On June 14, 2023, the IRS and Treasury issued proposed Treasury regulations (the “Proposed Regulations”) that provide eagerly awaited guidance on the rules for selling certain tax credits pursuant to a new regime introduced in the Inflation Reduction Act of 2022 (the “IRA”).[1]  Taxpayers are permitted to rely on the Proposed Regulations until final regulations are published.  In a separate regulatory package issued on the same date, the IRS and Treasury released a Temporary regulation (the “Temporary Regulation”) that implements a registration system (discussed below) with the IRS that parties will need to satisfy before any valid sale of credits; the Temporary Regulations will be effective as of June 21, 2023.[2]

On the same day, the IRS and Treasury also issued proposed and temporary Treasury regulations addressing rules under the IRA that make certain credits refundable under certain circumstances (so-called “direct pay”).  We will address the proposed and temporary “direct pay” regulations in a subsequent alert.

The Proposed Regulations and Temporary Regulation are detailed, and a comprehensive discussion of them is beyond the scope of this alert.  Instead, this alert begins with some background regarding section 6418[3] (the statutory provision permitting credit transfers), provides a short summary of some of the most important aspects of the Proposed Regulations and Temporary Regulation, and concludes with some observations regarding key implications of the guidance for market participants.  The IRS and Treasury received hundreds of taxpayer requests for guidance on these issues, and the regulatory package is commendable for its breadth.  As discussed below, some aspects of the guidance are very taxpayer-friendly, including clear guidance that a transferee who acquires a credit at a discount will not be subject to tax based upon that discount. By contrast, there are other aspects that are less taxpayer-friendly, such as a burdensome requirement that each individual energy property must be pre-registered with the IRS on an annual basis in order to transfer credits.  We expect market participants will push for adjustments to these less taxpayer-friendly aspects of the Proposed Regulations before they are finalized.

Background

Historically, federal income tax credits associated with the investment in and production of clean energy and carbon capture technologies have been non-refundable,[4] and using non-refundable tax credits has required tax liability against which the credits could be applied.  Because developers of clean energy (e.g., wind, solar) and carbon capture projects often earn credits in excess of their tax liability, these developers frequently enter into complex arrangements with third-party investors that have consistent and significant federal income tax liabilities (referred to as tax equity investors), such as banks, to shift entitlement to the project’s tax attributes (typically, credits and accelerated tax depreciation) to the tax equity investor.  These arrangements require significant and costly structuring.  Section 6418 is expected to reduce the need for complicated tax equity arrangements because it authorizes a number of eligible credits[5] to be simply sold by an eligible taxpayer to an unrelated third-party for cash.[6]

 Transferring a Credit

The Proposed Regulations provide substantial practical guidance on transferability, clarifying who is eligible to transfer, who is effectively able to purchase, what can be transferred, what can be paid for a transfer, how the transfer is treated for income tax purposes by the transferor and transferee, how (administratively) to transfer the credits, which taxpayer is subject to recapture, how excessive credit transfer penalties can be avoided, and how these rules apply to passthrough entities that are transferors or transferees.  The subsections below describe some of the most significant aspects of the guidance on these topics.

Who May Transfer Credits

Only “eligible taxpayers” are authorized to transfer eligible tax credits.  The IRA broadly defines “eligible taxpayers” to include most U.S. taxpayers,[7] including passthrough entities, but excludes certain “applicable entities” for which the IRA makes credits refundable.[8]  The Proposed Regulations confirm that, where a disregarded entity owns the property that generates the tax credit, the “eligible taxpayer” is the regarded owner of the disregarded entity.  The Proposed Regulations also impose a strict ownership requirement on transferors that denies transferability in the case of, for example, contractual counterparties who otherwise are allowed the credits under special rules such as section 45Q(f)(3)(B) (election to allow the section 45Q credit to the party that disposes, utilizes, or uses the qualified carbon oxide) or section 50(d)(5) (election to allow lessees to claim the investment tax credit, i.e., inverted leases).

Further, a credit may be transferred only once.  The preamble clarifies that any arrangement in which the ownership of an eligible credit transfers first from an eligible taxpayer to a dealer or intermediary and then to a transferee taxpayer would violate the single transfer limitation.[9]  However, an arrangement using a broker to match eligible taxpayers and transferee taxpayers should not violate this limitation, assuming the arrangement at no time transfers the ownership of the eligible credit to the broker or any taxpayer other than the transferee taxpayer.

Who May Purchase Credits

Taxable C corporations seem likely to make up most of the buy-side market for transferrable credits.[10] The Proposed Regulations will effectively prevent most individuals, trusts, and estates from purchasing credits because the Proposed Regulations provide that, for purposes of the passive activity credit rules (section 469), the transferee taxpayer will be considered to earn eligible credits through the conduct of a trade or business related to the eligible credit but will not materially participate in that trade or business.[11]  As a result, individuals would be required to treat the credits as passive activity credits, which (other than in certain limited circumstances) cannot offset tax liabilities attributable to wage income or portfolio income.

What Can be Transferred

As previously noted, the credits that may be transferred include those credits enumerated in section 6418, and the Proposed Regulations make clear that part or all of the credit that otherwise would be available to the transferor (including any “bonus” adder) may be transferred to one or more buyers.  Circumscribing this flexible rule, however, is a “vertical slice” restriction, which provides that a taxpayer has to transfer an undivided portion (including all bonus amounts) of the credit generated with respect to a particular energy property (e.g., 1 percent of the total credit).

In addition, the Proposed Regulations make clear that the credit transferred is determined on an energy-property-by-energy-property basis, meaning taxpayers can choose to transfer credits with respect to one property but not with respect to another property, even if that other property is of the same class (or, apparently, even if the properties are part of the same project).[12]

What Can be Paid for a Credit

Section 6418 states that any amounts paid by a transferee taxpayer in connection with the transfer of an eligible credit must be paid in cash.  The Proposed Regulations define “cash” and clarify when a payment needs to be made.  A “cash” payment is one made in United States dollars by cash, check, cashier’s check, money order, wire transfer, automated clearing house (ACH) transfer, or other bank transfer of immediately available funds.  Prepayments had raised several issues (e.g., that time value was invalid consideration for the credits), and the Proposed Regulations include a rule that blesses any payment made within the period beginning on the first day of the taxable year during which the credit is determined and ending on the due date (including extensions) for the transferor’s tax return for that year.[13]  Moreover, a transferee is permitted to make a contractual commitment to purchase eligible credits in advance of the date the credit is transferred to such transferee taxpayer, as long as all payments comply with the timing rules described in the preceding sentence. If any consideration provided by a transferor to a transferee does not satisfy these requirements, the entire payment fails the test, and the credit transfer fails and is invalid for federal income tax purposes.

How the Transferor is Treated for Income Tax Purposes

Section 6418 provides that payments received by a transferor in exchange for a transfer of eligible credits is not included in the transferor’s gross income, as long as those amounts are received “in connection with” a transfer election.  The Proposed Regulations clarify that an amount paid is “in connection” with a transfer election of an eligible credit (or portion thereof) if: (i) it is paid in cash, (ii) it directly relates to the specified credit portion (discussed below), and (iii) is not related to an excessive credit transfer. Thus, under the Proposed Regulations, it is clear that if a transfer election is ineffective for some reason, or if the actual amount of the credit is less than anticipated, the excess cash paid does not qualify for the gross income exclusion.

How the Transferee is Treated for Income Tax Purposes

Payments made by a transferee “in connection with” a transfer election (under the rules discussed above) are not deductible by the transferee taxpayer.  In addition, the Proposed Regulations clarify that the transferee does not recognize gross income if it buys an eligible credit at a discount.  The Proposed Regulations make specific note of not yet addressing the income tax treatment of transaction costs (for the transferor or the transferee), or the deductibility of losses incurred by a transferee who ultimately (i.e., after an audit) is determined to have overpaid for a credit, but the Treasury and the IRS note that they are currently developing rules on these general issues and are seeking taxpayer comments.

From a timing standpoint, the transferee takes the transferred credit into account in the first taxable year of the transferee ending with, or after, the taxable year of the transferor in which the credit was generated.  If the taxable years of a transferor and transferee end on the same date, the transferee will take the eligible credit into account in that taxable year.  If, however, their taxable years end on different dates, the transferee will take the eligible credit into account in the transferee’s first taxable year that ends after the taxable year of the transferor in which the credit was determined.  Importantly, under the Proposed Regulations, a transferee may take into account a credit that it has purchased, or intends to purchase, when calculating its estimated tax payments.

How (Administratively) to Transfer Credits

The Temporary Regulation prescribes several detailed requirements that must be complied with in order to file an election to transfer credits.  In addition to prescribing the information that transferors and transferees must include on their tax returns in order to make the transfer election,[14] there are several other significant administrative requirements under the Temporary Regulation.

Pre-Filing Registration Process. Would-be transferors must complete a pre-filing registration process and obtain a registration number for each eligible credit property with respect to which a transfer election is expected to be made.  A substantial amount of information is required to be submitted to obtain a registration number, and a registration number must be obtained for each energy property.  An eligible taxpayer who does not obtain a registration number and report the registration number on its return with respect to an eligible credit property is ineligible to make a transfer election.  This registration number is valid only for the taxable year in which the credit is determined for the eligible credit property for which the registration is completed, and, in the case of transferees, for a transferee’s taxable year in which the eligible credit is taken into account.[15]

Transfer Election Statement. The transferor and transferee must agree to a “transfer election statement,” which is a written document that describes the transfer of the eligible credit entered into between a transferor and transferee. The detailed statement must be completed before the transferor files the tax return for which the eligible credit is determined and before the transferee files a tax return for the year in which the eligible credit is taken into account, and is required to comply with a substantial number of requirements laid out in the Temporary Regulations.[16]

How to Avoid Excessive Credit Transfer Penalties

Under the IRA, a tax is imposed on credit transferees equal to any “excessive credit transfer” (generally, a redetermination of the initial credit amount not arising from a post-determination recapture event).  In addition, a 20-percent penalty tax will apply unless the transferee shows “reasonable cause” for the excessive credit transfer.

The Proposed Regulations state that reasonable cause will be determined based on the relevant facts and circumstances, but that generally the most important factor is the extent of the transferee’s efforts to determine that the amount of the credit to be transferred is not excessive and has not already been transferred to another taxpayer by the transferor.  These efforts may be shown by reviewing records and reasonably relying on third-party expert reports and representations by the transferor that the credit is not excessive and has not been transferred to another taxpayer.

Which Taxpayer Is Subject to Recapture

Some of the credits that are eligible to be transferred (e.g., the investment tax credit) are subject to recapture upon the occurrence of certain events.  The Proposed Regulations clarify that, in general, regular credit recapture rules apply to the transferee, even in a circumstance in which the recapture is caused solely by an action of the transferor.  An exception applies to recapture resulting from certain actions that occur at the partner or shareholder level with respect to partnership or S corporation transferors (discussed below).  The preamble makes clear that taxpayers can contract for indemnities for recapture events, without jeopardizing a transfer.

How the Rules Apply to Passthrough Entities

The Proposed Regulations provide detailed and extensive rules with respect to passthrough entities that are transferors or transferees.  Although the Proposed Regulations confirm that passthrough entities may be both transferors and transferees, they also clarify that any partner or S corporation shareholder is prohibited from further transferring any credits allocated to it by a partnership or S corporation, as applicable, that directly holds (including via a disregarded entity) the credit-generating property.  Consistent with the single transfer requirement, partners and shareholders in a transferee passthrough entity are not permitted to transfer credits that are allocated to them; importantly, however, the Proposed Regulations make clear that an allocation of credits by a transferee passthrough entity to its partners or shareholders does not constitute a transfer that runs afoul of the single transfer requirement. The Proposed Regulations contain additional rules (discussed below) designed to prevent partnerships, including tiered partnerships, from being used to avoid the single transfer requirement.

Notably, the rules clarify that certain characteristics of a transferor passthrough entity’s owners do not limit the amount of credits that a transferor passthrough entity is able to transfer.  Most importantly, passthrough entity transferors will not be limited by the application of the passive activity credit rules (which apply at the partner or shareholder level).[17]  There are, however, several exceptions to this general proposition.  First, passthrough entities are required to apply the “at-risk” rules of section 49 based on how those rules would apply to the passthrough entities’ partners or shareholders, as applicable.  Second, in the case of partnerships transferring certain credits (e.g., investment tax credits), the tax-exempt use property limitations will continue to reduce the amount of credits that can be transferred by certain partnerships with tax-exempt partners.

The Proposed Regulations provide that income received as consideration for transferred credits is treated as tax exempt and generally is allocated to each passthrough entity owner based on the amount of the underlying credit that would have been allocated to that passthrough entity owner in the absence of a transfer.  This rule applies through tiers of partnerships.  Thus, if a partnership (a lower-tier partnership) allocates tax-exempt income to a partner that is itself a partnership (an upper-tier partnership), the upper-tier partnership must allocate the tax-exempt income to its partners in the same manner that the credit would have been allocated to its partners absent the transfer election.

 With respect to transferor partnerships that transfer less than all of their transfer-eligible credits, the Proposed Regulations allow income to be allocated to those partners that wished to transfer their share of the credits so long as (1) the amount of credits allocated to any partner does not exceed the amount of credits such partner would have received if no transfer were made and (2) the amount of tax-exempt income allocated to any partner does not exceed the partner’s “proportionate share of tax-exempt income.”  A partner’s proportionate share of tax-exempt income is determined based on the amount of credits a partner would have received if the entire credit was transferred, adjusted for any credits actually allocated to the partner.   The Proposed Regulations provide an example illustrating this rule and calculating the amount of credits and tax-exempt income allocated to each partner.

On the transferee partnership side, the rules clarify that purchased credits will be treated as “extraordinary items” within the meaning of Treas. Reg. § 1.706-4(e)(2).  This treatment generally will prevent the allocation of purchased credits to partners who are not partners in a partnership on the first day that the transferee partnership makes a cash payment for the credit.[18]  Purchased credits will be allocated among a partnership’s partners in proportion to their shares of the nondeductible expenses used to fund the purchase of the credits that year.

The Proposed Regulations also provide specific recapture guidance for passthrough entities.  Under those rules, a transfer of an interest in a transferor partnership or S corporation (that, in the absence of a credit transfer, would have caused recapture of tax credits allocated to the transferring partner or shareholder, as applicable) will trigger recapture for the transferring partner or shareholder.  However, the transfer will not trigger recapture for the transferee if the transfer of the interest in the transferor partnership or S corporation did not cause the property in the hands of the transferor partnership to cease to be eligible property (e.g., depending on the terms of the transferor’s partnership agreement, the transferee may still suffer recapture on the sale by a partner of its interest in the transferor partnership if the buyer is a tax-exempt entity).[19]

Commentary

Many aspects of the Proposed Regulations are taxpayer friendly and will help facilitate credit transfer transactions, but other aspects of the guidance are less taxpayer friendly and could be adjusted to better promote Congressionally intended transfer transactions.  Numerous new rules with the potential for complete “cliff effect” disqualification of intended transfers will require great care in structuring unless those rules are modified when the Proposed Regulations are finalized.

• No Inverted Lessee Transferors. The rule allowing only the actual owner of the underlying property to transfer credits will prevent lessees in “inverted lease” structures from transferring credits. In an inverted lease structure (which dates to the 1962 origins of the investment tax credit), the lessor and the lessee elect for investment tax credit purposes to treat the lessee as having acquired the energy property for its fair market value. Market participants had been hopeful that the transferability rules would allow these lessees to transfer the investment tax credit, but the Proposed Regulations do not allow this.  That said, the IRS and Treasury’s stated rationale for denying transferability in inverted lease structures is likely to meet meaningful criticism.
• Partnership Syndications. The Proposed Regulations make clear that a partnership can be a transferee, which should make it feasible to functionally transfer the credits broadly with a single transfer election. However, the “extraordinary item” rules impose a significant limitation that will require careful consideration in structuring payments for credits.
• No Selling Bonus Credits Separately. The Proposed Regulations authorize transferors to transfer some or all of their eligible credits, authorize transfers to an unlimited number of transferees, and make it feasible to transfer on an energy-property-by-energy-property basis.  While these rules combine to provide substantial flexibility, they do not permit a transferor to transfer anything other than a vertical slice of a credit.  Many tax credits that are eligible to be transferred include both a base credit amount and various bonus adders (g., energy community bonus, domestic content bonus).  Taxpayers had requested to be able to transfer some or all of these bonus adders (which may bear more risk because of ongoing eligibility issues) separately from the base amount, but the Proposed Regulations make clear that this is not feasible.
• Cash Consideration Requirement – Some Flexibility, with Limits.
  • The Proposed Regulations make clear that the only consideration that may be paid to a transferor is cash consideration. A peppercorn of noncash consideration will invalidate the entire transfer—a huge trap for the unwary.
  • The Proposed Regulations provide some limited flexibility in terms of when payments may be made, but essentially limit payments so they are quasi-contemporaneous with the generation of the credits. The Proposed Regulations do authorize advance contractual commitments to purchase eligible credits, as long as actual payments are made in the prescribed regulatory window (which could be as long as 21-1/2 months).  This advance contractual commitment authorization will be essential to securing bridge financing and to the orderly functioning of the burgeoning brokerage market, but still will impose some potentially significant limitations on sponsors seeking to monetize a stream of tax credits (g., production tax credits under section 45) over time, likely putting the transferability rules at a further disadvantage to traditional tax equity financing (which allows for a significant up-front payment based on both anticipated depreciation and tax credits).  Additional authorization for advance commitments coupled with substantial prepayments would help close this gap between traditional tax equity and transferability.
• Tax-Free Discount Purchases. Market participants had been concerned about whether a purchase by a transferee at a discount to the face amount of the credit would result in the transferee recognizing taxable income on the difference.  The Proposed Regulations follow the position previously articulated by the Joint Committee on Taxation and make clear that this discount is not income.[20]  This rule is favorable to all stakeholders and will avoid transferees “grossing down” credit prices.      
• Burdensome Transfer Requirements. Various aspects of the transfer regime in the Proposed Regulations likely will prove administratively burdensome, making it more challenging for taxpayers to avail themselves of the rules.
  • For example, a separate transfer election must be made for each property (with a potential exception for the transfer of the investment tax credit, which may be able to be made on a project-wide basis). This requirement could be construed to require, for example, a separate election for each wind turbine comprising a wind facility.  Adding to this complexity is the fact that, for a production tax credit-eligible project, transfers must be made on a yearly basis. And where there are multiple buyers, separate transfer elections must be made for each of them.  Taken together, the specificity of these requirements could mean that a large number of elections may need to be made with respect to a single project.  We appreciate and support the government’s efforts to eliminate fraud or other duplication of credits, but we think these objectives could be achieved with rules that allow for a smaller number of transfer elections (g., allowing aggregation of all facilities in a wind farm using “single project” factors similar to those that have been used in earlier “begun construction” guidance).
  • In addition to potentially having to make numerous transfer elections with respect to a single project, the Proposed Regulations also impose a requirement for potential transferors to register the credits they intend to transfer before transferring them, prescribing a process that will require the submission of substantial information to obtain pre-registration. The rules also require that transferors and transferees agree upon a transfer election statement with detailed requirements and further prescribe a host of other tax return requirements, mandating yearly transfer elections.  These requirements will serve as a barrier for all but the most sophisticated and well-financed taxpayers, limiting the reach and benefit of the transfer rules.  In light of the fact that the rules in section 6418 were intended to eliminate the complexity and cost inherent in tax equity financing transactions, we are hopeful that the IRS and Treasury will consider ways to reduce the administrative complexity for would-be transferors in order to maximize the reach of the tax credit transfer rules.
• Recapture Risk. A number of market participants had been hopeful that recapture risk for credit transferees would be substantially limited, but the Proposed Regulations make clear that buyers generally bear recapture risk, although buyers are authorized to obtain contractual protection to reallocate this risk.  The Proposed Regulations do provide, however, that where the tax credit transferor is a partnership, transfers by the partners of interests in that partnership generally do not cause recapture to a credit transferee as long as the transfer of the partnership interest does not cause the partnership’s property to cease to be credit eligible (g., as long as transferee of the partnership interest does not cause tax-exempt use property issues).  As time goes on, the continued application of the tax-exempt use rules to transferor partnerships is likely to serve as a trap for the unwary because their application is counterintuitive (and even counter-policy) after the enactment of IRA.  That is, the tax-exempt use rules were designed to prohibit tax-exempt entities from monetizing their tax-exempt status; those rules serve an uncertain (at best) role in this IRA credit regime in which tax-exempt entities are effectively treated as taxpayers for all purposes relevant to such credits.
• Useful Allocation Rules for Transferor Partnerships. The Proposed Regulations provide taxpayer-friendly rules that will be particularly useful for sponsors wishing to transfer the credits that are allocated to them in tax equity partnerships.  Under a typical tax equity partnership, the bulk of the tax credits (usually 99 percent) are allocated to the tax equity investor until it achieves its “flip yield,” with the remaining 1 percent of the credits being allocated to the sponsor, who may not be able to use those credits.  The Proposed Regulations authorize a tax equity partnership to transfer a single partner’s share of the otherwise applicable credits and specially allocate the income from that transfer (this income is tax exempt) to that partner.  This should allow for more efficient credit monetization by sponsors, particularly given that the regulations make clear that the cash generated by a tax credit sale by a partnership can be used in whatever manner the partners decide.

Effective Date

Taxpayers may rely on these Proposed Regulations for taxable years beginning after December 31, 2022 and before the date the final regulations are published.  The Temporary Regulation (i.e., the pre-filing registration regime) is effective for any taxable year ending on or after June 21, 2023.

___________________________

[1] As was the case with the so-called Tax Cuts and Jobs Act, the Senate’s reconciliation rules prevented Senators from changing the Act’s name, and the formal name of the so-called Inflation Reduction Act is actually “An Act to provide for reconciliation pursuant to title II of S. Con. Res. 14.”

[2] The text of the Temporary Regulation was also included in the Proposed Regulations.

[3] Unless indicated otherwise, all section references are to the Internal Revenue Code of 1986, as amended (the “Code”), and all “Treas. Reg. §” or “Prop. Treas. Reg. §” references are to the Treasury regulations or proposed Treasury regulations, respectively, promulgated under the Code.

[4] The investment tax credit for energy property was briefly refundable at its inception (1978-1980) and was effectively payable as a cash grant for projects that began construction in 2009-2011.

[5] “Eligible credit” means the alternative fuel vehicle refueling property credit determined under section 30C to the extent treated as a credit listed in section 38(b), the renewable electricity production credit under section 45(a), the credit for carbon oxide sequestration under section 45Q(a), the zero-emission nuclear power production credit under section 45U(a), the clean hydrogen production credit under section 45V(a), the advanced manufacturing production credit under section 45X(a), the clean electricity production credit under section 45Y(a), the clean fuel production credit under section 45Z(a), the energy credit under section 48, the qualifying advanced energy project credit under section 48C, and the clean electricity investment credit under section 48E.  Credit carryforwards and carrybacks are not eligible credits.

[6] The terms “transferee,” “transferees,” and “transferee taxpayer” mean any taxpayer that is not related (within the meaning of sections 267(b) or 707(b)(1)) to the eligible taxpayer making the transfer election to which an eligible taxpayer transfers a specified credit portion of an eligible credit.

[7] U.S. taxpayers include those with employment or excise tax liability, not just those with income tax liability.

[8] The term “applicable entity” means (i) any tax-exempt organization exempt from the tax imposed by subtitle A (a) by reason of section 501(a) or (b) because such organization is the government of any U.S. territory or a political subdivision thereof, (ii) any State, the District of Columbia, or political subdivision thereof, (iii) the Tennessee Valley Authority, (iv) an Indian tribal government or subdivision thereof (as defined in section 30D(g)(9)), (v) any Alaska Native Corporation (as defined in section 3 of the Alaska Native Claims Settlement Act (43 U.S.C. 1602(m)), (vi) any corporation operating on a cooperative basis which is engaged in furnishing electric energy to persons in rural areas, or (vii) any agency or instrumentality of any applicable entity described in (i)(b), (ii), or (iv).  For the purposes of this client alert, the term “passthrough” or “passthrough entity” means a partnership or an S corporation, unless otherwise noted.

[9] Unless otherwise stated, all references to the “preamble” are to the preamble to the Proposed Regulations.

[10] Importantly, the new federal corporate alternative minimum tax (commonly referred to as “CAMT”), also enacted by the IRA, can be wholly offset by transferrable credits.

[11] The rule also will limit the utility of credit purchases by certain closely held personal service corporations.

[12] This approach deviates from the general class-by-class approach that applies for purposes of electing out of “bonus” depreciation under section 168(k).

[13] This rule is described in the preamble as safe harbor but operates as a requirement.

[14] Note that the transferor must make the election on its original return, including extensions (no late-election relief is available), and no transfer election may be made or revised on an amended return or on a partnership administrative adjustment request.

[15] Transferees are also required to report the registration number received from a transferor taxpayer on Form 3800 as part of the return for the taxable year with respect to which the transferee taxpayer takes the transferred specified credit portion into account.

[16] For example, an eligible taxpayer that determines eligible credits with respect to two properties would need to make a separate election with respect to each property.  For production-based credits that are available over a 10- or 12-year period, the election would need to be made each taxable year that the transferor elects to transfer credits.

[17] As discussed above, the passive activity credit rules will apply to credit transferees.

[18] If the transferee partnership and the transferor have different taxable years, the credit will be allocated only to partners in the transferee partnership as of the date that is the later of (i) the first day that the transferee partnership makes a cash payment for the credit and (ii) the first date the transferee partnership takes the credit into account under section 6418(d).

[19]   The passthrough transferor is not required to provide notice of such transfers to the transferee.

[20] Joint Committee on Taxation, Description of Energy Tax Changes Made by Public Law 117-169, JCX-5-23, 97 (April 17, 2023).

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This alert was prepared by Mike Cannon, Matt Donnelly, Emily Brooks, Alissa Fromkin Freltz*, Duncan Hamilton, and Simon Moskovitz.

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

Tax Group:
Michael Q. Cannon – Dallas (+1 214-698-3232, [email protected])
Matt Donnelly – Washington, D.C. (+1 202-887-3567, [email protected])
Kathryn A. Kelly – New York (+1 212-351-3876, [email protected])
Josiah Bethards – Dallas (+1 214-698-3354, [email protected])
Emily Risher Brooks – Dallas (+1 214-698-3104, [email protected])
Duncan Hamilton– Dallas (+1 214-698-3135, [email protected])
Simon Moskovitz – Washington, D.C. (+1 202-777-9532 , [email protected])

Power and Renewables Group:
Gerald P. Farano – Denver (+1 303-298-5732, [email protected])
Peter J. Hanlon – New York (+1 212-351-2425, [email protected])
Nicholas H. Politan, Jr. – New York (+1 212-351-2616, [email protected])

*Alissa Fromkin Freltz is an associate working in the firm’s Washington, D.C. office who currently is admitted to practice only in Illinois and New York.

© 2023 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice. Please note, prior results do not guarantee a similar outcome.

Palo Alto partner Michael Celio and associate Wesley Sze are the authors of “Navigating the choppy waters of bylaw forum-selection clauses after Seafarers” [PDF] published by the Daily Journal on June 20, 2023.

Decided June 16, 2023

United States, ex rel. Polansky v. Executive Health Resources, Inc., No. 21-1052

Today, the Supreme Court held 8-1 that the federal government may move at any time to dismiss a False Claims Act lawsuit over the objection of a relator, so long as it first intervenes in the action.

Background: The False Claims Act (FCA) allows private individuals, known as relators, to bring claims on behalf of the government against parties who have allegedly defrauded the federal government.  When a relator files a complaint based on an alleged violation of the FCA, the government has the opportunity to intervene and litigate the action itself, or it can decline to intervene and allow the relator to litigate the action on its behalf.  The statute provides that the Government “may dismiss the action”—notwithstanding the objections of the relator—if “the court has provided the [relator] with an opportunity for a hearing on the motion.”  31 U.S.C. § 3730(c)(2)(A).

Jesse Polansky brought an FCA claim against Executive Health Resources.  The government initially declined to intervene. After Polansky spent five years litigating the case, the government moved to dismiss the case, citing discovery costs, the low likelihood that the lawsuit would succeed, and concerns about Polansky’s credibility.  The district court granted the government’s motion and the Third Circuit affirmed, rejecting Polansky’s argument that the government lacks authority to seek dismissal under § 3730(c)(2)(A) after declining to intervene at the outset of the case.

Issue: Whether the government can seek dismissal of an FCA suit despite initially declining to intervene and, if so, what standard applies.

Court’s Holding:

The government may seek to dismiss an FCA lawsuit even after initially declining to intervene, as long as it intervenes before moving to dismiss.  Federal Rule of Civil Procedure 41(a)’s generally applicable standards—which permit voluntary dismissals “on terms that the court considers proper”—govern the government’s dismissal motion, but courts applying those standards should grant the government’s views substantial deference.

“[W]e hold that the Government may seek dismissal of an FCA action over a relator’s objection so long as it intervened sometime in the litigation, whether at the outset or afterward.”

Justice Kagan, writing for the Court

Gibson Dunn submitted an amicus brief on behalf of Pharmaceutical Research and Manufacturers of America in support of the winning respondent: Executive Health Resources, Inc.

What It Means:

• Today’s decision confirms what lower courts have widely held for years:  the government should be given wide latitude to dismiss an FCA suit when litigation of the suit is not in the government’s interest, including because it imposes discovery costs on federal employees and agencies that exceed any potential benefits or because it interferes with federal policy priorities.  The decision also could present additional opportunities for defendants facing abusive FCA litigation to enlist support from the government even at advanced stages of the litigation.
• The Court’s decision is consistent with the Department of Justice’s 2018 “Granston” memo, which required department lawyers to consider pursuing dismissal of cases brought by relators that are shown to be frivolous, parasitic or opportunistic, or otherwise contrary to the government’s policies and programs.  Michael D. Granston, U.S. Dep’t of Justice, Factors for Evaluating Dismissal Pursuant to 31 U.S.C. 3730(c)(2)(A) (Jan. 10, 2018).  The Department has, even after the Granston memo, exercised its authority to dismiss FCA lawsuits very sparingly, but may have more confidence to seek dismissal of FCA lawsuits now that the Court has confirmed its authority to do so at any stage.
• Justice Thomas questioned the constitutionality of the FCA’s provisions allowing private relators to bring False Claims Act actions on behalf of the federal government.  Justices Kavanaugh and Barrett, concurring in the Court’s decision, agreed with Justice Thomas’s view that there are “substantial arguments” that permitting private relators to represent the government is “inconsistent” with Article II and stated that the Court should address this “Article II issue” in a future case.  These arguments have previously failed in lower courts, but these separate opinions will draw new attention to the issue, which is of significant importance given the enormous growth of qui tam FCA litigation in recent decades.

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The Court’s opinion is available here.

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

Appellate and Constitutional Law Practice

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

False Claims Act / Qui Tam Defense & FDA and Health Care Practices

John D.W. Partridge +1 303.298.5931 [email protected]	Jonathan M. Phillips +1 202.887.3546 [email protected]	Winston Y. Chan +1 415.393.8362 [email protected]
Gustav W. Eyler +1 202.955.8610 [email protected]

The New York Court of Appeals, the highest court in New York, recently issued a decision regarding several elements of New York’s defamation law, including what plaintiffs qualify as “public figures” for purposes of determining their burden of proof for defamation claims, the applicability of New York privileges against defamation liability, and the scope of certain of the 2020 amendments to New York’s anti-SLAPP law.  Those amendments to sections 70-a and 76-a of the New York Civil Rights Law strengthened the protections for defendants in so-called SLAPP suits (“strategic lawsuits against public participation”) that seek to punish and chill the exercise of the rights of petition and free speech.  Notably, this appears to be the first decision from New York’s highest court regarding the amendments New York adopted to its anti-SLAPP law in 2020.

Background

In Gottwald v. Sebert,* the New York Court of Appeals considered a dispute between the singer/songwriter Kesha Rose Sebert, known as “Kesha,” and the music producer Lukasz Gottwald, known as “Dr. Luke.”[1]  In 2014, Kesha, who had been under contract with Gottwald in connection her recording career, sued Gottwald in California alleging that Gottwald had sexually assaulted her and seeking to void her contractual arrangements with him.[2]  The same day, Gottwald sued Kesha in New York, alleging that Kesha and her attorneys had defamed him.[3]

While Gottwald’s defamation action was pending, New York amended its existing anti-SLAPP law in a number of ways.[4]  New York’s previous anti-SLAPP law, enacted in 2008, was limited to litigation arising from a public application or permit, “usually in a real estate development situation.”[5]  Among other things, as relevant here, the 2020 amendments “substantially expanded” the definition of “an action involving public petition and participation” to which the anti-SLAPP law would apply.[6]  The anti-SLAPP law already required a plaintiff in any action to which the anti-SLAPP law applied to meet the “actual malice” standard, so expanding the scope of actions to which the anti-SLAPP law applies also expanded the actions in which plaintiffs were required to show actual malice.[7]  Similarly, the anti-SLAPP law already allowed defendants to file a counterclaim to seek compensatory and punitive damages; expanding the scope of the anti-SLAPP law also expanded the set of actions in which defendants could seek that relief.  And the 2020 amendments also created a mandatory fee-shifting provision, meaning that courts are required to award attorneys’ fees to defendants who defeat actions to which the anti-SLAPP law applies.[8]

After New York amended its anti-SLAPP law, Kesha sought leave to assert a counterclaim under the amended anti-SLAPP law for attorneys’ fees, damages for emotional distress, and punitive damages, as the amended law permits.[9]

After initial rulings at the trial court, the First Department intermediate appellate court issued two separate rulings on Kesha’s defenses, ruling that Gottwald was not a public figure; that whether Kesha’s statements were protected by New York privileges against defamation liability was a fact question that only the jury could resolve; and that the amended anti-SLAPP law did not apply to Gottwald’s claims because he had filed his claims before the amendments to the anti-SLAPP law were adopted.[10]

Kesha appealed both those rulings to the New York Court of Appeals, New York’s highest court.  On June 13, 2023, the New York Court of Appeals reversed the appellate court in whole or in part on each issue.[11]

Public Figure Status

Under governing precedent from the United States Supreme Court, as a matter of federal constitutional law, a defamation plaintiff found to qualify as a “public figure” can only establish defamation liability if he proves by clear and convincing evidence that defamatory statements were made about him with “actual malice,” meaning with knowledge that the statement was false or with reckless disregard as to whether the statement was false.[12]  Public figures come in two varieties.  A general or “all-purpose public figure” is so prominent as to qualify as a public figure for all purposes, regardless of what defamatory statements are made or what subject matter those statements address.[13]  Alternatively, plaintiffs will qualify as a “limited-purpose public figure” even if they do not have such broad notoriety if they nonetheless have invited and achieved public attention with respect to the subject matter the defamatory statements address.[14]

In the Gottwald case, the First Department intermediate appellate court held that Gottwald was not a general-purpose public figure because he was not a “celebrity” or a “household word.”[15]  And the court held he was not a limited-purpose public figure with respect to Kesha’s allegedly defamatory statements about him because those statements accused him of sexual assault and Gottwald had done nothing to achieve public prominence with respect to the “specific public dispute . . . [of] sexual assault and the abuse of artists in the entertainment industry.”[16]  Therefore, the court found, Gottwald’s acknowledged fame as a music producer and the notoriety he had achieved for his relationships with the artists he represented was irrelevant.[17]

A dissent at the First Department intermediate appellate court authored by Justice Saliann Scarpulla argued that the majority had misapplied the standard to determine when a plaintiff qualifies as a public figure.[18]  The dissent argued that Gottwald probably qualified even as a general-purpose public figure because, though not a “household name” everywhere, he was “a household name to those that matter.”[19]  But even if not, the dissent argued that Gottwald was at minimum a limited-purpose public figure “in connection with the dynamics of his relationship to the artists with whom he works and upon which he has built his well-known professional reputation.”[20]  The dissent argued that the panel’s application of the public-figure analysis was too narrow:  “That Dr. Luke has not spoken publicly about Kesha’s allegations of sexual assault is not surprising, is not relevant, and does not preclude a finding that he is a limited purpose public figure.  The definition of limited purpose public figure is not so cramped as to only include individuals and entities that purposefully speak about the specific, narrow topic (in this case a protégé’s sexual assault) upon which the defamation claim is based.”[21]

The New York Court of Appeals reversed, “agree[ing] with the dissent below” that Gottwald met the standard to qualify as a limited-purpose public figure, because he had “purposefully sought media attention for himself, his businesses, and for the artists he represented, including Sebert, to advance those business interests.”[22]  Therefore, Gottwald will be required to prove that Kesha made statements about him with “actual malice” to establish her liability.[23]

Privileges Against Defamation Liability

Kesha also argued that certain statements identified in Gottwald’s complaint were protected by certain of New York privileges against defamation liability:  New York’s absolute common-law privilege for statements made in connection with judicial proceedings; its qualified common-law privilege for statements made in anticipation of litigation; and its statutory privilege codified at Civil Rights Law Section 74 for “fair and true reports” of judicial proceedings.[24]

Absolute Common-Law Privilege For Statements Made In Connection With Judicial Proceedings

New York courts have held that statements made in connection with judicial proceedings are absolutely privileged against defamation liability if they are pertinent to that proceeding.[25]  Since 1986,[26] lower New York courts, beginning with the First Department intermediate appellate court, have identified an exception to that doctrine termed the “sham” exception, holding that the absolute privilege “will not be conferred where the underlying lawsuit was a sham action brought solely to defame the defendant.”[27]  The First Department intermediate appellate court reaffirmed this exception as recently as 2015, when it expressly rejected a trial court’s conclusion that the First Department’s “sham” exception had “waned” in value.[28]

In Gottwald, the First Department intermediate appellate court held that whether the “sham” exception applied was a fact question that turned on whether Kesha sued Gottwald in good faith or as a sham.[29]  Therefore, Kesha could not obtain summary judgment on the basis of that privilege; only the jury could decide whether Kesha could benefit from the absolute privilege for statements made in connection with judicial proceedings.[30]

The New York Court of Appeals reversed, holding that it was “error” to apply a “sham exception” to New York’s common-law absolute privilege for statements made in connection with judicial proceedings.[31]  It was “inconsistent” with the Court of Appeals’ prior decisions regarding the absolute privilege for a court to examine the motive of the speaker.[32]  Instead, if a statement was made in connection with a judicial proceeding and was pertinent to that proceeding, the absolute privilege applies.[33]  The New York Court of Appeals therefore held that the absolute privilege applied to statements Kesha and her attorneys made in connection with her litigation against Gottwald.[34]

Qualified Common-Law Privilege For Statements Made In Anticipation Of Litigation

New York courts have also recognized a qualified privilege for statements made in good-faith anticipation of litigation.[35]  However, unlike the absolute privilege for statements made in connection with a judicial proceeding, New York’s qualified privilege can be “lost . . . where a defendant proves that the statements were not pertinent to a good faith anticipated litigation.”[36]  And because Gottwald had argued there is a factual dispute as to whether Kesha actually had a good-faith anticipation of litigation at the time she made some challenged statements, the Court of Appeals agreed with the lower courts that the jury would have to determine whether the qualified privilege applied only after determining whether Kesha actually had a good-faith anticipation of litigation at the time that she and her agents made the relevant statements.[37]

Civil Rights Law Section 74 Fair Report Privilege

Finally, New York has adopted a statutory privilege immunizing statements that publish a “fair and true report of any judicial proceeding” where the statement is “substantially accurate.”[38]  The New York Court of Appeals has previously held that, unlike the common-law absolute privilege for statements made in connection with judicial proceedings, the statutory “fair report” privilege does include an exception for statements made by a plaintiff who “maliciously institute[s] a judicial proceeding” in order to make defamatory statements in connection with that proceeding.[39]  In Gottwald, the New York Court of Appeals agreed with the lower courts that whether the fair report privilege applied was a question for the jury after determining whether Kesha’s claims against Gottwald “were brought . . . in good faith or maliciously to defame Gottwald.”[40]

Applicability Of Amended Anti-SLAPP Law

Finally, the New York Court of Appeals considered whether the amendments to the anti-SLAPP law applied “retroactively” and applied to Gottwald’s claims even though he filed them before the New York anti-SLAPP law was amended.[41]  If the amendments applied “retroactively,” they would apply to Gottwald’s claims in their entirety throughout the entire course of the litigation, including over the six years the matter was litigated before the amendments were adopted in 2020.

Kesha primarily argued that two separate elements of the 2020 amendments to New York’s anti-SLAPP law should apply retroactively in Gottwald.  First, Kesha argued that Gottwald should be required to meet the “actual malice” standard, regardless of whether he qualified as a public figure.[42]  Second, Kesha argued that she should be entitled to file a counterclaim under the amended anti-SLAPP law that would entitle her to recover attorneys’ fees, damages for emotional distress, and punitive damages if she ultimately prevailed in the litigation.[43]

Until the Gottwald case was decided by the First Department intermediate appellate court, a significant number of state and federal courts had held that the 2020 amendments to the anti-SLAPP law did apply retroactively to any matter pending at the time they were adopted.[44]  The First Department intermediate appellate court in Gottwald was the first court to hold otherwise, holding instead that the amendments did not apply retroactively and applied only to claims filed after the amendments were adopted.[45]  The First Department intermediate appellate court reached that decision as to both the question of whether Gottwald was required under the amended anti-SLAPP law to meet the “actual malice” standard and as to the question of whether Kesha could file a counterclaim under that law for attorneys’ fees and damages—answering both questions in the negative.[46]

Because the New York Court of Appeals had already held that Gottwald did qualify as a public figure and therefore was required to meet the “actual malice” standard, it did not consider the question of whether the 2020 amendments to the anti-SLAPP law also independently required him to do so.[47]

The New York Court of Appeals held that the provisions of New York’s amended anti-SLAPP law authorizing a defendant to counterclaim for attorneys’ fees and damages did not apply retroactively.[48]  The Court held that the legislature did not expressly provide that the amendments should apply retroactively.[49]  In particular, the Court held that because the amendments that allowed a defendant to bring a counterclaim for attorneys’ fees and damages constituted a “statute imposing damages,” they should not “presumptively apply in pending cases.”[50]

Instead, the Court held that because the amendments to the anti-SLAPP law provided that defendants could recover attorneys’ fees and damages for an action “commenced or continued” improperly, the amendments could apply to Gottwald’s claims, but only with respect to events that occurred after the amendments were adopted.[51]  This did not constitute “retroactive” application, the Court held, because “these provisions are applied, according to their terms, to the continuation of the action beyond the effective date of the amendments.”[52]  In other words, the Court held that Kesha may bring a counterclaim under New York’s amended anti-SLAPP law to recover attorneys’ fees and damages, but only for attorneys’ fees and damages that arose after the amendments were enacted, and not before: “Because Gottwald’s liability [under the amended anti-SLAPP law] attached, if at all, when he chose to continue the defamation suit after the effective date of the statute, any potential calculation of attorneys’ fees or other damages begins at the statute’s effective date.”[53]

Dissent

Judge Jenny Rivera of the New York Court of Appeals dissented in part.[54]

Judge Rivera argued in dissent that the majority had erred regarding the scope of New York’s qualified privilege for statements made in anticipation of litigation.[55]  Judge Rivera would have held that on the undisputed record, the statements in question were clearly made in anticipation of litigation because they were made while pre-suit settlement negotiations were ongoing, shortly before Kesha filed suit in California against Gottwald, and were made either in connection with settlement negotiations or as part of sharing information with the press under pre-suit embargo.[56]  Judge Rivera argued that requiring a jury to decide whether Kesha had a good-faith anticipation of litigation on that record “severely limits settlement efforts” by allowing potential defamation liability to attach.[57]

Judge Rivera also argued in dissent that the majority had erred regarding the scope of New York’s statutory “fair report” privilege.[58]  Judge Rivera would have held that the statements of Kesha and her attorneys about litigation with Gottwald qualified as a “fair report” without examining her motives in bringing the litigation.[59]  Judge Rivera argued that the Gottwald majority had “extend[ed]” the “sham” exception to the New York statutory “fair report” privilege in a way that “risk[ed] eroding the privilege altogether.”[60]

Finally, Judge Rivera argued in dissent that the majority had erred regarding the retroactivity of the 2020 amendments to the New York anti-SLAPP law.[61]  Judge Rivera would have held that those amendments were retroactive and applied to Gottwald’s suit in its entirety, dating to the day it was commenced.[62]  In particular, Judge Rivera argued that the majority was wrong to treat the amendments that allowed defendants to assert a counterclaim for attorneys’ fees and damages as a new law that “introduced damages liability” for the first time.[63]  Judge Rivera argued that the 2020 amendments instead articulated a specific version of a remedy that always existed—the availability of sanctions, including attorneys’ fees and damages, for filing a frivolous lawsuit—and so should not be treated as a statute imposing liability on past conduct that had not been a basis for liability at the time that conduct occurred.[64]  Judge Rivera disagreed with the majority’s interpretation of the statutory phrase “commenced or continued,” which she would have found was a reason to hold the amendments applied retroactively, rather than applying only as of the date the amendments were adopted.  In Judge Rivera’s view, “[t]he majority’s prospective-only construction of the ‘commenced or continued’ language . . . is an overly narrow construction of that phrase.  The fact that any action continued at the time of the effective date of the amendments falls within the scope of the statute means just that; it does not necessarily or by implication mean that monetary relief is measured from the effective date.  Despite the majority’s effort to complicate straightforward language, the meaning and effect of the word ‘commenced’ in the phrase ‘commenced or continued’ tracks to the person who commenced the prohibited legal action.”[65]

Conclusion

This decision from the highest court of New York provides additional precedent regarding the categories of plaintiffs who will qualify as public figures under New York law, the availability of New York common-law and statutory privileges against defamation liability, the retroactivity of New York’s amended anti-SLAPP law, and the analysis New York courts should apply to evaluate whether newly enacted laws should have retroactive effect.  The New York Court of Appeals expressly left open the question of whether other provisions of New York’s amended anti-SLAPP statute will have retroactive effect as to cases pending at the time those amendments were adopted.

* Gibson, Dunn & Crutcher LLP represents Sony Music Entertainment with respect to third-party discovery in the trial court in Gottwald v. Sebert, No. 653118/2014 (Sup. Ct. N.Y. Cty.); claims against Sony Music Entertainment in the trial court have been dismissed.

________________________

[1] Gottwald v. Sebert (“Gottwald III”), No. 32, 2023 WL 3959051 (N.Y. June 13, 2023).

[2] Id. at *1.

[3] Id.

[4] Id. at *2.

[5] 2020 N.Y. Senate Bill No. 52-A/Assembly Bill No. 5991A (July 22, 2020), https://www.nysenate.gov/legislation/bills/2019/s52/amendment/a.

[6] Gottwald III, 2023 WL 3959051 at *5.

[7] Palin v. New York Times Co., 510 F. Supp. 3d 21, 28–29 (S.D.N.Y. 2020)(citing New York Times v. Sullivan, 376 U.S. 254 (1964) and N.Y. Civil Rights Law § 76-a(2)).

[8] Gottwald III, 2023 WL 3959051 at *5.

[9] Gottwald III, 2023 WL 3959051 at *2.

[10] Gottwald v. Sebert (“Gottwald II”), 165 N.Y.S.3d 38 (App. Div. 1st Dept. 2022); Gottwald v. Sebert (“Gottwald I”), 148 N.Y.S.3d 37 (App. Div. 1st Dept. 2021).

[11] Gottwald III, 2023 WL 3959051.

[12] Huggins v. Moore, 94 N.Y.2d 296, 301 (1999); New York Times Co. v. Sullivan, 376 U.S. 254, 279–80 (1964).

[13] Gottwald III, 2023 WL 3959051, at *2, *14 n.8.

[14] Gottwald III, 2023 WL 3959051, at *2.

[15] Gottwald I, 148 N.Y.S.3d at 43.

[16] Id. at 43–45.

[17] Id. at 44–45.

[18] Id. at 47–51 (Scarpulla, J., dissenting).

[19] Id. at 48–49 (Scarpulla, J., dissenting).

[20] Id. at 49–51 (Scarpulla, J., dissenting).

[21] Id. at 50 (Scarpulla, J., dissenting).

[22] Gottwald III, 2023 WL 3959051, at *2–3.

[23] Id. at *3.

[24] Id. at *3–4.

[25] Front, Inc. v. Khalil, 24 N.Y.3d 713, 718 (2015).

[26] Halperin v. Salvan, 117 A.D.2d 544, 548 (1st Dept. 1986).

[27] Gottwald I, 148 N.Y.S. at 46.

[28] Flomenhaft v. Finkelstein, 127 A.D.3d 634, 638 (1st Dep’t 2015).

[29] Gottwald I, 148 N.Y.S.3d at 46.

[30] Id.

[31] Gottwald III, 2023 WL 3959051, at *3.

[32] Id.

[33] Id.

[34] Id.

[35] Id. at *4.

[36] Id.

[37] Id.

[38] Id. (citing Civil Rights Law § 74, Holy Spirit Assn. for Unification of World Christianity v. New York, 49 N.Y.2d 63, 67 (1979)).

[39] Williams v. Williams, 23 N.Y.2d 592, 599 (1969).

[40] Gottwald III, 2023 WL 3959051, at *4.

[41] Id. at *5–7.

[42] Id. at *5.

[43] Id. at *6.

[44] Memorandum of Law in Support of Motion of Defendant-Respondent for Reargument or, in the Alternative, Leave to Appeal, Gottwald v. Sebert, No. 2021-03036, Dkt. 20 at 15 n.1 (N.Y. App. Div. 1st Dep’t Apr. 11, 2022).

[45] Gottwald II, 165 N.Y.S.3d at 39–40.

[46] Id.

[47] Gottwald III¸ 2023 WL 3959051, at *5.

[48] Id. at *6–8.

[49] Id. at *6.

[50] Id. at *7.

[51] Id. at *6.

[52] Id.

[53] Id.

[54] Gottwald III, 2023 WL 3959051, at *8–17 (Rivera, J., dissenting).

[55] Id. at *14–15 (Rivera, J., dissenting).

[56] Id.

[57] Id. at *14 (Rivera, J., dissenting).

[58] Id. at *15–16 (Rivera, J., dissenting).

[59] Id.

[60] Id. at *16 (Rivera, J., dissenting).

[61] Id. at *9–13 (Rivera, J., dissenting).

[62] Id. at *10–11 (Rivera, J., dissenting).

[63] Id. at *10 n.4, *12–13 (Rivera, J., dissenting).

[64] Id.

[65] Id.

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The following Gibson Dunn lawyers assisted in the preparation of this client update: Theodore Boutrous, Annie Champion, Connor Sullivan, Alexandra Perloff-Giles, and Angela Coco.

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 the following leaders and members of the firm’s Media, Entertainment & Technology Practice Group:

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Kevin Masuda – Co-Chair, Los Angeles (+1 213-229-7872, [email protected])
Benyamin S. Ross – Co-Chair, Los Angeles (+1 213-229-7048, [email protected])
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Orin Snyder – New York (+1 212-351-2400, [email protected])
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Munich partners Mark Zimmer and Katharina Humphrey are the authors of “Breaking Down Germany’s New Whistleblower Protection Act” [PDF] published by Law360 on June 14, 2023.

Colorado has developed a reputation in recent years as one of the more employee-friendly jurisdictions in the United States. One reason for this reputation is the much-publicized Equal Pay for Equal Work Act, particularly its wage transparency rules, which purported to require employers with even one Colorado-based remote employee to include specific compensation-and-benefits information in job postings and to announce all “promotional opportunities,” regardless of where within the company those opportunities are located or whether anyone in Colorado is qualified for them.

The Colorado legislature spent much of the latest session not only amending these job-posting requirements, but passing additional bills intended to offer workers greater protections. In May 2023, the Colorado legislature passed several bills that Governor Jared Polis recently signed into law. These new laws amend existing laws, for instance by introducing new worker protections, modifying standards of proof, and updating record retention requirements. The new laws include the following:

I. Senate Bill 23-105, Ensure Equal Pay For Equal Work Act (EEPEWA), introducing additional requirements concerning equal pay and job posting disclosures;

II. Senate Bill 23-172, Protecting Opportunities and Workers’ Rights (POWR) Act, expanding the reach of anti-discrimination laws;

III. Senate Bill 23-058, Job Application Fairness Act, prohibiting employers from asking about age-related information in initial job applications;

IV. Senate Bill 23-017, Additional Uses Paid Sick Leave, adding new qualifying reasons to use paid sick leave;

V. House Bill 23-1076, Workers’ Compensation, expanding employees’ medical impairment and disability benefits; and

VI. Senate Bill 23-111, Public Employees’ Workplace Protection Act, providing additional protections for public employees.

These laws likely will affect how employers draft and implement their employment policies and practices, and may give rise to litigation. Key additions and revisions to Colorado employment law are described below:

I. SB23-105 (Ensure Equal Pay for Equal Work Act) Amends Job Posting Disclosure Requirements.

The EEPEWA amends the Equal Pay for Equal Work Act (effective January 1, 2021), which imposed equal pay requirements and, more controversially, required employers to disclose salary ranges and employee benefits in job postings and disclose promotional opportunities to their employees, making it the first in a series of state pay transparency laws.

The EEPEWA, which was signed into law on June 5, 2023 and will go into effect on January 1, 2024, expands the investigatory mandate of the Colorado Department of Labor and Employment (CDLE) and both augments and reduces employers’ job posting disclosure requirements. Most notably, employers will have to disclose internally certain additional information about recently hired candidates to current employees, but (until July 1, 2029) will no longer have to make detailed salary and benefits disclosures if the employer has no physical presence in Colorado and has fewer than 15 remote employees in Colorado. Further details follow:

A. The EEPEWA Requires the CDLE to Take Further Protective and Investigative Measures.

The EEPEWA requires the CDLE to create and implement systems to accept and mediate complaints regarding violations of the sex-based wage equity provision of the Equal Pay for Equal Work Act and create new rules as necessary to accomplish this purpose. Previously, the Equal Pay for Equal Work Act simply permitted the CDLE to take these measures, but did not make them mandatory.

Furthermore, the EEPEWA requires the CDLE to investigate complaints or leads related to sex-based wage inequity (employing fact-finding procedures from the Equal Pay for Equal Work Act), promulgate rules as needed, and order compliance and relief if a violation is found. However, these enforcement actions will “not affect or prevent the right of an aggrieved person from commencing a civil action.”

In addition, starting January 1, 2024, individuals bringing sex-based wage discrimination claims may seek back pay going back twice as long as they could previously: up to six years instead of three.

B. The EEPEWA Requires Employers to Announce “Job Opportunities,” Whether or Not “Promotional,” But Not “Career Development” or “Career Progression” Opportunities.

Under the EEPEWA, employers must take reasonable steps to ensure that every “job opportunity” is announced, posted, or made known to all employees on the same day and before any selection decisions are made. However, employers physically outside Colorado that have fewer than 15 remote employees in Colorado need only provide notice of remote job opportunities through July 1, 2029. Perhaps anticipating complications related to temporary or stopgap employment, the EEPEWA further directs the CDLE to establish rules regarding “temporary, interim, or acting” job opportunities that require immediate hire.

According to new definitions in the EEPEWA, a “job opportunity” is a “current or anticipated vacancy” for which an employer is considering or interviewing candidates, or that an employer has posted publicly. Notably, a “job opportunity” does not encompass either a “career development” or a “career progression.”  “Career development,” as defined in the statute, refers to changes in an employee’s terms of “compensation, benefits, full-time or part-time status,” or job title that recognize an employee’s performance or contributions. And “career progression” means moving from one position to another based on objective metrics or time spent in a role.

C. The EEPEWA Requires Disclosing Information About Job Opportunities, Career Progression, and Selected Candidates.

The EEPEWA also imposes new disclosure requirements for “job opportunities,” requiring employers to include in job opportunity notices not only salary ranges and a general description of employee benefits but also “the date the application window is anticipated to close.”

Furthermore, within 30 days of selecting a candidate for a job opportunity, the EEPEWA requires the employer to make reasonable efforts internally to disclose certain information about the selected candidate—at a minimum, informing employees who will work with the new hire. This includes (a) the candidate’s name, (b) their former job title (if the candidate was an internal hire), (c) their new job title, and (d) information on how employees can express interest in similar job opportunities in the future, unless any such disclosure would violate the candidate’s privacy rights under other relevant laws or pose a risk to their health and safety.

For positions with “career progression,” moreover, the EEPEWA requires employers to make available to “eligible employees” information about the requirements for such progression, in addition to information about each position’s compensation, benefits, full-time or part-time status, responsibilities, and further advancement.

II. SB23-172 (POWR Act) Amends Colorado’s Anti-Discrimination Law.

On June 6, 2023, Governor Polis signed SB23-172, Protecting Opportunities and Workers’ Rights Act (POWR Act), into law. This Act amends Colorado’s anti-discrimination laws, including with regard to workplace harassment.

First, the POWR Act creates a new definition for “harassment” and modifies the standard of proof in workplace harassment claims. Currently, a complainant alleging harassment is required to demonstrate a hostile work environment. The POWR Act replaces the definition of “harassment” with one that includes “any unwelcome physical or verbal conduct.” Additionally, on any charge form or intake mechanism form, a complainant may select “harassment” as a basis or description of a discriminatory or unfair employment practice. The POWR Act also replaces the prior court-created “severe or pervasive” standard in determining whether workplace harassment is a discriminatory or unfair employment practice, instead introducing “a standard that prohibits unwelcome harassment.”

If an employee establishes harassment by a supervisor, the employer may benefit from an Ellerth/Faragher-type affirmative defense (providing employers a safe harbor from vicarious liability resulting from sexual harassment claims against a supervisory employee) if it can show that (1) it takes prompt, reasonable action to investigate or address alleged harassment when warranted; (2) it communicated to supervisors and non-supervisors the existence and details of its complaint and investigation/remediation process; and (3) the employee unreasonably failed to take advantage of this process.

The POWR Act also amends a provision of the Colorado Anti-Discrimination Act (CADA) regarding reasonable accommodation for people with disabilities. The prior version of the CADA provided that an employer could not be held liable for discriminating against individuals with disabilities by taking an adverse employment action “if the disability has a significant impact on the job.” The POWR Act removes this language from the CADA.

Furthermore, the POWR Act makes “marital status” a protected class in Colorado. The Act also imposes new recordkeeping mandates, requiring employers to maintain personnel and employment records for a minimum of five years, and to “maintain an accurate, designated repository of all written or oral complaints of discriminatory or unfair employment practices.”

Finally, the POWR Act voids nondisclosure provisions that limit an employee’s ability to disclose or discuss alleged discriminatory or unfair employment practices, unless they satisfy certain conditions.

Either an employee/applicant or the Colorado Civil Rights Commission may bring a complaint under the POWR Act. Individuals may recover actual damages, costs, and attorneys’ fees. Penalties and punitive damages also may be assessed in appropriate circumstances, including a potential $5,000 penalty for each instance in which an employer includes in an agreement a noncompliant nondisclosure provision.

The Act is expected to be effective on August 7, 2023, 90 days after the final adjournment of Colorado’s General Assembly on May 8, 2023. However, if a referendum petition is filed, the Act will need to be approved through a general election in November 2024.

III. SB23-058 Imposes New Rules Regarding Age-Related Questions in Job Applications.

SB23-058, the Job Application Fairness Act (JAFA), was signed into law on June 2, 2023. Starting July 1, 2024, the JAFA prohibits employers from seeking a prospective employee’s age-related information via the initial job application. This includes details such as date of birth and dates of attendance at, or graduation from, an educational institution.

The JAFA provides exceptions, however, for example where the employer seeks application materials such as copies of certifications and transcripts, if it adheres to certain processes. Additionally, employers may ask individuals to verify compliance with the age requirements under other laws and guidelines, such as the following:

• A bona fide occupational qualification pertaining to public or occupational safety;
• A federal law or regulation; or
• A state or local law or regulation based on a bona fide occupational qualification.

The CDLE will be in charge of enforcing the JAFA. The CDLE may issue warnings and compliance orders and impose civil penalties for repeated violations. Notably, a violation of the JAFA does not create a private right of action. If an individual believes their rights have been violated, they can file a complaint with the CDLE, which will investigate the complaint unless it determines pre-investigation that the complaint lacks merit.

Finally, the JAFA mandates that the CDLE adopt rules regarding handling complaints of violations, the process for notifying employers of alleged violations, and the requirements for maintaining and retaining employment records while an investigation is ongoing.

Before July 2024, Colorado employers should consider reviewing their hiring materials, including job postings and applications, and training employees involved in the hiring process to comply with JAFA requirements.

IV. SB23-017 Introduces Additional Uses for Paid Sick Leave.

On June 2, 2023, Governor Polis signed into law SB23-017, which expands the acceptable uses of paid sick leave under the Colorado Healthy Families and Workplaces Act (HFWA). The HFWA provides that employees can use paid sick leave to obtain medical care or legal services in certain situations for themselves or their family members.

SB23-017 introduces additional qualifying reasons to use paid sick leave, including taking time off to grieve, attend funeral services or memorials, or handle financial and legal matters that arise after the death of a family member; caring for a family member when that family member’s school or place of care has been closed under certain circumstances; or evacuating an employee’s place of residence in certain unexpected situations.

Employers must notify employees of their right to take paid leave under the HFWA, including the qualifying reasons for taking such leave.  In addition to providing the required notice, employers may wish to update their leave policies to reflect these additional uses.

SB23-017 is expected to become effective in early August 2023, about 90 days after the final adjournment of Colorado’s General Assembly in May. This may change if a referendum petition is filed, in which case the law would need to be approved through a general election in November 2024.

V. HB23-1076 Expands the Workers’ Compensation Act of Colorado.

HB23-1076, amending the Workers’ Compensation Act of Colorado, was signed on June 6, 2023. The Workers’ Compensation Act of Colorado currently mandates that businesses with employees operating in Colorado provide workers’ compensation insurance covering medical and lost-wage benefits to employees injured on the job, whether they are part-time or full-time.

HB23-1076 expands the existing medical-impairment-benefits limit from 12 to 36 weeks. Further, when an employee’s temporary total disability benefits end, HB23-1076 allows the employee to ask to return to regular work with a doctor’s written release.

HB23-1076 is expected to take effect on August 7, 2023, but if a referendum petition is filed, the Act would need to be approved through a general election in November 2024.

VI. SB23-111 Creates New Workplace Protections for Public Employees.

On June 7, 2023, Colorado enacted SB23-111, the Public Employees’ Workplace Protection Act, which aims to protect certain public employees from retaliation. The employees covered under this Act include those “employed by counties, municipalities, fire authorities, school districts, public colleges and universities, library districts, special districts, public defender’s offices, the university of Colorado hospital authority, the Denver health and hospital authority, the general assembly, and a board of cooperative services.” Public Employees’ Workplace Protection, Colo. Gen. Assemb., https://leg.colorado.gov/bills/sb23-111 (last visited June 7, 2023).

The Act also codifies public employees’ right to freely discuss or express views concerning public employee representation or workplace issues and to full participation in the political process. Moreover, the Act “prohibits certain public employers from discriminating against, coercing, intimidating, interfering with, or imposing reprisals against a public employee for engaging in any of the rights granted.” Id.

The Act grants the CDLE rulemaking and enforcement powers. The Act’s Section 29-33-105(3) (regarding the adjudication authority of the CDLE’s Division of Labor Standards and Statistics) is set to take effect on July 1, 2024. The rest of the Act is expected to take effect in August 2023, but this may change if the Act goes through a referendum and general election in November 2024.

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The following Gibson Dunn attorneys assisted in preparing this client update: Jessica Brown and Marie Zoglo.

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 Jessica Brown, Jason Schwartz or Katherine Smith:

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

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

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

© 2023 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice. Please note, prior results do not guarantee a similar outcome.

For nearly 200 years, the New York Court of Appeals has resolved issues of paramount significance for New York and the nation. As the state’s court of last resort, its judges regularly issue landmark decisions on issues ranging from state common law to the United States Constitution. Moreover, its broad jurisdiction over a wide array of cases in New York often results in rulings of great importance in commercial and other matters. The last two years have marked an important turning point for the Court, with the appointment of a new Chief Judge and four new judges to the seven-member bench. At the same time, the Court continued to resolve a number of significant issues, often through split opinions with lengthy concurrences and dissents. In this exclusive one-hour presentation, three experienced appellate practitioners – Mylan Denerstein, Akiva Shapiro, and Seth Rokosky – explain key developments at the Court. They discuss not only relevant background and changes to the Court, but also recent and pending cases of interest in a broad array of areas, including constitutional law, jurisdiction, civil procedure, torts, insurance, consumer protection, and employment law.

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PANELISTS:

Mylan L. Denerstein is a litigation partner in the New York office of Gibson, Dunn & Crutcher. Ms. Denerstein is a Chair of the Public Policy Practice Group and a member of the Crisis Management, White Collar Defense and Investigations, Financial Institutions, Labor and Employment, Securities Litigation, and Appellate Practice Groups. Ms. Denerstein leads complex litigation and internal investigations, representing companies confronting a wide range of legal issues, in their most critical times. Ms. Denerstein is known not only for her effective legal advocacy, but also for her ability to solve problems. In addition, Ms. Denerstein is Global Chair of the Firm’s Diversity Committee and Co-Partner in Charge of the New York office. Ms. Denerstein was previously a member of the Firm’s Executive Committee. Ms. Denerstein has served in a wide variety of roles in government, including in the New York State Governor’s Office, the New York State Attorney General’s Office, the U.S. Attorney General’s Office for the Southern District of New York, and the New York City Fire Department.

Akiva Shapiro is a litigation partner in Gibson, Dunn & Crutcher’s New York office, Chair of the Firm’s New York Administrative Law and Regulatory Practice Group, Co-Chair of its Religious Liberty Working Group, and a member of the Firm’s Appellate and Constitutional Law, Media, Entertainment and Technology, and Securities Litigation Practice Groups, among others. Mr. Shapiro’s practice focuses on a broad range of high-stakes constitutional, administrative, commercial, and appellate litigation matters. He is regularly engaged in front of New York’s trial courts, federal and state courts of appeal, and the U.S. Supreme Court.

Seth M. Rokosky is of counsel in the New York office of Gibson, Dunn & Crutcher. He is a member of the firm’s Litigation Department and focuses his practice in the Appellate and Constitutional Law group. Mr. Rokosky rejoined Gibson Dunn after serving in the New York Attorney General’s Office. As an Assistant Solicitor General in the Bureau of Appeals and Opinions, his public service included representing the State and its agencies as principal attorney on 43 appellate matters. He is currently serving as Co-Chair of the Appellate Practice Committee of the New York State Bar Association’s Commercial and Federal Litigation Section.

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MCLE CREDIT INFORMATION:

This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 1.0 credit hour, of which 1.0 credit hour may be applied toward the areas of professional practice requirement. This course is approved for transitional/non-transitional credit.

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New York partner Jason Cabral, Washington, D.C. partner Sara Weed and New York law clerk Alejandra Castañeda are the authors of “NYDFS’ Virtual Currency Oversight Plan Lacks Clarity” [PDF] published by Law360 on June 13, 2023.

Washington, D.C. of counsel David Schnitzer is the author of “Employers Should Take a Fresh Look at Their COVID-Era Vaccination and Testing Policies” [PDF] published by The National Law Journal on June 8, 2023.

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

I. International

1. PRI Minimum requirements reporting guidance on human rights

In May 2023, the United Nations Principles for Responsible Investment (“PRI”) released a report on “Minimum Requirements for PRI Investor Signatories”, which provides guidance to accompany the Policy, Governance and Strategy module of the 2023 Reporting Framework. The report outlines minimum requirements that investment managers and asset owner signatories must satisfy in their annual reporting obligations to PRI and can be used as a tool to determine whether companies are meeting certain mandatory key performance indicators. The guidance comprises three minimum requirements: (i) responsible investment policy – investor signatories must have formalised structures in place for responsible investment and more than the majority of assets under management must be covered by guidelines on ESG factors, (ii) senior-level oversight and accountability – senior individuals within an organization must have official oversight for the execution of a responsible investment strategy and any related policies and objectives, and be held accountable if such targets are not achieved, and (iii) responsibility for implementation – at least one individual within an organization must manage the organisation’s overall performance in relation to its responsible investment strategy by fostering a forward-thinking and ESG-aware approach to investment decisions, ensuring that the business has robust ESG policies in force and/or seeking opportunities to improve the existing ESG practices of holdings, policy makers, or other key stakeholders through voting and engagement.

2. SBTN releases first corporate science based targets for nature

On May 24, 2023, the Science Based Targets Network (“SBTN”) announced the release of inaugural science-based corporate targets for nature and biodiversity in an effort to encourage companies to voluntarily assess and prioritise their environmental impact and to set specific targets to address these issues. This follows initial guidance published in September 2020 and is the first release, which forms part of a multi-year plan to equip all businesses with comprehensive objectives founded on scientific research. In addition, the first release is just the beginning of SBTN’s journey in supporting companies in setting nature targets with scientific backing, and such targets which continue to widen in scope in line with science and technology progress. A paper that explains the inclusion of biodiversity in the first release has also been published as well as initial guidance on local stakeholder engagement.

II. United Kingdom

1. Heightened consumer protection obligations for UK businesses

New regulatory obligations for the UK Consumer Duty (“CD”) are due to come into force on July 31, 2023. This follows the publication of the final rules and guidance on July 27, 2022, which sets expectations to mitigate the risks to retail consumers investing in financial products and services. The CD applies to the regulated and ancillary activities of all firms authorised under the Financial Services and Markets Act 2000, the Payment Services Regulations 2017 and E-money Regulations 2011. Firms should now have completed their reviews to ensure that they align with the new regulations under the CD, which set higher and clearer standards of consumer protection for financial institutions. The new rules seek to ensure that consumer needs are prioritised by introducing: (i) a new Consumer Principle, which requires institutions to deliver positive outcomes for retail consumers, (ii) ‘cross-cutting rules’ with increased clarity to help businesses understand the four outcomes (which relate to (a) products and services, (b) price and value, (c) consumer understanding, and (d) consumer support) and (iii) requirements which reflect key components of the business-to-consumer relationship, which are central in driving good outcomes for customers. The underlying principle of the CD is reasonableness. This is an objective standard, which necessitates that firms act prudently, honestly and equitably in their dealings with consumers. Businesses have therefore been advised to incorporate their CD obligations into the relevant updates they are implementing to meet their ESG obligations to ensure that both sets of conditions are satisfied prior to the implementation deadline of the CD.

2. FRC introduces new corporate governance code and changes to audit committee

The Financial Reporting Council (“FRC”) launched an ongoing public consultation on May 24, 2023, on proposed revisions to the UK Corporate Governance Code (the “Code”). The purpose of the review is to strengthen the Code’s effectiveness in promoting good corporate governance, which plays a fundamental role in assessing sustainability-related risks and opportunities, and setting targets using internal controls, assurance and resilience. Five areas of development were identified in the report: (i) a revision to the sections of the Code which deal with the requirement for a framework of prudent and effective controls to provide a more solid springboard for reporting on and evidencing their effectiveness, (ii) emphasis on the importance of the board and audit committee’s responsibility for sustainability and ESG reporting and appropriate assurance in accordance with the company’s audit and assurance policy, (iii) the launch of the new Audit Committee Standard into the Code, (iv) an improvement to the application of comply-or-explain, where reporting is currently weaker, to reflect the latest FRC research and reports and (v) the relevance of the Code in remaining up to date with developments to legal and regulatory requirements as detailed in the UK government’s response to the White Paper, including enhanced reporting on malus and clawback arrangements.

On ESG matters, the Code underlines the importance of management adopting a considered approach to investment decisions by factoring environmental and social impact into how the company generates and maintains long-term growth, and to ensure that remuneration outcomes are clearly aligned to the company’s ESG objectives and overarching strategy. In addition, audit committees will need to report on how ESG targets were addressed and commissioned by the board in their annual report and conduct a review of sustainability matters. The consultation is expected to close on September 13, 2023, following which, the Code is anticipated to apply to accounting years commencing on or after January 1, 2025, to enable adequate time for implementation. The Code will form part of a broader reform package that seeks to improve accountability and therefore increased confidence by ‘Restoring trust in audit and corporate governance’ and supporting sustainable investments and stewardship decisions in the UK.

III. Europe

1. Update on the EU Artificial Intelligence Act

A draft negotiating mandate was adopted by the Internal Market Committee and Civil Liberties Committee on May 11, 2023, which sets out inaugural rules for artificial intelligence (“AI”) with 84 votes in favor, seven against and 12 abstaining. Members of European Parliament (“MEP”) are aiming to strike a balance between fostering AI innovation and protecting the general public. To that end, AI systems must be overseen by people and be used in a safe manner which is environmentally-friendly, transparent and traceable and not discriminatory or invasive. The mandate promotes the human-centric and ethical development of AI in Europe through a risk-based approach to the nascent technology. The environment has been identified as a high-risk AI area, which requires immediate and enhanced protection of fundamental rights, as well as an ongoing assessment of AI’s impact on the environment to mitigate such risks and to ensure compliance. MEPs have also included a list of prohibited intrusive and discriminatory uses of AI systems such as “real-time” remote biometric identification systems in public spaces and biometric categorization systems using sensitive characteristics such as gender, race, ethnicity, religion or political orientation. Before negotiations can commence on the final legislation, this draft-negotiating mandate needs to be unanimously supported by Parliament. The vote is expected to take place during the week commencing June 12-15, 2023.

2. Sustainable finance package to come in June 2023

A significant sustainable finance package is due to be published later this month by the EU as part of their long-term vision to make Europe climate-neutral by 2050. The EU’s financial services chief has said that the package will include a proposal on ESG ratings as well as new secondary legislation under the EU’s classification of economic activities eligible for green finance; its ‘green taxonomy.’ The proposal on the green taxonomy will comprise of guidance and six environmental objectives to make the framework more accessible and to encourage transition finance. The framework has been criticised, however, from businesses claiming that it is difficult to measure how green they are, using the classifications, whilst others oppose the deeming of certain nuclear and gas projects as ‘transitional’ activities, justifying green investment. The legal challenges are currently ongoing. There are plans for the EU executive to publish standards on sustainability reporting shortly following the release of the June package. The standards, which will implement the Corporate Sustainability Reporting Directive, will include further detail on disclosure requirements and will expand the scope of these requirements to a greater number of EU companies. It is expected that there will be a delay to the release of the second set of standards in order to allow companies to implement the upcoming measures.

3. EU Parliament adopts new deforestation regulation

The final text of a new EU Regulation aimed at tackling deforestation and forest degradation was adopted by the European Parliament on April 19, 2023 (the “Deforestation Regulation”). Under the Deforestation Regulation, companies will be required to conduct due diligence into the origin of a range of commodities, including cattle, cocoa, coffee, palm oil, rubber, soya and wood, to verify that they have not be obtained through deforestation. The purpose of the Deforestation Regulation is to address the growing rate of deforestation and degradation, and will form part of the European Green Deal initiative, which includes proposals to ensure that EU consumption does not contribute to worldwide deforestation and forest degradation. The Deforestation Regulation will repeal and replace the existing regime under the EU Timber Regulation (995/2010/EU) and will cover a much broader scope than the former legislation. Before offering products to the EU market, businesses will be required to ensure that products are ‘deforestation-free’ by submitting a due-diligence statement to the authorities before placing products on the market or exporting products to confirm that an adequate verification procedure has been conducted and to identify the source of the commodities used in respect of such products. The level of due diligence will be subject to a benchmarking exercise set out by the EU, which will assess countries based on their current risk of deforestation and forest degradation. Once in effect, businesses will have 18 months to implement the new rules, meaning that the Deforestation Regulation will likely be applicable from early 2025.

4. ESAs publish progress reports on greenwashing in the financial sector

On May 31, 2023, the three European Supervisory Authorities (i) the European Banking Authority (“EBA”); (ii) the European Insurance and Occupation Pensions Authority (“EIOPA”); and (iii) the European Securities and Markets Authority (“ESMA”) (collectively, the “ESAs”) published a Progress Report on the risks associated with greenwashing (the “Report”), with a formal press release put out on June 1, 2023. The Report provides a high-level assessment of the impact of greenwashing on industry players across various financial industries, including banking, insurance, occupational pensions and European securities. In particular, it explores the practical implications of greenwashing whereby ESG-related statements, declarations, actions, or communications are disseminated and misconstrued so that they are not a transparent or fair reflection of the essential sustainability composition of an entity, financial product or services, which in turn can mislead consumers, investors and other market participants.

The ESMA section of the Report demonstrated that the sustainable investment value chain is at risk of greater exposure to greenwashing due to the proliferation of false or misleading claims which arise in respect of a product’s sustainability profile. The EBA section of the Report focuses on greenwashing in the banking industry and its effect on banks, investment firms and payment service providers. The risk is perceived as low or medium for banks and medium to high for investment firms, however this is anticipated to increase in the future. The EIOPA section of the Report approaches greenwashing from the perspective of insurance and pension providers and concludes that the risk of greenwashing varies at different stage of the insurance and pensions lifecycle.

IV. United States

1. Latest ISS Report analysis

According to the latest Report by ISS Corporate Solutions, there has been a polarization of opinions in U.S. annual general meetings during the first half of this year, as shareholder proposals are divided between those in favor of supporting ESG-related issues with and those with a growing anti-ESG sentiment, albeit still a minority of proposals with none having been passed to date. The volume of shareholder proposals has increased by 14% in the last three years, particularly due to the rise in anti-ESG shareholder resolutions, which, although are still in the minority of opinions, have grown by more than 400% since 2020. ESG matters now account for more than 35% of proposals on social issues raised at annual general meetings and while the volume of environmental proposals has decreased in 2023, climate remains the most prevalent subcategory of proposals. While proposals have increased, support has fallen, with only 30.2% of shareholder proposals being submitted for final vote as of May 16, 2023.

2. U.S. states remain split on their approach to ESG matters

A bill was recently signed into law in Florida by Ron DeSantis, prohibiting public officials from investing state money into ESG objectives and banning ESG-bond sales. The legislation makes it obligatory for fund managers to include disclaimers in specific communications with portfolio companies to highlight that they do not represent Floridians’ views. This is one of the most far-reaching steps introduced by U.S. Republicans against sustainable investment and is against a backdrop of a highly political influx of anti-ESG laws. This legislation will impact existing ESG initiatives of financial businesses operating in Florida, therefore it is advisable that such organizations audit and align their current ESG policies with the new requirements imposed by the bill. Similarly, in Kansas, the Senate approved a similar piece of legislature, which prevents Kansas state officials from referencing ESG factors when investing in public funds or determining who receives government contracts.

By comparison, in New York City in April 2023, two of the five employee pension funds (the Teachers Retirement System and the New York City Employees’ Retirement System) adopted Net Zero Implementation strategies to achieve their ambitious goals of net zero emissions in their investment portfolios by 2040.

3. EPA proposes new rules to accelerate the use of “clean vehicles”

On April 12, 2023, the US Environmental Protection Agency (“EPA”) introduced new federal emissions standards to promote cleaner vehicles and to fuel a more rapid transition to a carbon-neutral future. The proposed standards would prevent nearly 10 billion tons of carbon dioxide emissions, improve air quality throughout the U.S., promise financial savings on fuel for drivers and reduce the nation’s reliance on oil imports.

4. Supreme Court adopts “Continuous Surface Connection” test for whether wetlands are covered by the Clean Water Act

On May 25, 2023, the Supreme Court held that the Clean Water Act only applies to those wetlands with a continuous surface connection to bodies of water that are “waters of the United States,” and therefore wetlands that fall outside this scope will not be in the remit of the Clean Water Act.

V. APAC

1. Philippine SEC adopts ASEAN sustainable and responsible funds standards

The Philippine Securities Exchange Commission (“SEC”) has adopted the Association of Southeast Asian Nations’ (“ASEAN”) Sustainable and Responsible Funds Standards (“SFRS”), setting out new guidance that will enable local and ASEAN-member investment companies, and collective investment schemes, to provide sustainable and responsible funds locally and across the region. The SFRS outlines minimum disclosure and reporting requirements, which address and target the need for a comparable, uniform and clear disclosure of information to safeguard against greenwashing.

2. Hong Kong consultation paper on mandatory climate-related disclosures for listed companies

The Hong Kong Stock Exchange published a consultation paper on April 14, 2023, proposing to make climate-related disclosures obligatory in ESG reports for all listed companies. There will be a two-year interim reporting period following the effective date of January 1, 2024, to enable businesses to adjust to the requirements.

3. India has approved new ESG disclosure rules to be made mandatory over time

The Securities and Exchange Board of India has approved new ESG disclosure rules, ratings and investing principles, which will develop the previous requirements under the Business Responsibility and Sustainability Report framework, outline ESG performance targets and will gradually make these items mandatory for the top 1000 listed companies over the next few years. The consultation paper recognizes that assurance of transparent disclosures is fundamental in enhancing the credibility of any sustainability related reporting.

4. MAS launches Finance for Net Zero Action Plan

The Monetary Authority of Singapore (“MAS”) has published a net zero financing plan, which expands on MAS’ Green Finance Action Plan launched in 2019, as part of Singapore’s long-term climate and sustainability agenda. The Finance for Net Zero Action Plan (“FiNZ”) seeks to achieve four strategic outcomes in connection with (i) data, definitions and disclosure, (ii) the climate resilience of the financial industry, (iii) the adoption of credible transition plans and (iv) the endorsement of green transition solutions and markets. The FiNZ includes finance mobilization strategies to catalyze Asia’s net zero transition and to support decarbonization activities in Singapore.

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

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

The following Gibson Dunn lawyers prepared this client update: Ayshea Baker, Grace Chong, Cynthia Mabry, Patricia Tan Openshaw, and Selina S. Sagayam.

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

Environmental, Social and Governance (ESG) Group Leaders and Members:
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])

© 2023 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice. Please note, prior results do not guarantee a similar outcome.

On June 6, 2023, the Public Company Accounting Oversight Board (“PCAOB”) proposed for public comment a draft auditing standard, A Company’s Noncompliance with Laws and Regulations, PCAOB Release 2023-003, that could significantly expand the scope of audits and potentially alter the relationship between auditors and their SEC-registered clients.  In a rare move, two PCAOB Board members—Duane DesParte and Christina Ho (the two accountants on the Board)—dissented from the proposal based on a range of concerns, including that it would unduly expand the scope of the public company audit.

This alert provides a high-level summary of the proposed standard, which runs more than 140 pages.  We also review the objections articulated by Board Members DesParte and Ho.

Overview

The proposal issued by the PCAOB would replace existing AS 2405, Illegal Acts by Clients (“Current AS 2405”), with a new AS 2405, A Company’s Noncompliance with Laws and Regulations (“Proposed AS 2405”).  The principal ways in which the Proposed AS 2405 would go beyond the Current AS 2405 include the following:

• The Current AS 2405 mirrors in substantial part Section 10A of the Securities Exchange Act of 1934, which requires the auditor to perform “procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts,” 15 U.S.C. § 78j-1(a)(1) (emphasis added). The Proposed AS 2405 would go further and require the auditor to: (i) identify all laws and regulations “with which noncompliance could reasonably have a material effect on the financial statements” (emphasis added), (ii) incorporate potential noncompliance with those laws and regulations into the auditor’s risk assessment, and (iii) identify whether noncompliance may have occurred through enhanced procedures and testing.  Proposed Standard ¶¶ 4-5.  As part of these procedures, an auditor would be required, among other things, to obtain an understanding of management’s own processes to identify relevant legal obligations and investigate potential noncompliance.   ¶ 6(a)(2).
• Upon identifying an instance of potential noncompliance, the auditor must perform procedures to understand the nature of the matter, as well as to evaluate whether in fact noncompliance with a law or regulation has occurred. ¶¶ 7-11.  These procedures go beyond those required by the Current AS 2405 and Section 10A.  Importantly, the proposed procedures would appear to require the auditor to undertake significant steps even in cases where it appears unlikely that the identified conduct will have a material effect on the financial statements and even in cases where the noncompliance itself is still in question.
• After identifying an instance of potential noncompliance, the auditor would communicate both with management, the audit committee (unless the matter is clearly inconsequential), and, in some cases, the board of directors as a whole. ¶¶ 12-15.  The Proposed AS 2405 contemplates that this communication may occur in two stages, the first after the auditor learns of the matter and the second after the auditor has conducted an evaluation of the matter.

Objections of Board Members DesParte and Ho

Board Members DesParte and Ho each issued a statement explaining the basis for their dissent from the proposal.  Some of the most significant concerns that they raised included:

• That the requirement to understand all laws and regulations that potentially could materially affect the financial statements would likely impose an undue burden on auditors;
• That, in Board Member DesParte’s words, the Proposed AS 2405 might require an auditor “to identify any and all information that might indicate instances of noncompliance [with] any law or regulation across the company’s entire operations, without regard to materiality,” a potentially significant expansion of responsibility that could require the auditor to rely increasingly on legal specialists;
• That the requirement to consider management’s disclosure about a potential instance of noncompliance may exceed the requirements of AS 2710, Other Information in Documents Containing Audited Financial Statements; and
• That the proposal does not adequately take smaller firms and smaller audit engagements into account.

Notably, Board Member DesParte concluded his remarks by expressing that, in light of the PCAOB’s aggressive standard-setting initiative overall,

I am increasingly concerned we are establishing new auditor obligations and incrementally imposing new auditor responsibilities in ways that will significantly expand the scope and cost of audits, and fundamentally alter the role of auditors without a full and transparent vetting of the implications, including a comprehensive understanding of the overall cost-benefit ramifications. I also wonder whether we are further contributing to the expectations gap by imposing responsibilities on auditors not aligned with their core competencies or the fundamental purpose of a financial statement audit.

The statements from Board Members DesParte and Ho underscore both the significance of this proposal and the range and magnitude of the concerns, for auditors and SEC registrants alike. Indeed, the procedures described above, as well as other aspects of the Proposed AS 2405 and other proposed amendments to PCAOB auditing standards, likely would substantially expand the scope of most audits in relation to identifying, assessing, and addressing potential noncompliance with laws and regulations, particularly for audits of complex, global organizations.  Among other things, the proposal appears not to fully consider the consequences—either for the auditor or for the issuer—of expanding the role of the auditor to include responsibilities that might lie outside the auditor’s core competencies, such as legal analysis.  The auditor’s increased responsibility to identify, evaluate, and report on legal compliance could alter what information the issuer may need to share with the auditor to help ensure that sufficient audit evidence is obtained, as well as the training and quality controls that might be necessary to achieve reasonable assurance that the auditor can evaluate and act on the information received.  Notably, too, the increased sharing of information from the audit client to the auditor that is required under the Proposed AS 2405 would present significant increased risk to the audit client’s legal privileges.  These are but a few of the significant issues that suggest that the Proposed AS 2405 would mean costlier and potentially more expansive audits, with the likely upshot that SEC registrants correspondingly also will need to undertake more expansive compliance initiatives (and share the results of such initiatives with the auditor) in order to satisfy the proposed audit requirements.  Both companies and their auditors will want to follow these proposals carefully and many will likely want to comment on these issues after having reviewed the Board’s proposal.

Conclusion

We encourage interested parties to consider submitting comments concerning this proposal.  Especially in light of the dissents by Board Members DesParte and Ho, the comment process should play an important role in shaping whether this proposal moves forward and in the Board’s consideration of this matter.

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

Accounting Firm Advisory and Defense Group:

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

Ron Hauben – New York (+1 212-351-6293, [email protected])

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

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© 2023 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice. Please note, prior results do not guarantee a similar outcome.

In this webcast, panelists from Gibson Dunn and Deloitte provide a comprehensive discussion of New York City’s Local Law 144, a groundbreaking law that regulates the use of AI tools in hiring and promotion. The law will be enforced beginning on July 5, 2023. The webcast delves into the notice and bias auditing requirements of Local Law 144 as well as the implications of the Department of Consumer and Worker Protection’s final rules implementing it. The panelists also explore open questions that remain and discuss practical approaches for conducting an assessment of an automated decision tool or system. Additionally, the panelists discuss trends they are observing from the EEOC and in proposed laws at the state and local level that focus on automated decision tools.

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PANELISTS:

Danielle J. Moss is a partner in the New York office of Gibson, Dunn & Crutcher and a member of the firm’s Labor and Employment and Litigation Practice Groups. She is recognized for representing employers across a wide range of matters, including high-stakes discrimination, harassment and retaliation claims, as well as wage and hour and restrictive covenant issues. She has also led numerous highly sensitive internal investigations.

Emily Maxim Lamm is an associate in the Washington, D.C. office of Gibson, Dunn & Crutcher. Ms. Lamm’s practice focuses on employment litigation, counseling, and investigations. Ms. Lamm has particular expertise counseling on the legal and policy developments surrounding artificial intelligence and automation across the employment lifecycle. She has also represented technology companies involving allegations of discrimination related to the use of algorithms and AI. Ms. Lamm frequently speaks and writes on AI issues in employment and holds a program certificate from Wharton Online in Artificial Intelligence for Decision Making.

Ryan Hittner is a Managing Director at Deloitte. With over 17 years of risk management experience related to models and advanced algorithms, Ryan leads the AI & Algorithmic Assurance practice which focuses on helping businesses responsibly build AI trust.

Morgan Dove is a Senior Manager at Deloitte. Morgan works within the AI & Algorithmic Assurance practice, with over 8 years of experience specializing in strategic transformations, model validation, and quantitative risk management.

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MCLE CREDIT INFORMATION:

This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 1.0 credit hour, of which 1.0 credit hour may be applied toward the areas of professional practice requirement. This course is approved for transitional/non-transitional credit.

Attorneys seeking New York credit must obtain an Affirmation Form prior to watching the archived version of this webcast. Please contact [email protected] to request the MCLE form.

Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 1.0 hour.

California attorneys may claim “self-study” credit for viewing the archived version of this webcast. No certificate of attendance is required for California “self-study” credit.

This webcast provides an overview of the current voluntary carbon offset market. We provide practical advice about how to access and participate in that market, and finally, we flag some litigation risks and concerns to be considered by those participating in the market.

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PANELISTS:

Abbey Hudson is a partner in Gibson Dunn’s Los Angeles office. Her practice focuses on environmental matters and complex trial litigation. She devotes a significant portion of her time to helping clients navigate environmental and emerging regulations and related governmental investigations. The Legal 500 United States named Ms. Hudson a Next Generation Lawyer in the category of Industry Focus – Environment – Litigation. Ms. Hudson has handled all aspects of environmental and mass tort litigation and regulatory compliance. She has provided counseling and advice on environmental and regulatory compliance to clients on a wide range of issues, including supply chain transparency requirements, comments on pending regulatory developments, and enforcement counseling.

Jeffrey L. Steiner is a partner in the Washington, D.C. office of Gibson, Dunn & Crutcher. He is Chair of the firm’s Derivatives practice group and Co-Chair of the firm’s Global Financial Regulatory practice group.  Mr. Steiner is also the co-lead to the firm’s Digital Assets and Blockchain Technology team and a member of the firm’s Financial Institutions, Energy, Regulation and Litigation, Investment Funds and Public Policy practice groups.

Adam Lapidus is Of Counsel in the New York office of Gibson Dunn & Crutcher. He is a member of the firm’s Derivatives practice group. Mr. Lapidus advises clients on derivatives and capital markets transactions. Representative products include equity derivatives, interest rate hedges, commodity derivatives, repurchase agreements, and privately negotiated FX and currency option transactions.

Ritchie Vaughan is an associate in the Los Angeles office of Gibson, Dunn & Crutcher LLP.  They currently practice with the firm’s real estate group, focusing on land use and zoning. Msr. Vaughan received their J.D. from The University of Virginia School of Law in 2022.  They graduated summa cum laude from Virginia Polytechnic and State University in 2009, receiving their Bachelor of Science in Forestry.  They also received their Master of Science in Forest Resources and Environmental Conservation from Virginia Tech.  They are a licensed real estate broker in the Commonwealth of Virginia, where they practiced real estate prior to law school.

Mark Tomaier is an associate in the Orange County office of Gibson, Dunn & Crutcher where he currently practices in the firm’s Litigation Department and is a member of the Environmental Litigation and Mass Tort Practice Group. He represents clients in complex litigation, government investigations, and compliance matters primarily relating to environmental law. He was named by the Environmental Law Institute as a 2022 “Emerging Leader” in environmental law and policy.

Arthur Halliday is a litigation associate in the Los Angeles office of Gibson, Dunn & Crutcher. Mr. Halliday earned his law degree in 2022 from Columbia Law School, where he was named a James Kent Scholar and awarded the Ruth Bader Ginsburg Prize.  At Columbia, he worked as an Articles Editor on the Columbia Journal of Law & Social Problems.  Mr. Halliday also served as co-president of the California Society, as a research assistant for Professor Elizabeth Emens, and as teaching assistant for Professor Jane Ginsburg and Professor Michael Gerrard.

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MCLE CREDIT INFORMATION:

This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 1.0 credit hour, of which 1.0 credit hour may be applied toward the areas of professional practice requirement. This course is approved for transitional/non-transitional credit.

Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 1.0 General hour.

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Neither the Connecticut Judicial Branch nor the Commission on Minimum Continuing Legal Education approve or accredit CLE providers or activities. It is the opinion of this provider that this activity qualifies for up to 1 hour toward your annual CLE requirement in Connecticut, including 0 hour(s) of ethics/professionalism.

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

This week, both the New York Stock Exchange (“NYSE”) and The Nasdaq Stock Market (“Nasdaq”, and together with NYSE, the “Exchanges”) filed amendments with the Securities and Exchange Commission (“SEC”) to provide a delayed effective date for the Exchanges’ proposed listing standards requiring listed companies to adopt clawback policies, as mandated by Rule 10D-1 under the Securities and Exchange Act of 1934. Specifically, the Exchanges are proposing that their new listing standards become effective on October 2, 2023. If the listing standards are approved by the SEC, companies will have until December 1, 2023 (60 days after the effective date) to adopt clawback policies satisfying the new listing standards  (“Rule 10D-1 policies”), and the policies would need to apply to any incentive compensation “received” (as defined in Rule 10D-1) on or after October 2, 2023. The NYSE’s amended proposal is available here, Nasdaq’s is available here, and our client alert on the SEC’s adoption of Rule 10D-1 is available here.

The delayed effective dates, which were highly anticipated, align with the SEC’s statement when it adopted Rule 10D-1 in October 2022 that it anticipated companies would have “more than a year from the date the final rules are published in the Federal Register to prepare and adopt compliant recovery policies.” On June 9, the SEC approved the Exchanges’ proposed listing standards, as modified by these amendments to include the October 2, 2023 effective date, on an accelerated basis. The delayed effective dates will ensure that companies have adequate time to draft, customize, and implement Rule 10D-1 policies. When doing so, companies should consider the following issues:

What form should the policy take, and should it be integrated with any existing clawback policy?

The Exchanges’ listing standards will require that companies adopt a written policy. Companies that have existing clawback policies need to determine whether to adopt a stand-alone Rule 10D-1 compliant policy, or whether to integrate that policy with their existing clawback policy. When faced with the prospect of an early effective date for the Exchanges’ listing standards, some companies were leaning toward adoption of a stand-alone policy, but either approach is acceptable, and with more time to draft and review a compliant policy, we expect both approaches to be common.  Factors to consider when making that decision include whether the existing policy applies in contexts other than financial restatements and whether the existing policy covers employees who are not “executive officers” as defined in Rule 10D-1, as well as more nuanced considerations such as how the look-back applies, how recoverable amounts are calculated, and what compensation is covered by the policy. Even if adopting a stand-alone Rule 10D-1 policy, companies should evaluate whether and, if so, how any existing policy will be amended to conform with provisions of the Rule 10D-1 policy, including any transition provisions to apply the existing policy to compensation received prior to the effective date of the Rule 10D-1 policy. Some companies may wish to reconsider the format of their policies, particularly if the current policies are embedded in corporate governance guidelines or other documents, and should consider whether they intend to voluntarily file any other clawback policy with the SEC when they are required to file their Rule 10D-1 policy as an exhibit to their annual reports (as discussed below).

Who needs to approve the policy?

Neither of the Exchanges specify what corporate actions need to be taken or by whom to adopt a Rule 10D-1 policy. For many companies, the authority will rest with the Board’s compensation committee, either through express language in the committee’s charter or through a more general allocation of responsibility to the committee for oversight of executive compensation matters. However, some companies may determine that the matter is better handled by a different board committee or, after a review of applicable committee charter language, may determine that the full Board should approve or ratify approval of the Rule 10D-1 policy.  Companies may also wish to consider their historic practice when addressing similar situations, such as when companies adopted hedging policies to address the disclosure requirements of Regulation S-K Item 407(i).

How is the policy enforced?

The Exchanges’ listing standards will require that companies not only adopt Rule 10D-1 policies, but also comply with those policies.  Companies could face delisting, as well as other possible legal exposure, if they do not recover incentive compensation on a reasonably prompt basis as provided for under their Rule 10D-1 policies. Accordingly, companies need to consider how they will enforce their policies if and when required. We expect that companies will rely on terms in incentive compensation plans, terms in award agreements under those plans, and/or stand-alone undertakings in which executives agree to be bound by and comply with a company’s clawback policies. Regardless of the context, greater specificity and explicit written acceptance/signatures by covered executives may enhance enforceability. At the same time, given the breadth of arrangements to which Rule 10D-1 policies could apply (Rule 10D-1 defines “incentive-based compensation” as “any compensation that is granted, earned, or vested based wholly or in part upon the attainment of a financial reporting measure” as that term is defined in Rule 10D-1), it could be helpful for provisions that will be relied upon to enforce the Rule 10D-1 policy to apply broadly to any compensation arrangement subject to Rule 10D-1.  Because the Rule 10D-1 policy needs to apply to any “incentive-based compensation” that is “received” on or after October 2, 2023, with the definition of “received” generally referring to when the applicable financial reporting measure is attained, a Rule 10D-1 policy typically will apply to incentive awards that were granted prior to October 2.  Thus, express executive acknowledgements that the Rule 10D-1 policy applies to past grants also may be helpful. Some companies may also seek to document that compensation can be recovered from any amounts that might otherwise be or become due to a current or former executive, including through offsets of amounts due under non-qualified deferred compensation arrangements.

How is the policy implemented?

As noted above, Rule 10D-1 policies will apply broadly to “incentive-based compensation” that is based in whole or in part on a “financial reporting measure,” which itself is broadly defined to include measures determined or derived wholly or in part from accounting measures or that are based on stock price or total shareholder return. Under Rule 10D-1 and the Exchanges’ listing standards, if a company experiences a restatement that triggers the applicability of the company’s Rule 10D-1 policy, the company will be required to document certain determinations and provide such documentation to the applicable Exchange. Companies should therefore carefully survey all compensation arrangements in which executive officers participate to determine which are based on a “financial reporting measure.” It will be helpful in administering Rule 10D-1 policies for companies to clearly document the extent to which their executive compensation arrangements do or do not involve a financial reporting measure and, going forward, to clearly document the extent to which financial reporting measures impact the compensation committee’s determinations regarding the form or amount of compensation granted, earned, vested, or otherwise provided to executive officers.

Does adoption of the policy trigger any disclosure?

Companies will be required to file their Rule 10D-1 policies as an exhibit to their Form 10-K.  Compliance with the disclosure requirements is required in the first annual report required to be filed after October 2, 2023, the effective date of the new listing standards, although the SEC stated also that it would not expect compliance with the disclosure requirement until companies are required to have adopted a policy under the applicable Exchange listing standard. Companies should carefully evaluate whether adoption of a Rule 10D-1 policy, or any amendments to existing incentive compensation plans or agreements that implement the policy, constitute material new compensation arrangements or material amendments or modifications that must be disclosed. However, we believe that in most cases those actions will not trigger a Form 8-K filing under Item 5.02(e), due to both the fact that the actions relate to a contingent potential adjustment to amounts payable under existing executive compensation arrangements, and the fact that a Rule 10D-1 policy operates essentially as just an extension of the time over which the evaluation of performance measures is applied. Additional Form 10-K check-box and proxy statement disclosure requirements also apply if a company experiences a restatement during the year, as discussed in our prior client alert, so companies should establish appropriate disclosure controls to allow them to satisfy these disclosure obligations.

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The following Gibson Dunn lawyers assisted in the preparation of this alert: Stephen Fackler, Krista Hanvey, Ronald Mueller, Christina Andersen, and Geoff Walter.

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

Executive Compensation and Employee Benefits Group:
Stephen W. Fackler – Palo Alto/New York (+1 650-849-5385/+1 212-351-2392, [email protected])
Sean C. Feller – Los Angeles (+1 310-551-8746, [email protected])
Krista Hanvey – Dallas (+ 214-698-3425, [email protected])
Christina Andersen – New York (+1 212-351-3857, [email protected])

Securities Regulation and Corporate Governance Group:
Elizabeth Ising – Washington, D.C. (+1 202-955-8287, [email protected])
Thomas J. Kim – Washington, D.C. (+1 202-887-3550, [email protected])
Brian J. Lane – Washington, D.C. (+1 202-887-3646, [email protected])
James J. Moloney – Orange County (+1 949-451-4343, [email protected])
Ron Mueller – Washington, D.C. (+1 202-955-8671, [email protected])
Michael J. Scanlon – Washington, D.C. (+1 202-887-3668, [email protected])
Michael Titera – Orange County (+1 949-451-4365, [email protected])
Lori Zyskowski – New York (+1 212-351-2309, [email protected])
Aaron Briggs – San Francisco (+1 415-393-8297, [email protected])
Julia Lapitskaya – New York (+1 212-351-2354, [email protected])

© 2023 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice. Please note, prior results do not guarantee a similar outcome.

Decided June 8, 2023

Jack Daniel’s Properties, Inc. v. VIP Products LLC, No. 22-148

Today, the Supreme Court unanimously reversed a decision that effectively barred trademark infringement and dilution claims against products that imitate a plaintiff’s trademark to identify the defendant’s products.

Background: VIP Products makes a humorous dog toy called “Bad Spaniels,” which is designed to look like a bottle of Jack Daniel’s whiskey. The toy is shaped like a bottle of Jack Daniel’s whiskey and is labeled with “Old No. 2 on your Tennessee Carpet” instead of Jack Daniel’s “Old No. 7 Tennessee Sour Mash Whiskey” and “100% SMELLY” instead of “40% ALC. BY VOL.” Jack Daniel’s owns trademarks in its whiskey bottle and many of the words and graphics on the label.

Jack Daniel’s sued VIP Products under the Lanham Act for trademark infringement, alleging the toy was likely to cause consumer confusion, and trademark dilution, alleging the toy tarnished the marks by associating famous whiskey with dog excrement.

The Ninth Circuit, relying on the test from the Second Circuit’s decision in Rogers v. Grimaldi, 875 F.2d 994 (2d Cir. 1989), held the First Amendment barred the trademark infringement claim because the toy is an “expressive work” that communicates a humorous message. The Ninth Circuit also held the dilution claim failed because the toy communicated a parodic message about Jack Daniel’s, even though VIP Products used the Bad Spaniels trademark and trade dress (the features cribbed from Jack Daniel’s) to identify the source of its own products.

Issue: Whether an expressive use of another’s trademark is entitled to heightened First Amendment protection in trademark infringement and dilution suits, where the alleged infringer uses the mark to identify the source of its own goods or services.

Court’s Holding:

No.  When an alleged infringer uses a trademark to identify the source of its own goods—in other words, uses the “trademark as a trademark”—the First Amendment does not preclude infringement liability. As for trademark dilution, a parodic use of another’s mark is exempt from liability only if not used to designate source.

Using “a trademark as a trademark … falls within the heartland of trademark law, and does not receive special First Amendment protection.”

Justice Kagan, writing for the Court

What It Means:

• Today’s decision underscores that, when a mark is used to identify the source of the alleged infringer’s own goods or services, the alleged infringer is not shielded from Lanham Act liability simply because the infringer is engaging in parody or commentary. The Court explained that, for both infringement and dilution claims, the crucial question is whether the use of the trademark serves a “source-designation function”—that is, whether it is being used by the infringer to identify its own products.
• The Court emphasized that its holding was “narrow.” Despite recognizing that Rogers has always been limited to cases involving “non-trademark uses”—in which the mark does not identify the source of the infringer’s good or service—the Court left open whether the Rogers test is ever appropriate. Justice Gorsuch, in a concurrence joined by Justices Thomas and Barrett, “underscore[d] that lower courts should handle Rogers . . . with care,” noting that neither its genesis nor its correctness was “entirely clear.”
• The Court remanded to the Ninth Circuit to consider whether the Bad Spaniels toy is likely to cause consumer confusion. The Court said the proceedings on remand should consider only this “standard trademark analysis.” In that analysis, the Court noted that the alleged infringer’s intent to ridicule the trademark might remain relevant in deciding likelihood of confusion.
• Justice Sotomayor, in a concurrence joined by Justice Alito, warned against excessive reliance on consumer surveys to assess consumer confusion, which is an increasingly common method of litigating confusion in trademark cases. Relying on surveys, she wrote, risks undoing the Lanham Act’s “careful balancing” of the individual benefit of a trademark against the societal benefit of free expression, by granting consumers an “effective veto over mockery” and commentary they do not understand or appreciate.

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The Court’s opinion is available here.

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

Appellate and Constitutional Law Practice

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

Related Practice: Fashion, Retail and Consumer Products

Howard S. Hogan +1 202.887.3640 [email protected]

Related Practice: Intellectual Property

Kate Dominguez +1 212.351.2338 [email protected]	Y. Ernest Hsin +1 415.393.8224 [email protected]	Josh Krevitt +1 212.351.4000 [email protected]
Jane M. Love, Ph.D. +1 212.351.3922 [email protected]

Munich partner Katharina Humphrey and associate Andreas Dürr are the authors of “How Ambitious New EU Directive Seeks To Fight Corruption,” [PDF] published by Law360 on June 7, 2023.

An unaccustomed acquirer may encounter a number of potential pitfalls for technology acquisitions. Failure to promptly identify, assess and potentially mitigate specific issues during diligence can undermine the initial rationale for or valuation of the transaction.  Moreover, acquirors need to be careful in any assessment to have a pragmatic and accurate understanding of the issues – such that risks are accurately understood with precision and that an acquirer does not either casually dismiss risk on one hand, or conversely, potentially over-react to a hypothetical worst-case scenario that has a very low probability of coming to fruition.

We detail below a non-exhaustive list of top technology sector-specific legal diligence concerns in acquisitions.

1. Ownership of IP

A primary concern in diligence is confirming the target owns, or otherwise has the right to use, the intellectual property it purports to own.  Issues can surface in a variety of contexts throughout the chain of ownership—from creation to subsequent transfers to encumbrances via commercial arrangements.  While this article does not delve into every potential issue, as a general matter in technology deals, it is critical to understand what intellectual property the target actually owns, or has the right to use, the rights and obligations attached thereto, the extent and scope of any encumbrances, and the transferability of the intellectual property.  Below are a few examples of issues acquirors should consider when completing this analysis.

a. The Proprietary Information and Invention Assignment Agreement (PIIAs) and Consulting Agreements

To ensure employees involved in the development of a target company’s technology no longer own rights in the developments, and that the target has the full rights to exploit its technology, an acquiror will want to review PIIAs executed by each current and former employee of the target, or at least from each employee involved in the development of, or exposed to, the target company’s technology. Each PIIA should include an express, current, and future assignment of all rights, title and interest in inventions developed during employment.  PIIAs should also include confidentiality restrictions whereby the employees agree not to disclose proprietary information of their employer. An acquiror must also confirm that founders and officers of the target have effectively assigned their intellectual property rights to the target company and that none of the PIIAs or other inventions assignment agreements exclude intellectual property used in the target company’s business as prior inventions. If any such individuals  have left the target company since its inception, to the extent that they were involved in material research and development efforts related to the target company’s business, an acquiror will need to weigh the pros and cons of insisting that the target company seek to intellectual property assignment agreements prior to the signing or closing of the transaction.

Similarly, an acquiror should to evaluate whether all contractors and consultants providing research and development or design services to the target company effectively assigned to the target their intellectual property rights in the results or work product of the services.  Often, such consulting services are provided by engineering resources outside of the United States.  In such circumstances, an acquiror should consult with local counsel in the relevant jurisdictions to ensure that the operative inventions assignment provisions are enforceable under applicable law and that the obligations of the target are consistent with such local law.

b. Licenses; Encumbrances

Technology companies frequently enter into commercial arrangements with third parties under which the company’s intellectual property is licensed, transferred, or encumbered in some way.  An acquiror should pay special attention to agreements that cover research and development, joint ventures, joint development, collaborations, cross-licenses and other arrangements that license intellectual property, where parties covenant not to sue each other, or that may otherwise encumber the target company’s intellectual property.  Key considerations include whether the license is transferable or sublicensable; exclusive or nonexclusive; limited geographically or worldwide; limited in duration, irrevocable or perpetual; and royalty-bearing or royalty-free.  License terms may include a “springing” license, whereby a counterparty is granted certain licensing rights upon a named event, such as a change in control or assignment.  If this springing license is triggered by the contemplated transaction, the acquiror may not receive all of the rights to the intellectual property that it was anticipating, and instead, may have licensing or royalty obligations to a third party or even a competitor.  Similarly, the intellectual property may be jointly owned through a joint venture or similar collaboration agreement or subject to development milestones that trigger ongoing obligations or royalties to the counterparty even after the acquiror takes control.  The target company’s intellectual property may also be subject to other distinct limitations, such as a covenant not to sue whereby the target agrees not to assert intellectual property rights against the counterparty for particular uses or products.

c. The Upward-Reaching Affiliate Issue

The issue of how “affiliates” is drafted in a target company’s intellectual property license agreements should be carefully considered in the transactional due diligence context. The issue is that the parties often fail to properly define the term “affiliate” or they define this term in a manner that is perhaps unintentionally overly-broad (e.g., includes any entity which controls, is controlled by or is under common control with licensor or licensee), such that, post-closing of the transaction, the license agreement could be deemed to apply to the acquiror’s patent portfolio.  Consider, for example, the following scenario:

• Company X enters into a license agreement for its entire patent portfolio with Company Y, in exchange for a license to Company Y’s entire patent portfolio. The grant language provides: Company X hereby grants a worldwide, irrevocable, royalty-free, fully-paid up license to Company Y to exploit the entire patent portfolio of Company X and Company X’s affiliates.
• Thereafter, Company X seeks to merge with Company Z. Unbeknownst to Company X, Company Z entered into a license agreement with Company Y that provides a significant source of revenue to Company Z.
• When Company Z merges with Company X, it also acquires the license agreement between Company X and Company Y. After the transaction closes, Company Y terminates its license agreement with Company Z, claiming that the license acquired from Company X includes the patent portfolio of Company Z, because Company Z is now an affiliate of Company X.

An acquiror generally would not expect to grant a patent license to third parties as a result of the consummation of an acquisition—in particular if such entity has a valuable patent monetization program or the beneficiary of the upward affiliate issue in a patent license agreement is a direct competitor of or is in litigation with such acquiror.

d. Transfer/Change in Control Restrictions

An acquiror will want to confirm early in the diligence process whether there are any “change in control” or anti-assignment provisions in the target company’s intellectual property agreements that would prohibit or limit the ability to transfer the intellectual property in the manner contemplated by the parties.  Even if not expressly prohibited by a change in control clause, the parties should confirm that the transaction will not trigger any anti-assignment prohibitions in the target company’s intellectual property contracts.  In general, intellectual property license agreements are deemed to convey rights that are personal to the licensor and non-transferable to a third party absent the consent of the licensor.  Thus, the question of whether or not a transfer occurs by virtue of a given transaction or is permitted under the agreement without the consent of the licensor may be important to consider in the context of a material inbound IP license agreement.  Some courts have held that a transfer of contractual intellectual property rights in a forward merger constitutes an impermissible transfer that violates anti-assignment prohibitions.  While courts in most jurisdictions have generally found that a reverse triangular merger does not trigger an assignment by operation of law, the effect of a reverse triangular merger on anti-assignment provisions should be evaluated, especially if a contract is material. This is particularly true in light of cases such as SQL Solutions Inc. v. Oracle Corporation, where a California court held that a reverse triangular merger could potentially trigger prohibitions on assignments by operation of law in certain circumstances. Provided key issues can be identified early in the process, counsel can implement the necessary structure, and require the necessary consents, to ensure the acquiror achieves its desired result.  If a consent cannot be obtained or likely cannot be obtained, understanding the effect on the target company’s business of losing the IP rights (or license fees or royalties associated with the procurement of a new license) will be important to assessing the deal’s valuation.

e. Government or University Funding

Funding from government or university sources such as grants, or even the use of university facilities, can often come with strings attached, including ownership or license rights in favor of the funding source.  Applicable statutes, grant terms, faculty employment agreements and university policies should be carefully reviewed to confirm whether a university or government funding source has any consent or intellectual property rights in, or with respect to, the transfer or use of any of the target company’s intellectual property.  Further, while during recent years, universities have become more supportive of their professors launching companies, not all universities have updated their policies regarding the same. As a result, an acquiror may need to require a target to obtain certain consents or releases from a government or university funding source as a closing condition to a transaction.  Outside the U.S., government funding can create tail liabilities that need to be allocated between the acquiror and seller – for example, in Israel, exporting IP developed using in part funds from the Israeli Ministry of Innovation, Science and Technology for development outside of Israel could likely trigger a non-trivial payment.

2. Open Source Software

Commonly used by software engineers in writing code, certain open source software kernels in a target company’s codebase may come with license terms that can present material issues for a Company looking to incorporate and monetize a target company’s software.  The most prominent example is “copyleft” or “viral” open source licenses that, per their terms, require in certain circumstances all modifications to or code incorporated with such code to be released to third parties in source code form.  This could cause significant issues if compliance with these terms would result in the disclosure of otherwise proprietary code or, alternatively, require the acquiror to invest significant time and resources in re-engineering the codebase to exclude the copyleft code.  If software is a material asset of the target, acquirors should carefully consider engaging an open source vendor to perform a code scan that can flag portions of code in the target company’s software that are subject to potentially problematic open source licenses.  Consider having outside counsel engage the consultant to preserve privilege over any findings.

3. Cybersecurity; Data Breach

In today’s environment, all companies are vulnerable to cybersecurity incidents. Even when not consumer facing, a company may house significant and sensitive data regarding its employees, proprietary technology, including source code, customers, suppliers and other counterparties.  What may seem at the outset to be a ‘small’ cybersecurity issue often balloons into a problem that requires extensive remediation efforts and can be subject to state-by-state notification and country-by-country reporting and remediation requirements.  Further, cybersecurity vulnerabilities that are exploited following the closing of an acquisition can be damaging to the brand and public trust of the acquiror.  An acquiror should require a target company to provide a detailed description of its cybersecurity protocols, policies, procedures, audit results and all recent penetration (“pen”) tests and should verify with the target how any issues flagged were remediated.  If a recent pen test is not available, an acquiror should strongly consider engaging a consultant to perform one as part of the diligence process.

4. Cyber Insurance

Given the increase in cyber incidents over the years, reviewing a target company’s insurance policies for any coverage from cyber breaches or other incidents has become an important part of any transaction.  However, these policies often include large exclusions for issues such as ransomware attacks or nation-state attacks.  As such, even with coverage in place, a policy may not provide the expected level of protection. An acquiror, together with counsel, should give careful consideration to how representations and indemnification protections concerning cybersecurity matters, such as pre-closing breaches, are constructed in the definitive agreement.  Further, the acquiror must evaluate both the target company’s and its own policies to understand if coverage will exist for historical cyber breaches that are not discovered until after the deal is consummated.

5. Adequate Protection of Trade Secrets

For many technology companies, their most valuable intellectual property asset is source code, which is typically maintained as a trade secret (if not patented or patentable subject matter). Thus, it is important to confirm that the target company engages in industry-standard practices and has implemented adequate controls to protect its trade secrets and has not licensed or disclosed its code in a manner that could enable third parties to gain access to the source code.  The target company, may, for example, have agreed to place its source code into an escrow account for the benefit of a third party.  Such agreements frequently include provisions that permit the release of source code to the third-party beneficiary in the event of a change of control of the target company.  The implications of such agreements should be considered with respect to the extent that the release of such code could impair the value of the trade secrets or would be inconsistent with the acquiror’s intended exploitation of the source code.

6. Data Privacy; Data Use

A target company’s data can be a valuable asset to an acquiror, but this value can be easily diminished if the target company did not secure the appropriate scope of use for such data.  An acquiror should pay special attention to the target company’s data privacy policies, sources and methods of procuring data, procedures and compliance, as well as applicable contractual provisions to ensure any planned use of the data by the acquiror is permitted.  The diligence exercise also needs to include the identification of, and review for compliance with, all applicable privacy laws such as the General Data Protection Regulation (GDPR), California Consumer Privacy Act (CCPA), California Privacy Rights Act (CPRA) and the ever expanding patchwork of other similar state, national and international laws and regulations.  The acquiror should confirm that the data can be transferred in the manner contemplated by the transaction by ensuring that the transfer of data upon consummation of the transaction is compliant with the target company’s privacy policy and any applicable laws and regulations.  For example, a target company’s privacy policy may require prior consent from the user to transfer its data in a merger or sale.  Some policies may also require erasure of data from non-consenting users, which may preclude the acquiror’s use of such data.  Consent may also be required for the transfer of certain types of “sensitive data” (e.g., PHI (protected health information)).

7. Employee Stock Options and 409A Valuations

Technology companies routinely grant employees stock options as part of their compensation packages.  To ensure the options are issued with an exercise price no less than fair market value, a target company should be able to provide yearly 409A valuations by a third party consultant setting forth the value of the common stock of the target at the time of evaluation.  Note, if the target company experiences a material event, such as a fundraise or execution of a term sheet, the target may no longer be able to reasonably rely on a prior 409A valuation. It is not unusual to discover during diligence that a target company has issued unallocated stock options after receiving and/or executing a term sheet with an acquiror based on a prior 409A valuation that does not incorporate this material, new valuation information.  Failure to identity and remedy this issue can result in adverse and unexpected tax consequences for both the target company and the employees that were issued these mispriced options – and create dissatisfaction with such employees in the period after an acquisition’s closing, precisely when an acquiror will be aiming to retain key technical personnel.

8. Trade Compliance/Anti-Corruption

Technology companies frequently are global in their sales, and subject both to export control regimes and anti-corruptions laws, such as the US Foreign Corrupt Practices Act (FCPA), UK Bribery Act and France’s Sapin II.  These areas often can be afterthoughts in a long list of diligence issues to tackle – however, if not discovered before closing a transaction, the post-closing penalty can include self-disclosure or, worse yet, a whistleblower-triggered investigation by a regulator, each of which can imperil the acquiror’s overall brand and business, not to mention financial liability.  Acquirors, in partnership with legal counsel, should evaluate a seller’s products and relevant export controls (EAR/ITAR in the US) as well as compliance with country and individual sanctions.  It is not unheard to discover seemingly ‘immaterial’ transactions to prohibited states that create significant consequences from regulators.  Likewise, counsel should review a company’s corruption compliance program, including specifically, training and any prior whistleblower complaints particularly surrounding high risk indicia such as “gift” programs or sponsored travel.

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Gibson Dunn has significant experience counseling clients in acquisitions in the technology sector, and our lawyers are available to assist in addressing any questions you may have regarding these issues. Please feel free to contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Mergers and Acquisitions, Private Equity, or Media, Entertainment and Technology practice groups, or the following authors of this article:

Ed Batts – Mergers & Acquisitions, Palo Alto (+1 650-849-5392, [email protected])

Carrie LeRoy – Technology Transactions, Palo Alto (+1 650-849-5337, [email protected])

Charles V. Walker – Mergers & Acquisitions, Houston (+1 346-718-6671, [email protected])

Jessica Howard – Mergers & Acquisitions, Orange County (+1 949-451-4007, [email protected])

© 2023 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice. Please note, prior results do not guarantee a similar outcome.

Gibson Dunn’s Public Policy Practice Group is closely monitoring the debate in Congress over potential oversight of artificial intelligence (AI). We offer this alert summarizing and analyzing the U.S. Senate hearings on May 16, 2023, to help our clients prepare for potential legislation regulating the use of AI. For further discussion of the major federal legislative efforts and White House initiatives regarding AI, see our May 19, 2023 alert Federal Policymakers’ Recent Actions Seek to Regulate AI.

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On May 16, 2023, both the Senate Judiciary Committee’s Subcommittee on Privacy, Technology, and the Law and the Senate Homeland Security and Governmental Affairs Committee held hearings to discuss issues involving AI. The hearings highlighted the potential benefits of AI, while acknowledging the need for transparency and accountability to address ethical concerns, protect constitutional rights, and prevent the spread of disinformation. Senators and witnesses acknowledged that AI presents a profound opportunity for American innovation, but warned that it must be adopted with caution and regulated by the federal government given the potential risks. A general consensus existed amongst the senators and witnesses that AI should be regulated, but the approaches to, and extent of, that regulation varied.

Senate Judiciary Committee Subcommittee on Privacy, Technology, and the Law Hearing: “Oversight of AI: Rules for Artificial Intelligence”

On May 16, 2023, the U.S. Senate Committee on the Judiciary Subcommittee on Privacy, Technology, and the Law held a hearing titled, “Oversight of AI: Rules for Artificial Intelligence.”[1] Chair Richard Blumenthal (D-CT) emphasized that his subcommittee was holding the first hearing in a series of hearings aimed at considering whether and to what extent Congress should regulate rapidly advancing AI technology, including generative algorithms and large language models (LLMs).

The hearing focused on potential new regulations such as creating a dedicated agency or commission and a licensing scheme, the extent to which existing legal frameworks apply to AI, and the alleged harms prompting regulation like intellectual property and privacy rights infringements, job displacement, bias, and election interference.

Witnesses included:

• Sam Altman, Chief Executive Officer, OpenAI;
• Gary Marcus, Professor Emeritus, New York University; and
• Christina Montgomery, Vice President and Chief Privacy and Trust Officer, IBM.

I. AI Oversight Hearing Points of Particular Interest

We provide a full hearing summary and analysis below. Of particular note, however:

• Chair Blumenthal opened the hearing by playing a statement written and voiced by AI that mimicked the senator’s own writing and voice. The Chair used this demonstration of the technology’s current capabilities to emphasize its alleged existing harms and risks. The potential harms, the Chair said, include “weaponized disinformation, housing discrimination, harassment of women and impersonation fraud, voice cloning,” as well as the potential workforce displacement. Chair Blumenthal took the position that existing law suggests AI companies should (1) be transparent by disclosing known risks and allowing independent researcher access and (2) be competing based on safety and trustworthiness. Moreover, Chair Blumenthal suggested use limitations “where the risk of AI is so extreme that we ought to impose restrictions, or even ban their use especially when it comes to commercial invasions of privacy for profit and decisions that affect people’s livelihoods.” Finally, the Chair raised the issue of accountability or liability for  harm.
• Ranking Member Senator Josh Hawley (R-MO) emphasized AI’s potential impact, questioning whether it will be an innovation more like the Internet or the atom bomb. Senator Hawley thought the question facing society, and Congress specifically, is whether Congress will “strike that balance between technological innovation and our ethical and moral responsibility to humanity, to liberty, to the freedom of this country.”
• Witnesses and several senators suggested creating a dedicated federal agency or commission and a licensing scheme. A “scorecard” or “nutrition label” discussed by Chair Blumenthal and Professor Marcus could indicate to consumers the particular AI system’s safety and “ingredients” (i.e., data, algorithms). Ms. Montgomery advocated for “precision regulation” that would focus on particularly risky uses of AI, rather than AI generally. Mr. Altman advocated for pre-public deployment testing and threshold requirements.
• Also relevant to the development of regulations and standards was the role of the international community, from the draft E.U. AI Act to international body involvement in the development of ethical norms. Senator Dick Durbin (D-IL), for example, asked how an international authority could fairly regulate all entities involved.
• Senators questioned the witnesses on the risks and benefits associated with specific AI applications, including risks to intellectual property and privacy rights. Senators were also greatly concerned about election interference, bias, competition and market dynamics, and job displacement.

II. Key Substantive Issues

Key substantive issues raised in the hearing included: (a) a potential AI federal agency and licensing scheme, (b) the applicability of existing frameworks for responsibility and liability, and (c) alleged harms and rights infringements.

a. AI Federal Agency and Licensing Scheme

The hearing focused on whether and to what extent the U.S. should regulate AI. As emphasized throughout the hearing, the impetus for regulation is the speed with which the technology is developing and dispersing into society coupled with senatorial regret over past failures to regulate emerging technology. Chair Blumenthal explained that “Congress has a choice now. We have the same choice when we face social media. We failed to seize that moment. The result is predators on the Internet, toxic content, exploiting children creating dangers for them.”

Senators discussed a potential dedicated federal agency or commission for regulating AI technology. Senator Peter Welch (D-VT) has “come to the conclusion that we absolutely have to have an agency.” Senator Lindsey Graham (R-SC) stated that Congress “need[s] to empower an agency that issues a license and can take it away.” Senator Cory Booker (D-NJ) likened the need for an AI-centered agency to the need for an automobile-centered agency that resulted in the creation of the National Highway Traffic Safety Administration and the Federal Motor Car Carrier Safety Administration. Mr. Altman similarly “would form a new agency that licenses any effort above a certain scale of capabilities, and can take that license away and ensure compliance with safety standards.” Senator Chris Coons (D-DE) was concerned with how to decide whether a particular AI model was safe enough to deploy into the public. Mr. Altman suggested “iterative deployment” to find the limitations and benefits of the technology, including giving the public time to “come to grips with this technology to understand it . . . .”

In Ms. Montgomery’s view, a precision approach to regulating AI strikes the right balance between encouraging and permitting innovation while addressing the potential risks of the technology. Mr. Altman “would create a set of safety standards focused on . . . the dangerous capability evaluations” such as “if a model can self-replicate and . . . self-exfiltrate into the wild.” Potential challenges facing a new federal agency include funding and regulatory capture on the government side, and regulatory burden on the industry side.

Senator John Kennedy (R-LA) asked the witnesses what “two or three reforms, regulations, if any” they would implement.

• Montgomery would implement transparency and accountability reforms. She also advocated for a use-based approach to regulation, including defining highest-risk cases and impact assessments. Ms. Montgomery would also require disclosures in connection with training data and models.
• Professor Marcus would require safety testing akin to what exists for the Food and Drug Administration (FDA). Moreover, Professor Marcus advocated for a “nimble monitoring agency” to address not just the pre-deployment review of AI, but also post-deployment monitoring with the ability to call products back. Finally, Professor Marcus stated he would fund AI research and an AI constitution, geared toward ethical and honest development of the field.
• Altman “would form a new agency that licenses any effort above a certain scale of capabilities, and can take that license away and ensure compliance with safety standards.” Moreover, he “would create a set of safety standards focused on . . . the dangerous capability evaluations.” Finally, Mr. Altman would require independent audits.

Transparency was a key repeated value that will play a role in any future oversight efforts. In his prepared testimony, Professor Marcus noted that “[c]urrent systems are not transparent. They do not adequately protect our privacy, and they continue to perpetuate bias.” He also explained that governmental oversight must actively include independent scientists to assess AI through access to the methods and data used.

b. Applicability of Existing Frameworks for Responsibility and Liability

Senators wanted to learn who is responsible or liable for the alleged harms of AI under existing laws and regulations. For example, Senators Durbin and Graham both raised questions about the application of 47 U.S.C. § 230, originally part of the Communications Decency Act, which creates a liability safe harbor for companies hosting user-created content under certain circumstances. Section 230 was at issue in two United States Supreme Court cases this term—Twitter v. Taamneh and Gonzalez v. Google—both of which were decided two days after the hearing.[2] The Supreme Court declined to hold either Twitter or Google liable for the effects of violent content posted on their platforms. However, Justice Ketanji Brown Jackson filed a concurring opinion in Taamneh, which left open the possibility of holding tech companies liable in the future.[3] The Subcommittee on Privacy, Technology, and the Law held a hearing in March, following oral arguments in Taanmeh and Gonzalez, suggesting the committee’s interest in regulating technology companies could go beyond existing frameworks.[4] Mr. Altman noted he believes that Section 230 is the wrong structure for AI, but Senator Graham wanted to “find out how [AI] is different than social media . . . .” Given Mr. Altman’s position that Section 230 did not apply to the tool OpenAI has created, Senator Graham wanted to know whether he could sue OpenAI if harmed by it. Mr. Altman said that question was beyond his area of expertise.

c. Alleged Harms and Rights Infringement

The hearing emphasized the potential risks and alleged harms of AI. Senator Welch stated that AI has risks “that relate to fundamental privacy rights, bias rights, intellectual property, dissent, [and] the spread of disinformation” during the hearing. For Senator Welch, disinformation is “in many ways . . . the biggest threat because that goes to the core of our capacity for self-governing.” Senator Mazie Hirono (D-HI) noted that measures can be built into the technology to minimize harmful results. Specifically, Senator Hirono asked about the ability to refuse harmful requests and how to define harmful requests—representing potential issues that legislators will have to grapple with while trying to regulate AI.

Senators focused on five key areas during the hearing: (i) elections, (ii) intellectual property, (iii) privacy, (iv) job markets, and (v) competition.

i. Elections

A number of senators shared the concern that AI can potentially be used to influence or impact elections. The alleged influence and impact, they noted, can be explicit or unseen. For explicit or direct election influence, Senator Amy Klobuchar (D-MN) asked what should be done about the possibility of AI tools directing voters to incorrect polling locations. Mr. Altman suggested that voters would understand that AI is just a tool that requires external verification.

During the hearing, Professor Marcus noted that AI can exert unseen influence over individual behavior based on data choices and algorithmic methods, but that these data choices and algorithmic methods are neither transparent to the public nor accessible to independent researchers under current systems. Senator Hawley questioned Mr. Altman about AI’s ability to accurately predict public opinion surveys. Specifically, Senator Hawley suggested that companies may be able to “fine tune strategies to elicit certain responses, certain behavioral responses” and that there could be an effort to influence undecided voters.

Ms. Montgomery stated that elections are an area that require transparent AI. Specifically, she advocated for “[a]ny algorithm used in [the election] context” to be “required to have disclosure around the data being used, the performance of the model, anything along those lines is really important.” This will likely be a key area of oversight moving into the 2024 elections.

ii. Intellectual Property

Several Senators voiced concerns that training AI systems could infringe intellectual property rights. Senator Marsha Blackburn (R-TN), for example, queried whether artists whose artistic creations are used to train algorithms are or will be compensated for the use of their work. Mr. Altman stated that OpenAI is “working with artists now visual artists, musicians, to figure out what people want” but that “[t]here’s a lot of different opinions, unfortunately,” suggesting some cooperative industry efforts have been met with difficulty. Senator Klobuchar asked about the impact AI could have on local news organizations, raising concerns that certain AI tools use local news content without compensation, which could exacerbate existing challenges local news organizations face. Chair Blumenthal noted that one of the hearings in this AI series will focus on intellectual property.

iii. Privacy

Several senators raised the potential privacy risks that could result from the deployment of AI. Senator Blackburn asked what Mr. Altman’s policy is for ensuring OpenAI is “protecting that individual’s right to privacy and their right to secure that data . . . .” Chair Blumenthal also asked what specific steps OpenAI is taking to protect privacy. Mr. Altman explained that users can opt out of OpenAI using their data for training purposes and delete conversation histories. At IBM, Ms. Montgomery explained, the company “even filter[s] [its] large language models for content that includes personal information that may have been pulled from public datasets as well.” Senator Jon Ossoff (D-GA) addressed child privacy, advising Mr. Altman to “get way ahead of this issue, the safety for children of your product, or I think you’re going to find that Senator Blumenthal, Senator Hawley, others on the Subcommittee and I are will look very harshly on the deployment of technology that harms children.”

iv. Job Market

Chair Blumenthal raised AI’s potential impact on the job market and economy. Mr. Altman admitted that “like with all technological revolutions, I expect there to be significant impact on jobs.” Ms. Montgomery noted the potential for new job opportunities and the importance of training the workforce for the technological jobs of the future.

v. Competition

Senator Booker expressed concern over “how few companies now control and affect the lives of so many of us. And these companies are getting bigger and more powerful.” Mr. Altman added that an effort is needed to align AI systems with societal values. Chair Blumenthal noted that the hearing had barely touched on the competition concerns related to AI, specifically the “monopolization danger, the dominance of markets that excludes new competition, and thereby inhibits or prevents innovation and invention.” The Chair suggested that a further discussion on antitrust issues might be needed.

Senate Homeland Security and Governmental Affairs Committee Hearing:“Artificial Intelligence in Government”

On the same day, the U.S. Senate Homeland Security and Governmental Affairs Committee (HSGAC) held a hearing to explore the opportunities and challenges associated with the federal government’s use of AI.[5] The hearing was the second in a series of hearings that committee Chair Gary Peters (D-MI) plans to convene to address how lawmakers can support the development of AI. The first hearing, held on March 8, 2023, focused on the transformative potential of AI, as well as the potential risks.[6]

Witnesses included:

• Richard A. Eppink, of Counsel, American Civil Liberties Union of Idaho Foundation;
• Taka Ariga, Chief Data Scientist, U.S. Government Accountability Office;
• Lynne E. Parker, Ph.D., Associate Vice Chancellor and Director, AI, Tennessee Initiative, University of Tennessee (and former deputy U.S. chief technology officer and director of the White House’s National AI Initiative Office);
• Daniel Ho, Professor, Stanford Law School; and
• Jacob Siegel, Writer

We provide a full hearing summary and analysis below. Of particular note, however:

• Chair Peters expressed his commitment to bipartisan legislation to regulate the federal government’s use of AI. He highlighted the pending legislation authored by him and Senator Mike Braun (R-IN), S. 1564, the AI Leadership Training Act, which would create an AI training program for federal supervisors and management officials.[7] After the hearing, the AI Leadership Training Act was successfully reported out of HSGAC. The bill is now awaiting consideration by the full Senate.
• Ranking Member Rand Paul (R-KY) focused on the potential for the federal government to use AI to police information, raising particular concerns about the potential use of AI by federal agencies for surveillance and censorship. He stated that it is “a mistake to concentrate on the technology and not the concentration of power,” explaining that he supports the use of AI, so long as fundamental rights are protected.
• Committee members and witnesses expressed concerns about the potential risks associated with the government’s use of AI, such as algorithmic bias, privacy infringement, suppression of speech, and the impact on jobs. Many of these concerns were echoed by senators in the Senate Judiciary Committee Subcommittee on Privacy, Technology, and the Law hearing discussed above.
• There was a general consensus that Congress needs to develop guidelines, standards, and regulatory frameworks to govern AI adoption across federal agencies. Speaking to reporters after the hearing, Chair Peters acknowledged the growing calls for Congress to create “clear lines of accountability and oversight,” but stated that they must “be thoughtful, deliberative and take [their] time.”

I. Potential Harms

Several senators and witnesses expressed concerns about the potential harms posed by government use of AI, including suppression of speech, bias and discrimination, data privacy and security breaches, and job displacement.

a. Suppression of Speech

In his opening statement and throughout the hearing, Ranking Member Paul expressed concern about the federal government using AI to monitor, surveil, and censor speech under the guise of combating misinformation. He warned that AI will make it easier for the government to invisibly “control the narrative, eliminate dissent, and retain power.” Senator Rick Scott (R-FL) echoed those concerns, and Mr. Siegel stated that the risk of the government using AI to suppress speech cannot be overstated. He cautioned against emulating “the Chinese model of top down party driven social control” when regulating AI, which would “mean the end of our tradition of self-government and the American way of life.”

b. Bias and Discrimination

Senators and witnesses also expressed concerns about the potential for biases in AI applications causing violations of due process and equal protection rights. For example, there was a discussion about apparent flaws identified in an AI algorithm used by the IRS, which resulted in Black taxpayers being audited at five times the rate of other races, and the use of AI-driven systems at the state-level to determine eligibility for disability benefits resulting in thousands of recipients being wrongfully denied critical assistance. Richard Eppink testified about his involvement in a class action lawsuit brought by the ACLU representing individuals with developmental and intellectual disabilities who were denied funds by Idaho’s Medicaid program because of a flaw in the state’s AI-based system. Mr. Eppink explained that the people who were denied disability benefits were unable to challenge the decisions, because they did not have access to the proprietary system used to determine their eligibility. He advocated for increased transparency into any AI systems used by the government, but cautioned that even if an AI-based system functions properly, the underlying data may be corrupted “by years and years of discrimination and other effects that have bias[ed] the data in the first place.” Senators expressed particular concerns about law enforcement’s use of predictive modeling to justify forms of surveillance.

c. Data Privacy and Cybersecurity

Hearing testimony highlighted concerns about the collection, use, and protection of data by AI applications, and the gaps in existing privacy laws. Senator Ossoff stated that AI tools themselves are vulnerable to data breaches and could be used to penetrate government systems. Daniel Ho highlighted the scale of the problem, noting that by one estimate the public sector needs to hire about 40,000 IT workers to address cybersecurity issues posed by AI. Given the enormous amounts of data that can be collected using AI and the “patchwork” system of privacy legislation currently in place, Mr. Ho said a data strategy like the National Secure Data Service Act is needed. Senators signaled bipartisan support for national privacy legislation.

d. Job Displacement:

Senators in the HSGAC hearing echoed the concerns expressed in the Senate Judiciary Committee Subcommittee hearing regarding the potential for AI-driven automation to cause job displacement. Senator Maggie Hassan (D-NH) asked Daniel Ho about the potential for AI to be used to automate government jobs. Mr. Ho responded that “augmenting the existing federal workforce [with AI] rather than displacing them” is the right approach, because ultimately there needs to be a human in charge of these systems. Senator Alex Padilla (D-CA) agreed and provided anecdotal evidence from his experience as Secretary of State of California, where the government introduced the first chatbot in California state government. He opined that rather than leading to layoffs and staff reductions, the chatbot freed up government resources to focus on more important issues.

II. Recommendations

The witnesses offered a number of recommended measures to mitigate the risks posed by the federal government’s use of AI and ensure that it is used in a responsible and ethical manner.

Those recommendations are discussed below.

a. Developing Policies and Guidelines

As directed by the AI in Government Act of 2020 and Executive Order 13961, the Office of Management and Budget (“OMB”) plans to draft policy guidance on the use of AI systems by the U.S. government.[8] Multiple senators and witnesses noted the importance of this guidance and called on OMB to ensure that it appropriately addresses the wide diversity of use cases of AI across the federal government. Lynne Parker proposed requiring all federal agencies to use the National Institute of Standards and Technology (NIST) AI Risk Management Framework (RMF) during the design, development, procurement, use, and management of their cases of AI.  Witnesses also suggested looking to the White House Office of Science and Technology’s Blueprint for an AI Bill of Rights as a guiding principle.

b. Creating Oversight

Senators and witnesses proposed several measures to create oversight over the federal government’s use of AI. Multiple witnesses advocated for AI use case inventories to increase transparency and for the elimination of the government’s use of “black box systems.” Richard Eppink argued that if a government agency or state-funded agency uses AI technology, there must be transparency about the proprietary system so Americans can evaluate whether they need to challenge the government decisions generated by the system. Lynne Parker stated that the U.S. is “suffering right now from a lack of leadership and prioritization on these AI topics” and proposed that one immediate solution would be to appoint AI chief officers at each federal agency to oversee use and implementation. She also recommended establishing an interagency Chief AI Officers Council that would be responsible for coordinating AI adoption across the federal government.

c. Investing in Training, Research, and Development:

Speakers at the hearing highlighted the need to invest in training federal employees and conducting research and development of AI systems. As noted above, after the hearing, the AI Leadership Training Act, which would create an AI training program for federal supervisors and management officials, was favorably reported out of committee. Multiple witnesses stated that Congress must act immediately to help agencies hire and retain technical talent to address the current gap in leadership and expertise within the federal government. Ms. Parker testified that the government must invest in digital infrastructure, including the National AI Research Resource (NAIRR) to ensure secure access to administrative data. The NAIRR is envisioned as a shared computing and data infrastructure that will provide AI researchers and students across scientific fields and disciplines with access to computing resources and high-quality data, along with appropriate educational tools and user support. While there was some support for public-private partnerships to develop and deploy AI, Senator Padilla and Mr. Eppink advocated for agencies building AI tools in house to prevent proprietary interests from influencing government systems. Chair Peters stated that a future HSGAC hearing will focus on how the government can work with the private sector and academia to harness various ideas and approaches.

d. Fostering International Cooperation and Innovation:

Lastly, Senators Hassan and Jacky Rosen (D-NV) both emphasized the need to foster international cooperation in developing AI standards. Senator Rosen proposed a multilateral AI research institute to enable likeminded countries to collaborate together to engage in standard setting. She stated, “China has an explicit plan to become a standards issuing country, and as part of its push to increase global influence it coordinates national standards work across government and industry. So in order for the U.S. to remain a leader in AI and maintain a national security edge, our response must be one of leadership coordination, and, above all cooperation.” Despite expressing grave concerns about the danger to democracy posed by AI, Mr. Seigel noted that the U.S. cannot abandon AI innovation and risk ceding the space to competitors like China.

III. How Gibson Dunn Can Assist

Gibson Dunn’s Public Policy, Artificial Intelligence, and Privacy, Cybersecurity and Data Innovation Practice Groups are closely monitoring legislative and regulatory actions in this space and are available to assist clients through strategic counseling; real-time intelligence gathering; developing and advancing policy positions; drafting legislative text; shaping messaging; and lobbying Congress.

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[1] Oversight of A.I.: Rules for Artificial Intelligence: Hearing Before the Subcomm. on Privacy, Tech., and the Law of the S. Comm. on the Judiciary, 118th Cong. (2023), https://www.judiciary.senate.gov/committee-activity/hearings/oversight-of-ai-rules-for-artificial-intelligence.

[2] Twitter, Inc. v. Taamneh, 143 S. Ct. 1206 (2023); Gonzalez v. Google LLC, 143 S. Ct. 1191 (2023).

[3] See Twitter, Inc. v. Taamneh, 143 S. Ct. 1206, 1231 (2023) (Brown Jackson, K., concurring) (noting that “[o]ther cases presenting different allegations and different records may lead to different conclusions.”).

[4] Press Release, Senator Richard Blumenthal, Blumenthal & Hawley to Hold Hearing on the Future of Tech’s Legal Immunities Following Argument in Gonzalez v. Google (Mar. 1, 2021).

[5]  Artificial Intelligence in Government: Hearing Before the Senate Committee on Homeland Security and Governmental Affairs, 118th Cong. (2023), https://www.hsgac.senate.gov/hearings/artificial-intelligence-in-government/

[6] Artificial Intelligence: Risks and Opportunities: Hearing Before the Homeland Security and Governmental Affairs Committee, 118th Cong. (2023), https://www.hsgac.senate.gov/hearings/artificial-intelligence-risks-and-opportunities/.

[7] S. 1564 – the AI Leadership Training Act, https://www.congress.gov/bill/118th-congress/senate-bill/1564.

[8] See AI in Government Act of 2020, H.R. 2575, 116th Cong. (Sept. 15, 2020); Exec. Order No. 13,960, 85 Fed. Reg. 78939 (Dec. 3, 2020).

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The following Gibson Dunn lawyers prepared this client alert: Michael Bopp, Roscoe Jones Jr., Alexander Southwell, Amanda Neely, Daniel Smith, Frances Waldmann, Kirsten Bleiweiss*, and Madelyn Mae La France.

Gibson, Dunn & Crutcher’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 in the firm’s Public Policy, Artificial Intelligence, or Privacy, Cybersecurity & Data Innovation practice groups:

Public Policy Group:
Michael D. Bopp – Co-Chair, Washington, D.C. (+1 202-955-8256, [email protected])
Roscoe Jones, Jr. – Co-Chair, Washington, D.C. (+1 202-887-3530, [email protected])
Amanda H. Neely – Washington, D.C. (+1 202-777-9566, [email protected])
Daniel P. Smith – Washington, D.C. (+1 202-777-9549, [email protected])

Artificial Intelligence Group:
Cassandra L. Gaedt-Sheckter – Co-Chair, Palo Alto (+1 650-849-5203, [email protected])
Vivek Mohan – Co-Chair, Palo Alto (+1 650-849-5345, [email protected])
Eric D. Vandevelde – Co-Chair, Los Angeles (+1 213-229-7186, [email protected])
Frances A. Waldmann – Los Angeles (+1 213-229-7914, [email protected])

Privacy, Cybersecurity and Data Innovation Group:
S. Ashlie Beringer – Co-Chair, Palo Alto (+1 650-849-5327, [email protected])
Jane C. Horvath – Co-Chair, Washington, D.C. (+1 202-955-8505, [email protected])
Alexander H. Southwell – Co-Chair, New York (+1 212-351-3981, [email protected])

*Kirsten Bleiweiss is an associate working in the firm’s Washington, D.C. office who currently is admitted to practice only in Maryland.

© 2023 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice. Please note, prior results do not guarantee a similar outcome.

On June 1, 2023, Hong Kong’s long-awaited licensing regime for virtual asset trading platforms (“VATPs”) went live, with the Hong Kong Securities and Futures Commission (“SFC”) marking the occasion by issuing a flurry of regulatory guidance for operators of VATPs (“Platform Operators”) in the form of guidelines, FAQs and handbooks.

This client alert discusses that regulatory guidance, with a particular focus on the key practical takeaways for prospective VATP licence applicants set out in the SFC’s Consultation Conclusions on the Proposed Regulatory Requirements for Virtual Asset Trading Platform Operators Licensed by the Securities and Futures Commission (the “Consultation Conclusions”). However, the guidance issued by the SFC spans a wide range of topics, including transitional arrangements, senior management accountability, onboarding of clients and cybersecurity. Prospective VATP licence applicants should ensure that they familiarise themselves with the SFC’s guidance and expectations for Platform Operators.

Consultation Conclusions Published on May 23, 2023

In February 2023, the SFC issued a highly-anticipated consultation paper inviting public comments on the proposed regulatory requirements applicable to Platform Operators.[1] We previously published a client alert on this topic.[2] Following a feedback period that concluded on March 31, 2023, the SFC published its Consultation Conclusions on May 23, 2023, which considered 152 submissions received by the SFC from industry associations, professional and consultancy firms, market participants, licensed corporations, individuals and other stakeholders.[3]

While the SFC found respondents generally supportive of the proposed regulatory requirements for Platform Operators in Hong Kong, a number of comments noted that the technical and implementation details may have been insufficiently clear.  In response, the SFC has modified or clarified some of the regulatory requirements as set out in the Guidelines for Virtual Asset Trading Platform Operators (the “VATP Guidelines”), and also published additional circulars, FAQs and guidelines on May 31, 2023 and June 1, 2023.

The SFC maintains that providing clear regulatory expectations will be critical to fostering responsible development, especially within Hong Kong’s virtual assets (“VA”) landscape. Adopting the principle of ‘same business, same risks, same rules’, the SFC aims to support and develop the VA industry by ensuring robust investor protection and critical risk management.

Circular on Transitional Arrangements

On May 31, 2023, the SFC issued the Circular on Transitional Arrangements of the New Licensing Regime for Virtual Asset Trading Platforms (the “Transitional Arrangements Circular”) to provide additional guidance on the transitional arrangements for VATPs under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615) licensing regime (the “AMLO VASP Regime”).[4]  The guidance in this Circular is consistent with the transitional arrangements explained in the SFC’s consultation paper published in February 2023 but provides further detail that will be relevant to VATPs preparing to apply for a licence by no later than February 29, 2024.

An important point to note is that, upon reviewing a licence application, if the SFC considers that the VATP licence applicant does not meet any of the deeming conditions (which includes proving to the SFC’s satisfaction that the VATP is capable of complying with the regulatory requirements applicable to VATPs), then the SFC may issue a notice to the VATP (the “no-deeming notice”) to inform the VATP that the deeming arrangement will not apply to it.  A VATP that receives a no-deeming notice will be subject to a deemed withdrawal procedure and must proceed to close down its business by May 31, 2024 or by the expiry of three months beginning on the day of the issuance of the no-deeming notice (whichever is the later), irrespective of whether it has objected to the deemed withdrawal of its licence application.  It will therefore be crucial for a VATP licence applicant to submit a robust licence application that proves that it can meet all of the deeming conditions, or else it risks being ineligible for the deeming arrangement.

Other regulatory guidance applicable to VATPs

In addition to the recently published Consultation Conclusions, the VATP Guidelines, and the Transitional Arrangements Circular, operators of VATPs should also be aware of additional regulatory guidance contained in the following documents published between May 31 and June 1, 2023:

• Licensing Handbook for Virtual Asset Trading Platform Operators;[5]
• Guideline on Anti-Money Laundering and Counter-Financing of Terrorism (For Licensed Corporations and SFC-licensed Virtual Asset Service Providers);[6]
• Prevention of Money Laundering and Terrorist Financing Guideline issued by the Securities and Futures Commission for Associated Entities of Licensed Corporations and SFC-licensed Virtual Asset Service Providers;[7]
• Disciplinary Fining Guidelines;[8]
• Scope of External Assessment Reports;[9]
• Circular on implementation of new licensing regime for virtual asset trading platforms;[10]
• Eight (8) FAQs on VATP licensing-related matters;[11] and
• Nine (9) FAQs on VATP conduct-related matters.[12]

The regulatory guidance set out in the documents above, in addition to the VATP Guidelines, will be essential to VATP licence applicants, as applicants will need to ensure that its licence application provides to the SFC that it is capable to comply with these regulatory requirements – or else the applicant may be issued a non-deeming notice (as explained above).

VATP licence application forms

The licensing forms for the new AMLO VASP licensing regime (which includes making a simultaneous licence application under the Securities and Futures Ordinance (Cap. 571) (“SFO”) for Type 1 and Type 7 regulated activities) are also now available on the SFC’s licensing forms website.[13]  Licensing forms will need to be submitted to the SFC electronically through the WINGS platform.

Some of the key aspects of the regulatory requirements highlighted in the Consultation Conclusions

Licensing requirement	The SFC has reiterated that Platform Operators should, as a matter of prudence, apply for approvals under both the existing SFC licensing regime and the AMLO licensing regime[14] to ensure business continuity, given that a VA’s classification may change from security to non-security, or vice versa. The SFC rejected the propositions that Platform Operators under the AMLO regime can withdraw a particular token which evolves into a security token and simply allow the client to sell down the token, as this will not be in the client’s best interests.  This stance suggests that applicants seeking an AMLO only licence should expect to face tough questions from the SFC as to their rationale for not also seeking a licence under the SFC’s existing licence regime. The SFC has also stated that the AMLO regime will cover VA trading platforms which are centralised and function in a manner similar to the types of automated trading venues licensed under the SFO – i.e., they use automated trading engines which match client orders and provide custody services as an ancillary service to their trading services. Given this, the SFC has also clarified that the scope of the AMLO regime does not include over-the-counter VA trading activities and VA brokerage activities, as these do not involve providing VA services with an automated trading engine and ancillary custody services.
Retail access and onboarding requirements	Platform Operators will be allowed to provide their services to retail investors provided that they comply with a range of robust investor protection measures covering onboarding, governance, disclosure and token diligence and admission, before providing services to retail investors. The SFC notes that it is crucial for retail investors to understand the features and risks of investing in VAs, as well as the potential losses.  As such, the SFC will require Platform Operators to conduct the full scope of the onboarding requirements, including assessing the investor’s risk tolerance, conducting an holistic assessment of the investor’s understanding of the nature and risks of VAs, etc.  The assessment made during the onboarding process will also be relevant in order to comply with the suitability requirements. It is relevant to note that Platform Operators will be required to comply with the full scope of the onboarding requirements, even if the retail client is knowledgeable about VAs (e.g. as a result of trading VAs for a number of years) or the client is an individual professional investor.  These requirements are broadly consistent with the regulatory requirements applied to traditional licensed corporations more generally. The SFC has also now issued FAQs providing further guidance on onboarding requirements, including matters such as how to assess an investor’s knowledge of VAs and risk tolerance levels.[15]
Governance	A Platform Operator will be required to set up a token admission and review committee that consists of senior management who are principally responsible for managing the Platform Operator’s key business line, compliance, risk management, and information technology functions (i.e., at a minimum the Manager in Charge (MICs) for these functions). The SFC has also now issued FAQs to augment the accountability of the senior management of Platform Operators through the imposition of a Manager in Charge regime for Platform Operators, which the SFC acknowledges is ‘substantially the same’ as that applicable to licensed corporations.[16]
Disclosure	The SFC notes that, although it understands the potential challenges of obtaining and verifying information provided by the issuer of a VA, it will still expect a Platform Operator to conduct due diligence on each virtual asset prior to admission for trading. As such, the Platform Operator is expected to obtain information for each VA which it can be reasonably satisfied is reliable and sufficient to base its token admission decision on. Accordingly, the SFC will require Platform Operators to take all reasonable steps to ensure that product specific information that they disclose is not false, biased, misleading or deceptive. The SFC has set out in the VATP Guidelines the minimum information that Platform Operators are required to disclose with regards to the risk disclosure statements, disclosures regarding the platform’s operations, and VA-specific disclosures.
Token admission	Similar to the SFC’s product due diligence requirements applicable to licensed corporations in respect of traditional financial products, the SFC will require a Platform Operator to  conduct due diligence on each VA it plans to admit for trading on its platform to ensure that the VA complies with the admission criteria established by the token admission and review committee. These due diligence requirements apply even if the VAs are not intended to be made available to retail investors, although there will likely be material differences in the admission criteria applicable to VAs that are or are not available for trading by retail investors. Furthermore, there is no exemption from conducting due diligence even if the VA in question has already been admitted for trading on another licensed VATP. Relevantly, the SFC has decided that it will not relax the requirement for a non-security token to have at least a 12-month track record (as it is one of the factors which the token admission and review committee must consider). The result is that a newly or recently launched VA with less than a 12-month track record cannot be admitted for trading by a Platform Operator, even if it is not available for trading by retail investors. However, the SFC has relaxed one aspect of its token admission requirements, with Platform Operators no longer being required to submit to the SFC written legal advice confirming that each token made available for trading by retail clients would not amount to a security token. Nevertheless, Platform Operators will still need to take reasonable steps to ensure that security tokens are not made available for trading by retail clients, as this could be a breach of the prospectus regime under the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32). The SFC has emphasised in the Consultation Conclusions the importance of having additional minimum criteria that need to be satisfied before a non-security token can be made available for trading by retail users. In this respect, the SFC has further tightened the eligible large-cap VA requirements to stipulate that at least one of the two acceptable indices must be issued by an independent index provider (that has experience publishing indices for conventional securities markets, and that is also compliant with the IOSCO Principles for Financial Benchmarks). Furthermore, in addition to being independent of the Platform Operator, the two index providers will also need to be independent of the issuer of the VA.  Additionally, the SFC emphasised in the Consultation Conclusions that being included in two acceptable indices is merely the minimum criterion for admitting a VA for retail trading, and that Platform Operators will also need to ensure that tokens admitted satisfy the Platform Operator’s token admission criteria (and also ensure that such tokens have high liquidity for tokens available for retail trading).
Stablecoins	The SFC has also clarified in the Consultation Conclusions that, prior to stablecoins being subject to regulation by the Hong Kong Monetary Authority (“HKMA”), Platform Operators should not admit stablecoins for retail trading.  The HKMA published the conclusions on its discussion paper on crypto-assets and stablecoins in January 2023, and the regulatory arrangements for stablecoins are expected to be implemented in 2023/24.  We previously published a client alert on this consultation.[17]
Insurance and compensation arrangements	The SFC will now require Platform Operators to have in place a compensation arrangement approved by the SFC to cover potential loss of 50% of client VAs in cold storage and 100% of client VAs in hot or other storage held by its custodian (see below for further discussion on custody arrangements). The SFC has also noted that the arrangement should be made up of the following: Third-party insurance; Funds (held in a demand deposit or time deposit with less than 6 months maturity) or VAs of the Platform Operator or any corporation within the same group as the Platform Operator which are set aside on trust and designated for such a purpose; and/or A bank guarantee from an authorised financial institution in Hong Kong.
Custody and security requirements	In this aspect of the Consultation, the SFC had sought industry suggestions in relation to technical solutions that could mitigate risks associated with custody of client assets, particularly in hot storage. However, the SFC’s response in the Consultation Conclusions focused on reiterating the SFC’s view that, given the importance of safe custody of VAs, the SFC will require what it terms a ‘direct regulatory handle’ over a firm exercising control of client VAs, and as such will require custody to be undertaken by a wholly-owned subsidiary of a Platform Operator. For the same reason, the SFC will require  all seeds and private keys holding customer VAs to be securely stored in Hong Kong, noting that if they were stored overseas, this would substantially hinder the SFC’s supervision and enforcement efforts.  As a result, the SFC has reiterated in the Consultation Conclusions that the use of third-party custodians will not be allowed. The SFC also noted that it had received ‘many’ comments requesting that the SFC amend the requirement that 98% of client VAs must be stored in cold storage and only 2% could be stored in hot or other storage so to permit a lower cold to hot storage ratio to be adopted. However, the SFC has reiterated that it believes that this ratio should not be lowered and that the ‘bulk’ of client VAs should be held in cold storage given that it is generally free of hacking / other cybersecurity risks. Further, while many respondents had indicated that they believed that a lower cold to hot storage ratio was required in order to ensure more expedient asset withdrawals, the SFC appears to have had little sympathy for this position. Instead, the SFC has reminded Platform Operators of the requirement under the Guidelines for Platform Operators’ comprehensive trading and operational rules to cover withdrawal procedures, including the time required to transfer VAs to a client’s private wallet after receiving a withdrawal request on its website.
Virtual asset derivatives	This aspect of the Consultation had sought input in relation to business models that would be adopted by Platform Operators if allowed to provide trading services in VA derivatives and the types of investors that would be targeted. The SFC noted in the Consultation Conclusions that respondents expressed general support for allowing Platform Operators to provide trading services in VA derivatives, and that the SFC understood the importance of VA derivatives to institutional investors. However, the revised Guidelines maintain the prohibition on Platform Operators offering trading or dealing in VA derivatives, with the SFC instead indicating in the Consultation Conclusions that it will conduct a separate review of this issue ‘in due course’.
Proprietary trading and other services	The SFC has noted that it received submissions suggesting that proprietary trading, including proprietary market making by a Platform Operator’s affiliates, should be allowed in order to enhance liquidity. While maintaining the prohibition on proprietary trading, the SFC has amended the requirements in the Guidelines to allow trading by affiliates of a Platform Operator other than trading through the Platform Operator (regardless of whether such trading is on-platform or is off-platform). The SFC noted that this amendment has been made on the basis that the previous iteration of the draft Guidelines effectively prohibited group companies of a Platform Operator from having any positions in VAs. The SFC also noted that it received a number of responses in relation to whether Platform Operators could provide other VA services such as earning, deposit-taking, lending or borrowing. The SFC’s position, however, is that allowing such services could create potential conflicts of interest for Platform Operators (and would require additional safeguards) and as such Platform Operators will not be permitted to conduct these activities ‘at this stage’. The SFC has also clarified in the Consultation Conclusions that while Platform Operators are prohibited from providing algorithmic trading services to their clients, the platform’s clients can use their own algorithmic trading systems when trading on a licensed platform.
Disciplinary Fining Guidelines	The SFC has clarified that all Platform Operators will be subject to the same fining criteria[18] regardless of the regime under which the Platform Operator is licensed. In rejecting a submission proposing that fines should be determined with reference to the total annual turnover of the Platform Operator, the SFC has stated that it will continue to determine quantum based on the legislative requirement in the AMLO that a fine should not exceed the higher of HK$10 million or three times the profit gained or loss avoided. However, the SFC has also noted that it will closely monitor the implementation of the Fining Guidelines, and determine whether legislative change may be required. In response to a comment, the SFC specifically noted that the fact that a particular type of conduct is widespread in unregulated entities would not be considered a mitigating factor for any misconduct by licensed Platform Operators. In the context of submissions requesting greater clarity on factors relevant to the SFC’s decision to take enforcement action against Platform Operators and/or individuals, the SFC has stated that it will take a holistic approach to disciplinary action in order to ensure that all culpable parties are held accountable for their conduct. In this vein, the SFC has noted in the Consultation Conclusions that the VATP Guidelines already provide that senior management of a Platform Operator bear the primary responsibility for ensuring compliance with the rules and guidelines applicable to Platform Operators. Further, as noted above, the SFC has also issued an FAQ on the augmentation of the accountability of senior management for Platform Operators, which extends the SFC’s Manager in Charge regime to Platform Operators.[19]

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[1]  “Consultation Paper on the Proposed Regulatory Requirements for Virtual Asset Trading Platform Operators Licensed by the Securities and Futures Commission”, published by the SFC (February 20, 2023), available at https://apps.sfc.hk/edistributionWeb/gateway/EN/consultation/doc?refNo=23CP1.

[2]  “Hong Kong SFC Consults On Licensing Regime For Virtual Asset Trading Platform Operators”, published by Gibson, Dunn & Crutcher (March 2, 2023), available at https://www.gibsondunn.com/hong-kong-sfc-consults-on-licensing-regime-for-virtual-asset-trading-platform-operators/.

[3] “Consultation Conclusions on the Proposed Regulatory Requirements for Virtual Asset Trading Platform Operators Licensed by the Securities and Futures Commission”, published by the SFC (May 23, 2023), available at https://apps.sfc.hk/edistributionWeb/gateway/EN/consultation/conclusion?refNo=23CP1.

[4] “Circular on transitional arrangements of the new licensing regime for virtual asset trading platforms” published by the SFC (May 31, 2023), available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC27.

[5] Published by the SFC on June 1, 2023, and available at: https://www.sfc.hk/-/media/EN/assets/components/Guidelines/File-current/Licensing-Handbook-for-VATPs-31-05-2023.pdf?rev=a94fa7324a964e328dd2415815611d76.

[6] Published by the SFC on June 1, 2023, and available at: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/guidelines/guideline-on-anti-money-laundering-and-counter-financing-of-terrorism-for-licensed-corporations/AML-Guideline-for-LCs-and-SFC-licensed-VASPs_Eng_1-Jun-2023.pdf?rev=d250206851484229ab949a4698761cb7.

[7] Published by the SFC on June 1, 2023, and available at: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/guidelines/prevention-of-money-laundering-and-terrorist-fi/AML-Guideline-for-AEs_Eng_1-Jun-2023.pdf?rev=243299fe5b11413495afee886891aa05.

[8] Published by the SFC on June 1, 2023, and available at: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/guidelines/SFC-Disciplinary-Fining-Guidelines_Part-5B/230524–SFC-Disciplinary-Fining-Guidelines-Eng.pdf?rev=9a355f946ff74c7892a921ab73461314&hash=0A14F0BC24C3854FB909953BEA90FC2A.

[9] Published by the SFC on June 1, 2023, and available at: https://www.sfc.hk/-/media/EN/files/LIC/Fintech/Scope-of-External-Assessment-ReportsJune-2023-EN.pdf?rev=7faaba6cd7f84f96806588b03dc86cad&hash=C7C407B725E545E7637F80BD4B5BE4F1.

[10] Published by the SFC on May 31, 2023, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC28.

[11] Published by the SFC on May 31, 2023, and available at: https://www.sfc.hk/en/Welcome-to-the-Fintech-Contact-Point/Virtual-assets/Virtual-asset-trading-platforms-operators/Regulatory-requirements/FAQs-on-licensing-related-matters.

[12] Published by the SFC on May 31, 2023, and available at: https://www.sfc.hk/en/Welcome-to-the-Fintech-Contact-Point/Virtual-assets/Virtual-asset-trading-platforms-operators/Regulatory-requirements/FAQs-on-conduct-related-matters.

[13] Available at: https://www.sfc.hk/en/Forms/Intermediaries/Licensing-forms.

[14] Licensing regime for Platform Operators under the Anti-Money Laundering Ordinance and Counter-Terrorist Financing Ordinance (Cap. 615).

[15] Published by the SFC on May 31, 2023 and available at: https://www.sfc.hk/en/Welcome-to-the-Fintech-Contact-Point/Virtual-assets/Virtual-asset-trading-platforms-operators/Regulatory-requirements/FAQs-on-conduct-related-matters/Dealing-with-clients/31-May-2023-Dealing-with-clients#F9658969756741BF96ED6ED786E29D98.

[16] Published by the SFC on May 31, 2023, and available at: https://www.sfc.hk/en/Welcome-to-the-Fintech-Contact-Point/Virtual-assets/Virtual-asset-trading-platforms-operators/Regulatory-requirements/FAQs-on-licensing-related-matters/Measures-for-augmenting-senior-management-accountability-in-Platform-Operators/Measures-for-augmenting-senior-management-accountability-in-Platform-Operators.

[17] “Hong Kong Monetary Authority Introduces Plans To Regulate Stablecoins” published on February 7, 2023, and available at: https://www.gibsondunn.com/hong-kong-monetary-authority-introduces-plans-to-regulate-stablecoins/.

[18] Published by the SFC on June 1, 2023, and available at: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/guidelines/SFC-Disciplinary-Fining-Guidelines_Part-5B/230524–SFC-Disciplinary-Fining-Guidelines-Eng.pdf?rev=9a355f946ff74c7892a921ab73461314&hash=0A14F0BC24C3854FB909953BEA90FC2A.

[19] Published by the SFC on May 31, 2023, and available at: https://www.sfc.hk/en/Welcome-to-the-Fintech-Contact-Point/Virtual-assets/Virtual-asset-trading-platforms-operators/Regulatory-requirements/FAQs-on-licensing-related-matters/Measures-for-augmenting-senior-management-accountability-in-Platform-Operators/Measures-for-augmenting-senior-management-accountability-in-Platform-Operators.

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The following Gibson Dunn lawyers prepared this client alert: Will Hallatt, Emily Rumble, Arnold Pun, Becky Chung, and Qingxiang Toh.

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 Digital Asset Taskforce or the Global Financial Regulatory team, including the following authors 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])
Qingxiang Toh – Singapore (+65 6507 3610, [email protected])

© 2023 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice. Please note, prior results do not guarantee a similar outcome.

This edition of Gibson Dunn’s Federal Circuit Update summarizes the Supreme Court’s recent decision in Amgen v. Sanofi and the current status of several other petitions pending before the Supreme Court, provides an update on a proceeding by the Judicial Council of the Federal Circuit, and summarizes recent Federal Circuit decisions concerning inventorship, attorneys’ fees, obviousness, and conception and reduction to practice.

Federal Circuit News

Supreme Court:

On May 18, 2023, the United States Supreme Court issued its decision in Amgen Inc. v. Sanofi (U.S. No. 21-757) and affirmed the Federal Circuit (see summary of Federal Circuit opinion from February 2021 update).

The Amgen patents at issue claimed an entire genus of antibodies that bind to specific amino acid residues on PCSK9 and block PCSK9 from binding to LDL receptors.  Antibodies that inhibit PCSK9 from binding to and degrading LDL receptors are used to treat patients with high LDL cholesterol, which can lead to cardiovascular disease, heart attacks, and strokes.  Amgen’s patents identified 26 of these PCSK9-inhibiting antibodies and disclosed two methods to make other antibodies that perform the binding and blocking functions it described.  Sanofi argued that neither of these two methods enable a person of ordinary skill in the art to generate additional antibodies reliably.

The Supreme Court agreed.  While the Court acknowledged that Amgen’s specification “enables the 26 exemplary antibodies it identifies,” “the claims before us sweep much broader than those 26 antibodies,” and Amgen’s two disclosed methods failed to enable a person of skill in the art how to make the entire universe of antibodies.  The first method described a step-by-step trial-and-error method that Amgen followed to identify the 26 exemplary antibodies.  The second method required scientists to make substitutions to the amino acid sequences of the known antibodies to determine if they work too.  The Court reasoned that this would force scientists to engage in “painstaking experimentation,” which was “not enablement.”

Noteworthy Petitions for a Writ of Certiorari:

This month, there is a new potentially impactful petition pending before the Supreme Court:

• CareDx Inc. v. Natera, Inc. (US No. 22-1066): The petition raises the question whether a new and useful method for measuring a natural phenomenon is eligible for patent protection under 35 U.S.C. § 101.  After respondent in this case waived its right to file a response, retired Federal Circuit Judge Paul R. Michel and Professor John F. Duffy filed an amici curiae brief in support of Petitioners.  The Court thereafter requested a response, which is due on June 29, 2023.

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

• After requesting a response in Avery Dennison Corp. v. ADASA, Inc. (US No. 22-822) and Arthrex, Inc. v. Smith & Nephew, Inc. (US No. 22-639), the Court denied the petitions. After requesting the views of the Solicitor General, the Court also denied the petitions in Interactive Wearables, LLC v. Polar Electro Oy (US No. 21-1281) and Tropp v. Travel Sentry, Inc. (US No. 22-22), although Justice Kavanaugh would have granted both petitions.

• The Court is considering petitions in Nike, Inc. v. Adidas AG et al. (US No. 22-927) and Ingenio, Inc. v. Click-to-Call Technologies, LP (US No. 22-873), having requested a response in both cases. The response in Nike has been filed, and the response in Ingenio is due June 26, 2023.

• The Court will consider NST Global, LLC v. Sig Sauer Inc. (US No. 22-1001) during its June 15, 2023 conference.

Other Federal Circuit News:

Release of Prior Orders in Ongoing Judicial Investigation.  As we summarized in our April 2023 update, the Judicial Council of the Federal Circuit released a statement confirming that a proceeding under the Judicial Conduct and Disability Act and the implementing Rules had been initiated naming Judge Pauline Newman as the subject judge.  On May 16, 2023 and June 5, 2023, the Federal Circuit released public versions of all prior orders of the Special Committee and the Judicial Council, as well as Judge Newman’s letter responses to date.  The orders may be accessed here and here.

Upcoming Oral Argument Calendar

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

Key Case Summaries (May 2023)

HIP, Inc. v. Hormel Foods Corp., No. 22-1696 (Fed. Cir. May 2, 2023):  HIP disputed the inventorship of a Hormel patent directed to methods of precooking bacon and meat pieces.  Hormel had entered into a joint agreement with David Howard, an employee of HIP’s predecessor company, to improve on its microwave cooking process for precooked bacon.  Howard alleged that during these initial meetings, he had disclosed the infrared preheating concept at issue.  Subsequent testing revealed that “preheating the bacon with a microwave oven prevented condensation from washing away the salt and flavor.”  Hormel then filed a patent application on this process, which was ultimately granted, but did not name Howard as an inventor.  The district court concluded that Howard should have been listed as a joint inventor on the patent having contributed the preheating with an infrared oven concept in one of the independent claims.

The Federal Circuit (Lourie, J., joined by Clevenger and Taranto, JJ.) reversed.  Under Federal Circuit precedent, an inventor must make a contribution to the claimed invention that is “not insignificant in quality when the contribution is measured against the dimension of the full invention.”  The Court determined that Howard’s alleged contribution of using an infrared oven is “insignificant in quality” to the claimed invention.  In fact, preheating with an infrared oven was mentioned only once in the patent specification as an alternative to a microwave oven.  In contrast, preheating with microwave ovens featured prominently throughout the specification.

Sanofi-Aventis Deutschland GmbH v. Mylan Pharmaceuticals Inc., No. 21-1981 (Fed. Cir. May 9, 2023):  Mylan petitioned the Patent Trial and Appeal Board (“Board”) for inter partes review (“IPR”) of a Sanofi patent directed to a drug delivery device.  The Board concluded that the challenged patent was unpatentable as obvious over prior art, including prior art reference, de Gennes.  Sanofi argued that de Gennes was not analogous art, but the Board disagreed finding that de Gennes focused on a problem that was “reasonably pertinent” to a problem faced by an inventor of the challenged patent, in part because the problem was addressed in a second prior art reference, Burren.

The Federal Circuit (Cunningham, J., joined by Reyna and Mayer, JJ.) reversed.  In determining whether a reference is analogous art, a patent challenger must compare the reference to the problem addressed by the challenged patent, not solely to the problem addressed by other prior art references.  Because Mylan argued solely that de Gennes was analogous to Burren, not the challenged patent, Mylan did not meet its burden to establish de Gennes was analogous art.

OneSubsea IP UK Limited v. FMC Technologies, Inc., No. 22-1099 (Fed. Cir. May 23, 2023):  OneSubsea sued FMC alleging infringement of ten OneSubsea patents related to the subsea recovering of production fluids from an oil or gas well.  FMC ultimately prevailed when the district court (Judge Atlas) granted its summary judgment motion of noninfringement.  FMC then filed a motion under 35 U.S.C. § 285 for attorneys’ fees.  After the briefing concluded, the case was reassigned to Judge Bennett following Judge Atlas’s retirement.  Judge Bennett denied FMC’s § 285 motion.

The Federal Circuit (Moore, C.J., joined by Clevenger and Dyk, JJ.) affirmed.  FMC argued that instead of applying an abuse-of-discretion standard, the Court should apply de novo review to the § 285 decision because Judge Bennett only briefly “lived with the case.”  The Court rejected this suggestion determining that appellate courts have consistently reviewed successor judges’ decisions on discretionary issues for abuse of discretion.

Medtronic, Inc. v. Teleflex Innovations S.À.R.L., Nos. 21-2356, 21-2358, 21-2361, 21-2363, 21-2365 (Fed. Cir. May 24, 2023):  Medtronic filed thirteen IPR petitions of five related Teleflex patents directed to guide extension catheters that use a tapered inner catheter.  In five of the final written decisions, the Board found that the primary prior art reference, Itou, did not qualify as prior art because the claimed inventions were conceived prior to Itou’s filing date and actually reduced to practice prior to the critical date, or diligently worked on toward constructive reduction to practice before the challenged patents’ effective filing date, which requires in part, that the invention would work for its intended purpose.

The majority (Lourie, J., joined by Moore, C.J.) affirmed.  While inventor testimony may serve as evidence of reduction to practice, it must be corroborated by independent evidence.  The majority concluded that the Board’s finding that the testing performed by Teleflex was sufficient to show that the claimed invention worked for its intended purpose.  The majority also determined that the inventors’ actual reduction to practice was sufficiently corroborated in the form of both documentary evidence and noninventor testimony.

Judge Dyk dissented.  In his opinion, the inventors’ testimony did not show that the prototypes would have worked for their intended purpose, in part because the tests were “more qualitative than quantitative,” and failed to “reproduce[] the operating conditions which would be encountered in any practical use of the invention.”  He also found that Teleflex failed to corroborate the inventors’ testimony, because “Teleflex produced essentially no internal documents corroborating any testing . . . in the critical period.”  Teleflex argued that this evidence likely existed at one time but had since been destroyed.  Judge Dyk disagreed with the majority’s concern that this would impose an “impossible standard” by requiring that “every point of reduction to practice be corroborated.”  In his opinion, a rule that favors retention of relevant documents does not create an “impossible standard” for inventors seeking to enforce a patent.

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