Client Alert Archives

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.

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[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])

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])

*Justin Fishman and Teddy Rube are associates working in the firm’s Washington, D.C. office who are 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.

We are pleased to provide you with Gibson Dunn’s ESG monthly update for September 2023. This month, our update covers the following key developments. Please click on the links below for further details.

I. INTERNATIONAL

1. UN publishes climate change report concluding that global emissions are not in line with Paris Agreement goals

The UN Framework Convention on Climate Change published a report ahead of an upcoming global stocktake at the UN climate change conference COP28 being held in Dubai in November and December. The report assesses collective progress towards achieving the long-term goals of the Paris Agreement in a series of 17 findings from technical deliberations in 2022 and 2023. Among other things, the report finds that global emissions are not in line with modelled global mitigation pathways consistent with the temperature goal of the Paris Agreement and that greater action is needed “on all fronts”, including in the implementation of domestic mitigation measures.

2. Credit ratings agencies take further steps to increase ESG transparency for investors

S&P Global Ratings announced on September 14, 2023 that it has updated its analytical approach for use of proceeds Second Party Opinions (SPOs), in order to provide more transparency to investors in the sustainable bond market. The update outlines the process for providing SPOs, defines an S&P Global Ratings Shade of Green, and explains how the latter is assigned to environmental projects.

Lloyds’ and Moody’s Analytics announced a new collaboration on September 15, 2023 to develop a solution that will help with quantifying greenhouse gas emissions across managing agents’ underwriting and investment portfolios, aiding managing agents in meeting expected regulatory reporting requirements under frameworks such as Streamlined Energy and Carbon Reporting for insurers.

3. ICMA and IFC publish global practitioner guidance on “blue bonds”

The International Capital Market Association and International Finance Corporation issued a Practitioner’s Guide on Bonds to Finance the Sustainable Blue Economy on September 6, 2023. “Blue bonds” are defined as green bonds focused on the sustainable use of maritime resources and the promotion of related sustainable economic activities. The guidance is intended for broad use by issuers, investors and underwriters, and builds on existing standards for the global sustainable bond markets which have been in circulation since 2014 (namely, the Green Bond Principles, Social Bond Principles, Sustainability Bond Guidelines and Sustainability-linked Bond Principles). It defines blue economy typology and eligibility criteria, suggests key performance indicators, showcases latest case studies, and highlights the critical need for increased financing to achieve UN Sustainable Development Goal No. 14.

4. Network for Greening the Financial System publishes conceptual framework for nature-related financial risks to guide policies and action by central banks and financial supervisors

The Network for Greening the Financial System published a technical document containing a beta version of an NGFS Conceptual Framework for nature-related financial risks on September 7, 2023. It aims to establish a common and mainstream understanding of the risks presented by the environmental degradation and climate change crisis, and to take the first step towards an integrated assessment of broader nature-related risks in addition to climate change risks, setting out a principle-based approach to help operationalize that understanding.

5. World Federation of Exchanges publishes guidance note on its Green Equity Principles

On September 14, 2023, the World Federation of Exchanges published a guidance note on its Green Equity Principles—a voluntary global framework for designating stocks and shares as green, which is intended to counter greenwashing and support funding towards sustainable economies. The Principles and the guidance note are open for public consultation until January 15, 2024.

6. Taskforce on Nature-related Financial Disclosures publishes final recommendations

The Taskforce on Nature-related Financial Disclosures (comprising 40 members representing financial institutions, corporates and market service providers, and supported by national governments), published its final Recommendations on nature-related risk management and disclosure on September 18, 2023. The recommendations provide companies and financial institutions with a set of (i) general requirements for nature-related disclosures and (ii) recommended disclosures structured around the four pillars of governance, strategy, risk and impact management, and metrics and targets.

The recommendations have been welcomed by the UK Parliamentary Environmental Audit Committee, which proposes that they be made mandatory for companies in the UK.

An executive summary of the recommendations is available here.

7. Glasgow Financial Alliance for Net Zero (GFANZ) launches consultation on its four transition finance strategies

On September 19, 2023, GFANZ announced that it had launched consultations seeking market feedback on its work to further refine the definitions of its transition finance strategies and support financial institutions to forecast the impact of these strategies on reducing emissions. The four strategies were developed last year with the goal of financing a whole economy transition to net zero, and include (i) developing and scaling climate solutions, (ii) financing assets that are already aligned to a 1.5C pathway, (iii) financing transitioning assets and (iv) phasing out high-emitting assets.

8. International Accounting Standards Board (IASB) announces it is exploring targeted actions to improve reporting of climate-related uncertainties

The IASB announced on September 20, 2023 that it is exploring targeted actions to improve reporting of climate-related and other uncertainties in financial statements, including publishing education materials and making targeted amendments to IFRS Accounting Standards. IASB materials relating to this project can be found here.

9. Intercontinental Exchange (ICE) announces plans to launch a physically delivered futures contract for carbon credits in the aviation industry

ICE announced on September 21, 2023 that it plans to launch a physically delivered futures contract for carbon credits eligible for use under the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA), an ICAO global market-based carbon credit scheme which allows airline operators to offset carbon dioxide emissions by retiring carbon credits. The contract launch is planned for October 9, 2023.

10. Nature Action identifies 100 companies to be targeted in an investor engagement process

Nature Action 100 published list of 100 target companies in which 190 institutional investor participants will engage to drive greater corporate ambition and action in key sectors with environmental impact. The companies have been selected on the basis that they have large market capitalization in sectors deemed to be systemically important in reversing nature loss, and analysis conducted by the Biodiversity Foundation indicates that they have a high potential impact on nature. Current actions to mitigate nature-based risks are not taken into account. US and Chinese companies are at the top of the list.

II. UNITED KINGDOM

1. UK government confirms it will consider withdrawing from Energy Charter Treaty if vital modernisation is not agreed

On 1 September 1, 2023, the UK government announced it is reviewing its Energy Charter Treaty membership and considering withdrawal if vital modernisation to the treaty, which has historically provided protections for fossil fuel investors, is not agreed. Members of the multilateral treaty, signed in 1994 to promote international investment in the energy sector, have been in negotiations since 2020 to modernise the treaty to reflect modern energy priorities and support the green transition, but this is being hampered by the decisions of several member states to leave the treaty.

2. Green Finance Institute publishes technical advice to UK government on developing and implementing a UK Green Taxonomy

On September 8, 2023, the Green Finance Institute’s Green Technical Advisory Group (GTAG) published two reports containing recommendations to the government as part of its ongoing provision of non-binding advice on market, regulatory and scientific considerations for developing and implementing a UK Green Taxonomy.

The report on operational considerations for taxonomy reporting advises on how to ensure data gaps are minimised to support more robust and decision-useful taxonomy disclosures without placing undue burden on businesses. It includes considerations on the use of proxies and estimates in taxonomy. reporting.

The report on treatment of green financial products under an evolving UK Green Taxonomy advises, firstly, on how activities previously considered environmentally sustainable are affected when the UK Green Taxonomy is implemented, and, secondly, on how taxonomy-aligned activities, products and investments are treated when the taxonomy evolves over time.

3. UK government announces plans to invest up to £650 million in new alternative R&D programmes

Following its decision not to associate to Euratom Research and Training Programme, the UK government announced on September 7, 2023 that it plans to implement a suite of new, alternative R&D programmes to support the UK’s nuclear fusion sector and strengthen international collaboration in support of the UK Fusion Strategy. This is in addition to the £126 million announced in November 2022 to support UK fusion R&D programmes. Further details on the alternative programmes will be set out later in the Autumn.

4. UK government announces £45.7 million for businesses to cut emissions and boost home-grown energy through government-backed projects

The UK government announced on September 13, 2023 that 26 businesses will receive a share of £45.7 million in an effort to clean up industrial processes and reduce business energy costs whilst supporting the UK’s transition to a cleaner more secure energy system. The UK’s largest malting site, a leading supplier of household paper and an innovative green fuel producer in Belfast are among those receiving part of this funding.

5. UK Treasury publishes draft statutory instrument updating the UK Emissions Trading Scheme

On September 19, 2023 HM Treasury published a draft statutory instrument amending the Greenhouse Gas Emissions Trading Scheme Order 2020, which established the UK ETS Scheme. The instrument seeks to update the UK ETS Scheme by (i) providing for the capping of aviation free allocation at 100% of emissions, (ii) clarifying the treatment of Carbon Capture and Storage plants in order to resolve some inconsistencies in how capture activities and installations are currently dealt with by the legislation, and (iii) amending free allocation rules for electricity generation so that operators can change their classification as an electricity generator if they have recently stopped exporting electricity.

According to the accompanying explanatory memorandum, the capping of aviation free allocation is intended to support the UK’s decarbonisation objectives and increased climate ambition in a way that maintains the market signal the UK ETS sends and supports a viable market. In 2021, aviation free allocation represented around 127% of the sector’s verified emissions, representing an over-allocation of more than 900,000 ETS allowances worth around £50 million, which the operators were able to sell for profit. The cap will operate by requiring aircraft operators to return allowances in excess of emissions at the beginning of a scheme year.

6. UK Prime Minister announces delay to ban on sale of new petrol and diesel cars

On 20 September Prime Minister Rishi Sunak announced the postponement of a series of policies that form part of the UK’s wider net zero targets, including a ban on the sale of new diesel and petrol cars from 2030 to 2035. This shift in policy has prompted a backlash from the UK automotive industry, which warned it would undermine investment certainty and complicate their plans to boost EV sales in the country this decade. The prime minister stated that the five-year delay aligns the UK with EU policy on the phase out of diesel and petrol cars.

7. UK financial regulators set out proposals to boost diversity and inclusion in regulated financial services firms

On September 25, 2023 the Financial Services Authority and Prudential Regulation Authority published consultation papers on proposals aimed at boosting diversity and inclusion to support healthy working cultures, reduce groupthink and unlock talent; enhancing the safety and soundness of firms; and improving understanding of diverse consumer needs. The proposed measures include requirements on firms to develop a diversity and inclusion strategy, disclose data against certain characteristics, and set targets to address under-representation.

The FCA’s consultation paper is available here and the PRA’s consultation paper is available here. The consultation is open until 18 December 2023.

III. EUROPE

1. European Parliament publishes study on establishing a horizontal European climate label for all products

The European Parliament released a study on September 5, 2023 which concludes that further preparation is required before a voluntary climate labelling scheme across all product categories can be established under EU law, including harmonizing and simplifying European product environmental footprint (PEF) methodology. Most current labelling schemes only supports comparisons within specified product groups, not between products of different categories; and the study refers to general agreement that it is desirable that it is important for consumers to be provided with information allowing them to directly compare products rather than just identifying the “best in class” products. However, the study also considers that it remains an open question as to whether a climate labelling scheme is desirable or whether it would be preferable to have a broader coverage of environmental impact categories, as suggested in the proposal for a Green Claims Directive.

2. European Parliament adopts revised Renewable Energy Directive

On September 12, 2023, the European Parliament passed the revised Renewable Energy Directive, (RED III), which updates the previous RED II. The updates are driven by the REPowerEU strategy presented on May 18, 2022, which seeks to reduce the EU’s reliance on Russian fossil fuel imports, as well as by the EU’s Green Deal and “Fit for 55” legislative package. The new directive stipulates the increase of the share of renewables in the EU’s final energy consumption by 2030 to a new binding target of 42.5% , but asks Member States to collectively strive to achieve a target of 45%, in line with the RePowerEU Plan.

Among other changes, the new directive provides that industry will need to increase the share of renewable sources in the amount of energy sources used for final energy and non-energy purpose at an annual rate of 1.6%.

The Council of the European Union formally adopted the directive on 9 October 2023.

3. European Commission proposes to raise monetary size threshold under Accounting Directive by 25% to account for inflation, removing micro- and SMEs from scope of Corporate Sustainability Reporting Directive

On September 13, 2023, the Commission issued an initiative to adjust upwards the thresholds in the Accounting Directive for determining the size category of a company, in order to account for the impact of inflation. The Commission states that the proposed increase would result in micro, small and medium-sized enterprises falling outside the scope of many EU sustainability (as well as financial) reporting provisions applicable to larger companies. The thresholds under the Accounting Directive have remained unchanged since 2013.

A public consultation on the initiative closed in early October.

Separately, Germany is pushing for the definition of SMEs to be expanded by raising the thresholds from 250 to 500 employees in order to exclude between 7,500 and 8,000 companies from the scope of the sustainability reporting rules (as reported by the Financial Times on September 18, 2023 on the basis of a government coalition document seen by the newspaper). France has been consulted on the proposal but has not yet divulged its position, while EU lawmakers are resistant to making late changes to the reporting rules adopted only this year.

4. European Parliament approves law requiring 70% green jet fuels at EU airports by 2050

The European Parliament announced on September 13, 2023 that MEPs have adopted a legislative proposal to accelerate the use of sustainable fuels in the aviation sector (position paper here). It is part of the EU’s plan to reduce greenhouse gas emissions by at least 55% by 2030 and achieve climate neutrality by 2050 as part of its “Fit for 55” package. The law will require EU airports and fuel suppliers to ensure that, from 2025, at least 2% of aviation fuels are green, increasing every five years to reach 70% by 2050. “Green fuels” include synthetic fuels, specific biofuels, recycled jet fuels, and renewable hydrogen, and exclude feed and food crop-based fuels and those derived from palm and soy materials.

The proposal includes introduction of a voluntary EU label for flight environmental performance 2025, to allow passengers to compare flights based on carbon footprint and efficiency.

Once approved by the European Council, the new regulations will take effect from 1 January 2024 and 1 January 2025.

5. European Commission launches consultation on the functioning of the Sustainable Finance Disclosures Regulation

On September 14, 2023, the Commission launched a targeted consultation and a public consultation seeking feedback on whether the Sustainable Finance Disclosure Regulation (SFDR) meets stakeholders needs and expectations and is fit for purpose—in particular, whether there are shortcomings in terms of legal certainty, useability of the regulation and its ability to help tackle greenwashing. The targeted consultation is addressed to public bodies and stakeholders who are more familiar with the SFDR and the EU’s sustainably finance framework as a whole, including financial market participants, investors, NGOs, relevant public authorities and national regulators. The public consultation is addressed to individuals and organisation with more general knowledge of the SFDR. The consultation is open until December 15.

6. Regulations for Carbon Border Adjustments Mechanism (CBAM) reporting published in the Official Journal of the European Union (OJEU)

The European Commission’s Implementing Regulation on the Rules for the application of CBAM was released in the OJEU on September 15, 2023 and came into effect on September 16, 2023 across all EU member states. Guidance documents are available here.

The CBAM will require EU-based importers of goods in certain sectors to purchase certificates for carbon emissions at a price equivalent to the weekly EU Emissions Trading System carbon price (which applies to EU-based producers). By applying a carbon price on imports equivalent to the carbon price of EU production, CBAM aims to levels the playing field of the price of carbon for CBAM products inside and outside the EU. The Implementing Regulation outlines the reporting requirements for importers of CBAM goods within the EU and provides a temporary method for calculating the emissions integrated into the production of these goods during the transitional period, which will last from 1 October 2023 to 31 December 2025. The first report is to be submitted by 31 January 2024.

The transitional period, and the reports from importers received during such period, will be used to assess the scope of CBAM and how it will apply during the definitive period from 1 January 2026.

7. EU provisionally agrees to ban “climate neutral” and other greenwashing claims by 2026

The Parliament and Council announced on September 19, 2023 that they have reached a provisional agreement on the proposed directive to empower consumers for the green transition, which is designed to ban misleading advertisements and provide consumers with better information on product durability. Among other things, it has been agreed that generic environmental claims such as “environmentally friendly”, “natural”, “biodegradable”, “climate neutral” or “eco” will be banned where there is not proof of recognised excellent environmental performance relevant to the claim; and claims that a product has neutral, reduced or positive impact on the environment that are based on emissions offsetting schemes will be banned outright. Prompting the consumer to replace consumables such as printer ink cartridges earlier than necessary, and presenting goods as repairable when they are not, will also be proscribed.

8. The Energy Efficiency Directive for the European Union has been published in the Official Journal of the European Union

The Energy Efficiency Directive (EU) 2023/1791 was published in the OJEU on 20 September, 2023 and will enter into force on 10 October, 2023, following which EU member states have two years to incorporate most of its provisions into their national law. The directive, which is part of the ‘Fit for 55’ package and the REPowerEU strategy, introduces key measures to boost energy efficiency, emphasising the ‘energy efficiency first’ principle which prioritises the consideration of cost-effective energy efficiency measures when formulating energy policies and making investment decisions.

The directive contains notable changes from previous directives, including the establishment of a legally binding EU target to reduce final energy consumption by 11.7% by 2030, with each EU member state required to set its indicative national contribution.

It further requires that members states prioritise vulnerable customers and social housing within their energy-saving efforts, introduces an annual energy consumption reduction target of 1.9% for the public sector, extends the annual 3% building renovation obligation to all levels of public administration, and introduces a new approach for businesses to implement energy management systems and conduct energy audits.

9. France becomes first EU member state to set deadline for implementation of Corporate Sustainability Reporting Directive

The French Ministry of Justice announced on September 20, 2023 that the Corporate Sustainability Reporting Directive (CSRD) will be transposed into law in early December, making France the first EU member state to set a deadline for implementation of the directive. It has been one of the leading members states on efforts to implement the new sustainability reporting rules. Under the current French draft law, French companies will engage their financial auditors, other auditors, or an independent assurance provider for CSRD assurance in order to comply with the new reporting obligations.

The Finnish Government announced on September 28, 2023 that it has submitted its CSRD transposition proposal to the Finnish parliament.

10. Europeans Court of Human Rights hears complaint from six young people suing 32 European states for climate change

On September 27, 2023, six young Portuguese people aged between 11 and 24 appeared before the European Court of Human Rights in Duarte Agostinho and Others v. Portugal and 32 Other States,

accusing European states of failing to tackle the human-caused climate crisis in violation of Article 2 (right to life) and Article 8 (right to respect for private and family life) of the ECHR especially when those obligations are read in the light of international climate treaties requiring signatory states to take steps to adequately regulate their contributions to climate change. Ukraine was among the original respondents but the case against it has been discontinued.

The applicants are asking the court to find that countries contributing to the climate crisis have obligations not only to protect their own citizens but also those outside their borders. The claim, which was filed in September 2020, was granted priority treatment by the Court. A ruling is expected in the first half of 2024.

11. European Supervisory Authorities publish report on extent of voluntary disclosure of principal adverse impacts under Article 18 of Sustainable Finance Disclosures Regulation

On September 28, 2023, the Joint Committee of the three European Supervisory Authorities (EBA, EIPOA and ESMA) published its second annual report on extent of voluntary disclosure of principal adverse impacts under SFDR, based on a survey of National Competent Authorities to assess the current state of entity-level and product-level voluntary principal adverse impact (PAI) disclosures under the SFDR.

The first annual report, which was published on July 28, 2022, concluded that the extent of take-up of the voluntary disclosures of principal adverse impact of investment decisions on sustainability factors varied significantly across jurisdictions and Financial Market Participants (FMPs) in the scope of the SFDR, making it difficult to identify definite trends.

The second report finds that while there is still significant variation across FMPs and jurisdictions, there has been an overall improvement in the application of voluntary disclosures, which are also easier to find on company websites. It identifies areas for improvement, however: firstly, explanations of non-consideration of PAIs are not yet fully complete and satisfactory; and secondly, where these have been considered, the disclosures on the degree of alignment with the Paris Agreement are still vaguely formulated. Finally, the report identifies voluntary disclosures of PAI considerations by financial products as an area for future analysis in subsequent reports.

IV. United States

State Law Updates:

1. California passes legislation mandating climate-related disclosure and regulating “green” claims

In October, California enacted two bills that impose significant and mandatory climate-related reporting requirements on any public or private U.S. business entity meeting certain annual revenues levels and doing business in the state. The Climate Corporate Data Accountability Act (Senate Bill No. 253) requires companies with total annual revenues over $1 billion to publicly and annually report their Scope 1, 2, and 3 greenhouse gas emissions, and the Greenhouse Gases: Climate-Related Financial Risk (Senate Bill No. 261) requires companies (except insurance companies) with total revenues greater than $500 million to biennially report their climate-related financial risks and the measures taken to reduce and adapt to them. At signing, Governor Gavin Newsom expressed concerns regarding the timing and cost of the legislation, among others, and signalled his Administration would work to address these concerns in 2024. For further detail, please see our client alert and blog post.

California also enacted Assembly Bill No. 1305, Voluntary Carbon Market Disclosures, which requires companies that market or sell voluntary carbon offsets (VCOs) in California to disclose on their website certain information about the applicable carbon offset project, including accountability measures for incomplete or unsuccessful projects. Companies operating in California that purchase or use VCOs and make “net zero” and “carbon neutral” claims would also be required to disclose information regarding the VCOs and support for their claims.

Securities and Exchange Commission (SEC) Updates:

2. SEC Chair gives testimony to Congressional committee on the SEC’s role in climate risk disclosure

On September 12, 2023, during testimony before the U.S. Senate Committee on Banking, Housing and Urban Affairs SEC Chair Gary Gensler said that while the SEC has no role as to climate risk itself and is neutral as to the merit of the climate-related risks taken by investors, it plays an important role in relation to the disclosures of those risks. Gensler added that the SEC is currently considering more than 15,000 comments on its March 2022 proposed climate change disclosure rules.

3. SEC amends the “Names Rule,” with expected impact on ESG funds

On September 20, 2023, the SEC announced that it adopted amendments to modernize and enhance the Investment Company Act “Names Rule,” which prohibits fund names from misrepresenting the fund’s investment and risks. The amendments are designed to increase investor protection by (among other things) broadening and enhancing the requirement for certain funds to adopt a policy to invest at least 80% of the value of their assets in accordance with the focus that the fund’s name suggests; targeting, in particular, fund names that indicate an ESG focus in the fund’s investment decisions.

The final rule is available here, and the fact sheet is available here.

4. SEC Investor Advisory Committee approves recommendations for human capital management disclosure standards

At a meeting on September 21, 2023, the SEC Investor Advisory Committee (IAC) made recommendations to the SEC to expand the existing human capital management disclosure rules adopted by the SEC in August 2020 and to a July 2023 proposal by the Financial Accounting Standards Board (FASB) to require that companies show employee compensation costs included in their income statement. The IAC views these existing initiatives as insufficient to give investors the full information needed for accurate valuation of human capital. The IAC recommended that the SEC’s new rules (which are expected to be proposed soon) require (i) narrative disclosure of how a company’s labor practices, compensation incentives and staffing fit within the company’s broader strategy, and (ii) disclosure of specific items including:

the number of employees who are full-time, part-time or contingent;
turnover or comparable workforce stability metrics;
total cost of the issuer’s workforce, broken down into major components of compensation; and
workforce demographic data sufficient to allow investors to understand the company’s efforts to access and develop new sources of talent, and to evaluate the effectiveness of these efforts.

U.S. Government Updates:

5. S. Treasury publishes nine principles highlighting emerging best practices for private sector financial institutions with net-zero commitments

On September 19, 2023, the U.S. Treasury issued a series of voluntary Principles for Net-Zero Financing & Investment as part of an effort to accelerate the green transition by catalyzing more private sector investment into climate change projects. The Principles are focused on financial institutions’ Scope 3 financed and facilitated greenhouse gas emissions (i.e., those for which the institutions are not directly responsible, but which are produced in their upstream and downstream value chains) – and are directed in particular at those firms that have made or are considering making a net-zero commitment.

6. President Biden approves Interagency Working Group recommendations to federal government agencies for expanded use of Social Cost of Greenhouse Gases metric in budgeting decisions

On September 21, 2023, the Biden Administration announced the approval of Interagency Working Group recommendations to expand use of the Social Cost of Greenhouse Gases metric—which has been in use by federal agencies for over a decade—in budgeting, procurement, and other agency decisions. This follows an estimate by the Office of Management and Budget that annual federal spending could increase by over $1 billion from climate-related disasters and annual federal revenue could be reduced by up to $2 trillion by 2100.

V. APAC

1. ESG Book and Sustainable Finance Institute Asia to collaborate on pilot ESG data disclosure initiative

On August 30, 2023, ESG Book (a digital platform for ESG data management disclosure and analytics) announced it would be partnering with Sustainable Finance Institute Asia on the Single Accesspoint for ESG Data (“SAFE”) Initiative – a pilot initiative to address ESG data requirements and disclosure gaps in Asian markets. Leading financial organisations in Asia have been invited to participate in the pilot.

2. South Korea proposes bill on human rights and environmental protection for corporate sustainable management

On September 1, 2023, the Democratic Party of South Korea proposed a Bill on Human Rights and Environmental Protection for Sustainable Business Management to make annual human rights and environmental due diligence on companies’ supply chains mandatory. The proposal cites recent legislative developments in the EU as evidence of an “international movement” to introduce non-financial performance indicators into management for the goal of corporate social responsibility and sustainability. In its current form, the proposal would apply to companies with more than 500 full time employees or generating profits of more than KRW 200B in a year.

3. Singapore expands CO2 extraction project to enhance ocean carbon absorption

Singapore is set to scale up a pioneering pilot initiative led by the Public Utilities Board (PUB), Singapore’s national water agency, and operated by US technology start-up Equatic, to harness electricity for carbon dioxide extraction from seawater, in order to boost the ocean’s capacity to absorb emissions. PUB aims to secure funding by the end of 2023 for a demonstration facility capable of handling 10 tons per day, with plans for further expansion. This endeavour aligns with Singapore’s commitment to achieving net-zero emissions by 2050 and reflects the growing recognition, as recognised by the Intergovernmental Panel on Climate Change, of the necessity of deploying carbon dioxide removals in addition to reducing emissions.

4. Shanghai Stock Exchange and owner of Saudi Exchange sign agreement to collaborate on various initiatives including ESG

Shanghai Stock Exchange and Saudi Tadawul Group, owner of the Saudi Exchange, signed a memorandum of understanding on September 3, 2023 to explore various avenues of cooperation on cross-listing, fintech and ESG initiatives, data exchange, and research. Saudi Arabia boasts the world’s seventh-largest stock market with a total market cap of US$ 3 trillion, while China ranks second with a total market cap of approximately US$ 9.9 trillion.

5. Beijing Private Equity Association publishes set of principles for sustainable investment disclosure by private fund managers

The Beijing Private Equity Association (a voluntary joint initiative in the equity investment fund industry) published General Principles for Disclosure of Sustainable Investment Information for Private Investment Fund Managers on September 4, 2023. The principles are designed to provide guidance to private fund managers on disclosing sustainable investment information that meetings regulatory and stakeholder requirements, to standardise the disclosure of sustainable investment-related information within the sector, and to encourage fund managers to provide more comprehensive, transparent and accurate sustainable investment-related data and information for the capital markets.

6. China adopts in principle rules for management of voluntary greenhouse gas emission reduction trading

The Ministry of Ecology and Environment has approved in principle Management Measures for Voluntary Greenhouse Gas Emission Reduction Trading, in anticipation of the launch of China’s voluntary greenhouse gas emission reduction trading market.

7. Philippines financial regulators propose green finance taxonomy

The Financial Sector Forum—a cross-industry regulator made up of the Bangko Sentral ng Pilipinas, the Insurance Commission, and Securities and Exchange Commission—has issued a proposed framework for a principles-based sustainable finance taxonomy, based in part on the ASEAN Taxonomy (as to which, see our previous alert here). Unlike other taxonomies that rely on specific environmental screening criteria, this approach allows issuers to use their judgment to assess compliance with high-level objectives, initially focusing on climate mitigation and adaptation. The taxonomy also incorporates social performance requirements, including human rights and the rights of the Indigenous community. A public consultation on the draft taxonomy was closed on October 6, 2023.

8. Malaysian Joint Committee on Climate Change meets to discuss climate-change reporting by financial institutions and newly established SME Focus Group

The Joint Committee on Climate Change (a collaboration formed in 2019 between Bank Negara Malaysia, Securities Commission, Bursa Malaysia and industry players known as “JC3” ) met on September 20, 2023, to review its progress and action plans—in particular of those of the committee’s new SME Focus Group, which is tasked with taking action aimed at ensuring that SMEs are not left behind in the transition to a greener economy. Other items for discussion included supporting financial institution’s implementation of the central bank’s Policy Document on Climate Risk Management and Scenario Analysis, and intensified engagements with industry in advance of the upcoming industry-wide Climate Risk Stress Test.

9. Indonesian Stock Exchange launches first carbon exchange

On September 26, 2023, President Joko Widodo announced that Indonesia has launched the Indonesia Carbon Exchange (IDX Carbon). This follows the release by the Indonesian Financial Services Authority (OJK) of Regulation No. 14/2023, which provides a general regulatory framework for carbon trading in Indonesia. The President emphasised that carbon trading in Indonesia should reference international standards but that these should not obstruct Indonesia’s achievement of its Nationally Determined Contribution target.

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, Sophy Helgesen, Elizabeth Ising, Grace Chong, Patricia Tan Openshaw, and Selina S. Sagayam.

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) Group:
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])

On 14 September 2023, the European Commission published “targeted“ and “public“ consultations on Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector (the “SFDR”). While the European Commission states that the views reflected in the consultation papers do not indicate its final position on the future shape of the SFDR, the tenor of both consultations provide useful insights into the potential implications of future reform for those financial market participants (“FMPs”) (which includes alternative investment fund managers (“AIFMs”)) who fall within the scope of the current regime.

The scope and detail of the questions asked in the consultation papers speak to Brussels’ serious concerns about the implementation of the SFDR since its introduction in March 2021, as well as its increasing contemplation of an overhaul of the existing framework. While any proposed changes would not come into force for several years, AIFMs and other FMPs should expect continuing legal uncertainty as it relates to future obligations under the SFDR.

The European Commission has set a deadline of 15 December 2023 for feedback on four distinct areas addressed in the consultations: (a) the current requirements of the SFDR; (b) its interaction with other sustainable finance legislation; (c) potential changes to disclosure requirements for financial market participants; and (d) the potential establishment of a categorisation system for financial products. The Commission aims to publish a finalised report on the SFDR in Q2 2024.

We set out below the future reforms seemingly under consideration by the European Commission and which AIFMs and other FMPs should follow with interest.

Topic 1: Current requirements of the SFDR

The first topic focuses on whether the SFDR has so far met its objective of “strengthening transparency through sustainability-related disclosures in the financial services sector” to support the transition to “a sustainable, climate-neutral economy”. The questions acknowledge recurring criticisms of the SFDR, chiefly relating to the extent to which the disclosures required by the SFDR are “sufficiently useful” to investors. The consultation also queries whether the current reporting obligations “prevent capital from being allocated to sustainable investments as effectively as it could be”.

Addressing potential issues with the implementation of the SFDR, the European Commission asks whether the costs of compliance with the SFDR framework are “proportionate to the benefits generated” and requests detailed breakdowns of the internal and external costs AIFMs have resultingly incurred.

In a welcome development, the European Commission also recognises the continuing difficulties FMPs face sourcing reliable data. The shortage of comprehensive, quality data has been a criticism levelled frequently against the SFDR. The consultation seeks to offer potential solutions, including allowing the use of estimates to fill data gaps where required.

Topic 2: Interaction with other sustainable finance legislation

Respondents to the consultation are invited to give views on any “potential inconsistencies or misalignments” which exist between the SFDR and other sustainable finance legislation, including the Taxonomy Regulation, the Benchmarks Regulation, the Corporate Sustainability Reporting Directive, the Markets in Financial Instruments Directive, the Insurance Distribution Directive and the Regulation on Packaged Retail Investment and Insurance Products.

Topic 3: Potential changes to the disclosure requirements for financial market participants

The European Commission seeks to assess the utility of entity-level disclosures to prospective investors. Given that a number of pieces of European Union legislation require sustainability-related entity-level disclosures, the consultation asks whether such requirements could be streamlined—a potential reform which could result in the removal of such requirements from the SFDR.

The consultation goes on to consider product-level disclosure requirements under the SFDR. Here, the European Commission indicates a preference to expand the scope of SFDR reporting obligations. It seeks feedback on whether uniform disclosure requirements should be imposed on all financial products offered within the EU, as opposed to only those making sustainability-related claims. This proposal is made on the basis that the implementation of uniform requirements could aid prospective investors in seeking to understand a product’s sustainability performance by enabling useful comparisons against products that are not designed to achieve any sustainability-related outcomes. The list of uniform disclosure requirements for all financial products which the consultation suggests includes taxonomy-related disclosures, engagement strategies, exclusions and information about how ESG-related evidence is used in the investment process.

Topic 4: Potential establishment of a categorisation system for financial products

Although the SFDR was designed as a disclosure regime, the European Commission acknowledges that “Articles 8 and 9 of the SFDR are being used as de facto product labels”. While this use “suggests there is a market demand for such tools in order to communicate the sustainability performance of financial products”, the consultation also notes “a labelling scheme might lead to risks of greenwashing”.

In order to mitigate against these risks, the European Commission seeks views on “the merits of developing a more precise product categorisation system based on precise criteria”. It outlines two potential strategies for the development of a product categorisation system:

build on the existing concepts within Articles 8 and 9, with additional (minimum) criteria for products to make clear the scope of each article; or
focus instead on the types of investment strategies chosen, with the existing concepts within Articles 8 and 9 likely disappearing from the current legal framework.

The target consultation also considers the introduction of specific prohibitions relating to the labelling and communication of financial products, such as banning products that do not fall under the relevant product categories from using such terms as “sustainable” and “green”.

Given the page space given to this topic in the consultation, it is evident that the Commission is giving genuine consideration to a product categorisation system. The development of a labelling system would have the effect of aligning the SFDR more closely with the UK’s (yet to be finalised) sustainable finance regulatory framework. We are also expecting the US Securities and Exchange Commission to publish proposals for its ESG rules for investment advisers which will include a labelling system. Greater alignment is of course to be welcomed, but interoperability is vital for those AIFMs operating globally.

Conclusion

Despite having been introduced less than three years ago, the wide-ranging scope of the European Commission consultation on the SFDR demonstrates that Brussels is increasingly receptive to a substantial, if not complete, overhaul of the existing regime. The potential implications for AIFMs falling within the scope of the current SFDR regime, including non-EU AIFMs marketing funds into the EU, could be highly significant—particularly if the European Commission chooses to expand the current disclosure obligations to all financial products. While the European Commission’s final proposals will not be revealed until Q2 2024 at the earliest, AIFMs can contribute to the policymaking process by providing feedback here.

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 the Gibson Dunn lawyer with whom you usually work, any member of Gibson Dunn’s Global Financial Regulatory or Investment Funds teams, or the following authors:

Michelle M. Kirschner – London (+44 20 7071 4212, [email protected])
James M. Hays – Houston (+1 346 718 6642, [email protected])

As of 13 October 2023, Germany has adopted a new type of class action. The new law is an incremental step towards more collective redress in Germany. The new regime maintains the existing restriction that requires qualified consumer protection organizations to bring the action. However, these entities may now seek damages from defendants directly on behalf of the class. Together with the several coinciding factors detailed below, the new class action might lead to a more fundamental change in the German litigation landscape.

The previous collective redress regime only allowed for declaratory judgments. After obtaining a judgment, plaintiffs had to file individual lawsuits to get the desired relief, i.e. payment of damages. This two-tier mechanism was one of several factors that evoked substantial criticism in Germany. It also made the so called “Declaratory Model Action” (“DMA”) unpopular with plaintiffs. In the five years since its inception in 2018, only roughly 35 DMAs were filed. The German legislator estimated in 2018 that 450 DMAs would be filed per year.

The new class action aims to address the deficiencies of the existing regime. It is based on the EU Directive 2020/1828 on Representative Actions (which we discussed in a prior client alert). The EU Directive requires all EU member states to implement new class action regimes by 2023 while allowing them considerable leeway to implement the directive’s broad requirements into their national legal systems. The Netherlands, for example, have created a plaintiff-friendly class action system with an opt-out mechanism.

Germany, on the other hand, has opted for a cautious evolution of its collective redress provisions. The hallmarks of the new German regime and our predictions for its future relevance are set forth below:

Qualified Entities as Plaintiffs

Just like under the previous regime, the new class action can only be brought by qualified consumer protection organizations under German law as well as qualified entities from other EU member states (so-called qualified entities – QEs). This requirement is meant to prevent frivolous class actions.

The consumer protection organizations are required to inform consumers on their homepages about all representative actions they are planning to or have already filed, as well as the status of all pending actions. Potential defendants may be able to use this as an early-warning system for new class actions against them.

Permissible Relief

Qualified entities can now directly sue defendants for damages or other forms of relief on behalf of the consumers concerned. After a favorable verdict for the class, the court will request the parties to devise a settlement on how to distribute the funds. If no settlement is reached, the court will appoint a claims administrator to distribute the funds. Funds which are not claimed by consumers or cannot be distributed to class members are transferred back to the defendant. There is no potential for a cy-pres award like in the U.S.

Broad Scope

Under the EU Directive, the member states are only obliged to allow class actions with regard to an exhaustive list of EU provisions on consumer protection. Germany has not restricted the scope of collective redress. All matters that could be litigated in an individual civil lawsuit in Germany can be litigated in the new class action. This includes classic subject matters for collective redress such as product safety and mass torts as well as the emerging litigation issues around ESG, data privacy, and private enforcement of new EU legislation (i.e. the EU Digital Markets Act or its proposed AI Regulation).

Class Definition

Unlike many class actions in the U.S., consumers have to opt-in to join a German class action and there is no requirement for class certification. However, the qualified entity acting as plaintiff will have to show in its statement of claim that at least 50 consumers are affected by the class action and that the consumers’ claims present substantially similar questions of law or fact. These two prongs are reminiscent of the numerosity and commonality requirements in U.S. class actions under Rule 23 (a) FRCP.

Consumers will have a longer period for considering an opt-in than before. They can opt into the class until three weeks after the conclusion of the oral hearing. This allows consumers to react to positive developments late in the proceedings.

Limitations on Third-Party Funding

The new law allows third-party funding for class actions, but imposes fairly strict requirements. If the requirements are not met, the class action will be dismissed. Any third party funding a class action may not be a competitor of the defendant or in any way (economically) dependent on the defendant. More importantly, the third-party funder must not be promised more than ten percent of the proceeds from the class action. If a class action is funded by a third-party, the plaintiff is obliged to disclose its arrangements with the funder.

These prerequisites will likely deter many third-party funders from entering the German class action litigation market.

No Additional Discovery Provisions

Germany has not made use of the leeway under the EU Directive to allow for more discovery in consumer class actions. While courts can order a party to produce certain documents clearly defined by the other party, there will be no U.S.-style discovery in German class actions.

However, courts may now repeatedly fine parties up to EUR 250,000 if they fail to comply with a court order to produce the requested document or item.

Parallel Individual Actions

Consumers who have not opted into the class action will be able to sue the same defendant individually for the same claims as in the class action. Defendants will, therefore, have to prepare to defend numerous individual lawsuits in parallel to the new class action.

Cost Recovery

As is customary in Germany and the EU, the losing party will be required to bear the costs of the class action. This again is meant to discourage frivolous lawsuits. In theory, this also includes the opposing party’s legal fees. However, the recoverable amount is limited by statute and depends on the amount in dispute. The new German law caps the amount in dispute at EUR 300,000. This equals a maximum amount for recoverable legal fees in the range of EUR 10,000.

Tolling of Statutes of Limitations

Opting into a class action suspends the statute of limitations for consumers – even for consumers who later opt out again.

Therefore, consumers can toll the statute of limitations by opting into a class action as a mere precaution. They are free to opt out at a later stage and pursue individual claims against the defendant, as long as they opt out before the cut-off point three weeks after the first oral hearing on the merits.

Settlements

Similar to U.S. class actions, all settlements in German class actions must be scrutinized by the court. The court will reject the settlement if it is not “fair”. Settlements are final and binding for the parties as well as the consumers who have opted into the class action. However, consumers may opt out of a settlement within a month after the settlement was published in the class action register.

Outlook

The new law has been met with both approval and criticism from stakeholders and interested parties. For the time being, the new class action regime as such will certainly not turn Germany into a class action hot spot. However, in combination with ever increasing regulatory activity by national and European rule makers, an increasing focus on private enforcement of regulations, and a German judiciary that is generally willing to create consumer-friendly law, such as in the context of the diesel emissions cases, this may provide to be just the perfect mix for a more fundamental change of the German litigation landscape in the long run. Companies are certainly well advised to monitor closely whether they may be the target of class actions under the new German regime, and to prepare accordingly.

The following Gibson Dunn lawyers prepared this client alert: Alexander Horn, Markus Rieder, Friedrich Wagner, and Annekathrin Schmoll.

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 in the firm’s Class Actions, Litigation, or Appellate and Constitutional Law practice groups, the authors, or any of the following leaders and members of the Class Actions Group:

Frankfurt:
Alexander Horn (+49 69 247 411 537, [email protected])

Munich:
Markus Rieder (+49 89 189 33 162, [email protected])
Friedrich A. Wagner (+49 89 189 33-262, [email protected])

Brussels:
Christian Riis-Madsen (+32 2 554 72 05, [email protected])

Paris:
Eric Bouffard (+33 (0) 1 56 43 13 00), [email protected])
Jean-Pierre Farges (+33 (0) 1 56 43 13 00, [email protected])
Pierre-Emmanuel Fender (+33 (0) 1 56 43 13 00, [email protected])

London:
Susy Bullock (+44 20 7071 4283, [email protected])
Patrick Doris (+44 20 7071 4276, [email protected])
Osma Hudda (+44 20 7071 4247, [email protected])
Ali Nikpay (+44 20 7071 4273, [email protected])
Philip Rocher (+44 20 7071 4202, [email protected])
Deirdre Taylor (+44 20 7071 4274, [email protected])
Doug Watson (+44 20 7071 4217, [email protected])

United States:
Theodore J. Boutrous, Jr. – Los Angeles (+1 213-229-7000, [email protected])
Christopher Chorba – Co-Chair, Class Actions Group – Los Angeles (+1 213-229-7396, [email protected])
Theane Evangelis – Co-Chair, Litigation 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 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])

The False Claims Act (FCA) is one of the government’s chief tools to address false claims involving government funds, imposing liability on “any person who… knowingly presents, or causes to be presented, a false or fraudulent claim for payment” to the federal government or who “knowingly makes, uses, or causes to be made or used, a false record or statement material to a false or fraudulent claim.”[1] Through its qui tam provisions, the FCA also allows private citizens to file suit on behalf of the government for statutory violations.[2]

The FCA has been increasingly used to address cybersecurity concerns for companies receiving government reimbursement. In October 2021, the DOJ announced its Civil Cyber-Fraud Initiative (the Initiative), emphasizing its intent to use the FCA to hold accountable entities that knowingly (1) provide deficient cybersecurity products or services, (2) misrepresent their cybersecurity practices or protocols, or (3) violate obligations to monitor and report cybersecurity incidents and breaches.[3] Since announcing the Initiative, the DOJ has acted on its commitment by introducing a range of new cybersecurity obligations in government contracts and pursuing various investigations into whether companies have made false statements regarding their cybersecurity compliance.

Digital health companies and drug and device makers are no exception. Recent cases and investigations have been brought against digital health companies and manufacturers of “cyber devices” whose products are directly or indirectly reimbursed by the government. Accordingly, digital health and cyber device companies need to be diligent regarding their cybersecurity systems and claims.

In light of recent enforcement trends, in this alert we discuss:

Recent Federal Food, Drug, and Cosmetic Act (FDCA) amendments requiring cybersecurity information in premarket submissions for cyber devices, as well as the potential implications for FCA liability, and
The rise of FCA cases for claims relating to cybersecurity in the healthcare industry more generally.

Cyber Devices and False Claims in the FDA Approval Process

Recent developments have expanded the risk of cybersecurity-related FCA claims against companies making submissions to the FDA for premarket approval or clearance of cyber devices. On December 29, 2022, the Consolidated Appropriations Act, 2022 (CAA), amended the FDCA to add section 524B, which requires that premarket submissions for cyber devices contain cybersecurity information, including the company’s plans to address cybersecurity vulnerabilities, processes to provide a reasonable assurance that the devices are cybersecure, a software bill of materials, and other information as the Secretary requires.[4] Under the new regulations, cyber devices are defined as any device that: (1) includes software validated, installed or authorized by the sponsor as a device or in a device; (2) has the ability to connect to the internet; and (3) contains any technological characteristics validated, installed, or authorized by the sponsor that could be vulnerable to cybersecurity threats.[5] FDCA section 524B became effective on March 29, 2023, 90 days after enactment of the CAA.[6] However, FDA announced a seven-month transition period of enforcement discretion during which FDA offered support to applicants to navigate the cybersecurity requirements.[7] FDA has stated that, as of October 1, 2023, it expects companies will have had sufficient time to adapt and comply with the new cybersecurity requirements.[8]

More extensive cybersecurity disclosures to FDA expand the potential for cybersecurity-related false statements and subsequent FCA risk. FCA cases for false statements to FDA rely on the “fraud-on-the-FDA” theory. Under the theory, a company may be liable under the FCA if false statements to FDA are material to FDA’s approval or clearance of the device, rendering later claims to a governmental entity, such as the Centers for Medicaid and Medicare Services, false.

The “fraud-on-the FDA” theory was rejected by the First Circuit in D’Agostino v. EV3, Inc., in 2016.[9] In that case, the court held that there was no causal link between false representations to FDA and subsequent payments by the Centers for Medicare and Medicaid Services (CMS).[10] However, since D’Agostino, cases in the Ninth Circuit and statements from the DOJ have suggested that the possibility of FCA liability based on false statements to FDA is not null.

In cases in 2017 and 2021, the Ninth Circuit allowed two FCA cases to go forward in cases where it found that 1) alleged false claims made FDA clearances or approvals fraudulent in the first instance, rendering the subsequent payments to be false, or 2) the false claims rendered the drug at issue not approved or cleared for any proper purpose, making the subsequent claims for payment false.[11] Following the Ninth Circuit’s decisions, the DOJ also filed a statement of interest in U.S. ex rel. Crocano v. Trividia, expressing its stance that “[compliance with the] FDCA may, in certain circumstances, be material to the government’s decision whether to pay for the affected product, and thus relevant in an FCA case.” [12] The Statement explains that per the DOJ’s understanding of the FCA, FDCA violations may be relevant where the violations are “significant, substantial, and give rise to actual discrepancies in the composition, function, safety, or efficacy of the affected product,” such that the product’s “quality, safety, and efficacy fell below what was specified to by the Food and Drug Administration through its approval process.” [13] The Second Circuit ultimately dismissed the case in Trividia, but left open the possibility that fraudulent statements to the FDA could result in FDA liability.[14]

While the courts have made it clear that there must be a very high showing of materiality between the false statement to FDA, FDA clearance or approval, and subsequent government payments, the possibility of FCA liability for false statements during the FDA approval process has not been entirely foreclosed. If a company’s false or fraudulent statement in a premarket submission to FDA regarding a company’s cybersecurity system is material to FDA’s approval of the device, such that in light of the misstatement, the “quality, safety, and efficacy of the device fell below what was specified to by the Food and Drug Administration through its approval process,” the statement may draw the attention of the government and FCA plaintiffs. Similarly, false or fraudulent statements in a premarket notification could be material to clearance of a 510(k) device. Information such as companies’ plans to address cybersecurity vulnerabilities, which are specifically required under the new statutory provision, and which FDA has stressed in guidance are critical to patient safety, may be considered material for the purposes of FCA claims.[15]

With this increased focus on cybersecurity for FCA investigations and the potential reopening of the fraud-on-the-FDA theory of liability, companies should take significant care in the statements made to FDA regarding their cybersecurity practices and procedures.

Cybersecurity-Related FCA Claims Since the Civil Cyber-Fraud Initiative

FCA claims involving cyber devices would fall readily into the line of enforcement actions brought against other companies for false claims relating to cybersecurity systems and disclosures. Prior to the launch of the Initiative, in U.S. ex rel. Delaney v. eClinicalWorks, eClinicalWorks, one of the largest vendors of electronic health records software, agreed to pay $155 million to resolve claims that it had allegedly misrepresented the security capabilities of its software as part of the certification process for the Department of Health and Human Services’ Electronic Health Records Incentive Program.[16] In U.S. ex rel. Awad v. Coffey Health System, the hospital system, Coffey Health, agreed to pay $250,000 to settle claims alleging that it falsely attested that it had conducted security risk analyses as part of the same Electronic Health Records Incentive Program.[17]

In the DOJ’s first resolution under the Initiative, United States ex rel. Lawler v. Comprehensive Health Servs., Inc. et al. and United States ex rel. Watkins et al. v. CHS Middle East, LLC, global medical services provider Comprehensive Health Services LLC agreed to pay $930,000 to settle claims that it allegedly failed to comply with contract requirements for medical services, including the use of a secure electronic medical records system.[18] More recent cases, such as a June 2023 settlement by Jelly Bean Communications Design LLC for alleged failures to maintain the ongoing cybersecurity of a health insurance website, suggest that the DOJ’s spotlight on cybersecurity and healthcare companies only stands to grow.[19]

Takeaways

Cybersecurity is a major focus area for government FCA investigations. In light of recent new cybersecurity requirements, content in premarket submissions to FDA on cybersecurity procedures and disclosures constitute another area of increasing risk for companies. It is critical for companies with products or services that may receive government reimbursement to ensure that their cybersecurity systems are up-to-date and any statements made regarding those systems are accurate. Doing so will be central to managing FCA risk in the rapidly-changing cybersecurity landscape.

_____________________________

[1] False Claims Act (FCA), 31 U.S.C. § 3729(a)(1)(A)–(B).

[2] Id. at § 3730(c)-(d).

[3] U.S. Dep’t of Justice, Press Release, “Deputy Attorney General Lisa O. Monaco Announces New Civil Cyber-Fraud Initiative” (Oct. 6, 2021).

[4] See U.S. Food & Drug Admin., “Cybersecurity in Medical Devices: Frequently Asked Questions” (Sept. 26, 2023).

[5] 21 U.S.C. § 360n-2(c); see also U.S. Food & Drug Admin., “Cybersecurity in Medical Devices: Frequently Asked Questions” (Sept. 26, 2023). A “device” is more generally defined by FDCA section 201(h) as an instrument, apparatus, implement, machine, contrivance, implant, in vitro reagent, or other similar or related article, including a component part, or accessory which is: (A) recognized in the official National Formulary, or the United States Pharmacopoeia, or any supplement to them; (B) intended for use in the diagnosis of disease or other conditions, or in the cure, mitigation, treatment, or prevention of disease, in man or other animals, or (C) intended to affect the structure or any function of the body of man or other animals, and which does not achieve its primary intended purposes through chemical action within or on the body of man or other animals and which is not dependent upon being metabolized for the achievement of its primary intended purposes. The term “device” does not include software functions excluded pursuant to section 520(o). Food, Drug & Cosmetic Act, section 201(h); U.S. Food & Drug Admin., “How to Determine if Your Product is a Medical Device” (March 29, 2022).

[6] CAA § 3305(c), 21 U.S.C. § 331 note.

[7] U.S. Food & Drug Admin., “Cybersecurity in Medical Devices: Frequently Asked Questions” (Sept. 26, 2023); 88 Fed. Reg. 19148 (Mar. 30, 2023).

[8] U.S. Food & Drug Admin., “Cybersecurity in Medical Devices: Frequently Asked Questions” (Sept. 26, 2023); 88 Fed. Reg. at 19149.

[9] D’Agostino v. EV3, Inc., 845 F.3d 1 (1st Cir. 2016).

[10] Id., at 7.

[11] Dan Abrams Co. v. Medtronic Inc., No. 19-56377 (9th Cir. 2021); US ex rel. Campie v. Gilead Sciences, Inc., 862 F. 3d 890 (9th Cir. 2017).

[12] U.S. Statement of Interest in U.S. ex rel. v. Trividia Health Inc., CASE NO. 22-CV-60160-RAR (S.D. Fla.).

[13] Id., at 2.

[14] United States of America ex rel., Patricia Crocano v. Trividia Health Inc., Order Granting Mot. to Dismiss (S.D. Fla. 2022).

[15] 21 U.S.C. § 360n-2(b)(1); U.S. Food & Drug Admin., Guidance for Industry and Food & Drug Admin. Staff, Cybersecurity in Medical Devices: Quality System Considerations and Content of Premarket Submissions (Sept. 27, 2023), at 11.

[16] U.S. Dep’t of Justice, Press Release, “Electronic Health Records Vendor to Pay $155 Million to Settle False Claims Act Allegations” (May 31, 2017).

[17] U.S. Dep’t of Justice, Press Release, “Kansas Hospital Agrees to Pay $250,000 To Settle False Claims Act Allegations” (May 31, 2019).

[18] U.S. Dep’t of Justice, Press Release, “Medical Services Contractor Pays $930,000 to Settle False Claims Act Allegations Relating to Medical Services Contracts at State Department and Air Force Facilities in Iraq and Afghanistan” (March 8, 2022).

[19] U.S. Dep’t of Justice, Press Release, “Jelly Bean Communications Design and its Manager Settle False Claims Act Liability for Cybersecurity Failures on Florida Medicaid Enrollment Website” (March 14, 2023).

The following Gibson Dunn lawyers assisted in preparing this alert: Winston Chan, Jonathan Phillips, Gustav Eyler, John Partridge, Christopher Rosina, Carlo Felizardo, and Nicole Waddick.*

Gibson Dunn lawyers regularly counsel clients on the False Claims Act issues. Please feel free to contact the Gibson Dunn lawyer with whom you usually work, the authors, or any leader or member of the firm’s False Claims Act/Qui Tam Defense Group:

False Claims Act/Qui Tam Defense Group:

Washington, D.C.
Jonathan M. Phillips – Co-Chair (+1 202-887-3546, [email protected])
F. Joseph Warin (+1 202-887-3609, [email protected])
Joseph D. West (+1 202-955-8658, [email protected])
Geoffrey M. Sigler (+1 202-887-3752, [email protected])
Lindsay M. Paulin (+1 202-887-3701, [email protected])
Gustav W. Eyler (+1 202-955-8610, [email protected])

San Francisco
Winston Y. Chan – Co-Chair (+1 415-393-8362, [email protected])
Charles J. Stevens (+1 415-393-8391, [email protected])

New York
Reed Brodsky (+1 212-351-5334, [email protected])
Mylan Denerstein (+1 212-351-3850, [email protected])
Alexander H. Southwell (+1 212-351-3981, [email protected])
Christopher Rosina – New York (+1 212-351-3855, [email protected])
Brendan Stewart (+1 212-351-6393, [email protected])

Denver
John D.W. Partridge (+1 303-298-5931, [email protected])
Robert C. Blume (+1 303-298-5758, [email protected])
Monica K. Loseman (+1 303-298-5784, [email protected])
Ryan T. Bergsieker (+1 303-298-5774, [email protected])

Dallas
Andrew LeGrand (+1 214-698-3405, [email protected])

Los Angeles
Nicola T. Hanna (+1 213-229-7269, [email protected])
Jeremy S. Smith (+1 213-229-7973, [email protected])
Deborah L. Stein (+1 213-229-7164, [email protected])
James L. Zelenay Jr. (+1 213-229-7449, [email protected])

Palo Alto
Benjamin Wagner (+1 650-849-5395, [email protected])

*Nicole Waddick is an associate practicing in the firm’s San Francisco office who currently is not admitted to practice law.

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

Specifically, the Final Amendments:

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

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

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

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

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

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

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

Current

Revised
(starting Sept. 30, 2024)

Initial 13G
Due Date

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

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

Periodic
13G/A Due Date and Trigger

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

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

Cash-Settled Derivatives

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

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

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

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

Group Formation

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

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

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

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

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

Effective Dates

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

Implications

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

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

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

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

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

Securities Regulation and Corporate Governance Group:
Elizabeth Ising – Washington, D.C. (+1 202-955-8287, [email protected])
James J. Moloney – Orange County (+1 949-451-4343, [email protected])
Lori Zyskowski – New York (+1 212-351-2309, [email protected])
Brian J. Lane – Washington, D.C. (+1 202-887-3646, [email protected])
Ronald O. Mueller – Washington, D.C. (+1 202-955-8671, [email protected])
Thomas J. Kim – Washington, D.C. (+1 202-887-3550, [email protected])
Michael A. Titera – Orange County (+1 949-451-4365, [email protected])
Aaron Briggs – San Francisco (+1 415-393-8297, [email protected])
Julia Lapitskaya – New York (+1 212-351-2354, [email protected])

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

Derivatives Group:
Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, [email protected])
Darius Mehraban – New York (+1 212-351-2428, [email protected])
Adam Lapidus – New York (+1 212-351-3869, [email protected])

Mergers and Acquisitions Group:
Ed Batts – Palo Alto (+1 650-849-5392, [email protected])
Robert B. Little – Dallas (+1 214-698-3260, [email protected])
Saee Muzumdar – New York (+1 212-351-3966, [email protected])

Gibson Dunn’s summary of director education opportunities has been updated as of October 2023. A copy is available at this link. Boards of Directors of public and private companies find this a useful resource as they look for high quality education opportunities.

This quarter’s update includes a number of new opportunities as well as updates to the programs offered by organizations that have been included in our prior updates. Some of the opportunities include unique events for members of private boards.

Read More

The following Gibson Dunn attorneys assisted in preparing this update: Hillary Holmes, Lori Zyskowski, Elizabeth Ising, and Ronald Mueller, with assistance from Mason Gauch and To Nhu Huynh from our Houston office.

Singapore’s highest court rendered decision in Kuvera Resources Pte Ltd v JPMorgan Chase Bank, N.A. [2023] SGCA 28, holding that the interpretation of a sanctions clause in the context of a letter of credit was to be strictly and objectively construed. In this case, the court held that the bank’s concern of a potential adverse finding by the US Office of Foreign Assets Control (“OFAC”) did not suffice to excuse it from paying on an otherwise complying presentation. The court further expressed doubt as to whether such a clause was compatible with the commercial purpose of a letter of credit.

Background Facts

In 2019, a contract for the sale of coal to be delivered in two shipments was entered into between an Indonesian seller and a UAE buyer. The appellant, Kuvera Resources Pte Ltd, had advanced funds to the seller to purchase coal for on-selling to the buyer and was the beneficiary of two irrevocable letters of credit payable at sight (“the LCs”). Both LCs were issued by a bank in Dubai, subject to the Uniform Customs and Practice for Documentary Credits, 2007 Revision (“UCP600”). JPMorgan (“the Bank”) was the advising and nominated bank for both LCs.

At the time, all of the Bank’s advices and confirmations contained a sanctions clause in the following terms:

[The Bank] must comply with all sanctions, embargo and other laws and regulations of the U.S. and of other applicable jurisdictions to the extent they do not conflict with such U.S. laws and regulations (“applicable restrictions”). Should documents be presented involving any country, entity, vessel or individual listed in or otherwise subject to any applicable restriction, we shall not be liable for any delay or failure to pay, process or return such documents or for any related disclosure of information.

Kuvera subsequently made complying presentations to the Bank, which were then screened for potential sanctions issues. It transpired that the vessel in this case was on an internal list maintained by the bank, on the basis that it might have been Syrian-owned despite its non-Syrian registration. The Bank’s list was different to the list published by OFAC on its website, as it included other entities that the Bank had determined had known businesses in sanctioned countries. On the basis of the vessel being on the Bank’s list, it declined to pay on the LCs.

The Decision

Interpretation of the sanctions clause

The Court of Appeal, which is Singapore’s highest court, found that the sanctions clause did not afford a basis to decline payment. The court held that the sanctions clause only permitted the bank to decline payment if the vessel was “listed in or otherwise subject to any applicable restriction.” The vessel, not being listed by OFAC and only in the bank’s internal document, did not qualify as having been “listed in…any applicable restriction.” The court then considered whether the vessel might be said to be “otherwise subject to any applicable restriction.”

The court rejected a subjective approach to this question, finding that it did not suffice even if it could be shown that OFAC may or would have found that paying Kuvera was a breach of US sanctions; nor did it matter that the Bank was reasonably concerned that making payment could or would have been found by OFAC to be a breach of US sanctions.

Instead, an objective approach was required. Accordingly, the only relevant question was whether, as a matter of objective determination, the vessel had been Syrian-owned at all material times.

The court explained that:

(a) Allowing a nominated bank to decline payment based on what OFAC (which was not identified in the sanctions clause) may eventually find was considered arbitrary and speculative. This did not afford a beneficiary any certainty as to payment. The court noted evidence that the OFAC process itself was elaborate and long-drawn.

(b) The list maintained by the Bank reflected its own judgment, and an entity could be listed even if the risk of violation of US sanctions was less than even. The court went on to opine that even the presence of ‘red flags’ surrounding the ownership of the vessel, but which could not be resolved entirely, did not suffice to demonstrate that the vessel was in fact subject to an applicable restriction.

(c) Even though there was correspondence with OFAC that resulted in OFAC opining that there would have been “an apparent violation of OFAC regulations” based on information provided by the Bank, the court viewed the request as seeking support from OFAC for a decision the Bank had already made.

The court went on to analyze the evidence put forward on the ownership of the vessel and found it insufficient to displace the presumption of ownership arising from the vessel’s non-Syrian registration. Accordingly, the Bank was unable to discharge its burden of justifying its non-payment.

Whether sanctions clauses are enforceable

The court accepted that additional conditions stipulated in a confirmation could be binding and need not be separately offered and accepted so long as they did not contradict the commercial purpose of the LCs. In this regard, the court expressed doubt whether the sanctions clause in question was inconsistent with the commercial purpose of the LCs, particularly in a situation concerning the nomination of a vessel. This was because the beneficiary would not be involved in nominating the vessel, and therefore would have no knowledge at the time of contracting whether the letter of credit would be enforceable.

The court also noted the lack of any direct authority expressly upholding the validity of a sanctions clause in the context of UCP600 or documentary letters of credit generally. While there was English authority recognizing sanctions clauses, these were in respect of general commercial transactions. The court was particularly focused on the fact that letters of credit had a unique characteristic as autonomous contracts, and that confirmations (which, in this case, contained the sanctions clause) were often unilateral and would not have been negotiated or agreed by the beneficiaries.

Lessons

The primary takeaway from this decision is that, at least under Singapore law, a sanctions clause will be construed strictly and objectively. If greater discretion is desired to decline payment based on an internal assessment by the bank, or even correspondence with OFAC, this needs to be spelt out clearly in the clause.

However, the greater the discretion afforded to decline payment, the greater the likelihood the court may also find the sanctions clause to be incompatible or inconsistent with the purpose of the letter of credit, which is to give the beneficiary “an assured right to be paid”. It may be that a sanctions clause agreed to by the parties to the underlying transaction, including the beneficiary, would be viewed more favorably. This, of course, changes how such transactions are presently carried out.

The following Gibson Dunn lawyers prepared this client alert: Paul Tan and David Wolber.

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 International Arbitration, International Trade, or Financial Institutions practice groups, or any of the following:

International Arbitration Group:
Cyrus Benson – London (+44 20 7071 4239, [email protected])
Penny Madden KC – London (+44 20 7071 4226, [email protected])
Rahim Moloo – New York (+1 212-351-2413, [email protected])
Philip Rocher – London (+44 20 7071 4202, [email protected])
Paul Tan – Singapore (+65 6507 3677, [email protected])

International Trade Group:
Kelly Austin – Hong Kong/Denver (+1 303-298-5980, [email protected])
Stephenie Gosnell Handler – Washington, D.C. (+1 202-955-8510, [email protected])
Michelle M. Kirschner – London (+44 20 7071 4212, [email protected])
Adam M. Smith – Washington, D.C. (+1 202-887-3547, [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])

Financial Institutions Group:
Stephanie Brooker – Washington, D.C.(+1 202-887-3502, [email protected])
M. Kendall Day – Washington, D.C. (+1 202-955-8220, [email protected])
Matthew Nunan – London (+44 20 7071 4201, [email protected])
Jamie Thomas – Singapore (+65 6507 3609, [email protected])

On October 4, 2023, Colorado’s Attorney General Philip J. Weiser issued a formal legal opinion (“Opinion”) confirming the legality and praising the benefits of diversity, equity, and inclusion (“DEI”) programs and policies in the workplace. The Opinion makes clear that, despite the increase in legal challenges to DEI programs after the Supreme Court struck down affirmative action in college admissions (Students for Fair Admissions v. President & Fellows of Harvard Coll., 600 U.S. 181 (2023) (“SFFA”)), the Colorado Attorney General’s Office is highly unlikely to challenge the DEI policies or programs of companies under its jurisdiction.

A. Background

Attorney General Weiser first affirmed his office’s commitment to workplace DEI initiatives on July 19, 2023, when he signed a joint letter to Fortune 100 companies from 21 Democratic attorneys general, reassuring companies that efforts to recruit diverse workforces and create an inclusive work environment are still legal after the SFFA decision. That letter was issued just six days after a group of 13 Republican state attorneys general published a letter to the same Fortune 100 companies, which threatened “serious legal consequences” for the use of race-based employment preferences and diversity policies.

In an October 4 press release, the Colorado Attorney General’s Office explained that AG Weiser issued the Opinion in an effort “to respond to questions and concerns about the constitutionality of DEI programs in the wake of the recent U.S. Supreme Court decision in [SFFA],” and to clarify that the Supreme Court decision was limited to colleges’ and universities’ admissions policies—not private workplaces, which are subject to Title VII of the Civil Rights Act of 1964 (“Title VII”).

B. Legal Opinion

The Colorado Attorney General’s five-page opinion poses the question, “Are Diversity, Equity, and Inclusion programs (‘DEI programs’) used by employers now unlawful following the recently decided [SFFA] decision[?]” AG Weiser’s short answer is “No.” He clarifies that “[w]orkplace DEI programs were not addressed and were not held unconstitutional by the U.S. Supreme Court in SFFA,” because that decision applied only to college and university admissions, and interpreted the Equal Protection Clause of the U.S. Constitution and Title VI of the Civil Rights Act of 1964, neither of which governs private companies that do not receive federal funds.

The Opinion further explains that the Supreme Court in SFFA “relied exclusively on case law developed in the context of university admissions programs” and found that the admissions policies at issue (1) failed the “strict scrutiny” test applicable to government policies that discriminate on the basis of race; (2) impermissibly used race as a negative or a stereotype; and (3) lacked an “end point.” The SFFA decision, therefore, “did not address the law governing consideration of race in the employment context, nor did it address the validity of DEI programs in hiring practices and in the workplace.”

AG Weiser observes that, by contrast, “[e]mployer DEI programs remain valid under federal law.” Irrespective of SFFA, he explains, it has long been illegal for an employer to discriminate on the basis of “race, color, religion, sex, or national origin.” 42 U.S.C. § 2000e-2(a)(1). Under this standard, DEI programs that “ensure that all employees receive access to the same opportunities in the workplace—not to ‘adversely affect’ or ‘deprive’ employees of opportunities—do not violate Title VII.” AG Weiser notes that a policy aimed at expanding an organization’s outreach “to historically underrepresented groups,” for instance, would be legal, as it would not adversely impact other applicants.

The Opinion also underscores the validity of the “valid affirmative action” defense, which, as AG Weiser explains, means that “employers may take protected status into account in employment decisions in certain limited circumstances,” where the affirmative action is taken to correct a “manifest imbalance” in a given position and does not “unnecessarily trammel” the rights of employees not subject to the affirmative action program. See United Steelworkers v. Weber, 443 U.S. 193, 208 (1979); Johnson v. Transportation Agency, 480 U.S. 616, 626-27 (1987).

AG Weiser further argues that, far from paring down DEI programs, employers may need to take additional steps to avoid policies that “have a disparate impact on protected classes of employees,” to avoid claims under Title VII. He therefore advises employers to “carefully monitor their policies to ensure that they are not inadvertently disadvantaging protected classes of employees through facially neutral policies.”

AG Weiser also offers a policy defense of DEI programs. The Opinion’s “Factual Background” section contends that Title VII exists to address “well documented” “inequities” in the workplace which persist to this day, including the facts that “[o]n average, women are paid less than men,” that “[w]omen, and particularly women of color, are less likely to hold executive positions,” and that “Black and Hispanic employees suffer workplace discrimination at a 60% higher rate than white employees.” “In order to combat these persistent inequities and achieve the benefits of a diverse workforce,” AG Weiser asserts, “public and private employers of all types have adopted DEI programs.” AG Weiser notes that such programs help “remove barriers” for underrepresented groups, while increasing diversity, equity, and inclusion. The Opinion lists what the AG views as valid DEI programs, including the hiring of “chief diversity officers who ensure that all employees enjoy access to mentoring and career development opportunities”; mentorship programs “to increase employee engagement and opportunities for advancement,” especially for underrepresented groups; recruiting efforts aimed at “ensur[ing] a diverse pipeline of applicants”; and employee affinity groups “that can help employees feel a sense of belonging, community, and worth in the workplace.”

The press release accompanying the Opinion confirms the AG’s commitment to DEI in clear terms: “Research demonstrates compelling reasons for why public and private employers would be interested in better meeting the needs of an increasingly diverse world. Organizations with diverse teams are more profitable and companies with diversity across the board are more innovative. The law permits DEI efforts to achieve these benefits of diversity, and employers should periodically review their policies to ensure they are in compliance with the law.”

C. Implications

AG Weiser already took a stance on private-sector DEI programs when he signed the Democratic AGs’ letter to Fortune 100 companies in July. This additional Opinion solidifies AG Weiser’s view on the value and legality of certain workplace DEI programs, signaling to Colorado employers that—at least from the Attorney General’s perspective—they may maintain existing, lawful DEI programs, and take appropriate steps to avoid “a disparate impact on protected classes of employees.” At the same time, depending on the nature of their DEI programs, employers still face legal risk from private plaintiffs and other government agencies who may challenge the legality of DEI programs and allege that they are discriminatory under Title VII or Section 1981 of the 1866 Civil Rights Act. Gibson Dunn has formed a DEI Task Force to assist employers with these issues.

The following Gibson Dunn attorneys assisted in preparing this client update: Jessica Brown, Jason C. Schwartz, Katherine V.A. Smith, and Anna Ziv.

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, the authors, or the following practice and DEI Task Force leaders and partners:

Jessica Brown – Partner, Labor & Employment Group, Denver
(+1 303-298-5944, [email protected])

Mylan L. Denerstein – Partner, Labor & Employment Group, 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])

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])

To continue assisting US companies with planning for SEC reporting and capital markets transactions into 2024, we offer our annual SEC Desktop Calendar. This calendar provides both the filing deadlines for key SEC reports and the dates on which financial statements in prospectuses and proxy statements must be updated before use (a/k/a financial staleness deadlines).

You can download a PDF of Gibson Dunn’s SEC Desktop Calendar for 2024 at the link below.

Read More

The following Gibson Dunn attorneys assisted in preparing this update: Hillary Holmes, Lori Zyskowski, Malakeh Hijazi and Kyle Clendenon.

On September 29, 2023, the U.S. Food and Drug Administration (FDA) released its highly anticipated proposed rule on laboratory-developed tests (LDTs) (“LDT Proposed Rule”), which was officially published in the Federal Register on Tuesday, October 3, 2023.[1] In the LDT Proposed Rule, FDA announced plans to formally classify LDTs as medical devices under its regulations, subjecting these tests to extensive premarket review and postmarket compliance requirements. If finalized, the LDT Proposed Rule would result in a significant impact to the growing laboratory testing industry. In addition, even if the Proposed Rule is not finalized, federal healthcare programs and private payors may use issuance of the Proposed Rule and its assertion of FDA authority over LDTs to refuse payment for tests on the basis that those test lack necessary premarket clearances or otherwise are not reasonable and necessary. FDA has invited interested stakeholders to submit comments to Docket No. FDA-2023-N-2177 by December 4, 2023.[2]

Historical Background

LDTs are diagnostic tests that are designed, manufactured, and used within a single laboratory.[3] FDA has historically asserted that LDTs are in vitro diagnostics,[4] which it regulates as medical devices under the Federal Food, Drug, and Cosmetic Act (FDCA).[5] In relevant part, the FDCA defines “device” as “ an instrument, apparatus, implement, machine, contrivance, implant, in vitro reagent, or other similar or related article . . . which is . . . intended for use in the diagnosis of disease or other conditions, or in the cure, mitigation, treatment, or prevention of disease, in man or other animals.”[6] Industry has pushed back on these characterizations, including in several citizen petitions,[7] claiming that LDTs are not “articles” that meet the definition of “device” under the FDCA, but are rather laboratory “services” that are instead regulated by the Centers for Medicare & Medicaid Services (CMS) and state agencies under the Clinical Laboratory Improvement Amendments (CLIA).[8] They have also asserted that tests that are manufactured and conducted solely in a single laboratory fall outside of FDA’s regulatory authority because they are not placed in commercial distribution or into interstate commerce.[9] Seemingly acknowledging the uncertain nature of FDA’s jurisdiction, Congress has considered, but not yet enacted, legislation to expressly provide FDA authority over LDTs, referred to as the Verifying Accurate Leading-edge IVCT Development (VALID) Act.[10]

Nonetheless, prior to Proposed Rule, FDA exercised enforcement discretion for LDTs it considered “low-risk,” as well as LDTs for certain specific uses.[11] It did, however, indicate its intention to enforce medical-device requirements for “medium” and “high-risk” devices.[12] Indeed, in 2019, FDA issued a warning letter to Inova Genomics Laboratory for marketing genetic tests for “predicting medication response,” “reducing negative side effects from certain medications,” and aiding in drug and dose selection without premarket clearance or approval.[13] FDA also issued a 2017 discussion paper, in which the agency proposed to phase in medical device requirements for all LDTs over a four year schedule, but has not yet taken action to implement this plan.[14]

In the LDT Proposed Rule, the Agency asserted that it had made clear that LDTs were medical devices at many points dating back to at least 1997, but had taken an enforcement discretion policy with these products.[15] FDA cited various concerns with the safety, validation, quality, and increasing complexity and ubiquity of LDTs, and their use in making critical medical decisions – including whether or not patients should seek, or healthcare providers should prescribe, treatments – as the basis for its decision to update its regulations to explicitly subject LDTs to its medical device authorities.[16]

As described in greater detail below, if finalized, the LDT Proposed Rule would subject LDT manufacturers to extensive medical device regulatory requirements. In addition, even if the Proposed Rule is not finalized, federal healthcare programs and private payors may use issuance of the Proposed Rule and its assertion of FDA authority over LDTs to refuse payment for tests on the basis that those test lack necessary premarket clearances or otherwise are not reasonable and necessary. Accordingly, it is crucial for interested stakeholders to participate actively in the notice-and-comment process to help shape a final rule on LDT regulation and to prepare for eventual litigation.

Proposed Changes to Assert Medical-Device Jurisdiction over LDTs

The actual changes FDA proposes to make to its regulations are minimal as its redline reflects:

FDA plans to amend the authority to 21 C.F.R. Part 809, which governs IVDs as follows: “21 U.S.C. 321(h)(1), 331, 351, 352, 355, 360b, 360, 360c, 360d, 360e, 360h, 360i, 360j, 371, 372, 374, 381.” The added authorities include the definition of “device” under the FDCA; provisions for medical device establishment registration, product listing, and premarket notification (510(k)); and, the statutory provision for premarket approval (PMA).[18] The deleted authorities address applications for the approval of new drugs for humans and animals.[19]
FDA also plans to amend the definition of IVD in 21 C.F.R. § 809.3(a) to expressly note that IVDs are medical devices regardless of whether they are manufactured by a laboratory: “In vitro diagnostic products are those reagents, instruments, and systems intended for use in the diagnosis of disease or other conditions, including a determination of the state of health, in order to cure, mitigate, treat, or prevent disease or its sequelae. Such products are intended for use in the collection, preparation, and examination of specimens taken from the human body. These products are devices as defined in section 201(h) of the Federal Food, Drug, and Cosmetic Act (the act), and may also be biological products subject to section 351 of the Public Health Service Act, including when the manufacturer of these products is a laboratory.”[20]

The impact of these changes, however, is significant. Indeed, as described throughout the LDT Proposed Rule, FDA intends to subject LDTs to the same extensive regulatory requirements applicable to other IVDs, including those pertaining to premarket review, as applicable, (e.g., 510(k)s, PMAs, or de novo classifications, for both current LDTs and for future changes made), the quality system regulation (QSR), medical device reporting (MDR), reports of corrections or removals, establishment registration and product listing, product labeling, and investigational use.

Compliance Policy for LDTs

Acknowledging the significance of the impacts of the proposed rule, FDA stated its intention to follow a four-year “phaseout” of its current enforcement discretion policy.[21] FDA specifically plans to extend this policy to “IVDs that are manufactured and offered as LDTs,” recognizing that some manufacturers have marketed IVDs as LDTs even where those tests do not fit what FDA generally considers an LDT. Id. FDA proposes that the phaseout policy proceed as follows:

Stage 1 (1 year after FDA publishes a final phaseout policy, planned for the preamble of the final rule): end of general enforcement discretion with respect to MDR and correction and removal reporting requirements.
Stage 2 (2 years after FDA publishes a final phaseout policy): end of general enforcement discretion for medical device requirements other than MDR, correction and removal reporting, QSR, and premarket review.
Stage 3 (3 years after FDA publishes a final phaseout policy):end of general enforcement discretion with respect to QSR requirements.
Stage 4 (3.5 years after FDA publishes a final phaseout policy, but not before October 1, 2027): end of general enforcement discretion with respect to premarket review for high-risk LDTs. Id. at 58, 64-66. FDA notes that it does not intend to take enforcement against high-risk devices with timely submitted PMAs until the agency completes review of its application.
Stage 5 (4 years after FDA publishes a final phaseout policy, but not before April 1, 2028): end of general enforcement discretion with respect to premarket review for medium and low-risk LDTs.[22]

The phaseout policy is, however, subject to a number of carveouts:

The phaseout policy does not extend to certain classes of tests that FDA considers not to have been subject to its prior enforcement discretion policy. These include tests intended for screening of donors for blood, or for human cells, tissues, and cellular and tissue-based products (HCT/Ps) required for infectious disease testing; tests intended for emergencies, potential emergencies, or material threats declared under FDCA section 564; and, direct-to-consumer (DTC) tests.[23]
Nor does FDA consider test components manufactured outside of a laboratory to be subject to the phaseout policy. FDA states that such components have always been outside the definition of LDT, and therefore of any FDA enforcement discretion policy.[24]
FDA is also “proposing to continue to apply the current general enforcement discretion approach going forward” to certain classes of tests.[25] These include “1976-Type LDTs,” which are generally less-complex tests with characteristics common at the time of the 1976 Medical Device Amendments (MDA) to the FDCA; human leukocyte antigen (HLA) tests within a single CLIA-certified laboratory which meets requirements to perform high-complexity histocompatibility testing; tests intended solely for forensic or law enforcement purposes; and, tests used exclusively for public health surveillance.[26] Although it is not abundantly clear, FDA appears to intend to exercise enforcement discretion for these classes of tests indefinitely – even beyond the end of the four-year phaseout period.
FDA expressly indicates that it does not intend to exercise general enforcement discretion to certain categories of tests for which it had previously done so: low-risk tests that are class I devices; tests currently on the market; and, tests for rare diseases. The agency observed that these tests are among those that have prompted its safety and validation concerns. These tests would therefore appear to be subject to the four-year phaseout policy, rather than a general enforcement discretion policy.[27]

FDA also noted that it may also adopt other enforcement discretion policies as appropriate, and sought input on particular types of enforcement discretion policies that would be appropriate for the agency to adopt. Specific types of LDTs for which FDA has solicited input on enforcement discretion include class I devices, tests in academic medical centers (AMCs), and tests regulated under existing programs, such as the New York State Department of Health Clinical Laboratory Evaluation Program (NYSDOH CLEP) and the Veterans Health Administration (VHA).[28]

Stakeholders should consider submitting comments on the LDT Proposed Rule to help shape FDA’s rulemaking, including whether FDA should regulate LDTs as medical devices at all. In particular, sponsors should seek to identify costs and complications not identified as considerations by FDA, such as the impact of increased compliance costs on affordability of LDTs, the possibility that LDTs may no longer be reimbursable under federal healthcare programs, and whether LDTs, even if regulated as medical devices, should be exempt from particular medical-device requirements; reliance interests that have been built up around the FDA’s longstanding enforcement policy but would be upset by adoption of the LDT Proposed Rule; and potential alternatives or modifications to FDA’s approach that the agency should consider, including any enforcement discretion policies.

Other consequences from the LDT Proposed Rule that sponsors should consider include:

Whether FDA’s proposed regulatory framework and phaseout policy could impact the ability of laboratories to timely develop tests that are vital to both patients and healthcare professionals;
Potential enforcement and compliance risks and costs that would stem from implementation of the LDT Proposed Rule, if finalized; and
Potential impact on reimbursement of diagnostic services by government health care programs and potential related enforcement risks.

Gibson Dunn is prepared to help sponsors and other interested entities consider potential effects of the LDT Proposed Rule, if finalized, and submit comments to FDA regarding the LDT Proposed Rule.

____________________________

[1] 88 Fed. Reg. 68006 (Oct. 3, 2023). FDA also published a press release accompanying the proposed rule. FDA News Release, “FDA Proposes Rule Aimed at Helping to Ensure Safety and Effectiveness of Laboratory Developed Tests” (Sept. 29, 2023) (“Press Release”).

[2] See Docket No. FDA-2023-N-2177.

[3] 88 Fed. Reg. at 68008; see also FDA, Draft Guidance for Industry, Food and Drug Administration Staff, and Clinical Laboratories, Framework for Regulatory Oversight of Laboratory Developed Tests (LDTs) (Oct. 2014) (“2014 Draft Guidance”), at 5.

[4] See 2014 Draft Guidance at 4 (“This document describes a risk-based framework for addressing the regulatory oversight of a subset of in vitro diagnostic devices (IVDs) referred to as laboratory developed tests (LDTs).”) (internal citations omitted).

[5] Id. at 4 n.1 (“Per 21 CFR 809.3(a) in vitro diagnostic devices are ‘those reagents, instruments, and systems intended for use in the diagnosis of disease or other conditions, including a determination of the state of health, in order to cure, mitigate, treat, or prevent disease or its sequelae.[‘] Such products are intended for use in the collection, preparation, and examination of specimens taken from the human body. These products are devices as defined in section 201(h) of the [FDCA] . . . .”).

[6] 21 U.S.C. § 321(h)(2).

[7] See, e.g., Letter to J. N. Gibbs, Hyman, Phelps & McNamara, P.C. re: 92P-0405 (Aug. 12, 1998), Docket No. FDA-1992-P-0047 (“HPM Citizen Petition Response”) (denial of 1992 citizen petition requesting that FDA “not regulate as medical device assays developed by clinical reference laboratories strictly for in-house use”); Citizen Petition from Am. Clinical Lab. Ass’n (ACLA) (June 4, 2013), Docket No. FDA-2013-P-0667 (“ACLA Citizen Petition”) (citizen petition requesting that FDA confirm that LDTs are not medical devices under the FDCA and refrain from issuing guidance or rulemaking purporting to regulate LDTs as medical devices); Letter to A. Mertz, ACLA re: Docket No. FDA-2013-P-0667 (July 31, 2014) (denial of ACLA Citizen Petition).

[8] See 42 U.S.C. § 263a; see also 42 C.F.R. Part 493 (CMS implementing regulations for CLIA).

[9] See HPM Citizen Petition Response, Enclosure at 7-9 (responding to arguments regarding commercial distribution and the Commerce Clause); ACLA Citizen Petition at 11-22 (asserting that FDA cannot regulate LDTs since they are not placed in commercial distribution).

[10] See S. 3404, 116th Cong. (2020); H.R. 6102, 116th Cong. (2020); S. 2209, 117th Cong. (2021); H.R. 4128, 117th Cong. (2021); S. 4348, 117th Cong. (2022); H.R. 2369, 118th Cong. (2023).

[11] 2014 Draft Guidance at 12-13.

[12] Id. at 13.

[13] Warning Letter to Inova Genomics Lab. (Apr. 4, 2019).

[14] See FDA, Discussion Paper on Laboratory Developed Tests (LDTs) (Jan. 13, 2017), at 4-5.

[15] 88 Fed. Reg. at 68015-20.

[16] Id. at 68009-14.

[17] Id. at 68031.

[18] See 21 U.S.C. §§ 321(h)(1), 360, 360e.

[19] See id. §§ 355, 360b

[20] 88 Fed. Reg. at 68031.

[21] Id. at 68021.

[22] Id. at 68024-27.

[23] Id. at 68021-22.

[24] Id. at 68022.

[25] Id.

[26] Id. at 68022-23.

[27] Id. at 68023.

[28] Id. at 68023-24.

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 leader or member of the firm’s FDA and Health Care practice group, or the following authors:

Gustav W. Eyler – Washington, D.C. (+1 202-955-8610, [email protected])
Carlo Felizardo – Washington, D.C. (+1 202-955-8278, [email protected])
John D. W. Partridge – Denver (+1 303-298-5931, [email protected])
Jonathan M. Phillips – Washington, D.C. (+1 202-887-3546, [email protected])
Winston Y. Chan – San Francisco (+1 415-393-8362, [email protected])
Jonathan C. Bond – Washington, D.C. (+1 202-887-3704, [email protected])

On September 27, 2023, the Fifth Circuit revived a lawsuit under the Worker Adjustment and Retraining Notification Act (“WARN Act”) brought against private equity firm Black Diamond Capital Management LLC, concluding that there was a dispute about whether the firm exercised de facto control over one of its portfolio companies.[1]

Background: The WARN Act requires covered employers to provide affected employees with 60 days’ notice before a plant closure or mass layoff—often known as a WARN Act notice.[2] If an employer fails to comply, affected employees may sue the employer for backpay, benefits, and attorney’s fees.[3]

In this case, Bayou Steel operated a steel mill in LaPlace, Louisiana. On September 30, 2019, Bayou Steel closed the LaPlace mill without providing WARN Act notices. After briefly pursuing and then dismissing an action in bankruptcy court against Bayou Steel, Plaintiffs sued the Black Diamond holding company that indirectly owned Bayou Steel, as well as Black Diamond Capital Management, LLC (“BDCM”), the private equity firm acting as the investment advisor, alleging that those entities acted functionally as the combined “single employer” of Bayou Steel’s employees. The district court concluded at summary judgment that the defendants were not liable under the WARN Act because they did not act as a single employer with Plaintiffs’ actual employer, Bayou Steel. Plaintiffs appealed.

Issue Presented on Appeal: Can a private equity firm acting as an investment advisor be liable for a WARN Act violation by its portfolio company in conducting a mass layoff?

The Fifth Circuit’s Holding: A private equity firm may be liable for employment claims arising from operations of a portfolio company if the firm exercised de facto control.

“The WARN Act imposes liability on the ‘employer who orders a plant closing or mass layoff’ without giving the required notice.”[4] To determine “whether a related entity is so intertwined with the employer that the two may be considered a single employer, such that the related entity may be liable for the actual employer’s WARN Act violation,” courts will consider:

“(i) common ownership,

(ii) common directors and/or officers,

(iii) de facto exercise of control,

(iv) unity of personnel policies emanating from a common source, and

(v) the dependency of the operations.”[5]

In 2016, the Third Circuit had applied a similar test in considering, but ultimately declining, to hold Sun Capital Partners liable for employment actions involving a portfolio company.[6] The Fifth Circuit’s decision in Fleming demonstrates that, at least under appropriate facts, the single employer theory advanced in Jevic could result in wider exposure to liability for employment actions.

Specifically, the Fifth Circuit explained that “the hinge of this case” was the third factor, “de facto control,” and examined whether BDCM was responsible for the WARN Act violation.[7] The evidence revealed that “BDCM was intimately involved in any number of significant decisions at Bayou Steel, so much so that Bayou Steel’s CEO felt micromanaged by BDCM employees who were ‘going around [him] constantly.’”[8] For example, BDCM had “helped Bayou Steel implement cost-cutting measures, including a reduction in force, changes to employee benefits and compensation, and renegotiation of vendor contracts” in 2017.[9] The Fifth Circuit ultimately held that the district court had “erred in granting summary judgment to BDCM because there [was] a genuine dispute of material fact as to whether BDCM exercised de facto control over Bayou Steel’s decision to close its LaPlace steel mill and order Plaintiffs’ layoffs.”[10]

What It Means:

Fleming makes clear that the issue of whether a private equity firm may be deemed a “single” or “joint employer” with a portfolio company for a WARN Act violation remains a potential area of risk for private equity managers and owners.
Although the outcome in Fleming was highly fact-driven, the Fifth Circuit’s decision may encourage plaintiffs to advance similar theories against private equity advisors (instead of or in addition to their direct employers) under the WARN Act and other employment statutes.
The decision in Fleming is a reminder that private equity firms and other specialized investment entities should be thoughtful about how they engage, advise, and interact with affiliated companies—even when there is not direct ownership. Courts will carefully scrutinize, in particular, any conduct that suggests that a private equity firm exerted control in decision-making surrounding plant closures, mass layoffs, and other employment actions.
Private equity firms should also be thoughtful in observing corporate formalities and maintaining appropriate corporate separateness, such as forming boards of directors and documenting decision-making processes.

___________________________

[1] See Fleming v. Bayou Steel BD Holdings II L.L.C., No. 22-30260, 2023 WL 6284736, at *1 (5th Cir. Sept. 27, 2023).

[2] See 29 U.S.C. § 2102(a).

[3] Id. § 2104(a).

[4] Fleming, 2023 WL 6284736, at *10 (quoting 29 U.S.C. § 2104(a)(1)).

[5] Id. (citing 20 C.F.R. § 639.3(a)(2)).

[6] See In re Jevic Holding Corp., 656 F. App’x 617, 619 (3d Cir. 2016).

[7] Fleming, 2023 WL 6284736, at *13.

[8] Id.

[9] Id. at *2.

[10] Id. at *15.

The following Gibson Dunn lawyers prepared this client alert: Karl Nelson, Anna Casey, and Claire Piepenburg.

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 Labor and Employment or Private Equity practice groups, or the following authors and practice leaders:

Labor and Employment Group:
Karl G. Nelson – Partner, Dallas (+1 214-698-3203, [email protected])
Jason C. Schwartz – Co-Chair, Washington, D.C. (+1 202-955-8242, [email protected])
Katherine V.A. Smith – Co-Chair, Los Angeles (+1 213-229-7107, [email protected])

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])

Gibson Dunn’s Supreme Court Round-Up provides a preview of cases set to be argued during the October 2023 Term and other key developments on the Court’s docket. During the October 2022 Term, the Court heard argument in 59 cases, released 58 opinions, and dismissed one case as improvidently granted.

Spearheaded by Miguel Estrada, the Supreme Court Round-Up keeps clients apprised of the Court’s most recent actions. The Round-Up previews cases scheduled for argument, tracks the actions of the Office of the Solicitor General, and recaps recent opinions. The Round-Up provides a concise, substantive analysis of the Court’s actions. Its easy-to-use format allows the reader to identify what is on the Court’s docket at any given time, and to see what issues the Court will be taking up next. The Round-Up is the ideal resource for busy practitioners seeking an in-depth, timely, and objective report on the Court’s actions.

To view the Round-Up, click here.

Gibson Dunn has a longstanding, high-profile presence before the Supreme Court of the United States, appearing numerous times in the past decade in a variety of cases. During the Supreme Court’s seven most recent Terms, 11 different Gibson Dunn partners have presented oral argument; the firm has argued a total of 17 cases in the Supreme Court during that period, including closely watched cases with far-reaching significance in the areas of intellectual property, securities, separation of powers, and federalism. Moreover, although the grant rate for petitions for certiorari is below 1%, Gibson Dunn’s petitions have captured the Court’s attention: Gibson Dunn has persuaded the Court to grant 34 petitions for certiorari since 2006.

* * * *

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the Supreme Court. Please feel free to contact the following attorneys in the firm’s Washington, D.C. office, or any member of the Appellate and Constitutional Law Practice Group.

Miguel A. Estrada (+1 202.955.8257, [email protected])
Kate Meeks (+1 202.955.8258, [email protected])
Jessica L. Wagner (+1 202.955.8652, [email protected])

This edition of Gibson Dunn’s Federal Circuit Update summarizes the current status of several petitions pending before the Supreme Court, additional materials released from the ongoing investigation by the Judicial Council of the Federal Circuit, and recent Federal Circuit decisions concerning motions to amend before the Patent Trial and Appeal Board, obviousness, and enablement.

Federal Circuit News

Noteworthy Petitions for a Writ of Certiorari:

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

VirnetX Inc. v. Mangrove Partners Master Fund, Ltd. (US No. 23-315): The questions presented are:
(1) “Whether the Federal Circuit erred in upholding joinder of a party under 35 U.S.C. §315(c), where the joined party did not “properly file[] a petition” for inter partes review within the statutory time limit.”

(2) “Whether the Commissioner’s exercise of the Director’s review authority pursuant to an internal agency delegation violated the Federal Vacancies Reform Act.”

As we summarized in our August 2023 update, there are a few other petitions pending before the Supreme Court.

In Intel Corp. v. Vidal (US No. 23-135), the Court granted an extension for the response, which is now due October 16, 2023. Three amici curiae briefs have been filed.

In HIP, Inc. v. Hormel Foods Corp. (US No. 23-185), the response brief was filed on September 28, 2023.

The Court denied the petitions in Killian v. Vidal (US No. 22-1220), Ingenio, Inc. v. Click-to-Call Technologies, LP (US No. 22-873), and CareDx Inc. v. Natera, Inc. (US No. 22-1066).

Other Federal Circuit News:

Report and Recommendation in Judicial Investigation. As we summarized in our August 2023 update, there is an ongoing proceeding by the Judicial Council of the Federal Circuit under the Judicial Conduct and Disability Act and the implementing Rules involving Judge Pauline Newman. On September 20, 2023, the Special Committee released additional materials in the investigation. The materials may be accessed here.

Upcoming Oral Argument Calendar

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

Key Case Summaries (September 2023)

Sisvel International S.A. v. Sierra Wireless, Inc., No. 22-1387 (Fed. Cir. Sept. 1, 2023): Sierra filed a petition for inter partes review asserting that certain claims of Sisvel’s patents related to mobile phone technology were invalid as anticipated and/or obvious over certain prior art. The Patent Trial and Appeal Board (“Board”) determined that all challenged claims were invalid and rejected Sisvel’s motion to amend because the amendments would improperly enlarge the scope of the claims.

The Federal Circuit (Stark, J., joined by Prost and Reyna, JJ.) affirmed. The Court agreed that Sisvel’s proposed substitute claims would have impermissibly enlarged claim scope. Sisvel argued on appeal that, when considered as a whole, the substitute claims were narrower in scope than the original claims. The Federal Circuit rejected this argument, explaining that if a substitute claim is broader “in any respect,” it is considered broader than the original claim “even though it may be narrower in other respects.”

Netflix, Inc. v. DivX, LLC, No. 22-1138 (Fed. Cir. Sept. 11, 2023): Netflix filed a petition for inter partes review asserting that certain claims of DivX’s patent, which relates to encoding and decoding multimedia files, were invalid as obvious. DivX argued in its patent owner response that one of the prior art references, Kaku, was not analogous prior art. The Board agreed with DivX that Netflix had not met its burden of establishing that Kaku was analogous prior art, in part, because Netflix had failed to identify the relevant field of endeavor.

The Federal Circuit (Stoll, J., joined by Hughes and Stark, JJ.) vacated and remanded. The Court determined that Netflix had articulated two alternative theories concerning the relevant field of endeavor, and that the Board erred in requiring Netflix to explicitly use the words “field of endeavor” when referring to them. The Court stated that it was “reluctant to affirm the Board’s factual finding” in this circumstance because it “rest[ed] on a failure to identify a field of endeavor rather than a clear analysis of why Kaku is not, in fact, directed to the same field of endeavor.” The Court therefore remanded to the Board to decide the question of whether the patent and Kaku were in the same field of endeavor.

Elekta Ltd. v. ZAP Surgical Systems, Inc., No. 21-1985 (Fed. Cir. Sept. 21, 2023): ZAP filed a petition for inter partes review of Elekta’s patent describing a method and apparatus for treating a patient using ionizing radiation. The patent claimed a linear accelerator mounted on a pair of concentric rings to deliver a beam of ionized radiation to a targeted area. The Board instituted review and determined all challenged claims were unpatentable as obvious, rejecting Elekta’s arguments that a skilled artisan would not have been motivated to combine an imaging device with a radiation device.

The Federal Circuit (Reyna, J., joined by Stoll and Stark, J.J.) affirmed. The Court found that substantial evidence, including the patentee’s statements in the prosecution history about whether imaging devices were relevant art, supported the Board’s findings that a skilled artisan would have been motivated to combine imaging systems with radiation-delivery systems. The Court rejected Elekta’s argument that the Board committed legal error by failing to expressly articulate any findings on reasonable expectation of success. Specifically, the Court held that “the Board made no error in addressing the issues of motivation to combine and reasonable expectation of success in the same blended manner that Elekta chose to present those very issues.” The Court held that “an implicit finding on reasonable expectation of success” was acceptable as long as the Court could “reasonably discern” an implicit finding by the Board on reasonable expectation of success.

Baxalta Incorporated v. Genentech, Inc., No. 22-1461 (Fed. Cir. Sept. 20, 2023): Baxalta sued Genentech alleging that Genentech’s Hemlibra^® product infringes Baxalta’s patent directed to a means of treating Hemophilia A, which is a blood clotting disorder. Baxalta’s patent relied on functional language to claim all isolated antibodies capable of binding to certain enzymes that promote blood coagulation. Sitting by designation in the District of Delaware, Judge Dyk determined that the patent did not enable the full claim scope, rending the claims invalid under Section 112.

The Federal Circuit (Moore, CJ, joined by Clevenger and Chen, JJ) affirmed. The Court noted that the inventors used “trial and error” amino acid substitution to identify 11 antibody sequences disclosed in the patent. The patent taught that this well-known substitution technique could also be used by others to find more antibodies meeting the claims from among millions of potential candidates. Following the Supreme Court’s ruling in Amgen v. Sanofi, 598 U.S. 594 (2023), the Court held that this failed to enable the full scope of the claims. As the Court explained, the patent did not disclose “any common structural (or other) feature delineating which antibodies” would meet the claims. Instead, the patent simply directed artisans “to make antibodies and test them,” leaving the public “no better equipped to make … claimed antibodies than the inventors were when they set out.” The Court held that this “roadmap” for “painstaking experimentation” did not enable the patent.

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])

The Securities and Exchange Commission (the “SEC” or the “Commission”) remains intensely focused on the regulation of the private investment funds industry. This roundup summarizes three recent enforcement and administrative items private fund advisers should be aware of.

1. Private Funds Rules Effective Dates Set

On August 23, 2023, the Commission adopted a package of new rules (the “Private Funds Rules”) for private fund advisers (“PFAs”) promulgated under the Investment Advisers Act of 1940 (the “Advisers Act”), which were summarized in our recent client alert here.[1] [2] The Private Funds Rules were published in the Federal Register on September 14, 2023, and will therefore become effective on the dates set forth below. Note, however, that the 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 deadlines below are therefore subject to cancellation if this litigation succeeds in securing the vacatur of the Private Funds Rules altogether.

For purposes of the below table, private fund advisers with $1.5 billion or more in private fund assets under management are referred to as “Larger Advisers,” and private fund advisers with less than $1.5 billion in private fund assets are referred to as “Smaller Advisers.”

Date	Requirement
November 13, 2023	All registered investment advisers (including those without private fund clients) must keep a written record of their annual review of their compliance program (Rule 206(4)-7(b))
September 14, 2024	Subject to certain exceptions, both Larger Advisers and Smaller Advisers (registered or unregistered) with must comply with: the Preferential Treatment Rule (Rule 211(h)(2)-3) the Restricted Activities Rule (Rule 211(h)(2)-1) *Registered* Larger Advisers must comply with: the Adviser-Led Secondaries Rule (Rule 211(h)(2)-2)
March 14, 2025	*Registered* Larger Advisers and Smaller Advisers must comply with: The Audit Requirement (Rule 206(4)-10) Quarterly Statement Requirements (Rule 211(h)(1)-2) All Smaller Advisers (registered or unregistered) must comply with: the Restricted Activities Rule (Rule 211(h)(2)-1) the Preferential Treatment Rule (Rule 211(h)(2)-3 *Registered* Smaller Advisers must comply with: the Adviser-Led Secondaries Rule (Rule 211(h)(2)-2)

More details regarding the nuances related to each rule are summarized in the client alert linked above.

2. Nine Investment Advisers charged in breach of Marketing Rule[3]

On September 12, 2023 the SEC announced that it had conducted an enforcement sweep with respect to violations of the hypothetical performance requirements under Advisers Act Rule 206(4)-1 (the “Marketing Rule”). As a result, nine investment advisers were found to have violated the Marketing Rule for the alleged advertising of hypothetical performance to the general public on public websites without adequate policies and procedures in place “reasonably designed to ensure that the hypothetical performance was relevant to the likely financial situation and investment objectives of the intended audience.” This is consistent with the Marketing Rule’s Adopting Release, in which the Commission stated that this requirement meant that hypothetical performance would generally not be appropriate for general advertising to retail investors.[4]

We expect that the majority of our PFA clients are not in the practice of putting performance projections into the public sphere so as to avoid general solicitation and preserve their exemption from registration of their offerings under the Securities Act of 1933 (the “Securities Act”) and registration of their funds under the Investment Company Act of 1940 (the “Investment Company Act”). Any clients who engage in general solicitation in reliance on Rule 506(c) of Regulation D under the Securities Act should be aware that advertising materials containing hypothetical performance information should be tightly controlled, and should note that investors who only meet the “accredited investor” status are not likely to be deemed sophisticated enough to understand hypothetical performance solely by virtue of such status.

In addition, all advisers should take note that we expect the SEC will continue to focus on violations of the Marketing Rule in its routine examinations. We recommend ensuring that counsel has reviewed any marketing materials in pitchbooks and private placement memoranda ahead of providing those materials to prospective investors. In addition, it bears reminding that many sponsors have historically been in the habit of providing a previous fund’s annual or quarterly reports to prospective investors in a new fund, or inviting prospective new fund investors to annual meetings where existing fund performance is discussed. Any materials, including, but not limited to, investment committee memoranda, related to older funds that are discussed with or provided to prospective new investors in a forthcoming fund should be carefully reviewed to ensure compliance with the Marketing Rule.

3. In Rare Action, Investment Adviser Found to be Acting as an Illegal Broker-Dealer

On September 12, 2023, the Commission entered an Order Instituting Administrative and Cease-and-Desist Proceedings against a registered PFA, pursuant to Sections 15(b) and 21C of the Securities Exchange Act of 1934 (the “Exchange Act”) and Section 203(e) of the Advisers Act (the “Order”).[5] In the Order, the Commission found that the PFA had “willfully violated Section 15(a)(1) of the Exchange Act” which makes it unlawful to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security … unless such broker or dealer is registered in accordance with [the other relevant provisions of the Exchange Act].”[6] The PFA was ordered to pay disgorgement of $594,897, prejudgment interest of $76,896 and a civil monetary penalty of $150,000, totaling $821,793 in sanctions for operating as an unregistered broker-dealer when it received fees in exchange for placing its investment advisory clients into certain third party investment vehicles (that primarily held real estate) without being registered with the Commission as a broker-dealer. The Order does not allege or imply any other aggravating factor (e.g., fraud, unsuitability) with respect to the offerings, and describes the conduct as having occurred between 2012 and 2021.

This action is notable because we have historically seen staff of the SEC address this type of conduct by issuing deficiencies during the course of examinations of investment advisers instead of referring the matter for enforcement action in the absence of other aggregating factors, such as fraud in the underlying offering. Advisers who facilitate introductions of potential investors to issuers should ensure that they do not receive any sort of compensation or fees in exchange for such referrals, unless registered as a broker dealer.

Additional Enforcement Forecast for the Future

Congress recently allocated additional funds to the Commission for the current fiscal year which the Commission has indicated that it plans to use to hire 400 more staff members, including 125 new personnel for its Enforcement Division.[7] As a result, we believe broad ranging enforcement action against private fund managers will only become more frequent in the future.

We would welcome the opportunity to speak with you and provide guidance in light of the developments discussed above.

___________________________

[1] See A Guide to Understanding the New Private Funds Rules, Gibson, Dunn & Crutcher, LLP (Aug. 25, 2023), link.

[2] See Private Fund Advisers; Documentation of Registered Investment Adviser Compliance, Investment Advisers Act Release No. IA-6383 (Aug 23, 2023), link.

[3] A copy of the press release and the settlement orders may be found here: https://www.sec.gov/news/press-release/2023-173.

[4] See Investment Adviser Marketing, Investment Advisers Act Release No. IA-5653 (Dec. 22, 2020), link.

[5] Order Instituting Administrative and Cease-and Desist Proceedings, Pursuant to Sections 15(b) and 21C of the Securities Exchange Act of 1934 and Section 203(e) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, Securities Exchange Act of 1934 Release No. 98354, Investment Advisers Act of 1940 Release No. 6415 (Sept. 12, 2023), link.

[6] Securities Exchange Act of 1934, 15 U.S.C.A. § 78o (West).

[7] See 2023 Mid-Year Securities Enforcement Update, Gibson, Dunn & Crutcher, LLP (Aug. 7, 2023), link.

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 in the firm’s Investment Funds practice group, or the following authors:

Kevin Bettsteller – Los Angeles (+1 310-552-8566, [email protected])
Lauren Cook Jackson – Washington, D.C. (+1 202-955-8293, [email protected])
Gregory Merz – Washington, D.C. (+1 202-887-3637, [email protected])
Shannon Errico – New York (+1 212-351-2448, [email protected])
Zane E. Clark – Washington, D.C. (+1 202-955-8228 , [email protected])

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])

The California Legislature recently passed two wide-reaching bills that will impose significant and mandatory climate-related reporting requirements for large public and private companies doing business in the state. Specifically, the bills will ultimately require annual disclosure of audited Scope 1, 2, and 3 greenhouse gas (“GHG”) emissions and biennial disclosure related to certain climate risks. In support of the bills, the California Legislature cited concerns such as the effect of climate change on the state’s economy, companies’ roles in contributing to and addressing climate-related risks to their own businesses and the state’s economy, and the ability of the state to develop emissions reduction requirements, as well as the lack of transparency and consistency resulting from current voluntary emissions disclosure. Both of the bills rely on existing reporting frameworks and standards established by international organizations, and as a result, some companies may find that they already track and report the necessary information, although for many others, these will be costly new undertakings.

These bills will become law, effective on October 14, 2023, unless Governor Gavin Newsom signs the bills at an earlier date or vetoes the bills. Governor Newsom has publicly stated that he plans to sign the bills, subject to minor language changes, although the nature of those changes and the timing of his signature are still uncertain. Once the legislation is final, a litigation challenge is possible.

Senate Bill No. 253, Climate Corporate Data Accountability Act (“SB 253”)[1]

SB 253 creates new GHG emissions reporting requirements for companies [2] that:

are organized in the United States,
have total annual revenues in excess of $1 billion, and
do business [3] in California (each, a “Reporting Entity”).

According to the September 7, 2023 Assembly Floor Analysis, SB 253 is expected to impact more than 5,300 companies.[4]

If enacted, SB 253 would require all Reporting Entities to publicly and annually report their fiscal year Scope 1, Scope 2, and Scope 3 GHG emissions to a newly established statewide GHG emissions reporting organization. The California Air Resources Board (the “CARB”), which is under the umbrella of the California Environmental Protection Agency, would be required to develop and adopt regulations to implement the reporting program by January 1, 2025, after considering input from various stakeholders, including government stakeholders, climate experts, investors, consumer and environmental groups, and “[r]eporting entities that have demonstrated leadership in full-scope greenhouse gas emissions accounting and public disclosure and greenhouse gas emissions reductions.”

Annual Scope 1 and Scope 2 GHG emissions reporting would begin in 2026 for the prior fiscal year, with the specific required date of filing to be determined by CARB. Disclosure of annual Scope 3 GHG emissions would follow in 2027, with CARB to set the deadline no later than 180 days after the deadline for disclosing Scope 1 and Scope 2 GHG emissions. However, on or before January 1, 2030, CARB is required to revisit and potentially update the date of these annual deadlines with the goal that the deadline for disclosure of Scope 3 GHG emissions would fall “as close in time as practicable” to the deadline for disclosure of Scopes 1 and 2 GHG emissions.

SB 253’s definitions of “Scope 1,” “Scope 2,” and “Scope 3” GHG emissions are generally consistent with those established in the Greenhouse Gas Protocol (the “GHG Protocol”)[5] and as subsequently adopted by a variety of international regulatory bodies. The Securities and Exchange Commission’s proposed rules on climate change disclosures (the “SEC’s Proposed Rules”) also rely on the GHG Protocol when defining reportable emissions, although, as discussed below, the Scope 3 requirements in the California law would apply to far more companies. [6] As passed by the legislature, SB 253 includes the following definitions:

“Scope 1 emissions” means all direct greenhouse gas emissions that stem from sources that a reporting entity owns or directly controls, regardless of location, including, but not limited to, fuel combustion activities.
“Scope 2 emissions” means indirect greenhouse gas emissions from consumed electricity, steam, heating, or cooling purchased or acquired by a reporting entity, regardless of location.
“Scope 3 emissions” means indirect upstream and downstream greenhouse gas emissions, other than scope 2 emissions, from sources that the reporting entity does not own or directly control and may include, but are not limited to, purchased goods and services, business travel, employee commutes, and processing and use of sold products.

Reporting Entities are required to measure and report their emissions in line with the GHG Protocol’s standards and guidance.

When determining the structure for these reports, CARB must minimize duplicative efforts by the Reporting Entities and permit them to submit reports “prepared to meet other national and international reporting requirements, including any reports required by the federal government,” if they meet SB 253’s requirements as well.

SB 253 would also require that each Reporting Entity’s disclosures be independently verified by a third-party assurance provider that is approved by CARB and has expertise in GHG emissions accounting. Assurance of Scope 1 and Scope 2 GHG emissions would be required at a limited assurance level beginning in 2026 and at a reasonable assurance level beginning in 2030.[7] Scope 3 GHG emissions may require assurance at a limited assurance level beginning in 2030.

CARB would also be subject to its own reporting requirements and would be required to contract with an academic institution to prepare a report on disclosures made by Reporting Entities by July 1, 2027, taking into account “the context of state greenhouse gas emissions reduction and climate goals.” Reporting Entities’ emissions disclosures and the CARB’s report are required to be made available to the public via a digital platform created by the new emissions reporting organization. Upon filing, Reporting Entities will annually pay a filing fee in an amount to be established by CARB to cover the costs of administration and implementation of the law. Finally, SB 253 authorizes administrative penalties up to $500,000 for noncompliance, including reporting late or not at all, but includes a safe harbor for Scope 3 GHG emissions such that (i) penalties will not apply to any misstatements regarding Scope 3 GHG emissions that were “made with a reasonable basis and disclosed in good faith,” and (ii) until 2030, penalties will only be assessed on Scope 3 reporting for failures to disclose.

Senate Bill No. 261, Greenhouse Gases: Climate-Related Financial Risk (“SB 261”)[8]

SB 261 imposes new reporting requirements on companies,[9] other than insurance companies, that:

are organized in the United States,
have total revenues greater than $500 million, and
do business in California (each a “Covered Entity”).

This risk reporting can be provided at the consolidated parent company level, and a separate report is not required for subsidiaries that independently qualify as a Covered Entity. According to the September 12, 2023 Senate Floor Analysis,[10] SB 261 is expected to impact more than 10,000 companies.

If enacted, SB 261 would require each Covered Entity to prepare a biennial report disclosing its climate-related financial risks and the measures it has adopted to reduce and adapt to those disclosed climate-related financial risks. A Covered Entity would make this report publicly available on its own website, and the first report must be published on or before January 1, 2026. Unlike SB 253, the reporting requirements do not depend on CARB adopting additional regulations to implement the reporting program, and no submission to CARB is required.

The bill defines “climate-related financial risk” as “material risk of harm to immediate and long-term financial outcomes due to physical and transition risks, including, but not limited to, risks to corporate operations, provision of goods and services, supply chains, employee health and safety, capital and financial investments, institutional investments, financial standing of loan recipients and borrowers, shareholder value, consumer demand, and financial markets and economic health.”

SB 261 requires that Covered Entities report their financial risks in accordance with the recommended frameworks found in the Final Report of Recommendations of the Task Force on Climate-related Financial Disclosures (“TCFD”).[11] TCFD is a widely used reporting framework that helps companies assess and report their exposure to climate-related risks. TCFD’s recommendations outline disclosure of climate-related risks in four areas: governance, strategy, risk management, and metrics and targets. TCFD also provides specific guidance for companies in the financial sector, as well as those in the energy, transportation, materials and buildings, and agriculture, food, and forest products industries. Covered Entities may also comply by preparing a publicly accessible report that includes climate-related financial risk disclosure if made either voluntarily or pursuant to a law, regulation, or listing requirement issued by a government entity or regulated exchange. Any such alternative report must use a framework consistent with SB 261’s requirements or the International Financial Reporting Standards Sustainability Disclosure Standards, as issued by the International Sustainability Standards Board (the “ISSB”). Where a Covered Entity’s report fails to fully comply with TCFD or ISSB standards, the entity will need to explain any gaps and describe how it take steps to provide complete disclosure.

Similar to SB 253, SB 261 requires CARB to contract with a climate reporting organization to prepare a biennial report on Covered Entities’ disclosures, which would include an “[a]nalysis of the systemic and sectorwide climate-related financial risks facing the state based on the contents of climate-related financial risk reports, including, but not limited to, potential impacts on economically vulnerable communities.” The climate reporting organization would also be responsible for gathering input on required disclosure from “representatives of sectors responsible for reporting climate-related financial risks, state agencies responsible for oversight of reporting sectors, investment managers, academic experts, standard-setting organizations, climate and corporate sustainability organizations, labor union representatives whose members work in impacted sectors, and other stakeholders.” Covered Entities could be subject to a fine of up to $50,000 per reporting year for violation of the statute and will be required to pay an annual fee to cover CARB’s costs in administering and implementing the law.

Key Takeaways

Unlike the SEC’s Proposed Rules, which apply only to public companies and investment firms, these two bills would impose reporting requirements for both public and private companies. And while both the SEC’s Proposed Rules and SB 253 reference the GHG Protocol when defining reportable emissions, SB 253’s Scope 3 GHG emissions reporting requirements are more onerous: specifically, while the SEC’s Proposed Rules would only require Scope 3 reporting by public companies where such emissions are material or part of a reduction target, SB 253 would require Scope 3 GHG emissions reporting for all Reporting Entities, regardless of whether Scope 3 emissions are material to the entity. Additionally, SB 253 authorizes (but does not require) CARB to establish a third-party assurance requirement for Scope 3 GHG emissions (in addition to the required assurance for Scope 1 and Scope 2 GHG emission disclosures) beginning in 2027, with assurance at a limited assurance level beginning in 2030. The SEC’s Proposed Rules, by comparison, only require third-party assurance for Scope 1 and Scope 2 GHG emissions.

The prospect of SB 253 and SB 261 becoming law seems almost a certainty since Governor Newsom has indicated he will sign these bills—although, as noted, a litigation challenge to the requirements is possible. Based on their statutory language, the risk report required by SB 261 would need to be filed in 2025, and the Scope 1 and Scope 2 GHG emissions disclosures required by SB 253 would need to be filed in 2026. As California has the largest economy of any state in the United States, this legislation would fundamentally alter the regulatory landscape for climate change disclosures in the United States. In the event the legislation becomes law without significant change and survives any litigation challenge, companies doing business in California will very soon have to begin to prepare for reporting these emissions and climate risk disclosures. Companies that qualify as either Reporting Entities or Covered Entities should start by taking stock of their existing climate-related disclosures—including in their SEC filings and on their websites (e.g., on an ESG webpage or stand-alone ESG report), as applicable—and assessing what additional disclosures, if any, would be needed to comply with SB 253 and SB 261. Those companies that are privately held and that have not to date provided any public climate-related disclosures likely will have the most work to do.

SB 253 would be the first widely-applicable law in the United States to require the assurance of Scope 1 and Scope 2 emissions reporting. As a result, companies will need to consider potential options for conducting the required GHG emissions attestation—e.g., whether the outside auditor or a different service provider. Note that CARB must approve the third-party assurance provider, which must be able to demonstrate that it has expertise in GHG emissions accounting. Companies may also need to implement, enhance, or alter their processes for collecting and measuring GHG emissions data, including, in the case of Scope 3 emissions data, by working with industry resources and partners in their value chains. This may also require updating any existing GHG emissions collection and reporting cadence, if needed, to align with reporting based on the fiscal year (rather than the calendar year).

____________________________

[1] Available at https://leginfo.legislature.ca.gov/faces/billTextClient.xhtml?bill_id=202320240SB253.

[2] This includes corporations, partnerships, limited liability companies, and “other business entit[ies] formed under” the laws of California, any state of the United States, the District of Columbia, or an act of Congress.

[3] The September 11, 2023 Senate Floor Analysis (the “SB 253 Analysis”) notes that existing tax code provisions define “doing business” in the state as “engaging in any transaction for the purpose of financial gain within California, being organized or commercially domiciled in California, or having California sales, property or payroll exceed specified amounts: as of 2020 being $610,395, $61,040, and $61,040, respectively.” Senate Rules Committee, Office of Senate Floor Analyses, SB 253, 2023-2024 Reg. Sess., at 2 (September 11, 2023), https://leginfo.legislature.ca.gov/faces/billAnalysisClient.xhtml?bill_id=202320240SB253.

[4] Assembly Floor Analyses, SB 253, 2023-2024 Reg. Sess. (September 7, 2023), https://leginfo.legislature.ca.gov/faces/billAnalysisClient.xhtml?bill_id=202320240SB253.

[5] See The Greenhouse Gas Protocol: A Corporate Accounting and Reporting Standard, Revised Edition (2004), at 25, https://ghgprotocol.org/sites/default/files/standards/ghg-protocol-revised.pdf.

[6] For more information on the SEC’s proposed rules on climate-related disclosures, see Summary of and Considerations Regarding the SEC’s Proposed Rules on Climate Change Disclosure, Gibson Dunn (April 2022), https://www.gibsondunn.com/summary-of-and-considerations-regarding-the-sec-proposed-rules-on-climate-change-disclosure/.

[7] “Reasonable assurance” is the same level of assurance provided for a company’s audited financial statements in the Form 10-K. It is an affirmative assurance that the GHG emissions disclosure is measured in accordance with the attestation provider’s standards. “Limited assurance” is a form of negative assurance commonly referred to as “review,” and it is the same level of assurance provided to a company’s unaudited financial statements in a Form
10-Q.

[8] Available at https://leginfo.legislature.ca.gov/faces/billNavClient.xhtml?bill_id=202320240SB261.

[9] This includes corporations, partnerships, limited liability companies, and “other business entit[ies] formed under” the laws of California, any state of the United States, the District of Columbia, or an act of Congress.

[10] Senate Rules Committee, Office of Senate Floor Analyses, SB 261, 2023-2024 Reg. Sess. (September 12, 2023), https://leginfo.legislature.ca.gov/faces/billAnalysisClient.xhtml?bill_id=202320240SB261.

[11] Available at https://www.fsb-tcfd.org/publications/.

The following Gibson Dunn lawyers prepared this client update: Eugene Scalia, Elizabeth Ising, Michael Murphy, William Thomson, Michael Scanlon, Thomas Kim, Cynthia Mabry, Lauren Assaf-Holmes, Meghan Sherley, and Nicholas Whetstone.

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, or the following authors, leaders, and members of the firm’s Administrative Law and Regulatory, Environmental, Social and Governance or Securities Regulation and Corporate Governance practice groups:

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

Environmental, Social and Governance (ESG) Group:
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])
Cynthia M. Mabry – Houston (+1 346-718-6614, [email protected])
Michael K. Murphy – Washington, D.C. (+1 202-955-8238, [email protected])
Selina S. Sagayam – London (+44 (0) 20 7071 4263, [email protected])
William E. Thomson – Los Angeles (+1 213-229-7891, [email protected])

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

Gibson, Dunn & Crutcher LLP is pleased to announce with Global Legal Group the release of the International Comparative Legal Guide to Sanctions 2024 – Germany Chapter. Gibson Dunn partner Benno Schwarz and associate Nikita Malevanny are co-authors of the publication which provides an overview of the EU sanctions regime as applied by Germany and covers relevant government agencies, applicable guidance, sanctions jurisdiction, export controls, criminal and civil enforcement, recent developments, and other topics. The chapter was co-authored with Veit Bütterlin and Svea Ottenstein from AlixPartners.

You can view this informative and comprehensive chapter via the link below:

CLICK HERE to view Sanctions 2024 – Germany Chapter.

About Gibson Dunn’s International Trade Practice:

Gibson Dunn’s International Trade Practice includes some of the most experienced practitioners in the field. Our global experience is unparalleled – the practice’s lawyers have worked extensively across Asia, Europe, the Gulf, and the Americas and many have served in senior government and enforcement roles as principal architects of key sanctions and export controls regimes and relief, including with respect to U.N. sanctions, and U.S. measures against Iran, Russia, Cuba, and Myanmar. For further information, please visit our practice page and feel free to contact Benno Schwarz (+49 89 189 33-210, [email protected]), Nikita Malevanny (+49 89 189 33-224, [email protected]) or the Gibson Dunn lawyer with whom you usually work.

About the Authors:

Benno Schwarz is a partner in the Munich office of Gibson Dunn and co-chair of the firm’s Anti-Corruption & FCPA Practice Group. He focuses on white collar defense and compliance investigations in a wide array of criminal regulatory matters. For more than 30 years, he has handled sensitive cases and investigations concerning all kinds of compliance issues, especially in an international context, advising and representing companies and their executive bodies. He coordinates the German International Trade Practice Group of Gibson Dunn and assists clients in navigating the complexities of sanctions and counter-sanctions compliance. He is regularly recognized as a leading lawyer in Germany in the areas of white-collar crime, corporate advice, compliance and investigations.

Nikita Malevanny is an associate in the Munich office of Gibson Dunn and a member of the firm’s White Collar Defense and Investigations, Litigation, and International Trade Practice Groups. He focuses on international trade compliance, including EU sanctions, embargoes and export controls. He also carries out internal and regulatory investigations in the areas of corporate anti-corruption, anti-money laundering and technical compliance. Handelsblatt / The Best Lawyers^TM in Germany 2023/2024 have recognized him in their list “Ones to Watch” for litigation and intellectual property law. He holds both German and Russian law degrees and speaks German, English, Russian and Ukrainian. He is a regular member of Gibson Dunn’s cross-border teams supporting and advising clients on global sanctions and export control aspects.

The U.S. Food and Drug Administration (FDA) recently published a draft guidance document proposing to regulate end-user output of prescription drug use-related software (PDURS) as labeling.[1] The draft guidance sets forth review pathways that could benefit prescription drug application sponsors, including by allowing sponsors to incorporate information about PDURS in the FDA-approved labeling and to seek premarket review for certain PDURS functions that meet the definition of a medical device. But by proposing to regulate PDURS-related information as labeling, the draft guidance poses potential enforcement risks for sponsors under the Federal Food, Drug, and Cosmetic Act (FDCA), the False Claims Act (FCA), and other laws, including through possible off-label promotion claims. Interested parties should consider submitting comments to FDA on the draft guidance. FDA has invited comments through December 18, 2023.

Introduction

On September 19, 2023, FDA published a new draft guidance document outlining the agency’s planned approach for regulating PDURS.[2] Sponsors of new drug applications for prescription drugs have developed PDURS as tools to connect with patients and healthcare providers in various ways, such as providing more information about drugs or their potential side effects and aiding in dosing and medication adherence. For example, sponsors have developed tablets, autoinjectors, and inhalers with integrated sensors that can allow providers to monitor when patients take the drug.[3] They have also created patient diary apps that allow patients to document symptoms they experience, and apps that help patients calculate appropriate doses of products such as insulin.[4]

The PDURS Draft Guidance marks a further step in the agency’s evaluation of novel technologies, like mobile apps, that are intended for use with FDA-regulated products. The agency previously has addressed when and how it intends to assert jurisdiction over certain software functions intended for use with medical devices as product components.[5] FDA also has described the types of mobile app functions it views as components of new tobacco products, including those that monitor where a product is located, activated, or used.[6]

FDA first proposed a framework for oversight and review of PDURS in a 2018 Federal Register notice.[7] FDA developed the PDURS Draft Guidance in response to comments it received on that 2018 notice.[8]

Under the PDURS Draft Guidance, end-user output produced by PDURS would be considered labeling. End-user output is defined by FDA to include any content that PDURS presents to the end user, including static or dynamic screen displays, sounds, or audio messages created by the software.[9] FDA recommends the inclusion of a description of the end-user output produced by PDURS in the prescribing information (PI) if evidence shows a meaningful effect on clinical outcomes or validated surrogate endpoints. In the PDURS Draft Guidance, FDA also outlines proposed oversight processes for device-connected PDURS, including premarket review for software functions regulated as medical devices.

The framework in the PDURS Draft Guidance presents both possibilities and risks for prescription drug sponsors. Sponsors that are able to provide supporting data for the clinical impact of PDURS they develop can utilize FDA’s regulatory pathways to augment their FDA-approved labeling and enable additional claims about their products. On the other hand, FDA’s regulation of PDURS end-user output as labeling would create another area of enforcement risk under FDCA requirements for prescription drug labeling. Moreover, sponsors might also face potential liability under the FCA if end-user output is not consistent with the FDA-approved label.

FDA Proposed Regulation of PDURS Output as Labeling:

FDA defines PDURS as software “that (1) is disseminated by or on behalf of a drug sponsor and (2) produces an end-user output that supplements, explains, or is otherwise textually related to one or more of the sponsor’s drug products.”[10] Accordingly, the PDURS Draft Guidance would not apply to third-party software that is not generated on behalf of a drug sponsor, even if the third-party developer’s “intention is for the software to be used with one or more drugs or combination products.”[11]

The PDURS Draft Guidance also makes clear that FDA views the software’s end-user output as labeling.[12] Under the FDCA, “labeling” refers to “all labels and other written, printed, or graphic matter (1) upon any article or any of its containers or wrappers, or (2) accompanying such article.”[13] Under the PDURS Draft Guidance, “end-user output” is broadly defined as “[a]ny material (content) that the [PDURS] presents to the end user (a patient, caregiver, or health care practitioner).”[14] These include static or dynamic screen displays, sounds, or audio messages created by PDURS.[15]

FDA recognizes two categories of labeling: the FDA-required labeling, which includes the PI and other labeling reviewed and approved by FDA in applications, and promotional labeling.[16] In the PDURS Draft Guidance, FDA views the end-user output associated with a software function as FDA-required labeling if a sponsor of a new drug application submits data from one or more adequate and well-controlled studies demonstrating that use of the software function results in a meaningful improvement on a clinical outcome or validated surrogate endpoint.[17] FDA also recommends that the PI describe such software functions and their end-user output.[18] Under the PDURS Draft Guidance, certain post-approval changes to the end-user output from such a software function would need to be submitted to FDA for review and approval, similar to other changes to the FDA-required labeling.[19]

In contrast, FDA views all other end-user output from PDURS as promotional labeling.[20] Under the PDURS Draft Guidance, end-user output that constitutes promotional labeling would need to be submitted to FDA on an FDA Form 2253 at the time of initial dissemination. Software updates that do not change the end-user output, such as security patches, would not require submission of an FDA Form 2253.[21] FDA also reminds sponsors in the PDURS Draft Guidance that, in accordance with the FDCA and FDA regulations, promotional labeling must be truthful and non-misleading, convey balanced information about a drug’s efficacy and risks, and reveal material facts about the drug, including facts about consequences that can result from use of a drug as suggested in a promotional piece.[22]

FDA Oversight for Device-Connected PDURS Functions

Under the PDURS Draft Guidance, additional considerations also would apply to certain PDURS functions that are “device-connected,” in that they receive input data from a device constituent that is part of a combination product.[23] Examples of such functions in the PDURS Draft Guidance include software that connects an app and an inhaler or autoinjector to capture and display data about the patient’s usage, and software that supplies information about a patient’s ingestion of a drug from embedded sensors in the tablet.[24]

FDA recommends that sponsors briefly describe device-connected software functions in the appropriate section of the FDA-approved labeling for the prescription drug, such as the “How Supplied/Storage and Handling” section.[25] In contrast, FDA does not generally expect the approved labeling to describe end-user output from PDURS that does not include device-connected software functions, unless the PDURS is considered essential to a safe and effective use of the drug, or the sponsor has submitted evidence that use of the PDURS leads to a clinically meaningful benefit.[26]

According to the PDURS Draft Guidance, device-connected functions could meet the definition of “medical device” under the FDCA and be subject to regulation by the Center for Devices and Radiological Health (CDRH). They also may require premarket device submissions, such as a 510(k) notification, de novo classification request, or premarket application (PMA).[27] When it reviews a premarket submission for a device-connected function, CDRH would consult with the Center for Drug Evaluation and Research (CDER) or the Center for Biologics Evaluation and Research (CBER), as applicable, to evaluate any considerations related to representations within the PDURS function. For PDURS functions that are medical devices cleared or approved by FDA, changes may require a new premarket submission or supplement.[28]

Postmarket changes to end-user output of PDURS functions that constitute promotional labeling and do not require a CDRH marketing submission should be submitted to FDA at the time of initial dissemination on Form FDA 2253.[29]

Consistent with FDA’s enforcement approach to device software functions, FDA intends to focus its device regulatory oversight on PDURS functions which are devices and whose functionality could pose a risk to patient safety if they fail to function as intended.[30]

FDA encourages interested parties to submit comments on the PDURS Draft Guidance to Docket No. FDA-2023-D-2482.[31] FDA requests the submission of comments by December 18, 2023, to allow for agency review before it begins work on the final version of the draft guidance.

Sponsors who currently use, or are considering using or developing, PDURS should consider submitting comments on the PDURS Draft Guidance to help shape the FDA’s development of final guidance. In particular, sponsors should seek to identify costs and complications not identified as considerations by FDA, such as those related to delays in development and FDA clearance or approval of PDURS, where required; challenges that may stem from necessary updates to end-user output from PDURS associated with the FDA-approved labeling; the discrepancy between the approaches in the PDURS Draft Guidance to sponsor-developed PDURS and to third-party-developed PDURS; and potential alternatives or modifications to the PDURS Draft Guidance’s approach that FDA should consider. Sponsors should also consider whether FDA’s proposed framework and review processes, particularly for PDURS described in the FDA-approved labeling, could impact their ability to timely develop and update software to help patients who use their products. Sponsors also should consider potential enforcement and compliance risks and costs that would stem from implementation of the PDURS Draft Guidance, including expansion of possible off-label promotion liability, which remains an active enforcement area for FDA and the U.S. Department of Justice[32] and a frequent claim in class actions.

Gibson Dunn is prepared to help sponsors and other interested entities consider potential effects of the PDURS Draft Guidance and submit comments to FDA recommending modifications to the PDURS Draft Guidance.

_____________________________

[1] 88 Fed. Reg. 64443 (Sept. 19, 2023); FDA, Draft Guidance for Industry: Regulatory Considerations for Prescription Drug Use-Related Software (Sept. 2023) (“PDURS Draft Guidance”).

[2] PDURS Draft Guidance.

[3] See, e.g., id. at 11; Office of Inspector Gen., Dep’t of Health & Hum. Serv. (“HHS OIG”), Advisory Opinion No. 19-02 (Jan. 24, 2019).

[4] See, e.g., PDURS Draft Guidance at 11-12, 14.

[5] See, e.g., FDA, Guidance for Industry and Food and Drug Administration Staff: Policy for Device Software Functions and Mobile Medical Applications (Sept. 2022) (“Device Software Functions Guidance”).

[6] 21 C.F.R. § 1114.7(i)(1)(i); see also 86 Fed. Reg. 55300, 55332 (Oct. 5, 2021).

[7] 83 Fed. Reg. 58574 (Nov. 20, 2018).

[8] PDURS Draft Guidance at 1; see Docket No. FDA-2018-N-3017.

[9] PDURS Draft Guidance at 6, 16.

[10] Id. at 16.

[11] Id. at 2.

[12] Id.

[13] 21 U.S.C. § 321(m).

[14] PDURS Draft Guidance at 16.

[15] Id. at 6.

[16] Id. at 2.

[17] Id. at 7.

[18] Id. at 7-8.

[19] Id.; see, e.g., 21 C.F.R. §§ 314.70, 601.12.

[20] PDURS Draft Guidance at 2.

[21] Id. at 9.

[22] Id. at 4-5; see, e.g., 21 U.S.C. §§ 321(n), 352(a)(1), (f)(1); 21 C.F.R. §§ 201.5, 201.6, 202.1.

[23] PDURS Draft Guidance at 5.

[24] Id. at 8, 11

[25] Id. at 8-9.

[26] Id. at 9.

[27] Id. at 3.

[28] Id. at 9-10.

[29] Id. at 9, 14-15.

[30] Id. at 3.

[31] See Docket No. FDA-2023-D-2482.

[32] See, e.g. U.S. Dep’t of Justice, Press Release, “Jet Medical and Related Companies Agree to Pay More Than $700,000 to Resolve Medical Device Allegations” (Jan. 4, 2023).

Gustav W. Eyler – Washington, D.C. (+1 202-955-8610, [email protected])
John D. W. Partridge – Denver (+1 303-298-5931, [email protected])
Jonathan M. Phillips – Washington, D.C. (+1 202-887-3546, [email protected])
Jonathan C. Bond – Washington, D.C. (+1 202-887-3704, [email protected])
Carlo Felizardo – Washington, D.C. (+1 202-955-8278, [email protected])

On September 21, 2023, the Federal Trade Commission (“FTC”), delivering on recent agency promises to increase scrutiny of private equity-backed transactions and strategies, released a complaint filed against private equity sponsor Welsh, Carson, Anderson, and Stowe (“Welsh Carson”) and U.S. Anesthesia Partners (“USAP”), a Texas-based provider of anesthesia services and Welsh Carson portfolio company. With this slate of claims, the FTC takes aim at Welsh Carson and USAP’s serial acquisitions over a decade, post-merger conduct, and the “roll-up” strategy employed by USAP and Welsh Carson.

The complaint alleges numerous violations of Sections 1 and 2 of the Sherman Act, asserting defendants monopolized, conspired to monopolize, and entered into agreements to fix prices and allocate markets with respect to commercially insured hospital-only anesthesiology services. The complaint also claims defendants violated Clayton Act Section 7 and Section 5 of the FTC Act through a string of serial acquisitions which allegedly lessened competition in Texas. The complaint asserts that defendants’ “roll-up” strategy represented an “unfair method of competition.” Finally, the complaint alleges that Welsh Carson’s acquisitions, pricing actions, and horizontal agreements together represent a “scheme to reduce competition in Texas” under Section 5 of the FTC Act. The FTC has asserted in this complaint a novel test for “unfair methods of competition” that forms the basis for separate and standalone claims under Section 5.

Roll-Up Strategy

Private equity firms look for opportunities to use their deal-making, operational, and financial expertise, along with their significant equity funding resources, to create more efficient companies in competitively fragmented landscapes. One strategy, the “roll-up” or (also often referred to as a “buy and build” strategy”), entails combining numerous, smaller companies in a particular industry. Private equity firms typically start with an initial, larger “platform” company acquisition, which then makes often numerous additional acquisitions to create a significantly larger organization that can achieve efficiencies and develop new or greater service offerings through scale, scope, and integration. These strategies can lower prices for consumers and provide other procompetitive benefits by reducing costs through centralizing common support functions or infrastructure costs, using size and scale to increase utilization and often obtain more favorable financing (driving down costs of debt), enhancing purchasing power to produce lower operating costs, and spreading costs across a larger buyer base to allow for innovation and growth into new products and services in ways that would be too expensive for independent smaller businesses.

The FTC’s Theories of Harm

Over the past several years, there has been a marked increase in rhetoric from enforcers related to antitrust scrutiny of private equity firms. Although the FTC has discussed leveraging new tools to police private equity[1], much of the FTC’s complaint against Welsh Carson and USAP relies on traditional antitrust theories of anticompetitive conduct and harm. The complaint defines a relevant product market (“commercially-insured hospital-only anesthesia services”) and several relevant geographic markets (metropolitan statistical areas, respectively, of Austin, Dallas, and Houston). It alleges that the serial acquisitions resulted in monopoly level market shares for USAP of 60-70% in each geographic area. The complaint asserts that high switching costs for hospitals, high barriers for entry, and horizontal agreements (both related to prices and territories) with other providers contributed to higher prices for consumers and an inability by hospitals to constrain prices for anesthesia services.

The more novel aspects of the FTC’s complaint include the joint Section 7 Clayton Act and Section 5 FTC Act claims, attacking the parties’ acquisitions and general roll-up strategy, the complaint takes aim simultaneously at multiple acquisitions over the course of years. Count 2 alleges a roll-up of the Houston market via 3 acquisitions over a period of 3 years, and Count 5 alleges a roll-up of the Dallas market via 6 acquisitions over a period of 3 years. This complaint continues a recent trend of U.S. agency review of consummated and long-past transactions under Section 7 of the Clayton Act, where historically such transactions rarely received oversight or enforcement so long after consummation. With the “roll-up” cause of action envisioned in the complaint, however, the FTC seems to open the door to challenging transactions well after closing, and with the benefit of hindsight assessment of the resulting impact of a multi-deal, multi-year M&A strategy, as part of an alleged broader conspiracy.

The complaint also includes a novel standalone Section 5 claim (Count 8), broadly challenging defendants’ alleged “scheme to reduce anesthesia competition in Texas.” This claim is unusual in that the FTC has refrained from asserting Section 5 where “enforcement of the Sherman or Clayton Act is sufficient to address the competitive harm arising from the act or practice.”[2] This divergence from past practice seems driven by an interest in developing an independent (and perhaps more flexible) framework for prosecuting “unfair methods of competition” in line with policy statements by the FTC issued over the last several years. The complaint’s allegation of a scheme to lessen competition through acquisitions and agreements with other providers across Texas rests solely on Section 5 authority. It alleges harms to consumers in the form of increased prices through mechanisms suitably addressable by Clayton Act Section 7 and Sherman Act Sections 1 and 2 (and are addressed through these laws in the other counts). Where the Section 5 count differs is that it alleges a scheme across the state of Texas, and utilizes Section 5 to claim “unfair methods of competition” without defining a relevant product or geographic market as they did with the local metropolitan region claims. If judicially recognized, this would allow the FTC to pursue claims against consolidation and pricing actions with fewer requirements and lower burdens of proof via effects-driven analysis over econometric analysis through established and defined relevant markets. Use of Section 5 as standalone authority may also attempt to circumvent the four-year statute of limitations restrictions on antitrust claims, as many of the contested transactions date farther back than four years.

Implications and Takeaways

All businesses, not just private equity sponsors, whose growth strategy includes significant M&A activity should remain mindful of the context in which it engages customers in price negotiation and competitors in collaborative agreements. As market shares increase, so too does the possibility of broader antitrust scrutiny. Although the complaint identifies the serial acquisitions as one cause of antitrust harm, the alleged pricing actions and agreements with competitors by a growing market participant may have precipitated the investigation and litigation.

Businesses that engage in mergers and acquisitions as part of their growth strategy should consider future M&A plans in light of past acquisitions. Businesses, particularly private equity firms, engaged in multiple acquisitions as part of a “consolidation” strategy (especially transactions where consequent price adjustments are expected) should prepare for increased scrutiny at the investigation stage regardless of the outcome of this lawsuit.

In this shifting and aggressive enforcement landscape, it is important to consult with counsel early and consider potential antitrust risks in M&A strategy broadly, and not just with respect to individual transactions. While roll-ups can be effective in enhancing competition in many different markets, private equity sponsors and their portfolio companies should be mindful that as an M&A-driven growth strategy produces market share increases, their strategy and overall conduct may attract increased agency scrutiny. Counsel can help advise proactively on risks in strategic initiatives and pipeline acquisitions, as well as assess the potential risk of enforcement involving past M&A-focused growth strategies and post-acquisition market conduct.

___________________________

[1] See, e.g. Draft Merger Guidelines, U.S. Department of Justice and Federal Trade Commission (July 19, 2023) (available here); Statement of Commissioner Rohit Chopra Regarding Private Equity Roll-ups and the Hart-Scott-Rodino Annual Report to Congress Commission, File No. P110014 (July 8, 2020) (available here); Statement of Chair Lina M. Khan, Joined by Commissioner Rebecca Kelly Slaughter and Commissioner Alvaro M. Bedoya Regarding JAB Consumer Fund/SAGE Veterinary Partners (June 13, 2022) (available here).

[2] Statement of Enforcement Principles Regarding “Unfair Methods of Competition” Under Section 5 of the FTC Act (August 13, 2015) (available here).

The following Gibson Dunn lawyers prepared this client alert: Rachel Brass, Mark Director, Sophie Hansell, Cynthia Richman, Dan Swanson, Chris Wilson, Jamie France, and Zoë Hutchinson.

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

Antitrust and Competition Group:
Rachel S. Brass – Co-Chair, San Francisco (+1 415-393-8293, [email protected])
Sophia A. Hansell – Washington, D.C. (+1 202-887-3625, [email protected])
Cynthia Richman – Washington, D.C. (+1 202-955-8234, [email protected])
Daniel G. Swanson – Los Angeles (+1 213-229-7430, [email protected])
Stephen Weissman – Co-Chair, Washington, D.C. (+1 202-955-8678, [email protected])
Chris Wilson – Washington, D.C. (+1 202-955-8520, [email protected])
Jamie E. France – Washington, D.C. (+1 202-955-8218, [email protected])

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])

On July 27, 2023, Hong Kong’s Securities and Futures Commission (“SFC”) published a “Circular on Licensing and Registration of Depositaries of SFC-authorised Collective Investment Schemes and Related Transitional Arrangements” (the “Circular”).[1] Trustees and custodians of SFC-authorised collective investment schemes (the “relevant CIS”) will have to be licensed or registered with the SFC for the new Type 13 regulated activity (“RA 13”) from October 2, 2024.

The Circular should be read in tandem with the soon to be enacted Schedule 11 to the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (“Schedule 11”).[2] Together, the Circular and Schedule 11 provide guidance on the SFC’s expectations regarding RA 13 licensing arrangements.

The new RA 13 regulatory regime intends to remedy what the SFC has previously described as a “patchy” approach to the regulation of depositories, whereby the SFC was unable to directly supervise depositaries. Instead, the SFC could only exercise indirect oversight through the requirements under the Product Codes.[3] The RA 13 regulatory framework was proposed by the SFC in September 2019 to fill this void left by a lack of specific, direct supervision mechanism over trustees and custodians of public funds.[4] In doing so, the new RA 13 regulatory regime will also align Hong Kong’s fund custody framework with international standards; most major jurisdictions (such as the United Kingdom and Singapore) have some form of direct regulatory powers over entities providing trustee, custodian or depositary services for public funds (at a minimum). Viewed broadly, the introduction of RA 13 is also consistent with the SFC’s focus on regulating entities providing custody services – for instance, its recent decision to regulate virtual assets custody under its new virtual assets trading platform (“VATP”) regime by requiring custody be undertaken by a wholly owned subsidiary of a licensed VATP operator.

I. Who needs a RA 13 license?

The amendments made to the Securities and Futures Ordinance (“SFO”) to introduce RA 13 define it as “providing depositary services for relevant CISs”.[5] In essence, what this means is that trustees and custodians (i.e. depositaries as defined under the amendments to the SFO) of a relevant CIS at the “top level” of the custodian chain will be required to be licensed or registered for RA 13 in order to provide the following services:

the custody and safekeeping of the CIS property, including property held on trust by the relevant CIS (“CIS Property”); and
the oversight of the CIS to ensure that it is operated according to scheme documents.[6]

In practice, many of these depositaries were not previously supervised by the SFC until the introduction of the new RA 13 regime. This suggests that individuals who will now be required to be licensed to undertake RA 13 activities will be subjected to direct SFC supervision for the first time, and may not be accustomed to being licensed.

II. What are the RA 13 regulatory requirements?

In the table below, we highlight the key regulatory requirements applicable to depositaries licensed for RA 13 (“RA 13 Depositaries”):

Capital thresholds	RA 13 Depositaries are required to maintain a paid-up share capital of not less than $10,000,000 and a liquid capital of not less than $3,000,000.[7]
Treatment of Scheme Money	RA 13 Depositaries that hold or receive scheme money under a relevant CIS (“Scheme Money”) must deposit such Scheme Money into segregated and designated trust accounts or client accounts within three business days after receipt. Each segregated account must be established and maintained for one relevant CIS only.[8] RA 13 Depositaries must not pay Scheme Money out of the segregated account unless such payment is (i) instructed in writing, or (ii) for the purpose of meeting payment, distribution, redemption settlement, or margin requirements, or (iii) to settle any charges or liabilities on behalf of the relevant CIS, as per the scheme documents.[9]
Treatment of Scheme Securities	Similarly, an RA 13 Depositary must deposit client securities which it holds or receives when providing depositary services (“Scheme Securities”) into a segregated and designated trust account or client account. Alternatively, the RA 13 Depositary can register the Scheme Securities in the name of the relevant CIS.[10] An RA 13 Depositary can only deal with Scheme Securities in accordance with written instructions or scheme documents. It must take reasonable steps to ensure that Scheme Securities are not otherwise deposited, transferred, lent or pledged.[11]
Record keeping obligations	In line with the record keeping requirements generally applicable to licensed intermediaries, RA 13 Depositaries are required to keep accounting, custody and other records to sufficiently explain and reflect the financial position and operation of the business, and support accurate profits and loss or income statements. Specifically, RA 13 Depositaries must also account for all relevant CIS Property, and make sure that its accounting systems can trace all movements of relevant CIS Property.[12]
OTCD reporting	RA 13 Depositaries are exempted from reporting specified over-the-counter (“OTC”) derivative transactions to the Hong Kong Monetary Authority (“HKMA”) when acting as a counterparty to the OTC derivative transaction.[13] Similarly, authorized institutions need not report the OTC derivative transaction to the HKMA if the counterparty of the transaction is an RA 13 Depositary acting in its capacity as a trustee of the relevant CIS.[14]

Further, the SFC has previously clarified that the Managers-In-Charge (“MIC”) requirements under the current licensing framework extend to RA 13 licensees.[15]

III. Are there any additional requirements applicable to specific classes of RA 13 Depositaries?

Schedule 11 sets out additional requirements applicable to specific classes of RA 13 Depositaries. In the table below, we summarize the key requirements applicable to RA 13 Depositaries authorized under the Code on Unit Trusts and Mutual Funds[16] and Code on Pooled Retirement Funds (“UT/RF RA 13 Depositaries”).[17] These are mostly RA 13 Depositaries operating Chapter 7 Funds (i.e. plain vanilla funds investing in equity and/or bunds), specialized schemes (such as hedge funds, listed open-ended funds), and pooled retirement funds.

Appointment and oversight of delegates or third parties	UT/RF RA 13 Depositaries should establish internal control policies and procedures to oversee appointed delegates or third parties. These internal control policies and procedures should cover the following: the selection of a delegate or third party, including assessment procedures and criteria on the delegate or third party’s competence, regulatory and financial status, capabilities and the effectiveness of their internal controls and systems; ongoing and regular monitoring of the delegate or third party to ensure compliance with regulatory requirements and maintenance of effective internal controls and systems; and management of actual or potential conflicts of interests arising from the appointment and oversight of delegates or third parties (where applicable). UT/RF RA 13 Depositaries should also establish appropriate contingency plans to cater for instances of breaches or insolvency of these delegates or third parties.[18]
Oversight of the relevant CIS	UT/RF RA 13 Depositaries should have oversight over the operations of the relevant CIS, and ensure that the CIS is operated or administered in accordance with the relevant constitutive documents.[19]
Subscription and redemption	UT/RF RA 13 Depositaries should monitor the relevant operators of each CIS to ensure (among other things): timely processing of subscription and redemption transactions; execution of subscription and redemption orders in accordance with the constitutive documents of the relevant CIS; timely deposits of subscription and redemption proceeds into a segregated bank account designated as a trust account or client account holding relevant CIS Property; reconciliation of subscription and redemption, and that the frequency of such reconciliation is consistent across subscription and redemption; and proper documentation of reasons for (i) suspension of dealing of unit or shares of the relevant CIS, and (ii) suspension of valuation, price or net asset value calculations of the relevant CIS.[20]
Distribution payments	UT/RF RA 13 Depositaries should supervise the relevant operators of each CIS to ensure that: distributions are calculated in accordance with the constitutive documents of the relevant CIS; and complete and accurate distribution payments are made on a timely basis. With respect to each relevant CIS, UT/RF RA 13 Depositaries should ensure that distribution proceeds are transferred according to the operator’s instruction on a timely basis into a designated and segregated or omnibus bank account.[21]
Custody and safekeeping of CIS Property	UT/RF RA 13 Depositaries can adopt the safeguards to ensure the safekeeping of CIS Property: assess and manage custody risk by making adequate organisational arrangements to minimise the risks of loss of the CIS Property; register the CIS Property in the name of the UT/RF RA 13 Depositary; verify ownership of the CIS Property using reliable sources; maintain updated and comprehensive records of the CIS Property; and ensure reconciliation is carried out daily for CIS Property in cash form.[22]

Notwithstanding the above, there are specific requirements applicable to RA 13 Depositaries authorized under the Code on Real Estate Investment Trusts (“REIT RA 13 Depositaries”).[23] These are RA 13 Depositaries operating closed-ended funds primarily investing in real estate. REIT RA 13 Depositaries are under a fiduciary duty to hold assets of Real Estate Investment Trusts (“REIT”) on trust for the benefit of the unitholders of the REIT. While the requirements applicable to UT/RF RA 13 Depositaries summarized above are generally applicable to REIT RA 13 Depositaries, Schedule 11 tailors some of these requirements to account for the unique features and product structure of REITs. The key modifications are summarized as follows:

Cash flow monitoring and cash reconciliation

Under the Code on Real Estate Investment Trusts (“REIT Code”), the management company of a REIT bears the obligation to manage cash flows. Schedule 11 modifies the custody requirements – which require UT/RF RA 13 Depositaries to carry out cash reconciliation of CIS Property daily – to instead require REIT RA 13 Depositaries to ensure that the management company has put in place proper cash flow management policies and controls, and supervise the implementation of such policies and controls.

Custody and safekeeping of CIS Property

REIT RA 13 Depositaries should ensure that all REIT assets (including the title documents of REIT-owned real estate) are properly segregated and held for the benefit of the unitholders in accordance with the REIT Code and the constitutive document of the REIT.

Where the REIT RA 13 Depositary considers it in the interests of the REIT for certain assets of the REIT to be held by the management company on behalf of the REIT, the REIT RA 13 Depositary should make sure that the management company has established proper safeguards and controls to properly segregate REIT assets. Additionally, the REIT RA 13 Depositary must maintain on-going oversight and control over the relevant assets.

IV. What are the next steps?

The SFC has begun accepting licensing applications for RA 13 since July 27, 2023. Depositaries are reminded to submit RA 13 applications on or before November 30, 2023. The RA 13 regime will take effect on October 2, 2024.

_____________________________

[1] “Circular on Licensing and Registration of Depositaries of SFC-authorised Collective Investment Schemes and Related Transitional Arrangements” (July 27, 2023), published by the SFC, available at https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC32

[2] The final text of Schedule 11 can currently be found at Appendix C, “Consultation Conclusions on Proposed Amendments to Subsidiary Legislation and SFC Codes and Guidelines to Implement the Regulatory Regime for Depositaries of SFC-authorised Collective Investment Schemes” (March 24, 2023), published by the SFC, available at https://apps.sfc.hk/edistributionWeb/api/consultation/conclusion?lang=EN&refNo=22CP1

[3] Namely, the Code on Unit Trusts and Mutual Funds, the Code on Open-Ended Fund Companies, the Code on Real Estate Investment Trusts, and the Code on Pooled Retirement Funds.

[4] “Consultation Paper on the Proposed Regulatory Regime for Depositaries of SFC-authorised Collective Investment Schemes” (September 27, 2019) (“2019 Consultation Paper”), published by the SFC, available at https://apps.sfc.hk/edistributionWeb/api/consultation/openFile?lang=EN&refNo=19CP3

[5] Section 3, “Securities and Futures Ordinance (Amendment of Schedule 5) Notice 2023” (March 20, 2023), available at https://www.gld.gov.hk/egazette/pdf/20232712/es22023271262.pdf

[6] “Scheme document” refers to (i) the trust deed constituting or governing the relevant CIS if the CIS is constituted in the form of a trust, (ii) the documents governing the formation or constitution of the relevant CIS if the CIS is constituted in any other form other than a trust, or (iii) other documents setting out the requirements relating to (a) the custody and safekeeping of any CIS Property, or (b) the oversight of the operations of the relevant CIS.

[7] Amended Schedule 1 of the Securities and Futures (Financial Resources) Rules, set out under section 10 of the “Securities and Futures (Financial Resources) (Amendment) Rules 2023” (March 20, 2023), available at https://www.gld.gov.hk/egazette/pdf/20232712/es22023271256.pdf

[8] Amended rule 10B of the Securities and Futures (Client Money) Rules, set out under section 7 of the “Securities and Futures (Client Money) (Amendment) Rules 2023” (“CMR Amendment Rules”) (March 20, 2023), available at https://www.legco.gov.hk/yr2023/english/subleg/negative/2023ln055-e.pdf

[9] Amended rule 10C of the of the Securities and Futures (Client Money) Rules, set out under section 7 of the CMR Amendment Rules

[10] Amended rule 9B of the Securities and Futures (Client Securities) Rules, set out under section 6 of the “Securities and Futures (Client Securities) (Amendment) Rules 2023” (“CSR Amendment Rules”) (March 20, 2023), available at https://www.legco.gov.hk/yr2023/english/subleg/negative/2023ln054-e.pdf

[11] Amended rules 9C and 10A of the Securities and Futures (Client Securities) Rules, set out under sections 6 and 7 of the CSR Amendment Rules respectively

[12] Amended rule 3A of the Securities and Futures (Keeping of Records) Rules, set out under section 5 of the “Securities and Futures (Keeping of Records) (Amendment) Rules 2023” (“KKR Amendment Rules) (March 20, 2023), available at https://www.legco.gov.hk/yr2023/english/subleg/negative/2023ln057-e.pdf

[13] Amended rule 10 of the Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) Rules, set out under section 4 of the “Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) (Amendment) Rules 2023” (“OTCD Amendment Rules”) (March 20, 2023), available at https://www.legco.gov.hk/yr2023/english/subleg/negative/2023ln061-e.pdf

[14] Amended rule 11 of the Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) Rules, set out under section 5 of the OTCD Amendment Rules

[15] Paragraph 26, 2019 Consultation Paper. The SFC’s MIC requirements are listed in the “Circular to Licensed Corporations Regarding Measures for Augmenting the Accountability of Senior Management” (December 16, 2016), available at https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=16EC68, and the related Frequently Asked Questions published by the SFC (last updated on January 26, 2022), available at https://www.sfc.hk/en/faqs/intermediaries/licensing/Measures-for-augmenting-senior-management-accountability-in-licensed-corporations

[16] “Code on Unit Trusts and Mutual Funds” (January 1, 2019), published by the SFC, available at https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/codes/section-ii-code-on-unit-trusts-and-mutual-funds/section-ii-code-on-unit-trusts-and-mutual-funds.pdf

[17] “Code on Pooled Retirement Funds” (December 2021), published by the SFC, available at https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/codes/code-on-pooled-retirement-funds/code-on-pooled-retirement-funds.pdf?rev=9badf81950734ee08c799832be6ff92b

[18] Section 6, Schedule 11

[19] Section 8, Schedule 11

[20] Section 9, Schedule 11

[21] Section 11, Schedule 11

[22] See section 14, Schedule 11 for the full list of safeguards.

[23] “Code on Real Estate Investment Trusts” (August 2022), published by the SFC, available at https://www.sfc.hk/-/media/EN/files/COM/Reports-and-surveys/REIT-Code_Aug2022_en.pdf?rev=572cff969fc344fe8c375bcaab427f3b

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

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

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