Client Alert Archives

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

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

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

I. Summary of the Disciplinary Action

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

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

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

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

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

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

II. The Statutory Secrecy Prohibition

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

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

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

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

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

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

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

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

III. The Importance of Maintaining Secrecy

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

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

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

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

__________

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

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

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

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

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

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

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

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

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

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.

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

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

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

Read More

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

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

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

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

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

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

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

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

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

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

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

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

I. Supreme Court Activity Concerning the Chevron Doctrine

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

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

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

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

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

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

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

II. An Update on Arbitrability of ERISA Benefits Claims

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

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

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

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

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

III. Further Important Developments Concerning ERISA-Governed Retirement Plans

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

A. How Courts Interpret the Pleading Standard Post-Hughes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

IV. Key Developments for Health & Welfare Plans

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

E. New Developments Regarding the No Surprises Act

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

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

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

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

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

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

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

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

V. ERISA Litigation Issues on the Horizon

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

Growing Prevalence of “Actuarial Equivalence” Suits

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

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

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

New Wave of Fiduciary-Breach Suits Concerning Plan Forfeiture Accounts

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

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

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

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

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

String of New Lawsuits Concerning Pension Risk Transfer Transactions

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

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

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

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

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

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

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

Justice Groban, writing for the Court

Background:

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

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

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

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

Issue:

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

Court’s Holding:

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

What It Means:

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

The Court’s opinion is available here.

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

Appellate and Constitutional Law Practice

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

Insurance and Reinsurance

Geoffrey M. Sigler
+1 202.887.3752
[email protected]

Deborah L. Stein
+1 213.229.7164
[email protected]

Matthew A. Hoffman
+1 213.229.7584
[email protected]

Related Practice: Litigation

Theodore J. Boutrous, Jr.
+1 213.229.7804
[email protected]

Theane Evangelis
+1 213.229.7726
[email protected]

This alert was prepared by associates Daniel R. Adler, Ryan Azad, and Dan Willey.

This alert describes the IRS’s recent focus on partnerships, provides background on basis adjustments under subchapter K, and discusses the Related-Party Basis Adjustment Guidance issued earlier today.

Earlier today, the IRS and Treasury issued a notice of proposed rulemaking, a notice of intent to publish future regulations, and a revenue ruling (collectively, the “Related-Party Basis Adjustment Guidance”) aimed at preventing taxpayers from benefiting from partnership basis adjustments in situations that the government views as inappropriate.[1]

As described in more detail below, the rules included in the Related-Party Basis Adjustment Guidance have three main elements.

Proposed Reporting Regime for Past and Future Basis Adjustments. These proposed regulations identify certain “covered transactions” as “transactions of interest” and require taxpayers (and material advisors) to report all such covered transactions to the IRS. These covered transactions would become transactions of interest on the date the proposed regulations are finalized. Once the proposed regulations are finalized, taxpayers and material advisors would have 90 days to disclose any existing covered transactions. Importantly, the rules require the reporting not just of transactions that were executed within taxable periods for which the assessment limitation period has not expired but also for transactions the effects of which are reflected on any tax return for such a period, regardless of how long ago the transaction was executed. It seems likely that many taxpayers would have considerable difficulty complying with the proposed reporting requirements if finalized in their current form.
Forthcoming Proposed Regulations Governing Future Basis Adjustments. Notice 2024-54 describes proposed regulations that the IRS and Treasury intend to issue under sections 732, 734, 743, and 1502 that would “mechanically” reduce or eliminate the benefit of related-party basis adjustment transactions.[2] As with the reporting regime described above, the forthcoming proposed regulations effectively would be retroactive in that they would apply to basis adjustments that arose in transactions that occurred in the past.
Explanation of IRS’s Economic Substance Doctrine Argument. Rev. Rul. 2024-14 sets out the IRS’s position that the economic substance doctrine, as codified in section 7701(o), applies to certain related-party transactions that give rise to basis adjustments.

If finalized, these rules will be relevant to any person who owns—or has at any time in living memory owned—an interest in a partnership in which a related person was also a partner. In addition, taxpayers should consider whether any of the proposed rules would apply to planned transactions.

This alert describes the IRS’s recent focus on partnerships, provides background on basis adjustments under subchapter K, and discusses the Related-Party Basis Adjustment Guidance.

Recent IRS Focus on Partnerships

In 2021, the IRS launched a “large partnership compliance” program focusing on partnership audit issues. In July 2023, the U.S. Government Accountability Office (the “GAO”) published a report on partnership audits, highlighting what it viewed as some shortcomings in the IRS’s approach to partnership audits.[3] In particular, the GAO pointed to the relatively low audit rate for large partnerships and the relatively high “no change” rate (that is, the rate at which partnership audits do not result in a change to tax liability).[4]

In response to the GAO report, on September 8, 2023, the IRS announced that it was expanding partnership audits.[5] Senior government officials have repeatedly expressed the IRS’s intent to issue guidance regarding the application of the basis adjustment rules (discussed in part II, below) to certain related-party transactions.[6]

Background on Basis Adjustments

Subchapter K (which houses the Code’s rules applicable to partnership taxation) includes several provisions that govern the interaction of a partner’s basis in its partnership interest with the partnership’s basis in its assets. In particular:

Section 732(a) provides that, when a partnership distributes property (other than money) to a partner in a non-liquidating distribution, the partner’s basis in the property is the lesser of (i) the partnership’s basis in the property and (ii) the partner’s basis in its interest before the distribution. Section 732(b) provides that, when a partnership makes a liquidating distribution, the partner’s basis in the distributed property is the partner’s basis in its interest before the distribution. Section 732(d) provides special rules with respect to property distributed to a partner that acquired its interest in the partnership when the partnership did not have a section 754 election in effect.
Section 734(b) provides that, when a partnership distributes property to a partner and either (i) the distributee partner recognizes gain or loss on the distribution or (ii) the basis of the distributed property in the distributee partner’s hands differs from the partnership’s adjusted basis in the distributed property immediately before the distribution, the partnership is required to adjust the basis of its remaining partnership property. A section 734(b) adjustment is made only if the partnership has a section 754 election in effect or the distribution results in a “substantial” reduction in basis under section 734(d).
Section 743(b) provides that, when there is a “sale or exchange” of a partnership interest, the partnership adjusts its basis in partnership property solely with respect to the transferee. Very generally, the amount of the adjustment is the amount necessary to ensure that, if the partnership were to sell all of its assets for their fair market values immediately after the transfer, the transferee partner would not recognize any gain or loss. As with a section 734(b) adjustment, a section 743(b) adjustment is made only if the partnership has a section 754 election in effect or the partnership has a “substantial built-in loss” with respect to the transfer of the partnership interest.

These basis adjustments arise in both taxable and tax-deferred transactions.[7]

In recent years, the IRS has expressed discomfort with basis adjustments that arise in nonrecognition transactions between related persons.[8] The IRS has, however, been unable to point to any law or regulation that prohibits taxpayers from undertaking such transactions (except in certain limited cases, such as transactions among members of a consolidated group that fall within the scope of Treas. Reg. § 1.1502-13 or transactions with respect to which Treas. Reg. § 1.701-2 may be applicable).[9]

Related-Party Basis Adjustment GuidanceA. Reporting Regime: Transactions of Interest

In the proposed regulations, the IRS and Treasury identify four types of transactions involving related parties that would be designated “transactions of interest.” (The proposed regulations would also apply in the absence of related parties if there are unrelated parties that are “tax-indifferent.”) This designation would make the transactions reportable transactions under the section 6011(b) regime. As a result, taxpayers that have engaged, or that later engage, in these transactions would be required to file disclosures with the IRS. (Material advisors on the transaction also would be required to make filings.)

Importantly, the proposed regulations would require reporting with respect to past transactions. Specifically, if, during any taxable year for which the assessment limitations period has not expired, a taxpayer either (i) engaged in a covered transaction or (ii) filed a tax return that reflected the results of a covered transaction (e.g., depreciation or amortization), the taxpayer would have only 90 days from the finalization of the proposed regulations to report the transaction to the IRS.

Complying with these rules would require taxpayers to review decades of transactions to determine whether any transaction is, or is substantially similar to, one of the transactions described in the proposed regulations and if so, determine whether the “results” of that transaction are reflected on an open-year return. Thus, for example, if a taxpayer entered into a transaction in 1979 that gave rise to a basis adjustment that attached to 39-year property, the final year in which that adjustment would have been depreciated would have been 2018 (or possibly 2019). If the 2018 return is still open, the transaction that occurred in 1979 would be reportable. (If the use of a net operating losses attributable to a basis adjustment is included, it is possible that transactions occurring during the Eisenhower administration would be picked up.)

The proposed regulations would also apply to transactions in which partners are not related but one partner is a “tax-indifferent party” that facilitates the transaction (for example, a partner that is tax-exempt or non-U.S.). As a result, there will be a considerable compliance burden for many taxpayers.

The four transactions described in Prop. Treas. Reg. § 1.6011-18 are:

(1) A partnership distributes property to a person who is a related partner in a current or liquidating distribution and the partnership increases the basis of one or more of its remaining properties under section 734(b).

(2) A partnership distributes property to a person who is a related partner in liquidation of the person’s partnership interest (or in complete liquidation of the partnership) and the basis of one or more distributed properties is increased under section 732(b).

(3) A partnership distributes property to a person who is a related partner, the basis of one or more distributed properties is increased under section 732(d), and the related partner acquired all or a part of its interest in the partnership in a transaction that would have been a transaction described in paragraph (4), below, if the partnership had a section 754 election in effect for the year of transfer.

(4) A partner transfers an interest in a partnership to a related partner in a recognition or nonrecognition transaction and the basis of one or more partnership properties is increased under section 743(b).

In each case, a transaction is reportable only if the sum of all basis increases resulting from all such transactions of a partnership or partner during the taxable year (without reduction for any basis adjustment in the same transaction or another transaction that reduces basis) exceeds by at least $5 million the gain recognized from such transactions, if any, on which U.S. federal income tax imposed is required to be paid by any of the related partners.

B. Forthcoming Proposed Regulations under Sections 732, 734, 743, and 1502

In addition to subjecting past and future transactions to the reporting requirements in section 6011, the IRS and Treasury announced an intention to issue two sets of proposed regulations that would reduce or eliminate the benefit of transactions involving partnerships and related parties (or tax-indifferent parties).

As with the reporting regime described above, these rules effectively would be retroactive because they would apply to taxable years ending on or after June 17, 2024 but would apply to basis adjustments that arise before the finalization of the regulations.

Proposed Related-Party Basis Adjustment Regulations

The first set of proposed regulations, which would be issued under sections 732, 734(b), 743(b), and 755, would apply to a wide range of ordinary course transactions and would (very generally) include rules intended to match the timing of the depreciation and amortization of the basis adjustment with the timing of the inclusion of the associated income or gain. The exact manner in which the rules accomplish this would depend on the type of basis adjustment.

Section 732(b) or (d) Adjustments. To the extent a positive section 732 basis adjustment corresponds to a basis decrease to a related partner (or the basis decrease the related partner would have had if the partnership had a section 754 election in effect), the basis adjustment would be recovered using the cost recovery method and remaining recovery period, if any, of the property the basis of which was decreased. Thus, for example, if a transaction results in an increase in the basis of distributed 5-year property and a decrease in the basis of retained 15-year property, the basis increase would be recovered over 15 years rather than 5. This rule would cease to apply when the corresponding property (i.e., the property the basis of which was decreased) is sold to an unrelated person in an arm’s-length transaction in which taxable gain or loss is fully recognized.

Section 734(b) Adjustments. Any positive section 734(b) adjustment arising from a related-party basis adjustment transaction would be recovered using the cost recovery method and remaining recovery period, if any, of the distributed property that gave rise to the section 734(b) adjustment. Thus, for example, if a partnership distributes 15-year property to a related partner and there is a section 734(b) adjustment that increases the partnership’s basis in its remaining property (all of which is 5-year property), the basis increase would be recovered over 15 years rather than 5. This rule would cease to apply when the property is sold to an unrelated person in an arm’s-length transaction in which taxable gain or loss is fully recognized.

Section 743(b) Adjustments. Any positive section 743(b) adjustment arising in a transfer between related parties would be non-depreciable and non-amortizable until the transferee partner becomes unrelated to the transferor and all other existing partners.

In each case, the proposed regulations would prohibit the use of any “suspended” basis adjustment to increase loss or decrease gain until the occurrence of applicable triggering events.

Proposed Consolidated Return Regulations

The second set of proposed regulations, which would be issued under section 1502, “would apply a single-entity approach with respect to interests in a partnership held by members of a consolidated group.”[10] Although the exact meaning of “single-entity approach” in this context is unclear, the intent is to “prevent distortions of a consolidated group’s income” and “avoid many of the anomalous results that arise” from transactions between members of a consolidated group.

The description of both sets of regulations in Notice 2024-54 is general and quite high level; there are many nuances and unanswered questions that the IRS and Treasury will need to consider and address in drafting the proposed regulations. One thing that is clear is that the proposed regulations will affect a large number of ordinary course transactions and impose considerable additional burdens on taxpayers.

C. Revenue Ruling on Economic Substance Doctrine

Rev. Rul. 2024-14 sets out the IRS’s position that certain related-party basis adjustment transactions may be covered by the economic substance doctrine as codified in section 7701(o). The ruling is unsurprising and, given that any revenue ruling effectively reflects the IRS’s litigating position and is not binding on taxpayers or the courts, is unlikely to be given much weight.

There are, however, a handful of interesting points worth noting.

The ruling appears to “mix and match” concepts from unrelated anti-abuse rules in a way that is not supported by existing law. In particular, the ruling introduces to the economic substance doctrine the concept of activities being undertaken “with a view” to a particular outcome. This “with a view” concept has its origins in the collapsable corporation rules of former section 341 and is found today in Treas. Reg. § 1.704-3(a)(10) but has never been relevant for the economic substance doctrine (as codified in section 7701(o)).

The ruling introduces the notion of “connected” transactions that occur over multiple tax years. This concept is not defined, and it is not clear from the ruling when transactions will be considered “connected” to each other.

The ruling makes the same mistake the district court made in Liberty Global in that it ignores the question of whether the economic substance doctrine is, as an initial matter, relevant to the facts at issue, as required under section 7701(o).[11] Because it is well accepted that, except, perhaps, in rare and unusual circumstances, there is no need for (and often there is not) a business purpose for a distribution, the economic substance doctrine likely is not relevant for many of the transactions about which the IRS is concerned.

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[1] Notice 2024-54; Notice of Proposed Rulemaking and Public Hearing, Certain Partnership Related-Party Basis Adjustment Transactions as Transactions of Interests Fed. Reg. 2024-12,282 (Jun. 18, 2024); Rev. Rul. 2024-14. As the preamble to the proposed regulations explains, the IRS and Treasury believe that related-party basis adjustment transactions are “carefully structured to exploit the mechanical basis adjustment provisions of subchapter K to produce significant tax benefits with little or no economic impact on the related parties, and in a manner that would not be a likely arrangement between partners negotiating at arm’s-length.”

[2] Any reference to “section” is a reference to section of the Internal Revenue Code of 1986, as amended (the “Code”), and any reference to Treasury regulations or “Treas. Reg. §” is a reference to sections of the United States Treasury regulations promulgated under the Code.

[3] U.S. Gov. Accountability Office, GAO-23-106020, Tax Enforcement: IRS Audit Processes Can Be Strengthened to Address a Growing Number of Large, Complex Partnerships (2023).

[4] The GAO report concluded that more than 80 percent of large partnership audits resulted in no change, more than double the rate of similarly sized corporate audits. In the GAO’s view, this reflects a shortcoming in the IRS’s audit strategy or conduct. The GAO does not seem to have considered, however, the possibility that large partnerships are less complex from a tax perspective when compared with similarly sized corporations. For example, a corporation with $1 billion of revenue may have manufacturing activities, international operations, R&D expenses and credits, and significant fixed assets. A partnership with $1 billion of revenue, however, may be a law firm or accounting firm with a comparatively simple business model with only domestic operations.

[5] News Release IR-2023-166 (Sept. 8, 2023).

[6] See, e.g., Kristen A. Parillo, IRS Cracking Down on Related-Party Basis Shifting, 175 TAX NOTES FEDERAL 1747 (June 13, 2022)

[7] For purposes of section 743(b), a “sale or exchange” generally includes nonrecognition transactions. See, e.g., section 761(e)(2) (distribution of a partnership interest), Treas. Reg. § 1.755-1(b)(5) (contribution of a partnership interest to a partnership), and CCA 201726012 (a reorganization to which section 368(a)(1)(A) or (D) applies).

[8] CCA 201726012 (discussing related-party basis adjustment transactions in a consolidated group). Congress has twice made changes to the basis adjustment rules to limit what were, at the time, perceived abuses. In 1984, as part of the Deficit Reduction Act of 1984 (P.L. 98-369), Congress added the flush language at the end of section 734(b) to prevent taxpayers from obtaining a benefit from a positive section 734(b) adjustment attributable to a lower-tier partnership interest where the lower-tier partnership did not have a section 754 election in effect. Then, in 1999, as part of the Tax Relief Extension Act of 1999 (P.L. 106-170), Congress enacted section 732(f) in an attempt to achieve the same result with respect to the stock of a corporation.

[9] See, e.g., CCA 201726012; CCA 202240017. It is not clear whether the regulations under Treas. Reg. § 1.701-2 are valid.

[10] Notice 2024-54 (Section 5).

[11] For a discussion of this issue, see https://www.taxnotes.com/tax-notes-today-federal/litigation-and-appeals/nam-urges-remand-economic-substance-case-consider-relevance/2024/05/08/7jhkp.

The following Gibson Dunn lawyers prepared this update: Eric B. Sloan, Mike Desmond, Pamela Lawrence Endreny, Matt Donnelly, James Jennings, and Adam Gregory.

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

Tax:
Dora Arash – Los Angeles (+1 213.229.7134, [email protected])
Sandy Bhogal – Co-Chair, London (+44 20 7071 4266, [email protected])
Michael Q. Cannon – Dallas (+1 214.698.3232, [email protected])
Jérôme Delaurière – Paris (+33 (0) 1 56 43 13 00, [email protected])
Michael J. Desmond – Los Angeles/Washington, D.C. (+1 213.229.7531, [email protected])
Anne Devereaux* – Los Angeles (+1 213.229.7616, [email protected])
Matt Donnelly – Washington, D.C. (+1 202.887.3567, [email protected])
Pamela Lawrence Endreny – New York (+1 212.351.2474, [email protected])
Benjamin Fryer – London (+44 20 7071 4232, [email protected])
Evan M. Gusler – New York (+1 212.351.2445, [email protected])
Kathryn A. Kelly – New York (+1 212.351.3876, [email protected])
Brian W. Kniesly – New York (+1 212.351.2379, [email protected])
Loren Lembo – New York (+1 212.351.3986, [email protected])
Jennifer Sabin – New York (+1 212.351.5208, [email protected])
Eric B. Sloan – Co-Chair, New York/Washington, D.C. (+1 212.351.2340, [email protected])
Edward S. Wei – New York (+1 212.351.3925, [email protected])
Lorna Wilson – Los Angeles (+1 213.229.7547, [email protected])
Daniel A. Zygielbaum – Washington, D.C. (+1 202.887.3768, [email protected])

Global Tax Controversy and Litigation:
Michael J. Desmond – Co-Chair, Los Angeles/Washington, D.C. (+1 213.229.7531, [email protected])
Saul Mezei – Washington, D.C. (+1 202.955.8693, [email protected])
Sanford W. Stark – Co-Chair, Washington, D.C. (+1 202.887.3650, [email protected])
C. Terrell Ussing – Washington, D.C. (+1 202.887.3612, [email protected])

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

The Policy Statement asserts that “the U.S. Government is playing an increasingly important role in carbon credit markets” and serves to “codify the U.S. Government’s approach to advance high-integrity voluntary carbon markets.”

On May 28, 2024, the Biden-Harris Administration (“Administration”) released a Joint Statement of Policy and new Principles for Responsible Participation in Voluntary Carbon Markets (the “Joint Statement”) announcing the U.S. government’s approach to further developing high-integrity voluntary carbon markets (“VCMs”).[1] The principles and statement are cosigned by Treasury Secretary Janet Yellen, Agriculture Secretary Tom Vilsack, Energy Secretary Jennifer Granholm, Senior Advisor for International Climate Policy John Podesta, National Economic Advisor Lael Brainard and National Climate Advisor Ali Zaidi.

Background:

High-integrity VCMs complement mandatory carbon markets as well as other clean energy products such as Renewable Energy Certificates (“RECs”) in a sustainability portfolio and are considered crucial to promoting sustainability goals and carbon reduction and removal efforts by providing a market for the purchase and sale of carbon offsets. While federal regulators such as the Commodity Futures Trading Commission (the “CFTC”), the Securities and Exchange Commission (the “SEC”) and the Environmental Protection Agency (“EPA”) are interested in VCMs, there is currently no primary federal regulatory regime for VCMs nor is there a clear legislative framework on the horizon.

The CFTC and the SEC have said that carbon credits are “environmental commodities,” which means that the carbon credits themselves are not derivatives and they are not securities. As a result, neither the CFTC nor the SEC has issued rules regulating the trading of carbon credits in VCMs. The CFTC has enforcement authority over fraud and manipulation in VCMs but no rulemaking authority. However, derivatives on carbon credits would be regulated by the CFTC and subject to the CFTC’s rules. The SEC has authority over public filers and others under its jurisdiction that participate in the VCMs, including disclosure requirements. There have been SEC enforcement actions related to greenwashing and funds’ environmental, social and governance (“ESG”)-related internal controls, as well as comment letters pressing public companies on perceived inconsistencies between sustainability report disclosures and their SEC filing obligations. Although trading in the VCMs is largely unregulated, there may be certain state regulation for brokers and other participants in VCMs. Accordingly, certain industry groups have been working to come up with consistent standards, practices, and codes of conduct across VCMs.

Absent a clear regulatory framework, there are some concerns that VCMs are sufficient to produce additional decarbonization activity and provide certainty that a carbon credit actually represents the removal or reduction of one tonne of carbon dioxide, or is equivalent, from the atmosphere as a result of a particular project.

VCMs are still developing in the United States. While pressure to participate in these markets mounts, many would-be participants are wary. Among other reasons, companies are cautious due to activist and regulatory scrutiny of greenwashing, consumer fraud, securities laws violations (e.g., greenwashing or disclosures), verification issues and associated reputational concerns.

As a counterweight, and to demonstrate its commitment to VCMs, the Joint Statement outlines how the U.S. Government seeks to shape VCMs in line with the principles for responsible participation detailed below. The publication of the Joint Statement indicates that the U.S. government thinks that current private sector initiatives have room for improvement. The principles enunciated in the Joint Statement are one component of the U.S. Government’s efforts in this area, and the Administration has called upon the “U.S. private sector and other stakeholders in the carbon credit value chain to responsibly participate in VCMs, consistent with the principles” of the Joint Statement.

Principles for Responsible Participation:

The Joint Statement announces seven principles, which are not exhaustive, that seek to codify and strengthen concepts and practices already developed market participants, governments and international bodies. The primary aim of these principles is to inform and support the continuing development of VCMs. The principles are as follows:

Principle 1: Carbon credits and the activities that generate them should meet credible atmospheric integrity standards and represent real decarbonization, including these elements:

Additional. The activity would not have occurred in the absence of the incentives of the crediting mechanism and is not required by law or regulation.
Unique. One credit corresponds to only one tonne of carbon dioxide (or its equivalent) reduced or removed from the atmosphere and is not double-issued.
Real and Quantifiable. Claimed emissions reductions or removals represent genuine atmospheric impact that is determined in a transparent and replicable manner using robust, credible methodologies. Relevant activities are designed to prevent emissions from occurring, being shifted, or intensifying beyond their boundaries as a result of the activity (“leakage”).
Validation and verification. Activity design is validated, and results are verified, by a qualified, accredited, independent third party.
Permanence of greenhouse gas benefits. The emissions removed or reduced will be kept out of the atmosphere for a specified period of time during which any credited results that are released back into the atmosphere are fully remediated.
Robust baselines. Baselines for emissions reduction and removal activities are based on rigorous methodologies that avoid over-crediting, prioritizing the use of performance benchmarks where applicable, and that evolve over time to reflect advancements in national climate policy, emissions pathways and decarbonization practices, and technology.

The Joint Statement also emphasized that verifiers and issuers of carbon credits play a pivotal role in VCMs, and that they should:

Effectively govern their standards to ensure transparency, accountability, responsiveness (e.g., to evolving best practice, science, and policy landscapes), and, when applicable, the longevity necessary to responsibly certify removal activities;
Operate or make use of a registry to transparently track the attributes, issuance, ownership, and retirement and/or cancellation of credits, coordinating where appropriate to ensure that activities are not registered with more than one registry;
Ensure robust measurement, monitoring, reporting, and verification (“MMRV”) of emissions reductions and removals;
Have procedures in place to effectively address double-counting risks, including to prevent double-registration and -issuance, to prohibit double-selling and -use, and to transparently reinforce multi-stakeholder efforts to avoid double-claiming as applicable;
Require publicly available and accessible, comprehensive, and transparent information on crediting activities;
Ensure verification of reported emissions reductions and removals, and validation of the relevant project or program, is undertaken by independent, accredited third parties;
Ensure their governance procedures address real or perceived conflicts of interest in relation to the standards body’s own governance, as well as in registry administration and in validation and verification activities; and
Support a robust enabling environment for equitable participation, including by projects and programs in developing countries.

Principle 2: Credit-generating activities should avoid environmental and social harm and should, where applicable, support co-benefits and transparent and inclusive benefits-sharing.

The Joint Statement here emphasizes protecting local communities, considering impacts on land, use, food security, and biodiversity and encourages stakeholder to respect Free, Prior and Informed Consent where applicable.

Principle 3: Corporate buyers that use credits should prioritize measurable emissions reductions within their own value chains.

Principle 3 relates to taking inventory of Scope 1, 2, and 3 emissions and regularly reporting them, and setting clear emissions targets across multiple time horizons, and collaborating with suppliers.

Principle 4: Credit users should publicly disclose the nature of purchased and retired credits.

Disclosure of purchased, cancelled, or retired credits should be issued at least annually and include reasonable detail sufficient for an outside observe to assess the integrity of credits. The format should be consistent and considerate of evolving market practices, including the consideration of aggregate public reporting.

Principle 5: Public claims by credit users should accurately reflect the climate impact of retired credits and should only rely on credits that meet high integrity standards.

Claims should rely only on the impact of credits that meet current high integrity standards at the time the claim is made and that avoid adverse impacts (see Principles 1 and 2 above). These claims should be in the context of a corporate climate strategy that prioritizes within-value-chain emissions reductions (see Principle 3 above). Unless remediation has occurred (e.g., through buffer pools), credits that have been reversed or otherwise negated should not be used as the basis for any claims.

Principle 6: Market participants should contribute to efforts that improve market integrity.

Consistent with past statements of the U.S. Government and regulatory agencies, the Joint Statement recognizes the need for private sector initiatives to develop high quality VCMs but is agnostic with respect to the particular market structure.

Principle 7: Policymakers and market participants should facilitate efficient market participation and seek to lower transaction costs.

Lowering transaction costs could facilitate greater market participation, and the Joint Statement encourages collaboration among all stakeholders to achieve these aims. The use of well-calibrated models may reduce MMRV costs and improve credit integrity.

Actions to Develop VCMs:

In its Fact Sheet[2] accompanying the announcement of the Joint Statement, the Administration also emphasized related efforts by the U.S. Government:

Creating New Climate Opportunities for America’s Farmers and Forest Landowners: The Department of Agriculture’s Agricultural Marketing Service published a Request for Information in the Federal Register asking for public input relating to the protocols used in VCMs.
Conducting First-of-its-kind Credit Purchases: The Department of Energy (“DOE”) announced the semifinalists for its $35 million Carbon Dioxide Removal Purchase Pilot Prize whereby DOE will purchase carbon removal credits directly from sellers on a competitive basis.
Advancing Innovation in Carbon Dioxide Removal (CDR) Technology: The U.S. is making comprehensive investments in programs to accelerate the development and deployment of critical CDR technologies that are designed to enable more supply of high-quality carbon credits.
Leading International Standards Setting: Global collaboration and bilateral partnerships to promote best practices.
Supporting International Market Development: The U.S. government is engaged in a number of efforts to support the development of high-integrity VCMs in international markets, including in developing countries, and to provide technical and financial assistance to credit-generating projects and programs in those countries.
Providing Clear Guidance to Financial Institutions Supporting the Transition to Net Zero: In September 2023, the Department of the Treasury released its Principles for Net-Zero Financing and Investment[3] to support the development and execution of robust net-zero commitments and transition plans. Later this year, Treasury will host a dialogue on accelerating the deployment of transition finance and a forum on further improving market integrity in VCMs.
Enhancing MMRV: Federal departments and agencies such as DOE, USDA, the Department of the Interior, the Department of Commerce, and the National Aeronautics and Space Administration are engaging in collaborative efforts to develop, test, and deploy technologies and other capabilities to measure, monitor, and better understand GHG emissions. (See also Principle 7 above.)
Advancing Market Integrity and Protecting Against Fraud and Abuse:S. Regulators, such as the CFTC, have been involved in promoting VCMs, such as:
- In December 2023, proposing guidance regarding factors that derivatives exchanges may consider when listing voluntary carbon credit derivative contracts to promote the integrity, transparency, and liquidity of these developing markets.[4]
- Earlier in 2023, issuing a whistleblower alert[5] to inform the American public of how to identify and report potential Commodity Exchange Act violations connected to fraud and manipulation in voluntary carbon credit spot markets and the related derivative markets.
- Creating the Environmental Fraud Task Force[6] to address fraudulent activity and bad actors in these carbon markets.
- Participating in international working groups and Co-Chairing the Carbon Markets Workstream of the International Organization of Securities Commission’s Sustainable Finance Task Force, which published a consultation on 21 good practices for regulatory authorities to consider in structuring sound, well-functioning VCMs in December 2023.[7]
Taking a Whole-of-Government Approach to Coordinate Action: The White House created an interagency Task Force on Voluntary Carbon Markets.

Takeaways and Considerations:

Although the Policy Statement does not call for legislation, it asserts that “the U.S. Government is playing an increasingly important role in carbon credit markets” and serves to “codify the U.S. Government’s approach to advance high-integrity VCMs.” In that regard, the Policy Statement may be best understood as a roadmap for developing and refining industry standards, as well as for future legislative and regulatory actions. Additionally, the Policy Statement may serve as a bridge to a state of play where participation and conduct in VCMs are not entirely voluntary for companies to meet their sustainability goals. In the meantime, VCMs will lack a formal regulatory regime.

Accordingly, companies should consider the following when determining whether and how to participate in VCMs:

Sustainability reports and public disclosures may justify or even necessitate VCM transactions.
Are your actions consistent with publicly stated sustainability goals?
Consider cost, accounting and risk profiles of VCMs and other sustainability-related products such as RECs or Inflation Reduction Act tax credits.
Develop a plan to purchase or sell products (timing and types of credits based on sustainability goals).
Assess federal, state, and international regulatory implications.
Identify transaction options (direct transactions, in a secondary market, through a broker, or in a principal market).
Understand documentation choices and assess market standards.
Review and evaluate your announced sustainability goals and targets.
Engage stakeholders regarding carbon reduction in supply chain.
Be mindful of inconsistencies in GHG emissions reporting (e.g., Inflation Reduction Act tax credit reporting).

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[1] See Voluntary Carbon Markets Joint Policy Statement and Principles (May 2024), available at: https://www.whitehouse.gov/wp-content/uploads/2024/05/VCM-Joint-Policy-Statement-and-Principles.pdf

[2] https://www.whitehouse.gov/briefing-room/statements-releases/2024/05/28/fact-sheet-biden-harris-administration-announces-new-principles-for-high-integrity-voluntary-carbon-markets/

[3] https://home.treasury.gov/system/files/136/NetZeroPrinciples.pdf

[4] For more detail on this CFTC proposal, please refer to Gibson Dunn’s earlier client alert, available here.

[5] https://www.cftc.gov/PressRoom/PressReleases/8723-23

[6] https://www.cftc.gov/PressRoom/PressReleases/8736-23

[7] https://www.iosco.org/library/pubdocs/pdf/IOSCOPD749.pdf

The following Gibson Dunn lawyers prepared this update: John Gaffney, Adam Lapidus, and Jeffrey Steiner.

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 leader or member of the firm’s Cleantech, Derivatives, Power and Renewables, Energy, Regulation and Litigation, or Tax practice groups:

Cleantech:
John T. Gaffney – New York (+1 212.351.2626, [email protected])

Derivatives:
Jeffrey L. Steiner – Washington, D.C. (+1 202.887.3632, [email protected])
Adam Lapidus – New York (+1 212.351.3869, [email protected])

Energy, Regulation and Litigation:
William R. Hollaway – Washington, D.C. (+1 202.955.8592, [email protected])

Power and Renewables:
Peter J. Hanlon – New York (+1 212.351.2425, [email protected])
Nicholas H. Politan, Jr. – New York (+1 212.351.2616, [email protected])

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

From the Derivatives Practice Group: This week, ISDA submitted an additional proposal to the US Basel III ‘endgame’ notice of proposed rulemaking and submitted a response on the Basel Committee on Banking Supervision’s G-SIB Window Dressing Consultation.

New Developments

CFTC’s Global Markets Advisory Committee Advances Recommendations on Basel III Endgame and Variation Margin Processes. On June 4, the CFTC’s Global Markets Advisory Committee (GMAC) advanced two recommendations to examine the impacts of proposed U.S. bank capital requirements and to improve collateral and liquidity management for non-centrally cleared derivatives. The GMAC approved the two recommendations without objection.
Biden-⁠Harris Administration Announces New Principles for High-Integrity Voluntary Carbon Markets. On May 28, the Biden-Harris Administration released a Joint Statement of Policy and new Principles for Responsible Participation in Voluntary Carbon Markets (VCMs) that codifies the U.S. government’s approach to advance high-integrity VCMs. The Principles for Responsible Participation include: (1) carbon credits and the activities that generate them should meet credible atmospheric integrity standards and represent real decarbonization; (2) credit-generating activities should avoid environmental and social harm and should, where applicable, support co-benefits and transparent and inclusive benefits-sharing; and (3) corporate buyers that use credits should prioritize measurable emissions reductions within their own value chains, among others. The announcement of the Principles also highlighted valuable work performed by the CFTC, including new guidance at COP28 to outline factors that derivatives exchanges may consider when listing voluntary carbon credit derivative contracts to promote the integrity, transparency, and liquidity of these developing markets and a new Environmental Fraud Task Force to address fraudulent activity and bad actors in carbon markets.
IOSCO Board Re-Elects CFTC Chairman Behnam as Vice Chair. On May 28, the Board of the International Organization of Securities Commissions (IOSCO) re-elected CFTC Chairman Rostin Behnam as a Vice Chair for the term 2024-2026, a role to which he was originally elected in October 2022. The election took place at IOSCO’s 2024 Annual Meeting in Athens, Greece. In announcing the results of the election, the CFTC stated that as a member of the IOSCO Board’s Management Team, Chairman Behnam helps guide IOSCO’s policy development and overall management. The CFTC stated that in addition to steering the CFTC’s engagement in an array of policy work within IOSCO, Chairman Behnam has co-led IOSCO’s Financial Stability Engagement Group and currently co-chairs the Carbon Markets Workstream within IOSCO’s Sustainable Finance Task Force.

New Developments Outside the U.S.

ESAs publish Joint Annual Report for 2023. On June 7, the Joint Committee of the European Supervisory Authorities (EBA, EIOPA and ESMA – the ESAs) published its 2023 Annual Report, providing an account of the joint work completed over the past year. The Joint Committee continued to play a coordinating role to facilitate discussions and the exchange of information across the three ESAs, the European Commission, and the European Systemic Risk Board (ESRB). The main areas of cross-sectoral focus were joint risk assessment, sustainable finance, digitalization, consumer protection, securitization, financial conglomerates, and central clearing. Among the Joint Committee’s main deliverables were policy products for the implementation of the Digital Operational Resilience Act (DORA) as well as ongoing work related to the Sustainable Finance Disclosure Regulation (SFDR). [NEW]
ESAs and ENISA Sign a Memorandum of Understanding to Strengthen Cooperation and Information Exchange. On June 5, the ESAs announced that they have concluded a multilateral Memorandum of Understanding (MoU) to strengthen cooperation and information exchange with the European Union Agency for Cybersecurity (ENISA). This multilateral MoU formalizes the ongoing discussions between the ESAs and ENISA to strengthen their already close cooperation as a result of the Directive On Measures For A High Common Level Of Cybersecurity (NIS2 Directive) and the Digital Operational Resilience Act (DORA).
ESAs Call for Enhanced Supervision and Improved Market Practice on Sustainability-related Claims. On June 4, the ESAs published their Final Reports on Greenwashing in the financial sector. In their respective reports the ESAs reiterate the common high-level understanding of greenwashing as a practice whereby sustainability-related statements, declarations, actions, or communications do not clearly and fairly reflect the underlying sustainability profile of an entity, a financial product, or financial services. According to the ESAs, this practice may be misleading to consumers, investors, or other market participants. The ESAs stressed that financial market players have a responsibility to provide sustainability information that is fair, clear, and not misleading. While the ESAs’ reports focus on the EU’s financial sector, they acknowledge that addressing greenwashing requires a global response, involving close cooperation among financial supervisors and the development of interoperable standards for sustainability disclosures.
The EBA and ESMA Invite Comments on the Review of the Investment Firms Prudential Framework. On June 3, ESMA and the European Banking Authority (EBA) published a discussion paper on the potential review of the investment firms’ prudential framework. The discussion paper aims at gathering early stakeholder feedback to inform the response to the European Commission’s call for advice. The consultation runs until August 30, 2024. To assess the impact of the possible changes discussed in the paper, the EBA also launched a data collection exercise on a voluntary basis.
ESAs Publish Templates and Tools for Voluntary Dry Run Exercise to Support the DORA Implementation. On May 31, the ESAs published templates, technical documents, and tools for the dry run exercise on the reporting of registers of information in the context of DORA announced in April 2024. Financial entities can use these materials and tools to prepare and report their registers of information of contractual arrangements on the use of ICT third-party service providers in the context of the dry run exercise, and to understand supervisory expectations for the reporting of such registers from 2025 onwards.
Final MiCA Rules on Conflict of Interest of Crypto Assets Providers Published. On May 31, ESMA published the Final Report on the rules on conflicts of interests of crypto-asset service providers (CASP) under the Markets in Crypto Assets Regulation (MiCA). In the report ESMA sets out draft Regulatory Technical Standards on certain requirements in relation to conflicts of interest for crypto-asset service providers (CASPs) under MiCA, with a view to clarifying elements in relation to vertical integration of CASPs and to further align with the draft European Banking Authority rules applicable to issuers of asset-referenced tokens.
ESMA Provides Guidance to Firms Using Artificial Intelligence in Investment Services. On May 30, ESMA issued a Statement providing initial guidance to firms using Artificial Intelligence technologies (AI) when they provide investment services to retail clients. When using AI, ESMA expects firms to comply with relevant MiFID II requirements, particularly when it comes to organizational aspects, conduct of business, and their regulatory obligation to act in the best interest of the client.
ESMA Reports on the Application of MiFID II Marketing Requirements. On May 27, ESMA published a combined report on its 2023 Common Supervisory Action (CSA) and the accompanying Mystery Shopping Exercise (MSE) on marketing disclosure rules under MiFID II. In the report, ESMA identifies several areas of improvements, such as the need for marketing communications to be clearly identifiable as such, and to contain a clear and balanced presentation of risks and benefits. In cases where products and services are marketed as having ‘zero cost’, ESMA identified they should also include references to any additional fees.

New Industry-Led Developments

VERMEG Integrates Common Domain Model into COLLINE Collateral Management System. On June 10, ISDA announced that VERMEG, a technology provider for the banking and insurance sector, has integrated the Common Domain Model (CDM) into its COLLINE collateral management system to support the consumption of digitized regulatory initial margin (IM) credit support annexes (CSAs). ISDA stated that VERMEG is the first entity to integrate the CDM to improve the efficiency of collateral processes, with several other firms currently in testing. [NEW]
Joint Response to BCBS G-SIB Window Dressing Consultation. On June 7, ISDA, the Global Financial Markets Association, and the Institute of International Finance submitted a joint response to the Basel Committee on Banking Supervision’s (BCBS) consultation on the revised assessment framework for global systemically important banks (G-SIBs). The associations believe the focus of the consultation – perceived window-dressing behavior – is not founded on robust evidence. [NEW]
ISDA and SIFMA Submit Additional Proposal for US Basel III NPR Letter. On June 4, ISDA and the Securities Industry and Financial Markets Association (SIFMA) submitted an additional proposal to the US Basel III ‘endgame’ notice of proposed rulemaking (NPR). The proposal covers the look-through approach for equity investments in funds. [NEW]
Preparing for the Dynamic Risk Management Accounting Model. On May 29, the International Accounting Standards Board (IASB) announced it has a project underway to develop a new model to account for dynamic risk management (DRM) activities under International Financial Reporting Standards (IFRS). It is widely expected that banks will need to apply this model, which could replace existing macro-hedge accounting models within IFRS. The IASB will also explore whether the DRM model could be applied to other risk types at a future date. ISDA published a whitepaper that sets out ISDA’s preliminary observations on the tentative decisions made by the IASB to date. According to ISDA, these observations are based on the current understanding of the model and interpretations of ongoing discussions, but they do not represent a formal industry view, which will not be possible until the IASB has publishes a discussion paper, an exposure draft or a set of deliberations.

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

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

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

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

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

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

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

Adam Lapidus – New York (+1 212.351.3869, [email protected])

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

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

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

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

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

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

Gibson Dunn discusses the background of the Opinion, the key findings and our main takeaways for both States and private actors, including the potential influence of the Opinion on future climate change litigation.

On 21 May 2024, the International Tribunal for the Law of the Sea (“ITLOS” or “Tribunal”) became the first international court to issue an advisory opinion on States’ obligations in respect to climate change (“Opinion”). The Tribunal concluded that anthropogenic (i.e. human-caused) greenhouse gas emissions (“GHGs”) constitute “pollution of the marine environment” under the United Nations Convention on the Law of the Sea (“UNCLOS” or “Convention”), triggering certain positive obligations of States, including a duty to prevent, reduce and control both land- and sea-based anthropogenic GHGs.

The Opinion is the first in a trio of advisory opinions by international courts that will likely be issued within twelve months of each other. It is envisaged that next, the Inter-American Court of Human Rights (“IACHR”) will deliver its opinion regarding States’ obligations derived from human rights norms in relation to the climate emergency. The International Court of Justice (“ICJ”) will then opine on the obligations of States under international law to ensure the protection of the climate system from anthropogenic GHGs for present and future generations, as well as the legal consequences for States where they, by their acts and omissions, have caused significant harm to the climate system. These opinions are expected in early- and mid- 2025, respectively.

Notably, the Opinion was issued just six weeks after the European Court of Human Rights’ (“ECtHR’s”) judgment in KlimaSeniorinnen v. Switzerland, in which the ECtHR, for the first time in its history, prescribed the content of States’ positive obligations under Article 8 of the European Convention on Human Rights (“ECHR”) in the context of climate change. According to the ECtHR, States have a primary duty to adopt, and to effectively apply in practice, general measures for achieving carbon neutrality—and with a view to achieving neutrality within the next three decades. (We previously reported on KlimaSeniorinnen here.)

In this Client Alert, we discuss the background and the potential implications of the Opinion for both States and private actors as well as offering our key takeaways.

Background

The Advisory Opinion was issued pursuant to a request (“Request”) by the Commission of Small Island States on Climate Change and International Law (“COSIS”). COSIS was established in 2022 and comprises eight States, which are low emitters of GHGs, but highly vulnerable to the impacts of climate change.

On 12 December 2022, COSIS asked ITLOS to opine on the specific obligations of States Parties to UNCLOS, including under Part XII (“Protection and Preservation of the Marine Environment”) to:

prevent, reduce and control pollution of the marine environment in relation to the deleterious effects that result or are likely to result from climate change, including through ocean warming and sea level rise, and ocean acidification, which are caused by anthropogenic GHGs into the atmosphere; and
protect and preserve the marine environment in relation to climate change impacts, including ocean warming and sea level rise and ocean acidification.

Part XII of the Convention sets out an affirmative and overarching general obligation “to protect and preserve the marine environment” (Article 192) followed by specific obligations—including to “take … all measures … necessary” to “prevent, reduce and control pollution of the marine environment from any source” (Article 194(1)) and “ensure that activities under their jurisdiction or control are so conducted as not to cause damage by pollution to other States and their environment” (Article 194(2)).

More than 50 States, inter-governmental and non-governmental organisations made written and oral submissions in the ITLOS proceedings, presenting a range of views as to how the questions in the Request should be answered.

ITLOS’ Key Conclusions

(a) Anthropogenic GHGs constitute “pollution of the marine environment”

Importantly, the Tribunal found that anthropogenic GHGs in the atmosphere constitute “pollution of the marine environment” within the meaning of Article 1(1)(4) of the Convention as it satisfies the three criteria of: (i) there being a substance or energy; (ii) the substance or energy is introduced by humans, directly or indirectly, into the marine environment; and (iii) such introduction results, or is likely to result, in deleterious effects. This finding triggered certain obligations for States under UNCLOS Part XII (and other relevant UNCLOS provisions)—some of which are discussed below.

In coming to this conclusion, the Tribunal (similarly to the ECtHR) relied on reports from the Inter-governmental Panel on Climate Change (“IPCC”) as authoritative assessments of the scientific knowledge on climate change. In this regard, the Tribunal noted that none of the participants had challenged the authoritative value of the IPCC reports.

(b) State Parties have an obligation to prevent, reduce and control pollution from anthropogenic GHGs

Article 194(1) of UNCLOS imposes an obligation upon States to take “all necessary measures” to reduce and control marine pollution from any source including anthropogenic GHGs—and eventually prevent such pollution from occurring at all. However, consistent with the Paris Agreement, this obligation does not require “immediate cessation” of marine pollution from anthropogenic GHGs.

Whilst the concept of “all necessary measures” is not defined in UNCLOS, the Tribunal considered that among such measures are those designed to reduce GHG emissions—commonly referred to as “mitigation measures” in the climate context. Similar to KlimaSeniorinnen, ITLOS explained that it is up to the State to determine what measures are necessary, but such measures must be determined “objectively”: (i) first, on the basis of the “best available science”—in which context the IPCC reports “deserve particular consideration”; and second, with reference to relevant international rules and standards—where the United Nations Framework Convention on Climate Change (“UNFCCC”) and the 2015 Paris Agreement “stand out … as primary treaties”, and in particular the objective in the Paris Agreement of limiting the temperature increase to 1.5° compared to pre-industrial levels.

(c) The nature of the obligation to prevent, reduce and control pollution (including transboundary pollution) is one of stringent due diligence, i.e. an obligation of conduct

The obligation to prevent, reduce and control pollution is an obligation of conduct. In other words, by this obligation, States are required to act with due diligence in taking necessary measures—and the level is stringent because of the high risks of serious and irreversible harm to the marine environment that anthropogenic GHGs present. The obligation of due diligence requires a State “to put in place a national system, including legislation, administrative procedures and an enforcement mechanism necessary to regulation … and to exercise adequate vigilance … with a view to achieving the intended objective”. The obligation is “particularly relevant” in a situation in which activities are mostly carried out by private actors. States must also apply the precautionary approach in their exercise of due diligence.

According to ITLOS, the standard of due diligence will vary according to scientific information, relevant international rules and standards, the risk of harm and the urgency involved. The implementation of the obligation may also vary according to the relevant States’ capabilities and resources.

(d) State Parties have an obligation to prevent, reduce and control transboundary pollution

Further, State Parties have a particular obligation with respect to transboundary pollution. States must “take all necessary measures” to ensure GHG emissions under their jurisdiction or control do not cause damage to other States and their environment, and pollution arising from such emissions does not spread beyond the areas where they exercise sovereign rights. The standard of due diligence in this context “can be even more stringent” because of the nature of transboundary pollution.

(e) State Parties have an obligation to implement laws and regulations to prevent, reduce and control marine pollution—including from land-based sources

As the Tribunal went on to discuss, there also exist complimentary obligations (Articles 207, 211 and 212), whereby State Parties must implement laws and regulations, to prevent, reduce and control marine pollution from land-based sources, as well as aircraft and vessels, taking account of treaties such as the UNFCCC and the Paris Agreement. The Tribunal explained that “central to” those laws and regulations is the reduction of anthropogenic GHG emissions, and measures “can be wide-ranging, from the establishment of administrative procedures for the regulation of pollution to the monitoring of risks and effects of marine pollution”.

(f) State Parties are required to undertake Environmental Impact Assessments (“EIAs”)

State Parties are, additionally, required to conduct EIAs under Article 206—which are “an essential part of a comprehensive environmental management system”. The EIA obligation is triggered when there are “reasonable grounds for believing” that the activities “may cause substantial pollution of or significant and harmful changes to the marine environment”.

Article 206 does not prescribe the scope and content of EIAs and so the Tribunal proceeded to fill in the gaps. On scope, it explained that activities under assessment are those within a State’s jurisdiction or control and comprise those of both private and State entities. Further, both sea- and land-based activities are included. Concerning content, the Tribunal noted that EIAs should embrace not only the specific aspects of the planned activities but the cumulative impacts of these and other activities on the environment. The Tribunal observed that the Agreement on the Conservation and Sustainable Use of Marine Biological Diversity of Areas Beyond National Jurisdiction contains detailed provisions on EIAs, implying that such provisions provide a suitable benchmark.

(g) State Parties must keep under surveillance the effects of activities that States have permitted, or in which they are engaged

State Parties must also keep under surveillance the effects of activities that States have permitted, or in which they are engaged. This obligation applies irrespective of the place where the activities are conducted or the nationality of the individuals or entities carrying out the activities.

(h) State Parties have the specific obligation to protect and preserve the marine environment from climate change impacts and ocean acidification

Under Article 192 of UNCLOS, State Parties have the specific obligation to protect and preserve the marine environment from climate change impacts and ocean acidification (which entails maintaining ecosystem health and the natural balance of the marine environment). This obligation has a broad scope, encompassing any type of harm or threat to the marine environment. Where the marine environment has been degraded, this obligation may call for measures to restore marine habitats and ecosystems. Again, the obligation is one of due diligence of a stringent standard.

Our Key Takeaways

The Opinion delivered by ITLOS is of considerable significance for many reasons. We have the following key takeaways:

First, while an advisory opinion from ITLOS does not create legally enforceable obligations on State Parties, they are nonetheless highly persuasive authorities for both international and domestic courts, in that an advisory opinion contributes to the clarification and development of international law.

The Opinion will, in our view, prove influential in the context of both pending and future climate change-related claims before international and domestic courts—particularly in cases against States[1] and / or State actors where it is alleged that actions being taken to mitigate against the effects of climate change are insufficient. This may include claims that supervision of non-State actors is lacking—and, in that regard, the Opinion referred, at paragraph 396, to the obligation on States to “ensure that non-State actors under their jurisdiction or control comply with such measures”.

It is worth noting that the Tribunal emphasised that failure to comply with the obligation to “take all necessary measures” would engage State responsibility. This suggests that a failure by a State Party to act leaves it vulnerable to UNCLOS proceedings pursuant to Article 235(1) in future (“States are responsible for the fulfilment of their international obligations concerning the protection and preservation of the marine environment”)—and/or claims that a State Party has failed to provide recourse to prompt and adequate compensation (or other relief) in respect of damage caused by marine pollution by juridical persons under their jurisdiction pursuant to Article 235(2).

Second, the Opinion is likely to have a “cross-fertilisation” effect. We expect that the IACHR and ICJ will seek to render advisory opinions that are consistent with the thrust of the ITLOS Opinion, albeit within their respective and somewhat different normative frameworks (and also to core elements of the ECtHR’s judgment in KlimaSeniorinnen). The task of the ICJ, however, will be a broader exercise since it will also deal with the question of “legal consequences” of State obligations in relation to climate change.

Third, the Opinion may prompt a regulatory response from States in terms of limiting GHG emissions from both sea- and land-based sources—though our view is that the ICJ advisory opinion may prove more influential in that regard to the extent that the ICJ opines on the substance of the Paris Agreement. Private actors should monitor changes to the regulatory landscape that may impact their operations.

Fourth, with respect to the Paris Agreement, the Opinion makes clear that UNCLOS exists alongside it (and the UNFCCC) as a legal basis for obligations to address climate change and its effects. Thus, the Opinion treats the UNCLOS and Paris Agreement regimes as distinct noting that States’ compliance with the Paris Agreement alone will not be sufficient to discharge the obligation to prevent, reduce and control pollution of the marine environment under UNCLOS. Likewise, ITLOS did not seek to tie “necessary measures” to the requirements under the Paris Agreement—such as the commitment in Article 4(2) to prepare, communicate and maintain successive nationally determined contributions that a State Party intends to achieve.

Fifth, the positive obligation to conduct EIAs where an activity may cause substantial pollution to the marine environment articulated in the Opinion is noteworthy. It may, for example, affect oil and gas licensing processes for exploration and production (both on- and offshore) as well as other high GHG-emitting projects. Of course, EIAs are routinely carried out in any event in many States. However, as noted, the EIA contemplated by the Tribunal includes “continuing surveillance” and an assessment of the “cumulative impact” of a project. EIAs will also now (in theory) have to be conducted in the context of the Tribunal’s clarification that anthropogenic GHGs constitute pollution of the marine environment. One can expect climate litigants to closely scrutinise the processes and outcomes of EIAs for high GHG emitting projects.

Finally, whilst the Opinion was unanimous, there was discussion by some judges in their Declarations to the Opinion of the relevance of human rights in interpreting obligations under UNCLOS. In the Opinion, the Tribunal merely states, in brief, that “climate change represents an existential threat and raises human rights concerns”.

In Judge Pawlak’s view, the Opinion could have gone further, “reflect[ing] the broader implications of recent developments in climate change justice”, specifically referring to the ECtHR’s KlimaSeniorinnen judgment. He acknowledged that pursuant to KlimaSeniorinnen, States have the responsibility to combat climate change to protect human rights and the decision “created preceden[t]” for other judicial institutions. Indeed, in Judge Pawlak’s view, KlimaSeniorinnen (as well as the UN Human Rights Committee’s decision in the Torres Strait Islanders case)—”which added human rights considerations to the global fight against climate change”—are “essential” and “not isolated.”

Judge Infante Caffi meanwhile thought the reference to human rights in the Opinion could have been supplemented by further arguments, noting the reference to human rights in the preamble to the Paris Agreement and the UN General Assembly’s resolution 76/300 with [t]he human right to a clean, healthy and sustainable environment”.

[1] In that context, please note that UNCLOS has been ratified by 168 parties. Notably, whilst the European Union has ratified the Convention, the United States has not.

The following Gibson Dunn lawyers prepared this update: Robert Spano, Ceyda Knoebel, Stephanie Collins, Alexa Romanelli, Sophie Hammond, and Daniel Szabo*.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you usually work, any leader or member of the firm’s International Arbitration and Transnational Litigation or Environmental, Social and Governance (ESG) practice groups, or the following authors:

Robert Spano – Paris/London (+33 1 56 43 14 07, [email protected])
Ceyda Knoebel – London (+44 20 7071 4243, [email protected])
Stephanie Collins – London (+44 20 7071 4216, [email protected])
Alexa Romanelli – London (+44 20 7071 4269, [email protected])
Sophie Hammond – London (+44 20 7071 4077, [email protected])

*Daniel Szabo, a trainee solicitor in the London office, is not admitted to practice law.

The Proposed Regulations generally would apply to projects placed in service after December 31, 2024, once final regulations are published in the Federal Register.

On June 3, 2024, the IRS and Treasury issued proposed regulations (the “Proposed Regulations”) under sections 45Y and 48E.[1] These sections, which were enacted as part of the Inflation Reduction Act of 2022, allow tax credits for certain clean energy projects beginning in 2025 in lieu of credits under sections 45 (the production tax credit) and 48 (the investment tax credit). Because the section 45Y and 48E credits are expected by some measures to be the single largest driver[2] of the reduction in greenhouse gas (“GHG”) emissions under the Inflation Reduction Act, taxpayers, policymakers, and market participants will have a keen interest in the Proposed Regulations and the subsequent finalization of this guidance.

The cornerstone of sections 45Y and 48E is a pivot from a prescribed list of credit-eligible technologies to a “technology neutral” system under which any qualifying energy generation or storage technology is credit eligible if it satisfies a “zero or negative” GHG emissions standard.[3]

Under the Proposed Regulations, certain technologies—wind, solar, geothermal, marine and hydrokinetic, and nuclear energy (both fission and fusion)—would be deemed to have per se zero or negative GHG emissions. Other potentially eligible technologies—such as renewable natural gas, biogas, and hydrogen fuel cells—would be subject to more stringent rules for determining their GHG emissions.

The Proposed Regulations generally would apply to projects placed in service after December 31, 2024 once final regulations are published in the Federal Register.

Calculation of the Tech-Neutral PTC and Tech-Neutral ITC

Tech-Neutral PTC

Section 45Y (the “Tech-Neutral PTC”) will provide taxpayers with a 10-year pre-inflation adjustment base credit of $15 per MWh of electricity produced and either sold to an unrelated person or, in the case of a facility equipped with a metering device that is owned and operated by an unrelated person, sold, consumed, or stored.[4][5] Using 2023 as an example, the inflation-adjusted rate would be $28 per MWh. The Tech-Neutral PTC also includes bonus amounts for projects located in energy communities and for projects that meet the domestic content bonus requirements, each of which would be a separate 10 percent increase in the base amount of the Tech-Neutral PTC.[6]

Tech-Neutral ITC

Section 48E (the “Tech-Neutral ITC”) provides a 30 percent base credit for a “qualified investment” with respect to a “qualified facility” or energy storage technology (“EST”), provided that prevailing wage and apprenticeship requirements are satisfied. Like the Tech-Neutral PTC, the Tech-Neutral ITC also includes bonus amounts for facilities located in energy communities or facilities that meet the domestic content bonus requirements (each a separate incremental 10 percentage point increase to the base credit) and for facilities that are allocated a low-income community bonus amount by the IRS (up to additional 20 percentage point increase, depending on the type of project).

Under the Proposed Regulations, the Tech-Neutral ITC would be subject to recapture if the qualified facility has a GHG emissions rate (discussed below) that exceeds 10 grams of CO₂e per kWh,[7] averaged over the taxable year, for any taxable year during the five-year period beginning on the date the qualified facility is originally placed in service. The new emissions-based recapture rule would vest 20 percent of the Tech-Neutral ITC each year in a manner similar to the existing ITC recapture rules under section 50(a). The Proposed Regulations would provide that a taxpayer must report the GHG emissions rate to the IRS during the recapture period of the qualified facility.[8]

Credit Stacking and Phase Out

Neither the Tech-Neutral PTC nor the Tech-Neutral ITC can be claimed for a facility for which a credit was determined under section 48E or 45Y, respectively, or section 45, 45J, 45Q, 45U, 48, or 48A for the taxable year or any prior taxable year.

The Proposed Regulations would provide that a taxpayer that claims a Tech-Neutral PTC or Tech-Neutral ITC with respect to one qualified facility may still be eligible for the Tech-Neutral ITC or Tech-Neutral PTC, respectively, with respect to a different qualified facility that is co-located with the first facility.

Both the Tech-Neutral ITC and Tech-Neutral PTC phase out for projects that begin construction after the later of 2032 and the year in which the IRS determines that the annual GHG emissions from the production of electricity in the United States are equal to or less than 25 percent of what they were in 2022.

Determining GHG Emissions Rates

The Inflation Reduction Act requires that the IRS publish annually a table setting forth the GHG emissions rate for types of facilities for purposes of the Tech-Neutral PTC and Tech-Neutral ITC, along with an expert analysis of any categories added or removed (consistent with the methodologies described below). Taxpayers must use and may rely on the table as of the date construction begins.

For the process of establishing GHG emissions rates, the Proposed Regulations would categorize facilities as either combustion and gasification facilities (“C&G Facilities”) or not (“Non-C&G Facilities”). The Proposed Regulations would provide that GHG emissions rates would exclude any qualified carbon dioxide generated in the facility’s production of electricity that is captured by the taxpayer and disposed of in secure geological storage or utilized in certain commercial processes described in section 45Q(f).

If a taxpayer’s facility type is not included in the IRS’s annual table, the Proposed Regulations would provide a process for taxpayers to receive a provisional emissions rate (“PER”) from the IRS similar to the process under section 45V. To receive a PER, a taxpayer first would need to seek an emissions value for its facility from the Department of Energy (which requires a formal study) or (in the case of C&G Facilities) determine an emissions value based on an IRS-designated lifecycle analysis model (“LCA,” discussed below); the taxpayer then would receive a PER by filing a petition that includes the emissions value for the applicable facility with its tax return for the first taxable year in which it claims the applicable credit.

Non-C&G Facilities

For Non-C&G Facilities other than wind, solar, hydropower, marine and hydrokinetic, nuclear fission and fusion, and certain types of waste energy recovery facilities (which, as noted above, are deemed to have zero or negative GHG emissions), the Proposed Regulations would provide that the GHG emissions rate must be determined through a technical and engineering assessment of the fundamental energy transformation into electricity (but not necessarily an LCA), considering all input and output energy carriers and chemical reactions or mechanical processes taking place at the facility in the production of electricity. Under a principles-based approach, emissions that may relate to the facility but do not occur “in the production of electricity” are excluded, such as off-site emissions related to land use changes or the production and transportation of fuels.

C&G Facilities

The Proposed Regulations would confirm that the GHG emissions rate for C&G Facilities must be determined, in part, pursuant to a qualifying LCA. The starting point for this LCA would be feedstock generation or extraction and the ending boundary would be the meter at the point of electricity production (i.e., excluding distribution, transmission, and use of electricity).

The qualifying LCA must be based on an anticipated baseline and take into account enumerated direct and indirect emissions. In contrast to the rule for Non-C&G Facilities, the Proposed Regulations would eschew a principles-based approach for excluded emissions for C&G Facilities and instead would list four categories of specifically excluded emissions (generally, construction-, maintenance-, infrastructure-, and distribution-related emissions). Nevertheless, an LCA may consider “alternative fates” (e.g., of biomass feedstocks) and may account for “avoided emissions.”[9]

In the preamble to the Proposed Regulations, the IRS and Treasury noted numerous issues that they are continuing to consider in modeling GHG emissions for C&G Facilities, including spatial and temporal LCA parameters, principles informing the LCA baselines, allocation of emissions to co-products and byproducts, use of book-and-claim accounting systems for tracking the emissions associated with fuel and feedstock sources, and special rules for facilities producing electricity from biogas, renewable natural gas, and fugitive methane (including a requirement that any such feedstock originate from its “first productive use”).

Other Rules

For facilities placed in service before 2025, the addition of a new unit or an addition of capacity after 2024 may be eligible for the Tech-Neutral PTC or Tech-Neutral ITC. For purposes of this rule, the Proposed Regulations would provide that a new unit or addition of capacity would be treated as a separate qualified facility and that a facility that is decommissioned or is in the process of decommissioning and restarts can be considered to have increased capacity if certain conditions are met.

Pursuant to the Inflation Reduction Act, the Tech-Neutral ITC generally will be unavailable if the property constitutes a “building or its structural components.” No such prohibition applied to most energy property (including solar energy property) under the section 48 legacy ITC. The Proposed Regulations generally would adopt pre-1986 guidance defining a “building” but do not provide any definition of “structural components.”[10]

The Proposed Regulations for the Tech-Neutral ITC would adopt some (but not all) of the approaches in the proposed regulations under section 48 published in November 2023, including that (i) a qualified facility includes “all functionally interdependent components,” (ii) a taxpayer must own at least a fractional interest in an entire “unit of qualified facility” to claim the Tech-Neutral ITC in respect of any component of that qualified facility, and (iii) retrofit costs must satisfy the “80/20” rule to be credit-eligible.[11]

Substantiation

The Proposed Regulations also would provide guidance on specific records required to be kept to substantiate eligibility for a Tech-Neutral PTC or Tech-Neutral ITC, including that a taxpayer must maintain documentation regarding the design, operation, and if applicable, feedstock or fuel source used by the facility that establishes that such facility had a negative or zero GHG emissions rate for the taxable year.

Observations

As with the section 48 proposed regulations, the fractional interest / multiple owners rule creates a cliff-effect trap that would require taxpayers to be certain they own at least a fractional interest in the entire “unit of energy property” or otherwise risk total credit disallowance. As discussed in our prior alert (found here), the rule directly conflicts with the Tax Court’s decision in Cooper v. Commissioner, 88 T.C. 84 (1987).
In contrast to the section 48 proposed regulations, the Proposed Regulations do not provide guidance on whether “second life” batteries would be counted for purposes of determining the Tech-Neutral ITC in respect of modifications to ESTs.
The statutory rule allowing taxpayers to qualify for the Tech-Neutral PTC without selling the underlying power to an unrelated third party differs from the existing PTC, which requires a sale, but this rule is only available in circumstances in which the production is measured using a meter that is owned and operated by an unrelated third party. The details in the Proposed Regulations regarding the metering requirement will be very important for taxpayers who wish to consume the power they produce, rather than selling it to a third party, and may result in the creation of a cottage industry focused on providing metering solutions.
The designation of certain technologies that are per se eligible for the Tech-Neutral PTC and Tech-Neutral ITC will be welcome news to many industries. Given the significant, potential burden to establish that other technologies are credit eligible (e.g., full LCA in some instances), we would anticipate that there may be a significant push by other industries for inclusion on this per se list in the final regulations.
Taxpayers constructing projects involving technologies that are not on the per se eligibility list may wish to consider taking steps to start construction before the end of 2024 to be eligible to claim the section 45 PTC or section 48 ITC, which have less stringent requirements and remain available for projects on which construction begins before 2025.
The new GHG emissions rate recapture rules will present new financing challenges for technologies that are not per se eligible, requiring tax equity and tax credit investors to craft legal protections against the risk that operational property is less efficient than expected. The insurance markets are likely to be an important tool in managing this risk.
The “building or its structural components” prohibition was an unfortunate development in the Inflation Reduction Act and may cause issues for dedicated energy projects that power buildings (e.g., solar or potentially small nuclear projects), which seems inconsistent with the intent of the law. The Proposed Regulations do not address these issues. It would be helpful for Treasury and the IRS to provide a definition of “structural components” and examples in the final guidance indicating that the “building or its structural components” prohibition would not preclude taxpayers from claiming the Tech-Neutral ITC in situations where it was routinely claimed for property dedicated to powering buildings before the Inflation Reduction Act.
Taxpayers looking to claim the Tech-Neutral PTC or Tech-Neutral ITC for a C&G Facility would be well-advised to review the questions asked by the IRS and Treasury regarding the guidance for modeling GHG emissions rates and to consider providing input in advance of the publication of the final regulations. Many of the LCA modeling issues and issues regarding use of biogas, renewable natural gas, and fugitive methane also were raised in the proposed regulations under section 45V published in December 2023, which received nearly 30,000 comments.

[1] Unless indicated otherwise, all section references are references to the Internal Revenue Code of 1986, as amended (the “Code”), and references to “regulations” are references to the Treasury regulations promulgated under the Code. In certain cases, if a taxpayer begins construction on a qualified facility before 2025, but places the facility in service after 2024, the taxpayer is apparently able to choose application of section 45, 45Y, 48, or 48E.

[2] King, Ben, et al., Tech-Neutral Tax Credits: The Foundation of US Electric Power Decarbonization, Rhodium Group, May 23, 2024, https://rhg.com/research/tech-neutral-tax-credits-electric-power/. The Rhodium Group study was cited by Treasury in its press release here. As was the case with the so-called Tax Cuts and Jobs Act, the Senate’s reconciliation rules prevented Senators from changing the Act’s name, and the formal name of the so-called Inflation Reduction Act is actually “An Act to provide for reconciliation pursuant to title II of S. Con. Res. 14.”

[3] Storage technology is not subject to the “zero or negative” GHG emissions standard.

[4] The Proposed Regulations also would provide requirements for combined heat and power system (“CHP”) property to be eligible for the Tech-Neutral PTC. Under the Proposed Regulations, CHP property must produce at least 20 percent of its useful energy in the form of thermal energy that is not used to produce electrical or mechanical power (or a combination thereof) and at least 20 percent of its total useful energy in the form of electrical or mechanical power (or a combination thereof). Additionally, the energy efficiency percentage of CHP property must be greater than 60 percent.

[5] The pre-adjustment base rates under sections 45Y and 48E assume the facility meets prevailing wage and apprenticeship requirements; our previous client alert on these requirements can be found here. Section 45Y(g)(4) provides that persons will be treated as related to each other if such persons would be treated as a single employer under the regulations prescribed under section 52(b). The Proposed Regulations would provide that a corporation that is a member of an affiliated group of corporations filing a consolidated return will be treated as selling electricity to an unrelated person even if the electricity is first sold to another member of the group before being sold to an unrelated person outside the group.

[6] Please see our previous client alerts on these adders, which can be found here (energy community bonus), here (initial domestic content bonus guidance), and here (further domestic content bonus guidance).

[7] CO2e stands for carbon dioxide equivalent. The Proposed Regulations assign global warming potential (“GWP-100”) values for purposes of determining “CO2e per kWh” in a manner similar to the GREET models for sections 45V and 45Z. For example, methane is assigned a GWP-100 that is 28 times greater than carbon dioxide.

[8] This reporting would be at the time and in the form and manner prescribed by the IRS, and also would apply if the taxpayer transferred a credit under section 6418. Please see our prior alert on the proposed regulations on credit transferability here.

[9] Offsets and offsetting activities unrelated to the production of electricity by a C&G Facility may not be taken into account in a qualifying LCA.

[10] Borrowing from Treas. Reg. § 1.48-1(e)(1), the Proposed Regulations would not treat either of the following as a “building”: (i) a structure that is essentially an item of machinery or equipment or (ii) a structure that is so closely related to the components of credit-qualifying property housed by the structure that both the components and the structure would be expected to be replaced if the components were replaced. Accordingly, both of those types of structures would be eligible to be treated as integral parts of a qualified facility in respect of which the Tech-Neutral ITC can be claimed.

[11] Please see our discussion of those proposed regulations here.

The following Gibson Dunn lawyers prepared this update: Mike Cannon, Matt Donnelly, Josiah Bethards, Nathan Sauers, and Alissa Fromkin Freltz.

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, any member of the firm’s Tax, Cleantech, or Power and Renewables practice groups, or the following authors:

Tax:
Michael Q. Cannon – Dallas (+1 214.698.3232, [email protected])
Matt Donnelly – Washington, D.C. (+1 202.887.3567, [email protected])
Josiah Bethards – Dallas (+1 214.698.3354, [email protected])
Nathan Sauers – Houston (+1 346.718.6715, [email protected])
Alissa Fromkin Freltz – Washington, D.C. (+1 202.777.9572, [email protected])

Cleantech:
John T. Gaffney – New York (+1 212.351.2626, [email protected])
Daniel S. Alterbaum – New York (+1 212.351.4084, [email protected])
Adam Whitehouse – Houston (+1 346.718.6696, [email protected])

Power and Renewables:
Peter J. Hanlon – New York (+1 212.351.2425, [email protected])
Nicholas H. Politan, Jr. – New York (+1 212.351.2616, [email protected])

Gibson, Dunn & Crutcher LLP announces release of the International Comparative Legal Guide to: Anti-Money Laundering 2024.

Gibson, Dunn & Crutcher LLP is pleased to announce with Global Legal Group the release of the International Comparative Legal Guide to: Anti-Money Laundering 2024. Gibson Dunn partners Stephanie L. Brooker and M. Kendall Day were the Contributing Editors of the publication, which covers issues including criminal enforcement, regulatory and administrative enforcement, and requirements for financial institutions and other designated businesses. The Guide, comprised of 5 expert analysis chapters and 19 jurisdictions, is live and FREE to access HERE.

Ms. Brooker, Mr. Day, and senior associate Chris Jones jointly authored “Anti-Money Laundering Laws and Regulations Top 12 Developments in Anti-Money Laundering Enforcement in 2023.”

In addition, Ms. Brooker, Mr. Day, and of counsel Ella Capone co-authored the jurisdiction chapter on “USA: Anti-Money Laundering 2024.”

You can view these informative and comprehensive chapters via the links below:

CLICK HERE to view Anti-Money Laundering Laws and Regulations Top 12 Developments in Anti-Money Laundering Enforcement in 2023

CLICK HERE to view USA: Anti-Money Laundering 2024

The following Gibson Dunn lawyers contributed to this publication: Stephanie Brooker, M. Kendall Day, Ella Capone, and Chris Jones.

Gibson Dunn has deep experience with enforcement defense and compliance issues regarding the Bank Secrecy Act, AML laws, and sanctions laws and regulations.

About the Authors:

Stephanie Brooker, a partner in the Washington, D.C. office of Gibson Dunn, is Co-Chair of the firm’s Global White Collar Defense and Investigations, Anti-Money Laundering, and Financial Institutions Practice Groups. Stephanie served as a prosecutor at DOJ, including serving as Chief of the Asset Forfeiture and Money Laundering Section, investigating a broad range of white-collar and other federal criminal matters, and trying 32 criminal trials. She also served as the Director of the Enforcement Division and Chief of Staff at FinCEN, the lead U.S. anti-money laundering regulator and enforcement agency. Stephanie has been consistently recognized by Chambers USA for enforcement defense and BSA/AML compliance as an “excellent attorney,” who clients rely on for “important and complex” matters, and for providing “excellent service and terrific lawyering.” She has also been named a National Law Journal White Collar Trailblazer and a Global Investigations Review Top 100 Women in Investigations.

Kendall Day is a nationally recognized white-collar partner in the Washington, D.C. office of Gibson Dunn, where he is Co-Chair of Gibson Dunn’s Global Fintech and Digital Assets Practice Group, Co-Chair of the firm’s Financial Institutions Practice Group, co-leads the firm’s Anti-Money Laundering practice, and is a member of the White Collar Defense and Investigations and Crisis Management Practice Groups. Kendall is recognized as a leading White Collar Attorney in the District of Columbia by Chambers USA – America’s Leading Business Lawyers. Most recently, Kendall was recognized in Best Lawyers 2024 for white-collar criminal defense. Prior to joining Gibson Dunn, Kendall had a distinguished 15-year career as a white-collar prosecutor with DOJ, rising to the highest career position in DOJ’s Criminal Division as an Acting Deputy Assistant Attorney General (“DAAG”). As a DAAG, Kendall had responsibility for approximately 200 prosecutors and other professionals. Kendall also previously served as Chief and Principal Deputy Chief of the Money Laundering and Asset Recovery Section. In these various leadership positions, from 2013 until 2018, Kendall supervised investigations and prosecutions of many of the country’s most significant and high-profile cases involving allegations of corporate and financial misconduct. He also exercised nationwide supervisory authority over DOJ’s money laundering program, particularly any BSA and money-laundering charges, DPAs and non-prosecution agreements involving financial institutions.

Ella Alves Capone is Of Counsel in the Washington, D.C. office, where she is a member of the White Collar Defense and Investigations and Anti-Money Laundering practice groups. Her practice focuses in the areas of white collar investigations and advising clients on regulatory compliance and the effectiveness of their internal controls and compliance programs. Ella routinely advises multinational companies and financial institutions, including cryptocurrency and other digital asset businesses, gaming businesses, fintechs, and payment processors, on BSA/AML and sanctions compliance matters. She also has extensive experience representing clients before DOJ, SEC, OFAC, FinCEN, and federal banking regulators on a variety of white collar matters, including those involving BSA/AML, sanctions, anti-corruption, securities, and fraud matters.

Chris Jones is a senior associate in the Los Angeles office of Gibson Dunn. He is a member of the White Collar Defense and Investigations, Litigation, Anti-Money Laundering, and National Security Practice Groups, among others. His practice focuses primarily on internal investigations and enforcement defense, regulatory and compliance counseling, and complex civil litigation. Chris has experience representing clients in a wide range of anti-corruption, AML, litigation, sanctions, securities, and tax matters. He has represented various clients in investigations by DOJ, SEC, FinCEN, and OFAC, including a number of AML-related investigations. Previously, Chris clerked for the Honorable Timothy J. Kelly of the United States District Court for the District of Columbia.

Contact Information:

For assistance navigating these issues, please contact the the Gibson Dunn lawyer with whom you usually work, the leaders or members of the firm’s Anti-Money Laundering practice group, or the authors:

Stephanie Brooker – Washington, D.C. (+1 202.887.3502, [email protected])
M. Kendall Day – Washington, D.C. (+1 202.955.8220, [email protected])
Ella Capone – Washington, D.C. (+1 202.887.3511, [email protected])
Chris Jones – Los Angeles (+1 213.229.7786, [email protected])

We are pleased to provide you with Gibson Dunn’s ESG update covering the following key developments during May 2024. Please click on the links below for further details.

I. GLOBAL

Science-Based Targets Initiative (SBTi) releases new Corporate Net-Zero Standards

On May 9, 2024, the SBTi released is Terms of Reference for its Corporate Net-Zero Standards (Standards), announcing that it would be making a comprehensive update to these Standards by the end of 2025. This major revision is premised on ensuring the Standards continue to be a credible standard for setting and delivering on ambitious, science-based corporate targets aimed at achieving net-zero consistent with 1.5°C at the global level by 2050. The objectives of the revised Standards will be to align with latest science and best practice, enhance the SBTi’s approach to addressing value chain emissions, integrate continuous improvement and assessment of target achievement, and improve the structure and interoperability of the Standards with other SBTi standards as well as external frameworks. It is expected that the draft Standards will be released for public consultation in Q4 2024.

International Financial Reporting Standards (IFRS) Foundation publishes its Inaugural Jurisdictional Guide for the adoption or other use of the International Sustainability Standards Board (ISSB) Standards

On May 28, 2024, the IFRS Foundation released its Inaugural Jurisdictional Guide for the adoption or other use of ISSB Standards. As regulators around the world continue to press forward with adopting the ISSB Standards, the IFRS Foundation’s Guide has been developed to promote globally consistent and comparable climate and other sustainability-related disclosures for capital markets. The Guide also seeks to provide transparency for market participants and regulators by showing them how different jurisdictions are progressing in this area, including describing the various jurisdictional approaches to the adoption or other use of ISSB Standards, such as full adoption, partial adoption and permission to use. There are now more than 20 jurisdictions that have taken steps to align themselves with the ISSB Standards, which represents close to 55% of global GDP.

In case you missed it…

Responsible Contracting Project (RCP) and Interfaith Center on Corporate Responsibility (ICCR) release Investor Guidance on Responsible Contracting

On April 11, 2024, the RCP and the ICCR released their joint Investor Guidance on Responsible Contracting (Guidance). The Guidance provides practical tools to investors on how to engage with their portfolio companies to support effective human rights and environmental (HRE) due diligence. This is becoming increasingly important as investors take into account a company’s HRE performance when making investment decisions. The Guidance will assist investors in their discussions with companies on responsible purchasing and contracting issues. In particular, the Guidance builds on the RCP’s toolkit to better assist investors in encouraging companies to draft the commitments they make in their sustainability reports using contractual language. The Guidance will also help companies to better align their strategies with the UN Guiding Principles for Business and Human Rights, and the Organisation for Economic Co-operation and Development’s (OECD’s) Guidelines for Multinational Enterprises on Responsible Business Conduct.

International Capital Market Association (ICMA), Islamic Development Bank (IsDB) and London Stock Exchange Group (LSEG) publish Guidance on Green, Social and Sustainability Sukuk

On April 29, 2024, the ICMA, the IsDB and the LSEG jointly published new guidance on the issuance of green, social, and sustainability sukuk (Sukuk Guidance). The Sukuk Guidance aims to develop the sustainable sukuk market by providing issuers and other key market participants with practical information on how sukuk can be (i) labelled as ‘green’, ‘social’ or ‘sustainability’, and (ii) aligned with the ICMA Principles, by using examples, case studies and best practices. The Sukuk Guidance also seeks to increase investors’ awareness of sukuk as an asset class in global fixed income markets.

International Sustainability Standards Board (ISSB) publishes its Digital Sustainability Taxonomy

On April 30, 2024, the ISSB published the IFRS Sustainability Disclosure Taxonomy (ISSB Taxonomy) to assist investors and other capital providers with analyzing sustainability-related financial disclosures efficiently. For companies using the ISSB Taxonomy, investors will be able to search, extract and compare sustainability-related financial disclosures. The ISSB Taxonomy is in line with IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information (June 2023), IFRS S2 Climate-related Disclosures (June 2023), and accompanying guidance which enables consistency and clarity in reporting. It does not introduce any new requirements.

II. UNITED KINGDOM

UK Government publishes new draft regulations for packaging and packaging waste

On May 1, 2024, the UK Department for Environment, Food & Rural Affairs (Defra) published its updated draft Producer Responsibility Obligations (Packaging and Packaging Waste) regulations 2024 for packaging and packaging waste to extend producer responsibility. The regulations aim to place the responsibility on producers to pay the full costs of the collection, recycling and disposal of the packaging they supply and use once it becomes waste. The regulations also seek to encourage packaging design improvements to reduce waste and environmental impact, as well as introduce recycling target for 2025 – 2030. Originally, the regulations were intended to be in force by 1 January 2025. However, this timeline may be impacted as a result of the UK Parliament’s dissolution on May 30, 2024 in light of the upcoming UK elections.

UK Sustainability Disclosure Standards (SDRs) due in Q1 2025

On May 16, 2024, the Department for Business & Trade published an update on the UK Government’s framework for the creation of the UK Sustainability Reporting Standards (UK SRS) in the form of the Sustainability Disclosure Requirements (SDR): Implementation Update 2024 guidance document. The guidance document sets out the timeframes and milestone for each core element of the SDR. In particular, the UK Government is looking to make the UK SRS (UK-endorsed ISSB standards) available in Q1 2025. If endorsed by the Government, and subject to a consultation process, the Financial Conduct Authority (FCA) will be able to use the UK SRS to require UK-listed companies to report sustainability-related information. A decision on future requirements is also forecasted for Q2 2025. The guidance document also sets out its intentions for (i) the FCA to consult on strengthening its expectations for transition plan disclosures that will align UK rules with ISSB standards, and (ii) a proposed ‘Green Taxonomy’ with a voluntary testing period for a minimum of two years before potentially exploring mandatory disclosures.

UK FCA anti-greenwashing rule comes into force

On May 31, 2024, the FCA’s anti-greenwashing rule (which is part of a package of measures finalized by the FCA on sustainability disclosure requirements and investment labels) for all FCA-authorized firms came into force after the FCA published its final guidance on this subject at the end of April 2024. The new rule is designed to protect consumers by requiring firms to accurately describe any sustainable products and services that they are selling. Firms have a responsibility to be fair, clear and not misleading. Specifically, they are required to ensure that sustainability references are: (i) correct and capable of being substantiated; (ii) clear and presented in a way that can be understood; and (iii) complete by not hiding or omitting important information and giving consideration to the full life cycle of the product or service. Additionally, comparisons to other products and services are to be fair and meaningful.

III. EUROPE

European Council delays reporting requirements under the EU Corporate Sustainability Reporting Directive (CSRD)

On April 29, 2024, the European Council approved the adoption of a directive to amend the CSRD to delay by two years the reporting obligations for certain sectors (oil and gas, mining, coal and quarrying, road transport, motor vehicles, textiles, agriculture and farming, food and beverage, real estate, power production and energy utilities, and capital markets, insurance and banking) and companies based outside of the EU. In recognition of the additional burden that the reporting requirements impose, the exempt companies will now have until June 30, 2026 to comply with the CSRD.

European Financial Reporting Advisory Group (EFRAG) and IFRS Foundation publish Interoperability Guidance

On May 2, 2024, the IFRS Foundation and EFRAG published their Interoperability Guidance. The Interoperability Guidance illustrates the significant alignment between the ISSB’s IFRS Sustainability Disclosure Standards and the European Sustainability Reporting Standards and seeks to reduce complexity and duplication for companies applying both standards. The Interoperability Guidance provides practical support on how a company can apply and comply with both sets of standards and sets out detailed analysis of the alignment in climate-related disclosures.

Spain withdraws from the Energy Charter Treaty (ECT)

On May 14, 2024, Spain confirmed its withdrawal from the ECT via its official state gazette. Spain’s decision, first initiated in October 2022, stems from its concerns that (i) the ECT has failed to sufficiently align with the Paris Agreement and the European Green Deal, and (ii) that a new modernized text of the ECT has flaws in its arbitral dispute resolution mechanism. Spain’s withdrawal from the ECT will take effect on April 17, 2025, one year after the date of receipt of Spain’s notification to the ECT’s depository. Its withdrawal will not have retroactive effect and current investors will retain protection under the ECT’s sunset clause until 2045. However, any new investments made on or after April 17, 2025 will not be entitled to protection.

European Securities and Markets Authority (ESMA) publishes final report on Guidelines on funds’ names using ESG or sustainability-related terms

On May 14, 2023, the ESMA published its final report setting out guidelines on funds’ names using ESG or sustainability-related terms (ESMA Guidelines). The report is a culmination of the ESMA’s proposals first laid out in December 2023. The ESMA Guidelines have two main objectives: (i) to ensure that investors are protected against unsubstantiated or exaggerated sustainability claims used in fund names, and (ii) to provide asset managers with clear and measurable criteria to assess their ability to use ESG or sustainability-related terms in fund names. In terms of scope of application, the ESMA Guidelines should apply to the EU as well as non-EU fund managers marketing EU or non-EU funds in the European Economic Area, although the ESMA Guidelines are not mandatory. The ESMA Guidelines are due to be published on the ESMA’s website and will be effective three months following publication.

CSRD Essentials resource published by European joint working group

On May 15, 2024, a joint working group consisting of the Global Reporting Initiative, Pascal Durand, Member of the European Parliament and CSRD Rapporteur, and the Lefebvre – Sarrut Group (amongst others), launched the CSRD Essentials resource to help explain the EU’s mandatory sustainability reporting requirements to policy makers and sustainability reporters. The CSRD Essentials simplify key aspects of the CSRD in 11 core chapters using accessible language. The resource focuses on (i) scope, timing and interactions with existing standards, (ii) reporting format, (iii) legal interconnections, (iv) auditing rules and internal supervision, and (v) small and medium enterprises, implementation procedures and penalties.

Institutional Investors Group on Climate Change (IIGCC) publishes report on EU regulatory barriers to net-zero

On May 29, 2024, the IIGCC publicly announced its release of the ‘Delivering 2030: Investor Expectations of EU Sustainable Finance’ April 2024 report which was developed in consultation with its investor members. The report identifies and analyzes policy-related barriers to achieving net-zero resulting from the EU’s existing sustainable finance policy framework and provides recommendations on how they can be overcome. In particular, it considers recommendations relating to EU regulation that include the EU taxonomy for sustainable activities, the Corporate Sustainability Reporting Directive (CSRD), the Corporate Sustainability Due Diligence Directive (CSDDD), and the Sustainable Finance Disclosure Regulation (SFDR).

EU Corporate Sustainability and Due Diligence Directive (CSDDD) receives final approval from European Council

On May 24, 2024, the European Council formally adopted the CSDDD[1] which will introduce obligations and liabilities for large companies regarding the adverse impact of their activities on human rights and the environment. The CSDDD will apply to both the companies’ operations, the activities of their subsidiaries, and the activities of their business partners along the companies’ chain of activities. Companies with more than 1000 employees and with a turnover greater than €450 million will fall within the directive’s scope, and it will cover both upstream goods production and downstream distribution, transport or storage provision. The CSDDD will require such companies to implement a risk-based system to monitor, prevent or remedy human rights or environmental damages. Companies in breach of the CSDDD will be required to change business practices and may be held liable for damage caused and face financial penalties in the form of compensation. Once published in the Official Journal of the EU, the CSDDD will enter into force on the twentieth day following publication. Member states will then have a two-year period for implementation. The timeline for the CSDDD’s application will be staggered depending on the size of the company, beginning with the largest companies within the scope of the CSDDD whom will be subject to its application from mid-2027 onwards.

European Council formally adopts decision to withdraw the EU and Euratom from the ECT

On May 30, 2024, further to the European Parliament’s approval in April 2024, the European Council formally approved the EU’s and Euratom’s withdrawal from the ECT. This follows the EU’s announcement that the ECT is no longer in line with the Paris Agreement and the EU’s ambitions for energy transition. Member states who wish to remain party to the ECT will have an opportunity to cast their vote during the next Energy Charter Conference. The EU and Euratom withdrawal will be effective from one year after the ECT’s depository receives the notification.

Poland releases new proposals for Polish hydrogen regulatory framework

On May 27, 2024, the Polish Ministry of Climate and Environment proposed a draft amendment to the existing Energy Law. The amendment to the legislation seeks to position hydrogen within the Polish energy law system, making hydrogen a separate type of fuel alongside solid, liquid and gaseous fuels and recognizing three types of hydrogen: (i) renewable hydrogen, (ii) low-emission hydrogen, and (iii) renewable hydrogen from a non-biological origin. The amendment also provides new rules for connecting hydrogen installation to gas and hydrogen networks, simplifies licensing requirements for hydrogen production and trading and provides new opportunities for investment in and the development of the Polish hydrogen sector. The draft is still in its early stages but is expected to be placed before the Polish Parliament later this year.

In case you missed it…

Luxembourg commences implementation of Corporate Sustainability Reporting Directive (CSRD) into domestic law

On March 29, 2024, Luxembourg initiated the process for the implementation of the CSRD into its domestic law by submitting the Bill of Law 8370 to the Luxembourg Chamber of Deputies. The new bill will expand obligations for corporate sustainability reporting on ESG matters in Luxembourg. It also seeks to promote sustainable corporate governance and a standardized reporting framework to ensure that businesses operating in Luxembourg disclose comprehensive and comparable data on ESG matters across jurisdictions. This will also help to promote corporate accountability, foster long-term value creation and align Luxembourg with the EU’s broader sustainability goals. The legislative process for the bill’s formal implementation is expected to be accelerated given the upcoming July 6, 2024 deadline for all EU member states to implement the CSRD.

Nasdaq launches Nasdaq futures for Swedish ESG Index

On April 10, 2024, Nasdaq launched Nasdaq futures on the OMX Sweden Small Cap 30 ESG Responsible Index in Sweden (Index). The Nasdaq futures solution aims to combine a diversified portfolio of small cap stocks into a single tradeable instrument, while providing investors with exposure to the Swedish small cap market. The Index tracks the performance of the 30 most liquid small cap securities listed on Nasdaq Stockholm whose issuers meet specific ESG screening criteria, as set out in the Index methodology. The ESG screening criteria also assists investors who wish to align their investments with positive societal and environmental outcomes.

European Parliament gives final approval to regulation prohibiting products made using forced labor

On April 23, 2024, the European Parliament announced its final approval to a new regulation enabling the EU to prohibit the sale, import, and export of goods made using forced labor. The regulation gives member state authorities and the European Commission the power to investigate suspicious goods, supply chains, and manufacturers. Should a product be deemed to have been made using forced labor (in whole or in part), it will not be authorized for sale within the EU or export from the EU. Once the regulation receives final formal approval from the European Council, member states must implement the legislation within three years from the date of its publishing in the Official Journal of the EU.

European Parliament adopts new measures to reduce packaging waste in the EU

On April 24, 2024, the European Parliament adopted new measures to make packaging more sustainable and reduce packaging waste in the EU. The regulation imposes packaging reduction targets (5% by 2030, 10% by 2035 and 15% by 2040) and focuses also on requiring EU countries to reduce the amount of plastic packaging waste generated. Certain single-use plastic packaging types will also be banned from January 1, 2030, including packaging for unprocessed fresh fruit and vegetables, foods and beverages filled and consumed in cafés and restaurants, individual portions such as condiments, and very lightweight plastic carrier bags (below 15 microns). The European Council has provisionally agreed to the measures but they will still require the European Council’s formal approval before the measures can enter into force.

IV. NORTH AMERICA

Biden Administration publishes Statement and Principles on Voluntary Carbon Markets

As summarized in our alert, on May 28, 2024, the Biden Administration released a Voluntary Carbon Markets Joint Policy Statement and Principles that includes observations on current voluntary carbon markets, as well as voluntary principles for U.S. market participants to consider when engaging in such markets.

Exxon Mobil Corporation (“Exxon”) shareholder proposal litigation continues; director slate elected despite “Vote No” Campaigns

On May 22, 2024, a federal district court in Texas ruled that Exxon may continue to pursue its legal challenge regarding a climate-related shareholder proposal (described in our client alert) against U.S.-based Arjuna Capital, but could not do so against Follow This, an organization based in the Netherlands, due to a lack of jurisdiction. On May 27, 2024, Arjuna Capital filed a letter sent to Exxon indicating Arjuna Capital’s unconditional and irrevocable covenant to refrain “from submitting any proposal for consideration by Exxon shareholders related to [greenhouse gases] or climate change” and requesting Exxon withdraw its lawsuit. Exxon responded on May 31, 2024 to affirm its intention to continue the lawsuit and critique the Arjuna Capital letter as an “empty promise” that could not moot the case and was insufficient to deprive Exxon of its requested relief. A hearing on the question of mootness is scheduled for June 17.

The litigation generated several “vote no” campaigns against Exxon’s directors in connection with the company’s annual shareholder meeting on May 29, 2024, including opposition from large pension funds such as the California Public Employees Retirement System (CalPERS). All directors were nonetheless re-elected at the meeting, with support ranging from 87% to 98% of votes cast.

U.S. Securities and Exchange Commission (“SEC”) Division of Corporation Finance Director provides insight on Form 8-K Cybersecurity Incident Disclosure

As detailed in our blog post, on May 21, 2024, the Division of Corporation Finance Director Erik Gerding published a statement reflecting his views and concerns regarding the emerging practice of public companies voluntarily disclosing cyber incidents under Item 1.05 of Form 8-K, which requires disclosure of material cyber incidents.

Briefing schedule set for litigation challenging SEC Climate Rules

The U.S. Court of Appeals for the Eighth Circuit issued an order on May 20, 2024 setting a briefing schedule for June to September 2024 in the consolidated litigation challenging the SEC’s final climate disclosure rules. A summary of the timeline and relevant considerations is available in our blog post.

On May 31, 2024, the Sierra Club and the Natural Resources Defense Council (“NRDC”) filed unopposed motions to voluntarily dismiss themselves from the litigation, which the Eighth Circuit has since granted.

U.S. Senators encourage SEC’s adoption of Anti-Greenwashing Rule

More than 20 U.S. Senators sent a letter to SEC Chair Gary Gensler on May 13, 2024 urging the SEC to finalize the anti-greenwashing rule it proposed in May 2022, asserting it “is critical for addressing greenwashing and other exaggerated or unfounded ESG-related claims amongst funds and investment advisors.” The Senators specified several aspects of the proposed rule that should be included in a final rule, such as requiring certain funds to disclose their engagement with issuers and proxy voting on ESG-related issues, as well as their greenhouse gas emissions.

California Climate Legislation receives funding, but continues to face legal challenges

California’s latest state budget for 2024 to 2025, released on May 10, 2024, now includes funding for the implementation of Senate Bills (“SB”) 253 and 261. The legislation, adopted in October and described in our client alert and blog post, will require annual greenhouse gas emissions disclosure and biennial climate risk disclosure beginning in 2026 by U.S. entities that do business in the state and exceed certain revenue thresholds. To execute the laws, the budget allocates funding to the California Air Resources Board.

Both SB 253 and 261 nonetheless continue to face legal challenges, as the U.S. Chamber of Commerce and other business and trade organizations have submitted a joint briefing schedule with the California Attorney General to address plaintiffs’ First Amendment claim and the state’s motion to dismiss the other claims. More background on the litigation is described in our client alert. A decision on these matters could be made by the end of 2024.

Federal Reserve Board publishes banking-focused climate Scenario Analysis Exercise Results

On May 9, 2024, the Federal Reserve Board released the results of its pilot climate scenario analysis exercise reviewing the climate-risk management practices and challenges of six large U.S. banking entities. The exercise asked the participating banks to examine how physical and transition climate risk could affect their organizations, produced several insights (including that the banks faced “significant data and modeling challenges in estimating climate-related financial risks”) and reported “a lack of comprehensive and consistent data related to building characteristics, insurance coverage, and counterparties’ plans to manage climate-related risks.” The Federal Reserve Board noted that “[i]n many cases, participants relied on external vendors to fill data and modeling gaps,” making it difficult for banks to assess how to best incorporate climate risks into their risk management frameworks.

U.S. Environmental Protection Agency (“EPA”) publishes Enhanced Methane Emissions Reporting Standards

On May 6, 2024, the EPA updated its Greenhouse Gas Reporting Program requirements for reporting petroleum and natural gas system methane emissions. The final rules seek in part to close the gap between actual emissions and those historically reported by updating calculation methods, requiring direct emission source monitoring, and using satellite data to quantify “large emission events” and identify “super-emitters.” The final rule supports the Biden Administration’s U.S. Methane Emission Reduction Plan, which seeks to reduce emissions across U.S. economic sectors.

Canadian Regulator opens investigation into Lululemon’s environmental claims

On May 6, 2024, the Competition Bureau of Canada announced it had initiated a formal investigation of alleged deceptive marketing practices by Lululemon in connection with the brand’s environmental marketing claims. A non-profit, Stand.earth, had previously filed a complaint to the Competition Bureau in February 2024 accusing Lululemon of greenwashing in its 2020 Be Planet sustainability campaign. The complaint alleges that the company’s recent 2022 impact report contradicted the company’s prior claims that it sought to reduce its greenhouse gas emissions.

V. APAC

Australia’s Responsible Investment Association Australasia (RIAA) launches Sustainability Classifications system

The RIAA launched its Sustainability Classifications during its conference held on May 1 – 2, 2024. This initiative seeks to help consumers and advisers of financial products understand the different levels of consideration given to sustainability factors for different investment products or services that are RIAA-certified so that they can make informed choices. The factors for consideration include responsible investment approaches, claims, processes, stewardship programs and disclosures. The Sustainability Classifications also focus on the approach by funds when considering ESG factors and the degree to which sustainability is addressed or targeted. The Sustainability Classifications cover three key levels: (i) ‘Responsible’, (ii) ‘Sustainable’, and (iii) ‘Sustainable Plus’, with the ‘Sustainable Plus’ classification requiring the highest number of factors to be met in order to obtain the classification.

Hong Kong Monetary Authority (HKMA) issues Taxonomy for Sustainable Finance

On May 3, 2024, HKMA published its Taxonomy for Sustainable Finance (Taxonomy) to enable investors to make informed decisions on green and sustainable finance in the interests of interoperability, comparability and inclusiveness with China’s and the EU’s green taxonomies. The taxonomy is a green classification framework which covers 12 economic activities under four sectors: (i) power generation, (ii) transportation, (iii) construction, and (iv) waste and water management. The HKMA also intends to expand the coverage of the taxonomy further to include more sectors and activities, including transition activities, in due course. Although use of the taxonomy is voluntary, the HKMA is encouraging banks to use it to assess the ‘greenness’ of projects and assets when labelling or identifying products, making disclosures and providing guidance for investment. The HKMA has also published Supplemental Guidance setting out more detailed information on the use and application of the Taxonomy.

Hong Kong begins consultation on ESG code for ratings and data providers

On May 17, 2024, Hong Kong’s Voluntary Code of Conduct Working Group (VCWG), whose members encompass Hong Kong’s ESG ratings and data products providers and is sponsored by the Hong Kong Securities and Futures Commission, announced the launch of its consultation on a voluntary code of conduct for ESG ratings and data products providers who deliver goods and/or services in Hong Kong. The current draft code aims to foster a trusted, efficient and transparent market, by introducing clear and globally consistent standards for ESG ratings and data products providers. It also seeks to clarify how such providers can interact with wider market participants. Accordingly, the current draft is based on the International Organization of Securities Commissions’ report on Environmental, Social and Governance Ratings and Data Products Providers and existing industry standards. The VCWG is working with the Secretariat of the International Capital Market Association to develop the code of conduct and the consultation will end on June 17, 2024.

Final Constitutional Court hearing of landmark South Korean climate litigation cases held in May 2024

The final hearing of four consolidated landmark climate litigation cases (filed between 2020 and 2023)[2] took place before South Korea’s Constitutional Court on May 21, 2024. The plaintiffs, more than 200 people including 62 children, are arguing that the South Korean government’s current response to climate change is insufficient to ensure a healthy environment for future generations and, in breach of their fundamental constitutional rights, the government has failed to adequately protect the plaintiffs from climate change. In particular, the fundamental rights in question are: (i) right to life; (ii) right to pursue happiness; (iii) right to general freedom; (iv) right to property; and (v) right to a healthy environment. South Korea’s next decade-long climate action plan is due to be revised in 2025 and the plaintiffs are calling for stronger policies and a more ambitious approach than that currently being taken. The case is the first of its kind in South Korea, and more widely, in East Asia.

International Tribunal for the Law of the Sea (ITLOS) publishes advisory opinion in response to request by Commission of Small Island States on Climate Change and International Law (COSIS)

On May 21, 2024, the ITLOS published its unanimous advisory opinion on the obligations of states to protect and preserve the world’s oceans from climate change impacts including ocean warming, sea level rise and ocean acidification. The opinion was published following the request made by the COSIS (six Caribbean and Pacific states) to the ITLOS on December 12, 2022 to clarify the specific environmental obligations of state parties to the 1982 UN Convention on the Law of the Sea (UNCLOS) with respect to climate change impacts on oceans. The ITLOS found that anthropogenic greenhouse gas emissions are a form of marine pollution under the UNCLOS. Consequently, state parties are to take “all necessary measures” in line with the best available science to reduce their greenhouse gas emissions in accordance with international legal obligations. Although not legally binding, the opinion clarifies the extent of states parties’ obligations under the UNCLOS. The ITLOS is the first international judicial body to give a climate-related advisory opinion. This is also the first time that an international court or tribunal has addressed the issue of climate change by applying the UNCLOS.

China issues exposure draft of Chinese Sustainability Disclosure Standards for Business Enterprises

On May 27, 2024, China’s Ministry of Finance issued an exposure draft for the Chinese Sustainability Disclosure Standards for Business Enterprises – Basic Standard (Basic Standards). China is seeking public opinion on the draft Basic Standards which consist of 33 articles setting general requirements for corporate sustainability information disclosures and would apply to companies established in China. The Ministry of Finance is planning to issue the finalised Basic Standards and accompanying guidance by 2027. There will be a phased approach for application to companies, beginning first with listed companies and voluntary disclosures before expanding to non-listed companies and mandatory disclosures. The Basic Standards are ultimately aimed at unifying corporate sustainability disclosures in China with the intention to then establish a comprehensive nationwide standard by 2030 to help companies better engage in global trade and investment activities and enhance their international competitiveness. The consultation period will run until June 24, 2024.

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

For further information about any of the topics discussed herein, please contact the ESG Practice Group Chairs or contributors, or the Gibson Dunn attorney with whom you regularly work.

__________

[1] See our previous client alert addressing the Corporate Sustainability Due Diligence Directive.

[2] Do-Hyun Kim et al. v. South Korea (2020); Byung-In Kim et al. v South Korea (2021); Woodpecker v South Korea (2022); Min-A Park v South Korea (2023).

The following Gibson Dunn lawyers prepared this update: Lauren Assaf-Holmes, Natalie Harris, Elizabeth Ising, Cynthia Mabry, 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):
Susy Bullock – London (+44 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 20 7071 4263, [email protected])

From the Derivatives Practice Group: This week, the European Supervisory Authorities each published a report on Greenwashing in the financial sector. The reports stress that financial market players have a responsibility to provide sustainability information that is clear, fair, and not misleading.

New Developments

CFTC’s Global Markets Advisory Committee Advances Recommendations on Basel III Endgame and Variation Margin Processes. On June 4, the CFTC’s Global Markets Advisory Committee (GMAC) advanced two recommendations to examine the impacts of proposed U.S. bank capital requirements and to improve collateral and liquidity management for non-centrally cleared derivatives. The GMAC approved the two recommendations without objection. [NEW]
Biden-⁠Harris Administration Announces New Principles for High-Integrity Voluntary Carbon Markets. On May 28, the Biden-Harris Administration released a Joint Statement of Policy and new Principles for Responsible Participation in Voluntary Carbon Markets (VCMs) that codifies the U.S. government’s approach to advance high-integrity VCMs. The Principles for Responsible Participation include: (1) carbon credits and the activities that generate them should meet credible atmospheric integrity standards and represent real decarbonization; (2) credit-generating activities should avoid environmental and social harm and should, where applicable, support co-benefits and transparent and inclusive benefits-sharing; and (3) corporate buyers that use credits should prioritize measurable emissions reductions within their own value chains, among others. The announcement of the Principles also highlighted valuable work performed by the CFTC, including new guidance at COP28 to outline factors that derivatives exchanges may consider when listing voluntary carbon credit derivative contracts to promote the integrity, transparency, and liquidity of these developing markets and a new Environmental Fraud Task Force to address fraudulent activity and bad actors in carbon markets.
IOSCO Board Re-Elects CFTC Chairman Behnam as Vice Chair. The Board of the International Organization of Securities Commissions (IOSCO) has re-elected CFTC Chairman Rostin Behnam as a Vice Chair for the term 2024-2026, a role to which he was originally elected in October 2022. This year’s election took place at IOSCO’s 2024 Annual Meeting in Athens, Greece. As a member of the IOSCO Board’s Management Team, Chairman Behnam helps guide IOSCO’s policy development and overall management. In addition to steering the CFTC’s engagement in an array of policy work within IOSCO, Chairman Behnam has co-led IOSCO’s Financial Stability Engagement Group and currently co-chairs the Carbon Markets Workstream within IOSCO’s Sustainable Finance Task Force.
CFTC Announces Updated Part 43 Block and Cap Sizes and Further Extends No-Action Letter Regarding the Block and Cap Implementation Timeline. On May 23, the CFTC’s Division of Data published updated post-initial appropriate minimum block sizes and post-initial cap sizes as determined under CFTC regulations. The Division of Market Oversight (DMO) also issued a letter further extending the no-action position originally taken in CFTC Letter No. 22-03 regarding the compliance dates for certain amendments, adopted in November 2020, to the CFTC’s swap data reporting rules concerning block trades and post-initial cap sizes. The updated post-initial appropriate minimum block and cap sizes will be effective October 7. The updated post-initial appropriate minimum block and post-initial cap sizes, as well as other swap reporting rules, forms, and requirements, are at Real-Time Reporting | CFTC.

New Developments Outside the U.S.

ESAs and ENISA Sign a Memorandum of Understanding to Strengthen Cooperation and Information Exchange. On June 5, the European Supervisory Authorities (EBA, EIOPA, and ESMA – the ESAs) announced that they have concluded a multilateral Memorandum of Understanding (MoU) to strengthen cooperation and information exchange with the European Union Agency for Cybersecurity (ENISA). This multilateral MoU formalizes the ongoing discussions between the ESAs and ENISA to strengthen their already close cooperation, as a result of the Directive on measures for a high common level of cybersecurity (NIS2 Directive) and the Digital Operational Resilience Act (DORA). [NEW]
ESAs Call for Enhanced Supervision and Improved Market Practice on Sustainability-related Claims. On June 4, the European Supervisory Authorities (ESAs) published their Final Reports on Greenwashing in the financial sector. In their respective reports the ESAs reiterate the common high-level understanding of greenwashing as a practice whereby sustainability-related statements, declarations, actions, or communications do not clearly and fairly reflect the underlying sustainability profile of an entity, a financial product, or financial services. According to the ESAs, Tthis practice may be misleading to consumers, investors, or other market participants. The ESAs stressed again that financial market players have a responsibility to provide sustainability information that is fair, clear, and not misleading. While the ESAs’ reports focus on the EU’s financial sector, they acknowledge that addressing greenwashing requires a global response, involving close cooperation among financial supervisors and the development of interoperable standards for sustainability disclosures. [NEW]
The EBA and ESMA Invite Comments on the Review of the Investment Firms Prudential Framework. On June 3, ESMA and the European Banking Authority (EBA) published a discussion paper on the potential review of the investment firms’ prudential framework. The discussion paper aims at gathering early stakeholder feedback to inform the response to the European Commission’s call for advice. The consultation runs until August 30, 2024. To assess the impact of the possible changes discussed in the paper, the EBA also launched a data collection exercise on a voluntary basis. [NEW]
ESAs Publish Templates and Tools for Voluntary Dry Run Exercise to Support the DORA Implementation. On May 31, the European Supervisory Authorities (EBA, EIOPA and ESMA – the ESAs) published templates, technical documents and tools for the dry run exercise on the reporting of registers of information in the context of Digital Operation Resilience Act (DORA) announced in April 2024. Financial entities can use these materials and tools to prepare and report their registers of information of contractual arrangements on the use of ICT third-party service providers in the context of the dry run exercise, and to understand supervisory expectations for the reporting of such registers from 2025 onwards.
Final MiCA Rules on Conflict of Interest of Crypto Assets Providers Published. On May 31, ESMA published the Final Report on the rules on conflicts of interests of crypto-asset service providers (CASP) under the Markets in Crypto Assets Regulation (MiCA). In the report ESMA sets out draft Regulatory Technical Standards on certain requirements in relation to conflicts of interest for crypto-asset service providers (CASPs) under MiCA, with a view to clarifying elements in relation to vertical integration of CASPs and to further align with the draft European Banking Authority rules applicable to issuers of asset-referenced tokens.
ESMA Provides Guidance to Firms Using Artificial Intelligence in Investment Services. On May 30, ESMA issued a Statement providing initial guidance to firms using Artificial Intelligence technologies (AI) when they provide investment services to retail clients. When using AI, ESMA expects firms to comply with relevant MiFID II requirements, particularly when it comes to organizational aspects, conduct of business, and their regulatory obligation to act in the best interest of the client.
ESMA Reports on the Application of MiFID II Marketing Requirements. On May 27, ESMA published a combined report on its 2023 Common Supervisory Action (CSA) and the accompanying Mystery Shopping Exercise (MSE) on marketing disclosure rules under MiFID II. In the report, ESMA identifies several areas of improvements, such as the need for marketing communications to be clearly identifiable as such, and to contain a clear and balanced presentation of risks and benefits. In cases where products and services are marketed as having ‘zero cost’, ESMA identified they should also include references to any additional fees.
ESMA Consults on Commodity Derivatives Under MiFID Review. On May 23, ESMA launched a public consultation on proposed changes to the rules for position management controls and position reporting. The changes come in the context of the review of the Market in Financial Instruments Directive (MiFID II). ESMA is consulting on changes to the technical standards (RTS) on position management controls, the Implementing Technical Standards (ITS) on position reporting, and on position reporting in Commission Delegated Regulation (EU).
ESMA Consults on Consolidated Tape Providers and Their Selection. On May 23, ESMA invited comments on draft technical standards related to Consolidated Tape Providers (CTPs), other data reporting service providers (DRSPs) and the assessment criteria for the CTP selection procedure under the Markets in Financial Instruments Regulation (MiFIR). The proposed draft technical standards are developed in the context of the review of MiFIR and will contribute to enhancing market transparency and removing the obstacles that have prevented the emergence of consolidated tapes in the European Union.
ESMA Makes Recommendations for More Effective and Attractive Capital Markets in the EU. On May 22, ESMA published its Position Paper on “Building more effective and attractive capital markets in the EU”. The Paper includes 20 recommendations to strengthen EU capital markets and address the needs of European citizens and businesses.
ESMA Consults on Three New Technical Standards. On May 21, ESMA launched a public consultation on non-equity trade transparency, reasonable commercial basis (RCB) and reference data under the MiFIR review. ESMA is seeking input on three topics: (1) pre- and post-trade transparency requirements for non-equity instruments (bonds, structured finance products and emissions and allowances); (2) obligation to make pre-and post-trade data available on an RCB intended to guarantee that market data is available to data users in an accessible, fair, and non-discriminatory manner; and (3) obligation to provide instrument reference data that is fit for both transaction reporting and transparency purposes.

New Industry-Led Developments

Preparing for the Dynamic Risk Management Accounting Model. On May 29, the International Accounting Standards Board (IASB) announced it has a project underway to develop a new model to account for dynamic risk management (DRM) activities under International Financial Reporting Standards (IFRS). It is widely expected that banks will need to apply this model, which could replace existing macro-hedge accounting models within IFRS. The IASB will also explore whether the DRM model could be applied to other risk types at a future date. ISDA published a whitepaper that sets out ISDA’s preliminary observations on the tentative decisions made by the IASB to date. According to ISDA, these observations are based on the current understanding of the model and interpretations of ongoing discussions, but they do not represent a formal industry view, which will not be possible until the IASB has publishes a discussion paper, an exposure draft or a set of deliberations. [NEW]
ISDA Submits Policy Paper on Derivatives and EU Agenda to European Commission. On May 24, ISDA shared its EU public policy paper, A Competitive, Resilient, Sustainable Europe: How derivatives can serve the EU’s strategic agenda, with the European Commission. The paper offers a roadmap for how derivatives can play a positive role in supporting key EU strategic priorities for the bloc’s 2024-2029 mandate. It shows that the financial system in general, and derivatives specifically, can help the EU to pursue competitiveness, economic security and a successful green transition. [NEW]
ISDA Tokenized Collateral Guidance Note. On May 21, ISDA published a guidance note to inform how counsel may approach a legal opinion on the enforceability of collateral arrangements entered into under certain ISDA collateral documentation where the relevant collateral arrangement comprises tokenized securities and/or stablecoins (together, “Tokenized Collateral”). This guidance note sets forth (i) a basic taxonomy of common tokenization structures and (ii) a non-exhaustive list of key issues to consider when analyzing the enforceability of collateral arrangements involving Tokenized Collateral.
ISDA Response to SFC and HKMA Joint’s Consultation Paper on Implementing UTI, UPI, and CDE. On May 17, ISDA responded to the Securities and Futures Commission (SFC) and Hong Kong Monetary Authority’s (HKMA) joint further consultation on enhancements to the OTC derivatives reporting regime for Hong Kong to mandate – (1) the use of Unique Transaction Identifier (UTI), (2) the use of Unique Product Identifier (UPI) and (3) the reporting of Critical Data Elements (CDE).

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

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

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

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

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

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

Adam Lapidus – New York (+1 212.351.3869, [email protected])

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

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

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

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

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

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

This edition of Gibson Dunn’s Federal Circuit Update for May 2024 summarizes the current status of a new petition pending before the Supreme Court, a Federal Circuit en banc decision regarding the obviousness inquiry for design patents, and recent Federal Circuit decisions concerning standing, finality, personal jurisdiction, printed matter doctrine, and interferences under the pre-AIA statute.

Federal Circuit News

Noteworthy Petitions for a Writ of Certiorari:

There were a couple new potentially impactful petitions filed before the Supreme Court in May 2024.

Chestek PLLC v. Vidal (US No. 23-1217): “Whether the PTO is exempt from notice-and-comment requirements when exercising its rulemaking power under 35 U.S.C. § 2(b)(2).” The response is due July 15, 2024.
Cellect LLC v. Vidal (US No. 23-1231): “Whether a patent procured in good faith can be invalidated on the ground that statutory Patent Term Adjustment, which requires lengthening a patent’s term to account for time lost to Patent and Trademark Office delays, can trigger a judge-made patent-invalidation doctrine.” The response is due July 22, 2024, and the New York Intellectual Property Law Association has already filed an amicus curiae brief.

Federal Circuit En Banc Opinions:

As we reported in our June 2023 update, the Federal Circuit granted the en banc petition in LKQ Corp. v. GM Global Technology Operations LLC. We provide a summary of the opinion below.

LKQ Corp. v. GM Global Technology Operations LLC, No. 21-2348, (Fed. Cir. May 21, 2024): LKQ filed a petition for inter partes review (“IPR”) challenging the validity of GM’s design patent for a vehicle fender as obvious over prior art reference Lian alone or in combination with the 2010 Hyundai Tucson fender. The Patent Trial and Appeal Board (“Board”) applied the two-part Rosen-Durling test requiring the primary reference be “basically the same” and the secondary reference be “so related” to the claimed design. The Board found that Lian could not serve as a primary reference, because it was not “basically the same” and ended its obviousness analysis. The original Federal Circuit panel affirmed the Board’s decision, holding it was bound by Rosen-Durling absent clear direction from the Supreme Court. The Federal Circuit then granted rehearing en banc.

The Federal Circuit (Stoll, J., joined by Moore, C.J., Dyk, Prost, Reyna, Taranto, Chen, Hughes, and Stark, JJ.) vacated and remanded, overruling the two-part Rosen-Durling test, which required a strict “basically the same” primary reference and “so related” secondary reference, as being “improperly rigid.” Instead, the Court adopted the obviousness analysis for utility patents, consistent with Congress’s statutory scheme as well as Supreme Court precedent. The Court did not agree with certain amici that its overruling of Rosing-Durling would create uncertainty, because the “Graham four-part obviousness test for utility patents has existed for a very long time and there is considerable precedent.” The Court thus vacated the Board’s decision and remanded for the Board to apply the new framework for evaluating obviousness of design patents.

Judge Lourie concurred with the Court’s decision to vacate and remand the Board’s decision, but disagreed that Rosing and Durling needed to be overruled. Instead, as Judge Lourie explained, to make the Rosing-Durling test less rigid, all the Court needed to do was replace the use of “must” and “only” in the analyses with words such as “generally,” “usually,” or “typically.” Thus, Judge Lourie would have modified, rather than outright overruled, Rosing and Durling.

Upcoming Oral Argument Calendar

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

Key Case Summaries (May 2024)

Intellectual Tech LLC v. Zebra Technologies Corp., No. 22-2207 (Fed. Cir. May 1, 2024): Intellectual Technology (“IT”) sued Zebra for patent infringement. Zebra moved to dismiss for lack of standing because a loan agreement between IT and its creditor, Main Street, granted Main Street the right to, among other things, sell, transfer, assign, encumber, and enforce IT’s patents if IT defaulted. The district court granted Zebra’s motion, holding that IT lacked constitutional standing because the agreement granted Main Street the right to license the asserted patent and thus deprived IT of all its exclusionary rights. The district court further held that the defect could not be cured because IT was in default at the time the complaint was filed.

The Federal Circuit (Prost, J., joined by Taranto and Hughes, JJ.) reversed and remanded. The Court held that IT had constitutional standing because it retained at least one exclusionary right—the right to license or assign the patents—rejecting Zebra’s interpretation of the agreement as granting all exclusionary rights to Main Street immediately upon default. Instead, Main Street and IT shared an ability to license while a default existed and therefore IT was not divested of all exclusionary rights. The Court clarified that the right of another, non-plaintiff entity to license a patent does not defeat constitutional standing.

Packet Intelligence v. NetScout Systems, Inc., No. 22-2064 (Fed. Cir. May 2, 2024): Packet Intelligence sued NetScout for infringement of patents directed to methods and apparatuses for monitoring packets exchanged over a computer network. Previously, the Federal Circuit had reversed the district court’s pre-suit damages award and vacated the award of enhanced damages (Packet I). During the pendency of that remand, the Board issued final written decisions in IPR proceedings initiated by third parties holding all challenged claims of the patents at issue unpatentable as obvious. NetScout then moved to dismiss Packet Intelligence’s infringement case against it or, in the alternative, to stay the district court litigation until the conclusion of Packet Intelligence’s appeal from the Board’s final written decisions. The district court denied NetScout’s motion to dismiss or stay the case and entered an amended final judgment of the issues litigated on remand from Packet I, eliminating pre-suit damages and reducing enhanced damages. Packet Intelligence timely appealed the Board’s decisions, and concurrently with this opinion, the Federal Circuit affirmed.

The Federal Circuit (Stark, J., joined by Lourie and Hughes, JJ.) vacated and remanded with instructions to dismiss the case as moot. The only issue before the Court was to decide if its decision in Packet I “rendered this case sufficiently final such that it is immune to the Board’s subsequent determination of unpatentability,” which occurs when that judgment “ends the litigation on the merits and leaves nothing for the court to do but execute the judgment.” The Court concluded that Packet Intelligence’s infringement case against NetScout remains pending because the Packet I decision remanded issues to the district court and did not “leave[] nothing for the court to do but execute the judgment,” rendering it vulnerable to subsequent developments. The Federal Circuit’s contemporaneous affirmance of the Board’s unpatentability decisions invalidated the patent claims, and thus, the Court remanded with instructions to dismiss the case.

SnapRays, dba SnapPower v. Lighting Defense Group, No. 23-1184 (Fed. Cir. May 2, 2024): The Amazon Patent Evaluation Express (“APEX”) is a low-cost procedure offered by Amazon to resolve claims that a third-party product infringes a utility patent. To initiate the process, a patent owner submits an APEX Agreement to Amazon identifying one claim of a patent and up to 20 allegedly infringing listings. Lighting Defense Group (“LDG”) submitted an APEX Agreement alleging certain SnapPower products sold on Amazon infringed LDG’s patent directed to a cover for an electrical receptacle. To avoid automatic removal of its listing, the seller has three options: (1) opt in to the APEX program and proceed with Amazon’s third-party evaluation, (2) resolve the claim with the patent owner directly, or (3) file a declaratory judgment action of noninfringement. SnapPower chose the third option and filed a declaratory judgment action in Utah, where SnapPower is located. LDG, a Delaware company with its principal place of business in Arizona, moved to dismiss for lack of personal jurisdiction, and the district court granted the motion.

The Federal Circuit (Moore, C.J., joined by Lourie and Dyk, JJ.) reversed and remanded. The Court determined that LDG purposefully directed its activities at SnapPower in Utah when it submitted the APEX Agreement specifically naming SnapPower’s listings. The Court noted that the SnapPower’s listings would be automatically removed if it took no action, which the Court distinguished from traditional cease and desist letters that could be ignored without automatic consequences. The intended effect would necessarily impact sales, marketing, and other activities of SnapPower in Utah.

IOENGINE, LLC v. Ingenico Inc., Nos. 21-1227, 21-1331, 21-1332 (Fed. Cir. May 3, 2024): Ingenico filed a series of IPRs challenging three IOENGINE patents directed to a portable device configured to communicate with a terminal. The Board applied the printed matter doctrine to accord no patentable weight to certain claim limitations that recited “encrypted communications” and “program code.”

The Federal Circuit (Chen, J., joined by Lourie and Stoll, JJ.) reversed-in-part and affirmed-in-part. The Court found the Board incorrectly applied the printed matter doctrine. The Court explained that the printed matter doctrine applies only to limitations that claim the content of information or in other words, the content specifically being communicated. In other words, printed matter “encompasses what is communicated . . . rather than the act of a communication itself.” In the challenged claims, “encrypted communications” and “program code” were not being claimed for any particular content they communicated, and as a result, the printed matter doctrine did not apply.

Speck v. Bates, No. 23-1147 (Fed. Cir. May 23, 2024): Speck and Bates both claimed an invention related to drug-coated balloon catheters. Speck’s patent claims priority back to a 2003 application, but did not issue until September 4, 2012. Bates’s patent application was filed on August 29, 2013, but is a continuation-in-part of and claims priority to an earlier application filed in 2001. Under pre-AIA 35 U.S.C. § 135(b)(1), a patent application that claims the “same as” or “substantially the same subject matter” as an issued patent must be filed within one year from the date on which the patent was granted unless the “applicant had been claiming substantially the same invention as the patentee” before the critical date. The Bates application was therefore filed six days before the critical date. After the critical date and during prosecution, Bates amended the claims to require the device be “free of a containment material atop the drug layer” to overcome a rejection by the examiner. The Board declared an interference on August 10, 2020, identifying Bates as the senior party and Speck as the junior party. Speck filed a motion to terminate the interference on the ground that the claims of the Bates application were time-barred under § 135(b)(1). The Board denied Speck’s motion because it found that the later amended claims did not differ materially from the pre-critical date claims.

The Federal Circuit (Dyk, J., joined by Bryson and Stoll, JJ.) reversed, vacated, and remanded, holding that the Board applied the wrong legal test. The Board only analyzed whether the post-critical date claims were present in the pre-critical date claims (i.e., the “one-way test”). However, the Court held that the “two-way test” is the proper test, meaning that the Board should have compared the two sets of claims to determine if either set contains material limitations not present in the other. Applying the two-way test, the Court held that the pre-critical date claims were materially different than the post-critical date claims, because the post-critical date claims would permit including the drug within the containment layer, but the pre-critical date claims did not. The Court therefore held that the Bates application was time-barred.

The following Gibson Dunn lawyers assisted in preparing this update: Blaine Evanson, Audrey Yang, Allen Kathir, Al Suarez, Vivian Lu, and Julia Tabat.

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, any leader or member of the firm’s Appellate and Constitutional Law or Intellectual Property practice groups, or the following authors:

Blaine H. Evanson – Orange County (+1 949.451.3805, [email protected])
Audrey Yang – Dallas (+1 214.698.3215, [email protected])

Appellate and Constitutional Law:
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, [email protected])

Intellectual Property:
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])

There has been a dearth of Commission enforcement actions relating to Reg BI since the rule became effective in June 2020. This action for ordinary conflict of interest concerns, and another from February, may signal a more active Reg BI enforcement regime moving forward.

On May 21, 2024, the Securities and Exchange Commission (the “SEC” or the “Commission”) entered an administrative cease and desist order (the “Order”)[1] against a dually-registered broker-dealer and investment adviser (the “BD/RIA” or “Firm”) concerning “failures . . . to address conflicts of interest in compliance with Regulation Best Interest (“Reg BI”) and the [Investment Advisers Act of 1940 (“Advisers Act”)].” In particular, the Firm’s representatives recommended that clients “transfer securities . . . to new investment accounts” at the Firm’s affiliated private bank without disclosing that the representatives would be compensated for the recommendations and resulting transfers.

There has been a dearth of Commission enforcement actions relating to Reg BI since the rule became effective in June 2020. The Commission thus far has seemed content to leave enforcement to FINRA, which has settled approximately 30 Reg BI enforcement matters since 2020. This action for ordinary conflict of interest concerns, and another from February[2], are indicative of a more active SEC Reg BI enforcement regime moving forward.

The Order states that the Firm, through its representatives, “recommended that certain of its brokerage customers and advisory clients transfer securities . . . to new investment accounts” with an affiliated “wealth management firm that is part of the same parent organization.” The BD/RIA paid a “finders’ fee” to representatives that made “three or more customer referrals” in a quarter, and an “additional annual fee based on the value of any securities and other assets that were transferred.” The SEC found that the BD/RIA “did not disclose in writing that the representatives were acting as associated persons of [BD/RIA] when they made the transfer recommendations, or that the representatives would receive compensation . . . for making the recommendations, or the conflict of interest associated with the transfer recommendation.”

The Firm’s written broker-dealer Reg BI policies required the Firm to periodically review and evaluate conflicts, disclose all conflicts, and review and update disclosures. But, according to the Order, the policies failed to specify how registered representatives (“RR”) and supervisors could “identify, review, or address conflicts of interest related to the receipt of finders’ fees and annual fees,” or (2) “provide a mechanism for the [F]irm to identify and disclose . . . to retail customers that [RRs] . . . would receive finders’ fees and annual fees.”

Similarly, the SEC found that the Firm’s investment adviser “had written policies and procedures that required disclosure of all conflicts of interest to its advisory clients, however, this policy did not require any disclosure of compensation related to the account referrals and securities transfers.”

The Enforcement action apparently followed from a referral from the Division of Examinations (“Examinations”). The Order states that Examinations issued a deficiency letter “concerning the [F]irm’s lack of compliance with Regulation BI” and that the Firm quickly “addressed the deficiencies . . . by adopting new written policies and procedures related to the disclosure of conflicts of interest concerning . . . recommendations of securities transfers to its affiliates.” Nonetheless, it also resulted in a settled order, in which the Firm agreed to (1) pay a civil penalty of $223,228 and (2) neither admit nor deny findings that it (a) “failed to satisfy the General Obligation of Regulation BI by failing to comply with the Disclosure Obligation, Conflict of Interest Obligation, and Compliance Obligation,” in violation of Rule 15l-1(a) under the Exchange Act, and (b) “violated” Sections 206(2) and 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, the latter of which requires that investment advisers “adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules.”

Analysis & Takeaways

This action is likely only the beginning of enforcement actions following from the SEC’s increased Reg BI enforcement focus, particularly on the conflicts and duty of care elements of the Rule.

The Order reflects an SEC expectation that Reg BI policies:
- Explain “how” to identify and address conflicts of interest related to compensation for product recommendations, and
- Provide a “mechanism” to identify and disclose conflicts of interest related to compensation for product recommendations.
Dual registrants may be particularly compelling targets for Reg BI enforcement so that the SEC can make side-by-side findings, one under the Advisers Act and the other under the Exchange Act (Reg BI), with respect to the same conduct by dual-hatted representatives implicating both regulatory regimes. This will enable the Commission to add settled enforcement actions as “precedent” to support the Staff’s FAQs on Reg BI, which arguably seek to substantially expand the scope of the Rule, in part by conflating the distinct roles of financial advisors when acting on behalf of the investment adviser versus the broker-dealer.

__________

[1] Order Instituting Administrative and Cease-and-Desist Proceedings, Pursuant to Sections 15(b) and 21C of the Securities Exchange Act of 1934 and sections 203(e) and 203(k) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, Release No. 100186 (May 21, 2024), available at https://www.sec.gov/files/litigation/admin/2024/34-100186.pdf.

[2] On February 16, 2024, the SEC entered an administrative cease and desist order against a dually-registered broker-dealer and investment adviser for Reg BI disclosure, care, and compliance violations for recommending to retail clients its “core menu funds” that “earned higher fees” without disclosing “substantially equivalent, lower-cost share classes of affiliated funds.” See https://www.sec.gov/news/press-release/2024-22.

The following Gibson Dunn lawyers assisted in preparing this update: Lauren Jackson, Tina Samanta, Jon Seibald, Mark Schonfeld, David Woodcock, Tim Zimmerman, and Bryan Clegg.

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, any leader or member of the firm’s Securities Enforcement practice group, or the authors:

Lauren Jackson – Washington, D.C. (+1 202.955.8293, [email protected])
Tina Samanta – New York (+1 212.351.2469, [email protected])
Jon Seibald – New York (+1 212.351.3916, [email protected])
Mark K. Schonfeld – Co-Chair, New York (+1 212.351.2433, [email protected])
David Woodcock – Co-Chair, Dallas (+1 214.698.3211, [email protected])
Timothy M. Zimmerman – Denver (+1 303.298.5721, [email protected])
Bryan Clegg – Dallas (+1 214.698.3365, [email protected])

Truck Insurance Exchange v. Kaiser Gypsum Co., No. 22-1079 – Decided June 6, 2024

Background:

In 2016, facing significant asbestos-related liability, Kaiser Gypsum Co. and its parent company Hanson Permanente Cement, filed for Chapter 11 bankruptcy. The debtors proposed a reorganization plan under Section 524(g) of the Bankruptcy Code, which allows a Chapter 11 debtor with substantial asbestos-related liability to establish a trust that assumes that liability. Section 524(g) also channels all present and future asbestos claims into the trust by enjoining entities from taking legal action to collect on those claims.

The debtors proposed a plan that treated insured and uninsured claims differently. Under the plan, uninsured claims were submitted directly to the trust for resolution. To reduce fraudulent and duplicative claims, claimants with uninsured claims were required to identify all related claims and file a release authorizing the trust to obtain documentation from other asbestos trusts about their submitted claims. But the plan required insured claims to be filed in the tort system, without the disclosure requirements applicable to uninsured claims.

Under Section 1109(b) of the Bankruptcy Code, a “party in interest” may “appear and be heard on any issue” in a Chapter 11 proceeding, including on a reorganization plan. Asserting party-in-interest status, Truck Insurance Exchange—the debtors’ primary insurer—objected to the plan. Truck argued, among other things, that the plan wasn’t proposed in good faith because it didn’t require the same disclosures and authorizations for insured and uninsured claims—disparate treatment that would expose Truck to millions of dollars in fraudulent tort claims.

The bankruptcy court concluded that Truck was not a party in interest—and so had no right to be heard on its objections—because the plan was “insurance neutral,” meaning that it didn’t alter Truck’s pre-bankruptcy rights or obligations. The district court agreed and confirmed the plan. The Fourth Circuit affirmed.

Issue:

Whether an insurer with financial responsibility for a bankruptcy claim is a “party in interest” that may object to a reorganization plan under Chapter 11 of the Bankruptcy Code.

Court’s Holding:

An insurer with financial responsibility for a bankruptcy claim is a “party in interest” that may object to a reorganization plan under Chapter 11 of the Bankruptcy Code.

What It Means:

In a unanimous 8-0 opinion by Justice Sotomayor (with Justice Alito recused), the Court held that “Section 1109(b)’s text, context, and history confirm that an insurer such as Truck with financial responsibility for a bankruptcy claim is a ‘party in interest’ because it may be directly and adversely affected by the reorganization plan.”
The Court explained that the plain meaning of “party in interest” refers to “entities that are potentially concerned with or affected by a proceeding.” The historical context and purpose of Section 1109(b) also support that interpretation, because “Congress consistently has acted to promote greater participation in reorganization proceedings,” which promotes the fairness of the process.
Applying those principles, the Court held that insurers such as Truck with financial responsibility for bankruptcy claims are parties in interest because they can be directly and adversely affected by the reorganization proceeding in numerous ways.
The Court decisively rejected the insurance neutrality doctrine, saying that it “is conceptually wrong and makes little practical sense.” The Court explained that the insurance neutrality doctrine conflates the merits of an insurer’s objection with the threshold party-in-interest inquiry. It is also too limited in scope as a practical matter, “wrongly ignor[ing] all the other ways” bankruptcy proceedings “can alter and impose obligations on insurers.”
Going forward, insurers will no longer have to establish that plans change their pre-petition obligations to be heard in Chapter 11 proceedings, including with respect to reorganization plans. Instead, insurers will need to show only that they have financial responsibility for bankruptcy claims to participate. The decision will give insurers responsible for bankruptcy claims more opportunity to protect their interests and identify problems with reorganization plans.

Gibson Dunn represented Truck Insurance Exchange as Petitioner.

The Court’s opinion is available here.

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

Appellate and Constitutional Law Practice

Thomas H. Dupree Jr. +1 202.955.8547 [email protected]	Allyson N. Ho +1 214.698.3233 [email protected]	Julian W. Poon +1 213.229.7758 [email protected]
Lucas C. Townsend +1 202.887.3731 [email protected]	Bradley J. Hamburger +1 213.229.7658 [email protected]	Brad G. Hubbard +1 214.698.3326 [email protected]
Jonathan C. Bond +1 202.887.3704 [email protected]	Russ Falconer +1 346.718.3170 [email protected]

Related Practice: Business Restructuring and Reorganization

Jean-Pierre Farges +33 1 56 43 13 00 [email protected]	David M. Feldman +1 212.351.2366 [email protected]	Scott J. Greenberg +1 212.351.5298 [email protected]
Robert Krakow +1 214.698.3124 [email protected]	Michael A. Rosenthal +1 212.351.3969 [email protected]

This alert was prepared by associates Stephen Hammer and Jessica Lee.

Connelly v. United States, No. 23-146 – Decided June 6, 2024

Today, the Supreme Court unanimously held that the proceeds from a life insurance policy taken out by a corporation to redeem a decedent shareholder’s stock are a corporate asset for federal estate tax purposes.

“An obligation to redeem shares at fair market value does not offset the value of life-insurance proceeds set aside for the redemption because a share redemption at fair market value does not affect any shareholder’s economic interest.”

Justice Thomas, writing for the Court

Background:

Michael and Thomas Connelly were the sole shareholders of a closely held building supply business valued at just under $4 million. The brothers entered an agreement obligating the corporation to redeem the shares of the first brother to die if the surviving brother declined to purchase them. The corporation then obtained a life-insurance policy on each brother to fund that stock redemption. This is a common practice in family businesses to prevent a decedent’s heirs form selling shares to outsiders.

When Michael Connelly died, the corporation used the life insurance proceeds to redeem his shares for $3 million. Michael’s estate did not treat the life-insurance proceeds as a net corporate asset because those proceeds were purportedly offset by a corresponding liability to purchase Michael’s shares, and it therefore paid estate taxes based on the corporation’s previous valuation of just under $4 million. The IRS concluded that the $3 million in life insurance proceeds were not offset by the corporation’s obligation to redeem Michael’s shares, such that the corporation was worth just under $7 million. The IRS sent a notice of deficiency to the estate, which paid the deficiency under protest.

The district court granted summary judgment for the IRS and the Eighth Circuit affirmed, holding that the life insurance proceeds were a net asset that increased the corporation’s value.

Issue:

Are the proceeds of a life insurance policy taken out by a corporation on a shareholder to redeem the shareholder’s stock a corporate asset when calculating the value of a deceased shareholder’s shares for federal estate tax purposes?

Court’s Holding:

Yes. Life insurance proceeds are an asset that increases a company’s fair market value, and a redemption obligation is not necessarily a liability that offsets that asset.

What It Means:

Today’s decision focuses on the economic realities of the underlying transaction, explaining that “[b]ecause a fair-market-value redemption has no effect on any shareholder’s economic interest, no willing buyer purchasing Michael’s shares would have treated [the corporation’s] obligation to redeem Michael’s shares at fair market value as a factor that reduced the value of those shares.”
The decision confirms that the IRS may tax life insurance proceeds as a corporate asset, even if those proceeds will ultimately be used to redeem a decedent shareholder’s outstanding shares. Companies and estate planners should carefully review succession plans, including shareholder life insurance provisions and buy-sell agreements, with today’s decision in mind.
Today’s decision imposes potentially substantial costs on a common practice among closely held companies to ensure ownership remains within a family upon a shareholder’s death. The Court acknowledged that its decision “will make succession planning more difficult for closely held corporations.” The Court also identified “other options,” such as cross-purchase agreements, that are still available to accomplish the same purposes as the device employed here, but recognized those options pose drawbacks of their own.
The Court emphasized the narrowness of its decision, and specifically noted that it did “not hold that a redemption obligation can never decrease a corporation’s value,” and gave as an example a redemption obligation that “require[s] a corporation to liquidate operating assets to pay for the shares, thereby decreasing its future earning capacity.”

Gibson Dunn represented the Chamber of Commerce of the United States of America and National Federation of Independent Business Small Business Legal Center, Inc., as Amici Supporting Petitioner.

The Court’s opinion is available here.

Appellate and Constitutional Law Practice

Thomas H. Dupree Jr. +1 202.955.8547 [email protected]	Allyson N. Ho +1 214.698.3233 [email protected]	Julian W. Poon +1 213.229.7758 [email protected]
Lucas C. Townsend +1 202.887.3731 [email protected]	Bradley J. Hamburger +1 213.229.7658 [email protected]	Brad G. Hubbard +1 214.698.3326 [email protected]
Jonathan C. Bond +1 202.887.3704 [email protected]

Related Practices: Tax and Global Tax Controversy & Litigation

Michael J. Desmond +1 213.229.7531 [email protected]	Saul Mezei +1 202.955.8693 [email protected]	Eric B. Sloan +1 212.351.5220 [email protected]
Sanford W. Stark +1 202.887.3650 [email protected]

This alert was prepared by associate Zach Carstens.

We are pleased to announce that Gibson, Dunn & Crutcher LLP, on behalf of leading industry groups, has won its challenge to a rule adopted by the U.S. Securities and Exchange Commission (“SEC”) that would have fundamentally changed the way private funds and their advisers are regulated.

In August 2023, the SEC adopted a sweeping rule that would have restricted, or even prohibited, the longstanding, widely used business arrangements of private funds—pooled investment vehicles like hedge funds and private equity funds that are generally not accessible to retail customers. Because private funds serve large, predominantly institutional investors capable of serving their own interests, Congress deliberately exempted them from the prescriptive regulatory regime applicable to retail-focused investment vehicles such as mutual funds. Yet, in its rule, the SEC adopted a host of new restrictions on private funds, including limitations on longstanding practices regarding side letters, disclosure or consent requirements for charging certain fees and expenses to funds, and onerous quarterly-reporting requirements. By the SEC’s own estimate, the rule would have cost $5.4 billion and required millions of hours of employee time.

Today, a unanimous panel of the Fifth Circuit vacated the rule in full. The Court held that the SEC exceeded its statutory authority because neither of the two provisions it relied on empowered it to adopt the rule. Decisively rejecting the SEC’s argument that a provision of the Dodd-Frank Act authorized it to issue rules for the protection of private fund investors, the Court agreed with Gibson Dunn’s argument that this provision applies only to retail customers, noting that private fund investors “have a significant hand in determining the terms on which they invest.” The Court also rejected as “pretextual” the SEC’s argument that it could adopt the rule under an anti-fraud provision of the Investment Advisers Act of 1940—concluding that the SEC failed to articulate any rational connection between fraud and the rule. “Because the promulgation of the Final Rule was unauthorized,” the Court concluded, “no part of it can stand.”

This significant victory provides private fund advisers with a degree of stability after months of uncertainty related to the numerous disruptive requirements that were set to go into effect under the rule. Under the Court’s decision, those requirements will no longer take effect because they have now been invalidated. In holding that the SEC exceeded its statutory authority under the two provisions at issue, the Court’s decision also may impose barriers to future SEC rulemakings regulating private fund advisers. The decision, National Association of Private Fund Managers v. SEC, No. 23-60471 (5th Cir.), is available here.

The petitioners—the National Association of Private Fund Managers, Alternative Investment Management Association Ltd., American Investment Council, Loan Syndications and Trading Association, Managed Funds Association, and National Venture Capital Association—were represented by partners Eugene Scalia and Helgi Walker, with associates Brian Richman, Max Schulman, Robert Batista, and Stephen Hammer.

The following Gibson Dunn lawyers assisted in preparing this update: Eugene Scalia, Helgi Walker, Kevin Bettsteller, Shukie Grossman, Brian Richman, and Stephen Hammer.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding the decision and its impact on the private funds industry, including investor negotiations and SEC examination and enforcement practices. Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Administrative Law and Regulatory, Investment Funds, or Private Equity practice groups, or the following Practice Group leaders:

Administrative Law and Regulatory:
Eugene Scalia – Washington, D.C. (+1 202.955.8210, [email protected])
Helgi C. Walker – Washington, D.C. (+1 202.887.3599, [email protected])
Stuart F. Delery – Washington, D.C. (+1 202.955.8515, [email protected])

Investment Funds:
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])
John Fadely – Singapore/Hong Kong (+65 6507 3688, [email protected])
Shukie Grossman – New York (+1 212.351.2369, [email protected])
Gregory Merz – Washington, D.C. (+1 202.887.3637, [email protected])
Edward D. Sopher – New York (+1 212.351.3918, [email protected])

Private Equity:
Richard J. Birns – New York (+1 212.351.4032, [email protected])
Ari Lanin – Los Angeles (+1 310.552.8581, [email protected])
Michael Piazza – Houston (+1 346.718.6670, [email protected])
John M. Pollack – New York (+1 212.351.3903, [email protected])

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

Fearless Fund Decision

On June 3, 2024, the Eleventh Circuit held in a 2-1 decision that American Alliance for Equal Rights (AAER) is entitled to a preliminary injunction in American Alliance for Equal Rights v. Fearless Fund, No. 23-13138 (11th Cir.). Judge Kevin Newsom, joined by Judge Robert Luck, concluded that AAER has Article III standing to sue even though it is suing on behalf of pseudonymous members, and that preliminary injunctive relief is appropriate because Fearless’ program is substantially likely to violate Section 1981 and is not protected by the First Amendment. This decision overturns the district court’s denial of AAER’s requested preliminary injunction and remands the case with instructions to the district court to enter a preliminary injunction preventing Fearless from closing its contest.

Fearless Foundation operates a charitable grant program providing $20,000 grants to businesses that are majority-owned by Black female entrepreneurs. AAER contends that the grant program violates Section 1981 because it racially discriminates against non-Black female entrepreneurs, including AAER’s members (referred to only as Owners A, B, and C). The district court denied AAER’s request for a preliminary injunction on the grounds that the First Amendment likely protects the program. A 2-1 divided motions panel of the Eleventh Circuit subsequently temporarily enjoined the program pending appeal.

After considering the parties’ briefing and oral argument, the majority opinion for the merits panel held that the plaintiff had standing to sue and that preliminary injunctive relief is appropriate. As to standing, the panel held that AAER does not need to name its members to establish organizational standing because the members’ declarations were sufficient to show that they were “able and ready” to apply to the program and that there was a “likelihood that they will actually take the proscribed action” of applying for the program. In reaching this holding, the court recognized that it had split with the Second Circuit’s decision in Do No Harm v. Pfizer, 96 F.4th106 (2d Cir. 2024).

As to the merits, the majority accepted AAER’s argument that the program is a contract subject to Section 1981, reasoning that there is a bargained-for exchange in which Fearless Foundation receives certain publicity rights in return for granting a contest winner $20,000. The majority disagreed with the district court’s decision that the First Amendment likely protects the program, deeming the program’s refusal to consider certain applications based on race to be conduct rather than First Amendment-protected expression. The court also concluded that AAER had satisfied the additional preliminary injunction factors, holding that the lost opportunity to compete for the program irreparably harms AAER’s members, and the equities and public interest weigh in favor of stopping impermissible discrimination.

Judge Rosenbaum dissented from the opinion, accepting Fearless’ argument that AAER lacks standing to sue because its barebones member declarations lack the particular and concrete facts necessary to indicate that the pseudonymous members have a “genuine interest” in applying for the program. Judge Rosenbaum also observed that Ed Blum, the leader of AAER and the architect of many challenges to affirmative action initiatives, has contrived this and other lawsuits to challenge race-conscious programs across the country, using pseudonymity to cloak the tenuous connection between these programs and any real-world harm. She compared the anonymous declarants to “floppers” who did not actually experience a foul.

Gibson Dunn represents Fearless Fund and Fearless Foundation in this matter. We are evaluating all options.

Other Key Developments:

On May 21, 2024, the United States District Court for the Northern District of Ohio dismissed a challenge to Hello Alice’s grant program that awards funding to Black entrepreneurs to support their small businesses in Roberts & Freedom Truck Dispatch v. Progressive Preferred Ins. Co., et al., No. 23-cv-1597 (N.D. Ohio 2023). Plaintiffs, represented by America First Legal (AFL), argued that Hello Alice’s program was a discriminatory contract in violation of Section 1981. The court accepted the defendants’ argument that the plaintiffs lack Article III standing because they fail to allege any injury in fact. The court noted that the application period for the grant the plaintiffs claimed to want to apply for had already closed by the time they filed their lawsuit, and the plaintiffs did not allege that the defendants would offer a grant with similar race-based eligibility criteria in the future. The case has garnered significant attention, with amicus curiae briefs from the EEOC, the Southern Poverty Law Center, the Lawyers’ Committee for Civil Rights Under the Law, the National Hispanic Bar Association, and Asian Americans Advancing Justice. On May 23, 2024, the plaintiffs filed a notice of appeal to the Court of Appeals for the Sixth Circuit.

On May 21, 2024, the Seventh Circuit heard oral arguments in Charles Vavra v. Honeywell International, Inc., No. 23-2823 (7th Cir.). Vavra, an engineer at Honeywell, brought a retaliation suit under Title VII and Illinois state law after he was terminated for refusing to watch a training video he claimed discriminated against white people. Vavra claimed in an email to HR that the training turned white people into “villains.” The district court granted summary judgment on Vavra’s claims last August after finding that he failed to show either that he was terminated due to bias or that the training itself was racist. Vavra appealed, and argued before the Seventh Circuit that the video crossed a line when it stated that workers carry unconscious biases. The panel, consisting of Judges St. Eve, Scudder, and Kirsch, appeared skeptical about how Vavra could know that the video was discriminatory since he did not watch it.

On May 22, 2024, Florida Attorney General Ashley Moody filed a complaint with the Florida Commission on Human Relations against Starbucks, arguing that its DEI policies violate Florida’s anti-discrimination laws. The complaint alleges that statements on the Starbucks website raise concerns that it is using racial quotas in violation of the Equal Protection Clause. Specifically, the complaint points to information regarding “annual inclusion and diversity goals,” and statements that executive compensation is tied to meeting DEI objectives. The complaint also urges the Commission to investigate Starbucks’s anti-bias training to determine whether such trainings constitute an “abusive work environment.” In support of the investigation, Florida Governor Ron DeSantis stated that programs such as the ones implemented by Starbucks “determine whether [employees] are the problem based on the color of their skin.”

On May 23, 2024, CBS Studios and parent company Paramount Global moved to dismiss a straight white male writer’s reverse discrimination suit, arguing that the First Amendment protects their rights to select their stories and storytellers. Beneker v. CBS Studios, No. 2:24-cv-01659 (C.D. Cal. 2024). The plaintiff, represented by America First Legal (AFL), claims that CBS violated Section 1981 and Title VII by refusing to hire him as a staff writer on the TV show “SEAL Team,” instead hiring several Black, female, and lesbian writers. He is seeking a declaratory judgment that CBS’s de facto hiring policy violates Section 1981 and/or Title VII, injunctions barring CBS from continuing to violate Section 1981 and Title VII, a full-time job as a producer, and damages. The defendants argued that because CBS is an “expressive enterprise,” the First Amendment protects its right to convey an artistic message and “select which writers are best suited” to convey that message. In the alternative, the defendants argued that the plaintiff’s claims are time-barred.

On May 23, 2024, a class action complaint was filed against the City of Evanston challenging a program meant to address historic racial injustice. Flinn v. City of Evanston, No. 1:24-cv-04269 (E.D. Ill. 2024). Evanston’s Restorative Housing Program compensates Black residents for housing discrimination they or their ancestors may have faced between 1919 and 1969. It assists eligible applicants with buying or improving their homes, and in some cases qualifies households for direct payments of up to $25,000. The plaintiffs allege that the program violates Section 1983 because it is limited to only Black residents or their ancestors. The suit seeks to certify a class of “all individuals who are able and ready to apply for the program and are eligible for a $25,000 payment but for the program’s race-based eligibility requirement.” The plaintiffs are asking for declaratory and injunctive relief, and an award of $25,000 to “all eligible individuals.”

On May 30, 2024, Judge Vernon S. Broderick dismissed a straight white male law student’s reverse discrimination suit against NYU for lack of subject-matter jurisdiction and failure to state a claim in Doe v. New York University, No. 1:23-cv-09187 (S.D.N.Y. 2023). The plaintiff claimed that the NYU Law Review’s policy to seek a diverse staff of editors and solicit personal statements discussing candidates’ experiences with diversity violates Title VI, Title IX, and Section 1981. The court held that the plaintiff lacks standing because his “speculative” injury is “riddled with contingencies” and his claim is not yet ripe because the Law Review’s policy has not yet been implemented. The court also concluded that even if the plaintiff had standing, his conclusory allegations would fail because the “Law Review’s continued commitment to diversity” does not give rise to a “plausible inference of unlawful conduct.”

Media Coverage and Commentary:

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

Law360, “11th Circ. Backs Freeze Of Grants For Black Women Only” (June 3, 2024): Law360’s Chart Riggall reports on the Eleventh Circuit’s opinion in Fearless Fund, explaining that Judge Newsom, writing for the majority, concluded the Fearless Strivers Grant Contest “had stepped well beyond the bounds of First Amendment protections by refusing to award grants to applicants who were not Black females.” In rejecting Fearless Fund’s First Amendment argument, Judge Newsom stated that “Fearless’s position—that the First Amendment protects a [] categorial race-based exclusion—risks sowing the seeds of antidiscrimination law’s demise.” Riggall also reported on Judge Rosenbaum’s skepticism regarding AAER’s standing to bring this suit in the first place, noting that Rosenbaum wrote that “no one doubts the sincerity of American Alliance for Equal Rights’s desire to challenge what it views as ‘distinctions and preferences made on the basis of race and ethnicity’ . . . But as American Alliance has portrayed its members’ alleged injuries, it has shown nothing more than flopping on the field.” Riggall explains that the case is far from over. As Gibson Dunn Partner and counsel for Fearless Fund Jason Schwartz explained, “this is not the final outcome in this case; it is a preliminary ruling without a full factual record.” Schwartz also noted that “this is the first court decision in the 150+ year history of the post-Civil War civil rights law that has halted private charitable support for any racial or ethnic group. The dissenting judge, the district court and other courts have agreed with us that these types of claims should not prevail.”
Wall Street Journal, “Appeals Court Blocks Venture Firm’s Grant Program for Black Women” (June 3): The Journal’s Erin Mulvaney reports on the Eleventh Circuit’s decision reversing the denial of a preliminary injunction against Atlanta-based investment firm Fearless Fund, calling it “a blow against diversity and inclusion programs that have been under increasing legal attack.” Judge Newsom, writing for a two-judge majority, wrote that if Fearless Fund’s decision not “to entertain applications from business owners who aren’t ‘black females’” was protected under the First Amendment “then so would be every act of race discrimination.” In dissent, Judge Rosenbaum wrote that the court lacked standing to review the merits of the suit because AAER had not made the requisite showing that its anonymous white male members were able and ready to apply for a Fearless Fund grant—and thus were harmed by theoretical exclusion from the contest. Jason Schwartz, Gibson Dunn partner and counsel for Fearless Fund, noted that this was the first court decision to stop private charitable giving based on race or ethnicity. “The discrimination in access to funding that the Fearless Foundation seeks to address is long-standing and irrefutable,” said Schwartz. Mulvaney noted that, although legal challenges to diversity and inclusion programs have met with mixed success, the “ultimate outcome of the Fearless Fund case and others like it could have broad ripple effects.”
Bloomberg Law, “Black Women Entrepreneur VC Grant Funds Block in Bias Case” (June 3, 2024): Writing for Bloomberg Law, Khorri Atkinson and Chris Marr cover the Eleventh Circuit’s recent ruling against the Fearless Fund. Atkinson and Marr note that the Eleventh Circuit was “unconvinced” by Fearless Fund’s characterization of its program as nothing more than a “commitment” to “the Black women-owned business community.” Instead, Atkinson and Marr note that the majority held that the real question was whether Fearless’s contest should receive First Amendment protection “by virtue of its rule excluding non-black entrants.” As Atkinson and Marr explain, Judge Rosenbaum offered a notable dissenting opinion questioning AAER’s standing to sue Fearless Fund, and noting that AAER appeared to have “manufacture[d] an injury” by claiming that its members were “ready and able” to participate in the Fearless Strivers Grant Contest. Edward Blum, the leader of AAER, expressed gratitude for the ruling, stating that “our nation’s civil rights laws do not permit racial distinctions because some groups are overrepresented in various endeavors, while others are under-represented.” In Blum’s view, “programs that exclude certain individuals because of their race such as the ones the Fearless Fund has designed and implemented are unjust and polarizing.”
The Washington Post, “Appeals court blocks Fearless Fund from awarding grants to Black women” (June 3, 2024): The Washington Post’s Julian Mark and Taylor Telford report on the Eleventh Circuit’s ruling against the Fearless Fund. Mark and Telford note that the case “is being closely watched because of its possible implications for race-conscious programs in the private sector, particularly in the world of grant-giving and foundations.” Mark and Telford report that the majority “brushed aside” the fund’s arguments that a contest solely for Black women was a form of protected expression under the First Amendment, and also rejected the argument that it was a valid program meant to remedy racial imbalances in the venture funding world. Arian Simone, the chief executive of Fearless Fund, called the decision “devastating” and said that “America is supposed to be a nation where one has the freedom to achieve, the freedom to earn, and the freedom to prosper. Yet, when we have attempted to level the playing field for underrepresented groups, our freedoms were stifled.” But Jason Schwartz, Gibson Dunn partner and counsel for Fearless Fund, said that “this is not the final outcome in this case” and said that Fearless Fund and its legal team are evaluating their options.”
Law.com, “‘Legal Version of Flopping’: Judges Spar Over Standing in Blocking Funding for Black Business Women” (June 4, 2024): Law.com’s Avalon Zoppo reports on the Eleventh Circuit’s decision in Fearless Fund, noting the exchanges between the majority opinion and the dissent on the question of whether AAER had established standing. Zoppo reports that in her dissenting opinion, Judge Rosenbaum said that none of the three members on whose behalf AAER is suing showed they were “able and ready” to actually apply for the program, and compared AAER to athletes who feign injury in an effort to get the referee to call a foul on their opponent. Judge Rosenbaum wrote that “[a]lthough three of American Alliance’s members pay lip service to the idea they are ‘ready and able’ to participate in Fearless’s Contest, their declarations show, in context, that none has a genuine interest in actually entering the Contest.” The majority opinion took issue with Judge Rosenbaum’s characterization of the plaintiff as “floppers,” saying “[r]espectfully, victims of race discrimination—whether white, black, or brown—are not floppers.” But Judge Rosenbaum criticized the majority opinion for “mischaracteriz[ing]” her dissent and said that the majority’s “failure to grapple even a little bit with the deficiencies in American Alliance’s standing allegations, speak volumes about the impropriety of assuming jurisdiction here.”
Bloomberg Law, “What’s Changed in Corporate America Since George Floyd’s Murder?” (May 25): Bloomberg Law’s Simone Foxman and Jeff Green discuss quantitative findings on changes in corporate America since George Floyd’s death in 2020. While Foxman and Green note a modest increase in Black people in influential roles like chief executives or attorneys, they write that “Black people control a smaller percentage of US household wealth than they did four years ago.” While they highlight a series of McKinsey & Company studies between 2015 and 2020 that demonstrate benefits to corporate America’s bottom line from emphasizing diversity in its workforce, they note that increased profits are not a shield from criticism from anti-DEI proponents. Foxman and Green note a silver lining that the many challenges to corporate DEI programs have revived DEI discussions among company executives, restoring “mentions of DEI or diversity in conference calls, earning calls and investor calls to pre-2020 levels.”
Law360, “Burrows Warns Against ‘Attacks’ On Diversity Efforts” (May 22): Writing for Law360, Amanda Ottaway covers EEOC Chair Charlotte Burrows’ speech at the 76th Annual Conference on Labor & Employment Law at NYU Law School. Commissioner Burrows discussed the confusion that the Supreme Court’s ruling in SFFA has caused in the private sector, offering her thoughts on how corporate DEI programs can continue to exist and thrive moving forward. Relying on the reasons Congress enacted Title VII of the Civil Rights Act, she explains that the Act “encompass[es] actions that make the workplace not just less discriminatory, but more fair.” To that end, she notes that corporations should take advantage of the fact that antidiscrimination laws also protect “people of goodwill” acting to ensure increased equity and inclusion within their ranks and beyond.
Law360, “ABA Faces Racial Bias Complaint Over Diversity Programs” (May 21)): Law360’s Ryan Boysen reports on a complaint the Wisconsin Institute for Law & Liberty’s (WILL) filed with the United States Department of Justice against the American Bar Association (ABA). Boysen reports that WILL accuses the ABA of administering multiple programs and initiatives on a “racially discriminatory” basis in violation of Title VI of the Civil Rights Act. For example, WILL asserts that the ABA’s Judicial Clerkship and Judicial Intern Opportunity Programs—initiatives designed to aid minority and LGBTQ applicants by leveling the playing field for prestigious clerkship and internship opportunities—“employ racial quotas and preferences,” and treat “race as a negative,” preventing some law students and attorneys from competing fairly due to their race. In addition to calling for an investigation into these ABA programs, Boysen reports that WILL is also seeking an investigation into any universities that have participated in the initiatives.

Case Updates:

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

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

Alexandre v. Amazon.com, Inc., No. 3:22-cv-1459 (S.D. Cal. Sept. 29, 2022): White, Asian, and Native Hawaiian entrepreneur plaintiffs, on behalf of a putative class of past and future Amazon “delivery service partner” (DSP) program applicants, challenged a DEI program that provides $10,000 grants to qualifying delivery service providers who are “Black, Latinx, and Native American entrepreneurs.” Plaintiffs allege violations of California state civil rights laws prohibiting discrimination and Section 1981. On December 6, 2023, Amazon moved to dismiss, and plaintiffs opposed the motion on February 16, 2024. Amazon filed a reply on March 20, 2024.
- Latest update: On May 23, 2024, Judge Michael M. Anello granted Amazon’s motion to dismiss. The court held that plaintiffs did not have standing to sue because they were “unwilling to apply for DSP contracts” and therefore their purported injury was “merely hypothetical and conjectural.” The court alternatively granted Amazon’s motion on the merits as to all three of the plaintiffs’ claims. The court dismissed the plaintiffs’ claims under Section 1981 because plaintiffs did not respond to Amazon’s argument that they did not suffer a loss of contractual interest because they were unwilling to apply to the program, and therefore “effectively abandoned their claims.” The court also dismissed both of plaintiffs’ claims under the Unruh Civil Rights Act, holding that the Act does not apply to relationships between two businesses.
Do No Harm v. Gianforte, No. 6:24-cv-00024 (D. Mont. 2024): On March 12, 2024, Do No Harm filed a complaint on behalf of “Member A,” a white female dermatologist in Montana, alleging that a Montana law violates the Equal Protection Clause by requiring the governor to “take positive action to attain gender balance and proportional representation of minorities resident in Montana to the greatest extent possible” when making appointments to the twelve-member Medical Board. Do No Harm alleges that since the ten filled seats are currently held by six women and four men, Montana law requires that the remaining two seats be filled by men, which would preclude Member A from holding the seat. On May 3, 2024, Governor Gianforte moved to dismiss the complaint for lack of subject matter jurisdiction, arguing that Do No Harm lacks standing because Member A has not applied for or been denied any position.
- Latest update: On May 24, 2024, Do No Harm filed an amended complaint, describing additional Members B, C, and D, who are each “qualified, ready, willing, and able to be appointed” to the board.

2. Employment discrimination and related claims:

DiBenedetto v. AT&T Servs., Inc., No. 21-cv-4527 (N.D. Ga. 2021): On November 2, 2021, the plaintiff, a white male former executive, brought claims against AT&T under Title VII, Section 1981, and the Age Discrimination in Employment Act (ADEA), alleging that he was wrongfully terminated due to his race, gender, and age.
- Latest update: On May 20, 2024, the plaintiff stipulated and agreed to dismiss with prejudice his race and gender discrimination claims. The plaintiff’s ADEA claim remains.

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

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

4. Actions against educational institutions:

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

DEI Legislation:

Below is a list of legislative developments relating to DEI:

On May 17, 2024, Colorado Governor Jared Polis vetoed House Bill 1260, or the “Worker Freedom Act,” which would have barred employers from requiring employees to attend meetings related to religious or political matters. The bill sought to prevent “captive audience meetings,” or mandatory meetings used by employers to discuss union organizing, but it expressly excluded DEI trainings and legally required harassment trainings. In a veto letter, Governor Polis cited the breadth of the bill’s provisions and language, concluding it was “too broad and too ambiguous to apply uniformly and fairly, leading to unintended consequences.” The Democrat-sponsored bill was one of six that Polis, also a Democrat, vetoed the same day, resulting in intra-party frustrations and a rally at the state capitol by union members.

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

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

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

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

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

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

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

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

We are pleased to provide you with the May 2024 edition of Gibson Dunn’s digital assets regular update. This update covers recent legal news regarding all types of digital assets, including cryptocurrencies, stablecoins, CBDCs, and NFTs, as well as other blockchain and Web3 technologies. Thank you for your interest.

ENFORCEMENT ACTIONS

UNITED STATES

Uniswap Labs Calls SEC’s Legal Case “Weak and Wrong”
On May 21, Uniswap Labs responded to the SEC’s Wells notice issued against the firm. The SEC issues a Wells notice if, after the SEC’s Staff concludes an investigation, the Staff intends to recommend to the Commission that charges be brought. The Wells notice provides a prospective respondent the chance to present defenses concerning the investigation and to influence the Staff’s recommendation and the Commission’s view of the matter. Uniswap Labs called the SEC’s legal case “weak and wrong” and stated that the SEC’s “aggressive theories” are an attempt to stretch the SEC’s reach beyond its jurisdiction. Uniswap Labs argued that the SEC “should embrace open-source technology that improves outdated commercial and financial systems, instead of attempting to litigate it out of existence.” On April 10, the SEC issued a Wells notice against Uniswap Labs, in which the SEC alleged that Uniswap DEX acted as Uniswap Labs’ unregistered securities exchange and unregistered securities broker-dealer. Uniswap Labs’ filing says that “the SEC arguments rest on the false assumption that just about ‘all’ tokens are securities (which the SEC then refuses to register).” The Block; CoinDesk; Wells Response.
Two Arrested over Novel Scheme that attacked Ethereum Blockchain and Stole $25 Million in Cryptocurrency
On May 23, DOJ unsealed an indictment charging that two brothers attacked the Ethereum blockchain using a novel scheme that allegedly leveraged transaction integrity protocols to fraudulently obtain approximately $25 million worth of cryptocurrency within approximately 12 seconds. The prosecutors said the two defendants developed a scheme, dubbed the “Exploit,” through which they manipulated and tampered with the process and protocols that validate and add transactions to the Ethereum blockchain. In doing so, the DOJ alleged, they fraudulently gained access to and modified pending private transactions to obtain victims’ cryptocurrency. Press Release.
Federal Judge Dismisses Suit and Sanctions SEC Over Bad-Faith Conduct
On May 28, a federal judge dismissed the SEC’s lawsuit against crypto group Debt Box and ordered the SEC to pay over $1.8 million in attorney and receivership fees. The ruling follows a March decision finding the SEC engaged in bad-faith conduct over a temporary restraining order to freeze Debt Box’s assets. Law360; Order.
FTC Executive Receives 7.5-Year Prison Sentence
On May 28, a Manhattan federal judge imposed a 7.5-year prison sentence on crypto-finance expert and former FTX executive Ryan Salame for duping a bank to authorize $1.5 billion of illegal transfers and making fraudulent campaign contributions for the exchange’s convicted founder Sam Bankman-Fried. Law360.
BTC-e Operator Pleaded Guilty to Money Laundering Conspiracy
On May 3, one of the operators of the defunct crypto exchange BTC-e, Alexander Vinnik, pleaded guilty to conspiracy to commit money laundering from 2011 to 2017. The DOJ alleged that BTC-e acted as “one of the primary ways by which cyber criminals around the world transferred, laundered, and stored the criminal proceeds of their illegal activities” before it was shut down by law enforcement in or around July 2017. Allegedly, operating as an unlicensed money service business, the now defunct exchange reportedly processed over $9 billion-worth of transactions and served over one million users worldwide, including numerous customers in the United States. According to the DOJ, Vinnik operated BTC-e with the intent to promote these unlawful activities and was responsible for over $121 million in losses. Vinnik was first arrested in 2017, but faced a lengthy extradition process in which he spent time in Greece and France before being sent to the U.S. Press Release; CoinDesk.
Former Cred Executives Indicted on Wire Faud Conspiracy and Related Crimes
On May 3, a federal grand jury charged the former CEO, CFO, and CCO of Cred, LLC with wire fraud conspiracy and related crimes in connection with their purported roles in an alleged scheme to defraud customers and investors that caused losses of customer cryptocurrency assets with a market value that may have exceeded $780 million. Per the DOJ, through Cred’s lending program, called “CredEarn,” the defendants “lured” customers to make investments with promises of significant returns on cryptocurrency investments but failed to disclose that “virtually all the assets to pay the yield were generated by a single company whose business was to make unsecured micro-loans to Chinese gamers.” Cred filed for bankruptcy in November 2020, estimating its liabilities to be between $100 million and $500 million at the time. Press Release; CoinDesk.

INTERNATIONAL

Hong Kong Regulator Says Worldcoin Operations Must Cease
On May 22, Hong Kong’s Privacy Commissioner for Personal Data (PCPD) “served an enforcement notice on Worldcoin Foundation, directing it to cease all operations of the Worldcoin project in Hong Kong in scanning and collecting iris and face images of members of the public using iris scanning devices.” The cryptocurrency project, which has received scrutiny from regulators globally, also was suspended in Kenya last year due to privacy concerns. CoinDesk; Cointelegraph; Reuters.

REGULATION AND LEGISLATION

UNITED STATES

U.S. House Approves Crypto Bill FIT21 to Provide Regulatory Clarification for Digital Assets
On May 22, the U.S. House of Representatives passed the Financial Innovation and Technology for the 21st Century Act (FIT21), which was the first time that a significant crypto bill had cleared a chamber of Congress. The bill aims to provide regulatory clarity for digital assets. The legislation, which was largely driven by House Republicans, “would establish a regime to regulate the U.S. crypto markets, setting consumer protections, installing the Commodity Futures Trading Commission (CFTC) as a leading regulator of digital assets and the watchdog of the non-securities spot markets and it would more clearly define what makes a crypto token a security or a commodity.” While some crypto enthusiasts have backed the bill, the SEC warned that this bill could create new financial risks. Reuters; CoinDesk.
SEC Approves Eight Spot Ether ETFs from Leading Financial Firms
On May 23, the U.S. Securities and Exchange Commission (SEC) approved eight spot Ether exchange-traded funds (ETFs) from prominent financial firms. This move marks a significant regulatory milestone, demonstrating increased institutional acceptance and regulatory clarity for Ether-based financial products. The ETFs still need their S-1 registration statements to be finalized before trading can start. Further legislative clarity is still needed to define the regulatory jurisdiction between the SEC and CFTC over digital assets. The Block; Cointelegraph.
House Passes Bill to Block Fed-Issued Digital Dollar
The U.S.House of Representatives passed the CBDC Anti-Surveillance Act which would bar the Federal Reserve from issuing a so-called central bank digital currency, a state-issued dollar on the blockchain. Republicans argue that the measure is necessary to protect consumer privacy and express concern regarding the tokens’ traceability on the blockchain, which could be used by the government to track citizen purchases and limit or control their behavior. Law360.
United States CFTC Proposes to Ban Political Event Contracts
On May 10, the U.S. Commodity Futures Trading Commission (CFTC) proposed a formal rejection of events contracts that bet on the outcome of political activity. Three of the five commissioners approved this proposed rule, as they saw these contracts as “contrary to the public interest.” Prediction platforms allow users to buy contracts on the outcomes of actual events, including elections and policy developments. These platforms have been particularly popular in crypto circles. Contracts on political contests, awards contests, and the outcomes of games would be banned for U.S. regulated companies under the proposal. CoinDesk; The Block.

INTERNATIONAL

UK Regulators Identified Crypto as One of the Biggest Money Laundering Risks in 2022-2023
In its annual supervision report on anti-money laundering and counter-terrorist financing (AML/CTF), the UK Treasury Department identified crypto firms, alongside retail banking, wholesale banking and wealth management as posing the greatest risk of being exploited for money laundering between 2022 and 2023. The conclusion from the report came from the risk assessments conducted by UK’s financial regulator, Financial Conduct Authority, on 238 firms. UK Treasury Report; CoinDesk.
In Taiwan, Proposed Anti-Money Laundering (AML) Changes Could Lead to Jail Time for Non-Compliance
On May 9, Taiwanese authorities announced that they sought to criminalize cryptocurrency firms that fail to abide by anti-money laundering (AML) rules. The Ministry of Justice’s proposed amendments to existing AML laws require domestic and overseas crypto firms seeking to operate in Taiwan to register for AML compliance. The penalty for failure to comply would be up to two years in prison. Currently, authorities can only impose administrative penalties on non-compliant crypto firms, but these new amendments would criminalize non-compliance. These proposed AML changes were to be sent to Taiwan’s national parliament for review. The Block.
Nigeria Reforms National Blockchain Policy Steering Committee
On May 21, Nigeria’s National Information Technology Development Agency (NITDA) announced that they were restructuring the National Blockchain Policy Steering Committee (NBPSC) in hopes of reassessing blockchain policy in Nigeria. The NBPSC was made up of members from government agencies, institutions, the private sector, academia, and the blockchain industry. The director-general of NITDA believed that the NBPSC’s reform would bring together “a fresh wave of experienced professionals and leading minds.” According to the NITDA, this reform is an effort would help “incorporate new emerging technologies and economic realities” in Nigeria. Cointelegraph.
Ramp Network, Crypto Infrastructure Firm, Secures Ireland Registration
On May 23, Ramp Network, a U.K.-based crypto infrastructure firm, secured Virtual Asset Service Provider (VASP) registration in Ireland and plans to establish its European headquarters there. This registration will enable users to exchange fiat for over 100 crypto assets. Ireland—an EU-member—would provide a pathway for Ramp to become a licensed Crypto Asset Service Provider (CASP) under the EU’s Markets in Crypto Assets Regulation (MiCA). This move by Ramp is another in recent fintech movement to Ireland, following other exchanges that have secured licenses and set up operations in the country. CoinDesk.

CIVIL LITIGATION

UNITED STATES

New York Attorney General Announces $2 Billion Settlement to End Litigation Against Genesis
In a May 20 notice, the New York Attorney General announced a $2 billion settlement with cryptocurrency firm Genesis to compensate allegedly defrauded investors. The Attorney General had claimed that Genesis had been “lying and cheating investors,” who sent more than $1.1 billion to Genesis through the Gemini Earn program. The settlement bans Genesis from operating in New York and requires the settlement funds to be returned to Genesis investors. Cointelegraph; The Block.
U.S. Supreme Court Allows Coinbase User Class Action to Proceed in Federal Court
On May 23, the U.S. Supreme Court issued a unanimous opinion in Coinbase Inc. v. Suski, ruling that a putative class-action lawsuit brought by Coinbase users should remain in federal courts rather than be sent to arbitration. The Court held that where “parties have agreed to two contracts – one sending arbitrability disputes to arbitration and the other either explicitly or implicitly sending arbitrability disputes to the courts—a court must decide which contract governs,” rather than an arbitrator. Law360; Opinion.

SPEAKER’S CORNER

UNITED STATES

Sens. Elizabeth Warren and Angus King Warn National Security Chiefs About Iranian Crypto Mining
In an open letter to Secretary of Defense Lloyd Austin, Secretary of the Treasury Janet Yellen and National Security Advisory Jake Sullivan, Senators Elizabeth Warren and Angus King warned about Iran’s “increasingly lucrative” relationship with crypto mining which “poses a direct threat to our national security.” The letter outlined Iran’s status as a leading jurisdiction for bitcoin mining and how its central bank channels cryptocurrency to fund the economy. “Cryptomining has become such a big industry in Iran that it has strained the country’s energy grid, leading the Iranian government to temporarily suspend cryptomining several times after it was blamed for massive blackouts.” Letter; CoinDesk.
Former SEC Commissioner Says SEC Has Taken “Too Expansive” a View on Digital Assets
At the May 9 TokenizeThis 2024 conference, Troy Paredes, who served as an SEC commissioner from 2008 to 2013, suggested that the SEC may be overreaching into the digital assets market. Paredes said that the SEC “has taken a very expansive view as to what constitutes a security.” Because “if it’s not a security, then it’s outside the scope of the federal securities laws in the SEC’s jurisdiction.” Cointelegraph.
CFTC Commissioner Discusses Turf War with SEC Over Crypto Regulation
In an interview, CFTC Commissioner Summer Mersinger discussed the turf war between the SEC and the CFTC, as both authorities seem to claim that they have authority over the crypto industry. Mersinger blamed the tension amongst the agencies mainly on a lack of clarity regarding each agency’s authority. Mersinger asserted that current statutory authority over crypto, as practiced through regulatory enforcement actions, was not sufficient to handle the evolving industry. Mersinger opined that the only way to bring clarity to the crypto industry would be to have a bill come out of Congress that said, “here’s how to handle cryptocurrencies.” Mersinger also indicated that the SEC and the CFTC needed to come up with some joint rulemaking around the crypto industry, and pointed to how Dodd Frank was a stellar example of joint rulemaking. CoinDesk.
SEC Chair Gary Gensler Opposes U.S. Crypto Bill FIT21
On May 22, SEC Chair Gary Gensler expressed that existing laws give the SEC enough authority to go against other U.S. regulatory agencies, including the White House and its Treasury Department, to regulate the crypto industry. In a statement issued against crypto bill FIT21, Gensler said that crypto firms had shown an “unwillingness to comply with applicable laws and regulations for more than a decade, variously arguing that the laws do not apply to them or that a new set of rules should be created and retroactively applied to them to excuse their past conduct.” Rep. French Hill (R-Ark.) stated that Gensler’s opinion on FIT21 was “isolated from other regulatory leaders.” CoinDesk; SEC Statement.

OTHER NOTABLE NEWS

Tether Enters Transaction Monitoring Partnership with Chainalysis
Tether, issuer of the largest stablecoin USDT, said on May 2 that it had teamed up with the blockchain data firm Chainalysis to monitor transactions with its tokens on secondary markets. According to the press release, the monitoring system included international sanctions compliance and illicit transfer detection that could be associated with activities like terrorist financing, and would help Tether identify crypto wallets that could “pose risks or may be associated with illicit and/or sanctioned addresses.” Tether CEO Paolo Ardoino said that this collaboration with Chainalysis “marks a pivotal step in our ongoing commitment to establishing transparency and security within the cryptocurrency industry.” Press Release; CoinDesk.
CME Group Plans to Launch Spot Bitcoin Trading
On May 16, Financial Times reported that the Chicago-based CME Group, the world’s largest futures exchange, planned to offer spot bitcoin trading to clients. Citing people “with direct knowledge of the talk,” Financial Times reported that CME had been holding discussions with traders who wanted to buy and sell bitcoin on a regulated marketplace. Introducing spot bitcoin trading on CME, which already hosted trading in bitcoin futures, would allow investors more easily to place so-called basis trades. CME’s potential entrance could mean that the large, regulated exchanges were becoming more comfortable with the infrastructure for trading digital assets, such as keeping coins safely secured. Financial Times; CoinDesk.
Bitcoin and Ethereum ETPs to Debut on London Stock Exchange
On May 22, the United Kingdom’s Financial Conduct Authority (FCA) approved Bitcoin and Ethereum-based exchange-traded products (ETPs) to be traded on the London Stock Exchange. However, only professional and institutional investors would be able to access these ETPs due to the 2021 ban on retail customers trading crypto derivatives. To get approval from the FCA, a crypto ETP should only be denominated in Bitcoin or Ethereum, be physically backed and non-leveraged, issuers must hold the underlying assets in cold storage, and the issuers must partner with an anti-money laundering licensed custodian in the United States, the United Kingdom, or the European Union. Cointelegraph.
Stand With Crypto Alliance Launches PAC for U.S. Elections
On May 10, the Stand with Crypto Alliance, formed in 2023, launched a new affiliated federal political action committee (PAC) to raise money to support politicians who are crypto-friendly. According to its website, the Stand with Crypto Alliance is a 501(c)(4) nonprofit with the aim of advocating for “clear, common-sense regulations in the crypto industry.” Crypto has become a greater part of the campaign trail, as presidential candidates have voiced their stances in hopes of swinging voters. Stand with Crypto’s PAC seeks to foster a grassroots movement, with donations limited to $5,000 from each of its members. Stand With Crypto; X (Twitter) Announcement; The Block.
Hong Kong Issuer Looks to Make Bitcoin ETF Available to Mainland China
On May 9, the CEO of Harvest, an issuer of a spot Bitcoin exchange-traded fund (ETF) in Hong Kong, announced at the Bitcoin Asia conference that Harvest was looking to make Bitcoin ETF accessible to investors in mainland China. The CEO is considering various options that would allow mainland Chinese investors to purchase Harvest Bitcoin and Ether ETFs by offering Harvest’s products through Hong Kong’s ETF Connect framework. ETF Connect, which launched in May 2022, gives mainland investors access to a range of selected ETFs listed in Hong Kong. On May 9, the South China Morning Post reported that as long as “everything goes smooth and well” in the next two years, Harvest will not rule out applying for its ETFs to be included in ETF Connect. Approval remains questionable, as the Chinese government has historically maintained a restrictive approach towards cryptocurrencies such as Bitcoin. Nevertheless, ETFs were a major topic at the Bitcoin Asia conference in Hong Kong. Cointelegraph; The Block.
Colombian President Allegedly Accepted $500,000 Illicit Crypto Donation
In early May, local media reported that Colombia’s President, Gustavo Petro, allegedly accepted upwards of $500,000 in digital tokens from a local crypto project. Colombia-based cryptocurrency project Daily COP reportedly made this illicit donation to Petro’s campaign in 2022. When Daily COP’s co-founder and Petro’s then-campaign manager discussed the donation, the parties purportedly aimed to form some sort of “joint venture [or] alliance with the government.” The Block.
Donald Trump Is First Major Party Candidate to Accept Crypto Donations
On May 21, Donald Trump became the first major party candidate to accept crypto donations. The announcement came just weeks after Trump declared himself as crypto’s candidate at a Mar-a-Lago gala. Although Trump has not proposed any concrete crypto policies, supporters welcomed the news as a win for crypto, particularly since Joe Biden’s administration has historically taken a broadly anti-crypto stance. Robert F. Kennedy Jr., who is running as an independent, has accepted crypto donations for months. CoinDesk.
First UK Crypto ETPs Launched on May 28
On May 28, the first bitcoin exchange-traded products (ETPs) debuted trading on the London Stock Exchange after receiving approval from the UK’s Financial Conduct Authority. The sponsoring asset managers were given the green light by the FCA to list ETPs investing in “physical” spot bitcoin and ether. The ETPs, however, will only be available to professional investors because the FCA has ruled that “crypto derivatives are ill-suited for retail consumers due to the harm they pose.” Financial Times.

The following Gibson Dunn attorneys contributed to this issue: Jason Cabral, Kendall Day, Jeff Steiner, Sara Weed, Chris Jones, Jay Minga, Nick Harper, Amanda Goetz, Raquel Sghiatti, Emma Li, and Zachary Montgomery.

FinTech and Digital Assets Group Leaders / Members:

FinTech and Digital Assets Group:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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