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The decision could effectively blunt the SEC’s ability to seek disgorgement for a wide range of alleged regulatory violations that do not result in financial harm to any investors.

In a case with potentially far-reaching implications for the SEC’s enforcement program, the Second Circuit recently held that the SEC is not entitled to disgorgement unless it can show the allegedly defrauded investors suffered pecuniary harm. The case, Securities and Exchange Commission v. Govil,[1] provides important limitations on the SEC’s ability to seek disgorgement, especially in circumstances where the allegedly violative conduct does not result in obvious “victims.” The case provides defense counsel with persuasive authority to oppose an SEC claim for disgorgement absent proof of any harm to investors especially if all the SEC alleges is a benefit to the defendant. The decision could effectively blunt the SEC’s ability to seek disgorgement for a wide range of alleged regulatory violations that do not result in financial harm to any investors.

Factual Background

Aron Govil founded and served as CEO of Cemtrex, Inc., an industrial and manufacturing technology company. In 2016 and 2017 Govil caused Cemtrex to issue new securities based on misrepresentations concerning the expected use of the funds that were raised, which Govil then transferred to his own accounts to pay for unrelated personal expenses. After he was caught, Govil entered into a settlement agreement with Cemtrex, which he no longer ran, and agreed to repay $7.1 million to the company by returning $5.6 million of Cemtrex securities and issuing a promissory note for $1.5 million. In addition, Govil also entered into a consent agreement with the SEC in which he agreed not to contest a civil enforcement action that would be brought by the SEC but which left the remedy unresolved.

After bringing an enforcement action, the Commission asked the district court to order disgorgement of approximately $7.3 million.[2] The district court did so over Govil’s objections, concluding that disgorgement was appropriate because Cemtrex’s defrauded investors were Govil’s “real victims” rather than Cemtrex itself, and that the $5.6 million in securities that Govil returned to Cemtrex would not offset what he owed as “Cemtrex shareholders received nothing” from that transfer.[3] Critically, however, the SEC offered no proof—and the district court made no findings—that Cemtrex’s shareholders suffered any pecuniary harm resulting from Govil’s fraud. Govil was ordered to disgorge approximately $6 million, from which he appealed.

The Second Circuit’s Decision

On appeal, the Second Circuit vacated the relief ordered by the district court and remanded the matter for further fact-finding. Applying the Supreme Court’s teachings in Liu that disgorgement “is permissible” as equitable relief only where it “is awarded for victims,”[4] the Second Circuit held that disgorgement under both 15 U.S. §§ 78u(d)(5) and 78u(d)(7) requires a finding that there were victims who suffered some financial loss. Noting that Liu “did not explain straightforwardly what a ‘victim’ is for the purpose of awarding ‘equitable relief,’” the Second Circuit held that “a ‘victim’” is “one who suffers pecuniary harm from the securities fraud” because allowing disgorgement to benefit investors who had not suffered any damages “would be conferring a windfall on those who received the benefit of the[ir] bargain” rather than “restoring the status quo for those investors.”[5] In doing so, the Court expressly rejected a presumption that investors have “suffered economic harm by definition when capital they invested in the company for corporate purposes [is] looted,” explaining that determining whether investors “actually suffered pecuniary harm” requires an analysis of “the type of securities held, the terms of those securities, and when those securities were sold” because defrauded investors might earn a profit on their investment notwithstanding a defendant’s wrongdoing.[6] As the Second Circuit reasoned, Liu “emphasized” that disgorgement as “an equitable remedy is about ‘returning the funds to victims,’” which necessarily “presupposes pecuniary harm” as funds “cannot be returned if there was no deprivation in the first place.”[7]

In reaching this conclusion, the Second Circuit also drew an important analogy between SEC enforcement actions and securities fraud actions brought by private plaintiffs. Although the SEC need not show loss causation or economic loss to prevail in litigation, the Court noted that private plaintiffs bringing securities fraud claims under Rule 10b-5 must prove that they “have suffered ‘economic loss’” and, similarly, that “pecuniary harm is an element” of common-law fraud claims.[8] Accordingly, the Court rejected the notion that investors who have not been shown to have suffered pecuniary harm should be allowed to receive “proceeds of disgorgement,” which otherwise “would allow the SEC to . . . circumvent the limitations on private claims under § 10(b) and the common law.”[9] Because there was no showing that Govil had caused any such pecuniary harm to Cemtrex’s investors, that relief was vacated to allow the district court to determine in the first instance if there was any such harm, a necessary prerequisite for disgorgement to be available.

In addition, the Second Circuit also held that the district court erred in not offsetting its disgorgement award by the value of the Cemtrex shares surrendered by Govil. Rejecting the SEC’s arguments, the Second Circuit reasoned that “a wrongdoer returns ‘value’ for the purpose of disgorgement whenever he returns property that holds value in his own hands” and that “a defendant need not return more than the amount by which he was unjustly enriched” because disgorgement is intended “‘to prevent wrongdoers from unjustly enriching themselves’” rather than “‘to compensate victims.’”[10]

Implications of Govil

Going forward, by limiting disgorgement and more closely aligning it with the relief available in private securities fraud actions in which economic loss and loss causation must be proven, the SEC will be forced to more clearly identify and prove the harm suffered by alleged “victims” in many of its enforcement actions. Although this analysis is relatively straightforward in more traditional securities fraud cases, Govil will likely result in serious questions being raised concerning the SEC’s ability to seek disgorgement in other aspects of its enforcement agenda. As the SEC moves ahead, both the SEC and those against whom disgorgement is sought will need to wrestle with Govil in areas where it is more difficult to identify victims who have suffered pecuniary harm resulting from the alleged securities law violations.

There is a wide range of regulatory enforcement actions in which the SEC has sought disgorgement despite the absence of identifiable victims who incurred a financial loss. Govil puts the SEC’s ability to seek disgorgement in such cases in serious question. Consider, for example, enforcement actions alleging the offering of securities without registration. In such cases, the SEC does not even allege that investors have been defrauded, let alone harmed. Going forward, it would seem that Govil precludes a claim for disgorgement. In Foreign Corrupt Practices Act cases, the SEC has historically sought disgorgement of profits allegedly earned by a company through business obtained or retained by virtue of an improper payment to a foreign official. After Govil, the SEC likewise would be challenged to identify a victim who has suffered a financial harm. In insider trading matters, the SEC routinely seeks disgorgement of imputed profits or avoided losses from defendants based on a differential between a trade price and a post-disclosure market price. However, the SEC has never undertaken, nor been required, to prove that there was an identifiable victim in the sense of a defrauded counterparty to the allegedly offending trade. And if required to meet such a burden of proof after Govil, one doubts that it could. Suffice it to say that the SEC likely did not foresee that the aggressive pursuit of disgorgement in a case in which Aron Govil had stipulated to liability would lead to such a potentially significant adverse impact on its broader enforcement program.

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[1] — F.4th —, 2023 WL 7137291 (2d Cir. 2023).

[2] The SEC sought disgorgement pursuant to 15 U.S.C. § 78u(d)(5) and § 78u(d)(7). Although the equitable remedy of disgorgement has been used by the SEC since the 1970s, see, e.g., SEC v. Manor Nursing Ctrs., Inc., 458 F.2d 1082 (2d Cir. 1972), it was not until 2002 that Congress expressly authorized the SEC to “seek . . . any equitable relief that may be appropriate for the benefit of investors” in § 78u(d)(5). The Supreme Court then clarified in Liu v. SEC that “a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims is equitable relief permissible under § 78u(d)(5).” 140 S.Ct. 1934, 1940 (2020). Congress enacted 15 U.S.C. § 78u(d)(7) six months after Liu narrowed the circumstances in which disgorgement is permissible, expressly authorizing the SEC to “seek . . . disgorgement” without reference to any limitations that might otherwise apply to relief already available under § 78u(d)(5). Although others courts have disagreed, the Second Circuit has previously held that the enactment of § 78u(d)(7) did not serve to undo the limitations that Liu imposed on the SEC’s disgorgement remedy. See SEC v. Ahmed, 72 F.4th 379 (2d Cir. 2023) (“We read ‘disgorgement’ in § 78(u)(d)(7) to refer to equitable disgorgement as recognized in Liu.”)

[3] SEC v. Govil, 2022 WL 1639467, at *3 (S.D.N.Y. May 24, 2022).

[4] 140 S.Ct. at 1940.

[5] 2023 WL 7137291, at *9.

[6] Id. at *10 n.16.

[7] Id. at *10 (quoting Liu, 140 S.Ct. at 1948, cleaned up).

[8] Id. at *11.

[9] Id.

[10] Id. at *12-13 (quoting SEC v. Cavanagh, 445 F.3d 105, 117 (2d Cir. 2006)).

The following Gibson Dunn lawyers assisted in preparing this alert: Reed Brodsky, Richard Grime, Mark Schonfeld, David Woodcock, Michael Nadler, and Peter Jacobs*.

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

Reed Brodsky – New York (+1 212.351.5334, [email protected])
Richard W. Grime – Washington, D.C. (+1 202.955.8219, [email protected])
Mark K. Schonfeld – New York (+1 212.351.2433, [email protected])
David Woodcock – Dallas (+1 214.698.3211, [email protected])
Michael Nadler – New York (+1 212.351.2306, [email protected])

*Peter Jacobs is an associate working in the firm’s New York office who is not yet admitted to practice law.

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.

Gibson Dunn has formed a Workplace DEI Task Force, bringing to bear the Firm’s experience in employment, appellate and Constitutional law, DEI programs, securities and corporate governance, and government contracts to help our clients develop creative, practical, and lawful approaches to accomplish their DEI objectives following the Supreme Court’s decision in SFFA v. Harvard. This is our second DEI Task Force Update (the first, issued on November 1, 2023, can be found here) and we will continue to circulate similar updates bi-monthly moving forward. Should you have questions about developments in this space or about your own DEI programs, please do not hesitate to reach out to any member of our DEI Task Force or the authors of this Update (listed below).

Key Developments:

On November 1, 2023, America First Legal Foundation (“AFL”) sent letters to the EEOC calling for the Commission to initiate investigations into the DEI initiatives of American Airlines, United Airlines, and Southwest Airlines. AFL also sent letters to each airline, alleging violations of both Title VII and Section 1981, and primarily referenced each company’s published DEI reports, which detail the companies’ efforts to hire and retain diverse talent through various hiring goals, affinity retreats, and training programs focused on diverse employees.

On November 2, 2023, AFL also sent the EEOC a letter calling for the agency to investigate NASCAR and a privately owned affiliate, Rev Racing, for violating Title VII through its “Drive for Diversity” and “Diversity Pit Crew Development” programs. The programs are part of NASCAR’s ongoing efforts to increase the diversity of its drivers and pit crew members by providing additional coaching, training, and apprenticeship to historically underrepresented demographics within its ranks. Before the SFFA decision, the selection criteria limited eligibility for these programs to women, Black or African Americans, Asians, and Hispanics. Following SFFA, NASCAR and Rev Racing expanded the programs to include all individuals from any “diverse background” or possessing “diverse experiences.” AFL’s letter questions whether the companies’ rebranding efforts led to an actual change in selection criteria.

At a press event on November 7, 2023, Kalpana Kotagal, the newest EEOC commissioner, said that she plans to collaborate with her two Democratic colleagues to encourage lawful diversity, equity, inclusion, and accessibility practices in the workplace. Kotagal was previously a civil rights and employment attorney, has represented workers in discrimination class actions, and is the co-author of the “Inclusion Rider,” a sample provision for actors’ or filmmakers’ contracts to ensure equity and inclusion at every level in a production. EEOC Chair Charlotte Burrows and Commissioner Kotagal also held a DEI listening session with corporate leaders on November 7.

On October 8, 2023, California governor Gavin Newsom signed into law Senate Bill 54 (“SB 54”), under which covered entities in the venture capital industry will be required to annually report certain diversity statistics to the California Civil Rights Department (“CRD”) if their portfolio companies or investors have a covered connection to California. The demographic data, which includes race, ethnic identity, individuals who identify as LGBTQ+, gender identity, disability status, veteran status, and California resident status, must be reported on an aggregated and anonymized basis. Investments made in the prior calendar year in portfolio companies with diverse founding teams must also be reported as a percentage of the covered entity’s aggregate venture capital investments. SB 54 allows the CRD to publish this anonymized information online and conceivably to sue funds on the basis of discrimination. SB 54 also delegates to the CRD the power to investigate and prosecute complaints of discrimination. SB 54 is scheduled to go into effect on March 1, 2025.

Gibson Dunn published a Client Alert on November 7, 2023, discussing in more depth the scope, consequences, and uncertainties of SB 54’s implementation.

Media Coverage and Commentary:

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

Bloomberg Law, “Nasdaq’s Board Diversity Win Invigorates SEC Disclosure Plans” (November 9): Bloomberg Law’s Andrew Ramonas and Clara Hudson report on the recent decision by the United States Court of Appeals for the Fifth Circuit upholding Nasdaq’s rules requiring companies listed on Nasdaq’s exchange to disclose certain information about their board members’ diversity characteristics. (Gibson Dunn represented Nasdaq in this matter.) Ramonas and Hudson report that the SEC is considering proposing regulations to enhance board-diversity disclosures. Although DEI remains a priority for many companies, a recent Spencer Stuart report on board appointments indicates that the proportion of new directors appointed between May 2022 and April 2023 who identified as female or underrepresented minorities is down from the prior year.
US Law Week, “Throw Out the Diversity Playbook and Reimagine Inclusive Hiring” (November 7): William & Mary Law School Dean A. Benjamin Spencer argues that traditional law-firm diversity programs were flawed because they “signaled—unfairly—that ‘diverse’ candidates mostly couldn’t cut it in the regular hiring process.” He advocates for an “inclusive excellence” approach, including identifying larger pools of prospective hires through regional and specialty group career fairs and junior lateral hiring.
The Brookings Institution, “Admissions at most colleges will be unaffected by Supreme Court ruling on affirmative action” (November 7): According to Sarah Reber, Gabriela Goodman, and Rina Nagashima of Brookings, new data based on public reporting confirm prior findings that affirmative action is primarily used by highly selective, private four-year colleges. The data further show that most students from historically excluded racial groups do not attend colleges using affirmative action. Reber and her colleagues write that it is unlikely that the SFFA ruling will have a significant effect on college enrollment of historically marginalized racial and ethnic groups overall, although enrollment at highly selective institutions is likely to decline.
The Washington Post, “A law that helped end slavery is now a weapon to end affirmative action” (November 6): According to the Post’s Julian Mark, more than a dozen lawsuits filed over the last three years attempt to use the Civil Rights Act of 1866 (42 U.S.C. § 1981), which Congress passed to provide newly emancipated slaves with equal rights of citizenship, to assert claims of reverse discrimination. Plaintiffs in these suits argue that Section 1981 prohibits race-conscious programs, even those designed to remedy historic underrepresentation of certain groups. But critics of these suits say plaintiffs “have distorted the law’s intent.” The article highlights Gibson Dunn’s representation of the Fearless Fund: “This is a seminal civil rights statute, passed right after the Civil War, to ensure that the newly freed people who were slaves have the same rights as everybody else,” Jason Schwartz, a lawyer with Gibson Dunn, a law firm defending the Fearless Fund, said in a recent interview. “And to try to use that statute as a weapon against Black people . . . is outrageous.”
Forbes, “Balancing Diversity And Meritocracy: The Gannett DEI Lawsuit” (November 6): Arizona State University professor Susan Harmeling summarizes a putative class-action complaint filed in August against Gannett, one of the country’s largest newspaper publishers. The plaintiffs allege that Gannett terminated and denied promotion to white employees while favoring less-qualified underrepresented minorities. Harmeling predicts that the case signals a new era in the DEI landscape as companies attempt to pursue broad diversity goals “while ensuring that meritocracy remains at the forefront of their employment practices.”
National Law Journal, “How Employers Can Embrace DEI Without Inviting Lawsuits” (November 2): NLJ’s Chris O’Malley provides an overview of recent DEI-related litigation and risk reduction strategies. He highlights Gibson Dunn’s defense of the Fearless Fund:Arguing for the fund, Jason Schwartz, of Gibson Dunn & Crutcher, cited the irony of using Section 1981 to attempt to end the grant program. “Here, the irony would be even worse to take Section 1981, passed in the wake of the Civil War, to make freedom real for Black citizens, and use it to shut down the charitable endeavor of my clients supporting other Black women who face discrimination.”O’Malley notes that one of the “unusual” ways plaintiffs might challenge DEI initiatives is through the form of antitrust suits, citing a New York State Bar Association report highlighting that impermissible information sharing about “competitive conduct” may be interpreted broadly “to include any metrics used to compete for business or talent, including DEI commitments.”
Wall Street Journal, “Small Business Gets Caught in DEI Crossfire” (October 12): WSJ’s Ruth Simon and Theo Francis write that reverse-discrimination lawsuits targeting programs providing grants and other support to minority-owned small businesses are having a negative effect on small-business funding more generally. The Small Business Administration has also been ordered by federal judges to adjust its distribution of certain grant funds meant for socially and economically disadvantaged individuals and groups. For one SBA program that provided grants to restaurants, a court ordered the SBA to stop giving priority to restaurants owned by minorities, women, and other disadvantaged groups, and to instead allocate the grants on a first-come, first-served basis.

Current Litigation:

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

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

Alexandre v. Amazon.com, Inc., No. 3:22-cv-1459 (S.D. Cal. Sept. 29, 2022): White, Asian, and Native Hawaiian entrepreneur plaintiffs, on behalf of a putative class of past and future Amazon “delivery service partner” program applicants, challenged a DEI program that provides a $10,000 grant to qualifying delivery service providers who are “Black, Latinx, and Native American entrepreneurs.” Plaintiffs alleged violations of California state civil rights laws prohibiting discrimination.
- Latest update: The court dismissed the plaintiffs’ initial complaint for lack of standing and failure to state a claim on September 9, 2023, but granted leave to amend. Plaintiffs filed an amended complaint on September 22. Defendants’ deadline to respond is December 6, 2023.
Am. Alliance for Equal Rights v. Fearless Fund Mgmt., LLC, No. 1:23-cv-03424-TWT (N.D. Ga. 2023), on appeal at No. 23-13138 (11th Cir. 2023): AAER sued a Black women-owned venture capital firm with a charitable grant program that provides $20,000 grants to Black female entrepreneurs; AAER alleged that the program violates Section 1981 and sought a preliminary injunction. Fearless Fund is represented by Gibson Dunn.
- Latest update: On November 6, 2023, AAER filed its merits brief in the Eleventh Circuit in support of a preliminary injunction. AAER argued that Fearless Fund’s grant program is not protected by the First Amendment because it is “conduct, not speech,” and is not “inherently expressive.” AAER also argued that Section 1981 prohibits discrimination against whites as well as other racial groups and that AAER’s failure to disclose the names of the putatively harmed non-black non-female business owners did not defeat its standing to bring suit.
Mid-America Milling Company v. U.S. Dep’t of Transportation, No. 3:23-cv-00072-GFVT (E.D. Ky. 2023): Two plaintiffs, construction companies, sued the Department of Transportation, requesting the court enjoin the DOT’s Disadvantaged Business Enterprise Program, an affirmative action program that awards contracts to minority-owned and women‑owned small businesses in DOT-funded construction projects with the statutory aim of having such business comprise 10% of certain DOT-funded contracts nationally. Plaintiffs allege that the program constitutes unconstitutional race discrimination in violation of the Fifth Amendment.
- Latest update: DOT’s deadline to respond to the complaint is December 30, 2023.

2. Employment discrimination under Title VII and other statutory law:

Harker v. Meta Platforms, Inc., No. 23-cv-7865 (S.D.N.Y. 2023): A lighting technician who worked on a set where a Meta commercial was produced sued Meta and a film producers association, alleging that Meta and the association violated Title VII, Sections 1981 and 1985 and New York law through a diversity initiative called Double the Line. Plaintiff also claims that he was retaliated against after raising questions about the qualifications of a coworker hired under the program.
- Latest update: On November 3, 2023, the defendants filed their motions to dismiss, arguing the plaintiff lacked standing and failed to state plausible discrimination claims because he did not actually apply for a Double the Line position, nor did he meet the non-racial eligibility qualifications had he applied. The plaintiff’s deadline to respond is December 5, 2023.

3. Board of Director or Stockholder Actions:

Craig v. Target Corp., No. 2:23-cv-00599-JLB-KCD (M.D. Fl. 2023): America First Legal sued Target and certain of its officers on behalf of a stockholder, claiming the board falsely represented that it monitored social and political risk, when it allegedly focused only on risks associated with not achieving ESG and DEI goals. Craig claims that this focus depressed Target’s stock price, alleging violations of Sections 10(b) and 14(a) of the Securities Exchange Act of 1934.
- Latest update: On November 7, 2023, Target filed a motion to dismiss for lack of standing and failure to state a claim. Target argued that the plaintiff’s case alleged only a policy disagreement, not fraud. On the plaintiff’s claim of misrepresentation, Target pointed out that it has never hidden its commitment to DEI or potential risks of its approach and that plaintiff purchased his stock before Target made any of the allegedly fraudulent statements, meaning he could not have relied on them.

The following Gibson Dunn attorneys assisted in preparing this client update: Jason Schwartz, Mylan Denerstein, Blaine Evanson, Molly Senger, Zakiyyah Salim-Williams, Zoë Klein, Matt Gregory, Mollie Reiss, Teddy Rube*, and Alana Bevan.

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

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

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

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

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

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

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

*Teddy Rube is an associate working in the firm’s Washington, D.C. office who is not yet admitted to practice law.

An overview of global privacy and cybersecurity considerations and red flags in M&A transactions

In today’s business environment, data privacy and cybersecurity are bedrocks of trust and confidence—for customers, partners, and other businesses alike. As personal information becomes increasingly digitized, bad actors have augmented cyber-attacks and phishing scams to penetrate business servers and systems. To protect the public, legislators and agencies across the world have passed data privacy and cybersecurity laws to set standards and measures for data privacy and cybersecurity compliance, leading to regulatory, compliance, public relations, and litigation risks. Managing data privacy and cybersecurity risks has become critical to M&A transactions, not only due to the significant exposure to potential legal liability, financial and reputational harm, but also the potential material impact on the company’s ability to conduct its operations (especially for data or technology driven companies).

The importance of data privacy and cybersecurity is evident from the keen interest of company management in technology, as highlighted by Accenture Research’s 2022 Technology in M&A survey, which found that 74% of CEOs view technology integration in M&A as “a source of competitive advantage or growth enabler, rather than the cost of doing business.” Furthermore, according to the same survey, 96% of CIOs reported that technology due diligence uncovered “issues or opportunities that had material impact on certain deals.”

Below, we highlight several privacy and cybersecurity considerations and red flags in M&A transactions, regardless of which side of the table you sit.

Applicability of U.S. State Privacy Laws

Applicability of the California Consumer Privacy Act, as amended by the California Privacy Rights Act (the “CCPA”), is a critical part of the due diligence process, as the CCPA is enforced by active regulators (both the California Attorney General and the new California Consumer Privacy Agency), and provides a private right of action in the event of certain security incidents. Statutory damages can reach up to $750 per consumer per incident, and CCPA regulatory penalties can be as high as $7,500 per each intentional violation (or $2,500 for unintentional violation).

Outside of California, state privacy laws are developing in other jurisdictions as well—13 states have passed laws, with laws in Virginia, Colorado, Utah, and Connecticut taking effect just this year. Closely assessing the applicability of, and compliance with, these various state privacy laws is essential to identifying the legal risks involved for businesses operating and catering to customers in the U.S. As a first step acquirors should review the state-specific threshold requirements for applicability, which may include the target company’s gross annual revenue and/or the number of state residents’ information processed. For example, the breadth of the CCPA’s applicability is particularly broad—any business that has over $25M in revenue a year, and processes personal information of a California resident, will be subject to the law. Notably, any business that says they do not collect personal information—a refrain not uncommon in this area—is likely wrong, if they do business in California or outside the U.S. Indeed, unique amongst the state laws, but more similar to the GDPR, the CCPA applies to information collected from B2B partners, employees, and others not traditionally seen as “consumers,” making these laws relevant to nearly every transaction.

Applicability of E.U. / UK GDPR and Other International Laws

Acquirors should assess whether the target company (i) has any establishment in the E.U. or UK, (ii) even in the absence of an establishment in the E.U. or UK offers goods or services to individuals in the E.U. or UK, or (iii) monitors the behavior of individuals in the E.U. or UK. If the General Data Protection Regulation, including as incorporated into UK law pursuant to the European Union (Withdrawal) Act 2018 (together, the “GDPR”), applies to the company, an acquiror should review the safeguards instituted to ensure safe transfer of personal information outside the European Economic Area (“EEA”). The GDPR also has complex and demanding compliance requirements including, but not limited to, (1) a requirement for controllers to notify supervisory authorities of security incidents within 72 hours, (2) enlistment of processors, by controllers, who contractually agree to implement safeguard required by the GDPR, and (3) stringent restrictions concerning cross-border data transfers to countries outside of the EEA and UK.

With increasingly high fines from public enforcement, and growing private enforcement through privacy litigation, the potential consequences of failing to comply with the GDPR are growing. Non-compliance with the GDPR can result in fines up to 20 million Euros, or up to 4% of the total worldwide annual turnover of the company’s preceding financial year. Since the GDPR entered into application in May 2018 until October 2023, more than 1,878 fines were imposed amounting to more than EUR 4.4 billion in total.

The competent supervisory authorities may also impose other sanctions, such as a temporary or definitive limitation (including a ban) on processing. In addition to civil penalties, there can also be potential criminal liability in some E.U. member states.

The legal landscape in the E.U. and UK also continues to evolve, particularly as new laws continue to go into effect in furtherance of the EU Commission’s European Data Strategy. The GDPR is also influencing new data privacy laws in other parts of the world, including the Middle-East and APAC regions. Australia, New Zealand, and Singapore have enacted GDPR-like enhancements, and other APAC countries are exhibiting a clear trend towards GDPR-like extra-territoriality and revenue-based fines.

Applicability of Sector-Specific Privacy and Cybersecurity Laws

Businesses can be regulated by sector-specific or information-specific privacy laws, such as the Health Insurance Portability and Accountability Act (“HIPAA”), the Fair Credit Reporting Act (“FCRA”), the Gramm-Leach-Bliley-Act (“GLBA”), the Cyber Incident Reporting for Critical Infrastructure Act (“CIRCIA”), the Children’s Online Privacy Protection Act (“COPPA”), the Biometric Information Privacy Act (“BIPA”), the CAN-SPAM Act, and the Telephone Consumer Protection Act (“TCPA”). It is important to assess if any of these sector-specific laws are applicable in light of the nature and activities of the target company. Failure to comply with requirements of such laws can be important red flags, as non-compliance can result in statutory damages, which are assessed on a per-incident basis, including exposing companies to class action suits, under certain laws. While some of these laws are very sector-specific, some (such as CAN-SPAM), may be a reasonable line of inquiry in nearly every transaction.

Outdated Privacy Notices or No Privacy Notice

Today, it is uncommon to find a brick-and-mortar company with no online presence, and no requirements or best practices to have transparent notices around the collection, processing, transfer, disclosure, sharing, storage, security, and use of personal information. Common red flags for privacy notices include having (1) no policy, (2) an outdated policy, (3) only an online policy (e.g., regarding collection of information online, but not relating to other parts of their business), (4) an online policy that does not match the data collection and processing practices of the target company, or (5) a policy that does not outline consumers’ rights related to their personal information.

Storage of Sensitive Personal Information

A target company may house important and sensitive personal information regarding its employees, customers, suppliers, and counterparties—if not end-consumers. Assessing how such sensitive data is stored, including whether it is stored in-house or through a third-party vendor, is an important initial step to assess risk. Acquirors should also inquire what security mechanisms are employed by the company, such as whether data at rest and in transit is encrypted using industry-grade mechanisms. If privacy laws are likely to apply, then there may be additional obligations relating to sensitive information (including under U.S. state privacy laws, the GDPR, HIPAA, the GLBA, and others) that should be analyzed.

Cybersecurity Protocols, Policies and Procedures, and Insurance

Companies are increasingly expected to establish cybersecurity protocols, policies, and procedures, and to conduct security trainings, audits, penetration tests, or other reviews of the company’s privacy and cybersecurity protections, and to address any material issues, vulnerabilities, or other risks in a timely manner.

The target company’s cyber liability insurance policies, and whether any claims have been made against such policies, are also relevant. As acquirors draft representation and indemnification protections concerning cybersecurity matters, it is necessary to review the insurance coverage cap and the categories of attacks covered by the policies.

AI Solutions

As companies are increasingly relying on AI solutions, acquirors should review whether the target company uses any AI products to assist the business, the type of AI products used, and analyze the scope and types of personal information stored and used by such AI products. Use and/or development of such tools can unveil a gamut of potential risks, including relating to privacy, IP, antitrust, and employment.

Security Incidents, Reports, Investigations, or Litigations

A crucial aspect of data privacy and cybersecurity diligence is the discovery and disclosure of details regarding past or present security incidents, inquiries, complaints, investigations, or litigation related to personal information. These issues are ubiquitous and important considerations that can affect negotiations for representations and warranties insurance and deal prices. As such, an acquiror should scrutinize, and the target company should disclose:

Any data privacy or security incidents, which can include (1) the nature of the information affected, including whether any personal information was affected, (2) whether the target company was required to notify individuals or regulators, (3) the extent of any impacts on the target company’s operations and revenue, (4) any remediation steps taken to prevent similar incidents from occurring, and (5) whether such incidents have led to any complaints by customers, or inquiries or investigations from relevant governmental authorities. Any risk monitoring mechanisms and practices to prevent these incidents and resultant legal issues. Even if the target company has not experienced any security incidents, an acquiror must review the target company’s risk monitoring mechanisms and practices, to ensure the company has measures in place to detect security incidents, and IT and cybersecurity policies and procedures to ensure preparedness, including whether a written information security policy, incident response plan, and business continuity and disaster recovery plan have been developed and implemented. These are all important indicators of a target company’s capacity to identify and respond to security incidents and other material system outages or instances of unauthorized access.

Acquirors should also be prepared to review data privacy or cybersecurity-related lawsuits or regulatory inquiries, settlements, and claims. These may arise in the context of the target company’s session replay litigation, regulatory inquiries in relation to BIPA, CCPA, and the FTC. More specifically, acquirors should be aware of target company’s data privacy practices because issues, such as lack of consent from customers, can lead to post-acquisition claims and inquiries concerning the absence of proper compliance measures for processing personal information.

Integrating the Diligence

Privacy and cybersecurity diligence can often reveal issues that are not readily apparent to an acquiror, some of which may be material, and some which may not be. Notwithstanding a target company’s disclosure of significant breaches and incidents in the disclosure schedule, other material red flags, including insufficient privacy policies or non-compliance with international, domestic, or local privacy and cybersecurity laws, can heavily influence the negotiations involved in draft agreements. Privacy and cybersecurity diligence may influence not only the price associated with the representations and warranties insurance, but also the price of the acquisition or merger itself. If a target company fails to adhere to relevant data privacy laws, post-closing remediation may be necessary to address any existing compliance gaps—for which an acquiror will have an early advantage in constructing adequate compliance measures, if diligence is performed well.

Our attorneys are leading industry experts, and we regularly advise on privacy and cybersecurity matters on behalf of the world’s largest companies. We efficiently identify the costs and resources needed to implement post-acquisition remediation, and assist in integrating the privacy and cybersecurity practices of target companies into acquirers’ global organizations. We also help manage target companies’ pre-existing security incidents and claims, and provide holistic assessments on the impacts of such events on the transaction or the acquiror’s business.

The following Gibson Dunn lawyers assisted in preparing this alert: Alexander Southwell, Ahmed Baladi, Cassandra Gaedt-Sheckter, Robert Little, Saee Muzumdar, Peter Moon, Amanda Estep, and Ruby Lang.

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

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

Private Equity:
Richard J. Birns – New York (+1 212-351-4032, [email protected])
Wim De Vlieger – London (+44 (0) 20 7071 4279, [email protected])
Federico Fruhbeck – London (+44 (0) 20 7071 4230, [email protected])
Scott Jalowayski – Hong Kong (+852 2214 3727, [email protected])
Ari Lanin – Los Angeles (+1 310-552-8581, [email protected])
Michael Piazza – Houston (+1 346-718-6670, [email protected])
John M. Pollack – New York (+1 212-351-3903, [email protected])

Privacy, Cybersecurity & Data Innovation:
Ahmed Baladi – Paris (+33 (0) 1 56 43 1300, [email protected])
S. Ashlie Beringer – Palo Alto (+1 650-849-5327, [email protected])
Jane C. Horvath – Washington, D.C. (+1 202-955-8505, [email protected])
Alexander H. Southwell – New York (+1 212-351-3981, [email protected])

© 2023 Gibson, Dunn & Crutcher LLP. All rights reserved. For contact and other information, please visit us at www.gibsondunn.com.Our lawyers provide an overview of global data privacy and cybersecurity considerations and red flags in M&A transactions.

A summary and commentary on the recent decision of the Hong Kong Court of Final Appeal regarding service of originating process by the Securities and Futures Commission

On 30 October 2023, the Hong Kong Court of Final Appeal (the “CFA”) handed down its reasons for dismissing the appeal in Securities and Futures Commission v Isidor Subotic and Others [2023] HKCFA 32[1]. The CFA confirmed that leave is not required for the Securities and Futures Commission (the “SFC”) to serve proceedings out of jurisdiction as the relevant provisions in the Securities and Futures Ordinance (the “SFO”) has empowered the Court of First Instance (the “CFI”) to hear and determine a claim made against persons who are not within the jurisdiction.

Background

In July 2019, the SFC commenced the present proceedings against various individuals and companies under sections 213 and 274 of the SFO. It was alleged that these parties were operating a false trading scheme involving artificially inflating the price of the share of a Hong Kong listed company before “dumping” them and causing loss to market participants and lenders. The SFC sought, amongst other relief, a restoration order in favour of the market participants involved and an injunction to freeze certain assets.

As six of the defendants in this case were located outside of Hong Kong (the “Foreign Defendants”), the SFC applied for and was granted leave to serve a concurrent writ on them outside of Hong Kong. The Foreign Defendants applied to set aside the order granting leave and sought a declaration that the CFI lacks jurisdiction over them, arguing that leave was wrongly granted as the SFC’s claims did not come within any of the “gateways” specified in Order 11, rule 1(1) of the Rules of the High Court (the “RHC”) (i.e., the types of claims for which leave to effect service outside of Hong Kong could be obtained).

The CFI[2] and the Court of Appeal[3] both upheld the decision granting leave to effect service out of the jurisdiction on the basis that claims of the SFC were either a claim founded on tort and damage was sustained or resulted from an act committed within the jurisdiction (“Gateway F”) or a claim for an injunction restraining a conduct within the jurisdiction. The Foreign Defendants then appealed to the CFA on grounds that the relief sought by the SFC under Section 213 of the SFO cannot be properly characterized as a claim and even if it is a claim, it is not founded on tort for the purpose of invoking Gateway F.

Before the CFA hearing, the CFA directed the parties to make submissions on whether leave was in fact necessary in the circumstances because under Order 11, rule 1(2) of the RHC, if a legislative provision already confers the CFI with jurisdiction in respect of a claim over a defendant outside of Hong Kong or in respect of a wrongful act committed outside Hong Kong, leave from the court is not required for effecting service of a writ out of the jurisdiction.

CFA’s Decision

The CFA unanimously dismissed the appeal and held that, according to Order 11, rule 1(2) of RHC, it was not necessary for the SFC to seek leave from the CFI to serve its claim on the Foreign Defendants.

In coming to such conclusion, the CFA looked into three questions in particular, namely (1) what are the claims that the SFC is making; (2) whether the CFI is empowered to hear and determine the claims made by the SFC by virtual of any written law; and (3) whether the CFI is so empowered notwithstanding that the person against whom the claim is made is not within the jurisdiction of the court or that the wrongful act giving rise to the claim did not take place within the jurisdiction.

On the first question, it was observed that the writ which the SFC served upon the Foreign Defendants seeks declarations that they are persons within section 213 of the SFO who have engaged in false trading activities in contravention of sections 274 and/or 295 of the SFO.

On the second question, having identified the claims of the SFC, the CFA then considered the effect of sections 213 and 274 of the SFO. The CFA held that these provisions are intended to operate in combination and must be read together. Whilst section 274 of the SFO defines the prohibited acts of false trading, section 213 of the SFO provides for the orders that the CFI may impose against the contraveners. It is clear that by virtue of the written law, CFI is empowered to hear and determine the claims put forwarded by the SFC under sections 213 and 274 of the SFO.

On the last question, the CFA found in the affirmative because upon contravention of section 274 of the SFO, the CFI is empowered under section 213 of the SFO to grant relief against a person “in Hong Kong or elsewhere” where such person does anything that constitutes false trading affecting the Hong Kong market. It was noted that the policy to confer the CFI with extraterritorial jurisdiction over persons outside of Hong Kong is justified considering that trading on the Hong Kong Stock Exchange is global and therefore it would be necessary to make sanctions legally available against overseas fraudulent parties who cause disruption to the local market and losses to other investors.

Notwithstanding the above, the CFA also made clear that the application of Order 11 rule 1(2) of the RHC is limited to cases where the written law in question clearly contemplates proceedings being brought against persons outside of jurisdiction or where the wrongful act did not take place within the jurisdiction. It is not sufficient if the written law is of general application and may be invoked against persons within or outside the jurisdiction.

Comment

This decision confirms that no leave is required for the SFC to serve a writ seeking reliefs such as restoration orders, damages and compensation orders or restraint orders under section 213 of the SFO on foreign defendants out of jurisdiction.

Such decision is consistent with the intent of the SFO to seek redress in relation to wrongful acts damaging to market participants whether such acts took place within or outside Hong Kong and to provide appropriate legal recourse against the wrongdoers. In light of the decision, it is expected that the SFC may take more aggressive enforcement actions against parties who have engaged in cross-border market misconduct and pursue them regardless of their physical location.

____________________________

[1] https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=155879

[2]https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=137397&currpage=T

[3]https://legalref.judiciary.hk/lrs/common/ju/ju_frame.jsp?DIS=149666

The following Gibson Dunn lawyers assisted in preparing this alert: Brian Gilchrist, Elaine Chen, Alex Wong, and Cleo Chau.

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

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

We are pleased to provide you with Gibson Dunn’s ESG monthly update for October 2023. This month, our update covers the following key developments.

I. INTERNATIONAL

UN Global Compact issues new guidance on sustainable infrastructure under China’s Belt and Road Initiative

During an event in Beijing on October 18, 2023 attended by high-level representatives from governments, business and academia, the UN Global Compact unveiled new guidance and assessment tools for companies to advance sustainable infrastructure under the Chinese government’s Belt and Road Initiative (BRI) — a global infrastructure development strategy adopted in 2013 to invest and cooperate with over 150 countries and international organisations. The guidance includes A Practical Guide for Private Sector Players on the Human Rights and Labour Principles, the Environment Principles, and the Anti-Corruption Principle, designed to promote application of the UN Global Compact’s Ten Principles in the infrastructure sector, and a Guidance and Assessment Tool for Companies on Maximizing Impact towards the SDGs, which aims to engage private sector players participating in infrastructure projects under the BRI to align their operations with the UN’s Sustainable Development Goals.

Network for Greening the Financial System publishes conceptual note on short-term climate scenarios

On October 3, 2023, the Network for Greening the Financial System — a group of central banks and financial supervisors working to help develop environment and climate risk management in the financial sector, and mobilise finance to support the transition toward a sustainable economy—released a Conceptual Note on Short-term Climate Scenarios. This note follows a public feedback survey conducted in February 2023 which identified short-term scenarios as a key priority. The note explains that short-term scenarios covering a three-to-five-year period enable better understanding of the near-term macro-financial impact of transitioning to a net zero economy upon the real economy, individual financial institutions, and the broader financial system—which is of particular importance against the backdrop of heightened uncertainties resulting from fossil energy supply and mounting scientific evidence that the world might exceed global temperatures increases of 1.5 °C within the next five years.

The note proposes five short-term climate scenario narratives (‘Highway to Paris’ (implementation of an ambitious mitigation pathway), ‘Green Bubble’ (glut of green private investment), ‘Sudden wake-up call’ (sudden change in public opinion and accelerated transition), ‘Low Policy Ambition and Disasters’ (severe acute physical disasters and higher risk premia), and ‘Diverging Realities’ (severe natural disasters, lack of external financing, disruption of transition-critical mineral supply chains hampering global transition)), all driven by different geopolitical, economic and technological factors to result in a range of plausible futures, and designed to provide the basis for climate stress testing related to central banks’ prudential and supervisory responsibilities.

The International Capital Markets Association releases paper on market integrity and greenwashing risks in sustainable finance

On October 10, 2023, The International Capital Markets Association (ICMA) released a new paper on market integrity and greenwashing risks in sustainable finance, which expands on its response in January 2023 to the European Supervisory Agencies’ Call for Evidence on greenwashing on November 15, 2022.

In the paper, ICMA sets out its concerns regarding proposals for a definition of greenwashing for regulatory purposes flagging that exhaustive definitions of greenwashing are problematic as they risk market paralysis or regression due to excessive reputational or litigation concerns, and that a broad catch-all definition of greenwashing would not distinguish between intentional and unintentional behaviour, having the unintended consequence of exacerbating “greenhushing”.

ICMA instead proposes a focussed definition of greenwashing for consideration by regulators, but suggests that unpacking greenwashing into areas of actual concern is a more effective approach than expanding the current definitions. The proposed definition for consideration reads as follows: “For financial regulatory purposes, greenwashing is a misrepresentation of the sustainability characteristics of a financial product and/or of the sustainable commitments and/or achievements of an issuer that is either intentional or due to gross negligence”.

ICMA also finds that, while ambition and materiality in the early development of the new sustainability-linked bond market may have been insufficient, there is a positive trend in the last 12 months, and that greenwashing is not prevalent in the green and sustainable bond market.

Financial Stability Board publishes annual progress report on climate-related disclosures

On October 12, 2023, the Financial Stability Board (FSB)—an international body that promotes the stability of the global financial system by coordinating national financial authorities and international standard-setting bodies—published its annual progress report on climate-related disclosures, which was delivered to G20 Finance Ministers and Central Bank Governors.

The report finds that significant further progress has been achieved on climate disclosures in the past years, including the publication of the International Sustainability Standards Board (ISSB) Standards in June 2023, which will serve as a global framework for climate-related and sustainability disclosures. It further finds that all FSB member jurisdictions have either requirements, guidance, or expectations in respect of climate-related disclosures currently in place or have taken steps to do so.

The report also references the findings of the Task Force on Climate-Related Financial Disclosures (TCFD) in its 2023 Status Report, which utilised artificial intelligence technology to analyse reporting by more than 1,350 public companies, highlighting that while the percentage of companies making TCFD-recommended disclosures continues to grow, more progress is needed.

Principles for Responsible Investment seeks support for Spring initiative addressing nature loss

The Principles for Responsible Investment (PRI)—a UN-supported international network of financial institutions—invited endorsers (asset owners, investment managers and service providers) on October 3, 2023 to publicly sign up to its Spring investor expectation statement.

The statement sets out the PRI’s stewardship initiative (“Spring”) to urge target companies to take action addressing deforestation and biodiversity loss either directly through their own engagement with policy makers or indirectly through engagement with investees with regards to their responsible political engagement practices given the importance of strong public policy design and implementation in this area. Investors endorsing the statement are not obligated to engage with the target companies but can choose simply to signal their support for the effort.

A list of the target companies is due to be published in early 2024 and the PRI are encouraging investors to sign up by 19 January 2024 to be included the first list of endorsers.

Institutional Shareholder Services announces results of annual global benchmark policy survey

On October 31, 2023, Institutional Shareholder Services (ISS) published the results of its 2023 Global Benchmark Policy Survey to inform its proxy development for the 2024 proxy season. The report sets out key findings related to: increased investor scrutiny of non-GAAP adjustments in US companies’ incentive pay program metrics; the ISS Japan benchmark policy of recommending votes against the re-election of top executives of companies based on return on equity performance; the ISS policy for Korea on director accountability and material governance failures; ISS director independence classification for directors who provide professional services; ISS policy on Foreign Private Issuers and companies listed on US markets; and investor preference regarding ISS approach (globally consistent versus market-specific) to policy guidelines relating to various Environmental and Social topics.

The Society for Corporate Governance submitted a comment letter on September 21, 2023, drawing attention to the “survey bias” observed by its members in the survey questions. The letter observes that given the “increased politicisation of ESG” there is a lack of consensus among the general public and investors regarding ESG generally. It questions the appropriateness of the ISS assuming the role of a quasi-regulator on the issue of Environmental and Social disclosure, and urges the ISS to avoid adopting benchmark policies that are prescriptive or standardised.

II. UNITED KINGDOM

UK Energy Act 2023: Landmark legislation becomes law

The UK Energy Act 2023 (EA 2023) Energy Bill, which originated as the Energy Bill in the House of Lords in July 2022, received royal assent on October 26, 2023. The Department for Energy Security and Net Zero’s announcement describes it as the “biggest piece of energy legislation in the UK’s history”.

The EA 2023 sets out measures to promote investment in low-carbon industries, protect consumers from unfair energy pricing and safeguard the country’s security of energy supply, including:

introduction of business models for the transport and storage elements of carbon capture usage and storage and hydrogen projects, industrial carbon capture and low-carbon hydrogen;
creation of a specific merger regime for energy networks under the Competition and Markets Authority;
introduction of a low-carbon heat scheme;
support for an increase in investment in the consumer market for electric heat pumps (as an alternative to domestic gas boilers) by providing for a new market standard and trading scheme;
facilitate the first large-scale hydrogen heating trial;
creation of a new regulatory environment for fusion energy; and
speeding up the deployment of offshore wind, while maintaining environmental protection.

Global First – UK’s Transition Plan Taskforce launches ‘first of its kind’ globally applicable Transition Plan Disclosure Framework

The Transition Plan Taskforce was launched by HM Treasury in April 2022 to develop a “gold standard” disclosure framework (the Disclosure Framework) for best practice climate transition plans, representing a key step in the UK’s efforts towards becoming the world’s first net-zero aligned financial centre.

The Disclosure Framework, published in October 2023 together with a one-page summary, sets out good practice for robust and credible transition plan disclosures, recognising that listed firms and investors need clear guidance on how best to comply with developing voluntary and mandatory corporate reporting rules, which in the UK will require large firms in the UK to produce transition plans that detail how they intend to deliver on net zero emission goals and respond to climate-related risks.

The UK’s Financial Conduct Authority has welcomed the launch of the Disclosure Framework and has already signalled its intention to consult on transition plan disclosures by UK listed companies in line with the Disclosure Framework.

The Disclosure Framework is designed to be available for voluntary and mandatory use internationally. Of particular note, the framework was designed to be consistent with and build on the final Climate-Related Disclosures standards (IFRS S2) issued by the International Sustainability Standards Board and has also drawn upon the Glasgow Financial Alliance for Net Zero framework for transition planning.

The Disclosure Framework applies three guiding principles of Ambition, Action and Accountability and is organised across five elements (foundations, implementation strategy, engagement strategy, metrics & targets and governance) and 10 disclosure sub-elements.

The final version of the Disclosure Framework is based on the draft launched for consultation in November 2022, the key findings of which can be found here.

Loan Market Association and the European Leveraged Finance Association publish updated best practice guide to sustainability-linked leveraged loans

The Loan Market Association (LMA) and the European Leveraged Finance Association have worked with their respective committees to jointly update the Best Practice Guide to Sustainability-Linked Leveraged Loans (the Guide), in response to the growing appetite in the leveraged loan market for engagement with sustainability-linked financings.

The Guide was published on October 5, 2023 and seeks to provide practical guidance on the application of the ‘Sustainability-Linked Loan Principles’ to leveraged loans, setting out what borrowers, finance parties and their respective advisers ought to consider when integrating sustainability factors into their facility agreements. It observes that the participants in leveraged loan markets are uniquely placed to lead sustainability efforts given that the asset class can lend itself to close relationships between borrowers and lenders, and that investors are already used to conducting “deep dives” into borrowers’ businesses.

In addition to the publication of the Guide, on October 12, 2023, the LMA published a Term Sheet for Draft Provisions for Sustainability-Linked Loans (SLL), prepared by a working group of financial institutions and law firms. The term sheet can be accessed by LMA members on its website.

The Law Society of England & Wales publishes guide to climate risk governance and greenwashing risks for in-house and private practice lawyers

On October 13, 2023, the Law Society of England and Wales published a guide providing information to in-house and private practice lawyers who advise companies on climate risk governance and greenwashing risks, and how these risks might impact solicitors’ and directors’ duties.

The guide intends to inform lawyers as to their duty to advise companies on their duties under the UK Companies Act 2006 and climate-related disclosures. It also addresses what is meant by “good climate governance” and includes certain definitions such as “Greenwashing”, “Climate risks” and “Net Zero”. The guide also includes certain useful resources to learn more about UK directors’ duties and climate risk and governance.

UK Government launches a review of emissions reporting under the UK’s existing streamlined energy and carbon reporting regime

The UK Government is seeking views on the streamlined energy and carbon reporting regime (SECR). The SECR started to apply for financial years starting on or after 1 April 2019 to most UK publicly traded companies, as well as large non-traded companies and large limited liability partnerships. It requires in-scope entities to disclose Scope 1 and Scope 2 greenhouse gas (GHG) emissions in their annual reports, while disclosures of Scope 3 emissions (which are indirect emissions that occur in a company’s value chain) are mostly voluntary. The SECR also requires disclosure of energy usage and energy efficiency measures. The UK Government is asking for feedback as to whether ‘Scope 3 emissions’ should be within the scope of SECR. The UK Government is seeking views on, among other things, the costs, benefits and practicalities of Scope 3 GHG reporting.

The UK Government has asked for feedback by December 14, 2023.

III. EUROPE

The Council of the European Council adopts the new Renewables Energy Directive

On October 9, 2023, the Council of the European Union formally adopted the amended Renewable Energy Directive (RED III). RED III raises the 2030 target for the share of renewable energy in the EU’s overall energy consumption from 32% to 42.5%, with a further indicative target of 2.5%, as well as introducing specific sub-targets for Member States in the industry, transport and building (district heating and cooling) sectors with a view to speeding up the integration of renewables in sectors where uptake has been slower. Member States now have 18 months to adjust national legislation accordingly.

RED III is part of the broader ‘Fit for 55’ package, aligning the EU’s energy and climate goals with the objective of reducing greenhouse gas emissions by at least 55% by 2030.

The European Parliament and the Council of the European Union adopt the European Green Bonds Regulation, the new voluntary standard to fight greenwashing

On October 5, 2023, the European Parliament formally adopted the regulation on European Green Bonds and optional disclosures for bonds marketed as environmentally sustainable and for sustainability-linked bonds (the EuGB Regulation), which was published on October 11, 2023. On October 24, 2023, the Council of the European Union has similarly announced its adoption of the EuGB Regulation.

The EuGB Regulation set out a framework that bond issuers, whether within or outside the EU, must follow if they wish to use the “European Green Bond” (EuGB) designation. It also includes voluntary disclosure guidelines for other environmentally sustainable bonds and sustainability-linked bonds issued in the EU.

The key aspects of this new standard are:

the link between the use of proceeds and the EU Taxonomy Framework;
increased transparency, through the required completion of a pre-issuance green bond factsheet and EU Prospectus Regulation compliant prospectus, post-issuance allocation report(s) and post-allocation impact report;
the voluntary “lite” disclosure regime applicable to bonds marketed as environmentally sustainable and sustainability-linked bonds;
the introduction of a supervised external reviewer regime; and
the introduction of supervisory and sanctioning powers to “national competent authorities”.

European Parliament’s Committee on Economic and Monetary Affairs has published a draft report on the proposal for a regulation of the European Parliament and of the Council on the transparency and integrity of Environmental, Social and Governance rating activities

On October 6, 2023, the European Parliament’s Committee on Economic and Monetary Affairs published a draft report on the European Commission’s proposal for a regulation of the European Parliament and of the Council on the transparency and integrity of environmental, social and governance (ESG) rating activities. The draft report was prepared by Rapporteur Aurore Lalucq, who submitted 97 amendments to the text proposed by the European Commission.

In the explanatory statement to the report, the Rapporteur outlines her views on the proposed regulation, including the following:

the disclosure requirements should be more stringent and instructive;
entities seeking multiple ratings should prioritise at least one provider with a market share below 5% to ensure diversity and competitiveness in the marketplace;
the reliability and transparency of ESG rating activities needs to be improved;
ESG rating providers should actively incorporate standardized ESG data into their assessments; and
the objectives of the rating providers need to be clarified.

The European Securities and Markets Authority has published a report on the climate-related matters in the financial statements

On October 25, 2023, the European Securities and Markets Authority (ESMA) published a report on disclosures of climate-related matters in the financial statements, which aims to assist and enhance the ability of issuers to provide more robust disclosures and create more consistency in how climate-related matters are accounted for in the financial statements drawn up in accordance with International Financial Reporting Standards. The report does not, however, set out best practices or prescribe the way in which the disclosure of climate-related matters should be made in the financial statements.

The report focuses on the following key topics, for which ESMA has deemed climate-related matters to likely have a higher impact: significant judgements, major source of estimation uncertainty and accounting policies; impairment of non-financial assets; useful lives of tangible and intangible assets; and provisions and other accounting topics.

IV. UNITED STATES

Federal banking regulators finalize guidance for large financial institutions on managing physical and transition risks associated with climate change

On October 24, 2023, the Office of the Comptroller of the Currency, Treasury, Board of Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation collectively finalized principles for climate-related financial risk management for large financial institutions (i.e., those with more than $100 billion in assets). Federal Reserve Chair Jerome H. Powell stressed in a same day statement that the principles are “squarely focused on prudent and appropriate risk management,” not making policy decisions addressing climate change, and that banks must understand and manage their material risks.

Financial officers of 21 states continue dialogue with proxy advisory firms on ESG proposals

State treasurers, auditors, and other financial officers from 21 states sent a follow-up letter on October 24, 2023 to proxy advisory firms Institutional Shareholder Services (ISS) and Glass Lewis that continued to express their concern regarding political, ideological, and personal bias in the firms’ voting recommendations made on ESG-related Rule 14a-8 shareholder proposals. In particular, the letter raised the potential for unfair treatment of proposals submitted by conservative proponents. It also focused primarily on proposals related to “debanking” risks as an area for the firms “to demonstrate [their] commitment to avoiding political bias” in the upcoming proxy season. This correspondence continued dialogue among the parties that began in May 2023. Prior responses from ISS and Glass Lewis are available here and here, respectively.

U.S. Department of Energy announces selection of seven sites to establish clean hydrogen hubs with a $7 billion investment

On October 13, 2023, the U.S. Department of Energy’s (DOE) Office of Clean Energy Demonstrations announced a $7 billion investment from the Bipartisan Infrastructure Law to launch seven Regional Clean Hydrogen Hubs (H2Hubs) across the country. The investment aims to foster “a national network of clean hydrogen producers, consumers, and connective infrastructure,” aligning with the DOE’s U.S. National Clean Hydrogen Strategy and Roadmap and Pathways to Commercial Liftoff: Clean Hydrogen. If the H2Hubs proceed as planned, the DOE expects them to annually reduce 25 million metric tons of carbon dioxide emissions from end-use and produce three million metric tons of hydrogen, in addition to substantial job creation.

California adopts legislation requiring diversity disclosure for private equity and venture capital funds, mandating climate-related disclosure, and regulating “green” claims

On October 8, 2023, California enacted Senate Bill 54, “Venture Capital Companies: Reporting,” which will be effective on March 1, 2025. The bill will require venture capital companies with certain connections to California to annually disclose to the California Civil Rights Department demographic data regarding portfolio company founding teams, including race, ethnic identity, disability status, gender identity, and veteran status, among other characteristics. More information on this development is available in our recent client alert here.

In early October, California also enacted three bills that will impose significant climate-related reporting obligations on public and private companies with connections to the State. For further detail, see our September update, client alert, and blog post.

New York Stock Exchange proposes new listing standards for securities of “Natural Asset” companies

The New York Stock Exchange (NYSE) proposed new listing standards in late September for a category of public companies called “Natural Asset Companies” (NACs). The NYSE defines these companies as corporations “whose primary purpose is to actively manage, maintain, restore (as applicable), and grow the value of natural assets and their production of ecosystem services.” Such companies may also “seek to conduct sustainable revenue-generating operations,” if certain conditions are satisfied. The proposed listing rules include governance and reporting requirements related to corporate charters, license agreements, mandatory written policies (e.g., environmental and social, biodiversity, human rights, etc.), and a mandatory pre-listing “Ecological Performance Report.” NACs would otherwise be subject to the Section 303A.00 corporate governance requirements, with specific responsibilities for their audit committees. The Intrinsic Exchange Group partnered with the NYSE for the proposal.

V. APAC

Australian Accounting Standards Board publishes draft sustainability reporting standards

In October 2023, the Australian Accounting Standards Board published a draft of the country’s sustainability reporting standards, out for consultation until March 1, 2024. The draft Australian Sustainability Reporting Standards (ASRS) – Disclosure of Climate-related Financial Information (ED SR1) have been developed using the International Sustainability Standards Board’s two sustainability disclosure standards, released in June 2023, and include ASRS 1 for general requirements for disclosure of climate-related financial information (developed using IFRS S1 as the baseline) and ASRS 2 for climate-related financial disclosures (developed using IFRS S2). A third standard (ASRS 101, References in Australian Sustainability Reporting Standards) has been developed as a service standard that lists the relevant versions of any non-legislative documents published in Australia and foreign documents that are referenced in ASRS standards.

Hong Kong’s Securities and Futures Commission announces plans to sponsor the development of a voluntary code of conduct for ESG ratings and data product providers

On October 31, 2023 the Hong Kong’s Securities and Futures Commission (HKSFC) announced plans to support and sponsor the development of a voluntary code of conduct (VCoC) for ESG ratings and data product providers. The VCoC will be developed via an industry-led working group, namely the Hong Kong ESG Ratings and Data Products Providers VCoC Working Group (VCWG).

The HKSFC has noted that the VCoC will align with international best practices as recommended by the International Organization of Securities Commissions. Further details of the VCWG are included in its terms of reference and a participation list has also been published by the HKSFC.

Japan announces issue of new government transition bonds and efforts to improve regional alignment on transition finance in Asia through the “Asia GX Consortium”

At the PRI in Person in Japan, on October 3, 2023, Prime Minister Fumio Kishida explained that the Japanese Government will work to improve regional alignment on transition finance in Asia. The Prime Minister outlined that the Japanese Government’s efforts will be based on its “GX” or “green transformation” plan and will encourage specific implementation of transition finance across Asian countries, launching an “Asia GX consortium” by the middle of 2024. The consortium will aim to drive GX investment in Asia, across both the public and private sectors. Prime Minister Kishida also announced that the Japanese Government will issue new government transition bonds titled “Climate Transition Bonds” this fiscal year and these will be the “world’s first government-issued transition bonds aligned with global standards”.

Monetary Authority of Singapore backs the use of carbon credits to finance the early retirement of coal-fired plants

The Monetary Authority of Singapore and McKinsey & Company published a working paper setting out how high-integrity carbon credits can be utilised as a complementary financing instrument to accelerate and scale the early retirement of coal-fired plants (CFPPs).

The paper explains that the phase-out of CFPPs is key to Asia’s energy transition and should be accompanied by the further development of clean energy. The paper explores the role that high-integrity carbon credits can play in this process and considers what is required to further development in a market for high-integrity carbon credits.

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

Warmest regards,

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

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

The following Gibson Dunn lawyers prepared this client update: Lauren Assaf-Holmes, Grace Chong, Sophy Helgesen, Elizabeth Ising, Tamas Lorinczy, Cynthia Mabry, Shannon McAvoy, Patricia Tan Openshaw, Selina S. Sagayam and David Woodcock.

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

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

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On November 2, 2023, Hong Kong’s Securities and Futures Commission (“SFC”) published two circulars providing guidance to intermediaries engaging in tokenised securities-related activities (the “Tokenised Securities Circular”),[1] and on the tokenisation of SFC-authorised investment products (the “Investment Products Circular”) (collectively, the “Circulars”).[2]

As further explained below, the Circulars reflect a distinct evolution in the SFC’s views on tokenised securities, in particular by explicitly superseding the SFC’s previous March 2019 statement characterising security tokens as complex products requiring extra investment protection measures and restricting their offering to professional investors (the “March 2019 Statement”).[3] Instead, the SFC has made it clear in the Tokenised Securities Circular that it now considers tokenised securities to be traditional securities with a tokenisation wrapper, as discussed further below, and has noted that there is a growing interest in tokenising traditional financial instruments in the market, including the issuance and distribution of tokenised funds by fund managers and management of funds that invest in tokenised securities. The two Circulars aim to assist intermediaries interested in exploring tokenisation by providing more guidance on regulatory expectations with respect to tokenised securities-related activities and how to address the risks specific to tokenised securities.

I. The Tokenised Securities Circular represents an important evolution in the SFC’s views of Tokenised Securities

As a starting point, the SFC has indicated that for the purposes of the Tokenised Securities Circular, it considers tokenized securities to be traditional financial instruments (e.g. bonds or funds) that are securities (as defined in the Securities and Futures Ordinance (“SFO”)) which utilise distributed ledger technology (e.g. blockchain technology) (“DLT”) or a similar technology in their security lifecycle (“Tokenised Securities”).[4] In the SFC’s words, these securities are “fundamentally traditional securities with a tokenisation wrapper”. Given this, the SFC has emphasised in the Tokenised Securities Circular that the existing legal and regulatory requirements for securities will continue to apply to Tokenised Securities.

In taking this approach, the Tokenised Securities Circular represents an important step forward from the March 2019 Statement, which characterised Security Tokens as complex products and imposed a “professional investor-only” (“PI-only”) restriction on the distribution and marketing of these securities. However, the SFC has now made it clear that tokenisation should not alter the complexity of the underlying security. Therefore, instead of a blanket categorisation of Tokenised Security as a “complex product”, the SFC now instructs intermediaries to adopt a “see-through approach”. In other words, intermediaries should determine the complexity of a Tokenised Security by assessing the underlying traditional security against the factors set out in the Guidelines on Online Distribution and Advisory Platforms and the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the “Code of Conduct”),[5] as well as guidance issued by the SFC from time to time.

Similarly, the SFC has indicated that as Tokenised Securities are fundamentally traditional securities with a tokenisation wrapper, there is no need to impose a mandatory PI-only restriction. However, the offerings of Tokenised Securities to the Hong Kong public will continue to be subject to the prospectus regime in the Companies (Winding Up and Miscellaneous Provisions) Ordinance and offers of investments regime under Part IV of the SFO (“Public Offering Regimes”). As such, Tokenised Securities that have not complied with the prospectus requirements or offers of investments regime can only be offered to PIs.

The SFC has also noted that existing conduct requirements for securities-related activities will apply to the distribution of or advising on Tokenised Securities, management of funds investing in Tokenised Securities and secondary market trading of Tokenised Securities on virtual asset trading platforms.

II. Key regulatory expectations when engaging in Tokenised Securities-related activities

The Tokenised Securities Circular goes on to set out guidance regarding the SFC’s expectations for intermediaries choosing to engage in Tokenised Securities related-activities, as summarised below.

Risk management considerations

The SFC has emphasised in the Tokenised Securities Circular that its approach remains “same business, same risks, same rules”. However, the SFC considers that tokenisation has created new risks for intermediaries in relation to ownership (e.g. in relation to how ownership interests are transferred and recorded) and technology risks (e.g. forking, network outages and cybersecurity risks).

These risks can vary depending on the type of the DLT network utilised for the Tokenised Securities, with the SFC flagging that intermediaries should apply particular caution in relation to Tokenised Securities in bearer form issued using permissionless tokens on open, public network that does not restrict access for privileges and offers decentralised, anonymous, and large-scale user base (“Public-Permissionless Network”). This is on the basis that these sorts of securities are exposed to increased cybersecurity risks due to the lack of restrictions for public access and the open nature of these networks. In the event of a cyberattack, theft or hacking, the SFC has flagged that investors may experience increased difficulties in recovering their assets or losses, and may face potentially substantive losses without recourse. Intermediaries should address such risks accordingly by adopting adequate safeguards and controls.

Considerations for intermediaries engaging in Tokenised Securities-related activities

In general, the SFC has noted that:

Intermediaries engaging in Tokenised Securities-related activities need to ensure that they have appropriate manpower and expertise to understand and manage the nature of these activities, especially the new risks posed by the underlying technology.
Intermediaries must also ensure that they act with due skill, care and diligence, and perform due diligence on both the underlying product (e.g. the underlying security such as a bond which is being tokenised) and the technology used for the tokenisation.

Issuance of Tokenised Securities

Where intermediaries issue or are substantially involved in the issuance of Tokenised Securities which they also intend to deal in or advise on (e.g. fund managers of tokenised funds), the SFC will consider that these intermediaries remain responsible for the overall operation of the tokenisation arrangement, even if they have entered into outsourcing arrangements with third party vendors or service providers. The SFC has set out a non-exhaustive list of considerations that intermediaries involving in issuance should consider in relation to technical and other risks (see Part A of the Appendix to the Tokenised Securities Circular).[6] These considerations include, for example, the experience of the third party vendors involved in the tokenisation process, the robustness of the DLT network, data privacy risks and enforceability of the Tokenised Security.

The SFC has also stated that for custodial arrangements, intermediaries should consider the features and risks of the Tokenised Securities when considering the most appropriate custodial arrangement in relation to such Tokenised Securities, and that it expects custodial arrangements for bearer form Tokenised Securities using permissionless tokens on Public-Permissionless Networks to take into consideration the factors set out at Part B of the Appendix.[7] These factors include, for example, the custodian’s management of conflicts of interest, its cybersecurity risk management measures and its experience in providing custodial services for Tokenised Securities.

Dealing in, advising on, or managing portfolios investing in Tokenised Securities

Intermediaries should conduct due diligence on the issuers and their third party vendors / service providers, as well as the features and risks arising from the tokenisation arrangement when dealing in, advising on, or managing portfolios investing in Tokenised Securities. Intermediaries should also ensure that they are satisfied that adequate controls have been put in place by the issuers and their third party vendors / service providers to manage ownership and technology risks posed by the Tokenised Security before engaging in any of these activities.

Disclosure obligations

The SFC expects intermediaries to make adequate disclosures to clients of relevant material information (including risks) specific to Tokenised Securities. Such material information should include, for example:

Whether off-chain or on-chain settlement is final;
Any limitations imposed on transfers of the Tokenised Securities;
Whether a smart contract audit was conducted before the smart contract was deployed;
Key administrative controls and business continuity plans for DLT-related events; and
The details of any custodial arrangement where applicable.

III. Other clarifications regarding Tokenised Securities

The Tokenised Securities Circular also includes three important clarifications regarding the SFC’s approach to Tokenised Securities going forward:

The SFC has previously stated that the “de minimis threshold” under the Proforma Terms and Conditions for Licensed Corporations which Manage Portfolios that Invest in Virtual Assets (“Terms and Conditions”) only applies to virtual assets, as defined under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance.[8] [9] Viewed in conjunction with the Circulars, fund managers managing portfolios investing in Tokenised Securities which meet the “de minimis threshold” would not be subjected to the Terms and Conditions unless these portfolios also invest in virtual assets meeting the “de minimis threshold”.
Virtual asset trading platforms (“VATPs”) licensed by the SFC are currently required to set up a SFC-approved compensation arrangement to cover potential loss of security tokens.[10] On application by the VATP, the SFC has indicated that it is willing to consider, on a case-by-case basis, excluding certain Tokenised Securities from the required coverage.
The SFC has also provided guidance in relation to digital securities other than Tokenised Securities – i.e. products which the SFC defines as securities as defined in the SFO which utilise DLT or other similar technology but which are not traditional financial instruments. The SFC has indicated that these sorts of digital securities which are not Tokenised Securities are likely to be complex products on the basis that they are likely to be bespoke in nature, terms and features, and not easily understood by a retail investor. Given this, intermediaries distributing such digital securities would be required to comply with the requirements for sale of complex products. Further, the SFC has reminded intermediaries not to offer these sorts of digital securities to retail investors in breach of the Public Offering Regimes. The SFC has also emphasised that intermediaries should exercise their professional judgment to assess each digital security which they deal with, including whether the security is a Tokenised Security, and should ensure that additional internal controls are implemented to address the specific risks and nature of such digital securities.

IV. Key considerations for the tokenisation of SFC-authorised investment products

The Investment Products Circular separately sets out the SFC’s requirements for considering allowing tokenisation of investment products authorised by the SFC for offering to the Hong Kong public. It must be emphasised that the SFC requirements for Tokenised Securities (as set out in Section II above) will also apply to the tokenisation of SFC-authorised investment products.

Echoing the approach taken by the SFC in the Tokenised Securities Circular, the SFC has indicated in the Investment Products Circular that it will take a “see through” approach to tokenised SFC-authorised investment products, and will allow primary dealing of tokenised SFC-authorised investment products provided that the underlying product meets certain specified product authorisation requirements and safeguards, as summarised below.

Tokenisation arrangement	Product providers of tokenised SFC-authorised investment products (“Product Providers”) should: Remain and ultimately be responsible for the management and operational soundness of the tokenisation arrangement and record keeping in relation to ownership, regardless of any outsourcing arrangement; Ensure that proper records of token holders’ ownership interests are maintained; Ensure that the tokenisation arrangement is operationally compatible with involved service providers; Impose additional and proper controls before adopting Public-Permissionless Networks (e.g. use of a permissioned token); Confirm and, where requested by the SFC, demonstrate that the tokenisation arrangement, record keeping of ownership information and integrity of the smart contract is properly managed and operated, and (where requested by the SFC) obtain third party audit or verification of the same; and Where requested by the SFC, obtain a satisfactory legal opinion to support the application for primary dealing of a tokenised SFC-authorised investment product.
Disclosure obligations	The following disclosures must be made clearly and comprehensively in offering documents of a tokenised SFC-authorised investment product: The nature of the tokenisation arrangement, including whether off-chain or on-chain settlement is final; The ownership representation of the tokens, including legal and beneficial title of the tokens, and ownership of or interests in the product; and The associated risks of the tokenisation arrangement, including cybersecurity, system outages, the possibility of undiscovered technical flaws, evolving regulatory landscape and potential challenges in the application of existing laws.
Distribution of tokenised SFC-authorised investment products	Only regulated intermediaries (e.g. licensed corporations or registered institutions) can distribute tokenised SFC-authorised investment products. This requirement extends to Product Providers who wish to distribute their own products. These regulated intermediaries must comply with existing requirements (e.g. client onboarding requirements and suitability assessments) as applicable.
Staff competence	Product Providers must ensure that they have at least one competent staff member with the relevant experience and expertise to operate and/or supervise the tokenisation arrangement and to manage the ownership and technology risks of the arrangement.
Prior SFC consultation or approval	Prior consultation with the SFC will be required for tokenisation of existing SFC-authorised investments and the introduction of new investment products with tokenisation features. Changes made to the tokenisation of existing SFC-authorised investments must also be approved by the SFC. For example, the SFC has noted that its prior approval must be sought before adding the disclosure of new tokenised unit or share class of an SFC-authorised fund to the offering documents for offering to the Hong Kong public, unless the tokenisation arrangement is substantially the same as the existing arrangement.

Meanwhile, driven by investor protection concerns, the SFC has adopted a more cautious attitude towards secondary trading of tokenised SFC-authorised investment products, on the basis that further careful consideration is required in order to provide a substantially similar level of investor protection to investors to that afforded to those investing in a non-tokenised product. The considerations flagged by the SFC include maintenance of proper and instant token ownership record, readiness of trading infrastructure and market participants to support liquidity, and fair pricing of tokenised products. The SFC has indicated that it will continue to engage with the market on proper measures to address risks involved in secondary trading.

V. Conclusion

While the Circulars provide welcome guidance to intermediaries in relation to tokenisation of traditional financial instruments, it is clear that the SFC will expect intermediaries to closely engage with them prior to embarking on any activities in relation to tokenised products. Given the fast-changing nature of the cryptocurrency space, the SFC may provide further guidance or impose additional requirements for Tokenised Securities and/or tokenised SFC-authorised investment products from time to time. In particular, it appears that the SFC may well release further guidance in relation to secondary trading of SFC-authorised investment products following further engagement with market participants. Interested intermediaries should closely monitor such developments and ensure continuous compliance.

____________________________

[1] “Circular on intermediaries engaging in tokenised securities-related activities”, published by the SFC on November 2, 2023, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC52

[2] “Circular on tokenisation of SFC-authorised investment products”, published by the SFC on November 2, 2023, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC53

[3] “Statement on Security Token Offerings” published by the SFC on March 28, 2019, available at: https://www.sfc.hk/en/News-and-announcements/Policy-statements-and-announcements/Statement-on-Security-Token-Offerings

[4] “Securities” is defined under section 1 of Part 1 of Schedule 1 to the SFO, available at: https://www.elegislation.gov.hk/hk/cap571

[5] See Chapter 6 of the Guidelines on Online Distribution and Advisory Platforms, published by the SFC in July 2019, available at: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/guidelines/guidelines-on-online-distribution-and-advisory-platforms/guidelines-on-online-distribution-and-advisory-platforms.pdf?rev=689af636b3ad4077929d46a94631e458. See also paragraph 5.5 of the Code of Conduct, published by the SFC, available at: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/codes/code-of-conduct-for-persons-licensed-by-or-registered-with-the-securities-and-futures-commission/Code_of_conduct-Sep-2023_Eng-Final-with-Bookmark.pdf?rev=209e9f3b717e4d70b45bfe45a0bb6288

[6] See Part A of Appendix to the “Circular on intermediaries engaging in tokenised securities-related activities” published by the SFC on November 2, 2023, available here: https://apps.sfc.hk/edistributionWeb/api/circular/openAppendix?lang=EN&refNo=23EC52&appendix=0

[7] See Part A of Appendix to the “Circular on intermediaries engaging in tokenised securities-related activities” published by the SFC on November 2, 2023, available here: https://apps.sfc.hk/edistributionWeb/api/circular/openAppendix?lang=EN&refNo=23EC52&appendix=0

[8] The Terms and Conditions are imposed on licensed corporations which manage or plan to manage portfolios with (i) a stated investment objective to invest in virtual assets; or (ii) an intention to invest 10% or more of the gross asset value of the portfolio in virtual assets (i.e. the “de minimis threshold”). See the Terms and Conditions, published by the SFC in October 2019, available at: https://www.sfc.hk/web/files/IS/publications/VA_Portfolio_Managers_Terms_and_Conditions_(EN).pdf

[9] “Joint Circular on Intermediaries’ Virtual Asset-Related Activities”, jointly published by the SFC and Hong Kong Monetary Authority on October 20, 2023, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/suitability/doc?refNo=23EC44

[10] See paragraph 10.22 of the “Guidelines for Virtual Asset Trading Platform Operators”, published by the SFC in June 2023, available at: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/guidelines/Guidelines-for-Virtual-Asset-Trading-Platform-Operators/Guidelines-for-Virtual-Asset-Trading-Platform-Operators.pdf?rev=f6152ff73d2b4e8a8ce9dc025030c3b8

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

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

William R. Hallatt – Hong Kong (+852 2214 3836, [email protected])
Grace Chong – Singapore (+65 6507 3608, [email protected])
Emily Rumble – Hong Kong (+852 2214 3839, [email protected])
Arnold Pun – Hong Kong (+852 2214 3838, [email protected])
Becky Chung – Hong Kong (+852 2214 3837, [email protected])

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

The Delaware Court of Chancery recently narrowed the enforceability of a “Con Ed” provision allowing a target company to seek lost stockholder premium as damages resulting from an acquiror’s breach in a failed merger. In Crispo v. Musk et al., Chancellor Kathaleen St. J. McCormick denied a stockholder-plaintiff’s petition for a mootness fee related to the efforts of Twitter (now known as “X”) to force Elon Musk to close their merger.[1] The Court held that Twitter stockholder Luigi Crispo lacked standing to seek lost premium damages from Musk under “two objectively reasonable interpretations” of the merger agreement’s provision that includes the lost share premium as available target company damages (the “Lost-Premium Provision”). Specifically, the Court held that the Lost-Premium Provision was unenforceable by stockholders because (a) the merger agreement did not clearly confer third-party beneficiary status on stockholders to seek such lost premium damages directly, or (b) the stockholder’s “implicit” limited rights to seek such damages under the Lost-Premium Provision had not vested when the complaint was filed because, at that time, Twitter was pursuing a claim for specific performance. In the course of determining the viability of the stockholder’s claim, the Court also held that a Lost-Premium Provision that defines lost-premium damages as exclusive to the target (a “damages-definition approach”) is unenforceable under Delaware law.

The first interpretation is reflective of the Court’s conclusion that a damages-definition approach to Con Ed provisions is an unenforceable penalty under hornbook contract law; whereas, the second interpretation infers “exceptionally narrow circumstances” in which the damages-definition approach will be interpreted to confer third-party beneficiary status on stockholders. Under either interpretation, the practical effect of the Court’s decision is to require M&A practitioners to reconsider how best to structure and negotiate merger agreement provisions that are intended to preserve significant damage claims resulting from a buyer breach that results in a failed deal.

Background

This case arose from Musk’s attempt to terminate his acquisition of Twitter in July 2022. The company immediately sued to specifically enforce the merger agreement; Crispo also sued Musk for specific performance and damages. In October 2022, the Court largely dismissed Crispo’s claims, holding, among other things, that Twitter stockholders lacked standing to specifically enforce the merger agreement. But it left open the possibility that the Lost-Premium Provision “conveyed third-party beneficiary status to stockholders claiming damages for breach of the [m]erger [a]greement.” Musk and Twitter closed the deal on October 27, 2022.

Months later, Crispo claimed partial credit for the deal’s consummation, and he petitioned the Court for a $3 million mootness fee. To be entitled to a mootness fee, Delaware law required Crispo to establish that his claim “seeking lost-premium damages was meritorious when filed.” Crispo’s petition teed up the question the Court had not reached in its prior decision—whether he had standing to seek his expectation damages from Musk as a third-party beneficiary under the merger agreement.

This question required the Court to reconcile the merger agreement’s express disclaimer of third-party beneficiary rights with the Lost-Premium Provision, which purported to hold the buyer liable for “the benefits of the transactions . . . lost by the Company’s stockholders . . . including lost stockholder premium.”

Analysis

The Court looked to the range of approaches to Lost-Premium Provisions that emerged after Consolidated Edison, Inc. v. Northeast Utilities (“Con Ed”)[2] to frame its analysis of the provisions at issue in Crispo. In Con Ed, the Second Circuit held that a merger agreement’s blanket prohibition on third-party beneficiary rights deprived target-company stockholders of standing to sue the buyer for the lost share premium where a deal fails due to buyer breach. As noted by the Court in Crispo, M&A practitioners concerned that “Con Ed threatened a significant tool that a target might leverage to force a buyer to consummate a deal” drafted so-called Con Ed provisions that were “aimed to make clear that the parties to the contract intended for the buyers to be liable for lost stockholder premium in the event of a busted deal.” In the wake of Con Ed, three variations of Con Ed provisions emerged: provisions (1) expressly granting stockholders third-party beneficiary status to pursue lost-premium damages claims directly against the buyer, (2) making the target the exclusive agent for recovering lost-premium damages on behalf of stockholders (the “exclusive agency approach”), or (3) at issue in Crispo, defining damages available to the target company to include the lost share premium (the “damages-definition approach”).

The Court found that the damages-definition approach used in the Lost-Premium Provision was inherently limited by the basic tenet of contract law rendering penalty provisions unenforceable as a matter of law. Because a target company has no entitlement to the share premium included in the merger consideration if the merger closes, any attempt to define target damages in a busted deal to include the “lost” premium would amount to a penalty, as such damages would exceed the target company’s expectation damages. Since lost-premium damages could not be sought by the target company, the Court reasoned, the Lost-Premium Provision was “only enforceable if it grants stockholders third-party beneficiary status.” But the Court found ample evidence that Twitter and Musk intended to deprive stockholders of such status. This “objectively reasonable interpretation” rendered the Lost-Premium Provision unenforceable as a whole.

Noting Delaware’s “cardinal rule” for avoiding a contract interpretation that renders a negotiated provision meaningless, the Court concluded, in the alternative, that the Lost-Premium Provision could be interpreted as implicitly granting stockholders third-party beneficiary status that vests in “exceptionally narrow circumstances”—namely, where a deal has been terminated and specific performance is no longer available, and for the limited purpose of seeking lost-premium damages. The Court inferred this “exceptionally narrow circumstance[]” from various aspects of the parties’ contractual scheme, including the drafters’ choice of “a Con Ed approach that commentators identified as intended to eliminate stockholder interference with the target’s ability to maximize its leverage under the [m]erger [a]greement” to pursue specific performance to force a closing. The Court concluded that “any third-party beneficiary status conferred on stockholders would not vest while the remedy of specific performance is still available.” Because Twitter was pursuing specific performance of the merger agreement at the time Crispo filed his complaint, Crispo’s right to seek lost-premium damages had not vested at that time and, thus, his lost-premium claim was not meritorious when filed.

Accordingly, Crispo lacked standing under either interpretation of the Lost-Premium Provision. The Court denied his petition for mootness fees and declined to determine which interpretation of the Lost-Premium Provision controlled.

Key Takeaways

In Crispo, the Court is unequivocal that a Con Ed provision “purporting to define a target company’s damages to include lost-premium damages”—the so-called damages-definition approach—is an unenforceable penalty under hornbook contract law. Thus, unless the Court’s “alternative” interpretation in Crispo is adopted by a court and a damages-definition approach is read to include an implicit, albeit limited, third-party beneficiary right for stockholders, the damages-definition approach appears not to be viable, at least in Delaware, unless the merger agreement also expressly confers third-party beneficiary status on stockholders to pursue lost-premium damages.
The Court’s decision seemingly endorsed the view that the exclusive agency approach to Con Ed provisions stands on questionable legal footing. Nonetheless, the Court did not directly pass upon this formulation. Moreover, practitioners may consider whether methods of express stockholder appointment of the target as agent for collection of lost-premium damages might be effective. In a footnote, the Court remarked that a “charter provision designating the company as the stockholder’s agent for the purpose of recovering lost-premium damages after [a] failed sale” could provide a solution. For many already-public companies, however, this approach may not be practicable.
Crispo creates uncertainty regarding the enforceability and scope of Con Ed provisions intended to benefit stockholders. Targets that want to leverage a Con Ed provision to compel a buyer to close should consider making the grant and scope of third-party beneficiary status express, rather than relying on a court to infer such an intent. This approach is likely to raise considerable issues for buyers, however, as they would potentially be subject to multiple stockholder suits, and likely will be difficult for sellers to negotiate successfully.
After Crispo, practitioners may want to focus attention on reverse termination fees or liquidated damages provisions sized to approximate the share premium payable in the merger, which would have the benefit of side-stepping the issue of the lost share premium as an element of expectation damages. But this approach is not without risk. A court may determine that a reverse termination fee (or liquidated damages stipulation) of magnitude approximating the lost premium also constitutes a penalty to the extent it reflects a target company’s receipt of the lost premium in another guise.
In light of the uncertainty following Crispo, the Delaware General Assembly could consider amendments to the Delaware General Corporation Law that authorize the exclusive agency approach.

____________________________

[1] Crispo v. Musk et al., — A.3d –, 2023 WL 7154477, at *13 (Del. Ch. Oct. 31, 2023).

[2] 426 F.3d 524 (2d Cir. 2005).

The following Gibson Dunn lawyers prepared this client alert: Mark D. Director, Monica K. Loseman, Brian M. Lutz, Craig Varnen, Jeff Lombard, Marina Szteinbok, Mark H. Mixon, Jr., and Marc Collier.

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

Mergers and Acquisitions Group:
Mark D. Director – Washington, D.C./New York (+1 202-955-8508, [email protected])
Robert B. Little – Co-Chair, Dallas (+1 214-698-3260, [email protected])
Saee Muzumdar – Co-Chair, New York (+1 212-351-3966, [email protected])

Private Equity Group:
Richard J. Birns – Co-Chair, New York (+1 212-351-4032, [email protected])
Ari Lanin – Co-Chair, Los Angeles (+1 310-552-8581, [email protected])
Michael Piazza – Co-Chair, Houston (+1 346-718-6670, [email protected])
John M. Pollack – Co-Chair, New York (+1 212-351-3903, [email protected])

Securities Litigation Group:
Monica K. Loseman – Co-Chair, Denver (+1 303-298-5784, [email protected])
Brian M. Lutz – Co-Chair, San Francisco/New York (+1 415-393-8379/+1 212-351-3881, [email protected])
Craig Varnen – Co-Chair, Los Angeles (+1 213-229-7922, [email protected])
Jeff Lombard – Palo Alto (+1 650-849-5340, [email protected])
Mark H. Mixon, Jr. – New York (+1 212-351-2394, [email protected])

On October 8, 2023, California signed into law Senate Bill 54 (“SB 54”)[1], which seeks to increase transparency into the diversity of founding teams in the venture capital industry. We expect that many of our private fund adviser clients may be picked up under SB 54’s broad definition of “Covered Entities,” and will thus be required to report diversity statistics to the California Civil Rights Department (“CRD”) if their portfolio companies or investors have a connection to California. We expect this legislation will have wide impact including to venture capital funds and potentially private equity funds with an active investment strategy (a) headquartered in California, (b) investing in portfolio companies based in California, or (c) soliciting or having limited partners based in California. SB 54 is currently scheduled to go into effect on March 1, 2025.

The below decision tree sets forth how to determine if SB 54’s reporting requirements apply to an entity.

Covered Entities Subject to the Reporting Requirements

Chart Footnotes

The California Code’s definition of a “Venture Capital Company” is complex, and whether an entity will be considered a VCC merits a case-by-case analysis. In simple terms, an entity generally will be a VCC in California if it is (i) a “Venture Capital Fund” as defined by the SEC, meaning it is a private fund that (1) holds itself out to investors as pursuing a venture capital strategy, (2) holds no more than 20% of the fund’s commitments in non-qualifying investments, including non-convertible debt, secondaries, public issuances, other private or registered funds, certain digital assets, or leveraged buyouts, (3) does not borrow or otherwise incur leverage in excess of 15% of the fund’s commitments, and then only on a short-term basis, and (4) limits investor redemption rights to “extraordinary circumstances”; (ii) a “Venture Capital Operating Company” as defined by the Department of Labor, meaning 50% of fund assets (valued at cost) must be invested in operating companies or derivative investments in which the fund has direct contractual management rights and the fund must exercise such management rights with respect to at least one portfolio company; or (iii) if 50% or more of the entity’s assets are “Venture Capital Investments” or related derivatives per Section 260.204.9 of the California Code at any time in a given reportable year. “Venture Capital Investment” means an acquisition of securities in an operating company as to which the investment adviser, the entity advised by the investment adviser, or an affiliated person of either has or obtains management rights, or the right to substantially participate in, to substantially influence the conduct of, or to provide (or to offer to provide) significant guidance and counsel concerning, the management, operations or business objectives of the operating company in which the venture capital investment is made.
No guidance or cross-reference was given regarding the definitions of “Early Stage” or “Emerging Growth Companies” under SB 54.
No guidance or cross-reference was given regarding what constitutes a “significant presence” in California under SB 54 and sponsors will need to make a subjective determination regarding the same.
See footnote [A] for the definition of Venture Capital Investment. No guidance or cross-reference was given regarding what constitutes “significant operations in California” under SB 54 and sponsors will need to make a subjective determination regarding the same.

Reporting Requirements

Under SB 54, covered entities are required to provide portfolio companies the opportunity to provide demographic data annually on a form that will be prescribed, and then make annual reports to the CRD with respect to portfolio companies in which they have invested over the prior calendar year on the (i) founding team demographics of their portfolio companies and (ii) investments each covered entity makes in portfolio companies with diverse founding teams.

Demographic data of portfolio company founding teams that must be reported under SB 54 on an aggregated and anonymized basis, to the extent it was provided by the covered entity[2], includes:

Race;
Ethnic identity;
Individuals who identity as LGBTQ+;
Gender identity, including nonbinary and gender-fluid identities;
Disability status;
Veteran status; and
California resident status.

Investments made in the prior calendar year in portfolio companies with diverse founding teams must also be reported as a percentage of the covered entity’s aggregate venture capital investments. SB 54 requires both aggregate reporting and categorical reports for each enumerated group above. Additionally, the covered entity must report the dollar amount of its portfolio company investments for the prior calendar year and the principal place of business of each portfolio company. SB 54 allows the CRD to publish this anonymized information online and collect fees for the administration of SB 54, and provides for legal recourse for failure to comply within sixty (60) days after March 1, 2025.

SB 54 notes that the CRD “may use any information collected…in a civil action brought by the CRD under this chapter or other law.” The introduction to the legislation also notes that existing law makes discrimination illegal, provides a cause of action against any person who “denies, aids or incites a denial, or makes any discrimination or distinction on the bases listed, as specified, and permits the recovery of attorney’s fees,” and establishes the CRD to investigate and prosecute complaints alleging discrimination. Accordingly, SB 54 conceivably lays the groundwork for the CRD to potentially sue sponsors on the basis of discrimination.

Consequences of Non-Compliance

If a covered entity does not comply with the reporting requirements, a court of competent jurisdiction can order injunctive relief and levy fines against the covered entity. The amount of the fine will depend on the “amount necessary to ensure compliance” and the court will take into account the covered entity’s size, assets under management, and reason for noncompliance.

Uncertainties and Timeline

The enforceability, scope, and furtherance of the legislative intent of SB 54 remain to be seen without further clarification from Governor Newsom’s administration and the California Attorney General’s Office. Areas of uncertainty could include the following:

Ambiguity of the scope of the law’s coverage regarding out-of-state entities, covered entities and its enforceability generally.
Litigation in light of the scope and whether the law meets its intent to further diversity, equity, and inclusion given the onerous reporting requirements.
The effect of the law is not applied evenly when considering smaller funds who could themselves be diverse as compared to activist arms of large institutional investors with more resources.
Dissuasion of soliciting and accepting California investors if a private fund does not otherwise have a connection to California.
- Given there are no threshold requirements to the investor prong of the covered entity definition, such as a minimum investment amount, this provision could expose clients who are non-California entities that meet the California definition of a “Venture Capital Company” to SB 54’s reporting requirements if they accept subscriptions from California residents, even if they are not marketing in California.
- Given there are no threshold requirements to the investor prong of the covered entity definition, such as a minimum investment amount, this provision could expose clients who are non-California entities that meet the California definition of a “Venture Capital Company” to SB 54’s reporting requirements if they accept subscriptions from California residents, even if they are not marketing in California.
- Given there are no threshold requirements to the investor prong of the covered entity definition, such as a minimum investment amount, this provision could expose clients who are non-California entities that meet the California definition of a “Venture Capital Company” to SB 54’s reporting requirements if they accept subscriptions from California residents, even if they are not marketing in California.
Whether the CRD will exercise its authority to take action against against founders who they determine discriminate in their selection of portfolio companies and managers.

The proposed effective date of March 1, 2025 would require all covered entities to collect the requested information for fiscal year 2024. This effective date likely will be in flux due to the uncertainties above. Nevertheless, it is advisable that private fund sponsors begin working to ensure they have the infrastructure to meet the reporting requirements due to the breadth of the law as it currently stands.

_____________________________

[1] Senate Bill 54, Ch. 594, 8 October 2023 available here.

[2] Portfolio companies may choose to provide diversity statistics, but also may decline to provide them, in their discretion. Sponsors are not permitted to discourage portfolio companies from providing the information.

The following Gibson Dunn attorneys assisted in preparing this client update: Lexi Hart, Shannon Errico, and Kevin Bettsteller.

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

Investment Funds Group:
Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, [email protected])
Kevin Bettsteller – Los Angeles (+1 310-552-8566, [email protected])
Albert S. Cho – Hong Kong (+852 2214 3811, [email protected])
Candice S. Choh – Los Angeles (+1 310-552-8658, [email protected])
John Fadely – Singapore/Hong Kong (+65 6507 3688/+852 2214 3810, [email protected])
A.J. Frey – Washington, D.C./New York (+1 202-887-3793, [email protected])
Shukie Grossman – New York (+1 212-351-2369, [email protected])
James M. Hays – Houston (+1 346-718-6642, [email protected])
Kira Idoko – New York (+1 212-351-3951, [email protected])
Gregory Merz – Washington, D.C. (+1 202-887-3637, [email protected])
Eve Mrozek – New York (+1 212-351-4053, [email protected])
Roger D. Singer – New York (+1 212-351-3888, [email protected])
Edward D. Sopher – New York (+1 212-351-3918, [email protected])
William Thomas, Jr. – Washington, D.C. (+1 202-887-3735, [email protected])
Shannon Errico – New York (+1 212-351-2448, [email protected])
Lexi Hart – Washington, D.C. (+1 202-777-9552, [email protected])

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

Enforcement Actions

United States

Sam Bankman-Fried Convicted On All Charges After Weeks-Long Criminal Fraud Trial

On November 2, a New York jury convicted FTX founder Sam Bankman-Fried of stealing billions of dollars’ worth of FTX customer deposits, culminating one of the highest-profile criminal fraud trials in recent history. The prosecution’s case took up the bulk of the four-week trial and was highlighted by the testimony of a half-dozen former FTX and Alameda Research employees and close friends of Bankman-Fried. The defense’s only witness was Bankman-Fried himself, whose testimony spanned two and a half days. After just over four hours of deliberation, the jury returned a conviction on all seven counts, including fraud, money laundering, and conspiracy. Sentencing is scheduled for March, with Bankman-Fried facing up to a life sentence. Bankman-Fried also faces additional charges, including bribery and bank fraud, which were charged after Bankman-Fried was extradited from the Bahamas. These charges could be separately tried next year. WSJ 1; New York Times; WSJ 2; CoinDesk; CoinTelegraph.

Federal Judge Denies SEC’s Bid To Appeal Ripple Labs’ Partial Win; SEC Drops Claims Against Two Executives

On October 3, U.S. District Judge Analisa Torres denied the SEC’s request to certify an interlocutory appeal of the judge’s partial ruling in July, holding that her prior order did not involve a controlling question of law and that there was not a “substantial ground for difference of opinion.” The SEC sought to appeal the judge’s holding that Ripple’s programmatic offers of XRP to consumers via crypto trading platforms did not constitute a sale or offer of a security under SEC v. Howey Co., 328 U.S. 293 (1946). The SEC argued in its request for certification that the Howey test was improperly applied. The SEC may appeal the July decision once the district court enters a final judgment resolving all claims.

On October 19, the SEC voluntarily dismissed its claims against Ripple Labs’ Executives Bradley Garlinghouse and Christian Larsen. The SEC previously alleged that the two aided and abetted Ripple’s Securities Act violations and a trial was set to begin in April 2024. Law360 1; Reuters; Law360 2.

US Targets Hamas, Warns Against Crypto Funding Following Israel Attack

On October 27, U.S. Treasury Deputy Secretary Wally Adeyemo warned that the U.S. would undertake enforcement against cryptocurrency firms that fail to stop terrorist groups from moving funds. Adeyemo’s statements followed a letter earlier in the month by Senator Elizabeth Warren and dozens of members of Congress that called on the Biden administration to crack down on the use of cryptocurrency by terrorists, citing a disputed report that Hamas and Palestinian Islamic Jihad were able to raise over $130 million in funds using cryptocurrency.

Elliptic, the firm behind some of the data cited in the report, responded in a blog post that there was “no evidence to suggest that crypto fundraising has raised anything close to” the figure cited, although some money included in the total number might have gone to small crypto brokers sometimes designated as terrorist organizations for their role in financing. Other crypto analysts, who did not provide data for the report, noted that some estimates have inaccurately assumed that all funds routed through these smaller service providers are associated with terrorism. Adeyemo’s remarks follow the Treasury’s October 18th imposition of sanctions on key Hamas members managing assets in a secret investment portfolio, as the Biden administration faced growing pressure to disrupt Hamas’s financing. Financial Times; WSJ; U.S. Department of the Treasury; Bloomberg; Washington Post; Elliptic 1; Elliptic 2; Reuters; CoinDesk; Seattle Times.

The New York Attorney Sues General Gemini, Genesis, And DCG

On October 19, the New York Attorney General Letitia James sued Genesis Global, its parent company Digital Currency Group (DCG), and Gemini Trust, claiming that the companies defrauded investors. The defendants have denied all of the claims. NY AG Press Release; CNN.

PayPal Receives SEC Subpoena Regarding Stablecoin

On November 1, PayPal revealed in a quarterly earnings report that it received a subpoena from the SEC’s Enforcement Division regarding its USD stablecoin, PayPal USD (PYUSD), which was launched in August. PayPal did not disclose additional details about the subpoena. The SEC has taken the position in enforcement actions that certain stablecoins qualify as securities. CoinDesk; WSJ.

FTC Settles With Voyager; Both The FTC And CFTC Proceed With Parallel Charges Against Former CEO

On October 12, the Federal Trade Commission (FTC) announced a settlement with crypto lending firm Voyager for allegedly deceptive marketing but has yet to settle with Stephen Ehrlich, a former Voyager executive, for charges arising from the same events. In their federal complaint, the FTC alleged that Voyager violated the FTC Act and the Gramm-Leach-Bliley Act (GLBA) by falsely claiming that customer deposits of cash and cryptocurrency would be insured by the Federal Deposit Insurance Corporation (FDIC). The complaint further alleges that both the company and Ehrlich were aware that their claims could mislead customers. In the proposed settlement, Voyager and its affiliated companies agreed to a judgment of $1.65 billion, which will be suspended in order for Voyager to distribute its remaining assets to consumers in bankruptcy proceedings. The settlement will also permanently ban the companies from offering, marketing, or promoting any product or service related to depositing, exchanging, investing, or withdrawing consumers’ assets. A parallel claim filed against Ehrlich by the Commodity Futures Trading Commission (CFTC) has not been settled. FTC Announcement; Blockworks; JDSupra.

CFPB Investigating Crypto Platform Hacks

The Director of the Consumer Financial Protection Bureau (CFPB), Rohit Chopra, announced recommendations for regulators’ future approach to payments policy, including CFPB having direct authority to address crypto platforms. “[T]o reduce the harms of errors, hacks and unauthorized transfers, the CFPB is exploring providing additional guidance to market participants to answer their questions regarding the applicability of the Electronic Fund Transfer Act (EFTA) with respect to private digital dollars and other virtual currencies,” said Chopra during the Brookings Institution event. The CFPB is investigating how to apply EFTA, which protects consumers from payments fraud, to crypto accounts. Financial Times; Forbes India.

SafeMoon Executives Arrested And Charged By DOJ And SEC

On November 1, SafeMoon CEO John Karony and Chief Technology Officer Thomas Smith were arrested in connection with criminal charges relating to their operation of the SafeMoon crypto project. Prosecutors allege that Karony, Smith, and founder Kyle Nagy (who also was charged) told investors that their funds were “locked” safely in liquidity pools, when instead the defendants allegedly used the funds to purchase luxury cars and real estate. The SEC contemporaneously filed related civil charges against the defendants based on allegations that the company’s SafeMoon token was an unregistered security. CoinDesk; FortuneCrypto; The Block; CoinTelegraph.

International

Three Arrows Capital Co-Founder Arrested In Singapore For Failing To Cooperate With Investigations

Local police arrested Su Zhu, co-founder of the defunct crypto hedge fund Three Arrows Capital Ltd., at Singapore’s Changi Airport on September 29. Su Zhu was attempting to flee the country after a Singapore court issued a “committal order” authorizing the arrest of Zhu and his co-founder Kyle Davies and sentencing them to four months in prison for failing to cooperate with investigations. According to liquidators of the bankrupt hedge fund, co-founders Su Zhu and Kyle Davies failed to produce requested documents and were unhelpful in locating assets needed to repay the company’s creditors. Three Arrows Capital collapsed in June 2022 after allegedly defaulting on $660 million in debt. At this time, the location of co-founder Kyle Davies remains unknown. Law360; CoinDesk.

Israel Orders Freeze Of Crypto Assets In Bid To Block Funding For Hamas

A week after the October 7 attack on Israel, Israeli authorities closed more than 100 cryptocurrency accounts and requested information on up to 200 additional accounts, in coordination between the country’s defense ministry and intelligence agencies. This follows Israel’s reported seizure of funds linked to Palestinian Islamic Jihad on July 4, including crypto exchange wallets in Tether (USDT), USD Coin (USDC), and Tron (TRX). Financial Times; Elliptic 1; WSJ; Elliptic 2; Reuters; CoinDesk.

Kenya Calls For Shutdown In Operations Of Worldcoin Due To Privacy Concerns

In late September, a Kenyan parliamentary panel issued a report recommending that the country’s information technology regulator, the Communications Authority of Kenya, shut down the operations of cryptocurrency project Worldcoin. The panel proposes to suspend Worldcoin’s “physical presence in Kenya until there is a legal framework for regulation of virtual assets and virtual service providers.” In August, Kenyan officials ordered a halt to WorldCoin’s operations and announced that an investigation revealed privacy concerns, including that Worldcoin may have scanned the eyes of minors, as the project lacks an age-verification mechanism. Reuters; Business Insider; Parliamentary Report; Digital Assets Recent Update.

Hong Kong Authorities Opened Investigation Into Japan Exchange (JPEX) For Fraud Allegations

Hong Kong opened an investigation into alleged fraud by Japan Exchange, or JPEX, as the city’s regulator, the Securities and Futures Commission, has accused the company of misleading investors. Up to 26 suspects have been arrested. The city’s authorities have received more than 2,300 complaints about the platform, with claims of losses totaling as much as $192 million USD. Allegations also include that JPEX misled investors by disclosing that they had applied for a crypto trading license and charged users exorbitant fees to withdraw funds. Financial Times; Bloomberg; South China Morning Post; The Standard.

London Metropolitan Police Establishes Specialized Unit For Crypto Investigations

The London Metropolitan Police has established a specialized 40-member team dedicated to investigating crypto-related offenses, including organized crime. Crypto fraud cases in the UK surged by 41% over the past year, causing losses of more than 306 million euros. The team has investigated 74 intelligence referrals to date and have 19 current active criminal investigations. Criminal networks use digital assets because of its capability to conceal assets and seamlessly facilitate cross-border transactions. The operations runs alongside the government’s ambition to make London a hub for crypto assets and the city’s new standards for the promotion of crypto products, which are among the toughest in the world. Financial Times; TronWeekly; AP News.

UK Financial Conduct Authority Imposes Restrictions On Rebuildingsociety.com Ltd

On October 10, the UK Financial Conduct Authority (FCA) restricted peer-to-peer lending platform rebuildingsociety.com Ltd from approving cryptoasset financial promotions. The FCA has targeted 146 unregistered crypto firms as promotional rules take effect. FCA Release; Blockchain; Blockworks 1; Blockworks 2.

Regulation and Legislation

United States

Government Accountability Office Reports SEC’s Cryptocurrency Accounting Guidance Is Subject To Congressional Oversight

On October 31, the Government Accountability Office reported that cryptocurrency accounting guidance that the Securities and Exchange Commission issued in 2022, SEC’s Staff Accounting Bulletin 121, is an agency “rule” as defined in the Administrative Procedures Act and therefore is subject to congressional oversight under the Congressional Review Act (CRA). The CRA requires regulators to submit reports on new rules to Congress and the comptroller general for review, yet the SEC did not comply with those procedures for Staff Accounting Bulletin 121. The determination has prompted some crypto advocates to call on the SEC to take steps to either withdraw the guidance or formalize it via rulemaking. Bloomberg; Law360; CoinTelegraph.

IRS Extends Broker Reporting Crypto Tax Rule Comment Period

On October 24, the U.S. Department of the Treasury and the IRS extended by two weeks the deadline for submitting comments on the agencies’ proposed rule that would impose tax-reporting obligations on a wide range of digital asset firms deemed to be “brokers.” The agencies extended the deadline to November 13 in response to “strong public interest”; thousands of comments already have been submitted. The agencies propose to define digital asset “brokers” to include centralized and decentralized trading platforms, digital asset payment processors, and digital wallet providers, among others. The proposed rule would exempt individual miners and validators from the “broker” classification. Senators Elizabeth Warren, Bernie Sanders, Sherrod Brown, and four other senators recently urged the Treasury and IRS to expedite issuance of a final rule. Federal Register; BlockWorks; CoinTelegraph.

Expectations Mount That SEC Will Soon Approve Bitcoin ETFs

Several asset managers have amended their applications seeking SEC approval of an exchange-traded fund, sparking optimism that the SEC is on the verge of approving a spot Bitcoin ETF. The SEC has previously approved only Bitcoin futures ETFs, yet it must decide at least two pending spot Bitcoin ETF applications by January 10, 2024 and others by March and April of 2024. The renewed optimism follows the D.C. Circuit’s ruling vacating the SEC’s denial of Grayscale’s application for a Bitcoin ETF. The SEC has declined to seek en banc or Supreme Court review of the decision. Yahoo Finance; Reuters; CoinDesk 1; CoinDesk 2; Financial Times; Business Insider.

FinCEN Proposes New Regulation For Transparency In Crypto Mixers And To Combat Terrorist Financing

On October 19, the U.S. Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) issued a proposed rule that would identify international Convertible Virtual Currency Mixing (CVC Mixing) as “a class of transactions of primary money laundering concern.” FinCEN grounded the proposal in part on “the risk posed by the extensive use of CVC mixing services by a variety of illicit actors.” Comments on the proposed rule must be submitted by January 22, 2024. FinCen Press Release; Notice of Proposed Rulemaking; CoinTelegraph.

California Governor Signs Crypto Licensing Bill

On October 13, California Governor Gavin Newsom signed Assembly Bill 39, which establishes the Digital Financial Assets Law, a comprehensive regulatory scheme akin to New York’s BitLicense. The Digital Financial Assets Law will require individuals and firms to obtain a Department of Financial Protection and Innovation (DFPI) license to engage in “digital financial asset business activity,” subject to certain exemptions. The law broadly defines “digital financial asset” to mean a “digital representation of value that is used as a medium of exchange, unit of account, or store of value, and that is not legal tender.” The law, which is set to go into effect on July 1, 2025, gives the DFPI authority to adopt a more detailed regulatory framework implementing the law’s requirements. CA Legislative; CoinDesk.

CFPB Director Suggests Applying The Electronic Fund Transfer Act To Digital Assets

At the Brookings Institution’s payments conference on October 6, Rohit Chopra, director of the Consumer Financial Protection Bureau, suggested potentially applying the Electronic Fund Transfer Act (EFTA) to “private digital dollars and other virtual currencies” to “reduce the harms of errors, hacks and unauthorized transfers.” The EFTA was enacted to protect consumers from electronic payments fraud and requires financial institutions to notify consumers of if or when they are liable for unauthorized electronic funds transfers. Chopra recommended the Treasury’s Financial Stability Oversight Council to classify some crypto activities as “systemically important payment clearing or settlement activity” to “ensure that a stablecoin is actually stable.” He further stated that the CFPB will issue orders to “certain large technology firms” to gain information on their practices on personal data and issuing private currency. Financial Times; CoinTelegraph.

NYDFS Announces Proposed Updates To Guidance On Listing Of Virtual Currencies

On September 18, the New York Department of Financial Services (NYDFS) issued proposed updates to its guidance on the listing and delisting of cryptocurrencies. NYDFS has proposed (i) heightened risk assessment standards for coin-listing policies and tailored, enhanced requirements for retail consumer-facing products or service offerings, and (ii) new requirements associated with coin-delisting policies. Comments on the proposed guidance were due by October 20, 2023. NYDFS plans to issue its final guidance following the closure of the comment period. NYDFS; Axios.

International

UK Publishes Report Clarifying Regulatory Approach For Crypto Ecosystem

On October 30, the UK government published a policy update further clarifying its approach for regulating the crypto industry. Consistent with its prior guidance, the government intends to seek legislation in two phases. First, in early 2024, the government intends to bring forward legislation allowing the Financial Conduct Authority to regulate fiat-backed stablecoins. Second, at a later time, the government plans to seek legislation to regulate activities relating to wider types of stablecoins and other digital assets, including algorithmic and crypto-backed stablecoins. This aligns with UK Prime Minister Rishi Sunak’s policy to make the UK a digital-asset hub. Report; CoinDesk 1; CoinTelegraph.

UK Lawmakers Pass Bill To Aid Seizure Of Illicit Cryptocurrency

On October 26, the UK government passed the Economic Crime and Corporate Transparency Bill, allowing UK law enforcement agencies to seize, freeze, and recover crypto assets to combat crime and terrorism. UK authorities can assess and verify identities of company directors, remove invalid registered office addresses, and share information with criminal investigation agencies. GOV.UK; GOV.UK Bill Stage; Parliament; CoinDesk 1; CoinDesk 2.

UK Financial Conduct Authority (FCA) Warns Crypto Promoting Firms

On October 25, UK’s Financial Conduct Authority (FCA) added 221 companies to its alert list for non-compliant firms after a new marketing regime took effect on October 8, 2023. The statement identifies common issues regarding safety or security claims, inadequately visible risk warnings, and inadequate information on the risks provided to customers. The new rules require crypto asset service providers to register with the FCA or seek an authorized firm to approve communication to local clients. FCA Statement; CoinTelegraph; CoinDesk.

European Securities And Market Authority (ESMA) Publishes Statement Clarifying Implementation of MiCA

On October 17, the European Securities and Markets Authority (ESMA) published a statement clarifying the timeline for the implementation of Markets in Crypto-Assets Regulation (MiCA). During the implementation stage until December 2024, ESMA, the National Competent Authorities (NCAs) of the Member States and other European Supervisory Authorities (ESAs) will prepare technical standards and guidelines specifying the application of rules on issuers, offerors, and digital asset service providers. ESMA specified that full MiCA rights and protections will not apply in the implementation stage until December 2024. Further, even after MiCA becomes applicable, the Member States may allow existing crypto-asset service providers to operate without a MiCA license up to an additional 18-month transitional period. ESMA Statement; JDSupra.

Australian Treasury Proposes To Regulate Crypto Exchanges

On October 16, the Australian Treasury proposed to require any crypto exchange that holds more than AUD 1,500 of any one client or more than AUD 5 million in total assets to obtain an Australian Financial Services license, granted by the Australian Securities and Investments commission. Australian Treasury; CoinDesk.

Civil Litigation

United States

SEC Declines To Appeal Grayscale Ruling

Earlier this month, the SEC chose not to appeal the ruling of the D.C. Circuit Court of Appeals that vacated the SEC’s denial of Grayscale Investment’s application to convert their Grayscale Bitcoin Trust (GBTC) into an exchange traded fund (ETF). With $14 billion in assets, GBTC is the largest traded closed-end fund tracking the price of Bitcoin (BTC). The SEC denied Grayscale’s application in June 2022 and Grayscale appealed the following day in the D.C. Circuit Court of Appeals. In August 2023, the court ruled that the SEC’s denial of the application was “arbitrary and capricious.” The SEC did not seek en banc rehearing by the October 13 deadline. On October 23, the D.C. Court of Appeals issued its formal mandate effectuating its decision. With this victory, Grayscale has re-entered the pool of nearly a dozen pending spot Bitcoin ETF applications. SEC chair Gary Gensler commented that the review is before staff and that he would “let that play out” before commenting on the matter. Grayscale’s win has strengthened market confidence that one or many spot bitcoin ETFs will be approved in the next year, although that result is not guaranteed. The SEC could still reject the applications on grounds different from those used in the now-overturned Grayscale denial. CoinDesk 1; CoinDesk 2; Cryptonews; Axios.

Judge in FTX Bankruptcy Case Rules To Keep Customer Names List Under Seal

Despite objections from media companies, Delaware Bankruptcy Judge John T. Dorsey allowed the names and addresses of companies on FTX’s creditor list to be shielded for another three months, after being shielded for 90 days in June. FTX argued that the creditor list should remain confidential because its customer list remains a valuable asset. On the other hand, the U.S. Trustee’s Office argued that the right of public access to court records must be taken into account. FTX’s Chapter 11 case began late last year, involving approximately 9 million individual and institutional customers who are creditors in the case. In over-the-counter markets where investors trade bankruptcy claims, the level of expected payouts for FTX creditors has more than tripled this year. Law360; CoinDesk.

Speaker’s Corner

United States

SEC Commissioner Hester Peirce Issues Statement Of Dissent On LBRY

On October 23, LBRY Inc., a crypto-based media project, dropped its challenge to a New Hampshire federal court ruling that it sold unregistered securities. LBRY announced that it had settled with the SEC and would shut down, its assets to be placed in receivership and used to satisfy debts. On October 27, SEC Commissioner Hester Peirce issued a dissent describing the case against LBRY as unsettling and manifesting “the arbitrariness and real-life consequences of the Commission’s misguided enforcement-driven approach to crypto.” Peirce argued that the SEC’s case against LBRY conflicted with the SEC’s mission “to ensure that people buying securities receive accurate and reliable information.” Peirce further criticized the Commission as having taken “an extremely hardline approach,” seeking remedies “entirely out of proportion to any harm.” Peirce also observed that LBRY’s disclosures did not cause investors any harm since the disclosures were not proven to be inadequate or misleading. Instead of pursuing this case, Peirce argued, the Commission should have “devoted [the time and resources] to building a workable regulatory framework that companies like LBRY could have followed.” Peirce Dissent; Law360; Odysee; Policy at Paradigm.

U.S. Senators Gillibrand And Lummis Press For Stablecoin And Illicit Finance Legislation

On October 24, U.S. Senators Kirsten Gillibrand (D-N.Y.) and Cynthia Lummis (R-Wyo.) spoke at the State of Crypto Policy & Regulation Conference, echoing the potential to pass a bipartisan stablecoin bill. Named after the two senators, the Lummis-Gillibrand bill, which cleared the House Financial Services Committee in 2022, proposes that the Commodity Futures Trading Commission (“CFTC”) regulate crypto exchanges and require regulated depository institutions to oversee all stablecoin users. The bill also pushes to more clearly define decentralized finance platforms in order to help entities determine whether they are centralized businesses, which would need to register with the CFTC under the bill. CoinDesk.

International

Brazil’s Central Bank President Strikes Balance Between Open Networks And Privacy In Digital Brazilian Real, A Form Of CBDC

Brazil Central Bank President Roberto Campos Neto aims to accelerate international transactions through the issuance of Digital Brazilian Real (DREX), a form of a central bank digital currency (CBDC). Neto stated, “if every country has a digital currency, and we are able to connect those currencies digitally, in a fast and secure way, you actually have achieved the goal of having a common currency without actually having to sacrifice your monetary policy.” DREX operates alongside PIX, the instant payment system that has digitized Brazil’s economy. PIX has resulted in more than 170 million transactions in one day. The Block; Banco Central Do Brasil.

Mexican Senator And Presidential Candidate Indira Kempis Pushes For Bitcoin As Legal Tender In Mexico

Mexican Senator and Presidential Candidate Indira Kempis reported that the digital peso should arrive sometime in 2024 and stated that she has been “looking for clear positions” from her fellow legislators on her 2022 proposal to make Bitcoin legal tender in the country. As of October 25, Mexican legislators have reacted both positively and negatively towards the bill, upon the installation of a Bitcoin ATM in the Mexican Senate. Decrypt; Forbes; Bitcoin.com.

Other Notable News

Argentina’s Pro-Bitcoin Javier Milei Heads To Run-Off Election Against Pro-CBDC Finance Minister Sergio Massa

On October 2, during an Argentinian presidential debate, Finance Minister and presidential candidate Sergio Massa announced the imminent launch of an Argentinean digital currency project to address the country’s inflation crisis. He wants to launch a CBDC to also address the corruption within the country, including instances of money laundering. Considered an ambitious idea, local specialists are skeptical of Massa’s plan. Rodolfo Andragnes, the President of ONG Bitcoin Argentina, expressed that Massa’s announcement intended to attract attention to his campaign, rather than proposed a defined action plan. The other frontrunner of the presidential election, Javier Milei, supports bitcoin, the “dollarization” of Argentina’s economy, and the elimination of the Central Bank of Argentina. The run-off election will take place on November 19, 2023. CoinDesk; El Cronista; La Nacion; Forbes.

Bitcoin Gains Recognition In Shanghai As A United Digital Currency

On September 25, the Shanghai Second Intermediate People’s Court in China published a report analyzing the legal attributes of digital currencies, the difficulties faced by judicial disposition of digital currencies, and adopting this perspective as an entry point to demonstrate the legal attributes of virtual currencies. The report highlighted the uniqueness and non-replicability of Bitcoin. The court focused on Bitcoin’s scarcity, inherent value of holders, ease of circulation and storage, and emphasized that Bitcoin can be obtained through mining, inheritance, or selling and buying. The People’s Republic of China has issued a blanket ban on cryptocurrencies. Shanghai Judicial Committee Member Report; ODaily; Yahoo Finance; CryptoNews; Forbes India.

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, Raquel Sghiatti, Peter Moon, Emma Li*, Elizabeth Walsh*, Vannalee Cayabyab and Yoo Jung Hah*

*Emma Li, Elizabeth Walsh, and Yoo Jung Hah are associates practicing in the firm’s New York, Denver, and Los Angeles offices, respectively, who are not yet admitted to practice law.

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, [email protected])

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

This edition of Gibson Dunn’s Federal Circuit Update summarizes the current status of several petitions pending before the Supreme Court, and recent Federal Circuit decisions concerning means-plus-function claims, apportionment, and forfeiting arguments not raised in an inter partes review (“IPR”) petition.

Federal Circuit News

Noteworthy Petitions for a Writ of Certiorari:

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

In Intel Corp. v. Vidal (US No. 23-135) and VirnetX Inc. v. Mangrove Partners Master Fund, Ltd. (US No. 23-315), the Court granted an extension for the responses, which are now due November 9, 2023 and December 27, 2023, respectively. Three amici curiae briefs have been filed in the Intel case.

The Court denied the petition in HIP, Inc. v. Hormel Foods Corp. (US No. 23-185).

Other Federal Circuit News:

Chief Judge Moore to Announce New Court Initiative. The Court issued an announcement on October 30, 2023 that Chief Judge Moore will announce a new Court initiative at the Federal Circuit Bar Association 2023 Annual Dinner & Reception. The announcement is here.

Upcoming Oral Argument Calendar

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

Key Case Summaries (October 2023)

Sisvel International S.A. v. Sierra Wireless, Inc., Nos. 22-1493, 22-1547 (Fed. Cir. Oct. 6, 2023): Sierra filed an IPR petition challenging Sisvel’s patent, which claimed techniques that improve on prior channel coding techniques used when transmitting data in radio systems. One of the challenged claims included the means-plus-function term “means for detecting a need for retransmission of the received coded data block.” The Patent Trial and Appeal Board (“Board”) concluded that there was insufficient algorithmic structure disclosed for the “means for detecting” term even though the specification named various software protocols. And despite an expert testifying that these were well-known and commonly used by persons of ordinary skill in the art, the Board reasoned that the expert’s testimony could not remedy the lack of corresponding structure disclosed in the specification.

The Federal Circuit (Chen, J., joined by Moore, C.J., and Clevenger, J.) affirmed-in-part, vacated-in-part, and remanded. The Court reviewed the case law regarding computer-implemented means-plus-function claims, which is divided into two distinct groups. In the first group, there is a “total absence of structure from the specification”; and in the second group, the specification discloses an algorithm, but it is inadequate as viewed in light of the knowledge of a skilled artisan. The Court concluded that because the asserted patent named “a discrete, limited, and specific set of software protocols,” there was an “arguably adequate” disclosure of an algorithm, and the Board should have evaluated the disclosed protocols in light of the knowledge of a skilled artisan to determine if they were adequate as corresponding structure.

Finjan LLC, f/k/a Finjan, Inc., v. SonicWall, Inc., No. 22-1048 (Fed. Cir. Oct. 13, 2023): Finjan sued SonicWall for infringing Finjan’s network security patents, including a group of patents protecting devices from undesirable downloads. The district court granted summary judgment of non-infringement to SonicWall as to these patents, and excluded certain testimony from Finjan’s expert for failure to properly apportion and for including substantial non-patented features in his analysis.

The majority (Cunningham, J., joined by Reyna, J.) vacated-in-part and affirmed-in-part. The majority affirmed summary judgment of non-infringement, upholding a construction of “downloadable” that required the security system receiving the packets to reassemble those packets into executable code, based on the parties’ agreed constructions and the specification. The majority also affirmed the district court’s exclusion of Finjan’s expert testimony for failing to exclude the value attributable to the non-patented features in the apportionment analysis.

Judge Bryson concurred-in-part and dissented-in-part. Judge Bryson disagreed that the patents required packet reassembly, pointing to the differences in language between the asserted claims and specifications suggesting that packet reassembly was optional, and the fact that the majority’s construction would “not read on any network that uses packetized files.”

Cyntec Company, Ltd. v. Chilisin Electronics Corp., No. 22-1873 (Fed. Cir. Oct. 16, 2023): Cyntec sued Chilisin for infringing its patents directed to molded chokes, which is a type of inductor used to eliminate undesirable signals in a circuit. The jury returned a verdict of infringement and awarded damages in the full amount requested by Cyntec.

The Federal Circuit (Stoll, J., joined by Moore, C.J. and Cunningham, J.) affirmed-in-part, reversed-in-part, vacated-in-part, and remanded. The Court determined that the district court had abused its discretion in not excluding the opinion of Cyntec’s damages expert who relied on unreliable data sources. In particular, the expert estimated the sales of the accused products by reviewing SEC filings or annual reports of customers who purchased or acquired the infringing products. The Court determined that the revenues in these annual reports included sales of irrelevant products and services, and Cyntec’s expert failed to account for these irrelevant products and services.

Netflix, Inc. v. DivX, LLC, Nos. 22-1203, 22-1204 (Fed. Cir. Oct. 25, 2023): Netflix filed two IPR petitions against two DivX patents directed to adaptive bitrate streaming of content on a playback device, such as a phone or computer. The Board determined that Netflix had not included certain arguments in its petition directed to certain claim limitations and therefore had not met its burden in proving that the claims were unpatentable as obvious.

The majority (Chen, J., joined by Linn, J.) affirmed, concluding that because Netflix had not adequately raised certain arguments before the Board that it now raised on appeal, Netflix had forfeited them. The majority determined that “[a] petitioner may not rely on a vague, generic, and/or meandering petition and later fault the Board for failing to understand what the petition really meant.”

Judge Dyk dissented. In his opinion, Netflix adequately raised two of the arguments in its petition, and he would have remanded for the Board to consider Netflix’s arguments on the merits.

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

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

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

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

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

Since the Supreme Court struck down race-based college admissions in SFFA v. Harvard last June, plaintiffs’ counsel and anti–affirmative action activists have turned their attention to corporate diversity programs. Although, as a technical matter, SFFA did not change existing law applicable to employer DEI programs, the increased scrutiny on affirmative action programs in the workplace in the wake of SFFA has heightened the risk that employers with robust DEI initiatives may face litigation from employees, potential contracting partners, advocacy groups, and government agencies. We have been closely tracking developments in this area and have prepared this analysis to help our clients navigate the increasingly thorny environment of DEI post-SFFA. We plan to circulate similar updates bi-monthly moving forward, although we anticipate this inaugural update will be longer than future updates. We have also formed a Workplace DEI Task Force, bringing to bear the Firm’s experience in employment, appellate and Constitutional law, DEI programs, securities and corporate governance, and government contracts to help our clients conduct legally privileged audits of their DEI programs, assess litigation risk, develop creative and practical approaches to accomplish their DEI objectives in a lawful manner, and defend those programs in private litigation and government enforcement actions as needed. Should you have questions about developments in this space or about your own DEI programs, please do not hesitate to reach out to any member of our DEI Task Force or the authors of this Update.

Key Developments:

Since June, several federal and state officials have issued statements regarding the legality of corporate diversity efforts. For example, thirteen Republican Attorneys General wrote letters to Fortune 100 companies, stating their view that many corporate DEI programs are discriminatory, while a group of Democrat Attorneys General separately opined that companies should “double-down on diversity-focused programs.” The Colorado Attorney General, who had joined the Democrat letter, recently issued a formal legal opinion, stating his view that DEI programs comply with federal law.

On June 29, 2023, EEOC Chair Charlotte Burrows issued an EEOC press release, taking the position that the Court’s decision does “not address employer efforts to foster diverse and inclusive workforces,” and that “[i]t remains lawful for employers to implement diversity, equity, inclusion, and accessibility programs that seek to ensure workers of all backgrounds are afforded equal opportunity in the workplace.” On the same day, EEOC Commissioner Andrea Lucas authored a Reuters article, stating her perspective that SFFA does not alter federal employment law because race-based decision-making by employers is already presumptively illegal under Title VII. Commissioner Lucas expressed her view that many employers’ programs already run afoul of existing law.

Shortly after SFFA, the Supreme Court granted certiorari in Muldrow v. City of St. Louis, an important case concerning the scope of the “adverse action” requirement under Title VII. The question presented in Muldrow is whether a lateral job transfer without an accompanying change in pay or benefits constitutes an adverse action sufficient to give rise to liability under Title VII. Muldrow could have substantial implications for employers’ diversity programs to the extent that the Court in Muldrow expands the definition of what can give rise to a claim under Title VII, as many corporate DEI programs do not implicate concrete employment decisions such as hiring, firing, or promotion but arguably impact other aspects of employment. Judge Ho on the Fifth Circuit seemingly embraced this more expansive position in a concurrence in Hamilton v. Dallas County, in which he suggested Title VII protects “anyone harmed by divisive workplace policies that allocate professional opportunities to employees based on their sex or skin color, under the guise of furthering diversity, equity, and inclusion.” Gibson Dunn recently filed an amicus brief in Muldrow on behalf of the Chamber of Commerce, National Federation of Independent Business Small Business Legal Center, Restaurant Law Center, and National Retail Federation, arguing that Title VII does not apply as a categorical matter to all allegedly discriminatory transfer decisions. The case will be argued on December 6, 2023.

In addition, plaintiffs have filed several new reverse-discrimination lawsuits under Section 1981 and Title VII. Those new lawsuits include challenges to specific, individual employment decisions as well as challenges to companies’ efforts to increase the diversity of their suppliers and other contracting partners. These cases are listed in the “Current Litigation” section below.

Data and Trends:

The majority of cases we have identified that were filed after the SFFA decision have involved claims under Section 1981 (which prohibits race discrimination in contracting relationships, including employment and procurement, among other things). Only two cases have involved claims under Title VII for employment discrimination, while a handful of others have asserted claims under state law, the Securities Exchange Act, the Fifth or Fourteenth Amendments, and Titles VI and IX. Because Title VII complainants must first file a charge with the Equal Employment Opportunity Commission (“EEOC”) before proceeding to federal court, we may see an increase in Title VII reverse discrimination litigation in the next several years as plaintiffs first make their way through the administrative process.

Most cases post-SFFA have been filed against private companies, although three cases have been filed against universities. Advocacy groups also have taken a specific focus on law firms, filing three lawsuits against large law firms and sending many other threatening letters to law firms with DEI initiatives.

One advocacy group has increasingly urged the EEOC to take action against employers for their DEI programs. America First Legal (“AFL”) has filed over fifteen letters with the EEOC since June 2022, and the stream has intensified since SFFA. These letters allege that companies are implementing discriminatory DEI policies in violation of Title VII, and request that one or more EEOC Commissioners file a Commissioner’s Charge. Commissioner’s Charges allow a Commissioner to initiate EEOC investigations equivalent to those initiated by an individual employee’s charge of discrimination—although an actual enforcement action requires a majority commission vote. While AFL’s letters differ somewhat in substance, they are broadly similar and allege that elements of companies’ DEI programs (including hiring, training, mentorship, partnerships, and public statements committing to diversity) constitute unlawful employment practices in violation of Title VII. A list of companies whose policies AFL has challenged include: Major League Baseball, Salesforce, Activision/Blizzard, The Kellogg Company, Nordstrom, Inc., Alaska Air, Unilever, Mars, Anheuser-Busch, McDonald’s Corporation, The Hershey Company, Starbucks, Lyft, DICK’S Sporting Goods, Yum! Brands and Morgan Stanley. While in previous years the number of Commissioner’s Charges filed were low, last year they increased dramatically, jumping from three in 2020 and 2021 to 29 filed in 2022. Commissioner Andrea Lucas, who is on record viewing DEI programs as unlawful, filed twelve Commissioner’s Charges last year, more than any other Commissioner. The nature of those charges is not public, so it is not clear that they relate to DEI programs.

The past two years have also seen increased anti-DEI advocacy and litigation threats by shareholders. Plaintiffs and advocacy groups have filed shareholder derivative actions claiming that employer DEI programs constitute a breach of corporate fiduciary duties. Additionally, advocacy groups like the American Civil Rights Project (“ACRP”) have sent threat letters to corporations and their boards, claiming that the legal risk associated with DEI programs threatens stockholders’ value. ACRP has publicly announced that it sent these letters to the boards of Lowe’s, Coca-Cola, Novartis AG, Pfizer, American Airlines, McDonald’s, Levi Strauss & Co., and more. As the list below shows, shareholder lawsuits have generally been unsuccessful thus far.

Current Litigation:

Below is a list of relevant cases, along with recent letters threatening litigation.

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

Am. Alliance for Equal Rights v. Winston & Strawn LLP, No. 4:23-cv-04113 (S.D. Tex. 2023): On October 30, 2023, advocacy group American Alliance for Equal Rights (“AAER”) sued law firm Winston & Strawn, challenging its 1L diversity fellowship program as racially discriminatory in violation of Section 1981. The firm had previously announced that it would continue the program in response to a threat letter from AAER.
Am. Alliance for Equal Rights v. Perkins Coie LLP, No. 3:23-cv-01877-L (N.D. Tex. 2023) and Am. Alliance for Equal Rights v. Morrison & Foerster LLP, No. 1:23-cv-23189 (S.D. Fl. 2023): On August 22, 2023, AAER sued two law firms, challenging their 1L diversity fellowship programs as racially discriminatory in violation of Section 1981. Morrison & Foerster is represented by Gibson Dunn.
- Latest updates: On October 6 (Morrison & Foerster) and October 11 (Perkins Coie), AAER voluntarily dismissed the suits based on the firms’ changes to their programs’ eligibility criteria; both firms’ diversity fellowships will be race-neutral moving forward.
Am. Alliance for Equal Rights v. Fearless Fund Mgmt., No. 1:23-cv-03424-TWT (N.D. Ga. 2023): On August 2, 2023, AAER sued a Black women-owned venture-capital fund that has a charitable grant program that provides $20,000 grants to Black female entrepreneurs; AAER alleged that the program violates Section 1981 and sought a preliminary injunction. Fearless Fund is represented by Gibson Dunn.
- Latest update: The district court denied the plaintiff’s motion for a preliminary injunction, but on September 30, 2023, the Eleventh Circuit temporarily enjoined the program pending appeal. The motions panel, over a strong dissent, rejected the fund’s argument that the grant program was protected by the First Amendment, reasoning that the First Amendment does not protect the right to “exclude persons from a contractual regime based on their race” unless the contracts are for the provision of “expressive services” or “pure speech.” AAER’s merits brief in the Eleventh Circuit is due to be filed on November 6, 2023.
Landscape Consultants of Texas, Inc, v. City of Houston, No. 4:23-cv-3516 (S.D. Tex. 2023): On September 19, 2023, plaintiff landscaping companies owned by white individuals filed an injunction against Houston’s government contracting set-aside program for “minority business enterprises” that are owned by members of racial and ethnic minority groups. The companies claim the program violates the Fourteenth Amendment and Section 1981.
- Latest update: The defendants’ deadline to file an answer or motion is November 13, 2023.
Correll v. Amazon.com, Inc., No. 3:21-cv-1833 (S.D. Cal. 2022): On October 28, 2021, a white male businessman sued Amazon, alleging that by having a feature within its website that allows consumers to identify products sold by non-white, non-male sellers, the company violated Section 1981 and separately California Civil Code §§ 51 and 51.5, which prohibit racial discrimination by businesses.
- Latest update: On September 19, 2023, the court granted Amazon’s motion to dismiss as to the Section 1981 allegations for failure to state a claim, but denied the motion as to the California Civil Code allegations and authorized limited discovery until November 22 as to the plaintiff’s standing for those claims. The court will hear oral argument on a motion for summary judgment on December 21.
Meyersburg v. Morgan Stanley & Co. LLC, No. 1:23-cv-07638 (S.D.N.Y. 2023): On August 29, 2023, a white male former executive director at Morgan Stanley sued his former employer, alleging he was fired and replaced with a Black woman with less experience, in violation of Section 1981 and the New York State Human Rights Law. Plaintiff cited Morgan Stanley’s DEI programs as evidence of discrimination.
- Latest update: On October 12, 2023, the parties jointly stipulated that the action would be arbitrated pursuant to a signed arbitration agreement, and the court stayed the action on October 23 pending the outcome of arbitration.
Bradley, et al. v. Gannett Co. Inc., 1:23-cv-01100 (E.D.V.A. 2023): On August 18, 2023, white plaintiffs sued Gannett over its alleged “Reverse Race Discrimination Policy,” in response to Gannett’s expressed commitment to having its staff demographics reflect the communities it covers, alleging violations of Section 1981.
- Latest update: Gannett has not yet filed a response.
Roberts & Freedom Truck Dispatch v. Progressive Preferred Ins. Co., No. 23-cv-1597 (N.D. Ohio. 2023): On August 16, 2023, plaintiffs represented by advocacy group America First Legal (AFL) sued Progressive Insurance, alleging that a grant program that awarded funding specifically to Black entrepreneurs to support their small businesses violated Section 1981.
- Latest update: Defendants’ initial motion to dismiss is due December 13, 2023.
Ultima Servs. Corp. v. USDA, No. 2:20-CV00041 (E.D. Tenn.): In March 2020, a company (owned by a white woman) that competes for USDA contracts sued to challenge a Small Business Administration (SBA) program giving preference in federal contracting to small businesses owned by racial minorities; the program at issue presumed that small businesses owned by racial minorities were entitled to participate in a program that sets aside contracts for “socially disadvantaged individuals.”
- Latest update: On July 19, 2023, the District Court held that the program was unconstitutional, in violation of Fifth Amendment equal protection, and enjoined the government from applying a race-based rebuttable presumption of social disadvantage in administering the SBA’s contracting program.
Alexandre v. Amazon.com, Inc., No. 3:22-cv-1459 (S.D. Cal. 2022): On September 29, 2022, White, Asian, and Native Hawaiian entrepreneur plaintiffs, on behalf of a putative class of past and future Amazon “delivery service partner” program applicants, challenged a DEI program that provides a $10,000 grant to qualifying delivery service providers who are “Black, Latinx, and Native American entrepreneurs.” Plaintiffs alleged violations of California state civil rights laws prohibiting discrimination.
- Latest update: As of October 2023, Amazon’s motion to dismiss is still pending with the court.
Crystal Bolduc v. Amazon.com, Inc., No. 4:22-cv-615-ALM (E.D. Tex. 2022): On July 20, 2022, AFL filed a putative federal class action lawsuit on behalf of white plaintiff who sought to become an Amazon delivery service provider alleging race discrimination in violation of Section 1981 in Amazon’s supplier-diversity initiatives, including a program extending $10,000 grants to Amazon delivery service providers allegedly based in part on race.
- Latest update: Amazon filed a motion to dismiss that was fully briefed as of May 15, 2023, and is still under consideration by the district court.
Do No Harm v. Pfizer, No. 1:22-cv-07908 (S.D.N.Y. 2022): On September 15, 2022, plaintiff association representing physicians, medical students, and policymakers sued Pfizer, alleging that the company’s Breakthrough Fellowship Program, which provided minority college seniors summer internships, two years of employment post-graduation, and a scholarship, violated Section 1981, in addition to Title VII and New York laws. The plaintiff-association alleges that the program illegally excludes white and Asian applicants. The association is represented by Consovoy McCarthy PLLC, the firm that also represents AAER in multiple lawsuits.
- Latest update: The case was dismissed on standing grounds in December 2022. Plaintiffs appealed and the Second Circuit heard argument in the case on October 3, 2023.

2. Employment discrimination under Title VII and other statutory law:

Retaliation for challenging or expressing concerns about diversity programs:

Farkas v. FirstEnergy Corp., No. cv-23-986280 (Ohio Ct. Common Pleas): On September 29, 2023, a white male former corporate counsel at FirstEnergy sued the company under Ohio’s antidiscrimination statute, alleging that he was fired in retaliation for expressing concerns about the company’s DEI programs.
- Latest update: FirstEnergy’s deadline to file an answer or motion is November 28, 2023.
Harker v. Meta Platforms, Inc., No. 23-cv-7865 (S.D.N.Y. 2023): On September 5, 2023, a lighting tech who worked on a set where a Meta commercial was produced sued Meta and a film producers’ association, alleging that Meta and the association violated Title VII, Sections 1981 and 1985 (conspiracy to interfere with rights) and New York law, through a diversity initiative called Double the Line. The plaintiff claims that after he raised questions about the qualifications of a coworker hired under the program, he was retaliated against by the defendants.
- Latest update: The defendants’ deadline to file an answer or motion is November 3, 2023.
Rogers v. Compass Group USA, Inc., No. 23-cv-1347 (S.D. Cal. 2023): On July 24, 2023, a former recruiter for Compass Group USA sued the company under Title VII for allegedly terminating her after she refused to administer the company’s “Operation Equity” diversity program, in which only women and people of color were entitled to participate. The plaintiff alleged that she was wrongfully terminated after she requested a religious accommodation to avoid managing the program, claiming it conflicted with her religious beliefs.
- Latest update: Compass Group filed its answer and affirmative defenses on to the plaintiff’s amended complaint on October 5, 2023, and the deadline for initial disclosures is January 3, 2023.

Hiring, firing, and other adverse actions on account of race:

Diemert v. City of Seattle, No. 2:22-cv-01640 (W.D. Wash. 2022): On November 16, 2022, the plaintiff, a white male, sued his former employer, the City of Seattle, alleging that the City’s diversity initiatives, which allegedly included mandatory diversity trainings involving critical race theory and encouraged participation in “race-based affinity group, caucuses, and employee resource groups,” amounted to racial discrimination in violation of Title VII and the Fourteenth Amendment. The plaintiff also alleged a hostile work environment claim.
- Latest update: On August 28, 2023, the court denied the City’s motion to dismiss, citing SFFA and the need for the city to demonstrate that the affinity groups and other programs meet strict scrutiny.
Netzel v. American Express Company, No. 2:22-cv-01423 (D. Ariz. 2022): On August 23, 2022, a group of former American Express employees alleged that the company’s diversity initiatives discriminated against white workers and that the company retaliated against the same workers after they complained, in violation of Title VII and Section 1981.
- Latest update: On August 3, 2023, the court granted American Express’s motion to compel the case to arbitration. An appeal is pending in the Ninth Circuit.
Phillips v. Starbucks Corp., No. 19-cv-19432 (D.N.J. 2019): On October 28, 2019, a white former Starbucks regional director sued the company for firing her based on her race, allegedly to protect its image after the coffee chain suffered bad press when two Black men were arrested in a café under the plaintiff’s purview. The plaintiff alleged discrimination and retaliation in violation of Title VII, Section 1981, and New Jersey state law.
- Latest update: On June 12, 2023, a New Jersey federal jury awarded $25.6 million in compensatory and punitive damages to the plaintiff. Post-trial motions are currently pending.
Duvall v. Novant Health Inc., No. 3:19-CV-00624 (W.D.N.C. 2019): On November 18, 2019, a white male marketing executive sued Novant, alleging that he was fired without cause from his management position because of his race and sex in violation of Title VII and North Carolina state law.
- Latest update: On October 26, 2021, a jury found for the plaintiff, who presented evidence at trial of Novant’s DEI programs and similar terminations of other white managers. The jury initially awarded $10 million in punitive damages, but the court later reduced this award to $300,000. Novant appealed and the Fourth Circuit has argument scheduled for December 7, 2023.
DiBenedetto v. AT&T Servs., Inc., No. 21-cv-4527 (N.D. Ga. 2021): On November 2, 2021, the plaintiff, a white male former executive, brought claims under Title VII, Section 1981, and the Age Discrimination in Employment Act against AT&T, alleging that he was wrongfully terminated due to his race, gender, and age.
- Latest update: On June 6, 2022, the court denied AT&T’s motion to dismiss. The court found that plaintiff’s allegations, including that AT&T “implemented a company-wide employment policy that programmatically favored non-white persons and women for hiring and retention,” plausibly suggested race or gender played an unlawful role in his termination.

Hostile work environment claims:

Young v. Colorado Dep’t of Corrections, No. 1:22-cv-00145-NYW-KLM (D. Co. 2022): On January 19, 2022, a white male former employee of Colorado’s Department of Corrections sued his former employer under Title VII, claiming that Colorado’s training materials for its “Equity, Diversity, and Inclusion” programs subjected him to a hostile work environment such that he was ultimately forced to resign.
- Latest update: The District Court granted Colorado’s motion to dismiss. The case is pending on appeal to the Tenth Circuit.

3. Challenges to agency rules, laws, and regulatory decisions:

Alliance for Fair Board Recruitment v. SEC, No. 21-60626 (5th Cir.): Plaintiff advocacy group sought review of the SEC’s approval of Nasdaq’s Board Diversity Disclosure Rule, which requires Nasdaq-listed companies to annually report aggregated statistical information about the Board’s self-identified gender and racial characteristics, and also requires companies to appoint at least two diverse directors or explain why they have not done so. Gibson Dunn represents Nasdaq as an intervenor in the case.
- Latest update: On October 18, 2023, the 5th Circuit rejected the plaintiff’s challenge to the rule on the grounds that Nasdaq, not the SEC, created the rule, and the SEC’s approval and potential future enforcement of the rule was not sufficient state action to bring a constitutional challenge against the SEC. On October 25, the plaintiff petitioned the Fifth Circuit for rehearing en banc.
Nat’l Ctr. for Pub. Policy Research v. SEC, No. 23-60230 (5th Cir. 2023): The petitioners, Kroger shareholders, had previously sought to require the Kroger Company to include a shareholder proposal that would have required Kroger to issue a report detailing risks associated with omitting “viewpoint” and “ideology” from the list of protected characteristics in its equal opportunity policy. The SEC concluded that Kroger could exclude the proposal from its proxy materials. On April 28, 2023, the petitioners sought judicial review of the SEC’s decision in the Fifth Circuit.
- Latest update: The petition for review is currently pending in the Fifth Circuit.
Alliance for Fair Board Recruitment v. Weber, No. 2:21-cv-1951 (E.D. Cal.): California passed Assembly Bill 979, which requires boards of public companies headquartered in California to include at least one to three members of “underrepresented groups”—individuals who identify as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, Alaska Native, gay, lesbian, bisexual, or transgender—or face a fine. On July 12, 2021, advocacy group Alliance for Fair Board Recruitment sued for an injunction, arguing the law violates the Equal Protection Clause and Section 1981.
- Latest update: The District Court enjoined the law in May 2023, and appeals from both sides are pending in the Ninth Circuit.

4. Board of Director or Stockholder Actions:

Nat’l Ctr. for Pub. Policy Research v. Schultz, No. 2:22-cv-00267-SAB (E.D. Wash. 2023): On August 30, 2022, shareholders and a conservative think tank filed a shareholder derivative action against Starbucks and its CEO over the company’s hiring goals for minorities, contracts with diverse suppliers and advertisers, and alleged practice of tying executive pay to diversity goals. The shareholders argued that the policies violate Section 1981, Title VII, and numerous state civil rights statutes, and thus the defendants endangered Starbucks and breached their fiduciary duties to shareholders.
- Latest update: On August 11, 2023, the court granted Starbucks’ motion to dismiss, reasoning that the public policy questions raised in the complaint are for companies and lawmakers, not courts, to decide. The court firmly stated that “[t]his Complaint has no business being before this Court and resembles nothing more than a political platform. Whether DEI and ESG initiatives are good for addressing long simmering inequalities in American society is up for the political branches to decide . . . it is clear to the Court that Plaintiff did not file this action to enforce the interests of Starbucks, but to advance its own political and public policy agendas.”
Craig v. Target Corp. et al., No. 23-00599 (M.D. Fl. 2023): On August 8, 2023, America First Legal on behalf of a Target stockholder sued the company and certain of its officers, claiming the Target board falsely represented that it monitored social and political risk, when it allegedly only focused on risks associated with not achieving ESG and DEI goals, thereby allegedly depressing Target’s stock price. The suit alleges violations of Sec. 10(b) and 14(a) of the Securities Exchange Act of 1934.
- Latest update: The defendants’ deadline to file an answer or motion is November 7, 2023.
Simeone v. Walt Disney Co., No. 2022-1120-LWW (Del. Chancery 2022): On December 9, 2022, a plaintiff shareholder sued under 8 Del. C. § 220 claiming that Disney breached its fiduciary duty to shareholders by expressing public opposition to Florida’s “Don’t Say Gay” bill, despite promises from Governor DeSantis that it would cause Disney economic harm, and filed a demand to inspect Disney’s books and records.
- Latest update: Disney won the suit on June 27, 2023, with a ruling that taking a position on the bill was a calculated management decision and that the shareholders were motivated by political ideology, not shareholder concerns.

5. Educational Institutions and Admissions (Fifth Amendment, Fourteenth Amendment, Title VI, Title IX):

Doe v. New York University, No. 1:23-cv-09187 (S.D.N.Y. 2023): On October 19, 2023, a white male first-year law student at NYU who intends to apply for the NYU Law Review sued the university, alleging the NYU Law Review’s use of race and sex or gender preferences in selecting its members constitutes a violation of Title VI and Title IX of the Civil Rights Act.
Students for Fair Admissions v. United States Naval Academy et al., No. 1:23-cv-02699-ABA (D. Md. 2023): On October 5, 2023, SFFA sued the U.S. Naval Academy in Annapolis, arguing that affirmative action in its admissions process violates the Fifth Amendment of the U.S. Constitution by taking applicants’ race into account.
- Latest update: On October 6, 2023, the plaintiffs moved for a preliminary injunction, and the defendants’ response is due December 1.
Students for Fair Admissions v. U.S. Military Academy at West Point, No. 7:23-cv-08262 (S.D.N.Y. 2023): On September 19, 2023, SFFA sued West Point Academy, arguing that affirmative action in its admissions process, including alleged racial “benchmarks” of “desired percentages” of minority representation, violates the Fifth Amendment of the U.S. Constitution by taking applicants’ race into account.
- Latest update: Plaintiffs filed for a preliminary injunction, and the defendants’ deadline to respond is November 17, 2023, with oral argument scheduled for December 21.
Coal. For TJ v. Fairfax County School Board, No. 1:21-cv-00296 (E.D.V.A. 2021): On March 3, 2021, an organization of primarily Asian American parents sued the Fairfax County School Board, claiming that the Board’s admissions procedures for the selective Thomas Jefferson High School for Science and Technology unconstitutionally discriminated against Asian Americans in violation of the Equal Protection Clause of the Fourteenth Amendment.
- Latest update: After the trial court granted summary judgment to the plaintiffs, on May 23, 2023, the Fourth Circuit reversed, holding that the admissions policy was constitutional. The plaintiffs filed a petition for certiorari to the Supreme Court in August 2023.

Threat Letters:

Threat letters to law firms regarding their diversity programs: In October, AAER sent litigation threat letters to five law firms: Fox Rothschild (October 16), Susman Godfrey (October 16), Winston & Strawn (October 9), Hunton Andrews Kurth (October 9), and Adams & Reese (October 9). AAER asked if the firms intend to continue with their 1L diversity fellowship programs, and threatened to sue them under Section 1981 if they did. On October 12, Adams & Reese responded with a letter, announcing their intention to not proceed with their 1L Minority Fellowship program in 2024. On October 19, Winston & Strawn responded by affirming their intention to continue its 1L diversity fellowship program. On October 30, AAER sued Winston & Strawn, which is described above.

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

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

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

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

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

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

*Teddy Rube is an associate working in the firm’s Washington, D.C. office who is not yet admitted to practice law.

On October 16, 2023, the U.S. Securities and Exchange Commission’s (the “SEC”) Division of Examinations released its 2024 examination priorities for the upcoming year (the “2024 Priorities”).[1] The publication of the 2024 Priorities comes at an important time in light of the final rules that the SEC adopted under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), in August of this year, which modify the inner workings of private funds and their sponsors by, among other things, restricting or requiring extensive disclosure of preferential treatment granted to investors, as well as imposing numerous additional reporting and other compliance requirements (the “New Private Funds Rules”).[2]

As anticipated, the 2024 Priorities further emphasize the SEC’s stated mission to increase “transparency into the examination program.” While the 2024 Priorities cover other important topics, we have highlighted the following key priorities that impact our private fund adviser clients and provided our analysis alongside them. We note that the following is not an exhaustive list of key priorities and is subject to change.

SEC Priority	GDC Analysis
The portfolio management risks present when there is exposure to recent market volatility and higher interest rates. This may include private funds experiencing poor performance, significant withdrawals and valuation issues, and private funds with more leverage and illiquid assets (such as real estate funds).	This priority seems largely focused on open-end funds that may experience liquidity shortfalls during periods of increased market volatility. For closed-end funds, this priority signals that in a difficult financial environment the SEC staff will be watching that sponsors are fairly valuing their funds’ assets and calculating their fees and performance accurately. Sponsors should continue to implement internal checks to ensure that their valuation policies are being followed and that positions are reassessed as conditions warrant. This priority also suggests a continued focus on advisers’ overall approach to portfolio risk and leverage management, including any policies and procedures adopted in that regard.
Adherence to contractual requirements regarding limited partner advisory committees or similar structures (e.g., advisory boards), including adhering to any contractual notification and consent processes.	Sponsors should periodically review their obligations related to limited partner advisory committee/board notices and consents to confirm that these obligations are being met and that such compliance is appropriately documented.
Conflicts, controls, and disclosures and use of affiliated service providers to ensure that such decisions are made, and processes are implemented, in the funds’ best interest and to allow investors to provide informed consent when needed. For example, such disclosure may include, but is not limited to, (i) disclosing processes for making initial and ongoing suitability determinations when allocating investments across investment vehicles managed by the same adviser or an affiliate, (ii) providing disclosure about how an adviser intends to mitigate or eliminate the conflicts of interest and (iii) disclosing economic incentives, such as the use of an affiliated firm to perform certain services.	Unless overturned or modified,[3] the New Private Funds Rules also will require sponsors to disclose fees to paid to the adviser and its affiliates on a quarterly basis. Given the SEC’s historic and continued focus on this area, sponsors would be wise to continue to approach affiliate transactions with special care, and strive to make a determination (documented by the sponsor’s conflicts committee where applicable) that any affiliate transactions have been effected in accordance with the fund’s governing documents, including any disclosure or informed consent requirements contained therein. Allocations of investment opportunities across multiple funds and other clients also will continue to be a focus of the SEC examination staff, and sponsors should ensure that appropriate documentation of allocation determinations is maintained.
Accurate calculation and allocation of private fund fees and expenses (both fund-level and investment-level), including valuation of illiquid assets (including adjustments to reflect write-downs or write-offs), calculation of post commitment period management fees (including whether a fund has the ability to recycle or reinvest proceeds after the commitment period), adequacy of disclosures, and potential offsetting of such fees and expenses.	The New Private Funds Rules set forth extensive reporting requirements related to fees and expenses, and the 2024 Priorities make clear that the SEC intends to spend significant time verifying calculations. We have seen the SEC pay increased attention to the calculation of fees at the end of a fund’s commitment period, particularly situations where the sponsor has a conflict of interest (such as the sponsor’s determination not to write off a permanently impaired investment such that management fees continue to be charged with respect to such investment).[4]
Due diligence practices for consistency with policies, procedures, and disclosures, particularly with respect to private equity and venture capital fund assessments of prospective portfolio companies.	It appears that the SEC intends to double check that sponsors are conducting due diligence in the manner they have communicated, both externally and internally. Sponsors would be wise to review marketing materials and internal policies for descriptions related to the due diligence that is undertaken when selecting investments. Sponsors should then confirm with the deal team whether the process has been followed and documented for all investments over the relevant period, and whether adjustments to disclosure or policy are needed or, alternatively, adjustments to the investment diligence process itself.
Compliance with Advisers Act requirements regarding custody, including accurate Form ADV reporting, timely completion of private fund audits by a qualified auditor and the distribution of private fund audited financial statements.	A continued focus on custody requirements does not come as a surprise as this has been a major point of emphasis of the SEC examination staff. Continued care and attention should be taken to ensure compliance with all aspects of the Advisers Act custody rule, which is highly technical, and that documentation of such compliance (for example, records of timely delivery of audited financial statements to investors) is maintained.
Policies and procedures for reporting on Form PF, including upon the occurrence of certain reporting events.	Please see our client alert, which can be found here, summarizing the SEC’s significant amendments to Form PF. Form PF amendments will go into effect on December 11, 2023 (i.e., “trigger” based filing requirements) and June 11, 2024 (i.e., additional reporting requirements as part of routine Form PF filings).

___________________________

[1] Available at: https://www.sec.gov/news/press-release/2023-222. See also https://www.sec.gov/files/2024-exam-priorities.pdf.

[2] For more information on the New Private Funds Rules, please see our client alert available here.

[3] The New Private Funds Rules are being challenged in court by an array of industry groups led by the National Association of Private Fund Managers, represented by Gibson Dunn. The U.S. Court of Appeals for the Fifth Circuit recently granted the challengers’ motion to expedite the case, which requested a decision by the end of May 2024. The challengers filed their opening brief on November 1, 2023.

[4] For more information on the recent SEC enforcement action against Insight Venture Management LLC (“Insight”) where the SEC found that Insight charged excess management fees to its investors through “inaccurate application of its permanent impairment policy” and failed to disclose a conflict of interest to investors concerning the same policy, please see our client alert available here.

The following Gibson Dunn attorneys assisted in preparing this client update: Tom Rossidis, Kevin Bettsteller, and Shannon Errico.

Investment Funds Group:
Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, [email protected])
Kevin Bettsteller – Los Angeles (+1 310-552-8566, [email protected])
Albert S. Cho – Hong Kong (+852 2214 3811, [email protected])
Candice S. Choh – Los Angeles (+1 310-552-8658, [email protected])
John Fadely – Singapore/Hong Kong (+65 6507 3688/+852 2214 3810, [email protected])
A.J. Frey – Washington, D.C./New York (+1 202-887-3793, [email protected])
Shukie Grossman – New York (+1 212-351-2369, [email protected])
James M. Hays – Houston (+1 346-718-6642, [email protected])
Kira Idoko – New York (+1 212-351-3951, [email protected])
Gregory Merz – Washington, D.C. (+1 202-887-3637, [email protected])
Eve Mrozek – New York (+1 212-351-4053, [email protected])
Roger D. Singer – New York (+1 212-351-3888, [email protected])
Edward D. Sopher – New York (+1 212-351-3918, [email protected])
William Thomas, Jr. – Washington, D.C. (+1 202-887-3735, [email protected])
Shannon Errico – New York (+1 212-351-2448, [email protected])
Tom Rossidis – New York (+1 212-351-4067, [email protected])

This update provides an overview of key class action-related developments during the third quarter of 2023 (July to September).

Part I summarizes an Eighth Circuit decision addressing waiver of arbitration in putative class actions;
Part II covers a Fourth Circuit opinion analyzing the impact of class action waivers on class certification proceedings;
Part III discusses a recent opinion from the D.C. Circuit that weighs in on certification of “issue” classes under Rule 23(c)(4);
And Part IV discusses two decisions reversing attorneys’ fee awards following class settlements.

I. The Eighth Circuit Holds Defendant Does Not Waive Right to Arbitrate by Waiting Until After Class Certification to Move to Compel Arbitration as to Absent Class Members

In H&T Fair Hills, Ltd. v. Alliance Pipeline L.P., 76 F.4th 1093 (8th Cir. 2023), landowners brought a putative class action against a natural gas pipeline construction company, alleging the company breached its easement contracts with the landowners. Although most of these contracts contained an arbitration clause, some did not—including the contracts with the named plaintiffs. Id. at 1097. After the district court certified the class, the company moved to compel arbitration of the claims of class members whose contracts contained arbitration provisions. Plaintiffs objected, arguing the company waived its right to compel arbitration because it “wait[ed] more than two years after the complaint was filed” before moving to compel as to the absent class members. Id. at 1098. The district court nevertheless granted the motion to compel, highlighting that the company “had no reason to raise arbitration as an affirmative defense” given that none of the named plaintiffs had easement contracts “subject to arbitration agreements.” Id. at 1098–99.

The Eighth Circuit agreed, holding that the company did not waive its right to arbitrate. “[N]one of the named plaintiffs … have arbitration provisions in their easements,” id. at 1100, and at least until a class was certified, it made little sense to force a defendant to compel arbitration as to absent class members—“parties who were not yet part of the case.” Id. The Eighth Circuit concluded that the company “acted consistently with its right to arbitrate” when it moved to compel arbitration “quickly after the class was certified” as to those class members whose contracts contained an arbitration provision. Id.

This holding contrasts with the Ninth Circuit’s recent decision in Hill v. Xerox Business Services, LLC, 59 F.4th 457 (9th Cir. 2023), which ruled that a defendant waived its right to compel arbitration against unnamed class members due to the defendant’s pre-certification conduct. The court noted the defendant engaged in over six years of pre-certification litigation, having never mentioned a particular arbitration provision in its affirmative defenses or opposition to class certification. Id. at 466. It was only after the district court certified the class that the defendant invoked that specific arbitration provision—which, in the Ninth Circuit’s view, was too late. In so holding, the Ninth Circuit rejected the argument pre-certification conduct can never vitiate a yet-to-exist right to arbitrate, reasoning that parties can implicitly relinquish such prospective rights at common law. See Id. at 469–470 & n.15. The Ninth Circuit also found it troublesome that the defendant had repeatedly asserted a right to arbitrate under a newer version of its employment contract “without also asserting the same” for the older version upon which it later tried to compel arbitration. Id. at 473–74.

II. The Fourth Circuit Vacates Certification Where District Court Failed to Consider Impact of Class Action Waiver Before Certifying Classes

In In re Marriott International, Inc., 78 F.4th 677 (4th Cir. 2023), the Fourth Circuit addressed the impact of a contractual class waiver on certification under Rule 23. The case involved claims against a hotel chain and its IT service provider after hackers allegedly breached a guest reservations database and gained access to millions of guest records. Id. at 680.

After holding that the named plaintiffs had adequately alleged an injury-in-fact for purposes of Article III standing, the district court certified classes for monetary damages under Rule 23(b)(3). Id. at 681. Defendants argued that the named plaintiffs did not satisfy the typicality requirement because they were all members of the hotel’s guest rewards program, the terms of which included a class action waiver. Id. at 682. By contrast, the class included absent class members who were not rewards members, and thus “had not signed such waivers.” Id. To address these “serious typicality concerns,” the district court redefined the classes to include only members of the guest rewards program. Id. The defendants sought interlocutory review under Rule 23(f). Id. at 684–85.

On appeal, the Fourth Circuit held that the district court erred by certifying classes “consisting entirely of plaintiffs who had signed a putative class waiver without first addressing the import of that waiver.” Id. at 687. The court reasoned that the “time to address a contractual class waiver is before, not after, a class is certified.” Id. at 686. In so holding, the court explained that a “class-waiver” defense is not a merits issue, as it speaks only to the “process available” to a plaintiff in pursuit of their claim, and not the “underlying merits of that claim.” Id. at 687. As a result, the district court should have ruled on the effect of the “[class] waiver defense before certifying a class.” Id.

III. D.C. Circuit Holds Rule 23(c)(4) “Issue” Classes Must Still Satisfy Rule 23(a) and Be Maintainable Under One Category of Rule 23(b)

Rule 23(c)(4) states that “[w]hen appropriate, an action may be brought or maintained as a class action with respect to particular issues.” Over the years, circuit courts have taken different approaches as to when certification under Rule 23(c)(4) is appropriate—and in particular, whether Rule 23(c)(4) can be used to skirt the predominance analysis under Rule 23(b)(3), since an “issue” class will have, by definition, a common issue. This past quarter, the D.C. Circuit addressed this issue and followed the Fifth Circuit’s approach of rigorously applying all of Rule 23’s requirements, even for classes sought to be certified under Rule 23(c)(4).

In Harris v. Medical Transportation Management, Inc., 77 F.4th 746 (D.C. Cir. 2023), medical transportation drivers brought a putative class action under the Fair Labor Standards Act (“FLSA”), D.C.’s wage-and-hour laws, and for common-law breach of contract against their employer, alleging it failed to pay them their full wages. Id. at 753–54. The plaintiffs also sought certification of a class of drivers under Rule 23 for the wage claims. Id. at 754. The district court found that although the plaintiffs met the requirements of Rule 23(a), they failed to meet the predominance requirement of Rule 23(b)(3). Id. The district court nonetheless certified a Rule 23(c)(4) “issue” class on the issue of whether the employer was a joint employer or a general contractor. Id. at 754–55.

After accepting the employer’s interlocutory appeal, the D.C. Circuit acknowledged that it had not yet addressed the question whether an “issue” class “can be certified when no lawsuit or cause of action has been certified as a class” and acknowledged the circuit split on the issue, noting “[o]ther circuits have applied Rule 23(c)(4) in a variety of ways.” Id. at 756–57 (collecting cases).

Siding with the approach first set out by the Fifth Circuit in Castano v. American Tobacco Co., 84 F.3d 734 (5th Cir. 1996), the D.C. Circuit held that, under Rule 23, all certified classes—including a Rule 23(c)(4) “issue” class—must meet both the threshold requirements of Rule 23(a) and be maintainable under one of Rule 23(b)’s categories. Harris, 77 F.4th at 757. Noting “Rule 23’s carefully calibrated limits on class certification,” the D.C. Circuit emphasized the importance of the predominance inquiry as “an important safeguard against unreasonably fractured litigation, [which] simultaneously protects the rights of named parties and absent class members alike.” Id. at 762. The D.C. Circuit concluded that “district courts must ensure that Rule 23(c)(4)’s authorization of issue classes does not end up at war with Rule 23(b)(3)’s predominance requirement,” lest courts let plaintiffs “effectively skirt the functional demands of the predominance requirement by seeking certification of an overly narrow issue class and then arguing that the issue (inevitably) predominates as to itself.” Id. (citing Castano, 84 F.3d at 745 n.21). The court therefore vacated certification and remanded, instructing the district court to explain “how the use of issue classes is ‘superior to other available methods for fairly and efficiently adjudicating the controversy’” (such as the alternative of “deciding a partial summary judgment motion focused on the issues proposed to be certified”). Id. (quoting Fed. R. Civ. P. 23(b)(3)).

IV. Continuing Trend of Applying Greater Scrutiny to Class Action Settlements, Seventh and Ninth Circuits Eschew Mechanical Approaches to Calculating Attorneys’ Fees and Reverse Class Counsel Fees Awards

In Lowery v. Rhapsody International, Inc., 75 F.4th 985 (9th Cir. 2023), plaintiffs’ counsel sought $1.7 million in attorneys’ fees based on a capped $20 million settlement fund with a claims rate of less than 0.3%—effectively, only a $50,000 recovery for the class. Id. at 988, 990. The district court granted class counsel’s full fee award based on the “lodestar” method, and the defendant appealed. Rejecting class counsel’s arguments, the Ninth Circuit held that attorneys’ fees should be based on the actual—and not theoretical—amount recovered by the class. Id. at 992. The court elaborated that district courts awarding fees “must consider the actual or realistically anticipated benefit to the class—not the maximum or hypothetical amount—in assessing the value of a class settlement” for purposes of evaluating the reasonableness of a fee award. Id.

The Ninth Circuit ordered the district court on remand to “disregard the theoretical $20 million settlement cap,” and instead focus on the amount actually claimed by the class because “[a]ny other approach would allow parties to concoct a high phantom settlement cap to justify excessive fees, even though class members receive nothing close to that amount.” Id. The court also “encourage[d]” the district court “to cross-check the fees against the benefit to the class and ensure that the fees are reasonably proportional to that benefit.” Id. at 993–94. In its view, the fact that class counsel’s fees “greatly exceed[ed] 25% of the value of the settlement” was a “major red flag” signifying “that lawyers [were] being overcompensated and that they achieved only meager success for the class.” Id. at 994. Lowery is a timely reminder to parties litigating in the Ninth Circuit to prepare for the possibility of heightened scrutiny of the class’s recovery when seeking approval of class settlements, particularly those with a claims-made structure.

In In re Broiler Chicken Antitrust Litigation, 80 F.4th 797, 800 (7th Cir. 2023), the Seventh Circuit vacated class counsel’s $57.4 million fee award in an antitrust case based on a settlement fund of $181 million. The district court considered whether the fees represented the “market rate,” and approved the award by relying on evidence that fee awards in antitrust cases in the Seventh Circuit “are almost always one-third” of the settlement value, which it viewed as a “strong indication” that this represented the “market rate.” Id. at 801. The Seventh Circuit vacated the award, holding that the district court’s market rate “evaluation fell short in two areas: the consideration of bids made by class counsel in auctions, and the weight assigned to out-of-circuit decisions.” Id. at 802.

As to the first area, the Seventh Circuit faulted the district court for discounting recent bids submitted by class counsel in other cases with declining fee award structures, believing such declining fee award structures “do not reflect market realities” and “create perverse incentives” by reducing attorneys’ incentives to seek a larger recovery. Id. at 803. The Seventh Circuit disagreed, clarifying that it “never categorically rejected consideration of bids with declining fee scale award structures” and that these prior auction bids by class counsel in other cases were probative of the hypothetical bargain that could have been struck ex ante. Id. at 802–03.

As to the second area, the Seventh Circuit disapproved of the district court’s decision to give less weight to fee awards received by the same class counsel in Ninth Circuit cases because the relevant law governing fee awards differed in some meaningful ways from Seventh Circuit law. Id. at 804. The Seventh Circuit held that even if Ninth Circuit law differed, class counsel’s economic choice to continue litigating in those Ninth Circuit cases was informative of the price of their legal services and the bargain they may have struck in this case. Id.

On remand, the court instructed the district court to reevaluate the bargain the parties would have struck ex ante while giving appropriate consideration and weight to the two additional factors. Id. at 805. The court “express[ed] no preference as to the amount or structure of the award,” but said that an attorney fee award of one-third of the net settlement “warrants greater explanation.” Id.

The following Gibson Dunn lawyers contributed to this client update: Lauren Fischer, Timothy Kolesk, Psi Simon,* Wesley Sze, Lauren Blas, Bradley Hamburger, Kahn Scolnick, and Christopher Chorba..

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

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

*Psi Simon is an associate practicing in the firm’s San Francisco office who is not yet admitted to practice law.

In the past month, Governor Gavin Newsom signed into law a variety of employment law changes for California employers. Below, we discuss eleven areas that may require attention from California employers.

1. Expanded Restrictions on Non-Compete Agreements

As detailed in our previous client alert, beginning on January 1, 2024, employers may not enter into or enforce employment agreements, “no matter how narrowly tailored,” that restrict an employee from “engaging in a lawful profession, trade, or business of any kind.”[1] This restriction applies “regardless of where and when” such agreements are presented or were originally executed.[2] Current, former, and prospective employees presented or threatened with such agreements may seek immediate injunctive relief or damages in California courts, as well as “reasonable attorney’s fees and costs.”[3] In addition, by February 14, 2024, California employers and non-California employers with California employees must notify current and former employees (defined as those employed after January 1, 2022) in writing that previously executed agreements covered by the new law are now void.[4]

Failure to comply with these new laws, including the notification requirement, may result in civil penalties for “unfair competition” under Business and Professions Code section 17206, which are capped at $2,500 per violation.[5] While neither statute addresses how civil penalties will be calculated—i.e. whether per employee, per non-compliant agreement, or per overall failure to notify an employee population, California courts are “afforded broad discretion” when determining the amount of civil penalties to impose under section 17206.[6]

The three limited statutory exceptions allowing restrictive covenants in the sale or dissolution of corporations, partnerships, and limited liability corporations remain in effect.[7]

2. Workplace Violence Prevention

A. Written Prevention Plans

By July 1, 2024, most California employers must create, adopt, and implement a written Workplace Violence Prevention Plan.[8] Generally, the plan must include “effective” procedures to: (1) investigate and respond to reports of workplace violence; (2) prohibit retaliation against reporters; (3) communicate with employees regarding workplace violence; (4) identify and evaluate workplace violence hazards; and (5) revise and review the plan as needed.[9] “Workplace violence” is broadly defined as “any act of violence or threat of violence that occurs in a place of employment.”[10]

The new law also requires annual employee training on various topics related to workplace violence and the employer’s plan, such as how to report workplace violence, potential corrective measures, and how to avoid physical harm.[11] Additional training will be required whenever an employer changes its plan or identifies a previously unrecognized workplace violence hazard.[12] The law does not specify how long each training must be. Employers must maintain training records and records of each workplace violence hazard or incident (including how they were identified, investigated, and corrected, as applicable) for five years.[13] “Violent incident” logs must include specific information, such as a description of the violence, involvement of law enforcement or security, and any protective action taken on the employee’s behalf.[14] Employees are entitled to view and copy the violent incident log, with certain medical information omitted, within 15 calendar days of a request.[15]

The new law does not apply to: (1) employers already covered Cal/OSHA’s Violence Prevention in Health Care requirements; (2) employees who telework from a location of their own choice outside of the employer’s control; (3) locations not accessible to the public with fewer than 10 employees at one time; (4) the Department of Corrections and Rehabilitation; and (5) law enforcement agencies.[16]

B. Temporary Restraining Orders

While not on the immediate horizon, as of January 1, 2025, employers may seek restraining orders on behalf of employees who have suffered harassment, and not just those with a “credible threat of violence.”[17] Under the new law, “harassment” is defined as “a knowing and willful course of conduct directed at a specific person that seriously alarms, annoys, or harasses the person,” “that serves no legitimate purpose,” that “would cause a reasonable person to suffer substantial emotional distress,” and actually does “cause substantial emotional distress” to the employee at issue.[18] The employee need not be named in the temporary restraining order.[19]

3. Expanded Leave Protections

A. Reproductive Loss Leave

As of January 1, 2024, employees are entitled to five days of protected time off for a “reproductive loss event.”[20] The new law applies to private employers with five or more employees, and any California employee employed for at least 30 days prior to the commencement of leave, even if a portion of that time was spent working outside of California.[21] The term “reproductive loss event” is broadly defined to include a failed adoption, failed surrogacy, miscarriage, stillbirth, or unsuccessful assisted reproduction.[22] Unlike California’s bereavement leave law, this new law does not contain a provision allowing employers to request documentation to confirm the reproductive loss event. In addition, employers must keep confidential an employee’s request, as well as any other information provided, from “internal personnel or counsel” unless necessary or otherwise required by law.[23]

Employers’ existing leave policies will determine whether the reproductive loss leave is paid or unpaid; however, employees must be allowed to use paid time off, paid vacation, paid personal leave, accrued paid sick leave, or other compensatory time off in lieu of taking the five days unpaid.[24] The five days must be taken within three months’ of the reproductive loss event, but need not be taken consecutively.[25] Employees who experience more than one reproductive loss event in a 12 month period need only be provided with a maximum of 20 days of leave.[26]

B. Increased Sick Leave

As of January 1, 2024, California employees must be provided with at least five days or 40 hours of paid sick leave under the Healthy Workplaces, Healthy Families Act, increased from the three days or 24 hours previously required.[27] Local ordinances may require higher amounts of paid sick leave.

Employers using the accrual method may still provide paid sick leave at an accrual rate of one hour for every 30 hours worked.[28] However, employees must now accrue at least three days of paid sick leave by their 90th calendar day of employment, and five days of paid sick leave by their 200th calendar day of employment.[29] Further, employees must be allowed to carry-over at least 10 days (or 80 hours) of paid sick leave to the following calendar year.[30]

Alternatively, employers may provide the full five days or 40 hours of paid sick leave upfront in a lump-sum each calendar year or 12-month period.[31] Employers using the upfront, lump-sum method do not have to accrue any sick leave or allow carryover to the following year; however, all sick leave provided must be available for use during the same calendar year in which the employer provides it.[32]

Employers may still require employees to work for 90 calendar days before using sick leave.[33] Accrued but unused sick time provided separate and apart from a vacation or omnibus paid time off policy still does not need to be paid out upon termination.[34]

4. Discretionary Stays Pending Appeals of Arbitrability

As of January 1, 2024, the California Code of Civil Procedure will no longer provide for automatic stays of trial court proceedings pending appeal of “order[s] dismissing or denying a petition to compel arbitration[.]”[35] Instead, trial courts will have discretion to deny a stay pending appeals of arbitrability.[36] Because S.B. 365 creates a procedural change, it is possible that courts will apply the discretionary standard to pending and future litigation. Given its marked departure from the U.S. Supreme Court’s recent decision in Coinbase, Inc. v. Bielski, 599 U.S. 736, 737 (2023), which held that the FAA requires “a district court [to] stay its proceedings while the interlocutory appeal on arbitrability is ongoing,” S.B. 365 will likely face preemption challenges on the ground that it disfavors arbitration. See Kindred Nursing Centers Ltd. P’ship v. Clark, 581 U.S. 246 (2017) (a state law that “discriminate[s] on its face against arbitration” or “singles out arbitration agreements for disfavored treatment … violates the FAA”).

5. Expanded Public Prosecution Rights

Beginning January 1, 2024, district attorneys, city attorneys, and county counsel (collectively, “public prosecutors”) will be able to prosecute or independently enforce violations of the Labor Code (except those related to agricultural labor relations, apprenticeships, or a Private Attorneys General Act action).[37] Essentially, public prosecutors will be able to step into the shoes of the Labor Commissioner for their geographic jurisdictions. Public prosecutors will be able to seek injunctive relief and seek the same attorney’s fees and costs the Labor Commissioner would be entitled to under Section 98.3 of the Labor Code.[38]

Importantly, the amended law also provides that any agreement between a worker and a putative employer limiting representative actions or mandating arbitration “shall have no effect on the authority of [a] public prosecutor or the Labor Commissioner to enforce the [Labor] [C]ode.”[39] Further, the law states that an “appeal of the denial of any motion … to impose such restrictions on a public prosecutor or the Labor Commissioner shall not stay the trial court proceedings.”[40] Because A.B. 594 entirely prohibits stays pending appeals of arbitrability in cases brought by public prosecutors or the Labor Commissioner, the anti-stay provision will likely be challenged on preemption grounds.

6. Increased Penalties for Independent Contractor Misclassification

Section 226.8 of the Labor Code will require courts and the Labor and Workforce Development Agency to impose $5,000 to $15,000 in civil penalties per violation starting on January 1, 2024 for: (1) willful misclassification, and/or (2) charging a willfully misclassified person a fee or “making any deductions from compensation” for any purpose “arising from [their] employment” that would otherwise be illegal if they were not misclassified (i.e. charges for necessary uniforms, tools, etc.).[41] The penalties can be increased to $10,000-$25,000 per violation where there is, or has been, a pattern or practice of violations.[42] These penalties are in addition to any other available penalties or fines.[43] A violator will be required to prominently display a notice on their website, for one year, stating that they have engaged in willful misclassification and have made business changes to avoid further violations, along with other information.[44]

The Labor Commissioner will have the power to enforce these rules, in accordance with existing Labor Code Sections 98, 98.1, 98.2, 98.3, 98.7, 98.74, or 1197.1, and can do the following: (1) determine that a person or employer has committed violations, (2) investigate alleged violations, (3) order appropriate temporary relief pending the completion of an investigation or hearing, (4) issue citations, and (5) file civil actions.[45] As for employees suing to enforce these rights, they can either recover damages or enforce a civil penalty under PAGA, but not both.[46]

7. Re-Hiring Rights for Laid-Off Hospitality Employees

Employers in the hospitality industry should be aware that as of January 1, 2024, California Labor Code Section 2810.8 will be expanded to cover more employees and extend the sunset period to December 31, 2025.[47] California Labor Code Section 2810.8 will require covered employers to provide “laid-off employee[s]” with information about available job positions for which they are qualified, and to offer positions to said employees based on a preference system and in accordance with a specified timeline.[48] Under the new law, “laid-off employee” means anyone employed “6 months or more and whose most recent separation from active employment by the employer occurred on or after March 4, 2020, and was due to a reason related to the COVID-19 pandemic, including a public health directive, government shutdown order, lack of business, reduction in force, or other economic non-disciplinary reason due to the COVID-19 pandemic.”[49] The law previously defined “laid off employee” as anyone “employed by the employer for 6 months or more in the 12 months preceding January 1, 2020, and whose most recent separation from active service was due to a reason related to the COVID-19 pandemic[.]”[50] Critically, the revised law presumes “that a separation due to a lack of business, reduction in force, or other economic, non-disciplinary reason is due to a reason related to the COVID-19 pandemic, unless the employer establishes otherwise by a preponderance of the evidence.”[51]

As with the original version of the law, covered employers include hotels with fifty or more guest rooms, airport hospitality operations and service providers, certain event centers, and employers that provide “janitorial, building maintenance, or security services” to office, retail, or other commercial buildings.[52]

8. Prior Marijuana Usage

Starting January 1, 2024, employers may not request information about an applicant or employee’s prior use of marijuana.[53] Employers also cannot discriminate against current or prospective employees on the basis of criminal history specifically related to prior marijuana use unless otherwise allowable by law.[54]

9. Labor Code’s New Rebuttable Presumption of Retaliation

A new rebuttable presumption of retaliation will be codified starting January 1, 2024. The California Labor Code will include a rebuttable presumption of retaliation if an employer takes adverse action against or disciplines an employee within 90 days of that employee engaging in protected conduct.[55] Protected conduct may include, but is not limited to, discussing, inquiring, or complaining about wages, or encouraging other employees to exercise their own protected conduct rights.[56] Neither the preamble nor the statute itself mentions whether the presumption will have retroactive effect.

10. Increased Minimum Wage for Fast Food Workers

As of April 1, 2024, fast-food workers at “national fast food chains” in California must receive at least $20 per hour in minimum wage.[57] “National fast food chains” is defined as “limited-service restaurants consisting of more than 60 establishments nationally that share a common brand, or that are characterized by standardized options for decor, marketing, packaging, products, and services, and which are primarily engaged in providing food and beverages for immediate consumption on or off premises where patrons generally order or select items and pay before consuming, with limited or no table service.”[58]

California Labor Code Section 1475 also creates the “Fast Food Council” within the Department of Industrial Relations. The Council must have its first meeting by March 15, 2024, and will ultimately be responsible for establishing minimum standards for wages, hours, and other working conditions “to ensure and maintain the health, safety, and welfare” of fast-food workers.[59]

Beginning on January 1, 2025, the Council will have the authority to increase minimum wages for fast-food workers on an annual basis through 2029, provided the increases meet certain criteria.[60]

11. Diversity Reporting for Venture Capital Firms

Venture capital firms should be aware that starting March 1, 2025, they will likely be required to annually report various demographic data about the companies in which they invest to the California Civil Rights Department (“CRD”).[61] Covered venture capital firms include any with portfolio companies based in or with significant operations in California, as well as any that solicit or receive funds from California residents.[62] The annual report must contain information about the gender identity, race, ethnicity, disability status and veteran status of the founders who receive their investments.[63] Founders may opt out of reporting without penalty, but venture capital firms who fail to provide any data they do receive will be subject to undisclosed fines.[64] Any data submitted will then appear in an online searchable database available to the public, and CRD may also use it “in furtherance of its statutory duties, including, but not limited to, using the information in a civil action” under the new law or other law.[65]

It should be noted though that Governor Newsom issued a contemporaneous statement with his signing of the law. He identified several concerns with the law, including “unrealistic timelines” and various questions regarding its funding. The specific requirements of the law are likely to change prior to its effective date.

__________________________

[1] 2023 Cal. S.B. No. 699 (2023-2024 Regular Session).

[2] Id. § 2 (Cal. Bus. & Prof. Code § 16600.5(b)).

[3] Id. § 2 (Cal. Bus. & Prof. Code §§ 16600.5(d), (e)).

[4] 2023 Cal. A.B. No. 1076 (2023-2024 Regular Session).

[5] Id. § 2 (Cal. Bus. & Prof. Code §§ 16600, 16600.1(c)).

[6] See Nationwide Biweekly Administration, Inc. v. Superior Court (2020) 9 Cal.5th 279, 326.

[7] Cal. Bus. & Prof. Code §§ 16601, 16602, 16602.5.

[8] 2023 Cal. S.B. No. 553 (2023-2024 Regular Session).

[9] Id. § 3 (Cal. Lab. Code § 6401.9(c)).

[10] Id. § 3 (Cal. Lab. Code § 6401.9(a)(6)(A)).

[11] Id. § 3 (Cal. Lab. Code § 6401.9(e)).

[12] Ibid.

[13] Id. § 3 (Cal. Lab. Code § 6401.9(f)).

[14] Id. § 3 (Cal. Lab. Code § 6401.9(d)).

[15] Id. § 3 (Cal. Lab. Code § 6401.9(f)(6)).

[16] Id. § 3 (Cal. Lab. Code § 6401.9(b)(2)).

[17] 2023 Cal. S.B. No. 428 (2023-2024 Regular Session).

[18] Id. § 1 (Cal. Lab. Code § 527.8(b)(4)).

[19] Id. § 1 (Cal. Lab. Code § 527.8(e)).

[20] 2023 Cal. S.B. No. 848 (2023-2024 Regular Session).

[21] Id. § 1 (Cal. Gov. Code §§ 12945.6(a)(3), (a)(2)).

[22] Id. § 1 (Cal. Gov. Code § 12945.6(a)(7)).

[23] Id. § 1 (Cal. Gov. Code § 12945.6(e)).

[24] Id. § 1 (Cal. Gov. Code § 12945.6(b)(4)).

[25] Id. § 1 (Cal. Gov. Code § 12945.6(b)(3)).

[26] Id. § 1 (Cal. Gov. Code § 12945.6(b)(1)).

[27] 2023 Cal. S.B. No. 616 (2023-2024 Regular Session).

[28] Id. § 2 (Cal. Lab. Code § 246(b)).

[29] Ibid.

[30] Id. § 1 (Cal. Lab. Code § 246(j)).

[31] Id. § 1 (Cal. Lab. Code § 246(d)).

[32] Ibid.

[33] Id. § 1 (Cal. Lab. Code § 246(c)).

[34] Id. § 1 (Cal. Lab. Code § 246(g)).

[35] 2023 Cal. S.B. No. 365 (2023-2024 Regular Session).

[36] Id. § 1 (Cal. Code. Civ. Proc. § 1294(a)).

[37] 2023 Cal. A.B. No. 594 (2023-2024 Regular Session).

[38] Id. § 4 (Cal. Lab. Code § 226.8(g)).

[39] Id. § 2 (Cal. Lab. Code § 182).

[40] Ibid.

[41] Id. § 4 (Cal. Lab. Code § 226.8).

[42] Id. § 4 (Cal. Lab. Code §§ 226.8(b), (c)).

[43] Ibid.

[44] Id. § 4 (Cal. Lab. Code § 226.8(e)).

[45] Id. § 4 (Cal. Lab. Code § 226.8(g)).

[46] Ibid.

[47] 2023 Cal. S.B. No. 723 (2023-2024 Regular Session).

[48] Id. § 1 (Cal. Lab. Code §§ 2810.8(a), (i)).

[49] Id. § 1 (Cal. Lab. Code § 2810.8(a)(10)).

[50] Ibid.

[51] Ibid.

[52] Id. § 1 (Cal. Lab. Code §§ 2810.8(a)(1)–(13)).

[53] 2023 Cal. S.B. No. 700 (2023-2024 Regular Session).

[54] Id. § 1 (Cal. Gov. Code § 12954(c)).

[55] 2023 Cal. S.B. No. 497 (2023-2024 Regular Session).

[56] Id. §§ 1, 3 (Cal. Lab. Code §§ 98.6(b); 1197.5(k)).

[57] 2023 Cal. A.B. No. 1228 (2023-2024 Regular Session).

[58] Id. § 3 (Cal. Lab. Code § 1474(a)).

[59] Id. § 3 (Cal. Lab. Code § 1474(b)).

[60] Id. § 3 (Cal. Lab. Code § 1474(d)(2)).

[61] 2023 Cal. S.B. No. 54 (2023-2024 Regular Session).

[62] Id. § 1 (Cal. Bus. & Prof. Code § 22949.85(a)).

[63] Id. § 1 (Cal. Bus. & Prof. Code § 22949.85(b)).

[64] Id. § 1 (Cal. Bus. & Prof. Code §§ 22949.85(b)(2), (g)).

[65] Id. §1 (Cal. Bus. & Prof. Code §§ 22949.85(d)(1)–(3)).

The following Gibson Dunn attorneys assisted in preparing this client update: Jason C. Schwartz, Katherine V.A. Smith, Tiffany Phan, Brandon Stoker, and Lauren Fischer.

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 practice group, or the following authors and practice leaders:

Tiffany Phan – Partner, Los Angeles (+1 213-229-7522, [email protected])

Brandon J. Stoker – Of Counsel, Los Angeles (+1 213-229-7574, [email protected])

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

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

On 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, [email protected])

Svetlana S. Gans – Partner, Administrative Law & Regulatory Group, Washington, D.C.
(+1 202-955-8657, [email protected])

Michael Holecek – Partner, Labor & Employment Group, Los Angeles
(+1 213-229-7018, [email protected])

Eugene Scalia – Co-Chair, Administrative Law & Regulatory Group, Washington, D.C.
(+1 202-955-8210, [email protected])

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

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

Helgi C. Walker – Co-Chair, Administrative Law & Regulatory Group, Washington, D.C.
(+1 202-887-3599, [email protected])

I. Introduction

On October 17, 2023, the Department of Commerce’s Bureau of Industry and Security (“BIS”) released three rules to update its export controls on advanced computing and semiconductor manufacturing items. Two are new interim final rules (“IFRs”) and the third is a final rule amending the Entity List.[1] For ease of reference we refer to two IFRs together as the 2023 Amendments and separately as the SME IFR and AC/S IFR.

Broadly, the two IFRs impose controls on additional types of semiconductor manufacturing equipment; refine the restrictions on U.S. persons to ensure U.S. companies cannot provide support to advanced semiconductor manufacturing in the People’s Republic of China (“China”); expand license requirements for the export[2] of semiconductor manufacturing equipment to apply to additional countries; adjust the licensing requirement criteria for advanced computing integrated circuits (hereinafter “Advanced ICs”); and impose new measures to address risks of circumvention of the controls by expanding them to additional countries. In the final rule, BIS seeks to further direct the flow of Advanced ICs and semiconductor manufacturing equipment (“SME”) away from two new China-headquartered entities and their subsidiaries by adding them to its BIS Entity List. With the exception of a Temporary General License that was issued with the SME IFR and the Entity List additions, which are now in effect, the IFR amendments will become effective on November 17, 2023.

According to BIS, these new rules, as with the October 7, 2022 IFR (hereinafter, “2022 Regulations”), are intended to address specific national security and foreign policy threats presented by China’s “military-civil fusion” program and its efforts to modernize its military through the use of Artificial Intelligence (“AI”) and supercomputing applications.[3] BIS has designed the 2023 Amendments to strengthen, expand, and reinforce the 2022 Regulations, which curtailed China’s ability to purchase and manufacture Advanced ICs for use in advanced weapon systems and other military applications of AI,[4] products that enable mass surveillance, and other technologies used in the abuse of human rights.[5]

BIS’s amendments are the latest in a whole of government effort spanning U.S. presidential administrations to employ various international trade regulation tools at the government’s disposal (including export controls, import controls, CFIUS, and economic sanctions) to ensure that the U.S. maintains military and strategic economic superiority over China. The 2023 Amendments also reflect an unprecedented effort by the Biden Administration to coordinate new international trade controls with key allies and to minimize the impact on U.S. allies. Such efforts include minimizing some of the known collateral impacts that current unilateral controls could have on international trade flows, especially on the Advanced IC and SME supply chains of U.S. and allied country companies, and encouraging a collective “friend-shoring” of U.S. and allied country supply chains for critical technologies. We further discuss the broader set of policies these export controls help in part to advance in our recent client alerts detailing President Biden’s August 2023 executive order imposing restrictions on outbound investments in China’s semiconductor, AI, and quantum computing industries and outlining the Biden Administration’s priorities as described in the recent National Security Strategy.

This update provides an overview of key changes and insights presented by the 2023 Amendments. In Section II, we summarize significant amendments contained in the SME IFR concerning expanded license requirements for SME exports, clarified and elaborated SME classifications, clarified and expanded prohibitions on U.S. person support of Advanced IC development and production, and a new temporary general license for SME-related exports. We then summarize significant amendments contained in the AC/S IFR concerning a new performance density parameter in the Export Control Classification Number (“ECCN”) description for Advanced ICS, measures to address circumvention risk, expand end-use restrictions, and guidance on due diligence and red flag identification.

In Section III, we analyze the implications of the new regulations. Importantly, the new regulations create increased diligence responsibilities and compliance costs for transaction parties due to enhanced transaction and counterparty diligence requirements and the need for greater upstream and downstream supply chain visibility. We also discuss how a divergence in the ways that BIS and the Department of Treasury Office of Foreign Assets Control (“OFAC”) construe key concepts such as support and facilitation, and in how they view the mechanics of recusal policies, may place certain U.S. person employees of non-U.S. employers and multinational firms at a higher risk of noncompliance. Additionally, we discuss BIS’s new guidance on the application of its foreign-direct product rules, and how two temporary general licenses and other features of the 2023 Amendments advance the U.S. policy of “friend-shoring” Advanced IC manufacturing.

In Section IV, we describe a BIS-acknowledged gap in its current ability to regulate AI foundational model training and other areas that BIS is now seeking further public comments to address.

II. Summary of the 2023 SME and Advanced AC/S IFR Amendments

In our client update on the 2022 Regulations, we detailed the initial steps taken by BIS to establish comprehensive controls restricting the export of technology, software, manufacturing equipment, and commodities crucial for the development of Advanced ICs, semiconductors, and supercomputers. BIS took a two-pronged approach to implement these watershed restrictions, creating (i) new Commerce Control List (“CCL”)-based Regional Stability (“RS”) controls and (ii) end-use/end-user-based controls for semiconductor manufacturing items destined for China and Macau. The RS restrictions required licenses for exports of Advanced ICs, computer commodities containing these ICs, and certain SME, along with associated software and technology, to China and Macau.[6] BIS’s end-use/end-user-based controls imposed licensing requirements for the export of specific items related to supercomputers and Advanced IC development and production based on the exporter’s knowledge of potential end uses in China or Macau.[7]

The 2023 Amendments fortify and broaden these controls in several ways.

A. SME IFR

1. Expansion of Destinations Now Requiring Licenses for SME

Perhaps the most significant change BIS has made through its SME IFR amendments is the expansion of the list of destinations for which manufacturers and distributors of SME will require export licensing. Whereas before, the licensing requirement applied only to China and Macau, it now applies to 21 other destinations for which the U.S. maintains an arms embargo (excluding Cyprus).[8] These countries are listed in Country Group D:5[9] and include Afghanistan, Belarus, Burma, Cambodia, Central African Republic, Democratic Republic of Congo, Cuba, Cyprus, Eritrea, Haiti, Iran, Iraq, North Korea, Lebanon, Libya, Russian Federation, Somalia, the Republic of South Sudan, Sudan, Syria, Venezuela, and Zimbabwe.[10] While it may seem unlikely that many of the countries now subject to these controls would be involved in Advanced IC development and production, this expansion is intended to account for the possibility that counterparties located in these jurisdictions might try to obtain SME for other end-users in other destinations, and also to apply the prohibitions to the longer list of countries that the United Nations[11] and the United States have identified as posing heightened risks for weapons of mass destruction (WMD) proliferation.

2. Elaborated SME Item Controls

The rule removes a kind of see-through ECCN 3B090 that BIS had introduced in its 2022 Regulations to control Advanced IC manufacturing equipment, the use of which had created issues for companies’ compliance systems because of the difficulty recording two ECCNs and their associated licensing requirements for the same product in their automated systems.[12] BIS now includes a specific positive list of SME items it sought to control with ECCN 3B090 in ECCNs 3B001 and 3B002.[13] In addition to refining past ECCN descriptions, the ECCN 3B001 subparagraphs impose licensing requirements on several additional types of SME that BIS has identified since its 2022 Regulations, including:

Equipment designed for silicon, carbon doped silicon, silicon germanium (“SiGe”), or carbon doped SiGe epitaxial growth with specified parameters;
Semiconductor wafer fabrication for equipment designed for ion implantation;
Equipment designed for dry etching, including isotropic dry etching;
Equipment designed for wet chemical processing and having the largest “silicon germanium-to-silicon etch selectivity” ratio of greater than or equal to 100:1;
Equipment designed for plasma enhanced chemical vapor deposition of carbon hard masks meeting specified parameters;
Spatial Atomic Layer Deposition (“SALD”) equipment having a wafer support platform that rotates around an axis having any of the following: a spatial plasma enhanced Atomic Layer Deposition (“ALD”) mode of operation, a plasma source, or a plasma shield or means to confine the plasma to the plasma exposure process region;
Equipment designed for ALD or chemical vapor deposition (“CVD”) of plasma enhanced low fluorine tungsten films;
Equipment designed to deposit a metal layer and maintain a specified vacuum or inert gas environment;
Equipment designed for depositing a metal layer and maintaining a specified vacuum or inert gas environment, including equipment designed for selective tungsten growth without a barrier and equipment designed for selective molybdenum growth without a barrier;
Equipment designed for depositing a ruthenium layer using an organometallic compound while maintaining the wafer substrate at a specified temperature;
Equipment assisted by remotely generated radicals enabling the fabrication of a silicon and carbon containing film having specified properties;
Equipment designed for void free plasma enhanced deposition of a low-k dielectric layer in gaps between metal lines with specified parameters;
Equipment designed for ion beam deposition or physical vapor deposition of multi-layer reflector for extreme ultraviolet (“EUV”) masks, EUV pellicles, and equipment for manufacturing EUV pellicles;
Equipment designed for coating, depositing, baking, or developing photoresist formulated for EUV lithography;
Semiconductor wafer fabrication annealing equipment with specified parameters;
Equipment designed for removing polymeric residue and copper oxide film and enabling deposition of copper metal in a vacuum (equal to or less than 0.01 Pa) environment;
Single wafer wet cleaning equipment with surface modification drying; and
Equipment designed for dry surface oxide removal preclean or dry surface decontamination.

The new ECCN 3B002 subparagraphs also impose new destination-based licensing requirements on the export of inspection equipment designed for EUV mask blanks or EUV patterned masks and restrict the use of certain license exceptions.

3. U.S. Person Support to the Development or Production of Advanced ICs

BIS also uses its 2023 Amendments to clarify and expand prohibitions on U.S. person support of Advanced IC development and production in certain jurisdictions—which BIS introduced in its 2022 Regulations—and to codify some of the guidance it has provided in the form of Frequently Asked Questions on the kinds of U.S. person support that now require licensing. BIS created the U.S. person support prohibition to ensure that U.S. companies and U.S. natural persons do not provide support to China or Macau-based companies, including their non-China and Macau-located subsidiaries, in their development or manufacturing of Advanced ICs, or support their acquisition of certain SME. Since the 2022 Regulations, any U.S. person involved in the shipping, transmission, transferring (i.e., from one end-user to another in the same country), or servicing the end-items or services identified to Advanced IC development or production facilities in China and Macau has required a BIS license to engage in those activities.

BIS has now broadened this control to extend to U.S. person support for development or production of Advanced ICs at any facility of an entity headquartered in (or whose ultimate parent company is headquartered in) either Macau or a country subject to a U.S. arms embargo where the production of Advanced ICs occurs.[14] BIS also similarly broadened the control on U.S. person support involving SME that can be used to produce Advanced ICs.[15] At the same time, BIS clarifies that its facility-focused support prohibition is intended to include facilities engaged in all phases of production, important late-stage product engineering or early-stage manufacturing steps (among others) may occur. However, BIS narrowed its facility-based prohibition in one important way, by limiting its scope to exclude “back-end” production steps, such as assembly, testing, or packaging steps that do not alter the technology level of an IC.[16]

Additionally, BIS added an exclusion for U.S. persons employed or working on behalf of a company headquartered in the United States or a destination specified in Country Group A:5 or A:6 and not majority-owned by an entity that is headquartered in Macau or a destination specified in Country Group D:5.[17] Country Groups A:5 or A:6 include U.S. allies and other countries that have adopted export controls similar to those of the United States, such as the United Kingdom (U.K.), Japan, South Korea, and Taiwan, and members of European Union (E.U.) and NATO, among others.[18]

4. Temporary General License for Continuing SME-Related Exports to Embargoed Countries and Macau

Amidst BIS’s expanded destination and item-based licensing requirements, BIS has also issued a new Temporary General License (“TGL”), which is valid through the end of 2025, to authorize companies headquartered in the United States, allied countries, and countries that maintain similar export controls to continue shipping less sensitive items to manufacturing facilities located in an arms embargoed country or Macau for limited purposes.[19] BIS intends this TGL to allow additional time for Advanced IC and SME producers located in the United States and the Group A:5 and A:6 countries, to identify alternative supply chains outside of arms embargoed countries.[20]

B. Advanced IC and Supercomputing IFR

The AC/S IFR maintains the licensing requirements from the 2022 Regulations and makes two types of updates to the 2022 Regulations to address efforts by China and others to circumvent the new Advanced IC licensing requirements in different ways. The first is an addition to its item-based control parameters for Advanced ICs. The second are a set of additional measures BIS has designed to address other types of circumvention risks.

1. BIS Has Added a New Parameter to Its Advanced IC Description to Reflect the Potential for Aggregate Computing Power

The AC/S IFR adds a new control parameter in the ECCN description for Advanced ICs, found in ECCN 3A090. Advanced ICs now include any ICs that meet or exceed the preexisting performance thresholds set in the 2022 Regulations or a new “performance density”[21] parameter. The “performance density” parameter recognizes that those seeking to use Advanced ICs for AI foundational model training to support specific military and intelligence applications can acquire many smaller, less or non-controlled ICs and then combine them to achieve the processing power and related capabilities that Advanced ICs provide.

While this new parameter may better reflect reality, the introduction of this new threshold will be a challenge for some companies to apply. Not only do many companies lack the types of engineering talent required to determine whether this control threshold has been met, but depending on their business model, some exporters might be required to perform this calculation for thousands of products. Compounding the difficulty, companies whose ICs, electronic assemblies, components, or computers incorporate parts from multiple suppliers may lack sufficient technical information regarding the parts to make the calculation, necessitating the need for outreach and technical exchange with manufacturers who may be reluctant to share the requested information for a variety of reasons. Given these factors, it may be difficult for many companies to perform the required calculations to determine whether their products pass the threshold and therefore require export control licensing.

2. 2023 Amendments Seek to Prevent the Circumvention of Its New Controls in Several Ways

The AC/S IFR also addresses circumvention risk in other ways.

a. Foreign Direct Product Rule

In its 2022 Regulations, BIS introduced two new foreign direct product (“FDP”) rules to reach non-U.S.-origin products used in advanced computing and supercomputers.[22] The 2023 Amendments expand the scope of the Advanced Computing FDP rule by expanding the destinations covered by the rule to cover Macau, all countries subject to an arms embargo (except Cyprus). Further, the new restrictions expand the scope of the restrictions worldwide whenever an exporter has “knowledge” that the items controlled by the rule are destined for any entity headquartered in, or whose ultimate parent company is headquartered in this expanded set of destinations. These changes are aimed at preventing companies from countries of concern from securing Advanced ICs directly or indirectly through their foreign subsidiaries and branches.

b. Advanced IC Licensing Requirements

To limit diversion risk of Advanced ICs, the AC/S IFR expands an ECCN-based license requirement for their export to any destination specified in Country Groups D:1, D:4, and D:5 (excluding Cyprus and Israel).[23] These items include the Advanced ICs and electronic assemblies, components, and computers described in the ECCN 3A090 and 4A090 subparagraphs, respectively, and to items BIS now specifies in new “.z” paragraphs that BIS has added to nine ECCNs to more easily identify items that meet or surpass the ECCN 3A090 and 4A090 control parameters.[24] BIS will review license applications for exports of these items to Macau or D:5 countries with a presumption of denial and license applications for exports to other countries with a presumption of approval, unless the recipient is headquartered in, or their ultimate parent company is headquartered in, either Macau or in any one of the embargoed countries to which the licensing requirement applies.[25]

At the same time, BIS also has created a new license exception – Notified Advanced Computing (“NAC”) – which will authorize exports of certain Advanced ICs and associated items to Group D countries, but will also enable BIS to monitor and track which Group D:1, D:4, and D:5 country end-users are seeking these Advanced ICs and for what purpose. NAC will be available to authorize exports to end users in all of these countries, but like all license exceptions, exporters are required to report their use in their export clearance filings (i.e., Electronic Export Information – “EEI,” filings).[26] Exporters of Advanced ICs to Country Group D:5 countries and Macau also will need to notify BIS of their intent to export the controlled ICs to end users in these destinations and then wait 25 days for BIS to evaluate the proposed export.[27] Moreover, in order to use License Exception NAC, the export must be made pursuant to a written purchase order (unless the export is for commercial samples) and cannot involve any prohibited end users or end uses (including “military end users” or “military end uses” as defined in the U.S. Export Administration Regulations (“EAR”)).[28]

BIS has also issued a second Temporary General License, valid through December 31, 2025, authorizing the export of Advanced ICs and electronic assemblies, components, and computers that contain Advanced ICs, and their associated software and technology to certain facilities in Country Groups D:1, D:4, and D:5 in order to enable companies to continue using facilities in these countries to perform more limited manufacturing tasks such as assembly, inspection, testing, quality assurance, and distribution.[29] Importantly, this TGL can only be used when the items being manufactured are not destined for ultimate end use in these countries, however, and the license cannot be used by a company that is headquartered in or whose ultimate parent is located in Macau or a destination specified in Country Group D:5.[30] We discuss the policy rationale for this TGL further in the next section.

c. 2023 Amendments’ End-Use Controls Revisions

The 2022 Regulations introduced a new end-use prohibition on the export of certain items when the exporter knows at the time of the export that the items will be used for a specified end use. In response to several public comments received on the 2022 Regulations, BIS substantially revised the format and content of the end-use licensing requirements and introduced a tiered license application review policy.

Consistent with other restrictions discussed above, BIS’s 2023 Amendments expanded the destination and end-use scope of the prohibitions beyond China and Macau to any destination subject to a U.S. arms embargo (Country Group D:5). BIS also further tailored its end-use licensing requirements depending on the items to be exported. For example, the export of items subject to U.S. export controls that will be used in almost any activity involving supercomputers, or that will be incorporated into or used in the development or production of components or equipment that will be used in supercomputers require a license. Another end-use licensing requirement applies to the exports of advanced computing items now described in ECCN “z” entries to any destination outside of the Group D countries if one knows that they are destined for use by a company that is headquartered in, or whose ultimate parent company is headquartered in, either Macau or an arms embargoed country. Tellingly, the example BIS provides for this end-use prohibition is the knowing export of one of the specified items to a China-headquartered cloud or data server provider located in a destination not otherwise excluded to, for example, train AI models in ways that would be contrary to U.S. national security interests. An additional, new end-use seeks to prevent entities located in Macau or an embargoed country from exporting ECCN 3E001 technology for use in making Advanced ICs to any production facility worldwide without a license. BIS also crafted an end-use licensing requirement for exports of certain kinds of SME when the exporter knows that they will be used in the development or production of front-end IC production and associated components, assemblies, and accessories.

No license exceptions are available to overcome the above licensing requirements, but BIS has established a tiered system for reviewing licenses. Specifically, license applications for Macau and destinations specified in arms embargoed countries will be reviewed with a presumption of denial. Whereas proposed exports involving other destinations and uses will be reviewed either under a on a case-by-case basis policy or a policy presumption of approval.

d. Due Diligence

Finally, BIS also provides additional guidance on its due diligence expectations and on the types of red flags that exporters should be looking when they are trying to determine whether a proposed export will require licenses. We analyze BIS’s diligence guidance and its expanding diligence expectations further in the next section.

III. Analysis

A. The Importance—and Challenge—of Being Diligent

BIS’s 2022 Regulations significantly increased the diligence responsibilities of transaction parties involved in semiconductor and semiconductor equipment development and production. For example, companies anywhere in the supply chain have had to review whether their products may be ultimately provided to semiconductor fabrication facilities engaging in Advanced IC manufacturing, to ultimately support the development or production of certain controlled equipment, or to ultimately be incorporated into a supercomputer—even when they were several steps removed from the final product. Over the past year, we supported many clients whose products are used in semiconductor development and production to map their upstream and downstream supply chains for particular products, develop new tools for gathering the required information, and rewrite their compliance procedures to ensure the relevant information is gathered and licensing analysis completed at the appropriate times.

The 2023 Amendments reflect BIS’s continuing and expanded expectation that companies should exercise heightened due diligence when dealing with the semiconductor and advanced computing industries in China. How important private sector diligence is to BIS’s implementation of these new controls is evident by how often BIS used the words “diligence” (26 times) and some formulation of the words “know/known/knowable/knowledge” (84 times) across the 2023 Amendments. BIS’s efforts to control Advanced IC, supercomputing, and SME development, supply chains, and use away from the countries targeted by the 2023 Amendments depends on private sector companies making new investments in their due diligence systems.

Not surprisingly, BIS received several comments from the public regarding the challenges of the diligence responsibilities imposed under the 2022 Regulations. In the SME IFR, BIS acknowledged public comments that companies further up the supply chain do not have full visibility into the specific operations of the end-user facilities.[31] In the AC/S IFR, BIS summarized (although disagreed with) public comments that its controls “represent[] an unprecedented burden shift” by “effectively mandat[ing] diligence via a licensing requirement.”[32] Ultimately, BIS did not relieve parties from the responsibility to be diligent, stating that China’s activities “warrant[] imposition of a higher level of affirmative duty to ‘know’ in order to not be subject to a license requirement.”[33]

Rather, BIS provided additional guidance on how to meet its expanding diligence expectations.

Know Your Customer Guidance and Red Flags. BIS updated its existing Know Your Customer Guidance and Red Flags to add additional red flag indicators, including a customer’s marketing materials, representations, and anticipated or intended future capabilities.[34] Following the 2022 Regulations, BIS had issued the FAQs for Interim Final Rule that stated that a reasonable level of due diligence for U.S. support activities outlined in 15 C.F.R. 744.6 include the “review of publicly available information, capability of items to be provided or serviced, proprietary market data, and end-use statements.” In response to a public comment BIS confirmed in the AC/S IFR that it expects companies to apply the same kinds of diligence to ensure their compliance with the SME end-use prohibitions.[35] Both guidance documents confirm that transaction parties must be vigilant even to aspirational development or production of their counterparties (and parties down the supply chain), which BIS acknowledged to be a “moving target.”[36]

End-User/End-Use Certification. In the 2022 Regulations, BIS provided a voluntary model end-user/end-use certification to assist people in applying the new FDP rules.[37] In the AC/S IFR, BIS clarified that the model certificate can be used with all FDP rules to ease the compliance burden. That said, BIS still stated that the certification is neither necessary to be obtained from all counterparties in China,[38] nor sufficient or determinative without other due diligence steps.[39] Rather, “[t]he exporter, reexporter, or transferor must evaluate all the information that it obtains during the normal course of business to determine if it has ‘knowledge’ that the item is ultimately destined for use in a prohibited activity.”[40] While the certification conveniently summarizes in one place which FDP rules apply to the product, note that completing such a certificate could require exporters to complete more than a dozen different permutations of the FDP rule analysis for every item the certificate is meant to accompany. We further discuss the unique burden of FDP rule analysis below.

Entity List. Alongside its 2023 Amendments, BIS also published a Federal Register notice adding 13 entities involved with developing large AI models and AI enabling ICs for defense purposes using U.S.-origin items to its Entity List. The additions were made in part to address public comments requesting that BIS publish a positive list of “semiconductor fabrication facilities” of concern.[41] BIS noted that while it intends to continue to “add additional entities to the Entity List as they are identified and approved by the End-User Review Committee,”[42] parties must still “do their own due diligence when dealing with parties not identified on the Entity List with a footnote 4 designation.”[43] BIS did not specifically respond to public comments that the due diligence would require significant efforts and may lead to disparate conclusions from exporter to exporter.

Although the 2023 Amendments provide some much-needed guidance, they also make it evident that BIS has high expectations for the private sector to be at the forefront of handling complex due diligence. Given the need to review multiple information sources, even including a counterparty’s aspirational development or production of technology, this type of screening is especially difficult to automate, and companies with relevant products will need to expend more compliance resources to fully address BIS’s heightened diligence expectations.

B. BIS’s U.S. Person Support Clarifications Place Certain Kinds of U.S. Person Employees at Higher Risk of Noncompliance

As noted above, BIS’s 2022 Regulations and 2023 Amendments revised the EAR’s U.S. Persons controls to ensure that U.S. persons are prohibited from supporting advanced semiconductor manufacturing in China and Macau without specific authorization from BIS. “U.S. persons” can refer to both juridical persons organized under the laws of the United States and their foreign branches, natural persons who are U.S. citizens, permanent legal residents, or refugees and asylees, and any other person located in the United States.[44] Note here that any persons located in the United States can include the U.S. located operations of non-U.S. companies. For multinational companies, including those based in jurisdictions of U.S. allies, this creates the need to evaluate whether the involvement of any U.S.-based personnel or operations in their non-U.S. origin transactions might also bring them within the scope of these new U.S. person support prohibitions.

With respect to natural persons, BIS reaffirms in its guidance that U.S. natural persons employed by non-U.S. Persons must comply with these end-use controls but notes that if a non-U.S. employer engages in transactions that U.S. natural person employees are restricted from performing, employees can excuse themselves from those types of activities or obtain a BIS license as needed.[45] BIS specifically notes that these activities include the shipping, transmitting, or transferring (in-country) to or within China or Macau (and the facilitation and servicing thereof) any item not subject to the EAR that the employee knows will be used to develop integrated circuits at China and Macau advanced IC fabrication facilities.[46] BIS rejected a broader construal of “support” to include performing any contract, service, or employment that one would know may assist or benefit advanced semiconductor fabrication in China.[47] BIS also codified past guidance it had provided in FAQs, noting that restricted facilitation does not include:

administrative, clerical, legal advice, or regulatory advice activities, including counseling on the requirements of the EAR (but does include other activities directly responsible for bringing about prohibited activity);
the provision of back-office services helping the business function (including IT services, financial services, or human resource support);
order intake and processing;
invoicing and cash or receivables collection activities; and
referring matters to non-U.S. persons.[48]

BIS also notes that the following two activities would typically be prohibited facilitation, but that BIS has authorized them so a U.S. person employee can engage in them:

trade compliance clearance of licensed shipments with China semiconductor customers including Entity List parties; and
providing administrative and limited servicing support for shipments to Entity List parties authorized by BIS licenses.[49]

BIS also lessened the compliance burdens for U.S. employees of companies that are headquartered in specified countries by excluding them from the requirement to obtain a license for these activities.[50] These countries include those in Country Group A:5 and A:6, provided that they are not majority-owned by an entity headquartered in Macau or Country Group D:5.

But for U.S. employees of companies whose roles do not meet the exclusion criteria, BIS does not address the possibility that employees may not be permitted to exclude themselves from performing their job requirements. Nor does BIS consider that their employers may not permit them to gather and provide the kind of information that BIS will require for its U.S. person support license applications, including detailed descriptions of planned production and sales of SME and Advanced ICs whose export BIS otherwise would not have jurisdiction to control. BIS was even less accommodating for U.S. natural persons who serve in executive roles in non-U.S. and non-Country Group A:5 and A:6 headquartered companies.

In response to a public comment asking whether BIS would presume that a company’s executives facilitated a restricted transaction even when they did not have knowledge of a violative transaction, BIS refused to provide a general response and went further to note that efforts by executives to limit the information that would normally come to them could result in an EAR violation if these steps were taken to avoid EAR licensing requirements.[51] We note BIS’s specific guidance on this point, like BIS’s guidance that restricted facilitation does not include referring opportunities to non-U.S. persons, is in direct opposition with the acceptable use recusal policies as compliance tools for U.S. economic sanctions, which allow U.S.-person executives and other decision makers to limit the executives’ access to information and their need to approve transactions that the company can engage in but a U.S. person cannot. As a result of BIS’s conflicting guidance on recusal, U.S. person executives who continue to work at non-U.S. semiconductor-focused companies could now find themselves at higher risk of violating U.S. export controls if they adopt more typical sanctions-focused recusal policies that limit the information they receive.

C. BIS Has Provided Some (But Not Enough) New Foreign Direct Product Rule Guidance

One of most significant expansions of U.S. export control jurisdiction over the last decade has been accomplished through BIS’s introduction of new FDP rules. Indeed, the number of FDP Rules has grown from a single National Security FDP rule in 2013 to now nine different FDP rules (each with at least two permutations) and differing use cases. Through the operation of FDP rules, BIS deems certain non-U.S. origin items located outside of the United States to be subject to the EAR’s licensing requirements when the items are a “direct product” of specified “technology” or “software,” or are produced by a complete plant or “major component” of a plant that itself is a “direct product” of the specified “technology” or “software.”

Although the FDP rules vary in scope and target, by making non-U.S. origin items subject to the EAR, they give the U.S. Government the jurisdiction to control where and to whom the affected items can be exported. Moreover, the FDP rules can create the foundation to further extend U.S. jurisdiction to other non-U.S. origin items that incorporate qualifying foreign direct products. Once foreign items become subject to the EAR via an FDP rule, those who seek to incorporate or bundle them into or with other non-U.S. origin items need to further consider other bases of U.S. jurisdiction over the other item, such as the EAR’s De Minimis Rule, which controls non-U.S. origin items that contain controlled (i.e. license requiring) U.S. content above various thresholds depending on the content and the item’s destination. For example, in the SME IFR, BIS also amended its De Minimis Rule to set a 0% de minimis threshold for certain specialized lithography equipment, meaning that any non-U.S. origin system containing this kind of equipment is subject to U.S. export controls.

The 2023 Amendments make significant changes to the Advanced Computing FDP rule, which BIS introduced in its 2022 Regulations. First, BIS significantly expands jurisdictions and companies impacted by the Advanced Computing FDP Rule, which previously was only applicable to exports to China and Macau. Under the revised Advanced Computing FDP Rule, BIS has implemented a worldwide licensing requirement for the export of foreign direct product Advanced ICs when they are being exported to; incorporated into any parts, components, computers, or equipment destined to; or for any company that is headquartered in any destination subject to a U.S. arms embargo or whose ultimate parent company is headquartered in any of those countries.[52] As such, this expanded rule, in addition to adding licensing requirements applicable to both U.S. and non-U.S. persons related to exports destined for an additional 21 countries, also seeks to prevent companies from these countries from bypassing these restrictions and securing controlled ICs through their foreign subsidiaries and branches. Additionally, BIS uses the IFR to complete a bit of housekeeping to make parallel the different FDP rules, removing ambiguities caused by slight variations in phrasing that had accumulated over recent amendments to the EAR. [53]

However, BIS’s amendments did not include clarification of a fundamental concept that BIS uses in its FDP rules. FDP rule analyses are among the most complex required by the EAR and the burden of completing FDP analyses falls most squarely on non-U.S. companies or companies producing their products outside of the United States. FDP Rule analysis requires a detailed understanding of the software and technology that is being used to not only produce one’s own product, but also of any equipment one is using in the production process and this equipment’s development and production software and technology. Despite regular exporter confusion regarding what constitutes a “major component” sufficient to bring an item that is used in the production of an item within the scope of the FDP rules, the 2023 Amendments do not provide any meaningful additional guidance. Indeed, the included definition, which defines a “major component” as “‘equipment’ that is essential to the ‘production’ of an item,”[54] is largely identical to the vague definition included in previous iterations. Given the limited guidance BIS has provided regarding how to distinguish a “major component” from, say, a minor component or any other item that is used in a production process through rulemaking, informal FAQs, or other guidance, foreign companies will have to assess for themselves whether the function of any equipment they identify as essential to the production process may be a “major component” subject to the relevant FDP rule.

FDP rule analyses also impose other indirect costs. At least for now, many non-U.S. companies that make up IC supply chains use equipment that may be the product of U.S. software or technology. However, non-U.S. companies often do not have sufficient information regarding the development and production history of their equipment to determine whether it might be the direct product of controlled software or technology. As a result, different manufacturers of similar products may come to differing conclusions regarding the applicability of U.S. export control requirements, which not only undermines their efficacy, but also leaves companies that get the analysis wrong potentially subject to BIS enforcement. In light of the uncertainties and attendant risks associated with using U.S. equipment, many companies may opt to eliminate U.S. equipment from their production processes altogether.

D. How Temporary General Licenses and Allied Country Exclusions Promote “Friend-shoring” of the Development and Production of Critical Technologies like SME and Advanced ICs

BIS is using several amendments to encourage the “friend-shoring”[55] of Advanced IC manufacturing. These include the two Temporary General Licenses discussed in Section II and BIS’s use of Country Group A:5 and A:6 exclusions.

Although the TGLs discussed in Section II allow companies headquartered in the United States or Country Group A:5 or A:6 countries continue exporting to and producing certain Advanced ICs in Group D countries, and to continue using facilities in these jurisdictions to develop and produce less restricted SME parts, components, and equipment at the direction of companies, the terms of these TGLs only extend through December 31, 2025.[56] The uncertainty surrounding whether BIS will extend these terms acts to incentivize companies located in the U.S. and in eligible countries to relocate their supply chains to their own or other allied jurisdictions during the TGL’s limited term.

BIS has also granted Group A:5 and A:6 headquartered companies varying exclusions from the presumption of denial for all licenses requests under its end-use controls on supercomputing and semiconductor manufacturing. Its updated license review policy includes a presumption of approval where the end user of the product is headquartered in Country Groups A:5 or A:6, provided that they are not majority-owned by an entity headquartered in either Macau or a destination specified in Country Group D:5.[57] By applying restrictions on exports to Group D countries while simultaneously privileging allied countries and affording them more favorable license treatment, the U.S. signals that allied countries will remain a “safe harbor” for Advanced IC manufacturing.

Similarly, allowing exports by these companies of less restricted items used in the production of SME to Country Group D:5 countries can channel the development of more advanced SME away from these countries. These exclusions and more refined licensing requirements help to minimize the immediate effects of the U.S. Government’s unilateral controls on allied country companies, enabling them to continue using historical supply chains for certain activities while acting as a kind of carrot to lead their governments to adopt analogous controls going forward.

IV. BIS Acknowledges a Big Gap in Its Regulations and Requests Public Comments

Despite the significant regulations implemented in October 2022 and October 2023, BIS acknowledges that regulatory gaps still exist. A significant one relates to use of datacenter Infrastructure as a Service (IaaS) offerings for AI training. Specifically, China and other countries impacted by the new rules can potentially bypass controls on “supercomputers” through the rental or leasing of the computing power required for training AI foundational models on IaaS platforms.

While current regulations restrict engagements with supercomputing efforts in China and Macau, and the 2023 Amendments expand the country scope of these restrictions, IaaS solutions can still enable the offloading of China’s computational workloads to computers in other countries, which would allow it to circumvent U.S. export controls on Advanced IC-enabled supercomputing. The risk is especially magnified in light of the absence of multilateral end-use/end-user controls in this arena. BIS continues to review the potential for such circumvention and how a regulatory response could mitigate the issue and notably, specifically seeks public comments on how it could use regulatory tools to address access to IaaS provided AI “development” by customers who might use them to develop large dual-use AI foundation models with potential capabilities of concern, such as models exceeding certain thresholds of parameter count, training compute, and/or training data.[58]

BIS also requests public comments on a number of other issues, including on how BIS could use technical parameters to distinguish Advanced ICs and computers more commonly used for small or medium scale training of AI foundational models from those used for large AI foundational models with different capabilities of concern.[59] BIS also asks companies to assess the impact of imposing licensing requirements on the use of foreign national employees to support Advanced IC and SME, and to share what practices they already use to safeguard technology and intellectual property, among other questions.[60]

Although BIS did not accept every commenter’s suggested revisions to the 2022 Regulations in this latest round of amendments, many of the amendments BIS did make reflect a recognition by BIS that EAR control parameters need to be regularly updated and that it should, whenever possible, try to minimize the unintended collateral impacts its new regulations are having on companies worldwide. BIS’s recent changes to its public comment process, which allow companies to submit both public and business confidential information that will not be published, now lower the risk that companies can provide technical and other business proprietary information to better inform BIS’s future rulemaking. BIS will accept public comments on its 2023 Amendments until December 17, 2023.

* * *

We work every day to help companies apply complex export controls to their business operations and to build compliance and licensing strategies to address export controls in integrative and business savvy ways. We also regularly work with clients to monitor and filing public comments and to develop briefings that better inform BIS’s policies and licensing decisions. We welcome the opportunity to support you.

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[1] Dep’t of Comm. Bureau of Ind. and Sec., Export Controls on Semiconductor Manufacturing Items Interim Final Rule (Oct. 17, 2023) (hereinafter “SME IFR”); Dep’t of Comm. Bureau of Ind. and Sec., Implementation of Additional Export Controls: Certain Advanced Computing Items (Oct. 17, 2023); Dep’t of Comm. Bureau of Ind. and Sec., Supercomputer and Semiconductor End Use; Updates and Corrections Interim Final Rule (Oct. 17, 2023) (hereinafter “AC/S IFR”).

[2] Most of changes made to licensing requirements in the 2023 Amendments apply to exports, re-exports, and transfers (in country). For ease of reference, we refer to all three types of shipments as “exports” in this alert, and will only specific re-exports or transfers when an amended regulation applies to fewer shipment types.

[3] Press Release, U.S. Dep’t of Comm. Bureau of Ind. and Sec., “Commerce Strengthens Restrictions on Advanced Computing Semiconductors, Semiconductor Manufacturing Equipment, and Supercomputing Items to Countries of Concern” (Oct. 17, 2023), https://www.bis.doc.gov/index.php/component/docman/?task=doc_download&gid=3355.

[4] Id.

[5] Id.

[6] 15 C.F.R. § 742.6.

[7] 15 C.F.R. § 744.23.

[8] 15 C.F.R. §§ 742.4(a)(4), 742.6(a)(6)(i) (as of Nov. 17, 2023). BIS uses the long formulation “Group D:1, D:4 and D:5 countries, when the countries are not also specified in Group A:5 and A:6” in several places in the 2023 Amendments. As of today, there are only two countries, Cyprus and Israel, that appear in Groups A:5 or A:6 and also on any Group D list. Accordingly, we use the short hands “(excluding Cyprus)” when referring to targeted arms embargoed destinations and “(excluding Cyprus and Israel)” when referring to the broader targeting of Group D countries, throughout this alert. Please note that the Country Group lists are subject to revision. A full list of the Country Groups can be found in Supplement No. 1 to Part 740 of the EAR, linked here.

[9] The Export Administration Regulations (“EAR”) use Supplement No. 1 to 15 CFR Part 740 to identify groups of countries which are subject to different licensing policies based on United Nations sanctions, U.S. national security and foreign policy grounds, or as a result of their participation in different international treaties and other export control and non-proliferation focused plurilateral agreements. Supplement No. 1 is used not only to define licensing requirements, but also eligibility for different EAR license exceptions. Importantly, country groupings are nonexclusive and certain countries can appear in more than one group which complicates BIS’s efforts easily identify the subsets of countries to which different regulatory provisions apply.

[10] See 15 C.F.R. Part 740, Supplement No. 1.

[11] Some of the countries identified in Country Group D:5 are under United Nations-mandated arms embargoes.

[12] See SME IFR 54.

[13] Id.

[14] 15 C.F.R. § 744.6(c)(2)(i) (as of Nov. 17, 2023).

[15] 15 C.F.R. § 744.6(c)(2)(iii) (as of Nov. 17, 2023).

[16] 15 C.F.R. § 744.23(a)(5) (as of Nov. 17, 2023).

[17] 15 C.F.R. § 744.23(a)(3) (as of Nov. 17, 2023).

[18] See 15 C.F.R. Part 740, Supplement No. 1 for a full list of destinations within Country Groups A:5 and A:6.

[19] Supplement No. 1 to Part 736(d)(2) (as of Nov. 17, 2023).

[20] SME IFR 6-7, 70.

[21] BIS defines performance density as Total Processing Performance (“TPP”) divided by “applicable die area.” TPP is “2 x ‘MacTOPS’ x ‘bit length of the operation’, aggregated over all processing units on the integrated circuit.” The applicable die area for the ECCN 3A090 measurement is measured in millimeters squared and includes all die area of logic dies manufactured with a process node that uses a non-planar transistor architecture.

[22] 15 CFR §§ 734.9(h), (i) (as of Nov. 17, 2023).

[23] 15 C.F.R. § 746.2 (as of Nov. 17, 2023). Expanding the requirement that previously applied only to China and Macau.

[24] AC/S IFR 68.

[25] 15 CFR § 742.6(a)(10) (as of Nov. 17, 2023).

[26] 15 CFR § 740.8 (as of Nov. 17, 2023).

[27] 15 CFR § 740.8(a)(2) (as of Nov. 17, 2023).

[28] 15 CFR § 740.8(a)(1) (as of Nov. 17, 2023).

[29] Supplement no. 1 to part 736(d)(2) (as of Nov. 17, 2023).

[30] Id.

[31] See SME IFR, supra note 1, 51.

[32] AC/S IFR, Topic 62.

[33] AC/S IFR, Topic 61; see also SME IFR, Topic 51.

[34] Supplement No. 3 to Part 732.

[35] AC/S IFR, Topic 48; BIS, FAQs for Interim Final Rule, https://www.bis.doc.gov/index.php/documents/product-guidance/3181-2022-10-28-bis-faqs-advanced-computing-and-semiconductor-manufacturing-items-rule-2/file.

[35] AC/S, Topic 53.

[36] AC/S IFR, Topic 53.

[37] Supplement No. 1 to Part 734.

[38] See AC/S IFR, Topic 47.

[39] See SME IFR, Topic 49.

[40] SME IFR, Topic 49.

[41] SME IFR, Topic 23.

[42] SME IFR, Topic 23; AC/S, Topic 47.

[43] SME IFR, Topic 23.

[44] 15 C.F.R. § 772.1.

[45] SME IFR, Topic 63.

[46] 15 C.F.R. §746.6(c)(2) (as of Nov. 17, 2023).

[47] SME IFR, Topic 58.

[48] SME IFR, Topic 60.

[49] Id.

[50] Id.

[51] SME IFR, Topic 62.

[52] 15 C.F.R. § 734.9(h) (as of Nov. 17, 2023). BIS specifically exempts companies located in Cyprus and Israel through its exclusion note on Group A:5 and A:6 countries.

[53] See AC/S IFR, 100.

[54] BIS, Foreign-Produced Direct Product (FDP) Rule as it Relates to the Entity List §736.2(b)(3)(vi) and footnote 1 to Supplement No. 4 to Part 744, updated October 28, 2021.

[55] The “Friend-shoring” concept first appeared in a speech by Secretary of the Treasury Janet Yellen to the Atlantic Council in April 2022. In that speech “friend-shoring” is described a form of trade integration that prevents countries from using their market position in key raw materials, technologies, or products to have the power to disrupt the U.S. economy or exercise unwanted geopolitical leverage. Janet Yellen, Remarks by Secretary of the Treasury Janet L. Yellen on Way Forward for the Global Economy, April 13, 2022.

[56] SME IFR 19.

[57] SME IFR 35.

[58] AC/S IFR 103-104.

[59] AC/S IFR 106.

[60] AC/S IFR 105.

The following Gibson Dunn attorneys prepared this alert: Christopher Timura, Mason Gauch, Chris Mullen, Claire Yi, Sarah Pongrace, Lauren Trujillo, Gerti Wilson, Alana Sheppard, Nikita Malevanny, and Adam M. Smith.

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

United States
Judith Alison Lee – Co-Chair, Washington, D.C. (+1 202-887-3591, [email protected])
Ronald Kirk – Co-Chair, Dallas (+1 214-698-3295, [email protected])
Adam M. Smith – Co-Chair, Washington, D.C. (+1 202-887-3547, [email protected])
Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, [email protected])
David P. Burns – Washington, D.C. (+1 202-887-3786, [email protected])
Nicola T. Hanna – Los Angeles (+1 213-229-7269, [email protected])
Marcellus A. McRae – Los Angeles (+1 213-229-7675, [email protected])
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, [email protected])
Christopher T. Timura – Washington, D.C. (+1 202-887-3690, [email protected])
Hayley Lawrence – Washington, D.C. (+1 202-777-9523, [email protected])
Annie Motto – New York (+1 212-351-3803, [email protected])
Chris R. Mullen – Washington, D.C. (+1 202-955-8250, [email protected])
Sarah L. Pongrace – New York (+1 212-351-3972, [email protected])
Anna Searcey – Washington, D.C. (+1 202-887-3655, [email protected])
Samantha Sewall – Washington, D.C. (+1 202-887-3509, [email protected])
Audi K. Syarief – Washington, D.C. (+1 202-955-8266, [email protected])
Scott R. Toussaint – Washington, D.C. (+1 202-887-3588, [email protected])
Claire Yi – New York (+1 212-351-2603, [email protected])
Shuo (Josh) Zhang – Washington, D.C. (+1 202-955-8270, [email protected])

Asia
Kelly Austin – Hong Kong/Denver (+1 303-298-5980, [email protected])
David A. Wolber – Hong Kong (+852 2214 3764, [email protected])
Fang Xue – Beijing (+86 10 6502 8687, [email protected])
Qi Yue – Hong Kong (+852 2214 3731, [email protected])
Felicia Chen – Hong Kong (+852 2214 3728, [email protected])
Arnold Pun – Hong Kong (+852 2214 3838, [email protected])

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

On October 18, 2023, following the signing of an electoral roadmap between Venezuela’s opposition and the regime of President Nicolás Maduro, the Biden administration announced a major relaxation of U.S. sanctions on Venezuela. The broad package of measures—which eases restrictions on Venezuela’s oil and gas sector, gold sector, and secondary trading in certain Government of Venezuela securities—represents a seismic shift from the “maximum pressure” campaign that since 2019 has prohibited virtually all U.S. nexus dealings involving key sectors of Venezuela’s energy-driven economy. From a policy perspective, such incremental, and in some cases time-limited, sanctions relief appears calculated to incentivize the Maduro regime to take concrete steps toward the restoration of Venezuelan democracy with an eye toward holding a free and fair presidential election late next year.

Notably, most U.S. sanctions on Venezuela, including a prohibition on most U.S. nexus transactions involving the Government of Venezuela, remain in effect. Moreover, the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”) has indicated that the continued availability of even partial sanctions relief is contingent upon the Maduro regime meeting its commitments under the country’s electoral roadmap, as well as with respect to individuals wrongfully detained in Venezuela. If the Maduro regime reneges on those commitments, OFAC reserves the right to amend or revoke existing licenses at any time. Those limitations notwithstanding, by authorizing a wide range of transactions involving Venezuela’s crucial oil and gas sector, the Biden administration has unveiled the most economically consequential easing of restrictions on Caracas since the advent of the Venezuela sanctions program—and opened the door to possible further sanctions relief in the months ahead.

Oil and Gas Sector

Among the measures announced in October 2023, the most impactful is Venezuela General License (“GL”) 44 which authorizes U.S. persons, until April 18, 2024, to engage in all transactions related to oil or gas sector operations in Venezuela, including transactions involving state-owned oil giant Petróleos de Venezuela, S.A. (“PdVSA”), subject to certain conditions. Crucially, that general license sets forth a non-exhaustive list of authorized activities that includes: (1) the production, lifting, sale, and exportation of oil or gas from Venezuela, and the provision of related goods and services; (2) payment of invoices for goods or services related to oil or gas sector operations in Venezuela; (3) new investment in oil or gas sector operations in Venezuela; as well as (4) delivery of oil and gas from Venezuela to creditors of the Government of Venezuela, including creditors of PdVSA entities, for the purpose of debt repayment.

The limitations included in GL 44 are relatively modest in scope. For example, that license expressly does not authorize transactions involving certain blocked Venezuelan financial institutions; transactions involving certain Russian-owned or -controlled entities; or transactions involving “new” debt that are unrelated to the payment of invoices or the delivery of oil and gas to the Government of Venezuela’s creditors. The license also excludes from its authorizations transactions involving Venezuela’s digital currency, known as the petro; dealings in debts owed to the Government of Venezuela; and the unblocking of property—which, as a practical matter, prevents the Maduro regime from accessing its holdings of cash and securities in the United States, which remain frozen.

Although GL 44 on its face is limited to an initial period of six months, with the possibility that it could at a later date be renewed if the Maduro regime delivers on its electoral promises, the license nevertheless marks the most substantial easing of U.S. sanctions on Venezuela to date.

Under the Trump administration, the United States during 2019 sharply escalated restrictions on Venezuela by imposing blocking sanctions on numerous substantial enterprises, including the state-owned oil company PdVSA, the state-owned gold mining company, the country’s central bank, and ultimately the entirety of the Government of Venezuela. Expanding on those earlier measures, the United States sought to further restrict the Maduro regime’s access to energy revenue by on multiple occasions in 2020 designating non-U.S. parties, including shipping companies and vessels, to OFAC’s Specially Designated Nationals and Blocked Persons (“SDN”) List for engaging in dealings involving Venezuelan-origin oil.

With the notable exception of a general license issued in November 2022 that authorizes certain specified transactions related to the operation and management by one named U.S. energy company of its joint ventures in Venezuela involving PdVSA, the United States had until this month continued to maintain sanctions pressure on Venezuela’s oil and gas sector. With the issuance of GL 44, U.S. persons and non-U.S. persons can potentially engage in a wide variety of U.S. nexus transactions involving Venezuela’s oil and gas sector, including exporting Venezuelan crude, investing in new energy projects, and recovering sums owed by the Government of Venezuela and PdVSA entities—including old, new, and future debts incurred in covered activities—through payments in the form of Venezuelan-origin petroleum and petroleum products.

Gold Sector

In addition to easing sanctions on Venezuelan oil and gas, the Biden administration further broadened the Maduro regime’s access to potential sources of hard currency by easing sanctions on Venezuela’s gold sector. In particular, OFAC issued a general license that authorizes, without any time limitation, most U.S. nexus transactions involving Venezuela’s state-owned gold mining company, CVG Compania General de Mineria de Venezuela CA (“Minerven”), and its majority-owned entities. Underscoring the apparent U.S. policy interest in permitting such gold-related transactions to proceed, that license authorizes U.S. persons to engage in dealings involving Minerven entities, including with the involvement of certain blocked Venezuelan financial institutions, namely the Banco Central de Venezuela or the prominent commercial lender Banco de Venezuela SA Banco Universal.

Concurrent with the issuance of that license, OFAC published guidance indicating that non-U.S. persons no longer risk becoming designated to an OFAC restricted party list such as the SDN List solely for operating in the gold sector of the Venezuelan economy. Taken together, these measures suggest a willingness on the part of the current U.S. administration to allow the Maduro regime to monetize Venezuela’s considerable natural resources.

Government of Venezuela and PdVSA Securities

Finally, in a key development for investors and financial institutions, the measures announced in October 2023 extend beyond Venezuela’s extractive industries to include an easing of sanctions on secondary trading in certain securities issued by the Government of Venezuela or PdVSA.

Since August 2017, in an effort to limit the Maduro regime’s access to long-term financing, the United States has restricted U.S. persons from dealing in certain Venezuelan sovereign bonds, plus certain debt of, and equity in, PdVSA entities. During that period, OFAC issued and repeatedly extended a pair of general licenses that until this month authorized U.S. persons to engage in all transactions related to certain specified Government of Venezuela or PdVSA securities, subject to the condition that any divestment or transfer of such securities had to be to a non-U.S. person. On October 18, 2023, OFAC further amended those two licenses by issuing GL 3I and GL 9H, which presently authorize U.S. persons to both sell and purchase such securities—thereby permitting secondary trading in specified Venezuelan sovereign bonds and specified PdVSA debt and equity.

Although the Biden administration has substantially expanded the circumstances under which U.S. persons can deal in financial instruments issued by the Government of Venezuela, two key limitations remain. Prospective investors should be mindful that, except as separately authorized by OFAC, secondary market transactions involving specified Government of Venezuela or PdVSA securities generally cannot involve blocked persons (e.g., selling such securities to, or purchasing such securities from, an SDN). Further, U.S. persons continue to be prohibited from participating in the primary market for newly issued Government of Venezuela or PdVSA securities.

Next Steps Between Washington and Caracas

In short, the recent easing of U.S. sanctions on Venezuela is noteworthy both for its breadth and for the fact that much of the relief extended to Caracas rests on a promise by the Maduro regime to in the future take further steps toward the restoration of Venezuelan democracy. As it remains to be seen whether the Maduro regime will ultimately hold up its end of the bargain, a further easing of U.S. sanctions on Venezuela appears unlikely, at least in the near term. However, in the event that the Maduro regime indeed takes concrete steps toward holding free and fair elections—such as lifting a ban on certain opposition candidates holding public office, allowing opposition candidates reasonable access to state-run media outlets, and permitting international observers to monitor the casting and counting of ballots—it is not out of the question that the United States could next year further ease certain remaining sanctions on Venezuelan financial institutions, Venezuelan financial instruments, or conceivably the Government of Venezuela itself.

The following Gibson Dunn lawyers prepared this client alert: Erika Suh Holmberg, Scott Toussaint, Annie Motto, Adam M. Smith, and Rahim Moloo.

International Trade Group:

International Arbitration Group:

Cyrus Benson – Co-Chair, London (+44 20 7071 4239, [email protected])
Penny Madden KC – Co-Chair, London (+44 20 7071 4226, [email protected])
Rahim Moloo – Co-Chair, New York (+1 212-351-2413, [email protected])

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.

Worldwide Carbon Markets Continue to Grow

In May, the World Bank published its 2023 State and Trends of Carbon Pricing. Almost a quarter of the world’s emissions are now covered by carbon credits, up from just 7% a decade ago. The voluntary market remains the primary driver behind carbon credit market activity.

But regulatory mechanisms are becoming increasingly common, with several nations implementing new carbon regulations this year and many more teeing up for future rollouts. While the United States federal government has recently favored funding green supply chains, the European Union and the rest of the world are increasingly adopting carbon trading schemes and carbon taxes.

The World Bank noted that carbon offset prices and issuances fell relative to the prior year. Some of this is likely due to concerns and criticisms about carbon offsets, tougher economic conditions, and supply bottlenecks. Additionally, standardizing contracts within the marketplace appears to be increasing liquidity and putting downward pressure on carbon trading. Among regulatory carbon markets, prices for the EU emissions trading system (“ETS”) fell mid-year before bouncing back, for example, while both New Zealand’s and Korea’s ETS prices remain low. Within the voluntary carbon market, buyers tended to prefer newer vintages over old ones and renewable energy projects over nature-based credits. Prices for credits are expected to rise once again.

Read More

The following Gibson Dunn lawyers assisted in the preparation of this alert: Abbey Hudson, Brad Roach, Lena Sandberg, Arthur Halliday, Yannis Ioannidis, Alexandra Jones, Virginia Somaweera, Mark Tomaier, Richie Vaughan, 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, Energy, or Tax practice groups, or the following authors:

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

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

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

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

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

Tax Group:
Michael Q. Cannon – Dallas (+1 214-698-3232, [email protected])
Matt Donnelly – Washington, D.C. (+1 202-887-3567, [email protected])

We are pleased to provide you with Gibson Dunn’s Accounting Firm Quarterly Update for Q3 2023. The Update is available in .pdf format at the below link, and addresses news on the following topics that we hope are of interest to you:

PCAOB Continues Aggressive Standard-Setting Activity
PCAOB Staff Report Finds 40 Percent of Audits Have Part I.A Deficiencies
SEC Chief Accountant Issues Statements on Crypto Assurance Work and Risk Assessment
Second Circuit Decertifies Investor Class in Long-Running Dispute
UK Supreme Court Strikes Down Litigation Funding
NYSE and Nasdaq Listing Standards on Clawbacks Take Effect
New York DFS Proposes Second Amendment to Cybersecurity Regulation
California Broadens Restrictions on Employee Non-Competes
California Passes Legislation Establishing Climate-Related Reporting Requirements
Other Recent SEC and PCAOB Regulatory Developments

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

Read More

Accounting Firm Advisory and Defense Group:

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

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

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

In addition to the Accounting Firm Advisory and Defense Practice Group Chairs listed above, this Update was prepared by David Ware, Timothy Zimmerman, Benjamin Belair, Adrienne Tarver, Monica Limeng Woolley, Douglas Colby, and Nicholas Whetstone.

On August 9, 2023, the Biden Administration issued Executive Order (“EO”) 14,105, outlining proposed controls on outbound U.S. investment in certain foreign entities.[1] The EO was accompanied by an Advance Notice of Proposed Rulemaking (“ANPRM”) issued by the U.S. Department of the Treasury (“Treasury”) seeking information regarding implementation of the EO.[2] In an earlier update, Gibson Dunn explained Treasury’s ANPRM and the complicated compliance landscape it proposed to create.

As part of the rulemaking process, Treasury opened a 45-day window to allow for public comment on the ANPRM that closed on September 28, 2023. Treasury requested feedback on a broad list of 83 questions.[3] The comment period generated significant interest from industries that will be affected by the potential outbound investment regime (the comments may be viewed in full at Regulations.gov). Major actors in the investment community; manufacturers; semiconductor, microelectronics, and quantum companies; financial institutions; and trade associations all weighed in with broad and specific comments. Across industries, commenters emphasized the need for more clarity, narrower coverage to prevent chilling of investment and spill-over into non-targeted industries, and wider exemptions.

As discussed in our previous update, it is very rare for Treasury to conduct a notice and comment rulemaking process under the International Emergency Economic Powers Act (“IEEPA”), the authority offered in the EO. Thus, significant uncertainty remains surrounding the proposed rule’s implementation or how comments will factor in. The discussion below lays out certain key unresolved issues and concerns raised in the submitted comments.

I. Clearer definitions and guidance regarding covered U.S. persons, covered foreign persons, and “country of concern”:

First, many commenters noted that the definitions are vague with respect to which U.S. actors or investors, foreign partners, and types of investments and transactions are subject to the restrictions.

1. Clarify which “U.S. persons” are covered by the rule.

The ANPRM proposes to adopt the definition of “U.S. person” set out in the EO, which comports with the standard definition in U.S. sanctions practice, and includes “any United States citizen, lawful permanent resident, entity organized under the laws of the United States or any jurisdiction within the United States, including any foreign branches of any such entity, and any person in the United States.”[4]

Commenters asked Treasury to clarify that the obligation to comply with the EO applies only to the U.S. person entity or individual undertaking the covered transaction and not to other parties involved in or tangential to the transaction, including third-party financial institutions.[5]
Commenters also recommended Treasury clarify the status of dual citizens under the regulations.[6]
Commenters further noted that the definitions of U.S. persons and covered foreign person should be made mutually exclusive to prevent situations where a company is classified as both.[7]
Similarly, many commentators noted that the definition of U.S. person creates ambiguity as to whether non-U.S. companies that have U.S. nationals as board members or senior employees will be affected by the regulations, and requested more clarity.[8]
Commenters representing European parent companies of U.S. subsidiaries also expressed concern that they might erroneously be considered “U.S. persons.”[9]

2. Clarify the indicia for identifying a “covered foreign person”.

Treasury has proposed to define “covered foreign person” to mean either (1) a “person of a country of concern” that is engaged in, or that a U.S. person knows or should know will be engaged in, an identified activity with respect to a “covered national security technology or product”; or (2) a person whose direct or indirect subsidiaries or branches are referenced in item (1) and which, individually or in the aggregate, comprise more than 50 percent of that person’s consolidated revenue, net income, capital expenditure, or operating expenses.[10]

Many commenters indicated that the kind of information needed to make either of these two determinations is often unavailable for various reasons, meaning it will be hard for U.S. persons to comply and properly conduct due diligence. Commenters emphasized that access to Chinese banking and ownership information is not readily available, and in some cases is obscured or prohibited by China’s legal regime; thus, U.S. persons may not be able to fully assess whether covered activity comprises more than 50 percent of a foreign person’s revenue, net income, or other metrics in the ANPRM.[11]
Others noted that the 50 percent rule would fail to capture various loophole situations—for example, where a large company has a small subsidiary that is only a small portion of a large company’s revenue—making the regulations less effective.[12] They noted that the definition similarly does not clarify whether it refers to an operating company employing the personnel engaged in the covered activity, or whether a holding company may be considered “engaging in” the covered activity.[13]
Many commenters indicated that it may be hard for companies to monitor for changes in these already hard-to-get metrics over time.[14] As a solution to these issues, many urged Treasury to publish and maintain a fixed list of entities determined to be “covered foreign persons,” following the example of existing Department of Commerce restricted party lists (such as the Entity List) or Treasury sanction lists (such as the List of Specially Designated Nationals and Blocked Persons (SDN) List).[15] If Treasury does not rely on such lists, many suggested that Treasury should draw very narrow categories, including a de minimis standard that covers only entities “primarily” or “substantially” engaged in a covered activity.[16]

3. Definition of “person from a country of concern” is similarly vague and as written might create overlaps or loopholes.

Treasury has proposed multiple broad definitions of “person of a country of concern.”[17]

Many noted that these definitions are overly broad and could unintentionally restrict, for example, the formation of a joint venture or the founding of a startup between U.S. persons and individuals who have Chinese backgrounds but are lawfully resident in the United States, and suggested exempting lawful U.S. residents from this definition.[18]
To address this, some commentators encouraged Treasury to establish a greenfield and young startup exception to the definition of “person of a country of concern” as in the CFIUS context to ensure innovative businesses are founded in the U.S.[19] Others suggested Treasury clarify whether the presence of a minority investor from a country of concern will trigger restrictions on the entity.[20]

II. Compliance and obligations under the regulations:

To determine whether a transaction will be covered by the new regime, Treasury has proposed that a U.S. person would “need to know, or reasonably should know” from an appropriate amount of due diligence “that it is undertaking a transaction involving a covered foreign person and that the transaction is a covered transaction.”[21]

Commenters overwhelmingly requested clear steps and extensive guidance to make it easier for investors to comply, in addition to requests for other details on how compliance standards will be applied.

1. The due diligence obligations & “knowledge” standard are vague and should be clarified.

Many commenters feel that Treasury’s proposed due diligence standard is speculative. For example, the ANPRM standard would require U.S. persons to assess whether an entity “will foreseeably be engaged in regulated conduct.”[22]

Commenters requested more clarity for these vague phrases.
In addition, given the difficulty of determining the criteria that define covered persons and activities, multiple commenters called for Treasury to use an “actual knowledge” standard as opposed to a “constructive knowledge” standard.[23]
Many commenters also recommended Treasury adopt a “safe harbor” or a “reasonable reliance” standard, which would allow U.S. persons to rely on diligence responses from the prospective investee or foreign partner.[24]
Other commenters sought a standard that would require knowledge to be based only on information available to the U.S. person at the time of the transaction, not based on information available later.[25]To clear up ambiguity for complying parties, commenters urged Treasury to publish extensive guidance that describes relevant due diligence steps, red flags, and other specific examples of sufficient practices to meet the standard for “reasonable and appropriate” due diligence.[26]
Others suggested Treasury simply adopt the existing diligence requirements of the Export Administration Regulations (“EAR”), which would not require a new compliance standard.[27]

2. The ANPRM should be prospective, not retroactive.

Almost all commenters agreed that the EO and the regulation should be prospective, not retroactive, and most agreed that it should be applied only to transactions and investments made after finalization of the rule. One trade association for institutional limited partners urged that the final regulation only apply to financial commitments made after the finalization of the rule, as opposed to previously made commitments.[28] Some commenters highlighted that the rule is ambiguous as to whether Treasury would seek to exercise authority to unwind transactions, and urged that investments once made should not be able to be unwound or divested.[29]

3. Clarify who is liable for failure to comply with the reporting requirements.

Commenters requested Treasury confirm explicitly that such liability resides solely with the U.S. person undertaking a covered transaction, as imposing an obligation on third parties who are not legally responsible for the transaction will create practical problems, disadvantage U.S. financial institutions vis-à-vis their competitors, and will not advance the national security objectives of the EO.[30] Some commentators wanted to clarify that the filings would be a post-closing notification requirement (so as to not disadvantage U.S. investors and introduce regulatory uncertainty regarding pending transactions).[31]

III. Covered transactions and excepted/exempted transactions:

Commenters sought to clarify Treasury’s proposed covered transactions and expand its exemptions to prevent overbroad coverage. In particular, commenters sought to ensure that passive investments by both limited partners and non-limited partners, venture capital and private equity investments, and other transactions are not covered by the regulations. In addition, major financial institution and investment commenters urged Treasury to clarify that coverage does not indiscriminately restrict services provided by financial institutions to their customers with respect to covered transactions.

1. Multiple sectors request exemptions for passive investments and clarification regarding limited partners.

Most groups representing financial institutions, private equity, and venture capital urged Treasury to clarify and expand exemptions for passive investments.

Commenters representing investors urged Treasury to permit limited partners to invest beyond the proposed de minimis threshold, arguing that the nature of limited partner investments are passive and thus not the kind of investments the regulations are meant to target.[32] Commenters urged exemptions for most or all passive investments that do not exceed a certain de minimis threshold (multiple commenters proposed a below-10 percent equity and voting interest) or that do not grant rights in the target company should be exempted, including investments into a venture capital fund, private equity fund, or other pooled investment funds.[33] If not, they urged Treasury to clarify the “knowledge” and “directing” standard for limited partners to ensure that U.S. persons do not automatically meet these criteria merely by serving on a Limited Partnership Advisory Committee or an Investment Committee.[34] Finally, commenters recommended Treasury align exceptions and definitions for publicly traded securities with Treasury’s Chinese Military-Industrial Complex Companies (“CMIC”) List and generally parallel securities language with other existing regulatory programs.[35]

2. Commenters requested clear and broad exemptions for financial institutions, including as third parties providing services to their customers during transactions.

Many financial, private equity, and venture capital commenters encouraged Treasury to clarify that the scope of “covered transactions” does not include services provided by financial institutions to their clients with respect to covered transactions. Commenters urged the exemption of a long list of transactions, including when a third party institution is serving as an advisor, underwriter, source of debt financing, sponsor, arranger, issuer, or in any other capacity as a U.S. financial institution acting in an intermediary or other capacity.[36] Generally, commenters requested clarification of the treatment of categories like debt financing, investments in index funds, and “indirect” transactions.[37]

3. Commenters suggested other key areas for exemptions.

Commenters requested four more main categories of exemptions. Many sought a clear exception for intracompany transfers, whether just for existing subsidiaries that are already covered foreign persons or regardless of domicile. Relatedly, some recommended exempting (or clarifying the treatment of) corporate restructuring transactions.[38] Second, multiple commenters sought a blanket exemption for joint research ventures unless they are tied to military security concerns; others sought blanket exemptions for intellectual property licensing and sales activities.[39] Third, others requested that “teaching partnerships” be excluded as part of the category of research collaborations that are exempted.[40] And fourth, technology and manufacturing groups sought clarification that certain activities, such as contract manufacturing of consumer technology products, or simple conveyance of national security products, are exempt from the regulations.[41]

IV. Covered national security products and technologies:

Many commenters identified two main categories of covered technology that were defined overbroadly, which could significantly chill investment: AI and quantum technology. In general, commenters urged Treasury to regulate more precisely and with greater awareness of the importance of non-military uses of these technologies.

1. Covered technologies should be narrowly and clearly defined.

Commenters mostly agreed that the definitions of covered products and technologies were vague and overly broad, but disagreed on the best alternative. Some debated whether coverage should depend on a technology’s “primary” or “exclusive” use.[42] Others argued that the final rule should focus on end users rather than end uses, and should rely on existing lists of actors such as the CMIC List maintained by Office of Foreign Assets Control or the Entity List maintained by the Department of Commerce.[43] Still others suggested that the definitions be based on objective features such as technical parameters of products or technology, or their export control classification numbers.[44]

2. The definition of “AI Systems”.

Several commenters across industries viewed the definition of “AI system” as overly broad, and were concerned that the proposed regulations would cover technologies designed for commercial use and without military application. These commenters predicted that the proposed definition would chill investment in cutting-edge technologies. They suggested that the scope of coverage be limited to technology that has a dual military and commercial use, or that is specifically or exclusively designed for military or surveillance applications.[45] Other commenters proposed that Treasury employ categorical exemptions for particular industries (such as for AI used in medical technology)[46] or that it focus on restricting specific end users.[47]

3. Quantum technologies.

Quantum technology companies requested more clarity and nuance in the scope of coverage of “quantum computers and components.” These commenters pointed out that the coverage of “components” could be overbroad and risks expanding the scope of the rule to cover any piece of hardware that might go into a quantum computer, including some household items and technologies.[48] Others recommended either removing the term “component” or defining it more narrowly based on technical capabilities. One international quantum company suggested looking to regulations enacted by the Spanish government in May 2023 for workable definitions.[49] Yet other commenters urged that the definitions of “quantum sensors,” “quantum networking,” and “quantum communications systems,” be narrowed or qualified to recognize that these technologies have commercial, non-military applications.[50]

V. Other implementation concerns:

Some commenters weighed in on enforcement procedures, coordination with other agencies and governments, and the scope of the regulation as a whole.

1. Alternative enforcement mechanisms.

Many requested that Treasury create a mechanism to apply for waivers, under which an otherwise prohibited transaction might be approved if in the public interest.[51] Others proposed an advisory opinion process, through which Treasury could provide advance notice of whether a particular transaction would be notifiable or prohibited. Commenters pointed to similar processes offered by the SEC, CFIUS, and other agencies.[52]

2. Alignment with allies and other federal programs.

Several commenters urged Treasury to encourage allies to establish similar regulations, so as not to put the United States or U.S. persons at a competitive disadvantage. Manufacturers and trade associations raised the concern that without coordination, manufacturing demand would flow to foreign jurisdictions without similar investment controls.[53]

Other commenters suggested that the new regulations be aligned with existing mechanisms such as the CHIPS Act guardrails, the EAR, and sanctions regimes.[54] Some recommended that the definition of “countries of concern” be aligned with the definitions used by the Defense Department and included in the CHIPS Act.[55] Finally, others stated that existing export control and sanctions regimes are sufficiently effective and significantly less invasive, and urged Treasury to rely on those programs rather than implementing an outbound investment regime.[56]

3. The scope of the regulatory project.

A few commenters, including manufacturing groups and unions, urged “a broad view as to the scope of coverage” and “encourage[d] its expansion over time.”[57] Former U.S. Deputy National Security Advisor Matt Pottinger even recommended that certain software and AI transactions be entirely prohibited (as opposed to permitted with notification) because the Chinese government has the legal power to access technologies developed by “any firm operating in China,” rendering notification ineffective.[58]

Most commenters, however, suggested Treasury narrow the scope of coverage. Some even questioned the wisdom of regulating outgoing investment at all. China-based organizations objected to the regulations as a whole,[59] and, as discussed below, House Financial Services Committee Chairman Patrick McHenry questioned the policy and legal authority behind the regulatory program.

VI. A high-ranking House leader raised significant policy disagreements and legal concerns with the ANPRM’s approach:

On September 27, 2023, House Financial Services Chairman (and current Acting Speaker of the House of Representatives) Patrick McHenry wrote a letter to Treasury Secretary Yellen commenting on the ANPRM.

First, Chairman McHenry raised legal issues with the proposed regulations, asserting that the Office of Investment Security cannot statutorily implement the regulation, and also questioned the ANPRM’s reliance on the International Emergency Economic Powers Act (IEEPA) as part of the authority for the regulation, describing its use as “novel.”[60] Second, he questioned the Biden Administration’s policy of decreasing U.S.-driven investment in China, arguing that instead public policy should be to increase private U.S. investment and control of Chinese entities.[61] Third, he questioned whether the program should be administered through Treasury’s OFAC sanctions regime, rather than through the CFIUS regime.[62] Chairman McHenry’s comments are significant because they may identify grounds for parties to challenge the final regulations and because they highlight a sharp disagreement in the top levels of government regarding the role of U.S. investment in China.

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

____________________________

[1] Exec. Order No. 14,105, 88 Fed. Reg. 54,867 (Aug. 11, 2023).

[2] Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern, 88 Fed. Reg. 54,961 (Aug. 14, 2023) [hereinafter ANPRM].

[3] ANPRM, 88 Fed. Reg. at 54,962.

[4] See ANPRM, 88 Fed. Reg. at 54,963–64.

[5] See, e.g., Securities Industry and Financial Markets Association (“SIFMA”), Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 1–2 (Sept 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0042.

[6] See, e.g., Semiconductor Industry Association, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 6–7 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0056.

[7] Id. at 7.

[8] See, e.g., The Confederation of the Netherlands Industry and Employers, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 2 (Sept. 25, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0011.

[9] See, e.g., Transatlantic Business Initiative, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 3–4 (Sept. 27, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0010.

[10] See ANPRM, 88 Fed. Reg. at 54,964.

[11] See, e.g., SIFMA, supra note 5, at 8 (“Treasury should consider the possibility of potential conflicts of law from other jurisdictions that may place restrictions on the export of data from China and create other challenges in obtaining research on investment targets in China . . . .”).

[12] See, e.g., Hewlett Packard Enterprise, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 2 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0032.

[13] See, e.g., SIFMA, supra note 5, at 6–7.

[14] See, e.g., Hewlett Packard Enterprise, supra note 12, at 2.

[15] See, e.g., Business Roundtable, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 6–7 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0028.

[16] See, e.g., id. at 7.

[17] See ANPRM, 88 Fed. Reg. at 54,962.

[18] See, e.g., Quantum Economic Development Consortium, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 4 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0057.

[19] See, e.g., National Venture Capital Association, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 6–7 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0054.

[20] See, e.g., Information Technology Industry Council, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 3 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0035.

[21] See ANPRM, 88 Fed. Reg. at 54,969–70.

[22] Id. at 54,969.

[23] See, e.g., American Investment Council, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 3 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0053.

[24] See, e.g., id. at 3; see also Goldman Sachs, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 4 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0036.

[25] See, e.g., Goldman Sachs, supra note 24, at 4.

[26] See, e.g., American Investment Council, supra note 23, at 3.

[27] See, e.g., Squire Patton Boggs LLP, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 7 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0060.

[28] See, e.g., Institutional Limited Partners Association (“ILPA”), Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 9-10 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0055.

[29] See, e.g., U.S. Chamber of Commerce, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 6 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0038.

[30] See, e.g., Business Roundtable, supra note 15, at 4–5.

[31] See, e.g., Squire Patton Boggs LLP, supra note 27, at 8–9.

[32] See, e.g., Institutional Limited Partners Association, supra note 28, 2–4.

[33] See, e.g., National Venture Capital Association, supra note 19, at 4–5; SIFMA, supra note 5, at 11; Business Roundtable, supra note 15, at 13.

[34] See, e.g., British Private Equity & Venture Association, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 2-3 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0034.

[35] See, e.g., Investment Company Institute, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 3-4 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0027; see also SIFMA, supra note 5, at 10–11.

[36] See, e.g., SIFMA, supra note 5, at 2-5; U.S. Chamber of Commerce, supra note 29, at 13–15.

[37] See, e.g., Investment Company Institute, supra note 35, at 5, 11–12.

[38] See, e.g., Investment Company Institute, supra note 35, at 5; U.S. Chamber of Commerce, supra note 29, at 17; SIFMA, supra note 5, at 10.

[39] See, e.g., SEMI, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 3 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0029; Information Technology Industry Council, supra note 20, at 3-5.

[40] See, e.g., Eastern Michigan University, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 1–2 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0033.

[41] See, e.g., National Association of Manufacturers, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 4 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0021.

[42] See, e.g., Squire Patton Boggs LLP, supra note 27, at 2–3.

[43] See, e.g., National Venture Capital Association, supra note 19, at 8.

[44] See, e.g., Business Roundtable, supra note 15, at 2–3.

[45] See, e.g., Hewlett Packard Enterprise, supra note 12, at 5–6.

[46] See, e.g., Advanced Medical Technology Association, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 2–3 (Sept. 29, 2023).

[47] See, e.g., National Venture Capital Association, supra note 19, at 8.

[48] See, e.g., Quantum Economic Development Consortium, supra note 18, at 4–6.

[49] Bluefors Oy, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 3 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0062.

[50] See, e.g., Infleqtion, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 2-3 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0050.

[51] See, e.g., SIFMA, supra note 5, at 12.

[52] See, e.g., U.S. Chamber of Commerce, supra note 29, at 4–5.

[53] See, e.g., Semiconductor Industry Association, supra note 6, at 4–6.

[54] See, e.g., National Association of Manufacturers, supra note 41, at 2.

[55] See, e.g., MEMA, Comments by MEMA, The Vehicle Suppliers Association, on Notice of Advanced Rulemaking on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 3 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0048.

[56] See, e.g., Transatlantic Business Initiative, supra note 9, at 1.

[57] Alliance for American Manufacturing, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 2–3 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0022; AFL-CIO, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 2 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0040.

[58] Matt Pottinger, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern (Sept. 29, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0061.

[59] See, e.g., China Chamber of International Commerce, Comments on Executive Order 14105 and ANPRM 5–7 (Sept. 28, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0018.

[60] Representative Patrick McHenry, Comment Letter on Proposed Rule on Provisions Pertaining to U.S. Investments in Certain National Security Technologies and Products in Countries of Concern 1–2 (Sept. 27, 2023), https://www.regulations.gov/comment/TREAS-DO-2023-0009-0013.

[61] Id. at 3–4.

[62] Id.

The following Gibson Dunn lawyers prepared this client alert: Stephenie Gosnell Handler, Adam M. Smith, Amanda Neely, Chris Mullen, Samantha Sewall, Teddy Rube,* and Justin Fishman.*

Gibson Dunn’s International Trade lawyers are highly experienced in advising companies about the potential legal implications of their international transactions and regularly assist clients in their efforts to comply with the shifting legal landscape and to implement best practices. The firm’s Congressional Investigations team has represented numerous clients responding to congressional inquiries regarding national security issues, and its Public Policy Practice Group frequently works with clients to monitor developments on Capitol Hill and the Administration in real time and to ensure their voices are heard in the policy debate. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Gibson Dunn attorneys also have vast experience preparing effective submissions to government regulators and remain ready to assist with this process as well as to help prepare stakeholders for discussions with members of the Treasury or other federal agencies on the proposed regulations.

Please contact the Gibson Dunn lawyer with whom you usually work, the following practice leaders and members, or the authors in Washington, D.C. for additional information about how we may assist you:

Stephenie Gosnell Handler (+1 202-955-8510, [email protected])
Adam M. Smith (+1 202-887-3547, [email protected])
Amanda H. Neely (+1 202-777-9566, [email protected])
Chris R. Mullen (+1 202-955-8250, [email protected])
Samantha Sewall (+1 202-887-3509, [email protected])

International Trade Group:

United States
Judith Alison Lee – Co-Chair, Washington, D.C. (+1 202-887-3591, [email protected])
Ronald Kirk – Co-Chair, Dallas (+1 214-698-3295, [email protected])
Adam M. Smith – Co-Chair, Washington, D.C. (+1 202-887-3547, [email protected])
Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, [email protected])
David P. Burns – Washington, D.C. (+1 202-887-3786, [email protected])
Nicola T. Hanna – Los Angeles (+1 213-229-7269, [email protected])
Marcellus A. McRae – Los Angeles (+1 213-229-7675, [email protected])
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, [email protected])
Christopher T. Timura – Washington, D.C. (+1 202-887-3690, [email protected])
Hayley Lawrence – Washington, D.C. (+1 202-777-9523, [email protected])
Annie Motto – Washington, D.C. (+1 212-351-3803, [email protected])
Chris R. Mullen – Washington, D.C. (+1 202-955-8250, [email protected])
Sarah L. Pongrace – New York (+1 212-351-3972, [email protected])
Anna Searcey – Washington, D.C. (+1 202-887-3655, [email protected])
Samantha Sewall – Washington, D.C. (+1 202-887-3509, [email protected])
Audi K. Syarief – Washington, D.C. (+1 202-955-8266, [email protected])
Scott R. Toussaint – Washington, D.C. (+1 202-887-3588, [email protected])
Claire Yi – New York (+1 212-351-2603, [email protected])
Shuo (Josh) Zhang – Washington, D.C. (+1 202-955-8270, [email protected])

*Justin Fishman and Teddy Rube are associates working in the firm’s Washington, D.C. office who are not yet admitted to practice law.