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Please join us for this 60-minute program. The panel covers key developments to be aware of headed into the 2023 Form 10-K reporting season, including recent SEC rulemaking and comment letters, disclosure trends and other developments such as:

New Cybersecurity Risk Management, Strategy, and Governance Disclosures
New Share Repurchase and Rule 10b5-1 Plan Disclosures
SEC Comment Letter and Company Disclosure Trends

PANELISTS:

Mike Titera is a partner in the Orange County office and a member of the Firm’s Securities Regulation and Corporate Governance Practice Group. His practice focuses on advising public companies regarding securities disclosure and compliance matters, financial reporting, and corporate governance. Mr. Titera often advises clients on accounting and auditing matters and the use of non-GAAP financial measures. He also has represented clients in investigations conducted by the Securities and Exchange Commission and the Financial Industry Regulatory Authority. Mr. Titera’s clients range from large-cap companies with global operations to small-cap companies in the pre-revenue phase. His clients operate in a range of sectors, including the retail, technology, pharmaceutical, hospitality, and financial services sectors. Mr. Titera is a frequent author on a range of securities law issues. His recent publications include articles in Insights and Deal Lawyers. Mr. Titera also co-authors a chapter regarding audit committees in the treatise “A Practical Guide to SEC Proxy and Compensation Rules” and contributed to a chapter about accounting-related matters in “Director’s Handbook: A Field Guide to 101 Situations Commonly Encountered in the Boardroom,” a recent publication of the American Bar Association.

Thomas J. Kim is a partner in the Washington D.C. office of Gibson, Dunn & Crutcher, LLP, where he is a member of the firm’s Securities Regulation and Corporate Governance Practice Group. Mr. Kim focuses his practice on a broad range of SEC disclosure and regulatory matters, including capital raising and tender offer transactions and shareholder activist situations, as well as corporate governance, environmental social governance and compliance issues. He also advises clients on SEC enforcement investigations – as well as boards of directors and independent board committees on internal investigations – involving disclosure, registration, corporate governance and auditor independence issues. Mr. Kim has extensive experience handling regulatory matters for companies with the SEC, including obtaining no-action and exemptive relief, interpretive guidance and waivers, and responding to disclosures and financial statement reviews by the Division of Corporation Finance. Mr. Kim served at the SEC for six years as the Chief Counsel and Associate Director of the Division of Corporation Finance, and for one year as Counsel to the Chairman.

David Korvin is a corporate associate in the Washington, D.C. office of Gibson, Dunn & Crutcher, where he currently practices in the firm’s Securities Regulation and Corporate Governance Practice Group. He advises public companies and their boards with respect to corporate governance, federal securities, financial reporting and accounting, insider trading, stock exchange, shareholder engagement, ESG and executive compensation matters. Prior to joining Gibson Dunn, David was an attorney at the Securities and Exchange Commission in the Division of Corporation Finance, where he handled the legal review of Securities Act and Exchange Act filings and served as a member of the Shareholder Proposal Taskforce.

Meghan Sherley is a corporate associate in the Orange County office of Gibson, Dunn & Crutcher, where she currently practices in the firm’s corporate department. Her practice is focused on securities regulation and corporate governance, including matters relating to ESG, compliance, and other general corporate matters. She writes and presents on these topics, including on trends and developments in human capital management disclosures. Meghan’s pro bono engagements include advising nonprofit entities on a variety of compliance and transactional matters.

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

Gibson Dunn has formed a Workplace DEI Task Force, bringing to bear the Firm’s experience in employment, appellate and Constitutional law, DEI programs, securities and corporate governance, and government contracts to help our clients develop creative, practical, and lawful approaches to accomplish their DEI objectives following the Supreme Court’s decision in SFFA v. Harvard. 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).

Key Developments:

In California, new challenges have emerged to DEI-related programs in the state’s community college system. In April 2023, the California Community College system adopted new regulations, requiring faculty to “employ teaching, learning, and professional practices that incorporate DEIA . . . principles” and directing community colleges to “consider[] an employee’s demonstrated, or progress toward, proficiency in diversity, equity, inclusion, and accessibility [ ] competencies” in employee evaluations. Cal. Code Regs. tit. 5, §§ 53602, 53605. Two groups of professors, represented by the nonprofit organization Foundation for Individual Rights and Expression (FIRE), sued the California Community College system in June and August 2023 in the Eastern District of California. Both suits seek to enjoin the application of the new evaluation standards. The professors argue that the system’s new regulations compel speech in violation of the First and Fourteenth Amendments by requiring faculty to either parrot the state’s stance on DEI or be punished. On November 14, 2023, a magistrate judge in the June lawsuit (Johnson v. Watkin) recommended granting an injunction, writing that “California’s goal of promoting diversity, equity, inclusion, and accessibility in public universities does not give it the authority to invalidate protected expressions of speech.” The district court has not yet ruled on this recommendation. More details on these cases can be found in the case updates section below.

On November 21, 2023, America First Legal Foundation (“AFL”) sent a letter to the EEOC, calling for the Commission to initiate an investigation into Macy’s, Inc.’s DEI initiatives. The letter to the Commission, as well as a letter AFL sent to Macy’s Board of Directors, alleges violations of Title VII and Section 1981 based on the company’s 2022 Diversity & Inclusion Annual Report. The stated goals of the Report include achieving ethnic and gender diversity of 50% for the company’s models, 30% for its senior-level management, and 5% for its supplier relationships.

On November 8, 2023, United States Senator Eric Schmitt (R – Missouri) introduced Senate Bill 3252, proposing to terminate the authorities of certain DEI offices and officers of the Federal Government. The Bill, short-titled the “Abolish Government DEI Act,” lists a total of 40 executive offices and officer positions that would be terminated on the date of the Bill’s enactment. The Bill targets the DEI and Civil Rights offices of numerous executive departments and agencies, including—among others—the Department of State, the Department of the Interior, the Department of the Treasury, the Department of Energy, the Department of Health and Human Services, and the Equal Employment Opportunity Commission. The Bill, if enacted, would abolish a number of DEI officer positions in these agencies and would prohibit the head of a covered agency from carrying out “any plan relating to diversity, equity, and inclusion.” The Administrator of the United States Agency for International Development would also lose the ability to implement the agency’s Diversity, Equity, Inclusion, and Accessibility strategy. The Bill has been read twice and referred to the Committee on Homeland Security and Governmental Affairs.

Media Coverage and Commentary:

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

New York Law Journal, “‘Affirmative Recruiting’ Under Title VII” (November 15): New York University School of Law Professor Samuel Estreicher and employment attorneys Erin Connell and Alexandria Elliott explore courts’ historical treatment of race- and diversity-conscious recruiting under Title VII. The authors survey EEOC guidance and decisions from federal courts of appeals and find that, although Title VII does not explicitly prohibit consideration of race or other protected characteristics in recruiting, diversity-focused recruiting violates Title VII when it results in a disparate impact in hiring. Estreicher, Connell, and Elliott advise that employers should focus on diversifying talent pools while maintaining merits-focused hiring practices to mitigate risk in the current landscape.
Law360, “10th Cir. Keeps Cards Close To Vest In DEI Bias Suit” (November 17): Law 360’s Grace Elleston reports on the recent oral argument heard by a three-judge panel of the Tenth Circuit in Young v. Colorado Department of Corrections. Joshua Young, a white ex-corrections officer, is appealing the dismissal of his Title VII suit that claims a Colorado Department of Corrections DEI training session created a hostile work environment by implying that white people are inherently racist. Elleston notes that Judge Timothy M. Tymkovich seemed skeptical that a single training session could meet the severe and pervasive standard necessary to create a hostile work environment for white employees, and queried whether a training session perceived by the plaintiff to cause offense based on his race could alter the conditions of his employment. Elleston concludes that the panel’s questioning shed little light on how it will rule.
Inc., “How Firms Are Winning Anti-DEI Lawsuits” (November 22): According to Brit Morse, Associate Editor at Inc., the recent wave of litigation challenging law firm diversity programs has only strengthened those firms’ commitment to promoting diversity in the legal profession. Those firms’ strategy of adjusting diversity program criteria seems to be working, writes Morse, and may also work for companies in other industries seeking to mitigate risk while maintaining a strong commitment to diversity. But Morse emphasizes that those hardest hit by recent litigation may be nonprofits and minority business owners reliant on diversity-focused funding, which is increasingly becoming the target of advocacy groups challenging diversity initiatives in court.
Paradigm, “New Data: 2023 DEI Trends & 2024 Opportunities” (November 19): Paradigm Co-Founder and CEO (and former civil rights attorney) Joelle Emerson highlights Paradigm’s new report on corporate DEI trends. The report aggregates data from 148 companies using Paradigm’s strategy and analytics platform. Emerson identifies four areas of opportunity for DEI in 2024, recommending that companies increase reliance on data to identify areas for improvement and to track progress, use DEI training to “reset the narrative” about diversity goals, focus on increasing (and measuring) inclusion, and assess hiring plans to ensure access to a wider pool of diverse candidates.
Bloomberg News, “Corporate America Is Rethinking Diversity Hiring” (November 22): Bloomberg’s Jeff Green and Kelsey Butler report on the corporate response to the recent wave of lawsuits targeting diversity programs. Interviews with employment lawyers, consultants, and diversity executives suggest that “[t]he biggest companies that were already committed to diversity initiatives prior to 2020 are more likely to be sticking with their programs,” while “[e]mployers that are newer to DEI or haven’t really started are more likely to pull back.” But the authors indicate that, despite these different approaches, the majority of private employers are changing the language they use to discuss diversity initiatives and reducing public communications about DEI efforts.
The Charlotte Post, “Affirmative action backlash hits maternal health program” (November 26): Freelance journalist Ronnie Cohen reports on the lawsuit filed in May 2023 by the Californians for Equal Rights Foundation—represented by the American Civil Rights Project—against the city of San Francisco and the state of California over the “Abundant Birth Project,” which provides monthly stipends to pregnant San Franciscans who are Black or of Pacific Island heritage. According to its website, the Project aims to address higher-than-average rates of maternal mortality and preterm births among members of these communities. But the plaintiffs argue that the Project, along with other city programs providing financial support to Black and transgender residents, violates Title VI and the equal protection clauses of the Fourteenth Amendment and the California Constitution.

Current Litigation:

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

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

Am. Alliance for Equal Rights v. Fearless Fund Mgmt., LLC, No. 1:23-cv-03424-TWT (N.D. Ga. 2023), on appeal at No. 23-13138 (11th Cir. 2023): Advocacy group American Alliance for Equal Rights (“AAER”) sued a Black women-owned venture capital firm with a charitable grant program that provides $20,000 grants to Black female entrepreneurs; AAER alleged that the program violates Section 1981 and sought a preliminary injunction. Fearless Fund is represented by Gibson Dunn.
- Latest update: On November 13, 2023, the Eleventh Circuit granted the parties’ motion to expedite oral argument and tentatively scheduled argument for the week of January 29, 2024.
Landscape Consultants of Texas, Inc. v. City of Houston, No. 4:23-cv-3516 (S.D. Tex. 2023): Plaintiff landscaping companies owned by white individuals challenged Houston’s government contracting set-aside program for “minority business enterprises” that are owned by members of racial and ethnic minority groups. The companies claim the program violates the Fourteenth Amendment and Section 1981.
- Latest update: On November 13, 2023, the City of Houston filed its motion to dismiss, arguing that the plaintiffs failed to state claims for disparate treatment under the Equal Protection clause and contracting discrimination under Section 1981. In particular, the City argued that one plaintiff, as a company owned 51% by a woman, might have been treated identically to a minority business enterprise, and that all plaintiffs failed to allege that they were “actually prevented, and not merely deterred” from contracting with the City. The City also argued that since the plaintiffs never actually submitted a bid to contract with Houston, they could not make out a Section 1981 claim.
Am. Alliance for Equal Rights v. Winston & Strawn LLP, No. 4:23-cv-04113 (S.D. Tex. 2023): AAER sued law firm Winston & Strawn, challenging its 1L diversity fellowship program as racially discriminatory in violation of Section 1981. The firm had previously announced that it would continue the program in response to a threat letter from AAER.
- Latest update: On October 30, 2023, AAER moved for a preliminary injunction seeking to bar the firm from considering race as a factor for its diversity fellowship program, to require it to use race-neutral language for program eligibility, and if necessary, to require the firm to restructure its hiring process. On November 14, 2023, the district court entered a briefing schedule; Winston & Strawn’s response is due on December 11, 2023.

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

Netzel v. American Express Company, No. 2:22-cv-01423 (D. Ariz. 2022), on appeal at No. 23-16083 (9th Cir. 2023): On August 23, 2022, a group of former American Express employees alleged that the company’s diversity initiatives discriminated against white workers and that the company retaliated against the same workers after they complained, in violation of Title VII and Section 1981.
- Latest update: After the district court granted American Express’s motion to compel arbitration, the plaintiffs appealed to the Ninth Circuit, filing their opening brief on November 9, 2023. The plaintiffs argue in part that they should not be compelled to arbitrate because they seek “public injunctive relief” against alleged “racial discrimination . . . that specifically harms the general public,” a right they claim is not waivable under California law. American Express’s response is due January 10, 2024.

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

Johnson v. Watkin, No. 1:23-cv-00848-ADA-CDB (E.D. Cal. 2023): On June 1, 2023, a community college professor in California sued to challenge new “Diversity, Equity and Inclusion Competencies and Criteria Recommendations” enacted by the California Community Colleges Chancellor’s Office, claiming the regulations violated the First and Fourteenth Amendments. The plaintiff alleged that the adoption of the new competency standards, which require professors to be evaluated in part on their success in integrating DEI-related concepts in the classroom, will require him to espouse DEI principles with which he disagrees, or be punished. The plaintiff moved to enjoin the policy.
- Latest update: On November 14, 2023, a magistrate judge issued a recommendation and proposed order to grant a preliminary injunction. The judge recommended enjoining the colleges from investigating or disciplining the plaintiff based on his proposed political speech in the classroom. The judge also recommended denying the defendant’s motion to dismiss. The parties have until November 29, 2023 to file their objections to the magistrate judge’s findings.
Palsgaard v. Christian, No. 1:23-cv-01228-SAB (E.D. Cal. 2023): On August 17, 2023, community college professors in California filed suit, challenging the adoption of the state’s new DEI-related evaluation competencies and corresponding language in their faculty union contract, which they allege requires them to endorse the state’s views on DEI concepts. The plaintiffs challenge the regulations and contract language as compelled speech in violation of the First and Fourteenth Amendments.
- Latest update: On August 23, 2023, the plaintiffs moved for a preliminary injunction, which is fully briefed. The court has not yet ruled on the motion. The defendants’ current deadline to respond to the initial complaint is December 15, 2023.

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

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])

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

The amendments impact settlement agreements entered into on or after November 17, 2023. The expanded statute of limitations applies to claims arising on or after February 15, 2024.

New York recently passed two noteworthy employment laws. First, it expanded restrictions on the use of non-disclosure and non-disparagement provisions in agreements settling claims of discrimination, harassment, or retaliation. These expanded restrictions impact settlement agreements entered into on or after November 17, 2023. Second, effective February 15, 2024, New York extended the statute of limitations from one to three years for all claims resulting from unlawful discriminatory practices under the New York State Human Rights Law (NYSHRL).

Expanded Restrictions on Non-Disclosure and Non-Disparagement Provisions in Settlement Agreements: Calculating damages arising from a breach of a confidentiality/non-disparagement restriction can often be challenging for employers. As a result, settlement agreements frequently include a liquidated damages provision whereby the complainant agrees to pay a specified amount of damages to an employer (including some or all of the settlement payment) in the event of a breach. Such provisions are no longer permissible in New York as the newly enacted amendments to New York General Obligations Law § 5-336 state that in any agreement settling claims involving discrimination, harassment, or retaliation, a release is unenforceable if the agreement requires the complainant to pay liquidated damages or forfeit all or part of the consideration for the agreement for violation of a non-disclosure or non-disparagement provision. The newly enacted amendments also invalidate a release in a covered settlement agreement if it contains or requires any affirmative statement, assertion, or disclaimer that the complainant was not in fact subject to unlawful discrimination, harassment, or retaliation.

Changes Regarding the Procedure to Memorialize a Complainant’s Preference for Confidentiality: NY General Obligations Law § 5-336(1) sets out a particular process and timeframe for employers to memorialize a complainant’s preference for confidentiality in a settlement agreement where the factual foundation of the settlement involves claims of discrimination, harassment, or retaliation. Specifically, employers must ensure: (i) the non-disclosure provision is the complainant’s preference; (ii) the non-disclosure provision is set forth in writing; and (iii) the complainant has up to 21 days to consider such terms and 7 days to revoke their acceptance.

New York law previously required that complainants be given a non-waivable 21-day consideration period for covered settlement agreements. Now, for pre-litigation settlements, the amendments allow a complainant to waive the 21-day consideration period and sign the agreement before that period expires. Still, the agreement cannot be effective until after the expiration of the 7-day revocation period.

Employers should take note that NY CPLR § 5003-B—which applies to settlements reached after a lawsuit has been filed in New York state court—requires plaintiffs to wait the full 21-day consideration period before signing a settlement agreement that would prevent the disclosure of the underlying facts and circumstances of any discrimination claim. Accordingly, the 21-day consideration period is still not waivable in agreements settling a discrimination claim that has been filed in court.

Independent Contractors Covered: The recent amendments state that NY General Obligations Law § 5-336 now applies to independent contractors, in addition to employees and potential employees. Accordingly, any covered settlement agreement with an independent contractor is now subject to § 5-336.

Communications with Attorney General Added to Protected Activity: Since § 5-336’s passage in 2018, New York employers have been required to notify complainants that provisions in any agreement (not just settlement agreements) that prevent the disclosure of factual information related to any future claim of discrimination do not prohibit the complainant from speaking with law enforcement, the EEOC, the New York State Division of Human Rights, a local commission of human rights, and attorneys. The amendments further require that complainants be notified that they are not prohibited from speaking with the New York Attorney General. Accordingly, employers should review and update their agreements to include the requisite carve-outs.

Expanded Statute of Limitations: As previewed above, in addition to amending § 5-336, New York enacted a separate law extending the statute of limitations for all claims resulting from unlawful discriminatory practices under the NYSHRL from one to three years. The new statute of limitations applies to claims arising on or after February 15, 2024.

Takeaway

Employers in New York State should review relevant agreements to ensure compliance with these amendments and be prepared to face a potential uptick in lawsuits over time in light of the impending extended statute of limitations under the NYSHRL.

The following Gibson Dunn attorneys assisted in preparing this update: Harris Mufson, Danielle Moss, Hayley Fritchie, and Tia Kerkhof.

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

Harris M. Mufson – Partner, New York (+1 212.351.3805, [email protected])

Danielle J. Moss – Partner, New York (+1 212.351.6338, [email protected])

Jason C. Schwartz – Co-Chair, Washington, D.C. (+1 202.955.8242, [email protected])

Katherine V.A. Smith – Co-Chair, Los Angeles (+1 213.229.7107, [email protected])

The Court’s decision also distinguishes the ADGM and DIFC’s approaches to English law.

A unique feature of the ADGM—certainly within the region—is that the English common law, as it stands from time to time, not only applies and has legal force in the jurisdiction, but also forms part of the ADGM’s laws. This is enshrined in Article 1(1) of the Application of English Law Regulations 2015 (“Regulations”).

On 17 November 2023, the ADGM Court of Appeal published an important decision in AC Network Holding Ltd. v. Polymath Ekar SPV1, confirming, among other things, that whilst ADGM judges “are not sitting as English law judges”, “they are bound to apply the rule laid down by the [Regulations]”. Lord Hope contrasted this with the position in the Dubai International Financial Center (“DIFC”): “The position in the Dubai International Financial Centre is different. Common law rules in various areas have been codified, and it is only if those rules or the laws of other relevant legal systems do not provide an answer that the laws of England and Wales are applied.”

This decision provides clarity to parties contracted to resolve disputes before the ADGM courts, and emphasises the unique position of English law in the ADGM, which the Court of Appeal observed “lies at the heart of the system of law that was created for the ADGM”.

Context and Factual Background

With the adoption of the Regulations in 2015, the ADGM opted to fully transplant English law as its applicable private law.[1] The result is that the entire, constantly updated, corpus of English common law applies in the ADGM. However, as the AC case demonstrates, there remained some doubts as to the full effect of this legal transplant.

AC concerned the sale of shares in a car-sharing company operating in Dubai, Abu Dhabi and Saudi Arabia. In 2020, the company’s minority shareholders were compelled, pursuant to a “Drag Along Notice” (“Notice”) issued by the majority shareholders, to sell their shareholding to a third party.

The minority shareholders challenged the validity of the Notice on the ground that the third party purchaser was not a ‘bona fide purchaser’ as required by the Shareholders’ Agreement (“Agreement”). Rather, they claimed that the purchaser was actually the majority shareholder himself, merely acting through a corporate veil. The minority shareholders sued the majority for the economic torts of intentionally procuring a breach of the Agreement as well as of conspiracy to use unlawful means to breach the Agreement. The Agreement was governed by English Law and any disputes arising under the Agreement were subject to the exclusive jurisdiction of the ADGM courts.

Court of First Instance

The ADGM Court of First Instance agreed with the minority shareholders that the Notice was invalid, insofar as the majority shareholder, by standing on “both sides of the fence,” had effectively expropriated the company’s shares in bad faith. However, the Court did not find that this breach was intentional, with the majority shareholder having received assurance from its legal counsel that the transfer was lawful.[2] In considering the unlawful means conspiracy claim, the Court was faced with a question of English law: did this claim also require knowledge of the unlawfulness of the conduct?

In answering this question, the minority shareholders pointed to a 2021 decision of the English Court of Appeal in Racing Partnership, where a majority of judges held that such knowledge was not required.[3] However, the ADGM Court of First Instance declined to follow this decision, holding that while Article 1(1) of the Regulations made English court decisions and precedent “highly relevant,” it did not bind ADGM courts.[4] Instead, it was the ADGM Court of First Instance’s duty to ascertain the “correct position” in English law, which may not be reflected in the latest case law.[5]

In this analysis, the ADGM Court of First Instance found that Racing Partnership confused rather than settled English law, with the correct position being that knowledge was, in fact, a requirement to establish the tort of conspiracy by unlawful means. Having already found that the majority shareholder lacked knowledge that his conduct was unlawful, the minority shareholders’ claims were dismissed.[6]

Court of Appeal

On appeal, the minority shareholders claimed that the Court of First Instance had erred in its application of English law, and consequently, the Regulations. They argued that Article 1(1) of the Regulations required that the ADGM courts apply English law including respecting the doctrine of precedent, the principle that within a single legal system, lower courts are bound by the prior decisions of higher courts.

The ADGM Court of Appeal agreed. In its reading, Article 1(1) of the Regulations required ADGM courts to apply English law principles, which would necessarily include the bedrock doctrine of precedent.[7] With some exceptions, a lower court would thus be required to apply decisions of higher courts even if they felt that the decision was faultily reasoned or had an unjust result.[8] In this context, the ADGM Court of Appeal found that the English Court of Appeal’s decision Racing Partnership was binding authority in the ADGM.[9] With knowledge of the illegality of its conduct no longer required, the ADGM Court of Appeal found the majority shareholder was liable for conspiracy to use unlawful means to breach the Agreement.[10]

Implications

The ADGM Court of Appeal’s decision in AC has profound implications in the ADGM. As the decision recognises, respect for the doctrine of precedent injects predictability into the ADGM’s application of English law, which was the primary reason for the Regulations in the first place. No longer will ADGM judges be encouraged (or permitted) to depart from latest English case law to undertake novel (and potentially complex) analyses of the ‘correct’ position under English law. Instead, the practice before the ADGM courts will be greatly synthesised with that before English courts, providing relief to clients and lawyers already familiar with these courts and their rulings.

AC also has the notable effect of further entrenching the ADGM’s wholesale adoption of English common law, which stands in contrast to other special economic zones and financial zones in the region (including in the UAE). For example, the DIFC explicitly codified various common law rules as DIFC law with adjustments, with English common law only applied to fill gaps in these existing DIFC codes.[11] The merit of the ADGM model—evidenced by the ADGM’s growing attractiveness to foreign investors worldwide—is its immediate familiarity to clients and lawyers well-versed with English law. The AC decision is another welcome step in the right direction.

__________

[1] Application of English Law Regulations 2015, art. 1(1) (“The common law of England (including the principles and rules of equity), as it stands from time to time, shall apply and have legal force in, and form part of the law of the Abu Dhabi Global Market”.)

[2] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 16.

[3] Racing Partnership v. Done Bros Ltd. [2021] Ch 233

[4] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 18.

[5] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 19.

[6] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 19.

[7] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 25.

[8] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶¶ 32-33.

[9] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 45.

[10] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 46.

[11] AC Network Holding Ltd. v. Polymath Ekar SPV1 [2023] ADGMCA 0002, ¶ 2.

The following Gibson Dunn attorneys assisted in preparing this update: Nooree Moola and Praharsh Johorey.

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, the authors, or any of the following leaders and members of the firm’s global Litigation, International Arbitration, or Mergers and Acquisitions practice groups:

Renad Younes – Abu Dhabi (+971 2 234 2602, [email protected])
Marwan Elaraby – Dubai/Abu Dhabi (+971 4 318 4611, [email protected])
Nooree Moola – Dubai (+971 4 318 4643, [email protected])
Praharsh Johorey – Dubai (+1 212.351.3911, [email protected])
Cyrus Benson – London (+44 20 7071 4239, [email protected])
Penny Madden KC – London (+44 20 7071 4226, [email protected])

Munich partner Katharina Humphrey, London associate Amy Cooke and Munich associate Andreas Dürr are the authors of “London verschärft das Unternehmensstrafrecht” [PDF] (London Tightens Corporate Criminal Law) published in issue No. 228 from November 25, 2023, of the German newspaper Boersen-Zeitung. The article outlines the expansion of corporate criminal liability in the UK and its impact also on German companies.

The Court’s decision raises important considerations for asset managers, non-U.S. funds, and other non-U.S. persons that invest in the United States.

On November 15, 2023, the Tax Court released its opinion in YA Global v. Commissioner,[1] holding, among other things, that YA Global — a Cayman Islands fund with a U.S. investment manager — was engaged in a U.S. trade or business and therefore was correctly assessed U.S. federal withholding tax liability with respect to its non-U.S. partners. YA Global had been closely followed ever since the IRS first released its analysis of the case in 2015.[2] Although YA Global’s activities and arrangements with its investment manager, based on the facts as described by the Court, were unusual as compared with those of a typical non-U.S. fund that makes U.S. investments, the case raises several important considerations for asset managers, non-U.S. funds, and other non-U.S. persons that invest in the United States.

I. Background

U.S. federal income tax law requires non-U.S. persons to pay tax on income effectively connected with a U.S. trade or business (“ECI”).[3] Section 1446(a) requires a partnership to withhold and pay tax on the portion of any ECI allocable to a non-U.S. partner. Neither the Code nor the Treasury Regulations define a U.S. trade or business for this purpose.[4] Instead, whether a taxpayer is engaged in a U.S. trade or business depends on the particular facts and circumstances.[5]

To be considered engaged in a U.S. trade or business, a non-U.S. person must conduct continuous and regular activity in the United States for profit.[6] Importantly, mere management of investments does not give rise to a trade or business regardless of the amount of time and effort devoted to the activity.[7] In addition, the Code provides a safe harbor that prevents a non-U.S. person from being treated as engaged in a U.S. trade or business if the non-U.S. person’s activities are limited to (i) trading in stocks or securities through an independent agent, or (ii) if the non-U.S. person is not a “dealer,” trading in stocks or securities for its own account or through a broker or other agent (collectively, the “Trading Safe Harbor”).[8] For this purpose, the Treasury regulations define “securities” and the act of trading in securities quite broadly.[9] And, notably, the regulations provide that the volume of stock or security transactions effected during the taxable year is not taken into account in determining whether the taxpayer is engaged in a U.S. trade or business.[10]

In 2015, the IRS Office of Associate Chief Counsel (International) released a legal memorandum (the “CCA”) discussing the facts of YA Global.[11] The CCA concluded that (a) YA Global was engaged in “lending” and “underwriting” activities that were so extensive that they rose to the level of a U.S. trade or business, (b) the “lending” and “underwriting” activities did not constitute “trading in stocks or securities” for purposes of the Trading Safe Harbor, and (c) even if YA Global’s activities otherwise constituted “trading in stocks or securities” for this purpose, YA Global would not have qualified for the Trading Safe Harbor because YA Global was a dealer acting through a non-independent agent.

Now, eight years later, the Tax Court has also concluded that YA Global’s activities constituted a U.S. trade or business, albeit based on a somewhat different analysis from that of the CCA.

The Tax Court’s decision in YA Global is the most significant development regarding this issue since the CCA was published. Non-U.S. funds that invest in the United States should take particular note of this decision, especially given the IRS’s current campaign entitled Financial Service Entities engaged in a U.S. Trade or Business,[12] which is intended to address whether non-U.S. credit funds are engaged in a U.S. trade or business.

II. Facts

The following summarizes the facts as described by the Court in its opinion. In its briefs and responses, however, YA Global disputed certain of these characterizations of its activities and investments.

1. The Main Parties

YA Global Investments, LP, a Cayman Islands limited partnership (“YA Global”), was the flagship fund of Yorkville Advisors, LLC, a U.S.-based fund sponsor (“Yorkville Advisors”). YA Global had no employees and took the position that it was not engaged in a U.S. trade or business during the tax years at issue (2006, 2007, and 2008).

Yorkville Advisors served as YA Global’s general partner until 2007 and as its investment manager under a 2005 investment management agreement (the “Management Agreement”).[13] The Management Agreement appointed Yorkville Advisors as YA Global’s “Agent” and granted Yorkville Advisors a power of attorney, though YA Global could provide notice of specific investment restrictions, and, under a 2007 amendment, Yorkville Advisors’ actions were subject to the “policies and control” of YA Global’s general partner. In return for its management services, Yorkville Advisors received a management fee equal to a specified percentage of YA Global’s assets. Yorkville Advisors (presumably in its role as general partner) also received a 20 percent incentive fee based on YA Global’s profits. During each year at issue, YA Global’s assets constituted at least 72 percent of Yorkville Advisors’ total assets under management, and, for most of the relevant period, YA Global was the only fund Yorkville Advisors managed.

YA Offshore Global Investments, Ltd., a Cayman Islands limited company (“YA Offshore”), was a limited partner in YA Global. YA Offshore took the position that it was not engaged in a U.S. trade or business, either directly or through YA Global.

2. Activities of YA Global and Yorkville Advisors

During the tax years at issue, YA Global invested primarily in convertible debentures, standby equity distribution agreements (“SEDAs”), and other securities of microcap and low-priced public companies trading on the over-the-counter public markets (investments like these sometimes are described as private investments in public securities.)

SEDAs. In a typical SEDA, YA Global committed to purchase a maximum dollar value of a company’s stock over a fixed period (typically two years). The purchase price for the stock generally was discounted to 95 to 97 percent of the stock’s market price at the time of purchase. YA Global entered into 25 SEDA transactions in 2006, 19 in 2007, and 9 in 2008.

Convertible Debentures. YA Global acquired convertible debentures from companies, some of which included a fixed conversion price, while others set the conversion price at a discount to the market price of the company’s stock at the time of conversion. YA Global generally exercised a conversion feature when it was ready to sell the stock it would receive on conversion. YA Global acquired 202 convertible debentures in 2006, 116 in 2007, and 111 in 2008.

Fees. The companies in which YA Global invested typically paid “fees” to Yorkville Advisors and/or YA Global in connection with the SEDAs and convertible debentures. The CEOs of two of Yorkville Advisors’ portfolio companies stated they viewed the fees as part of their overall cost of capital, not fees for services. According to the Court, in some cases, Yorkville Advisors used the fees it received from portfolio companies to pay its expenses and then remitted the excess to YA Global. In other cases, according to the Court, Yorkville Advisors remitted all of the fees to YA Global. Finally, in some cases, Yorkville Advisors kept the fees but reduced the management fees YA Global paid to Yorkville Advisors by a corresponding amount.[14]

Marketing. The Court found that YA Global held itself out in its marketing materials as being willing and able to provide capital to portfolio companies. The founder and president of Yorkville Advisors stated that its strong reputation led many companies seeking funding to contact them directly, and that employees attended conferences seeking to make connections at portfolio companies. Marketing materials referred to introductions provided by investment bankers, law firms, and accounting firms.

Tax Returns. YA Global filed a partnership information return on Form 1065 for each of the years at issue but did not file Form 8804 (reporting withholding tax liability under section 1446), because YA Global took the position that it was not engaged in a U.S. trade or business. The parties executed Forms 872-P, extending the assessment period to March 31, 2015, and the IRS asserted deficiencies on March 6, 2015.

III. Analysis and Key Holdings

1. YA Global Was Engaged in a U.S. Trade or Business

As a preliminary matter, the Court held that Yorkville Advisors was an agent of YA Global because the Management Agreement named Yorkville Advisors as YA Global’s agent and required Yorkville Advisors to comply with ongoing directions from YA Global. The Court contrasted this arrangement with that of a service provider where directions and guidelines are established as an initial matter and generally are not subject to change. As a result, the Court determined that all of the activities of Yorkville Advisors in the United States were attributable to YA Global.

The Court then held that YA Global was engaged in a U.S. trade or business based on a three-part analysis: (i) Yorkville Advisors’ activities conducted on behalf of YA Global were continuous, regular, and engaged in for the primary purpose of producing income or profit (i.e., constituted a trade or business) (according to the Court, YA Global did not dispute this point); (ii) in the Court’s view, the activities were not limited to the management of investments but included the performance of services and, thus, did not fall within the judicial exception set out in Higgins;[15] and (iii) because the Court characterized YA Global’s activities as including the provision of services, the activities were not covered by the Trading Safe Harbor.

The majority of the Court’s discussion focuses on the second part of this analysis—the judicial exception for the management of investments. In the Court’s view, whether YA Global, and Yorkville Advisors on its behalf, were simply managing YA Global’s investments turned on whether YA Global earned income from the companies in which it invested beyond just a return on the capital invested in those companies. In that regard, the Court found that the fees or discounts the companies provided to YA Global, or to Yorkville Advisors as YA Global’s agent, were given in respect of services provided by Yorkville Advisors in negotiating and structuring the investments. The Court rejected YA Global’s arguments that YA Global and Yorkville Advisors provided no services to the portfolio companies and that the fees or discounts were merely part of the companies’ cost of capital (even though that is how the companies viewed them) or that certain of the fees should instead be viewed as put option premiums.[16] In the Court’s view, the companies “received something of value from Yorkville Advisors above and beyond the capital they received from YA Global.” According to the Court, that “something of value” was Yorkville Advisors’ work in sourcing, negotiating, conducting due diligence, structuring, and managing the transactions on behalf of YA Global.[17] Thus, the Court determined that YA Global was not merely an investor managing its investments.

The Court applied essentially the same test to determine that YA Global did not qualify for the Trading Safe Harbor. Noting that “[t]raders, like investors, simply earn returns on the capital they invest,” the Court held that because it viewed YA Global as earning income from fees that went beyond returns for the use of capital, YA Global was not a trader for purposes of the Trading Safe Harbor.[18]

2. YA Global Was a Dealer for Purposes of Section 475

After concluding that YA Global was engaged in a U.S. trade or business for the years at issue, the Court held that, to calculate the amount of YA Global’s ECI allocable to non-U.S. partners for those years, YA Global’s annual income should have been determined under section 475(a)’s mark-to-market rules for dealers.

Section 475(a) requires dealers in securities to recognize ordinary gain or loss each taxable year as if they sold all their securities on the last day of the year, at fair market value (the “mark-to-market” requirement).[19] For this purpose, a “dealer in securities” is any taxpayer that (i) “regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business,” or (ii) “regularly offers to enter into, assume, offset, assign or otherwise terminate positions in securities with customers in the ordinary course of a trade or business.”[20]

Securities held for investment (i.e., not inventory) and debt acquired or originated by the taxpayer in the ordinary course of a trade or business of the taxpayer but not held for sale are both exempt from the mark-to-market requirement so long as the taxpayer properly identifies them as such.[21]

The Court found that YA Global was a “dealer in securities” for purposes of section 475 because it regularly purchased securities from the portfolio companies in which it invested, and, according to the Court, those portfolio companies were its customers.[22] The Court also found that YA Global did not meet the identification requirements under section 475(b)(2) and therefore did not establish that any securities it held met the “held for investment” exception. As a result, the Court held that YA Global was subject to the mark-to-market requirement for the tax years at issue.

3. All of YA Global’s Income Was ECI

Under section 1446, partnerships are required to withhold and pay tax on ECI allocable to a non-U.S. partner.[23] For section 1446 withholding purposes, income from sales of personal property is U.S.-source when attributable to an office or other fixed place of business in the United States, even if, for example, the personal property is securities of a non-U.S. company.[24] And U.S.-source income from the sale of personal property, other than capital assets, is ECI for a non-U.S. person that is engaged in a U.S. trade or business.[25] Because the Court held that Yorkville Advisors was a non-independent agent of YA Global, the Court attributed Yorkville Advisors’ U.S. office to YA Global. Further, because the Court held that YA Global was a dealer under section 475, all of YA Global’s stocks and securities were personal property other than capital assets, with the result that all gain or loss resulting from their sale and all mark-to-market gains or losses were ECI. Therefore, the Court held that all of YA Global’s income allocable to non-U.S. partners during the tax years at issue was ECI subject to withholding under section 1446.

4. YA Offshore’s Nonpartnership Deductions Did Not Reduce Withholding
Tax Liability

Generally, a non-U.S. partner’s distributive share of partnership deductions may reduce its allocable share of the partnership’s ECI and, thus, the partnership’s section 1446 withholding tax liability with respect to that partner. Nonpartnership deductions (i.e., those that are only deductible by a partner rather than by the partnership) reduce a non-U.S. partner’s share of the partnership’s section 1446 withholding tax liability if the partner provides a certification to the partnership of the nonpartnership deductions available to reduce the non-U.S. partner’s ECI.[26] The Court held that, because YA Offshore did not timely file U.S. federal income tax returns and therefore could not provide any withholding certificates to YA Global, YA Offshore’s nonpartnership deductions did not reduce YA Global’s liability for section 1446 withholding tax.

5. Statute of Limitations Did Not Begin Running When Form 1065 Was Filed

Generally, a taxpayer does not start the statute of limitation running by filing one return when a different return is required, unless the return filed is sufficient to advise the IRS that liability exists for the tax that should have been disclosed on the other return.[27] The Court found that YA Global was liable for section 1446 withholding tax in respect of its ECI. Therefore, YA Global was required to file Form 8804 for each applicable year in addition to its Form 1065. YA Global did not file a Form 8804 for any of the years at issue, and the Court found that its Forms 1065 were insufficient to advise the IRS of its liability under section 1446. Therefore, the Court held that the statute of limitations for the relevant taxable years had not begun running (and therefore had not expired).

IV. Key Takeaways

Non-U.S. funds and other non-U.S. persons that invest in the United States should carefully review their activities (and the related documentation) in light of the decision in YA Global. As noted above, the IRS currently is engaged in a campaign to determine whether certain non-U.S. funds are engaged in a U.S. trade or business. The Court’s decision in YA Global may provide added support for this campaign, as well as motivation for the IRS to challenge taxpayers on this issue.
Most non-U.S. funds, particularly credit funds, follow strict guidelines to ensure that their activities do not rise to the level of a U.S. trade or business. To be conservative, these guidelines typically assume that the fund manager’s activities on behalf of the fund will be attributed to the fund under the IRS’s broad view of agency attribution. Many of these funds have management agreements similar to the agreement between YA Global and Yorkville Advisors. The Court’s determination that Yorkville Advisors’ activities were attributable to YA Global strongly supports the continued use of these strict guidelines and, in particular, their application to the U.S.-based fund manager’s activities on behalf of the non-U.S. fund.
The Court’s determination that the receipt of fees caused YA Global to be engaged in a U.S. trade or business suggests that non-U.S. funds should be very careful in structuring fee arrangements. Fortunately, typical fund fee arrangements are distinguishable from the Court’s description of the fee arrangements entered into by Yorkville Advisors. Most funds do not receive structuring, diligence, and other fees—either directly or as a passthrough from their fund manager. Instead, if the fund’s manager or its affiliate receives fees from a portfolio company, the fund may receive a corresponding offset against future management fees equal to a pro rata amount (based on the fund’s ownership percentage of the portfolio company) of the fees paid to the manager. As a result, the manager or its affiliate profits from fees received on its own account, and the fund receives the offset simply to avoid a double payment.
Some funds receive commitment fees or purchase price discounts attributable to their agreement to invest a specified amount of capital and/or their role as seed investor. Typically, funds do not provide any services in exchange for these discounts. In the case of debt investments, these amounts are often treated as a reduction of the issue price and result in original issue discount (which is taxed as interest); alternatively, both the Tax Court and the IRS have determined that in some cases commitment fees are properly viewed as put option premiums.[28] Although the Court in YA Global acknowledged that in many cases the portfolio companies viewed the fees they paid as part of the economic cost of gaining “access to” capital, the Court distinguished paying for access to capital from paying for capital and held that the former constituted fees for services even though, economically, it is difficult to understand the distinction. The Court also rejected YA Global’s argument that certain of the fees should be viewed as put option premiums, notwithstanding the case law and Revenue Ruling in support of YA Global’s argument. Presumably the Court’s conclusion with respect to the fees and discounts reflected the unusual facts of the YA Global case, as described in the opinion. The Court did not reach a conclusion on the IRS’s arguments that the fund was engaged in loan origination and underwriting activities, but these points may have been what propelled the Court to view Yorkville Advisors (and YA Global) as having provided “services” to the portfolio companies in which the fund invested.
Most U.S.-managed funds that actively buy and sell stocks and securities rely on the Trading Safe Harbor. If a fund is considered a dealer, however, it cannot qualify for the Trading Safe Harbor unless it acts through an independent agent. Although the Court did not decide whether YA Global was acting as a dealer under section 864, the Court’s holding that YA Global was a dealer for purposes of section 475, including its broad and, to date, unprecedented view of the meaning of “customers,” strikes a cautionary note.[29] Again though, it was likely the unique nature of YA Global’s activities and investments (according to the facts described in the case) that caused the Court to conclude that YA Global was a dealer. In particular, despite YA Global’s arguments to the contrary, the Court appeared to view YA Global’s role in the SEDA and convertible note transactions as locking in a discount or spread similar to a dealer (in contrast to funds that are simply active traders for their own account that make their profits from market price fluctuations).
As a procedural matter, the case highlights the importance of filing protective U.S. tax returns, including Form 8804, to preserve the ability to claim deductions and to start the statute of limitations running.

__________

[1] 161 T.C. No. 11 (2023).

[2] Chief Counsel Advice 201501013 (Sept. 5, 2014).

[3] Sections 871(b) and 882 of the Internal Revenue Code of 1986, as amended (the “Code”). All section references in this publication are to the Code or the Treasury Regulations issued thereunder. Non-U.S. persons also are required to file a U.S. federal income tax return if they are engaged in a U.S. trade or business, including if they are a partner in a partnership that is engaged in a U.S. trade or business. Treas. Reg. §§ 1.6012-1(b) and -2(g); section 875.

[4] Section 864(b) provides that the performance of personal services within the United States constitutes a U.S. trade or business, subject to certain exceptions, and also provides several exemptions from being engaged in a U.S. trade or business, as discussed further in this publication.

[5] Treas. Reg. § 1.864-2(e); Groetzinger v. Comm’r, 480 U.S. 23 (1987); Higgins v. Comm’r, 312 U.A. 212 (1941).

[6] See, e.g., Pinchot v. Comm’r, 113 F.2d 718 (2d Cir. 1940)(taxpayer’s activity “required regular and continuous activity of the kind which is commonly concerned with the employment of labor; the purchase of materials; the making of contracts; and the many other things which come within the definition of business.”); de Amodio v. Comm’r, 34 TC 894 (1960), aff’d, 299 F.2d 623 (3d Cir. 1962); Spermacet Whaling & Shipping Co. v. Comm’r, 30 TC 618 (1958), aff’d, 281 F.2d 646 (6th Cir. 1960); Groetzinger v. Comm’r, 480 U.S. 23 (1987); Lewenhaupt v. Comm’r, 20 T.C. 151 (1953), aff’d, 221 F.2d 227 (9th Cir. 1955); Rev. Rul. 88-3, 1988-1 C.B. 268. Section 864(b).

[7] See, e.g., Higgins v. Comm’r, 312 U.S. 212 (1941) (active management of investments and collection of rents, interest and dividends by a non-U.S. person in the U.S. did not result in a U.S. trade or business); Treas. Reg. § 1.864-3(b), Ex. 2 (supervising investments does not constitute a trade or business).

[8] Section 864(b)(2)(A)(i) contains the exemption for trading done through an independent agent in the United States, and section 864(b)(2)(A)(ii) contains the exemption for non-dealers trading for their own accounts.

[9] Treas. Reg. § 1.864-2(c)(2)(i)(c) provides: “…the term ‘securities’ means any note, bond, debenture or other evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing.”

[10] Treas. Reg. § 1.864-2(c)(2)(i)(c) provides: “…the effecting of transactions in stocks or securities includes buying, selling (whether or not by entering into short sales), or trading in stocks, securities, or contracts or options to buy or sell stocks or securities, on margin or otherwise, for the account and risk of the taxpayer, and any other activity closely related thereto (such as obtaining credit for the purpose of effectuating such buying, selling, or trading).”

[11] Chief Counsel Advice 201501013 (Sept. 5, 2014).

[12] Financial Service Entities engaged in a U.S. Trade or Business, IRS Large Business and International Division (June 10, 2021).

[13] Yorkville Advisors GP, LLC was the general partner for the other years at issue.

[14] This management fee reduction mechanism is quite common in the fund industry. YA Global’s other fee arrangements described by the Court, where portfolio companies paid fees directly to YA Global or where Yorkville Advisors remitted fees to YA Global, are not typical, although the taxpayer disputed the Court’s characterization of some of these arrangements. It appears that some of the “fees” discussed by the Court were actually additional shares of stock, warrants, or purchase price discounts received by YA Global in connection with its investment commitment.

[15] Higgins v. Comm’r, 312 U.A. 212 (1941).

[16] According to the Court, it rejected the put option characterization because, in the Court’s view, the writer of a put option receives the premium for taking the risk that it will be called upon to purchase stocks or securities in the future for more than their fair market value, and it did not view YA Global as taking that risk.

[17] Because the Court concluded YA Global was engaged in the performance of services, it did not decide whether YA Global was engaged in a lending or underwriting trade or business (as the IRS had argued in the CCA and in certain of its briefs). YA Global v. Comm’r, 161 T.C. No. 11, 22 n.21 (2023).

[18] The Court seemingly rejected any notion that the activities for which Yorkville Advisors received compensation on behalf of YA Global were closely related to its trading in stocks and securities and thus within the Trading Safe Harbor under Treas. Reg. § 1.864-2(c)(2)(i)(c), quoting the IRS’s broad statement in its submissions that “‘[t]axpayers engaged merely in trading and investment simply do not earn income designated as fees.’” YA Global v. Comm’r, 161 T.C. No. 11, 36 n.33 (2023).

[19] Section 475(d)(3)(A)(i).

[20] Section 475(c)(i). A “security” for this purpose includes any share of stock in a corporation, note, bond, debenture, or other evidence of indebtedness, or warrant to acquire stock. Sections 475(c)(2)(A), 475(c)(2)(C), and 475(c)(2)(E).

[21] Section 475(b)(1)-(2); Treas. Reg. § 1.475(b)-1(a); see also Rev. Rul. 97-39, 1997-2 C.B. 62, 62.

[22] Although it is difficult to understand how the portfolio companies were customers, the Court pointed to Treas. Reg. § 1.475(c)-1(a)(2), which, “in contrast to the statute it interprets, does not use the term ‘customers.’ In place of that term, the regulation refers to the taxpayer’s ‘regularly hold[ing] itself out as being willing and able to enter into’ specified positions.” The Court concluded “[t]he regulation thus establishes that a taxpayer’s ‘customers,’ for purposes of section 475(c)(1)(B), are those with whom the taxpayer does what it ‘regularly holds itself out’ to do.”

[23] Treas. Reg. § 1.1446-2.

[24] Section 865(e)(2)(A).

[25] Section 864(c)(3).

[26] Treas. Reg. § 1.1446-6(c).

[27] Commissioner v. Lane-Wells Co., 321 U.S. 219 (1944).

[28] Federal Home Loan Mortgage Corp. v. Comr., 125 T.C. 248 (2005); Rev. Rul. 81-160; 1981-1 C.B. 312

[29] Treas. Reg. § 1.864-2(c)(iv) defines a dealer in stocks or securities as “[a] merchant of stocks or securities, with an established place of business, regularly engaged as a merchant in purchasing stocks or securities and selling them to customers with a view to the gains and profits that may be derived therefrom. Persons who buy and sell, or hold, stocks or securities for investment or speculation, irrespective of whether such buying or selling constitute the carrying on of a trade or business… are not dealers in stocks or securities….”

The following Gibson Dunn attorneys assisted in preparing this update: Jennifer Fitzgerald, Pamela Lawrence Endreny, Emily Leduc Gagné*, Eric Sloan, Hayden Theis, Daniel Zygielbaum, Anne Devereaux*, James Jennings, and Loren Lembo.

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 practice group:

Dora Arash – Los Angeles (+1 213.229.7134, [email protected])
Sandy Bhogal – Co-Chair, London (+44 (0) 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 (0) 20 7071 4232, [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])
Jeffrey M. Trinklein – London/New York (+44 (0) 20 7071 4224), [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])

*Anne Devereaux is of counsel working in the firm’s Los Angeles office who is admitted to practice in Washington, D.C.; Emily Leduc Gagné is an associate working in the firm’s New York office who is admitted to practice in Ontario, Canada.

A Survey of Disclosures from the S&P 100 During the Three Years Following Adoption of the Securities and Exchange Commission Rule

Human capital resource disclosures by public companies have continued to be a focus since the U.S. Securities and Exchange Commission (the “Commission”) adopted the new rules in 2020; not only for companies making the disclosures, but employees, investors, and other stakeholders reading them. This alert updates the alert we issued in January 2023, “Evolving Human Capital Disclosures: A Survey of Disclosures from the S&P 100 During the Two Years Following Adoption of the Securities and Exchange Commission Rule,” available here, and reviews disclosure trends among S&P 100 companies, each of which has now included human capital disclosure in their past three annual reports on Form 10-K. This alert also provides practical considerations for companies as we head into 2024.

The overall takeaway from our survey, which categorized disclosures into 27 topic areas, was that companies are generally tailoring the length of their disclosures and the topics covered and including slightly more quantitative information in some areas.[1] We note the following trends regarding the S&P 100 companies’ disclosures compared to the previous year:

Length of disclosure. Forty-eight percent of companies increased the length of their disclosures, four percent of companies’ disclosures remained the same, and the remaining 48% of companies decreased the length of their disclosures (with the decreases generally attributable to the removal of discussion related to COVID-19).
Number of topics covered. Twenty-two percent of companies increased the number of topics covered (with the categories seeing the most increases being diversity statistics by race/ethnicity and gender, employee mental health, monitoring culture, talent attraction and retention, and talent development), while 34% decreased the number of topics covered (the majority of which were attributable to the removal of disclosures related to COVID-19), and the remaining 46% covered the same number of topics.
Breadth of topics covered. The prevalence of 16 topics increased, seven decreased, and four remained the same.
- The most significant year-over-year increases in frequency involved the following topics: quantitative diversity statistics on gender (60% to 65%), employee mental health (46% to 50%), culture initiatives (22% to 26%), efforts to monitor culture (60% to 64%), and talent attraction and retention (90% to 94%).
- The most significant year-over-year decrease involved COVID-19 disclosures, which declined in frequency from 69% to 34%. Other year-over-year decreases involved discussion of governance and organizational practices (56% to 51%) and diversity targets and goals (23% to 19%).
Most common topics covered. The topics most commonly discussed this most recent year generally remained consistent with the previous two years. For example, diversity and inclusion, talent development, talent attraction and retention, and employee compensation and benefits remained four of the five most frequently discussed topics, while quantitative talent development statistics, supplier diversity, community investment, and quantitative statistics on new hire diversity remained four of the five least frequently covered topics.
Industry trends. Within the technology, finance, and energy industries, the trends that we saw in the previous year regarding the frequency of topics disclosed generally remained the same.

I. Background on the Requirements

On August 26, 2020, the Commission voted three to two to approve amendments to Items 101, 103, and 105 of Regulation S-K, including the principles-based requirement to discuss a registrant’s human capital resources to the extent material to an understanding of the registrant’s business taken as a whole.[2] Specifically, public companies’ human capital disclosure must include “the number of persons employed by the registrant, and any human capital measures or objectives that the registrant focuses on in managing the business (such as, depending on the nature of the registrant’s business and workforce, measures or objectives that address the development, attraction, and retention of personnel).”

Notably, the Commission’s agenda list includes new human capital disclosure rules that are expected to be more prescriptive than the current rules, in part,[3] because one of the main criticisms of the existing human capital rules is lack of comparability across companies. Based on our survey, while company disclosures under the existing principles-based rules vary—which is expected under the principles-based regime—our survey was able to introduce some comparability. The next four sections show the relevant data from our survey.[4]

II. Disclosure Topics

Our survey classifies human capital disclosures into 27 topics, each of which is listed in the following chart, along with the number of companies that discussed the topic in each of 2021, 2022, and 2023. Each topic is described more fully in the sections following the chart.

A. Workforce Composition

Among S&P 100 companies, 58% included disclosures relating to workforce composition in one or more of the following categories:

Full-time/part-time employee split. While most companies provided the total number of full-time employees, only 16% of the companies surveyed included a quantitative breakdown of the number of full-time versus part-time employees, compared to the same percentage in the previous year and up slightly from 14% in 2021. Similarly, 67% of companies provided statistics on the number of seasonal employees and/or independent contractors or a breakdown of employees by business segment, job function, or geographical location, up from 65% in 2022 and 61% in 2021.
Unionized employee relations. Of the companies surveyed, 37% stated that some portion of their workforce was part of a union, works council, or similar collective bargaining agreement, compared to 38% the previous year and 33% in 2021.[5] These disclosures generally included a statement providing the company’s opinion on the quality of labor relations, and in many cases, disclosed the number of unionized employees.
Quantitative workforce turnover rates. Although a majority of companies discussed employee turnover and the related topics of talent attraction and retention in a qualitative way (as discussed in Section II.B. below), only 20% of companies surveyed provided specific employee turnover rates (whether voluntary or involuntary), compared to the same percentage in the previous year and 17% in 2021.

B. Diversity

Among S&P 100 companies, 97% included disclosures relating to diversity in one or more of the following categories:

Diversity and inclusion. This was the most common type of disclosure, with 96% of companies including a qualitative discussion regarding the company’s commitment to diversity, equity, and inclusion (“DEI”), compared to the same percentage the previous year and up from 90% in 2021. The depth of these disclosures varied, ranging from generic statements expressing the company’s support of diversity in the workforce to detailed examples of actions taken to recruit and support underrepresented groups and increase the diversity of the company’s workforce.
Priorities within diversity. Companies disclosed different areas of focus for diversity efforts and programming within the organization. The most common disclosure was diversity in the retention or development of the company’s current workforce (45% of companies surveyed in 2023, compared to 45% in 2022 and 41% in 2021), followed by diversity in the company’s hiring practices (42% in 2023, compared to 42% in 2022 and 35% in 2021), followed by diversity in the company’s promotion practices (24% in 2023, compared to 26% in 2022 and 23% in 2021), and then diversity in the company’s suppliers (11% in 2023, compared to 10% in 2022 and 9% in 2021).
Quantitative diversity statistics. Many companies also included a quantitative breakdown of the gender or racial representation of the company’s workforce: 65% included statistics on gender and 60% included statistics on race or ethnicity (compared to 60% and 57% in 2022, respectively, and 48% and 43% in 2021, respectively). Companies provided gender statistics on both a global and U.S. basis, whereas nearly all companies provided race or ethnicity statistics for their U.S. workforce only. Most companies provided these statistics in relation to their workforce generally, regardless of position; however, an increased subset (40% in 2023, compared to 37% in 2022 and 26% in 2021) included separate statistics for different classes of employees (g., managerial, vice president and above, etc.). Similarly, 10% of companies also provided separate statistics for their boards of directors (compared to 10% in 2022 and 4% in 2021). Some companies also included numerical goals for gender or racial representation, either in terms of overall representation, promotions, or hiring; 19% of companies included these diversity goals or targets (compared to 23% in 2022 and 18% in 2021).

C. Recruiting, Training, Succession

Among S&P 100 companies, 98% included disclosures relating to talent and succession planning in one or more of the following categories:

Talent attraction and retention. These disclosures were generally qualitative and focused on efforts to recruit and retain qualified individuals. While providing general statements regarding recruiting and retaining talent were common, with 94% of companies including this type of disclosure (compared to 90% in 2022 and 65% in 2021), quantitative measures of retention, like workforce turnover rate, were uncommon, with only 20% of companies disclosing such statistics (as noted above).
Talent development. Disclosures related to talent development were tied with talent attraction and retention as the most common category, with 96% of companies including a qualitative discussion regarding employee training, learning, and development opportunities, up from 93% the previous year and 82% in 2021. This disclosure tended to focus on the workforce as a whole rather than specifically on senior management. Companies generally discussed training programs such as in-person and online courses, leadership development programs, mentoring opportunities, tuition assistance, and conferences, and a minority also disclosed the number of hours employees spent on learning and development. Some companies discussed quantitative figures related to talent development, such as dollars or hours spent on training, with 14% of companies including this type of disclosure (compared to 11% in both 2022 and 2021).
Succession planning. Only 21% of companies surveyed addressed their succession planning efforts (compared to 19% in 2022 and 18% in 2021), which may be a function of succession being a focus area primarily for executives rather than the human capital resources of a company more broadly.

D. Employee Compensation[6]

Among S&P 100 companies, 88% included disclosures relating to employee compensation, up from 86% the previous year and 74% in 2021. All of those companies included a qualitative description of the compensation and/or benefits program offered to employees. Of the companies surveyed, 42% addressed pay equity practices or assessments (up from 41% in 2022 and 31% in 2021), and substantially fewer companies included quantitative measures of the pay gap between racially or ethnically diverse and nondiverse employees or male and female employees (17% of companies surveyed in 2023, 14% in 2022 and 12% in 2021) or quantitative measures such as a minimum wage or investment in benefits (17% of companies surveyed in 2023, 14% in 2022, and 14% in 2021).

E. Health and Safety

Among S&P 100 companies, 76% included disclosures relating to health and safety in one or both of the following categories:

Workplace health and safety. Of the companies surveyed, 61% included qualitative disclosures relating to workplace health and safety, down from 64% in the previous year but up from 51% in 2021, typically consisting of statements about the company’s commitment to safety in the workplace generally and compliance with applicable regulatory and legal requirements. However, 8% of companies surveyed provided quantitative disclosures in this category (up from 7% in 2022 and 6% in 2021), generally focusing on historical and/or target incident or safety rates or investments in safety programs. These quantitative disclosures tended to be more prevalent among industrial, energy, and manufacturing companies. While many companies continued to provide disclosures on safety initiatives undertaken in connection with COVID-19, the decrease in safety disclosures in 2022 is largely due to the substantial decline in COVID-19 disclosures generally, which is discussed separately below.
Employee mental health. In connection with disclosures about standard benefits provided to employees, or additional benefits provided as a result of the pandemic, 50% of companies disclosed initiatives taken to support employees’ mental or emotional health and wellbeing, up from 46% the prior year and 36% in 2021.

F. Culture and Engagement

In addition to the many instances where companies mentioned a general commitment to culture and values, 70% of S&P 100 companies discussed specific initiatives they were taking related to culture and engagement in one or more of the following categories:

Culture and engagement initiatives. Of the companies surveyed, 26% included specific disclosures relating to practices and initiatives undertaken to build and maintain their culture and values, up from 22% in the previous year and 15% in 2021. These companies most commonly discussed efforts to communicate with employees (g., through town halls, CEO outreach, trainings, or conferences and presentations) and to recognize employee contributions (e.g., awards programs and individualized feedback). Many companies also discussed culture in the context of diversity-related initiatives to help foster an inclusive culture.
Community investment. Some companies disclose information about community investment, donations, or volunteer programs sponsored by the company, with 10% of companies surveyed providing such disclosure in 2023, compared to 9% in 2022 and 7% in 2021.
Monitoring culture. Disclosures about the ways that companies monitor culture and employee engagement were much more common, with 64% of companies providing such disclosure, up from 60% the previous year and 52% in 2021. Companies generally disclosed the frequency of employee surveys used to track employee engagement and satisfaction, with some reporting on the results of these surveys, sometimes measured against prior year results or industry benchmarks.

G. COVID-19

The number of S&P 100 companies that included information regarding COVID-19 and its impact on company policies and procedures or on employees generally declined sharply, with 34% of companies making such disclosure, compared to 69% in 2022 and 67% in 2021. COVID-19-related topics addressed ranged from work-from-home arrangements and safety protocols taken for employees who worked in person to additional benefits and compensation paid to employees as a result of the pandemic and contributions made to organizations supporting those affected by the pandemic. This sharp decline in COVID-19 disclosures is consistent with a more general trend of companies discussing COVID-19 less frequently as a result of its decreasing significance and illustrates the expected evolution of disclosure resulting from a principles-based framework.

H. Human Capital Management Governance and Organizational Practices

Over half of S&P 100 companies (51% of those surveyed, compared to 56% in 2022 and 40% in 2021) addressed their governance and organizational practices (such as oversight by the board of directors or a committee and the organization of the human resources function).

III. Industry Trends

One of the main rationales underlying the adoption of principles-based—rather than prescriptive—requirements for human capital disclosures is that the relative significance of various human capital measures and objectives varies by industry. This is reflected in the following industry trends that we observed:[7]

Technology Industries (E-Commerce, Internet Media & Services, Hardware, Software & IT Services, and Semiconductors). For the 21 companies in the Technology Industries, at least 85% discussed each of talent development and training opportunities, talent attraction, recruitment and retention, employee compensation, and diversity. Compared to the S&P 100 as a whole, relatively uncommon disclosures among this group included part-time and full-time employee statistics (5%), succession planning (10%), COVID-19 (24%), supplier diversity (5%), and unionized employee relations (19%). However, these industries saw increased rates of disclosure compared to the S&P 100 for quantitative turnover rates (43%) and qualitative pay equity (57%).
Finance Industries (Asset Management & Custody Activities, Consumer Finance, Commercial Banks, and Investment Banking & Brokerage). For the 13 companies in the Finance Industries, a large majority included quantitative diversity statistics regarding race (85%) and gender (92%) and qualitative disclosures regarding employee compensation (92%), and, compared to other industries, a relatively higher number discussed pay equity (62%) and quantified their pay gap (38%). Relatively uncommon disclosures among this group included part-time and full-time employee statistics, unionized employee relations, quantitative workforce turnover rates, and succession planning (in each case less than 16%).
Energy Industries (Oil & Gas Exploration & Production and Electric Utilities & Power). For the seven companies in the Energy Industries, a large majority included quantitative diversity statistics regarding race (71%) and gender (86%), qualitative disclosures regarding employee compensation (86%), and governance and organizational practices (71%), and, compared to other industries, a relatively higher number discussed unionized employee relations (57%) and quantified their workforce turnover rates (57%). Relatively uncommon disclosures among this group included part-time and full-time employee statistics, diversity in promotion, diversity targets or goals, culture initiatives, quantitative employee compensation statistics, pay equity, and quantitative pay gap (in each case less than 15%).

IV. Disclosure Format

The format of human capital disclosures in S&P 100 companies’ annual reports on Form 10‑K continued to vary greatly.

Word Count. The length of the disclosures ranged from 106 to 2,094 words, with the following statistical trends in the past three years:

	2023	2022	2021
Minimum word count	106	109	105
Maximum word count	2,094	1,995	1,931
Median	1,025	949	818
Mean	987	964	828

Metrics. The disclosure requirement specifically asks for a description of “any human capital measures or objectives that the registrant focuses on in managing the business” (emphasis added). Our survey revealed that companies are increasingly providing quantitative metrics, with 85% of companies providing disclosure in at least one of the quantitative categories we discuss above (up from 82% in 2022 and 68% in 2021) and only 5% electing not to include any type of quantitative metrics beyond headcount numbers (down from 8% in 2022 and 12% in 2021). The group of companies that identify important objectives they focus on but omit quantitative measures related to those objectives has been shrinking as more companies choose to include metrics. For example, 96% of companies discussed their commitment to diversity, equity, and inclusion (compared to 96% in 2022 and 89% in 2021), and 65% and 61% of companies disclosed quantitative metrics regarding gender and racial diversity, respectively (compared to 60% and 58%, respectively, in 2022 and 47% and 43%, respectively, in 2021).

Graphics. Although the minority practice, 27% of companies surveyed also included tables, charts, graphics or similar formatting used to draw attention to particular elements, up from 24% the previous year and 21% in 2021, which were generally used to present statistical data, such as diversity statistics or breakdowns of the number of employees by geographic location.

Categories. Most companies organized their disclosures by categories similar to those discussed above and included headings to define the types of disclosures presented.

V. Upcoming Rulemaking and Investor Advisory Committee Recommendations

At its meeting on September 21, 2023, the Commission’s Investor Advisory Committee (“IAC”) approved subcommittee recommendations (the “IAC Recommendations”) to expand required human capital management disclosures.[8] The Commission must now decide whether to incorporate the IAC Recommendations into its anticipated human capital management rule proposal, which according to the most recent Regulatory Flexibility agenda, which is admittedly aspirational, was expected to be issued in October.[9]

The IAC Recommendations contain prescriptive disclosure requirements—many of which have been previously considered as part of the 2020 rulemaking—for various quantitative metrics in the business description of Form 10-K under Item 101(c) of Regulation S-K as well as narrative disclosure in Management Discussion and Analysis. The recommended changes to Item 101(c) would require disclosure of the following metrics:

Headcount Metrics. Companies would be required to disclose “[t]he number of people employed by the issuer, broken down by whether those people are full-time, part-time, or contingent workers.” This disclosure would include “reporting on all similarly situated persons whose work contributes to a material level of revenue or income.”
Turnover Metrics. Companies would be required to disclose “turnover or comparable workforce stability metrics.” The IAC Recommendations do not address whether the calculation of turnover would be determined by the SEC or by companies individually.
Components of Compensation. The IAC Recommendations also require disclosure of “[t]he total cost of the issuer’s workforce, broken down into major components of compensation.” This would require companies to break out each component of labor costs (g., salary, equity, etc.), rather than aggregating labor costs with other line-item expenses, such as cost of goods sold or selling, general, and administrative costs, on the companies’ income statements.
Demographic Data. Companies would also be required to disclose “[w]orkforce demographic data sufficient to allow investors to understand the company’s efforts to access and develop new sources of talent, and to evaluate the effectiveness of these efforts.” This disclosure would include “diversity across gender, race/ethnicity, age, disability, and/or other categories viewed as important to investors and relevant to the business” and “diversity at senior levels.” The IAC Recommendations includes a brief reference in a footnote that any new rules could provide a “limited exception for disclosure of workforce composition outside the United States to consider laws and regulations in non-U.S. jurisdictions” without providing any additional guidance.

The recommended narrative disclosure in MD&A would discuss how the company’s “labor practices, compensation incentives, and staffing fit within the broader firm strategy. Such a discussion would address what portion of labor costs management views as an investment and why, including how labor is allocated across areas designed to promote firm growth (e.g., R&D) and those necessary to maintain current operations rather than increase sales revenue (e.g., compliance).”

While one of the key criticisms of the current rule appears to be lack of standardized disclosure that would allow for greater comparability among companies, it is not clear that human capital disclosures that are material to each company can be truly standardized given the different industries, sizes, geographic reach, and other qualities of public companies. As shown by the data discussed above, in response to the 2020 principles-based rules, public companies are providing more robust human capital disclosures in their SEC filings and are continuing to evolve these disclosures with each filing.

VI. Comment Letter Correspondence

Comment letter correspondence from the staff of the Division of Corporation Finance (the “Staff”), which often helps put a finer point on principles-based disclosure requirements like this one, has shed relatively little light on how the Staff believes the new requirements should be interpreted. Consistent with what we found at this time last year and the year before, the comment letters, all of which involved reviews of registration statements, were generally issued to companies whose disclosures about employees were limited to the bare-bones items companies have discussed historically, such as the number of persons employed and the quality of employee relations. From these companies, the Staff simply sought a more detailed discussion of the company’s human capital resources, including any human capital measures or objectives upon which the company focuses in managing its business. There were also a few comment letters where the Staff asked companies to clarify statements in their human capital disclosures. Based on our review of the responses to those comment letters, we have not seen a company take the position that a discussion of human capital resources was immaterial and therefore unnecessary.

VII. Implications of Recent U.S. Supreme Court Decisions

On June 29, 2023, the United States Supreme Court released its opinion in Students for Fair Admissions v. Harvard, in which the Court held that Harvard’s and the University of North Carolina’s use of race in their admissions policies was unlawful. Although the Supreme Court’s holding addressed only college and university admissions and not private-sector employers, the increased scrutiny on affirmative action programs in the workplace in the wake of SFFA has heightened the risk that employers with robust DEI initiatives may face litigation from employees, potential contracting partners, advocacy groups, and government agencies. Since the SFFA opinion was released, advocacy groups have sent dozens of letters to companies claiming that their DEI programs violate federal antidiscrimination law, including Title VII (discrimination in employment) and Section 1981 (discrimination in contracting), and arguing that the legal risk associated with DEI programs threatens stockholders’ value, and a number of lawsuits have been filed. Many companies are carefully reviewing their DEI programs and related public disclosures in light of these risks. For more information on the latest DEI developments, please see our DEI Task Force newsletter here.

VIII. Conclusion

Based on our survey, companies continue to be thoughtful about their human capital disclosures—expanding their disclosures in some areas (e.g., quantitative diversity statistics on gender) and reducing them in others (e.g., COVID-19)—in response to ever-changing circumstances. That is precisely what principles-based disclosure rules are designed to elicit.

To that end, as companies prepare for the upcoming Form 10-K reporting season, they should consider the following:

Confirming (or reconfirming) that the company’s disclosure controls and procedures support the statements made in human capital disclosures and that the human capital disclosures included in the Form 10-K remain appropriate and relevant. In this regard, companies may want to compare their own disclosures against what their industry peers did these past three years, including specifically any notable additional disclosures made in the past year.
Reviewing disclosures in light of the IAC Recommendations to assess whether any of the human capital measures or objectives may be material to the company.
Setting expectations internally that these disclosures likely will evolve. As shown by the measurable increase in disclosure in the third year of reporting, companies should expect to develop their disclosure over the course of the next couple of annual reports in response to peer practices, regulatory changes, and investor expectations, as appropriate. The types of disclosures that are material to each company may also change in response to current events, as was shown by the sharp decrease in COVID-19 related disclosures this past year.
Addressing in the upcoming disclosure, if not already disclosed, the progress that management has made with respect to any significant objectives it has set regarding its human capital resources as investors are likely to focus on year-over-year changes and the company’s performance versus stated goals.
Addressing significant areas of focus highlighted in engagement meetings with investors and other stakeholders. In a 2021 survey, 64% of institutional investors surveyed cited human capital management as a key issue when engaging with boards (second only to climate change at 85%).^{^[10]}
Revalidating the methodology for calculating quantitative metrics and assessing consistency with the prior year. Former Chairman Clayton commented that he would expect companies to “maintain metric definitions constant from period to period or to disclose prominently any changes to the metrics.”

_________________

[1] Data provided is as of November 3, 2023. The categorization data necessarily involves subjective assessment and should be considered approximate.

[2] See 17 C.F.R. § 229.101(c)(2)(ii).

[3] Agency Rule List – Spring 2023 Securities and Exchange Commission, Office of Information and Regulatory Affairs (2023), available here.

[4] Note that companies often include additional human capital management-related disclosures in their ESG/sustainability/social responsibility reports, on their websites, and in their proxy statements, but these disclosures are outside the scope of the survey, which is focused on disclosures included in Part I, Item 1 of annual reports on Form 10-K.

[5] While never expressly required by Regulation S-K, as a result of disclosure review comments issued by the Division of Corporation Finance over the years and a decades-old and since-deleted requirement in Form 1-A, it has been a relatively common practice to discuss collective bargaining and employee relations in the Form 10-K or in an IPO Form S-1, particularly since the threat of a workforce strike could be material.

[6] Our survey reviewed the employee compensation disclosures contained in Part I, Item 1 of each company’s Form 10-K and did not separately review any employee compensation information included in companies’ financial statements or the notes thereto.

[7] For purposes of our survey, we grouped companies in similar industries based on both their four-digit Standard Industrial Classification code and their designated industry within the Sustainable Industry Classification System. The industry groups discussed in this section cover 41% of the companies included in our survey.

[8] Available at https://www.sec.gov/files/spotlight/iac/20230921-recommendation-regarding-hcm.pdf.

[9] Agency Rule List – Spring 2023 Securities and Exchange Commission, Office of Information and Regulatory Affairs (2023), available here.

[10] See Morrow Sodali 2021 Institutional Investor Survey, available at https://morrowsodali.com/insights/institutional-investor-survey-2021.

The following Gibson Dunn attorneys assisted in preparing this update: Elizabeth Ising, Mike Titera, Julia Lapitskaya, Lauren Firestone, Zoë Klein, and Meghan Sherley.

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

Securities Regulation and Corporate Governance:
Elizabeth Ising – Co-Chair, Washington, D.C. (+1 202.955.8287, [email protected])
James J. Moloney – Co-Chair, Orange County (+1 949.451.4343, [email protected])
Lori Zyskowski – Co-Chair, New York (+1 212.351.2309, [email protected])
Brian J. Lane – Washington, D.C. (+1 202.887.3646, [email protected])
Ronald O. Mueller – Washington, D.C. (+1 202.955.8671, [email protected])
Thomas J. Kim – Washington, D.C. (+1 202.887.3550, [email protected])
Michael A. Titera – Orange County (+1 949.451.4365, [email protected])
Aaron Briggs – San Francisco (+1 415.393.8297, [email protected])
Julia Lapitskaya – New York (+1 212.351.2354, [email protected])

Labor and Employment:
Jason C. Schwartz – Co-Chair, Washington, D.C. (+1 202.955.8242, [email protected])
Katherine V.A. Smith – Co-Chair, Los Angeles (+1 213.229.7107, [email protected])

An Expert Analysis of National Security Deference Given in the US and EU Foreign Direct Investment Regimes

Gibson, Dunn & Crutcher LLP is pleased to announce with Global Legal Group the release of the International Comparative Legal Guide – Foreign Direct Investment Regimes 2024. Gibson Dunn partners Stephenie Gosnell Handler and Robert Spano were contributing editors to the publication, which covers issues including foreign investment policy, law and scope of application, jurisdiction and procedure and substantive assessment. The Guide, comprised of 30 jurisdictions, is live and FREE to access HERE.

Ms. Handler, Mr. Spano, and associates Sonja Ruttmann, Alexa Romanelli, and Hugh Danilack co-authored the Expert Analysis Chapter, “National Security Deference Given in the US and EU Foreign Direct Investment Regimes.”

Please view this informative and comprehensive chapter via the links below:

CLICK HERE to view “National Security Deference Given in the US and EU Foreign Direct Investment Regimes.”

CLICK HERE to view, download or print a PDF version.

The following Gibson Dunn lawyers assisted in preparing this publication: Stephenie Gosnell Handler, Robert Spano, Sonja Ruttmann, Alexa Romanelli, Hugh Danilack, and Mason Gauch.

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

Stephenie Gosnell Handler – Washington, D.C. (+1 202.955.8510, [email protected])

Robert Spano – London/Paris (+44 20 7071 4902, [email protected])

Sonja Ruttmann – Munich (+49 89 189 33 150, [email protected])

Alexa Romanelli – London (+44 20 7071 4269, [email protected])

Hugh N. Danilack – Washington, D.C. (+1 202.777.9536, [email protected])

Mason Gauch – Houston (+1 346.718.6723, [email protected])

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

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

Factual Background

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

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

The Second Circuit’s Decision

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

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

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

Implications of Govil

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

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

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

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

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

[4] 140 S.Ct. at 1940.

[5] 2023 WL 7137291, at *9.

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

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

[8] Id. at *11.

[9] Id.

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

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

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

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

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

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

Key Developments:

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

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

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

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

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

Media Coverage and Commentary:

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

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

Current Litigation:

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

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

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

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

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

3. Board of Director or Stockholder Actions:

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

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

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

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

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

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

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

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

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

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

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

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

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

Applicability of U.S. State Privacy Laws

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

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

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

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

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

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

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

Applicability of Sector-Specific Privacy and Cybersecurity Laws

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

Outdated Privacy Notices or No Privacy Notice

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

Storage of Sensitive Personal Information

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

Cybersecurity Protocols, Policies and Procedures, and Insurance

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

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

AI Solutions

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

Security Incidents, Reports, Investigations, or Litigations

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

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

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

Integrating the Diligence

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

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

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

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

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

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

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

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

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

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

Background

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

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

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

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

CFA’s Decision

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

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

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

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

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

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

Comment

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

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

____________________________

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

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

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

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

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

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

New York partner Eric Sloan and associate James Jennings are the authors of “Disproportionate S Corporation Rollovers: Lindsey Buckingham Was Right” [PDF] published by Tax Notes Federal on November 13, 2023.

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

I. INTERNATIONAL

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Institutional Shareholder Services announces results of annual global benchmark policy survey

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

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

II. UNITED KINGDOM

UK Energy Act 2023: Landmark legislation becomes law

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

III. EUROPE

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

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

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

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

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

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

The key aspects of this new standard are:

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

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

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

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

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

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

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

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

IV. UNITED STATES

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

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

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

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

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

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

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

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

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

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

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

V. APAC

Australian Accounting Standards Board publishes draft sustainability reporting standards

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

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

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

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

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

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

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

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

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

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

Warmest regards,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Risk management considerations

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

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

Considerations for intermediaries engaging in Tokenised Securities-related activities

In general, the SFC has noted that:

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

Issuance of Tokenised Securities

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

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

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

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

Disclosure obligations

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

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

III. Other clarifications regarding Tokenised Securities

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

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

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

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

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

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

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

V. Conclusion

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

____________________________

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Background

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

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

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

Analysis

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

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

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

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

Key Takeaways

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

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

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

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

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

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

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

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

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

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

Covered Entities Subject to the Reporting Requirements

Chart Footnotes

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

Reporting Requirements

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

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

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

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

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

Consequences of Non-Compliance

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

Uncertainties and Timeline

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

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

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

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

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

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

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

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

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

Enforcement Actions

United States

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

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

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

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

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

US Targets Hamas, Warns Against Crypto Funding Following Israel Attack

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

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

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

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

PayPal Receives SEC Subpoena Regarding Stablecoin

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

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

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

CFPB Investigating Crypto Platform Hacks

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

SafeMoon Executives Arrested And Charged By DOJ And SEC

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

International

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

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

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

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

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

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

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

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

London Metropolitan Police Establishes Specialized Unit For Crypto Investigations

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

UK Financial Conduct Authority Imposes Restrictions On Rebuildingsociety.com Ltd

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

Regulation and Legislation

United States

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

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

IRS Extends Broker Reporting Crypto Tax Rule Comment Period

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

Expectations Mount That SEC Will Soon Approve Bitcoin ETFs

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

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

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

California Governor Signs Crypto Licensing Bill

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

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

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

NYDFS Announces Proposed Updates To Guidance On Listing Of Virtual Currencies

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

International

UK Publishes Report Clarifying Regulatory Approach For Crypto Ecosystem

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

UK Lawmakers Pass Bill To Aid Seizure Of Illicit Cryptocurrency

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

UK Financial Conduct Authority (FCA) Warns Crypto Promoting Firms

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

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

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

Australian Treasury Proposes To Regulate Crypto Exchanges

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

Civil Litigation

United States

SEC Declines To Appeal Grayscale Ruling

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

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

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

Speaker’s Corner

United States

SEC Commissioner Hester Peirce Issues Statement Of Dissent On LBRY

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

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

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

International

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

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

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

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

Other Notable News

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

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

Bitcoin Gains Recognition In Shanghai As A United Digital Currency

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

The following Gibson Dunn lawyers prepared this client alert: Ashlie Beringer, Stephanie Brooker, Jason Cabral, M. Kendall Day, Jeffrey Steiner, Sara Weed, Ella Capone, Grace Chong, Chris Jones, Jay Minga, Nick Harper, Raquel Sghiatti, Peter Moon, Emma Li*, Elizabeth Walsh*, Vannalee Cayabyab and Yoo Jung Hah*

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

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

FinTech and Digital Assets Group:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Federal Circuit News

Noteworthy Petitions for a Writ of Certiorari:

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

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

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

Other Federal Circuit News:

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

Upcoming Oral Argument Calendar

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

Key Case Summaries (October 2023)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Munich partner Markus Rieder, Frankfurt of counsel Alexander Horn and Frankfurt associate Annekathrin Schmoll are the authors of “9 Hallmarks Of The New German Class Action Regime” [PDF] published by Law360 on November 6, 2023.