS-IOSCO Report Sets Out Recommendations for Good Margin Practices in Non-Centrally Cleared Markets. On January 17, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) published a report on streamlining VM processes and IM responsiveness of margin models in non-centrally cleared markets, which sets out recommendations for market practices intended to enhance market functioning. The report articulates the policy analyses work carried out by the BCBS-IOSCO in two areas discussed in the September 2022 Review of margining practices: (i) exploring the need to streamline variation margin processes in non-centrally cleared markets and (ii) investigating the responsiveness of initial margin models in non-centrally cleared markets. The consultative report sets out eight recommendations intended to encourage the widespread implementation of good market practices but does not propose any policy changes to the BCBS-IOSCO frameworks. BCBS and IOSCO stated that the first four recommendations aim to address challenges that could inhibit a seamless exchange of variation margin during a period of stress. The other four highlight practices for market participants to implement initiatives in an effort to ensure the calculation of initial margin is consistently adequate for contemporaneous market conditions and proposes that supervisors should monitor whether these developments are sufficient to make this model responsive enough to extreme market shocks.
ISDA Launches Sustainability-linked Derivatives Clause Library. On January 17, ISDA launched a clause library for sustainability-linked derivatives (SLDs), designed to provide standardized drafting options for market participants to use when negotiating SLD transactions with counterparties. SLDs embed a sustainability-linked cashflow in a derivatives structure and use key performance indicators (KPIs) to monitor compliance with environmental, social and governance (ESG) targets, incentivizing parties to meet their sustainability objectives.
BCBS, CPMI, and IOSCO Publish Consultative Report on Transparency and Responsiveness of Initial Margin in Centrally Cleared Markets. On January 16, BCBS, the Bank for International Settlements’ Committee on Payments and Market Infrastructures (CPMI) and IOSCO jointly published a consultative report—Transparency and responsiveness of initial margin in centrally cleared markets– review and policy proposals—which interested parties are invited to comment on. BCBS, CPMI, and IOSCO stated that the ten policy proposals in the report aim to increase the resilience of the centrally cleared ecosystem by improving participants’ understanding of central counterparties (CCPs) initial margin calculations and potential future margin requirements. The proposals cover CCP simulation tools, CCP disclosures, measurement of initial margin responsiveness, governance frameworks and margin model overrides, and clearing member transparency.
ISDA and SIFMA Response to US Basel III NPR. On January 16, ISDA and the Securities Industry and Financial Markets Association (SIFMA) submitted a joint response on the US Basel III ‘endgame’ notice of proposed rulemaking (NPR). The response focuses on the Fundamental Review of the Trading Book (FRTB), the revised credit valuation adjustment (CVA) framework, the securities financing transactions requirements and elements of the standardized approach to counterparty credit risk rules. In the response, the associations propose a number of calibration changes to ensure the rules are appropriate and risk sensitive and avoid adverse consequences to US capital markets.
ISDA and SIFMA Response to G-SIB Surcharge Framework Consultation. On January 16, ISDA and SIFMA submitted a response to a consultation by the US Federal Reserve on proposed changes to the G-SIB surcharge. The response raises concerns that the revised G-SIB surcharge would lead to inappropriately high capital requirements for banks offering client clearing services, potentially discouraging them from participating in this business and contravening a long-standing policy objective to promote central clearing. Specifically, the response argues that client derivatives transactions cleared under the agency model should not be included in the complexity and interconnectedness categories of the G-SIB surcharge calculation.

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

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

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

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

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

Darius Mehraban, New York (212.351.2428, dmehraban@gibsondunn.com)

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

Adam Lapidus – New York (+1 212.351.3869, alapidus@gibsondunn.com)

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

Roscoe Jones Jr., Washington, D.C. (202.887.3530, rjones@gibsondunn.com)

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

David P. Burns, Washington, D.C. (202.887.3786, dburns@gibsondunn.com)

Marc Aaron Takagaki, New York (212.351.4028, mtakagaki@gibsondunn.com)

Hayden K. McGovern, Dallas (214.698.3142, hmcgovern@gibsondunn.com)

Karin Thrasher, Washington, D.C. (202.887.3712, kthrasher@gibsondunn.com)

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

Among the meaningful changes in the Final Rules, the Commission did not adopt a safe harbor from the “investment company” definition under the Investment Company Act of 1940, as amended (the “Investment Company Act”) for SPACs.

On January 24, 2024, the U.S. Securities and Exchange Commission (the “Commission”), by a three-to-two vote, adopted new rules and amendments (the “Final Rules”) to enhance disclosure and investor protections in initial public offerings (“IPO”) by special purpose acquisition companies (“SPACs”) and in subsequent business combinations between SPACs and private operating companies (“de-SPAC transaction”).[1]

The Final Rules are thematically aligned with the rule proposal issued by the Commission nearly two years ago in March 2020,[2] but with meaningful changes as noted below, including not adopting a safe harbor from the “investment company” definition under the Investment Company Act of 1940, as amended (the “Investment Company Act”) for SPACs.

The adopting release for the Final Rules (the “Adopting Release”) provides a lengthy and comprehensive discussion that builds upon the Commission’s prior statements and actions regarding SPAC IPOs and de-SPAC transactions.[3] As noted by the Commission’s Chair, Gary Gensler, in the accompanying press release, the Final Rules are intended to “help ensure that the rules for SPACs are substantially aligned with those of traditional IPOs.”[4] Chair Gensler further noted that the measures adopted in the Final Rules “will help protect investors by addressing information asymmetries, misleading information, and conflicts of interest in SPAC and de-SPAC transactions.”[5]

The Adopting Release is available here and a Fact Sheet is available here. The Final Rules will become effective 125 days after publication in the Federal Register. Compliance with the structured data requirements, which require tagging of information disclosed pursuant to new subpart 1600 of Regulation S-K in Inline XBRL, will be required 490 days after publication of the rules in the Federal Register.

I. Overview

There are four key components of the Final Rules:

Disclosure and Investor Protection. The Final Rules impose specific disclosure requirements with respect to, among other things, compensation paid to sponsors, potential conflicts of interest, shareholder dilution, and the fairness of the business combination, for both the SPAC IPOs and de‑SPAC transactions;
Business Combinations Involving Shell Companies. Under the Final Rules, the Commission will deem 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, as amended (the “Securities Act”), amend the financial statement requirements applicable to transactions involving shell companies, and 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, as amended (the “PSLRA”) when marketing a de-SPAC transaction;
Projections. The Final Rules amend the Commission’s guidance on the presentation of projections in any filings with the Commission (not only on de-SPAC transactions, but affecting all projections filed with the Commission) and adds new guidance only for de-SPAC transactions, in both instances to address the reliability of such projections; and
Status of SPACs under the Investment Company Act of 1940. The Proposed Rules included a safe harbor that qualifying SPACs could have used to avoid registering as investment companies under the Investment Company Act. The Final Rules do not include a safe harbor, and instead, the Commission takes the position that SPACs should consider investment company status in light of the facts and circumstances and provides further guidance on what actions might cause a SPAC to fall into the investment company definition.

We provide below our key takeaways, a summary of the Final Rules and links to Commissioner statements regarding the Final Rules.

II. Key Takeaways

Below are the key takeaways from the Final Rules:

Timing. Although the Final Rules will not be in effect for about 4 months, existing SPACs and their targets should expect to receive comments from the Commission staff along the broader lines of the Final Rules. SPACs and their targets also should consider the extent to which they will want to comply voluntarily with certain of the Final Rules, especially those focused on financial statement requirements and enhanced disclosures.
Conforming SPACs to Traditional IPOs. The Final Rules go to great lengths to contrast the current SPAC regulatory regime against the one applicable to traditional IPOs and to “level” the playing field between the two. Closer alignment of the two regimes may reduce some potential benefits of a de-SPAC transaction (g., availability of alternative financing sources and expedited path to becoming a public company) while also exposing the SPAC, its target and their advisors to additional liability.
No PSLRA Protection. The PSLRA safe harbor against a private right of action for forward-looking statements is not available in, among other transactions, an offering by a blank check company or a “penny stock” issuer, or in an initial public offering. Some market participants believed the PSLRA safe harbor was otherwise available in de-SPAC transactions when a SPAC is not a blank check company under Rule 419. Under the Final Rules, the Commission adopts a new definition of “blank check company” for purposes of the PSLRA making clear that SPACs may no longer rely on the safe harbor provision under the PSLRA as it relates to the use of projections and other forward-looking statements when marketing a de-SPAC The lack of the PSLRA safe harbor, especially coupled with enhanced disclosure requirements relating to projections under the Final Rules, may lead to changes in the presentation of projections and assumptions, or the abandonment of projections in a SPAC board’s evaluation of a potential de-SPAC target, which will further undermine the viability of the de-SPAC transaction as an alternative to traditional IPOs for target companies that do not have a lengthy operating history.
Co-Registrant Liability. The Final Rules impose Section 11 liability on target companies and their officers and directors as co-registrants under Form S-4 and Form F-4 Liability will now extend to both SPAC and target company disclosures contained in such filings. Target companies assessing a de-SPAC transaction should now consider whether its current director and officer liability insurance is sufficient prior to the filing of an initial Form S-4 or Form F-4 for its de-SPAC transaction given the potential for increased liability related to the target’s disclosures.
Extension of Current Disclosure Guidance (Projections, Dilution, Sponsor, Conflicts). The Final Rules codify current guidance and practice by the Commission, and require additional information and specificity (in some cases, beyond current rules and guidance). Nonetheless, some of the prescriptive rulemakings around enhanced disclosures—including required financial statements, disclosure of sources of dilution, sponsor control and relationships, and potential conflicts of interest—should not be particularly novel for practitioners as many of these requirements are based on existing rules and guidance.
Board Determination. If required by the law of the jurisdiction of a SPAC’s organization, a SPAC must disclose its board’s determination whether the de-SPAC transaction is advisable and in the best interests of the SPAC and its shareholders and discuss the material factors considered in making the determination. The Final Rules specify that such factors must include, without limitation and to the extent considered, the valuation of the target company, financial projections relied upon by the board of directors, the terms of any financing materially related to the de-SPAC transaction, the dilutive impact of the transaction, and any fairness opinion. While the Proposed Rules would have required disclosure of the SPAC board’s reasonable belief as to the fairness of a de-SPAC transaction and related financings to the SPAC’s shareholders when approving a de-SPAC transaction, that requirement is not included in the Final Rules. Coupled with the enhanced disclosure requirements related to any projections used in a de-SPAC transaction, the Final Rules may result in SPACs not using a target company’s projections to assess a transaction or for marketing purposes, and SPACs may decide against obtaining fairness opinions in connection with de-SPAC transactions.
Underwriter Liability. The Commission did not adopt its proposal of extending underwriter status (and resulting potential liability) in the de-SPAC transaction to those underwriters to SPAC IPOs involved, directly or indirectly, in the de-SPAC transaction (g., advisory services, placement agent services, and other activities related to the de-SPAC transaction would all be considered direct and indirect activities). Rather, the Commission noted in the Final Rules that it will apply the terms “distribution” and “underwriter” “broadly and flexibly” in light of the facts and circumstances of a particular transaction, including a de-SPAC transaction. The introduction of proposed underwriter liability in the Proposed Rules and pivot back to statutory interpretation creates further ambiguity and uncertainty on a going-forward basis. 2022 and 2023 saw a dramatic pullback by financial advisors in their participation in the SPAC market, and we anticipate that certain financial advisors will choose not to participate in SPAC IPOs and de-SPAC transactions as a result of the ambiguity under the Final Rules.
Investment Company Act Safe Harbor. The Commission did not adopt its proposed new safe harbor for SPACs under the Investment Company Act, which would have exempted SPACs from being treated as an “investment company” if the SPAC met certain subjective criteria, related to, among other things, the nature and management of the assets held by the SPAC and the SPAC’s general purpose. Similar to its approach with respect to SPAC IPO underwriter liability, the Final Rules opt to provide general guidance regarding activities that could cause a SPAC to be an “investment company.” As a result, SPACs should carefully assess and monitor their activities, and consider changing their operations if necessary to bring them into compliance with the Investment Company Act.

III. Summary of Final Rules

1. New Subpart 1600 of Regulation S-K

The Final Rules create a new Subpart 1600 of Regulation S-K solely related to SPAC IPOs and de-SPAC transactions. Among other things, this new Subpart 1600 prescribes specific disclosure requirements with respect to the sponsor, potential conflicts of interest, potential shareholder dilution, and fairness to shareholders.

Sponsor, Affiliates, and Promoters

To provide investors with a more complete understanding of the role of SPAC sponsors, affiliates, and promoters,[6] the Commission has adopted Item 1603(a) of Regulation S-K, to require:

Experience. Description of the experience, material roles, and responsibilities of sponsors, affiliates, and promoters.
Arrangements. Discussion of any agreement, arrangement, or understanding (i) between the sponsor and the SPAC, its officers, directors, or affiliates, in determining whether to proceed with a de-SPAC transaction and (ii) regarding the redemption of outstanding securities.
Sponsor Control. Discussion of the controlling persons of the sponsor and any persons who have direct or indirect material interests in the sponsor. The Commission declined to adopt the proposed requirement that SPACs also provide an organizational chart that shows the relationship between the SPAC, the sponsor, and the sponsor’s affiliates.
Lock-Ups. A table describing the material terms of any lock-up agreements with the sponsor and its affiliates.
Compensation. Discussion of the nature and amounts of all compensation (including securities issued by the SPAC) that has been or will be awarded to, earned by, or paid to the sponsor, its affiliates, and any promoters for all services rendered in all capacities to the SPAC and its affiliates, as well as the nature and amounts of any reimbursements to be paid to the sponsor, its affiliates, and any promoters upon the completion of a de-SPAC

Potential Conflicts of Interest

To provide investors with a more complete understanding of the potential conflicts of interest between (i) any SPAC sponsor or affiliate, target company officers and directors, or the SPAC’s officers, directors, or promoters, and (ii) unaffiliated security holders of the SPAC, the Commission adopted a new Item 1603(b) of Regulation S-K. This new Item includes a discussion of conflicts arising as a result of a determination to proceed with a de-SPAC transaction and from the manner in which a SPAC compensates the sponsor or the SPAC’s executive officers and directors, or the manner in which the sponsor compensates its own executive officers and directors.

Relatedly, Item 1603(c) of Regulation S-K will require disclosure of the fiduciary duties that each officer and director of a SPAC owes to other companies.

Sources of Dilution

In an effort to conform and enhance disclosure relating to dilution in SPAC IPOs and de-SPAC transactions, the Commission has adopted Items 1602 and 1604 of Regulation S-K, respectively.

IPO Dilution Disclosure. In providing disclosure pursuant to Item 506, SPAC disclosure previously estimated dilution as a function of the difference between the initial public offering price and the pro forma net tangible book value per share after the offering, often including an assumption of the maximum number of shares eligible for redemption in a de-SPAC transaction. The Final Rules will now require additional granularity on the prospectus cover page, requiring SPACs to present redemption scenarios in quartiles up to the maximum redemption scenario. In addition to changes to the cover page, the Final Rules also supplement Item 506 disclosure by requiring a description of material potential sources of future dilution following a SPAC’s initial public offering, as well as tabular disclosure of the amount of potential future dilution from the public offering price that will be absorbed by non-redeeming SPAC shareholders, to the extent quantifiable.
De-SPAC Dilution Disclosure. In addition to disclosure at the IPO stage of a SPAC’s lifecycle, the Final Rules require additional disclosure regarding material potential sources of dilution as a result of the de-SPAC As seen in comment letters issued by the Commission following the release of the Proposed Rules, the Commission has requested additional granularity with respect to post-closing pro forma ownership disclosure, often requiring the disclosure of various redemption thresholds and the effects of potential sources of dilution. The Final Rules now codify this practice by requiring disclosure in a tabular format that includes intervals representing selected potential redemption levels that may occur across a reasonably likely range of outcomes. The Final Rules do not prescribe specific redemption levels for which dilution information must be provided, but looking at the SPAC IPO dilution requirements (as discussed above), quartile disclosure up to the maximum redemption scenario may be acceptable.

Board Determination Regarding De-SPAC Transaction

Under Item 1606, if the law of the jurisdiction of the SPAC’s organization requires the SPAC’s board of directors to determine whether the de-SPAC transaction is advisable and in the best interests of the SPAC and its shareholders, then the SPAC will be required to disclose that determination. Item 1606 of Regulation S-K will also require a discussion, of the material factors considered in making that determination. This is one of the few areas of the Final Rule where the Commission declined to adopt a more stringent standard, with the initial proposed rule creating a potential “backdoor” opinion requirement by asking that a board of directors affirmatively state whether it reasonably believes a de-SPAC transaction, including any related financing, was fair to the unaffiliated securityholders of the SPAC.

Relatedly, if any director voted against, or abstained from voting on, approval of the de-SPAC transaction or any related financing transaction, SPACs would be required to identify the director, and indicate, if known, after making reasonable inquiry, the reasons for the vote against the transaction or abstention.

2. Aligning De-SPAC Transactions with IPOs

Target Company as Co-Registrant

Under the current rules, only the SPAC and its officers and directors are required to sign the registration statement and are liable for material misstatements or omissions. The Final Rules require the target company to be treated as a co-registrant with the SPAC when a Form S-4 or Form F-4 registration statement is filed by the SPAC in connection with a de-SPAC transaction.[7] Registrant status for a target company and its officers and directors will result in such parties being liable for material misstatements or omissions pursuant to Section 11 of the Securities Act. Under the Final Rules, target companies and their officers and directors will be liable with respect to their own material misstatements or omissions, as well as any material misstatements or omissions made by the SPAC or its officers and directors. As a result, the Final Rules seeks to further incentivize target companies and SPACs to be diligent in monitoring each other’s disclosure.

Smaller Reporting Company Status

Currently, de-SPAC companies are able to avail themselves – as almost all SPACs have done since 2016[8] – of the smaller reporting company rules for at least one year following the de-SPAC transaction (and most SPACs would still retain this status at the time of the de-SPAC transaction when the SPAC is the legal acquirer of the target company). The “smaller reporting company” status benefits the combined company after the de-SPAC transaction by availing it of scaled disclosure and other accommodations as it adjusts to being a public company.

Citing the disparate treatment between traditional IPO companies and de-SPAC companies (the former having to determine smaller reporting company status at the time it files its initial registration statement and the latter retaining the SPAC’s smaller reporting company status until the next annual determination date), the Final Rules require de-SPAC companies to determine compliance with the public float threshold (i.e., public float of (i) less than $250 million, or (ii) in addition to annual revenues less than $100 million, less than $700 million or no public float)[9] prior to the time it makes its first filing with the Commission (other than the Form 8-K filed with Form 10 information).

The public float must be measured as of a date within four business days after the consummation of the de-SPAC transaction. The revenue threshold must be determined by using the annual revenues of the target company as of the most recently completed fiscal year for which audited financial statements are available. The de-SPAC company must reflect its re-determination in its first periodic report due after a 45-day period following the consummation of the de-SPAC transaction.

Target companies will need to consider the burdens of additional reporting requirements in light of the potential of not being able to qualify as a smaller reporting company following their de-SPAC transactions.

PSLRA Safe Harbor

The PSLRA provides a safe harbor for forward-looking statements under the Securities Act and the Securities Exchange Act of 1934, as amended (the “Exchange Act”), under which a company is protected from liability for forward-looking statements in any private right of action under the Securities Act or Exchange Act when, among other things, the forward-looking statement is identified as such and is accompanied by meaningful cautionary statements.

The safe harbor, however, is not available when the forward looking statement is made in connection with an offering by a “blank check company,” a company that is (i) a development stage company with no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person, and (ii) is issuing “penny stock.”[10]

Because of the penny stock requirement, many practitioners have considered SPACs to be afforded protection under the PSLRA safe harbor as it does not otherwise meet the second prong of the definition of blank check company for purposes of the PSLRA safe harbor. The Final Rules will adopt a new definition of “blank check company” for purposes of the PSLRA to remove the penny stock requirement, thus effectively removing a SPAC’s ability to qualify for the PSLRA safe harbor provision for the de-SPAC transaction.

This inability to rely on the PSLRA is coupled with the Final Rules’ addition of new and modified projections disclosure requirements (as further discussed below). It remains unclear whether the application of the Final Rules will lead to changes in the use of projections and assumptions (especially considering the current environment where market participants, investors, and financiers have come to expect detailed projections disclosure, similar to what is used in public merger and acquisitions (“M&A”) transactions), or the abandonment of projections in assessing and marketing a de-SPAC transaction.

Underwriter Status and Liability

Historically, Section 11 and Section 12(a)(2) of the Securities Act[11] have imposed underwriter liability on underwriters of a SPAC’s IPO. The Commission declined to adopt its proposal to establish that a de-SPAC transaction would constitute a “distribution” under applicable underwriter regulations, which would have automatically extended underwriter liability to the SPAC IPO underwriter if it engaged in certain de-SPAC activities or compensation arrangements.

Instead, the Final Rules provide general guidance regarding statutory underwriter status, following its “longstanding practice of applying the statutory terms “distribution” and “underwriter” broadly and flexibly, as the facts and circumstances of any transaction may warrant.”[12] The Commission may find a “statutory underwriter” where someone is selling for the issuer or participating in the distribution of securities in the combined company to the SPAC’s investors and the broader public, even though it may not be named as an underwriter in any given offering or may not be engaged in activities typical of a named underwriter in traditional capital raising.[13]

The Commission’s extensive broad interpretation of the concept of “statutory underwriter,” coupled with the traditional “due diligence” defenses of underwriters,[14] suggests that SPACs and target companies should expect extensive diligence requests from financial institutions, advisors, and their counsel in connection with a de-SPAC transaction, requests from investment banks that advisors to a SPAC and its target provide negative assurance and comfort letters in connection with the de-SPAC transaction, and other related changes to the de-SPAC transaction process that add complexity, time, and cost.

3. Business Combinations Involving Shell Companies

The Commission’s concern related to private companies becoming U.S. public companies via de-SPAC transactions is substantially related to the perceived opportunity for such private companies to avoid “Securities Act registration and the related disclosures which are intended to protect investors.”[15]

Rule 145a

Based on the structure of certain de-SPAC transactions, the Commission expressed concern that, unlike investors in transaction structures in which the Securities Act applies (and a registration statement would be filed, absent an exemption), investors in reporting shell companies may not always receive the disclosures and other protection afforded by the Securities Act at the time the change in the nature of their investment occurs, due to the business combination involving another entity that is not a shell company.

Rule 145a intends to address the issue by deeming any direct or indirect business combination of a reporting shell company (other than a business combination related shell company) involving another entity that is not a shell company constitutes “a sale of securities to the reporting shell company’s shareholders.”[16] By deeming such transaction to be a “sale” of securities for the purposes of the Securities Act, the Final Rule is intended to address potential disparities in the disclosure and liability protections available to shareholders of reporting shell companies, depending on the transaction structure deployed.

Rule 145a defines a reporting shell company as a company (other than an asset-backed issuer as defined in Item 1101(b) of Regulation AB) that has:

no or nominal operations;
either:
- no or nominal assets;
- assets consisting solely of cash and cash equivalents; or
- assets consisting of any amount of cash and cash equivalents and nominal other assets; and
an obligation to file reports under Section 13 or Section 15(d) of the Exchange Act.

The Final Rule notes that the sales covered by Rule 145a will not be covered by the exemption provided under Section 3(a)(9) of the Securities Act, because the exchange of securities would not be exclusively with the reporting shell company’s existing security holders, but also would include the target company’s existing security holders.

We would also note that this provision has broader market implications as it would apply to all reporting shell companies (other than a “business combination related shell company,” as defined in Rule 405 under the Securities Act and Rule 12b-2 under the Exchange Act), and not just SPAC transactions.

Financial Statement Requirements in Business Combination Transactions Involving Shell Companies

The Final Rule amends the financial statements required to be provided in a business combination with an intention to bridge the gap between such financial statements and the financial statements required to be provided in an IPO. The Commission views such Final Rule as simply codifying “current staff guidance for transactions involving shell companies.”[17] While the below information is presented in the context of a de-SPAC transaction, we would note that these requirements will apply to all shell companies (other than a “business combination related shell company,” as defined in Rule 405 under the Securities Act and Rule 12b-2 under the Exchange Act), and not just SPAC transactions.

Number of Years of Financial Statements

Rule 15-01(b) will require a registration statement for a de-SPAC transaction where a business is combining with a shell company registrant to include the same financial statements for that business as would be required in a Securities Act registration statement for an IPO of that business.

Audit Requirements

Rule 15-01(a) will require the examination of the financial statements of a business that is or will be a predecessor to a shell company to be audited by an independent accountant in accordance with the standards of the Public Company Accounting Oversight Board (“PCAOB”) for the purpose of expressing an opinion, to the same extent as a registrant would be audited for an IPO, effectively codifying the staff’s existing guidance.[18]

Age of Financial Statements

Rule 15-01(c) will provide for the age of the financial statements of a business involved in a business combination with a shell company to be based on whether such private company would qualify as a smaller reporting company in a traditional IPO process, ultimately aligning with the financial statement requirements in a traditional IPO.

Acquisitions of a Business or Real Estate Operation by a Predecessor

The Commission is implementing a series of rules intended to clarify when companies should disclose financial statements of businesses acquired by SPAC targets or where such business are probable of being acquired by SPAC targets. Rule 15-01(d) will address situations where financial statements of other businesses (other than the predecessor) that have been acquired or are probable to be acquired should be included in a registration statement or proxy/information statement for a de-SPAC transaction. The Final Rule will require application of Rule 3-05 and Rule 8-04 (or Rule 3-14 and Rule 8-06 with respect to real estate operation) of Regulation S-X to acquisitions by a predecessor to the shell company, which the staff views as codifying its existing guidance.

Amendments to the significance tests in Rule 1-02(w) of Regulation S-X will require the significance of the acquisition target of the private target in a de-SPAC transaction to be calculated using the SPAC’s target’s financial information, rather than the SPAC’s financial information.

In addition, Rule 15-01(d)(2) will require the de-SPAC company to file the financial statements of a recently acquired business, that is not or will not be its predecessor pursuant to Rule 3-05(b)(4)(i) in an Item 2.01(f) of Form 8-K filed in connection with the closing of the de-SPAC transaction where such financial statements were omitted from the registration statement for the de-SPAC transaction, to the extent the significance of the acquisition is greater than 20% but less than 50%.

Financial Statements of a Shell Company Registrant after the Combination with Predecessor

Rule 15-01(e) allows a registrant to exclude the financial statements of a SPAC for the period prior to the de-SPAC transaction if (i) all financial statements of the SPAC have been filed for all required periods through the de-SPAC transaction, and (ii) the financial statements of the registrant include the period on which the de-SPAC transaction was consummated. The Final Rule eliminates any distinction between a de-SPAC structured as a forward acquisition or a reverse recapitalization.

Other Amendments

In addition, the Final Rules are also addressing the following related amendments:

amendment of Item 2.01(f) of Form 8-K to (i) refer to “predecessor,” rather than “registrant,” to clarify that the information required to be provided “relates to the acquired business and for periods prior to consummation of the acquisition”[19] and (ii) establish that registrant need not present audited financial statements for predecessor for any period prior to the earliest audited period if, at the time of filing, the predecessor meets the conditions of an “emerging growth company”; and
amendment of Rules 3-01, 8-02, and 10-01(a)(1) of Regulation S-X to expressly refer to the balance sheet of the predecessors, consistent with the provision regarding income statements.

4. Enhanced Projections Disclosure

Disclosure of financial projections is not expressly required by the U.S. federal securities laws; however, it has been common practice for SPACs to use projections of the target company and post-de-SPAC company in its assessment of a proposed de-SPAC transaction, its investor presentations, and soliciting material once a definitive agreement is executed.

The Final Rules amend existing Commission guidance under Item 10(b) of Regulation S-K with respect to the use of any projections of future economic performance for any registrant and persons other than the registrant for any filings subject to Regulation S-K, as well as to add new, supplemental disclosure requirements applying only to de-SPAC transactions, under the new Item 1609 of Regulation S‑K.

Amended Item 10(b) of Regulation S-K

Under Item 10(b) of Regulation S-K, management may present projections regarding a registrant’s future performance, provided that (i) there is a reasonable and good faith basis for such projections, and (ii) they include disclosure of the assumptions underlying the projections and the limitations of such projections, and the presentation and format of such projections. Citing concerns of instances where target companies have disclosed projections that lack a reasonable basis,[20] the Final Rules amend Item 10(b) of Regulation S-K as follows:[21]

Clarification of Applicability to Target Company. Item 10(b) of Regulation S-K currently refers to projections regarding the “registrant.” The Final Rule will modify the language to clarify that the guidance therein applies to any projections of future economic performance of both the registrant and persons other than the registrant (which would include a target company in a de-SPAC transaction), that are included in the registrant’s Commission filings.
Historical Results. Disclosure of projected measures that are not based on historical financial results or operational history should be clearly distinguished from projected measures that are based on historical financial results or operational history.
Prominence of Historical Results. Similar to non-GAAP presentation, the Commission will consider it misleading to present projections that are based on historical financial results or operational history without presenting such historical measure or operational history with equal or greater prominence.
Non-GAAP Measures. Presentation of projections that include a non-GAAP financial measure should include a clear definition or explanation of the measure, a description of the GAAP financial measure to which it is most closely related, and an explanation why the non-GAAP financial measure was used instead of a GAAP measure. The Final Rule notes that the reference to the nearest GAAP measure called for by amended Item 10(b) will not require a reconciliation to that GAAP measure; however, the need to provide a GAAP reconciliation for any non-GAAP financial measures will continue to be governed by Regulation G and Item 10(e) of Regulation S-K.

Important to note that the guidance in the amended Item 10(b) applies to all projections of future economic performance of any registrant and persons other than the registrant that are included in the registrant’s filings with the Commission (not only to de-SPAC transactions).

Proposed Item 1609 of Regulation S-K

In light of the traditional SPAC sponsor compensation structure (i.e., compensation in the form of post-closing equity) and the potential incentives and overall dynamics of a de-SPAC transaction, the Commission has adopted a new rule specific to de-SPAC transactions that will supplement the amendments to Item 10(b) of Regulation S-K (as discussed above). Specifically, the new Item 1609 of Regulation S-K that will require SPACs to provide the accompanying disclosures to financial projections:

Purpose of Projections. Any projection disclosed by the registrant in the filing (or any exhibit thereto) must include disclosure regarding (i) the purpose for which the projection was prepared, and (ii) the party that prepared the projection.
Bases and Assumptions. Disclosure will include all material bases of the disclosed projections and all material assumptions underlying the projections, and any material factors that may materially affect such assumptions. This would include a discussion of any factors that may cause the assumptions to be no longer reasonable, material growth or reduction rates or discount rates used in preparing the projections, and the reasons for selecting such growth or reduction rates or discount rates[22].
Views of Management and the Board. Disclosure must discuss whether or not the projections disclosed continue to reflect the views of the board of directors (or similar governing body) and/or management of the SPAC or target company, as applicable, as of the most recent practicable date prior to the date of the disclosure document required to be disseminated to security holders. If the projections do not continue to reflect the views of the board of directors (or similar governing body) and/or management, the SPAC should include a discussion of the purpose of disclosing the projections and the reasons for any continued reliance by the management or board on the projections.

Similar to the amendments to Item 10(b), the first two requirements summarized above should not come as a particular surprise to existing SPACs and their counsel as projections disclosure has been a significant area of scrutiny by the Commission in the registration statement and proxy statement review process.

We note, however, that the requirement under Item 1609 to add disclosure as to management’s and/or the board’s current views likely will require additional disclosure beyond what has been typical market practice. In particular, projections disclosure in a registration statement or proxy statement is often made in the context of a historical lookback to the projections in place at the time the board of directors of the SPAC assessed whether to enter into a de-SPAC transaction with the target company. These projections typically are not updated with newer data during the pendency of the transaction since the purpose of such disclosure is to inform investors of the board’s rationale for approving the transaction. Item 1609 does not explicitly require the updating of projections, but it does require the parties to disclose whether the included projections reflect the view of the SPAC and the target company as of the date of filing. Moreover, the potential to provide revised projections, coupled with obligations to disclose management’s and board’s continuing views, may prove challenging disclosure to be made between the signing of a business combination agreement and the filing of a registration statement or proxy statement and during the review period for such registration statement or proxy statement.

5. Status of SPACs under the Investment Company Act of 1940

Because pre-transaction SPACs are not engaged in any meaningful business other than investing their IPO proceeds, there has been uncertainty regarding whether they are “investment companies” under the Investment Company Act of 1940.[23] The Proposed Rules included a safe harbor that would have excluded certain SPACs from being defined as investment companies; however, the Commission instead set forth in the Final Rules facts and circumstances guidance relevant to investment-company classification using the five Tonopah factors employed in the standard analysis.[24]

Nature of SPAC Assets and Income. If a SPAC were to invest in investment securities like corporate bonds—especially if those investments exceeded 40% of the SPAC’s assets—it would likely be an investment company. (Assets commonly held by SPACs today, such as U.S. government securities, money market funds, and cash, likely would not count heavily toward investment-company status.) Similarly, if a SPAC were to derive most of its income from investment securities, it would likely be an investment company.
Management Activities. If a SPAC were to hold investment securities while its managers did not actively seek a de-SPAC transaction, or while its managers actively managed those securities to achieve investment returns, the SPAC would more likely be an investment company. Relatedly, SPAC sponsors should be aware that they may be classified as “investment advisors” under the Investment Advisors Act of 1940.[25]
Duration. The longer a SPAC takes to achieve a de-SPAC transaction, the more likely its investment-company-like characteristics qualify it as an investment company. The Commission identifies two timelines as relevant for this analysis. Rule 3a-2 under the Investment Company Act provides a one-year safe harbor for “transient investment companies.” And blank-check companies under Investment Company Act Rule 419 are not investment companies because their duration is limited to 18 months. Because these timelines reflect the Commission’s thinking in similar circumstances, though outside of the SPAC context, SPACs operating beyond 12 or 18 months should assess whether they otherwise qualify as investment companies.
Holding Out. A SPAC that markets itself like an investment company is likely to be considered to be an investment company. For example, a SPAC that advertises itself an alternative to mutual funds is holding itself out as an investment company.
Merging with an Investment Company. A SPAC that proposes to engage in a de-SPAC transaction with an investment company is likely to itself be an investment company.

SPACs should carefully assess all the facts and circumstances to determine whether they must register as investment companies. In particular, they should pay attention to the 12- and 18-month thresholds and whether investment securities account for most of their assets, income, or efforts.

IV. Conclusions

These Final Rules come as no surprise to SPAC market participants. Indeed, a comparison of existing de-SPAC transaction disclosure practices with many of the Final Rules merely evidences a codification of what the market has already adopted and anticipated over the nearly twenty-two month period since the Proposed Rules were first released. While the market appears to have already anticipated some of these changes, it remains to be seen whether the Final Rules will have any meaningful effect on current market conditions, as evidenced by the substantial retraction in the SPAC market over the last year, or if the SPAC market itself has naturally run its course in light of broader macro-economic trends.

Although we may view many of the Final Rules as reiterating the status quo, the Commission’s efforts here are noteworthy in that the Final Rules also touch upon broader market considerations. For example, the Final Rules’ facts and circumstances guidance with respect to the applicability of “underwriter” or “investment company” status, and the changes to Item 10(b) related to projections disclosure, are not limited solely to SPACs and should be considered relevant to other public market participants and advisors in similar and adjacent circumstances. As a result, we encourage our clients and public market participants to reach out to us to see how this rulemaking may affect their going-forward operations and business plans.

V. Commissioner Statements

For the published statements of the Commissioners, please see the following links:

Commissioner Jaime Lizárraga

Commissioner Caroline A. Crenshaw

Commissioner Mark T. Uyeda (Dissenting)

Commissioner Hester M. Peirce (Dissenting)

[1] U.S. Securities and Exchange Commission, Special Purpose Acquisition Companies, Shell Companies, and Projections, Exchange Act Release No. 99418 (January 24, 2024) (“Final Rules”), available at https://www.sec.gov/files/rules/final/2024/33-11265.pdf.

[2] For our discussion of the proposed rules, see Gibson, Dunn & Crutcher LLP, SEC Proposes Rules to Align SPACs More Closely with IPOs (April 6, 2022), available at https://www.gibsondunn.com/sec-proposes-rules-to-align-spacs-more-closely-with-ipos/.

[3] See Gibson, Dunn & Crutcher LLP, SEC Staff Issues Cautionary Guidance Related to Business Combinations with SPACs (April 6, 2021), link here (addressing certain accounting, financial reporting and governance issues related to SPACs and the combined company following a SPAC business combination), see also Gibson, Dunn & Crutcher LLP, SEC Division of Corporation Finance Issues Interpretations Addressed to SPACs’ Business Combinations (March 24, 2022), link here (discussing new Compliance and Disclosure Interpretations that addressed certain issues related to the business combination process of de-SPAC transactions), and Gibson, Dunn & Crutcher LLP, SEC Publishes C&DIs Addressing Tender Offer Issues (March 17, 2023), link here (discussing new Compliance and Disclosure Interpretations that addressed various tender offer issues in connection with de-SPAC transactions).

[4] U.S. Securities and Exchange Commission, Press Release (2024-8), SEC Adopts Rules to Enhance Investor Protections Relating to SPACs, Shell Companies, and Projections (January 24, 2024), available at https://www.sec.gov/news/press-release/2024-8.

[5] Id.

[6] The term “promoter” is defined in Securities Act Rule 405 and Exchange Act Rule 12b-2.

[7] Under Section 6(a) of the Securities Act, each “issuer” must sign a Securities Act registration statement. The Securities Act broadly defines the term “issuer” to include every person who issues or proposes to issue any securities.

[8] Final Rules, p. 220.

[9] 17 CFR 229.10(f)(1).

[10] The term “penny stock” is defined in 17 CFR 240.3a51-1.

[11] Section 11 of the Securities Act imposes on underwriters, among other parties identified in Section 11(a), civil liability for any part of the registration statement, at effectiveness, which contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading, to any person acquiring such security. Further, Section 12(a)(2) imposes liability upon anyone, including underwriters, who offers or sells a security, by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading, to any person purchasing such security from them.

[12] Final Rules, p. 284

[13] Id., p. 285

[14] Although the Securities Act does not expressly require an underwriter to conduct a due diligence investigation, the Final Rules reiterates the Commission’s long-standing view that underwriters nonetheless have an affirmative obligation to conduct reasonable due diligence. Final Rules, p. 288. This was also mentioned by the Commission in fn. 184 of the Proposed Rule (citing In re Charles E. Bailey & Co., 35 S.E.C. 33, at 41 (Mar. 25, 1953) (“[An underwriter] owe[s] a duty to the investing public to exercise a degree of care reasonable under the circumstances of th[e] offering to assure the substantial accuracy of representations made in the prospectus and other sales literature.”); In re Brown, Barton & Engel, 41 SEC 59, at 64 (June 8, 1962) (“[I]n undertaking a distribution . . . [the underwriter] had a responsibility to make a reasonable investigation to assure [itself] that there was a basis for the representations they made and that a fair picture, including adverse as well as favorable factors, was presented to investors.”); In the Matter of the Richmond Corp., infra note 185 (“It is a well-established practice, and a standard of the business, for underwriters to exercise diligence and care in examining into an issuer’s business and the accuracy and adequacy of the information contained in the registration statement . . . The underwriter who does not make a reasonable investigation is derelict in his responsibilities to deal fairly with the investing public.”)).

[15] Final Rules, p. 290.

[16] Id., p. 290-91.

[17] Id., p. 112 (citing the staff guidance under the Division of Corporation Finance’s Financial Reporting Manual).

[18] Id., p. 112 (citing the staff guidance under the Division of Corporation Finance’s Financial Reporting Manual at Section 4110.5).

[19] Id., p. 339.

[20] For example, the Commission cites to recent enforcement actions against SPACs, alleging the use of baseless or unsupported projections about future revenues and the use of materially misleading underlying financial projections. See, e.g., In the Matter of Momentus, Inc., et al., Exch. Act Rel. No. 34-92391 (July 13, 2021); SEC vs. Hurgin, et al., Case No. 1:19-cv05705 (S.D.N.Y., filed June 18, 2019); In the Matter of Benjamin H. Gordon, Exch. Act Rel. No. 34-86164 (June 20, 2019); and SEC vs. Milton, Case No. 1:21-cv-6445 (S.D.N.Y., filed July 29, 2021).

[21] The Final Rules made three technical revisions to item 10(b). The first two changes are to enhance clarity and avoid potential ambiguity. The third revision is to create consistency with the terms used in existing Item 10(e)(1)(i)(A) of Regulation S-K. In Item 10(b)(2)(i), they replaced the term “foregoing measures of income” with the term “foregoing measurers of income (loss).” In Item 10(b)(2)(iii), they replaced the term “historical financial measure” with the term “historical financial results.” In Item 10(b)(2)(iv), they revised the item to require a description of the GAAP financial measure “most directly comparable” to the non-GAAP measure, rather than “mostly closely related.”

[22] Two examples of “discount rates” are: (1) the weighted average cost of capital used to discount to present value the future cash flows over the period of years projected in a discounted cash flow analysis and (2) the rate applied to the terminal value in a discounted cash flow analysis to calculate its present value.

[23] See 15 U.S.C. §§ 80a-3(a)(1)(A), (a)(1)(C).

[24] See In the Matter of Tonopah Mining Co., 26 S.E.C. 426 (July 21, 1947).

[25] See 15 U.S.C. § 80b-2(a)(11).

__________

The following Gibson Dunn attorneys assisted in preparing this update: Evan D’Amico, Gerry Spedale, James Springer, and Rodrigo Surcan.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Capital Markets, Mergers and Acquisitions, Securities Enforcement, or Securities Regulation and Corporate Governance practice groups, or the following practice leaders and authors:

Evan M. D’Amico – Washington, D.C. (+1 202.887.3613, edamico@gibsondunn.com)
Gerry Spedale – Houston (+1 346.718.6888, gspedale@gibsondunn.com)
James O. Springer – Washington, D.C. (+1 202.887.3516, jspringer@gibsondunn.com)
Rodrigo Surcan – New York (+1 212.351.5329, rsurcan@gibsondunn.com)

Mergers and Acquisitions:
Robert B. Little – Dallas (+1 214.698.3260, rlittle@gibsondunn.com)
Saee Muzumdar – New York (+1 212.351.3966, smuzumdar@gibsondunn.com)

Capital Markets:
Andrew L. Fabens – New York (+1 212.351.4034, afabens@gibsondunn.com)
Hillary H. Holmes – Houston (+1 346.718.6602, hholmes@gibsondunn.com)
Stewart L. McDowell – San Francisco (+1 415.393.8322, smcdowell@gibsondunn.com)
Peter W. Wardle – Los Angeles (+1 213.229.7242, pwardle@gibsondunn.com)

Securities Regulation and Corporate Governance:
Elizabeth Ising – Washington, D.C. (+1 202.955.8287, eising@gibsondunn.com)
James J. Moloney – Orange County (+1 949.451.4343, jmoloney@gibsondunn.com)
Lori Zyskowski – New York (+1 212.351.2309, lzyskowski@gibsondunn.com)
Brian J. Lane – Washington, D.C. (+1 202.887.3646, blane@gibsondunn.com)
Ronald O. Mueller – Washington, D.C. (+1 202.955.8671, rmueller@gibsondunn.com)
Thomas J. Kim – Washington, D.C. (+1 202.887.3550, tkim@gibsondunn.com)
Mike Titera – Orange County (+1 949.451.4365, mtitera@gibsondunn.com)
Aaron Briggs – San Francisco (+1 415.393.8297, abriggs@gibsondunn.com)
Julia Lapitskaya – New York (+1 212.351.2354, jlapitskaya@gibsondunn.com)

An analysis of important trends and developments in AML regulation and enforcement, including key priorities emphasized by enforcers, notable enforcement actions and prosecutions, significant judicial opinions, and an important legislative development.

U.S. enforcers increasingly rely on the anti-money laundering (“AML”) statutes to police a wide variety of conduct. Broadly speaking, there are two types of AML statutes: (1) statutes that prohibit certain conduct (for example, knowingly engaging in a financial transaction with the intent to conceal unlawful activity), or (2) statutes that impose affirmative obligations on certain types of businesses to engage in identification and reporting of suspicious financial activity (for example, the Bank Secrecy Act (“BSA”)).

In this alert, we analyze the most important trends and developments in AML regulation and enforcement by recapping significant developments during the preceding year. In this inaugural edition, we recap 12 of the most important developments of 2023, including key priorities emphasized by enforcers, notable enforcement actions and prosecutions, significant judicial opinions, and an important legislative development.

Agency Priorities

We begin with a look at some of the U.S. government’s most significant priorities in the AML space: national security and the Corporate Transparency Act.

The Biden Administration Continues to Focus on National Security and AML

In 2023, the Biden administration prioritized investigations and prosecutions in the national security arena, particularly those implicating AML and sanctions. Department of Justice (“DOJ”) officials have repeatedly described sanctions as “the new FCPA”—relevant to an expanding number of industries, the focus of an increasingly multilateral enforcement regime, and subject to voluntary self-disclosure incentives.[1] Even businesses far removed from the defense sector such as tobacco, cement, and shipping faced enforcement actions for allegedly paying insufficient attention to the national security risks posed by certain actors, regions, and activities.[2] Further, money laundering-related cases now routinely intersect with international sanctions and export control violations.[3]

The U.S. government has backed its enforcement priorities with substantial resourcing. DOJ’s National Security Division designated its first Chief Counsel for Corporate Enforcement, Ian Richardson, and announced the hiring of 25 new prosecutors to investigate national security-related economic crimes.[4] Moreover, the Criminal Division’s Bank Integrity Unit likewise added six prosecutors—a 40 percent increase—to target national security-related financial misconduct.[5]

DOJ, along with the Departments of Treasury and Commerce, has embraced a “whole of government” approach to national security and illicit finance. One example is its growing use of inter-agency task forces. In 2023, DOJ’s Task Force Kleptocapture hit its stride with asset seizures (using inter alia money-laundering seizure theories) totaling more than $500 million of criminal assets with ties to the Russian regime.[6] Building on the success of Kleptocapture, the Departments of Justice and Commerce also launched the Disruptive Technology Strike Force,[7] a multi-agency task force that works to prevent U.S. adversaries from illicitly acquiring sensitive U.S. technology. The Disruptive Technology Strike Force already has brought money laundering prosecutions against those who allegedly evaded U.S. trade restrictions.[8] DOJ and Treasury—along with U.S. allies—have likewise continued to convene the Russian Elites, Proxies, and Oligarchs (REPO) Task Force.[9] This task force works to investigate and counter Russian sanctions evasion, including cryptocurrency and money laundering, and has blocked or frozen more than $58 billion of sanctioned Russian assets.[10]

U.S. enforcers have also released a number of alerts emphasizing the interplay between money laundering and national security issues. Treasury’s Financial Crimes Enforcement Network (“FinCEN”) is the U.S. government’s leading anti-money laundering regulator. In 2023, FinCEN issued three AML alerts to help detect potentially suspicious activity relating to Hamas’s financing and Russian export control violations.[11] FinCEN also issued supplemental AML alerts with Commerce’s Bureau of Industry and Security (“BIS”) that highlighted export evasion typologies.[12] In a similar vein, DOJ’s National Security Division began issuing joint advisories with Commerce and Treasury that provide the private sector with information about enforcement actions against those who use money laundering to support violations of U.S. sanctions and export controls.[13]

The Corporate Transparency Act’s Reporting Requirements to Assist AML Investigations

In January of 2021, the Anti-Money Laundering Act of 2020 became law.[14] One of the provisions in the bill was the Corporate Transparency Act (“CTA”), which established a new regime in the United States requiring many corporate entities to file a form with FinCEN disclosing their beneficial owners.[15]

To implement the CTA, FinCEN has currently issued two rules (with a third in progress). The first rule, the “Reporting Rule,” sets forth which entities need to disclose their beneficial ownership information (“BOI”) to FinCEN and by when. Entities subject to these reporting requirements include both “domestic reporting companies” and “foreign reporting companies.” Domestic reporting companies are defined as corporations, limited liability companies, or any other entity created by the filing of a document with a secretary of state or tribal nation.[16] Foreign reporting companies are corporations, LLCs, or other entities formed under the laws of a foreign country and registered to do business within any U.S. state.[17]

Domestic and foreign reporting companies must file BOI data with FinCEN unless an exemption applies. The CTA affords 23 exemptions for various entities—including public companies, money services businesses, select banks and credit unions, and large operating companies, defined as having more than 20 full time employees, an office space, and $5 million in gross receipts or sales in the United States the prior tax year.[18] There is also an exemption for investment advisers and investment funds, as detailed further in a prior Gibson Dunn client alert.[19] Additionally, subsidiaries of certain exempt entities need not report BOI information in particular circumstances as well.[20] However, pursuant to recent guidance from FinCEN, that exception only applies to subsidiaries that are “fully, 100 percent owned or controlled by an exempt entity.”[21]

If no exemption applies, then select domestic and foreign entities must disclose relevant BOI information. In general, these BOI reports must identify two categories of individuals: (1) the beneficial owners of the entity (defined as those natural persons who own at least 25% of the entity or who exercise “substantial control” over it); and (2) the company applicants of the entity (meaning those directly involved in or responsible for the filing that creates the company).[22] Companies formed before January 1, 2024, however, need only submit the names of their beneficial owners and not the identities of company applicants.[23] FinCEN’s Reporting Rule became operative as of January 1, 2024, with the regulation specifying varying deadlines for submission of BOI data.[24]

The effects of the CTA will continue to unfold in the coming months and years, but it has created significant work for companies as they sort through which of their corporate entities have any reporting obligations.

Notable Corporate AML Resolutions

2023 saw a number of notable AML resolutions. We discuss those which broke new ground below.

MindGeek: A Novel Application of The Spending Statute, 18 U.S.C. § 1957

In a prototypical case, U.S. prosecutors must prove three things to establish a violation of the general money laundering statute (18 U.S.C. § 1956): (1) the commission of an underlying felony (a “Specified Unlawful Activity” or “SUA”); (2) knowingly engaging in a financial transaction; and (3) specific intent to conceal or further the SUA through the financial transaction.[25] U.S. enforcers, however, have a second powerful tool at their disposal—the money laundering “spending statute” (18 U.S.C. § 1957). In a case involving the spending statute, prosecutors are relieved of the burden to prove specific intent to conceal or commit a further crime. Rather, the spending statute requires only (1) the commission of an SUA; and (2) knowingly engaging in a financial transaction involving $10,000 or more of proceeds from the SUA.[26]

On December 21, 2023, DOJ entered into a Deferred Prosecution Agreement with Aylo Holdings S.A.R.L. and its subsidiaries (collectively known as “MindGeek”) involving a novel and aggressive theory using the money laundering spending statute. MindGeek is the parent company of Pornhub and similar websites.[27] DOJ charged MindGeek with violating the spending statute for knowingly engaging in monetary transactions related to sex trafficking activity. DOJ’s theory centered on MindGeek’s relationship with two of its content partners, GirlsDoPorn.com (“GDP”) and GirlsDoToys.com (“GDT”) and the operators of those sites (referred to in the DPA as “the GDP Operators”).[28] According to the resolution documents, both GDP and GDT had specialized channels on MindGeek’s platforms, including Pornhub. Between mid-2017 and mid-2019, MindGeek allegedly received over $100,000 in payments from the GDP Operators.[29] DOJ also alleged that MindGeek “received payments from advertisers attributable to GDP and GDT content” totaling approximately $763,000.[30]

In order to establish that MindGeek had knowledge that the proceeds were from illicit origins, DOJ relied on a mosaic of sources to purportedly establish knowledge, including civil and criminal legal filings, news stories about these cases, takedown requests, and a business records subpoena.[31] Specifically, DOJ alleged that MindGeek’s knowledge derived from:

MindGeek’s receipt of a subpoena for production of business records from plaintiffs’ counsel in a lawsuit filed against GDP in 2016. The complaint in that lawsuit alleged that the GDP Operators had tricked the plaintiffs into appearing in pornographic videos posted to GDP by promising them that their videos would not be posted online;[32]
MindGeek’s receipt of content removal requests from plaintiffs in the lawsuit,[33] plaintiffs’ counsel, and other individuals;[34]
Publicly available criminal filings announcing the sex trafficking charges against GDP operators;[35] and
MindGeek executives’ receipt and internal discussion of news articles about the stages of the civil and criminal proceedings against GDP operators.[36]

On the basis of these allegations, MindGeek entered into a DPA asserting a violation of 18 U.S.C. § 1957.[37] MindGeek agreed to submit to a monitorship for three years[38] and pay a total fine of $974,692.06.[39] Notably, MindGeek agreed to compensate victims in the “full amount of [their] losses” caused by publication of their images on MindGeek’s websites, not including losses for pain and suffering, including a minimum of $3,000 per victim who can demonstrate harm.[40] Also, the DPA contained a stipulation that MindGeek “did not commit, conspire to commit, or aid and abet the commission of sex trafficking.”[41]

This is a novel and aggressive use of § 1957 because DOJ relied on sources such as the public allegations of wrongdoing and a business records subpoena to establish knowledge. Although the resolution may be explained in part by the nature of the industry involved, the resolution nevertheless suggests that public allegations of wrongdoing, the receipt of a business records subpoena, take down requests, and receipt and discussion of news articles about allegations can serve as ways that DOJ may try to establish knowledge under § 1957 against companies.

U.S. Enforcers Extend Reach of BSA and Sanctions to Non-U.S. Crypto Company

Binance is the world’s largest crypto currency exchange by trading volume and it is an overseas, non-U.S. company. On November 21, 2023, Binance reached a settlement to resolve a multi-year investigation with DOJ, the Commodity Futures Trading Commission (“CFTC”), the U.S. Department of Treasury’s Office of Foreign Assets Control (“OFAC”), and FinCEN.[42] Gibson Dunn represented Binance in this resolution.

Although Binance is a non-U.S. company, the enforcers alleged that it historically had U.S. users on its platform. As a result, the enforcers alleged that Binance needed to register as a foreign-located money services business and maintain an adequate AML program under U.S. law because it did business “wholly or in substantial part” within the United States.[43]

Prior to the Binance resolution, sanctions resolutions with cryptocurrency exchanges generally involved U.S. exchanges, which are prohibited from providing financial services to persons in jurisdictions subject to sanctions regulated by OFAC.[44] As a non-U.S. person, Binance could do business in sanctioned jurisdictions.[45] However, because Binance’s platform historically had both U.S. users and users from sanctioned jurisdictions, enforcers alleged that Binance used a “matching engine [. . .] that matched customer bids and offers to execute cryptocurrency trades.”[46] The failure to have sufficient controls on the matching engine, which operated randomly in matching users for trades, meant that it would “necessarily cause” transactions between U.S. users and users targeted by U.S. sanctions.[47] Enforcers took the position that these transactions violated U.S. civil and criminal sanctions law because the International Emergency Economic Powers Act (“IEEPA”) prohibits, among other things, “causing” a violation of sanctions by another party.[48] In other words, by randomly pairing trades between a historical U.S. user and person from a sanctioned jurisdiction, Binance was causing the U.S. person to violate their sanctions obligations. This resolution illustrates the breadth of U.S. jurisdiction to police sanctions offenses, even against non-U.S. companies.

Criminally, Binance pled guilty to (1) conspiracy to conduct an unlicensed money transmitting business, in violation of 18 U.S.C. § 1960 and 31 U.S.C. § 5330 for failure to register,[49] (2) failure to maintain an effective anti-money laundering program, in violation of 31 U.S.C. §§ 5318(h), 5322,[50] and (3) violating IEEPA, 50 U.S.C. § 1701 et seq.[51] Binance also entered into parallel civil settlements with FinCEN (failure to register, AML program) and OFAC (sanctions).[52] Further, Binance also entered into a settlement with the CFTC for violating various sections of the Commodities Exchange Act and related provisions.[53]

As part of the resolution, Binance agreed to pay $4.3 billion to the U.S. government over an approximately 18-month period.[54] Binance also agreed to continue with certain compliance enhancements and agreed to a three-year DOJ monitorship.[55]

FinCEN Designates Bitzlato as a “Primary Money-Laundering Concern” Pursuant to New Powers Designed to Target Russian Money Laundering

On January 18, 2023, FinCEN issued an order identifying Bitzlato Limited, a Hong Kong based cryptocurrency exchange, as a “primary money laundering concern.”[56] It issued this designation because Bitzlato was allegedly “repeatedly facilitating transactions for Russian-affiliated ransomware groups, including Conti, a Ransomware-as-a-Service group that has links to the Russian government and to Russian-connected darknet markets.”[57] The Bitzlato order is the first order issued pursuant to FinCEN’s powers under the Combatting Russian Money Laundering Act.[58]

In 2021, Congress passed the Combatting Russian Money Laundering Act (“Section 9714(a)”), which expanded the actions that FinCEN can take whenever it designates an entity as a “primary money laundering concern.”[59] Previously, whenever the Treasury Secretary had “reasonable grounds” for concluding that an entity is of “primary money laundering concern,”[60] then the Treasury Secretary could impose special measures that would limit the entity’s access to the global financial system.[61] Section 9714(a) provides additional powers to FinCEN to “prohibit, or impose conditions upon, certain transmittals of funds (to be defined by the Secretary) by any domestic financial institution or domestic financial agency.”

Under the terms of the Bitzlato order, FinCEN prohibits financial institutions (as defined in 31 C.F.R. § 1010.100(t)) from engaging in the transmittal of funds from or to Bitzlato. In remarks addressing the order, Deputy Secretary Adeyemo remarked that designating Bitzlato as a primary money laundering concern was a “unique step” that has only been taken a handful of times.[62]

DOJ also brought a parallel criminal proceeding against Bitzlato co-founder and Russian national Anatoly Legkodymov, who pleaded guilty to operating an unlicensed money transmitter and agreed to dissolve Bitzlato.[63]

Looking ahead, FinCEN will likely continue to be aggressive in using its authorities in the digital assets space. On October 19, 2023, for instance, FinCEN issued a Notice of Proposed Rulemaking which proposed to designate cryptocurrency mixers as a primary money laundering concern under Section 311 of the Patriot Act.[64] This is FinCEN’s first proposed Section 311 action involving a class of transactions.

FinCEN Imposes Civil Penalty on Shinhan, Reflecting Increased Scrutiny of Customer Due Diligence and Transaction Monitoring Systems

On September 29, 2023, FinCEN imposed a $15 million civil penalty on Shinhan Bank America for willful violation of the BSA.[65] The Consent Order reflects FinCEN’s growing scrutiny of—and increasingly granular expectations for—customer due diligence and transaction monitoring systems.

Notably, FinCEN criticized Shinhan’s overly “rigid” methodology for calculating customer risk rating scores and emphasized that banks should maintain formal customer risk rating procedures.[66] Risk ratings should not be solely based on customer type (e.g., individual vs. corporate entity) or the type of product (e.g., home mortgage vs. letter of credit). Rather, they should be individually assessed—both at onboarding and throughout the customer relationship—and be based on the customer’s activity and any new information learned about the customer.[67]

The Shinhan Order also makes clear that customers’ risk ratings should inform financial institutions’ monitoring of transactions. The Order notes that Shinhan’s transaction monitoring system did not cluster accounts belonging to the same customer relationship or aggregate transaction activity across different transaction types, undermining its ability to identify suspicious activity. It also includes examples of scenarios that banks should consider incorporating into their transaction monitoring systems, including:

wire transfers sent to several beneficiaries from a single originator, or sent from several originators to a single beneficiary;
transactions passing through a large number of jurisdictions; and
transactions conducted using Remote Deposit Capture.

Moreover, the Order states that these systems should be regularly and comprehensively tested to ensure all scenarios alert as intended, all relevant data properly feeds into the system, scenarios are sufficient and tailored for each product, and scenarios are appropriately applied to ingested data.[68]

FinCEN Issues First Action Against Trust Company

On April 26, 2023, FinCEN assessed a $1.5 million civil penalty against South Dakota-chartered Kingdom Trust Company for willful violation of the BSA.[69] This was FinCEN’s first action against a trust company.

FinCEN assessed a penalty against Kingdom Trust after the company opened accounts and provided services for Latin America-based trading companies and financial institutions with virtually no controls to identify or assess suspicious transactions.[70] A consultant referred clients based in Uruguay, Argentina, Panama, and other locations to the Trust.[71] Kingdom Trust then held cash and securities for these customers and initiated a high volume of suspicious transactions worth approximately $4 billion that went unchecked and unreported.[72] Despite providing services to customers who were the subject of prior media reports related to money laundering and securities fraud, the Trust’s AML compliance program consisted of a single individual responsible for manually reviewing daily transactions.[73]

FinCEN’s action against Kingdom Trust reflects the agency’s growing focus on entities beyond traditional financial institutions, including those not historically subject to the BSA, such as real estate businesses and investment advisors.[74] FinCEN’s action against Kingdom Trust reflects the agency’s unwillingness to “tolerate trust companies with weak compliance programs that fail to identify and report suspicious activities, particularly with respect to high-risk customers whose businesses pose an elevated risk of money laundering.”[75]

FinCEN Issues First Action Under Gap Rule Against Bancrédito for Failing to Report Suspicious Transactions

On September 15, 2023, FinCEN levied a $15 million civil monetary penalty against Bancrédito International Bank and Trust Corporation (Bancrédito).[76] Bancrédito (which held U.S. dollar-denominated accounts on behalf of numerous Central American and Caribbean financial institutions) allegedly failed to both report suspicious transactions (“SARs”) involving movement of U.S. dollars and never established or maintained an AML program, as required by the recently enacted “Gap Rule” (31 C.F.R. § 1020.210).[77]

The enforcement action against Bancrédito is notable in multiple respects. It is the first time that FinCEN took action against a Puerto Rican International Banking Entity (“IBE”). The U.S. Department of the Treasury’s 2022 National Money Laundering Risk Assessment alleged that IBEs pose an elevated risk of money laundering.[78] It is also the first enforcement action under FinCEN’s recently enacted “Gap Rule.” Previously, banks lacking federal functional regulators (such as private banks, non-federally insured credit unions, and certain trust companies) were exempt from select AML program obligations, namely (1) the development of internal policies, procedures, and controls; (2) the designation of a compliance officer; (3) facilitating an ongoing employee training program; and (4) requiring an independent audit function to test programs.[79] However, the “Gap Rule,” effective beginning in 2021, functionally filled that “gap” by requiring the newly covered entities to meet those specific AML requirements (along with also complying with pre-existing BSA obligations such as reporting SARs).[80]

Individual Prosecutions

2023 also featured a number of notable prosecutions of individuals under U.S. money laundering statutes, including in connection with sanctions evasion and in the digital assets industry.

Money Laundering and Sanctions Evasion

In 2023, federal prosecutors on DOJ’s Task Force KleptoCapture brought several prosecutions against the associates of sanctioned oligarch Viktor Vekselberg. OFAC designated Vekselberg as a Specially Designated National (“SDN”) in March 2018.[81] In 2023, DOJ brought a number of prosecutions which reflect the growing intersection between money laundering and sanctions evasion.[82]

On January, 20, 2023, DOJ announced the indictment of Vladislav Osipov and Richard Masters for facilitating a sanctions evasion and money laundering scheme related to a 255-foot luxury yacht owned by Vekselberg.[83] Osipov and Masters used U.S. companies to manage the operation of the vessel and to obfuscate Vekselberg’s involvement, including using payments through third parties and non-U.S. currencies to do business with U.S. companies.[84]

DOJ also targeted Vekselberg’s property portfolio in the United States and those who helped him manage it. On February 7, 2023, federal prosecutors announced the indictment of Vladimir Voronchenko, an associate of Vekselberg’s, for making more than $4 million in payments to maintain four U.S. properties owned by Vekselberg and for his attempt to sell two of those properties.[85] A few weeks later, on February 24, prosecutors brought a civil forfeiture complaint against six of Vekselberg’s properties in New York City, Southampton, New York, and Fisher Island, Florida, alleging that they were the proceeds of sanctions violations and involved in international money laundering.[86]

Vekselberg’s U.S. associates also faced prosecution for their role in money laundering and evading U.S. sanctions. On April 25, 2023, New York attorney Robert Wise pled guilty to conspiracy to commit international money laundering for unlawfully transferring Russian funds into the United States in violations of U.S. sanctions.[87] Voronchenko had retained Wise to assist him in managing Vekselberg’s U.S. properties.[88] Immediately after Vekselberg’s designation as an SDN, Wise’s IOLTA Account began to receive wires from new sources, a Russian bank account, and a bank account in the Bahamas held in the name of a shell company controlled by Voronchenko.[89] Despite being aware of Vekselberg’s designation as an SDN, Wise received 25 wire transfers totaling nearly $3.8 million in his IOLTA account between June 2018 and March 2022 and used these funds to maintain and service Vekselberg’s properties in defiance of U.S. sanctions.[90]

Collectively, these actions demonstrate the increasing interplay between violations of U.S. sanctions and money laundering laws.

Money Laundering Prosecutions of Cryptocurrency Executives for Fraud

2023 also included a number of money laundering prosecutions against executives in the digital assets industry. The most significant of 2023’s individual prosecutions sounded in fraud and subsequent laundering of the fraud proceeds.

On November 2, 2023, a New York jury convicted FTX founder Sam Bankman-Fried of stealing billions of dollars’ worth of FTX customer deposits, capping one of the highest-profile criminal fraud trials in recent history.[91] One of the charges against Bankman-Fried was violating 18 U.S.C. § 1956(a)(1)(B)(i), on the basis that he knowingly engaged in a transaction involving proceeds of illegal activity in order hide the illegal origins of the funds; and Section 1957(a), on the basis that he engaged in a transaction involving criminally derived property exceeding $10,000.[92] These charges related to the transfer of customer funds from Bankman-Fried’s centralized exchange, FTX, to FTX’s sister organization, the hedge fund Alameda Research.[93] Bankman-Fried was convicted on all seven counts, including the money laundering charges.[94] Bankman-Fried’s sentencing hearing is scheduled for March 2024.[95]

Earlier in 2023, Nate Chastain, the former Head of Product at NFT Trading Platform OpenSea, was convicted by a jury of wire fraud and money laundering in what is considered the first insider-trading case involving digital assets. Chastain was accused of purchasing NFTs before they were featured on OpenSea’s homepage, where they subsequently rose in price. Perhaps because the question of whether NFTs are subject to securities laws remains open,[96] DOJ prosecuted Chastain under wire fraud and money laundering statutes.[97] DOJ alleged money laundering because, by engaging in insider trading of NFTs, Chastain knowingly conducted a financial transaction involving the proceeds of an unlawful activity (i.e., wire fraud), in violation of 18 U.S.C. § 1956(a)(1)(B)(i).[98]

Another notable fraud-based cryptocurrency executive prosecution of 2023 involved the former SafeMoon executives, who were accused of making a series of fraudulent misrepresentations about the cryptocurrency that they managed and marketed.[99] DOJ charged a violation of 18 U.S.C. § 1956(a)(1)(B)(i) on the theory that the executives knowingly engaged in and covered up transactions involving the proceeds of securities fraud and wire fraud.[100]

Judicial Opinions

The Implications of Narrowing the Honest Services Wire Fraud Statute

Two judicial decisions in 2023 could affect how prosecutors pursue future money laundering prosecutions. These opinions involve the now highly-publicized FIFA corruption and Varsity Blues scandals—occasions where individuals allegedly made illicit payments to secure lucrative FIFA contracts and favorable college admission decisions, respectively. In both United States v. Full Play Grp., S.A., 2023 WL 5672268 (E.D.N.Y. Sept. 1, 2023) (involving the FIFA corruption matter) and United States United States v. Abdelaziz, 68 F.4th 1 (1st Cir. 2023) (a decision relating to Varsity Blues), federal courts held that certain transactions failed to qualify as unlawful instances of honest services wire fraud—a predicate offense that prosecutors frequently rely on when charging money laundering.[101]

In Full Play, several individuals and companies in the entertainment industry sought to earn media and other related contracts with various sports organizations (including soccer’s FIFA).[102] In an effort to secure these contracts, the media representatives were alleged to have paid FIFA officials significant sums in side payments.[103] Though various individuals were charged with honest services wire fraud for their actions, the district court found that such payments (i.e., those made to private employees of a foreign corporation and labeled as foreign commercial bribery) did not qualify as actionable instances of honest services fraud under 18 U.S.C. §§ 1343 and 1346.[104] In reaching that conclusion, the district court applied two Supreme Court opinions issued last term: Percoco v. United States, 598 U.S. 319 (2023) and Ciminelli v. United States, 598 U.S. 306 (2023). Citing specifically to the Percoco decision, the district court found that honest services fraud “must be defined with the clarity typical of criminal statutes and should not be held to reach an ill-defined category of circumstances simply because of a smattering” of earlier precedents.[105] Applying that standard, the district court vacated the convictions because no applicable precedents precisely addressed (and thus criminalized) comparable instances of foreign commercial bribery.[106] Full Play is currently the subject of an appeal in the Second Circuit.[107]

Similarly, albeit before Percoco and Ciminelli were decided, the Abdelaziz court removed another type of transaction from the range of prosecutable offenses under the honest services fraud provision. In that case, a parent was convicted of making illicit side payments to college admissions personnel—intending that the payments would secure preferential admissions decisions for his child.[108] On appeal, the Abdelaziz court overturned the conviction—finding that such conduct did not amount to honest services wire fraud. In reaching that result, the court specified that the transaction at issue—one where the alleged briber (the convicted parent) actually compensated the alleged victim (the university)—did not fit the conventional understanding of “bribe” or “kickback” under 18 U.S.C. §§ 1343 and 1346.[109] Because no prior decision had specifically barred payments that so clearly benefitted an alleged victim, it could not be considered a criminal deprivation of honest services.

As the courts continue to narrow the scope of the honest services wire fraud statute, prosecutors will be forced to craft different theories of honest services wire fraud and/or rely on different predicate offenses when identifying an SUA required for charging money laundering.

Legislation

2023 also saw an important legislative change in the bribery space, which will also impact money laundering prosecutions.

The Impact of FEPA for Money Laundering Prosecutions

On December 22, 2023, federal lawmakers passed the Foreign Extortion Prevention Act (“FEPA”). FEPA criminalizes what is colloquially referred to as “demand side” bribery—instances in which foreign officials demand, solicit, seek, or receive bribes from a domestic person or U.S.-located company.[110] Before FEPA’s passage, no particular provision under federal law penalized this particular scheme—with the Foreign Corrupt Practices Act (“FCPA”) focusing instead on the supply side of offering or paying bribes to foreign persons.[111] FEPA arms prosecutors with a new tool to root out alleged instances of foreign bribery or extortion that is focused on foreign public officials.

More than just an anti-corruption mechanism, FEPA will also equip prosecutors with an additional tool to pursue money laundering prosecutions as well. By its terms, any contemplated or actual violation of FEPA would qualify as an SUA under the money laundering statutes.[112] Passage of this law will allow prosecutors to rely on U.S. law (i.e., FEPA) when charging foreign officials with money laundering, as opposed to having to allege that the conduct constituted bribery under the foreign laws of another country, which is also an SUA.

Conclusion

2023 was a notable year in the AML enforcement space. We anticipate that 2024 will also be active, as the impacts of FinCEN’s AML whistleblower program begin to be felt, and the additional prosecutors come online in the Criminal Division’s Bank Integrity Unit and the National Security Division’s Counterintelligence and Export Control Section. Moreover, there are yet-to-be issued rules expected both for regulation of the real estate industry and for registered investment advisors.

__________

[1] See, e.g., Principal Associate Deputy Attorney General Marshall Miller Delivers Remarks at the Global Investigations Review Annual Meeting (Sept. 21, 2023), https://www.justice.gov/opa/speech/principal-associate-deputy-attorney-general-marshall-miller-delivers-remarks-global (“It is for all of these reasons that the DAG [Deputy Attorney General] has warned that from a compliance standpoint ‘sanctions are the new FCPA.’”).

[2] See Principal Associate Deputy Attorney General Marshall Miller Delivers Remarks at the Global Investigations Review Annual Meeting (Sept. 21, 2023), https://www.justice.gov/opa/speech/principal-associate-deputy-attorney-general-marshall-miller-delivers-remarks-global (“Even business operations and lines far removed from the defense sector – like cigarettes, cement, and shipping – can pose dire national security risks if companies are not highly sensitive to high-risk actors, high-risk regions, and high-risk activities.”).

[3] Principal Associate Deputy Attorney General Marshall Miller Delivers Remarks at the Ethics and Compliance Initiative IMPACT Conference (May 3, 2023), https://www.justice.gov/opa/speech/principal-associate-deputy-attorney-general-marshall-miller-delivers-remarks-ethics-and (“From money laundering and cyber- and crypto-enabled crime to sanctions and export control evasion and even funneled payments to terrorist groups, corporate crime increasingly — now almost routinely — intersects with national security concerns.”).

[4] Principal Associate Deputy Attorney General Marshall Miller Delivers Remarks at the Global Investigations Review Annual Meeting (Sept. 21, 2023), https://www.justice.gov/opa/speech/principal-associate-deputy-attorney-general-marshall-miller-delivers-remarks-global.

[5] Deputy Attorney General Lisa Monaco Delivers Remarks at American Bar Association National Institute on White Collar Crime (Mar. 2, 2023), https://www.justice.gov/opa/speech/deputy-attorney-general-lisa-monaco-delivers-remarks-american-bar-association-national; Principal Associate Deputy Attorney General Marshall Miller Delivers Remarks at the Global Investigations Review Annual Meeting (Sept. 21, 2023), https://www.justice.gov/opa/speech/principal-associate-deputy-attorney-general-marshall-miller-delivers-remarks-global.

[6] Deputy Assistant Attorney General Eun Young Choi Delivers Keynote Remarks at GIR Live: Sanctions & Anti-Money Laundering Meeting (Nov. 16, 2023), https://www.justice.gov/opa/speech/deputy-assistant-attorney-general-eun-young-choi-delivers-keynote-remarks-gir-.live.

[7] Press Release, U.S. Dep’t of Just., Justice and Commerce Departments Announce Creation of Disruptive Technology Strike Force (May 16, 2023), https://www.justice.gov/opa/pr/justice-and-commerce-departments-announce-creation-disruptive-technology-strike-force; see also Press Release, U.S. Dep’t of Just., Justice Department Announces Five Cases as Part of Recently Launched Disruptive Technology Strike Force (May 16, 2023), https://www.justice.gov/opa/pr/justice-department-announces-five-cases-part-recently-launched-disruptive-technology-strike.

[8] Id.

[9] Press Release, U.S. Dep’t of Just., Russian Elites, Proxies, and Oligarchs Task Force Ministerial Joint Statement (Mar. 17, 2022), https://www.justice.gov/opa/pr/russian-elites-proxies-and-oligarchs-task-force-ministerial-joint-statement.

[10] Press Release, U.S. Dep’t of Just., Russian Elites, Proxies, and Oligarchs Task Force Ministerial Joint Statement (Mar. 17, 2023), https://www.justice.gov/opa/pr/russian-elites-proxies-and-oligarchs-task-force-ministerial-joint-statement; Statement, U.S. Dep’t of Just., Joint Statement from the REPO Task Force (Mar. 9, 2023), https://home.treasury.gov/news/press-releases/jy1329.

[11] Press Release, Fin. Crimes Enf’t Network, U.S. Dep’t of the Treasury, FinCEN Alert to Financial Institutions to Counter Financing to Hamas and its Terrorist Activities (Oct. 20, 2023), https://www.fincen.gov/sites/default/files/2023-10/FinCEN_Alert_Terrorist_Financing_FINAL508.pdf; Supplemental Alert: FinCEN and the U.S. Department of Commerce’s Bureau of Industry and Security Urge Continued Vigilance for Potential Russian Export Control Evasion Attempts (May 19, 2023), https://www.fincen.gov/sites/default/files/shared/FinCEN%20and%20BIS%20Joint%20Alert%20_FINAL_508C.pdf; FinCEN Alert on Potential U.S. Commercial Real Estate Investments by Sanctioned Russian Elites, Oligarchs, and Their Proxies (Jan. 25, 2023), https://www.fincen.gov/sites/default/files/shared/FinCEN%20Alert%20Real%20Estate%20FINAL%20508_1-25-23%20FINAL%20FINAL.pdf.

[12] Supplemental Alert: FinCEN and the U.S. Department of Commerce’s Bureau of Industry and Security Urge Continued Vigilance for Potential Russian Export Control Evasion Attempts (May 19, 2023), https://www.fincen.gov/sites/default/files/shared/FinCEN%20and%20BIS%20Joint%20Alert%20_FINAL_508C.pdf; FinCEN & BIS Joint Notice: FinCEN and the U.S. Department of Commerce’s Bureau of Industry and Security Announce New Reporting Key Term and Highlight Red Flags Relating to Global Evasion of U.S. Export Controls (Nov. 6, 2023), https://www.fincen.gov/sites/default/files/shared/FinCEN_Joint_Notice_US_Export_Controls_FINAL508.pdf.

[13] See U.S. Dep’t of Com., U.S. Dep’t of the Treasury, and U.S. Dep’t of Just., Tri-Seal Compliance Note: Cracking Down on Third-Party Intermediaries Used to Evade Russia-Related Sanctions and Export Controls (Mar. 2, 2023), https://www.justice.gov/nsd/file/1277536/dl?inline. See also Deputy Attorney General Lisa Monaco Delivers Remarks at American Bar Association National Institute on White Collar Crime (Mar. 2, 2023), https://www.justice.gov/opa/speech/deputy-attorney-general-lisa-monaco-delivers-remarks-american-bar-association-national.

[14] See William M. (Mac) Thornberry National Defense Authorization Act for Fiscal Year 2021, Pub. L. 116-283, Div. F.

[15] Id., § 6403 (adding 31 U.S.C. § 5336).

[16] 31 C.F.R. § 1010.380(c)(1)(i).

[17] 31 C.F.R. § 1010.380(c)(1)(ii).

[18] 31 C.F.R. § 1010.380(c)(2)(i)-(xxiii).

[19] 31 C.F.R. § 1010.380(c)(2)(x)-(xi); Gibson Dunn, The Impact of FinCEN’s Beneficial Ownership Regulation on Investment Funds (Aug. 10, 2023), https://www.gibsondunn.com/the-impact-of-fincens-beneficial-ownership-regulation-on-investment-funds/.

[20] 31 C.F.R. § 1010.380(c)(2)(xxii).

[21] FinCEN: Beneficial Ownership Information Reporting, Frequently Asked Questions (Jan. 12, 2024), https://www.fincen.gov/boi-faqs.

[22] 31 C.F.R. § 1010.380(b)-(e).

[23] 31 C.F.R. § 1010.380(b)(2)(iv).

[24] 31 C.F.R. § 1010.380(a)(1)(i)(B).

[25] See United States v. Huezo, 546 F.3d 174, 178 (2d Cir. 2008) (“The substantive offense of ‘transaction money laundering’ requires proof of both knowledge and specific intent.”) (citing Cuellar v. United States, 128 S. Ct. 1994 (2008)).

[26] See United States v. Wright, 341 F. App’x 709, 713 (2d Cir. 2009) (“To demonstrate a § 1957 violation, the government must prove, inter alia, that the money Wright used to lease the car exceeded $10,000 and was ‘derived from specified unlawful activity.’”).

[27] Deferred Prosecution Agreement at 1, United States v. Aylo Holdings S.A.R.L., No. 1:23-cr-00463 (E.D.N.Y. Dec. 21, 2023), https://www.justice.gov/d9/2023-12/2023.12.21_dpa_final_court_exhibit_version_0.pdf (hereinafter “DPA”).

[28] Attachment B to Deferred Prosecution Agreement, United States v. Aylo Holdings S.A.R.L., No. 1:23-cr-00463 (E.D.N.Y. Dec. 21, 2023) (hereinafter “MindGeek Information”), https://www.justice.gov/d9/2023-12/2023.12.21_dpa_final_court_exhibit_version_0.pdf, ¶ 8.

[29] Id. ¶ 10.

[30] Id.

[31] Id.

[32] Id. ¶ 16.

[33] Id. ¶ 17.

[34] Id. ¶¶ 20, 27.

[35] Id. ¶ 23.

[36] Id. ¶¶ 18, 22, 29, 30.

[37] See DPA at 1.

[38] Id. at 2.

[39] Id. at 2–3.

[40] Id. at 9–10.

[41] Id. at 5.

[42] See Binance Blog, Binance Announcement: Reaching Resolution with U.S. Regulators (Nov. 21, 2023), https://www.binance.com/en/blog/leadership/binance-announcement-reaching-resolution-with-us-regulators-2904832835382364558.

[43] 31 C.F.R. § 1010.100(ff).

[44] See, e.g., Press Release, U.S. Dep’t of the Treasury, Treasury Announces Two Enforcement Actions for Over $24M and $29M Against Virtual Currency Exchange Bittrex, Inc. (Oct. 11, 2022), https://home.treasury.gov/news/press-releases/jy1006 (announcing an enforcement action against Bittrex, Inc., a virtual currency exchange that was based in Washington state).

[45] See International Emergency Economic Powers Act (IEEPA), 50 U.S.C. § 1701(a)(1)(A) (empowering the President to prohibit transactions by “any person, or with respect to any property, subject to the jurisdiction of the United States.”); see also Office of Foreign Assets Control, Frequently Asked Questions: 11. Who Must Comply with OFAC Regulations?, https://ofac.treasury.gov/faqs/11 (“U.S. persons must comply with OFAC regulations, including all U.S. citizens and permanent resident aliens regardless of where they are located, all persons and entities within the United States, all U.S. incorporated entities and their foreign branches. In the cases of certain programs, foreign subsidiaries owned or controlled by U.S. companies also must comply. Certain programs also require foreign persons in possession of U.S.-origin goods to comply.”).

[46] Attachment A, “Statement of Facts,” to the Plea Agreement in United States v. Binance Holdings Ltd., No. 23-178RAJ (Nov. 21, 2023), https://www.justice.gov/opa/media/1326901/dl?inline (hereinafter “Binance SOF”) at 7, ¶ 22.

[47] Id.

[48] 50 U.S.C. § 1705(a) (“It shall be unlawful for a person to violate, attempt to violate, conspire to violate or cause a violation of any license, order, regulation, or prohibition issued [pursuant to IEEPA].”).

[49] Plea Agreement in United States v. Binance Holdings Ltd., No. 23-178RAJ (Nov. 21, 2023), https://www.justice.gov/opa/media/1326901/dl?inline (hereinafter “Binance Plea Agreement”), at ¶ 2.

[50] Id.

[51] Id.

[52] See Nikhilesh De, Binance to Make ‘Complete Exit’ From U.S., Pay Billions to FinCEN, OFAC on Top of DOJ Settlement, CoinDesk (Nov. 21, 2023), https://www.coindesk.com/policy/2023/11/21/binance-to-make-complete-exit-from-us-pay-billions-to-fincen-ofac-on-top-of-doj-settlement/.

[53] Id.

[54] Binance Plea Agreement ¶ 24.

[55] Id at ¶ 32.

[56] Press Release, Fin. Crimes Enf’t Network, U.S. Dep’t of the Treasury, FinCEN Identifies Virtual Currency Exchange Bitzlato as a ‘Primary Money Laundering Concern’ in Connection with Russian Illicit Finance (Jan. 18, 2023), https://www.fincen.gov/news/news-releases/fincen-identifies-virtual-currency-exchange-bitzlato-primary-money-laundering.

[57] Press Release, U.S. Dep’t of the Treasury, Remarks by Wally Adeyemo on Action Against Russian Illicit Finance (Jan. 18, 2023), https://home.treasury.gov/news/press-releases/jy1193.

[58] Public Law 116-283, § 9714(a) (Jan. 1, 2021).

[59] See 88 Fed. Reg. 3919, 3920 (Feb. 1, 2023), https://www.federalregister.gov/documents/2023/01/23/2023-01189/imposition-of-special-measure-prohibiting-the-transmittal-of-funds-involving-bitzlato (explaining passage of the Combatting Russian Money Laundering Act).

[60] 31 U.S.C. § 5381A(a)(1).

[61] 31 U.S.C. § 5381A(b) (commonly known as Section 311 of the Patriot Act).

[62] Press Release, U.S. Dep’t of the Treasury, Remarks by Wally Adeyemo on Action Against Russian Illicit Finance (Jan. 18, 2023), https://home.treasury.gov/news/press-releases/jy1193.

[63] Press Release, U.S. Dep’t of Just., Founder and Majority Owner of Bitzlato, a Cryptocurrency Exchange Charged with Unlicensed Money Transmitting (Jan. 18, 2023), https://www.justice.gov/usao-edny/pr/founder-and-majority-owner-bitzlato-cryptocurrency-exchange-charged-unlicensed-money.

[64] 88 Fed. Reg. 72701, 72704 (Oct. 23, 2023), https://www.federalregister.gov/documents/2023/10/23/2023-23449/proposal-of-special-measure-regarding-convertible-virtual-currency-mixing-as-a-class-of-transactions.

[65] In The Matter Of: Shinhan Bank America, No. 2023-03 (Sept. 29, 2023), https://www.fincen.gov/sites/default/files/enforcement_action/2023-09-29/SHBA_9-28_FINAL_508.pdf.

[66] Id.

[67] Id.

[68] Id.

[69] Press Release, Fin. Crimes Enf’t Network, U.S. Dep’t of the Treasury, FinCEN Assesses $1.5 Million Civil Money Penalty against Kingdom Trust Company for Violations of the Bank Secrecy Act (Apr. 26, 2023), https://www.fincen.gov/news/news-releases/fincen-assesses-15-million-civil-money-penalty-against-kingdom-trust-company.

[70] Id.

[71] Id.

[72] Id.

[73] Id.

[74] See generally Statement of Himamauli Das, Acting Dir., Fin. Crimes Enf’t Network, U.S. Dep’t of the Treasury, Before the Comm. on Fin. Servs., U.S. House of Representatives (Apr. 27, 2023), https://www.fincen.gov/sites/default/files/2023-04/HHRG-118-HFSC-DasH-20230427.pdf; Remarks by Brian Nelson, Under Sec. for Terrorism and Fin. Intel., U.S. Dep’t of the Treasury, at SIFMA’s Anti-Money Laundering and Financial Crimes Conference (May 25, 2022), https://home.treasury.gov/news/press-releases/jy0800.

[75] Id.

[76] In The Matter Of: Bancrédito International Bank and Trust Corporation, No. 2023-02 (Sept. 15, 2023), https://www.fincen.gov/sites/default/files/enforcement_action/2023-09-15/Bancredito_Consent_FINAL_091523_508C.pdf.

[77] Press Release, Fin. Crimes Enf’t Network, U.S. Dep’t of the Treasury, FinCen Announces $15 Million Civil Money Penalty against Bancrédito International Bank and Trust Corporation for Violations of the Bank Secrecy Act (Sept. 15, 2023), https://www.fincen.gov/news/news-releases/fincen-announces-15-million-civil-money-penalty-against-bancredito-international.

[78] National Money Laundering Risk Assessment (Feb. 2022), https://home.treasury.gov/system/files/136/2022-National-Money-Laundering-Risk-Assessment.pdf.

[79] Id.; see also 31 U.S.C. § 5318(h).

[80] See generally 31 C.F.R. § 1020.210; see also 85 Fed. Reg. 57129 (Nov. 16, 2020), https://www.federalregister.gov/documents/2020/09/15/2020-20325/financial-crimes-enforcement-network-customer-identification-programs-anti-money-laundering-programs.

[81] Press Release, U.S. Dep’t of Just., Associate of Sanctioned Oligarch Indicted for Sanctions Evasion and Money Laundering (Feb. 7, 2023), https://www.justice.gov/opa/pr/associate-sanctioned-oligarch-indicted-sanctions-evasion-and-money-laundering.

[82] Press Release, U.S. Dep’t of Just., New York Attorney Pleads Guilty to Conspiring to Commit Money Laundering to Promote Sanctions Violations by Associate of Sanctioned Russian Oligarch (Apr. 25, 2023), https://www.justice.gov/opa/pr/new-york-attorney-pleads-guilty-conspiring-commit-money-laundering-promote-sanctions.

[83] Press Release, U.S. Dep’t of Just., Arrest and Criminal Charges Against British and Russian Businessmen for Facilitating Sanctions Evasion of Russian Oligarch’s $90 Million Yacht (Jan. 20, 2023), https://www.justice.gov/usao-dc/pr/arrest-and-criminal-charges-against-british-and-russian-businessmen-facilitating.

[84] Id.

[85] Press Release, U.S. Dep’t of Just., Associate of Sanctioned Oligarch Indicted for Sanctions Evasion and Money Laundering (Feb. 7, 2023), https://www.justice.gov/opa/pr/associate-sanctioned-oligarch-indicted-sanctions-evasion-and-money-laundering.

[86] Press Release, U.S. Dep’t of Just., Civil Forfeiture Complaint Filed Against Six Luxury Real Estate Properties Involved In Sanctions Evasion And Money Laundering (Feb. 24, 2023), https://www.justice.gov/usao-sdny/pr/civil-forfeiture-complaint-filed-against-six-luxury-real-estate-properties-involved?utm_medium=email&utm_source=govdelivery.

[87] See Superseding Information, United States v. Wise, No. 1:23-cr-00073, Dkt. 4 (S.D.N.Y. 2023).

[88] Id.

[89] Id.

[90] Press Release, U.S. Dep’t of Just., New York Attorney Pleads Guilty to Conspiring to Commit Money Laundering to Promote Sanctions Violations by Associate of Sanctioned Russian Oligarch (Apr. 25, 2023), https://www.justice.gov/opa/pr/new-york-attorney-pleads-guilty-conspiring-commit-money-laundering-promote-sanctions.

[91] See Gibson Dunn, Gibson Dunn Digital Assets Recent Updates – November 2023 (Nov. 6, 2023), https://www.gibsondunn.com/gibson-dunn-digital-assets-recent-updates-november-2023/.

[92] See Superseding Indictment, United States v. Bankman-Fried, No. 1:22-cr-00673, Dkt. 115 (S.D.N.Y. March 28, 2023), https://www.justice.gov/criminal-fraud/file/1593626/dl at ¶¶ 92–95.

[93] Press Release, U.S. Dep’t of Just., United States Attorney Announces Charges Against FTX Founder Sam Bankman-Fried (Dec. 13, 2022), https://www.justice.gov/usao-sdny/pr/united-states-attorney-announces-charges-against-ftx-founder-samuel-bankman-fried.

[94] James Fanelli and Corinne Ramey, Sam Bankman-Fried Is Convicted of Fraud in FTX Collapse, Wall St. J. (Nov. 2, 2023), https://www.wsj.com/finance/currencies/verdict-sam-bankman-fried-trial-ftx-guilty-4a54dbfe.

[95] Id.

[96] Id.

[97] See Chris Dolmestch and Bob Van Voris, First NFT Insider-Trading Trial Leads to Criminal Conviction, Wall St. J. (May 3, 2023), https://www.bloomberg.com/news/articles/2023-05-03/first-nft-insider-trading-trial-leads-to-criminal-conviction.

[98] See Jody Godoy, Ex-OpenSea manager sentenced to 3 months in prison for NFT insider trading (Aug. 22, 2023), https://www.reuters.com/legal/ex-opensea-manager-sentenced-3-months-prison-nft-insider-trading-2023-08-22/.

[99] Press Release, U.S. Dep’t of Just., Founders and Executives of Digital-Asset Company Charged in Multi-Million Dollar International Fraud Scheme (Nov. 1, 2023), https://www.justice.gov/usao-edny/pr/founders-and-executives-digital-asset-company-charged-multi-million-dollar.

[100] United States v. Karony, No. CR-23-433 (E.D.N.Y Oct. 31, 2023), https://www.justice.gov/media/1334306/dl.

[101] See 18 U.S.C. § 1956(c)(7).

[102] United States v. Full Play Grp., S.A., No. 15-CR-252S3PKC, 2023 WL 5672268, at *1-9 (E.D.N.Y. Sept. 1, 2023).

[103] Id.

[104] Id. at *23.

[105] Id. at *20 (internal quotation omitted).

[106] Id. at *23 n.26.

[107] U.S. v. Webb, No. 23-7183 (2d. Cir. 2024).

[108] Abdelaziz, 68 F.4th at 13.

[109] Id. at 29.

[110] National Defense Authorization Act for Fiscal Year 2024, S. 2226, 118th Cong. § 5101(2), codified at 18 U.S.C. § 201(f).

[111] See generally 15 U.S.C. § 78dd-1.

[112] Defining specified unlawful activities to include violations of 18 U.S.C. § 201—the subsection of the federal code wherein FEPA will be codified.

The following Gibson Dunn attorneys assisted in preparing this update: M. Kendall Day, Stephanie Brooker, Chris Jones, Ella Capone, Justin duRivage*, Maura Carey*, and Ben Schlichting.

Gibson Dunn has deep experience with issues relating to the Bank Secrecy Act, other AML and sanctions laws and regulations, and the defense of financial institutions more broadly. For assistance navigating white collar or regulatory enforcement issues involving financial institutions, please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Anti-Money Laundering / Financial Institutions, White Collar Defense & Investigations, or International Trade practice groups, the authors, or any of the following practice group leaders:

Anti-Money Laundering / Financial Institutions:
Stephanie Brooker – Washington, D.C.(+1 202.887.3502, sbrooker@gibsondunn.com)
M. Kendall Day – Washington, D.C. (+1 202.955.8220, kday@gibsondunn.com)

White Collar Defense and Investigations:
Stephanie Brooker – Washington, D.C. (+1 202.887.3502, sbrooker@gibsondunn.com)
Winston Y. Chan – San Francisco (+1 415.393.8362, wchan@gibsondunn.com)
Nicola T. Hanna – Los Angeles (+1 213.229.7269, nhanna@gibsondunn.com)
F. Joseph Warin – Washington, D.C. (+1 202.887.3609, fwarin@gibsondunn.com)

Global Fintech and Digital Assets:
M. Kendall Day – Washington, D.C. (+1 202.955.8220, kday@gibsondunn.com)
Jeffrey L. Steiner – Washington, D.C. (+1 202.887.3632, jsteiner@gibsondunn.com)
Sara K. Weed – Washington, D.C. (+1 202.955.8507, sweed@gibsondunn.com)

Global Financial Regulatory:
William R. Hallatt – Hong Kong (+852 2214 3836, whallatt@gibsondunn.com)
Michelle M. Kirschner – London (:+44 20 7071 4212, mkirschner@gibsondunn.com)
Jeffrey L. Steiner – Washington, D.C. (+1 202.887.3632, jsteiner@gibsondunn.com)

International Trade:
Ronald Kirk – Dallas (+1 214.698.3295, rkirk@gibsondunn.com)
Adam M. Smith – Washington, D.C. (+1 202.887.3547, asmith@gibsondunn.com)

*Maura Carey and Justin duRivage are associates practicing in the firm’s Palo Alto office who are not yet admitted to practice law.

On October 27, 2023, the National Labor Relations Board (“NLRB”) published a final rule setting forth a new standard for determining joint-employer status under the National Labor Relations Act (“NLRA”). This new rule replaces a prior rule published by the NLRB in 2020. Notably, the final rule replaces the prior “substantial direct and immediate control” threshold with an analysis of whether the putative joint employer has the authority to control the essential terms and conditions of employment, regardless of whether such control is actually exercised. The final rule is set to take effect on December 26, 2023.

1) Inclusion of Reserved Control

The new standard’s inclusion of reserved control contemplates situations where an entity maintains the authority to control the essential terms and conditions of employment (i.e., by potentially intervening at any moment), even if it has not exercised it and remains passive in day-to-day operations. This is similar to an aspect of the Labor Department’s proposed rule addressing employee and independent contractor classification under the Fair Labor Standards Act, which would eliminate a regulatory provision stating that actual practice is more probative of employment status than what is contractually or theoretically possible. See 87 Fed. Reg. 62,218, 62,257–59 (Oct. 13, 2022). The Labor Department recently submitted its draft final rule to the White House’s Office of Management and Budget for review, which is usually the final step in the rulemaking process.

2) Recognition of Indirect Control

In addition to reserved control, the NLRB’s final rule takes into account control exercised through an intermediary or controlled third parties, a concept drawn from Section 2(2) of the NLRA. The NLRB explained that the inclusion of indirect control as a means for establishing joint employment is intended to prevent entities from evading joint-employer status by using intermediaries to make decisions about the essential terms and conditions of employment.

3) Defined Essential Terms & Conditions of Employment

The final rule broadly defines essential terms and conditions of employment to include wages, benefits, hours of work, scheduling, job assignments, supervision, work rules, tenure, and working conditions related to safety and health. Joint-employer status is only found under the final rule when an entity employs workers and has the authority to control at least one of these terms or conditions, regardless of whether they exercise that control directly or indirectly.

4) Collective Bargaining Obligations

Once an entity is deemed a joint employer due to its control over the essential terms and conditions of employment, the NLRB takes the position that it must engage in collective bargaining regarding these specific terms. Note, however, that the final rule clarifies that a joint employer is only obligated to bargain over subjects it has the authority to control, not those beyond its purview.

5) Challenges to the Final Rule Likely Ahead

The NLRB’s new rule is likely to face litigation (as prior rules have) and challenges from Congress. On October 26, Senators Bill Cassidy (R-La.) and Joe Manchin (D-W.Va.) announced that they will introduce a Congressional Review Act (“CRA”) resolution to overturn the new rule in light of their concern about its implications for small businesses and the American franchise model. If successful, the CRA would not only nullify the new rule but also prohibit the NLRB from publishing a rule that is “substantially the same.”

* * * *

The NLRB’s 2023 joint-employer standard could have far-reaching implications for employers across industries. Accordingly, in preparation for the final rule’s implementation on December 26, 2023, employers should proactively engage in a careful, case-specific examination to grasp and clearly define their employment relationships with other entities, including roles, responsibilities, and the extent of control exerted over the essential terms and conditions of employment.

Gibson Dunn attorneys are closely monitoring these developments and available to discuss these issues as applied to your particular business.

The following Gibson Dunn attorneys assisted in preparing this client update: Michael Holecek, Jason Schwartz, Svetlana Gans, Rachel Brass, Katherine Smith, Andrew Kilberg, and Emily Lamm.

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

Rachel S. Brass – Partner, Labor & Employment Group, San Francisco
(+1 415-393-8293, rbrass@gibsondunn.com)

Svetlana S. Gans – Partner, Administrative Law & Regulatory Group, Washington, D.C.
(+1 202-955-8657, sgans@gibsondunn.com)

Michael Holecek – Partner, Labor & Employment Group, Los Angeles
(+1 213-229-7018, mholecek@gibsondunn.com)

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

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

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

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

On October 10, 2023, the Securities and Exchange Commission (the “Commission” or “SEC”) adopted final rules (the “Final Amendments”), significantly amending the beneficial ownership reporting requirements under Regulation 13D-G as promulgated pursuant to Sections 13(d) and 13(g) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The Final Amendments are based on the Commission’s February 10, 2022 proposed amendments (the “Proposed Amendments”), and primarily impact Schedule 13D and 13G (“13D/G”) filing deadlines, while issuing guidance on topics such as the reporting obligations related to certain derivatives and the scenarios for potential group formation.

Specifically, the Final Amendments:

Accelerate the 13D/G filing deadlines as detailed below
Extend the 13D/G filing cut-off times from 5:30 p.m. to 10 p.m. EST
Require disclosure of cash-settled derivative securities under Item 6 of Schedule 13D
Impute group member acquisitions to the group once a group has been formed (excluding intragroup transfers of securities)
Require the use of a structured, machine-readable data language (XBRL) for 13D/G filings

In addition, instead of adopting certain of the Proposed Amendments, the SEC provided guidance with respect to (i) the reporting obligations related to cash-settled derivatives and (ii) the types of situations where a Section 13(d) group may or may not be deemed to have formed.

The tables below summarize the more substantive changes to the Schedule 13D/G beneficial ownership reporting requirements.

Schedule 13D	Current	Revised (starting Feb. 5, 2024)
Initial 13D Due Date (under Rule 13d-1(a))	Within 10 days of acquiring more than 5% beneficial ownership	Within 5 business days of acquiring more than 5% beneficial ownership
Initial 13D Due Date (Following Loss of 13G Eligibility under Rules 13d-1(e), (f), and (g))	Within 10 calendar days after the event that causes ineligibility	Within 5 business days of losing eligibility to file on Schedule 13G
13D/A Trigger	“Material” change	“Material” change
13D/A Due Date	“Promptly”	Within two business days after the triggering event

Schedule 13G filed by Qualified Institutional Investors (“QIIs”)	Current	Revised (starting Sept. 30, 2024)
Initial 13G Due Date	45 days after year-end in which beneficial ownership exceeds 5%	45 days after quarter-end in which beneficial ownership exceeds 5%
Periodic 13G/A Due Date and Trigger	Annual amendments: due 45 days after year-end if any change (not including changes due to fluctuations in number of shares outstanding)	Quarterly amendments: due 45 days after quarter-end if a material change (not including changes due to fluctuations in number of shares outstanding)
Ownership Change 13G/A Due Date	10 business days after month-end if beneficial ownership exceeds 10% or there is a 5% decrease in beneficial ownership Thereafter, upon deviation by more than 5% of a covered class of equity securities	Five business days after month-end if beneficial ownership exceeds 10% Thereafter, upon deviation by more than 5% of a covered class of equity securities

Schedule 13G filed by “Passive” Investors (Rule 13d-1(c))	Current	Revised (starting Sept. 30, 2024)
Initial 13G Due Date	Within 10 days of acquiring more than 5% beneficial ownership	Within 5 business days of acquiring more than 5% beneficial ownership
Periodic 13G/A Due Date and Trigger	Annual amendments: due 45 days after year-end if any change (not including changes due to changes in shares outstanding)	Quarterly amendments: due 45 days after quarter-end if a material change (not including changes due to changes in shares outstanding)
Ownership Change 13G/A Due Date	“Promptly” upon acquiring more than 10% beneficial ownership Thereafter, upon deviation by more than 5% of a covered class of equity securities	Within 2 business days of acquiring more than 10% beneficial ownership Thereafter, upon deviation by more than 5% of a covered class of equity securities

Schedule 13G filed by “Exempt” Investors
(Rule 13d-1(d))

Current

Revised
(starting Sept. 30, 2024)

Initial 13G
Due Date

45 days after year-end in which beneficial ownership exceeds 5%

45 days after quarter-end in which beneficial ownership exceeds 5%

Periodic
13G/A Due Date and Trigger

Annual amendments: due 45 days after year-end in which any change occurred (other than change in percentage solely due to change in shares outstanding)

Quarterly amendments: due 45 days after quarter-end if material change occurred

Cash-Settled Derivatives

The Commission declined to adopt proposed Rule 13d-3(e), which would have caused holders of certain cash-settled derivative securities, excluding security-based swaps (“SBS”), to be considered beneficial owners of the reference equity security. Instead, the Commission issued guidance on the circumstances under which a holder of a cash-settled derivative security, excluding SBS, may be deemed the beneficial owner of the reference equity security under Rule 13d‑3.

The SEC originally proposed Rule 13d-3(e) in response to concerns that holders of certain cash-settled derivatives were excluded from the definition of “beneficial owner” but could still exert influence over an issuer by, among other methods, pressuring a counterparty to the derivative transaction to make certain decisions regarding the voting and disposition of the issuer’s securities. In response to public comments, the Commission determined that issuing guidance on the topic would be sufficient.

The SEC’s guidance makes reference to its Security-Based Swaps Release which outlines three characteristics of a derivative position that may lead to the imputation of beneficial ownership: (i) the derivative security confers voting and/or investment power (or a person otherwise acquires such power based on the purchase or sale of a derivative security); (ii) the derivative security is used with the purpose or effect of divesting or preventing the vesting of beneficial ownership as part of a plan or scheme to evade the reporting requirements; or (iii) the derivative security grants a right to acquire an equity security. The Commission clarified that this guidance applies to non-SBS cash-settled derivatives, indicating that holders of a wide range of cash-settled derivatives could be considered beneficial owners when these circumstances exist.

The Commission also amended Item 6 of Schedule 13D to explicitly remove any implication that a person is not required to disclose interests in all derivative securities that use a covered class of security as a reference security. The new Item 6 expressly states that derivative contracts, arrangements, understandings, and relationships with respect to an issuer’s securities, including cash-settled SBS and other derivatives which are settled exclusively in cash, must be disclosed. The SEC believes that investors will benefit from this more complete picture of Schedule 13D filers’ economic interests in the relevant issuer.

Group Formation

In addition, the SEC declined to adopt certain of the Proposed Amendments relating to Rule 13d-5 that would have broadly expanded the type of investor activities giving rise to group formation. Instead, the Commission chose to issue guidance directly in the adopting release to the Final Amendments (the “Adopting Release”) on the scope of activities that could give rise to group formation.

In doing so, the Commission acknowledged that neither the relevant statute nor SEC rules define “group.” Instead, the Commission reiterated that the relevant standard for determining the existence of a “group” is found in Sections 13(d)(3) and 13(g)(3) of the Exchange Act. The Commission stated that the determination of whether two or more persons are acting as a group “depends on an analysis of all the relevant facts and circumstances and not solely on the presence or absence of an express agreement, as two or more persons may take concerted action or agree informally.”

The guidance on activities that may or may not give rise to formation of a group is presented in question and answer format. In a helpful manner, the Commission described the following situations where a Section 13(d) group would not arise:

Communications between two or more shareholders concerning a particular issuer, including topics relating to the improvement of the issuer’s long-term performance, changes in issuer practices, submissions or solicitations in support of a non-binding shareholder proposal, a joint engagement strategy (that is not control-related), or a “vote no” campaign against individual directors in uncontested elections.
Two or more shareholders engaging in joint communications with an issuer’s management.
Two or more shareholders making recommendations regarding the structure of the board of directors (so long as no discussion of individual directors or board expansion occurs and no commitments, agreements, or understandings are made among shareholders regarding their voting for director candidates).
Two or more shareholders jointly submitting a non-binding shareholder proposal.
A shareholder and an activist investor communicating regarding the activist’s proposals, (so long as the shareholder does not make a commitment to a particular course of action).

However, in the Commission’s view a group is likely to form where a beneficial owner of a substantial block of shares (one that is or will be required to file a Schedule 13D) intentionally communicates to other market participants (including investors) that such a filing will be made (to the extent this information is not yet public) with the purpose of causing such persons to make purchases, and one or more of the other market participants makes purchases in the same covered class of securities as a direct result of that communication. The concept of such “tipping” was discussed in the Proposing Release and is used in the Adopting Release as an example of where, in the Commission’s view, a group would likely result.

Effective Dates

The Final Amendments were published in the Federal Register on November 7, 2023 and will become effective on February 5, 2024. Compliance with the revised Schedule 13G filing deadlines will be required beginning on September 30, 2024. Compliance with the structured data requirement for Schedules 13D and 13G will be required on December 18, 2024. Compliance with the other rule amendments will be required upon their effectiveness. In determining whether to file a Schedule 13G/A for year-end 2023, on or before February 14, 2024, we recommend holders file if there is any change (other than changes due to a fluctuation in the number of shares outstanding) consistent with most filers’ traditional approach to reporting their ownership as of December 31.

Implications

As long anticipated in light of prior comments by Chair Gensler as well as the previously proposed changes, these final amendments in theory seek to modernize the reporting timing for Schedules 13D and 13G given the modern computer age and instant nature of disclosure dissemination. That said, as a practical matter, the new rules are likely to materially impact equity accumulation strategies for activist investor hedge funds in three respects:

The reduction from 10 calendar days to 5 business days for an initial Schedule 13D filing will shave down the period that activists have to purchase equity securities more gradually to mitigate upward price pressure and optimize their basis. Commentators have differing opinions on how material the time deadline reduction will be – but it is likely to be non-trivial.
Second, it is clear that the Commission will be looking closely at synthetic alternatives to actual equity ownership of a reportable class. Derivatives – particularly cash-settled equity swaps – have become popular instruments for activist hedge funds to lever the financial impact of their positions without having to actually purchase securities (or arguably, in the past having had to disclose all such positions).
Finally, while the Commission’s guidance regarding group formation in and of itself does not represent a paradigm shift, the attention placed on this area by the Commission makes it clear that interactions between activist funds – sometimes in practice performed intentionally casually by such funds – can still trigger group formation. The Commission is poised to scrutinize ‘wolf packs’ of multiple activists who can suddenly take near-concurrent positions in a given company while denying purported coordination that would in turn require formal recognition of the formation of a group.

Separate from ‘pure play’ activist hedge funds, the changes could also alter the landscape for potential acquirers who use a minority stake as a foothold in an acquisition strategy – albeit a complex strategy with the interplay of shareholder rights plans and other factors. Such investors may start as a ‘passive investor’ who must flip from Schedule 13G to Schedule 13D if they develop ‘control intent’ with respect to a given company. Investors who hold equity stakes from 5%-19.9% qualify for the ‘short form’ Schedule 13G so long as they are ‘passive’ and do not have ‘control intent’ through actions such as advocating for board changes or a change of control process/acquisition intent. If a ‘passive investor’ develops ‘control intent’ and seeks to consummate an acquisition transaction with the company – the new timeline reduces the amount of time to proceed from developing control intent to inking an acquisition contract before required public disclosure of intent on a Schedule 13D.

The following Gibson Dunn attorneys assisted in preparing this update: James J. Moloney, Ed Batts, Jeffrey L. Steiner, David Korvin, Lexi Hart, Chris Connelly, and Nicholas Whetstone.

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

Securities Regulation and Corporate Governance Group:
Elizabeth Ising – Washington, D.C. (+1 202-955-8287, eising@gibsondunn.com)
James J. Moloney – Orange County (+1 949-451-4343, jmoloney@gibsondunn.com)
Lori Zyskowski – New York (+1 212-351-2309, lzyskowski@gibsondunn.com)
Brian J. Lane – Washington, D.C. (+1 202-887-3646, blane@gibsondunn.com)
Ronald O. Mueller – Washington, D.C. (+1 202-955-8671, rmueller@gibsondunn.com)
Thomas J. Kim – Washington, D.C. (+1 202-887-3550, tkim@gibsondunn.com)
Michael A. Titera – Orange County (+1 949-451-4365, mtitera@gibsondunn.com)
Aaron Briggs – San Francisco (+1 415-393-8297, abriggs@gibsondunn.com)
Julia Lapitskaya – New York (+1 212-351-2354, jlapitskaya@gibsondunn.com)

Capital Markets Group:
Andrew L. Fabens – New York (+1 212-351-4034, afabens@gibsondunn.com)
Hillary H. Holmes – Houston (+1 346-718-6602, hholmes@gibsondunn.com)
Stewart L. McDowell – San Francisco (+1 415-393-8322, smcdowell@gibsondunn.com)
Peter W. Wardle – Los Angeles (+1 213-229-7242, pwardle@gibsondunn.com)

Derivatives Group:
Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com)
Darius Mehraban – New York (+1 212-351-2428, dmehraban@gibsondunn.com)
Adam Lapidus – New York (+1 212-351-3869, alapidus@gibsondunn.com)

Mergers and Acquisitions Group:
Ed Batts – Palo Alto (+1 650-849-5392, ebatts@gibsondunn.com)
Robert B. Little – Dallas (+1 214-698-3260, rlittle@gibsondunn.com)
Saee Muzumdar – New York (+1 212-351-3966, smuzumdar@gibsondunn.com)

On June 30, 2023, the New York City Department of Consumer and Worker Protection (the “DCWP”) released Frequently Asked Questions (“FAQ”)[1] regarding New York City’s Local Law 144,[2] which went into effect on July 5, 2023.

Local Law 144 restricts employers and employment agencies from using an automated employment decision tool (“AEDT”) in hiring and promotion decisions unless it has been subject to an annual bias audit conducted by an “independent auditor.” The law also imposes posting and notice requirements to New York City applicants and employees subject to the use of AEDTs. The FAQs provide insight into how the DCWP will approach enforcing Local Law 144, including its penalty schedule, which imposes penalties ranging from $375 to $1500 for each violation of the bias audit, notice, and posting requirements.[3]

As summarized at a high-level below, the FAQs provide some helpful guidance for covered employers but questions remain regarding the law’s scope and audit requirements.

1. NYC Office Location Is Key.

The FAQs clarify that Local Law 144 only applies to employers with a physical office in New York City that use an AEDT for (i) jobs located in New York City, at least part-time or (ii) for remote positions, if the location “associated with [such remote position]” is an office in New York City.

2. Covered Employment Decisions Need Not Be Final.

The DCWP previously emphasized during May 2023 roundtable events that Local Law 144 covers employment decisions “at any point in the process.” Otherwise stated, the analysis of whether Local Law 144 applies is not limited to the ultimate employment decision.[4]

The FAQs echo this position and emphasize that the law defines “employment decisions” to include screening for hire or promotion. However, the FAQs also make clear that conducting outreach or sending invitations to potential job or promotion candidates falls outside the scope of the law.

3. Compliance Responsibility Rests With Employers, Not Vendors.

The FAQs state that a vendor of an AEDT is not responsible for conducting a bias audit of its tool. Instead, in the DCWP’s view, covered employers and employment agencies are responsible for complying with Local Law 144’s bias audit requirements.

4. Demographic Information May Not Be Inferred.

The FAQs expressly state that employers and employment agencies may not infer or impute data about an applicant’s demographic information. This differs from other areas of law, such as the EEO-1 Component 1 Report, which permits observer identification to be used to determine an employee’s race or ethnicity.[5]

Accordingly, bias audits may only be conducted using historical or test data, and cannot be run on demographic information inferred by an algorithm or otherwise.

5. No Set Threshold For Statistical Significance.

The DCWP has chosen not to set a specific standard for determining statistical significance, thereby leaving the determination to the independent auditor. If test data is used in lieu of historical data because the auditor determined that the historical data was not statistically significant, the public summary of the bias audit results must explain this decision.

6. No Specific Test Data Requirements.

The DCWP previously stated that Local Law 144’s bias audit requirement provides flexibility regarding what data is used and who (e.g., the vendor or employer) may provide data to the independent auditor.[6] The FAQs likewise provide that the DCWP has not set requirements for test data to allow for the “development of best practices in this rapidly developing field.”

Notwithstanding this apparent flexibility and flux, the FAQs state that the summary of the bias audit must include the source of the data and an explanation of the data used. For example, if the test data is limited to a specific region or time period, the public summary is expected to explain why and/or how.

7. Bias Audit Need Not Be Position Specific.

Employers that hire for an array of different positions may rely on a bias audit that is based on the historical data of multiple employers if it is either (a) their first time using the AEDT or (b) they provide historical data from their use of the AEDT to the independent auditor. To that end, the FAQs state that there is no requirement that the employers providing historical data for a bias audit use the AEDT to hire or promote for the same type of position. The FAQs therefore suggest that the data used for the bias audit can be aggregated from an assortment of different positions—though whether doing so may be accurate or prudent will vary case-by-case.

8. Notice Need Not Be Position Specific.

The notice posted in the employment section of an employer’s website for job applicants or in a written policy or procedure for candidates for promotion need not be position specific. The FAQs therefore appear to indicate that a notice’s description of the job qualifications and characteristics assessed by the AEDT may be categorical.

9. Discrimination Claims Will Be Referred To The City Commission On Human Rights.

The FAQs state that any claims of discrimination involving AEDTs that are sent to the DCWP will be automatically referred to the New York City Commission on Human Rights. The DCWP will enforce only Local Law 144’s prohibition on the use of AEDTs without a bias audit and the required notice and posting.

10. Numerous Questions And Ambiguities Remain.

Despite committing to address many unanswered questions raised during the DCWP’s roundtable events, the FAQs leave a number of open questions.

For example, there is still no clarification regarding the statute’s ill-fitting definition of an employment agency.[7] The final rules implementing Local Law 144 defined an “employment agency” as “all persons who, for a fee, render vocational guidance or counseling services, and who directly or indirectly represent” that they perform one of the enumerated functions such as arranging interviews or having knowledge of job openings or positions that cannot be obtained from other sources with a reasonable effort.[8] Since Local Law 144 is limited to applicants who have applied for a position (and not potential applicants), it is unclear how a definition focused on employment agencies attracting or assisting prospective applicants will be reconciled with the apparently narrower scope of the law.

The FAQs state that test data can be used to conduct a bias audit if demographic data is not available or collected, but it remains unclear whether covered employers could (let alone must) artificially create test data to conduct a bias audit, especially since the FAQs state that demographic data should not be inferred.

Finally, the FAQs state that a remote position “associated” with a New York City office is within the scope of the law, but the DCWP does not clarify or explain how a remote position may be “associated” with a New York City office. For example, it remains unclear if an “association” will be found if a remote employee reports to a manager in New York City, must occasionally come into the New York City office, or if their paycheck is issued from the employer’s New York City office.

Conclusion

To date, New York City’s Local Law 144 is the most expansive effort in the United States to attempt to regulate the use of automated decision tools in employment. Its impact will undoubtedly be closely watched (and scrutinized) by legal commentators and other states and cities. In the wake of the law’s passage and throughout the subsequent rulemaking process, employers in New York City have been grappling with various questions about the law’s scope and requirements. The FAQs are helpful in answering some of these questions. But many remain. As such, effective July 5, employers are faced with the unsettling prospect of attempting to comply with Local Law 144 without clear and comprehensive guidance.

______________________________

[1] DCWP, Automated Employment Decision Tools: Frequently Asked Questions (June 2023), https://www.nyc.gov/assets/dca/downloads/pdf/about/DCWP-AEDT-FAQ.pdf.

[2] NYC Int 1894-2020, Local Law 144 (enacted December 11, 2021), https://legistar.council.nyc.gov/LegislationDetail.aspx?ID=4344524&GUID=B051915D-A9AC-451E-81F8-6596032FA3F9.

[3] RCNY, tit. 6, ch. 6, § 6-81, Automated Employment Decision Tools Penalty Schedule (effective Aug. 5, 2022), https://codelibrary.amlegal.com/codes/newyorkcity/latest/NYCrules/0-0-0-134007.

[4] DCWP, Local Law 144 of 2021 Automated Employment Decision Tool Roundtable with Business Advocates/Employers (May 2023), https://www.nyc.gov/assets/dca/downloads/pdf/about/DCWP-AEDT-Educational-Roundtable-with-Business-Advocates-Employers.pdf.

[5] U.S. EEOC, 2021 EEO-1 Component 1 Frequently Asked Questions (FAQs), https://www.eeocdata.org/pdfs/2021_EEO_1_Component_1_FAQs.pdf.

[6] Id.

[7] See Harris Mufson, Danielle Moss, and Emily Lamm, 10 Ways NYC AI Discrimination Rules May Affect Employers, Law360 (Apr. 19, 2023) (discussing the definition of “employment agency” under the final rules implementing Local Law 144).

[8] DCWP, Notice of Adoption of Final Rule, https://rules.cityofnewyork.us/wp-content/uploads/2023/04/DCWP-NOA-for-Use-of-Automated-Employment-Decisionmaking-Tools-2.pdf.

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

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

Harris M. Mufson – New York (+1 212-351-3805, hmufson@gibsondunn.com)

Danielle J. Moss – New York (+1 212-351-6338, dmoss@gibsondunn.com)

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

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

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

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, provides an update on a proceeding by the Judicial Council of the Federal Circuit, and summarizes recent Federal Circuit decisions concerning secondary considerations, inventorship, inherency, and enablement.

Federal Circuit News

Noteworthy Petitions for a Writ of Certiorari:

A new potentially impactful petition was filed before the Supreme Court in June 2023:

Killian v. Vidal (US No. 22-1220): The petition raises the questions (1) whether the Federal Circuit’s “departures of the Supreme Court’s Alice/Mayo jurisprudence . . . enabled the USPTO to violate the” Administrative Procedure Act (“APA”) and the Due Process Clause of the Fifth Amendment; and (2) whether the exceptions created by Article III courts to 35 U.S.C. § 101 exceeds the courts’ constitutional authority.

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

In CareDx Inc. v. Natera, Inc. (US No. 22-1066), after the respondents waived their right to file a response, retired Federal Circuit Judge Paul R. Michel and Professor John F. Duffy filed an amici curiae brief in support of Petitioners. The Court thereafter requested a response, which is now due on July 31, 2023.

The Court denied the petitions in Nike, Inc. v. Adidas AG (US No. 22-927) and NST Global, LLC v. Sig Sauer Inc. (US No. 22-1001). A response has been filed in Ingenio, Inc. v. Click-to-Call Technologies, LP (US No. 22-873).

Noteworthy Federal Circuit En Banc Petitions:

On June 30, 2023, the Federal Circuit granted the en banc petition filed in LKQ Corp. v. GM Global Technology Operations LLC, No. 21-2348 (Fed. Cir. June 30, 2023). The Court requested that the parties file new briefs to address questions related to the obviousness inquiry for design patents.

Other Federal Circuit News:

Release of Materials in Ongoing Judicial Investigation. As we summarized in our May 2023 update, there is an ongoing proceeding by the Judicial Council of the Federal Circuit under the Judicial Conduct and Disability Act and the implementing Rules involving Judge Pauline Newman. Last month, the Court approved and released public versions of all prior orders of the Special Committee and the Judicial Council, as well as Judge Newman’s letter responses to date. On June 20, 2023, the Court released additional materials in the ongoing investigation. The orders may be accessed here.

Upcoming Oral Argument Calendar

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

Key Case Summaries (June 2023)

Yita LLC v. MacNeil IP LLC, No. 22-1383 (Fed. Cir. June 6, 2023): The Patent Trial and Appeal Board (“Board”) determined as part of an inter partes review (“IPR”) that the challenged claims of one of MacNeil’s patents directed to constructing a vehicle floor tray based on digital scans would not have been obvious. Despite determining that the claims would have been obvious over the asserted prior art, the Board found MacNeil’s evidence of secondary considerations “compelling” enough to overcome this determination of obviousness.

The Federal Circuit (Taranto, J., joined by Chen and Stoll, JJ.) reversed. The Court stated that under the Court’s precedent, objective evidence of nonobviousness lacks a nexus to the claimed invention if the evidence exclusively relates to a “known” feature in the prior art. The Court held that the Board therefore erred in concluding that because the feature was not “well known” in the prior art, that MacNeil’s secondary considerations evidence was sufficient to overcome its prior art based obviousness determination.

Blue Gentian, LLC v. Tristar Products, Inc., Nos. 21-2316, 21-2317 (Fed. Cir. June 9, 2023): Blue Gentian sued Tristar for infringement of its patents generally related to an expandable hose. Tristar counterclaimed that each of the asserted patents were invalid for failing to name a co-inventor, Gary Ragner. The district court agreed and concluded that Mr. Ragner contributed three key features of the invention and should have been named an inventor on the patents.

The Federal Circuit (Prost, J., joined by Chen and Stark, JJ.) affirmed. The Court first rejected Blue Gentian’s argument that the district court erred by not engaging in claim construction, holding that there must be a material dispute about claim scope to require claim construction prior to an inventorship determination. Here, Blue Gentian failed to identify “a dispute about claim scope that was material, or even related to, inventorship.” Additionally, because the patent owner argued during prosecution that the three key features at issue distinguished the invention over the prior art, the Court held that it follows that these features are not insignificant in quality and amounted to a significant contribution to conception that met the requirements needed to be considered a joint inventor.

Parus Holdings, Inc., v. Google LLC, Nos. 2022-1269, 2022-1270 (Fed. Cir. June 12, 2023): Google filed an IPR petition concerning Parus’s patents directed to an interactive voice system that allowed a user to request information from a voice web browser. Google asserted that certain claims of these patents would have been obvious over a number of prior art references, including Kovatch. Parus argued that Kovatch did not qualify as prior art because the claimed inventions were conceived of and reduced to practice before the earliest possible priority date for Kovatch. In support of its arguments, Parus submitted over 1,400 pages of material, but only cited small portions of that material in its briefs without meaningful explanation. The Board declined to consider these arguments because Parus failed to comply with 37 C.F.R. § 42.6(a)(3), which prohibits incorporation by reference.

The Federal Circuit (Lourie, J., joined by Bryson and Reyna, JJ.) affirmed. The Court held that the Board did not violate the APA. The Board had determined that Parus failed to cite to the relevant record evidence with specificity and explain the significance of the produced materials in its briefing, and incorporated its arguments by reference in violation of 37 C.F.R. § 42.6(a)(3), and thus, the Court determined that the Board’s disregard of Parus’s arguments cannot be an abuse of discretion.

In re Couvaras, No. 22-1489 (Fed. Cir. June 14, 2023): The pending claims of the patent application at issue are directed to a method of increasing prostacyclin release to improve vasodilation, which decreases blood pressure. The increased prostacyclin is achieved by co-administering two well-known antihypertensive agents. The examiner finally rejected the claims finding that the claimed results of the compounds’ administration naturally flowed from administration of the known antihypertensive agents. Couvaras then appealed to the Board. The Board agreed with the examiner and found that the increase in prostacyclin release was “inherent in the obvious administration of the two known antihypertension agents.”

The Federal Circuit (Lourie, J., joined by Dyk and Stoll, JJ.) affirmed. Courvaras argued that even if the recited mechanism of action (the increased release of prostacyclin) was inherent, the Board erred in dismissing it as having no patentable weight, because the mechanism was unexpected. The Court rejected this argument holding that “[r]eciting the mechanism for known compounds to yield a known result cannot overcome a prima facie case of obviousness, even if the nature of that mechanism is unexpected.”

Medytox v. Galderma, No. 22-1165 (Fed. Cir. June 27, 2023): Galderma filed a post-grant petition of Medytox’s patent directed to a method for treating frown lines using an animal-protein-free botulinum toxin composition, which allegedly displayed an increased sustained effect compared to BOTOX^®. Medytox filed a motion to amend seeking to cancel the challenged claims and file substitute claims. In a final written decision, the Board found in part that the substitute claims were unpatentable for lack of enablement, because the specification only disclosed three responder rates: 52%, 61%, and 62%, and a skilled artisan would not have been able to achieve higher responder rates included in the claimed ranges without undue experimentation.

The Federal Circuit (Reyna, J., joined by Dyk and Stark, JJ.) affirmed. Citing the Supreme Court’s recent opinion in Amgen Inc. v. Sanofi, 143 S. Ct. 1243 (2023), the Federal Circuit determined that the Board did not err in concluding that the substitute claims were not enabled because a skilled artisan would not have been able to achieve responder rates higher than the limited examples disclosed in the specification.

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

Blaine H. Evanson – Orange County (+1 949-451-3805, bevanson@gibsondunn.com)
Audrey Yang – Dallas (+1 214-698-3215, ayang@gibsondunn.com)

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

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

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

On June 30, 2023, Sacramento Superior Court Judge James Arguelles held that the California Privacy Protection Agency (CPPA) cannot enforce its regulations issued on March 29, 2023, until March 29, 2024—about nine months later than the date the California Privacy Rights Act (CPRA) permitted enforcement of any provisions added or amended by the law.[1] This development provides helpful breathing room for businesses seeking to comply. It is important to note that this reprieve only exists for the new regulations issued under the CPRA on March 29, 2023, not all aspects of the CPRA, as explained below.

Delay Begets Delay

The saga of the CCPA, which ultimately led to the California privacy regulations saga, began in 2017. An advocacy group, Californians for Consumer Privacy, began collecting signatures and by 2018, was in position to successfully submit a ballot initiative for consideration by California voters in the November 2018 election titled the “California Consumer Privacy Act,” or CCPA. State legislators negotiated a compromise with key stakeholders, including Californians for Consumer Privacy, and enacted a last-minute compromise draft through the legislative process in exchange for pulling the initiative off of the November 2018 ballot.[2] The state legislature passed the California Consumer Privacy Act (CCPA) as AB 375 and it was signed into law on June 28, 2018, with provisions becoming operative January 1, 2020.

After the passage of the CCPA, but even before it came into effect, Californians for Consumer Privacy remained dissatisfied with the state of California privacy law and began a second ballot initiative, the California Privacy Rights Act (CPRA). Voters approved the initiative (Proposition 24) in November 2020. The CPRA amended the CCPA by, among other things, adding additional consumer rights, including the right to correct inaccurate personal information, the right to opt out of certain “sharing” of data (rather than just the right to opt out of “sale” of data), and the right to limit the use and disclosure of sensitive personal information.

The CPRA also created the California Privacy Protection Agency (CPPA) and charged it with promulgating final regulations under the law and, along with the Attorney General, enforcing the law and those regulations. The CPRA specified that “[t]he timeline for adopting final regulations required by the act … shall be July 1, 2022” and “[n]otwithstanding any other law, civil and administrative enforcement … shall not commence until July 1, 2023[.]”[3]

The CPPA, however, failed to finalize regulations by July 1, 2022, and businesses seeking to comply with the new requirements were left to wonder about both the ultimate content of the regulations and their potential enforcement exposure and liability. On March 29, 2023, nine months after the deadline, the CPPA issued final regulations relating to twelve of the fifteen topics contemplated by the CPRA—leaving businesses just three months to comply. Today, there are still no regulations concerning three key elements of the CPRA, that the CPPA is tasked with tackling, namely cybersecurity audits, risk assessments, and automated decision-making technology.[4] Further, the CPPA has publicly discussed other specific topics of consideration that it intends to address (on a much longer timeline), including employment-related data issues, and social media API access. The CPPA has not indicated a clear timeline to promulgate regulations or enforce the law in any of the remaining areas, despite consideration that certain of them are more difficult than others, and undergoing a diligence process.[5]

The Chamber of Commerce’s Lawsuit

The California Chamber of Commerce sued, seeking a delay of the CPRA for a period of one year after all required regulations were issued.[6]

Following a hearing on June 30, 2023, the California Superior Court, Sacramento County issued a Minute Order considering this request, applying rules of statutory interpretation to determine the voters’ intent in passing the CPRA and the appropriate resultant timeline for enforcement.[7] The court held that “the plain language of the statute indicates the [CPPA] was required to have final regulations in place by July 1, 2022” and “the [CPPA] should be prohibited from enforcing the Act on July 1, 2023 when it failed to pass final regulations by the July 1, 2022 deadline.”[8] “The very inclusion of [the timeline prescribed by subdivision (d)] indicates the voters intended there to be a gap between the passing of final regulations and enforcement of those regulations.”[9] The court also disagreed with the CPPA’s argument that the delayed regulations did not prejudice businesses seeking to comply with the law.[10]

Yet the court did not agree that enforcement of the entire regulatory scheme should be delayed. “[T]he Court agrees with the [CPPA] that delaying the [CPPA]’s ability to enforce any violation of the Act for 12 months after the last regulation in a single area has been implemented would likewise thwart the voters’ intent to protect the privacy of Californians as contemplated by Proposition 24.”[11]

The court struck a balance between the Chamber’s and the CPPA’s arguments, allowing enforcement of the regulations on a piecemeal basis, one year after they are finalized: “the Court hereby stays the Agency’s enforcement of any Agency regulation implemented pursuant to Subdivision (d) for 12 months after that individual regulation is implemented.”[12] “By way of example, if an Agency regulation passes regarding Section 1798.185 subdivision (a), subsection (16) (requiring the Agency issue regulations governing automated decision-making technology) on October 1, 2023, the Agency will be prohibited from enforcing a violation of said regulation until October 1, 2024. The Agency may begin enforcing those regulations that became final on March 29, 2023 on March 29, 2024.”[13]

The order is good news for businesses subject to the law, which will have an extra nine months to comply with the CPRA regulations that were finalized on March 29, 2023. The order also provides a clear timeline for enforcement of forthcoming CPRA regulations, including in the three areas mentioned above. The CPRA is only permitted to enforce these new regulations twelve months after they have been finalized by the Office of Administrative Law.

Other California Privacy Regulations—and the Underlying Laws—Are in Force

It is important to note that the court’s ruling focuses regulations promulgated under the CPRA. To the extent the statutory basis for existing CCPA regulations remained unchanged by the CPRA, those regulations may continue to be enforced. In addition, to the extent the CPPA intends to bring enforcement actions for a business’s failure to comply with requirements set out in the CPRA’s statutory text, itself, the court’s ruling is not likely to prevent it from doing so. But enforcement may be muddied by questions as to whether any compliance failures are the result of actual non-compliance or whether they were caused by a good-faith misunderstanding based on lack of insights from the regulations. In any case, the CPPA remains able to bring enforcement actions for failure to comply with provisions of the CCPA that were left unamended when the CPRA was enacted.

Viewed through that lens, though the ruling provides relief for businesses rushing to comply with the delayed CPRA regulations, the impact of the court’s ruling may be considered somewhat limited: only enforcement of the March 29, 2023 regulations are delayed until March 29, 2024 (and enforcement of any forthcoming regulations will begin one year after they are finalized). Enforceable regulations concern a host of topics relating to the seven core consumer rights under the CCPA and related topics.[14]

The CPPA May Continue the Fight

The CPPA may appeal the Superior Court order. The default California rules provide an automatic stay of trial court proceedings and of enforcement of the Superior Court’s order.[15] This means that the Superior Court’s order to delay the enforcement of the CPRA regulations could be put on pause. If that happens, the CPPA’s regulations could be enforceable, pending the CPPA’s appeal. If appealed, the Chamber could seek to maintain the status quo of the Superior Court’s order, allowing the delay of enforcement of the CPRA regulations to continue. In assessing such a request, the Court of Appeal would balance hardships and benefits, likely weighing the public’s and state’s interests in earlier enforcement of privacy regulations against the interests of businesses in having the time that voters’ prescribed to comply with the law.[16]

The CPPA Will Speak

The CPPA has scheduled a public meeting for July 14, 2023. The proposed agenda confirms that the CPPA Board will publicly discuss key updates, including enforcement. In addition, “the Board will meet in closed session to confer and receive advice from legal counsel regarding” the Chamber lawsuit.[17] We will continue to monitor the development of the CPPA, CCPA, CPRA, and other notable state privacy laws and regulations.

__________________________

[1] California Chamber Of Commerce vs. California Privacy Protection Agency (June 30, 2023) 34-2023-80004106-CU-WM-GDS (J. Arguelles order); Cal. Civ. Code § 1798.185, subd. (d) (“Notwithstanding any other law, civil and administrative enforcement of the provisions of law added or amended by this act shall not commence until July 1, 2023, and shall only apply to violations occurring on or after that date.”).

[2] The California legislature generally cannot repeal voter initiatives, once passed. These compromises are a common way for the legislature to refine voter initiatives. California Constitution, Article II, Section 10 (c); California Election Code, Section 9034.

[3] Cal. Civ. Code § 1798.185, subd. (d).

[4] Id. § 1798.185, subd. (a).

[5] The CPPA has invited and received pre-rulemaking comments on the three remaining topics. California Privacy Protection Agency, Preliminary Rulemaking Activities on Cybersecurity Audits, Risk Assessments, and Automated Decisionmaking (Feb. 10, 2023), available at https://cppa.ca.gov/regulations/pre_rulemaking_activities_pr_02-2023.html

[6] California Chamber of Commerce vs. California Privacy Protection Agency (March 30, 2023) 34-2023-80004106-CU-WM-GDS (complaint).

[7] Order at 3-5.

[8] Id. at 4.

[9] Id.

[10] Id. at 5.

[11] Id. at 4-5.

[12] Id.

[13] Id.

[14] For additional reading concerning the scope of the enforceable regulations, please review our Privacy, Cybersecurity and Data Innovation Practice Group’s publications.

[15] Cal. Cod Civ. Proc. § 916. The Superior Court’s order proceeded on the Chamber’s petition for writ of mandate (dismissing other causes of action for declaratory and injunctive relief as moot). Order at 5. In traditional mandamus, perfecting appeal automatically stays effect of the writ. Johnston v. Jones (1925) 74 Cal.App. 272; Cal. Code Civ. Proc. § 1094.5.

[16] See Building Code Action v. Energy Resources Conservation & Dev. Com. (1979) 88 Cal.App.3d 913, 922.

[17] California Privacy Protection Agency Board, Meeting Notice and Agenda (June, 30, 2023), available at https://www.cppa.ca.gov/meetings/agendas/20230714.pdf.

The following Gibson Dunn lawyers assisted in preparing this alert: Cassandra Gaedt-Sheckter, Jane Horvath, Vivek Mohan, Eric Vandevelde, Benjamin Wagner, Christopher Rosina, and Tony Bedel.

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

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

Europe
Ahmed Baladi – Co-Chair, PCDI Practice, Paris (+33 (0) 1 56 43 13 00, abaladi@gibsondunn.com)
Kai Gesing – Munich (+49 89 189 33-180, kgesing@gibsondunn.com)
Joel Harrison – London (+44(0) 20 7071 4289, jharrison@gibsondunn.com)
Vera Lukic – Paris (+33 (0) 1 56 43 13 00, vlukic@gibsondunn.com)

Asia
Connell O’Neill – Hong Kong (+852 2214 3812, coneill@gibsondunn.com)
Jai S. Pathak – Singapore (+65 6507 3683, jpathak@gibsondunn.com)

Decided July 6, 2023

Kuciemba v. Victory Woodworks, Inc., S274191

The California Supreme Court held today that employers owe no duty of care, under state tort law, to nonemployees (including employees’ family members) to prevent the spread of COVID-19.

Background:
Robert Kuciemba worked for Victory Woodworks in San Francisco. He contracted COVID-19 while at work, allegedly because Victory transferred workers from a job site where there were many infections to his site. He brought the virus home and transmitted it to his wife, whose age and ill health made her especially vulnerable to COVID. She was hospitalized for over a month as a result.

The Kuciembas sued Victory in California court, raising a variety of state-law tort claims. After Victory removed the case to federal court, the district court dismissed the complaint. It first ruled that Mrs. Kuciemba’s claims against Victory were barred by the derivative-injury doctrine—namely, that California’s Workers Compensation Act provides the exclusive remedy for work-related injuries and third-party claims that are “collateral to or derivative of” work-related injuries. The court also ruled in the alternative that Victory had no duty of care to prevent the spread of COVID to Mrs. Kuciemba.

The Kuciembas appealed to the Ninth Circuit, which—noting the lack of clear precedent addressing the scope of the derivative-injury doctrine or the duty of care in a case like the Kuciembas’—certified both issues to the California Supreme Court. The Supreme Court accepted certification and heard argument in May 2023.

Issues:
1. If an employee gets COVID-19 at work and transmits the virus to his spouse, does the derivative-injury doctrine bar the spouse’s claim against the employer?

2. Does an employer owe a duty to the households of employees to exercise ordinary care to prevent the spread of COVID-19?

Court’s Holding:
1. No. Third-party claims are barred by the derivative-injury doctrine only when they are “legally dependent on the employee’s injury,” such as with an heir’s wrongful-death or spouse’s loss-of-consortium claim. The derivative-injury doctrine does not bar “a family member’s claim for her own independent injury,” even if the injury was “caused by the same negligent conduct of the employer” that injured the employee.

2. No. Although it is generally “foreseeable that an employer’s negligence in permitting workplace spread of COVID-19 will cause members of employees’ households to contract the disease,” “the significant and unpredictable burden that recognizing a duty of care would impose on California businesses, the court system, and the community at large counsels in favor of” declining to impose such a duty on employers.

What It Means:

The opinion acknowledges that “there is only so much an employer can do” to prevent the spread of viruses such as COVID-19: “Employers have little to no control over the safety precautions taken by employees or their household members outside the workplace,” and they cannot control whether individual employees comply with precautions such as “mask wearing and social distancing.”
The Court’s opinion clarifies the scope of California’s “analytically challenging” derivative-injury doctrine, explaining that it bars a plaintiff’s claim only if she must “prove injury to the employee as at least part of a legal element” of her claim. It is not enough that the third party’s injury would not have occurred but for the employee’s injury.
Even where foreseeability factors weigh in favor of recognizing a duty, courts will decline to impose a duty of care that would “alter employers’ behavior in ways that are harmful to society.”
The Court declined to address “[w]hether a local measure enacted on an emergency basis could appropriately impose a tort duty extending to employees’ household members,” which was beyond the scope of the questions certified from the Ninth Circuit.

The Court’s opinion is available here.

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

Appellate and Constitutional Law Practice

Thomas H. Dupree Jr. +1 202.955.8547 tdupree@gibsondunn.com	Allyson N. Ho +1 214.698.3233 aho@gibsondunn.com	Julian W. Poon +1 213.229.7758 jpoon@gibsondunn.com
Blaine H. Evanson +1 949.451.3805 bevanson@gibsondunn.com	Bradley J. Hamburger +1 213.229.7658 bhamburger@gibsondunn.com	Michael J. Holecek +1 213.229.7018 mholecek@gibsondunn.com

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

Enforcement Actions

United States

SEC Sues Binance, Binance.US, and Founder Changpeng Zhao
On June 5, the SEC filed a 13-claim complaint against Binance, Binance.US, and Binance founder Changpeng Zhao in D.C. federal court, alleging they engaged in unregistered offers and sales of crypto asset securities, including the Binance branded, fiat-backed stablecoin BUSD. The SEC claims Binance and Binance.US were acting as an exchange, broker-dealer, and clearing agency, and intentionally chose not to register with the SEC. Binance and Binance.US dispute these allegations. The SEC subsequently filed a motion for a TRO, seeking to freeze Binance.US’s assets. On June 13, after a hearing, Judge Amy Berman Jackson ordered the parties to mediation to attempt to negotiate a resolution to the SEC’s requested TRO. On June 19, the parties submitted and Judge Jackson signed a consent order. Complaint; Law360; Law360 2; Law360 3; Rolling Stone; Order.
SEC Sues Coinbase
On June 6, the SEC filed a 5-count complaint against Coinbase and its parent company Coinbase Global in the Southern District of New York. The SEC alleges that Coinbase violated securities laws since 2019 by failing to register as an exchange, broker, or clearing agency despite facilitating trading and settlement of several digital assets that the SEC alleges are securities, including ADA, SOL, MATIC, and others. The SEC also alleges that Coinbase has operated as an unregistered broker by offering its Coinbase Prime and Coinbase Wallet services, and that Coinbase’s staking service for several digital assets, including Ethereum, constitutes unregistered securities offerings. On June 28, Coinbase filed a 177-page answer to the SEC’s complaint, calling the suit an “extraordinary abuse of process” that “offends due process and the constitutional separation of powers.” In a separate letter to the Court, Coinbase said that it intended to file a motion for judgment on the pleadings on the ground that the SEC lacks jurisdiction over the subject matter of the suit because the tokens at issue are not securities. Complaint; CoinDesk; CoinDesk 2; Rolling Stone.
Crypto Exchange Bittrex Moves to Dismiss SEC Enforcement Action
On June 30, crypto exchange Bittrex moved to dismiss an SEC enforcement action alleging that the exchange operated as an unregistered securities exchange, broker, and clearing agency. Echoing arguments made by others in the industry, Bittrex argues that the major questions doctrine bars the SEC’s efforts to regulate tokens as securities, that secondary market transactions in tokens do not involve “investment contracts,” and that the SEC’s lawsuit deprives Bittrex of constitutionally required fair notice. The case is pending in the U.S. District Court for the Western District of Washington. CoinTelegraph; Motion.
Judge Severs Bankman-Fried Criminal Charges, Declines to Dismiss Them
On May 8, FTX’s founder and former CEO filed motions to dismiss most of the criminal charges against him, marking Bankman-Fried’s first detailed defense in his U.S. federal criminal case. Among other things, Bankman-Fried argued that under the U.S.-Bahamas extradition treaty the Bahamas needs to “consent” to the additional charges brought after the extradition. On May 30, prosecutors responded to these motions. Among other things, the government argued it has sought the consent of the Bahamian government to proceed with the charges brought post-extradition and will drop those charges if the Bahamas does not consent. On June 15, District Judge Lewis Kaplan severed the post-extradition charges against Bankman-Fried and ordered a second trial on those charges in March 2024. On June 30, Judge Kaplan denied Bankman-Fried’s motions to dismiss. CoinTelegraph 1; CoinDesk; New York Times; Law360; Docket; CoinTelegraph 2.
CoinEx Agrees to Settle Registration Charges for $1.8 Million
On June 14, global cryptocurrency exchange CoinEx agreed to settle charges that it had failed to register as a broker-dealer with the New York Attorney General for $1.8 million. The company also terminated its U.S. users’ accounts and blocked them from creating new accounts. Law360; Stipulation.
Wahi Brothers Settle Insider Trading Charges with the SEC
On May 30, the SEC settled charges with a former Coinbase product manager, Ishan Wahi, and his brother Nikhil. The two were arrested last year on charges of wire fraud conspiracy and “wire fraud in connection with a scheme to commit insider trading.” Both brothers pleaded guilty. Ishan Wahi was sentenced to 24 months in prison and ordered to forfeit 10.97 ether and 9,440 Tether, and Nikhil was sentenced to 10 months in prison and ordered to forfeit $892,500—with more than half as restitution to Coinbase as a victim of the Wahi defendants’ misconduct. The court has since held the restitution order in abeyance while the brothers contest the amount of attorneys’ fees awarded to Coinbase. On June 29, Coinbase asked the court to again grant its restitution request. The SEC announced that because of the brother’s prison sentences, it will not seek any other penalties. The settlement puts an end to the case brought by the SEC which was set to answer the question of whether cryptocurrencies at the heart of the case were indeed securities, as the SEC has argued and Coinbase, as amicus, forcefully disputed. SEC; CoinDesk; Law360.
Judge Torres Denies SEC’s Motion to Seal Hinman Documents
On May 16, United States District Judge Analisa Torres denied the SEC’s motion to seal records of its internal deliberations regarding a speech by former director William Hinman. In the June 2018 speech, the former SEC corporation finance director stated that ether is not a security. The SEC filed the motion on December 22, 2022 to seal the internal emails, text messages, and expert reports that followed Hinman’s speech. Judge Torres found that these documents “are not protected by the deliberative process privilege because they do not relate to an agency position, decision or policy.” Ripple has considered the speech a key piece of evidence in its ongoing legal battle with the SEC, which alleges that sales of Ripple’s XRP violated U.S. securities laws. Order; CoinTelegraph.
Gemini Moves to Dismiss SEC Suit
On May 29, Gemini filed a motion to dismiss the SEC’s lawsuit claiming that the operation of Gemini’s now defunct crypto lending program, called Gemini Earn, was a sale of unregistered securities. Gemini argued that the contracts involved were “simple lending arrangements” and that the SEC case is complicating the process of returning funds to investors. Law360; CoinTelegraph.
Green United Executives Argue SEC Has No Authority Over Crypto
On May 19, Wright Thurston and Kristoffer Krohn filed motions to dismiss an SEC enforcement action in the U.S. District Court for the District of Utah. The SEC sued the defendants in March 2023, alleging that the defendants fraudulently offered securities by selling “Green Boxes” and “Green nodes” marketed as miners for the GREEN token on the “Green Blockchain.” The SEC claimed the hardware sold didn’t mine GREEN as it was an Ethereum-based ERC-20 token that could not be mined and the Green Blockchain didn’t exist. The defendants in their motions to dismiss argue, among other things, that the SEC has no authority over the digital asset ecosystem, claiming that Congress “considered and rejected” the SEC’s authority over crypto. They also argue that the SEC has been “unclear and inconsistent” in defining digital assets and criticize the agency’s regulation-by-enforcement approach in the crypto space. CoinTelegraph; Thurston’s Motion; Krohn’s Motion.

International

Do Kwon Wins Bail Request, Upends Montenegrin Elections with Campaign Funding Claim, Is Sentenced to Four Months
On June 5, a Montenegro high court again approved $428,000 bail forDo Kwon subject to house arrest pending an extradition request from South Korea. Only days before a June 11 election in Montenegro, Do Kwon claimed in a letter from custody that “crypto friends” had provided campaign funding to a leading candidate, upending the election’s anticipated results. In March, Kwon, along with former Terraform Labs executive Han Chang-joon, was arrested in Montenegro for allegedly attempting to travel with falsified documents. South Korean authorities had been searching for Kwon since Terraform Labs collapsed in May last year. The two South Korean nationals were back in court on June 16 for a hearing in which Kwon’s lawyers said their client denied having funded the leading candidate’s campaign. Kwon and Han were subsequently sentenced to four months for falsifying official documents. Since his arrest, both South Korea and the U.S. have requested Kwon’s extradition to face criminal charges following his trial in Montenegro. CoinDesk 1; CoinTelegraph 1; CoinDesk 2; New York Times; CoinTelegraph 2; TechCrunch.

Regulation and Legislation

United States

Republicans Release Digital Asset Market Structure Proposal
On June 2, Chairman McHenry of the House Financial Services Committee and Chairman Thompson of the House Committee on Agriculture released a discussion draft of legislation providing a statutory framework for digital asset regulation. The discussion draft represents a “common approach to digital asset regulation that would bring existing consumer and investor protections to digital asset-related activities and intermediaries.” The House Financial Services Committee plans to vote on the proposed legislation in the second week of July. Press Release; Discussion Draft; The Block.
House Proposed a Comprehensive Regulatory Framework for Stablecoins
On June 13, the House Financial Services Committee released a discussion draft of a proposed statutory framework for stablecoins. During a June 21 oversight hearing, Chairman McHenry indicated that the committee will debate the bill during the July session. Press Release; Discussion Draft; The Block.
New NFA Regulation Takes Effect
On May 31, a new rule issued by the National Futures Association—the self-regulatory organization for the U.S. derivatives industry—takes effect. Compliance Rule 2-51 is applicable to NFA member firms and associated persons engaging in activities involving bitcoin and ether, including spot or cash market activities. The rule imposes anti-fraud, just and equitable principles of trade, and supervision requirements on members and associates, and codifies members’ existing disclosure obligations under NFA Interpretative Notice 9073. Law360.
Prometheum Congressional Testimony Attracts Industry Criticism
On June 13, Aaron Kaplan, the founder and co-CEO of crypto exchange Prometheum, testified before the House Financial Services Committee that the SEC has laid out a compliant path for crypto in the United States. Prometheum recently received a first-of-its-kind FINRA approval to operate as a special purpose broker-dealer for digital assets in anticipation of listing digital assets for trading. Kaplan’s remarks provoked some controversy across the industry and on Twitter, with certain competitors criticizing the company and Kaplan’s remarks. The Blockchain Association submitted FOIA requests for more information about the company. Hearing; CoinTelegraph 1; CoinTelegraph 2.
CFTC Warns Clearing Agencies to Monitor Crypto Risks
On May 30, the CFTC’s Division of Clearing and Risk issued a staff advisory warning clearing agencies that provide services for crypto products that they must contain risks associated with digital assets through mitigation strategies, or they will face the agency’s scrutiny. The advisory also notes that, given increased cybersecurity risks and other perceived dangers involving digital assets, the CFTC’s division will emphasize compliance regarding its “core principles” of system safeguards, conflicts of interest, and physical delivery.” Law360.
Proposed Tax on Crypto Mining Removed from Spending Bill
On May 28, in the lead up to legislation to raise the U.S. debt ceiling, lawmakers released a draft bill that did not include the previously proposed Digital Assets Mining Energy (DAME) 30% excise tax on electricity used by crypto miners. The tax would have increased by 10% each year over three years on electricity generated starting in 2024. CoinTelegraph.
Filecoin Sponsor Receives SEC Comment Letter
On May 17, Grayscale announced that it received a comment letter from the SEC asking it to withdraw the registration of a trust investing in Filecoin, because the SEC believes Filecoin meets the definition of a security. On May 31, crypto trading firm Cumberland announced that it would halt over-the-counter trading in the token used by the decentralized storage platform Filecoin, citing regulatory environment concerns. GlobeNewswire; The Block.
Federal Bank Regulatory Agencies Release Interagency Guidance on Third-Party Risk Management
On June 6, the Federal Reserve, FDIC and OCC released final interagency guidance designed to aid banking organizations in managing risks associated with third-party relationships, including those with FinTechs and companies in the digital assets space. The interagency guidance replaces prior guidance of the agencies and details risk management strategies at various stages of third-party relationships, such as planning, due diligence, contract negotiation, ongoing monitoring, and termination. The agencies underscore that the interagency guidance does not have the force and effect of law and does not impose any new requirements on banking organizations. Nonetheless, third-party risk management will remain an area of heightened focus and scrutiny by supervisors and examiners, particularly with respect to third parties that are: FinTechs; digital assets providers; critical to bank operations or organizational business continuity and resiliency; customer-facing; subject to heightened consumer compliance and other prudential requirements; or represent concentration risk. As such, FinTechs and other companies and service providers that partner with banks to deliver regulated financial services should expect potential additional scrutiny from both their bank partners and their bank partners’ regulators. Interagency Press Release; Interagency Guidance on Third-Party Relationships: Risk Management; Federal Reserve Board Memo; Federal Reserve SR 23-4: Interagency Guidance on Third-Party Relationships: Risk Management; FDIC Financial Institution Letter (FIL-29-2023); OCC Bulletin 2023-17.
Federal Deposit Insurance Corporation Continues Focus on Deposit Insurance Representations
On June 15, the FDIC issued advisory letters demanding three companies cease and desist from making false and misleading statements about FDIC deposit insurance. The advisory letters highlight the FDIC’s continuing efforts to review companies’ public statements, disclosures and other marketing materials for compliance with Section 18(a)(4) of the Federal Deposit Insurance Act (12 U.S.C. § 1828(a)(4)) and the FDIC’s 2022 final rule regarding advertising or other representations about FDIC deposit insurance (12 C.F.R. Part 328, Subpart B). To ensure compliance, banks and bank partners should, at a minimum, ensure subject materials: (a) clearly disclose that the nonbank company offering the service is not an insured bank; (b) identify the insured bank(s) where any customer funds may be held on deposit; (c) communicate that FDIC deposit insurance is not available in the event of the bankruptcy of the nonbank company and is only available should the FDIC-insured bank at which deposits are properly held fail; and (d) communicate that non-deposit products are not FDIC-insured products and may lose value. FDIC’s Letter to Bodega Importadora de Pallets; FDIC’s Letter to Money Avenue, LLC; FDIC’s Letter to OKCoin USA, Inc.

International

EU Formally Adopts Markets in Crypto-Assets Regulation (MiCA)
On May 31, the EU formally adopted MiCA, the first EU legal framework expressly regulating crypto assets. MiCA aims to protect investors by increasing transparency and putting in place a comprehensive framework for issuers and service providers such as trading venue and crypto asset wallets, including compliance with anti-money laundering rules. MiCA was published in the EU’s official journal on June 9, 2023, and entered into force on June 29, 2023, the 20th day following the date of its publication. Stablecoin issuers, which will face much stricter regulations under the new law, will have 12 months to ensure they are in compliance with the law, while other crypto issuers and so-called crypto asset service providers (CASPs) will have 18 months to prepare. CoinDesk; European Council.
EU Countries, Lawmakers Reach Deal on Data Act
On June 27, legislative negotiators from the European Union reached an agreement on the Data Act, a set of new rules governing fair access and use of data on internet-connected devices. The Act, which was passed by the European Parliament on March 14, has been criticized by the crypto industry for imposing requirements on smart contracts, including requiring them to include a kill switch. There are conflicting reports about whether the final draft, which has not yet been released, will assuage these concerns. The Data Act now awaits voting by the European Parliament and Council before it can become law. CoinDesk.

UK Crypto, Stablecoin Legislation Formally Approved
On June 29, King Charles formally approved the Financial Services and Markets Act, which gives UK regulators authority to supervise cryptocurrencies and stablecoins. The bill treats all crypto as a regulated activity, supervises crypto promotions, and incorporates stablecoins into payment rules. The U.K.’s Treasury, Financial Conduct Authority, the Bank of England, and Payments Systems Regulator will have the power to introduce and enforce regulations for the sector. Specific rules for the crypto sector could be implemented within a year. CoinDesk.

ESMA Calls on EU Investment Firms to Clearly State That Crypto Is Unregulated
On May 25, the European Securities and Markets Authority (ESMA), EU’s securities regulator, issued a public statement highlighting the risks arising from the provision of unregulated products and/or services by investment firms in the EU. ESMA expressed its concerns that where “investment firms engage in providing both regulated and unregulated products and/or services there is a significant risk that investors may misunderstand the protections they are afforded when investing in those unregulated products and/or services.” In such situations, ESMA recommended few steps for the investment firms, including noting in all marketing communications whether a given product is regulated or not, or clearly explaining “what investor protections are lost/not applicable when investing in a product.” ESMA.
UAE Issues New AML Rules for Digital Assets
On May 31, the Central Bank of the United Arab Emirates published guidance for licensed financial institutions on risks “related to virtual assets and virtual assets service providers.” The guidance specifies new rules on anti-money laundering and combating the financing of terrorism for banking institutions engaging with crypto in the UAE, including requiring licensed financial institutions to verify the identities of all customers. CoinTelegraph.
Hong Kong and UAE Central Banks Coordinate on Crypto Regulations
On May 29, the Central Bank of the UAE and the Hong Kong Monetary Authority held a bilateral meeting in which they agreed to cooperate on regulating virtual assets by implementing financial infrastructure and cross-border trade settlements. Decrypt.
Singapore Releases New Crypto Regulations
On July 3, the Monetary Authority of Singapore (MAS) announced new regulations for Digital Payment Token (DPT) service providers to safekeep customer assets under a statutory trust before the end of the year. The statutory trust is intended to mitigate the risk of loss or misuse of customers’ assets, and facilitate the recovery of customers’ assets in the event of a DPT service provider’s insolvency. MAS will also restrict DPT service providers from facilitating lending and staking of DPT tokens by their retail customers. These measures were introduced following an October 2022 public consultation on regulatory measures to enhance investor protection and market integrity in DPT services. Among other things, the MAS also issued a new consultation paper proposing requirements for DPT service providers to address unfair trading practices. Consultation Feedback; Consultation Paper on Proposed Amendments; Consultation Paper on Market Integrity

Civil Litigation

United States

Court Rules Bankman-Fried Cannot Subpoena Former FTX Counsel
On June 23, Judge Kaplan of the Southern District of New York denied FTX founder and former CEO Sam Bankman-Fried’s request to subpoena documents from Fenwick & West related to their earlier legal work for FTX, finding that the requested subpoena was “a fishing expedition.” Judge Kaplan also rejected Bankman-Fried’s argument that FTX was “so enmeshed in the government’s investigation that [it] must be considered part of the ‘prosecution team’ for purposes of the government’s discovery obligations,” holding that documents held by FTX are not in the government’s “possession, custody, or control.” CoinDesk; Law360; Order.
Third Circuit Retains Jurisdiction over Coinbase Mandamus Petition
On June 20, the U.S. Court of Appeals for the Third Circuit ruled that the SEC must provide an update on its progress in deciding Coinbase’s petition for rulemaking by October 11, 2023. The Court will maintain jurisdiction over Coinbase’s rulemaking petition in the interim. Coinbase’s rulemaking petition asks the SEC to explain, among other things, which digital assets the SEC believes to be securities and how industry players should go about registering them. CoinGeek.
Supreme Court Rules in Favor of Coinbase in Arbitration Lawsuit
On June 23, the U.S. Supreme Court held that a lawsuit against Coinbase should have been automatically stayed when the company appealed the federal district court’s denial of its motion to compel arbitration of a putative class action. Although the decision does not touch on issues specific to the crypto industry, the ruling is the first by the Supreme Court involving a crypto industry participant. Client Alert; Law360; Opinion.
Proposed Class Action Suit Filed Against Shaq for NFT Promotion
On May 23, a proposed class action was filed against basketball player Shaquille O’Neal, alleging that his promotion of Astrals Project NFTs violated securities laws by marketing unregistered digital assets. Law360.
MDL Created for FTX Investor Actions
On May 25, FTX investors asked the Judicial Panel on Multidistrict Litigation (JPML) to consolidate investor litigation actions relating to the demise of FTX before one federal judge in the Southern District of Florida. On June 5, the panel granted the motion and ordered the creation of a multi-district litigation before U.S. District Judge K. Michael Moore in Miami. Law360; Bloomberg.

Speaker’s Corner

United States

Senator Elizabeth Warren Calls for Crypto Legislation to Stop Fentanyl Trade
On May 31, Elizabeth Warren stated during a Senate hearing that she aims to combat cryptocurrency’s role in the illegal Chinese fentanyl trade. Warren suggested her Digital Asset Anti-Money Laundering Act may help cut off the crypto payments, and she said the bill will be reintroduced in this Congress.CoinDesk.

DeSantis Urges to ‘Protect’ Bitcoin in His Campaign Launch
On May 24, in announcing a bid for President in an interview on Twitter with Elon Musk, Ron DeSantis said that “as president, we’ll protect the ability to do things like Bitcoin.” DeSantis called those on Capitol Hill “central planners” who “want to have control over society.” DeSantis also mentioned that Congress has never specifically addressed cryptocurrency, and instead the regulation was created by “the bureaucracy” and made it so “that people cannot operate in that space.”CoinTelegraph.

International

Chief of G-7’s Financial Action Task Force Calls for Stronger Global Collaboration to Target Crime and Terrorism Financing
On May 18, T. Raja Kumar, President of FATF, an intergovernmental organization that sets money laundering and terrorist financing standards, urged G-7 leaders to “effectively” implement FATF’s crypto anti-money laundering norms ahead of the May G-7 summit in Hiroshima. Kumar said that “countries need to take urgent action to shut down lawless spaces, which allow criminals, terrorists and rogue states to use crypto assets.” In particular, he called on the implementation of the ‘travel rule,’ which requires virtual assets service providers to identify the sender and receiver of the transaction. His recommendations were echoed by the G-7 finance ministers and central bank governors meeting on May 13 in Japan. Global Governance Project; G7 Finance Ministers and Central Bank Governors Meeting Communiqué.

Other Notable News

BlackRock Applies for Spot Bitcoin ETF
On June 15, BlackRock filed an S-1 with the SEC for the iShares Bitcoin Trust, whose assets would consist primarily of Bitcoin held by Coinbase and which would reflect the spot price of Bitcoin. The move was seen as an indication of continued institutional support for crypto and was quickly followed by a number of similar filings, including by Fidelity Investments. According to a June 30 Wall Street Journal report, the SEC informed Nasdaq and Cboe Global Markets, the exchanges that filed on behalf of Blackrock and Fidelity, that their applications are not sufficiently clear and comprehensive. Cboe updated and re-filed its applications on June 30. On July 3, BlackRock resubmitted its filing through Nasdaq with new details. CoinDesk 1; S-1; CoinDesk 2; Wall Street Journal; MarketWatch.
Crypto Custodian Prime Trust Faces Nevada Receivership, Asset Freeze
On June 27, Nevada’s Financial Institutions Division filed a request to take crypto custodian Prime Trust into receivership and freeze its operations due to alleged insolvency. The request for receivership states that Prime Trust owes clients around $150 million in fiat currency and cryptocurrencies and that part of this shortfall resulted from the company losing its ability to access “legacy wallets.” CoinDesk.
NY Fed and Singapore Monetary Authority Publish Joint CBDC Study Results
On May 18, the Federal Reserve Bank of New York’s New York Innovation Center and the Monetary Authority of Singapore published a research report detailing the results of a joint study, with findings that distributed ledger technology could be used to improve the efficiency of cross-border wholesale payments and settlements involving multiple currencies. Report; CoinTelegraph.

The following Gibson Dunn lawyers prepared this client alert: Ashlie Beringer, Stephanie Brooker, Jason Cabral, M. Kendall Day, Jeffrey Steiner, Sara Weed, Ella Capone, Grace Chong, Chris Jones, Jay Minga, Nick Harper, Alfie Lim, Bart Jordan, Andrea Lattanzio, and Jan Przerwa.

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

FinTech and Digital Assets Group:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

On March 23, 2023, the Federal Trade Commission (“FTC”) issued a Notice of Proposed Rulemaking (“NPRM”) to significantly expand legal requirements for sellers that use negative option offers.[1] Negative option offers allow a seller to interpret a consumer’s silence or inaction as acceptance of an offer and include prenotification and continuity plans, automatic renewal plans, and free trial offers that convert into automatic renewal plans unless canceled before the end of the trial period. The NPRM was published in the Federal Register on April 24, 2023, and the comment deadline is June 23, 2023.

The FTC’s stated objective is to create enforceable performance-based requirements for all negative option offers across all media pertaining to: misrepresentations, disclosures, consents, and cancellation methods.[2] But the proposed Rule would extend beyond the offer’s negative option features to “any material fact related to the [offer’s] underlying good or service.”[3] Consequently, negative option sellers could face substantial civil penalties for violations of the proposed Rule for any allegedly deceptive facet of the broader consumer transaction.

The proposed Rule could be finalized by the end of the year. Companies should consider how this Rule might impact their business and consider submitting a comment to the NPRM addressing: (i) the prevalence of the alleged deceptive and unfair conduct relating to negative option features; (ii) empirical evidence concerning compliance costs, and the degree to which they would outweigh anticipated benefits; (iii) negative consequences to consumers that might arise from the Rule; and (iv) potential exemptions to the rules, including for industries subject to billing and notice requirements under separate federal or state legal regimes, such as the telecommunications or energy industries.

The Proposed Rule Would Significantly Broaden Requirements and Risks For Sellers Using Negative Option Features.

The proposed Rule would replace regulations that apply only to prenotification negative option plans for physical goods with more expansive requirements that would be applicable to all media containing any type of negative option feature. The proposed Rule would also incorporate negative option rules contained in other laws and regulations, such as the Restore Online Shoppers’ Confidence Act (“ROSCA”) and the Telemarketing Sales Rule (“TSR”) to “establish a comprehensive scheme for regulation of negative option marketing in a single rule… — [a] one-stop regulatory shop[.]”[4] The FTC asserts that the existing ROSCA and TSR rules are insufficient to protect consumers and serve as a deterrence because misrepresentations concerning negative options continue to be prevalent in the marketplace.[5]

The proposed requirements include the following:

Disclosures of Material Terms: Sellers must disclose clearly and conspicuously all material terms related to both the negative option feature and the underlying good or service prior to collecting billing information from the consumer. Material terms include: (i) the nature and amount of charges to be imposed, including any future increases or recurring payments; (ii) deadline(s) for a consumer to affirmatively object to charges; (iii) the date(s) charges will be submitted for payment; and (iv) information on how to cancel a negative option feature.[6]
Broad Prohibition on Misrepresentations: Sellers must not misrepresent, expressly or by implication, any material fact related to the transaction, including the negative option feature, or those related to the underlying good or service.[7]
Easy Cancellation Methods: Sellers must provide consumers with a cancellation method that is at least as easy as the method used to initiate the negative option feature. For instance, if consumers enter into a negative option feature on a seller’s website, they should be able to cancel the negative option feature through the same or an easier process on the seller’s website. If a consumer consented to the feature in-person, the seller must offer a simple cancellation option by phone and/or on its website in addition to, where practical, a similar in-person cancellation method. Sellers cannot require consumers who signed up via their website to call a phone number in order to cancel their negative option agreement.[8]
Consent to Negative Option Feature: Sellers must obtain consumers’ express, informed consent to a negative option feature separately from any other part of a transaction and prior to charging them. Sellers cannot obtain simultaneous consent to charges for an instant purchase and to accept a negative option feature. Sellers must retain records of these consents for three years, or one year after the negative option ends, whichever is longer.[9]
Requirement for Immediate Cancellation Upon Consumer Request: Sellers must immediately cancel the negative option feature upon request from a consumer, unless the seller obtains the consumer’s unambiguous affirmative consent to receive a save prior to cancellation. Sellers cannot present additional and alternative offers during a cancellation attempt, unless a consumer first expressly consents to receive information about offers. Sellers must retain records of these consents for three years, or one year after the negative option ends, whichever is longer.[10]
Annual Reminders: At least annually, sellers must send consumers reminders describing the product or service, the frequency and amount of charges, and the means to cancel. This provision does not apply to negative option agreements involving the delivery of physical goods.[11]

Noncompliance with any of these requirements would be considered an unfair or deceptive practice in violation of Sections 5 and 19 of the FTC Act, subject to civil penalties, currently up to $50,120 per day for ongoing violations.[12]

Former Commissioner Christine Wilson wrote a five-page dissent stating that the proposed Rule went “far beyond practices for which the rulemaking record supports a prevalence of unfair or deceptive practices.”[13] Among other problems, Commissioner Wilson noted that the proposed Rule “is not confined to negative option marketing” and “covers any misrepresentation made about the underlying good or service sold with a negative option feature,” notwithstanding that the Commission did not include and seek comments about such general misrepresentations in its Advance Notice of Proposed Rulemaking.[14] Because the proposed Rule would allow the FTC to invoke Section 19 of the FTC Act to obtain civil penalties or consumer redress, she explained, marketers could be liable for civil penalties for product-efficacy claims “even if the negative option terms are clearly described, informed consent is obtained, and cancellation is simple.”[15]

Commissioner Wilson also stated that the breadth of the proposed Rule would evade the Supreme Court’s decision limiting the FTC’s authority to seek disgorgement in cases enforcing the general prohibition on unfair or deceptive practices in Section 5 of the FTC Act.[16] In addition, she said that the breadth of the proposed Rule is inconsistent with the FTC’s cases under ROSCA, and “will treat marketers differently for purposes of potential Section 5 violations, depending on whether they sell products or services with or without negative option features.”[17] We anticipate that there will be a significant number of comments submitted that raise similar arguments, potentially among others, in opposition to the proposed rulemaking, and if the rulemaking is finalized, similar legal challenges are likely to be raised in courts.

Gibson Dunn attorneys are closely monitoring these developments and available to discuss these issues as applied to your particular business and assist in preparing a public comment for submission on this proposed Rule.

_________________________

[1] Negative Option Rule NPRM, Fed. Trade Comm’n (Mar. 23, 2023). The Commission voted 3-1, along party lines, to publish the NPRM. Chair Khan and Commissioners Slaughter and Bedoya released a joint statement in support of the proposed Rule. See Joint Statement, Fed. Trade Comm’n (Mar. 23, 2023). Former Commissioner Wilson dissented. See Dissenting Statement of Commissioner Christine S. Wilson, Fed. Trade Comm’n (Mar. 23, 2023).

[2] Id. at 3.

[3] Id. at 77-78 (the proposed Rule’s requirements pertaining to misrepresentations and disclosures).

[4] Id. at 42.

[5] Id. at 10-12.

[6] Id. at 77-78.

[7] Id. at 77.

[8] Id. at 80-81.

[9] Id. at 78-80.

[10] Id. at 81.

[11] Id. at 82.

[12] FTC Publishes Inflation-Adjusted Civil Penalty Amounts for 2023, Fed. Trade Comm’n (Jan. 6, 2023).

[13] Dissenting Statement of Commissioner Christine S. Wilson, pg. 1, Fed. Trade Comm’n (Mar. 23, 2023).

[14] Id. at 2.

[15] Id.

[16] Id. at 2, 5; see also AMG Capital Mgmt., LLC v. FTC, 141 S. Ct. 1341 (2021).

[17] Id. at 5.

The following Gibson Dunn lawyers prepared this client alert:

Svetlana S. Gans – Washington, D.C. (+1 202-955-8657, sgans@gibsondunn.com)
Ella Alves Capone – Washington, D.C. (+1 202-887-3511, ecapone@gibsondunn.com)
Victoria Granda – Washington, D.C. (+1 202.955.8249, vgranda@gibsondunn.com)
Natalie Hausknecht – Denver, CO (+1 303.298.5783, nhausknecht@gibsondunn.com)

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. Please contact the Gibson Dunn lawyer with whom you usually work, any member of Gibson Dunn’s Privacy, Cybersecurity and Data Innovation, Public Policy, and Administrative Law and Regulatory teams.

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

Public Policy Group:
Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com)
Roscoe Jones, Jr. – Washington, D.C. (+1 202-887-3530, rjones@gibsondunn.com)

Administrative Law and Regulatory Group:
Eugene Scalia – Washington, D.C. (+1 202-955-8543, escalia@gibsondunn.com)
Helgi C. Walker – Washington, D.C. (+1 202-887-3599, hwalker@gibsondunn.com)

In this webcast, Gibson Dunn attorneys provide an overview of the FCPA developments and emerging trends from 2022 and will discuss current and anticipated areas of focus for 2023. Intended to complement our Year-End FCPA Update, this webcast discusses in greater detail recent FCPA enforcement updates of note, including enforcement policy developments, DOJ’s use of monitorships, voluntary disclosures, declinations with disgorgement, and opinion letters within the past year. We also discuss DOJ’s increasing focus on compliance programs and what that means for companies in terms of law enforcement expectations and industry best practices.

PANELISTS:

Patrick Stokes is Co-Chair of the firm’s Anti-Corruption and FCPA Practice Group and a partner in the Washington, D.C. office, where he focuses his practice on internal corporate investigations, government investigations, enforcement actions regarding corruption, securities fraud, and financial institutions fraud, and compliance reviews. Mr. Stokes is ranked nationally and globally by Chambers USA and Chambers Global as a leading attorney in FCPA. Prior to joining the firm, Mr. Stokes headed the DOJ’s FCPA Unit, managing the FCPA enforcement program and all criminal FCPA matters throughout the United States covering every significant business sector. Previously, he served as Co-Chief of the DOJ’s Securities and Financial Fraud Unit.

John W.F. Chesley is a partner in the Washington, D.C. office. Mr. Chesley has served as the Interim Chief Ethics & Compliance Officer of a publicly-traded, multinational corporation, and his white collar defense work has been recognized repeatedly by Global Investigations Review, Law 360, National Law Journal, and other publications. He represents corporations, audit committees, and executives in internal investigations and before government agencies in matters involving the FCPA, procurement fraud, environmental crimes, securities violations, antitrust violations, and whistleblower claims. He also litigates government contracts disputes in federal courts and administrative tribunals.

Ella Alves Capone is Of Counsel in the Washington, D.C. office, where her practice focuses on advising multinational corporations and financial institutions in enforcement actions, internal investigations, and corporate compliance matters involving anti-corruption laws and a variety of financial services laws and regulations. She regularly counsels clients on the implementation, assessment, and enhancement of their compliance programs and internal controls.

Bryan Parr is Of Counsel in the Washington, D.C. office and a member of the White Collar Defense and Investigations, Anti-Corruption & FCPA, and Litigation Practice Groups. Mr. Parr’s practice focuses on white-collar defense and regulatory compliance matters around the world. Mr. Parr has extensive expertise in government and corporate investigations, including those involving the Foreign Corrupt Practices Act (FCPA) and anticorruption. He has defended a range of companies and individuals in U.S. Department of Justice (DOJ), SEC, and CFTC enforcement actions, as well as in litigation in federal courts and in commercial arbitrations.

MCLE CREDIT INFORMATION:

This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 2.0 credit hours, of which 2.0 credit hours may be applied toward the areas of professional practice requirement. This course is approved for transitional/non-transitional credit.

Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 2.0 hour.

Gibson, Dunn & Crutcher LLP is authorized by the Solicitors Regulation Authority to provide in-house CPD training. This program is approved for CPD credit in the amount of 2.0 hours. Regulated by the Solicitors Regulation Authority (Number 324652).

Neither the Connecticut Judicial Branch nor the Commission on Minimum Continuing Legal Education approve or accredit CLE providers or activities. It is the opinion of this provider that this activity qualifies for up to 2 hours toward your annual CLE requirement in Connecticut, including 0 hour(s) of ethics/professionalism.

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

On March 30, 2023, the United States—along with over twenty international partners—adopted a nonbinding Code of Conduct outlining its commitment to use export control tools to address serious human rights concerns. Specifically, the Subscribing States[1] to the Code of Conduct will work together to target “the export of dual-use goods or technologies to end-users that could misuse them for the purposes of serious violations or abuses of human rights,” with a particular focus on the misuse of surveillance tools.[2] For the United States, this effort includes amendments to the Export Administration Regulations (“EAR”) that expressly make “protecting human rights worldwide” a basis for designation to the Entity List.[3]

As the Departments of State and Commerce have acknowledged, this Export Controls and Human Rights Initiative (“ECHRI”) Code of Conduct is yet another example of the U.S.’s continued efforts “to put human rights at the center of [its] foreign policy.”[4] In fact, although the Code of Conduct makes the United States’ focus on the intersection of export controls and human rights more explicit, in reality it builds on existing agency practice in recent years.

Between these existing practices and the Code of Conduct’s focus on collaboration with civil society, academia, and the international community, however, this may suggest even more robust enforcement and creative uses of regulatory authority in the coming years. To ensure continued compliance, companies engaged in the export of sensitive technologies will need to think creatively about integrating human rights evaluations into their existing trade due diligence processes.

I. ECHRI Code of Conduct’s Key Commitments

This recent Code of Conduct is the result of more than a year of work by the Export Controls and Human Rights Initiative, a multilateral effort initially created by the United States, Australia, Denmark, and Norway in December 2021.[5] In addition to ECHRI’s founding members, the following states committed to the Code of Conduct at the time of its publication: Albania, Bulgaria, Canada, Croatia, Czechia, Ecuador, Estonia, Finland, France, Germany, Japan, Kosovo, Latvia, The Netherlands, New Zealand, North Macedonia, Republic of Korea, Slovakia, Spain, and the United Kingdom.[6]

Although a non-binding document, the ECHRI Code of Conduct outlines a number of political commitments designed to ensure the effective application of export controls to protect human rights internationally. These include commitments of each Subscribing State to:

Make efforts to ensure that domestic legal, regulatory, policy and enforcement tools are updated to control the export of dual-use goods or technologies to end-users that could misuse them for the purposes of serious violations or abuses of human rights;
Engage with the private sector, academia, researchers, technologists, and members of civil society (including those from vulnerable groups) for consultations concerning these issues and concerning effective implementation of export control measures;
Share information regarding threats and risks associated with such tools and technologies with other Subscribing States on an ongoing basis;
Share, develop, and implement best practices among Subscribing States to control exports of dual-use goods and technologies to state and non-state actors that pose an unacceptable risk of human rights violations or abuses;
Consult with industry and promote non-state actors’ implementation of human rights due diligence policies and procedures in line with the UN Guiding Principles on Business and Human Rights or other complementing international instruments, and share information with industry to facilitate due diligence practices;
Aim to improve the capacity of States that have not subscribed to the Code of Conduct, and encourage other States to join or act consistent with the Code of Conduct.

In addition to these substantive goals, the Code of Conduct establishes procedural commitments for Subscribing States. Most significantly, these include ongoing meetings of Subscribing States designed to further develop the Code of Conduct by sharing information and creating mechanisms for the resolution of policy questions.

Notably, these multilateral efforts to coordinate export control strategies follow the international community’s unprecedented coordination on trade controls in response to the war in Ukraine, which we have discussed further in past client alerts. In fact, there is significant crossover between the current membership of the ECHRI Code of Conduct and those states that have worked in coordination on implementing Russia-related sanctions and export controls. For example, many states who have adopted the Code of Conduct are also members of the coalition that has adopted a price cap on the maritime transport of Russian-origin oil, as discussed further in our client alert on the subject. Similarly, most Code of Conduct states are exempted from the Department of Commerce’s Russia/Belarus Foreign Direct Product Rules because they have implemented “substantially similar export controls on Russia and Belarus” as the U.S.[7] As coordination among these states on a wide range of trade issues continues to increase, we can expect robust collaboration on implementation of the Code of Conduct.

Moreover, the Code of Conduct emphasizes the goal of increased adoption by other states by highlighting that the Code “does not specifically mention any of the multilateral export control regimes, such as the Wassenaar Arrangement.” Instead, the Code of Conduct is explicitly left open for any participant in the Summit for Democracy to join, regardless of their ratification of other multilateral regimes. Not only would broad future adoption increase the Code’s efficacy, but by tying membership to participation in the Summit for Democracy, the Code of Conduct reinforces a shared commitment to the democratic values central to human rights.

II. U.S. Implementation: The Entity List

Since 1997, the U.S. Department of Commerce—specifically its Bureau of Industry & Security (“BIS”)—has maintained an “Entity List“ of foreign persons subject to heightened license requirements for the export, reexport, or in-country transfer of specified items. As the first step toward implementing the ECHRI Code of Conduct, BIS published a final rule on March 30 confirming human rights concerns as a valid basis for designation to the Entity List.[8]

Initially, inclusion on the Entity List was limited primarily to foreign persons presenting risk of involvement in the proliferation of weapons of mass destruction (“WMDs”).[9] Over time, however, grounds for inclusion expanded to include any foreign persons “reasonably believed to be involved, or to pose a significant risk of being or becoming involved, in activities contrary to the national security or foreign policy interests of the United States.”[10]

Despite this potentially broad language, designations to the Entity List, historically, were relatively infrequent and narrowly focused on issues such as the proliferation of conventional weapons and WMDs, support for terrorism, and violations of U.S. sanctions and export controls. Though not explicitly linked to human rights, even these narrow grounds for designation demonstrate a U.S. focus on serious humanitarian and human rights violations arising out of U.S. exports. This focus has only increased in recent years, as BIS has dramatically increased the rate of designations—including some designations explicitly based on involvement in human rights abuses.

For example, beginning in 2019, BIS began designating a number of Chinese entities “implicated in human rights violations and abuses” against the Uyghurs and other ethnic minorities in the Xinjiang Uyghur Autonomous Region (the “XUAR”) of China.[11] Likewise, in 2021, BIS designated eight Burmese entities in response to human rights violations that occurred following the country’s February 2021 military coup.[12]

In light of this enforcement history, BIS’s recent final rule merely “confirm[s]” that the “protection of human rights worldwide” is a U.S. foreign policy objective sufficient to justify designation to the Entity List.[13] Although it does not represent a change in understanding, this amendment is likely to signal an increased use of export controls to target human rights violators, especially with respect to technologies involved in “enabling campaigns of repression and other human rights abuses.”[14]

In a statement accompanying publication of this rule, Assistant Secretary of Commerce for Export Enforcement Matthew S. Axelrod warned that “Export Enforcement will continue to work vigorously to identify those who use U.S. technology to abuse human rights and will use all law enforcement tools at our disposal to hold them accountable.”[15] This robust enforcement appears to already be in motion: concurrent with the publication of its amendment to the EAR, BIS designated eleven entities to its Entity List for their involvement in human rights abuses. These newly listed entities ranged from the Nicaraguan National Police and Burmese military contractors to Chinese companies implicated in surveillance and repression in the XUAR.[16]

III. The Continued Convergence of Human Rights & Export Controls

The Entity List is one of numerous trade control mechanisms the U.S. Government has used in recent years to address the intersection of international trade and human rights violations. Looking ahead, we can expect the Department of Commerce to deploy the following additional tools and sources of authority to implement the Code of Conduct.

a. Item-Based Controls

BIS most prominently introduced the concept of human rights into item-based crime control and detection (“CC”) controls in 2020. Specifically, in July 2020, BIS requested public comments regarding potential additional or modified controls on several items that may be used to assist human rights violations abroad, including facial recognition devices and other biometric systems, non-lethal visual disruption lasers, and long-range acoustic devices.[17] In its request for comments, BIS noted that these items could be used in mass surveillance, censorship, privacy violations, or other human rights abuses.[18]

Although BIS has not yet implemented additional CC controls pursuant to the comments received, in October 2020, BIS amended its CC controls to reflect a human rights-focused licensing policy.[19] Pursuant to this amendment, for items controlled for CC reasons, license applications are generally treated favorably “unless there is civil disorder in the country or region or unless there is a risk that the items will be used to violate or abuse human rights,” a restriction that is expressly designed “to deter human rights violations and abuses, distance the United States from such violations and abuses, and avoid contributing to civil disorder in a country or region.”[20]

In light of the ECHRI Code of Conduct commitment to “control the export of dual-use goods or technologies to end-users that could misuse them for the purposes of serious violations or abuses of human rights,” we may see additional controls on these surveillance systems and technologies.[21]

b. End-Use Based Controls

Another area with significant human rights implications is the end-use prohibitions of the EAR. Under Section 1754(d) of the Export Control Reform Act of 2018 (“ECRA”), the Department of Commerce is directed to require a license for U.S. persons to engage in specific “activities” in connection with nuclear explosive devices, missiles, chemical or biological weapons, whole plants for chemical weapons precursors, and foreign maritime nuclear projects—even without any export, reexport, or in-country transfer of items subject to the EAR.

BIS has increasingly used this specific export controls authority in recent years. In January 2021, BIS expanded this authority to control U.S. person activities in connection with military intelligence end-use, citing to a general authority provided in the ECRA.[22] “Military intelligence end-use” involves U.S. person support provided to the intelligence or reconnaissance organization of the armed services or national guard of Burma, China, Cuba, Iran, North Korea, Russia, Syria, or Venezuela. While this control is primarily focused on foreign military intelligence efforts, as such efforts are often inextricably intertwined with political repression and human rights issues, this control can be expected to take an increasingly important approach as a tool to uphold the U.S. position on human rights. Thus, as U.S. policies shift, we may also start seeing expansions to the list of foreign governments that are subject to the military intelligence end-use and end-user controls.

Further, in October 2022, BIS announced an unprecedented expansion of this authority in controlling U.S. person support for items used to produce certain advanced semiconductors and supercomputers in China.[23] According to BIS, because “China’s military-civil fusion effort makes it more difficult to tell which items are made for restricted end uses,” U.S. person support for advanced semiconductors and supercomputers “necessary for military programs of concern” would require a license even if the precise end-use could not be determined.[24] Similar types of controls with a human rights angle may be on the horizon—whether for additional items such as surveillance systems or for additional foreign governments other than China.

IV. Engagement with Civil Society, Academia, and the Private Sector

The ECHRI Code of Conduct emphasizes Subscribing States’ commitment to engage with civil society, academia, and the private sector on various issues relating to the implementation of effective human rights-focused export controls. If other areas of trade controls focused on human rights are any indication, these sectors can be expected to play a large role in driving enforcement priorities at the intersection of human rights and export controls.

The Code of Conduct appears to envision a two-way relationship between the government and civil society, academia, and the private sector: On one hand, states commit to facilitate due diligence and work with industry groups to promote human rights compliance. On the other hand, these other sectors can provide consultations on issues of human rights and the effective implementation of export controls. In the latter scenario, civil society and academia, in particular, may play a critical role in fact-gathering and presenting allegations of human rights violations to the U.S. government.

In fact, civil society and academia already play this role in the context of other human rights-focused trade restrictions, from sanctions to customs law. For example, the U.S. nonprofit Human Rights First coordinates a coalition of over 300 civil society organizations to facilitate the production of dossiers to share with the U.S. Government to promote the designation of specific human rights violators pursuant to the Global Magnitsky Sanctions program.[25] And, in the realm of customs law, the U.S. government has been particularly responsive to reports from civil society and academia in enforcing the Uyghur Forced Labor Prevention Act (“UFLPA”), discussed in our previous client alerts. Just this past December, for example, the U.K.’s Sheffield Hallam University published a report alleging that major automotive manufacturers had used components made with forced labor in the XUAR.[26] Shortly thereafter, U.S. Customs and Border Protection began detaining shipments from numerous automotive manufacturers pursuant to the UFLPA.

In addition to human rights-focused organizations, technological organizations and industry groups may prove critical to the implementation of the Code of Conduct. The Code’s commitments specifically envision engagement with “technologists” to advise on the effective implementation of export control measures. These specialists will be able to provide BIS with the information to determine which dual-use technologies pose risks of serious human rights abuses.

V. Effective Integration of Human Rights and Trade Compliance

With increasing overlap between human rights standards and trade compliance obligations—as evinced by the Code of Conduct—companies throughout the world must think critically about how to integrate human rights and trade practices to ensure compliance in this dynamic regulatory landscape. Companies should coordinate both internally and externally to identify opportunities to make their compliance programs more human rights-focused. Referring to existing U.S. guidance and international frameworks can also help them strengthen contractual relationships and due diligence practices to better protect human rights.

a. Internal Stakeholder Mapping

To integrate corporate efforts on human rights and trade compliance, a company should first identify the team of internal stakeholders who can provide visibility into the company’s various activities. Open communication among these departments will be critical to maintaining compliance, especially as human rights concerns continue to converge with trade obligations. Accordingly, having a clear understanding of relevant stakeholders and their perspectives is an important first step.

For example, members of a company’s logistics or legal team may have access to the most up-to-date information on a particular shipment and its end-users. A member of the environmental, social, and governance (“ESG”) or public relations team, however, may be most up-to-date on human rights issues dominating the news cycle—and, therefore, government enforcement priorities. Likewise, engineering or product teams may be best equipped to assess whether any individual product—particularly in the technology sectors—may have an unintended dual use that could be exploited to violate human rights, such as integration into surveillance efforts by foreign governments. Regular communication across these groups will allow companies to foresee reputational and commercial risks posed by exporting dual-use products to entities at risk of designation.

b. Industry and Civil Society Coordination

Just as the United States will coordinate with other Subscribing States to share information and strengthen programs, companies should prioritize opportunities to coordinate among industry groups and even with civil society to develop best practices.

Since advanced goods and technologies will be a primary target of the export controls the ECHRI Code of Conduct envisions, companies producing technology with the potential to be used for repression, surveillance, or other human rights abuses should collaborate to develop due diligence and risk assessment programs scoped to the specific concerns of their industry. For example, industry groups representing companies exporting facial recognition technology—which poses a high risk of use for surveillance—can develop technology-specific export due diligence best practices that can be implemented by all of their members.

Companies should also engage with civil society to learn about evolving human rights concerns. As discussed above, the U.S. government has indicated its intention to collaborate with civil society and academia in implementing human rights-focused export controls, and reports from these organizations are likely to drive U.S. enforcement priorities. By actively engaging with civil society, companies position themselves to stay ahead of the enforcement curve by developing early awareness and risk mitigation protocols before, for example, a counterparty is added to the Entity List.

c. Contracting for Human Rights Compliance

Even after determining it is permissible to export goods to a particular entity, companies should identify opportunities to obtain legal and reputational protections through their contracts.

Companies can use contractual provisions not only to obtain access to additional information about counterparties (and their business associates) but also to secure protection in the event a counterparty is later found to be involved in human rights violations. Such provisions are even more essential in the context of distributors or channels partners, where companies may be relying on the partner to conduct diligence on the ultimate end-users. With the potential decreased visibility into these sales, partner contracts should go beyond standard compliance representations to ensure companies have a strong legal basis to investigate and remediate any issues that may arise.

These contractual protections include provisions that allow companies to obtain information from their partners, such as audit rights, or that require partners to proactively disclose information regarding end-users. Effective contracting will also provide for consequences for non-compliance, including termination and indemnification. Companies may also incorporate structural mechanisms to mitigate risk, including by expressly limiting the territorial scope of its partners.

Companies can also streamline the contracting process by grouping third parties into categories based on a human rights risk profile or by the type of contractual relationship. This process allows for category-specific risk assessments and contract templates, while also allowing companies to consider what contracting incentives can be used to motivate categories of counterparties to support their human rights and trade compliance efforts.

d. Existing Guidance & Human Rights Frameworks

Although the ECHRI Code of Conduct reflects a strengthened commitment to use export controls to address human rights concerns, existing frameworks continue to provide helpful guidance on corporate due diligence and risk assessments. Indeed, the Code of Conduct expressly encourages the private sector to conduct due diligence in line with “the UN Guiding Principles on Business and Human Rights or other complementing international instruments.”[27]

In the United States, the U.S. government has already provided specific guidance on how to implement the UN Guiding Principles for certain transactions covered by the ECHRI Code of Conduct. In September 2020, for example, the U.S. State Department published Guidance on Implementing the UN Guiding Principles for Transactions Linked to Foreign Government End-Users for Products or Services with Surveillance Capabilities in recognition of the fact that certain products or services with surveillance capabilities can be misused to violate or abuse human rights when exported to public or private end-users who do not respect basic freedoms and the rule of law.[28]

The State Department’s guidance identifies due diligence concerns and potential red flags to consider at various steps when transacting with government end-users, along with suggested safeguards to detect and halt abuse. In fact, the guidance provides a number of recommended contractual safeguards, in line with our guidance above.[29] While this guidance is primarily focused on government end-users, it also covers transactions with non-state actors in high-risk jurisdictions where governmental or quasi-governmental entities may be undisclosed end-users. Lastly, the guidance’s appendices provide helpful resources for further compliance guidance, from human rights frameworks and reports to examples of foreign laws suggesting the possible misuse of surveillance-related exports.[30]

The ECHRI Code of Conduct expresses a commitment to use export controls to address a wide range of entities—not just government end-users. However, given the Code of Conduct’s focus on “surveillance tools and other technologies . . . that can lead to serious violations of human rights,” the U.S. State Department’s 2020 guidance provides a baseline understanding of the U.S. government’s expectations for due diligence and risk mitigation when exporting goods or technologies with surveillance capabilities.[31]

Additionally, for exports destined for China—and especially the XUAR—companies should consult the Xinjiang Supply Chain Business Advisory issued by the Departments of State, Treasury, Commerce, and Homeland Security.[32] This advisory outlines specific risks and concerns about due diligence related to the export of goods or technology that could be used for surveillance in the XUAR.

While other governments will adopt their own guidance and related measures, we assess that many countries will look to the U.S. model as they develop their domestic authorities.

VI. Conclusion

The Biden administration has made clear that it will continue to use an aggressive, yet multilateral, approach to enforce human rights around the world, and the ECHRI Code of Conduct appears to be another example of this priority. By integrating their human rights and trade compliance efforts, however, companies can protect themselves from risk in this area.

As human rights concerns increasingly motivate export controls, open communication among internal stakeholders and with civil society will be key to preventing human rights-related export violations. Companies should think critically about every step of their contracting processes to maximize legal and reputational protection, particularly when working with distributors or channels partners. Existing U.S. guidance and international human rights instruments can help companies throughout the world address these and other due diligence issues as they update policies and procedures to ensure effective compliance.

_________________________

[1] At the time of the Code of Conduct’s publication, the following countries comprise the Subscribing States: Albania, Australia, Bulgaria, Canada, Costa Rica, Croatia, Czechia, Denmark, Ecuador, Estonia, Finland, France, Germany, Japan, Kosovo, Latvia, The Netherlands, New Zealand, North Macedonia, Norway, Republic of Korea, Slovakia, Spain, the United Kingdom, and the United States.

[2] Code of Conduct for Enhancing Export Controls of Goods and Technology That Could Be Misused and Lead to Serious Violations or Abuses of Human Rights, U.S. Dep’t of State, https://www.state.gov/wp-content/uploads/2023/03/230303-Updated-ECHRI-Code-of-Conduct-FINAL.pdf (hereafter “Code of Conduct”).

[3] Additions to the Entity List; Amendment to Confirm Basis for Adding Certain Entities to the Entity List Includes Foreign Policy Interest of Protection of Human Rights Worldwide, 88 Fed. Reg. 18,983 (Mar. 30, 2023) (revising 15 C.F.R. § 744.11 to explicitly add involvement in activities that are contrary to the “foreign policy interest of the protection of human rights throughout the world” as a basis for designation to the Department of Commerce’s Entity List)

[4] Press Release, Export Controls and Human Rights Initiative Code of Conduct Released at Summit for Democracy, U.S. Dep’t of State (Mar. 30, 2023), https://www.state.gov/export-controls-and-human-rights-initiative-code-of-conduct-released-at-the-summit-for-democracy/; Press Release, Biden Administration and International Partners Release Export Controls and Human Rights Initiative Code of Conduct, U.S. Dep’t of Commerce (Mar. 30, 2023), https://www.bis.doc.gov/index.php/documents/about-bis/newsroom/press-releases/3257-2023-03-30-bis-press-release-echri-code-of-conduct/file.

[5] Joint Statement on the Export Controls and Human Rights Initiative, U.S. Dept. of State (Dec. 10, 2021), https://www.whitehouse.gov/briefing-room/statements-releases/2021/12/10/joint-statement-on-the-export-controls-and-human-rights-initiative/.

[6] Press Release, Export Controls and Human Rights Initiative Code of Conduct Released at Summit for Democracy, U.S. DEP’T OF STATE (Mar. 30, 2023), https://www.state.gov/export-controls-and-human-rights-initiative-code-of-conduct-released-at-the-summit-for-democracy/.

[7] Additions to the List of Countries Excluded From Certain License Requirements Under the Export Administration Regulations (EAR), 87 Fed. Reg. 21,554 (Apr. 12, 2022); see 15 C.F.R. Part 746, Supplement No. 3.

[8] Press Release, Commerce Adds Eleven to Entity List for Human Rights Abuses and Reaffirms Protection of Human Rights as Critical U.S. Foreign Policy Objective, Bureau of Indus. and Sec’y (Mar. 30, 2023), https://www.bis.doc.gov/index.php/documents/about-bis/newsroom/press-releases/3256-2023-03-30-bis-press-release-human-rights-entity-list-additions/file.

[9] Entity List, Bureau of Indus. and Sec’y (last accessed Apr. 2, 2023), https://www.bis.doc.gov/index.php/policy-guidance/lists-of-parties-of-concern/entity-list.

[10] 15 C.F.R. § 744.16 (2022).

[11] See, e.g., Addition of Certain Entities to the Entity List, 84 Fed. Reg. 54,002 (Oct. 9, 2019).

[12] See Addition of Entities to the Entity List, 86 Fed. Reg. 13,179 (Mar. 8, 2021); see also Addition of Certain Entities to the Entity List; Correction of Existing Entry on the Entity List, 86 Fed. Reg. 35,389 (July 6, 2021).

[13] Additions to the Entity List; Amendment to Confirm Basis for Adding Certain Entities to the Entity List Includes Foreign Policy Interest of Protection of Human Rights Worldwide, 88 Fed. Reg. 18,983 (Mar. 30, 2023) (emphasis added).

[14] Press Release, Commerce Adds Eleven to Entity List for Human Rights Abuses and Reaffirms Protection of Human Rights as Critical U.S. Foreign Policy Objective, Bureau of Indus. and Sec’y (Mar. 30, 2023), https://www.bis.doc.gov/index.php/documents/about-bis/newsroom/press-releases/3256-2023-03-30-bis-press-release-human-rights-entity-list-additions/file.

[15] Id.

[16] Additions to the Entity List, supra note 13.

[17] Advanced Surveillance Systems and Other Items of Human Rights Concern, 85 Fed. Reg. 43,532 (July 17, 2020).

[18] Id. at 43,533.

[19] Amendment to Licensing Policy for Items Controlled for Crime Control Reasons, 85 Fed. Reg. 63,007 (Oct. 6, 2022).

[20] Id. at 63,009.

[21] Code of Conduct, supra note 2.

[22] Expansion of Certain End-Use and End-User Controls and Controls on Specific Activities of U.S. Persons, 86 Fed. Reg. 4,865 (Jan. 15, 2021); see 15 C.F.R. § 744.22.

[23] Implementation of Additional Export Controls: Certain Advanced Computing and Semiconductor Manufacturing Items; Supercomputer and Semiconductor End Use; Entity List Modification, 87 Fed. Reg. 62,186 (Oct. 13, 2022); see 15 C.F.R. § 744.6.

[24] Implementation of Additional Export Controls: Certain Advanced Computing and Semiconductor Manufacturing Items; Supercomputer and Semiconductor End Use; Entity List Modification, 87 Fed. Reg. 62,186, 62,187 (Oct. 13, 2022)

[25] Global Magnitstky and Targeted Sanctions, Human Rights First (last accessed Apr. 2, 2023), https://humanrightsfirst.org/efforts/global-magnitsky-targeted-sanctions/.

[26] Driving Force: Automotive Supply Chains and Forced Labor in the Uyghur Region, Sheffield Hallam Univ. Helena Kennedy Centre for Int’l Justice (Dec. 2022), https://acrobat.adobe.com/link/track?uri=urn%3Aaaid%3Ascds%3AUS%3A69ce4867-d7e7-4a6a-a98b-6c8350ceb714&viewer%21megaVerb=group-discover.

[27] Code of Conduct, supra note 2.

[28] Guidance on Implementing the UN Guiding Principles for Transactions Linked to Foreign Government End-Users for Products or Services with Surveillance Capabilities, U.S. Dept. of State (Sep. 30, 2020), https://www.state.gov/wp-content/uploads/2020/10/DRL-Industry-Guidance-Project-FINAL-1-pager-508-1.pdf. As this document explains, these products and services can violate a host of fundamental rights that are protected by the Universal Declaration of Human Rights and the International Covenant on Civil and Political Rights, such as the right to be free from arbitrary or unlawful interference with privacy. See id. at 3.

[29] Id. at 11.

[30] Id. at 14–19.

[31] Code of Conduct, supra note 2.

[32] Xinjiang Supply Chain Business Advisory (Jul. 2, 2020, updated Jul. 13, 2021), U.S. Dept. of Treasury, https://www.state.gov/wp-content/uploads/2021/07/Xinjiang-Business-Advisory-13July2021-1.pdf

The following Gibson Dunn lawyers prepared this client alert: Sean Brennan*, Christopher Timura, Claire Yi, Anna Searcey, Stephenie Gosnell Handler, Adam M. Smith, Chris Mullen, Maria Banda, and Annie Motto.

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, the authors, or the following members and leaders 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, jalee@gibsondunn.com)
Ronald Kirk – Co-Chair, International Trade Practice, Dallas (+1 214-698-3295, rkirk@gibsondunn.com)
Adam M. Smith – Washington, D.C. (+1 202-887-3547, asmith@gibsondunn.com)
Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, shandler@gibsondunn.com)
David P. Burns – Washington, D.C. (+1 202-887-3786, dburns@gibsondunn.com)
Nicola T. Hanna – Los Angeles (+1 213-229-7269, nhanna@gibsondunn.com)
Marcellus A. McRae – Los Angeles (+1 213-229-7675, mmcrae@gibsondunn.com)
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, cmbrown@gibsondunn.com)
Christopher T. Timura – Washington, D.C. (+1 202-887-3690, ctimura@gibsondunn.com)
Annie Motto – Washington, D.C. (+1 212-351-3803, amotto@gibsondunn.com)
Chris R. Mullen – Washington, D.C. (+1 202-955-8250, cmullen@gibsondunn.com)
Sarah L. Pongrace – New York (+1 212-351-3972, spongrace@gibsondunn.com)
Anna Searcey – Washington, D.C. (+1 202-887-3655, asearcey@gibsondunn.com)
Samantha Sewall – Washington, D.C. (+1 202-887-3509, ssewall@gibsondunn.com)
Audi K. Syarief – Washington, D.C. (+1 202-955-8266, asyarief@gibsondunn.com)
Scott R. Toussaint – Washington, D.C. (+1 202-887-3588, stoussaint@gibsondunn.com)
Claire Yi – Washington, D.C. (+1 202-887-3644, cyi@gibsondunn.com)
Shuo (Josh) Zhang – Washington, D.C. (+1 202-955-8270, szhang@gibsondunn.com)

Asia
Kelly Austin – Hong Kong (+852 2214 3788, kaustin@gibsondunn.com)
David A. Wolber – Hong Kong (+852 2214 3764, dwolber@gibsondunn.com)
Qi Yue – Hong Kong – (+852 2214 3731, qyue@gibsondunn.com)
Fang Xue – Beijing (+86 10 6502 8687, fxue@gibsondunn.com)

Europe
Attila Borsos – Brussels (+32 2 554 72 10, aborsos@gibsondunn.com)
Susy Bullock – London (+44 (0) 20 7071 4283, sbullock@gibsondunn.com)
Patrick Doris – London (+44 (0) 207 071 4276, pdoris@gibsondunn.com)
Sacha Harber-Kelly – London (+44 (0) 20 7071 4205, sharber-kelly@gibsondunn.com)
Michelle M. Kirschner – London (+44 (0) 20 7071 4212, mkirschner@gibsondunn.com)
Penny Madden – London (+44 (0) 20 7071 4226, pmadden@gibsondunn.com)
Irene Polieri – London (+44 (0) 20 7071 4199, ipolieri@gibsondunn.com)
Benno Schwarz – Munich (+49 89 189 33 110, bschwarz@gibsondunn.com)
Nikita Malevanny – Munich (+49 89 189 33 160, nmalevanny@gibsondunn.com)

*Sean Brennan is an associate working in the firm’s Washington, D.C. offices who currently is admitted to practice only in New York.

On March 27, 2023, the U.S. Department of Justice and U.S. Federal Trade Commission (together, the “Agencies”) hosted international and state antitrust enforcers for panel discussions on current and emerging enforcement trends. Agency leaders Assistant Attorney General (“AAG”) Jonathan Kanter and FTC Chair Lina M. Khan used the Summit to showcase their efforts to update the antitrust laws and expand their enforcement efforts in the “modern economy.”

Three key themes emerged from the Summit:

The Agencies believe case law based on economic theory developed in the 1970s must be updated, especially to account for application to modern economic structures.
To set new precedent, the Agencies must aggressively challenge and litigate cases, even if they lose at trial.
As part of their broader effort to expand enforcement, the Agencies are attempting to reinvigorate seldom-used enforcement tools, such as the Robinson-Patman Act and criminal enforcement of Sherman Act Section 2.

The Agencies are expected to bring merger challenges and conduct cases under novel theories of harm to develop new precedent.

During the Summit, federal, state, and international enforcers discussed their efforts to ensure competition in the “new” economy (which they described as being media and technology markets characterized by innovation, network effects, and so-called platform-based business models). Enforcers specifically celebrated the formation of technology and AI task forces, updated enforcement guidelines to reflect novel theories of harm, and recent enforcement actions against technology firms they consider dominant.

During these discussions, Agency leadership announced their intent to push courts to update judicial precedent by aggressively bringing enforcement actions under novel or seldom-used theories of harm. Chair Khan and AAG Kanter expressed concern that “stale” antitrust doctrine has been under-deterring anticompetitive conduct in the “new” and “old” economies alike and announced that aggressive test cases—even if they result in trial losses—were needed. Throughout panel presentations, Agency leadership specifically committed to bringing test cases challenging mergers and alleged monopolistic conduct.

Mergers and Acquisitions: John Newman, Deputy Director of the FTC’s Bureau of Competition, indicated that the FTC would continue to aggressively challenge acquisitions in what it views to be nascent digital markets. Newman specifically cited the FTC’s challenge to Meta’s acquisition of Within as a “success” in that the FTC persuaded the court that its market definition and theory of harm were valid, despite ultimately losing on the merits.

Monopolization: Deputy Assistant Attorney General Hetal Doshi indicated that DOJ would continue to criminally prosecute alleged monopolization and agreements to allocate labor markets. Doshi announced that DOJ was working to establish “indicia of criminality” that would elevate monopolization from a civil to a criminal offense and that DOJ would bring test cases to develop these indicia as appropriate. Chair Khan announced the FTC was focused on prosecuting “incumbent [technology firms who] resort to anticompetitive tactics to protect their moat and protect their dominance.”

The Agencies are expected to attempt to reinvigorate enforcement efforts under seldomly used statutes.

Agency leadership also recommitted to using every “tool in the toolbox” to protect competition, including the Robinson-Patman Act and Clayton Act Sections 3 and 8. Chair Khan stated that a key pillar of her leadership approach was the continued full “activation” of all antitrust statutes at her disposal. Throughout the panel, the Agencies specifically identified three statutes they intend to enforce more aggressively.

Robinson-Patman Act: The Robinson-Patman Act (RPA), which prohibits price discrimination, was enacted to protect small businesses by preventing larger companies from using their purchasing power to obtain better prices. However, it has been seldom enforced since 1970 due to concerns it harmed consumers by punishing efficient firms. Current Democratic FTC leadership has repeatedly declared the non-enforcement of the RPA was an error, and the FTC has recently launched RPA investigations into multiple industries. Chair Khan also indicated that the FTC’s next challenge under the RPA would be filed in “short order.”

Clayton Act Section 3: Section 3 of the Clayton Act prohibits anticompetitive exclusive dealing arrangements, tying arrangements, and requirements contracts. Chair Khan committed to using Section 3 and Section 5 of the FTC Act to prosecute unfair selling and buying practices and highlighted the FTC’s complaint against two companies (alleging the firms violated Section 3 by paying distributors to block generic pesticide products) as a framework for future enforcement actions.

Clayton Act Section 8: Section 8 of the Clayton Act prohibits interlocking directorates, where a person simultaneously serves as a director or officer of two competing corporations. The law is designed to prevent conflicts of interest and promote fair competition by ensuring that competing companies have independent leadership. AAG Kanter highlighted four recent enforcement actions under Section 8 and committed to enforcing the statute more broadly, especially against private equity firms.

* * *

As the Agencies expand enforcement and bring novel challenges, companies and individuals should be cognizant that district and circuit courts ultimately determine whether conduct violates the antitrust laws and tend to favor adherence to precedent instead of embracing novel and untested theories of liability. As a recent string of Agency defeats at trial demonstrate, parties may ultimately succeed in vindicating their conduct through litigation in federal court.

The following Gibson Dunn lawyers prepared this client alert: Rachel Brass, Jay Srinivasan, Stephen Weissman, Jamie France, Caroline Ziser Smith, Veronica Altabef, Hadhy Ayaz, Logan Billman, Tiffany Mickel*, and Nick Rawlinson.

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

Antitrust and Competition Group:
Jamie E. France – Washington, D.C. (+1 202-955-8218, jfrance@gibsondunn.com)
Jay P. Srinivasan – Los Angeles (+1 213-229-7296, jsrinivasan@gibsondunn.com)
Rachel S. Brass – Co-Chair, San Francisco (+1 415-393-8293, rbrass@gibsondunn.com)
Stephen Weissman – Co-Chair, Washington, D.C. (+1 202-955-8678, sweissman@gibsondunn.com)

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

*Tiffany Mickel is an associate in the Washington, D.C. office admitted only in Maryland and practicing under supervision of members of the District of Columbia Bar under D.C. App. R. 49.

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, sbullock@gibsondunn.com)

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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.

Blaine H. Evanson – Orange County (+1 949-451-3805, bevanson@gibsondunn.com)
Audrey Yang – Dallas (+1 214-698-3215, ayang@gibsondunn.com)

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

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:
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Tiffany Phan – Los Angeles (+1 213-229-7522, tphan@gibsondunn.com)
Jason C. Schwartz – Co-Chair, Labor & Employment Group, Washington, D.C. (+1 202-955-8242, jschwartz@gibsondunn.com)
Katherine V.A. Smith – Co-Chair, Labor & Employment Group, Los Angeles (+1 213-229-7107, ksmith@gibsondunn.com)

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, jalee@gibsondunn.com)
Ronald Kirk – Co-Chair, International Trade Practice, Dallas (+1 214-698-3295, rkirk@gibsondunn.com)
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, cmbrown@gibsondunn.com)
David P. Burns – Washington, D.C. (+1 202-887-3786, dburns@gibsondunn.com)
Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, shandler@gibsondunn.com)
Nicola T. Hanna – Los Angeles (+1 213-229-7269, nhanna@gibsondunn.com)
Marcellus A. McRae – Los Angeles (+1 213-229-7675, mmcrae@gibsondunn.com)
Adam M. Smith – Washington, D.C. (+1 202-887-3547, asmith@gibsondunn.com)
Christopher T. Timura – Washington, D.C. (+1 202-887-3690, ctimura@gibsondunn.com)
Laura R. Cole – Washington, D.C. (+1 202-887-3787, lcole@gibsondunn.com)
Annie Motto – Washington, D.C. (+1 212-351-3803, amotto@gibsondunn.com)
Chris R. Mullen – Washington, D.C. (+1 202-955-8250, cmullen@gibsondunn.com)
Samantha Sewall – Washington, D.C. (+1 202-887-3509, ssewall@gibsondunn.com)
Audi K. Syarief – Washington, D.C. (+1 202-955-8266, asyarief@gibsondunn.com)
Scott R. Toussaint – Washington, D.C. (+1 202-887-3588, stoussaint@gibsondunn.com)
Shuo (Josh) Zhang – Washington, D.C. (+1 202-955-8270, szhang@gibsondunn.com)

Asia
Kelly Austin – Hong Kong (+852 2214 3788, kaustin@gibsondunn.com)
David A. Wolber – Hong Kong (+852 2214 3764, dwolber@gibsondunn.com)
Fang Xue – Beijing (+86 10 6502 8687, fxue@gibsondunn.com)
Qi Yue – Beijing – (+86 10 6502 8534, qyue@gibsondunn.com)

Europe
Attila Borsos – Brussels (+32 2 554 72 10, aborsos@gibsondunn.com)
Nicolas Autet – Paris (+33 1 56 43 13 00, nautet@gibsondunn.com)
Susy Bullock – London (+44 (0) 20 7071 4283, sbullock@gibsondunn.com)
Patrick Doris – London (+44 (0) 207 071 4276, pdoris@gibsondunn.com)
Sacha Harber-Kelly – London (+44 (0) 20 7071 4205, sharber-kelly@gibsondunn.com)
Penny Madden – London (+44 (0) 20 7071 4226, pmadden@gibsondunn.com)
Benno Schwarz – Munich (+49 89 189 33 110, bschwarz@gibsondunn.com)
Michael Walther – Munich (+49 89 189 33 180, mwalther@gibsondunn.com)
Richard W. Roeder – Munich (+49 89 189 33 115, rroeder@gibsondunn.com)

* 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.

Securities Enforcement Practice Group Leaders:
Richard W. Grime – Washington, D.C. (+1 202-955-8219, rgrime@gibsondunn.com)
Mark K. Schonfeld – New York (+1 212-351-2433, mschonfeld@gibsondunn.com)

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

New York
Zainab N. Ahmad (+1 212-351-2609, zahmad@gibsondunn.com)
Reed Brodsky (+1 212-351-5334, rbrodsky@gibsondunn.com)
Joel M. Cohen (+1 212-351-2664, jcohen@gibsondunn.com)
James J. Farrell (+1 212-351-5326, jfarrell@gibsondunn.com)
Barry R. Goldsmith (+1 212-351-2440, bgoldsmith@gibsondunn.com)
Mary Beth Maloney (+1 212-351-2315, mmaloney@gibsondunn.com)
Alexander H. Southwell (+1 212-351-3981, asouthwell@gibsondunn.com)
Lawrence J. Zweifach (+1 212-351-2625, lzweifach@gibsondunn.com)
Tina Samanta (+1 212-351-2469, tsamanta@gibsondunn.com)

Washington, D.C.
Stephanie L. Brooker (+1 202-887-3502, sbrooker@gibsondunn.com)
Daniel P. Chung (+1 202-887-3729, dchung@gibsondunn.com)
M. Kendall Day (+1 202-955-8220, kday@gibsondunn.com)
Jeffrey L. Steiner (+1 202-887-3632, jsteiner@gibsondunn.com)
Patrick F. Stokes (+1 202-955-8504, pstokes@gibsondunn.com)
F. Joseph Warin (+1 202-887-3609, fwarin@gibsondunn.com)
Lauren Cook Jackson (+1 202-955-8293, ljackson@gibsondunn.com)
David C. Ware (+1 202-887-3652, dware@gibsondunn.com)

San Francisco
Winston Y. Chan (+1 415-393-8362, wchan@gibsondunn.com)
Thad A. Davis (+1 415-393-8251, tadavis@gibsondunn.com)
Charles J. Stevens (+1 415-393-8391, cstevens@gibsondunn.com)
Michael Li-Ming Wong (+1 415-393-8234, mwong@gibsondunn.com)

Palo Alto
Michael D. Celio (+1 650-849-5326, mcelio@gibsondunn.com)
Paul J. Collins (+1 650-849-5309, pcollins@gibsondunn.com)
Benjamin B. Wagner (+1 650-849-5395, bwagner@gibsondunn.com)

Denver
Robert C. Blume (+1 303-298-5758, rblume@gibsondunn.com)
Monica K. Loseman (+1 303-298-5784, mloseman@gibsondunn.com)

Los Angeles
Michael M. Farhang (+1 213-229-7005, mfarhang@gibsondunn.com)
Douglas M. Fuchs (+1 213-229-7605, dfuchs@gibsondunn.com)
Nicola T. Hanna (+1 213-229-7269, nhanna@gibsondunn.com)
Debra Wong Yang (+1 213-229-7472, dwongyang@gibsondunn.com)

* 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.

[chart]

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.

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[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:

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

Oil and Gas Group:
Michael P. Darden – Houston (+1 346 718 6789, mpdarden@gibsondunn.com)
Anna P. Howell – London (+44 (0) 20 7071 4241, ahowell@gibsondunn.com)
Brad Roach – Singapore (+65 6507 3685, broach@gibsondunn.com)

Power and Renewables Group:
Gerald P. Farano – Denver (+1 303-298-5732, jfarano@gibsondunn.com)
Peter J. Hanlon – New York (+1 212-351-2425, phanlon@gibsondunn.com)
Nicholas H. Politan, Jr. – New York (+1 212-351-2616, npolitan@gibsondunn.com)

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