We are pleased to present a comparative guide to restructuring procedures in the UK, US, DIFC, ADGM and UAE.

The easy-to-use comparative guide is organised by key aspects of the restructuring processes and compares and contrasts the selected restructuring regimes in each jurisdiction so that the reader can easily identify the differences.

The comparative guide will be particularly relevant for clients operating in the UAE who may be considering restructuring options in the current market conditions.

Comparative Guide to Restructuring Procedures in the UK, US, DIFC, ADGM and UAE

For further information, please contact the Gibson Dunn lawyer with whom you usually work, or the following authors, with any questions, thoughts or comments arising from this update.

Aly Kassam – Dubai (+971 (0) 4 318 4641, [email protected])
Scott J. Greenberg – New York (+1 212-351-5298, [email protected])
David M. Feldman – New York (+1 212-351-2366, [email protected])
Ben Myers – London (+44 (0) 20 7071 4277, [email protected])
Galadia Constantinou – Dubai (+971 (0) 4 318 4663, [email protected])
Ashtyn Hemendinger – New York (+1 212-351-2349, [email protected])

*  *  *  *  *

Gibson Dunn’s Middle East practice focuses on regional and global multijurisdictional transactions and disputes whilst also acting on matters relating to financial and investment regulation. Our lawyers, a number of whom have spent many years in the region, have the experience and expertise to handle the most complex and innovative deals and disputes across different sectors, disciplines and jurisdictions throughout the Middle East and Africa.

Our corporate team is a market leader in MENA mergers and acquisitions as well as private equity transactions, having been instructed on many of the region’s highest-profile buy-side and sell-side transactions for corporates, sovereigns and the most active regional private equity funds. In addition, we have a vibrant finance practice, representing both lenders and borrowers, covering the full range of financial products including acquisition finance, structured finance, asset-based finance and Islamic finance. We have the region’s leading fund formation practice, successfully raising capital for our clients in a difficult fundraising environment.

Our international Business Restructuring and Reorganization Practice is a leader in U.S., European, Middle East and cross-border insolvencies and workouts. Our lawyers advise companies in financial distress, their creditors and investors, and parties interested in acquiring assets from companies in distress. We also guide hedge funds, private equity firms and financial institutions investing in distressed debt and/or equity through the restructuring and bankruptcy process. The group has been widely recognized by top industry publications, including Chambers and The Guide to the World’s Leading Insolvency Lawyers. Our lawyers are committed to understanding the businesses of their clients and crafting solutions, including complex out-of-court workouts and in-court restructurings. We also advise on innovative DIP and exit financing agreements to both debtors and DIP providers.

We are pleased to present Gibson Dunn’s eighth “Federal Circuit Year In Review,” providing a statistical overview and substantive summaries of the 130 precedential patent opinions issued by the Federal Circuit between August 1, 2019 and July 31, 2020. This term was marked by significant panel decisions with regard to the constitutionality of the PTAB and its jurisdiction and procedures (Arthrex, Inc. v. Smith & Nephew, Inc., 941 F.3d 1320 (Fed. Cir. 2019), Samsung Electronics America, Inc. v. Prisua Engineering Corp., 948 F.3d 1342 (Fed. Cir. 2020), and Nike, Inc. v. Adidas AG, 955 F.3d 45 (Fed. Cir. 2020)), subject matter eligibility (American Axle & Manufacturing, Inc. v. Neapco Holdings LLC, 967 F.3d 1285 (Fed. Cir. 2020) and Illumina, Inc. v. Ariosa Diagnostics, Inc.,952 F.3d 1367 (Fed. Cir. 2020)), and venue (In re Google LLC). The issues most frequently addressed in precedential decisions by the Court were: obviousness (43 opinions); infringement (24 opinions); claim construction (22 opinions); PTO procedures (21 opinions); and Jurisdiction, Venue, and Standing (19 opinions).

Use the Federal Circuit Year In Review to find out:

  • The easy-to-use Table of Contents is organized by substantive issue, so that the reader can easily identify all of the relevant cases bearing on the issue of choice.
  • Which issues may have a better chance (or risk) on appeal based on the Federal Circuit’s history of affirming or reversing on those issues in the past.
  • The average length of time from issuance of a final decision in the district court and docketing at the Federal Circuit to issuance of a Federal Circuit opinion on appeal.
  • What the success rate has been at the Federal Circuit if you are a patentee or the opponent based on the issue being appealed.
  • The Federal Circuit’s history of affirming or reversing cases from a specific district court.
  • How likely a particular panel may be to render a unanimous opinion or a fractured decision with a majority, concurrence, or dissent.
  • The Federal Circuit’s affirmance/reversal rate in cases from the district court, ITC, and the PTO.

The Year In Review provides statistical analyses of how the Federal Circuit has been deciding precedential patent cases, such as affirmance and reversal rates (overall, by issue, and by District Court), average time from lower tribunal decision to key milestones (oral argument, decision), win rate for patentee versus opponent (overall, by issue, and by District Court), decision rate by Judge (number of unanimous, majority, plurality, concurring, or dissenting opinions), and other helpful metrics. The Year In Review is an ideal resource for participants in intellectual property litigation seeking an objective report on the Court’s decisions.

Gibson Dunn is nationally recognized for its premier practices in both Intellectual Property and Appellate litigation. Our lawyers work seamlessly together on all aspects of patent litigation, including appeals to the Federal Circuit from both district courts and the agencies.

Please click here to view the FEDERAL CIRCUIT YEAR IN REVIEW

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

Mark A. Perry – Washington, D.C. (+1 202-887-3667, [email protected])
Omar F. Amin – Washington, D.C. (+1 202-887-3710, [email protected])
Nathan R. Curtis – Dallas (+1 214-698-3423, [email protected])

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

Appellate and Constitutional Law Group:
Allyson N. Ho – Dallas (+1 214-698-3233, [email protected])
Mark A. Perry – Washington, D.C. (+1 202-887-3667, [email protected])

Intellectual Property Group:
Wayne Barsky – Los Angeles (+1 310-552-8500, [email protected])
Josh Krevitt – New York (+1 212-351-4000, [email protected])
Mark Reiter – Dallas (+1 214-698-3100, [email protected])

© 2020 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

Direct listings have emerged as one of the new innovative pathways to the U.S. public capital markets, thought to be ideal for entrepreneurial companies with a well-recognized brand name or easily understood business model. We have also found them attractive to companies that are already listed on a foreign exchange and are seeking a dual listing in the United States. Because direct listings have been limited to secondary offerings by existing shareholders, they have not been an attractive option for companies seeking to raise new capital in connection with going public. That has changed now that the NYSE will permit primary offerings in connection with direct listings – or “Primary Direct Floor Listings” (see “Gibson Dunn Guide to Direct Listings” below).

Primary offerings through direct listings pose new challenges and questions, but nonetheless have the potential to expand access to the U.S. public markets. This new option to raise capital in connection with a listing is expected to increase the number of companies that find direct listings attractive, although we do not expect direct listings to serve as a replacement for underwritten IPOs generally.[1] Many of the open questions we discussed when the NYSE’s Selling Shareholder Direct Floor Listing rules were amended in 2018 (link here) are raised again with the new rules on Primary Direct Floor Listings (see “Open Questions” below).

History

It has taken more than a year for the NYSE’s rule changes to become effective. As we previously discussed (link here), in December 2019, the NYSE submitted its first rule proposal to the SEC that would permit a privately held company to conduct a direct listing in connection with a primary offering, but this proposal was quickly rejected by the SEC. As we further detailed (link here), the NYSE subsequently revised and resubmitted the proposal, which was approved by the SEC on August 26, 2020 following a public comment period. However, only five days later, the SEC stayed its approval order after a notice from the Council of Institutional Investors (CII) that it intended to file a petition for the SEC to review the SEC’s approval. CII objected to the proposals to allow Primary Direct Floor Listings arguing that such an offering would harm investors by limiting investors’ legal recourse for material misstatements in offering documents. In particular, CII raised concerns regarding the ability of investors to “trace” the purchase of their shares to the applicable offering document. Another criticism of the NYSE’s proposal is that the rule changes could not guarantee sufficient liquidity for a trading market in the applicable securities to develop following the direct listing.

Final Approval

On December 22, 2020, the SEC issued its final approval of the NYSE’s proposed rules. The SEC states that, following a de novo review and further public comment period, it has found that the NYSE’s proposal was consistent with the Exchange Act and the rules and regulations issued thereunder and, furthermore, that the proposed rules would “foster[] competition by providing an alternate method for companies of sufficient size [to] decide they would rather not conduct a firm commitment underwritten offering.” The SEC order discussed several procedural safeguards included by the NYSE in its proposed rules that were intended to “clarify the role of the issuer and financial advisor in a direct listing” and “explain how compliance with various rules and regulations” would be addressed. These changes include the introduction of an “Issuer Direct Offering Order type,” the clarification of how market value would be determined in connection with primary direct listings and the agreement to retain FINRA to monitor compliance with Regulation M and other anti-manipulation provisions of federal securities laws.

Notably, the SEC’s order rejects the notion that offerings not involving a traditional underwriter would “‘rip off’ investors, reduce transparency, or involve reduced offering requirements or accounting methods,” finding that the relevant “traceability issues are not exclusive to nor necessarily inherent in” Primary Direct Floor Listings. In approving the NYSE’s proposal and reaching its conclusion that the NYSE’s proposal provided a “reasonable level of assurance” that the applicable market value threshold supports a public listing and the maintenance of fair and orderly markets, the SEC specifically noted that the applicable thresholds for the equity market value under the revised rules were at least two and a half times greater than the market value standard that exists for a traditional IPO ($40 million). The SEC order also positively discussed steps taken by the NYSE to ensure compliance by participants in the direct listing process with Regulation M and other provisions of the federal securities laws.

“This is a game changer for our capital markets, leveling the playing field for everyday investors and providing companies with another path to go public at a moment when they are seeking just this type of innovation,” NYSE President Stacey Cunningham said in a statement. In a separate statement, Commissioner Elad L. Roisman stated, “Primary direct listings represent an alternative way for companies to fairly and efficiently offer shares to the public in a manner that preserves important investor protections” and have “the additional benefit of increasing opportunities for investors to purchase shares at the initial offering price, rather than having to wait to buy in the aftermarket.”

The two Commissioners who dissented (Allison Herren Lee and Caroline A. Crenshaw) and certain investor protection groups have issued statements expressing concern that the absence of a traditional underwriter removes a key gatekeeper present in traditional IPOs that helps prevent inaccurate or misleading disclosures.

New Requirements for Primary Direct Floor Listings

Under the NYSE’s rules, a privately held company seeking to conduct a primary offering in connection with a direct listing will qualify for such a primary offering if (a) it meets the already existing requirements for a direct listing (e.g., 400 round lot holders, 1.1 million publicly held shares outstanding and minimum price per share of at least $4.00 at the time of initial listing); and (b) (i) the company issues and sells common equity with at least $100 million in market value in the opening auction on the first day of listing, or (ii) the market value of common equity sold in the opening auction by such company and the market value of publicly held shares (i.e., excluding shares held by officers, directors and 10% owners) immediately prior to listing, together, exceed $250 million. In each case, such market value will be calculated using a price per share equal to the lowest price of the price range established by the issuer in its registration statement for the primary offering (the price range is defined as the “Primary Direct Floor Listing Auction Price Range”).

The NYSE will also create a new order type to be used by the issuer in a Primary Direct Floor Listing and rules regarding how that new order type would participate in a Direct Listing Auction. Specifically, the NYSE will introduce an Issuer Direct Offering Order (“IDO Order”), which would be a Limit Order to sell that is to be traded only in a Direct Listing Auction for a Primary Direct Floor Listing. The IDO Order would have the following requirements: (1) only one IDO Order may be entered on behalf of the issuer and only by one member organization; (2) the limit price of the IDO Order must be equal to the lowest price of the Primary Direct Floor Listing Auction Price Range; (3) the IDO Order must be for the quantity of shares offered by the issuer, as disclosed in the prospectus in the effective registration statement; (4) the IDO Order may not be cancelled or modified; and (5) the IDO Order must be executed in full in the Direct Listing Auction. Consistent with current rules, a Designated Market Maker (“DMM”) would effectuate a Direct Listing Auction manually, and the DMM would be responsible for determining the Auction Price. Under the new rules, the DMM would not conduct a Direct Listing Auction for a Primary Direct Floor Listing if (1) the Auction Price would be below the lowest price or above the highest price of the Primary Direct Floor Listing Auction Price Range; or (2) there is insufficient buy interest to satisfy both the IDO Order and all better-priced sell orders in full. If there is insufficient buy interest and the DMM cannot price the Auction and satisfy the IDO Order as required, the Direct Auction would not proceed and such security would not begin trading.

While not a change, the NYSE emphasized in its proposal that any services provided by a financial advisor to the issuer of a security listing in connection with a Selling Shareholder Direct Floor Listing or a Primary Direct Floor Listing (the “financial advisor”) and the DMM assigned to that security must provide such services in a manner that is consistent with all federal securities laws, including Regulation M and other anti-manipulation requirements.

Nasdaq Is Next

The Nasdaq Stock Market also has pending before the SEC a proposed rule change to allow primary offering in connection with direct listings in the context of Nasdaq’s own distinct market model, some of which require fewer record holders than the NYSE for direct listings. Additionally, on December 22, Nasdaq submitted a separate proposed rule change on this issue for which Nasdaq seeks immediate effectiveness without a prior public comment period. On December 23, the Staff of the Division of Trading and Markets of the SEC issued a public statement that “the Staff intends to work to expeditiously complete, as promptly as possible accommodating public comment, a review of these proposals, and as with all self-regulatory organizations’ proposed rule changes, will evaluate, among other things, whether they are consistent with the requirements of the Exchange Act and Commission rules.”

Gibson Dunn Guide to Direct Listings

Any company considering a direct listing is encouraged to carefully consider the risks and benefits in consultation with counsel and financial advisors. Members of the Gibson Dunn Capital Markets team are available to discuss strategy and considerations as the rules and practice concerning direct listings evolve. Gibson Dunn will also continue to update its Current Guide To Direct Listings (available here) from time to time to further describe the applicable rules and provide commentary as practices evolve.

Open Questions

It remains to be seen how the NYSE’s revised rules and forthcoming rules from NYSE and Nasdaq will play out in practice. Some of the relevant open questions include:

  • Will the loss of a traditional firm-commitment underwriter create additional risks for investors? The NYSE’s revised rules permit companies to raise new capital without using a firm-commitment underwriter. The two Commissioners who dissented (Allison Herren Lee and Caroline A. Crenshaw) and certain investor protection groups have expressed concern that the absence of a traditional underwriter removes a key gatekeeper present in traditional IPOs that helps prevent inaccurate or misleading disclosures. In its order approving the NYSE’s revised rules on Primary Direct Floor Listings, the SEC suggests that, depending on the facts and circumstances, a company’s financial advisers could be subject to Securities Act liability, or at least lawsuits alleging underwriter liability, in connection with direct listings. The two dissenting Commissioners, however, suggest that guidance as to what may trigger status as a statutory underwriter should have been considered and concurrently provided.
  • Will a Primary Direct Floor Listing create new risks for the listing company? Under current rules and precedent, in a Primary Direct Floor Listing the listing company may have more rather than less liability in a direct listing than a traditional IPO. In a traditional IPO, because of customary lockup arrangements, investors can generally guarantee the traceability of their shares to the registration statement because only shares issued under the registration statement are trading in the market until the lockup period expires. Under current case law, which is being appealed, the tracing requirement has been seemingly abandoned, meaning all the shares in the market can potentially make claims under Section 11.
  • How will legal, diligence and auditing practices develop around direct listings? Because the listing must be accompanied by an effective registration statement under the Securities Act, the liability provisions of Section 11 and 12 of the Securities Act will be applicable to sales made under the registration statement. We note that in many of the direct listings to date, the companies have engaged financial advisors to assist with the positioning of the equity story of the company and advise on preparation of the registration statement, in a process very similar to the process of preparing a registration statement for a traditional IPO. Because a company will be subject to the same standard for liability under the federal securities laws with respect to material misstatements and omissions in a registration statement for a direct listing to the same extent as for a registration statement for an IPO, a company’s incentives to conduct diligence to support the statements in its registration statement do not differ between the two types of transactions. Similarly, financial statement requirements, and the requirements as to independent auditor opinions and consents, do not differ between registration statements for direct listings and IPOs. Furthermore, follow-on offerings by the company that involve firm-commitment underwriting or at-the-market programs will require the traditional diligence practices. To date, there have been no lawsuits alleging that financial advisers in a direct listing could be subject to Securities Act liability in connection with direct listings.
  • What impact will the expanded availability of direct listings have on IPO activity? One could argue that the greatest attraction of a direct listing is that it can nearly match private markets in being faster and less costly than an IPO. In some cases, it could provide similar liquidity as a traditional IPO, although trading price certainty and trading volume could be lower following a direct listing than following an IPO. Direct listings have been available on the NYSE and Nasdaq for a decade but have not been utilized regularly by large private companies in lieu of a traditional IPO. In any event, the requirement for 400 round lot holders will continue to be a hurdle for many private companies looking to list directly.
  • How will the initial reference price and/or price range in the prospectus be determined? There is no reference price from another market for the DMM to apply and no negotiation between the issuer and the underwriter as in an IPO. The NYSE seems to bridge this gap with the requirement for the DMM to consult with an independent financial adviser to determine the initial reference price in a Selling Shareholder Direct Listing and, in a Primary Direct Floor Listing, to determine the price range to be set forth in the applicable prospectus. Eventually, a standardized set of practices around the financial adviser’s work and presentation of the price to the issuer and the Exchange should develop.
  • Without the firm-commitment IPO process, in which the offering is oversold and heavily marketed, how will direct listed shares trade in the aftermarket? Without an underwritten offering, the issuer will not engage in price finding and book building activities. In a direct listing, the issuer will also take on much of the role of investor outreach that is borne by underwriters in a traditional IPO. Although direct listing marketing efforts may include one or more investor days and a roadshow-like presentation, sell-side analysts will presumably not be involved, building models and educating investors. It may be more difficult for the issuer to tell its forward-looking story and build value into the trading price of the stock without research coverage prior to or after the listing. For this reason, the most successful direct listings to date have been well-known companies with widely recognized brands that have successfully engaged with a broad set of new investors. We expect that companies engaging in direct listings will continue to develop more robust internal investor/shareholder relations functions than may be needed for a company conducting a traditional IPO.
  • Will large private placements (often called “private IPOs”) have a new advantage? The expanded option to direct list, whether in a secondary or primary format, through an independent valuation alone may mean investors in a private company can have access to public markets faster than through an IPO process. When private companies market private equity capital raises, including private IPOs, they might use the direct listing option as a marketing tool to attract investors to the private placement.
  • Are there any companies that are well-positioned for a Primary Direct Floor Listing? The NYSE’s revised rules may prompt well-positioned companies to consider a capital raise where the private or IPO markets are otherwise unattractive. Furthermore, until Nasdaq’s rules are approved, how will the NYSE’s rules affect the decision of where to list?

Read More

Thank you to associate Evan Shepherd* for his valuable assistance with this article and the Current Guide to Direct Listings.

 _______________________

[1] The SEC Final Release states in footnote 114: “While the Commission acknowledges the possibility that some companies may pursue a Primary Direct Floor Listing instead of a traditional IPO, these two listing methods may not be substitutable in a wide variety of instances. For example, some issuers may require the assistance of underwriters to develop a broad investor base sufficient to support a liquid trading market; others may believe a traditional firm commitment IPO is preferable given the benefits to brand recognition that can result from roadshows and other marketing efforts that often accompany such offerings. Thus, we do not anticipate that all companies that are eligible to go public through a Primary Direct Floor Listing will choose to do so; the method chosen will depend on each issuer’s unique characteristics.”

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Capital Markets or Securities Regulation and Corporate Governance practice groups, or the authors:

J. Alan Bannister – New York (+1 212-351-2310, [email protected])
Hillary H. Holmes – Houston (+1 346-718-6602, [email protected])
Boris Dolgonos – New York (+1 212-351-4046, [email protected])
Stewart L. McDowell – San Francisco (+1 415-393-8322, [email protected])
James J. Moloney – Orange County, CA (+1 949-451-4343, [email protected])
Evan Shepherd* – Houston (+1 346-718-6603, [email protected])

Please also feel free to contact any of the following practice leaders:

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

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

*Mr. Shepherd is admitted only in New York and is practicing under the supervision of Principals of the Firm.

© 2021 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

Over the course of December 2019, Gibson Dunn published its “Current Guide to Direct Listings” and “An Interim Update on Direct Listing Rules” discussing, among other things, the direct listing as an evolving pathway to the public capital markets and the U.S. Securities and Exchange Commission’s (SEC) rejection of a proposal by the New York Stock Exchange (NYSE) to permit a privately held company to conduct a direct listing in connection with a primary offering, respectively.

The NYSE continued to revise its proposal in consultation with the SEC and, on August 26, 2020, the SEC approved an amendment to the NYSE’s proposal that will permit primary offerings in connection with direct listings. The August 26 order, which would have become effective 30 days after being published in the Federal Register, was stayed by the SEC on September 1, 2020 in response to a notice from the Council of Institutional Investors (CII) that it intended to file a petition for the SEC to review the SEC’s approval. On December 22, 2020, the SEC issued its final approval of the NYSE’s proposed rules. Consequently, Gibson Dunn has updated and republished its Current Guide to Direct Listings to reflect today’s landscape, including an overview of certain issues to monitor as direct listing practice evolves included as Appendix I hereto.

Direct Listings: An evolving pathway to the public capital markets.  

Direct listings have increasingly been gaining attention as a means for a private company to go public. A direct listing refers to the listing of a privately held company’s stock for trading on a national stock exchange (either the NYSE or Nasdaq) without conducting an underwritten offering, spin-off or transfer quotation from another regulated stock exchange. Under historical stock exchange rules, direct listings involve the registration of a secondary offering of a company’s shares on a registration statement on Form S-1 or other applicable registration form publicly filed with, and declared effective by, the Securities and Exchange Commission, or the SEC, at least 15 days in advance of launch—referred to as a Selling Shareholder Direct Listing.[1] Existing shareholders, such as employees and early stage investors, whose shares are registered for resale or that may be resold under Rule 144 under the Securities Act, are able to sell their shares on the applicable exchange, but are not obligated to do so, providing flexibility and value to such shareholders by creating a public market and liquidity for the company’s stock. Historically, companies were not permitted to raise fresh capital as part of the direct listing process. On December 22, 2020, however, the SEC issued its final approval of rules proposed by the NYSE that permit a primary offering along with, or in lieu of, a direct secondary listing—referred to as a Primary Direct Floor Listing.[2] Upon listing of the company’s stock, the company becomes subject to the reporting and governance requirements applicable to publicly traded companies, including periodic reporting requirements under the Securities Exchange Act of 1934, as amended (the Exchange Act), and governance requirements of the applicable exchange.

Companies may pursue a direct listing to provide liquidity and a broader trading market for their shareholders; however, the listing company can also benefit even if not raising capital in a Primary Direct Floor Listing. A direct listing, whether a Primary Direct Floor Listing or a Selling Shareholder Direct Listing, will provide a company with many of the benefits of a traditional IPO, including access to the public markets for capital raising and the ability to use publicly traded equity as an acquisition currency.

Advantages of a direct listing as compared to an IPO.

Immediate Benefits to Existing Shareholders.

In both a Selling Shareholder Direct Listing and Primary Direct Floor Listing, all selling shareholders whose shares are registered on the applicable registration statement or whose shares are eligible for resale under Rule 144 will have the opportunity to participate in the first day of trading of the company’s stock. Shareholders who choose to sell are able to do so at market trading prices, rather than only at the initial price to the public set in an IPO. The ability to sell at market prices on the first day of a listing can be a significant benefit to existing shareholders who elect to sell. However, this benefit assumes there is sufficient market demand for the shares offered for resale.

Potentially Wider Initial Market Participation.

The traditional IPO process includes a focused set of participants, and institutional buyers tend to feature prominently in the initial allocation of shares to be sold by the underwriting syndicate. Direct listings offer access to a wider group of investors, as any investor may place orders through its broker.  In a Selling Shareholder Direct Listing, any prospective purchasers of shares are able to place orders with their broker-dealer of choice, at whatever price they believe is appropriate, and such orders become part of the initial-reference, price-setting process. The price-setting mechanisms applicable to Primary Direct Floor Listings differ in material respects from the practice that has developed with respect to Selling Shareholder Direct Listings. In a Primary Direct Floor Listing, prospective purchasers of shares are able to place orders with their broker-dealer of choice at whatever price they believe is appropriate, but will have priority for purchases at the minimum offering price specified in the related prospectus.

Flexibility in Marketing.

IPO marketing has become more flexible since the introduction of rules providing for “testing-the-waters” communications by Emerging Growth Companies and, starting December 3, 2019, all companies.[3] However, a direct listing allows a company to avoid the rigidity of the traditional roadshow conducted for a specified period of time following the publicly announced launch of an IPO and allows it to tailor marketing activities to the specific considerations underlying the direct listing. For instance, the traditional roadshow has been replaced in some direct listings by an investor day whereby the company invites investors to learn about the company one-to-many, such as via a webcast, which can be considered more democratic as all investors have access to the same educational materials at once. Marketing efforts may include one or more of these investor days and a roadshow-like presentation, conducted at times deemed most advantageous (although the applicable registration statement must still be publicly filed for at least 15 days in advance of any such marketing efforts). Although the approximate timing of the direct listing can be inferred from the status of the publicly filed registration statement, the company may have more flexibility as to the day its shares commence trading on the applicable stock exchange.

Brand Visibility.

As direct listings are still a relatively novel concept in U.S. capital markets, any direct listing with moderate success, in particular a direct listing involving a primary capital raise, will likely draw broad interest from market participants and relevant media. This effect is multiplied when the listing company has a well-recognized brand name.

No Underwriting Fees.

A direct listing can save money by allowing companies to avoid underwriting discounts and commissions on the shares sold in the IPO. In direct listings to date, the companies have engaged financial advisers to assist with the positioning of the company and the preparation of the registration statement. Such financial advisors have been paid significant fees, though substantially less than traditional IPO underwriting discounts and commissions. This may marginally decrease a company’s cost of capital, although the company will still incur significant fees to market makers or specialists, independent valuation agents, auditors and legal counsel.

More Flexible Lockup Agreements.

In most direct listings to date, existing management and significant shareholders are not typically subject to the restrictions imposed by 180-day lockup agreements standard in IPOs. Notwithstanding, as practice evolves, practice may vary from transaction to transaction. For example, Spotify’s largest non-management shareholder was subject to a lockup and Palantir’s directors and executive officers were subject to a lockup period. We expect that lockup arrangements in direct listings will continue to be more tailored to the particular company’s circumstances than in traditional IPOs.

Certain issues to consider before choosing a direct listing.

Establishing a Price Range or Initial Reference Price.

No marketing efforts are permissible without a compliant preliminary prospectus on file with the SEC, and such prospectus must include an estimated price range. In a traditional IPO and Primary Direct Floor Listing, the cover page of the preliminary prospectus contains a price range of the anticipated initial sale price of the shares. In a Selling Shareholder Direct Listing, the current market practice is to describe how the initial reference price is derived (e.g., by buy-and-sell orders collected by the applicable exchange from various broker-dealers). These buy-and-sell orders have in the past been largely determined with reference to high and low sales prices per share in recent private transactions of the subject company. In cases where a company does not have such transactions to reference, additional information will be necessary to educate and assist investors and help establish an initial bid price. In addition, the listing company in a direct listing may elect to increase the period between the effectiveness of its registration statement and its first day of trading, thereby allowing time for additional buy-and-sell orders to be placed. In either case, the financial advisor to the company will play an important role in establishing a price range or initial reference price, as applicable.

Financial Advisors and Their Independence.

In a Selling Shareholder Direct Listing, the rules of both the NYSE and Nasdaq require that the listing company appoint a financial advisor to provide an independent valuation of the listing company’s “publicly held” shares and, in practice, assist the applicable exchange’s market maker or specialists, as applicable, in setting a price range or initial reference price, as applicable. In past direct listings, in particular those involving the NYSE, the financial advisor that served this role was not the financial advisor the listing company engaged to advise generally, including to assist the company define objectives for the listing, position the equity story of the company, advise on the registration statement, assist in preparing presentations and other public communications and help establish a firm price range in a Primary Direct Floor Listing. As reviewed in detail below, the financial advisor that values the “publicly held” shares and assists the applicable exchange’s market maker or specialists, as applicable, must be independent, which under the relevant rules disqualifies any broker-dealer that has provided investment banking services to the listing company within the 12 months preceding the date of the valuation.

Shares to be Registered.

In a direct listing, in addition to new shares being issued in connection with a Primary Direct Floor Listing, a company generally registers for resale all of its outstanding common equity which cannot then be sold pursuant to an applicable exemption from registration (such as Rule 144), including those subject to registration rights obligations. The company may also register shares held by affiliates and non-affiliates who have held the shares for less than one year or otherwise did not meet the requirements for transactions without restriction under Rule 144.[4] Companies may also register shares held by employees to address any regulatory concerns that resales of shares by employees occurring around the time of the direct listing may not have been entitled to an exemption from registration under the Securities Act. All shares subject to registration may be freely resold pursuant to the registration statement only as long as the registration statement remains effective and current. The company will typically bear the related costs.

Direct Listing-Specific Risks.

Traditional IPOs offer certain advantages that are not currently present in direct listings. Going public without the structure of an IPO process is not without risk, such as the need to obtain research coverage in the absence of an underwriting syndicate that has research analysts or the need to educate investors on the company’s business model. Any company considering a direct listing should contemplate whether its investor relations apparatus is capable of playing an outsized role in coordinating marketing efforts and outreach to potential investors, both in connection with the listing and after the transaction. Notably, in a Selling Shareholder Direct Listing, the listing company’s management plays no role in setting the initial reference price, and certain market-making activities conducted by the underwriting syndicate may be unavailable. In a Primary Direct Floor Listing, the listing company’s management may play an outsized role in determining an initial price range. Either scenario may present unacceptable risk for companies that may otherwise be poised to undertake a direct listing.

The NYSE and Nasdaq rules applicable to a direct listing.

Background.

The direct listing rules of both the NYSE[5] and Nasdaq Global Select Market[6] are substantially similar and are structured as an exception to each exchange’s requirement concerning the aggregate market value of the company to be listed. Prior to the direct listing rules, companies that did not previously have their common equity registered under the Exchange Act were required to show an aggregate market value of “publicly held” shares in excess of $100 million ($110 million for Nasdaq Global Select Market, under certain circumstances), such market value being established by both an independent third-party valuation and recent trading prices in a trading market for unregistered securities (commonly referred to as the Private Placement Market).

“Publicly held” shares include those held by persons other than directors, officers and presumed affiliates (shareholders holding in excess of 10%). The Private Placement Market includes trading platforms operated by any national securities exchange or registered broker-dealers. Generally, in a direct listing, the relevant company either (i) does not have its shares traded on a Private Placement Market prior its listing or (ii) underlying trading in the Private Placement Market is not sufficient to provide a reasonable basis for reaching conclusions about a company’s trading price.

Direct Listings on Secondary Markets.

Nasdaq rules permit direct listings onto the Nasdaq Global Market and Nasdaq Capital Market, the second- and third-tier Nasdaq markets, respectively.[7] If the company to be listed on a secondary market does not have recent sustained trading activity in a Private Placement Market, and thereby must rely on an independent third-party valuation consistent with the rules described above, such calculation must reflect a (i) tentative initial bid price, (ii) market value of listed securities and (iii) market value of publicly held shares that each exceed 200 percent of the otherwise applicable requirements.

Requirements for a Direct Listing.

The direct listing rules discussed above were intended to provide relief for privately held “unicorns,” or companies that are otherwise sufficiently capitalized and which do not need to raise money. Each exchange’s listing standards applicable to direct listings by U.S. companies are summarized, by relevant exchange, in the table that follows:

Overview of Listing Standards Applicable to Direct Listings

 

NYSE (Selling Shareholder Direct Listing)

NYSE (Primary Direct Floor Listing)

Nasdaq Global Select Market

Nasdaq Global Market

Nasdaq Capital Market

Market Value of Publicly Held Shares (i.e., held by persons other than directors, officers and presumed affiliates)

The listing company must have a recent valuation from an independent third party indicating at least $250 million in aggregate market value of publicly held shares. (Rule 102.01A(E))[8]

The listing company (i) must sell at least $100 million of shares in the opening auction or (ii) show that the aggregate market value of shares sold in the opening auction, together with publicly held shares, exceeds $250 million, in each case with market value calculated using the lowest price per share set forth in the related prospectus.

The listing company must have a recent valuation from an independent third party indicating at least $250 million in aggregate market value of publicly held shares. (Rule IM-5315-1(b))9

The listing company must have a recent valuation[9] from an independent third party indicating in excess of $16 million to $40 million in aggregate market value of publicly held shares, depending on the financial standard met below. (Rule 5405)

The listing company must have a recent valuation10 from an independent third party indicating in excess of $10 million to $30 million in aggregate market value of publicly held shares, depending on the financial standard met below. (Rule 5505)

Financial Standards

The listing company is required to meet one of the following applicable financial standards:

(i)       Each of (a) aggregate adjusted pre-tax income for the last three fiscal years in excess of $10 million, (b) with at least $2 million in each of the two most recent fiscal years and (c) positive income in each of the last three fiscal years (the “NYSE Earnings Test”).

(ii)     Global market capitalization of $200 million (the “Global Market Capitalization Test”).

Same as the NYSE (Selling Shareholder)

The listing company is required to meet one of the following applicable financial standards:

(i)       Each of (a) aggregate adjusted pre-tax income for the last three fiscal years in excess of $11 million, (b) with at least $2.2 million in each of the two most recent fiscal years and (c) positive income in each of the last three fiscal years (the “Nasdaq Earnings Standard”).

(ii)     Each of (a) average market capitalization in excess of $550 million over the prior 12 months, (b) $110 million in revenue for the previous fiscal year and (c) aggregate cash flows for the last three fiscal years in excess of $27.5 million and positive cash flows for each of the last three fiscal years (the “Capitalization with Cash Flow Standard”).

(iii)   Each of (a) average market capitalization in excess of $850 million over the prior 12 months and (b) $90 million in revenue for the previous fiscal year (the “Capitalization with Revenue Standard”).

(iv)    Each of (a) market capitalization in excess of $160 million, (b) total assets in excess of $80 million, and (c) stockholders’ equity in excess of $55 million (the “Assets with Equity Standard”).

The listing company is required to meet one of the following applicable financial standards:

(i)       Each of (a) aggregate adjusted pre-tax income in excess of $1 million in the latest fiscal year or in two of the last three fiscal years and (b) Stockholders’ equity in excess of $15 million.

(ii)     Each of (a) Stockholders’ equity in excess of $30 million and (b) two years of operating history.

(iii)   Market value of listed securities in excess of $150 million.

(iv)    Total assets and total revenue in excess of $75 million in the latest fiscal year or in two of the last three fiscal years.

The listing company is required to meet one of the following applicable financial standards:

(i)       Each of (a) Stockholders’ equity in excess of $15 million and (b) two years of operating history.

(ii)     Each of (a) Stockholders’ equity in excess of $4 million and (b) market value of listed securities in excess of $100 million.

(iii)   Total assets and total revenue in excess of $75 million in the latest fiscal year or in two of the last three fiscal years.

Distribution Standards

The listing company must meet all of the following distribution standards:

(i)       400 round lot shareholders;

(ii)     1.1 million publicly held shares; and

(iii)   Minimum initial reference price of $4.00.

Same as the NYSE (Selling Shareholder)

The listing company must meet all of the following liquidity requirements:

(i)       450 round lot shareholders or 2,200 total shareholders;

(ii)     1.25 million publicly held shares; and

(iii)   Minimum initial reference price of $4.00.

The listing company must meet all of the following distribution standards:

(i)       400 round lot shareholders;

(ii)     1.1 million publicly held shares; and

(iii)   Minimum initial reference price of $8.00.

The listing company must meet all of the following liquidity requirements:

(i)       300 round lot shareholders;

(ii)     1 million publicly held shares; and

(iii)   Minimum initial reference price of $8.00 OR closing price of $6.00.[10]

Engagement of Financial Advisor

Any valuation used in connection with a direct listing must be provided by an entity that has significant experience and demonstrable competence in the provision of such valuations. (Rule 102.01A(E))

A valuation agent will not be deemed to be independent if (Rule 102.01A(E)):

(i)       At the time it provides such valuation, the valuation agent or any affiliated person or persons beneficially own in the aggregate, as of the date of the valuation, more than 5% of the class of securities to be listed, including any right to receive any such securities exercisable within 60 days.

(ii)     The valuation agent or any affiliated entity has provided any investment banking services to the listing applicant within the 12 months preceding the date of the valuation. For purposes of this provision, “investment banking services” include, without limitation, acting as an underwriter in an offering for the issuer; acting as a financial adviser in a merger or acquisition; providing venture capital, equity lines of credit, PIPEs (private investment, public equity transactions), or similar investments; serving as placement agent for the issuer; or acting as a member of a selling group in a securities underwriting.

(iii)   The valuation agent or any affiliated entity has been engaged to provide investment banking services to the listing applicant in connection with the proposed listing or any related financings or other related transactions.

Not required in connection with a Primary Direct Floor Listings as the related prospectus is required to include a price range within which the company anticipates selling the shares it is offering.

Any valuation used in connection with a direct listing must be provided by an entity that has significant experience and demonstrable competence in the provision of such valuations. (Rule IM-5315-1(e))

A valuation agent shall not be considered independent if (Rule IM-5315-1(f)):

(i)       At the time it provides such valuation, the valuation agent or any affiliated person or persons beneficially own in the aggregate, as of the date of the valuation, more than 5% of the class of securities to be listed, including any right to receive any such securities exercisable within 60 days.

(ii)     The valuation agent or any affiliated entity has provided any investment banking services to the listing applicant within the 12 months preceding the date of the valuation. For purposes of this provision, “investment banking services” include, without limitation, acting as an underwriter in an offering for the issuer; acting as a financial adviser in a merger or acquisition; providing venture capital, equity lines of credit, PIPEs (private investment, public equity transactions), or similar investments; serving as placement agent for the issuer; or acting as a member of a selling group in a securities underwriting.

(iii)   The valuation agent or any affiliated entity has been engaged to provide investment banking services to the listing applicant in connection with the proposed listing or any related financings or other related transactions.

Same as the Nasdaq Global Select Market

Same as the Nasdaq Global Select Market

Upon satisfaction of the above requirements of the applicable exchange, the exchange will generally file a certification with the SEC, confirming that its requirements have been met by the listing company. After such filing, the company’s registration statement may be declared effective by the SEC (assuming the SEC review has run its course). In practice, the SEC has reviewed registration statements that contemplate a direct listing in substantially the same manner it reviews traditional IPO registration statements, with some additional focus on process as direct listing practice and the related rules evolve. After the registration statement is declared effective by the SEC, the company becomes subject to the governance requirements of the applicable exchange (subject to compliance periods) and the reporting requirements under the Exchange Act. The company may then establish the day its equity will commence trading in consultation with the applicable exchange, which could be the same day as the SEC declares the registration statement effective, assuming, in the case of a Selling Shareholder Direct Listing, the exchange’s market maker or specialists, as applicable, and the financial advisor appointed by the company are able to determine an initial reference price.

NYSE’s recent rule changes: Primary capital raise via direct listing

Allowing companies to conduct their initial public offering outside of the traditional IPO format (i.e., an underwritten firm commitment) could potentially revolutionize the way in which companies go public. Historically, companies were not permitted to raise fresh capital as part of the direct listing process. On June 22, 2020, the NYSE filed a revised proposal with the SEC that would allow companies to publicly raise capital through a direct listing, which was approved by the SEC staff on August 26, 2020. The NYSE’s proposal, which would have become effective 30 days after being published in the Federal Register, was stayed by the SEC on September 1, 2020, after the Council of Institutional Investors (CII) made public its intention to file a petition for the SEC’s Commissioners to review the August 26 order approving the NYSE’s proposal. The grounds for CII’s Petition for Review of an Order are discussed below. On December 22, 2020, the SEC issued its final approval of the NYSE’s proposed rules. The NYSE’s rules, which we expect will become effective 30 days after being published in the Federal Register, will allow a company to sell shares on its own behalf, without underwriters, in addition to or in place of a secondary offering by shareholders.

Under the NYSE’s rules, companies hoping to conduct a primary offering while listing pursuant to the NYSE’s proposed rules will be required to either:

  • sell at least $100 million in the opening auction on the first day of listing, thereby ensuring that there will be at least $100 million in public float after the first trade; or
  • the aggregate market value of publicly held shares immediately prior to listing together with the market value of shares sold by the company in the opening auction totals at least $250 million, with such market value calculated using a price per share equal to the lowest price of the price range established in the related prospectus.

The NYSE previously proposed a “Distribution Standard Compliance Period” whereby, in a Primary Direct Floor Listing, the requirements to have 400 round lot shareholders and 1.1 million publicly held shares would be operative after a 90-day grace period. Under the proposal approved by the SEC, companies conducting a Primary Direct Floor Listing must meet these and all other initial listing requirements at the time of initial listing.

To facilitate Primary Direct Floor Listings, the NYSE’s proposal includes a new order type that would permit a Primary Direct Floor Listing to settle only if (i) the auction price would be within the price range specified by the company in its effective registration statement and (ii) all shares to be offered by the company can be sold within the specified price range, together with other technical revisions to the order process to enable and ensure compliance with the foregoing. Notably, the NYSE will create a new order type to be used by the issuer in a Primary Direct Floor Listing, referred to as an Issuer Direct Offering Order (“IDO Order”), which would be a limit order to sell that is to be traded only in a Primary Direct Floor Listing. The IDO Order would have the following requirements: (1) only one IDO Order may be entered on behalf of the issuer and only by one member organization; (2) the limit price of the IDO Order must be equal to the lowest price set forth in the applicable prospectus; (3) the IDO Order must be for the quantity of shares offered by the issuer, as disclosed in the prospectus in the effective registration statement; (4) the IDO Order may not be cancelled or modified; and (5) the IDO Order must be executed in full in the direct listing auction. The NYSE’s proposal also includes additional revisions to related definitions that are “intended to clarify the application of the existing rule and . . . not substantively change it.”

Nasdaq.

The Nasdaq Stock Market also has pending before the SEC a proposed rule change to allow primary-offering, direct listings in the context of Nasdaq’s own distinct market model, some of which require fewer record holders than the NYSE for direct listings. Additionally, on December 22, Nasdaq submitted a separate proposed rule change on this issue for which Nasdaq seeks immediate effectiveness without a prior public comment period. On December 23, the Staff of the Division of Trading and Markets of the SEC issued a public statement that “the Staff intends to work to expeditiously complete, as promptly as possible accommodating public comment, a review of these proposals, and as with all self-regulatory organizations’ proposed rule changes, will evaluate, among other things, whether they are consistent with the requirements of the Exchange Act and Commission rules.”

CII’s Objection & SEC Response

On August 31, 2020, the Council of Institutional Investors (CII) notified the SEC of its intention to file a petition for the SEC’s Commissioners to review the August 26 order approving the NYSE’s proposed rule change.[11] On September 8, 2020, CII filed its petition for review with the SEC, setting forth its principal criticism that liberalization of direct listing regulations in the face of current limitations on investors’ legal recourse for material misstatements and omissions is not consistent with Section 6(b)(5) of the Exchange Act,[12] which requires exchange rules be “designed . . . to protect investors and the public interest.” CII previously raised concerns that the NYSE proposal would not guarantee sufficient liquidity for a trading market in the securities to develop after the listing, but did not raise this concern in its petition for review.

Section 11 & Traceability Concerns.

Section 11 of the Securities Act of 1933 (Section 11) provides legal action against a wide range of corporate actors in connection with material misstatements or omissions contained in a registration statement, where a person acquires securities traceable to that registration statement in reliance on such misstatements or omissions. Under the precedent established in Barnes v. Osovsky,[13] a person bringing such a claim for material misstatements or omissions contained in a registration statement under Section 11 must generally show that either the securities they held were purchased at the time of their initial offering or that they were issued under the deficient registration statement and purchased at a later time in the secondary market, which is referred to in concept as traceability. As discussed above, in a direct listing, a company generally registers for resale all of its outstanding common equity that cannot then be sold pursuant to an applicable exemption from registration. Generally, holders of shares that are eligible for resale pursuant to an applicable exemption from registration may, simultaneous with shares sold under an effective registration statement, sell unregistered shares in transactions under Rule 144 or otherwise not subject to, or exempt from, registration under the Securities Act. As a result, shares available in the market upon a direct listing include both shares sold under the registration statement and shares sold pursuant to an exemption from registration (and therefore not under the registration statement). At a high level, shares sold pursuant to a registration statement may be subject to claims under Section 11 as well as under Rule 10b-5 under the Exchange Act (the general anti-fraud provisions of the Exchange Act), while shares sold otherwise than under a registration statement may be subject to claims only under Rule 10b-5.  Due to differences in the standards of the two rules, and defenses available to the company or other defendants, it may generally be more difficult for a holder to make successful claims with respect to shares not sold pursuant to a registration statement.

As highlighted by CII in its petition, investor concerns about the traceability of shares sold in a direct listing were highlighted in a recent case of first impression concerning direct listings.[14] In that case, the listing company argued that a Section 11 claim could not be brought as the complaining investors could not distinguish between the shares sold under the registration statement and unregistered shares sold by an insider and were consequently unable to establish traceability. Although the district court in that case denied the motion to dismiss, appeal of the issue before the U.S. Court of Appeals for the Ninth Circuit is pending. The ultimate decision in the Ninth Circuit, which includes Silicon Valley, could play an outsized role in future cases.

In earlier commentary, the SEC noted that although the NYSE’s proposal did present a “recurring” Section 11 concern, as the issue was not “exclusive” to Primary Direct Floor Listings, approval of the NYSE’s proposal did not pose a “heighted risk to investors” (emphasis added). CII’s petition also raises certain proposals that it argues would alleviate investors’ burden in proving traceability, such as the introduction of blockchain-traceable shares, and should be addressed in advance of liberalizing direct listing rules to accommodate Primary Direct Floor Listings.

Final Approval.

On December 22, 2020, the SEC issued its final approval of the NYSE’s proposed rules, finding the NYSE’s proposal is consistent with the Exchange Act and the rules and regulations issued thereunder and, furthermore, that the proposed rules would “foster[] competition by providing an alternate method for companies of sufficient size [to] decide they would rather not conduct a firm commitment underwritten offering.” The SEC’s December 22 order discussed several procedural safeguards included by the NYSE in its proposed rules that were intended to “clarify the role of the issuer and financial advisor in a direct listing” and “explain how compliance with various rules and regulations” would be addressed. These changes include the introduction of an “IDO Order type,” the clarification of how market value would be determined in connection with primary direct listings and the agreement to retain FINRA to monitor compliance with Regulation M and other anti-manipulation provisions of federal securities laws.

Notably, the SEC’s December 22 order rejects the notion that offerings not involving a traditional underwriter would “‘rip off’ investors, reduce transparency, or involve reduced offering requirements or accounting methods,” finding that the relevant “traceability issues are not exclusive to nor necessarily inherent in” Primary Direct Floor Listings. In approving the NYSE’s proposal and reaching its conclusion that the NYSE’s proposal provided a “reasonable level of assurance” that the applicable market value threshold supports a public listing and the maintenance of fair and orderly markets, the SEC specifically noted that the applicable thresholds for the equity market value under the revised rules were at least two and a half times greater than the market value standard that exists for a traditional IPO ($40 million). The SEC order also positively discusses steps taken by the NYSE to ensure compliance by participants in the direct listing process with Regulation M and other provisions of the federal securities laws.

The two Commissioners who dissented (Allison Herren Lee and Caroline A. Crenshaw) and certain investor protection groups have issued statements expressing concern that, because of the absence of traditional underwriters, the primary direct listing process will lack a key gatekeeper present in traditional IPOs that helps prevent poorly run or fraudulent companies from going public. In its order approving the NYSE’s revised rules on Primary Direct Floor Listings, the SEC suggests that, depending on the facts and circumstances, a company’s independent financial adviser could be subject to Securities Act liability, or at least lawsuits alleging underwriter liability, in connection with direct listings. The two dissenting Commissioners, however, suggest that guidance as to what may trigger status as a statutory underwriter should have been considered and concurrently provided.

Conclusion

In any event, direct listings are a sign of the times. As U.S. companies raise increasingly large amounts of capital in the private markets, the public capital markets are responding to the need to provide a wider variety of means for a private company to enter the public capital markets and provide liquidity to existing shareholders. Although direct listings will undoubtedly provide new opportunities for entrepreneurial companies with a well-recognized brand name or easily understood business model, we do not expect direct listings to replace IPOs any time soon. Direct listing practice is evolving and involves new risks and speedbumps. There are a number of novel issues and open questions raised by the evolving direct listing landscape, some of which are highlighted in Appendix I hereto (Open Questions for Direct Listings). Regulatory divergence between the price-setting mechanisms applicable to Primary Direct Floor Listings and Selling Shareholder Direct Listings may spur further rulemaking to conform to  applicable standards. Gibson Dunn will also continue to update this Current Guide to Direct Listings from time to time to further describe the applicable rules and provide commentary as practices evolve. Any company considering an entry to the public capital markets through a direct listing is encouraged to carefully consider the risks and benefits in consultation with counsel and financial advisors. Members of the Gibson Dunn Capital Markets team are available to discuss strategy, options and considerations as the rules and practice concerning direct listings evolve.

___________________

[1]       Many foreign private issuers have listed their shares, in the form of American Depositary Shares (evidenced by American Depositary Receipts), on U.S. exchanges without a simultaneous U.S. capital raising, seeking such listing in connection with the company’s filing of a registration statement on Form 20-F under the Securities Exchange Act of 1934, as amended, and the depositary bank’s filing of a registration statement on Form F-6 under the Securities Act of 1933, as amended (a so-called “Level II ADR facility”). Such Level II ADR facilities are outside the scope of this article and should be separately considered with the advice of counsel.

[2]       The NYSE’s most recent proposal, submitted on June 22, 2020, is available at the following link: https://www.sec.gov/comments/sr-nyse-2019-67/srnyse201967-7332320-218590.pdf. The NYSE’s prior proposal, submitted on December 12, 2019, is available at the following link: https://www.nyse.com/publicdocs/nyse/markets/nyse /rule-filings/filings/2019/SR-NYSE-2019-67%2c%20Re-file.pdf. The NYSE’s initial proposal, submitted on November 26, 2019, which was withdrawn, is available at the following link: https://www.nyse.com/publicdocs/nyse/markets/nyse/rule-filings/filings/2019/SR-NYSE-2019-67.pdf.

[3]       The SEC’s revision to Rule 163B under the Securities Act of 1933, as amended, which permits “testing-the-waters” communications by all issuers, was adopted on September 25, 2019. The adopting release is available at the following link: https://www.sec.gov/rules/final/2019/33-10699.pdf.

[4]       The SEC has published a helpful guide concerning Rule 144 transactions that is available at the following link: https://www.sec.gov/reportspubs/investor-publications/investorpubsrule144htm.html. Such a transaction is outside the scope of this article and should be separately considered with the advice of counsel

[5]       Certain NYSE rules are reviewed herein. The NYSE Listed Company Manual, which contains all of the listing standards and other rules applicable to a company listed on the NYSE, is available at the following link: https://nyse.wolterskluwer.cloud/listed-company-manual.

[6]       Certain Nasdaq rules are reviewed herein. The Nasdaq Equity Rules, which contain all of the listing standards and other rules applicable to a company listed on Nasdaq, are available at the following link: http://nasdaq.cchwallstreet.com/.

[7]       On August 15, 2019, Nasdaq submitted to the SEC proposed rule changes related to direct listings on the Nasdaq Global Market and Nasdaq Capital Market, the second- and third-tier Nasdaq markets, respectively. The Nasdaq proposal, submitted on August 15, 2019, is available at the following link: https://www.sec.gov/rules/sro/nasdaq/2019/34-86792.pdf. Nasdaq’s amendment to its proposal, submitted on November 26, 2019, is available at the following link:  https://www.sec.gov/comments/sr-nasdaq-2019-059/srnasdaq2019059-6482012-199454.pdf. The SEC’s adopting release approving the Nasdaq proposal is available at the following link: https://www.sec.gov/rules/sro/nasdaq/2019/34-87648.pdf.

[8]       There must be an independent valuation where a company goes public without an underwriting syndicate that would otherwise represent to the applicable exchange that such exchange’s distribution requirements will be met by the contemplated offering. If consistent and reliable private-market trading quotes are available, both the independent valuation and valuation based on private-market trading quotes must show a market value of “publicly held” shares in excess of $100 million ($110 million for Nasdaq Global Select Market, under certain circumstances).

[9]       In lieu of a valuation for listings on the Nasdaq Global Market and Nasdaq Capital Market, the exchange may accept “other compelling evidence” that the (i) tentative initial bid price, (ii) market value of listed securities and (iii) market value of publicly held shares each exceed 250 percent of the otherwise applicable requirements. Under the rules, as amended, such compelling evidence is currently limited to cash tender offers by the company or an unaffiliated third party that meet certain other requirements.

[10]     To qualify under the closing price alternative, the listing company must have: (i) average annual revenues of $6 million for three years, or (ii) net tangible assets of $5 million, or (iii) net tangible assets of $2 million and a three-year operating history, in addition to satisfying the other financial and liquidity requirements listed above. If listing on the Nasdaq Capital Markets under the NCM Listed Securities Standard in reliance on the closing price alternative, such closing price must be in excess of $4.00.

[11]     The Council of Institutional Investors’ August 31 notice to the SEC is available at the following link: https://www.cii.org/ files/issues_and_advocacy/correspondence/2020/August%2031%202020%20%20letter%20to%20SEC-AB.pdf. The SEC’s letter to the NYSE notifying the exchange of the stay of the SEC staff’s August 26 order is available at the following link: https://www.sec.gov/rules/sro/nyse/2020/34-89684-carey-letter.pdf.

[12]     The Council of Institutional Investors’ Petition for Review of an Order is available at the following link: https://www.sec.gov/rules/sro/nyse/2020/34-89684-petition.pdf.

[13]        373 F.2d 269 (2d Cir. 1967).

[14]     See generally Pirani v. Slack Technologies, Inc., 445 F.3d 367 (N.D. Cal. 2020).

APPENDIX I

Open Questions for Direct Listings (as of January 8, 2021)

Some of the relevant open questions include:

  • Will the loss of a traditional firm-commitment underwriter create additional risks for investors? The NYSE’s revised rules permit companies to raise new capital without using a firm-commitment underwriter. The two Commissioners who dissented (Allison Herren Lee and Caroline A. Crenshaw) and certain investor protection groups have expressed concern that the absence of a traditional underwriter removes a key gatekeeper present in traditional IPOs that helps prevent inaccurate or misleading disclosures. In its order approving the NYSE’s revised rules on Primary Direct Floor Listings, the SEC suggests that, depending on the facts and circumstances, a company’s financial advisers could be subject to Securities Act liability, or at least lawsuits alleging underwriter liability, in connection with direct listings. The two dissenting Commissioners, however, suggest that guidance as to what may trigger status as a statutory underwriter should have been considered and concurrently provided.
  • Will a Primary Direct Floor Listing create new risks for the listing company? Under current rules and precedent, in a Primary Direct Floor Listing the listing company may have more rather than less liability in a direct listing than a traditional IPO. In a traditional IPO, because of customary lockup arrangements, investors can generally guarantee the traceability of their shares to the registration statement because only shares issued under the registration statement are trading in the market until the lockup period expires. Under current case law, which is being appealed, the tracing requirement has been seemingly abandoned, meaning all the shares in the market can potentially make claims under Section 11.
  • How will legal, diligence and auditing practices develop around direct listings? Because the listing must be accompanied by an effective registration statement under the Securities Act, the liability provisions of Section 11 and 12 of the Securities Act will be applicable to sales made under the registration statement. We note that in many of the direct listings to date, the companies have engaged financial advisors to assist with the positioning of the equity story of the company and advise on preparation of the registration statement, in a process very similar to the process of preparing a registration statement for a traditional IPO. Because a company will be subject to the same standard for liability under the federal securities laws with respect to material misstatements and omissions in a registration statement for a direct listing to the same extent as for a registration statement for an IPO, a company’s incentives to conduct diligence to support the statements in its registration statement do not differ between the two types of transactions. Similarly, financial statement requirements, and the requirements as to independent auditor opinions and consents, do not differ between registration statements for direct listings and IPOs. Furthermore, follow-on offerings by the company that involve firm-commitment underwriting or at-the-market programs will require the traditional diligence practices. To date, there have been no lawsuits alleging that financial advisers in a direct listing could be subject to Securities Act liability in connection with direct listings.
  • What impact will the expanded availability of direct listings have on IPO activity? One could argue that the greatest attraction of a direct listing is that it can nearly match private markets in being faster and less costly than an IPO. In some cases, it could provide similar liquidity as a traditional IPO, although trading price certainty and trading volume could be lower following a direct listing than following an IPO. Direct listings have been available on the NYSE and Nasdaq for a decade but have not been utilized regularly by large private companies in lieu of a traditional IPO. In any event, the requirement for 400 round lot holders will continue to be a hurdle for many private companies looking to list directly.
  • How will the initial reference price and/or price range in the prospectus be determined? There is no reference price from another market for the DMM to apply and no negotiation between the issuer and the underwriter as in an IPO. The NYSE seems to bridge this gap with the requirement for the DMM to consult with an independent financial adviser to determine the initial reference price in a Selling Shareholder Direct Listing and, in a Primary Direct Floor Listing, to determine the price range to be set forth in the applicable prospectus. Eventually, a standardized set of practices around the financial adviser’s work and presentation of the price to the issuer and the Exchange should develop.
  • Without the firm-commitment IPO process, in which the offering is oversold and heavily marketed, how will direct listed shares trade in the aftermarket? Without an underwritten offering, the issuer will not engage in price finding and book building activities. In a direct listing, the issuer will also take on much of the role of investor outreach that is borne by underwriters in a traditional IPO. Although direct listing marketing efforts may include one or more investor days and a roadshow-like presentation, sell-side analysts will presumably not be involved, building models and educating investors. It may be more difficult for the issuer to tell its forward-looking story and build value into the trading price of the stock without research coverage prior to or after the listing. For this reason, the most successful direct listings to date have been well-known companies with widely recognized brands that have successfully engaged with a broad set of new investors. We expect that companies engaging in direct listings will continue to develop more robust internal investor/shareholder relations functions than may be needed for a company conducting a traditional IPO.
  • Will large private placements (often called “private IPOs”) have a new advantage? The expanded option to direct list, whether in a secondary or primary format, through an independent valuation alone may mean investors in a private company can have access to public markets faster than through an IPO process. When private companies market private equity capital raises, including private IPOs, they might use the direct listing option as a marketing tool to attract investors to the private placement.
  • Are there any companies that are well-positioned for a Primary Direct Floor Listing? The NYSE’s revised rules may prompt well-positioned companies to consider a capital raise where the private or IPO markets are otherwise unattractive. Furthermore, until Nasdaq’s rules are approved, how will the NYSE’s rules affect the decision of where to list?

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Capital Markets or Securities Regulation and Corporate Governance practice groups, or the authors:

Alan Bannister– New York (+1 212-351-2310, [email protected])
Hillary H. Holmes – Houston (+1 346-718-6602, [email protected])
Boris Dolgonos – New York (+1 212-351-4046, [email protected])
Stewart L. McDowell – San Francisco (+1 415-393-8322, [email protected])
James J. Moloney – Orange County, CA (+1 949-451-4343, [email protected])
Evan Shepherd* – Houston (+1 346-718-6603, [email protected])

Please also feel free to contact any of the following practice leaders:

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

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

*Mr. Shepherd is admitted only in New York and is practicing under the supervision of Principals of the Firm.

© 2021 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

This Alert reports on recent intellectual property law developments relating to the COVID-19 pandemic, and provides updates on various developments we covered in previous alerts. First, we briefly review the intellectual property-related provisions of the COVID-19 relief and government funding bill that the President signed into law at the end of December. Second, we discuss ongoing efforts around the world to facilitate the donation of intellectual property rights, including through the Open COVID Pledge, and a proposal pending before the World Trade Organization (“WTO”). Finally, we include updated figures regarding the frequency of patent litigation in 2020, and note manufacturer 3M’s success in using trademark law to combat price gouging of its personal protective equipment.

(1) New Intellectual Property Laws in the COVID-19 Relief and Government Funding Bill

The COVID-19 relief and government funding bill that became law on December 27, 2020 incorporates three sections focused on intellectual property-related measures: the Copyright Alternative in Small-Claims Enforcement Act (“CASE Act”), which amends certain provisions of the Copyright Act, 17 U.S.C. § 101 et seq; amendments to the Federal Criminal Code that make it a felony to engage in unauthorized streaming of copyrighted content (commonly referred to as the Protecting Lawful Streaming Act); and the Trademark Modernization Act, which includes revisions to the Lanham Act, 15 U.S.C. § 1051 et seq. We summarize these developments below; more detailed discussions can be found in Gibson Dunn’s prior alerts about the intellectual property Acts in the bill, available here and here.

The CASE Act (Consolidated Appropriations Act of 2021, Division Q, Title II, Subtitle A) establishes a new Copyright Claims Board (“Board”) within the United States Copyright Office to serve as an alternative forum to federal courts for parties to resolve small copyright infringement claims, with streamlined procedures, and limited remedies amounting to no more than $30,000 in total damages in a single proceeding for registered works, and $15,000 of the same for unregistered works.[1] Decisions of the Board will not be precedential, and the Act provides for limited appellate review. This new procedure has the potential to provide individual rights holders (such as composers and graphic artists), an alternative mechanism that should be more efficient and affordable than federal court litigation for resolving small claims. Whether copyright owners will use this alternative forum remains to be seen.

An additional measure, widely referred to as “The Protecting Lawful Streaming Act” (Consolidated Appropriations Act of 2021, Division Q, Title II, Subtitle A), adds a new Section 2319C to the federal criminal code that makes it a criminal offense for a person “to willfully, and for purposes of commercial advantage or private financial gain” digitally transmit material without authorization of the copyright owner, or the law. The provision will allow the Department of Justice to bring felony charges against digital transmission services that are “primarily designed” for the purpose of streaming copyrighted materials without authorization. The maximum penalty for violation is imprisonment for up to ten years.[2] Before this provision, criminal copyright infringement based on unauthorized streaming could be charged only as a misdemeanor.

The Trademark Modernization Act of 2020 (Consolidated Appropriations Act of 2021, Division Q, Title II, Subtitle B) revises various provisions of the Lanham Act, 15 U.S.C. §§ 1501 et seq., in response to a recent rise in fraudulent trademark applications. Specifically, the Act enhances trademark examination proceedings by formalizing the process third-parties may use to submit evidence to the USPTO, and by providing the Office with greater authority and flexibility to set deadlines for trademark applicants to respond to actions taken by examiners.[3] The Act also clarifies the standard for finding the irreparable harm necessary for injunctions in trademark cases, bringing uniformity in response to inconsistencies that have emerged across federal courts after the Supreme Court’s decision in eBay Inc. v. MercExchange, LLC, 547 U.S. 388 (2006).[4]

(2) Ongoing Efforts to Facilitate the Donation of Intellectual Property Rights During the COVID-19 Pandemic

WTO Proposal to Suspend IP Rights Under the TRIPS Agreement. The TRIPS council met again on December 10, 2020, to discuss a proposal, originally submitted in October by South Africa and India, seeking the temporary waiver of various provisions in Section II of the TRIPS Agreement that grant Member countries intellectual property rights, and impose obligations to enforce them. The proposal, if passed, would effectively waive all copyright, trademark, industrial design, and patent rights provided under the TRIPS Agreement, insofar as such rights relate to the prevention, containment, or treatment of COVID-19; the effective waiver would apply until vaccination is widespread and “the majority of the world’s population has developed immunity” to the virus.[5] The TRIPS Agreement already includes provisions that require compulsory licensing of intellectual property rights during health emergencies to assist low-income countries that do not have the capacity to make pharmaceutical products. Proponents of the proposed waiver contend that these provisions are cumbersome and do not facilitate the necessary access to other personal protective equipment and vaccines.[6]

The TRIPS proposal has gained support from more than 99 countries, but major players, including the United States, the United Kingdom, Japan, Canada, and the European Union oppose it. The United Kingdom explained that its opposition to the proposal arises in part from a lack of “clear ways in which IP has acted as a barrier to accessing vaccines, treatments, or technologies” in the response to COVID-19.[7] The WTO has postponed further discussion of the proposal.

Open COVID Pledge. Organizations continue to sign onto the Open COVID Pledge, through which signatories grant a non-exclusive, royalty-free, worldwide license to use their patents and copyrights “for the sole purpose of ending” the COVID-19 pandemic. The pledge now includes patents related to wearable technology to perform contact tracing and proximity alerts, face covering and face shield designs, and computer software relating to diagnosing the virus. A Japanese-led Open COVID Pledge Coalition was founded last spring. That coalition, which includes several major Japanese companies, has also continued to grow, with voluntary pledges now having contributed approximately 1 million patents.

COVID-19 Technology Access Framework. The COVID-19 Technology Access Framework, which was established in April, creates a mechanism for universities to grant “non-exclusive royalty free licenses . . . for the purpose of making and distributing products to prevent, diagnose and treat COVID-19 infection during the pandemic and for a short period thereafter.” Since our prior reporting on the framework (see here), 21 more universities have now signed on.

Medicines Patent Pooling. As we previously reported, the UN-backed nonprofit Medicines Patent Pool (“MPP”) has been compiling patent information relating to products that are being used in clinical trials to treat COVID-19. The MPP also negotiates licenses with patent holders to facilitate widespread access to treatments. Twenty-one generic pharmaceutical manufacturers have now signed a pledge to work with the MPP to (among other things) negotiate licenses for patented COVID-19 therapeutics, and to accelerate development and delivery timelines for new treatments.

(3) Patent Litigation Sees Steady Increase While 3M’s Use of Trademark Law to Combat Price Gouging Proves Successful

Patent Lawsuits. Nearly 4,000 patent cases were filed in federal district courts in 2020, an increase of approximately 400 cases over 2019.[8] The Patent Trial and Appeal Board has seen a small increase in filings, with approximately 1500 petitions for inter partes, covered business method, and post-grant review, filed in 2020—an increase of approximately 200 proceedings over 2019.[9] District courts across the country continue to delay jury trials, and hold hearings remotely. The Federal Circuit’s May 18, 2020 order suspending in-person oral arguments indefinitely, and opting in favor of telephonic arguments (or no argument at all, if the Court so orders) remains in effect. In the Eastern District of Texas, Judge Gilstrap announced in November that all of his jury trials would be postponed until March 2021, with other judges ordering similar delays. Many courts, however, continue to hold the majority of proceedings online and have ordered jury trials to be continued. The Western District of Texas has postponed all jury trials until after January 31 while the Southern District of New York has postponed the same until after February 12.

3M Litigation. As reported in a previous update, in the summer of 2020, manufacturer 3M brought a wave of lawsuits across the country against online vendors, asserting claims under the Lanham Act for the sale of counterfeit PPE using 3M’s trademarks, and related state law claims, in an effort to combat both the counterfeit production of PPE, as well as price gouging of the same. In some of these cases, 3M established irreparable harm under a reputational theory of injury—namely, that “[n]o amount of money could repair the damage to 3M’s brand and reputation” if it were associated with “price-gouging at the expense of healthcare workers and other first responders in the midst of the COVID-19 crisis.”[10] In analyzing these trademark infringement claims based on the sale of counterfeit PPE at inflated prices, courts have also paid particular attention to the “bad faith” prong of the trademark infringement analysis, with one, for example, noting that the defendant’s decision to stop selling automobiles in favor of selling N95 masks constituted “textbook bad faith.”[11]

*          *          *

We are continuing to monitor intellectual property-related updates and trends relating to COVID-19.

____________________

   [1]   17 U.S.C. § 1504(e)(1)(A), (D).

   [2]   Id. § 2319C(c).

   [3]   15 U.S.C. § 1051(f).

   [4]   15 U.S.C. § 1116(a).

   [5]   WTO, Council for Trade-Related Aspects of Intellectual Property Rights, Waiver from Certain Provisions of the TRIPS Agreement for the Prevention, Containment and Treatment of COVID-19, p. 2, October 2, 2020, https://docs.wto.org/dol2fe/Pages/SS/directdoc.aspx?filename=q:/IP/C/W669.pdf&Open=True.

   [6]   See WTO, Members discuss intellectual property response to the COVID-19 pandemic, October 20, 2020, https://www.wto.org/english/news_e/news20_e/trip_20oct20_e.htm.

   [7]   See, e.g., UK Mission to the WTO, UN, and Other International Organizations (Geneva), “UK Statement to the TRIPS Council: Item 15 Waiver Proposal for COVID-19,” UK Government, October 16, 2020.

   [8]   These figures were obtained from Docket Navigator’s Omnibus Reporting of Patent Cases by year. A “patent case” here refers to actions “addressing the infringement, validity or enforceability of a U.S. patent flagged with Nature of Suit (“NOS”) 830 in the PACER system as well as other cases that are known to meet the above criteria.” Docket Navigator, Scope of Data Available in Docket Navigator, https://search.docketnavigator.com/help/scope.html (last visited January 6, 2021).

[9]   Docket Navigator, Omnibus Report PTAB Petitions,  https://search.docketnavigator.com/patent/binder/390087/13 (last visited January 8, 2021). This does not include proceedings conducted pursuant to 35 U.S.C. § 6(b)(1)-(3), such as appeals of adverse decisions of examiners, appeals of reexaminations, or derivation proceedings.

[10]   3M Co. v. Performance Supply, LLC, 1:20-cv-02949, Dkt. No. 23 (S.D.N.Y. May 4, 2020).

[11]   Id.

Gibson Dunn lawyers regularly counsel clients on the issues raised by this pandemic, and we are working with many of our clients on their response to COVID-19.  For additional information, please contact any member of the firm’s Coronavirus (COVID-19) Response Team.  Please also feel free to contact the Gibson Dunn lawyer with whom you usually work, or the authors in New York:

Richard Mark (+1 212-351-3818, [email protected])
Joe Evall (+1 212-351-3902, [email protected])
Doran Satanove (+1 212-351-4098, [email protected])
Wendy Cai (+1 212-351-6306, [email protected])

© 2021 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

Los Angeles partner Maurice Suh, of counsel Daniel Weiss and associate Zathrina Perez are the authors of “Supreme Court needs to rethink NCAA ‘amateurism’” [PDF] published by the Daily Journal on January 5, 2021.

Washington, D.C. counsel Roscoe Jones Jr., New York partner Joel Cohen, Washington, D.C. partner Michael Bopp, New York partner Arthur Long, Washington, D.C. partner Jeffrey Steiner, Washington, D.C. associate Samantha Ostrom, Orange County associate Maggie Zhang and San Francisco associate Alexandra Farmer are the authors of “Financial Policy in the Incoming Biden Administration: What Can We Expect?” [PDF] published by Wall Street Lawyer in its December 2020 issue.

President-elect Joe Biden has signaled that robust consumer protection will be a major focus of his policy agenda. In this webcast, an experienced team of Gibson Dunn consumer protection attorneys will preview the incoming administration’s anticipated consumer protection agenda in areas including consumer fraud, privacy, and consumer financial protection. We also will discuss what, if any, impact this policy shift is likely to have on state-level enforcement. Topics to be discussed include:

  • DOJ and SEC consumer fraud enforcement;
  • FTC consumer protection enforcement, including privacy and cybersecurity enforcement;
  • HHS privacy enforcement;
  • CFPB consumer financial protection enforcement; and
  • State Attorney General consumer protection enforcement in key jurisdictions, including New York and California.

View Slides (PDF)

PANELISTS:

Joel M. Cohen is a partner in the New York office and Co-Chair of the firm’s global White Collar Defense and Investigations Practice Group. He is a trial lawyer and former federal prosecutor highly-rated in Chambers and ranked a “Super Lawyer” in Criminal Litigation by Global Investigations Review. Mr. Cohen’s practice focuses on financial institution litigation, FCPA/anticorruption issues, and other international disputes and discovery.

Alex Southwell is a partner in the New York office and Co-Chair of the firm’s Privacy, Cybersecurity and Consumer Protection Practice Group.  He is a Chambers-ranked former federal prosecutor and was named a “Cybersecurity and Data Privacy Trailblazer” by The National Law Journal.  Mr. Southwell’s practice focuses on white-collar criminal and regulatory enforcement defense, internal investigations and compliance monitoring, and he has considerable experience in information technology-related investigations, counseling, and litigation.

Ryan Bergsieker is a partner in the Denver office and a former federal cybercrimes prosecutor.  He is recognized by Chambers as one of the top white collar defense and government investigations lawyers in Colorado, and was named by BTI to its Client Service All-Stars List.  Mr. Bergsieker’s practice focuses on government investigations, complex civil litigation, and cybersecurity/ data privacy counseling.

Winston Y. Chan is a former federal prosecutor and litigation partner in the San Francisco office.  He has particular expertise representing clients in enforcement actions and investigations by California’s Attorney General and local district attorneys.  Mr. Chan is a Chambers-ranked attorney in White Collar Crime and Government Investigations, recognized by Benchmark Litigation as a “Litigation Star”, and recommended annually by Global Investigations Review.

Mylan Denerstein is a partner in the New York office and Co-Chair of the firm’s Public Policy Practice Group.  Ms. Denerstein leads complex litigation and internal investigations and represents companies facing a diverse range of legal issues, typically involving federal, state and municipal government agencies.  She is a former federal prosecutor and also served as Counsel to New York State Governor Andrew Cuomo.  She was named by Benchmark Litigation as a 2021 “Top 250 Women in Litigation” and a 2021 “Litigation Star” nationally and in New York.

Elizabeth Papez is a litigation and regulatory partner in the Washington D.C. office and a former federal prosecutor and Justice Department official.  She is repeatedly recognized as one of Benchmark USA’s Top 250 Women in Litigation nationwide.  Ms. Papez’s practice focuses on high-stakes consumer protection, securities, and antitrust matters with parallel civil regulatory and litigation exposure.  She has particular experience with the application of federal competition and consumer protection laws and multi-jurisdictional discovery and data-sharing considerations.

Ashley Rogers is a partner in the Dallas office.  She is a member of the firm’s Litigation Department and practices in the Privacy, Cybersecurity and Consumer Protection Practice Group.  Ms. Rogers’ practice focuses on a wide range of data privacy and consumer protection matters, and she has particular experience representing clients in the technology and internet industries in putative data privacy class actions and in government investigations.

Amanda Aycock is a senior associate in the New York office, and a member of the firm’s Litigation Department and Privacy, Cybersecurity and Consumer Protection Practice Group.  Her practice is cross-disciplinary and includes significant experience in consumer protection, data privacy, contract, antitrust, and criminal law.  She was named in 2020 by Legal 500 as a Rising Star” in corporate investigations and white collar criminal defense, and as a “Name to Note” for white collar matters emanating from the technology, media and entertainment industries.

Victoria Weatherford is a senior associate in the San Francisco office and member of the firm’s Litigation Department.  She has particular experience representing clients in enforcement actions and investigations by California’s Attorney General and local district and city attorneys, in California writs and appeals, and at trial.  She is recognized as one of the ABA’s “On the Rise – Top 40 Young Lawyers” in 2020.  From 2014-2018, she served as a Deputy City Attorney in the San Francisco City Attorney’s Office, where she first-chaired statewide consumer protection cases to trial under California’s Unfair Competition Law and False Advertising Law.

MCLE CREDIT INFORMATION:

This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 1.5 credit hours, of which 1.5 credit hours may be applied toward the areas of professional practice requirement.

This course is approved for transitional/non-transitional credit. Attorneys seeking New York credit must obtain an Affirmation Form prior to watching the archived version of this webcast. Please contact [email protected] to request the MCLE form.

Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 1.5 hours.

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

San Francisco partner Ethan Dettmer and Washington, D.C. associates Suria Bahadue and Matthew Rozen are the authors of “Invalid appointments and the restoration of DACA,” [PDF] published by the Daily Journal on January 4, 2021.

On 18 December 2020, the European Commission (the “Commission”) launched a comprehensive public consultation (the “Consultation”) on the revision of the European Union (“EU”) antitrust rules specifically applicable to distribution agreements, namely, the 2010 Vertical Block Exemption Regulation (Regulation 330/2010 or “VBER”) and the 2010 Vertical Guidelines, both of which will expire on 31 May 2022.[1]

The Commission is consulting with a view to gathering feedback on a number of policy options:[2]

  • On one side, the Commission proposes to adopt an arguably more lenient approach to the application of EU competition rules to certain types of vertical arrangements, ranging from: long-term non-compete obligations, efficiency-generating resale price maintenance (“RPM”), sustainability agreements in the context of the European Green Deal,[3] active sale restrictions outside of pure exclusive distribution, and measures indirectly restricting online sales.
  • On the other side, the Commission is considering adopting a stricter competition law enforcement strategy in relation to other types of vertical agreements such as: restrictions on price comparison websites and on online advertising, dual distribution and parity obligations (e.g., most favoured nation, or “MFN” clauses).

The Consultation is open until 26 March 2021, and will be followed by a report on the findings and results of the impact assessment phase. This will result in the publication of the proposed new draft VBER and accompanying Vertical Guidelines. Given the range of policy options under consideration by the Commission, this Consultation gives companies involved in both traditional and online retail business a unique opportunity to seek to influence the shape of future vertical restraint policies.

1.   Background & Historical Context

Since the 1960s, the Commission has had in place regulations and guidance exempting certain categories of distribution agreements from the application of EU competition rules prohibiting anti-competitive agreements or arrangements.[4] The current VBER entered into force on 1 June 2010.

The VBER block exempts from the application of EU competition law distribution agreements where the market shares of the supplier and reseller do not exceed 30% in the respective relevant markets. The exemption applies if the agreement does not include so-called ‘hard-core’ restrictions.[5] Where companies cannot safely determine that their distribution agreement is covered by the VBER ‘safe harbour’, the company will need to consider: (i) if the agreement contains any ‘hard-core’ or excluded restrictions, (ii) if it may have any foreseeably anti-competitive effects on competition, and (iii) if there are any efficiencies that may benefit the agreement from an individual exemption under Article 101(3) TFEU. The Vertical Guidelines provide guidance to companies to perform these individual assessments.

2.   The 2010 VBER and Vertical Guidelines and the Commission’s Approach to E-Commerce and Other Restrictions

The VBER and the Vertical Guidelines currently in force include rules and guidance that aim at fostering cross-border trade and online commerce as well as promoting competition. For example, the 2000 Vertical Guidelines allowed suppliers to require that quality standards be met in order to allow the resale of products through a distributor’s website.[6] The 2010 version of the Guidelines implicitly limited the application of such quality standards in the context of the Internet to situations involving selective distribution arrangements. And in any event, the standards had to be applied in an “overall equivalent” manner to both physical and online points of sale (i.e., stricter standards could not be applied only to online sales).[7] The 2010 Vertical Guidelines also set out a list of obligations and restrictions that suppliers were not permitted to impose on online resellers without potentially breaching EU competition law.[8]

The application of antitrust rules to e-commerce was significantly influenced by the 2011 Judgment of the Court of Justice of the EU (“CJEU”) in Pierre Fabre, which found that EU competition law prohibited manufacturers from engaging generally in online sales restrictions. In Pierre Fabre, the restriction resulted from the obligation on distributors to sell personal care products only in the presence of qualified pharmacists, de facto excluding sales through distributors’ websites.[9] The CJEU fully endorsed the view that e-commerce constituted a legitimate channel for the resale of products, and that a prohibition of e-commerce sales amounted to a hard-core restriction of competition ‘by object’. Pierre Fabre was followed by other decisions at EU and national level which confirmed the strict approach of European competition authorities and courts against measures likely to restrict e-commerce.[10]

By 2017, however, the Commission and the CJEU had started to become more nuanced in their approach to e-commerce, in particular regarding the sale of goods in online marketplaces. In the Commission’s final report in its E-Commerce Sector Enquiry, the Commission considered the perceived erosion of manufacturers’ freedom to limit online sales, and concluded that suppliers’ restrictions on distributors which made sales on online marketplaces were not per se anti-competitive.[11] Later that year, in Coty, the CJEU confirmed that manufacturers of luxury goods could seek to preserve the luxury image of those goods by preventing their sale in online marketplaces.[12]

3.   The Commission’s Review of the VBER and the Vertical Guidelines

Against the backdrop of the findings of the E-Commerce Sector Enquiry and the Coty judgment, in 2018 the Commission launched a review of the 2010 VBER and the Vertical Guidelines, which are due to be replaced by 31 May 2022.

The first part of the review process lasted through September 2020, with the Commission gathering evidence on the functioning of the current VBER and the Vertical Guidelines. Respondents indicated that both the 2010 VBER and the Vertical Guidelines had to be revised, especially in light of the profound impact of e-commerce and digitalisation, the increase in direct sales by manufacturers to customers, the wider use of retail price parity clauses, and the emergence of online platforms. Furthermore, the Commission found that there are certain practices and restrictions that have become more commonplace over the past few years, for which additional guidance is required (e.g., dual distribution, online platform bans and restrictions on the use of price comparison websites).[13]

4.   The Commission’s Ongoing Impact Assessment

On 23 October 2020, the Commission published a Roadmap[14] for an impact assessment of the initiatives tabled to address the deficiencies identified in the 2010 VBER and Vertical Guidelines, identifying the following priorities:

1)   The need to clarify, simplify and complete EU competition rules applicable to vertical agreements regarding:

  • the assessment of possible efficiencies resulting from resale price maintenance (“RPM”), which is currently a hard-core restriction under the VBER.
  • how to address restrictions that have become more prevalent since 2010 (e.g., restrictions on the use of price comparison websites, or online advertising restrictions).
  • the treatment of new market players, such as online platforms and marketplaces, especially in areas of distribution not addressed by the current case law, such as agency agreements and dual distribution (i.e., situations in which a supplier sells its goods or services directly to end customers, thereby competing with its distributors at the retail level).
  • the objectives of the European Green Deal,[15] in relation to agreements pursuing sustainability objectives.

2)   Non-compete clauses: These include obligations imposed on buyers not to manufacture, purchase, sell or resell goods or services which compete with those of the supplier, and are currently block exempted by the VBER provided that, inter alia, their duration does not exceed five years and is not automatically renewable. The Commission will consider a more lenient treatment of non-compete clauses whose duration may exceed this period due to automatic extensions, provided that they are subject to termination rights or renegotiation obligations.

3)   Dual distribution: This occurs where a supplier sells its products to consumers both directly and through independent resellers. The growth of online sales has led to a significant increase in dual distribution practices, leading the Commission to consider issues such as: (i) horizontal competition concerns arising from suppliers’ activities in the same market as resellers; (ii) the ability of dual distribution to satisfy the test for efficiencies that is used under Article 101(3) TFEU; and (iii) the comparison of the supplier’s situation with that of other wholesale distributors and resellers which are not in a position to benefit from the VBER in comparable situations.

To address the more widespread use of dual distribution, the Commission has identified the following policy options (with the possibility of Options 2 and 3 being introduced in combination):

  • Option 1: baseline scenario (i.e., no policy change).
  • Option 2: limiting the scope of the exemption to situations that are not likely to raise horizontal concerns by, for example, by introducing a threshold based on the parties’ market shares in the retail market, and by aligning the exemption with what is considered to be capable of being exempted in the case of agreements among competitors.[16]
  • Option 3: extending the exemption to dual distribution practices by wholesalers and/or importers.
  • Option 4: removing the exemption from the VBER, thereby requiring an individual assessment under Article 101(3) TFEU for all dual distribution cases.

4)   Active sales restrictions: The VBER treats as ‘hard-core’ situations where a supplier restricts the territory into which, or the customers to whom, a reseller can sell the products. Resellers should generally be allowed to approach direct individual customers (‘active sales’) and to respond to unsolicited requests from individual customers (‘passive sales’). However, the current rules permit restrictions on active sales in limited cases, notably where they are justified to protect investments made by exclusive distributors.

The rigidity of the current VBER framework regarding the treatment of active and passive sales can render it difficult for suppliers to implement distribution networks that are tailored to their specific needs. For example, the VBER and the Vertical Guidelines do not foresee the use of ‘shared exclusivities’ between two or more distributors in a particular territory (i.e., shielded from active sales by distributors established outside of their territory), or the genuine combination of exclusive and selective distribution methods for the same product lines in the same territory.[17]

The Commission has therefore identified the following policy options (with Options 2 and 3 possibly being introduced in combination):

  • Option 1: baseline scenario (i.e., no policy change).
  • Option 2: expanding the existing exemptions available for the prohibition of active sales in order to give suppliers more flexibility to design their distribution systems.
  • Option 3: ensuring more effective protection for selective distribution systems, by allowing restrictions on sales made from outside the allocated selective distribution territory to unauthorised distributors inside that territory.

5)   Indirect measures restricting online sales: As noted above, most restrictions on distributors to sell through the Internet are considered to be ‘hard-core’ restrictions, which will generally not benefit from the automatic exemption under the VBER.[18] The current versions of the VBER and the Vertical Guidelines apply the same approach to certain indirect measures that might hinder online sales, such as charging the same distributor a higher wholesale price for products intended to be sold online than with respect to products sold off-line (‘dual pricing’), or where selective criteria are imposed for online sales that are not truly equivalent to the criteria imposed in brick-and-mortar shops (the “overall equivalence” principle).[19]

The Commission recognises that, by not allowing suppliers to charge different wholesale prices depending on the actual costs of maintaining different channels, the current rules may prevent them from incentivising associated investments, notably in physical stores.

As a result, the Commission has identified the following policy options (with Options 2 and 3 possibly being introduced in combination):

  • Option 1: baseline scenario (i.e., no policy change).
  • Option 2: no longer treating dual pricing strategies as a ‘hard-core’ competition restriction, with certain safeguards to be defined in accordance with principles established under case law.
  • Option 3: no longer considering as a ‘hard-core’ restriction the imposition of selective criteria for online sales that are not “overall equivalent” to the criteria imposed in brick-and-mortar shops, with safeguards to be defined in accordance with principles set forth under case law.

6)   Parity obligations (so-called ‘most-favoured nation’, or “MFN”, clauses): These types of clause require a business to offer the same or better conditions to its contracting party as those it offers to any other party, or by the company itself through its direct sales channels. Parity obligations are generally block exempted under the conditions of the VBER. However, the increase in their use, notably by online platforms, has led to the identification of possible anti-competitive effects under certain scenarios (e.g., obligations that require parity with other indirect sales or marketing channels).

In order to address these scenarios, the Commission has identified the following policy options:

  • Option 1: baseline scenario (i.e., no policy change).
  • Option 2: removing the benefit of the VBER and including within the list of excluded restrictions (Article 5 VBER) obligations that require parity relative to specific types of sales channel – thereby requiring an individual effects-based assessment of such obligations under Article 101 TFEU. For example, the benefit of the VBER could be generally excluded for parity obligations that relate to indirect sales and marketing channels, including online platforms and other intermediaries.
  • Conversely, parity obligations relating to other types of sales channel would continue to benefit from the block exemption, on the basis that they are more likely to create efficiencies that satisfy the conditions of Article 101(3) TFEU.
  • Option 3: removing the benefit of the VBER ‘safe harbour’ for all types of parity obligations, by including them in the list of excluded restrictions (Article 5 VBER). This option would require companies to perform an individual effects-based assessment in all such cases.

5.   The Consultation – A Call for Action

With the release of its Consultation on 18 December 2020, the Commission is seeking to address the wide range of issues described above and to prepare for the adoption of a revised VBER and Vertical Guidelines in 2022.

While some of the issues addressed in the Consultation have long been highlighted by antitrust agencies, practitioners and industry stakeholders, a number of other issues have also raised heightened attention because of the extra impetus enjoyed by e-commerce during the last years.

The issues and potential solutions identified by the Commission in the Consultation (which is open until 26 March 2021) are important for manufacturers and resellers of all products, but especially for consumer products. Companies may therefore wish to take this opportunity to try to shape the future form of the EU competition rules which will apply to their distribution arrangements.

_____________________

[1]  The Consultation is available in the following link: https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/12636-Revision-of-the-Vertical-Block-Exemption-Regulation/public-consultation.

[2]  These issues and policy options were first set out in the VBER’s inception impact assessment, published on 23 October 2020. See Ref. Ares(2020)5822391 – 23.10.2020, available at: https://ec.europa.eu/info/law/better-regulation/.

[3]  The European Green Deal is the EU plan to create a sustainable economy, and provides for an action plan to boost the efficient use of resources by moving to a clean, circular economy, and to restore biodiversity and cut pollution. See further: https://ec.europa.eu/info/strategy/priorities-2019-2024/european-green-deal_en.

[4]  Article 101(1) TFEU prohibits all agreements or concerted practices that have as their object or effect the restriction of competition where the effect of that restriction may affect trade between Member States.

[5]  See Article 4 of the VBER for a list of ‘hard-core’ restrictions. The VBER also identifies a limited number of restrictions which, if contained in a vertical arrangement, do not benefit from the VBER ‘safe harbour’ but which do not preclude the application of the VBER ‘safe harbour’ to the rest of the agreement (provided that the other conditions set out in the VBER are fulfilled).

[6]  See Commission notice – Guidelines on Vertical Restraints, OJ C 291, 13 October 2000, pp. 1-44, para. 51.

[7]  See Vertical Guidelines, para. 54.

[8]  See Vertical Guidelines, para. 52.

[9]  See Case C-439/09 Pierre Fabre Dermo-Cosmetique EU:C:2011:649.

[10]  For more information, see A. Font Galarza, E. Dziadykiewicz, and A. Guerrero Perez, ‘Selective Distribution and e-Commerce: Recent developments in EU and national case law’, e-Competitions Bulletin, No. 63958, 2014. See further, e.g., Case COMP/AT.40428 – Guess.

[11]  See Report from the Commission to the Council and the European Parliament, Final report on the E-commerce Sector Inquiry, COM(2017) 229 final, 10 May 2017; and the accompanying Staff Working Document, SWD(2017) 154 final, 10 May 2017, Section 4.4.8.

[12]  See Case C-230/16 Coty Germany GmbH v Parfümerie Akzente GmbH EU:C:2017:941.

[13]  See Commission Staff Working Document Evaluation of the Vertical Block Exemption Regulation, SWD(2020) 172 final, 8 September 2020.

[14]  See: https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/12636-Revision-of-the-Vertical-Block-Exemption-Regulation.

[15]  The European Green Deal is the EU plan to create a sustainable economy, and provides for an action plan to boost the efficient use of resources by moving to a clean, circular economy, and to restore biodiversity and cut pollution. See further: https://ec.europa.eu/info/strategy/priorities-2019-2024/european-green-deal_en.

[16]  For Commission regulations that establish block exemptions applicable to horizontal agreements among competitors, see, e.g., Commission Regulation (EU) No 1217/2010 of 14 December 2010 on the application of Article 101(3) of the Treaty on the Functioning of the European Union to certain categories of research and development agreements, OJ L 335, 18 December 2010, pp. 36-42; Commission Regulation (EU) No 1218/2010 of 14 December 2010 on the application of Article 101(3) of the Treaty on the Functioning of the European Union to certain categories of specialisation agreements, OJ L 335, 18 December 2010, pp. 43-47; and Commission Regulation (EU) No 316/2014 of 21 March 2014 on the application of Article 101(3) of the Treaty on the Functioning of the European Union to categories of technology transfer agreements, OJ L 93, 28 March 2014, pp. 17-23.

[17]  The Vertical Guidelines currently find that combined selective and exclusive distribution can only be block exempted if active selling in other territories is not restricted (para. 152). This dilutes significantly the impact that exclusivities are meant to have in a distribution network. The Vertical Guidelines currently only foresee the possibility of restricting active sales by selective retailers into other territories for the purpose of overcoming free-riding problems pursuant to an individual assessment (para. 63).

[18]  As indicated above, qualitative criteria that are “overall equivalent” to criteria imposed on physical stores may also be imposed on Internet stores. Suppliers may also request that distributors have one or more brick-and-mortar shops or showrooms as a condition for becoming a member of its distribution system (Vertical Guidelines, para. 54).

[19]  See Vertical Guidelines, paras. 52-56. The Commission foresees very specific exceptional scenarios where dual distribution may benefit from an individual exemption under Article 101(3) TFEU (see para. 64).

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For additional information, 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:

Kai Gesing – Munich (+49 89 189 33 180, [email protected])
Alejandro Guerrero – Brussels (+32 2 554 7218, [email protected])
Jens-Olrik Murach – Brussels (+32 2 554 7240, [email protected])
Christian Riis-Madsen – Brussels (+32 2 554 72 05, [email protected])
Deirdre Taylor – London (+44 20 7071 4274, [email protected])
David Wood – Brussels (+32 2 554 7210, [email protected])

Antitrust and Competition Group:

Brussels
Peter Alexiadis (+32 2 554 7200, [email protected])
Attila Borsos (+32 2 554 72 11, [email protected])
Jens-Olrik Murach (+32 2 554 7240, [email protected])
Christian Riis-Madsen (+32 2 554 72 05, [email protected])
Lena Sandberg (+32 2 554 72 60, [email protected])
David Wood (+32 2 554 7210, [email protected])

Frankfurt
Georg Weidenbach (+49 69 247 411 550, [email protected])

Munich
Michael Walther (+49 89 189 33 180, [email protected])
Kai Gesing (+49 89 189 33 180, [email protected])

London
Patrick Doris (+44 20 7071 4276, [email protected])
Charles Falconer (+44 20 7071 4270, [email protected])
Ali Nikpay (+44 20 7071 4273, [email protected])
Philip Rocher (+44 20 7071 4202, [email protected])
Deirdre Taylor (+44 20 7071 4274, [email protected])

Hong Kong
Kelly Austin (+852 2214 3788, [email protected])
Sébastien Evrard (+852 2214 3798, [email protected])

Washington, D.C.
Adam Di Vincenzo (+1 202-887-3704, [email protected])
Scott D. Hammond (+1 202-887-3684, [email protected])
Kristen C. Limarzi (+1 202-887-3518, [email protected])
Joshua Lipton (+1 202-955-8226, [email protected])
Richard G. Parker (+1 202-955-8503, [email protected])
Cynthia Richman (+1 202-955-8234, [email protected])
Jeremy Robison (+1 202-955-8518, [email protected])
Andrew Cline (+1 202-887-3698, [email protected])
Chris Wilson (+1 202-955-8520, [email protected])

New York
Eric J. Stock (+1 212-351-2301, [email protected])
Lawrence J. Zweifach (+1 212-351-2625, [email protected])

Los Angeles
Daniel G. Swanson (+1 213-229-7430, [email protected])
Samuel G. Liversidge (+1 213-229-7420, [email protected])
Jay P. Srinivasan (+1 213-229-7296, [email protected])
Rod J. Stone (+1 213-229-7256, [email protected])

San Francisco
Rachel S. Brass (+1 415-393-8293, [email protected])
Caeli A. Higney (+1 415-393-8248, [email protected])

Dallas
Veronica S. Lewis (+1 214-698-3320, [email protected])
Mike Raiff (+1 214-698-3350, [email protected])
Brian Robison (+1 214-698-3370, [email protected])
Robert C. Walters (+1 214-698-3114, [email protected])

In a surprise u-turn, on 31 December 2020, the UK government took steps to narrow the scope of mandatory reporting under DAC 6. In the UK, only cross-border arrangements falling under the Category D hallmark (broadly, those that (a) have the effect of circumventing the OECD’s Common Reporting Standard or (b) obscure beneficial ownership) will be reportable. The change will apply to both historic, and future, cross-border arrangements.

The amendment to the existing legislation is intended as a temporary step. In the coming year, the UK intends to introduce, and consult on, legislation to implement mandatory reporting under the OECD Mandatory Disclosure Rules (the “MDR”).

These actions will significantly reduce the number of arrangements that need to be reported to HMRC. Nevertheless, reporting under DAC 6 is already required in some EU member states (such as Germany), and will be required elsewhere in Europe in the coming months. Accordingly, it needs to be considered whether arrangements that would previously have been reportable to HMRC under DAC 6 now need to be reported to other tax authorities.

EU Council Directive 2011/16 (as amended) (known as DAC 6) requires UK intermediaries (or failing which, taxpayers) to report, and HMRC to exchange, information regarding cross-border arrangements which meet one or more specified characteristics (hallmarks) and which concern at least one EU country. Regulations implementing DAC 6 reporting obligations into UK law (the “Regulations”) came into force on 1 July 2020.

At the end of the Brexit transition period at 11pm on 31 December 2020, obligations requiring the UK to implement DAC 6 fell away. During the course of last year, the UK government had indicated that DAC 6’s UK implementation would be unaffected by, and that the Regulations would remain in force following, the end of the Brexit transition period. However, under the Free Trade Agreement agreed between the UK and the EU on 24 December 2020, the UK is only required to ensure any legislation it implements at the end of the transition period relating to the exchange of information concerning potential cross-border tax planning arrangements offers the level of protection provided for by the “standards and rules which have been agreed in the OECD…”.

Accordingly, on 31 December 2020, the UK government published legislation (taking effect at the end of the transition period) to narrow the scope of the Regulations in line with the MDR. As a result, only cross-border arrangements (i.e. those concerning the UK or an EU member state) that fall within Category D of Part II of DAC 6 will fall within the scope of UK reporting obligations.[1] Broadly, an arrangement will be reportable under Category D if the arrangement either: (i) has the effect of undermining reporting obligations under agreements for the automatic exchange of information (e.g. the EU Common Reporting System, or the OECD’s Common Reporting Standards); or (ii) involves non-transparent legal or beneficial ownership chains that:

  • do not carry on a substantive economic activity;
  • are incorporated, managed, resident, controlled or established in any jurisdiction other than the jurisdiction of residence of one or more of the beneficial owners of the assets held by such persons, legal arrangements or structures; and
  • have unidentifiable beneficial owners.

Historic arrangements

For reportable transactions after 30 June 2020, the first UK DAC 6 reporting deadline is 30 January 2021, and for transactions on or before 30 June 2020 where the first step in implementation was taken on or after 25 June 2018, it is 28 February 2021.

The effect of the amending Regulations (which has been confirmed by HMRC) is that the narrower reporting obligation will not only apply to future arrangements, but will also apply to historic arrangements for the period prior to 31 December 2020. Accordingly, only those arrangements which fall within a hallmark under Category D would need to be reported to HMRC.

Practical impact

The amendments to the Regulations have reduced the scope of disclosures to HMRC under DAC 6. Nevertheless, a full DAC 6 assessment and hallmark analysis will still be required in respect of EU jurisdictions involved in a transaction, in order to determine whether a DAC 6 filing obligation arises in those member states. Cross-border transactions that would otherwise have been reportable to HMRC may need to be reported to EU tax authorities. It is expected that the exception would be cross-border transactions that were reportable under hallmarks A, B, C and E of DAC 6 solely as a result of a UK nexus. However, it remains to be seen whether EU member states will update their domestic legislation implementing DAC 6 to require reporting of arrangements that concern only the UK and a non-EU jurisdiction. Such amendments would likely raise a number of practical issues, including, for example, questions as to who should bear the reporting obligation where intermediaries in the relevant EU jurisdiction have limited knowledge of the wider arrangements.

From a practical perspective, the UK’s divergence from the DAC 6 standard may create additional administrative burdens for those intermediaries and taxpayers with pan-European operations that had planned to coordinate and submit DAC 6 reports in the UK. As the UK’s actions were not trailed, these businesses may, at short notice, need to shift the coordination and submission of reports to an EU member state involved in the reportable arrangement. For those businesses that had already begun preparing data for submission using HMRC’s XML schema, additional administrative work may be needed to ensure this data can be submitted to other relevant EU member states’ databases. It remains to be seen whether (to lessen such burdens) HMRC may be willing to accept submissions on a voluntary basis or whether (if HMRC was so willing) this would be permissible under the laws of relevant EU member states.

Going forward

OECD Mandatory Disclosure Rules

We understand that the UK government will consult on draft legislation to implement the MDR in due course. The MDR were first published in March 2018, and form part of the OECD’s recommendations set out in the “Model Mandatory Disclosure Rules for CRS Avoidance Arrangements and Opaque Offshore Structures”.[2] They are designed for jurisdictions wanting to implement disclosure obligations on certain intermediaries involved in arrangements intended to circumvent disclosure obligations under the OECD’s Common Reporting Standard.[3]

It is unclear whether such legislation would, in the immediate term, substantively alter the scope of mandatory reporting obligations provided for under the Regulations (as amended). Looking forward, however, enhanced reporting is fast becoming a popular measure, internationally, for tackling tax avoidance, evasion and non-compliance. Countries outside the EU have introduced disclosure requirements that go beyond the MDR (with Mexico being the latest country to implement a disclosure regime modelled on DAC 6). Given this trend, it is expected that the OECD will further expand the scope of the MDR in the future. Accordingly, despite the reduced scope of the UK’s current reporting regime, wider mandatory disclosure obligations may well become standard practice for taxpayers party to, and intermediaries advising on, cross-border arrangements.

Exchange of tax information

Before the end of the transition period, the UK was required to exchange tax information (including information relating to tax rulings and advance transfer pricing agreements, EU Common Reporting Standards, country-by-country reporting and beneficial ownership) with EU member states under the various provisions of Directive 2011/16/EU (the “DAC”). However, it is not yet clear: (i) how reports relating to Category D cross-border arrangements will be shared between HMRC and other tax authorities under the current DAC 6 exchange framework; (ii) whether HMRC will have access to information relating to cross-border arrangements falling within hallmarks A, B, C or E; and (iii) whether HMRC will retain access to other information currently shared under the DAC, given that the UK is no longer part of the EU. The FTA, for example, is silent on such matters.[4]

Outside of the DAC, there are existing international frameworks that allow for the exchange of tax information between tax authorities. In particular, (a) the OECD provides a platform for the spontaneous exchange of tax rulings and advance transfer pricing agreements and (b) most double tax treaties between the UK and EU member states allow for the exchange of information between the treaty parties on request, in each case where the information is foreseeably relevant to the recipient tax authority. Furthermore, the OECD provides an information sharing platform for jurisdictions that have entered into bilateral agreements to exchange information, should the UK seek to enter into such agreements with EU member states. For the moment, however, it remains to be seen whether existing frameworks will provide sufficient information sharing rights for HMRC.

_____________________

   [1]   The Category D hallmarks are contained in Annex IV Part II of the EU Council Directive 2018/822 of 25 May 2018 amending Directive 2011/16/EU at: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex:32018L0822

   [2]   OECD (2018), Model Mandatory Disclosure Rules for CRS Avoidance Arrangements and Opaque Offshore Structures, OECD, Paris. https://www.oecd.org/tax/exchange-of-tax-information/model-mandatory-disclosure-rules-for-crs-avoidance-arrangements-and-opaque-offshore-structures.htm

   [3]   The CRS was introduced in 2014 as a global reporting standard for the cross-border exchange of financial information.

   [4]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:22020A1231(01)&from=EN

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the Tax Practice Group or the authors:

Sandy Bhogal – London (+44 (0) 20 7071 4266, [email protected])
Benjamin Fryer – London (+44 (0) 20 7071 4232, [email protected])
Bridget English – London (+44 (0) 20 7071 4228, [email protected])
Fareed Muhammed – London (+44 (0) 20 7071 4230, [email protected])
Barbara Onuonga – London (+44 (0) 20 7071 4139,[email protected])
Aoibhin O’ Hare – London (+44 (0) 20 7071 4170, [email protected])
Avi Kaye – London (+44 (0) 20 7071 4210, [email protected])

© 2021 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 December 18, 2020, three federal banking regulators—the Office of the Comptroller of the Currency (“OCC”), the Board of Governors of the Federal Reserve System (“Board”), and the Federal Deposit Insurance Corporation (“FDIC”)—jointly issued a notice of proposed rulemaking that would impose rapid notification requirements on banking organizations and bank service providers following “significant” computer-security incidents.

Under the proposal, “banking organizations” include all institutions subject to a primary federal bank regulator: for the OCC, national banks, federal savings associations, and federal branches and agencies of non-U.S. banks; for the Board, all U.S. bank holding companies and savings and loan holding companies, state member banks, the U.S. operations of foreign banking organizations, and Edge and agreement corporations; and for the FDIC, all insured state nonmember banks, insured state-licensed branches of foreign banks, and state savings associations.

The proposal defines “bank service providers” by reference to the Bank Service Company Act (“BSCA”) as entities that provide BSCA-regulated services—“check and deposit sorting and posting, computation and posting of interest and other credits and charges, preparation and mailing of checks, statements, notices, and similar items, or any other clerical, bookkeeping, accounting, statistical, or similar functions performed for a depository institution,” including “data processing, back office services, and activities related to credit extensions.”[1] With the increasing significant use of third-party vendors to supply technology-related services to banks, this inclusion is important.

The proposal would require a banking organization to notify its primary federal regulator when it believes in “good faith” that it has experienced a “significant” computer-security incident—which the proposal terms a “notification incident.” Notification of regulators would be required “as soon as possible and no later than 36 hours” after the organization determines that a notification incident has occurred. The proposal defines a “computer-security incident” as “an occurrence that—(i) [r]esults in actual or potential harm to the confidentiality, integrity, or availability of an information system or the information that the system processes, stores, or transmits; or (ii) [c]onstitutes a violation or imminent threat of violation of security policies, security procedures, or acceptable use policies.” The proposal describes a “notification incident” as a computer-security incident that “could jeopardize the viability of the operations of an individual banking organization, result in customers being unable to access their deposit and other accounts, or impact the stability of the financial sector.”[2] Notification incidents can arise from both criminal and non-malicious computer-security incidents.

The proposal would require a bank service provider to notify “at least two individuals at affected banking organization customers immediately after experiencing a computer-security incident that it believes in good faith could disrupt, degrade, or impair services provided subject to the BSCA for four or more hours.” The bank service provider would not be required to determine if such an incident rises to the level of a “notification incident” for particular banking organizations; rather, the bank service provider would be required to inform affected banking organization customers, who would themselves have that responsibility.

Additionally, the proposal would require a banking organization subsidiary of another banking organization to notify both its primary federal regulator and its parent banking organization that the subsidiary had experienced a notification incident “as soon as possible.” The proposal would then require the subsidiary’s parent banking organization to make a separate assessment about whether the parent organization had also suffered a notification incident requiring it to notify its primary federal regulator as result of the incident at the subsidiary. Thus, the proposal would require both the subsidiary and parent banking organizations to separately determine whether they had each suffered a notification incident, and should both make such a determination, would require both to notify their regulators individually.

In contrast, the proposal would not require a non-bank subsidiary of a banking organization to notify its regulator following a notification incident at the non-bank subsidiary. Instead, the proposal would seemingly require the non-bank subsidiary to notify its parent banking organization. The parent banking organization would then be required to determine whether the computer-security incident at its non-bank subsidiary constituted a notification incident, and if so, to notify the parent banking organization’s primary federal regulator.

Entities that wish to comment on the proposed rule must submit their comments no later than 90 days after the proposal is published in the Federal Register.

The proposed rule is the latest attempt to impose obligations on financial institutions that have suffered a cyber incident. Regulations requiring notification following a data breach have been in place for years, but, as we have previously noted, state and federal regulators have recently begun imposing rules requiring faster and more in-depth notifications following cybersecurity incidents. For example, since 2017, the New York Department of Financial Services has required financial institutions to notify the Superintendent of Financial Services “as promptly as possible but in no event later than 72 hours” following a cybersecurity incident.[3]

These proposed and enacted regulations requiring rapid notification following cybersecurity incidents highlight the need for financial institutions to be able to respond quickly to and report accurately and effectively on cyber events. Such notification requirements will help incentivize banking organizations to assess whether they have a well-functioning incident response plan and effective lines of communication among their information security, legal, and other relevant departments already in place before a cybersecurity incident occurs. This is important for organizations to be able to quickly assess incidents—which can often be challenging to understand fully—and be positioned to notify regulators within the required time period following an incident. Among other preparation measures, cross-departmental training exercises can help improve the functionality of response processes before they are tested in an actual cybersecurity event.

_____________________

   [1]  See 12 U.S.C. §§ 1861-1867.

   [2] The proposed rule’s complete definition of “notification incident” is “a computer-security incident that a banking organization believes in good faith could materially disrupt, degrade, or impair—(i) the ability of the banking organization to carry out banking operations, activities, or processes, or deliver banking products and services to a material portion of its customer base, in the ordinary course of business; (ii) any business line of a banking organization, including associated operations, services, functions and support, and would result in a material loss of revenue, profit, or franchise value; or (iii) those operations of a banking organization, including associated services, functions and support, as applicable, the failure or discontinuance of which would pose a threat to the financial stability of the United States.”

   [3] N.Y. Comp. Codes R. & Regs. tit. 23, § 500.17 (2020).

The following Gibson Dunn lawyers assisted in the preparation of this article: Ryan T. Bergsieker, Arthur S. Long, Alexander H. Southwell and Marie D. Zoglo.

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, the authors, or any member of the firm’s Privacy, Cybersecurity and Consumer Protection or Financial Institutions practice groups.

Financial Institutions Group:

Matthew L. Biben – New York (+1 212-351-6300, [email protected])
Stephanie Brooker – Washington, D.C. (+1 202-887-3502, [email protected])
M. Kendall Day – Washington, D.C. (+1 202-955-8220, [email protected])
Arthur S. Long – New York (+1 212-351-2426, [email protected])

Privacy, Cybersecurity and Consumer Protection Group:

United States
Alexander H. Southwell – Co-Chair, PCCP Practice, New York (+1 212-351-3981, [email protected])
Debra Wong Yang – Los Angeles (+1 213-229-7472, [email protected])
Matthew Benjamin – New York (+1 212-351-4079, [email protected])
Ryan T. Bergsieker – Denver (+1 303-298-5774, [email protected])
Howard S. Hogan – Washington, D.C. (+1 202-887-3640, [email protected])
Joshua A. Jessen – Orange County/Palo Alto (+1 949-451-4114/+1 650-849-5375, [email protected])
Kristin A. Linsley – San Francisco (+1 415-393-8395, [email protected])
H. Mark Lyon – Palo Alto (+1 650-849-5307, [email protected])
Karl G. Nelson – Dallas (+1 214-698-3203, [email protected])
Ashley Rogers – Dallas (+1 214-698-3316, [email protected])
Deborah L. Stein – Los Angeles (+1 213-229-7164, [email protected])
Eric D. Vandevelde – Los Angeles (+1 213-229-7186, [email protected])
Benjamin B. Wagner – Palo Alto (+1 650-849-5395, [email protected])
Michael Li-Ming Wong – San Francisco/Palo Alto (+1 415-393-8333/+1 650-849-5393, [email protected])

Europe
Ahmed Baladi – Co-Chair, PCCP Practice, Paris (+33 (0)1 56 43 13 00, [email protected])
James A. Cox – London (+44 (0)20 7071 4250, [email protected])
Patrick Doris – London (+44 (0)20 7071 4276, [email protected])
Bernard Grinspan – Paris (+33 (0)1 56 43 13 00, [email protected])
Penny Madden – London (+44 (0)20 7071 4226, [email protected])
Michael Walther – Munich (+49 89 189 33-180, [email protected])
Kai Gesing – Munich (+49 89 189 33-180, [email protected])
Alejandro Guerrero – Brussels (+32 2 554 7218, [email protected])
Vera Lukic – Paris (+33 (0)1 56 43 13 00, [email protected])
Sarah Wazen – London (+44 (0)20 7071 4203, [email protected])

Asia
Kelly Austin – Hong Kong (+852 2214 3788, [email protected])
Connell O’Neill – Hong Kong (+852 2214 3812, [email protected])
Jai S. Pathak – Singapore (+65 6507 3683, [email protected])

© 2021 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

After a complicated path to passage, today the Senate completed the override of President Trump’s veto of the National Defense Authorization Act and, as part of that legislation, passed the Anti-Money Laundering Act of 2020 (“AMLA” or the “Act”).[1] The AMLA is the most comprehensive set of reforms to the anti-money laundering (“AML”) laws in the United States since the USA PATRIOT Act was passed in 2001. The Act’s provisions range from requiring many smaller companies to disclose beneficial ownership information to FinCEN to mandating awards to whistleblowers that report actionable information about Bank Secrecy Act (“BSA”)/AML violations. This alert identifies 10 of the biggest takeaways for financial institutions from the AMLA.[2]

  1. The AMLA May Lead to More AML Enforcement, Including Through Expanded Whistleblower Provisions

The AMLA has a number of provisions that could result in significantly increased civil and criminal enforcement of AML violations. First and foremost, it provides for a significantly expanded whistleblower award program. Specifically, it states that when an AML enforcement action brought by DOJ or the U.S. Treasury Department results in monetary sanctions over $1 million, the Secretary of the Treasury “shall” pay an award of up to 30 percent of what was collected to whistleblowers who “voluntarily provided original information” that led to a successful enforcement action.[3] The previous whistleblower award program limited awards in most cases to $150,000 and was discretionary[4] – in our experience, that much more modest award program did not generate significant interest among potential whistleblowers or the plaintiffs’ bar. The Act also includes anti-retaliation protections for whistleblowers and, in the event of a violation of these provisions, allows them to file a complaint with the Department of Labor and, if it is not adjudicated within a certain period of time, to seek recourse in federal district court.[5]

It would be hard to overstate the far-reaching potential effects of this new program. By way of analogy, in 2010, the SEC announced its own whistleblower program to reward individuals who provided the agency with high-quality information.[6] The program has prompted a significant number of tips to the SEC. As of October 2020, the SEC Office of the Whistleblower had received more than 40,000 tips from whistleblowers in every state in the United States and approximately 130 countries around the world.[7] And this program has led to some significant SEC whistleblower awards, which may have encouraged further reporting. In October 2020, for instance, the SEC awarded $114 million to a whistleblower, the largest single award in history.[8]

As with the SEC whistleblower program, the new awards for BSA whistleblowers may incentivize employees and plaintiffs’ attorneys to provide a substantial number of new tips to law enforcement, even if many of them do not result in enforcement actions. Indeed, the number of employees at financial institutions who have access to information that could potentially form the basis for an AML whistleblower complaint is many times greater than in other contexts. Many large financial institutions employ hundreds of individuals in functions with AML responsibilities. For example, it remains to be seen whether this provision will weaponize the information held by even front-line compliance employees tasked with elevating suspicious activity for potential SAR filings when those employees do not see a SAR ultimately get filed.

  1. The AMLA Increases Penalties for BSA/AML Violations in a Number of Ways

Another harbinger of increased enforcement is the expanded penalties enacted under the AMLA. As we explained in a January 2020 client alert, in recent years DOJ has been increasingly aggressive in using its money laundering authority to police international corruption and bribery, as illustrated by the 1MDB, FIFA, and PDVSA prosecutions.[9] And the incoming Biden administration has indicated that cracking down on illicit finance at home and abroad will be a top priority.[10]

The AMLA creates a number of new penalties that will help the government do so. It creates a new prohibition on knowingly concealing or misrepresenting a material fact from or to a financial institution concerning the ownership or control of assets involved in transactions over $1 million involving assets of a senior foreign political figure, close family member, or other close associate.[11] The Act also makes it a crime to knowingly conceal or misrepresent a material fact from or to a financial institution concerning the source of funds in a transaction that involves an entity that is a primary money laundering concern.[12] The penalties for violating these provisions are up to 10 years imprisonment and/or a $1 million fine.[13]

The Act also generally enhances penalties for various BSA/AML violations. For instance, it provides that any person “convicted” of violating the BSA shall, “in addition to any other fine under this section, be fined in an amount that is equal to the profit gained by such person by reason of such violation,” and, in the event the person was employed at a financial institution at the time of the violation, repay to the financial institution any bonus paid during the calendar year during or after which the violation occurred.[14] The Act additionally prohibits individuals who have committed an “egregious” violation of the BSA from sitting on the boards of U.S. financial institutions for 10 years.[15] Furthermore, the AMLA creates enhanced penalties for repeat violators, providing that if a person has previously violated the BSA, the Secretary of the Treasury “may impose” additional civil penalties of up to the greater of three times the profit gained or loss avoided by such person as a result of the violation or two times the maximum statutory penalty associated with the violation.[16]

  1. The AMLA Significantly Increases the Government Resources Committed to Address Money Laundering

The AMLA also contains a host of provisions designed to better resource the government to address money laundering. It establishes special hiring authority for FinCEN and the Office of Terrorism and Financial Intelligence.[17] It also creates a number of unique roles, including FinCEN domestic liaisons to oversee different regions of the United States, as well as Treasury attachés and FinCEN foreign intelligence unit liaisons to be stationed at U.S. embassies or foreign government facilities.[18] The Act additionally creates a Subcommittee on Innovation and Technology to advise the Secretary of the Treasury on innovation with respect to AML and calls for BSA “Innovation Officers” and “Information Security Officers” at FinCEN and other federal financial regulators.[19] Although these staffing reforms may not directly impact financial institutions, the government’s increased focus and sophistication in addressing money laundering may result in additional inquiries from law enforcement, regulations, and guidance.

  1. The AMLA Provides Additional Statutory Authority for DOJ to Seek Documents from Foreign Financial Institutions

DOJ typically has three avenues to pursue documents from foreign financial institutions. It can: (i) make a request under the Mutual Legal Assistance Treaty (or, in the absence of a treaty, a letter rogatory) with the country in question, which can be a slow process; (ii) it can issue a Bank of Nova Scotia subpoena, which requires written approval from DOJ’s Office of International Affairs[20]; or (iii) it can issue a subpoena pursuant to 31 U.S.C. § 5318(k) to a foreign financial institution that maintains a correspondent bank account in the United States.

The AMLA significantly expands the scope of DOJ’s (and Treasury’s) authority to seek and enforce correspondent account subpoenas under Section 5318. Previously, these subpoenas could be issued to any foreign bank that maintained a correspondent account in the United States and could “request records related to such correspondent account.”[21] The AMLA broadens this authority to allow DOJ to seek “any records relating to the correspondent account or any account at the foreign bank, including records maintained outside of the United States,” if the records are the subject of an investigation that relates to a violation of U.S. criminal laws, a violation of the BSA, a civil forfeiture action, or a Section 5318A investigation.[22] Thus, by statute, DOJ now has the authority to subpoena from foreign banks not only records related to correspondent accounts, but records from any account at the foreign bank if they fall within one of the broad investigative categories identified in the statute. The AMLA also requires the foreign financial institution to authenticate all records produced.[23] In the event a foreign financial institution fails to comply, the Act authorizes the Attorney General to seek contempt sanctions, and the Attorney General or Secretary of the Treasury may direct covered U.S. financial institutions to terminate their correspondent relationships with the foreign financial institution refusing to comply and can impose penalties on those institutions that fail to do so.[24]

  1. The AMLA Includes a Pilot Project for Sharing SAR Data Across International Borders

An issue that many of our financial institution clients face is how to share information contained in suspicious activity reports (“SARs”) across U.S. borders to affiliates located in other countries.[25] Historically, FinCEN has issued guidance to partially address the problem by permitting sharing of SAR information with foreign parent organizations or U.S. affiliates.[26] The AMLA further addresses this issue by providing that within a year after the legislation is enacted, the Treasury Department shall issue rules that create a pilot program for financial institutions to share information related to SARs, including their existence, “with the institution’s foreign branches, subsidiaries, and affiliates for the purpose of combating illicit finance risks.”[27] Notably, it contains jurisdictional carve-outs that would not permit sharing with any entities located in China or Russia (which can be waived by the Secretary of the Treasury on a case-by-case basis for national-security reasons) or in jurisdictions that are state sponsors of terrorism, subject to U.S. sanctions, or that the Secretary of the Treasury determines cannot reasonably protect the security and confidentiality of the data.[28] The pilot project is set to last three years, and can be extended for an additional two years upon a showing by the Treasury Department that it is useful and in the U.S. national interest.[29]

  1. The AMLA Specifically Applies the BSA to Nontraditional Value Transfers, Including Cryptocurrency

As financial institutions have become more adept at fighting money laundering in the past decade, the government has become increasingly concerned that criminals may turn to other mediums, such as cryptocurrency and art, to try to launder money. For instance, in November 2020, DOJ announced that it seized over $1 billion worth of Bitcoin that was tied to drug sales and other illicit products and services on the online marketplace Silk Road before it was shut down.[30] And using high-end artwork was one of the ways in which the alleged co-conspirators in the 1MDB scandal attempted to launder the proceeds of their alleged crimes, by purchasing various high-end pieces of art and then seeking banks or financiers “who take art as security for … bank loans.”[31]

While U.S. enforcers had argued that preexisting anti-money laundering authorities could reach transactions involving cryptocurrency and art, the application of preexisting AML regulations to cryptocurrency, in particular, has often been an uneasy fit. The preexisting AML regime was a set of rules written largely for an analog world, and its application to the digital realm left open important questions, particularly in the context of criminal enforcement actions. Now, however, the Act expands the definition of financial institution and money transmitting business to include businesses engaged in the exchange or transmission of “value that substitutes for currency,” potentially reinforcing the government’s position that the BSA applies to cryptocurrency.[32] The AMLA also adds antiquities dealers, advisors, and consultants to the definition of “financial institution” under the BSA.[33] As to art, the AMLA requires the government to prepare a study within a year that assesses money laundering and terrorist financing through the art trade, including “which markets … should be subject to regulation,” “the degree to which the regulations, if any, should focus on high-value trade in works of art,” and “the need, if any, to identify persons who are dealers, advisors, consultants, or any other persons who engage as a business in the trade in works of art.”[34]

  1. Many Smaller Companies Will Be Required to Disclose Beneficial Ownership Information to FinCEN, Which Will Also Be Available to Financial Institutions

The lack of a requirement for corporations to provide beneficial ownership information at the state or federal level in the United States has long been seen by law enforcement as a loophole that criminals can exploit. For instance, in 2016, the Financial Action Task Force (“FATF,” an international body that sets AML standards) recommended that the United States “[t]ake steps to ensure that adequate, accurate and current [beneficial owner] information of U.S. legal persons is available to competent authorities in a timely manner, by requiring that such information is obtained at the Federal level.”[35]

Accordingly, one of the most significant developments in the AMLA is the requirement for “reporting compan[ies]” to disclose beneficial ownership information to FinCEN, which will in turn maintain a nonpublic beneficial ownership database.[36] The definition of “reporting company” exempts a wide range of entities, including many classes of financial institutions (such as registered issuers, credit unions, broker-dealers, money transmitters, and exchanges) and larger U.S. companies, which are defined as companies that employ more than 20 full-time employees in the United States, had more than $5 million in gross revenue in the past year, and are operating at a physical office in the United States.[37] Thus, the new requirement is aimed at smaller businesses and shell companies.

Although the reporting requirement generally does not apply to financial institutions, it nevertheless has important consequences for them. The Act allows FinCEN to disclose beneficial ownership information to a financial institution with the reporting company’s consent to facilitate the financial institution’s compliance with Customer Due Diligence requirements.[38] As such, financial institutions will have to develop processes to effectively evaluate information from this beneficial ownership database. Moreover, the AMLA provides significant penalties for misuse of beneficial ownership information. Failure to disclose beneficial ownership information subjects a person to civil monetary penalties of $500 per day and a fine up to $10,000 and/or imprisonment of up to two years.[39] By contrast, unauthorized disclosure of beneficial ownership information is subject to the same civil penalty, but with fines up to $250,000—25 times the fine for failure to report—and/or imprisonment of up to five years.[40]

  1. The AMLA Requires the Government to Establish AML Priorities That Will Feed Into Examinations of Financial Institutions

The AMLA requires the Secretary of the Treasury to publish “public priorities for anti-money laundering and countering the financing of terrorism policy” within 180 days after the law’s enactment.[41] The priorities must be “consistent with the national strategy for countering the financing of terrorism and related forms of illicit finance.”[42] FinCEN will have 180 days after the priorities are released to promulgate rules to carry out these priorities.[43] Financial institutions, for their part, will be required to “review” and “incorporat[e]” these priorities into their AML programs, which will be a measure “on which a financial institution is supervised and examined.”[44]

  1. The AMLA Begins to Address Inefficiencies in SAR and CTR Filing Processes

Some argue that the current SAR and CTR filing processes are the worst of both worlds: they are incredibly burdensome for financial institutions but simultaneously bury enforcers with so much information that they cannot separate the wheat from the chaff. The $10,000 threshold for CTRs, for example, was set in 1970, and were it to be adjusted for inflation, the current threshold for filing a CTR today would be more than $60,000.[45] The lack of indexing for these thresholds has resulted in a swelling volume of mandatory reports; more than 16 million CTRs were filed in 2019.[46] Similarly, the SAR thresholds were set over 20 years ago, and the “current regime promotes the filing of SARs that may never be read, much less followed up on as part of an investigation”[47]—resulting in over 2.7 million SARs filed in 2019.[48]

The AMLA begins to take steps to address these criticisms. It requires that, when imposing requirements to report suspicious transactions, the Secretary of the Treasury shall, among other things, “establish streamlined, including automated, processes to, as appropriate, permit the filing of noncomplex categories of reports.”[49] It also requires the government to conduct formal reviews of whether the CTR and SAR thresholds should be adjusted and to determine if there are changes that can be made to the filing process to “reduce any unnecessarily burdensome regulatory requirements” while ensuring the information has a high degree of usefulness to enforcers.[50]

The AMLA also contains a number of provisions to try to ensure the usefulness of information provided by financial institutions. For instance, it requires FinCEN to periodically disclose to financial institutions “in summary form[] information on suspicious activity reports filed that proved useful to Federal or State criminal or civil law enforcement agencies during the period since the most recent disclosure,” provided the information does not relate to an ongoing investigation or implicate national security.[51] Similarly, the AMLA requires FinCEN to publish threat pattern and trend information at least twice a year to provide meaningful information about the preparation, use, and value of reports filed under the BSA.[52]

  1. The AMLA Continues to Promote Collaboration Between the Public and Private Sectors

As FinCEN has recognized, “[s]haring information through … public-private partnerships supports more, and higher-quality, reports to FinCEN and assists law enforcement in detecting, preventing, and prosecuting terrorism, organized crime, money laundering, and other financial crimes.”[53] To that end, FinCEN has sought to improve collaboration between law enforcement and financial institutions over the years. For instance, in 2017, FinCEN created the “FinCEN Exchange” to “enhance information sharing with financial institutions.”[54]

The AMLA contains a number of provisions designed to further promote collaboration between the public and private sectors. It formalizes the FinCEN Exchange by statute, and requires the Secretary of the Treasury to periodically report to Congress about the utility of the Exchange and recommendations for further improvements.[55] The Act requires that data shared under the Exchange be done so in accordance with federal law and in “such a manner as to ensure the appropriate confidentiality of personal information”; it also “shall not be used for any purpose” other than identifying and reporting on financial crimes.[56] Furthermore, the Act requires the Secretary of the Treasury to convene a team consisting of stakeholders from the public and private sector “to examine strategies to increase cooperation between the public and private sectors for purposes of countering illicit finance.”[57]

________________________

   [1]   William M. (Mac) Thornberry National Defense Authorization Act for Fiscal Year 2021, H.R. 6395. Division F of the NDAA is the Anti-Money Laundering Act of 2020, and Title XCVII within the bill contains additional provisions relevant to the financial services industry.

   [2]   This alert is not a comprehensive summary of every provision of the AMLA, the specific provisions of the law discussed herein, or the broader NDAA. For example, the NDAA contains a provision providing the SEC explicit authority to seek disgorgement in federal court, which is discussed in a separate Gibson Dunn client alert available here.

   [3]   AMLA, § 6314 (adding 31 U.S.C. § 5323(b)(1)).

   [4]   See 31 U.S.C. § 5323.

   [5]   AMLA, § 6314 (adding 31 U.S.C. § 5323(g)).

   [6]   Press Release, U.S. Secs. & Exch. Comm’n, SEC Proposes New Whistleblower Program Under Dodd-Frank Act, (Nov. 3, 2010), https://www.sec.gov/news/press/2010/2010-213.htm.

   [7]   U.S. Secs. & Exch. Comm’n, Whistleblower Program Annual Report 27-30 (2020), https://www.sec.gov/files/2020%20Annual%20Report_0.pdf.

   [8]   Press Release, SEC Issues Record $114 Million Whistleblower Award, Securities and Exchange Commission, Oct. 22, 2020, https://www.sec.gov/news/press-release/2020-266.

   [9]   Developments in the Defense of Financial Institutions – The International Reach of the U.S. Money Laundering Statutes, Gibson Dunn (Jan. 9, 2020), https://www.gibsondunn.com/developments-in-defense-of-financial-institutions-january-2020/.

[10]   Amy MacKinnon, Biden Expected to Put the World’s Kleptocrats on Notice, Foreign Policy (Dec. 3, 2020), https://foreignpolicy.com/2020/12/03/biden-kleptocrats-dirty-money-illicit-finance-crackdown/.

[11]   AMLA, § 6313 (adding 31 U.S.C. § 5335(b)).

[12]   AMLA, § 6313 (adding 31 U.S.C. § 5335(c)).

[13]   AMLA, § 6313 (adding 31 U.S.C. § 5335(d)).

[14]   AMLA, § 6312 (adding 31 U.S.C. § 5322(e)).

[15]   AMLA, § 6310 (adding 31 U.S.C. § 5321(g)).

[16]   AMLA, § 6309 (adding 31 U.S.C. § 5321(f)).

[17]   AMLA, § 6105.

[18]   AMLA, §§ 6106, 6107, 6108.

[19]   AMLA, §§ 6207, 6208, 6303.

[20]   Justice Manual § 9-13.525, U.S. Department of Justice, https://www.justice.gov/jm/jm-9-13000-obtaining-evidence#9-13.525 (“[A]ll Federal prosecutors must obtain written approval from the Criminal Division through the Office of International Affairs (OIA) before issuing any unilateral compulsory measure to persons or entities in the United States for records located abroad.”).

[21]   31 U.S.C. § 5318(k)(3)(A).

[22]   AMLA, § 6308 (31 U.S.C. § 5318(k)(3)(A)(i) as revised).

[23]   AMLA, § 6308 (31 U.S.C. § 5318(k)(3)(A)(ii) as revised).

[24]   AMLA, § 6308 (31 U.S.C. § 5318(k)(D), (E) as revised).

[25]   See 31 U.S.C. § 5318(g)(2)(A)(i) (providing that financial institutions or their employees involved in reporting suspicious transactions may not notify “any person involved in the transaction that the transaction has been reported.”).

[26]   Interagency Guidance on Sharing Suspicious Activity Reports with Head Offices or Controlling Companies (Jan. 20, 2006), https://www.fincen.gov/sites/default/files/guidance/sarsharingguidance01122006.pdf; Fin. Crimes Enf’t Network, FIN-2010-G006, Sharing Suspicious Activity Reports by Depository Institutions with Certain U.S. Affiliates (Nov. 23, 2010), https://www.fincen.gov/sites/default/files/shared/fin-2010-g006.pdf.

[27]   AMLA, § 6212 (adding 31 U.S.C. § 5318(g)(8)(B)(i)).

[28]   AMLA, § 6212 (adding 31 U.S.C. § 5318(g)(8)(C)).

[29]   AMLA, § 6212 (adding 31 U.S.C. § 5318(g)(8)(B)(iii)).

[30]   Press Release, U.S. Dept. of Justice, United States Files A Civil Action To Forfeit Cryptocurrency Valued At Over One Billion U.S. Dollars, (Nov. 5, 2020), https://www.justice.gov/usao-ndca/pr/united-states-files-civil-action-forfeit-cryptocurrency-valued-over-one-billion-us.

[31]   United States of America v. One Pen and Ink Drawing By Vincent Van Gogh Titled “La Maison De Vincent A Arles” et al., No. 2:16-cv-5366 (C.D. Cal. July 20, 2016), Dkt. 1 ¶¶ 440-43, https://www.justice.gov/archives/opa/page/file/877156/download

[32]   AMLA, § 6102(d); see also Press Release, Sen. Mark Warner, Warner, Rounds, Jones Applaud Inclusion of Bipartisan Anti-Money Laundering Legislation in NDAA (Dec. 3, 2020), https://www.warner.senate.gov/public/index.cfm/2020/12/warner-rounds-jones-applaud-inclusion-of-bipartisan-anti-money-laundering-legislation-in-ndaa (highlighting “[e]nsuring the inclusion of current and future payment systems in the AML-CFT regime” as among the achievements of the new NDAA).

[33]   AMLA, § 6110(a)(1) (31 U.S.C. § 5312(a)(2)(Y) as amended).

[34]   AMLA, § 6111(e).

[35]   FATF, Anti-money laundering and counter-terrorist financing measures in the United States: Executive Summary 11 (2016), http://www.fatf-gafi.org/media/fatf/documents/reports/mer4/MER-United-States-2016-Executive-Summary.pdf.

[36]   AMLA, § 6403 (adding 31 U.S.C. § 5336)

[37]   AMLA, § 6403 (adding 31 U.S.C. § 5336(a)(11)).

[38]   AMLA, § 6403 (adding 31 U.S.C. § 5336(c)(2)(B)(iii)).

[39]   AMLA, § 6403 (adding 31 U.S.C. § 5336(h)(3)(A)).

[40]   AMLA, § 6403 (adding 31 U.S.C. § 5336(h)(3)(B)).

[41]   AMLA, § 6101(a) (adding 31 U.S.C. § 5311(b)(4)(A)).

[42]   AMLA, § 6101(a) (adding 31 U.S.C. § 5311(b)(4)(C)).

[43]   AMLA, § 6101(a) (adding 31 U.S.C. § 5311(b)(4)(D)).

[44]   AMLA, § 6101(a) (adding 31 U.S.C. § 5311(b)(4)(E)).

[45]   Blaine Luetkemeyer, Steve Pearce, It’s Time to Modernize the Bank Secrecy Act, American Banker (June 13, 2018), https://www.americanbanker.com/opinion/its-time-to-modernize-the-bank-secrecy-act.

[46]   FinCEN Report of Transactions in Currency, 85 Fed. Reg. 29,022, 29,023 (May 14, 2020), https://www.govinfo.gov/content/pkg/FR-2020-05-14/pdf/2020-10310.pdf.

[47]   The Clearing House, A New Paradigm: Redesigning the U.S. AML/CFT Framework to Protect National Security and Aid Law Enforcement 13 (2017), here.

[48]   See FinCEN Report of Reports by Financial Institutions of Suspicious Transactions, 85 Fed. Reg. 31,598, 31,599 (May 26, 2020), https://www.govinfo.gov/content/pkg/FR-2020-05-26/pdf/2020-11247.pdf.

[49]   AMLA, § 6202 (adding 31 U.S.C. § 5318(g)(5)(D)).

[50]   AMLA, §§ 6204, 6205.

[51]   AMLA, § 6203(b).

[52]   AMLA, § 6206 (adding 31 U.S.C. § 5318(g)(6)).

[53]   Press Release, Fin. Crimes Enf’t Network, FinCEN Exchange in New York City Focuses on Virtual Currency, https://www.fincen.gov/resources/financial-crime-enforcement-network-exchange.

[54]   Press Release, Fin. Crimes Enf’t Network, FinCEN Launches “FinCEN Exchange” to Enhance Public-Private Information Sharing, (Dec. 4, 2017), https://www.fincen.gov/news/news-releases/fincen-launches-fincen-exchange-enhance-public-private-information-sharing.

[55]   AMLA, § 6103 (adding 31 U.S.C. § 310(d)(2), (3)).

[56]   AMLA, § 6103 (adding 31 U.S.C. § 310(d)(4)(A), (4)(B), 5(B)).

[57]   AMLA, § 6214.

The following Gibson Dunn lawyers assisted in preparing this client alert: Stephanie Brooker, M. Kendall Day, Linda Noonan, Ella Alves Capone, Chris Jones and Alexander Moss.

Gibson Dunn has deep experience with issues relating to the Bank Secrecy Act, other AML and sanctions laws and regulations, and the defense of financial institutions more broadly. For assistance navigating white collar or regulatory enforcement issues involving financial institutions, please contact any of the authors, the Gibson Dunn lawyer with whom you usually work, or any of the leaders and members of the firm’s Financial Institutions, White Collar Defense and Investigations, or International Trade practice groups.

Stephanie Brooker –  Washington, D.C. (+1 202-887 3502, [email protected])
M. Kendall Day– Washington, D.C. (+1 202-955-8220, [email protected])
Linda Noonan – Washington, D.C. (+1 202-887-3595, [email protected])
Ella Alves Capone – Washington, D.C. (+1 202-887-3511, [email protected])
Chris Jones* – San Francisco (+1 415-393-8320, [email protected])
Alexander Moss – Washington, D.C. (+1 202.887.3615, [email protected])

Please also feel free to contact any of the following practice group leaders:

Financial Institutions Group:
Matthew L. Biben – New York (+1 212-351-6300, [email protected])
Stephanie Brooker – Washington, D.C. (+1 202-887-3502, [email protected])
Arthur S. Long – New York (+1 212-351-2426, [email protected])

White Collar Defense and Investigations Group:
Joel M. Cohen – New York (+1 212-351-2664, [email protected])
Charles J. Stevens – San Francisco (+1 415-393-8391, [email protected])
F. Joseph Warin – Washington, D.C. (+1 202-887-3609, [email protected])

International Trade Group:

Ronald Kirk – Dallas (+1 214-698-3295, [email protected])
Judith Alison Lee – Washington, D.C. (+1 202-887-3591, [email protected])
Adam M. Smith – Washington, D.C. (+1 202-887-3547, [email protected])

*Mr. Jones is admitted only in New York and Washington, D.C. and is practicing under the supervision of Principals of the Firm.

© 2020 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 December 4, 2020, Judge Rakoff of the Southern District of New York denied a motion to dismiss breach of fiduciary duty claims against former directors of Jones Group (the predecessor to Nine West).[1] The lawsuit arises from the board of directors’ approval of a buyout transaction that distributed $1.2 billion to Jones Group shareholders, while allegedly rendering the company insolvent. The Court allowed the claims to proceed, finding that the directors, by their own admission, failed to conduct a reasonable investigation into whether the transaction as a whole was beneficial to the company or would render the company insolvent. The Court concluded that the director defendants were not exempt from responsibility for the steps of the integrated transaction that were implemented after they resigned from the board because they allegedly knew that those steps were part of an integrated multi-step transaction and would be completed substantially concurrently with their resignation. The directors were not entitled to the protections of the business judgment rule because they expressly avoided any investigation regarding two key steps in the transaction; they allegedly turned a blind eye to the intention to complete those steps after the initial merger.

This preliminary decision merits discussion, but it does not represent a watershed expansion of exposure for directors or expansion of their fiduciary duties. Instead, it reinforces the simple rule that in order to obtain the protection of the business judgment rule the board must in fact make an informed business judgment, and declining to review key components of an integrated multi-step transaction is reckless. Ordinarily, the business judgment rule and the exculpatory provisions in a company’s bylaws offer a significant shield against liability for directors, except in the most egregious of circumstances. However, those protections only operate when the directors make a reasonable investigation and a business judgment, which the Jones Group directors expressly chose not to do when they opted not to approve or disapprove the key elements of the multi-step transaction that allegedly rendered the company insolvent. As the Court very aptly noted, “the business judgment rule presupposes that directors made a business judgment.”[2]

Facts of the Case

In the years leading up to the 2014 leverage buyout transaction, Jones Group—a publicly traded global footwear and apparel company—was suffering financially. The only bright spot was the performance of two brands, Stuart Weitzman and Kurt Geiger, that Jones Group had purchased for $800 million just a few years earlier.

In July of 2012, the board began considering a sale of the company and retained Citigroup Global Markets to act as its advisor. Citigroup advised the board, in relevant part, that in a transaction where Jones Group retained all of its businesses (including the successful Stuart Weitzman and Kurt Geiger brands), the company could support a maximum debt to EBITDA ratio of 5.1. The following year, the private equity firm Sycamore Partners Management reached a deal to purchase Jones Group for $15 per share, representing a $2.15 billion implied enterprise value for the company.

The merger agreement between Jones Group and Sycamore Partners originally involved five allegedly integrated components:

  1. Jones Group would merge with a Sycamore affiliate;
  2. Sycamore would contribute at least $385 million in equity to the post-merger surviving entity (“Nine West”);
  3. Nine West would increase its total debt burden from $1 billion to $1.2 billion;
  4. Jones Group shareholders would be cashed out at $15 per share (for a total of $1.2 billion); and
  5. the successful Stuart Weitzman and Kurt Geiger brands, along with one additional business unit, would be sold to another Sycamore affiliate for substantially less than fair market value.

The board unanimously approved the merger agreement on December 19, 2013 but excluded from its approval the 3rd and 5th steps (the debt increase and the carve-out transaction of the Stuart Weitzman and Kurt Geiger brands). The merger agreement included provisions that obligated Jones Group to assist Sycamore in both planning the carve-out transaction and syndicating the additional debt. The directors allegedly knew that these were parts of an integrated transaction, that all steps would occur substantially concurrently, and that their affirmative vote was putting the wheels in motion to strip the most valuable assets out of the merged company and burden it with unsustainable debt. They allegedly chose to approve parts of the multi-step transaction and turn a blind-eye to the harmful steps they allegedly knew they were facilitating.

Prior to the closing, Sycamore reduced its equity contribution from $395 million to $120 million, and increased the total amount of new debt from $1.2 billion to $1.55 billion. This raised the company’s post-transaction debt to EBITDA ratio to between 6.6 and 7.8.—well above the 5.1 maximum ratio that Citigroup initially indicated was sustainable. Although the merger agreement contained a fiduciary out clause, the directors did not reconsider their approval even after the initial transaction was modified in ways detrimental to the company.

In anticipation of the carve-out transaction, Sycamore hired valuation advisors to provide a solvency opinion for Jones Group as it would exist after the transfer of the successful Stuart Weitzman and Kurt Geiger brands (Jones Group without the successful brands, “RemainCo”). Sycamore allegedly created and provided to their advisors “unreasonable and unjustified” EBITDA projections for RemainCo to inflate its value and justify the below-market price for the Stuart Weitzman and Kurt Geiger brands. Sycamore ultimately settled on a $1.58 billion valuation of RemainCo, just above the $1.55 billion total debt burden that was planned by Sycamore. The directors of Jones Group were not, according to the complaint, directly aware of the fact that Sycamore had manipulated the projections of RemainCo in order to achieve the $1.58 billion valuation. However, the complaint alleged that the directors received updated reports and projections from Jones Group management on a monthly basis and were therefore aware of the poor performance of Jones Group overall, as well as the comparatively stellar performance of the Stuart Weitzman and Kurt Geiger brands.

The merger closed on April 8, 2014, at which point Jones Group directors were replaced by two Sycamore principals. As part of the closing of the merger, the new directors caused Nine West to sell the Stuart Weitzman and Kurt Geiger brands to a newly formed Sycamore affiliate for just $641 million. This number was far less than the $800 million that Jones Group had paid to acquire these brands just a few years earlier, even though these brands had been very successful during the interim. The complaint alleged that the fair market value of these brands was $1 billion. In April of 2018, about four years after the merger closed, Nine West filed for bankruptcy.

Allegations

The Court found that the following allegations justified denial of the motion to dismiss and refusal to apply the deferential business judgment standard of review to the actions of the directors:

  1. The directors chose not to review or approve two of the major steps of the merger transaction—the issuance of additional debt and a carve-out transaction that sold off the most successful parts of the company post-merger, even though they knew their approval of the merger would lead to the completion of these additional steps in the intended multi-step transaction. Both steps were crucially important in causing the overleveraging that eventually led to the bankruptcy of the company.
  2. The directors allegedly ignored certain “red flags” that should have caused them to investigate potential solvency issues related to the transaction. The failure to investigate these red flags when the directors could have withdrawn support for the transaction was, according to the Court, reckless.

Breach of Fiduciary Duty Claim

The director defendants moved to dismiss the breach of fiduciary duty claims on two grounds. First, they argued that their approval of the transaction was protected by the business judgment rule, and second, that even if the business judgment rule did not apply, they were protected by exculpatory provisions in Jones Group’s bylaws. The Court rejected both arguments based on the same fundamental allegations: the directors had not in fact exercised any business judgment because they expressly avoided approving the two key steps of the multi-step transaction, and the directors were responsible for those steps because they knew the entire multi-step transaction would be consummated substantially concurrently. The directors’ failure to review the merits of each step of the transaction was reckless.

Under Pennsylvania law, which is especially deferential towards directors in the merger context, adherence to the business judgment standard is presumed so long as a majority of the disinterested directors approve the merger unless the disinterested directors did not assent to such act in good faith after reasonable investigation.

The Court found that the complaint sufficiently alleged that the directors failed to conduct a reasonable investigation into whether the transaction as whole (including the additional debt burden and the carve-out transaction) would render the company insolvent. The complaint alleged that the directors had excluded from their approval the two steps in the multi-step transaction that rendered RemainCo insolvent, even after Sycamore substantially increased the debt burden and decreased its equity contribution. The Court concluded that the business judgment rule did not apply because the rule, even under the deferential merger standard, only protects decisions undertaken after reasonable investigation and the complaint alleged there was no investigation (reasonable or otherwise).

Furthermore, the Court rejected the directors’ argument that they could not be liable for actions effectuated after they ceased to be in control of the company, explaining that, accepting the allegation in the complaint as true for purposes of the motion to dismiss, the multi-step transaction “reasonably collapses into a single integrated plan.”[3] In making this determination, the Court found it significant that the directors allegedly knew about the post-merger steps and, further, that those post-merger steps were certain to occur upon approval of the transaction. In a different recent decision in the Southern District of New York, In re Tribune Co. Fraudulent Conveyance Litigation, 2018 WL 6329139 (S.D.N.Y. Nov. 30, 2018), the court declined to collapse a two-step LBO transaction where the second step occurred more than six months after the first and its occurrence was subject to various preconditions including regulatory approval and the issuance of a second solvency opinion.[4] Contrasted to the facts here, where all five steps of the transaction were certain to occur substantially concurrently, the second step in Tribune was subject to conditions precedent that might not be satisfied and, therefore, was not certain to occur when the first step occurred or when the board members resigned.[5]

Exculpatory Bylaw Provisions Did Not Protect the Directors

Jones Group’s bylaws contained an exculpatory provision that limited a director’s monetary liability to breaches involving self-dealing, willful misconduct, or recklessness. The Court found that the complaint sufficiently alleged that the directors’ decision to set in motion the multi-step transaction, including the two steps that allegedly rendered the company insolvent and stripped it of its best assets, without reviewing the merits of those steps, was reckless.

The complaint alleged that the directors consciously disregarded whether the additional debt and carve-out transactions were in the best interests of the company by specifically excluding those elements of the transaction from their assessment or approval. The Court found that the complaint also alleged certain “red flags” that should have put the director defendants on notice that the additional debt and carve-out transactions would leave the company insolvent.

The first red flag was that the $2.2 billion valuation that the company received in the transaction, minus the $800 million historical purchase price of the carve-out businesses, implied that the rest of Jones Group was worth, at most, $1.4 billion. This relatively simple math—that a company worth no more than $1.4 billion was to be saddled with $1.55 billion of debt—should have alerted the directors that they needed to investigate RemainCo’s solvency. The second red flag was the simple fact that the increased debt burden would increase the debt to EBITDA ratio to between 6.6 and 7.8—both of which were substantially above the 5.1 maximum ratio that Citigroup had previously advised the board was sustainable.

The Court held that the red flags alleged in the complaint, coupled with the failure of the board to conduct any investigation in the face of such notice, was reckless. The denial of the motion to dismiss and conclusion that the complaint adequately alleged recklessness is premised in large part on the directors’ alleged decision to abdicate their duties by not reviewing the merits of two of the steps of the multi-step transaction and not an indication that an informed, but incorrect, assessment of the merits of the transaction would not have been protected.

Aiding and Abetting the Breach of Fiduciary Duty Claim

In addition to claims for their own breaches of fiduciary duty, the directors also faced allegations of aiding and abetting the breaches of the fiduciary duties of the two Sycamore principals who became directors after the closing of the merger. The Court, rather summarily, upheld this claim for two reasons.

First, the Court rejected the directors’ argument that any acts taken before the Sycamore principals became directors cannot form the basis of this claim, finding that no such temporal requirement for the fiduciary relationship existed, and that there were no grounds for creating one. The allegations that the directors had enabled the Sycamore directors to strip away assets and overleverage RemainCo by approving the merger without reviewing the merits of the transfers of the crown jewels or the additional debt, even though the directors allegedly had actual knowledge these additional steps would be taken post-merger, was sufficient to state a claim for aiding an abetting the actions of the Sycamore directors.

Second, the complaint adequately pled that the director defendants knowingly participated in the breaches because the same “red flags” discussed above were sufficient to show that the directors had actual or constructive knowledge that the contemplated carve-out transactions constituted a breach of fiduciary duty by the Sycamore principals, which the director defendants knew the Sycamore directors intended to carry out as part of the multi-step transaction. The directors’ decision not to address the merits of two critical steps in the multi-step transaction may even justify an inference that the directors knew that these steps were problematic.

Key Considerations

While this decision is not a departure from established law, it does provide guidance to directors and other interested parties as to what practices must be employed to satisfy their fiduciary duties and minimize liability risk. Process is critical. To obtain the benefits of the business judgment rule directors must actually exercise business judgement and cannot intentionally distance themselves from responsibility for certain steps in an integrated multi-step transaction that they knowingly facilitate, especially when all steps in the transaction occur substantially concurrently.

This opinion denies a motion by the director defendants to dismiss the claims against them. It is not a ruling finally imposing liability. On a motion to dismiss, the court is required to accept all facts in the plaintiff’s complaint as true and to view them in the light most favorable to the plaintiff. Additionally, the Court was applying Pennsylvania law. While fiduciary duty law is fairly similar across jurisdictions, this decision is merely persuasive authority regarding one state’s fiduciary duty laws. That said, the Court refused to apply the business judgment standard, which is one of the key protections available to directors.

This decision reaffirms that directors must thoroughly and meaningfully review all parts of a transaction that are contemplated when they decide whether to approve it, even if some steps of a multi-step integrated transaction may occur after the director is no longer a board member. A director cannot evade the obligation to review part of the transaction by simply excluding it from the board approval analysis. Directors should anticipate that a multi-step transaction may be viewed by a court as a single transaction, even if certain steps are to be completed post-closing by different directors or entities. However, directors can further protect themselves by insisting on a bifurcated transaction structure with meaningful conditions so that any risky steps (e.g., incurrence of additional debt, spinoff transactions, etc.) will only occur if the company is solvent and can support the transaction.

In evaluating a transaction, directors should also consider whether the valuation metrics they receive are compatible all other current financial information that had been provided to the directors. While there is nothing in the Nine West decision to indicate that directors cannot rely on the analyses and presentations of advisors and experts, the Court’s comments regarding the disconnect between the numbers provided to the valuation advisors by the proposed buyer and other information available to the directors may imply an expectation that a reasonable exercise of business judgment requires directors to consider whether valuation metrics are at odds with the other information that they have regarding financial performance of the company.

______________________

  [1]   In re Nine W. LBO Sec. Litit., __ F. Supp. 3d __, 2020 WL 7090277 (S.D.N.Y. Dec. 4, 2020). All of the facts and legal analysis in this memorandum are from the above citation unless otherwise noted.

  [2]   Id. at * 29.

  [3]   Id. at * 30.

  [4]   In re Tribune Co. Fraudulent Conveyance Litig., 2018 WL 6329139, at *8-9 (S.D.N.Y. Nov. 30, 2018). In step one of the Tribune transaction, the company borrowed money to repurchase approximately 50% of its outstanding stock, and then in step two the company borrowed additional money to redeem the remaining stock through a go-private transaction. Id. at *2.

  [5]   This decision does not suggest that a director would be liable for a transaction undertaken by a future board for which the prior board had no knowledge. But these cases suggest that a board may be able to insulate itself from liability for future actions undertaken for which it has knowledge, so long as those future actions are considered in a meaningful way or, like in Tribune, future transactions are meaningfully bifurcated from the transaction that the directors approve.

Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization practice group, or any of the following:

Michael A. Rosenthal – New York (+1 212-351-3969, [email protected])
Jeffrey C. Krause – Los Angeles (+1 213-229-7995, [email protected])
Oscar Garza – Orange County, CA (+1 949-451-3849, [email protected])
Matthew G. Bouslog – Orange County, CA (+1 949-451-4030, [email protected])
Douglas G. Levin – Orange County, CA (+1 949-451-4196, [email protected])

Please also feel free to contact the following practice group leaders:

Business Restructuring and Reorganization Group:
David M. Feldman – New York (+1 212-351-2366, [email protected])
Scott J. Greenberg – New York (+1 212-351-5298, [email protected])
Robert A. Klyman – Los Angeles (+1 213-229-7562, [email protected])
Jeffrey C. Krause – Los Angeles (+1 213-229-7995, [email protected])
Michael A. Rosenthal – New York (+1 212-351-3969, [email protected])

© 2020 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 December 27, 2020, President Trump signed the bipartisan COVID-19 relief and government funding bill, which incorporated the Copyright Alternative in Small-Claims Enforcement Act of 2020 (“CASE Act”) that had been pending as part of H.R. 133, as well as legislation designed to increase criminal penalties for illicit streaming of copyright-protected content. The CASE Act contains various revisions to the Copyright Act, 17 U.S.C. §§ 101 et seq., with the goal of creating a new avenue for copyright owners to enforce their rights without having to file a lawsuit in federal court. The CASE Act creates a Copyright Claims Board within the United States Copyright Office that may adjudicate small claims of copyright infringement using streamlined procedures and award limited remedies, including no more than $30,000 in total damages in any single proceeding. The stimulus package also includes the language of a separate bipartisan bill, the Protecting Lawful Streaming Act, that amends Title 18 of the U.S. Code to make it a felony (rather than just a misdemeanor) to unlawfully stream copyright-protected content online for profit, with penalties of up to 10 years of imprisonment. We briefly summarize these key copyright provisions below.

  • Creation of Copyright Claims Board. While federal courts generally exercise exclusive jurisdiction over claims of copyright infringement,[1] the CASE Act establishes a Copyright Claims Board as an alternative forum in which parties may voluntarily resolve small claims of copyright infringement arising under Section 106 of the Copyright Act.[2] The Board consists of three Copyright Claims Officers who may conduct individualized proceedings to resolve disputes before them, including by managing discovery and conducting hearings as necessary, and awarding monetary and other relief.[3] The Officers must issue written decisions setting forth their factual findings and legal conclusions.[4]  But parties that choose to proceed before the Board waive their right to formal motion practice and a jury trial.[5] Participation in a proceeding before the Board is voluntary, and parties may opt out upon being served with a claim, choosing instead to resolve their dispute in federal court.[6]
  • Board Decisions. The CASE Act grants the Register of Copyrights authority to issue regulations setting forth specific claim-resolution procedures, but the CASE Act expressly articulates choice-of-law principles and states that Board decisions are not precedential.
    • Choice of Law: Although the Board sits within the Copyright Office in Washington, D.C., the Board must follow the law in the federal jurisdiction in which the action could have been brought if filed in federal court.[7] Given the conflicts that could arise where an action could have been brought in multiple jurisdictions that are split on a legal question, the Act provides that the Board may apply the law of the jurisdiction the Board determines has the most significant ties to the parties and conduct at issue.[8]
    • Board Decisions Are Not Precedential: The CASE Act provides that Board decisions may not be cited or relied upon as legal precedent in any action before any tribunal, including the Board.[9] And Board decisions have preclusive effect solely with respect to the parties to the proceeding and the claims asserted and resolved in the proceeding.[10]
  • Board Remedies. As in federal court, parties before the Board may seek actual or statutory damages. But the CASE Act caps the amount of damages the Board may award. Specifically, the Board may not award more than $15,000 in statutory damages per work, may not consider whether infringement was willful (and, therefore, may not increase a per work statutory award based on willfulness, as is permitted in federal court), and may not award more than $30,000 in total actual or statutory damages in any single proceeding, notwithstanding the number of claims asserted.[11] While attorneys’ fees are recoverable under the Copyright Act,[12] the Board may not award attorneys’ fees except in the case of bad faith conduct—in which case, any fee award may not exceed $5,000, absent extraordinary circumstances, such as where a party has engaged in a pattern of bad faith conduct.[13]
  • Limited Appellate Review. The CASE Act permits parties to seek limited review of Board decisions. After the Board issues its written decision in a matter, a party may submit to the Board a written request for reconsideration.[14] If the Board declines to reconsider its decision, the party may ask the Register of Copyrights to review the Board’s decision under an abuse of discretion standard of review.[15] If the Register does not provide the requested relief, the party may then seek an order from a district court vacating, modifying, or correcting the Board’s determination under only very limited circumstances: if (a) the determination was the result of fraud, corruption, misrepresentation, or other misconduct; (b) the Board exceeded its authority or failed to render a final determination; or (c) the determination was based on a default or failure to prosecute due to excusable neglect.[16]
  • Bar on Repeat Frivolous Filings. In an attempt to deter copyright trolls from filing repeated, frivolous claims before the Board, the CASE Act provides that any party who pursues a claim or defense in bad faith more than once in a 12-month period may be barred from initiating a claim before the Board for 12 months.[17] The CASE Act also grants the Register of Copyrights authority to issue regulations limiting the number of proceedings a claimant may initiate in any given year.[18]
  • Implications of the CASE Act. The CASE Act authorizes the Register of Copyrights to issue implementing regulations setting forth specific procedures for proceedings before the Board, so it remains to be seen exactly how the Board will conduct proceedings before it. It also is an open question how and whether the Board will resolve constitutional questions that arise in copyright infringement actions, such as First Amendment questions relating to the fair use defense. Further, it remains to be seen whether defendants in small copyright disputes will consent to Board proceedings, or will opt out in favor of the federal courts. Regardless, the CASE Act creates mechanisms for the more efficient and economical pursuit of small claims of copyright infringement, where the expense of litigating in federal court would otherwise exceed any potential recovery.
  • Protecting Lawful Streaming Act. The separate criminal copyright provisions tucked into the stimulus bill are designed to address a loophole under current law that allows the reproduction and distribution of copyright-protected material to be charged as felonies, but only allows the live streaming (or “publicly performing”) of such works to be charged as a misdemeanor. According to the legislative history, the bill sponsors thought it was important to recognize that streaming, rather than copying, has become the primary way that audiences consume entertainment. This new statutory language will allow the U.S. Justice Department to bring felony charges not against individual users, but rather against a digital transmission service that: (1) is primarily designed or provided for the purpose of streaming copyrighted works without the authority of the copyright owner or the law; (2) has no commercially significant purpose or use other than to stream copyrighted works without the authority of the copyright owner or the law; or (3) is intentionally marketed or directed to promote its use in streaming copyrighted works without the authority of the copyright owner or the law.[19] The statutory language represents a compromise with some critics who had feared that broader criminal provisions could be used to limit free speech online.

______________________

[1]   28 U.S.C. § 1338(a) (“The district courts shall have original jurisdiction of any civil action arising under any Act of Congress relating to … copyrights,” and “[n]o State court shall have jurisdiction over any claim for relief arising under any Act of Congress relating to … copyrights.”).

[2]   H.R. 133 § 1502(a); § 1504(c); see also 17 U.S.C. § 106 (“the owner of copyright under this title has the exclusive rights to … reproduce the copyrighted work”; “to prepare derivative works based upon the copyrighted work”; “to distribute copies or phonorecords of the copyrighted work to the public”; “to perform the copyrighted work publicly”; “to display the copyrighted work publicly”; and “to perform the copyrighted work publicly”).

[3]   H.R. 133 §§ 1502(b)(1)–(3), 1503(a)–(b), 1504(e)(2).

[4]   Id. § 1506(s)–(t).

[5]   Id. § 1506(c), (e)-(g), (m), (p).

[6]   Id. §§ 1504(a), 1506(g).

[7]   Id. § 1506(a)(2).

[8]   Id. § 1506(a)(2).

[9]   Id. § 1507(a)(3).

[10]   Id. § 1507(a).

[11]   Id. § 1504(e)(1)(A), (D).

[12]   17 U.S.C. § 505.

[13]   H.R. 133 §§ 1504(e)(3), 1506(y)(2).

[14]   Id. § 1506(w).

[15]   Id. § 1506(x).

[16]   Id. § 1508(c).

[17]   Id. § 1506(y)(3).

[18]   Id. § 1504(g).

[19]   18 U.S.C. § 2319C.

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 lawyer with whom you usually work in the firm’s Intellectual Property, Media, Entertainment and Technology, or Fashion, Retail, and Consumer Products practice groups, or the following authors:

Howard S. Hogan – Washington, D.C. (+1 202-887-3640, [email protected])
Ilissa Samplin – Los Angeles (+1 213-229-7354, [email protected])
Jonathan N. Soleimani – Los Angeles (+1 213-229-7761, [email protected])
Shaun Mathur – Orange County (+1 949-451-3998, [email protected])

Please also feel free to contact the following practice leaders:

Intellectual Property Group:
Wayne Barsky – Los Angeles (+1 310-552-8500, [email protected])
Josh Krevitt – New York (+1 212-351-4000, [email protected])
Mark Reiter – Dallas (+1 214-698-3100, [email protected])

Media, Entertainment and Technology Group:
Scott A. Edelman – Los Angeles (+1 310-557-8061, [email protected])
Kevin Masuda – Los Angeles (+1 213-229-7872, [email protected])
Orin Snyder – New York (+1 212-351-2400, [email protected])

© 2020 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 December 21, 2020, Congress passed a massive $2.3 trillion, 5,593-page, bicameral and bipartisan year-end legislation package to fund the government and provide long-delayed coronavirus relief. H.R. 133 includes $1.4 trillion to fund the government and $900 billion in coronavirus relief via the Coronavirus Response and Relief Supplemental Appropriations Act, 2021 (the “Act”). Following the $2.3 trillion coronavirus relief package signed into law last March, the current legislation is the second-largest economic stimulus in U.S. history. This is the fourth coronavirus relief package that Congress has passed this year, bringing the total sum that Congress has spent on coronavirus relief up to roughly $3 trillion.

The Act passed Congress overwhelmingly, by a vote of 359-53 in the House and 92-6 in the Senate. President Trump has criticized the bill sharply, but the strong votes in both chambers may dissuade him from vetoing the measure. The passage of the massive legislation marks nearly nine months since Congress last provided coronavirus relief to a nation besieged by a pandemic and businesses on the brink of economic collapse in the absence of federal funding.

While the Act includes a wide variety of provisions, this alert will focus largely on language relating to the Paycheck Protection Program (“PPP”), which allows for second draw loans for the hardest-hit businesses. The Act also expands the list of expenses PPP funds may cover and clarifies that ordinarily tax deductible business expenses are still deductible even if PPP loans were used to cover those costs. Other provisions of the Act include PPP set-asides for businesses that traditionally have difficulty accessing mainstream banking services and expanded the types of organizations eligible for relief. The Act also provides funding for the SBA to conduct auditing and fraud-detection efforts over the administration of PPP loans.

Other COVID-19 relief provisions include billions in funding for “shuttered venue operators,” such as live venues, closed movie theaters, and museums. Moreover, any entity that received an Economic Disaster Injury Loan advance under the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) no longer needs to deduct the amount of their advance from their PPP loan forgiveness amount. Below is a summary of the key provisions most relevant to our clients and friends.

Paycheck Protection Program Revival and Changes

The Act revives and makes key changes to the Paycheck Protection Program Flexibility Act of 2020 (“PPP Flexibility Act”) that Congress passed, and the President signed into law, in June of 2020.[i] As discussed in a previous Gibson Dunn client alert, President Signs Paycheck Protection Program Flexibility Act, the PPP Flexibility Act relaxed certain requirements of and restrictions on PPP loans, which were established by the CARES Act and clarified by subsequent guidance from the Small Business Administration (“SBA”) and the U.S. Department of the Treasury. If President Trump signs the legislation, the SBA is required to establish regulations on implementing the programs in the Act within 10 days of the signing.

Importantly, the Act revives the signature small-business relief effort that Congress established last spring, committing $285 billion for additional PPP loans and extending the deadline to apply for PPP loans to March 31, 2021. The Act allows the hardest-hit businesses to receive a second draw PPP loan, with extra relief provided to food services and hotels; expands the list of eligible expenses that PPP funds may cover; and permits PPP recipients to deduct expenses covered with PPP funds. The Act also expands the types of programs eligible for first-time PPP loans, while prohibiting publicly-traded companies and companies affiliated with China or Hong Kong from receiving new loans.

The first round of PPP loans was largely viewed as a success. As of August 8, 2020—when the first round of PPP loans closed—the SBA had approved 5,212,128 PPP loans. More than 5,000 lenders participated in administering the program, and the average loan was approximately $100,729. In total, the loans amounted to more than $525 billion.[ii] As of November 22, 2020, the SBA had received 595,144 loan forgiveness applications, totaling approximately $83 billion, of which the SBA had forgiven approximately $38 billion.

Second Draw Loans

Significantly, the Act reopens the PPP to certain businesses that already received a PPP loan. The program’s expiration in August of this year left over $130 billion in unused funds that will now be reallocated to the General Treasury, and the program’s rules initially prevented businesses who received loans from obtaining a second PPP loan. The Act offers a second PPP loan to companies who meet certain eligibility criteria. Specifically, businesses applying for a second draw loan must show that they—and their affiliates— “employ not more than 300 employees.” Additionally, businesses are eligible only if they have used or will use the full amount of their initial PPP loan and have lost at least 25 percent of their revenue in any quarter of 2020. Although initial press reports covering the Act indicated that eligible businesses must have at least a 30 percent reduction in their revenue, the finalized Act created a lower eligibility threshold. Specifically, eligible entities must have gross receipts that demonstrate a 25 percent or more reduction from the gross receipts of the entity during the same quarter in 2019. Entities that submit applications on or after January 1, 2021 are eligible to utilize their gross receipts from the fourth quarter of 2020. However, entities not in operation on or after February 15, 2020 are not eligible for initial PPP loans nor second draw loans.

Maximum Second Draw Loan Amount

While the loan amount for most borrowers will be the same as the amount of their initial PPP loans, second draw loans are capped at $2 million per borrower. This is significantly lower than the $10 million cap placed on initial PPP loans in the CARES Act. For borrowers who received a PPP loan within the last 90 days at the time of their second draw application, the proposed bill requires that the aggregate of the initial and second draw loan does not exceed $10 million.

Larger Second Draw Loan Amounts for Food and Hotel Industries

Second draw loan borrowers are generally allowed to receive a loan amount of up to two-and-one-half times their average monthly payroll. The Act, however, allows businesses within the accommodation and food services industries to receive second draw loans of up to three-and-one-half times their monthly average payroll costs. The maximum loan amount of $2 million still applies.

Restrictions on People’s Republic of China and Hong Kong Affiliated Entities

Notably, the second draw loan provision also restricts businesses or entities affiliated with the People’s Republic of China (“PRC”) or the Special Administrative Region of Hong Kong (“Hong Kong”) from receiving additional relief. The Act states that a borrower is ineligible for a second draw loan if: 1) an entity created in or organized under the laws of the PRC or Hong Kong or with significant operations in the PRC or Hong Kong holds 20 percent or more interest in the borrower; or 2) a member of the borrower’s Board of Directors is a resident of the PRC.

Changes to PPP Eligibility

The Act made changes and clarifications to what kinds of entities are eligible for PPP loans. Significantly, 501(c)(6) organizations—that were previously not eligible to receive PPP assistance—will now be eligible to receive a first-time loan under the PPP program. To be eligible, 501(c)(6) organizations must have no more than 300 employees and may not be primarily engaged in political or lobbying activities. Specifically, the lobbying activities of the organization cannot comprise more than 15 percent of the business’s total activities and cannot exceed $1 million in costs during the most recent tax year of the organization that ended prior to February 15, 2020. The Act defines lobbying activities to include any entity that is organized for research or for engaging in advocacy in areas such as public policy or political strategy or otherwise describes itself as a think tank in any public documents.

The Act also allows certain news organizations that were previously ineligible because of affiliation with other newspapers or other businesses to access PPP loans. Under the Act, any station that is licensed by the Federal Communications Commission (“FCC”) under Title III of the Communications Act of 1934 is eligible to receive a PPP loan if the entity either: 1) employs not more than 500 employees per physical location or otherwise meets the applicable SBA size standard; or 2) is a nonprofit organization designated as a public broadcasting entity by the Communications Act of 1934. The news outlet must be majority-owned or controlled by a business that is a newspaper publisher or in the radio and television broadcasting industry, as defined by the North American Industry Classification Code (the “Code”), unless it is a public broadcasting entity, in which case its trade or business must fall under the Code. All news organizations must certify that proceeds of the loan will be used to support the component of the business that produces or distributes locally-focused or emergency information.

The Act also excludes entities that are not otherwise eligible under the SBA’s traditional eligibility rules codified under 13 C.F.R. § 120.110.[iii] Additionally, publicly traded companies are not eligible for PPP loans under the Act, codifying what was previously understood through guidance from the Department of the Treasury, but unclear on the face of CARES Act.

PPP Loan Forgiveness – Covered Period and Range of Eligible Expenses

The covered period is the time allotted for borrowers to spend PPP loan proceeds on qualified expenses for purposes of forgiveness. The legislation allows borrowers to choose a “covered period” of 8 or 24 months.

Congress also voted to expand the number of forgivable expenses under the Act. Forgivable expenses, which were previously limited to payroll costs and certain mortgage, rent, and utility expenses, now include supplier costs, investments in facility modifications, and personal protective equipment that businesses require to operate safely. Business software and cloud computing services that help facilitate business operations are also included.

Repeal of Emergency Injury Disaster Loan Advance Deduction Prohibition

The Act repeals a provision in the CARES Act requiring PPP borrowers to deduct the amount of their Economic Injury Disaster Loan (“EIDL”) advance—up to $10,000—from their PPP forgiveness amount. The Act reflects Congress’s view that those that received EIDL advances should be afforded additional relief.

Permitted Tax Deductions for PPP Borrowers

The Act clarifies that organizations receiving PPP loans will be allowed to deduct from taxable income expenses paid for by funds received under the loan. Secretary of the Treasury, Steven Mnuchin, previously prohibited corporations from making such tax deductions, citing the Administration’s view that allowing the deductions would amount to “double-dipping” because the loan forgiveness amount is already excluded from income for tax purposes. However, the Act clarifies that it was Congress’s intent that the CARES Act allow for such tax deductions. Thus, businesses receiving PPP funds will be allowed to deduct business expenses as if they used non-PPP funds to cover those costs.

Simplified Forgiveness Applications for Small PPP Loans

The Act simplifies the loan forgiveness process for recipients of a PPP loan of $150,000 or less. To begin the loan forgiveness process, recipients must sign and submit a letter of certification, which will be provided by the SBA Administrator no later than 24 days after the Act’s enactment. The certification letter will be no more than one page in length and will verify the loan recipient’s eligibility to their lender. The letter must provide specific information relating to the entity’s loan including: 1) the number of employees the eligible recipient was able to retain because of the covered loan; 2) the estimated amount of the covered loan amount spent by the eligible recipient on payroll costs; and 3) the total loan value.

No Enforcement Action Against Lenders

The Act makes clear that an enforcement action may not be brought against lenders that rely on an applicant’s certification for an initial PPP loan or second draw PPP loan as long as the lender: 1) acts in good faith relating to loan origination or forgiveness of the PPP loan; and 2) all other relevant Federal, State, local, and other statutory and regulatory requirements applicable to the lender are satisfied with respect to the PPP loan.

Funds for Community Development Financial Institutions

The Act includes PPP set-asides for very small businesses with ten employees or fewer through community-based lenders like Community Development Financial Institutions and Minority Depository Institutions. In total, the Act provides $12 billion in capital investments to support these institutions, which makes loans and grants to businesses that are often unable to get traditional banks to do business with them.

Conflicts of Interest for Government Officials

As a nod to public concerns about PPP forgiveness, the Act places disclosure requirements on high-level government officials who receive a PPP loan. This provision applies to the President, Vice President, heads of executive agencies, and Members of Congress, including their spouses. The public disclosure must be made within 30 days of forgiveness of the PPP loan.

Additional Notable Provisions of the Act

The Act also includes various other COVID-19 relief provisions, including:

  • Grants for Shuttered Venue Operators. The Act authorizes $15 billion in relief to eligible live venues, closed movie theaters, zoos, and museums, which were particularly hard-hit by the pandemic. Of the allocation, $2 billion goes toward eligible entities that have no more than 50 full-time employees. The bill takes an incremental approach to disbursing funds. Only eligible entities that saw a 90 percent or more loss in revenue during the period beginning on April 1, 2020 and ending on December 31, 2020 when compared to the same period in 2019 are eligible to receive funds within the initial 14 days during which the SBA allocates funds. Entities with a 70 percent or more loss in revenue are eligible to receive funds after the initial 14-day period ends. After the first 28 days of issuing grants, the SBA may award a grant to any eligible entity.
  • SBA Fraud and Prevention Programs. Congress allocated $50 million to the Small Business Administration for audits and other fraud prevention programs to monitor the agency’s administration of PPP loans.
  • Rental Assistance. The Act extends the Centers for Disease Control and Prevention’s September 4, 2020 eviction moratorium through January 31, 2021.
  • Transportation Relief. The Act extends the Payroll Support Program included in the CARES Act, to support the airline industry and airline industry workers. Specifically, the Act allocates $15 billion for airline payroll support, $1 billion for airline contractor payrolls, and $2 billion for airports and airport concessionaires.
  • Business Meal Expense Deduction. The Trump Administration secured a provision within the Act that allows all corporations to temporarily deduct meal expenses. Advocates of the provision believe that it will provide a significant boost to the restaurant industry, encouraging corporations to cover meal expenses. The business meal deduction will be available until January 1, 2023.
  • Affirming Federal Reserve Emergency Loan Powers. Title VI of the Act re-allocates $429 billion in unused Treasury direct loans and excess funds from Federal Reserve facilities authorized by the CARES Act back into the general Treasury Fund. Although ending the Federal Reserve’s emergency loan authority was a source of contention for lawmakers, the Act struck a compromise, requiring Congress to authorize any future emergency loans issued by the Federal Reserve, rather than ending the Federal Reserve’s ability to lend altogether.
  • No Corporate Immunity Provision. Although discussed during negotiations, lawmakers declined to include within the Act a corporate immunity provision, which would have granted corporate employers immunity from COVID-19 related lawsuits brought by employees.

_______________________

[i] For additional details about the PPP please refer to Gibson Dunn’s Frequently Asked Questions to Assist Small Businesses and Nonprofits in Navigating the COVID-19 Pandemic and prior Client Alerts about the Program: Federal Reserve Modifies Main Street Lending Programs to Expand Eligibility and Attractiveness; President Signs Paycheck Protection Program Flexibility Act; SBA “Paycheck Protection” Loan Program Under the CARES Act; Small Business Administration and Department of Treasury Publish Paycheck Protection Program Loan Application Form and Instructions to Help Businesses Keep Workforce Employed; Small Business Administration Issues Interim Final Rule and Final Application Form for Paycheck Protection Program; Small Business Administration Issues Interim Final Rule on Affiliation, Summary of Affiliation Tests, Lender Application Form and Agreement, and FAQs for Paycheck Protection Program; Analysis of Small Business Administration Memorandum on Affiliation Rules and FAQs on Paycheck Protection Program; Small Business Administration Publishes Additional Interim Final Rules and New Guidance Related to PPP Loan Eligibility and Accessibility; and Small Business Administration Publishes Loan Forgiveness Application.

[ii] This data was collected from the U.S. Small Business Administration website and may be reviewed here. The data does not reflect any changes or cancellations to PPP loans made after August 8, 2020.

[iii] Excluded businesses also include financial business primarily engaged in the business of lending; passive businesses owned by developers or landlords that do not actively use or occupy the assets acquired or improved with the loan proceeds; life insurance companies; business organizations located in a foreign country; pyramid sale distribution plans; businesses deriving more than one-third of gross annual revenue from legal gambling activities; businesses engaged in any illegal activity; private clubs and businesses which limit the number of memberships for reasons other than capacity; government-owned entities (except for businesses owned or controlled by a Native American tribe); loan packagers earning more than one third of their gross annual revenue from packaging SBA loans; businesses with an Associate who is incarcerated, on probation, on parole, or has been indicted for a felony or a crime of moral turpitude; businesses in which the lender or CDC, or any of its Associates owns an equity interest; businesses primarily engaged in political or lobbying activities; speculative businesses; and unless waived by the SBA, businesses that have previously defaulted on a Federal loan or Federally assisted financing. 13 C.F.R. § 120.110 (What businesses are ineligible for SBA business loans?).

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, or the following authors:

Michael D. Bopp – Washington, D.C. (+1 202-955-8256, [email protected])
Roscoe Jones, Jr. – Washington, D.C. (+1 202-887-3530, [email protected])
Courtney M. Brown – Washington, D.C. (+1 202-955-8685, [email protected])
William Lawrence – Washington, D.C. (+1 202-887-3654, [email protected])
Amanda Sadra * – Los Angeles, CA (+1 213-229-7016, [email protected])

* Not admitted to practice in California; currently practicing under the supervision of Gibson, Dunn & Crutcher LLP.

© 2020 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

New York partner Akiva Shapiro and associates Lee Crain and Amanda LeSavage are the authors of “Tips for District Court Amicus Brief Success,” [PDF] published by the New York Law Journal on December 23, 2020.

Brussels of counsel Alejandro Guerrero and London of counsel Sarah Wazen are the contributors to the “Belgium” chapter of the Data Protection & Privacy Laws feature published by Financier Worldwide in November 2020.

Paris partner Ahmed Baladi is the contributor to the “France” [PDF] chapter of the Data Protection & Privacy Laws feature published by Financier Worldwide in November 2020.

New York associate James Manzione is the author of “Real Estate Partnerships: The Basics and Some Technical Stuff,” [PDF] published by Tax Notes Federal on November 23, 2020.