The United States, the European Union, the United Kingdom, Australia, and Japan issued or announced sanctions targeting Russia and the Russia-backed separatist regions of Ukraine known as the Donetsk People’s Republic and the Luhansk People’s Republic. The United States took the first step by issuing broad jurisdiction-based sanctions on the two regions, similar to the existing sanctions on the Crimea region of Ukraine, and followed up with additional sanctions targeting Russia’s financial system. NATO allies also announced sanctions—including targeted designations by the United Kingdom and a sanctions package by the European Union—and non-NATO allies promised tough sanctions in close coordination. As tensions continue to rise, we will likely see more series of tools from the NATO countries and their allies to exert economic pressure on Russia to deescalate the ongoing crisis in Ukraine and withdraw its army from Ukraine’s borders.
Hear from our experts about these developments and how companies should proactively assess their exposure to the sanctions and export controls measures being discussed.
MODERATOR:
Judith Alison Lee is a partner in the Washington, D.C. office and Co-Chair of the firm’s International Trade Practice Group. Ms. Lee is a Chambers ranked leading International Trade, Export Controls, and Economic Sanctions lawyer practicing in the areas of international trade regulation, including USA Patriot Act compliance, economic sanctions and embargoes, export controls, and national security reviews (“CFIUS”). Ms. Lee also advises on issues relating to virtual and digital currencies, blockchain technologies and distributed cryptoledgers.
PANELISTS:
Patrick Doris is a partner in the London office whose practice includes transnational litigation, cross-border investigations, and compliance advisory for clients including major global investment banks, global corporations, leading U.S. operators in the financial sectors, and global manufacturing companies, among others. He advises financial sector clients and others on OFAC and EU sanctions violations, responses to major cyber-penetration incidents, and other matters relating to national supervisory and regulatory bodies.
Richard Roeder is an associate in the Munich office who was previously seconded to the Washington, D.C. office and worked with the firm’s U.S. sanctions and export control team and assisted clients in managing the challenges posed by the divergence between U.S. and EU economic and financial sanctions. He advises clients in the banking, insurance, automotive, mining, oil and gas, healthcare and information technology industries in the areas of sanctions, anti-money-laundering and anti-corruption compliance.
Adam Smith is a partner in the Washington, D.C. office and a highly experienced international trade lawyer. Mr. Smith previously served in the Obama Administration as the Senior Advisor to the Director of OFAC and as the Director for Multilateral Affairs on the National Security Council. Mr. Smith focuses on international trade compliance and white collar investigations, including with respect to federal and state economic sanctions enforcement, the FCPA, embargoes, and export controls.
Claire Yi is an associate in the Washington, D.C. office and a member of the firm’s International Trade and White Collar Defense and Investigations Practice Groups. Ms. Yi’s background includes having interned in the Compliance and Business Risk Department at the World Bank-International Finance Corporation, in the Office of the Inspector General at the State Department, and in the Office of the Legal Adviser at the State Department.
New York partners Reed Brodsky and Eric J. Stock are the authors of “What the Antitrust Case Against Martin Shkreli Tells Us About the Latest Trends in Antitrust Enforcement and Shareholder Liability” [PDF] published by the New York Law Journal on February 28, 2022.
New York associate Jessica Trafimow, a recent law graduate, assisted in the preparation of the article.
Antitrust enforcers in the United States and abroad, traditionally, have applied relatively lenient scrutiny to mergers between a supplier or input provider and a customer (so-called “vertical transactions”). That stereotype, however, is now squarely in question. In the last year, the Federal Trade Commission (FTC) has challenged three proposed vertical transactions – two of which have been abandoned by the parties. And just last week, the Antitrust Division of the Justice Department filed suit to block another vertical transaction. This increased enforcement, combined with the 2021 withdrawal of the Vertical Merger Guidelines,[1] signals an era of uncertainty for certain kinds of vertical transactions that, in the past, would have closed with few if any remedies. In this alert, we discuss the agencies’ recent enforcement actions and the implications for companies considering vertical transactions.
Recent Challenges to Vertical Transactions
Lockheed-Aerojet. In January 2022, the FTC challenged Lockheed’s proposed acquisition of Aerojet, a supplier of missile propulsion systems used in missiles made by Lockheed and other defense prime contractors. The FTC alleged that the merger would lessen competition by giving Lockheed control over critical components that its rival prime contractors and propulsion suppliers need to compete. The FTC further alleged that Aerojet has access to competitively sensitive information about Lockheed’s rivals and the merger would grand Lockheed access to that proprietary information.[2]
In a similar transaction involving Northrop Grumman’s proposed acquisition of Orbital ATK, only a few years earlier in 2018, the parties settled similar agency concerns with behavioral remedies, including (i) a commitment to continue selling rocket motors to rivals; and (ii) an agreement to segregate the business with a firewall.[3] Reportedly, Lockheed and Aerojet proposed a firewall here, but the proposed remedy was rejected by the FTC.[4] The parties abandoned the transaction earlier this month after the FTC had filed suit, seeking to enjoin the deal.[5]
NVIDIA-Arm. In December 2021, the FTC sued to block semiconductor chip supplier NVIDIA Corp.’s acquisition of chip designer, Arm, Ltd. The FTC alleged the transaction would provide NVIDIA control over critical Arm technology and enable the merged firm to limit production and prevent Arm from licensing innovations that conflict with NVIDIA’s business interests. The FTC further alleged the merger would provide NVIDIA with competitively sensitive information regarding Arm licensees, many of which are NVIDIA competitors.[6]
This merger complaint was the first brought under the leadership of FTC Chair Lina Khan, after a lengthy investigation, in which, the Commission cooperated with other investigating authorities, including the United Kingdom’s Competition and Markets Authority (CMA), the European Commission (EC), and China’s State Administration for Market Regulations (SAMR).
Again, the parties offered remedies – here, to spin-off Arm’s licensing business as an independent entity, albeit under NVIDIA’s ultimate control – but they did not satisfy the FTC.[7] Reportedly, the FTC sought input from third-parties before rejecting the proposal, as it typically does.[8] In the UK, NVIDIA offered remedies during the Phase I review such as (i) equal access and open licensing for Arm’s intellectual property; and (ii) safeguards for confidential information. But these commitments were insufficient to prevent a Phase II investigation.[9] The parties abandoned the transaction earlier this month.
Illumina-Grail. In March 2021, the FTC challenged Illumina’s proposed acquisition of Grail, maker of a noninvasive, early cancer detection test. Illumina is the only provider of DNA sequencing products essential to these kinds of early detection tests, according to the FTC complaint. The FTC’s complaint further alleged that the merger would enable Illumina to raise the prices of Grail’s future competitors and impede their development of products that would rival Grail’s technology.[10] The agency originally filed a motion for preliminary injunction in federal court in May 2021, but withdrew the request, citing the reduced risk of the transaction in closing considering the ongoing EC review.[11] The EC took up a review upon a recommendation from several member states.
Illumina offered 12-year supply contracts to its customers with guarantees of continued supply and no price increases.[12] The companies also offered, supposedly, “far-reaching behavioral remedies” to the EC, but the details of these remedies were not made public.[13] The EC review remains ongoing and the FTC administrative trial is seeking to enjoin the transaction recently concluded, with a decision expected in the coming months.
Key Takeaways for Parties Considering Vertical Transactions
New Theories of Alleged Harm. While economic analysis has traditionally been used to demonstrate procompetitive benefits of vertical transactions to consumers (e.g., lower costs), the agencies in these cases allege that the potential for the merged firm to disadvantage market participants outweighs any potential benefits. The focus of the agencies’ claims appears to be on harm to others’ ability to compete. According to the agencies, such harm might arise where one or both of the merging parties has a high market share in its respective market.
Bipartisan Enforcement. Each of the three FTC challenges to a vertical transaction in the last year has followed a unanimous Commission vote. This bipartisan consensus indicates that we are likely to see a continued increase in challenges to M&A activity across all administrations.
Intra-Governmental Cooperation. Competition agencies regularly cooperate with other government agencies with relevant expertise. For example, in Lockheed’s proposed vertical acquisition of Aerojet, the U.S. Department of Defense reviewed the transaction and made undisclosed recommendations to the FTC.[14] In 2018, Broadcom’s hostile takeover of Qualcomm was halted by a presidential order because the transaction raised national security concerns.[15] In connection with NVIDIA’s proposed acquisition of Arm, the UK Secretary of State for Digital, Culture, Media, and Sports (DCMS) requested a public interest intervention and directed the CMA to review the transaction for national security concerns.[16] DCMS was particularly concerned with the integral role semiconductors play in the United Kingdom’s infrastructure, especially in defense and national security.
International Investigations and Cooperation. Vertical transactions are receiving heightened scrutiny from regulatory agencies around the world, including, most notably, the U.S. antitrust agencies, EC and European Union member states, and SAMR. Further, antitrust agencies across the globe are increasing cooperation. For example, in the NVIDIA-Arm transaction, the EC indicated it is “cooperating with competition authorities around the world.”[17] It appears that this increased cooperation may lengthen the merger review period. Coordination among agencies was the suspected reason behind the unprecedented eight-month SAMR pre-filing investigation.[18] And in the Illumina-Grail transaction, the EC has exercised the ability to take referrals from member states without those member states independently having jurisdiction to review the transaction under their own merger control regimes.[19]
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[1] Fed. Trade Comm’n, Statement of Chair Lina M. Khan, Commissioner Rohit Chopra, and Commissioner Rebecca Kelly Slaughter on the Withdrawal of the Vertical Merger Guidelines Commission File No. P810034 (Sept. 15, 2021), here.
[2] Compl. [Redacted-Public Version], In the Matter of Lockheed Martin Corp. and Aerojet Rocketdyne Holdings, Inc., Docket No. 9405 (Feb. 14, 2022), https://www.ftc.gov/system/files/documents/cases/d09405_-_assignment_of_joint_motion_to_dismiss_complaint_-_public_1.pdf, ¶¶ 12–15.
[3] Curtis Eichelberger, Confluence of government actors likely to place Lockheed, Aerojet merger under greater US scrutiny (Aug. 2, 2021), https://mlexmarketinsight.com/news-hub/editors-picks/area-of-expertise/antitrust/confluence-of-government-actors-likely-to-place-lockheed-aerojet-merger-under-greater-us-scrutiny.
[4] Lockheed Martin, Lockheed Martin Reports Fourth Quarter And Full Year 2021 Financial Results (Jan. 25, 2022), https://news.lockheedmartin.com/2022-01-25-Lockheed-Martin-Reports-Fourth-Quarter-and-Full-Year-2021-Financial-Results; Aerojet Rocketdyne, Aerojet Rocketdyne Holdings, Inc. Announces Update on Proposed Merger Transaction with Lockheed Martin (Jan. 25, 2022), https://www.rocket.com/article/aerojet-rocketdyne-holdings-inc-announces-update-proposed-merger-transaction-lockheed-martin.
[5] Aerospace, Lockheed Martin Cancels Aerojet Rocketdyne Merger After Antitrust Pressure (Feb. 14, 2022), https://dot.la/lockheed-martin-cancels-aerojet-rocketdyne-2656663782.html; see Fed. Trade Comm’n, Statement Regarding Termination of Lockheed Martin Corporation’s Attempted Acquisition of Aerojet Rocketdyne Holdings Inc. (Feb. 15, 2022), https://www.ftc.gov/news-events/press-releases/2022/02/statement-regarding-termination-lockheed-martin-corporations.
[6] Compl. [Redacted-Public Version], In the Matter of Nvidia Corp. SoftBank Group Corp., and Arm, Ltd., Dkt No. 9404 (Dec. 2, 2021), here, ¶¶ 7–12 .
[7] Flavia Fortes, Curtis Eichelberger and Austin Peay, Nvidia-Arm deal blocked by US FTC, remedies didn’t address concerns (Dec. 2, 2021), https://content.mlex.com/#/content/1341929.
[9] Competition Markets and Authority, Digital Secretary asks CMA to carry out further investigation into NVIDIA’s takeover of Arm (Nov. 16, 2021), https://www.gov.uk/government/news/digital-secretary-asks-cma-to-carry-out-further-investigation-into-nvidias-takeover-of-arm.
[10] Compl. [Redacted-Public Version], In the Matter of Illumina Inc. and Grail Inc., Docket No. 9401 (March 13, 2021), here, ¶¶ 1, 11–14.
[11] Curtis Eichelberger and Austin Peay, Illumina closes Grail deal while EC continues review, US FTC trial starts Aug. 24 (Aug. 18, 2021), https://content.mlex.com/#/content/1317564.
[12] MLex, Illumina offers contract to customers for 12-year supply with guarantees of continued supply, no price increases (April 1, 2021), here; Curtis Eichelberger and Nicholas Hirst, Illumina, Grail fix for merger’s anticompetitive harms adopted by five companies (Nov. 2, 2021), https://content.mlex.com/#/content/1334057.
[13] Natalie McNellis, Illumina makes EU remedy offer for Grail acquisition; deadline extended to March 25 (Jan. 28, 2022), https://content.mlex.com/#/content/1354851.
[14] U.S. Dep’t of Defense, DoD Statement on Proposed Lockheed Martin and Aerojet Rocketdyne Merger (Jan. 25, 2022), https://www.defense.gov/News/Releases/Release/Article/2910941/dod-statement-on-proposed-lockheed-martin-and-aerojet-rocketdyne-merger/.
[15] Federal Register, Regarding the Proposed Takeover of Qualcomm Incorporated by Broadcom Limited (March 12, 2019), https://www.federalregister.gov/documents/2018/03/15/2018-05479/regarding-the-proposed-takeover-of-qualcomm-incorporated-by-broadcom-limited.
[16] Competition and Markets Authority, Proposed acquisition of ARM Limited by NVIDIA Corporation: public interest intervention (April 19, 2021), https://www.gov.uk/government/publications/proposed-acquisition-of-arm-limited-by-nvidia-corporation-public-interest-intervention.
[17] European Commission, Mergers: Commission opens in-depth investigation into proposed acquisition of Arm by NVIDIA (Oct. 27, 2021), https://ec.europa.eu/commission/presscorner/detail/pt/ip_21_5624.
[18] MLex Staff, Nvidia-Arm merger review clock officially begins in China (Jan. 25, 2022), https://content.mlex.com/#/content/1353624?referrer=content_seehereview.
[19] European Commission Press Corner, Mergers: Commission starts investigation for possible breach of the standstill obligation in Illumina / GRAIL transaction (Aug. 20, 2021), https://ec.europa.eu/commission/presscorner/detail/en/ip_21_4322.
The following Gibson Dunn lawyers prepared this client alert: Adam Di Vincenzo, Kirsten Limarzi, Rachel Brass, Stephen Weissman, Chris Wilson, and Jacqueline Sesia.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please feel free to contact the Gibson Dunn attorney with whom you usually work in the firm’s Antitrust and Competition Practice Group, or the following:
Adam Di Vincenzo – Washington, D.C. (+1 202-887-3704, [email protected])
Kristen C. Limarzi – Washington, D.C. (+1 202-887-3518, [email protected])
Chris Wilson – Washington, D.C. (+1 202-955-8520, [email protected])
Rachel S. Brass – Co-Chair, Antitrust & Competition Group, San Francisco
(+1 415-393-8293, [email protected])
Stephen Weissman – Co-Chair, Antitrust & Competition Group, Washington, D.C.
(+1 202-955-8678, [email protected])
Ali Nikpay – Co-Chair, Antitrust & Competition Group, London (+44 (0) 20 7071 4273, [email protected])
Christian Riis-Madsen Co-Chair, Antitrust & Competition Group, Brussels (+32 2 554 72 05, [email protected])
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In the current market environment, strong pre-IPO readiness can position companies to more swiftly access IPO market windows. This recorded presentation explores preliminary planning, structuring and governance considerations for private companies considering an IPO. Our lawyers also discuss alternative exit strategies and how steps taken to prepare for an IPO can be beneficial to companies that ultimately do not go public. Join our team of capital markets panelists in the first installment of our 2022 Series – IPO and Public Company Readiness.
PANELISTS:
Aaron Briggs is a partner in Gibson Dunn’s San Francisco office, where he works in the firm’s Securities Regulation and Corporate Governance practice group. Mr. Briggs’ practice focuses on advising public companies of all sizes (from pre-IPO to mega-cap), with a focus on technology and life sciences companies, on a wide range of disclosure, compliance, corporate governance, investor communications and ESG matters. Prior to re-joining the firm in 2018, Mr. Briggs served as Executive Counsel – Corporate, Securities & Finance at GE.
Evan M. D’Amico is a partner in Gibson Dunn’s Washington, D.C. office, where his practice focuses primarily on mergers and acquisitions. Mr. D’Amico advises companies, private equity firms, boards of directors and special committees in connection with a wide variety of complex corporate matters, including mergers and acquisitions, asset sales, leveraged buyouts, spin-offs and joint ventures. He also has experience advising issuers, borrowers, underwriters and lenders in connection with financing transactions and public and private offerings of debt and equity securities. Mr. D’Amico has particular expertise in advising special purpose acquisition companies (SPACs), operating companies and investors in connection with SPAC business combinations and financing transactions.
Julia Lapitskaya is a partner in Gibson Dunn’s New York office and a member of the firm’s Securities Regulation and Corporate Governance practice group. Ms. Lapitskaya advises clients on a wide range of securities and corporate governance matters, with a focus on SEC and listing exchanges’ compliance and reporting requirements, corporate governance best practices, annual meeting matters, shareholder activism, board and committee matters, ESG and executive compensation disclosure issues, including as part of initial public offerings and spin-off transactions.
Eric M. Scarazzo is a partner in Gibson Dunn’s New York office. He is a member of the firm’s Capital Markets, Securities and Regulation and Corporate Governance, Power and Renewables, Global Finance, and Mergers and Acquisitions practice groups. As a key member of the capital markets practice, Mr. Scarazzo is involved in some of the firm’s most complicated and high-profile securities transactions. Additionally, he has been a certified public accountant for over 20 years. His deep familiarity with both securities and accounting matters permits Mr. Scarazzo to play an indispensable role supporting practice groups and offices throughout the firm. He provides critical guidance to clients navigating the intersection of legal and accounting matters, principally as they relate to capital markets financings and M&A disclosure obligations.
Harrison Tucker is an associate in Gibson Dunn’s Houston office, where he currently practices with the firm’s Capital Markets, Mergers and Acquisitions and Securities Regulation and Corporate Governance practice groups. He represents public and private businesses in a broad range of corporate and securities matters. Mr. Tucker represents issuers and investment banking firms in both equity and debt offerings, including Rule 144A offerings. His practice also includes mergers and acquisitions and general corporate concerns, including Exchange Act reporting and corporate governance.
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The United States has now imposed additional new sanctions and sweeping export controls that not only target key pillars of the economies of Russia and Belarus but will also have significant collateral effects across a wide range of other sectors in Russia. These latest measures follow an initial tranche of sanctions announced on February 21 and 22, 2022, which we discussed in depth in our alert from last week. Following the surge of Russian troops into Ukraine in an invasion that the White House condemned as “an unprovoked and unjustified attack,” the new measures are significant in size and scope and range across targeting Russia’s largest financial institutions, restricting access to U.S. capital markets, restricting access to technology, and even designating President Vladimir Putin personally for blocking sanctions. Cumulatively, sanctions and export controls announced over the past week represent U.S. efforts to exert “unprecedented diplomatic and economic costs on Russia.” We enter the upcoming week with potentially more of these efforts in store—including the removal of select Russian banks from the Society for Worldwide Interbank Financial Telecommunication (“SWIFT”) messaging system, as announced on February 26, 2022.
Sanctions on the Russian Economy
The new round of U.S. sanctions announced on February 24, 2022 includes “significant and unprecedented” action to impose a severe economic toll on the Russian economy, including measures that target almost 80 percent of all banking assets in Russia. The sanctions specifically target Russia’s two largest banks and also impose restrictions related to new debt and equity in more than a dozen Russian state-owned enterprises and large privately-owned financial institutions. Combined with the measures announced earlier in the week, these measures are designed to cut off large portions of the Russian economy from access to the U.S. financial system, crimping the ability of major Russian enterprises both to engage in dollar-denominated trade and to raise new capital.
Full Blocking Sanctions on VTB Bank and Other Financial Institutions
Pursuant to Executive Order (“E.O.”) 14024, the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”) has enacted blocking sanctions on state-owned VTB Bank (“VTB”), Russia’s second-largest financial institution and the holder of almost 20 percent of Russia’s banking assets. As a result of this action, all of the bank’s property and interests in property that come within U.S. jurisdiction are frozen and, except as authorized by OFAC, U.S. persons are generally prohibited from engaging in transactions involving VTB. By operation of OFAC’s Fifty Percent Rule, similar restrictions apply to any entities that are owned, directly or indirectly, 50 percent or more by one or more blocked persons, including VTB. Notably, VTB is among the largest financial institutions that the United States has ever targeted with blocking sanctions.
In addition to VTB, the United States concurrently imposed blocking sanctions on Otkritie, Sovcombank, Novikombank, and dozens of their majority-owned subsidiaries.
Correspondent and Payable-Through Account Sanctions on Sberbank
In a further measure targeted at Russia’s financial sector, OFAC imposed correspondent and payable-through account (“CAPTA”) sanctions through new Directive 2 under E.O. 14024 on Sberbank, the largest financial institution in Russia and the main creditor of Russia’s economy. Although stopping short of full blocking sanctions like those imposed on VTB Bank—presumably on account of Sberbank’s sheer size and centrality to the Russian economy—effective as of March 26, 2022, U.S. financial institutions will be prohibited from opening or maintaining a correspondent or payable-through account for or on behalf of, or processing a transaction involving, Sberbank or any of its majority-owned subsidiaries. The practical effect of this measure is that Russia’s largest bank has been cut off from the U.S. financial system and U.S. dollar-denominated trade. The foreign financial institutions that are subject to CAPTA sanctions are identified on OFAC’s List of Foreign Financial Institutions Subject to CAPTA (“CAPTA List“).
Restrictions on New Debt and Equity
OFAC also issued Directive 3 under E.O. 14024 to place new debt and equity restrictions on 13 major Russian state-owned enterprises and financial institutions. Together, the targeted firms hold assets of nearly $1.4 trillion and will now be restricted from raising money in the U.S. capital market. In particular, these restrictions—which are broadly similar to the sectoral sanctions imposed on certain Russian enterprises in the wake of the Kremlin’s 2014 annexation of Crimea—prohibit transactions by U.S. persons or dealings within the United States involving new debt of longer than 14 days maturity and new equity issued by the following entities: Sberbank, AlfaBank, Credit Bank of Moscow, Gazprombank, Russian Agricultural Bank, Gazprom, Gazprom Neft, Transneft, Rostelecom, RusHydro, Alrosa, Sovcomflot, and Russian Railways. From a policy perspective, these measures are designed to severely limit Russia’s ability to raise new capital for its military activities in Ukraine.
Crucially, like existing sectoral sanctions on Russia, both of the new Directives announced by OFAC (Directives 2 and 3) are narrow in scope as both expressly provide that, absent some other prohibition, all other lawful U.S. nexus activities involving the targeted entities are permitted.
General Licenses
Concurrent with these sanctions, OFAC issued eight general licenses applicable under the Russian Harmful Foreign Activities Sanctions Program:
- General License 5, “Official Business of Certain International Organizations and Entities,” authorizes transactions for the conduct of the official business of certain international organizations and entities.
- General License 6, “Transactions Related to the Exportation or Reexportation of Agricultural Commodities, Medicine, Medical Devices, Replacement Parts and Components, or Software Updates, or the Coronavirus Disease 2019 (COVID-19) Pandemic,” authorizes certain transactions ordinarily incident and necessary to humanitarian trade in agricultural commodities, medicine, and medical devices.
- General License 7, “Authorizing Overflight Payments, Emergency Landings, and Air Ambulance Services,” authorizes payment of charges for services rendered in connection with overflights of Russia or emergency landings in the Russia by aircraft registered in the United States or owned or controlled by U.S. persons.
- General License 8, “Authorizing Transactions Related to Energy,” authorizes, until June 24, 2022, certain transactions related to energy involving five named Russian entities and their subsidiaries. Transactions “related to energy” is specifically defined to mean “the extraction, production, refinement, liquefaction, gasification, regasification, conversion, enrichment, fabrication, transport, or purchase of petroleum, including crude oil, lease condensates, unfinished oils, natural gas liquids, petroleum products, natural gas, or other products capable of producing energy, such as coal, wood, or agricultural products used to manufacture biofuels, or uranium in any form, as well as the development, production, generation, transmission, or exchange of power, through any means, including nuclear, thermal, and renewable energy sources.”
- General License 9, “Authorizing Transactions Related to Dealings in Certain Debt or Equity,” authorizes, until May 25, 2022, dealings in debt or equity of five named Russian entities and their subsidiaries issued prior to February 24, 2022. Any divestment or transfer of debt or equity relying on this authority must be made to a non-U.S. person.
- General License 10, “Authorizing Certain Transactions Related to Derivative Contracts,” authorizes, until May 25, 2022, the winding down of derivative contracts entered into with five named Russian entities and their subsidiaries prior to February 24, 2022. Any payments to a blocked person must be made into a blocked account.
- General License 11, “Authorizing the Wind Down of Transactions Involving Certain Blocked Persons,” authorizes, until March 26, 2022, transactions ordinarily incident and necessary to the wind down of transactions involving Otkritie, Sovcombank, VTB, or any entity in which one of those persons owns a 50 percent or greater interest.
- General License 12, “Authorizing U.S. Persons to Reject Certain Transactions,” authorizes, until March 26, 2022, U.S. persons to reject (rather than block) all transactions prohibited by E.O. 14024 involving certain blocked persons that are not authorized. Persons relying on this general license should review the implications for their rejected transaction reporting obligations to OFAC.
Sanctions on President Putin and Russian Elites
Following a meeting with NATO and other allies on Friday, February 25, 2022, OFAC designated Russian President Vladimir Putin, Minister of Foreign Affairs Sergei Lavrov, Minister of Defense Sergei Shoigu, and Chief of the General Staff Valery Gerasimov to the Specially Designated Nationals and Blocked Persons (“SDN”) List pursuant to E.O. 14024. With this designation, President Putin joins the “exceedingly rare” company—including North Korea’s Chairman Kim Jong Un, Syria’s President Bashar al-Assad, and Belarus’s President Alyaksandr Lukashenka—of sitting heads of states personally targeted by U.S. sanctions.
The announcement of sanctions against President Putin as an individual comes one day after OFAC also designated several members of the Russian elite—also called “enablers” of the President by OFAC—to the SDN List pursuant to E.O. 14024. Notably, OFAC designated Sergei Ivanov, Andrey Patrushev, and Ivan Sechin, all of whom are adult children of close Putin associates who had themselves either been previously designated or who were re-designated in connection with this latest round of sanctions. Additionally, OFAC designated several senior executives at state owned banks. In listing out the key Russian elites that have so far been designated, OFAC warned that it “will designate more in the future if Russia’s unprovoked campaign against Ukraine does not immediately conclude.”
Sanctions on Nord Stream 2 Pipeline
On February 23, 2022, OFAC designated to the SDN List Nord Stream 2 AG, the Swiss company in charge of an eponymous gas pipeline project that Germany halted the day before, as well as its chief executive officer. These designations were made under the authority provided by the Protecting Europe’s Energy Security Act of 2019, which the Biden administration had previously waived exercising in May 2021. In announcing this significant policy shift, President Biden applauded Germany for halting the certification of the pipeline project and noted that the two countries “closely coordinated our efforts to stop the Nord Stream 2 pipeline.” OFAC accompanied this designation with General License 4 that provides a short, one-week wind-down period that expires on March 2, 2022.
Sanctions on Belarusian Financial Institutions and Defense Sector
After Russian troops positioned in Belarus launched an invasion in Ukraine on February 24, 2022, OFAC responded that same day by imposing sanctions not just on Russia but also on 24 Belarusian entities and individuals. Compared to the sanctions imposed on Russia, these Belarus-focused sanctions remain highly targeted. However, designations of Belarusian entities and individuals indicate Treasury’s serious approach to any country that supports or facilitates Russia’s invasion of Ukraine. The sanctions issued on February 24, 2022 focus primarily on two sectors of the Belarusian economy: financial institutions and the defense sector.
Belarusian Financial Institutions
Pursuant to Executive Order 14038, OFAC designated the state-owned Bank Dabrabyt and Belarussian Bank of Development and Reconstruction Belinvestbank (“Belinvestbank”), along with two of Belinvestbank’s subsidiaries. E.O. 14038, issued in August 2021, authorizes blocking sanctions against persons determined by the U.S. Secretary of the Treasury, in consultation with the U.S. Secretary of State, “to be owned or controlled by, or to have acted or purported to act for or on behalf of, directly or indirectly, the Government of Belarus.” E.O. 14038 has previously been used to implement sanctions targeting “the degradation of democracy in Belarus” under the Lukashenka regime.
U.S. sanctions on certain Russian financial institutions (discussed above) are already expected to have a significant impact on the Belarusian economy. U.S. Secretary of the Treasury Janet Yellen commented that, “due to the interconnectedness between the two countries, the actions Treasury took against Russia [on Thursday, February 24, 2022] will also impose severe economic pain on the Lukashenka regime.” When combined with the designation of the two Belarusian banks, these sanctions targeted nearly 20 percent of Belarus’s entire financial sector.
Belarusian Defense Sector
OFAC also targeted Russia’s reliance on the Belarusian defense and related materiel sector by designating ten defense industry entities, as well as executives of some of those entities, pursuant to E.O. 14038. These designations build on OFAC’s December 2021 designation of five Belarusian defense firms “in response to the Lukashenka regime’s blatant disregard for international norms and the wellbeing of its own citizens.”
In addition to these entities, OFAC added two senior officials of the Belarusian government’s security apparatus—Belarusian Minister of Defense Viktor Khrenin and State Secretary of the Security Council of Belarus Aleksandr Volfovich—to the SDN List.
Belarusian Elites
Beyond targeting financial institutions and the defense sector, OFAC continues to target Belarusian elites who support the Lukashenka regime’s erosion of democracy in Belarus. The February 24, 2022 sanctions also included the designation of Aliaksandr Zaitsau and his company OOO Sokhra, which engages in gold mining and the promotion of Belarusian industrial products in Africa and the Middle East. According to OFAC, Zaitsau continues to maintain close ties to the Lukashenka family.
Concurrent with these designations of Belarusian entities and individuals, OFAC issued two general licenses related to the Belarus Sanctions Program:
- General License 6, “Official Business of the United States Government,” authorizes all otherwise prohibited transactions for the conduct of the U.S. Government’s official business.
- General License 7, “Official Business of Certain International Organizations and Entities,” authorizes transactions for the conduct of the official business of certain international organizations and entities.
Expansion of Export Controls Targeting Russia
The U.S. Department of Commerce’s Bureau of Industry and Security (“BIS”) on February 24, 2022 simultaneously issued a Final Rule on the Implementation of Sanctions Against Russia Under the Export Administration Regulations (“EAR”). The Final Rule uses several policy tools, each described below, to create a dramatic expansion of restrictions on exports, reexports, and in-country transfers to Russia.
Importantly, in a notable gesture of multilateral coordination, BIS incorporated several exclusions for “partner countries” in the restrictions. “Partner countries” refer to those countries that are adopting or have expressed intent to adopt substantially similar export controls measures to those the United States has adopted, and can be found in a list provided in Supplement No. 3 to Part 746 of the EAR. Currently, “partner countries” include the European Union member states, Australia, Canada, Japan, New Zealand, and the United Kingdom.
Expansion of Item-Based Licensing Requirements
The Final Rule imposes additional license requirements for export, reexport, and in-country transfer to Russia of all items with Export Control Classification Numbers (“ECCNs”) in Categories 3–9 of the Commerce Control List (“CCL”)—which include, among others, dual-use items used in electronics design, development and production, computers, telecommunications, manufacturing, aerospace, navigation, and marine applications. The new license requirements impact items described under 58 separate ECCNs that were not previously controlled for export to Russia, and BIS will review all such license applications with a presumption of denial unless the planned exports are in support of a short list of end uses, such as safety of flight. The expansion of items controlled for export to Russia also means that foreign-made items that incorporate U.S.-controlled content that were not previously subject to U.S. export control licensing requirements will now be subject to those requirements when destined for Russia, unless they are being exported from countries that are adopting export controls similar to those the United States has now adopted. As a result, companies exporting from many countries may now need to reassess whether their products have become subject to BIS licensing requirements due to these changes.
Additionally, in line with earlier sanctions announced on February 21, 2022, there are new license requirements that impose an effective trade embargo on all exports, reexports, and in-country transfers to the separatist regions of Ukraine—the so-called Donetsk People’s Republic (“DNR”) and Luhansk People’s Republic (“LNR”). The license requirements are applicable for all items subject to the EAR, other than food and medicine designated as EAR99 and certain EAR99 or ECCN 5D992.c software for Internet-based communications.
These changes went into effect on February 24, 2022.
Extension of Export Licensing Requirements to New Products Produced Using Controlled Software and Technology
The United States has long controlled certain foreign-made products that were produced directly from certain national security-controlled U.S. software and technology or from plants or components of plants that were produced from this software and technology. Because these controls, called Foreign Direct Product (“FDP”) rules, hinge on the use of controlled software and technology, they effectively extend U.S. export controls to products made outside of the United States that do not otherwise incorporate U.S. content. Under this rule, U.S. export controls could be applied not only to chips that incorporate U.S.-origin processors, but also to any chips that are manufactured using certain U.S. equipment.
In 2020, seeking a new way to restrict supply chains to Huawei affiliates designated on BIS’s Entity List, BIS created a new FDP rule to reach semiconductors, computers, and telecommunication items that were directly produced using U.S.-origin software, technology, plants, or major components of plants that were destined for supply chains that involved Huawei in almost any role. BIS defined the concept of “direct product” in an especially broad way to include not only any item that incorporates any part, component, or equipment produced using the defined items, but also to capture any item used in their production. Thus, even products that were merely tested using the controlled equipment would now require export licensing when Huawei-affiliated entities designated on BIS’s Entity List were involved. The few short regulatory provisions and footnotes that described this new rule sent trade compliance specialists scrambling, even within suppliers many tiers removed from Huawei, to determine whether the software, technology, or equipment they were using to make their products was export-controlled in ways that made their products suddenly subject to new U.S. export licensing requirements.
In the Final Rule announced on February 24, 2022, BIS has now created two new FDP rules that will impact not just a single company in Russia, but a broad swath of both low- and high-technology sectors in the Russian economy. The first is an FDP rule that applies to all exports, reexports, and in-country transfers ultimately destined for Russia (the “Russia FDP Rule”), and the second is an FDP rule that applies to all exports, reexports, and in-country transfers ultimately destined for Russian military end users (the “Russia MEU FDP Rule”). We compare these rules side-by-side in the below table.
|
Russia FDP Rule |
Russia MEU FDP Rule |
|
Export of foreign-produced item would require a license if it is:
AND
|
Export of foreign-produced item would require a license if it is:
AND
|
|
Does not apply to foreign-produced items that would be designated as EAR99 (items not listed on the CCL), which includes many consumer items used by the Russian people. |
Applies to all foreign-produced items, including those designated EAR99, with limited exceptions. |
For the Russia MEU FDP Rule, the “footnote 3 designation” means that an entity will have, under the “license requirement” note on its Entity List designation, a citation that says “See § 734.9(g).3” Along with the creation of the Russia MEU FDP Rule, BIS immediately assigned the “footnote 3 designation” to nearly 50 entities, which means that a license is required to export, reexport, or transfer all FDP items to these entities and that license applications will be reviewed under a policy of denial. Forty-five of these entities, including the Ministry of Defence of the Russian Federation, were previously on the Commerce Department’s Military End User (“MEU”) List, but have now been moved to the Entity List, thus subjecting them to broader restrictions. Two new entities—the International Center for Quantum Optics and Quantum Technologies LLC, and SP Kvant—were newly added to the Entity List with footnote 3 designations.
Currently, all partner countries are fully excluded from the scope of both new FDP rules. This means that items produced in the partner countries would not be subject to the FDP rules’ licensing requirements.
Although BIS has given exporters until March 26, 2022 to comply with the new FDP rules, we expect that it will take many companies much longer to assess whether the items they are making are now subject to either of the two new Russia-specific FDP rules. Especially given the breadth of the Russia MEU FDP Rule, we expect that many companies outside of Russia will simply cease all supply to designated and potential military end users in Russia.
Expansion of Military End Use and Military End User Controls
The Final Rule also expands the existing Russia ‘military end use’ and ‘military end user’ controls to all items subject to the EAR, with limited exceptions. Previously, the ‘military end use’ and ‘military end user’ controls had applied only to a subset of items identified in Supplement No. 2 to Part 744 of the EAR. Now, these controls apply broadly, with limited exceptions for food and medicine designated as EAR99 and items classified as ECCN 5A992.c or 5D992.c, so long as they are not for Russian “government end users” or Russian state-owned enterprises.
License Review Policy and License Exceptions
License requests under these new requirements will be reviewed with a policy of denial with limited exceptions. Exceptions to the license review policy, which are specific to an ECCN’s reasons for control and would be reviewed on a case-by-case basis, are for applications related to safety of flight, maritime safety, humanitarian needs, government space cooperation, civil telecommunications infrastructure, government-to-government activities, and to support limited operations of partner country companies in Russia.
There may be certain license exceptions that apply to the exports, reexports, and in-country transfers to Russia, but many of these license exceptions are only available under limited circumstances. For example:
- License exception TMP (Temporary Imports, Exports, Reexports, and Transfers in Country) is available for items for use by the news media.
- License exception TSU (Technology and Software Unrestricted) is available for software updates to civil end users that are subsidiaries of, or joint ventures with, companies headquartered in the United States or partner countries.
- License exception ENC (Encryption Commodities, Software, and Technology) is available for encryption items, but not if they are destined for Russian government end users and Russian state-owned enterprises.
- License exception CCD (Consumer Communication Devices) is available for certain consumer communication devices, but not if they are destined for government end users or certain individuals associated with the government.
As a result, persons relying on these license exceptions would need to conduct due diligence on the end users to ensure that they are complying with the precise scope of the license exceptions.
No case-by-case license application review or license exceptions are available for items subject to licensing requirements under the Russia MEU FDP Rule.
Next Steps
On February 26, 2022, the White House, together with the European Commission, France, Germany, Italy, the United Kingdom, and Canada, issued a joint statement announcing their commitment to impose further sanctions in response to “Putin’s war of choice,” including the removal of select Russian banks from the SWIFT network, the principal messaging system for global financial institutions to send and receive transaction-related information. In response to concerns that Russia has built up its foreign reserves to withstand the blow of Western sanctions, the countries also committed to preventing the Russian Central Bank from deploying its international reserves in ways that undermine the impact of sanctions. Japan signed on the joint statement during its day on February 27, 2022, completing the entire G7’s support for these upcoming measures.
A constant subject of policy discussions since the 2014 annexation of Crimea, removal of Russian banks from SWIFT did not seem to be gathering global support until just days ago. The joint statement represents both a seismic shift in policy and an impressive example of multilateral coordination, and the countries will be launching a joint task force that would carry on the spirit of coordinated sanctions implementation by identifying and freezing assets of sanctioned persons. However, details of how to achieve the selective SWIFT removal or Central Bank restrictions are yet to be finalized, and we will be following closely for more announcements.
The next steps are now dependent on Russia’s next moves. In a matter of just one week, the U.S. Government has issued a new Executive Order, several directives, designations, and general licenses under three different sanctions programs, as well as new export controls regulations. These measures were an outcome of significant multilateral coordination, by what President Biden called “a coalition of partners representing well more than half of the global economy.” As Russia continues its military incursion further into Ukraine, more Western sanctions are on the horizon. Russia, in turn, will begin considering its counteractions to respond to Western financial pressure. Following the Western sanctions in 2014, Russia responded with restrictions on agricultural imports and gas flows to Europe—this time, more could be in store, including the criminalization of compliance with foreign sanctions. As industry strives to understand these wide-ranging and complex new sanctions and export controls, we are likely to see more guidance from the U.S. Government to help foreign investors and multinational companies navigate the changing—and challenging—regulatory landscape.
The following Gibson Dunn lawyers assisted in preparing this client update: Claire Yi, Scott R. Toussaint, Lindsay Bernsen Wardlaw, Jacob A. McGee, Sean J. Brennan, Judith Alison Lee, Adam M. Smith, and Christopher Timura.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the above developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s International Trade practice group:
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Los Angeles partners James Zelenay and Nick Hanna and associate Harper Gernet-Girard are the authors of “FCA enforcement, one year into the Biden administration” [PDF] published by the Daily Journal on February 22, 2022.
Washington, D.C. partner Kristen Limarzi is the author of “The FTC’s Efforts to Break Up Facebook Misses Actual Concerns” [PDF] published by Bloomberg Law on February 17, 2022.
Decided February 24, 2022
Unicolors, Inc. v. H&M Hennes & Mauritz, LP., No. 20-915
Today, the Supreme Court held 6-3 that a copyright holder can file a copyright infringement suit even if its copyright registration application included inaccurate information that was the result of an innocent mistake of fact or law.
Background:
A copyright holder cannot bring an infringement suit unless it holds a valid copyright registration certificate. A certificate is valid even if it contains inaccurate information, unless the inaccuracy “was included on the application for copyright registration with knowledge that it was inaccurate” and, “if known, would have caused the Register of Copyrights to refuse registration.” 17 U.S.C. § 411(b). After Unicolors sued H&M for copyright infringement, H&M argued that Unicolors’ copyright registration certificate was invalid because Unicolors had knowingly included inaccurate information in its application by applying to register multiple works in a single application even though it had made those works separately available to clients and the public.
The district court ruled that a certificate is invalid under § 411(b) only if the applicant intended to defraud the Copyright Office, and Unicolors’ mistake of law did not evidence an intent to defraud. The Ninth Circuit reversed, holding that § 411(b) does not contain an intent-to-defraud requirement, and that Unicolors’ application contained factual information Unicolors knew was inaccurate. It was irrelevant, in the Ninth Circuit’s view, whether the inaccuracy was the result of Unicolors’ inadvertent misunderstanding of a principle of copyright law.
Issue:
Whether 17 U.S.C. § 411(b)’s “knowledge” requirement excuses inadvertent mistakes of fact or law.
Court’s Holding:
Yes. The “knowledge” element in § 411(b) requires a showing that the copyright registration applicant actually knew that the inaccurate information in its application was inaccurate, and excuses inaccuracies that were the result of an innocent mistake of fact or law.
“Lack of knowledge of either fact or law can excuse an inaccuracy in a copyright registration.”
Justice Breyer, writing for the Court
What It Means:
- The Court’s decision means that copyright holders can defend inaccuracies in registration certificates on the ground that they were the product of an innocent mistake of either fact or law. The Court’s ruling could provide additional protection for copyright registrants such as novelists, poets, and painters who may be unfamiliar with the complexities of the Copyright Act or who in good faith reach incorrect conclusions about what the law requires.
- Although copyright holders can file new registration applications to fix innocent inaccuracies, copyright claims have a three-year statute of limitations, and statutory damages and attorneys’ fees are available only for infringements that occur after a valid registration is in place. Today’s ruling potentially expands the scope of cases involving inaccurate copyright registrations.
- The Court emphasized that willful blindness to an inaccuracy may constitute actual knowledge under § 411(b), and that circumstantial evidence—such as the significance of the error, the complexity of the relevant rule, and the applicant’s experience with copyright law—could influence whether the applicant was actually aware of, or willfully blind to, the inaccuracy.
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:
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Los Angeles partner Heather Richardson, Orange County associate Jennafer Tryck, and Washington, D.C. associate Tessa Gellerson are the authors of “How Courts Are Ruling On The Arbitrability Of ERISA Claims” [PDF] published by Law360 on February 24, 2022.
On February 21 and 22, 2022, the United States, the European Union, the United Kingdom, Australia, and Japan issued and/or announced sanctions targeting Russia and the Russia-backed separatist regions of Ukraine known as the Donetsk People’s Republic (“DNR”) and the Luhansk People’s Republic (“LNR”). The United States took the first step by issuing broad jurisdiction-based sanctions on the two regions, similar to the existing sanctions on the Crimea region of Ukraine, and followed up with additional sanctions targeting Russia’s financial system. NATO allies also announced sanctions—including targeted designations by the United Kingdom and a sanctions package by the European Union—and non-NATO allies promised tough sanctions in close coordination. These actions are only among a few of several tools we expect the United States and its allies will use in the coming days and weeks as Russia continues to stoke military tension in the region.
These actions follow nearly a decade of lasting conflict in eastern Ukraine and a quick escalation over the past few weeks. After the 2014 Ukrainian revolution and the Euromaidan movement, which saw a pro-Western government elected in Ukraine, pro-Russia protests against the new government began in eastern Ukraine. These protests in the DNR and LNR regions eventually developed into full-scale fighting, with Russia backing the separatists against the Ukrainian military and more than 10,000 people killed in the conflict. Shaky ceasefires between the two sides have existed for several years, but in recent days, artillery shelling has increased along with other violations of the ceasefire agreements, with the Ukrainian government claiming that these attacks were orchestrated by Russia or pro-Russia separatists in the region.
In response to formal appeals from the de facto leaders of the breakaway regions for sovereign recognition from Russia, Russian president Vladimir Putin convened a meeting of his security council on Monday, February 21, 2022 under the pretext of seeking recommendations on how to answer the requests. After the meeting of the council, Putin delivered a televised address to the public, referring to eastern Ukraine as “historically Russian territory” and saying that it is “necessary to take a long overdue decision to immediately recognize the independence and sovereignty of the Donetsk People’s Republic and the Luhansk People’s Republic.” Immediately thereafter, Putin ordered Russian troops to enter the regions for a “peacekeeping” mission under the treaties of “friendship and mutual assistance” that Russia ratified that same day with the individual regions. All diplomatic efforts to maintain the territorial integrity of Ukraine while the parties sought to ease building tensions thus suffered a serious setback.
US Issues New Executive Order Imposing Sweeping Sanctions on Separatist Regions
Just hours after Putin’s televised speech, President Biden signed a new Executive Order issuing broad sanctions on the DNR and LNR regions of Ukraine, and any other regions of Ukraine as may be determined by the Secretary of the Treasury, in consultation with the Secretary of State (collectively, the “Covered Regions”). The Executive Order is nearly identical to Executive Order 13685 that announced comprehensive sanctions on the Crimea region of Ukraine in 2014.
First, the Executive Order prohibits: (1) new investment in the Covered Regions by a U.S. person; (2) import of any goods, services, or technology from these regions to the United States; and (3) export of any goods, services, or technologies from the United States or by a U.S. person to these regions. The Executive Order further prohibits U.S. persons from financing, facilitating, or guaranteeing transactions by foreign persons that U.S. persons would be prohibited from engaging directly.
Second, the Executive Order authorizes blocking sanctions on any person determined by the Secretary of the Treasury, in consultation with the Secretary of State, to be: (1) a person operating in the Covered Regions; or (2) a leader, official, senior executive officer, or board member of an entity operating in the Covered Regions. The Executive Order also authorizes sanctions on an entity determined to be owned or controlled by a blocked person pursuant to the Executive Order, or any person who has provided material support for a blocked person pursuant to the Executive Order. No such individual designations have yet been made, which is very similar to how OFAC responded at the inception of Executive Order 13685.
Concurrent with the signing of the Executive Order, OFAC issued six general licenses:
- General License 17, “Authorizing the Wind Down of Transactions Involving the So-called Donetsk People’s Republic or Luhansk People’s Republic Regions of Ukraine” authorizes all prohibited transactions “that are ordinarily incident and necessary to the wind down of transactions involving” the Covered Regions until March 23, 2022.
- General License 18, “Authorizing the Exportation or Reexportation of Agricultural Commodities, Medicine, Medical Devices, Replacement Parts and Components, or Software Updates to Certain Regions of Ukraine and Transactions Related to the Coronavirus Disease 2019 (COVID-19) Pandemic” authorizes the export of agricultural commodities, medicine, medical devices, replacement parts and components, or software updates to the Covered Regions. This authorization is similar to that of the existing General License 4 with respect to the Crimea region, but is more expansive in that it does not include the exclusions that are in General License 4 (e.g., export to military or law enforcement purchasers, certain agricultural commodities, and certain medicines), that it expands the scope to software updates in addition to replacement parts, and that it includes a separate COVID-19 authorization.
- General License 19, “Authorizing Transactions Related to Telecommunications and Mail” authorizes transactions that are ordinarily incident and necessary to the receipt or transmission of telecommunications in the Covered Regions. This authorization is similar to the existing General License 8 with respect to the Crimea region.
- General License 20, “Official Business of Certain International Organizations and Entities” authorizes official business of certain international organizations and entities in the Covered Regions. Of note, the list of international organizations includes the Organization for Security and Co-operation in Europe, an entity that has been actively seeking to de-escalate the conflict in recent days.
- General License 21, “Authorizing Noncommercial, Personal Remittances and the Operation of Accounts” authorizes transactions that are ordinarily incident and necessary to the transfer of noncommercial, personal remittances to or from the Covered Regions. This authorization is similar to the existing General License 6 with respect to the Crimea region.
- General License 22, “Authorizing the Exportation of Certain Services and Software Incident to Internet-Based Communications” authorizes export of certain services incident to the exchange of personal communications over the internet or software necessary to enable such services in the Covered Regions. This is similar to the existing General License 9 with respect to the Crimea region, but is more expansive in that it does not require the services and software to be widely available to the public with no cost to the user.
The issuance of these expansive general licenses is in line with the White House’s repeated messaging that the sanctions “are not directed at the people of Ukraine” or “the innocent people who live in the so-called DNR and LNR regions.” Particularly during the COVID-19 pandemic, the Biden administration has continued to include broad humanitarian exceptions in new sanctions measures, including those taken in response to the situations in Myanmar and Ethiopia. It is noteworthy that OFAC further created an expansive COVID-19 authorization for transactions related to the prevention, diagnosis, or treatment of the COVID-19 pandemic, without any specific definition or exception.
General License 17 is also consistent with OFAC’s past practices of allowing parties a period of time to adjust to significant new sanctions measures to minimize the immediate disruption to the global economy. Similar to the more recent wind-down licenses from OFAC, there is no requirement for U.S. persons participating in authorized transactions to file a report with OFAC, which reduces the administrative burden of relying on the license. However, the 30-day wind-down period is much shorter than the typical 60- to 90-day periods that OFAC has granted in announcing other sanctions measures. It is likely that future wind-down licenses from OFAC regarding sanctions targeting Russia will be similarly brief.
Parties planning to rely on these general licenses should note that all six general licenses expressly limit their authorizations to transactions and activities that are prohibited by this particular Executive Order. The general licenses do not authorize transactions with persons or entities designated pursuant to other sanctions programs. As a result, parties should be careful not to engage in transactions and activities that are prohibited under another authority, such as the sectoral sanctions under Executive Order 13662. Parties should also take note of the differences between the general licenses granted with respect to the Crimea sanctions and to the DNR and LNR sanctions, in case a counterparty is sanctioned under both Executive Order 13685 and the new Executive Order.
US Imposes Sanctions on Russian Financial Services Sector
On February 22, 2022, OFAC designated to the SDN List two financial institutions that it determined are crucial to financing the Russian defense industry—Corporation Bank for Development and Foreign Economic Affairs Vnesheconombank (VEB) and Promsvyazbank Public Joint Stock Company (PSB)—along with 42 of their subsidiaries. OFAC also designated three individuals—Denis Aleksandrovich Bortnikov, Petr Mikhailovich Fradkov, and Vladimir Sergeevich Kiriyenko—who OFAC determined were “powerful Russians in Putin’s inner circle.”
All of the designations were made under the authority of the Executive Order 14024, which we discussed in depth in a previous update. Importantly, Executive Order 14024 had authorized blocking sanctions against persons determined to operate in certain sectors of the Russian economy, with specific sectors to be determined by the Secretary of the Treasury, in consultation with the Secretary of State. When Executive Order 14024 was issued in April 2021, OFAC had identified the technology sectors and defense and related materiel sector as potential targets of future designations. In the most recent action taken on February 22, 2022, OFAC additionally identified the financial services sector of the Russian economy, making it easier for the United States to use a single, consolidated sanctions tool to target the entire financial services sector. OFAC accompanied this determination with FAQ 964, noting that its determination merely lays the groundwork for future sanctions against persons that operate in the financial services sector, rather than actually serving as sanctions on the entire financial services sector.
Additionally, OFAC issued Directive 1A, amending and superseding Directive 1 that was issued under Executive 14024. Importantly, Directive 1A includes restrictions on the participation in the secondary market for ruble or non-ruble denominated bonds issued after March 1, 2022 by the Central Bank of the Russian Federation, the National Wealth Fund of the Russian Federation, or the Ministry of Finance of the Russian Federation. As a result of this new Directive 1A, the Central Bank of the Russian Federation, the National Wealth Fund of the Russian Federation, and the Ministry of Finance of the Russian Federation have been designated to the Non-SDN Menu-Based Sanctions List.
Concurrent with these additional sanctions, OFAC issued two general licenses:
- General License 2, “Authorizing Certain Servicing Transactions Involving State Corporation Bank for Development and Foreign Economic Affairs Vnesheconombank” authorizes all prohibited transactions “that are ordinarily incident and necessary to the servicing of bonds issued before March 1, 2022 by the Central Bank of the Russian Federation, the National Wealth Fund of the Russian Federation, or the Ministry of Finance of the Russian Federation,” but to the extent that such transaction is not prohibited by the new Directive 1A.
- General License 3, “Authorizing the Wind Down of Transactions Involving State Corporation Bank for Development and Foreign Economic Affairs Vnesheconombank” authorizes all prohibited transactions “that are ordinarily incident and necessary to the wind down of transactions involving” VEB for a 30-day period until March 24, 2022.
Again, parties planning to rely on these general licenses should note that the general licenses expressly limit their authorizations to transactions and activities that are prohibited by Executive Order 14024.
EU Announces Sanctions Package to be Implemented
The EU has announced, yet not formally issued, new sanctions on Russia. While in the morning of February 22, 2022, the presidents of the European Council and the European Commission had welcomed “the steadfast unity of [EU] Member States and their determination to react with robustness and speed,” the subsequent announcement of the specific contemplated measures was more limited in scope than expected by many and only came after a surprisingly lengthy meeting of EU Foreign Affairs Ministers. The formal issuance and implementation of the contemplated measures is now expected in the course of the week.
First, in what the EU has now referred to as “solid package” of “calibrated measures,” EU financial sanctions (broadly comparable to U.S. SDN designations) will target individuals and entities involved in the violations of international law by the Kremlin, including in the recognition of the Donetsk and Luhansk regions as independent entities.
Second, the EU will target banks that finance the Russian military apparatus and contribute to the destabilization of Ukraine. Such banks have not yet been named and will either be targeted via EU financial sanctions or via more limited EU economic sanctions (broadly comparable to U.S. SSI designations).
Third, the EU has announced that it plans to ban trade between the EU and the Donetsk and Luhansk regions by implementing comprehensive EU Economic Sanctions comparable to those implemented after the annexation by Russia of Crimea in 2014.
Finally, the EU announced new measures to restrain Russian efforts to raise further capital on EU’s financial markets by limiting respective access for the Russian state and government. Such measures will likely take the form of targeted EU Economic Sanctions and prohibit or at least limit dealings with, for example, transferable securities and money-market instruments with a certain maturity and prohibit making loans or credit to those targeted.
The EU also announced that it had prepared and stands ready to adopt additional measures at a later stage if needed in the light of further developments.
Germany Stops Certification of Nord Stream 2
As a first reaction, the German Chancellor Olaf Scholz announced that the certification of the Nord Stream 2 pipeline has been stopped, and thus the pipeline will not become operational until further notice. This action was perhaps the least expected response and carries significant practical impact. The Nord Stream 2 project was intended to supply energy from Russia to the European Union, and Germany—along with other EU member states—had so far contested any attempts to impose sanctions on the Nord Stream 2 project in light of Russian aggression, in part due to the European Union’s heavy reliance on energy sources from Russia. With this action, Germany sent a clear message that it stands ready to join severe sanctions against Russia.
United Kingdom Sanctions Russian Banks and Oligarchs
On February 10, 2022, the UK pre-emptively amended its legislation on Russia sanctions—the Russia (Sanctions) (EU Exit) Regulations 2019 (S.I. 2019/855) (the “UK Russia Sanctions Regulations”)—via the enactment of The Russia (Sanctions) (EU Exit) (Amendment) Regulations 2022 (SI 2022/123) (the “Amended Regulations”).
The Amended Regulations widened the scope of the UK Russia Sanctions Regulations by expanding its designation criteria. The designation criteria now include entities and individuals that are involved in “obtaining a benefit from or supporting the Government of Russia.” Previously, the UK could only impose travels bans or asset freezes on those involved in “destabilising Ukraine or undermining or threatening the territorial integrity, sovereignty or independence of Ukraine.”
For the purposes of the Amended Regulations, being “involved in obtaining a benefit from or supporting the Government of Russia” includes, among other things, carrying on business “of economic significance” or “in a sector of strategic significance” to the Government of Russia, those sectors being the Russian chemicals, construction, defense, electronics, energy, extractives, financial services, information, communications, digital technologies, and transport sectors. This is therefore a very significant expansion in the scope of the designation criteria which empowers the UK to impose sanctions on a wide range of businesses that may not necessarily have a strong nexus to the Russian government, save that the nature of their business and/or the sector(s) in which they operate are of economic significance to the Russian government.
Using its new powers under the Amended Regulations, the UK government updated the UK Sanctions List on February 22, 2022 by designating five Russian banks (Bank Rossiya, Black Sea Bank for Development and Reconstruction, Joint Stock Company Genbank, IS Bank, Public Joint Stock Company Promsvyazbank) as well as three wealthy individuals (Gennadiy Nikolayevich Timchenko, Boris Romanovich Rotenberg and Igor Arkadyevich Rotenberg) as being subject to an asset freeze.
The UK’s Prime Minister, Boris Johnson, has described this sanctions package as “the first tranche, the first barrage“ of what the UK is prepared to do. Foreign Secretary, Liz Truss, said in her statement that “this first wave of sanctions will hit oligarchs and banks close to the Kremlin. It sends a clear message that the UK will use [its] economic heft to inflict pain on Russia and degrade their strategic interests.” She further stated that “in the event of further aggressive acts by Russia against Ukraine,” the UK has prepared “an unprecedented package of further sanctions ready to go. These include a wide-ranging set of measures targeting the Russian financial sector, and trade.” However, for some in the UK, these measures do not go far enough, and Boris Johnson is under pressure to impose tougher sanctions.
Allies Outside NATO Join in Announcing Tough Response
Japan’s Minister of Foreign Affairs Hayashi Yoshimasa stated that Japan would continue to monitor the development of the situation in Ukraine with serious concern and coordinate a tough response, including sanctions in cooperation with the international community.
Australia’s Minister of Foreign Affairs declared that the Australian Government was coordinating closely with the United States, United Kingdom, European Union, and other governments around the world to ensure there were severe costs for Russia’s aggression and that, along with its partners, Australia was prepared to announce swift and severe sanctions that would target key Russian individuals and entities responsible for undermining Ukraine’s sovereignty and territorial integrity.
Possible Next Steps
There has been much speculation in recent days about the sanctions packages that would be revealed upon Russia’s invasion of Ukraine. So far, many world leaders have stopped short of calling Russia’s recognition of the two regions and his deployment of the Russian military to these regions a full-scale invasion, perhaps in part as an effort to deescalate tension or to leave space for additional sanctions if the situation worsens. However, the recent measures allow more authority for the Western countries to issue additional sanctions in case of further escalation—such as a new Executive Order that authorizes sanctions on persons operating in the separatist regions of Ukraine and a financial services sector determination that authorizes sanctions on persons operating in the Russian financial services sector. As tensions continue to rise, we will likely see more series of tools from the NATO countries and their allies to exert economic pressure on Russia to deescalate the ongoing crisis in Ukraine and withdraw its army from Ukraine’s borders. Companies should continue to pay attention to the ongoing developments and proactively assess their exposure to the sanctions and export controls measures being discussed.
In the lead up to the recent sanctions, leaders of the NATO countries engaged in close coordination and dialogue and had reported that they have “wrapped up“ and are “unified“ on potential sanctions packages to be used. However, we have seen varying degrees of severity and speed in the measures that each of the governments were able to impose immediately following the action from Russia. We expect there to be continued effort for coordination and convergence across the various jurisdictions, but we are closely tracking the differences in the sanctions imposed in different jurisdictions and the resulting compliance impact for companies operating in the global market.
The following Gibson Dunn lawyers assisted in preparing this client update: Claire Yi, Jacob A. McGee, Richard Roeder, Julian Reichert, Alexander Stahl, Kanchana Harendran, David A. Wolber, Judith Alison Lee, Adam M. Smith, Christopher Timura, Michael Walther, Benno Schwartz, Patrick Doris, and Attila Borsos.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the above developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s International Trade practice group:
United States:
Judith Alison Lee – Co-Chair, International Trade Practice, Washington, D.C. (+1 202-887-3591, [email protected])
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Nicola T. Hanna – Los Angeles (+1 213-229-7269, [email protected])
Marcellus A. McRae – Los Angeles (+1 213-229-7675, [email protected])
Adam M. Smith – Washington, D.C. (+1 202-887-3547, [email protected])
Christopher T. Timura – Washington, D.C. (+1 202-887-3690, [email protected])
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, [email protected])
Laura R. Cole – Washington, D.C. (+1 202-887-3787, [email protected])
Chris R. Mullen – Washington, D.C. (+1 202-955-8250, [email protected])
Samantha Sewall – Washington, D.C. (+1 202-887-3509, [email protected])
Audi K. Syarief – Washington, D.C. (+1 202-955-8266, [email protected])
Scott R. Toussaint – Washington, D.C. (+1 202-887-3588, [email protected])
Shuo (Josh) Zhang – Washington, D.C. (+1 202-955-8270, [email protected])
Asia:
Kelly Austin – Hong Kong (+852 2214 3788, [email protected])
David A. Wolber – Hong Kong (+852 2214 3764, [email protected])
Fang Xue – Beijing (+86 10 6502 8687, [email protected])
Qi Yue – Beijing – (+86 10 6502 8534, [email protected])
Europe:
Attila Borsos – Brussels (+32 2 554 72 10, [email protected])
Nicolas Autet – Paris (+33 1 56 43 13 00, [email protected])
Susy Bullock – London (+44 (0) 20 7071 4283, [email protected])
Patrick Doris – London (+44 (0) 207 071 4276, [email protected])
Sacha Harber-Kelly – London (+44 (0) 20 7071 4205, [email protected])
Penny Madden – London (+44 (0) 20 7071 4226, [email protected])
Matt Aleksic – London (+44 (0) 20 7071 4042, [email protected])
Benno Schwarz – Munich (+49 89 189 33 110, [email protected])
Michael Walther – Munich (+49 89 189 33 180, [email protected])
Richard W. Roeder – Munich (+49 89 189 33 115, [email protected])
© 2022 Gibson, Dunn & Crutcher LLP
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This past year was another busy one for Employee Retirement Income Security Act (“ERISA”) litigation, including significant decisions from the United States Supreme Court and the federal courts of appeals on issues impacting retirement and healthcare plans, coupled with the change in presidential administrations that resulted in new rules affecting ERISA plan sponsors and administrators.
Last year, Gibson Dunn also welcomed back Eugene Scalia as a partner to the Firm’s Washington, DC office after he served as the 28th U.S. Secretary of Labor from September 2019 to January 2021. Scalia’s return adds further depth to Gibson Dunn’s bench of elite ERISA litigators, who take an interdisciplinary approach to their work resolving complex matters for our clients, and bring together the Firm’s deep knowledge base and significant experience from across a variety of its award-winning practice groups, including: Executive Compensation & Employee Benefits, Class Actions, Labor & Employment, Securities Litigation, FDA & Health Care, and Appellate & Constitutional Law.
This year’s Annual ERISA Litigation Update summarizes key legal opinions and developments to assist plan sponsors and administrators navigating the rapidly changing ERISA litigation landscape.
Section I highlights two notable opinions from the United States Supreme Court rejecting a challenge to the individual mandate in the Affordable Care Act on standing grounds, and addressing the pleading standard in ERISA “excessive fee” fiduciary-breach cases. We are also watching pending petitions for certiorari concerning the application of ERISA’s fiduciary requirements to business transactions between plan administrators and third-party service providers, and ERISA preemption of state-run IRA programs for private-sector workers.
Section II delves into how the federal courts have applied the Supreme Court’s decision in Thole v. U.S. Bank, 140 S. Ct. 1615 (2020), addressing Article III standing in ERISA cases. We also discuss the implications for ERISA litigants of the Court’s recent decision on Article III standing in TransUnion LLC v. Ramirez, 141 S. Ct. 2190 (2021).
Section III addresses the continuing impact of the Supreme Court’s decision in Rutledge v. Pharmaceutical Management Association, 141 S. Ct. 474 (2020), on the issue of ERISA preemption.
Section IV provides an analysis of how the federal courts are assessing the enforceability of arbitration agreements in ERISA plans.
Section V discusses how the courts continue to grapple with the standard of review for ERISA benefits claims.
Section VI offers an overview of the Department of Labor’s rule changes concerning environmental, social, and governmental (“ESG”) investing, and the implications of those changes for ERISA plan fiduciaries.
I. Key 2021 Supreme Court Decisions & Cases to Watch
The United States Supreme Court decided two cases in 2021 with significant implications for ERISA plans and their sponsors and administrators. In California v. Texas, 141 S. Ct. 2104 (2021), the Court dismissed a challenge to the Affordable Care Act (“ACA”) by holding that the plaintiffs lacked Article III standing to bring the suit. In Hughes v. Northwestern University, the Court held that allegations that a defined-contribution retirement plan breached ERISA’s duty of prudence by offering high-cost investment options may be actionable even if the plan also offers lower-cost options. But the Court declined to adopt an ERISA-specific pleading standard for these fiduciary-breach claims.
The Court has also ordered further briefing on pending petitions for certiorari in ERISA cases concerning the application of ERISA’s fiduciary requirements to arms-length contracts between a plan administrator and third-party service providers, and the scope of ERISA preemption over state-run programs that enroll private sector employees in retirement savings programs.
A. California et al. v. Texas et al. and Texas et al. v. California et al. Uphold the Affordable Care Act
In California v. Texas, 141 S. Ct. 2104 (2021) (consolidated with Texas v. California), the Supreme Court rejected on Article III standing grounds the latest challenge to the constitutionality of the ACA. In 2012, the Court rejected constitutional challenges under the Commerce Clause to the requirement in the ACA that individuals must maintain health insurance coverage, also known as the individual mandate. Nat’l Fed’n of Indep. Bus. v. Sebelius, 567 U.S. 519 (2012). The Court reasoned that the ACA was not a command to buy health insurance—which Congress would lack the power to enact—but merely a tax for not doing so. Id. at 574–75.
In December 2017, Congress amended the ACA to eliminate the penalty for not buying health insurance, but did not eliminate the ACA’s individual mandate. Two individuals and several states, including Texas, then challenged the individual mandate as unconstitutional, arguing that because it no longer carried a penalty, it no longer qualified as a tax. They also argued that because the individual mandate is essential to the ACA, the entire statute must be struck down. When the Trump Administration declined to defend the ACA’s constitutionality, several states, including California, intervened to defend the statute and challenge the plaintiffs’ Article III standing. The Fifth Circuit held that the plaintiffs possessed standing and held that the individual mandate is unconstitutional. Texas v. United States, 945 F.3d 355, 377–93 (5th Cir. 2019), as revised (Dec. 20, 2019), as revised (Jan. 9, 2020), rev’d and remanded sub nom. California v. Texas, 141 S. Ct. 2104 (2021).
The Supreme Court reversed, holding that neither the individual plaintiffs nor the plaintiff states had Article III standing to challenge the individual mandate. See California, 141 S. Ct. at 2114–2116. The individual plaintiffs claimed that they satisfied the standing requirements because of the payments they have made and will continue to make to carry the minimum essential coverage that the ACA requires. But the Court reasoned that even if payments necessary to hold the insurance coverage required by the ACA were an injury, that injury would not be traceable to the government, because without any penalty for noncompliance, the statute is unenforceable against the individual plaintiffs. Id.
The Court likewise concluded that the states did not have Article III standing because they failed to show that their injuries were fairly traceable to unlawful government conduct. Id. at 2116. The states claimed they were indirectly injured by the mandate because it would cause more people to enroll in Medicaid or state employee health insurance programs. But the states failed to demonstrate “that an unenforceable mandate will cause their residents to enroll in valuable benefits programs that they would otherwise forgo.” Id. at 2119. Texas also asserted that it would bear increased direct costs because of ACA reporting and administrative requirements, but the Court found that these costs were not caused by the mandate and would remain even if it were struck down. Id. at 2119–20.
Justice Alito, joined by Justice Gorsuch, dissented, concluding instead that (1) the state plaintiffs possess standing in light of the increased regulatory and financial burdens from complying with the ACA, and they did not forfeit these claims, and (2) the individual mandate is unconstitutional and not severable from the rest of the ACA. Id. at 2124 (Alito, J., dissenting).
The decision is a significant one for ERISA because it eliminates, for now, some of the uncertainty around the validity of the ACA, including the ACA’s ERISA-specific requirements such as the large employer health insurance mandate. But the decision leaves unresolved the merits questions presented in the case—i.e., whether the individual mandate is constitutional or whether it is severable from the rest of the ACA—which the Court may be asked to revisit in future cases.
B. Hughes v. Northwestern University Addresses Pleading Standard in ERISA Fiduciary-Breach Suits
In Hughes v. Northwestern University, the Supreme Court reiterated in an unanimous decision that a district court’s review of a pleading challenge in an ERISA “excessive fees” fiduciary breach suit is a context-specific inquiry that requires courts to assess whether plaintiffs plausibly allege—under Ashcroft v. Iqbal, 556 U.S. 662 (2009) and Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007)—that plan fiduciaries failed to monitor all plan investments and remove imprudent ones.
Northwestern University offered its employees defined-contribution retirement plans, in which the employees maintain individual investment accounts and choose how to invest their contributions. Hughes v. Nw. Univ., 142 S. Ct. 737, 740 (2022). Former and current employees of Northwestern alleged that the plans’ fiduciaries violated the duty of prudence under ERISA by providing employees with a menu of investment options that included allegedly high cost and poorly performing options that caused plan participants to incur excessive fees. Id. at 741. The plans also included the types of low-fee options that plaintiffs preferred. Id. at 741–42.
The Seventh Circuit affirmed the dismissal of petitioners’ claims for failure to plausibly allege a breach of fiduciary duty. Divane v. Nw. Univ., 953 F.3d 980, 993 (7th Cir. 2020). The court held in relevant part that Northwestern had complied with its duty of prudence by offering a menu of investment options that included low-cost funds, along with the other higher-cost options challenged in the complaint. Id. at 991–92.
Relying on Tibble v. Edison Int’l, 575 U.S. 523 (2015), the Supreme Court reversed, holding that the Seventh Circuit erred in dismissing the plaintiffs’ claims without making a “context-specific inquiry” that “take[s] into account [a fiduciary’s] duty to monitor all plan investments and remove any imprudent ones.” Hughes, 142 S. Ct. at 740. The Supreme Court reasoned:
[E]ven in a defined-contribution plan where participants choose their investments, plan fiduciaries are required to conduct their own independent evaluation to determine which investments may be prudently included in the plan’s menu of options. . . . If the fiduciaries fail to remove an imprudent investment from the plan within a reasonable time, they breach their duty.
Id. at 742 (citing Tibble, 575 U.S. at 529–30). The Court remanded the case to the Seventh Circuit so that it could “reevaluate the allegations as a whole” and “consider whether petitioners have plausibly alleged a violation of the duty of prudence as articulated in Tibble, applying the pleading standard discussed” in Iqbal and Twombly. Id. Under that standard, plaintiffs must plead “enough facts to state a claim to relief that is plausible on its face.” Twombly, 550 U.S. at 570; see also Iqbal, 556 U.S. at 679 (allegations must “permit the court to infer more than the mere possibility of misconduct”). The Court concluded its opinion by addressing the importance of affording deference to plan fiduciaries, stating: “At times, the circumstances facing an ERISA fiduciary will implicate difficult tradeoffs, and courts must give due regard to the range of reasonable judgments a fiduciary may make based on her experience and expertise.” Hughes, 142 S. Ct. at 742.
Ultimately, the Court’s decision in Hughes was narrow. It did not establish a new pleading standard for ERISA fiduciary-breach claims, as petitioners had sought, nor did it set out the specific allegations that would be sufficient to plead a claim under plaintiffs’ fiduciary-breach theories. It is thus left to be seen whether this decision will pave the way for more “excessive fee” suits, whether the district courts will rely on Hughes to permit more cases to proceed to discovery, or whether the Supreme Court’s guidance concerning deference to plan fiduciaries will prompt courts to find that allegations that other investment options were theoretically available at a lower cost are not alone enough to withstand a pleading challenge.
C. Supreme Court Petitions to Watch
We are also monitoring three pending petitions for certiorari implicating ERISA issues. John Doe 1 v. Express Scripts Inc. (No. 21-471) and OptumHealth Care Solutions LLC v. Peters (No. 21-761) address the application of ERISA’s fiduciary requirements to arms-length transactions between a plan administrator and a third-party that provides services to a plan. Howard Jarvis Taxpayers Association v. CA Secure Choice Retirement Program (No. 21-558), concerns whether California’s auto-IRA program, which enrolls private-sector employees in a state-run retirement savings program, is preempted by ERISA.
1. John Doe 1 v. Express Scripts Inc. (No. 21-471)
In John Doe 1 v. Express Scripts Inc., health insurance policyholders seek to revive a proposed class action accusing Anthem and Express Scripts of violating fiduciary duties under ERISA by entering into a self-interested contractual arrangement that resulted in the plans and participants paying above-market prices for prescription drugs. The case arose from Anthem’s decision, as administrator of self-insured ERISA health plans, to sell its in-house pharmacy benefit management business to Express Scripts. Plaintiffs allege that in exchange for a substantially higher purchase price for the business, Anthem agreed to delegate to Express Scripts discretion to set the drug prices charged to Anthem customers, including prices that plaintiffs claim far exceeded industry standards.
Plaintiffs petitioned the Supreme Court to hear the case after the Second Circuit affirmed dismissal, holding that Anthem and Express Scripts were not acting as fiduciaries under ERISA when executing and acting upon the drug pricing contract. See Doe 1 v. Express Scripts, Inc., 837 F. App’x 44 (2d Cir. 2020). The Second Circuit relied in part on the Sixth Circuit’s decision in DeLuca v. Blue Cross Blue Shield of Mich., which held that an insurer did “not act[ ] as a fiduciary when it negotiated” rate changes for certain medical services, “principally because those business dealings were not directly associated with the benefits plan at issue but were generally applicable to a broad range of health-care consumers.” 628 F.3d 743, 747 (6th Cir. 2010). As to Anthem, the court explained that even if Anthem’s decisions “may ultimately affect how much plan participants pay for drug prices,” they were business dealings not directly associated with the plans they may ultimately have affected. Doe 1, 837 F. App’x at 49. The Second Circuit also agreed with the district court that Express Scripts did not act as a fiduciary when it set prices for prescription drugs, even though it had “extraordinarily broad discretion,” because “at bottom the ability to set such prices is a contractual term, not an ability to exercise authority over plan assets.” Id.
Plaintiffs petitioned for certiorari, contending that the Second and Sixth Circuit decisions had established an invalid, extra-statutory “business decisions” exemption from ERISA’s definition of “fiduciary,” causing a split with the Fourth, Fifth, Seventh, Eighth, and Ninth Circuits, which do not apply such an exemption. On December 13, 2021, the Supreme Court invited the Solicitor General to file a brief expressing the views of the United States. If the Court takes up this case, it could impact whether plan administrators and their contractors may face liability as plan fiduciaries when making business decisions, such as executing service-provider contracts, that affect prices paid by the plan or its participants.
2. OptumHealth Care Solutions, LLC v. Peters (No. 21-761)
In OptumHealth Care Solutions, LLC v. Peters, the Supreme Court has called for a response to a petition for a writ of certiorari by OptumHealth Care Solutions LLC addressing ERISA section 406(a)’s prohibition against certain “transactions” by plan fiduciaries involving a “party in interest.” The petition challenges a Fourth Circuit decision holding that a non-fiduciary service provider, with no preexisting relationship to a plan, may qualify as a “party in interest” by contracting with a plan fiduciary and getting paid under those contracts.
The case arises from an agreement by Aetna to pay OptumHealth Care Solutions, Inc. (“Optum”) to provide access to Optum’s networks of chiropractors and physical therapists for members of a self-funded health plan administered by Aetna. Peters v. Aetna Inc., 2 F.4th 199, 210 (4th Cir. 2021). Plaintiff alleges that instead of paying Optum out of the fees Aetna received from the plan, Aetna requested that Optum add its administrative fee to the claims submitted by Optum’s downstream health care providers. Id. This arrangement allegedly caused Optum’s fees to be passed on to plan members, instead of being paid by Aetna, as the plan allegedly required. Id. Among other theories, plaintiff claimed that Aetna’s contract with Optum violated ERISA’s prohibition on transactions with parties in interest. Id. at 213. The district court disagreed, concluding that Optum could not be liable as a party in interest because it had no preexisting relationships with either the plan or Aetna. Id.
The Fourth Circuit reversed, holding that Optum could be held liable “based on its apparent participation in and knowledge of Aetna’s administrative fee billing model.” Id. at 240. Because Optum lacked a prior relationship with the plan, the Fourth Circuit concluded that it was not a party in interest at the time it entered into the service agreement with Aetna. But the Fourth Circuit nonetheless held that a reasonable factfinder could find Optum liable as a party in interest when it performed the contract by providing services to the plan allegedly with knowledge of circumstances that rendered the billing arrangement with Aetna unlawful. Id.
Optum filed a cert petition, asking the Supreme Court to resolve the question of whether a service provider can qualify as a party in interest under ERISA section 406(a) if the provider lacks a preexisting relationship with the plan that is independent of the relationship created by the allegedly prohibited transaction. In its petition, Optum contends that the Fourth Circuit’s decision exposes plan fiduciaries and non-fiduciary service providers to litigation simply by engaging in and being paid under an arms-length services agreement, and thereby creates a split with the Tenth Circuit, which held in Ramos v. Banner Health, 1 F.4th 769, 784, 787 (10th Cir. 2021), that ERISA does not categorically prohibit plan fiduciaries from contracting with third-party service providers, and that such an interpretation of the statute would lead to “absurd result[s]” that would extend to “run-of-the-mill service agreements, opening plan fiduciaries up to litigation merely because they engaged in an arm’s length deal with a service provider.” In Ramos, the Tenth Circuit concluded that “some prior relationship must exist between the fiduciary and the service provider to make the provider a party in interest” under ERISA. Id. at 787. The Fourth Circuit’s decision in Peters would appear not to require evidence of a “prior relationship” to trigger prohibited transaction liability.
The Supreme Court sought a response from respondent on Optum’s petition for a writ of certiorari, suggesting the Court may want to weigh in on whether a “preexisting relationship” is required before a third-party contractor providing administrative services to a plan may qualify as a “party in interest.”
3. Howard Jarvis Taxpayers Association v. CA Secure Choice Retirement Program (No. 21-558)
We are also monitoring a pending petition for a writ of certiorari that asks the Supreme Court to review a preemption challenge to CalSavers, California’s state-run auto-enrollment IRA program. CalSavers is one of a handful state-run IRA programs for private sector workers. It applies to eligible employees of certain private employers in California that do not provide their employees with a tax-qualified retirement savings plan. Eligible employees are automatically enrolled in CalSavers, but may opt out. If they do not opt out, their employers must remit certain payroll deductions to CalSavers, which then funds the employees’ IRAs. California manages and administers the IRAs and acts as the program fiduciary.
Howard Jarvis Taxpayers Association challenged the CalSavers program, arguing that it is preempted by ERISA. The Ninth Circuit rejected this argument, concluding that ERISA does not preempt CalSavers, and relying in part on the Supreme Court’s decision in Rutledge v. Pharmaceutical Care Management Association, 141 S. Ct. 474 (2020). See Howard Jarvis Taxpayers Ass’n v. California Secure Choice Ret. Sav. Program, 997 F.3d 848, 863 (9th Cir. 2021). As we discussed in last year’s ERISA update, the Supreme Court held in Rutledge that ERISA did not preempt an Arkansas statute regulating the rates at which pharmacy benefit managers (“PBMs”) reimburse pharmacies for prescription drug costs because the law “is merely a form of cost regulation . . . [that] applies equally to all PBMs and pharmacies in Arkansas,” and therefore is not subject to ERISA preemption because it did not have an impermissible connection with or reference to ERISA. Rutledge, 141 S. Ct. at 481. In Howard Jarvis, the Ninth Circuit relied on the Supreme Court’s reasoning in Rutledge to hold that ERISA did not preempt CalSavers, reasoning that:
CalSavers is not an ERISA plan because it is established and maintained by the State, not employers; it does not require employers to operate their own ERISA plans; and it does not have an impermissible reference to or connection with ERISA. Nor does CalSavers interfere with ERISA’s core purposes.
997 F.3d at 852–53. In so holding, the Ninth Circuit rejected plaintiff’s argument that CalSavers is preempted because it “competes with” ERISA plans and will “frustrate, not encourage the formation of” ERISA plans. Id. at 864. The court concluded that the Supreme Court’s decision in Rutledge made clear that “‘ERISA does not pre-empt’ state laws that ‘merely increase costs or alter incentives for ERISA plans without forcing plans to adopt any particular scheme or substantive coverage.’” Id. (quoting Rutledge, 141 S. Ct. at 480).
The Supreme Court requested the CalSavers program to respond to a petition for a writ of certiorari filed by Howard Jarvis Taxpayers Association. A decision by the Court in this case may have far-reaching impact for the viability of state-run auto-IRA programs that are proliferating throughout the country, including in Colorado, Connecticut, Illinois, Maryland, New Jersey, and Oregon. For further discussion of how courts of appeals have applied Rutledge, including further discussion of the Ninth Circuit’s decision in Howard Jarvis Taxpayers Association v. CA Secure Choice Retirement Program, see infra Section III.
II. Article III Standing in ERISA Cases Under Thole v. U.S. Bank and TransUnion LLC v. Ramirez
As we addressed in our update last year, Article III standing continues to be a key issue for ERISA litigants. Here we analyze how the federal courts are implementing the Supreme Court’s Article III standing decisions in Thole v. U.S. Bank, 140 S. Ct. 1615 (2020), and TransUnion LLC v. Ramirez, 141 S. Ct. 2190 (2021), in the ERISA context.
In Thole, the Supreme Court held that participants in a fully funded defined-benefit pension plan lacked Article III standing to sue under ERISA for breach of fiduciary duties because, while the plan lost $750 million due to the fiduciaries’ alleged breach, the participants had no “concrete stake in the lawsuit.” Thole, 140 S. Ct. at 1618–19. Plaintiffs continued to receive all of their vested benefits to which they were legally entitled, and those “benefits are fixed and will not change, regardless of how well or poorly the plan is managed.” Id. at 1620, 1622. The Court’s decision in Thole means that plaintiffs do not have standing to bring a breach of fiduciary duty claim against a defined-benefit plan unless they have suffered a concrete injury such as the plan’s failure to make the required benefit payments. Id. at 1619.
In the year and a half since Thole came down, the courts of appeals have generally declined to extend Thole outside the defined-benefit plan context. However, at least one district court has taken a broader view and applied Thole in the context of employer-sponsored health plans, finding plaintiffs lacked standing because they could not allege that their own claims for benefits were impaired by cross-plan offsetting.
In Ortiz v. American Airlines, Inc., the Fifth Circuit declined to extend Thole to claims of breach of fiduciary duty brought by plan participants in a defined-contribution retirement plan. 5 F.4th 622, 629 n.9 (5th Cir. 2021). In relevant part, plaintiffs alleged that defendants should have offered a stable-value investment option in their plan, and that plaintiffs lost investment income by investing in the lower return option in their plan. Id. at 629. Defendants argued that Thole should preclude Article III standing because the plaintiffs did not have a cognizable injury giving them a concrete stake in the lawsuit. Id. The Fifth Circuit disagreed, explaining that Thole “explicitly drew a distinction between a defined-benefit plan and a defined contribution plan, such as a 401(k), in which the retirees’ benefits are typically tied to the value of their accounts, and the benefits can turn on the plan fiduciaries’ particular investment decisions.” Id. (quotation markss omitted). Here, however, the court noted that plaintiffs had presented evidence that the plan fiduciaries’ decisions, although affecting the plan as a whole, resulted in “lost investment income” to their individual accounts that was concrete and redressable for purposes of standing. Id. at 629.
The Third Circuit will have the opportunity to decide an appeal raising a similar issue in the near future. In Boley v. Universal Health Services, Inc., 498 F. Supp. 3d 715 (E.D. Pa. 2020), plaintiffs allege that fiduciaries for their defined-contribution retirement plan imprudently offered high-fee investment options in the plan, resulting in the plan and its participants paying excessive fees. Id. at 718. Plaintiffs alleged that they invested in only seven of the plan’s many fund offerings during the putative class period, and defendants argued that under Thole, plaintiffs lacked standing to bring claims as to the remaining funds, because plaintiffs could not show a personal injury to their individual account balances due to the performance of the funds in which they did not invest. Id. at 719. The district court disagreed, concluding that plaintiffs had standing to challenge funds in which they did not invest because, unlike in Thole, plaintiffs’ claims alleged, among other things, a “[p]lan-wide breach as to process,” and this “imprudent process forced [plaintiffs], and all Plan participants, to choose from an expensive menu of investment options” that injured all plan participants, including plaintiffs. Id. at 719, 721, 723–24 (quotation marks omitted). Defendants have appealed this decision, with argument held on February 11, 2022. See generally Boley v. Universal Health Svcs., Inc., No. 21-2014 (3d Cir.). Thus, like the Fifth Circuit in Ortiz, the Third Circuit will have to decide whether allegations of injury stemming from fiduciaries’ alleged retention of imprudent investment options—thereby causing a plan to generate less investment income for its participants—are sufficient to satisfy Article III standing even where the named plaintiffs do not allege they invested in the challenged funds.
Last year, the Second Circuit also had the opportunity to weigh in on the breadth of Thole. In Gonzales de Fuente v. Preferred Home Care of New York LLC, the court affirmed dismissal of plaintiffs’ complaint on standing grounds where plaintiffs were participants in a defined-benefit health plan who claimed breach of ERISA fiduciary duties due to alleged misappropriation of employer contributions to the plan, which plaintiffs contended should have been used to provide them a superior plan. 858 F. App’x. 432 (2d Cir. 2021). The case implicated New York’s wage parity law, which forbids employers from retaining any “portion of the dollars spent or to be spent to satisfy the wage or benefit portion” of employee compensation. Id. at 434 (quoting N.Y. Pub. Health Law § 3614-c(5)(a)). Plaintiffs argued that the New York law made their status under ERISA more like that of defined contribution plan participants, and they argued they suffered “concrete injuries in the form of increased out-of-pocket costs and reduced coverage.” Id. at 433. In rejecting this argument, the Second Circuit relied on Thole to hold that plaintiffs lacked standing to bring their ERISA claims because they had received, and would receive, all promised benefits under their health plan, and any compensation plaintiffs may have been entitled to under the New York law was separate from their ERISA claim. Id. at 434.
The United States District Court for the District of Minnesota reached a similar result in Scott v. UnitedHealth Group, Inc., 540 F. Supp. 3d 857, 859 (D. Minn. 2021). The court rejected plaintiffs’ argument that they had standing to challenge their employers’ health plans’ practice of cross-plan offsetting because their plans are funded in part by their payroll contributions. Id. at 862. The court found that, as in Thole, the “plaintiffs do not have any claim to the plans’ assets; instead, their only claim is to receive the benefits to which they are entitled” under the plans. Id. at 863. Thus, the court found that rather than being a defined contribution plan, an employer-sponsored health plan is “closely analogous” to a defined-benefit plan. Id. at 864. Applying Thole, the court held that plaintiffs did not have standing because they could not allege that any of their own claims for benefits had been denied due to the alleged cross-plan offsetting. Id. at 865.
The Supreme Court further clarified the requirements for Article III standing last year in TransUnion LLC v. Ramirez, 141 S. Ct. 2190 (2021), limiting the size of a putative class action alleging violations of the Fair Credit Reporting Act (“FCRA”) for failing to ensure that information on TransUnion’s credit reports is accurate before disseminating them. Id. at 2200. Even though most class members did not suffer an injury from the disclosure of their credit reports to third parties, the Ninth Circuit affirmed certification of the class and concluded that all class members had Article III standing to recover damages because of the mere “risk of harm to their concrete privacy, reputational, and informational interests protected by the FCRA.” Id. at 2202; id. at 2216 (Thomas, J., dissenting) (emphasis added).
The Supreme Court reversed in part, narrowing the class to plaintiffs who could establish Article III standing, reasoning that “Article III does not give federal courts the power to order relief to any uninjured plaintiff” regardless of whether they are part of a class. Id. at 2208 (Kavanaugh, J.) (quoting Tyson Foods, Inc. v. Bouaphakeo, 577 U.S. 442, 466 (2016) (Roberts, C.J., concurring)). The Court explained that the violation of a federal statute is not, alone, sufficient to confer standing under Article III, id. at 2206, but may be sufficient if the harm alleged has a “‘close relationship’ to a harm traditionally recognized as providing a basis for a lawsuit,” id. at 2200. Here, the Court explained, plaintiffs whose credit reports bearing misleading information had been disclosed to third parties could establish Article III standing based on reputational harm analogous to the traditional tort of defamation. Id. at 2205, 2209. But the Court held that the rest of the plaintiffs—whose credit reports were not disseminated to third parties—lacked standing to seek damages because they merely faced, at most, a “risk of future harm.” Id. at 2210. Although “a person exposed to a risk of future harm may pursue forward-looking, injunctive relief to prevent the harm from occurring, at least so long as the risk of harm is sufficiently imminent and substantial,” the Court held that “in a suit for damages, the mere risk of future harm, standing alone, cannot qualify as a concrete harm—at least unless the exposure to the risk of future harm itself causes a separate concrete harm.” Id. at 2210–11.
These holdings may have significant consequences in ERISA cases. In ERISA class actions, TransUnion appears to require Plaintiffs to establish that each class member suffered an Article III injury, potentially raising individualized inquiries that could impede class certification. Further, TransUnion clarifies the standard for establishing Article III standing, potentially limiting ERISA claims premised on purely procedural injuries or risk of future harm in actions seeking damages or other retrospective relief. Taken together, the Thole and TransUnion decisions give ERISA defendants paths to argue (1) that plan participants lack concrete harm sufficient to confer Article III standing, and (2) for limits on available remedies.
III. Impact of the Supreme Court’s Decision in Rutledge v. Pharmaceutical Care Management Association on ERISA Preemption
As we anticipated in our 2020 ERISA Update, the Supreme Court’s decision in Rutledge v. Pharmaceutical Care Management Association, 141 S. Ct. 474 (2020) has played a significant role over the last year-and-a-half in litigation concerning ERISA preemption of state laws. Subject to certain exceptions, ERISA preempts any state law that “relate[s] to” an ERISA plan, 29 U.S.C. § 1144(a), meaning that the law has either a “connection with” or a “reference to” ERISA plans, Egelhoff v. Egelhoff ex rel. Breiner, 532 U.S. 141, 147 (2001) (citation omitted). A state law has an impermissible connection with ERISA plans if it “governs … a central matter of plan administration or interferes with nationally uniform plan administration.” Gobeille v. Liberty Mut. Ins. Co., 577 U.S. 312, 320 (2016) (internal quotation marks and citation omitted). And a state law impermissibly refers to ERISA plans if it “acts immediately and exclusively upon ERISA plans” or “the existence of ERISA plans is essential to the law’s operation.” Id. at 319–20 (citation omitted).
In Rutledge, the Court applied these principles to an Arkansas statute regulating the rates at which pharmacy benefit managers (PBMs), acting as middlemen between ERISA plans and pharmacies, reimburse pharmacies for prescription drug coverage. 141 S. Ct. at 478. Although PBMs generally pass drug prices on to plans, the Court held that “ERISA does not pre-empt state rate regulations that merely increase costs or alter incentives for ERISA plans without forcing plans to adopt any particular scheme of substantive coverage.” Id. at 480. The Court explained that the statute in question did not have an impermissible connection with ERISA plans because it merely regulated the cost of covered prescription drugs, not plan choices about which drugs to cover. Id. at 481. The Court also explained that the statute did not “refer to” ERISA plans because it affected plans only indirectly and it “regulate[d] PBMs whether or not the plans they service fall within ERISA’s coverage.” Id.
Last year, the Eighth, Seventh, and Ninth Circuits, as well as a number of district courts, had the opportunity to apply Rutledge, and these decisions suggest the courts are taking a narrower view of ERISA preemption.
In Pharmaceutical Care Management Association v. Wehbi, 18 F.4th 956, 964 (8th Cir. 2021), the Supreme Court vacated an earlier Eighth Circuit decision and directed the court to reconsider the case in light of Rutledge. As in Rutledge, Wehbi involved a preemption challenge to a state statute regulating in various ways the relationship between PBMs and pharmacies. Id. Most notably, the law “limit[ed] the accreditation requirements that a PBM may impose on pharmacies as a condition for participation in its network.” Id. at 968. The Eighth Circuit had initially held that the statute was preempted because it had an impermissible “reference to” ERISA, in that the statute’s “definitions of and references to ‘pharmacy benefits manager,’ ‘third-party payer,’ and ‘plan sponsor’” either referenced ERISA plans or were “taken verbatim” from ERISA. Pharm. Care Mgmt. Ass’n v. Tufte, 968 F.3d 901, 905 (8th Cir. 2020). But on remand neither party disputed that Rutledge had undercut any argument for “reference to” preemption. 18 F.4th at 969–70. The Eighth Circuit recognized this shift in the law, explaining that while “[p]reviously, circuit precedent held that the existence of ERISA plans is essential to a law’s operation if the law can apply to an ERISA plan,” now “the existence of ERISA plans is essential to a law’s operation only if the law cannot apply to a non-ERISA plan.” Id. at 969 (emphases added).
The briefing on remand focused on “connection with” preemption. The Eighth Circuit held, however, that the statute was not preempted on that basis. Id. at 970. Addressing a recurring issue, the panel explained that “the challenged provisions do not escape preemption” simply because “they regulate PBMs rather than plans.” Id. at 966. But the panel nonetheless concluded that the statute—including its limited accreditation requirements—was not preempted because it “constitute[d], at most, regulation of a noncentral ‘matter of plan administration’ with de minimis economic effects and impact on the uniformity of plan administration across states.” Id. at 968–69 (citation omitted). In upholding North Dakota’s authority to restrict the accreditation requirements a PBM may impose on pharmacies as a condition of participation in its network, the decision raises important questions about the ability of states to regulate membership in plan networks in both the pharmacy and medical treatment contexts.
Courts have also applied Rutledge in other contexts. For instance, in Halperin v. Richards, 7 F.4th 534 (7th Cir. 2021), the Seventh Circuit considered whether ERISA preempts state law claims against a company’s “directors and officers who serve[d] dual roles as both corporate and ERISA fiduciaries.” Id. at 539. The plaintiffs—creditors of a company undergoing bankruptcy proceedings—alleged that the company’s directors and officers had conspired with the trustee for the company’s ERISA-covered employee stock ownership plan to inflate the valuations of the company’s stock to drive up their own pay, which was tied to the stock ownership plan valuations. Id. The defendants argued that the claims were preempted because the company’s “valuations were governed by ERISA” and they acted solely in their ERISA roles when evaluating the company’s stock. Id. at 540. The Seventh Circuit concluded, however, that ERISA did not preempt these claims against the directors and officers, explaining that Rutledge stands for the proposition that “[s]ome parallel state rules … are not preempted,” id. at 541, and holding that “ERISA contemplates parallel state-law liability against directors and officers serving dual roles as both corporate and ERISA fiduciaries,” id. at 542. The court nonetheless held that ERISA preempted the claims against the trustee and its non-fiduciary contractor, as claims against those individuals “would interfere with the cornerstone of ERISA’s fiduciary duties.” Id. at 539.
The Ninth Circuit also relied on Rutledge in the decision at issue in the petition for a certiorari in Howard Jarvis Taxpayers Association v. CA Secure Choice Retirement Program, which is discussed supra in Section 1.C.2. See Petition for Writ of Certiorari, Howard Jarvis Taxpayers Ass’n v. CA Secure Choice Ret. Program (No. 20-15591).
A number of district court decisions have also applied Rutledge to find that ERISA does not preempt various state laws and claims. See, e.g., ACS Primary Care Physicians Sw., P.A. v. UnitedHealthcare Ins. Co., 514 F. Supp. 3d 927, 941–42 (S.D. Tex. 2021) (emergency care statutes); Emergency Physician Servs. of New York v. UnitedHealth Grp., Inc., 2021 WL 4437166, at *2, 8–9 (S.D.N.Y. Sep. 28, 2021) (breach of implied-in-fact contract and unjust enrichment claims for failing to reimburse emergency services at a reasonable rate ); Emergency Servs. of Oklahoma, PC v. Aetna Health, Inc., 2021 WL 3914255, at *1–3 (W.D. Okla. Aug. 24, 2021) (same); Elena v. Reliance Standard Life Ins. Co., 2021 WL 2072373, at *2–4 (S.D. Cal. May 24, 2021) (intentional infliction of emotional distress claim based on post-traumatic stress disorder intensified by “ridicule” suffered from third-party claim administrator’s agent with regards to disability coverage claim); Sarasota Cnty. Pub. Hosp. Bd. v. Blue Cross & Blue Shield of Florida, Inc., 511 F. Supp. 3d 1240, 1243–44, 1249 (M.D. Fla. 2021) (breach of preferred provider agreement); Florida Emergency Physicians Kang & Assocs., M.D., Inc. v. United Healthcare of Florida, Inc., 526 F. Supp. 3d 1282, 1289, 1298–99 (S.D. Fla. 2021) (conspiracy to “manipulate and depress the usual or customary reimbursement rate” for medical services).
We expect ERISA preemption will continue to be a highly litigated area this year, with courts being asked to apply Rutledge to a broad array of state regulations and common law claims. And should the Supreme Court grant the pending petition in Howard Jarvis Taxpayers Association v. CA Secure Choice Retirement Program, it would have the opportunity to further define the parameters of ERISA preemption.
IV. Arbitrability of ERISA Fiduciary-Breach Claims
The arbitrability of ERISA section 502(a)(2) fiduciary-breach claims continued to generate contentious litigation in 2021. As we detailed in our 2020 ERISA Update, the Ninth Circuit’s 2019 decision in Dorman v. Charles Schwab Corp., 934 F.3d 1107, 1111–12 (9th Cir. 2019) struck down decades of case law holding that fiduciary-breach lawsuits under ERISA could not be arbitrated. This in turn led many companies to write new arbitration language into their plans. We can now shed more light on the enforceability of these arbitration terms as additional courts of appeal have weigh in, including the Seventh and Second Circuits, as well as district courts in Ohio and Florida. As these cases suggest, federal courts continue to struggle with whether and how to enforce arbitration agreements in ERISA plans, and we expect arbitrability to continue to be a hotly litigated issue this year.
In September, the Seventh Circuit decided Smith v. Board of Directors of Triad Manufacturing, Inc., 13 F.4th 613, 615 (7th Cir. 2021), a case brought by an individual on his own behalf, and on behalf of a putative class, alleging a claim for fiduciary breach under ERISA section 502(a)(2) for mismanagement of his retirement plan and seeking removal of the plan fiduciaries. However, plaintiff’s suit ran headlong into his plan’s arbitration provision, which in relevant part, provided that plaintiff could not “seek or receive any remedy which has the purpose or effect of providing additional benefits or monetary or other relief to any Eligible, Employee, Participant or Beneficiary other than the Claimant.” Id. at 616. The district court denied defendants’ motion to compel arbitration, and the Seventh Circuit affirmed. The appellate court “[j]oin[ed] every other circuit to consider the issue” in holding that “ERISA claims are generally arbitrable.” Id. at 620. But the court concluded that the particular arbitration provision at issue ran afoul of the effective vindication doctrine, which holds that an arbitration provision may be held unenforceable on public policy grounds when it “operate[s] … as a prospective waiver of a party’s right to pursue statutory remedies.” Id. at 620–21 (citing Am. Exp. Co. v. Italian Colors Rest., 570 U.S. 228, 235 (2013)). Deploying the doctrine—which “rare[ly]” applies—the Seventh Circuit reasoned that the plan’s arbitration provision precluded certain remedies that ERISA “expressly permit[s].” Id. at 623. Specifically, the provision precluded plaintiff from seeking relief that extended beyond himself, even though ERISA expressly contemplates “such other equitable or remedial relief as the court may deem appropriate.” Id. at 621. Because the provision would preclude plaintiff from pursuing the remedy of removing the plan fiduciary, which “would go beyond just [plaintiff] and extend to the entire plan,” the provision operated as a waiver of statutory remedies and could not be enforced. Id. at 621–623. However, the court was careful to explain that “the problem with the plan’s arbitration provision is its prohibition on certain plan-wide remedies, not plan-wide representation,” signaling that the court took no issue with the provision’s class action waiver. Id. at 622. The Seventh Circuit also saw “no conflict” between its decision and the Ninth Circuit’s decision in Dorman because the Dorman arbitration provision “lacked the problematic language present here.” Id. at 623.
The Second Circuit’s recent decision in Cooper v. Ruane Cunniff & Goldfarb Inc., 990 F.3d 173 (2d Cir. 2021), provides yet another example of the emerging and divergent approaches to assessing the arbitrability of section 502(a)(2) fiduciary-breach claims. There, a split panel reversed a district court order compelling arbitration. Id. at 175–76. Rather than taking issue with the enforceability of the clause itself (as in Smith) the court noted that the plaintiff’s claims did not fall within the scope of the arbitration provision. Id. at 179. The provision covered “all legal claims arising out of or relating to employment,” but the defendant had not argued that plaintiff’s claim for fiduciary breach arose out of his employment, so the question before the Court was limited: did plaintiff’s fiduciary breach claim “relat[e] to [his] employment”? Id. at 180. The majority answered in the negative, reasoning that arbitration was only required when the “merits of th[e] claim involve facts particular to an individual plaintiff’s own employment.” Id. at 184. Writing in dissent, Judge Sullivan articulated a more expansive view of the arbitrability of fiduciary-breach claims. He argued that “[w]here, as here, an arbitration agreement uses broad language that is ambiguous about whether an issue in dispute is arbitrable, we must resolve that ambiguity in favor of arbitration.” Id. at 186 (Sullivan, J., dissenting).
This year, the Sixth Circuit will also hear an appeal in Hawkins v. Cintas Corp., No. 19-1062, 2021 WL 274341 (S.D. Ohio Jan. 27, 2021), wherein the district court declined to compel arbitration of breach of fiduciary duty claims brought on behalf of the plaintiffs’ plan. Id. at *7. The district court reasoned that the claims were not arbitrable because they were brought on behalf of the plan and there was “no agreement” between the plan and the defendant to arbitrate plan disputes. Id. at *3–4. Specifically, while the plaintiffs’ participant agreements stated that “‘the rights and claims of Employee’ will be arbitrated,” that language bound only the individual employee, not the plan. Id. at *6. The court explicitly distinguished Dorman, emphasizing that the defendant had provided no evidence that any plan document actually bound the plan to arbitration. Id. Separately, the court rejected defendant’s argument that, as sponsor of the plan, it could either consent to arbitration via the filing of a motion to compel, or otherwise “modify Plan documents to require Plan claims to proceed to arbitration.” Id. at *5, 7. Because the court found no valid agreement to arbitrate existed between the plan and the defendant, it ruled that the claims must proceed in federal court absent intervention by the Sixth Circuit.
These approaches to the arbitrability of section 502(a)(2) claims may be sowing seeds for a potential circuit split. By way of example, a Florida district court recently rejected the Seventh Circuit’s reasoning in Smith and enforced the arbitrability of fiduciary-breach claims over an effective vindication challenge. See Holmes et al. v. Baptist Health So. Florida, No. 21-22986, 2022 WL 180638 (S.D. Fla. Jan. 20, 2022). The Holmes plaintiffs brought fiduciary breach claims on their own behalf, and on behalf of the plan, and a putative class of those similarly situated. Plaintiffs’ plans contained an arbitration clause providing that “[a]ny claim … which arises out of, or relates to, or concerns the Plan … shall be resolved exclusively by binding arbitration.” Id. at *1. Relying on Smith, plaintiffs argued that the provision was unenforceable under the effective vindication doctrine because it forbade “Plan-wide relief—such as removal of the plan’s fiduciaries and appointment of new fiduciaries, which is authorized under § 1109(a),” but precluded by the arbitration clause. Id. at *2. The district court disagreed. It pointed to the absence of any Eleventh Circuit authority applying the effective vindication doctrine to void an arbitration clause and reasoned that unlike the provision in Smith which “completely denied some types of statute-authorized relief to the Plan, the clause here does not, as individual claimants can each recover the harm to their defined contribution accounts, and they can recover Plan-wide relief that does not provide additional benefits or monetary relief to others.” Id. at *3.
We expect to see more litigation over the arbitrability of section 502(a)(2) claims as courts continue to flesh out the enforceability, scope, and application of plan arbitration provisions.
V. The Standard of Review of ERISA Benefits Claims
As we discussed last year, federal courts continue to examine the scope and standard of review for ERISA benefits claims. In general, courts review a plan administrator’s benefits decision de novo unless the terms of the plan grant the administrator discretion to interpret the plan and award benefits, in which case courts review the claims decisions under a deferential “abuse of discretion” standard (sometimes called “arbitrary and capricious” review). See Firestone Tire & Rubber Co. v. Bruch, 489 U.S. 101, 115 (1989). Benefit plans commonly grant this discretion to their administrators, so the deferential standard often applies to ERISA benefits claims, with the Supreme Court repeatedly parrying attempts by plaintiffs to strip administrators of this deference. See, e.g., Metro. Life Ins. Co. v. Glenn, 554 U.S. 105, 115 (2008); Conkright v. Frommert, 559 U.S. 506, 522 (2010). Nonetheless, lower courts continue to grapple with how to apply these standards of review at different stages of litigation and the appropriate burden on each party under each standard.
A recent appellate decision confronted this issue and provided potentially helpful guidance while deepening a circuit split and leaving questions concerning whether courts may make factual determinations at summary judgment, and the standard of review when there is evidence that a plan administrator acted under a conflict of interest.
A. Circuits Appear Split Over the Permissibility of Factual Determinations at Summary Judgment
The Eighth Circuit’s recent decision in Avenoso v. Reliance Standard Life Ins. Co., 19 F.4th 1020 (8th Cir. 2021), deepens a circuit split over the role of summary judgment in ERISA benefits disputes. Because there is no right to a jury trial in ERISA cases and review of benefits determinations is generally limited to the administrative record, see id. at 1025, benefits cases are often decided on cross-motions for summary judgment without need for a trial. The First Circuit has thus held that summary judgment in ERISA cases “is simply a vehicle for teeing up the case for decision on the administrative record,” allowing the court to “weigh the facts, resolve conflicts in evidence, and draw reasonable inferences.” Doe v. Harvard Pilgrim Health Care, Inc., 974 F.3d 69, 72 (1st Cir. 2020) (citations omitted). In Avenoso, however, the Eighth Circuit joined the Second, Sixth, Seventh, Ninth, and Eleventh Circuits in rejecting this approach and holding that district courts are not permitted to make factual determinations when reviewing ERISA benefits claims at the summary judgment stage, under either the de novo or abuse of discretion standards. See 19 F.4th at 1025–26; O’Hara v. Nat’l Union Fire Ins. Co. of Pittsburgh, 642 F.3d 110, 116 (2d Cir. 2011); Patton v. MFS/Sun Life Fin. Distribs., Inc., 480 F.3d 478, 484 n.3 (7th Cir. 2007); Shaw v. Conn. Gen. Life Ins., 353 F.3d 1276, 1282, 1286 (11th Cir. 2003); Kearney v. Standard Ins., 175 F.3d 1084, 1095–96 (9th Cir. 1999) (en banc); Wilkins v. Baptist Healthcare Sys., Inc., 150 F.3d 609, 619 (6th Cir. 1998). The court explained that when considering these claims at summary judgment, “weigh[ing] the evidence, mak[ing] credibility determinations, or attempt[ing] to discern the truth of any factual issue” is improper. Avenoso, 19 F.4d at 1024.
Avenoso preserves an important but limited role for bench trials in ERISA benefits cases. The Eight Circuit explained that a bench trial may be necessary when the district court needs to review evidence from outside the administrative record to determine, for example, the degree of deference owed to the administrator’s decision, or to resolve a dispute over whether a piece of information was part of the administrative record. Id. at 1026. Because such instances could involve “new evidence, including witness testimony[,] [s]ummary judgment . . . serve[s] the important function of sparing the court, the parties, and the witnesses the time and expense of a bench trial in the event that the case can be resolved without one.” Id.; see also Wilkins, 150 F.3d at 619 (“The district court may consider evidence outside of the administrative record only if that evidence is offered in support of a procedural challenge to the administrator’s decision, such as an alleged lack of due process afforded by the administrator or alleged bias on its part.”). Other circuits have also agreed that a bench trial may sometimes be necessary to resolve factual disputes—such as choosing between competing physician reports—when a plan does not grant discretion to the administrator and the district court therefore reviews the administrator’s decisions de novo. See Avenoso, 19 F.4d at 1026–28; Shaw, 353 F.3d at 1282, 1286; see also, e.g., Kearney, 175 F.3d at 1095.
B. Plaintiffs Have Achieved Mixed Results Challenging Decisions Based on Alleged Conflicts of Interest of Plan Administrators
This past year courts also continued to grapple with how to handle deference to an administrator’s benefits decision when there is evidence of a conflict of interest—i.e., where the administrator both makes eligibility determinations and pays benefits. Courts generally agree that the mere existence of a conflict of interest does not establish an abuse of discretion, and the effect of a conflict of interest depends on a case-specific inquiry. Several decisions in the past year nonetheless provide guidance as to the circumstances in which a conflict of interest may prove to be a key driver of the outcome.
As a general matter, recent decisions have described the impact of a conflict of interest in various ways. In Boyer v. Schneider Elec. Holdings, Inc., 993 F.3d 578 (8th Cir. 2021), for example, the Eight Circuit stated that “a tie . . . might be resolved against a conflicted administrator,” but it ultimately upheld the decision at issue because the administrator’s interpretation of the plan was reasonable, its fact findings were “supported by substantial evidence,” and there was no evidence that the company “permit[ted] outcomes on claims decisions to influence the company’s evaluation and compensation of those who make the decisions.” Id. at 581–84. In Weiss v. Banner Health, 846 F. App’x 636 (10th Cir. 2021), meanwhile, the Tenth Circuit stated that an administrator’s conflict may “decrease[] the level of deference to which its decision is entitled,” but it upheld the administrator’s decision even “[t]aking the conflict of interest into account” because the administrator could reasonably rely on the medical guidelines used to interpret the plan and the decision was supported by both internal and external reviewers who considered all of the relevant evidence. Id. at 640–41.
Other notable decisions suggest circumstances in which a plaintiff may overcome deference to the plan fiduciary based in part on the presence of a conflict of interest. In Noga v. Fulton Financial Corp. Employee Benefit Plan, 19 F.4th 264 (3d Cir. 2021), the plaintiff had twice been determined eligible for disability benefits by insurer-affiliated medical professionals, and each time the insurer had engaged a third-party consultant to review the claim, leading the plan to overturn its initial favorable determination. Id. at 277–78. In finding an abuse of discretion, the Third Circuit emphasized the “unusual timing of, impetus for, and scope of requests for outside review.” The first request occurred more than a year after the insurer learned of the facts that supposedly prompted the request, and less than a month after a nurse employed by the insurer recertified that the plaintiff remained totally disabled. Id. at 268–69, 277. The other occurred during plaintiff’s administrative appeal of this initial denial, a day after a benefits analyst overturned the termination of benefits relying on records from both his physicians and a different insurer-employed nurse, who determined plaintiff lacked “consistent work function at any level.” Id. at 269, 278. Because these facts suggested that the review requests were “tied” to the insurer’s “structural” conflict of interest, and the record otherwise “favor[ed] the continued award of benefits,” the Third Circuit held that the insurer had abused its discretion, and it affirmed the order that plaintiffs’ benefits be reinstated. Id. at 278–29.
In Roehr v. Sun Life Assurance Co. of Canada, meanwhile, the Eighth Circuit held that, while an administrator can mitigate the effect of a conflict of interest with outside review of the record, it cannot solely “rel[y] on the same evidence to both find a disability and later discredit that disability.” 21 F.4th 519, 525–26 (8th Cir. 2021). There, plaintiff’s physicians had diagnosed no specific cause for plaintiff’s tremors and also noted that these tremors were intermittent, and the plan administrator relied on these evaluations to provide benefits for ten years. Id. at 521–24. With no particular triggering medical reason, the plan administrator, seeking “to reduce any potential conflict of interest or bias,” then had third-party physicians review the plaintiff’s file, who determined that the lack of a diagnosis and the absence of references to tremors in periodic medical evaluations showed that plaintiff was able to work, which the plan administrator relied upon to deny benefits. Id. 523–25. The court found this reversal of course to be an abuse of discretion because the new, non-physical evaluations’ medical findings were entirely consistent with the diagnosis the defendant had relied upon to provide benefits for a decade (intermittent tremors with no known cause), and the defendant “pointed to no information available to it that altered in some significant way its previous decision to pay benefits.” Id. at 525–26. Specifically, although the court held that third-party medical review of the record can preserve deferential review despite a conceded conflict of interest, it noted that “‘the previous payment of benefits is a circumstance’ weighing against the termination of benefits.” Id. at 525 (quoting McOsker v. Paul Revere Life Ins., 279 F.3d 586, 589 (8th Cir. 2002)). A plan administrator should therefore not wait “almost a decade” to use such review to support a “change in decision,” especially when the decision is not supported by new medical evidence, such as an “independent medical exam.” Id. at 526
Nonetheless, as in Boyer and Weiss, circuit courts continue to be unreceptive to overturning discretionary decisions by plan administrators even in the face of a conflict of interest if the plaintiff cannot point to evidence that the conflict played a role in the eligibility determination. As the Sixth Circuit emphasized in Lloyd v. Procter & Gamble Disability Benefit Plan, Plan #501, the mere presence of a conflict of interest typically is insufficient to overturn an administrator’s determination absent “‘significant evidence’ that the conflict actually affected or motivated the decision at issue.” No. 20-4329, 2021 WL 4026683, at *11 (6th Cir. Sept. 3, 2021). Thus, the presence of a conflict of interest and conflicting medical opinions can be insufficient to support a finding of an abuse of discretion where a plan and administrator justifiably relied on at least some medical evaluations, and that decision did not appear to be specifically tainted. See id. at *6–11.
In the absence of a conflict of interest, plaintiffs continue to face steep obstacles to recovery, particularly when a plan vests its administrator with discretion in resolving contested claims issues. In Michael J. P. v. Blue Cross & Blue Shield of Texas, for example, the Fifth Circuit reversed summary judgment in favor of the plaintiff, concluding that the denial of benefits was supported by substantial evidence. No. 20-30361, 2021 WL 4314316, at *6 (5th Cir. Sept. 22, 2021). The court stated that “even if an ERISA plaintiff supports his claim with substantial evidence, or even with a preponderance, he will not prevail” as long as defendants can support their decision with “more than a scintilla” of evidence with “a rational connection between the known facts and the decision or between the found facts and the evidence.” Id. at *2 2 (quoting Foster v. Principal Life Ins. Co., 920 F.3d 298, 304 (5th Cir. 2019)). Finding that defendants met this burden by proffering physicians and reports demonstrating the lack of need for the sought medical treatment, id. at *4–6, it was “beside the point” what evidence plaintiffs had to the contrary, id. at *7.
Notably, Michael J. P. featured a significant concurrence by Judge Oldham, who agreed that the majority had correctly applied the circuit’s “substantial evidence” standard, but questioned the ultimate validity of that standard. See id. at *8 (Oldham, J., concurring). He first suggested that “substantial evidence” review was derived from practice under the Labor Management Relations Act of 1947 (“LMRA”), but the Supreme Court in Firestone had questioned importing the LMRA’s review standard into ERISA. Michael J. P., 2021 WL 4314316, at *8–9 (citing Firestone, 489 U.S. at 109–10); see also Glenn, 554 U.S. at 121 (Roberts, C.J., concurring in part and concurring in the judgment). He also suggested that the Fifth Circuit’s version of substantial evidence review in ERISA cases—requiring only more than a “scintilla” of evidence supporting the decision—is radically different from substantial evidence review conducted elsewhere, including administrative law challenges, which ordinarily entail a more “holistic” analysis of the record, “taking into account contradictory evidence . . . .” Id. at *9–10 (quoting Universal Camera Corp. v. NLRB, 340 U.S. 474 (1951); citing Dish Network Corp. v. Nat’l Lab. Rels. Bd., 953 F.3d 370, 377 (5th Cir. 2020), as revised (Mar. 24, 2020)). Ultimately, Judge Oldham expressed concern that the current form of substantial evidence review used in ERISA cases to assess whether an administrator has abused its discretion in making benefits determinations, adopted through legal, logical, and historical errors, may “make[] it particularly difficult for ERISA beneficiaries to vindicate their rights under the cause of action created by Congress.” Id. at *10. While it is unclear whether Judge Oldham’s views will gain traction in the Fifth Circuit or elsewhere, it is indicative of the kind of skepticism that courts sometimes exhibit towards deferential review of decisions by administrators exercising discretionary authority over ERISA plans.
VI. Changing Department of Labor Rules for ESG Investing
In closing, we highlight an important rule change proposed in 2021 by the Department of Labor (“DOL”) concerning environmental, social, and governance (“ESG”) investing. As we predicted last year, a new rule proposed and adopted by the DOL late in the Trump administration was targeted for significant revisions by the Biden administration. The new proposed rule purports to provide guidance to plan fiduciaries on the factors they must consider when assessing whether to add or retain investment options in ERISA retirement plans, and states that ESG factors “often” should be among those considerations.
As we discussed last year, in the final days of the Trump administration, the DOL proposed and adopted a rule that ERISA fiduciaries must make investment decisions “based solely on pecuniary factors”; and an investment intended “to promote non-pecuniary objectives” at the expense of sacrificing returns or taking on additional risk would constitute a breach of fiduciary duty under ERISA. Financial Factors in Selecting Plan Investments, 85 Fed. Reg. 72,846, 72,851, 72,848 (Nov. 13, 2020). Though the final version of the rule did not explicitly reference ESG funds, the DOL’s press release announcing the rule expressly stated that the rule’s purpose was to provide further guidance “in light of recent trends involving [ESG] investing.” U.S. Dep’t of Labor, U.S. Department of Labor Announces Final Rule to Protect Americans’ Retirement Investments (Oct. 30, 2020), https://www.dol.gov/newsroom/releases/ebsa/ebsa20201030. The new rule took effect on January 12, 2021. 85 Fed. Reg. at 72,885.
On October 14, 2021, the DOL published a new proposed rule, entitled “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” which specifies that a fiduciary’s assessment of whether an investment option or decision is prudent “may often” require “an evaluation of the economic effects of climate change and other ESG factors on the particular investment or investment course of action.” 85 Fed. Reg. 57,272, 57,276 (Oct. 14, 2021). The proposed rule explains that “this provision is intended to counteract negative perception of the use of climate change and other ESG factors in investment decisions caused by the 2020 Rules.” 85 Fed. Reg. 57,276.
While some fiduciaries and plan beneficiaries have welcomed the proposed rule and the opportunity to consider ESG factors in the investment selection process, others have expressed concern that the proposed rule may go too far and require fiduciaries to show why ESG were not considered in the selection of investments, and thus may open fiduciaries to yet another avenue of litigation. See, e.g., Ellen Meyers, Retirement advisers group, AARP wary of Labor Department’s ESG proposal, Roll Call (Jan. 6, 2022), https://rollcall.com/2022/01/06/retirement-advisers-group-aarp-wary-of-labor-departments-esg-proposal/.
In a December 2021 letter to Labor Secretary Marty Walsh, several Senate Republicans emphasized the potential “traps for plan fiduciaries” and “increased litigation risk” that the new rule would create, stating that the rule establishes “a de facto mandate on fiduciaries of retirement plans, requiring them to consider ESG factors.” Pat Toomey, Mike Crapo, Richard Burr & Tim Scott, Re: Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights [RIN 1210-AC03] (Dec. 10, 2021), https://www.scott.senate.gov/imo/media/doc/2021-12-10%20Ranking%20Members%20Letter%20to%20DOL.pdf. In their letter, the Senators asked the DOL to withdraw the proposed rule, but this would appear to be an unlikely outcome under the current democratic administration. Id.
The period for commenting on the proposed rule closed on December 13, 2021. We will continue to track developments in the rule as it goes into effect.
The following Gibson Dunn lawyers assisted in the preparation of this alert: Eugene Scalia, Karl Nelson, Geoffrey Sigler, Heather Richardson, Matthew Rozen, Jennafer Tryck, Lana El-Farra, Tessa Gellerson, Alex Ogren, Amanda Sansone, Clare Steinberg, Luke Zaro, and Yan Zhao.
Gibson Dunn lawyers are available to assist in addressing any questions you may have about these developments. Please contact the Gibson Dunn lawyer with whom you usually work, or any of the following:
Eugene Scalia – Washington, D.C. (+1 202-955-8543, [email protected])
Karl G. Nelson – Dallas (+1 214-698-3203, [email protected])
Geoffrey Sigler – Washington, D.C. (+1 202-887-3752, [email protected])
Katherine V.A. Smith – Los Angeles (+1 213-229-7107, [email protected])
Heather L. Richardson – Los Angeles (+1 213-229-7409,[email protected])
Matthew S. Rozen – Washington, D.C. (+1 202-887-3596, [email protected])
Jennafer M. Tryck – Orange County (+1 949-451-4089, [email protected])
© 2022 Gibson, Dunn & Crutcher LLP
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Munich partner Mark Zimmer and associate Katharina Humphrey are the authors of “Petzen? Ja, bitte! Meldesysteme nach der Whistleblower-Richtlinie der EU” [PDF] published in the issue 7/2022 of the German publication Betriebs-Berater. The article focuses on the Whistleblower Directive (EU) 2019/1937, group-wide whistleblower systems and challenges for companies, especially with more than 250 employees.
Where a contract specifies its governing law, but is silent as to the governing law of the arbitration agreement, the question arises as to which law governs the arbitration agreement – the governing law of the contract, or the law of the seat?
The UK Supreme Court recently delivered its second judgment in as many years on this question in Kabab-Ji SAL (Lebanon) (Appellant) v Kout Food Group (Kuwait) (Respondent) [2021] UKSC 48.
In 2020, the Supreme Court in Enka Insaat Ve Sanayi AS v OOO ‘Insurance Company Chubb’ [2020] UKSC 38 (“Enka”) held that where the parties have expressly or impliedly made a choice of law to govern a contract that contains an arbitration clause, that would generally be sufficient indication of the parties’ choice of law to govern the arbitration agreement as well.
In its much-anticipated Kabab-Ji decision, the UK Supreme Court recently reached the same conclusion in the context of proceedings to enforce an arbitral award. In a decision that directly contradicted the findings of the Paris Court of Appeal in parallel annulment proceedings, the UK Supreme Court found that the arbitration agreement was governed by English law, being the governing law of the contract—not French law, being the law of the seat, as found by the Paris Court of Appeal. The Supreme Court found that the tribunal had wrongly asserted jurisdiction over the respondent on that basis. This decision is an example of “exceptional circumstances”, where the English courts have refused the enforcement of an arbitral award under the New York Convention. Although the decision provides useful guidance on the process under English law for determining the law governing the arbitration agreement, it further entrenches the divide between the UK and French courts’ approaches to the jurisdiction of arbitral tribunals.
The key takeaways for parties considering arbitration clauses in their transaction documents following these decisions are:
- The English law approach to determining the law applicable to an arbitration agreement is now clear, as first confirmed by the Enka decision and now by the Kabab-Ji decision, having previously been unresolved for many years.
- However, there remains uncertainty at the international level. The Paris Court of Appeal considered the same award that the English courts considered in Kabab-Ji, and reached the opposite conclusion on which governing law applied to the parties’ arbitration agreement. In the underlying award, the English-qualified arbitrator and the two civil law arbitrators had also reached different conclusions. An appeal is currently pending before the French Cour de Cassation, but it is expected that the Paris Court of Appeal’s decision will be upheld.
- In order to achieve certainty, contracting parties should ensure that they identify the law specifically governing their arbitration agreement, whether or not that is the same law that governs the main contract.
- Stated differently, contracting parties should not assume that the law of the seat will govern the validity of the arbitration agreement, particularly as a matter of English law.
Background
The case related to a Franchise Development Agreement (“FDA”) between Kabab-Ji SAL (Lebanon) (“Kabab-Ji”) and Al Homaizi Foodstuff Company (“AHFC”), a subsidiary of Kout Food Group (Kuwait) (“KFG”).
In 2015, following a dispute under the FDA, Kabab-Ji commenced arbitration proceedings against the parent company KFG (who was not a party to the FDA) but not its subsidiary AHFC. The FDA was expressly said to be governed by English law. The FDA also contained an arbitration agreement, which provided that the seat of arbitration would be Paris and that the ICC Rules would apply. The arbitration agreement did not specify the applicable governing law, but stated that “[t]he arbitrator(s) shall also apply principles of law generally recognised in international transactions”,[1] which the parties agreed referred to the UNIDROIT Principles of International Commercial Contracts (“UNIDROIT Principles”). Notably, the FDA included ‘no oral modification’ clauses.
Arbitration Proceedings
Although KFG took part in the arbitration, it did so whilst maintaining that it was not a party to the FDA or the arbitration agreement it contained. Nevertheless, the tribunal issued an award in favour of Kabab-Ji in 2017. A majority of the tribunal decided that:
- French law (the law of the seat of arbitration) was the governing law of the arbitration agreement;
- Applying French law, KFG was a party to the arbitration agreement;
- English law (the governing law of the FDA) was the relevant body of law to determine whether KFG had acquired substantive rights and obligations under the FDA; and
- KFG was also a party to the FDA as there had been a novation and KFG was in breach of the FDA, with the result that the tribunal awarded USD 6,734,628.19 to Kabab-Ji.
Parallel proceedings were then commenced by KFG in France (to annul the award) and by Kabab-Ji in England (to enforce the award).
French Annulment Proceedings
KFG brought an action in the French courts to annul the award on jurisdictional grounds, submitting that KFG was not a party to the arbitration agreement, which was to be governed by English law. The Paris Court of Appeal referred to principles of international substantive arbitration law and held that, under those principles: (i) an arbitration agreement is independent from the underlying contract, and (ii) the law of the seat is the appropriate governing law to determine the validity and existence of the arbitration agreement, unless the parties intended otherwise. There was no contrary intention suggesting that a governing law other than the law of the seat (French law) should be applied. Jurisprudence from the French courts stated that a non-signatory party to an arbitration agreement “should be deemed to have agreed to the [arbitration] clause if the arbitral tribunal finds that this party had the will to participate in the performance of the agreement”.[2] The Paris Court of Appeal therefore upheld the arbitral tribunal’s finding that KFG was party to the arbitration agreement with reference to multiple factors, including that: (i) KFG’s organisational chart included personnel in charge of the performance of the FDA, and (ii) KFG was involved in the performance of the FDA for a number of years, including in their termination and renegotiation.[3] The court therefore upheld the award, finding that French law (the law of the seat) was the governing law of the arbitration agreement and that KFG was a party to it. KFG appealed to the Cour de Cassation, whose decision is pending.
English Enforcement Proceedings
Alongside the French proceedings, proceedings were brought by Kabab-Ji in the English Commercial Court to enforce the award under s. 101 of the Arbitration Act 1996. At first instance, the court found that English law governed the validity of the arbitration agreement. The court considered it likely that under English law, KFG was not party to the FDA or, therefore, the arbitration agreement, but this was left open for further determination. The proceedings were stayed pending the annulment proceedings in the Paris Court of Appeal.
Both Kabab-Ji and KFG appealed. The English Court of Appeal dismissed Kabab-Ji’s appeal and gave summary judgment in favour of KFG, finding that there was an express choice of English law as the governing law of the arbitration agreement. As a matter of English law, KFG could not have become a party to the FDA and its arbitration agreement without either consenting to this in writing (as required by the ‘no oral modification’ clauses in the FDA) or there being circumstances giving rise to an estoppel. This had not occurred, and the English Court of Appeal found that the judge at first instance should have made a final determination on this issue. On that basis, recognition and enforcement was refused.
UK Supreme Court Ruling
Kabab-Ji was given permission to appeal on various grounds, which the court condensed into the following issues:
(1) Which law governed the validity of the arbitration agreement?
(2) If English law was the applicable governing law, was there any real prospect that KFG had become a party to the arbitration agreement?
(3) Was the Court of Appeal justified in giving summary judgement refusing recognition and enforcement of the award, as a matter of procedure?
In a unanimous judgment, the Supreme Court found in favour of KFG and held that:
(1) English law governed the validity of the arbitration agreement;
(2) Under English law, there was no real prospect that a court would find KFG had become a party to the arbitration agreement; and
(3) Procedurally, the Court of Appeal was justified in giving summary judgement refusing recognition and enforcement of the award.
The Supreme Court’s reasoning was as follows:
Issue 1: Which law governed the validity of the arbitration agreement?
The Supreme Court referred to the summary in Enka of Article V(1)(a) of the New York Convention[4] (“Article V(1)(a)”), which established that the validity of an arbitration agreement is governed by:
- the law chosen by the parties; and
- in the event no choice has been made, the law of the country where the award is made.[5]
In Enka, the Supreme Court found that where an arbitration agreement does not specify the applicable governing law, a choice of governing law in the contract containing the arbitration agreement would generally be sufficient indication of the governing law. Importantly, in Kabab-Ji, the Supreme Court confirmed that the principle in Enka applied not only prior to the issuance of the award but also at the enforcement stage. As such, the governing law specified in the FDA—English law—was the applicable law of the arbitration agreement.
Kabab-Ji unsuccessfully advanced arguments that the law of the seat (French law) should apply. The arbitration agreement stated that the UNIDROIT Principles were applicable. Kabab-Ji argued that when this was read alongside the governing law clause (which specified that English law governed the contract), there was “no sufficient indication of the law which is to govern the validity of the arbitration agreement”[6], as the blend of English law and UNIDROIT Principles did not qualify as “law” under Article V(1)(a) and s. 103(2)(b) of the Arbitration Act 1996. As the parties had not chosen a “law” to govern the arbitration agreement, Kabab-Ji argued that the law of the seat was to be applied pursuant to Article V(1)(a).[7] The court rejected this argument as “illogical and inconsistent with the principle of party autonomy”,[8] as parties who opted for a certain governing law supplemented by additional principles would be denied their choice of both. Instead a different governing law (the law of the seat) would apply to their arbitration agreement, contrary to what the parties had chosen.
Kabab-Ji also sought to rely upon the ‘validation principle’[9] to argue that the choice of English law as the governing law would not extend to the arbitration agreement if the application of English law would result in there being no valid arbitration agreement between Kabab-Ji and KFG. The Supreme Court noted that the validation principle was a method of contractual interpretation and Kabab-Ji’s argument sought to “extend the validation principle beyond its proper scope”.[10] The Supreme Court concluded that the principle does not apply to questions of validity where the court has to determine whether an arbitration agreement exists at all.
Issue 2: If English law is the applicable governing law, had KFG become a party to the arbitration agreement?
The Supreme Court held that there was no real prospect of evidence being adduced that the KFG had become party to the arbitration agreement. In reaching this conclusion, particular attention was paid to the requirements in the FDA’s ‘no oral modification’ clauses. These placed the burden on Kabab-Ji to prove that there was a sufficiently arguable case that KFG had consented to becoming a party to the arbitration agreement in writing, or that KFG was estopped from relying on the failure to comply with those requirements. No evidence was adduced by Kabab-Ji beyond evidence of an informal unwritten promise and so the Supreme Court held that Kabab-Ji had failed to discharge this burden.
Issue 3: Was the Court of Appeal justified in giving summary judgement refusing recognition and enforcement of the award, as a matter of procedure?
The Supreme Court held that Article V(1) of the New York Convention and s. 103 of the Arbitration Act 1996 did not prevent the Court of Appeal from giving summary judgment refusing recognition and enforcement of the award. The English courts will decide whether determination should be made by summary judgment or a full evidential hearing in accordance with the Civil Procedural Rules. The Court of Appeal was therefore entitled to summarily determine the case, given it was in the interests of justice and the overriding objective to do so.
Commentary
The Supreme Court in Kabab-Ji confirmed the general principle established in Enka that, as a matter of English law, the governing law of a contract will govern an arbitration agreement within that contract where there is no express provision in the arbitration agreement itself. However, this has put the UK Supreme Court at odds with the French courts, with the Paris Court of Appeal having dismissed annulment proceedings against the award, finding that, under French law, the respondent was a party to the arbitration agreement. In its judgment, the Supreme Court emphasised that “the risk of contradictory judgments cannot be avoided”[11] and there is no universal consensus regarding the interpretation of Article V(1)(a) by the courts of contracting states
It remains to be seen what the French Cour de Cassation will decide. Kabab-Ji may also be inclined to attempt to enforce the Paris-seated award in another civil law jurisdiction, where a civil law court may find similarly to the French courts. This highlights that the international division in approach to Article V(1)(a) is unsatisfactory, and increases the risk of parallel proceedings in different jurisdictions and enforcement challenges. It may also prompt parties to ‘shop’ for arbitrators who will take a particular view of the governing law of arbitration agreements.
Perhaps the biggest lesson is for contracting parties to always incorporate an express choice of governing law of the arbitration agreement when drafting arbitration clauses. This is especially important when the seat of arbitration is in a different jurisdiction to that of the governing law. This is an oft-overlooked part of arbitration clauses, but one that can have serious consequences in international arbitration and enforcement. The experienced team at Gibson Dunn are well placed to assist on specific drafting queries.
Procedurally, the case also highlights the fact that the English courts will be prepared to use summary procedures in enforcement proceedings where appropriate, which saves both time and costs. The English courts will determine whether a case is suitable for summary determination on a case-by-case basis, having regard to procedural factors such as the overriding objective.
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[2] Judgment of Paris Court of Appeal (23 June 2020), Kabab-Ji S.A.L Company v. Kout Food Group Company [36]
[3] Judgment of Paris Court of Appeal (23 June 2020), Kabab-Ji S.A.L Company v. Kout Food Group Company [33]-[48]
[4] Convention on the Recognition and Enforcement of Foreign Arbitral Awards adopted by the United Nations Conference on International Commercial Arbitration on 10 June 1958 (“New York Convention”).
[5] The court noted that where the parties have chosen the seat of arbitration, the award will be deemed to be made at the place of the seat. See [2021] UKSC 48, [26].
[7] Kabab-Ji also relied on s. 103(2)(b) of the Arbitration Act 1996 which replicates Article V of the New York Convention
[9] The UKSC defined the validation principle as “the principle that contractual provisions, including any choice of law provision, should be interpreted so as to give effect to, and not defeat or undermine, the presumed intention that an arbitration agreement will be valid and effective”. See [2021] UKSC 48, [49].
The following Gibson Dunn lawyers assisted in the preparation of this client update: Cyrus Benson, Penny Madden QC, Nooree Moola, Michael Stewart and Sophia Cafoor-Camps.
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 International Arbitration, Judgment and Arbitral Award Enforcement or Transnational Litigation practice groups, or any of the following practice leaders and members:
Cyrus Benson – London (+44 (0) 20 7071 4239, [email protected])
Penny Madden QC – London (+44 (0) 20 7071 4226, [email protected])
Jeff Sullivan QC – London (+44 (0) 20 7071 4231, [email protected])
Nooree Moola – Dubai (+971 (0) 4 318 4643, [email protected])
© 2022 Gibson, Dunn & Crutcher LLP
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Federal securities filings continued to slow during the second half of 2021. The volume of new securities cases filed in 2021 fell by 36% compared to 2020, and 51% compared to 2019. Nonetheless, federal and state securities laws continue to develop in the courts. This year-end update summarizes major developments since our last update in August 2021:
- The second half of 2021 was relatively quiet with regard to noteworthy securities litigation activity from the Supreme Court. We discuss the settlement of a case that would have asked the Court to decide whether the PSLRA’s discovery-stay provision applies in state court, and a ruling that ERISA plan fiduciaries must conduct their own independent evaluation to determine which investments may be prudently included in the plan’s menu of options.
- Three recent decisions from Delaware courts will impact how stockholder derivative claims are investigated and litigated. We also discuss two decisions that enforced an advance notice bylaw and a contractual waiver of statutory appraisal rights.
- We continue to monitor courts’ application of the disseminator theory of liability recognized by the Supreme Court’s 2019 decision in Lorenzo, including differing interpretations regarding whether liability under Lorenzo applies to a broad swath of misrepresentations, or only in the more limited context of fraudulent dissemination.
- We again survey securities-related lawsuits arising out of, or otherwise related to, the COVID-19 pandemic, including securities class actions, stockholder derivative actions, and SEC enforcement actions. As courts have begun issuing decisions on motions to dismiss filed earlier in the pandemic, plaintiffs continue bringing new securities cases, including against pharmaceutical and biotechnology companies based upon representations made concerning the development of new COVID-19 vaccines.
- In the second half of 2021, several cases interpreted and applied the Supreme Court’s 2015 Omnicare decision regarding liability based on a false opinion. During this period, a notable portion of claims survived motions to dismiss in which defendants asserted that the misrepresentations or omissions at issue were non-actionable statements of opinion under Omnicare. Although these cases illustrate that some courts are willing to let certain complaints play out, even where the allegedly false or misleading statements include explicit language noting that the content is mere belief and opinion, other cases demonstrate that Omnicare still presents a significant pleading barrier. We will continue to monitor developments in this important area.
- We continue monitoring the development of price impact theory following last year’s remand of Goldman Sachs Group, Inc. v. Arkansas Teacher Retirement System. Despite considering the “mismatch” between alleged misstatements and alleged corrective disclosures on a “sliding scale,” the trial court held that defendants failed to sever the link plaintiff established between stock price drops, alleged misstatements, and corrective disclosures.
- Finally, we address notable developments in the federal courts, including (1) the Second Circuit’s vacating the dismissal of a securities class action because Section 10(b) liability may be premised on misstatements that concern unsustainable rather than fraudulent conduct, (2) the Ninth Circuit’s holding that purchasers of shares sold in a direct listing have statutory standing, (3) a federal district court’s holding that transactions in unlisted American Depositary Receipts are not domestic under the “irrevocable liability” test, and (4) the Second Circuit’s affirming the dismissal of an event driven securities action, finding the claim was only one of corporate mismanagement rather than fraud.
I. Filing And Settlement Trends
Data from a newly released NERA Economic Consulting (“NERA”) study shows that 2021 represented a continuation of the securities litigation trends begun in 2020. 2021 was the second year of decreased filings after the steady upward figures we saw from 2017-2019. A sharp decrease in the number of merger-objection cases filed in 2021 (down to 14 from 103 in 2020) drove a decline in the number of new federal class actions filed in 2020 (down to 205 from 321 in 2010). The “Electronic Technology and Technology Services” and “Health Technology and Services” sectors now represent 57% of all filings.
The median settlement value of federal securities cases in 2021—excluding merger-objection cases and cases settling for more than $1 billion or $0 to the class—decreased substantially from prior years (at $8 million, down from $14 million in 2020 and $13 million in 2019). Consistent with this trend, average settlement values (excluding merger-objection and zero-dollar settlements) also declined in 2021 (at $21 million, down from $47 million in 2020 and $29 million in 2019).
A. Filing Trends
Figure 1 below reflects the filing rates of 2021 (all charts courtesy of NERA). 205 cases were filed last year, down considerably from the peak in 2017-2019. Note, however, that this figure does not include class action suits filed in state court or state court derivative suits, including those in the Delaware Court of Chancery.
Figure 1:
B. Mix Of Cases Filed In 2021
1. Filings By Industry Sector
Even though the number of filings decreased in 2021 compared to 2020, the distribution of non-merger filings, as shown in Figure 2 below, was relatively consistent with the previous two years. Notably, the “Electronic Technology and Technology Services” and “Health Technology and Services” sectors now account for more than 50% of all filings, continuing the steady upward trend since 2016. “Finance” filings experienced the steepest decline, dropping by 6% (after rising by 6% in 2020).
Figure 2:
2. Merger Cases
As shown in Figure 3 below, there were 14 merger-objection cases filed in federal court in 2021. This represents an 86% year-over-year decrease from 2020, a 94% year-over-year decrease from 2019, and the lowest number of such filings since 2010. This figure is significantly lower than in 2016, when the Delaware Court of Chancery put an effective end to the practice of disclosure-only settlements in In re Trulia Inc. Stockholder Litigation, 29 A.3d 884 (Del. Ch. 2016), which helped drive the increase in merger-objection filings between 2015 and 2017.
Figure 3:
C. Settlement Trends
As reflected in Figure 4 below, the average settlement value declined by over 50% in 2021, reaching $21 million, after rebounding from $29 million in 2019 to $47 million in 2020.
Figure 4:
Turning to the median settlement value, Figure 5 shows that the consistency of 2018 to 2020, when median settlement value remained $13-14 million, came to an end in 2021. Last year saw the median value drop to $8 million. (Note that median settlement value excludes settlements over $1 billion, merger objection cases, and zero-dollar settlements.)
Figure 5:
Finally, as shown in Figure 6, Median NERA-Defined Investor Losses were steady in 2021, rising to $731 million from $698 million in 2020. The Median Ratio of Settlement to Investor Losses also held steady at 1.8% in both years.
Figure 6:
II. What To Watch For In The Supreme Court
The second half of 2021 was relatively quiet with regard to noteworthy activity from the Supreme Court in the area of securities litigation. Two developments of note are discussed below.
A. Pivotal Settlement
As we previewed in our 2021 Mid-Year Securities Litigation Update, on July 2, 2021, the Supreme Court granted certiorari in Pivotal Software, Inc. v. Superior Court of California, No. 20-1541. That case involved the question whether the discovery-stay provision in the Private Securities Litigation Reform Act (“PSLRA”)—which requires a stay prior to adjudication of a motion to dismiss—also extends to stockholder actions brought in state court. State courts have been increasingly divided on the issue since the Supreme Court’s 2018 decision in Cyan, Inc. v. Beaver County Employees Retirement Fund, 138 S. Ct. 1061 (2018), affirming potential state court jurisdiction over Securities Act claims.
On January 13, 2022, the parties in Pivotal notified the Court that they have finalized a settlement, and filed a motion for preliminary approval with the Superior Court of California. See Letter from the Parties Updating Clerk on Settlement Proceedings, Pivotal Software, Inc. v. Superior Court of Cal., No. 20-1541 (Jan. 13, 2022). As a result, the question whether the PSLRA’s discovery-stay provision applies to private actions in state court will not be answered by the Supreme Court in Pivotal. Although the provision will remain a known quantity in federal court, until such time as the Supreme Court has another opportunity to revisit the issue, parties in state courts will be left to grapple with the meaning of the PSLRA’s instruction that the discovery stay is required “[i]n any private action.” 15 U.S.C. § 77z-1-(b)(1).
B. Northwestern University ERISA Decision
On January 24, 2022, the Supreme Court issued its decision in Hughes v. Northwestern University, — S. Ct. —-, 2022 WL 199351 (U.S. Jan. 24, 2022). In a unanimous decision, the Court held that offering low-cost investment options alongside the other allegedly high-cost options in a defined-contribution retirement plan does not, in and of itself, categorically foreclose a claim for breach of ERISA’s duty of prudence. Id.
Petitioners—former and current employees of Northwestern University—alleged that Northwestern University violated its ERISA-imposed duty of prudence by providing employees with a menu of investment options for their defined-contribution plans, some of which were high-cost options that caused employees to incur excessive fees. Id. at *2. Northwestern responded that the plan also offered low-cost investment options alongside the higher-cost options. Id. at *3. The Seventh Circuit affirmed the dismissal of petitioners’ claims for failure to plausibly allege a breach of fiduciary duty, primarily relying on the inclusion of low-cost options. Id. at *4.
The issue presented to the Supreme Court was whether participants in a defined-contribution retirement plan may state a claim for breach of ERISA’s fiduciary duty of prudence on the theory that investment options offered in the plan were too numerous and that many of the options were too costly, notwithstanding that the plan’s fiduciaries offered low-cost investment options in the plan as well. Relying on the obligation to monitor plan investment options articulated in Tibble v. Edison International, 575 U.S. 523 (2015), the Court ruled that the Seventh Circuit had erred in dismissing the claims without making a “context-specific inquiry” that “take[s] into account [a fiduciary’s] duty to monitor all plan investments and remove any imprudent ones.” Hughes, 2022 WL 199351, at *2. Justice Sotomayor, writing for the Court, noted that “even in a defined-contribution plan where participants choose their investments, plan fiduciaries are required to conduct their own independent evaluation to determine which investments may be prudently included in the plan’s menu of options.” Id. at *4.
As a case-specific application of Tibble, the Northwestern decision likely does not significantly change the litigation landscape for ERISA claims involving plan investment options. The decision does make clear that merely making available alternative investment options does not categorically prevent ERISA plaintiffs from stating a plausible claim for breach of the duty of prudence. At the same time, the Court recognized that “[a]t times, the circumstances facing an ERISA fiduciary will implicate difficult tradeoffs, and courts must give due regard to the range of reasonable judgments a fiduciary may make based on her experience and expertise.” Hughes, 2022 WL 199351, at *4.
III. Delaware Developments
A. Delaware Supreme Court Adopts A Universal Three-Part Test For Demand Futility In Derivative Actions
In September, the Delaware Supreme Court in United Food & Commercial Workers Union & Participating Food Industry Employers Tri-State Pension Fund v. Zuckerberg, 262 A.3d 1034 (Del. 2021) (en banc), adopted a three-part demand futility test that blended the long-standing tests set forth in Aronson v. Lewis, 473 A.2d 805 (Del. 1984) (for affirmative decisions made by a majority of the same board considering the demand, which focused on the substance of the challenged transaction), and Rales v. Blasband, 634 A.2d 927 (Del. 1993) (for all other situations, which focused on the independence of the decision on a litigation demand).
In Zuckerberg, Plaintiff filed a derivative complaint in the Court of Chancery, seeking damages related to Facebook’s expenditures in a class action suit that challenged a stock reclassification that was ultimately abandoned. Zuckerberg, 262 A.3d at 1040. Plaintiff did not make a pre-suit demand on Facebook’s board, arguing demand was futile under Aronson because the negotiation and approval of the reclassification was an invalid exercise of the board’s business judgment and because a majority of directors were allegedly beholden to Facebook’s CEO. Id. The Court of Chancery found Aronson’s framework “not up to the task,” and instead applied a new three-part blended test and dismissed the complaint for failure to plead that demand was futile. Id. at 1057–58.
Under this new test, courts will consider whether a complaint pleads particularized facts demonstrating that each director (1) “received a material personal benefit from the alleged misconduct that is the subject of the litigation demand;” (2) would face “a substantial likelihood of liability on any of the claims that are the subject of the litigation demand;” and (3) “lacks independence from someone who received a material personal benefit from the alleged misconduct that is the subject of the litigation demand or who would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand.” Id. at 1058. Demand is excused as futile under this test if the answer to any of these questions is “yes” for at least half of the members of the board. Id. at 1059.
The Delaware Supreme Court affirmed, adopting the Court of Chancery’s blended three-part test as the “universal test for assessing whether demand should be excused as futile.” Id. at 1058. The Court explained that “changes in the law have eroded the ground upon which [the Aronson] framework rested . . . and it is both appropriate and necessary that the common law evolve in an orderly fashion to incorporate these developments.” Id. In particular, where a corporation has a Section 102(b)(7) clause in its charter that exculpates directors from liability for breaches of the duty of care, directors do not face a “substantial likelihood of liability” that would excuse a pre-suit demand under Aronson’s second prong. Id. at 1050–54.
The ruling provides clarity and simplifies the process for determining demand futility by offering a “universal test” that focuses the “inquiry on the decision regarding the litigation demand, rather than the decision being challenged,” and eliminating the complexity over whether to apply the Aronson or Rales tests. Id. at 1058–59.
B. Delaware Court Of Chancery Demonstrates The “High Hurdle” Of Pleading Wrongful Demand Refusal Is Not Insurmountable
In October, the Court of Chancery in Drachman v. Cukier, 2021 WL 5045265 (Del. Ch. Oct. 29, 2021), issued a rare decision declining to dismiss a complaint that alleged a board wrongfully refused a litigation demand, finding that it was reasonable to infer from the pleading that “the directors just did not care about complying with the legal requirements of Delaware law.” Id. at *8. In Drachman, plaintiffs made a pre-suit demand notifying the company’s board that proposals at an annual stockholder meeting failed to receive the requisite votes and thus the company erred in approving the proposals. Id. at *2. The board responded that the demand was without merit and declined to take remedial action, id.; indeed, the company did not take corrective action until one year later, when it obtained the requisite votes to ratify the challenged amendments, id. at *3.
To meet the “high hurdle” necessary to plead wrongful refusal under Court of Chancery Rule 23.1, as the Drachman plaintiffs did, plaintiffs must allege particular facts raising a reasonable doubt that “(1) the board’s decision to deny the demand was consistent with its duty of care to act on an informed basis, that is, was not grossly negligent; or (2) the board acted in good faith, consistent with its duty of loyalty.” Id. at *6, 8. The Drachman court reasoned that “the [d]emand pointed out a straightforward violation of Section 242(b), yet—despite the language of the [proxy materials] explaining how votes would properly be tabulated—the Board rejected the [d]emand and waited nearly a year to remedy the mistake.” Id. at *8. This opinion serves as a reminder that although directors enjoy wide discretion in exercising their business judgment with respect to stockholder demand letters—and plaintiffs face a “steep road” in pleading wrongful refusal, id. at *6—a board’s decision declining to take correction in the face of a valid demand may not be entitled to deference in court.
C. Delaware Supreme Court Overrules Gentile In Favor Of Simple Test To Distinguish Direct From Derivative Claims
In a re-examination of the law on overpayment claims, the Delaware Supreme Court overruled its 15-year-old precedent set forth in Gentile v. Rossette, 906 A.2d 91 (Del. 2006), holding that “equity overpayment/dilution claims, absent more, are exclusively derivative.” Brookfield Asset Mgmt., Inc. v. Rosson, 261 A.3d 1251, 1267 (Del. 2021). We discussed this possibility in our 2020 Year-End Securities Litigation Update. In Rosson, former minority stockholders brought a claims for breach of fiduciary duty to challenge TerraForm Power’s private placement of common stock to controlling stockholder Brookfield for alleged inadequate value. Id. at 1255.
The Court of Chancery denied defendants’ motion to dismiss, which sought to classify the dilution claims as derivative and thus extinguished by a recent merger. Id at 1260. The lower court turned first to the “simple test” of Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031, 1033 (Del. 2004), under which the question of whether a stockholder’s claim is direct or derivative “must turn solely on the following questions: (1) who suffered the alleged harm (the corporation of the stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually?).” Relying on Tooley, the court held that “dilution claims are classically derivative,” even where “a controlling stockholder allegedly causes a corporate overpayment in stock and consequent dilution of the minority interest.” Rosson, 261 A.3d at 1260. Nevertheless, the lower court found that the stockholders properly stated direct claims under Gentile’s “unsatisfying” exception to Tooley’s rule when a controlling stockholder is involved in transactions that resulted in an improper transfer of value and voting power from minority stockholders. Id. at 1261.
On appeal, the Delaware Supreme Court agreed with the Chancery Court’s analysis that the direct claims would not survive without Gentile’s carveout because the stockholders’ overpayment claim alleged derivative harm to the corporation. Id. at 1266. After examining the “clear conflict between Gentile and Tooley, the confusion Gentile imposes on Tooley’s straightforward analysis, and the policy reasons for removing the exception,” the court overruled Gentile and reversed the lower court’s denial of defendants’ motion to dismiss. Id. at 1267. The court recognized three issues with Gentile: (1) economic and voting dilution is not an injury to stockholders independent of injury to the corporation; (2) Gentile applied “confusing” standards, including an out-of-date “special injury test” that detracts from Tooley’s “goal of adding clarity to a difficult and important area of our law”; and (3) the focus of a court’s inquiry should be on who suffered the harm and who would receive the benefit of the recovery, not on the identity of the wrongdoer. Id. at 1267–74. The Supreme Court further observed that Gentile “creates the potential practical problem of allowing two separate claimants to pursue the same recovery.” Id. at 1277.
As it did just three days later in Zuckerberg, discussed supra Section III.A, in Rosson, the Court provided a much needed simplification of Delaware law on derivative claims and demonstrated a willingness to adapt the common law to meet real-world developments.
D. Court of Chancery Relies On Equitable Principles To Enforce Advance Notice Bylaw
In October, the Court of Chancery declined to apply both the enhanced scrutiny of Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988), and the business judgment rule in examining a board’s decision to enforce an advance notice bylaw and reject a rival slate of board nominees. Plaintiff dissident stockholders submitted advance notice of their intent to nominate a slate of candidates for pharmaceutical company CytoDyn Inc.’s board, which the board rejected as contrary to CytoDyn’s bylaws. Rosenbaum v. CytoDyn Inc., 2021 WL 4775140, at *1 (Del. Ch. Oct. 13, 2021). After a paper trial on the stockholders’ request for injunctive relief allowing their candidates to stand for election, the court adopted the company’s argument that the stockholders’ notice was deficient because it failed to disclose who supported their efforts and failed to disclose that one of the nominees might seek to facilitate an insider transaction. Id. at *2.
The parties advocated for competing standards of review on the board’s refusal to put the nominations to a vote. The stockholders argued that under Blasius, the board bore “the heavy burden of demonstrating a compelling justification” because it acted “for the primary purpose of impeding the exercise of stockholder voting power.” Id. at *13 (citing Blasius, 564 A.2d at 661). The company argued that the proper standard was the deferential business judgment rule because the board’s decision is covered by contract, namely the bylaws. Id. The court rejected both approaches.
First, the Court of Chancery held that Blasius should not be held so broadly as to apply to “all cases where a board of directors has interfered with a shareholder vote.” Id. at *14. Instead, its exacting standard should be used “sparingly” when “self-interested or faithless fiduciaries” engaged in “manipulative conduct” to “deprive stockholders of a full and fair opportunity to participate in the matter. Id. (citing In re MONY Group, Inc. S’holder Litig., 853 A.2d 661, 674 (Del. Ch. 2004)). Though the board delayed responding to the nomination notice, the court credited the fact that the advance notice bylaw was reasonable, “commonplace,” and was adopted years earlier. Id. The court also rejected the company’s preferred business judgment standard due to the inherent “structural and situational conflict” present when a board enforces bylaws against stockholders. Id.
Instead, the court drew on longstanding principles of equity to examine whether the board unreasonably applied the validly enacted bylaws under the circumstances. Id. at *15. The court held that stockholders played “fast and loose” by submitting their deficient nominations on the eve of the deadline, leaving themselves with no opportunity to cure under bylaws that did not contain an express process to do so. Id. at *2. Had the stockholders provided their nominations earlier, they “might have a stronger case that the Board’s prolonged silence upon receipt of the notice was evidence of manipulative conduct.” Id. at *17. But under the circumstances, it was incumbent upon the stockholders to submit a compliant notice, and the court found that the board was justified in rejecting their slate.
E. Delaware Supreme Court Enforces Ex Ante Waiver of Statutory Appraisal Rights
Over a rare dissent, the Delaware Supreme Court recently enforced a provision in a stockholder agreement waiving corporate stockholders’ right to pursue statutory appraisal for certain transactions. Manti Holdings, LLC v. Authentix Acquisition Co., Inc., 261 A.3d 1199 (Del. 2021). In 2017, Authentix Acquisition Company, Inc. (“Authentix”) merged with a third-party entity. Minority stockholders filed a petition for appraisal of their stock under Section 262 of the Delaware General Corporation Law (“DGCL”). Id. at 1199. As we discussed in our 2018 Year End Securities Litigation Update, upon Authentix’s motion, the Court of Chancery enforced the stockholders’ agreement “that they ‘refrain’ from exercising their appraisal rights with respect to the merger” and dismissed the petition. Id. at 1203 (quoting agreement).
On appeal, the majority, with Justice Montgomery-Reeves writing, held that “neither statutory law nor public policy prohibits Authentix from enforcing the [waiver] against the petitioners.” Id. at 1214 (cleaned up). Although the majority agreed with petitioners that “the DGCL has mandatory provisions that are fundamental features of the corporate entity’s identity” that “cannot be varied by a contract,” it was cognizant of “Delaware’s strong policy favoring private ordering.” Id. at 1203, 1216. Thus, the majority did not read Section 262’s provision that stockholders “shall be entitled to an appraisal” as creating an unassailable right, since case law permits mandatory rights to be waived unless prohibited. Id. at 1219 (citing Graham v. State Farm Mut. Auto. Ins. Co., 565 A.2d 908, 912 (Del. 1989)). It was also “unconvinced” that “the fundamental nature of appraisal rights” “play a sufficiently important role in regulating the balance of power between corporate constituencies” to justify forbidding their waiver as a matter of public policy. Id. at 1223, 1224. Instead, the majority held that “Section 262 does not prohibit sophisticated and informed stockholders, who were represented by counsel and had bargaining power, from voluntarily agreeing to waive their appraisal rights in exchange for valuable consideration.” Id. at 1204; see also id. at 1224. Such was the case here, as the court repeatedly noted.
The majority’s ruling may permit ex ante contractual waivers of other stockholder rights set forth in the DGCL. In dicta, it recognizes that “there may be other stockholder rights that are so fundamental to the corporate form that they cannot be waived ex ante.” Id. at 1226. Except for “certain rights designed to police corporate misconduct or to preserve the ability of stockholders to participate in corporate governance,” however, the majority stops short of providing a ready list. In dissent, Justice Valihura would have held that Section 262 appraisal rights are fundamental, mandatory features of corporate governance that cannot be waived, but even if they could be modified, such a provision should, at the very least, be contained within the corporate charter. Id. at 1250–51 (Valihura, J., dissenting).
IV. Further Development Of Disseminator Liability Theory Upheld In Lorenzo
As initially discussed in our 2019 Mid-Year Securities Litigation Update, the Supreme Court held in Lorenzo v. SEC, 139 S. Ct. 1094 (2019), that those who disseminate false or misleading information to the investing public with the intent to defraud can be liable under Section 17(a)(1) of the Securities Act, Section 10(b) of the Exchange Act, and Rules 10b-5(a) and 10b-5(c), even if the disseminator did not “make” the statement within the meaning of Rule 10b-5(b). In the wake of Lorenzo, secondary actors—such as financial advisors and lawyers—could face “scheme liability” under Rules 10b-5(a) and 10b-5(c) simply for disseminating the alleged misstatement of another, if a plaintiff can show that the secondary actor knew the alleged misstatement contained false or misleading information.
Since our 2021 Mid-Year Securities Litigation Update, courts in the Second and Eleventh Circuits have wrestled with the scope of Lorenzo, considering whether Lorenzo allows a plaintiff to bring Rule 10b-5(a) and (c) scheme liability claims based on the same conduct as Rule 10b-5(b) misrepresentation claims absent allegations of dissemination.
Applying Lorenzo broadly, district courts in Florida and New York have denied motions to dismiss Rule 10b-5(a) and (c) claims after holding that scheme liability can now arise from the same conduct forming the basis for a Rule 10b-5(b) claim. For example, in SEC v. Complete Business Solutions Group, Inc, 538 F. Supp. 3d 1309, 1317, 1340 (S.D. Fla. 2021), the SEC accused defendants of selling unregistered securities—backed by small business loans—to investors and making several misrepresentations about the underlying loans’ risk. The district court determined that the SEC had adequately alleged that the defendants made misrepresentations or omissions under Rule 10b-5(b). The court also denied the defendants’ motion to dismiss the Rule 10b-5(a) and (c) claims of scheme liability, which were based on the very same statements that formed the 10b-5(b) claims, reasoning that, after Lorenzo, a plaintiff no longer has to plead “deceptive acts distinct from the alleged misrepresentation forming the basis of a Rule 10b-5(b) claim.” Id. at 1339–40.
Similarly, in SEC v. Sequential Brands Group., Inc., 20-CV-10471 (JPO), 2021 WL 4482215, at *6 (S.D.N.Y. Sept. 30, 2021), the SEC alleged that Sequential Brands Group engaged in a deceptive scheme by covering up quantitative evidence of an impairment to its goodwill. When multiple quantitative analyses showed that its goodwill had fallen by millions of dollars, Sequential Brands Group did not disclose those calculations but instead changed its methodology to a purportedly “biased” qualitative assessment that suggested goodwill had not been impaired. This withholding of information and change of methodology “resulted in regular misleading statements on public filings.” Id. The district court held that such allegedly fraudulent accounting practices could form the basis for scheme liability, analogizing to the deceptive dissemination at issue in Lorenzo. Gibson Dunn represents Sequential Brands Group in this matter. In SEC v. GPL Ventures LLC, 21 Civ. 6814 (AKH), 2022 WL 158885, at *9 (S.D.N.Y. Jan. 18, 2022), the SEC charged GPL Ventures (“GPL”), an issuer, and others with participating in a pump and dump fraud scheme in connection with the purchase of more than 1.5 billion shares of HempAmericana, Inc. The district court concluded that, because GPL was accused of being a “puppetmaster[] of a scheme to launder their investments for profit,” it could potentially be held liable for the misleading promotions, despite not making or disseminating the alleged misrepresentations itself. Id. at *10.
But on the other side of the coin, in SEC v. Rio Tinto PLC, another court in the Southern District of New York dismissed the SEC’s scheme liability claims after concluding that the SEC failed to “allege that Defendants disseminated [the] false information, only that they failed to prevent misleading statements from being disseminated by others.” See 17 Civ. 7994 (AT) (DCF), 2021 WL 818745, at *2 (S.D.N.Y. Mar. 3, 2021). Since we discussed this case in our 2021 Mid-Year Securities Litigation Update, the district court certified an interlocutory appeal to the Second Circuit on this issue. The appeal is fully briefed and should provide the Second Circuit with an opportunity to weigh in on Lorenzo’s reach. Gibson Dunn represents Rio Tinto in this and other litigation.
As these developments suggest, the application of the Lorenzo disseminator liability theory continues to evolve among and within the circuits. We will continue to monitor closely the changing applications of Lorenzo and provide a further update in our 2022 Mid-Year Securities Litigation Update.
V. Survey Of Coronavirus-Related Securities Litigation
As the third year of the COVID-19 pandemic begins, we are seeing new trends in coronavirus-related securities litigation. With the continuing development of vaccines, tests, and treatments for COVID-19, there has been a shift from cases focused on safety and travel to suits against pharmaceutical and biotechnology companies based on claims regarding the efficacy and authorization of their drugs.
As vaccines have been approved and businesses have reopened, we are also seeing more suits against companies related to statements made about their pandemic-related successes or losses and whether those trends should be expected to continue post-pandemic.
Courts have begun to issue orders on motions to dismiss in some of the pandemic-related cases we identified in previous updates. We report on notable decisions in this section, but it is still too early to identify any lasting COVID-specific jurisprudence in how courts have treated these cases. We will continue to monitor developments in these and other coronavirus-related securities litigation cases. Additional resources regarding company disclosure considerations related to the impact of COVID-19 can be found in the Gibson Dunn Coronavirus (COVID-19) Resource Center.
A. Securities Class Actions
1. False Claims Concerning Commitment To Safety
Hartel v. GEO Grp., Inc., No. 20-cv-81063, 2021 WL 4397841 (S.D. Fla. Sept. 23, 2021): In our 2020 Year-End Securities Litigation Update, we reported on the filing of this lawsuit, in which the plaintiffs alleged that GEO Group, a private corrections facilities operator, misled investors about the effectiveness of its COVID-19 response—exposing residents and employees to health risks and leaving the company “vulnerable to significant financial and/or reputational harm.” Dkt. No. 1 at 3, 9, 12. After a COVID-19 outbreak was reported in one GEO-run facility, GEO’s stock price fell by ten percent in two days. 2021 WL 4397841, at *2. In December 2020, the defendants filed a motion to dismiss, arguing in part that the complaint ignored material, explicit disclosures of risks during the relevant period; that the forward-looking statements that formed the basis for some claims were not actionable; and that the plaintiffs failed to plead falsity, loss causation, and scienter. Dkt. No. 36 at 8–13, 15–19. On September 23, 2021, Judge Rodney Smith granted the defendants’ motion to dismiss in part—as to certain statements and certain individual defendants—and directed the filing of a second amended complaint that did not include any claims based on non-actionable forward-looking statements, puffery, corporate optimism, or opinion. 2021 WL 4397841, at *15. The plaintiffs filed a second amended complaint on October 4, see Dkt. No. 46, and in November the parties completed briefing on a new motion to dismiss, which remains pending, see Dkt. No. 53.
2. False Claims About Vaccinations, Treatments, And Testing For COVID-19
a. Updates On Previously Reported Cases
Yannes v. SCWorx Corp., No. 1:20-cv-03349, 2021 WL 2555437 (S.D.N.Y. June 21, 2021): As we discussed in our 2020 Mid-Year Securities Litigation Update, this case involved allegations that the company artificially inflated its stock price with a false claim that it had received a purchase order for millions of COVID-19 rapid testing kits. Dkt. No. 1 at 1. In September 2020, this case was consolidated with other stockholder class actions. Dkt. No. 40. Judge Koeltl denied a motion to dismiss in June 2021, finding that the complaint adequately pleaded a strong inference of defendants’ scienter and alleged that the statements were materially misleading. 2021 WL 2555437, at *3–8. On January 5, 2022, the action was stayed to allow the parties to prepare a joint stipulation of settlement. Dkt. No. 74.
In re Sorrento Therapeutics, Inc. Sec. Litig., No. 20-cv-00966, 2021 WL 6062943 (S.D. Cal. Nov. 18, 2021): We previously discussed this case in our 2020 Mid-Year Securities Litigation Update, under the name Wasa Medical Holdings v. Sorrento Therapeutics, Inc. As we described in that Update, a stockholder filed this lawsuit against Sorrento after Sorrento allegedly claimed that it had discovered a “cure” for COVID-19. In November 2021, Judge Battaglia granted the defendants’ motion to dismiss, in part because the challenged statement that “there is a cure” for COVID-19 was a “statement of corporate optimism” that could not be the basis for a claim under Section 10(b) of the Securities Exchange Act. 2021 WL 6062943, at *7. The plaintiffs filed an amended complaint on November 30, 2021, Dkt. No. 58, and defendants filed a motion to dismiss on December 30, 2021, Dkt. No. 61.
b. Newly Filed Cases
Sinnathurai v. Novavax, Inc., No. 21-cv-02910 (D. Md. Nov. 12, 2021): A stockholder of Novavax, a company that develops and produces vaccines, alleges that the company and certain officers made false and misleading statements about the timeline and prospects for the company’s COVID-19 vaccine. Dkt. No. 1 at 1–2. As alleged in the complaint, in March 2021, Novavax announced that it had been in dialogue with the FDA to obtain an Emergency Use Authorization (“EUA”) for its product NVX-CoV2373, which was “in development as a vaccine for COVID-19.” Id. at 1, 6. In that announcement, Novavax specified that the EUA filing could occur as early as the second quarter of 2021 and that it expected to have capacity to manufacture “over 2 billion annualized doses” in mid-2021. Id. at 6–7. In May 2021, a newspaper reported that Novavax’s EUA filing would be delayed until at least June, due to “a regulatory manufacturing issue,” and Novavax announced that day that its EUA filing was delayed until at least July 2021. Id. at 8–9. In August 2021, Novavax announced further delay of its EUA filing until the fourth quarter of 2021. Id. at 12. And in October 2021, another news article reported on manufacturing issues at Novavax that had been “so severe that they strained global COVID-19 vaccination efforts.” Id. at 15. Thereafter, in November 2021, the stockholder filed suit, alleging that after each of these disclosures, Novavax’s share price declined. Id. at 2–3. In December 2021, the defendants filed a notice of intent to file a motion to dismiss. Dkt. No. 13.
In re Emergent Biosolutions Inc. Sec. Litig., No. 8:21-cv-00955, 2021 WL 6072812 (D. Md. Dec. 23, 2021): In this suit, stockholders allege that Emergent, a biopharmaceutical company, and certain officers and high-level employees misled the public about the company’s business and operations though misrepresentations and omissions. Dkt. No. 1 at 14. In June 2020, Emergent received funds through the federal government’s Operation Warp Speed program, which was created to “encourage rapid development, manufacturing, and distribution of COVID-19 vaccines.” 2021 WL 6072812, at *1. The Operation Warp Speed funding was provided to reserve space for vaccine manufacturing at Emergent’s facilities in Baltimore and for Emergent to upgrade those facilities. Id. Emergent also signed agreements with Johnson & Johnson and AstraZeneca to support the mass production of their vaccines, once they were approved for distribution. Id. As alleged in the complaint, in the press releases announcing these agreements and in other statements, Emergent drew attention to its “manufacturing strength” and “expertise in development and manufacturing.” Dkt. No. 1 at 7–9. But Emergent failed to disclose “myriad issues” at the Baltimore facilities, which had been identified in FDA inspections but not disclosed to the public until after a March 31, 2021 article reported on the Baltimore facilities’ contamination of up to 15 million doses of the Johnson & Johnson vaccine. Id. at 2–3, 9–10. After additional reporting revealed the severity of the contamination and Emergent’s “history of violations,” Emergent’s stock price declined “precipitously.” Id. at 10. In December 2021, the court consolidated three class action suits, appointed a lead plaintiff, and selected lead counsel. 2021 WL 6072812, at *6–7.
3. Failure To Disclose Specific Risks
Martinez v. Bright Health Grp. Inc., No. 1:22-cv-00101 (E.D.N.Y. Jan. 6, 2022): This putative class action alleges that Bright Health’s June 25, 2021 offering documents overstated Bright Health’s post-IPO business and financial prospects and failed to disclose that Bright Health was ill-equipped to handle the impact of COVID-19 related costs, which led to a 32.33% fall in stock price on November 11, 2021. Dkt. No. 1 at 2–4. Bright Health has not yet responded to the complaint.
4. False Claims About Pandemic And Post-Pandemic Prospects
In re Progenity, Inc., No. 20-cv-1683, 2021 WL 3929708 (S.D. Cal. Sept. 1, 2021): This putative class action alleges that Progenity, a biotechnology company that develops testing products, made misleading statements and omitted material facts in its registration statement. Dkt. No. 1 at 2. Specifically, the complaint alleges that Progenity allegedly failed to disclose that it had overbilled government payors and that it was suffering from negative trends in Progenity’s testing volumes, selling prices, and revenues as a result of the COVID-19 pandemic. Id. The complaint further alleges that Progenity falsely emphasized its “resilient” business and that it had already “observed positive signs of recovery” from the COVID-linked slowdown. Id. at 8. On September 1, 2021, the court dismissed the case with leave to file a second amended complaint, finding no actionable false or misleading statements. Dkt. No. 48. Plaintiffs filed a second amended complaint on September 22, 2021. Dkt. No. 49. The case was transferred on January 3, 2022 to Judge Lopez, who is currently considering a second motion to dismiss. Dkt. Nos. 52–54.
Dixon v. The Honest Co., Inc., No. 2:21-cv-07405 (C.D. Cal. Sept. 15, 2021): Stockholders of the Honest Co., a seller of “clean lifestyle” products, filed this putative class action alleging that the company’s registration statement omitted the fact that the company’s results were impacted by a multimillion-dollar COVID-19 stock-up of diapers, wipes, and household and wellness products, and that at the time of its IPO the company was experiencing decelerating demand for the products. Dkt. No. 1 at 1, 3. The complaint alleges that as a result, the company’s statements about “its business, operations, and prospects, were materially misleading and/or lacked a reasonable basis.” Id. The court recently granted a motion to consolidate this case with other, similar cases brought against the Honest Co. Dkt. No. 47.
Douvia v. ON24, Inc., No. 21-cv-08578 (N.D. Cal. Nov. 3, 2021): This putative class action by stockholders of ON24, Inc., a “cloud-based digital experience platform,” alleges that the company’s offering documents were materially inaccurate, misleading, and incomplete because they failed to disclose that the company’s surge in new customers due to COVID-19 did not fit the company’s traditional customer profile and thus the customers were unlikely to renew their contracts, leading to a decrease in the company’s financial results. Dkt. No. 1 at 1, 2. Motions to consolidate, appoint a lead plaintiff, and appoint lead counsel are currently before the court. Dkt. No. 65.
Hollywood Police Officers’ Ret. Sys. v. Citrix Sys., Inc., No. 21-cv-62380 (S.D. Fla. Nov. 19, 2021): The plaintiffs allege that Citrix made materially false and misleading statements that caused substantial losses to investors. Dkt. No. 1 at 2. Citrix, a software company that provides users with secure remote access to computer networks, decided to shift to a subscription license model. Id. Due to the COVID-19 pandemic, however, Citrix offered shorter duration, on-premise licenses that would later transition to subscription licenses. Id. According to the complaint, because of this offer and the COVID-19 pandemic, Citrix’s sales were boosted, and the company touted its success to investors. Id. The plaintiffs allege that, in reality, the company’s transition to subscription licenses was not as successful as the company had disclosed, as customers failed to make the transition, instead preferring short-term on-premise licensing due to the COVID-19 pandemic. Id. at 3. Motions to appoint lead plaintiff and to appoint lead counsel are currently before the court. Dkt. Nos. 16–21.
Leventhal v. Chegg, Inc., No. 5:21-cv-09953 (N.D. Cal. Dec. 22, 2021): This putative class action alleges that Chegg, a textbook, tutoring, and online research provider, falsely claimed that as a result of its “unique position to impact the future of the higher education ecosystem” and “strong brand and momentum,” Chegg would continue to grow post-pandemic. Dkt. No. 1 at 2. The complaint alleges that Chegg knew that its growth was a temporary effect of the pandemic and was not sustainable. Id. at 2–3. As a result, the plaintiff alleges that Chegg took advantage of its artificially inflated stock price by selling $1 billion of common stock to investors in its secondary offering. Id. at 3.
Collins v. DocuSign, Inc., No. 21-cv-07071 (E.D.N.Y. Dec. 22, 2021): The plaintiffs allege that DocuSign, a software company that “enables users to automate the agreement process and provide legally binding e-signatures from nearly any devise,” made false and misleading statements and failed to disclose the impact of COVID-19 on the company’s business. Dkt. No. at 1, 2, 13. Specifically, plaintiffs allege that Docusign failed to disclose that COVID-19 had a positive impact of the company and that DocuSign downplayed the impact that a “return to normal” would have on the company’s growth and business. Id.
5. Insider Trading And “Pump and Dump” Schemes
In re Eastman Kodak Co. Sec. Litig., No. 6:21-cv-6418, 2021 WL 3361162 (W.D.N.Y. Aug. 2, 2021): We discussed the first in the series of cases that have now been consolidated under the heading In re Eastman Kodak Co. Securities Litigation in our 2020 Year-End Securities Litigation Update and then followed up on it in our 2021 Mid-Year Securities Litigation Update. Tang v. Eastman Kodak Co., No. 20-cv-10462 (D.N.J. Aug. 13, 2020), was a putative class action in which stockholders alleged Eastman Kodak violated Sections 10(b) and 20(a) of the Exchange Act by failing to disclose that the company’s officers were granted stock options before the company’s public announcement that it had received a loan to produce drugs for the treatment of COVID-19. Dkt. No. 1 at 2. As we noted in our 2021 Mid-Year Update, Tang v. Eastman Kodak Co. was transferred from the District of New Jersey to the Western District of New York. Around the same time, another class action against Eastman Kodak, McAdams v. Eastman Kodak Co., No. 21-cv-6449 (S.D.N.Y. Aug. 26, 2020), was transferred from the Southern District of New York to the same court. 2021 WL 3361162, at *1. In late June 2021, the court in the Western District of New York consolidated the two actions, and in August, the court appointed lead plaintiff and lead counsel. Id.
In re Vaxart Inc. Sec. Litig., 3:20-cv-05949, 2021 WL 6061518 (N.D. Cal. Dec. 22, 2021): Stockholders allege that Vaxart insiders—directors, officers, and a major stockholder—profited from misleading statements that (1) overstated Vaxart’s progress toward a successful COVID-19 vaccine; and (2) implied that Vaxart’s “supposed vaccine” had been “selected” by the federal government’s Operation Warp Speed program. Dkt. No. 1 at 6–7. After Vaxart’s stock price rose in response to these statements, the insiders “cashed out,” exercising options and warrants worth millions of dollars. Id. at 7–8.
After this case was consolidated with other, related stockholder class actions (including Hovhannisyan v. Vaxart, Inc., No. 20-cv-06175 (N.D. Cal. Sept. 1, 2020), which we first discussed in our 2020 Year-End Securities Litigation Update), Judge Chhabria issued a decision on the defendants’ motion to dismiss on December 22, 2021, and, in doing so, observed that the case is an “unusual” one. 2021 WL 6061518. The court noted that the plaintiffs easily satisfied the pleading requirement for scienter, which can be a high hurdle for private plaintiffs. Instead, the court observed plaintiffs faced a challenge pleading that the statements at issue were materially misleading to a reasonable investor, where the press releases and other statements at issue “included several accurate passages alongside highly misleading ones,” so that an investor might have been able to “sift through” them and find the false statements untrustworthy. Id. at *1. Judge Chhabria ultimately concluded, however, that, considering the totality of the statements and the “unique context” of the Operation Warp Speed program, the plaintiffs had sufficiently alleged that the statements were materially misleading. Id. at *1, *4–5. The motion to dismiss was granted only as to the major-stockholder defendant, as the plaintiffs had failed to allege that the entity was a “maker” of the misleading statements or controlled Vaxart’s public statements. Id. at *8.
B. Stockholder Derivative Actions
Equity-League Pension Tr. Fund v. Great Hill Partners, L.P., No. 2020-0992-SG, 2021 WL 5492967 (Del Ch. Nov. 23, 2021): In November 2020, Wayfair stockholders initiated this derivative action asserting that (1) the directors had breached their fiduciary duties in connection with a private investment in a public equity (“PIPE”) transaction undertaken during the COVID-related economic downturn in early 2020, see 2021 WL 5492967, at *4; (2) noteholders had been unjustly enriched by that transaction, id. at *5; and (3) a private equity investor and its designee director had been unjustly enriched in an early March 2020 purchase of Wayfair stock, id. In November 2021, the Court of Chancery granted defendants’ motion to dismiss in its entirety because the plaintiffs had failed to plead demand futility. Id. at *1.
In re Vaxart, Inc. Stockholder Litig., No. 2020-0767-PAF, 2021 WL 5858696 (Del. Ch. Nov. 30, 2021): Unlike the Vaxart class action securities litigation discussed above, this case was filed derivatively on behalf of the Vaxart corporate entity. In particular, Vaxart stockholders alleged that the officers, directors, and purported controlling stockholder kept private the announcement regarding the company’s selection to participate in Operation Warp Speed so that they could keep the stock price artificially low before exercising their options. 2021 WL 5858696, at *1, *13. Because the plaintiffs failed to plead demand futility as to their derivative claims, on November 30, 2021, the court granted the defendants’ motion to dismiss as to the derivative claims, and requested supplemental briefing on other issues. Id. at *24.
C. SEC Cases
SEC v. E*Hedge Sec. Inc., No. 1:20-cv-22311 (S.D. Fla. June 3, 2020): We previously discussed this case in our 2020 Mid-Year Securities Litigation Update. The SEC filed suit against an internet investment advisor firm and its president for failing to turn over its books and records while touting investment opportunities related to treatments and vaccines for COVID-19. Dkt. No. 1 at 1–2, 6. Although the defendants responded to the initial complaint, they subsequently failed to answer or otherwise respond to the SEC’s amended complaint. See Dkt. No. 29 at 1. On March 9, 2021, the court issued an order granting the SEC’s motion for default judgment for a permanent injunction restraining E*Hedge Securities from violating Sec. 204 of the Investment Advisor’s Act of 1940 by failing to turnover books and records as required by the statute, and being registered with the SEC as an investment adviser while it is statutorily prohibited from doing so under Sec. 203A of the same statute. Dkt. No. 29 at 2.
SEC v. Berman, No. 20-cv-10658, 2021 WL 2895148 (S.D.N.Y. June 8, 2021): We previously discussed a related criminal case in our 2020 Year-End Securities Litigation Update. In the criminal case, a federal grand jury indicted the CEO of Decision Diagnostics Corp. (also a defendant in this civil case) on December 15, 2020, for allegedly attempting to defraud investors by making false and misleading statements about the development of a new COVID-19 rapid test, which the CEO falsely claimed was on the verge of FDA approval. Dkt. No. 1 at 6–7. As alleged, the product in question was actually still in its conceptual stage. Id. at 9. On December 17, 2020, two days after the indictment in the criminal case, the SEC filed a civil enforcement action based on the same underlying facts and alleging that both Decision Diagnostics Corp. and its CEO, Keith Berman, violated Section 10(b) of the Exchange Act and Rule 10b-5. 2021 WL 2895148, at *1. In this civil case, the court stayed discovery in June 2021 in light of the parallel criminal case against the CEO. Id.
SEC v. Wellness Matrix Grp., Inc., No. 21-cv-1031, 2021 WL 6104812 (C.D. Cal. Oct. 14, 2021): We previously discussed this case in our 2021 Mid-Year Securities Litigation Update. The SEC charged Wellness Matrix, a wellness company, and its controlling stockholder with violations of Section 10(b) and Rule 10b-5 by allegedly misleading investors regarding the availability and approval status of the corporation’s at-home COVID-19 testing kits. Dkt. No. 1 ¶¶ 6–7, 9. On August 23, 2021, the controlling stockholder filed his answer in which he asserted several counterclaims against the SEC, including for trademark infringement, libel, and slander. 2021 WL 6104812, at *1. On October 14, 2021, the court granted the SEC’s motion to dismiss defendants’ counterclaims but denied the SEC’s motion to strike defendant’s unclean hands defense and challenges to the court’s jurisdiction. Id. The SEC’s motion was unopposed and the court’s decision to dismiss the defendant controlling stockholder’s counterclaims validated the SEC’s argument that Section 21(g) of the Exchange Act “bars defendants from bringing a counterclaim in an SEC enforcement action without the SEC’s consent.” Id. at *2. The court chose to deny the SEC’s motion as to the defendant’s unclean hands and jurisdictional defenses, however, because the SEC failed to identify the language in the answer it was seeking to strike, and the court “decline[d] to sift through the Answer and guess.” Id. at *3.
VI. Falsity Of Opinions – Omnicare Update
There was significant activity in the second half of 2021 with respect to “opinion” liability under the federal securities laws. Lower courts continue to examine the standard for imposing liability based on a false opinion as set forth by the Supreme Court in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 575 U.S. 175 (2015). In Omnicare, the Supreme Court held that “a sincere statement of pure opinion is not an ‘untrue statement of material fact,’ regardless whether an investor can ultimately prove the belief wrong,” but that an opinion statement can form the basis for liability in three different situations: (1) the speaker did not actually hold the belief professed; (2) the opinion contained embedded statements of untrue facts; or (3) the speaker omitted information whose omission made the statement misleading to a reasonable investor. Id. at 184–89.
In the second half of 2021, courts continued the trend of applying Omnicare to claims under the Exchange Act (Omnicare was decided in the context of a Section 11 claim), including in numerous actions under Section 10(b) and Rule 10b-5. For example, in Villare v. Abiomed, Inc., No. 19 CIV. 7319 (ER), 2021 WL 4311749, at *19–20 (S.D.N.Y. Sep. 21, 2021), the Southern District of New York applied, without discussion or note, the Omnicare analysis to claims under the Exchange Act. See also Del. Cnty. Emps. Ret. Sys. v. Cabot Oil & Gas Corp., No. CV H-21-2045, 2022 WL 112029, at *10 (S.D. Tex. Jan. 12, 2022) (applying Omnicare to a claim brought under Section 10(b) of the Securities Exchange Act); Constr. Indus. & Laborers Joint Pension Tr. v. Carbonite, Inc., 22 F.4th 1, 7(1st Cir. 2021) (holding that the plaintiff adequately stated a Section 10(b) claim under Omnicare).
A notable portion of claims survived motions to dismiss in which defendants asserted that the misrepresentations or omissions at issue were non-actionable statements of opinion under Omnicare. For example, the First Circuit in Carbonite, Inc., 22 F.4th 1, held that a plaintiff adequately stated a Section 10(b) claim against a software company based on misleading statements by the company’s executives. Id. at 7. The plaintiffs in that case alleged that a software company misstated and misled investors as to the capabilities of a new data-backup product. Id. at 4-5. The complaint cited a statement made by the chief financial officer touting that the company “put something out that we think is just completely competitive and just a super strong product.” Id. at 7. The plaintiffs painted a different picture, claiming that the product “never worked.” Id. at 5. Despite being phrased in the form of a belief (“we think”), the First Circuit noted that the CFO’s opinion was precisely the type of actionable statement contemplated by Omnicare. Id. at 7–8. The court explained that the CFO’s statement “plausibly conveyed” several facts: first, that the CFO actually believed the product would be “completely competitive” and “super strong;” second, that the CFO’s belief “fairly align[ed] with the information” he possessed at the time; and third, that the CFO’s opinion was based on “the type of reasonable inquiry that an investor in context would expect to have been made.” Id. at 7 (citing Omnicare, 575 U.S. at 188–89). Because the complaint plausibly alleged that “at least one and possibly all three of these facts must be false,” it “sufficiently allege[d] that [the CFO] misled investors.” Id. at 8.
In Sheet Metal Workers Loc. 19 Pension Fund v. ProAssurance Corp., No. 2:20-CV-00856-AKK, 2021 WL 5866731, at *15 (N.D. Ala. Dec. 10, 2021), the court held that plaintiffs plausibly alleged that defendants’ statements of opinion “contained embedded statements of fact that the defendants allegedly knew were false or misleading,” which nullified the fact that “the defendants used the word ‘belief’ to couch some of their statements.” Similarly, in In re 2U, Inc. Sec. Class Action, No. CV TDC-19-3455, 2021 WL 3418841 (D. Md. Aug. 5, 2021), the District of Maryland found that some forward looking statements of opinion were nonetheless actionable where an officer expressed confidence in continued growth rates that were inconsistent with internal projections. Id. at *11. The officer noted that the positive projections were based on “information currently available,” despite the officer knowing that the growth rates were in fact declining. Id. Thus, the statement was materially misleading because the speaker “provided no warnings or other information that would have corrected a reasonable person’s reading of those statements.” Id.; see also Enzo Biochem, Inc. v. Harbert Discovery Fund, LP, No. 20-CV-9992 (PAC), 2021 WL 4443258, at *12 (S.D.N.Y. Sept. 27, 2021) (“Even if the [statements regarding the qualifications of the board candidates] were statements of opinion, liability could still attach under Section 14(a) if a jury were to find that [defendant] failed to accurately state its opinion in the proxy solicitations.”).
Although these cases illustrate that courts are willing to let certain complaints play out, even where the allegedly false or misleading statements include explicit language noting that the content is mere belief and opinion, Omnicare still presents a significant pleading barrier. For example, in Turnofsky v. electroCore, Inc., No. CV 19-18400, 2021 WL 3579057 (D.N.J. Aug. 13, 2021), the District of New Jersey relied on Omnicare to dismiss a Section 11 claim against a bioelectronic medicine company. Id. at *5. The plaintiffs alleged that electroCore, a company seeking to develop nerve stimulation technology, misrepresented its “competitive strengths” in its registration statement. Id. at *4. Although the registration statement noted that the company’s proprietary technology was “novel,” the complaint alleged that the opposite was true: “several other competitors were also being granted FDA clearance for the same [technology].” Id. The court disagreed, noting that the plaintiffs had not demonstrated the statements “were plausibly false” or even “materially misleading.” Id. at *5. The court also noted that the statements highlighted by the plaintiffs were opinions protected under Omnicare. Id. For example, the preamble to the registration statement included the language “we believe” immediately prior to the statements concerning the company’s “competitive strengths” and “novel” technology. Id. Additionally, the company’s statements did “not imply that similar medical devices were not entering the market” or that “competitors had not been granted FDA clearance.” Id.; see also, e.g., Sayce v. Forescout Techs., Inc., No. 20-CV-00076-SI, 2021 WL 4594768, at *6 (N.D. Cal. Oct. 6, 2021) (holding that a general belief in a favorable outcome, such as statements that the company “expect[ed]” and “look[ed] forward” to a closing, “[did] not create an affirmative impression or promise that [the closing]” would actually occur); In re Progenity, Inc., No. 20-CV-1683-CAB-AHG, 2021 WL 3929708, at *9 (S.D. Cal. Sept. 1, 2021) (finding the statement “we believe our business is resilient and we have observed positive signs of recovery so far” was not actionable under Omnicare); Employees’ Ret. Sys. of City of Baton Rouge & Par. of E. Baton Rouge v. MacroGenics, Inc., No. GJH-19-2713, 2021 WL 4459218, at *13 (D. Md. Sept. 29, 2021) (“[T]he statement that ‘we anticipate’ a positive trend to continue is also protected as a ‘sincere statement of pure opinion’ under Omnicare.”).
Another category of cases have held that an opinion is not actionable solely because there are underlying facts cutting against the opinion. In In re Philip Morris International, Inc. Securities Litigation, No. 1:18-CV-08049 (RA), 2021 WL 4135059, at *9 (S.D.N.Y. Sept. 10, 2021), the plaintiffs alleged that the defendants made false and misleading statements to the effect that studies of a cigarette alternative were “very encouraging,” and the product “has the potential to reduce the risk of smoking-related diseases.” The court considered the statements to be opinions because of the use of qualifiers such as “potential” or “likely” in connection with statements about the product’s reduction in harm from smoking cigarettes. Id. The defendants’ failure to disclose certain adverse test results was not actionable because “[i]t is well-established that a statement of opinion is not misleading simply because the issuer knows, but fails to disclose, some fact cutting the other way.” Id. (internal quotation marks omitted); see also Villare, 2021 WL 4311749 at *20 (explaining that “failure to include a fact that would have potentially undermined Defendants’ optimistic projections,” was not actionable because “Defendants were only tasked with making statements that fairly aligned with the information in the issuer’s possession at the time”) (internal quotation marks omitted)).
Courts continue to sort through what qualifies as a statement of opinion versus a statement of fact. A recent decision notes that the absence of language such as “I think” or “I believe” suggests that the statement is, indeed, a statement of fact. In re Quantumscape Securities Class Action Litig., No. 3:21-CV-00058-WHO, 2022 WL 137729, at *16 (N.D. Cal. Jan. 14, 2022) (“None of these statements use opinion-qualifying language such as ‘I think’ or ‘I believe.’ All express ‘certainty’ about an existing thing or occurrence.”). Other courts have taken a categorical approach, holding, for example, that “[a] goodwill determination is a statement of opinion.” SEC v. Sequential Brands Grp., Inc., No. 20-CV-10471 (JPO), 2021 WL 4482215, at *7 (S.D.N.Y. Sept. 30, 2021).
A recent federal district court decision also highlighted a “split in authority regarding whether” an audit report is an “opinion” subject to Omnicare. Hunt v. Bloom Energy Corp., No. 19-CV-02935-HSG, 2021 WL 4461171, at *13 (N.D. Cal. Sept. 29, 2021); compare Special Situations Fund III QP, L.P. v. Marrone Bio Innovations, Inc., 243 F. Supp. 3d 1109, 1116 (E.D. Cal. 2017) (“Omnicare did nothing to upset prior caselaw holding auditors liable for erroneous financial statements in registration statements.”) with Querub v. Hong Kong, 649 F. App’x 55, 58 (2d Cir. 2016) (applying Omnicare to an auditor’s report in a summary order), and Johnson v. CBD Energy Ltd., No. CV H-15-1668, 2016 WL 3654657, at *10 (S.D. Tex. July 6, 2016) (collecting cases).
Finally, several recent decisions have emphasized the significance of the context surrounding the statements in question to determine whether the opinion is actionable under Omnicare. In Delaware County Employees Retirement System v. Cabot Oil & Gas Corporation, No. CV H-21-2045, 2022 WL 112029, at *10 (S.D. Tex. Jan. 12, 2022), the Southern District of Texas granted a motion to dismiss a Section 10(b) claim because the context surrounding the allegedly impermissible statement mitigated any potential misunderstanding. There, plaintiffs alleged that an oil and gas company had misled investors by providing a general explanation of the “legal [and] regulatory requirements” in the industry. Id. The complaint alleged that these general statements of applicable regulations had “hid[den] the fact that [the company] had received Notices of Violation.” Id. The court rejected this notion by pointing to the fact the company, in the very same document as the statements the plaintiffs took issue with, had disclosed the “substantial costs and liabilities related to environmental compliance issues” it may face. Id. The court cited Omnicare for the proposition that an investor would read a statement “in light of all its surrounding text.” Id.; see also Turnofsky, 2021 WL 3579057 at *5 (finding that other sections of a registration statement had “disclosed competitors’ advantages,” thereby undermining the plaintiffs’ claim that the defendant had omitted that information; the court also noted that Omnicare commanded lower courts to “address the statement’s context”).
We will continue to monitor developments in these and similar cases.
VII. Halliburton II Market Efficiency And “Price Impact” Cases
We continue to follow developments as the federal courts interpret the Supreme Court’s 2014 decision in Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. 258 (2014) (“Halliburton II”), preserving the “fraud-on-the-market” presumption of class-wide reliance in Rule 10b-5 cases, but also permitting defendants to rebut this presumption at the class certification stage with evidence that the alleged misrepresentation did not impact the issuer’s stock price. As detailed in our 2021 Mid-Year Securities Litigation Update, the Supreme Court’s decision in Goldman Sachs Group, Inc. v. Arkansas Teacher Retirement System, 141 S. Ct. 1951 (2021) (“Goldman Sachs”), has resolved a number of recurring questions lower courts struggled with following the Halliburton II decision. There, the Court confirmed that in deciding whether to certify a class after defendants challenge the Basic presumption of reliance, the need to consider all evidence of price impact extends to considering the generic nature of allegedly fraudulent statements, even if such evidence overlaps with merits issues, such as loss causation or materiality. See id. at 1955, 1960–61. The Court also held that at the class certification stage defendants bear the burden of persuasion on the issue of price impact in order to rebut the presumption of reliance. Id. at 1962–63.
Another issue that was addressed by the Court in Goldman Sachs but not resolved was the so-called “inflation-maintenance theory,” used by plaintiffs to show price impact where the statement itself does not induce inflation but a later “corrective disclosure” is accompanied by a drop in the stock price. See Goldman Sachs, 141 S. Ct. at 1959 n.1, 1961. Although the Court expressly declined to take a position on the “validity or . . . contours” of the inflation-maintenance theory, it noted that the mismatch between generic misrepresentations and later, specific corrective disclosures will be a key consideration in the price-impact analysis, and that where such a mismatch exists, “there is less reason to infer front-end price inflation . . . from the back-end price drop.” Id.
On remand, the Second Circuit found that it was unclear whether the district court considered the generic nature of the alleged misrepresentations, and therefore remanded the case for the district court to consider the parties’ price impact arguments a third time. Arkansas Tchr. Ret. Sys. v. Goldman Sachs Grp., Inc., 11 F.4th 138, 143 (2d Cir. 2021).
Back in the District Court, Judge Crotty considered the parties’ price impact evidence again in light of the Supreme Court’s enhanced guidance, including the extent of the “mismatch” between the alleged misstatements and alleged corrective disclosures on a “sliding scale.” In re Goldman Sachs Grp., Inc. Sec. Litig., 2021 WL 5826285, at *13–14 (S.D.N.Y. Dec. 8, 2021). The court again held that plaintiff linked the stock price drops to both the corrective disclosures and the alleged misstatements and that defendants failed to sever that link. Id. at *9–10. It also held that the statements were not so generic “as to diminish their power to maintain pre-existing price inflation,” but rather “did in fact maintain price inflation.” Id. at *11. Judge Crotty also held that, although the challenged statements and corrective disclosures “do not present equivalent levels of genericness,” defendants failed to identify a sufficient “mismatch” to undermine the inference of price impact. Id. at *14. Following Judge Crotty’s third certification order, Goldman Sachs has appealed the decision to the Second Circuit for the third time.
We will continue to follow the Goldman Sachs case and other developments in this area. We anticipate that upcoming opinions will continue to address the extent to which a mismatch between the challenged statement and corrective disclosure can undermine the evidence of price impact in cases based on inflation-maintenance theory, and we will report on significant matters in future updates.
VIII. Other Notable Developments
A. Second Circuit Revives Class Action Because Section 10(b) Does Not Require That Misstatements Concern An Underlying “Fraudulent Scheme Or Practice”
In In re Hain Celestial Group, Inc. Securities Litigation, 20 F.4th 131 (2d Cir. 2021), the Second Circuit vacated the dismissal of securities fraud claims brought under Section 10(b) of the Exchange Act and Rule 10b-5. The plaintiff investors alleged that the defendant health food product company had engaged in “channel stuffing,” “whereby valuable and unsustainable sales incentives—including price reductions and grants of an absolute right to return unsold merchandise—were given near the end of each quarter to Hain’s largest distributors to induce them to buy more product than needed so that Hain would meet its quarterly sales targets and analysts’ estimates.” Id. at 132–33. The plaintiff class argued both that the defendants’ failure to attribute Hain’s performance to channel stuffing in various financial statements rendered those statements materially misleading, in violation of Rule 10b-5(b), and that the channel stuffing itself constituted an unlawful scheme to defraud investors, in violation of Rule 10b-5(a) and (c). In re Hain Celestial Grp. Inc. Sec. Litig., 2020 WL 1676762, at *9 (E.D.N.Y. Apr. 6, 2020). The district court rejected these arguments and dismissed the complaint entirely. It first held that the alleged channel stuffing constituted a legitimate business practice, and therefore could not be the predicate for liability under Rule 10b-5(a) or (c). Id. at *12. The district court also rejected the Rule 10b-5(b) claim, because “its predicate is the illegitimacy of the channel stuffing practices the Court already found to be legitimate” and “the Defendants were under no generalized obligation to disclose wholly legal sales incentives simply because the Lead Plaintiffs allege those incentives to be unsustainable.” Id.
On appeal, the plaintiffs challenged only the Rule 10b-5(b) dismissal. In re Hain, 20 F.4th at 136. The Second Circuit vacated the dismissal of that claim, holding that “[t]he district court mistakenly imported the requirement of clauses (a) and (c) of a fraudulent scheme or practice into clause (b), which includes no such requirement.” Id. The appellate court explained that “[t]he success of . . . a complaint in alleging a violation of clause (b) does not depend on whether the alleged channel stuffing practices themselves were fraudulent or otherwise illegal.” Id. at 137. In doing so, however, the Second Circuit did not address the district court’s analysis of prior Circuit precedent holding that, “up to a point, companies must be permitted to operate with a hopeful outlook, and that as a result, executives are not required to take a gloomy, fearful or defeatist view of the future.” In re Hain, 2020 WL 1676762, at *13 (internal quotation marks omitted). Nor did the Second Circuit address the district court’s reliance on past district court decisions finding that companies are not obligated to disclose “unsustainable” practices “where [they] engaged in no misconduct and the statements at issue attributed the company’s growth to broad trends and corporate strengths, without pointing to any specific factors or sources of revenue.” Id. at *14 (internal quotation marks and alterations omitted). Instead, the Second Circuit only instructed the district court to consider anew whether a Rule 10b-5(b) claim had been adequately pleaded. See In re Hain, 20 F.4th at 138. This decision indicates that corporations and executives could be exposed to securities fraud liability if they fail to accurately attribute financial performance to unsustainable practices, even if those practices are wholly legitimate.
B. Ninth Circuit Finds Statutory Standing For Purchaser In Direct Listing
In Pirani v. Slack Technologies, Inc., 13 F.4th 940 (9th Cir. 2021), the Ninth Circuit became the first court of appeals to address whether purchasers of shares sold in a direct listing had statutory standing to assert claims under Sections 11 and 12 of the Securities Act. In a 2-1 decision, the panel majority affirmed the district court’s holding that shareholders do have standing to bring such claims.
In 2018, the New York Stock Exchange introduced a rule, approved by the SEC, that allows companies to go public through a Selling Shareholder Direct Floor Listing (a “direct listing”). Id. at 944. Under this procedure, the company does not issue or sell any new shares. Instead it files a registration statement “solely for the purpose of allowing existing shareholders to sell their shares on the exchange.” Id. at 944. This procedure differs from a traditional initial public offering (“IPO”), in which all of the shares sold to the public are newly issued shares that are all registered under a registration statement. Id. at 943. Another major difference between a direct listing and an IPO is that in a direct listing, both shares registered under the registration statement and shares that are not registered (because they are exempt from the registration requirements of the Securities Act pursuant to SEC Rule 144) may be sold as soon as the company goes public. See id. By contrast, in an IPO, unregistered shares typically are subject to a lock-up period which prevents them from being sold when a company first goes public. Id. This means that all of the shares that initially trade after an IPO are registered. Id. at 943. Therefore, whereas an investor would know that any shares purchased following an IPO must be registered, an investor who purchased shares following a direct listing would have no way of knowing whether the shares he purchased were registered or unregistered. Id. at 944.
In June 2019, Slack went public through a direct listing, which permitted its existing shareholders to sell up to 118 million registered shares and 165 million unregistered shares. Id. The plaintiff purchased 30,000 Slack shares on the day of the public listing, and 220,000 additional shares in ensuing months. Id. He later brought claims under Sections 11 and 12 of the Securities Act, alleging that the registration statement Slack issued in connection with the direct listing omitted material information that rendered Slack’s disclosures misleading. Id. at 944–45. The question presented to the Ninth Circuit was whether the plaintiff had statutory standing to bring these claims despite the fact that he had no knowledge of whether the shares he purchased were registered under the challenged registration statement. Id. at 945.
Under well-settled precedent, a plaintiff must be able to trace the shares he purchased to those registered under the registration statement being challenged in order to have statutory standing. Courts have consistently held that it is nearly impossible for plaintiffs to trace in cases involving “successive registrations, whereby a company issues a secondary offering to the public such that there are multiple registration statements under which a share may be registered,” because plaintiffs will not know whether the shares they purchased came from the challenged registration statement instead of another registration statement. Id. at 946. Slack argued this same problem was present in its direct listing because the market contained both shares registered under the challenged registration statement (which may confer standing) and many more shares that were unregistered (which may not). Id. at 948. Nevertheless, the panel majority concluded that the plaintiff had standing “[b]ecause this case involves only one registration statement” and “does not present the traceability problem identified by [the Ninth Circuit] in cases with successive registrations.” Id. at 947. The panel majority reasoned that both registered and unregistered shares could confer standing because, under NYSE direct listing rules, both could be sold on the exchange only because Slack had an effective registration statement. Id. The panel majority further reasoned that a contrary interpretation would “create a loophole” exempting issuers from Section 11 and Section 12 liability so long as they go public via a direct listing. Id. at 948.
Judge Miller dissented, arguing that the majority improperly based its holding on the text of NYSE rules instead of the text of the statutes at issue; that there was no principled distinction between successive-registration cases and this one; and that the majority’s reliance on policy arguments was improper. Id. at 952–53 (Miller, J., dissenting). Defendants have petitioned for rehearing and rehearing en banc, and that petition remains pending. Gibson Dunn represents Slack in this litigation.
C. California Court Finds Transactions In Unlisted American Depositary Receipts Not Domestic Under “Irrevocable Liability” Test
Judge Pregerson of the District Court for the Central District of California denied a motion for class certification in a putative class action brought by two pension funds against Toshiba. Stoyas v. Toshiba Corp., 2022 WL 220920, at *1 (C.D. Cal. Jan. 25, 2022). The action began in 2015, when plaintiffs brought claims under Sections 10(b) and 20(a) of the Exchange Act against Toshiba, alleging substantial accounting improprieties. Stoyas v. Toshiba Corp., 896 F.3d 933, 937–38 (9th Cir. 2018). The case was initially dismissed on extraterritoriality grounds, but the Ninth Circuit revived the case in a widely covered 2018 opinion. See id. at 938, 952. On remand, the plaintiffs, who purchased Toshiba’s American Depositary Receipts (“ADRs”) on the over-the-counter (“OTC”) market, moved to certify a class on behalf of two groups of purchasers: OTC purchasers of Toshiba securities and all citizens and residents of the U.S. who purchased Toshiba common stock. Stoyas, 2022 WL 220920, at *2.
The court denied plaintiffs’ motion for class certification on Rule 23(a) typicality grounds, concluding that there was no typicality because at least one of the named plaintiffs had purchased its ADRs in foreign transactions. Id. at *3. In reaching this conclusion, the court specifically noted that that plaintiff’s “ability to acquire ADRs was contingent upon the purchase of underlying shares of common stock [in Japan] that could be converted into ADRs,” and that, once the underlying common stock was acquired, the plaintiff was “bound to take and pay for the ADRs, once converted.” Id. at *4. Thus, the “triggering event” that caused that plaintiff to “incur irrevocable liability occurred in Japan,” and, thus, that plaintiff’s purchase of ADRs was a “foreign transaction” as defined by the Ninth Circuit’s Stoyas opinion. Id. at *5. Accordingly, the court denied the plaintiffs’ motion for class certification. Id.
D. Second Circuit Upholds Dismissal Of Class Action Reaffirming That Corporate Mismanagement Is Not Securities Fraud
On August 25, 2021, the Second Circuit in Plumber & Steamfitters Local 773 Pension Fund v. Danske Bank A/S, 11 F.4th 90 (2d Cir. 2021), affirmed a district court decision dismissing a securities class action complaint brought by three pension funds, which alleged that Danske Bank had covered up a money-laundering scandal. Id. at 95, 106. In 2016, “the Danish Financial Supervisory Authority (DFSA) reprimanded and later fined Danske Bank for compliance shortcomings” related to its Estonian branch, and in the next few years it came to light that “over $200 billion worth of [that branch’s] transactions were suspect.” Id. at 95, 97. In their complaint, the plaintiffs argued that Danske Bank had made actionable misstatements or omissions in its financial statements. Id. at 98. Specifically, the plaintiffs alleged that “ill-gotten profits from the Estonian Branch were baked into” the bank’s financial results and that it was “misleading for Danske to release those numbers without simultaneously disclosing what it knew about possible money laundering at the branch.” Id.
The Second Circuit affirmed the dismissal of the action in full, stating that “the allegations do not move the claims outside the realm of corporate mismanagement and into the realm of securities fraud.” Id. at 96. The court emphasized that “companies do not have a duty to disclose uncharged, unadjudicated wrongdoing” and noted that “accurately reported financial statements do not automatically become misleading by virtue of the company’s nondisclosure of suspected misconduct that may have contributed to the financial results.” Id. at 98–99. To hold otherwise would mean that “every company whose quarterly financial reports include revenue from transactions that violated [anti-money laundering or] AML regulations could be sued for securities fraud.” Id. at 99. With regard to alleged omissions in statements made by Danske Bank in 2014 concerning a $326 million goodwill impairment, the court noted that “[o]ld information tends to become less salient to a prospective purchaser as the market is influenced by new information,” meaning “materiality can have a half-life.” Id. at 101. Thus, the court concluded that the 2014 statements made by Danske Bank were “too remote in time to have assumed actual significance in the deliberations of a purchaser in 2018” given the “intervening load of information” about the Estonian branch’s AML issues between 2016 and 2018. Id. at 102 (internal quotation marks omitted).
The following Gibson Dunn attorneys assisted in preparing this client update: Jefferson Bell, Shireen Barday, Chris Belelieu, Michael Celio, Monica Loseman, Brian Lutz, Mark Perry, Craig Varnen, Lissa Percopo, Mark H. Mixon, Jr., Alisha Siqueira, Tim Deal, Marc Aaron Takagaki, Lindsey Young, Katy Baker, Andrew G. Barron, Andrew Bernstein, Lizzy Brilliant, Priya Datta, Leon S. Freyermuth, Brenna L. Gibbs, Nathalie Gunasekera, Andrew Howard, Erica L. Jansson, Cody Johnson, Ina Kosova, Lydia Lulkin, Adrian Melendez-Cooper, Zachary Montgomery, Megan R. Murphy, Jeffrey Myers, Zachary Piaker, Hannah Regan-Smith, Mari Vila, and Jasmine L. Vitug.
Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following members of the Securities Litigation practice group:
Monica K. Loseman – Co-Chair, Denver (+1 303-298-5784, [email protected])
Brian M. Lutz – Co-Chair, San Francisco/New York (+1 415-393-8379/+1 212-351-3881, [email protected])
Craig Varnen – Co-Chair, Los Angeles (+1 213-229-7922, [email protected])
Shireen A. Barday – New York (+1 212-351-2621, [email protected])
Christopher D. Belelieu – New York (+1 212-351-3801, [email protected])
Jefferson Bell – New York (+1 212-351-2395, [email protected])
Matthew L. Biben – New York (+1 212-351-6300, [email protected])
Michael D. Celio – Palo Alto (+1 650-849-5326, [email protected])
Paul J. Collins – Palo Alto (+1 650-849-5309, [email protected])
Jennifer L. Conn – New York (+1 212-351-4086, [email protected])
Thad A. Davis – San Francisco (+1 415-393-8251, [email protected])
Ethan Dettmer – San Francisco (+1 415-393-8292, [email protected])
Mark A. Kirsch – New York (+1 212-351-2662, [email protected])
Jason J. Mendro – Washington, D.C. (+1 202-887-3726, [email protected])
Alex Mircheff – Los Angeles (+1 213-229-7307, [email protected])
Robert F. Serio – New York (+1 212-351-3917, [email protected])
Robert C. Walters – Dallas (+1 214-698-3114, [email protected])
Avi Weitzman – New York (+1 212-351-2465, [email protected])
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
What you need to know now.
On Wednesday, February 9, 2022, the SEC proposed changes to its rules for investment advisers to private funds. The proposal, if adopted, will be a seismic shift in the regulatory landscape for private fund advisers.
We plan to share a detailed analysis soon. For now, please find below a quick Q&A update.
Q1: What is in the proposal?
A1: New requirements and prohibitions.
New Requirements
The new rules, if adopted as proposed, will require a private fund adviser to:
- Provide fund investors with quarterly statements that include standardized disclosures on fees and expenses (generated at the fund and portfolio investment levels) and investment performance (with distinct requirements for liquid and illiquid funds);
- For purposes of calculating IRR and MOIC, performance must be presented on an unlevered basis;
- Obtain annual audited financial statements for each fund advised by the adviser, and deliver the audited financial statements to each of the fund’s investors;
- Obtain an independent, professional fairness opinion for all “adviser-led secondary transactions” and deliver copies of the opinion to investors participating in the transaction;
- Prepare and retain a written report of the adviser’s annual compliance program review;
- Disclose to all prospective investors in a fund, prior to investment, the details of any preferential rights granted to any of the fund’s investors;* and
- Disclose annually to all fund investors the details of any preferential rights granted to any of the fund’s investors.*
*The last two bullets apply to all private fund advisers, including those that are not required to register.
New Prohibitions
The new rules, if adopted as proposed, will prohibit all registered and exempt-reporting advisers to private funds from:
- Providing preferential treatment to one or more investors with respect to (i) redemption or other liquidity rights, or (ii) access to information regarding portfolio investments and exposures;
- Accelerating the payment of portfolio company monitoring fees;
- Allocating to a fund costs related to government examinations or investigations of the adviser;
- Allocating to a fund adviser-level regulatory or compliance related costs;
- Allocating costs related to portfolio investments held by multiple funds and co-investment vehicles on a non pro rata basis;
- Returning clawbacks of carried interest net of taxes;
- Benefiting from any indemnification or limitations of liability for breach of fiduciary duty, willful malfeasance, bad faith, recklessness or simple negligence; and
- Borrowing from a fund.
Q2: I am an adviser that already prepares audited financial statements for our fund(s). How does the new audit requirement differ from the Custody Rule’s audit requirement?
A2: The proposed audit requirement differs from the Custody Rule’s audit requirement in a number of respects. For example, the proposed rules:
- Require the adviser to take “all reasonable steps” to cause funds advised but not controlled by the adviser (e.g., sub-advised funds) to prepare and deliver audited financial statements;
- Require advisers to “promptly” deliver statements after completion of the audit (instead of within 120 days of the fund’s fiscal year end);
- Require the auditor to notify the SEC if (i) the auditor resigns or is terminated, or (ii) the auditor is unable to deliver a clean opinion.
If you do not already prepare audited financial statements for the fund(s) you manage: The new rules do not have a surprise audit alternative.
Q3: What is an “adviser-led secondary transaction” that requires a professional, independent fairness opinion?
A3: An adviser-led secondary transaction is defined as a transaction in fund interests initiated by the investment adviser that offers fund investors a choice to either:
- sell all or a portion of their interests in the fund; or
- convert or exchange all or a portion of their interests in the fund for interests in another vehicle advised by the adviser or its related persons.
Secondary transactions in which an adviser provides assistance on an LP’s request, but is not involved in setting the price for the transaction, would not be considered “adviser-led.”
Q4: What about my business would change under the proposed rules?
A4: It depends. Much of the proposal aligns with current industry best practices and is already part of business-as-usual for private fund advisers with sophisticated institutional clients. For example, many advisers already:
- Provide quarterly statements (albeit the form and content of these statements may have to change to comply with the new proposed requirements);
- Prepare and provide audited financial statements for their funds; and
- Obtain fairness opinions in connection with fund restructurings, continuation funds and other secondary transactions;
- Document the results of their annual compliance program reviews in writing.
However, other aspects of the proposal represent costly, time consuming and logistically challenging undertakings. For example:
- The proposed new disclosure requirements with respect to preferential treatment will be burdensome and logistically challenging to implement as compared to current practices regarding side letters and fund closing processes; and
- The prohibitions on returning clawbacks net of taxes and indemnification for simple negligence are inconsistent with market practice.
Q5: When will we know whether the rules will be adopted?
A5: We will not know for months, perhaps years. Market participants will have 30 days after the proposal is published in the Federal Register or until April 11, 2022, whichever is later, to submit comments on the proposal to the SEC. There is no proscribed timeline thereafter by which final rules must be completed and released.
Q6: If the proposed rules are not yet adopted, why should I care now?
A6: You should care for at least two reasons:
- In a recent Risk Alert, the SEC’s Examination Division highlighted a number of the issues identified in the rules proposal. The SEC could regulate through examination and enforcement in advance of the Commission completing a final rulemaking.
- The proposal has been a long time coming and many significant components of the proposal are likely to be adopted. Chair Gensler, Commissioners Lee and Crenshaw all issued similar, full-throated endorsements of the proposal. However, Commissioner Pierce issued a dissenting statement and voted against the proposal. The proposal has been met with nearly instantaneous and strenuous objections from the private fund industry. Accordingly, we expect a robust comment process that may lead to modifications before the final rules are adopted.
Q7: How did we get here?
A7: The SEC’s focus on the private fund industry has steadily grown since 2010 and has dramatically intensified over the last year.
- In December 2020, the SEC replaced the advertising and solicitation rules for advisers, with the new Marketing Rule. The new rule significantly impacts communications between private fund advisers and investors in private funds. Compliance is required by November 2022.
- In the SEC’s Spring 2021 regulatory agenda, the new SEC Chair included increased regulation of the private fund industry – alongside cryptocurrency, SPACs, and ESG disclosures – as one of his top regulatory priorities.
- In November 2021, Chair Gensler told the ILPA Summit that the time has come to “take stock” and “bring sunshine and competition to the private fund space” because private funds – which manage $17 trillion – play an important role in the country’s capital markets.
- On January 26, 2022, the SEC proposed updates to reporting requirements on Form PF.
- On January 27, 2022, the Examination Division released the Risk Alert referenced above, entitled “Observations from Examinations of Private Fund Advisers.”
- On February 9, 2022, the SEC issued its 341-page rules proposal for increased regulation of advisers to private funds.
- On February 9, 2022, the SEC also proposed cybersecurity-related rules for investment advisers that would, among other things, require firms to (1) disclose cybersecurity risks and incidents on the Form ADV 2A and (2) report significant cybersecurity incidents on a new Form ADV-C. The comment period for the proposal is the same as described in A5 above.
Q8: Is there anything else I need to know?
A8: Yes. We will soon publish a more detailed analysis of the Feb. 9 proposals. In the meantime, we note that all investment advisers are required to comply with the new Marketing Rule by no later than November 5, 2022. We strongly recommend that you begin planning for this deadline now. As a practical matter, we suggest drafting any offering documents or marketing materials with new Rule’s disclosure standards in mind, especially if you anticipate using the materials after your firm converts over to compliance with the new Rule.
The following Gibson Dunn attorneys assisted in preparing this client update: Gregory Merz, Lauren Cook Jackson, and Crystal Becker.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Investment Funds practice group, or any of the following:
Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, [email protected])
Albert S. Cho – Hong Kong (+852 2214 3811, [email protected])
Candice S. Choh – Los Angeles (+1 310-552-8658, [email protected])
John Fadely – Hong Kong (+852 2214 3810, [email protected])
A.J. Frey – Washington, D.C. (+1 202-887-3793, [email protected])
Y. Shukie Grossman – New York (+1 212-351-2369, [email protected])
John Senior – New York (+1 212-351-2391, [email protected])
Roger D. Singer – New York (+1 212-351-3888, [email protected])
Edward D. Sopher – New York (+1 212-351-3918, [email protected])
C. William Thomas, Jr. – Washington, D.C. (+1 202-887-3735, [email protected])
Gregory Merz – Washington, D.C. (+1 202-887-3637, [email protected])
Lauren Cook Jackson – Washington, D.C. (+1 202-955-8293, [email protected])
Crystal Becker – New York (+1 212-351-2679, [email protected])
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
On February 9, 2022, the Securities and Exchange Commission (the “Commission”) announced a proposed rule to shorten the standard settlement cycle for most broker-dealer transactions from two business days after the trade date (“T+2″) to one business day after the trade date (“T+1″), while soliciting comments regarding challenges and possible approaches to achieving settlement by the end of trade date (“T+0″). To facilitate a T+1 settlement process, the Commission is proposing new requirements designed to protect investors, reduce risk between a transaction and its completion, and increase operational efficiency. The proposed rules and rule amendments would establish a compliance date of March 31, 2024.
The following Gibson Dunn attorneys assisted in preparing this update: Alan Bannister, Boris Dolgonos, Andrew Fabens, Hillary Holmes, Peter Wardle, Rodrigo Surcan, Thomas Canny, Harrison Tucker, and Justine Robinson.
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
The real estate leasing market is booming in some locations and industries, but restructurings may be on the horizon with rising interest rates and the ongoing impact of COVID. Join our panel of experts for a recorded discussion on how leases could be treated in bankruptcy, including (a) whether the leases will be treated as “residential” or “non-residential” and why you should care; (b) whether your master lease will withstand an attempt to treat it as severable, capable of partial rejection and assumption; (c) whether your lease could be recharacterized as an unsecured disguised financing; (d) the enforceability of a right of first refusal; and (e) the impact of bankruptcy on a month-to-month tenancy, as well as strategies you can implement now to mitigate risks in the next cycle.
PANELISTS:
Robert A. Klyman is a Partner in the Los Angeles office of Gibson, Dunn & Crutcher and Co-Chair of Gibson Dunn’s Business Restructuring and Reorganization Practice Group. In his international practice, Mr. Klyman represents companies, lenders, ad hoc groups of secured and unsecured creditors, acquirers and boards of directors in all phases of restructurings and workouts. His experience includes representing lenders and bondholders in complex workouts; advising debtors in connection with traditional, prepackaged and ‘pre-negotiated’ bankruptcies; counseling strategic and financial players who acquire debt or provide financing as a path to take control of companies in bankruptcy; structuring and implementing numerous asset sales through Section 363 of the Bankruptcy Code; and litigating complex bankruptcy and commercial matters arising in chapter 11 cases, both at trial and on appeal.
Steven Klein is a Partner in the New York office of Gibson, Dunn & Crutcher and is a member of Gibson Dunn’s Real Estate Practice Group. Mr. Klein’s practice covers a broad range of real estate transactions, including acquisitions and dispositions, joint ventures, financings, leasing, construction and development, restructurings and recapitalizations. He also has substantial experience in REIT offerings, REIT mergers and formation of investment funds. He has advised clients on securitized funding agreements, permanent and mezzanine loan agreements, loan restructuring agreements, partnership and limited liability company agreements, private placement memoranda, property management agreements, retail and office leases and regional shopping centre agreements.
Kim Schlanger is a Partner in the Houston office of Gibson, Dunn & Crutcher and a member of the firm’s Real Estate Practice Group. Ms. Schlanger’s practice covers a broad range of commercial real estate transactions, including advising developers and investors in connection with the development, financing, acquisition and disposition of a variety of asset classes, including office buildings, multi-family developments, hotels and mixed-use projects throughout the United States. She has been involved in the development of many landmark buildings across the country. Ms. Schlanger has extensive experience in the structuring and negotiation of joint venture agreements (both single-asset and “programmatic”) for the purpose of commercial and residential real estate acquisition and development.
Matthew G. Bouslog is Of Counsel in the Orange County office of Gibson, Dunn & Crutcher LLP where he practices in the firm’s Business Restructuring and Reorganization Practice Group. Mr. Bouslog specializes in representing companies in complex restructuring matters. Mr. Bouslog was recognized in 2021 Best Lawyers: Ones to Watch for his work in (i) Bankruptcy and Creditor Debtor Rights / Insolvency and Reorganization Law and (ii) Real Estate Law. Mr. Bouslog frequently represents debtors, creditors, and other interested parties in out-of-court and in-court restructurings, distressed acquisitions, and bankruptcy-related litigation.
Michael Farag is an associate in the Los Angeles office of Gibson, Dunn & Crutcher. He currently practices with the firm’s Business Restructuring and Reorganization Practice Group. Mr. Farag focuses on complex restructuring and insolvency proceedings. Prior to joining the firm, Mr. Farag served as a judicial law clerk in the United States Bankruptcy Court for the Central District of California, first for the Honorable Martin R. Barash, then for the Honorable Robert N. Kwan.
MCLE CREDIT INFORMATION:
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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.
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In what one Member of Congress described as “the most significant labor legislation of this century,” Congress just passed a bill that would allow employees to avoid enforcement of any pre-dispute agreements that require employees to arbitrate sexual assault or harassment claims, which President Biden seems prepared to sign into law. While there have been several unsuccessful attempts over the years to pass such a law, this bill appears to be headed for enactment.
On Monday, February 7, the U.S. House of Representatives passed HR 4445, titled the “Ending Forced Arbitration of Sexual Assault and Sexual Harassment Act of 2021,” by a vote of 335 to 97, and the Senate just passed it by voice vote yesterday morning. The bill renders unenforceable with respect to sexual assault or harassment claims at the employee’s discretion any predispute arbitration agreement that requires employees to arbitrate disputes involving nonconsensual and/or unwanted sexual acts or contact, advances, physical contact that is sexual in nature, sexual attention, sexual comments and propositions for sexual activity, conditioning employment benefits on sexual activity, or retaliation for rejecting unwanted sexual attention. This limitation would cover any agreement involving such conduct regardless of whether the claims at issue arise under federal, state, local, or tribal law. For context, this bill expands upon the laws of certain states, such as New York, which bar the forced arbitration of sexual assault and harassment claims, as well as the federal Franken Amendment, which does the same for federal contractors under certain circumstances.
In addition, HR 4445 would render unenforceable, again at the employee’s discretion and with respect to the above claims, predispute joint-action waivers that bar employees from participating in joint, class, or collective actions concerning sexual assault or harassment claims brought in a judicial, arbitral, administrative, or any other forum. This limitation would apply to such waivers found in arbitration agreements, as well as to waivers found elsewhere in other employment agreements. The bill would also explicitly require courts, rather than arbitrators, to determine both the applicability of HR 4445 to a given arbitration agreement and the validity and enforceability of any agreement to which the bill applies, regardless of whether the agreement at issue delegates such authority to an arbitrator.
Significantly, the bill specifies that it will not apply retroactively to any claims that arose or accrued prior to its enactment. The bill also gives potential plaintiffs the option to pursue arbitration if they so elect.
As previewed above, in a Statement of Administration Policy issued on February 1, the White House stated that it supports the bill’s passage, and that it looked forward to “broader legislation” to address “other forced arbitration matters, including arbitration of claims regarding discrimination on the basis of race, wage theft, and unfair labor practices.” Otherwise stated, HR 4445 will soon be law, and might well be a harbinger of other changes to come relating to arbitration agreements in other contexts.
Given its significance, it is likely that these new requirements will be litigated in the near future, which could bring some clarity regarding the precise scope of this bill. As always, Gibson Dunn attorneys are available to answer any questions you may have regarding HR 4445, including but not limited to how it might relate to your company’s existing arbitration agreements.
The following Gibson Dunn lawyers contributed to this client update: Jason C. Schwartz, Katherine V.A. Smith, Joshua S. Lipshutz, Jesse A. Cripps, Theane Evangelis, Michael Holecek, Gabrielle Levin, Danielle J. Moss, Harris M. Mufson, Tiffany Phan, Hayley Fritchie, and Jacob Rierson.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Labor and Employment or Class Actions practice groups, or the following authors:
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])
Joshua S. Lipshutz – Washington, D.C. (+1 202-955-8217, [email protected])
Jesse A. Cripps – Los Angeles (+1 213-229-7792, [email protected])
Theane Evangelis – Co-Chair, Litigation Practice Group, Los Angeles (+1 213-229-7726, [email protected])
Michael Holecek – Los Angeles (+1 213-229-7018, [email protected])
Gabrielle Levin – New York (+1 212-351-3901, [email protected])
Danielle J. Moss – New York (+1 212-351-6338, [email protected])
Harris M. Mufson – New York (+1 212-351-3805, [email protected])
Tiffany Phan – Los Angeles (+1 213-229-7522, [email protected])
© 2022 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
Happy New Year of the Tiger to our clients and friends!
2021 was the year where the PRC Government launched a broad regulatory assault on Chinese “Big Tech” companies. The State Administration for Market Regulation (“SAMR”) did its part by imposing significant fines on Alibaba and Meituan for abuses of dominance, and administrative penalties in more than 100 cases for failure to notify, over 80 of which involved platform companies, such as Alibaba, Baidu, Didi, Meituan, Suning, and JD.com. The Government also released the Anti-Monopoly Guidelines for the Platform Economy Sector in February 2021 to provide guidance on enforcement in the tech space.
On the merger front, SAMR reviewed approximately 700 transactions, imposed remedies on four of them, and, more significantly, blocked one transaction – this is only the third time that China’s antitrust authority has ever done so.
2022 should see a continued increase in antitrust enforcement. In this respect, SAMR’s Anti-Monopoly Bureau has been elevated in the Chinese bureaucracy, which signals its importance to the Government.
The Government also published its Draft Amendment to the Anti-Monopoly Law (“AML”) for public comment in October 2021 and the proposed changes could be adopted in 2022.
1. Legislative / Regulatory Developments
Anti-Monopoly Guidelines for the Platform Economy Sector (“Platform Guidelines”). In February 2021, SAMR issued specific guidance on the applicability of the AML to digital platforms, including e-commerce and social media companies. The Platform Guidelines confirm that transactions involving variable interest entities (“VIE”) are subject to merger review, and grant SAMR broad discretion to investigate transactions involving digital platforms. They also set out the types of agreements that may constitute monopoly agreements in the platform economy context, some of which go beyond the traditional written or verbal agreements or meeting of minds. For example, under the Platform Guidelines, the use of technical methods, data, and algorithms may constitute a horizontal or vertical monopoly agreement, and a most favoured nation (“MFN”) clause may constitute a vertical monopoly agreement. In addition, the Platform Guidelines provide that an undertaking’s ability to control and process data will be taken into account by SAMR when reviewing abuse of dominance cases, both in assessing market dominance and in analysing conduct (e.g. an undertaking penalizing uncooperative operators with traffic restrictions or search downgrades).
For more detail on the Platform Guidelines, please refer to our client alert, Antitrust in China – 2020 Year in Review, published on March 4, 2021.
Draft Amendment to the Anti-Monopoly Law (“Draft Amendments to the AML”). After over a decade, China has taken a major step towards introducing critical changes to the AML, which came into force in 2008. Following SAMR’s publication of the first draft of the amendments to the AML in early 2020, the Standing Committee of the National People’s Congress (“NPCSC”) released its Draft Amendments to the AML for public consultation on October 23, 2021. The public consultation period closed on November 21, 2021.
The Draft Amendments to the AML propose changes that affect all aspects of the AML, including merger control, non-merger enforcement, and procedural rules. In particular, they impose significantly harsher penalties on undertakings for failure to file, and introduce fines against individuals for engaging in anticompetitive behaviour.
Moreover, the Draft Amendments to the AML propose new provisions targeting platform companies, specifically noting that (1) undertakings “shall not exclude or restrict competition by abusing the advantages in data and algorithms, technology and capital and platform rules,” and that (2) it would be considered an abuse of dominance if an undertaking with a dominant market position “uses data, algorithms, technologies and rules of the platform to erect obstacles and impose unreasonable restrictions on other undertakings.” The new provisions signal the continued focus of China’s antitrust enforcement on the platform economy.
Other notable proposed amendments include the introduction of the “stop-the-clock” mechanism (thus giving SAMR greater flexibility to extend the merger review process), abandoning the per se treatment of resale price maintenance (though the burden of proof lies with undertakings), providing a safe harbour for monopoly agreements, and expressly imposing liability on cartel facilitators.
In terms of next steps, the NPCSC will review the feedback received and further deliberate on the amendments before signing them into law. While there is no official announcement on the timing, it is expected that the NPCSC would finalize and pass the amendments in 2022.
For more detail on the Draft Amendments to the AML, please refer to our client alert, China Publishes Draft Amendment to the Anti-Monopoly Law, published on October 27, 2021.
Elevation of Status of Anti-Monopoly Bureau. In November 2021, the Anti-Monopoly Bureau, which was a subdivision under SAMR, was promoted to the deputy ministerial level. While the Bureau remains subject to SAMR supervision, this elevated status ensures that it will benefit from increased manpower and budget and demonstrates the Chinese government’s commitment to further strengthening antitrust enforcement.
Under the revamped organization, the deputy ministerial-level agency contains three divisions that focus on (1) policy implementation, (2) merger control and investigation of gun-jumping, and (3) supervision of monopoly agreements and abuse of market dominance. Most notably, in the latter two divisions, there is a subdivision that specifically targets the platform economy, further underscoring China’s determination to closely scrutinize potential anticompetitive behaviour in the technology sector.
2. Merger Control
In 2021, SAMR unconditionally approved more than 99% of approximately the 700 deals it reviewed and imposed conditions in only four transactions. However, it blocked one transaction—the proposed merger between HUYA Inc. (“Huya”) and DouYu International Holdings Limited (“DouYu”). This is only the third time that a Chinese antitrust authority has blocked a merger since the inception of China’s merger control regime in 2008.
Like in 2020, SAMR took on average 14-15 days to complete its review of cases under the simplified procedure. It took an average of 288 days to complete its review of conditionally approved cases, and 187 days to complete its review of the single blocked transaction.
Separately, SAMR announced that they penalized parties in almost 100 transactions for failure to notify. This represents a nearly sevenfold increase in the number of failure to notify cases compared with 2020.
2.1 Prohibition Decision
In July 2021, SAMR prohibited the proposed merger between Huya, a company controlled by Tencent, and DouYu, in which SAMR found Tencent exercised joint control with DouYu’s founder team. Both companies provide videogame live-streaming services. According to SAMR, the proposed merger effectively gave Tencent sole control over DouYu.
In its review, SAMR found that the proposed merger would result in the merged entity having a market share of over 70% by turnover, 80% by number of active users, and 60% by number of live streamers. Given the significant post-merger market shares and that the videogame live-streaming market has high entry barriers, SAMR concluded that the proposed merger would strengthen Tencent’s dominant position and restrict or eliminate competition in the videogame live-streaming market.
SAMR’s review also found that post-merger, Tencent would have the ability and incentive to implement a two-way vertical foreclosure in both the upstream online-game operator market and the downstream videogame live-streaming market, given Tencent’s existing market share of over 40% in the upstream market and the merged entity’s significant market share in the downstream market noted above. Specifically, SAMR contended that:
- Tencent, as an online-game operation service provider, owns online-game copyright licenses that are critical for the downstream videogame live-streaming market. Post-merger, Tencent would have the ability and incentive to foreclose downstream competitors by, for example, precluding their access to copyright licenses, thereby restricting or eliminating competition in the downstream videogame live-streaming market.
- As videogame live-streaming is an effective channel to promote videogames of upstream online-game operation service providers, Tencent would have the ability and incentive to preclude upstream competitors from having the live-streaming channels promote their games, thereby restricting or eliminating competition in the upstream online-game operation service provider market.
2.2 Conditional Approval Decisions
Cisco Systems Inc. (“Cisco”) / Acacia Communications Inc. (“Acacia”). In January 2021, SAMR imposed behavioural conditions on Cisco’s proposed acquisition of Acacia. SAMR found competition concerns resulting from the vertical relationship between the parties, namely Acacia being in the upstream global market for coherent digital signal processors (“DSP”) and Cisco being in the downstream Chinese market for optical transmission systems. To remedy these concerns, the parties offered a number of commitments, to which SAMR agreed, including the following: (1) to continue performing all existing contracts; (2) to continue supplying coherent DSP to Chinese customers on fair, reasonable and non-discriminatory (“FRAND”) terms; and (3) not to bundle, tie, or impose unreasonable conditions in the supply of coherent DSP.
Danfoss A/S / Eaton Corporation. In June 2021, SAMR imposed structural conditions on Danfoss’s acquisition of Eaton’s hydraulic business. SAMR concluded that the proposed transaction would increase the concentration in China’s orbital motor market given that, among other considerations, (1) the parties are the two largest players in the market with a combined market share of 50% to 55%, such that the combined entity would have a dominant position in the market; (2) the parties are each other’s closest competitor and the proposed transaction would remove competitive restraints; and (3) the proposed transaction would raise market entry barriers given the parties’ existing advantages (e.g. reputation). To resolve these competition concerns, Danfoss agreed to divest its orbital motor business in China.
Illinois Tool Works Inc. (“ITW”) / MTS Systems Corporation (“MTS”). In November 2021, SAMR imposed behavioural conditions on ITW’s proposed acquisition of MTS. The proposed transaction would result in ITW obtaining sole control over MTS. SAMR identified competition concerns in the high-end electrohydraulic servo material testing equipment market, as the parties have a combined market share of 65% to 70%. SAMR imposed a range of behavioural remedies on the parties, including (1) to continue performing all existing contracts with Chinese customers and maintaining the same level of service quality for them; and (2) to maintain prices for the relevant testing products in China no higher than their average price within the past 24 months.
SK Hynix Inc. (“SK Hynix”) / Intel Corporation (“Intel”). In December 2021, SAMR imposed behavioural conditions on SK Hynix’s acquisition of Intel’s NAND memory chip business. In its review, SAMR defined the relevant markets as the worldwide and China markets of (1) peripheral component interconnect express (“PCIe”) enterprise-class solid-state disk (“SSD”); and (2) serial advanced technology attachment (“SATA”) enterprise-class SSD. It concluded that the proposed transaction would give rise to competition concerns given the higher degree of market concentration post-acquisition (over 30% globally and over 50% in China), a decrease in the number of major players in the relevant markets post-acquisition (from three to two in the PCIe enterprise-class SSD market and from four to three in the SATA enterprise-class SSD market), and high barriers to entry.
To resolve these concerns, SAMR imposed a number of behavioural conditions on the combined entity, including the following: (1) to continue expanding the quantity of production of the two types of SSDs in the next five years; (2) to maintain prices for the relevant products at or below their average price over the past 24 months; (3) to continue supplying all products in China on FRAND terms; (4) to refrain from exclusive dealing, bundling, or tying when supplying products in China; (5) to refrain from entering into any agreement, or engage in any concerted act, with major competitors in China on price, output, or sales volume; and (6) to assist a third-party competitor to enter the two markets.
2.3 Enforcement Against Non-Notified Transactions
In 2021, SAMR issued a fine for failure to notify in almost 100 cases, 84 of which involved platform companies. Approximately 90% of all cases received the maximum fine of RMB 500,000 (~USD 78,642), while the remaining cases received a fine of at least RMB 150,000 (~USD 23,593). SAMR also imposed remedies in one failure to file case.
3. Non-Merger Enforcement
As they have done in recent years, SAMR and its local bureaus continued to target the pharmaceutical sector in a wide range of enforcement actions, including abuse of a dominant position, resale price maintenance, price fixing, and market allocation. SAMR’s enforcement against pharmaceutical companies in 2021 remained focused on Chinese Active Pharmaceutical Ingredients (“API”) manufacturers, such as the imposition of a RMB 100.7 million (~USD 15.8 million) fine on the country’s leading supplier of batroxobin API, the Hong Kong-listed Simcere Pharmaceutical, for abuse of a dominant position in China’s batroxobin API market through refusal to supply.
Moreover, there were a series of enforcement actions targeting platform companies in 2021, once again demonstrating SAMR’s close regulatory scrutiny of the platform economy sector. Two of the cases stood out in particular due to the scale of the business and the significant amount of fine:
- In April 2021, SAMR imposed a fine of RMB 18.228 billion (~USD 2.87 billion) on Alibaba for abuse of a dominant position. The fine amounted to 4% of Alibaba’s annual sales in China in 2019. SAMR’s investigation concluded that Alibaba prohibited merchants from operating stores or participating in promotional activities on Alibaba’s rival platforms, and implemented a reward and penalty mechanism on the merchants’ compliance (e.g. by downgrading online ratings of merchants who refused to comply).
- In October 2021, SAMR imposed a fine of RMB 3.44 billion (~USD 541 million) on China’s food delivery giant, Meituan, for abusing its dominant position. This amounted to 3% of Meituan’s 2020 turnover in China. SAMR found that Meituan punished merchants who refused to comply with Meituan’s exclusivity agreements by charging these merchants high commission rates and granting them less exposure on Meituan’s platform.
Gibson Dunn 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 Antitrust and Competition Practice Group, or the following authors in the firm’s Hong Kong office:
Sébastien Evrard (+852 2214 3798, [email protected])
Bonnie Tong (+852 2214 3762, [email protected])
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