Whatever industry you are in, you are undoubtedly concerned about preparing your business to face the threat of the novel coronavirus (COVID-19).[1] Both the Centers for Disease Control (“CDC”) and the Occupational Safety and Health Administration (“OSHA”) have recently encouraged employers to develop employee protection plans.[2] OSHA’s guidance in particular cautions that “existing OSHA standards may apply to protecting workers from exposure to and infection with” the virus; among other things, the guidance invokes the “General Duty Clause” of the Occupational Safety and Health Act (which imposes certain obligations to protect employees from “recognized hazards”).[3]

Below, we identify some of the key considerations for businesses working to reduce the risk of employee exposure. We also outline key steps to take when an employee tests positive for COVID-19 or must care for someone with the disease.

The government response to the outbreak evolves daily, and we encourage employers to monitor federal, state, and local health department updates; legislative developments; executive actions; and Department of Labor guidance. Among other things, employers should monitor developments regarding paid leave for employees affected by COVID-19;[4] the bill that passed the House late Friday is addressed below.

Options for Reducing the Risk of Employee Exposure to COVID-19

Employers have many options for reducing the risk of employee exposure, and each comes with its own risks that should be managed carefully. The list below is not intended to be exhaustive, and is also focused on managing employee exposure to the virus. Additional considerations may apply to customers, vendors, contractors, and others with whom you interact.

Workplace Adjustments: Both OSHA and the CDC recommend that employers promote good hygiene and infection control practices. Employers can promote handwashing by either providing a place for employees to wash their hands thoroughly with soap or, if running water is unavailable, provide alcohol-based hand rubs containing at least 60% alcohol.[5] Both agencies encourage employers to ensure the availability of adequate tissues and trash receptacles (preferably of the “no-touch” variety).[6] Employers who operate set shifts or other fixed work schedules may want to consider (where feasible) added flexibility around employee breaks or other opportunities for employees informally to take time that may be needed to attend to increased hygiene concerns. Housekeeping practices may also need to be adjusted in light of the pandemic.[7] In some workplaces, it may be appropriate to install high-efficiency air filters, increase ventilation rates, or install physical barriers like sneeze guards.[8] OSHA has offered other recommendations depending on the expected level of exposure and hazard assessment for the particular workplace and job—for example, health care workers obviously are in a different position than office workers and may need additional protection (such as airborne infection isolation rooms).[9]

The CDC also recommends placing posters in the workplace that advocate good hand-washing practices, cough-and-sneeze etiquette, and staying home when sick.[10] Where employers are increasing the availability of telecommuting, it may be helpful to provide this information electronically as well.

Restricting Travel: Many employers are restricting business travel, and the CDC is regularly updating its travel notices.[11] Views regarding the appropriate level of travel restrictions may vary by industry.

Employees may also be exposed to COVID-19 through personal travel. When considering creating guidelines on employees’ personal travel, employers should be mindful that some jurisdictions limit employer regulation of off-duty conduct.[12] Rather than restrict personal travel to affected areas, employers may instead elect to require that employees traveling to those areas self-report to Human Resources and, if their travel indicates an elevated risk, excluding them from the workplace for an appropriate period of time.

Restricting or Screening Visitors: Employers may also wish to restrict visitors or screen visitors for exposure to COVID-19. When doing so, employers should take into consideration visitors’ potential privacy rights (e.g., by posting clear notices of any screening policies, dealing with screening results discreetly, and storing disclosure forms securely). If employers use any screening tools that capture biometric identifiers, they should also be mindful of enhanced privacy rights under state laws such as the Illinois Biometric Information Privacy Act.[13] Many courthouses and other public buildings have banned entry by persons who have traveled to high-risk countries, are ill, or are quarantined,[14] and many employers, office buildings, and other facilities have implemented parallel restrictions for employees and visitors.

Instituting Work-from-Home/Telecommuting Policies: Where some or all of an employee’s work may be performed remotely, employers may consider permitting employees to work from home on a short-term basis.

For many employers, although short-term changes may be feasible in pandemic conditions, permanent changes would pose an undue hardship. Therefore, when implementing a new work-from-home/telecommuting policy or expanding an existing one, employers should take steps to mitigate the risk that these temporary changes create an unworkable precedent for the future.[15] Communicating the short-term and emergency nature of policy changes is one way to limit risk. Furthermore, employers should retain the right to monitor, modify, or withdraw the policy at any time.

Employers should also be mindful that when employees work from home, doing so may raise its own exposure to potential liability for employment law violations. Key considerations include:

Recording hours worked: The Fair Labor Standards Act (FLSA) requires that employers maintain records of hours worked by non-exempt employees. If such employees are working from home, working time may be less clearly demarcated, and employers should ensure that employees accurately record their time spent on work activities.[16]

Ensuring meal and rest period compliance: Even when employees work remotely, employers should ensure that they comply with state laws regarding meal and rest periods.[17]
Business expense reimbursements: For some workers, remote work may result in increased expenses. The FLSA mandates that, if employees pay for certain business-related expenses, those expenses cannot reduce the employees’ pay below minimum wage in a given workweek.[18] In addition, some states require that employers cover all reasonable and necessary business expenses, regardless of whether those expenses reduce pay below minimum wage.[19]
Fair implementation of policy: Employers should work to ensure that remote working policies are implemented fairly and consistently, in order to avoid accusations of discrimination.

Employers should separately consider the increased cybersecurity risk of remote work and ensure that their networks are prepared for increased traffic and risk.

Instructing Employees Not to Work:

Where telecommuting is not an option, employers may instruct employees to stay home and not come to work at all.

Some employers may conclude that entire facilities should be temporarily shut down, in which case the primary concern will be the question of payment during the shut-down; that is addressed below. In the event that COVID-19 requires a long term or potentially permanent closure of any facilities or layoffs of workers, employers should consult the Worker Adjustment and Retraining Notification (“WARN”) Act and its state counterparts in order to determine whether advance notice is required (and, if so, whether it is excused by the circumstances). At the federal level, temporary lay-offs, hours reductions, or shut-downs will generally only trigger WARN if they last longer than six months.[20]

Other employers may identify specific people or groups of people who should stay home on a temporary basis. For these employers, additional considerations include:

Asking employees about travel and other exposure to COVID-19: Employers may generally ask employees to disclose that they are returning from travel to affected areas or whether they have been exposed to COVID-19.[21]
Asking employees to disclose symptoms of COVID-19: Many employers may wish to ask employees whether they are experiencing a fever, cough, or other COVID-19 symptoms. In its pandemic influenza guidance, the EEOC advised that, at least as to “employees who report feeling ill at work or who call in sick,” employers may ask employees if they are experiencing symptoms of influenza.[22] Depending on the severity of the pandemic, the EEOC reasoned, inquiries about employees’ symptoms are either “not disability-related” or “disability related [but] justified by a reasonable belief based on objective evidence that the severe form of pandemic [] poses a direct threat.”[23] This same reasoning could support asking such questions even if employees have not affirmatively reported feeling ill; as long as employers are not selective about asking these questions (e.g., asking only older people or people of a specific national origin), asking these questions is likely low-risk under current conditions. However, “all information about employee illness” must be “maintain[ed]. . . as a confidential medical record in compliance with the ADA.”[24] Because COVID-19 is more severe than the seasonal flu, this guidance suggests that, currently, “employers may measure employees’ body temperature.” Furthermore, employers should avoid being selective in asking people whether they are experiencing symptoms; making assumptions about who is most likely to have the disease could increase the risk of discrimination claims.
Screening employees based on body temperature: Taking an employee’s temperature will generally qualify as a medical examination, which the ADA restricts. Nevertheless, because COVID-19 has become widespread and is more severe than seasonal flu, the EEOC suggests that it is likely that employers are justified in taking employees’ temperature.[25] Specifically, in the context of pandemic influenza, the EEOC states that, “If pandemic influenza symptoms become more severe than the seasonal flu or the H1N1 virus in the spring/summer of 2009, or if pandemic influenza becomes widespread in the community as assessed by state or local health authorities or the CDC, then employers may measure employees’ body temperature.”[26] Keep in mind that a regular body temperature does not ensure that a person is free of the virus.
Restricting discussions of underlying conditions or comorbidities: Some populations are more vulnerable to COVID-19. But in the context of pandemic H1N1 and seasonal influenza, the EEOC advised that employers may not ask asymptomatic employees to disclose whether they have a medical condition that could make them more vulnerable to complications.[27] As the COVID-19 pandemic develops, and if contracting it poses a “direct threat,” it is possible that these disability-related inquiries would be permissible, but that question is unsettled.[28] In the event that an employee “voluntarily discloses” a vulnerability to COVID-19, the employer may ask what accommodations the employee needs and should be as flexible as possible in response, but the employer should keep the medical information confidential.[29]
Anti-discrimination laws: As always, employers should avoid taking into account—or appearing to take into account—protected status when deciding who to send home. For example, employers should not affirmatively send home only those who are above a certain age, nor should employers appear to discriminate against people who are or appear to be of Chinese national origin. Any guidelines developed by the employer should be uniformly applied.

Employers will also need to decide whether to pay employees for unexpected time off due to COVID-19. In so doing, employers should be mindful of the following:

The likelihood of federal action: On Friday night, the House of Representatives passed a COVID-19 relief package by a vote of 363-40. The bill creates a complicated paid sick leave program with a matching tax credit. All of the paid leave provisions only apply to employers with fewer than 500 employees.First, the bill amends the FMLA to require that covered employers provide paid leave for certain COVID-19-related absences (self-quarantining at the direction of a doctor or public health care official, caring for a similarly-affected family member, or caring for a child whose school or daycare has been closed). The paid sick leave under the FMLA kicks in after the first 14 days of absence, although employees may elect to use other forms of paid leave during those first 14 days, but employers may not require this. Employees entitled to this leave must be paid at two-thirds of their usual pay.[30]Second, in addition to amending the FMLA to add a paid sick leave component, there is a stand-alone Emergency Paid Sick Leave Act, which may be available to employees without the 14-day waiting period. That leave is available for the same reasons as the FMLA leave, as well as other reasons, such as if an employee is experiencing COVID-19 symptoms and needs time to obtain a medical diagnosis or care. Employees entitled to this leave must be paid either at their regular rate if they are directly affected or, in the event that they need to care for a family member, at two-thirds of their regular rate.[31]Third, the bill creates a payroll tax credit for companies that have to pay for these forms of leave.[32]
We expect that the Senate will act promptly on the bill, and there may be further changes to the bill before it is passed. In the meantime, both the CDC and OSHA encourage employers to explore flexible leave policies in response to this pandemic and many larger employers are considering programs similar to those required for smaller employers under the House bill.[33]
Union employees and collective bargaining agreements: For unionized workforces, collective bargaining agreements (CBAs) may address whether the time off must be paid or may create a requirement to bargain over this issue.

FLSA requirements: As the Department of Labor confirmed in a recent COVID-19 Q&A, for non-exempt employees, the FLSA “generally applies to hours actually worked” and “does not require employers who are unable to provide work to non-exempt employees to pay them for hours the employees would otherwise have worked.”[34] But for overtime-exempt employees, who must be paid on a “salary basis,” the employees “must receive their full salary in any week in which they perform any work, subject to certain very limited exceptions.”[35] Employers who direct employees to use their vacation time for a week with a partial shut-down during the pandemic should ensure that employees without enough vacation time still receive the equivalent of their full salary for that week.[36]For longer-term schedule reductions, employers may consider reducing salaries of exempt salaried employees, so long as they comply with the salary basis minimums set forth in the FLSA and its implementing regulations.[37]Employers may also consider across-the-board reductions in hourly or salaried employees’ pay in order to save jobs. This is generally permissible with advance notice if applied in a nondiscriminatory manner and provided it does not reduce pay below minimum wage for hourly workers or below the salary minimum for exempt employees.
Predictive scheduling laws and “show-up” pay: Although federal law does not require paying hourly workers when facilities are closed or shifts are cancelled, predictive scheduling laws may come into play. Predictive scheduling or “fair scheduling” laws generally require that companies in certain industries—often food or retail, but sometimes other industries as well—provide employees with 10 to 14 days’ notice of their schedules. If employers do not do so, they may need to pay a schedule change premium or “predictability pay.”[38] Employers should consult all applicable predictive scheduling laws and determine whether premium pay is owed because of COVID-19 closures or cancellations; exigent circumstances may justify failure to make these payments.If employers send employees home after they have already shown up for the day, they may be required to pay “show up pay” or “reporting pay” under state law, although some of these laws make exceptions for “acts of God.”[39]
State laws and executive orders regarding paid sick leave, paid caregiver or similar leave, disability insurance, and unemployment insurance: Employers should continue to comply with the growing patchwork of state and local laws governing paid leave for illnesses and other absences. In addition to the many state laws that require sick leave, some state laws specifically provide for limited paid leave in the event of school closures.[40] Furthermore, some states, like Colorado, have implemented paid sick leave requirements specifically in response to COVID-19; Colorado’s rules require four days of sick leave but cover only specific industries (leisure and hospitality; food services; child care; education; community living facilities; nursing homes; home health).[41]Federal contractors should also ensure compliance with Executive Order 13706, which imposed paid leave requirements.In certain circumstances, state disability insurance or unemployment insurance may cover employee absences. The Department of Labor has issued guidance permitting state unemployment insurance programs significant flexibility in responding to COVID-19.[42] The pending COVID-19 relief package also makes emergency changes to unemployment insurance funding, and requires the Department of Labor to create a model notice for employers to give employees affected by COVID-19.[43]
Compliance issues with pay advances: Some employers may be considering pay advances for non-exempt employees. It is critical that any pay advance program be implemented in accordance with federal and state requirements. Among other things, the employee’s agreement to recoupment of the funds should be provided in writing before the advance is made. Furthermore, if the funds are recouped from future earnings, employers need to ensure that the deductions do not decrease a workweek’s total pay below the minimum wage.[44]
Risks of making exceptions to standard policy: In addition to ordinary vacation, sick pay or other paid time off policies, some employers may elect to provide extra paid leave, permit no-penalty absences, or allow employees to use PTO or sick-pay outside of regular policies on a temporary basis during the pandemic. As with new or expanded telecommuting policies, it will be helpful to communicate both the exceptional nature of these policies and the fact that the pandemic is the motivating factor behind them. Furthermore, these policies should be implemented fairly and consistently.[45]

Staggering Shifts and Split Shifts: Both OSHA and the CDC have suggested that employers consider staggering employee shifts to reduce the number of people on-site at any given time.[46] Employers may also consider splitting shifts, rotating who will come to the office and who will work remotely. When considering this approach, employers should check for applicable state and local laws that affect the timing of meal and rest periods.[47] If the use of staggered shifts results in longer shifts for some employees, employers should also follow state and local laws regarding payment of overtime.[48] And when staggered shifts result in some employees working late at night, employers should also consider OSHA guidance on minimizing fatigue-related injuries and preventing workplace violence.[49]

What to Do If an Employee Tests Positive or Needs to Care for an Ill Family Member:

Contact local health agency and clean affected areas appropriately: In the event your employee tests positive for COVID-19, you may instruct them to go home or avoid the workplace. You should also contact your local health agency. They will need to know about all positive tests in the area, and they may also be able to advise you on your response. In particular, they may have the most up-to-date guidance about what steps you need to take to clean the worksite.

Inform exposed employees: The CDC has advised employers to inform fellow employees of their possible exposure to COVID-19, without disclosing the identity of the person who tested positive.[50] You may also wish to advise customers, vendors, and visitors of their exposure.

Determine whether the employee qualifies for FMLA leave: The Department of Labor has issued informal guidance regarding COVID-19 and the Family and Medical Leave Act (“FMLA”).[51] The FMLA “would not . . . protect[]” an employee staying home “for the purpose of avoiding exposure.” The FMLA would protect an employee who tests positive (or who is caring for a relative who tests positive) if the individual’s COVID-19 becomes a “serious health condition” as defined by the statute and regulations (e.g., if it causes serious complications for the employee or the relevant family member).[52]

Maintain confidentiality: A number of federal laws, including the FMLA, the ADA, and the Genetic Information Nondiscrimination Act (GINA), impose confidentiality requirements that may be relevant to records regarding COVID-19, employees’ symptoms, and co-morbidities. In general, the EEOC has advised that, “[e]mployers must maintain all information about employee illness as a confidential medical record in compliance with the ADA.”[53] Furthermore, employers should avoid involuntary disclosure of confidential information to employees’ supervisors, although employers may share information about the specific accommodations needed by employees.[54]

Record the incident if needed: In recent guidance, OSHA advised that its recordkeeping requirements may apply to employee cases of COVID-19.[55] Regulations require employers to record “fatalities, injuries, and illnesses” that are “work-related” and meet certain other criteria.[56] If an employee contracts COVID-19 while on the job, it is possible that the illness would be recordable.[57]

Prepare for workers compensation claims: Workers compensation eligibility varies by state. In the event an employee was exposed to COVID-19 in the workplace, it is possible—though far from guaranteed—that workers compensation would apply.[58]

Manage return-to-work certifications carefully: Generally speaking, an employer may require a doctor’s note or similar certification before allowing a previously-affected employee to return to work.[59] Be aware that the CDC, OSHA, and the EEOC have all advised that, during a pandemic, it may be more difficult for employees to obtain doctor’s notes.[60] Specifically, OSHA and the CDC state, “Do not require a healthcare provider’s note for employees who are sick with acute respiratory illness to validate their illness or to return to work, as healthcare provider offices and medical facilities may be extremely busy and not able to provide such documentation in a timely way.”[61] (Emphasis added). However, it seems likely that this advice was drafted primarily to address employees needing to absent themselves from work. The EEOC and Department of Labor both acknowledge the likely need for return-to-work certifications, and although CDC and OSHA urge consideration of “alternative” certifications where possible, it is unclear what non-traditional options will actually be available to employers in the coming weeks. Separately, in the event that a COVID-19-affected employee did qualify for FMLA leave or state paid leave, employers should follow the standard procedures for requiring return-to-work certifications under those laws.[62]

Be mindful of discrimination risks: When an employee is ready to return to work, employers should avoid treating them differently on the basis of their prior infection.

Seek counsel before requiring vaccinations: Currently, no vaccine for COVID-19 is available. However, in the event that a vaccine is developed, employers will need to structure any vaccine policy carefully to account for accommodations on the basis of disability or sincerely held religious beliefs.[63]

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding developments related to the COVID-19 outbreak. For additional information, please contact any member of the firm’s Coronavirus (COVID-19) Response Team.

Gibson Dunn attorneys regularly counsel clients on the compliance issues raised by this pandemic, and we are working with many of our clients on their response to COVID-19. Please also feel free to contact the Gibson Dunn attorney with whom you work in the Labor and Employment Group, or the following authors:

Catherine A. Conway – Co-Chair, Labor & Employment Practice Group, Los Angeles (+1 213-229-7822, [email protected])

Amanda C. Machin – Washington, D.C. (+1 202-887-3705, [email protected])

Michele L. Maryott – Irvine (+1 949-451-3945, [email protected])

Karl G. Nelson – Dallas (+1 214-698-3203, [email protected])

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

____________________________________________________________________

[1] We refer throughout to “COVID-19” instead of coronavirus because many of the cited guidance materials are specific to this pandemic.

[2] CDC, Interim Guidance for Businesses and Employers, https://www.cdc.gov/COVID-19/ 2019-ncov/community/guidance-business-response.html (Last visited March 12, 2020); OSHA, Guidance on Preparing Workplaces for COVID-19, https://www.osha.gov/ Publications/OSHA3990.pdf. OSHA’s guidance was issued jointly with the Department of Health and Human Services. The CDC has also created a one-pager for employers, available at https://www.cdc.gov/coronavirus/2019-ncov/downloads/workplace-school-and-home-guidance.pdf.

[3] Id. at p. 17 (emphasis added). OSHA standards on Personal Protective Equipment and Bloodborne Pathogen Programs may also apply. Id.

[4] The National Conference of State Legislators is tracking COVID-19 legislation, but this may not cover emergency regulations issued by state labor departments. See NCSL, State Action on Coronavirus (COVID-19), https://www.ncsl.org/research/health/state-action-on-coronavirus-covid-19.aspx.

[5] Id. at 8; CDC, Interim Guidance for Businesses and Employers.

[6] Id.; OSHA, Guidance on Preparing Workplaces for COVID-19, 8-9.

[7] CDC, Interim Guidance for Businesses and Employers; OSHA, Guidance on Preparing Workplaces for COVID-19, 8-9.

[8] OSHA, Guidance on Preparing Workplaces for COVID-19, 12.

[9] Id. at 13; OSHA is separately updating industry-specific guidance on its COVID-19 webpage: https://www.osha.gov/SLTC/covid-19/.

[10] CDC, Interim Guidance for Businesses and Employers.

[11] CDC, Travel Health Notices, https://wwwnc.cdc.gov/travel. There are currently “Level 3” notices for South Korea, Iran, China, and parts of Europe. “Level 3” means that the CDC is encouraging Americans to avoid non-essential travel to these areas. See also OSHA, Guidance on Preparing Workplaces for COVID-19, 13 (advising companies to discontinue non-essential travel).

[12] See, e.g., N.Y. Labor Law § 201-d (prohibiting discharge on the basis of lawful “recreational activities”); Reiseck v. Universal Comms. of Miami, No. 06-0777, 2009 WL 812258, at *4 (S.D.N.Y. Mar. 26, 2009) (determining that employer did not violate statute by firing employee who was traveling to Florida weekly because employer fairly determined the work could not be performed from Florida), vacated in part on other grounds by 591 F.3d 101 (2d Cir. 2010).

[13] 740 ILCS 14/1.

[14] See, e.g., New York Supreme Court, Coronavirus – Revised Courthouse Procedures (March 12, 2020), https://www.nycourts.gov/legacypdfs/courts/1jd /supctmanh/PDF/cv19-procedures.pdf; United States District Court for the Eastern District of Michigan, Notice of Courthouse Visitor Restrictions (March 11, 2020), http://www.mied.uscourts.gov/PDFFIles/NtcCourthouseRestrictions.pdf.

[15] As in the context of other laws, the fact that an accommodation was made for one person may be relevant to whether that accommodation is “feasible” under the ADA for another employee. Cf. Equal Employment Opportunity Commission v. TriCore Reference Laboratories, 849 F.3d 929, 941 (10th Cir. 2017) (discussing role of precedent under the Pregnancy Discrimination Act). However, it is not dispositive; interpretive guidance under the ADA acknowledges that a particular accommodation may impose an undue hardship on an employer in one circumstance but not another. 29 C.F.R., Appendix to Part 1630 (Interpretive Guidance on Title I of the Americans with Disabilities Act) (“Whether a particular accommodation will impose an undue hardship for a particular employer is determined on a case by case basis. Consequently, an accommodation that poses an undue hardship for one employer at a particular time may not pose an undue hardship for another employer, or even for the same employer at another time.”).

[16] See Department of Labor, Fact Sheet #21: Recordkeeping Requirements under the Fair Labor Standards Act (FLSA), https://www.dol.gov/agencies/whd/fact-sheets/21-flsa-recordkeeping.

[17] See, e.g., Cal. Labor Code § 226.7.

[18] Department of Labor, COVID-19 or Other Public Health Emergencies and the Fair Labor Standards Act Questions and Answers, https://www.dol.gov/agencies/whd/flsa/pandemic.

[19] See, e.g., Cal. Labor Code § 2802; 820 ILCS 115/9.5 (Illinois); see also 12 NYCCR 142-2.10 (regarding wage deductions).

[20] 20 C.F.R. 639.3(f).

[21] EEOC, Pandemic Preparedness in the Workplace and the Americans with Disabilities Act § III.B.8, https://www.eeoc.gov/facts/pandemic_flu.html (“If the CDC or state or local public health officials recommend that people who visit specified locations remain at home for several days until it is clear they do not have pandemic influenza symptoms, an employer may ask whether employees are returning from these locations, even if the travel was personal.”).

[22] EEOC, Pandemic Preparedness in the Workplace and the Americans with Disabilities Act § III.B.6.

[23] Id.

[24] Id.

[25] Id. at § III.B.7.

[26] Id.

[27] EEOC, Pandemic Preparedness in the Workplace and the Americans with Disabilities Act § III.B.9; id. at § III.A.1 (stating, in the context of pre-pandemic guidance, that “[a]n inquiry asking an employee to disclose a compromised immune system or a chronic health condition is disability-related because the response is likely to disclose the existence of a disability. The ADA does not permit such an inquiry in the absence of objective evidence that pandemic symptoms will cause a direct threat.”).

[28] Id. at § III.B.9; see also id. at n.33 (“When pandemic influenza symptoms only resemble those of seasonal influenza, they do not provide an objective basis for a “reasonable belief” that employees will face a direct threat if they become ill.”).

[29] Id.

[30] H.R. 6201, Division C (March 13, 2020), https://docs.house.gov/ billsthisweek/20200309/ BILLS-116hr6201-SUS.pdf.

[31] Id., Division E.

[32] Id., Division G.

[33] CDC, Interim Guidance for Businesses and Employers (“Ensure that your sick leave policies are flexible and consistent with public health guidance and that employees are aware of these policies” and “[t]alk with companies that provide your business with contract or temporary employees about the importance of sick employees staying home and encourage them to develop non-punitive leave policies”); OSHA, Guidance on Preparing Workplaces for COVID-19, 11 (same).

[34] Department of Labor, COVID-19 or Other Public Health Emergencies and the Fair Labor Standards Act Questions and Answers.

[35] Id.

[36] Id. (citing WHD Opinion Letter FLSA2005-41).

[37] DOL, Fact Sheet #17A: Exemption for Executive, Administrative, Professional, Computer & Outside Sales Employees Under the Fair Labor Standards Act (FLSA), https://www.dol.gov/agencies/whd/fact-sheets/17a-overtime; Department of Labor, Field Operations Handbook § 22g11 (“A prospective reduction in the predetermined salary amount to not less than the applicable minimum salary due to a reduction in the employee’s normal scheduled workweek is permissible and will not defeat the exemption, provided that the reduction in salary is a bona fide reduction that is not designed to circumvent the salary basis requirement (e.g., a 20 percent reduction in an exempt employee’s salary while assigned to work a normally scheduled 4-day reduced workweek due to the financial exigencies of the employer and/or to avoid layoffs would not violate the regulations as long as the reduced predetermined salary amount is at a rate that is not less than the applicable minimum salary of $455.00 per week)”).

[38] See, e.g., San Francisco, Formula Retail Employee Rights Ordinances, https://sfgov.org/olse/formula-retail-employee-rights-ordinances; see also HR Dive, Predictive Scheduling Laws (Dec. 2, 2019), https://www.hrdive.com/news/a-running-list-of-states-and-localities-with-predictive-scheduling-mandates/540835/.

[39] See, e.g., Cal. Code Regs., tit. 8, § 11010(5) (“Reporting Time Pay”) (“Each workday an employee is required to report for work and does report, but is not put to work or is furnished less than half said employee’s usual or scheduled day’s work, the employee shall be paid for half the usual or scheduled day’s work, but in no event for less than two (2) hours nor more than four (4) hours, at the employee’s regular rate of pay, which shall not be less than the minimum wage”); 7 D.C. Admin. Code § 907.1 (“The employer shall pay the employee for at least four (4) hours for each day on which the employee reports for work under general or specific instructions but is given no work or is given less than four hours of work, except that if the employee is regularly scheduled for less than four hours a day, such employee shall be paid for the hours regularly scheduled. The minimum daily wage shall be calculated as follows: payment at the employee’s regular rate for the hours worked, plus payment at the minimum wage for the hours not worked, as described above.”); 454 MA Admin. Code 27.04(1) (“When an employee who is scheduled to work three or more hours reports for duty at the time set by the employer, and that employee is not provided with the expected hours of work, the employee shall be paid for at least three hours on such day at no less than the basic minimum wage. 454 CMR 27.04 shall not apply to organizations granted status as charitable organizations under the Internal Revenue Code.”); NJ Admin. Code 12:56-5.5 (“(a) An employee who by request of the employer reports for duty on any day shall be paid for at least one hour at the applicable wage rate, except as provided in (b) below; (b) The provisions of (a) above shall not apply to an employer when he or she has made available to the employee the minimum number of hours of work agreed upon by the employer and the employed prior to the commencement of work on the day involved”); 12 CRR-NY 142-2.3 (“An employee who by request or permission of the employer reports for work on any day shall be paid for at least four hours, or the number of hours in the regularly scheduled shift, whichever is less, at the basic minimum hourly wage.”).

[40] See New Jersey Earned Sick Leave Act Notice, https://www.nj.gov/labor/forms_ pdfs/mw565sickleaveposter.pdf.

[41] Colorado Department of Labor and Employment, Colorado Health Emergency Leave with Pay, 7 CCR 1103-10 (March 11, 2020), https://www.colorado.gov/pacific/cdle/ colorado-health-emergency-leave-pay-%E2%80%9Ccolorado-help%E2%80%9D-rules.

[42] Department of Labor, U.S. Department of Labor Announces New Guidance on Unemployment Insurance Flexibilities During COVID-19 Outbreak (March 12, 2020), https://www.dol.gov/newsroom/releases/eta/eta20200312-0.

[43] H.R. 6201, Division D.

[44] DOL Opinion Letter, FLSA2005-3 (discussing prepayment plan for overtime wages), https://www.dol.gov/sites/dolgov/files/WHD/legacy/files/2005_01_07_3_ FLSA_PrepaymentPlan.pdf; Cal. DLSE, Opinion Letter (Nov. 25, 2008), https://www.dir.ca.gov/dlse/opinions/2008-11-25-1.pdf.

[45] Department of Labor, COVID-19 or Other Public Health Emergencies and the Family and Medical Leave Act Questions and Answers.

[46] OSHA, Guidance on Preparing Workplaces for COVID-19, 13; CDC, Interim Guidance for Businesses and Employers.

[47] See, e.g., Cal. Labor Code § 512.

[48] See Department of Labor, State Minimum Wage Laws, https://www.dol.gov/agencies/whd/minimum-wage/state (identifying, by state, the number of hours after which premium pay is required). Note that under federal law, extra pay for night or weekend work is not automatically required. See DOL, E-Laws Adviser, https://webapps.dol.gov/ elaws/faq/esa/flsa/ 005.htm?_ga=2.39763365.725891313.1583959806-662641776.1578432998.

[49] See OSHA, Long Work Hours, Extended or Irregular Shifts, and Worker Fatigue, https://www.osha.gov/SLTC/workerfatigue/index.html; OSHA, Workplace Violence, https://www.osha.gov/SLTC/workplaceviolence/.

[50] CDC, Interim Guidance for Businesses and Employers.

[51] Department of Labor, COVID-19 or Other Public Health Emergencies and the Family and Medical Leave Act Questions and Answers, https://www.dol.gov/agencies/whd/fmla/pandemic.

[52] Id.

[53] EEOC Guidance, Pandemic Preparedness in the Workplace and the Americans with Disabilities Act § III.B.6.

[54] See 29 C.F.R. § 1630.14(c)(1)(i).

[55] OSHA, Guidance on Preparing Workplaces for COVID-19, 18; see OSHA, COVID-19, https://www.osha.gov/SLTC/covid-19/standards.html.

[56] 29 C.F.R. § 1904.4(a); id. at § 1904.7.

[57] 29 C.F.R. § 1904.5 sets forth the standards for determining work-relatedness of fatalities, injuries, and illnesses.

[58] See, e.g., Washington State Department of Labor and Industries, Workers’ Compensation Coverage and Coronavirus (COVID-19) Common Questions, https://lni.wa.gov/agency/outreach/workers-compensation-coverage-and-coronavirus-covid-19-common-questions; California Labor & Workforce Development Agency, Coronavirus 2019 (COVID-19) Resources for Employers and Workers, https://www.labor.ca.gov/coronavirus2019/#chart.

[59] EEOC Guidance, Pandemic Preparedness in the Workplace and the Americans with Disabilities Act § III.C.16 (“such inquiries are permitted under the ADA either because they would not be disability-related or, if the pandemic influenza were truly severe, they would be justified under the ADA standards for disability-related inquiries of employees”).

[60] EEOC, Pandemic Preparedness in the Workplace and the Americans with Disabilities Act § III.B.13; Department of Labor, COVID-19 or Other Public Health Emergencies and the Family and Medical Leave Act Questions and Answers; OSHA, Guidance on Preparing Workplaces for COVID-19, 11; CDC, Interim Guidance for Businesses and Employers.

[61] Id.

[62] Department of Labor, COVID-19 or Other Public Health Emergencies and the Family and Medical Leave Act Questions and Answers.

[63] EEOC, Pandemic Preparedness in the Workplace and the Americans with Disabilities Act § III.B.13. This guidance also states that, “Generally, ADA-covered employers should consider simply encouraging employees to get the influenza vaccine rather than requiring them to take it.”

Gibson Dunn attorneys regularly counsel clients on the compliance issues raised by this pandemic, and we are working with many of our clients on their response to COVID-19. Please feel free to contact any of the Gibson Dunn lawyers listed above.

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

Shareholder lawsuits are not only complicated to litigate, but due to the high financial stakes, these actions can be among the most threatening to a company and its directors and officers. It has been twenty-five years since Congress enacted the Private Securities Litigation Reform Act of 1995, and since that time, private actions under the federal securities laws have continued to be filed at a steady pace. Over the last decade, the U.S. Supreme Court and the State Supreme Courts have issued multiple decisions impacting the way shareholder actions are litigated and decided. This one-hour briefing highlights recent developments and trends in this constantly evolving and complex area of the law.

Faculty discuss:

Shareholder actions filing and settlement trends
Discussion of scheme liability claims following the U.S. Supreme Court’s ruling in Lorenzo v. SEC (2019)
Update on trends in 1933 Act litigation in state courts in the wake of the Supreme Court’s ruling in Cyan v. Beaver County Employees Retirement Fund (2018), including various state courts’ rulings on such threshold questions as:
- application of the PSLRA’s automatic stay of discovery pending resolution of a motion to dismiss
- motions to stay state court actions in favor of parallel federal proceedings concerning the same issuer
- the pleading standards applicable to 1933 Act claims in state courts

View Slides (PDF)

PANELISTS:

Jennifer L. Conn is a partner in the New York office of Gibson, Dunn & Crutcher. Ms. Conn is a co-editor of PLI’s Securities Litigation: A Practitioner’s Guide, Second Edition. She has extensive experience in a wide range of complex commercial litigation matters, including those involving securities, financial services, accounting malpractice, antitrust, contracts, insurance and information technology. She is also a member of Gibson Dunn’s General Commercial Litigation, Securities Litigation, Appellate, and Privacy, Cybersecurity and Consumer Protection Practice Groups.

Alexander K. Mircheff is a partner in the Los Angeles office of Gibson, Dunn & Crutcher. Mr. Mircheff is a co-author of PLI’s Securities Litigation: A Practitioner’s Guide, Second Edition. His practice emphasizes securities and appellate litigation, and he has substantial experience representing issuers, officers, directors, and underwriters in class action and shareholder derivative matters. Mr. Mircheff has handled matters across a variety of industries, including biotech, financial services, accounting, real estate, entertainment, engineering, manufacturing, and consumer products. He is also a member of Gibson Dunn’s Securities Litigation, Appellate, Class Actions, Labor and Employment and Litigation Practice Groups.

Robert F. Serio is a partner in the New York office of Gibson, Dunn & Crutcher and a Co-Chair of Gibson Dunn’s Securities Litigation Practice Group. Mr. Serio is also a co-editor of PLI’s Securities Litigation: A Practitioner’s Guide, Second Edition. His practice involves complex commercial and business litigation, with an emphasis on securities class actions, shareholder derivative litigation, SEC enforcement matters and corporate investigations. He is also a member of the Appellate, Class Actions, FCPA, and White Collar Defense and Investigations Practice Groups.

San Francisco partner Ethan Dettmer, Washington, D.C. partner Joshua Lipshutz and San Francisco associate Eli Lazarus are the authors of “High court ruling will allow egregious misconduct to go unchecked,” [PDF] published by the Daily Journal on March 10, 2020.

As companies around the world respond to COVID-19, questions arise about whether coordinated or even unilateral efforts to deal with the virus could prompt antitrust scrutiny. Antitrust laws generally prohibit agreements that unreasonably restrain trade. Certain particularly harmful agreements, such as agreements among competitors to fix prices, rig bids, or allocate markets, are unlawful per se. Others are evaluated based on their effects on competition. Antitrust laws also prohibit the abuse of monopoly power or near-monopoly power.

There is no general exemption from competition laws for public health emergencies. Just this week, the U.S. Department of Justice announced its intent to “hold accountable anyone who violates the antitrust laws of the United States in connection with the manufacturing, distribution, or sale of public health products.”[1]

At the same time, certain collaborations among competitors can be lawful, provided they are justified by legitimate business concerns, and companies retain wide latitude to take unilateral steps to protect their business, workers, and the public.

Below we address some of the most common questions regarding COVID-19 responses and the antitrust laws in the United States, Europe, and China, but seeking advice about any specific business practice in advance is the best way to minimize risk. Attorneys in Gibson Dunn’s Antitrust and Competition Practice Group are available to help companies design COVID-19 responses that comply with the antitrust laws.

Information Sharing and Standard Setting

The U.S. antitrust agencies have recognized that there are legitimate, pro-competitive reasons why competitors may want to share information, particularly in response to a crisis.[2] For example, it may be useful for companies to benchmark their response to COVID-19 against their competitors in order to improve their own response to the virus and to minimize disruptions in supply chains or labor markets.

Information exchanges among competitors should always be designed and reviewed by antitrust counsel, but certain general rules apply. Companies should identify legitimate goals for the information exchange that are pro-competitive or competitively neutral and ensure that all communications with competitors are limited to what is reasonably necessary to achieve those goals. Conversations among competitors should follow an agenda prepared in advance and reviewed by counsel. And care should be taken to avoid discussing competitively-sensitive information like current or future prices, costs, or output.

While companies may, with proper guidance and oversight, exchange appropriate information about best practices with respect to COVID-19, adherence to those best practices should be entirely voluntary for each company to adopt at its own discretion. For example, competitors may discuss best practices for remote working, extended leave, and travel restrictions. But mandatory standards should not be adopted nor agreements otherwise reached.

Likewise, the European Commission has recognized that benchmarking against the best practices in an industry can improve efficiency. Information sharing and benchmarking are generally assessed on a case-by-case basis, taking into account any pro-competitive justifications. For example, information sharing that allows suppliers to better forecast areas of oversupply and undersupply may be acceptable, provided it “does not go beyond what is necessary to correct the market failure.”[3] In any event, the sharing of particularly sensitive or strategic information – such as future pricing – may be deemed unlawful by object under Article 101 of the Treaty on the Functioning of the European Union (“TFEU”). Before discussing any aspect of pricing or output in such forums, advice should be obtained from European qualified outside counsel.

In China, the exchange of competitively sensitive information can constitute a violation of the Anti-Monopoly Law if it has anti-competitive effects. But the Anti-Monopoly Law also exempts certain agreements with “beneficial purposes,” many of which are not recognized as efficiencies in other jurisdictions. For instance, Article 15(4) exempts anti-competitive agreements entered into for the purpose of “maintaining the public welfare,” such as environmental protection, energy conservation, and disaster relief. Article 15(5) provides a possible exemption for anti-competitive agreements undertaken to “mitigate the severe decrease of sales volume or overstock during economic recessions” (often referred to as “crisis cartels”). Like Article 101(3) of the TFEU, however, the Anti-Monopoly Law requires companies to self-assess and if investigated, demonstrate that the agreement or coordination does not seriously restrict competition and that consumers share the resulting benefits.

Absent guidance from the State Administration for Market Regulation (“SAMR”) on these exemptions, it is unclear how they will be applied to coordinated responses to COVID-19. Thus, it is prudent to follow the best practices explained above – namely, to identify legitimate, pro-competitive goals and to limit the coordination to what is reasonably necessary to achieve those goals.

If collaborating or sharing information with a competitor will enable a more effective response to COVID-19, Gibson Dunn attorneys are available to help design a collaboration consistent with the antitrust laws.

Unilateral Refusals to Deal

Companies have wide latitude to decide for themselves with whom to deal. And ordinarily, even firms with market power can unilaterally refuse to deal with certain suppliers, customers, or competitors for a valid business reason.

Thus, a company can generally refuse to deal with firms that fail to adopt adequate measures to protect workers and customers, or promote misinformation that may exacerbate the public health risks. Such steps should only be taken unilaterally and not in coordination with other companies. And again, antitrust guidance in advance of terminating a business relationship can help to minimize risk.

Price Gouging

Companies are generally free to price their goods and services as they see fit, as long as those decisions are made unilaterally. However, antitrust regulators around the world have recently issued warnings against price gouging and other unfair trade practices in response to COVID-19.

In the U.S., there is no federal law prohibiting price gouging.[4] Thus, during the recent COVID-19 outbreak, the Federal Trade Commission has focused on deceptive advertising and consumer fraud.

In contrast, states such as New York and California have laws that restrict price gouging. On March 4, 2020, for example, California declared a state of emergency, which triggers a prohibition against price gouging of food, emergency supplies, medical supplies, gasoline, emergency cleanup services, hotel accommodations, and transportation.[6] Other State Attorneys General have announced similar investigations.

In China, the SAMR has wide powers under the Price Law to supervise and inspect the prices of goods and services and to investigate unfair pricing behaviors, including using misleading or false pricing practices, covertly manipulating prices by raising or reducing grade levels of goods and services, and illegally seeking exorbitant profits (even absent any market power).

In the wake of the COVID-19 outbreak, the SAMR implemented strict pricing supervision at national and local levels. The SAMR’s Price Supervision, Inspection and Anti-Monopoly Bureau reported that a number of mask manufacturers complained about the increase in their production costs, which led some manufacturers to suspend production.[7] In order to tackle this issue, the SAMR extended its price supervision to cover not just masks, but the entire supply chain, including manufacturing equipment and raw materials.[8] Several e-commerce platforms are now voluntarily monitoring the prices of masks and protective gear on their platforms to ensure that they comply with China’s pricing regulations.

As of February 24, 2020, the SAMR has investigated around 4,500 entities for the price gouging of masks and commenced investigations into around 11,000 companies for pricing violations concerning medical protective gear and other essential products.[9] In addition, local authorities in Beijing, Tianjin, Jiangxi, Shanghai and Hubei similarly imposed heavy penalties on those who drove up the prices of such products, including fines of RMB 2 to 3 million (approx. $286,000 to $430,000).[10]

In Europe, a number of national regulators have taken action against price gouging. The UK’s Competition and Markets Authority announced that it would take action against violations of consumer protection and competition laws, such as excessive pricing and misleading advertising.[11] Italy’s competition authority is seeking information on how online platforms are preventing unjustified price spikes and false claims regarding the efficacy of products.[12] And the Polish competition authority has opened investigations into wholesalers who allegedly terminated contracts with hospitals to sell protective equipment on the market for disproportionately high prices.[13]

In light of these warnings against price gouging and unfair trade practices, companies should ensure that their pricing activity is not only independent from its competitors, but also reasonable and justified. Claims about the efficacy of products, such as protective gear, should be verified and substantiated by credible evidence.

Industry Bailouts

Some countries have already announced the intention to adopt aid measures that will help commercial sectors that are particularly vulnerable to the financial consequences of COVID-19. In Europe, companies that are to receive such aid need to ensure that the measures comply with the EU State Aid rules and have been cleared by the European Commission. Conversely, competitors of recipients of aid may see opportunities to intervene to secure a fair market outcome.

_____________________

[1] Press Release, Department of Justice, “Justice Department Cautions Business Community Against Violating Antitrust Laws in the Manufacturing, Distribution, and Sale of Public Health Products” (March 9, 2020), available at: (https://www.justice.gov/opa/pr/justice-department-cautions-business-community-against-violating-antitrust-laws-manufacturing).

[2] In 2014, the agencies recognized a legitimate need for competitors to share information about cybersecurity threats to improve the safety of our nation’s networks. Thus, they concluded that a properly designed sharing of cybersecurity threat information was not likely to raise antitrust concerns. For more information, see DoJ and FTC: Antitrust Policy Statement on Sharing of Cybersecurity Information (April 10, 2014), available at: https://www.justice.gov/sites/default/files/atr/legacy/2014/04/10/305027.pdf.

[3] European Commission, Guidelines on the applicability of Article 101 of the TFEU to horizontal co-operation agreements, para 110.

[4] During Hurricane Katrina, the Chair of the Federal Trade Commission explained to Congress that a seller with lawfully acquired market power can charge any price that the market will bear. For more information, see FTC, Prepared Statement of the Federal Trade Commission – FTC Initiatives to Protect Consumers and Competitive Markets in the Wake of Hurricane Katrina (September 22, 2005), available at: https://www.ftc.gov/sites/default/files/documents/public_statements/prepared-statement-federal-trade-commission-subcommittee-commerce-trade-and-consumer-protection/050922katrinatest.pdf

[6] State of California, Proclamation of a State of Emergency (March 4, 2020), available at: https://www.gov.ca.gov/wp-content/uploads/2020/03/3.4.20-Coronavirus-SOE-Proclamation.pdf

[7] Central People’s Government, “Press conference held by the Joint Prevent and Control Mechanism of the State Council introduces measures for maintaining market order in accordance with the law: A focus on the efficient investigation and punishment of behavior involving fake masks and price gouging on masks” (February 9, 2020), available at http://www.gov.cn/xinwen/2020-02/09/content_5476343.htm.

[8] Central People’s Government, “SAMR’s Urgent Notice Concerning the SAMR’s Crackdown on Pricing Violations in the Production of Masks and Other Products Relating to Epidemic Prevention and Control During the Period of Epidemic Prevention and Control” (February 5, 2020), available at http://www.gov.cn/zhengce/zhengceku/2020-02/06/content_5475223.htm.

[9] SAMR: More than 4,500 companies have been investigated for driving up mask prices” (February 25, 2020), available at http://www.xinhuanet.com/fortune/2020-02/25/c_1125623897.htm

[10] See footnote 7, above.

[11] CMA, “CMA statement on sales and pricing practices during Coronavirus outbreak” (March 5, 2020), available at: https://www.gov.uk/government/news/cma-statement-on-sales-and-pricing-practices-during-coronavirus-outbreak

[12] ACGM, “ICA: Coronavirus, the Authority intervenes in the sale of sanitizing products and masks” (February 27, 2020), available at: https://en.agcm.it/en/media/press-releases/2020/3/ICA-Coronavirus-the-Authority-intervenes-in-the-sale-of-sanitizing-products-and-masks

[13] UOKiK, “UOKiK’s proceedings on wholesalers’ unfair conduct towards hospitals” (March 4, 2020), available at: https://www.uokik.gov.pl/news.php?news_id=16277

The following Gibson Dunn lawyers prepared this client update: Kristen Limarzi, Daniel Swanson, Rachel Brass, Christian Riis-Madsen and Emily Seo. Please also feel free to contact the authors or any of the following leaders and members of the Antitrust and Competition Practice Group:

Washington, D.C.
D. Jarrett Arp (+1 202-955-8678, [email protected])
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])

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])

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])

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])

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])

Thank you for your interest in Gibson Dunn’s Securities Regulation and Corporate Governance Practice. Below is a recent posting to our Securities Regulation and Corporate Governance Monitor blog:

Coronavirus Disease 2019 Update: Impact under Nasdaq Rules of SEC Relief to Affected Companies (click on link)
___________________

VIEW BLOG

Please also feel free to contact any of the editors and members of the Securities Regulation and Corporate Governance Monitor.

Brussels partner Peter Alexiadis is the author of “Cartels in the utility sectors: An overview of EU and national case law,” [PDF] published in Concurrences on January 23, 2020.

Frankfurt partner Finn Zeidler is the author of “Aus der Praxis: Privilegierte Klageänderung in der Berufungsinstanz” [PDF] published by zpoblog.de on March 10, 2020.

Please join our panel as they discuss current developments in capital markets in the oil and gas industry. Specifically, the panelists will provide insights, updates and practical guidance regarding market conditions, preferred equity, high-yield bonds, and SPACs. They also explore developing approaches to raising capital in the industry such as rights offerings and direct listings.

View Slides (PDF)

PANELISTS:

Michael Casey is a Partner and Managing Director in the Houston office of Goldman Sachs & Co. He has over 20 years of energy investment banking experience and has advised on a variety of capital raising and strategic transactions. Michael has broad capital raising and financing experience across equity and debt markets, both public and private, as well as joint ventures and private equity investments. In addition to his financing transaction experience, Michael has significant experience in M&A, having advised on numerous public company mergers, as well as advising both sellers and buyers on private company and asset transactions.

Hillary H. Holmes is a partner in the Houston office of Gibson, Dunn & Crutcher and Co-Chair of the firm’s Capital Markets practice group. Ms. Holmes advises companies in all sectors of the energy industry on long-term and strategic capital planning, disclosure and reporting obligations under U.S. federal securities laws, corporate governance and M&A transactions. She represents issuers, underwriters, MLPs, financial advisors, private investors, management teams and private equity firms in all forms of capital markets transactions. Her experience comprises IPOs, registered offerings of debt and equity securities, private placements of debt and equity securities, structured preferred equity, joint ventures and private equity investments. She frequently advises boards of directors, special committees, and financial advisors in M&A transactions involving conflicts of interest or unique complexities.

Doug Rayburn is a partner in the Dallas and Houston offices of Gibson, Dunn & Crutcher. His principal areas of concentration are securities offerings, mergers and acquisitions and general corporate matters. He has represented issuers and underwriters in over 200 public offerings and private placements, including initial public offerings, high yield offerings, investment grade and convertible note offerings, offerings by MLPs, and offerings of preferred and hybrid securities. Additionally, Mr. Rayburn represents purchasers and sellers in connection with mergers and acquisitions involving both public and private companies, including private equity investments and joint ventures. His practice also encompasses corporate governance and other general corporate concerns.

Gerry Spedale is a partner in the Houston office of Gibson, Dunn & Crutcher. He has a broad corporate practice, advising on mergers and acquisitions, joint ventures, capital markets transactions and corporate governance. He has extensive experience advising public companies, private companies, investment banks and private equity groups actively engaging or investing in the energy industry. His over 20 years of experience covers a broad range of the energy industry, including upstream, midstream, downstream, oilfield services and utilities.

With confirmed cases of COVID-19 now in more than 50 countries and the death toll rising almost daily, experts are predicting that the situation will get significantly worse before it gets better. Concerns over the impact of the virus have caused significant volatility in the stock markets over the last week and the potential scale of the impact across a very wide range of industries is just beginning to be realized. Therefore for private equity sponsors now is the time to be checking their financing documents to fully understand how COVID-19 might have an impact on the operations and financial results of their portfolio companies and their ability to remain in compliance.

Key areas of focus for private equity sponsors include the following:

Financial Covenants/Equity Cure/Covenant Reset

In most markets in the Asia-Pacific region, leveraged facilities typically still have two or three maintenance financial covenants. Given the myriad of ways that a public health emergency like COVID-19 can affect businesses, and the scale of the impact, it seems inevitable that the virus will cause some companies to breach these financial covenants. The threshold questions then become which covenants will be breached, when will they be breached and what steps can sponsors take to address the problem.

It should be noted that Australia is an exception to the foregoing, with a significant number of unitranche financings that only contain a single leverage covenant and increasingly Term Loan B structures. Moreover, in the US and Europe Term Loan B structures with only a single springing leverage covenant for the benefit of the revolving lenders are commonplace. Sponsors should be aware, however, that even in Term Loan B structures, a precipitous fall in EBITDA could mean that some companies become more reliant on their revolving facilities, thereby pushing them above the springing test threshold.

Business Interruption Insurance
In determining whether a covenant breach is likely, it is worth first carefully considering whether there is business interruption insurance in place that will cover the losses incurred by a portfolio company. While proceeds of business interruption insurance can typically be added to EBITDA for purposes of calculating compliance with the maintenance covenants, whether a particular policy covers business interruption resulting from COVID-19 will be very much fact-specific and turn on its exact language. Many property insurance policies cover business interruption, but coverage for such loss often requires “direct physical loss or damage” which in many cases will not apply. Also, to the extent that business interruption insurance coverage is available, the EBITDA definition needs to be carefully reviewed to see whether amounts claimed can be included (more typical) or whether the insurance proceeds have to be actually received by the group in order to be included in EBITDA (which could create a timing issue).

Scrubbing the Definitions – Restructuring Initiatives/Other Add-backs
Upon initially concluding that a covenant breach is projected, the sponsor, the CFO of the portfolio company and their counsel should “scrub” the definitions to ensure that all available add-backs, synergies and initiatives, and the pro forma effect of each of them, have been properly included in the calculations. Thought should also be given to commencing certain planned initiatives and actions ahead of schedule to take advantage of the pro forma effect.

Prepayments to Avoid the Breach
In some circumstances, it may be possible to fix a potential covenant breach with a prepayment. For example, a well-timed voluntary prepayment of an amortizing facility made from cash on hand now, could, in addition to reducing leverage, potentially avoid a breach of the debt service cover ratio in the subsequent three quarters (often with a dollar-for-dollar reduction in debt service). Similarly, where sponsors have flexibility to apply mandatory prepayments first against amortizing debt, we have in the past seen sponsors use proceeds from disposals which have not yet been reinvested (or to specifically dispose of assets) in order to reduce both leverage and debt service.

Additional Preemptive Equity
Typically sponsors always have the ability to inject additional capital into a portfolio company’s business (by way of equity or subordinated debt), which would reduce net debt regardless of whether a prepayment is made. Nonetheless, this is not the typical approach for sponsors facing a prospective financial covenant breach unless the amount injected can be subsequently designated as a “cure amount” and there is additional benefit to injecting it earlier (for example, to fix a clean-down issue (as discussed below) or to avoid a mandatory prepayment if that is required under the equity cure).

Sponsors are then broadly faced with either (i) using the equity cure; (ii) asking for a waiver or (iii) negotiating a covenant reset/broader amendment or refinancing.

Equity Cure
Typically sponsors can “cure” financial covenant breaches within 15-20 business days of the date on which a compliance certificate is required to be delivered by the portfolio company to its lenders. Careful consideration needs to be given to the parameters of the equity cure provisions (which typically, but not always, apply to all of the covenants).

For example, can the cure be used preemptively and subsequently be designated as a cure amount? Some sponsors will opt to provide the equity cure at the same time they deliver the compliance certificate so that they are effectively never in breach. However, others will use the additional 15-20 business day grace period so that they are not making a call on their investors sooner than is necessary. For those who wait, the next question is whether a default continues during that cure period. If so, for most sponsors the issue that arises is whether or not their portfolio company needs to draw on any of the facilities during this time, as a continuing default would typically be a drawstop (except for rollover advances). Therefore careful planning around this approach is required.

Other key questions to analyze in the context of an equity cure are:

How is the cure actually implemented? Under many facilities in the Asia-Pacific region, sponsors are able to add cure amounts to EBITDA which obviously brings with it a multiplier effect, as opposed to being required to use such amount to make an actual prepayment to reduce debt (which is typically the case in Australia, outside of Term Loan Bs, for example). Similarly, where adding the cure amount to EBITDA is not permitted, under some facility agreements such cash is allowed to be retained by the portfolio company (thereby reducing net debt to the extent it remains in the company, rather than being required to be prepaid). Also, where a prepayment of the cure amount is required, the facility agreement may not obligate the company to use 100% of the cure amount for this purpose.
What are the limits on the cure? For example, how many cures are permitted over the life of the facilities (typically 4-5)? Are over-cures permitted (often they are)? Are cures permitted in successive quarters? Where the cure amount is applied to EBITDA, does this carry over for the next three financial quarters (almost always it does)?
Is there a mulligan? The true “mulligan” – taken from the golfing world – provides that an initial breach of the financial covenants is not a default unless the same test is breached on the subsequent test date. In the Asia-Pacific region, true mulligans are fairly rare. It is common, however, to see a deemed cure which provides that where there is an initial breach, it is deemed to have been remedied if the portfolio company is in compliance on the subsequent test date and the lenders have not accelerated the loans. In this scenario, where there is a projected single-quarter blip in performance, some sponsors might look to the lender syndicate to see if they have relationship lenders with blocking stakes (typically 33.34% or more in the Asia-Pacific region) who agree to prevent an acceleration event from occurring, but more often sponsors in this situation will seek a waiver or a covenant reset.

Covenant Waiver
For sponsors with a projected one-off financial covenant breach, they may seek a simple waiver of that breach. In the Asia-Pacific region, the waiver will typically require 66 2/3% of the lenders to consent to the waiver and a waiver fee would typically be paid.

Covenant Reset
Where a sponsor is projecting more than a one-off problem with the financial covenants, it is more typical that it would seek to reset the covenants to re-establish sufficient headroom. This approach is obviously a more protracted process than a one-time waiver as the lenders will need to get comfortable with an updated plan and financial model, and often involves a broader negotiation as some lenders may request changes to provisions such as amortization, excess cashflow sweep and pricing. They will also expect an amendment fee. Like a waiver, typically in the Asia-Pacific region 66 2/3% of the lenders would be required to reset the covenants. The sponsors may or may not negotiate the covenant reset in conjunction with an agreement to inject more equity into the portfolio company. Of course, they are more likely to agree to inject additional equity as part of the covenant reset if there is an underlying, fundamental issue with the company’s performance rather than it simply being adversely affected by what are hopefully near-term situations such as COVID-19. In the latter case, sponsors may also proactively consider a broader “amend and extend” or refinancing of the facilities to fix the covenant issues and address any other issues such as impending maturities or a need for more flexibility in certain areas.

Clean-Down

Depending on the nature of the portfolio company’s business, some facilities will have “clean-down” requirements on their revolving facilities (seen in a minority of sponsor deals). These provisions require cash drawings under the revolving and ancillary facilities to be reduced to an agreed amount (sometimes zero), either physically or net of cash and cash equivalents for a short period of time (typically 1-5 consecutive business days) in a year with a short period of time (say, 1 month) between clean-downs. Clean-downs are designed to demonstrate that the revolving facilities are not being used for permanent debt. Where there is an ability to utilize the revolving facility for permanent debt such as acquisitions, joint ventures or capital expenditures, the drawings of such amounts would necessarily need to be excluded from any clean-down.

COVID-19 is likely to mean that some companies are more reliant on their revolving facilities than usual and may struggle to meet their clean-down obligations. In this type of circumstance, in addition to waivers of the requirement, we have seen sponsors in the past preemptively inject equity into the company to fix the clean-down issue. In turn, the sponsors can subsequently designate the same proceeds as cure amounts to equity cure a covenant breach some quarters later.

Representations and Warranties

The representations and warranties in a facility agreement serve two primary purposes: (i) to flush out information regarding the portfolio company where the consequence of a breach is an Event of Default; and (ii) to serve as a drawstop on new utilizations of the facilities.

A number of typical representations and warranties should be given consideration in the context of COVID-19 (there may also be other deal-specific representations which need to be reviewed). First, the second limb of the “No Default” representation, which is a look-forward to defaults or termination events under other agreements (not the finance documents) and is typically subject to a “Material Adverse Effect” qualification. This representation could be relevant where a company’s performance under a “material contract” is adversely affected by COVID-19 or a counterparty breaches such a contract. In addition, where a company has contracts which would reach this threshold of materiality, there is often an additional “Material Contracts” representation which should be reviewed.

Second, sponsors must check whether their facility agreement contains a particularly troublesome material adverse change representation which is included in the LMA’s leveraged standard form. It provides that “Since the date of the most recent financial statements delivered pursuant to Clause 25.1 (Financial statements) there has been no material adverse change in the assets, business or financial condition of the Parent or the [Restricted] Group [or the Group].” This provision is a tripwire and should never be accepted by sponsors, although it is in a number of facility agreements in the market. This frequently misunderstood representation does not relate to the performance of the business since the closing of the loan facility, but rather since the date of the most recent financial statements and, equally importantly, is not the negotiated, defined “Material Adverse Effect” standard but is tied to the looser term “material adverse change.” The tripwire here is that the portfolio company could be performing well above both its business plan and financial model but has a temporary but material dip in performance which can result in a performance breach despite the fact that it is in compliance with its covenants.

Third, the “No Proceedings” representations which relate to litigation and judgments should be reviewed. Invariably, some companies will be subject to litigation resulting from their failure to perform under their contracts, and it is likely that many parties will assert that COVID-19 is a force majeure event such that noncompliance with their contractual obligations was beyond their control and not actionable as a breach of contract. All of this could result in many businesses becoming tangled in complex and protracted litigation even when they intended to fulfill their obligations.

Finally, it is recommended to look at the “Insolvency” representation. This representation is linked to the insolvency-related events of default and discussed below.

Reporting Obligations

Reporting obligations to lenders vary from facility to facility but, in addition to financial information, typically include matters relating to litigation, judgements and, where relevant, material contracts as well as the catch all of whatever else is requested by a finance party. Sponsors are well-advised to discuss early and often with the management of their portfolio companies as to what, how and when information will be disclosed to lenders, particularly in light of the highly evolving nature of COVID-19 and its potential effect on businesses.

Events of Default

Insolvency/Insolvency Proceedings/Creditors Process
These events of default speak for themselves and are unlikely to be the first breach of the facilities for a portfolio company that is seriously adversely affected by COVID-19. Nonetheless, they warrant consideration and attention because, among other things, the threshold for insolvency varies from jurisdiction to jurisdiction as do the duties of the directors.

Audit Qualification
Most traditional leveraged facilities in the Asia-Pacific region contain an event of default if the auditors qualify their report either on a going concern basis or a failure to disclose information. In the aftermath of the last financial crisis, there was much debate around whether a projected breach of a financial covenant which is noted in the auditors’ report amounts to a qualification – thus causing an event of default ahead of any actual breach of covenant. In most cases, the conclusion was that for a simple projected financial covenant default, the auditors do not “qualify” their report but include an “emphasis of matter”. The emphasis of matter is a paragraph which highlights a matter that in the auditor’s opinion is of fundamental importance to a reader’s understanding of the financial report but which falls short of the technical standard of an auditor qualification. However, although this has been the general conclusion in the case of projected breaches, it should be confirmed on a case-by-case basis with the relevant professionals in the local jurisdiction.

Litigation & Material Judgments
As discussed above, the impact of COVID-19 will inevitably be the cause of some contractual breaches which will result in litigation and judgments and need to be considered here.

Material Adverse Effect
Most traditional leveraged facilities in the Asia-Pacific region have a catch all Material Adverse Effect event of default. Sponsors in a reasonably strong negotiating position will negotiate the definition of “Material Adverse Effect” aggressively so that it is very limited and does not include the LMA formulation, which includes a look-forward on the ability to comply with financial covenants and/other obligations. Also, this event of default is typically negotiated to be an objective test – rather than the subjective “which the Majority Lenders reasonably believe….” construct of the LMA. Unfortunately, there are examples in the Asia-Pacific region that follow the LMA formulation. On the other hand, if this definition and event of default are correctly negotiated, while it may be scrutinized, in the absence of any other “black and white” events of default having occurred (such as a financial covenant breach), most lenders would be unlikely to rely solely on a Material Adverse Effect event of default in order to take any acceleration actions.

How We Can Help

Reviewing facility agreements and conducting an in-depth analysis of the current and future impact of COVID-19 on portfolio companies is necessarily a complex task, and there is no one-size-fits-all answer. Each case will need to be examined based on the particular facts and the specific drafting of the finance documents. Our global finance team is available to answer your questions and assist in evaluating your finance documents to identify any potential issues and work with you on the best strategy to address them.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Global Finance or Private Equity practice groups, or the author:

Michael Nicklin – Hong Kong (+852 2214 3809, [email protected])
Jamie Thomas – Singapore (+65 6507.3609, [email protected])

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

Global Finance Group:
Michael Nicklin – Hong Kong (+852 2214 3809, [email protected])
Jamie Thomas – Singapore (+65 6507.3609, [email protected])

Private Equity Group:
Paul Boltz – Hong Kong (+852 2214 3723, [email protected])
Scott Jalowayski – Hong Kong (+852 2214 3727, [email protected])
Brian Schwarzwalder – Hong Kong (+852 2214 3712, [email protected])

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

On January 30, 2020, the Commodity Futures Trading Commission (“CFTC” or “Commission”) approved on a party-line, 3-2 vote,[1] a proposed rule on federal speculative position limits for derivatives (the “2020 Proposal”),[2] to conform to the amendments to the Commodity Exchange Act (“CEA”) resulting from the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).[3] The 2020 Proposal would establish federal speculative position limits on 25 physically-settled commodity derivatives and their linked cash-settled futures, options on futures, and economically equivalent swaps. In connection with setting the federal position limits, the 2020 Proposal would also establish exemptions from such position limits for certain transactions that qualify as bona fide hedges. Comments on the 2020 Proposal, which asks a number of specific questions, are due by April 29, 2020. The expectation is that this deadline will not be extended, as CFTC Chairman Tarbert has expressed his desire to finalize position limits this year.[4]

The 2020 Proposal marks the fifth time over the past decade that the CFTC has proposed rules to implement the position limits provisions resulting from the Dodd-Frank Act’s amendments to the CEA. The CFTC initially issued proposed and final rules on speculative position limits in 2011;[5] however, the 2011 Final Rule was vacated by the U.S. District Court for the District of Columbia in 2012.[6] Following the vacatur of the 2011 Final Rule, the CFTC issued three additional proposed rules regarding speculative position limits in December 2013, June 2016 and December 2016, none of which were ever finalized.[7]

This client alert provides a brief overview of the differences between the 2020 Proposal and prior proposals; a summary of the 2020 Proposal; and insights regarding the 2020 Proposal and its potential impacts.

I. Differences from Prior Proposed Rules

In issuing the 2020 Proposal, the CFTC’s interpretation of Section 737(a)(4) of the Dodd-Frank Act[8] differs from prior proposals in that the CFTC interprets the section to require a finding, before establishing a position limit, that such limit is “necessary” to “diminish, eliminate, or prevent” excessive speculation.[9] The 2020 Proposal notes that the U.S. District Court for the District of Columbia in ISDA identifies that the statutory language allowing the CFTC to regulate excessive speculation is subject to multiple interpretations and is ultimately ambiguous as to whether the CFTC must determine that a position limit is necessary prior to establishing the limit.[10] Rather than providing a definitive statutory interpretation, the court in ISDA directed the CFTC to use its “experience and expertise” to determine whether a necessity finding is required before the CFTC establishes a position limit.[11]

Following ISDA, the CFTC’s position, as evidenced by the 2013 and 2016 proposals, was that the standards set forth in CEA Section 4a(a)(1)[12] do not require that it make a particular necessity finding. Moreover, in the 2013 and 2016 proposals, the Commission found that Section 737 of the Dodd-Frank Act required that it impose position limits on “all markets in physical commodities.”[13] Accordingly, the 2020 Proposal differs from prior proposals by reading CEA Section 4a(a)(1) to place the burden on the government to determine what position limits are necessary.[14]

The 2020 Proposal seeks to impose speculative position limits on 25 core referenced futures contracts for which it has made a necessity finding.[15] Note, however, that position limits on contracts listed on exchanges (i.e., designated contract markets) would continue to apply at the specific exchanges beyond the 25 required federal limits to the extent specified in the particular exchange rulebooks.

Unlike prior proposals, there is no express intent in the 2020 Proposal to expand position limits beyond the 25 core referenced futures contracts to include all commodities at a future date. Any position limits for a new commodity would have to proceed under a similar necessity finding and notice and comment rulemaking. Chairman Tarbert has described this approach to the necessity finding for position limits as a “big picture approach.”[16] Chairman Tarbert explained that the approach takes into account the fact that position limits impose a burden, whether “on parties having to track their positions relative to limits, or potentially the loss of a business opportunity because the risks cannot be hedged” and as such seeks to impose these limits only when necessary.[17]

II. Contracts Subject to Position Limits

A. Federal Spot Month Position Limits Would Apply to 25 Core Referenced Futures Contracts (and Linked/Equivalent Contracts)

1. 25 Core Referenced Futures Contracts

The 2020 Proposal establishes position limits on 25 core referenced futures contracts (which are physically-settled futures derivatives contracts) and their linked cash-settled futures, options on futures, and economically equivalent swaps (collectively, the “Referenced Contracts”). Nine of the proposed 25 core referenced futures contracts are currently subject to federal speculative position limits under Part 150 of the CFTC’s regulations. Those nine legacy agricultural contracts are: (1) CBOT Corn; (2) CBOT Oats; (3) CBOT Soybeans; (4) CBOT Wheat; (5) CBOT Soybean Oil; (6) CBOT Soybean Meal; (7) MGEX Hard Red Spring Wheat; (8) ICE Cotton No. 2; and (9) CBOT KC Hard Red Winter Wheat.

Of the remaining 16 core referenced futures contracts, seven are agricultural contracts, five are metals contracts, and four are energy contracts. These commodities may appear familiar to those that have followed the CFTC’s actions around federal position limits, as they are the same commodities listed in the CFTC’s 2016 position limits proposals. Those futures contracts are: (1) CME Live Cattle; (2) CBOT Rough Rice; (3) ICE Cocoa; (4) ICE Coffee C; (5) ICE FCOJ-A; (6) ICE U.S. Sugar No. 11; (7) ICE U.S. Sugar No. 16; (8) COMEX Gold; (9) COMEX Silver; (10) COMEX Copper; (11) NYMEX Platinum; (12) NYMEX Palladium; (13) NYMEX Henry Hub Natural Gas; (14) NYMEX Light Sweet Crude Oil; (15) NYMEX New York Harbor ULSD Heating Oil; and (16) NYMEX New York Harbor RBOB Gasoline. Position limit levels are intended to be low enough to protect excessive speculation and price discovery; high enough to ensure sufficient liquidity for bona fide hedgers; within a range of acceptable levels; and to account for differences between markets. The limits set forth in the 2020 Proposal apply to all Referenced Contracts, not only to core referenced futures contracts, such that linked cash-settled futures and options on futures, as well as economically equivalent swaps would need to be aggregated when calculating. Notably, while the definition of Referenced Contracts would include linked contracts (discussed below), the definition would not include: (1) location basis contracts; (2) commodity index contracts; (3) swap guarantees; and (4) trade options that meet the requirements of CFTC Regulation 32.3.[18]

2. Cash-Settled Futures and Options on Futures

The 2020 Proposal’s definition of Referenced Contract would incorporate cash-settled look-alike futures contracts and related options that are either “(i) directly or indirectly linked, including being partially or fully settled on, or priced at a fixed differential to, the price of that particular core referenced futures contract; or (ii) directly or indirectly linked, including being partially or fully settled on, or priced at a fixed differential to, the price of the same commodity underlying that particular core referenced futures contract for delivery at the same location or locations as specified in that particular core referenced futures contract.”[19]

As a result, under the 2020 Proposal federal position limits would apply to all cash-settled futures and options on futures contracts on physical commodities that are linked, whether directly or indirectly, to a physically-settled contract subject to federal position limits. The CFTC views such cash-settled contracts as “generally economically equivalent to physical-delivery contracts in the same commodity” and notes that without federal position limits “in both the physically-delivered and cash-settled contracts [a trader] may have increased ability and incentive to manipulate one contract to the benefit of the other.”[20] It should be noted that there are separate federal spot month position limits for physically-delivered Referenced Contracts compared to cash-settled Referenced Contracts, meaning that during the spot month, such physically-delivered Referenced Contracts are not able to be netted against cash-settled Referenced Contracts.[21]

The CFTC notes that it proposes to publish a CFTC Staff Workbook of Commodity Derivative Contracts under Regulations Regarding Position Limits for Derivatives (“CFTC Staff Workbook”) in connection with the 2020 Proposal. The CFTC Staff Workbook would “provide a non-exhaustive list of Referenced Contracts” and would help market participants determine categories of contracts that would fit within the Referenced Contract definition.[22]

3. Economically Equivalent Swaps

The 2020 Proposal provides for a new definition for economically equivalent swaps, which will be defined as “swaps with ‘identical material’ contractual specifications, terms, and conditions to a referenced contract.”[23] This definition of “economically equivalent swap” is narrower than the definition set forth in the CFTC’s 2016 proposals, meaning that fewer swaps would be subject to federal speculative position limits under the 2020 Proposal than the prior proposals. Swaps in commodities other than natural gas that have identical contractual terms but differences in lot size specifications, notional amounts, or delivery dates diverging by less than one day would be economically equivalent swaps; for natural gas contracts, similar contracts with a two day window would still be determined to be economically equivalent swaps.[24]

Such economically-equivalent swaps could be netted against other Referenced Contracts in the commodity for the purpose of determining one’s aggregate positions for federal position limits.

4. Setting and Calculating of Spot Month Limits

The spot month limits apply to all of the Referenced Contracts. Position limit levels are set at or below 25 percent of deliverable supply, as estimated using recent data supplied by the designated contract market listing the core referenced futures contracts (and as verified by the CFTC). The 25 percent threshold is intended to make it difficult for a participant to corner the market, as “any potential economic gains resulting from the manipulation” of such a percentage ownership “may be insufficient to justify the potential costs, including the costs of acquiring, and ultimate offloading, the positions used to effectuate the manipulation.”[25] This limits the potential for a market participant to use the Referenced Contracts to affect the price of the commodity. The Commission further expects that the 25 percent limit level will not result in a reduction in liquidity for bona fide hedgers in the identified markets. Finally, the Commission cites as a reason for its choice of the 25 percent threshold the fact that that threshold is customarily used by some of the exchanges.[26]

The position limits apply separately to physically-settled and cash-settled contracts, meaning that a market participant may not net cash-settled Referenced Contracts against physically-settled Referenced Contracts. Rather, all of a participant’s positions in a physically-settled Referenced Contract, across all exchanges, are netted and subject to the relevant limit, whereas all of a market participant’s positions in cash-settled contracts linked to physically-settled core referenced futures contracts are netted and independently subject to the federal spot month limit for a given commodity.[27] The Commission disallowed netting out of a concern that allowing netting could disrupt “the price discovery function” of the core referenced futures contract or “allow a market participant to manipulate the price of” a core referenced futures contract.[28]

The 25 percent deliverable supply based limits are roughly twice as high as existing federal limits. Some have argued that, without a transition period and analysis on how the market will react to these new limits, market disruption may be likely. In his dissent, Commissioner Berkovitz specifically notes that distributing these limits across non-spot months could lessen the potential to disrupt the convergence process and disrupt market signals that large speculative trading may pose.[29]

The proposed spot month limits for Referenced Contracts are set forth in Annex A to this alert.

B. Federal Non-Spot Month Position Limits Would Only Apply to the Nine Legacy Core Referenced Futures Contracts (and Linked/Equivalent Contracts)

The 2020 Proposal also applies position limits outside of the spot month, referred to as the “non-spot month,” to Referenced Contracts based on the nine legacy agricultural commodities currently subject to federal position limits. The remaining 16 Referenced Contracts do not have non-spot month position limits, other than the exchange-set limits and/or position accountability levels.

The non-spot month limits are set at 10 percent of open interest for the first 25,000 contracts of open interest, with a marginal increase of 2.5 percent of open interest above 50,000 contracts thereafter. These non-spot limits have been in place for decades, and the Commission believes their removal could result in market disruption. Market participants trading in these contracts requested the Commission maintain the non-spot month limits to promote “market integrity.”[30] While the 2020 Proposal updates these limit levels, as they had not been updated in over a decade, the Commission’s methodology for setting these limits has not changed, except that the 2.5 percent of open interest will be applied above 50,000 contracts, rather than the current level of 20,000 contracts.[31] The Commission explains that this change is meant to accommodate the near doubling of open interest in these markets.

While the Commission proposed federal non-spot month limits only for the nine legacy contracts, the Commission also requires the exchanges to establish “exchange-set position limits and/or position accountability levels in the non-spot months” for the remaining core referenced futures contracts, “consistent with Commission standards set forth in [the 2020 Proposal].”[32] Accordingly, market participants would need to continue to monitor the exchange position limits going forward, as they may be different from the federal position limits set forth in the 2020 Proposal.

The proposed non-spot month limits for the nine legacy agricultural contracts are set forth in Annex A to this alert.

C. Exemptions from Federal Position Limits

The 2020 Proposal establishes exemptions from the federal position limits for certain bona fide hedging transactions. The Commission proposes a new definition of bona fide hedges that market participants wishing to request an exemption from position limits must meet. As a corollary to the revised definition, the Commission also lists certain enumerated hedges that are examples of bona fide hedges in Appendix A to Part 150; contracts that qualify as an enumerated hedge are self-effectuating and do not require Commission approval. However, and as explained further below, market participants must still submit applications for exemptions from exchange-set position limits for these contracts, as applicable.

1. Enumerated Hedges

Positions in Referenced Contracts that meet any of the enumerated hedges that are listed in Appendix A to proposed Part 150 would meet the bona fide hedging definition set forth in CEA Section 4a(c)(2)(A) and the proposed definition of bona fide hedging set forth in the 2020 Proposal. Below is a list of the enumerated hedges set forth in the 2020 Proposal:

Hedges of unsold anticipated production;
Hedges of offsetting unfixed-price cash commodity sales and purchases;
Hedges of anticipated mineral royalties;
Hedges of anticipated services;
Cross-commodity hedges;
Hedges of inventory and cash commodity fixed-price purchase contacts;
Hedges of cash commodity fixed-price sales contracts;
Hedges by agents;
Offsets of commodity trade options;
Hedges of unfilled anticipated requirements;
Hedges of anticipated merchandising.

The CFTC provides specific guidance around these enumerated hedges in proposed Appendix A to Part 150 and in the preamble to the 2020 Proposal. Exemptions for positions that qualify as enumerated hedges are self-effectuating for purposes of federal position limits, provided that the market participant complies with exchange requirements by requesting an exemption from exchange-set position limits.[33]

2. Non-Enumerated Hedges

The 2020 Proposal’s definition of bona fide hedge would require that the position (1) represents a substitute for transactions made at a later time in a physical marketing channel; (2) is economically appropriate to the reduction of price risks in the conduct of a commercial enterprise; and (3) arises from the potential change in value of actual or anticipated (A) assets, (B) liabilities or (C) services a person provides or purchases.[34] Alternatively, a position may qualify as a bona fide hedge where it is a pass-through swap and pass-through swap offset pair, where the pass-through swap offset is a futures, option on a futures, or swap position entered into by the pass-through swap counterparty in the same physical commodity as the pass-through swap, or where the futures, option on futures, or swap position reduces price risks attendant to a previously-entered-into swap position.[35] The 2020 Proposal would require that bona fide hedging transactions or positions in commodities must always (and not just normally) be connected to the production, sale, or use of a physical cash-market commodity.[36]

Market participants may request approval for an exemption to the federal position limits for bona fide hedges that are not listed in the enumerated list in proposed Appendix A to Part 150 by demonstrating that they meet the definition of a bona fide hedge. Unlike the enumerated exemptions, these exemptions are not self-effectuating and the 2020 Proposal would require a market participant to request the non-enumerated hedge in one of two ways: (1) apply directly to the Commission (and also to the exchange) or (2) use a new streamlined process by requesting only through the exchange.

Under the new proposed streamlined process for requesting a bona fide hedge exemption set forth in the 2020 Proposal, a market participant may request an exemption from federal and exchange-level position limits by filing a single application to an exchange, pursuant to the exchange rules. This proposed streamlined process delegates the initial authority for approving an application for a non-enumerated hedge to the exchange, where the exchange maintains Commission-approved standards for such applications; if an exchange authorizes a non-enumerated hedge for a market participant, it must notify the CFTC of its determination. Upon notice of the exchange’s authorization of such an application, the CFTC will have a 10-day review period (or two days where sudden or unforeseen needs exist) during which it can object to such authorization. So long as the Commission does not object to the exchange determination, the request is deemed approved upon expiration of such 10-day period. The 2020 Proposal asks whether this 10 day (or two day) period may be too short (or too long). Commissioner Stump noted in her statement that the “10/2-day rule” is impracticable, in that it is too long from a market participant’s perspective to make hedging decisions quickly, and too short a time period for the Commission to determine whether the position is a bona fide hedge. Commissioner Stump expressed a preference that non-enumerated hedges be approved at the exchange level, given their familiarity with the hedging practices in their markets.[37] The 2020 Proposal outlines what must be included in the market participant’s application to an exchange for recognition of an exemption.[38]

While the 2020 Proposal does not dictate timelines for exchanges to review exemption applications that are submitted by market participants, it does provide that an exchange may adopt rules to allow a market participant to submit for approval a bona fide hedging application within five days after federal position limits are exceeded, if such market participant exceeds the limits due to sudden or unforeseen circumstances and can provide materials to demonstrate such circumstances.[39] The Commission notes that applications submitted after a person exceeds the federal speculative limit should not be habitual and that if it were to find that the position does not qualify as a bona fide hedge, the applicant would need to bring its position into compliance within a commercially reasonable time.

3. Risk Management Exemption Removed

This revised definition removes the risk management exemption, which had enabled market participants to treat a position entered into for “risk management purposes” as a bona fide hedge, unless the position otherwise satisfies the requirements of the pass-through provisions for a pass-through swap.[40] This is because the proposal modified the “temporary substitute test” to require that a bona fide hedging transaction or position in a physical commodity must “always,” and not “normally,” be connected to the production, sale, or use of a “physical cash-market commodity.”

4. Carve Outs Contained in CFTC Regulation 150.3

Other exemptions from federal position limits include certain spread positions (such as calendar spreads and energy crack processing spreads),[41] certain financial distress positions, certain natural gas positions held during the spot month, and pre-Dodd-Frank enactment and transition period swaps. These exemptions, however, are listed in proposed CFTC Regulation 150.3, and not proposed Appendix A to Part 150.

D. Exemptions from Exchange-Level Position Limits and Certain Reporting Requirements

In addition to the federal position limits, market participants will remain responsible for complying with all exchange-level position limits for products listed on a particular exchange and must apply for exemptions from such exchange-level limits for both enumerated and non-enumerated hedges in accordance with the exchange rules.

While the list of enumerated hedges in Appendix A to Part 150 is self-effectuating for federal purposes, the market participant will still be required to follow exchange rules to claim the exemption. For example, in CME Rulebook Rule 559 “[a] person seeking an exemption from position limits must apply to the Market Regulation Department on forms provided by the Exchange.”[42] Those requirements will remain in effect even after a final federal position limits rule is implemented.

In addition, the 2020 Proposal will eliminate certain reporting requirements, including removing the reporting obligations associated with Form 204[43] and Parts I and II of Form 304.[44] Instead of requiring these forms to be submitted, the CFTC will instead rely upon the cash positions report from the exchanges. This new system will place a greater focus on the data reported to exchanges. For example, under the 2020 Proposal, an energy trader that trades NYMEX natural gas and also the look-alike contract on ICE would have to report his/her cash positions to both exchanges (including equivalent cash positions). This outcome may prove to be more burdensome for market participants than submitting a single report to the CFTC.

E. Aggregation and Netting

Under CFTC Regulation 150.4, which was amended in 2016 by the CFTC’s Final Rule on Aggregation, positions a person holds must be aggregated with positions for which the person controls trading or holds a ten percent or greater ownership interest.[45] Long positions across exchanges and short positions across exchanges must be netted, and that net value is subject to federal position limits. A person that holds more than one account or pool with substantially identical trading strategies must aggregate all such positions with all other positions held by that person and their affiliates. Economically equivalent swaps must be added to, and netted against, other Referenced Contracts in the same commodity for the purpose of determining the aggregate position. The 2020 Proposal also provides a new definition of “Eligible Affiliates” that would make clear that an eligible affiliate may aggregate its positions even though it is eligible to disaggregate positions.[46] Several exemptions to the requirement to aggregate are contained in the existing rule, including for futures commission merchants and certain independent trading strategies, among others.

As discussed above, positions in physically-settled contracts may not be netted with positions in linked cash-settled contracts when calculating for position limits. This means that (1) all of a trader’s long and short positions in a particular physically-settled Referenced Contract (executed across all exchanges and OTC, as applicable) are netted and (2) all of a trader’s long and short positions in any cash-settled Referenced Contracts (executed across all exchanges and OTC, as applicable) linked to such physically-settled core referenced futures contract are netted independently (rather than collectively along with the physically settled positions) subject to the federal spot month limit for that commodity.[47] Non-Referenced Contracts cannot be used to net against Referenced Contracts.

ANNEX A

Below are the nine “legacy” contracts along with the 2020 Proposal’s spot month and non-spot-month limits for those contracts:

Legacy Agricultural Contracts	2020 Proposal’s Spot Month Limit	2020 Proposal’s Single Month and All-Months Combined Limit
CBOT Corn (C)	1,200	57,800
CBOT Oats (O)	600	2,000
CBOT Soybeans (S)	1,200	27,300
CBOT Wheat (W)	1,200	16,900
CBOT Soybean Oil (SO)	1,100	17,400
CBOT Soybean Meal (SM)	1,500	19,300
MGEX Hard Red Spring Wheat (MWE)	1,200	12,000
ICE Cotton No. 2 (CT)	1,800	12,000
CBOT KC Hard Red Winter Wheat (KW)	1,200	11,900

Below are the additional 16 core referenced futures contracts and the proposed spot month limits set forth in the 2020 Proposal:

Agriculture	2020 Proposal	Metals	2020 Proposal	Energy	2020 Proposal
CBOT Rough Rice (RR)	800	COMEX Gold (GC)	6,000	NYMEX Henry Hub Natural Gas (NG)	2,000
ICE Cocoa (CC)	4,900	COMEX Silver (SI)	3,000	NYMEX Light Sweet Crude Oil (CL)	6,000/5,000/4,000[48]
ICE Coffee C (KC)	1,700	COMEX Copper (HG)	1,000	NYMEX New York Harbor ULSD Heating Oil (HO)	2,000
ICE FCOJ-A (OJ)	2,200	NYMEX Platinum (PL)	500	NYMEX New York Harbor RBOB Gasoline (RB)	2,000
ICE U.S. Sugar No. 11 (SB)	25,800	NYMEX Palladium (PA)	50
ICE U.S. Sugar No. 16 (SF)	6,400
CME Live Cattle (LC)	600/300/200[49]

_________________________

[1] CFTC Commissioners Dan Berkovitz and Rostin Behnam dissented.

[2] Position Limits for Derivatives, 85 Fed. Reg. 11,596 (Feb. 27, 2020).

[3] Dodd-Frank Wall Street Reform and Consumer Protection Act, § 737(a)(4), Pub. L. No. 111-203, 124 Stat. 1376, 1723 (July 21, 2010).

[4] Chris Clayton, “CFTC Chair Keeps Focus on Ag,” Progressive Farmer (Nov. 18, 2019), available at https://www.dtnpf.com/agriculture/web/ag/news/business-inputs/article/2019/11/18/commission-preparing-release-new.

[5] See Position Limits for Derivatives, 76 Fed. Reg. 4752 (Jan. 26, 2011); Position Limits for Futures and Swaps, 76 Fed. Reg. 71,626 (Nov. 18, 2011) (the “2011 Final Rule”).

[6] Int’l Swaps & Derivatives Ass’n v. U.S. Commodity Futures Trading Comm’n, 887 F. Supp. 2d 259 (D.D.C. 2012) (“ISDA”).

[7] See Position Limits for Derivatives, 78 Fed. Reg. 75,680 (Dec. 12, 2013); Position Limits for Derivatives; Certain Exemptions and Guidance, 81 Fed. Reg. 38,458 (June 13, 2016); Position Limits for Derivatives, 81 Fed. Reg. 96,704 (Dec. 30, 2016).

[8] 7 U.S.C. 6a(a)(2)(A).

[9] 7 U.S.C. 6a(a)(1).

[10] 887 F. Supp. 2d 259, 267 (D.D.C. 2012).

[11] Id. at 270.

[12] 7 U.S.C. § 6a(a)(1).

[13] 2020 Proposal at 11,665.

[14] Statement of Commissioner Tarbert, (Jan. 30, 2020), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/tarbertstatement013020.

[15] In particular, with respect to the 25 core referenced futures contracts, the CFTC identified their particular importance “in the price discovery process for their respective underlying commodities”; that “physical delivery of the underlying commodity” is required; and that in certain instances “especially acute economic burdens . . . would raise from excessive speculation causing sudden or unreasonable fluctuations or unwanted changes in the price of the commodities underlying these contracts.” 2020 Proposal at 11,603.

[16] Statement of Commissioner Tarbert (Jan. 30, 2020), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/tarbertstatement013020.

[17] Id.

[18] Id. at 11,620-11,621. In the final trade options rule, the CFTC explained that federal position limits should not apply to trade options and that it would address trade options in the context of any final rulemaking for federal position limits. See Trade Options, 81 Fed. Reg. 14,971 (Mar. 21, 2016).

[19] 2020 Proposal at 11,615.

[20] 2020 Proposal at 11,620.

[21] Id. at 11,635-11,637.

[22] Id. at 11,621.

[23] Id. at 11,599.

[24] 2020 Proposal at 11,599.

[25] Id.at 11,626.

[26] Id.

[27] Id.at 11,636.

[28] Id.

[29] Dissenting Statement of Commissioner Berkovitz (Jan. 30, 2020), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/berkovitzstatement013020b.

[30] 2020 Proposal at 11,628.

[31] Id. at 11,630.

[32] Id. at 11,598.

[33] Id. at 11,601.

[34] Id. at 11,600. With respect to assets, the Commission notes that it would include “assets which a person owns, produces, manufactures, processes, or merchandises or anticipates owning, producing, manufacturing, processing, or merchandising.” Id. at 11,717.

[35] 2020 Proposal at 11,717.

[36] Id. at 11,601.

[37] Statement of Commissioner Stump (Jan. 30, 2020), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/stumpstatement013020.

[38] 2020 Proposal at 11,652.

[39] Id. at 11,653.

[40] Id. at 11,641.

[41] If a spread strategy is not covered under the definition of “spread transaction” in proposed CFTC Regulation 150.3, then a market participant would need to petition the CFTC for such spread exemption.

[42] See CME Rulebook, Section 559, available at https://www.cmegroup.com/content/dam/cmegroup/rulebook/CME/I/5/5.pdf.

[43] Form 204 is a monthly report of cash positions in grains, soybeans, soybean oil, and soybean meal.

[44] Form 304 is a statement of cash positions in cotton.

[45] 17 CFR § 150.4(a)(1); Aggregation of Positions: Final Rule, 81 Fed. Reg. 91,454 (Dec. 16, 2016).

[46] 2020 Proposal at 11,636. Under the proposed definition, an “eligible affiliate” includes certain entities that, among other things, are required to aggregate their positions under CFTC Regulation 150.4 and that do not claim an exemption from aggregation.

[47] Id. at 11,635-11,636.

[48] The proposed spot month limit for Light Sweet Crude Oil is subject to a step-down limit: (1) for contracts as of the close of trading three business days prior to the last trading day of the contract; (2) for contracts as of the close of trading two business days prior to the last trading day of the contract; and (3) for contracts as of the close of trading one business day prior to the last trading day of the contract. 2020 Proposal at 11,599.

[49] The Live Cattle federal spot month limit is subject to a step-down (1) at the close of trading on the first business day following the first Friday of the contract month; (2) at the close of trading on the business day prior to the last five trading days of the contract month; and (3) at the close of trading on the business day prior to the last two trading days of the contract month. 2020 Proposal at 11,599.

The following Gibson Dunn lawyers assisted in preparing this client update: Jeffrey Steiner, Jennifer Mansh and Chelsea Gunter.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions, Derivatives or Energy, Regulation and Litigation practice groups, or any of the following:

Financial Institutions / Derivatives Groups:
Matthew L. Biben – New York (+1 212-351-6300, [email protected])
Michael D. Bopp – Washington, D.C. (+1 202-955-8256, [email protected])
Stephanie Brooker – Washington, D.C. (+1 202-887-3502, [email protected])
Arthur S. Long – New York (+1 212-351-2426, [email protected])
Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, [email protected])

Energy, Regulation and Litigation Group:
William S. Scherman – Washington, D.C. (+1 202-887-3510, [email protected])
Jeffrey M. Jakubiak – New York (+1 212-351-2498, [email protected])

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

London partner Sacha Harber-Kelly and associate Steve Melrose are the authors of “Is the Guralp Systems Limited No-Penalty DPA a Tectonic Shift or Factual Peculiarity?,” [PDF] published by the Anti-Corruption Report on February 19, 2020.

Orange County partner Oscar Garza and associates Douglas Levin and Matthew Bouslog are the authors of “Second Circuit Breathes New Life into § 546(e), Answering Unaddressed Question by Merit,” [PDF] published by the American Bankruptcy Institute Journal in its March 2020 issue.

Over the past several years, antitrust enforcers around the world have sharpened their focus on employers’ use of no-poach and non-compete agreements. In the United States, since the Antitrust Division of the Department of Justice and the Federal Trade Commission jointly issued guidance in 2016 for human resource professionals regarding the application of the federal antitrust laws in this area, the DOJ has emphasized that it has opened investigations into the use of no-poach agreements and clarified its positions, most recently arguing in various Statements of Interest for how the antitrust laws should be applied in this area. State Attorneys General have also opened investigations into the use of no-poach and non-compete agreements, and Attorneys General have offered interpretations of how state competition laws affect these types of agreements. Private civil class actions based on these types of agreements continue to be filed against employers across diverse industries, including franchise companies, railways, and hospitals. In Asia, enforcement of anti-competitive hiring practices is gaining momentum, with regulators in Hong Kong and Japan issuing detailed guidelines on competition law considerations for human resources personnel.

Join Gibson Dunn for a one-hour discussion of these developments.

View Slides (PDF)

PANELISTS:

Rachel S. Brass is a partner in the San Francisco office where her practice focuses on antitrust and competition law and employment class action litigation. Since the DOJ and FTC issued their Antitrust Guidance for HR Professionals in October 2016, and put HR and employment related conduct in the antitrust crosshairs, Rachel has counseled companies on this antitrust/employment interface, as well as companies in state and federal investigations, and class action litigation. She spoke on these issues recently at the U.S. DOJ’s Public Workshop on Competition in Labor Markets. In addition, Rachel has special broad experience in international competition matters and teaches an upper-level course in International Antitrust Law at Berkeley Law School.

Kristen Limarzi is a partner in the Washington, D.C. office of Gibson, Dunn & Crutcher, where her practice focuses on investigations, litigation, and counseling on antitrust merger and conduct matters, as well as appellate and civil litigation. Ms. Limarzi previously served as the Chief of the Appellate Section of the U.S. Department of Justice’s Antitrust Division, where she helped to develop the DOJ and FTC’s Antitrust Guidance for HR Professionals and oversaw the filing of statements of interests by the United States in private suits challenging no-poach arrangements. In addition, she recently participated in the FTC’s Public Workshop on Non-Compete Clauses in the Workplace.

Sébastien Evrard is a partner in the Hong Kong office of Gibson, Dunn & Crutcher, where he is a member of the firm’s Antitrust and Competition Practice Group. Based in Asia since 2010, Mr. Evrard handles complex antitrust matters throughout Asia, including merger control, non-merger investigations, and litigation. His practice also focuses on the antitrust aspects of intellectual property rights. Mr. Evrard’s experience spans a wide range of industries including aviation/shipping, banking, energy/mining, media/entertainment, software/hardware, telecommunications, pharmaceuticals, automotive, and fast moving consumer goods. He has represented clients before multiple regulators in Asia and Europe, and has litigated cases in multiple jurisdictions. He speaks English, French and Dutch.

Matthew Parrott is an associate in the Orange County Office of Gibson Dunn and a member of the firm’s Antitrust and Trade Regulation Practice Group where his practice focuses primarily on antitrust and competition litigation and counseling. In recent years, Mr. Parrott has represented and counseled clients on antitrust issues related to no-poach provisions in various settings. He also represents clients in criminal and civil antitrust litigations and investigations, class actions, alternative dispute resolution proceedings, and appeals. Mr. Parrott is experienced in all phases of litigation—from drafting and responding to pleadings to conducting trials and appeals.

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Los Angeles partner James Zelenay Jr. and associate Sean Twomey are the authors of “False Claims Act Enforcement Under the Trump Administration,” [PDF] published by the Daily Journal on February 24, 2020.

Los Angeles partner Abbey Hudson, Los Angeles associate Dione Garlick and Palo Alto associate Collin James Vierra are the authors of “Community Shared Solar: Promising Option For Calif. Builders,” [PDF] published by Law360 on February 26, 2020.

The Telephone Consumer Protection Act has long been a favorite of the plaintiffs privacy bar, as the act provides up to $1,500 in damages per unwanted call.[1] That adds up very quickly in even the most modestly sized class actions.

Since the TCPA was enacted in 1991, the Federal Communications Commission has for years essentially updated the law through its own orders. These orders have applied the TCPA to technology like text messages and app-to-text messaging, none of which was even a glimmer in the eyes of those who passed the law decades ago.

Similarly, although the TCPA was passed during a time where an automatic telephone dialing system, or autodialer, was limited to a machine that would randomly generate 10 digits to be called, the FCC determined that an autodialer is not limited to those systems. Moving beyond the plain language of the statute, the FCC said that a predictive dialer would constitute an autodialer so long as the system stores numbers and automatically dials them.

Several of the circuit courts across the country then essentially inoculated the FCC’s interpretations from being questioned in TCPA litigation. These courts, adopting a narrow reading of the Hobbs Act’s mandate that courts of appeals have “exclusive jurisdiction to … determine the validity of all final orders of the [FCC],” held that they were not able to upset the FCC’s determinations because they were prohibited from reviewing the FCC’s orders in private TCPA litigation.[2]

But as Timothy Loose, Jeremy Smith, Wesley Sze and Danielle Hesse explain in a recent Law360 article, the times are changing, and the tide is now moving toward limiting the reach of the TCPA and the FCC’s expansive interpretations. Moreover, the viability of the entire statute will be questioned by the U.S. Supreme Court. The end of the TCPA class action frenzy may be near.

4 Questions That May Signal The End Of TCPA Class Actions (click on link)

___________________

[1] 47 U.S.C. § 227(b)(3).
[2] 28 U.S.C. § 2342(1).

Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues. Please feel free to contact the Gibson Dunn lawyer with whom you usually work, or the authors:

Timothy W. Loose – Los Angeles (+1 213-229-7746,[email protected])
Jeremy S. Smith – Los Angeles (+1 213-229-7973, [email protected])
Wesley Sze – Palo Alto (+1 650-849-5347, [email protected])
Danielle Hesse* – Los Angeles (+1 213-229-6827, [email protected])

* Danielle Hesse is a litigation associate in Gibson Dunn’s Los Angeles office.

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

In January of 2020, the Maryland House and Senate introduced identical bills — HB0439 in the House and SB0216 in the Senate (together, the “Proposed Legislation”) — that would apply an additional 17% state income tax to (i) carried interest and management fee income attributable to certain investment management services provided in the state of Maryland and (ii) carried interest and management fee income earned by residents of Maryland, regardless of where the investment management services giving rise to the income are performed.[1]

Maryland joins California, Connecticut, the District of Columbia, Illinois, Massachusetts, New Jersey, New York, and Rhode Island in proposing some version of an additional tax on carried interest. Like Maryland, many of those states have included an exception for real estate businesses and an expiration provision should a federal bill with an identical effect become law (each as discussed below). However, Maryland’s Proposed Legislation departs from many of its predecessors in that its effectiveness is not contingent on the same or similar legislation passing in other states. This may provide a significant incentive for Maryland private equity and venture funds to leave the state and, potentially, for Maryland businesses seeking private equity or venture capital funding to move to neighboring jurisdictions. The Proposed Legislation, if adopted, could also encourage individuals who are currently Maryland residents and derive substantial income from the provision of non-Maryland investment management services to relocate to another state. To date, only New Jersey has adopted carried interest legislation, and that legislation remains inoperative because New York, Connecticut, and Massachusetts have not adopted similar legislation. Accordingly, no state has adopted legislation that would be similar in scope and effect to the Proposed Legislation.

We summarize the provisions of the Proposed Legislation below.

Income Subject to the Tax

Under current tax law, an owner of an interest in a passthrough entity is taxed on the owner’s allocable share of the passthrough’s taxable income. Moreover, the character of that income to the owner generally is the same as it is to the passthrough entity. In contrast, fees paid to an owner of an interest in a passthrough entity for services performed for the entity typically are treated as “guaranteed payments” and are taxed at ordinary income rates. The Proposed Legislation would create a special rule that applies an additional 17% surtax to taxable income from certain investment management services, including both management fees (typically taxed as ordinary income) and “carried interests” (typically taxed at lower capital gains rates).

The 17% surtax would apply only to income generated by “Investment Management Services” provided by a partner or shareholder in a partnership, S corporation, or other entity (such as a limited liability company). Investment Management Services include those services a “substantial quantity” of which are (i) advising on whether an investor should invest in, purchase, or sell Specified Assets (defined below), (ii) managing, acquiring, or disposing of a Specified Asset, (iii) arranging financing with respect to acquiring a Specified Asset, or (iv) any activity in support of any of the services described in clauses (i) through (iii) of this paragraph.

The Proposed Legislation defines “Specified Assets” as securities, real estate property held for investment or rental, partnership interests, commodities, options, or derivative contracts. Although Investment Management Services include those performed by S corporation shareholders, the definition of Specified Asset in the Proposed Legislation omits shares in an S corporation. Thus, those shareholders or partners performing Investment Management Services with respect to investments that are interests in S corporations (including limited liability companies that have elected to be S corporations) may not be captured by the current draft of the Proposed Legislation.

Because the deductibility of state and local taxes is currently limited under U.S. federal tax law, certain management fee income of Maryland residents (which is already taxed at ordinary U.S. federal income and state tax rates) would be subject to combined tax rates of up to 59.75% under the Proposed Legislation. Carried interest income of Maryland residents (typically taxed at lower long-term capital gains rates at the federal level) would be subject to combined tax rates of up to 48.90%.

Real Estate Exception

Notably, the Proposed Legislation excepts from the 17% surtax those partners or shareholders holding an interest in a partnership, S corporation or other entity owning primarily real estate assets. Specifically, to qualify for the exception, the Proposed Legislation requires that 80% of the “average fair market value” of the partnership, S corporation or other entity consist of real estate. This exception would be expected to apply to certain real estate businesses, such as real estate investment trusts.

Application to Maryland Residents

The Proposed Legislation provides that those corporations or individuals (including spouses of applicable individuals filing a joint return) who are Maryland residents must pay the 17% surtax on income attributable to Investment Management Services even if the income is not derived from Investment Management Services performed in Maryland. All Maryland residents who derive income from Investment Management Services provided as a partner or shareholder in a passthrough entity could therefore be subject to the 17% surtax, unless the real estate exception applies.

Application to Nonresidents

Nonresidents of Maryland also would be subject to the Proposed Legislation’s 17% surtax to the extent they receive income generated by Investment Management Services performed in Maryland, unless the real estate exception applies. The tax could apply to any private equity fund or venture capital fund that invests in a Maryland business, regardless of where the investing fund is located. It also may apply to income derived from a fund’s investment in a portfolio company located in Maryland.

Effective Date and Status

If the Proposed Legislation were to be enacted in this Session of the Maryland General Assembly, it would apply to the current (2020) tax year. If Congress passes and the President signs legislation with an identical effect applied at the federal level, the Proposed Legislation (assuming it had been enacted) would be rendered ineffective shortly after the Maryland Department of Legislative Services receives notice of the new federal law.

As of the date of this client alert, the bills have been referred to review by Maryland’s House Ways and Means Committee and Senate Budget and Taxation Committee. A similar bill was proposed in the Maryland House in February of 2019 and was subsequently withdrawn after an unfavorable report by the Ways and Means Committee.

______________________

[1] The Proposed Legislation is similar in certain respects to (but materially different from) the federal rules applicable to certain carried interest gains that became law on December 22, 2017. Pub. L. 115–97, title I, § 13309(a)(2), Dec. 22, 2017, 131 Stat. 2054.

The following Gibson Dunn lawyers prepared this client update: Benjamin Rippeon, Eric Sloan, Virginia Blanton and Collin Metcalf.

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 firm’s Tax or Private Equity practice groups, or the following authors:

Benjamin Rippeon – Washington, D.C. (+1 202-955-8265, [email protected])
Eric B. Sloan – New York (+1 212-351-2340, [email protected])

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

Tax Group:
Jeffrey M. Trinklein – Co-Chair, London/New York (+44 (0)20 7071 4224 /+1 212-351-2344), [email protected])
David Sinak – Co-Chair, Dallas (+1 214-698-3107, [email protected])
Brian W. Kniesly – New York (+1 212-351-2379, [email protected])
Eric B. Sloan – New York (+1 212-351-2340, [email protected])
Edward S. Wei – New York (+1 212-351-3925, [email protected])
Benjamin Rippeon – Washington, D.C. (+1 202-955-8265, [email protected])
Daniel A. Zygielbaum – Washington, D.C. (+1 202-887-3768, [email protected])
Dora Arash – Los Angeles (+1 213-229-7134, [email protected])
Paul S. Issler – Los Angeles (+1 213-229-7763, [email protected])
Lorna Wilson – Los Angeles (+1 213-229-7547, [email protected])
James Chenoweth – Houston (+1 346-718-6718, [email protected])
Scott Knutson – Orange County (+1 949-451-3961, [email protected])
Sandy Bhogal – London (+44 (0)20 7071 4266, [email protected])
Benjamin J. Fryer – London (+44 (0)20 7071 4232, [email protected])
Jérôme Delaurière – Paris (+33 (0)1 56 43 13 00, [email protected])
Hans Martin Schmid – Munich (+49 89 189 33 110, [email protected])

Private Equity Group:
George P. Stamas – Washington, D.C./New York (+1 202-955-8280/+1 212-351-5300, [email protected])
Mark D. Director – Washington, D.C./New York (+1 202-955-8508/+1 212-351-5308, [email protected])
Steven R. Shoemate – New York (+1 212-351-3879, [email protected])
Sean P. Griffiths – New York (+1 212-351-3872, [email protected])
Scott Jalowayski – Hong Kong (+852 2214 3727, [email protected])
Ari Lanin – Los Angeles (+1 310-552-8581, [email protected])

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

Decided February 26, 2020

Intel Corp. Investment Policy Committee v. Sulyma, No. 18-1116

Today, the Supreme Court unanimously held that a fiduciary’s disclosure of plan information alone does not trigger ERISA’s three-year limitations period in fiduciary breach cases. “Actual knowledge” sufficient to trigger this limitations period requires participants be “aware of” the disclosed information.

Background:
Section 413(2) of the Employee Retirement Income Security Act of 1974 (ERISA) requires that claims for breach of fiduciary duty be brought no later than “three years after the earliest date on which the plaintiff had actual knowledge of the breach or violation.” 29 U.S.C. § 1113(2). Absent “actual knowledge,” breach of fiduciary duty claims under ERISA must be brought within six years of the breach or violation. In 2015, Christopher Sulyma, a former Intel employee, sued multiple retirement plans, claiming that his retirement plans improperly overinvested in alternative investments. More than three years, but less than six years, before that suit was filed, Sulyma received disclosures that explained the investments Sulyma claimed were imprudent. The Ninth Circuit held that the disclosures did not trigger the three-year bar because Sulyma testified he had not read the disclosures and Intel had not established Sulyma had subjective awareness of what was disclosed. The United States filed an amicus brief in support of Sulyma defending that position and participated in oral argument.

Issue:
Whether the ERISA three-year limitations period in Section 413(2), which runs from “the earliest date on which the plaintiff had actual knowledge of the breach or violation,” bars suit when all relevant information was disclosed to the plaintiff more than three years before the plaintiff filed the complaint, but the plaintiff chose not to read, or could not recall having read, the information.

Court’s Holding:
No. A plan participant has “actual knowledge of the breach” only if the participant was “aware of” the relevant plan information. Disclosure of plan information alone does not trigger the three-year limitations period in Section 413(2).

“[T]o have ‘actual knowledge’ of a piece of information, one must in fact be aware of it.”

Justice Alito, writing for the unanimous Court

Gibson Dunn submitted an amicus brief on behalf of the National Association of Manufacturers, the Chamber of Commerce of the United States, the Securities Industry and Financial Markets Association, the American Benefits Counsel, the ERISA Industry Committee, and the American Retirement Association in support of petitioner: Intel Corp. Investment Policy Committee

What It Means:

Applying the ordinary meaning of “actual knowledge,” the Court reasoned that a plaintiff cannot have “actual knowledge” of materials he has not read, “however close at hand the fact might be.” The Court acknowledged that the plain meaning of “actual knowledge” would substantially diminish protections for ERISA fiduciaries, but held that this policy consideration was best left to Congress.
As a result of the Court’s opinion, retirement plans and employers may now be subject to more lawsuits and greater litigation costs because participants need only allege that they did not read plan documents to expand the ERISA statute of limitations from three to six years.
The Court emphasized that today’s opinion does not preclude a showing of “actual knowledge” through inference from circumstantial evidence, nor does it preclude defendants from contending that evidence of “willful blindness” supports a finding of “actual knowledge.” Litigating these issues will require individualized factual inquiries that may pose an obstacle to class certification.
The Court left open what a plaintiff must “actually know” about a defendant’s conduct to trigger the three-year limitations period.
This “actual knowledge” standard may be helpful to corporations and other defendants in securities and fraud cases. Relying on this holding, defendants may argue that a plaintiff must establish awareness of relevant information to prove scienter.

The Court’s opinion is available here.

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

Appellate and Constitutional Law Practice

Allyson N. Ho
+1 214.698.3233
[email protected]

Mark A. Perry
+1 202.887.3667
[email protected]

Miguel A. Estrada
+1 202.955.8257
[email protected]

Related Practice: Securities Litigation

Robert F. Serio
+1 212.351.3917
[email protected]

Daniel J. Thomasch
+1 212.351.3800
[email protected]

Brian M. Lutz
+1 415.393.8379
[email protected]

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

Increasingly, companies face challenges in answering what might seem like a basic question—is a particular worker the “employee” of that company? In many industries, the answer turns on whether a worker is properly classified as an “independent contractor.” But often, even if the worker is an employee, the next question is, whose? On February 25, 2020, the National Labor Relations Board (“NLRB” or the “Board”) issued a final rule that will help companies find the answer; the final rule will guide the NLRB in determining whether a business is a joint employer of employees directly employed by another employer for purposes of the National Labor Relations Act (“NLRA”). It rolls back the more expansive test for determining joint employer liability that the NLRB adopted in the 2015 Browning-Ferris decision, and restores the standard the Board applied for several decades prior to that decision.

The final rule is an important development for companies covered by the NLRA who use sub-contractors, staffing agencies, franchise models, and other arrangements that have historically faced litigation over their alleged joint employer status. The NLRB’s rule also follows shortly behind a similar final rule governing joint employer status under the Fair Labor Standards Act (“FLSA”), announced by the Department of Labor (“DOL”) on January 12, 2020.

Below, we provide a summary of the NLRB’s final rule. The full text of the rule, which spans almost 200 pages, is available here. It will be formally published in the Federal Register on February 26, and will take effect on April 27 of this year.

* * *

On February 25, 2020, the NLRB issued its final rule on the standard for determining joint-employer status under the NLRA. The rule rolls back the more expansive test that the Board adopted in Browning-Ferris Industries of California, Inc. d/b/a BFI Newby Island Recyclery, 362 NLRB 1599, 1600 (2015), which made it possible for a business to be deemed a joint employer if it exhibited “indirect control” over another employer’s employees or reserved the ability to exert such control. The rule reinstates the standard that the NLRB applied for several decades prior to the Browning-Ferris decision. This standard provides that a company is only a joint employer if it exercises “substantial direct and immediate” control over one or more essential terms and conditions of employment of another employer’s employees.

Under the final rule, an employer may be considered a joint employer of a separate employer’s employees only if the two employers “share or codetermine the employees’ essential terms and conditions of employment.” The rule defines essential terms and conditions of employment to include eight core aspects of a worker’s job: wages, benefits, hours of work, hiring, discharge, discipline, supervision, and direction. To share or codetermine the essential terms and conditions of employment, the rule provides that an employer must possess and exercise “such substantial direct and immediate control” over one or more of those eight core aspects of employment as would warrant a finding that the business “meaningfully affects matters relating to the employment relationship” with those employees.

The rule defines “substantial” direct control as actions that have “a regular or continuous consequential effect on an essential term or condition of employment.” And it explicitly notes that any direct control that is “sporadic, isolated or de minimis” will not be enough to warrant a finding of joint employment. The rule makes clear that joint-employer status must be determined on the totality of the relevant facts in each particular employment setting.

Further, the rule provides that evidence of indirect or contractually reserved control over essential employment terms—which could have led to a joint employer finding under the Browning-Ferris test—can be considered as part of the Board’s joint employer analysis only to the extent it supports evidence of direct and immediate control. In other words, this evidence cannot, by itself, give rise to joint employer status without substantial direct control. Evidence of control over mandatory subjects of bargaining other than essential terms and conditions may also be considered but is not dispositive. Additionally, the rule provides that routine elements of an arms-length contract, such as permitting another employer to participate in its benefit plans or requiring compliance with certain regulations or codes, are not probative of joint-employer status.

What does this mean for employers covered by the NLRA?

The legal standard used by the NLRB has significant implications for businesses that rely on franchisees and subcontracted workers. The NLRB’s final and more narrow rule restricts the circumstances in which businesses that use employees hired by third parties will be considered joint employers, and therefore reduces the risk of litigation for unfair labor practices, and reduces many companies’ obligations to bargain with franchisee or subcontracted workers. For instance, if a company is found to be a joint employer, it must participate in collective bargaining with employees and the unions that represent them over their terms and conditions of employment. Additionally, picketing directed at a joint employer that would otherwise be secondary and unlawful is primary and lawful. Further, companies found to be joint employers may be held jointly and severally liable for unfair labor practices committed by the other employer.

The NLRB’s final rule follows closely behind the DOL’s final rule for determining joint-employer status under the FLSA—issued on January 12, 2020. The NLRB’s rule is consistent with the DOL’s rule, which also looks to an employer’s actual control over workers. In making the factual determination of actual control, the DOL’s rule considers the employer’s hiring or firing, supervision and control of schedule and conditions of employment, determination of employee’s rate and method of payment, and maintenance of the employee’s employment records. Both rules require that the employer actually exercise control over terms and conditions of the employee’s work, and make clear that mere contractual right of control alone is insufficient to establish joint-employer status. These new rules reduce the risk of joint employer liability and recognize the practical realities of many tiered business relationships.

Gibson Dunn lawyers regularly counsel clients on the complex question of employment status and frequently litigate these issues across the country. Please contact the Gibson Dunn attorney with whom you work in the Labor and Employment Group, or the following authors or practice group leaders:

Catherine A. Conway – Co-Chair, Los Angeles (+1 213-229-7822, [email protected])
Jason C. Schwartz – Co-Chair, Washington, D.C. (+1 202-955-8242, [email protected])
Greta B. Williams – Washington, D.C. (+1 202-887-3745, [email protected])
Brittany A. Raia – Washington, D.C. (+1 202-887-3773, [email protected])
Kelley Pettus – Washington, D.C. (+1 202-887-3579, [email protected])

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

On February 19, 2020, the European Commission (“EC”) presented its long-awaited proposal for comprehensive regulation of artificial intelligence (“AI”) at European Union (“EU”) level: the “White Paper on Artificial Intelligence – A European approach to excellence and trust” (“White Paper”).[1] In an op-ed published on the same day, the president of the EC, Ursula von der Leyen, wrote that the EC would not leave digital transformation to chance and that the EU’s new digital strategy could be summed up with the phrase “tech sovereignty.”[2]

As anticipated in our 2019 Artificial Intelligence and Automated Systems Annual Legal Review, the White Paper favors a risk-based approach with sector and application-specific risk assessments and requirements, rather than blanket sectoral requirements or bans. Together with the White Paper, the EC released a series of accompanying documents, including a “European strategy for data” (“Data Strategy”)[3] and a “Report on the safety and liability implications of Artificial Intelligence, the Internet of Things and robotics” (“Report on Safety and Liability”).[4] The documents outline a general strategy, discuss objectives of a potential regulatory framework and address many potential risks and concerns related to the use of AI and data. The White Paper is thus the first step to start the legislative process, which was announced by EC president Ursula von der Leyen at the beginning of her presidency.[5] Currently, it is expected that the draft legislation, which is part of a bigger effort to increase public and private investment in AI to more than €20 billion per year over the next decade,[6] will become available by the end of 2020.

We discuss the key contents of the White Paper, the Data Strategy and the Report on Safety and Liability below, focusing on those topics that would have the most significant impact on technology companies active in the EU, if they were enacted in future legislation.

I. WHITE PAPER ON ARTIFICIAL INTELLIGENCE

The White Paper is the centerpiece of a package of measures to address the challenges of AI. It sets out different policy options with the “twin objective of promoting the uptake of AI and of addressing the risks associated with certain uses of this new technology.” The White Paper, which is a document used by the EC to launch a debate with the public, stakeholders, the European Parliament and the Council in order to reach a political consensus, is structured into two parts: (1) The first part sets out more political and technical aspects to promote a partnership between the private and the public sector in order to form an “ecosystem of excellence” and (2) the second part proposes key elements of a future regulatory framework for AI to create an “ecosystem of trust”.

While the first part of the White Paper mostly contains general policy proposals intended to boost AI development, research and investment in the EU, the second part outlines the main features of a possible regulatory framework for AI. In the EC’s view, lack of public trust is one of the biggest obstacles to a broader proliferation of AI throughout the EU. Thus, as we have discussed previously,[7] similar to the General Data Protection Regulation (“GDPR”), the EC intends for the EU to maintain its “first out of the gate” status and increase public trust by attempting to regulate the inherent risks of AI. The main risks identified by the EC concern fundamental rights (including data privacy and non-discrimination) as well as safety and liability issues. Apart from possible adjustments to existing legislation, the EC concludes that a new regulation specifically on AI is necessary to address these risks.

According to the White Paper, the key issue for any future legislation would be to determine the scope of its application. The assumption is that any legislation would apply to products and services relying on AI. Furthermore, the EC identifies “data” and “algorithms” as the main elements that compose AI, but also stresses that the definition of AI needs to be sufficiently flexible to provide legal certainty while also allowing for the legislation to keep up with technical progress.

In terms of substantive regulation, the EC favors a context-specific risk-based approach instead of a GDPR “one size fits all” approach. An AI product or service will be considered “high-risk” when two cumulative criteria are fulfilled:

(1) Critical Sector: The AI product or service is employed in a sector where significant risks can be expected to occur. Those sectors should be specifically and exhaustively listed in the legislation; for instance, healthcare, transport, energy and parts of the public sector, such as the police and the legal system.

(2) Critical Use: The AI product or service is used in such a manner that significant risks are likely to arise. The assessment of the level of risk of a given use can be based on the impact on the affected parties; for instance, where the use of AI produces legal effects, leads to a risk of injury, death or significant material or immaterial damage.

If an AI product or service fulfils both criteria, it will be subject to the mandatory requirements of the new AI legislation. However, additionally, the use of AI based applications for certain purposes should always be considered high-risk when they fundamentally impact individual rights. This could include the use of AI for recruitment processes or for remote biometric identification (such as facial recognition). Moreover, even if an AI product or service is not considered “high-risk”, it will remain subject to existing EU-rules such as the GDPR.[8] Notably, the EC expressly takes the view that the GDPR already regulates all issues related to personal data.

Taking into account the “Ethics Guidelines for Trustworthy Artificial Intelligence” of the High Level Expert Group on Artificial Intelligence,[9] the EC sets out six key requirements, which could be included in the upcoming AI legislation:

1. Training Data

The EC proposes several requirements related to training data, such as a requirement to train AI systems on data sets that are sufficiently broad and representative, as well as a requirement to ensure that privacy and personal data are adequately protected during the use of AI-enabled products and services. Further, the adequate protection of personal data during the use of AI products and services should be ensured.

2. Data and Record-keeping

In light of the complexity and opacity of many AI systems, the EC recommends that the regulatory framework prescribe the keeping of accurate records regarding the data set used to train and test the AI systems (including a description of the main characteristics and how the data set was selected), the retention of the data sets themselves and the documentation on the programming and training methodologies, processes and techniques used to build, test and validate the AI systems. The records, data sets and documentation would have to be retained during a limited, reasonable time period to enable effective enforcement and regress of potential victims. Where necessary, arrangements should be made to ensure that confidential information, such as trade secrets, is protected.

3. Information Provision

In the EC’s view, transparency requirements, such as ensuring clear information regarding the AI system’s capabilities and limitations and informing individuals when they are interacting with an AI system and not a human being, could also be considered. However, no such information would need to be provided in situations where it is immediately obvious to the user that they are interacting with AI systems.

4. Robustness and Accuracy

To minimize the risk of harm, the EC suggests that the regulatory framework should require that AI systems are robust and accurate, that their outcomes are reproducible, that they can adequately deal with errors or inconsistencies throughout all life cycle phases, and that they are resilient against both overt and more hidden attacks.

5. Human Oversight

The EC recognizes that the appropriate degree of human oversight to ensure that AI systems do not undermined human autonomy or cause other adverse effects may vary from case to case. For example, the rejection of an application for social security benefits may be decided upon by an AI system, but should become effective only subject to human review and validation; conversely, the rejection of an application for a credit card may be taken by an AI system with the possibility of subsequent human review. Additionally, operational blocks could be built into the AI system in the design phase, for instance an automatic stop for a driverless car when the conditions do not permit the safe operation of the car.

6. Specific Requirements for Remote Biometric Identification

As we have discussed recently,[10] the EC considered a five-year ban on the use of facial recognition technology in public spaces. Instead, without providing any clear time frame, the EC now intends to launch a broad public debate on the specific circumstances which might justify the use of remote biometric identification and on possible safeguards to be employed.

The White Paper also addresses personal and geographic scope of the future AI legislation. Since many actors may be involved in the lifecycle of an AI system (developers, producers, distributers, end-users, etc.), it is proposed that obligations under the future legislation should be distributed among the different actors based on who would be best placed to address the respective risks. Regarding geographic scope, the EC emphasizes that the objectives of the legislative may only be achieved if the requirements set out in the future legislation apply to all companies providing AI based products or services in the EU, regardless of their actual location.

In terms of compliance and enforcement, the EC favors a mandatory prior conformity assessment for all providers of high-risk AI applications to verify compliance with the above mentioned criteria. This could include checks of the algorithms and of data sets used during the development phase. The ex post enforcement of the new requirements as well as the ex ante conformity assessment could be entrusted to existing governance bodies in the individual EU Member States and an overarching European governance structure.

Finally, the White Paper proposes the introduction of a voluntary labelling scheme for non “high-risk” AI applications, where interested parties would be awarded with a quality label for their AI products and services.

II. DATA STRATEGY

The Data Strategy presents policy measures aiming to foster a European “data economy” within the next five years. As already evident by the EC’s focus on Big Tech firms in the area of antitrust, the EC continues this trend by trying to break the dominance of US and Chinese tech firms with new proposals including the option to introduce a compulsory “data access” right for competitors.[11] In a statement during the presentation of the Data Strategy, the European Commissioner for the Internal Market, Thierry Breton, said that the EU had missed the battle for personal data, but the “battle for industrial data starts now.”[12]

To achieve this aim, the Data Strategy recommends to create a single European data space[13] and identifies several issues, such as the fragmentation of legal frameworks between EU Member States, the availability of quality data, and imbalances in market power and data infrastructures that are currently impeding the EU’s ability to take a leading role in the global data economy. To overcome these challenges, the EC lists a number of proposals which focus on creating a legal framework, building the necessary infrastructure and honing in on the vast potential of non-personal “industrial data.” This also includes the possibility for non-European companies to access and use EU data, provided they comply with the applicable laws and standards.

Specifically, the EC’s Data Strategy is based on four pillars, which include concrete proposals for regulatory action:

1. Introduction of a cross-sectoral legislative framework for data access and use

According to the EC, a legislative framework for the governance of common European data spaces will be put into place in Q4 2020. This framework could include standardization mechanisms and harmonized description of datasets to improve both data accessibility and interoperability between sectors in line with so-called “FAIR principles”, namely Findability, Accessibility, Interoperability and Reusability. Further, the EC intends to move forward with the adoption of an implementing act on high-value data sets under the Open Data Directive[14] in Q1 2021 in order to make available key public sector reference data in machine-readable format. Finally the EC is contemplating a new “Data Act” to be introduced in 2021 which would provide incentives for horizontal data sharing across sectors and could include a “data access” right for competitors, as described above. Further regulatory action includes an update of the Horizontal Co-operation Guidelines[15] to provide more guidance to companies on the compliance of data sharing and pooling arrangements with EU competition law, a review of jurisdictional issues related to data and – possibly – the explicit regulation of the online platforms economy which is currently being analyzed by the EC’s “Observatory on the Online Platform Economy.”[16]

2. Investments in data and infrastructures for hosting, processing and using data and interoperability

In order to create an environment in which data-driven innovation is fostered, the EC plans to invest in a project on European data spaces and federated cloud infrastructures. Drawing upon public and private sources, the EC hopes to gather funding in the amount of €4 to 6 billion, of which the EC wants to contribute €2 billion. In March 2020 the EC will present a wider set of strategic investments in new technologies, such edge computing, quantum computing, cyber-security and 6G networks, as part of its industrial strategy. Additionally, the EC promises to bring together a coherent framework around the different applicable rules for cloud services, in the form of a cloud rulebook by Q2 2022 and to introduce a cloud services marketplace for EU users by Q4 2022.

3. Strengthening the digital rights of individuals

Through this initiative the EC is considering the development of “personal data spaces” for individuals. According to the EC, individuals should be in control of their data at “a granular level”, to be achieved by enhancing the data portability right under the GDPR, introducing stricter requirements on interfaces for real-time data access and creating a universally usable digital identity. These issues will be explored in the context of the Data Act that could be introduced in 2021.

4. Development of common European data spaces in strategic sectors

Finally, the EC envisions the development of nine common European data spaces across strategic sectors, including the industrial/manufacturing, transport/logistics, healthcare, financial services, energy and agricultural sectors. The idea is to create large pools of industrial data, combined with the necessary infrastructure, to use and exchange data as well as appropriate governance mechanisms. Although these data spaces mainly concern industrial data, the EC emphasizes that they will be developed in full compliance with data protection rules and the highest available cyber-security standards.

III. REPORT ON SAFETY AND LIABILITY

The EC’s Report on Safety and Liability, which also accompanies the White Paper, analyses the EU’s current product safety and liability legislation.[17] It determines that the existing EU horizontal and sector-specific legislative framework is robust and reliable, since the current definition of product safety already includes an extended concept of safety, and that liability issues are generally covered by the liability concept already in place. However, the EC also identifies certain gaps with respect to the legal management of specific risks posed by AI systems and other digital technologies that should be covered in future product safety and product liability legislation.

In light of the recommendations contained in the Report on Safety and Liability, future product safety legislation may cover, inter alia, the following aspects:

Connectivity and cyber vulnerabilities: Product connectivity, interconnectivity and interaction of products with other devices may compromise the safety of the product directly and indirectly (e.g., when a product is hacked). Thus, the EC recommends the adoption of explicit provisions such as an explicit assessment of the risks which stem from interconnectivity in order to provide better protection of users and more legal certainty.
Autonomy: Unintended outcomes based on the use of AI could cause harm to users and exposed persons. In order to improve the safety of users, the EC takes inspiration from sector-specific laws to recommend the adoption of horizontal legislation that obliges the appropriate economic operator (i.e. the manufacturer, the distributor or the software producer) to carry out new risk assessment procedures during the products’ lifetime. Furthermore, the EC suggests the adoption of specific requirements to ensure human oversight of AI products and systems, starting from their design throughout their lifecycle.
Mental health risks: The EC anticipates that the behavior of AI applications may generate mental health risks and harm, which should be explicitly covered by the definition of product safety in future legal frameworks. In particular, legislation in this field should cover vulnerable users, such as elderly persons in care environments.
Data dependency: Risks to safety may result from a product’s faulty collection or processing of data, including a lack of accuracy or relevance. Against this backdrop, the EC recommends that EU product safety legislation should address the risks of faulty data at the product design stage as well as throughout the entire lifecycle.
Opacity: With regard to the “black-box effect” in the decision-making processes of AI systems, the EC has identified a possible new challenge for product safety ex-post enforcement mechanisms that is not covered by existing legislation. The EC therefore suggests considering transparency requirements for algorithms, as well as requirements for robustness, accountability and human oversight of decision-making. This could include imposing obligations on developers of algorithms to disclose design parameters and metadata of datasets in case accidents occur.
Software: While EU product safety legislation may cover risks stemming from software integrated into a product or device, the EC proposes to adapt and clarify existing rules in the case of stand-alone software placed on the market as it is or downloaded into a product after its placement on the market (e.g. an app that is downloaded on a mobile device). In particular, this would concern stand-alone software that has an impact on the safety of an AI product or system.
Complex value chains: EU product safety legislation imposes obligations on several economic operators following the principle of “shared responsibility”. However, the EC suggests that provisions specifically requesting cooperation between economic operators in the supply chain and users should be adopted. For example, each actor in the value chain who has an impact on the product’s safety, from software producers to repairers modifying the product, should assume responsibility and provide the next actor in the chain with the necessary information and measures.

In light of the recommendations contained in the Report on Safety and Liability, future product liability legislation may cover, inter alia, the following aspects:

Complexity of products, services, and the value chain: The EC considers the definition of “product” in the current Product Liability Directive to be sufficiently broad to cover AI products and systems. However, in the view of the EC, the scope of the Product Liability Directive should be clarified to reflect the complexity of such products and systems and to ensure that compensation is always available for damage caused by products that are defective because of software or other digital features.
Burden of proof in complex environments: The current liability regime in the EU relies on the parallel application of the Product Liability Directive, which features a system of strict liability, and fault-based and/or strict liability rules of the individual EU Member States. In order to mitigate the consequences of complexity, the EC is seeking industry feedback whether and to what extent it may be necessary to alleviate or reverse the burden of proof required by the individual EU Member State’s liability rules for damage caused by the operation of AI applications. For instance, a reversal as regards fault and causation could apply where the relevant economic operator failed to meet specific mandatory cyber-security or other safety rules.
Connectivity and openness: Connectivity and openness characteristics of AI products may influence the safety expectations with regard to damage that results from cyber-security breaches. Furthermore, connected products may also be used for purposes beyond those reasonably expected by the manufacturer. Therefore, the EC considers legislation in order to clarify and facilitate compensation for damages caused to users, particularly in situations concerning foreseeable reasonable use and contributory negligence (e.g., the failure of the injured party to download a safety update).
Autonomy and opacity: In addition to issues such as complexity, the fact that AI applications can improve their performance by learning from experience creates a challenge to the effective enforcement of liability claims. The EC notes that a guiding principle for EU product safety and product liability remains the obligation of producers to ensure that all products put on the market are safe throughout their entire lifecycle and for the use that can reasonably be expected. In order to address the remaining uncertainties regarding the liability of manufacturers the EC proposes revisiting the notion of ‘putting into circulation’ that is currently used by the Product Liability Directive to cover products that have been changed or altered, and to clarify who is liable for any changes that are made to the product.
High-risk applications: The EC is seeking views on whether and to what extent strict liability, as it exists in some national laws of individual EU Member States, may be necessary in order for possible victims of high-risk AI devices and services (i.e. where there is a possibility of significant harm to important legal interests, like life, health and property) to achieve effective compensation. Further, the EC is also seeking views on whether strict liability should be coupled with an obligation of the relevant economic operator to have in place available insurance. For the operation of non high-risk AI devices and services, the EC suggests that changes to the burden of proof might be required as well, since the victim may not be able to obtain the relevant data required to assess liability from the potentially liable party.

CONCLUSION

While there is no specific draft legislation yet, we expect that the EC will deliver concrete proposals later this year after the public consultation phase has ended. Companies active in the field of AI should closely follow the latest developments in the EU given the proposed geographic reach of the future AI legislation, which is likely to affect all companies doing business in the EU. With the presentation of the White Paper, the Data Strategy and the Report on Safety and Liability, EC President Ursula von der Leyen and her new commission have made it clear that they have ambitious plans for Europe’s digital transformation. Certainly we will see a lot of legislative activity in Europe aimed at challenging the US and Chinese dominance in the digital realm, not only with regard to AI. After all, the EC is striving “to export its values across the world”[18] and “actively promote its standards.”[19]

As the EC has launched a public consultation period and requested comments on the proposals set out in the White Paper and the Data Strategy, this is an important opportunity for companies and other stakeholders to provide feedback and shape the future EU regulatory landscape for AI. If you are interested in submitting comments, you may do so at https://ec.europa.eu/info/consultations_en until May 19, 2020.

We have been advising clients on regulatory and governance issues in anticipation of such legislative actions in the EU, and we invite anyone interested to reach out to us to discuss these developments.

___________________

[1] EC, White Paper on Artificial Intelligence – A European approach to excellence and trust, COM(2020) 65 (Feb. 19, 2020), available at https://ec.europa.eu/info/sites/info/files/commission-white-paper-artificial-intelligence-feb2020_en.pdf.

[2] EC, Shaping Europe’s digital future: op-ed by Ursula von der Leyen, President of the European Commission, AC/20/260, available at https://ec.europa.eu/commission/presscorner/detail/en/AC_20_260.

[3] EC, A European strategy for data, COM(2020) 66 (Feb. 19, 2020), available at https://ec.europa.eu/info/files/communication-european-strategy-data_en.

[4] EC, Report on the safety and liability implications of Artificial Intelligence, the Internet of Things and robotics, COM(2020) 64 (Feb. 19, 2020), available at https://ec.europa.eu/info/files/commission-report-safety-and-liability-implications-ai-internet-things-and-robotics_en.

[5] Ursula von der Leyen, A Union that strives for more: My agenda for Europe, available at https://ec.europa.eu/commission/sites/beta-political/files/political-guidelines-next-commission_en.pdf.

[6] EC, Artificial Intelligence for Europe, COM(2018) 237 (Apr. 25, 2018), available at https://ec.europa.eu/digital-single-market/en/news/communication-artificial-intelligence-europe.

[7] H. Mark Lyon, Gearing Up For The EU’s Next Regulatory Push: AI, LA & SF Daily Journal (Oct. 11, 2019), available at https://www.gibsondunn.com/wp-content/uploads/2019/10/Lyon-Gearing-up-for-the-EUs-next-regulatory-push-AI-Daily-Journal-10-11-2019.pdf.

[8] The exact implications and requirements of the GDPR on AI based products and services are still not entirely clear, see further, Ahmed Baladi, Can GDPR hinder AI made in Europe?, Cybersecurity Law Report (July 10, 2019), available at https://www.gibsondunn.com/can-gdpr-hinder-ai-made-in-europe/.

[9] For further detail, see our 2019 Artificial Intelligence and Automated Systems Annual Legal Review.

[10] See our 2019 Artificial Intelligence and Automated Systems Annual Legal Review.

[11] While the exact prerequisites are not yet clear, the EC notes that a data access right should only be made compulsory where specific circumstances require it (i.e. where a market failure in a specific sector is identified or can be foreseen and cannot be resolved by competition law) and where it is appropriate under fair, transparent, reasonable, proportionate and/or non-discriminatory conditions.

[12] Samuel Stolton and Vlagyiszlav Makszimov, Von der Leyen opens the doors for an EU data revolution, Euractiv (Feb. 20, 2020), available at https://www.euractiv.com/section/digital/news/von-der-leyen-opens-the-doors-for-an-eu-data-revolution/.

[13] This is defined in the Data Strategy as “a genuine single market for data, open to data from across the world”.

[14] Directive (EU) 2019/1024 of the European Parliament and of the Council of June 20, 2019, OJ L 172, p. 56-83.

[15] European Commission, Guidelines on the applicability of Article 101 of the Treaty on the Functioning of the European Union to horizontal co-operation agreements, 2011/C 11/01, OJ C 11, p. 1-72.

[16] See https://ec.europa.eu/digital-single-market/en/eu-observatory-online-platform-economy.

[17] The current framework consists of, inter alia: the General Product Safety Directive (Directive 2001/95/EC of the European Parliament and of the Council of Dec. 3, 2001, OJ L 11, 15.1.2002, p. 4-17); specific horizontal and sectorial rules, such as the Market Surveillance Regulation (Regulation (EC) No. 765/2008 of the European Parliament and of the Council of July 9, 2008, OJ L 218, 13.8.2008, p. 30-47, and the Machinery Directive (Directive 2006/42/EC of the European Parliament and of the Council of May 17, 2006, OJ L 157, p. 24-86); and the Product Liability Directive (Directive 85/374/EEC of July 25, 1985).

[18] Supra note 1, EC, White Paper on Artificial Intelligence – A European approach to excellence and trust, p. 9.

[19] Supra note 3, EC, A European strategy for data, p. 24.

The following Gibson Dunn lawyers prepared this client update: H. Mark Lyon, Michael Walther, Alejandro Guerrero, Selina Grün and Frances Waldmann.

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 Artificial Intelligence and Automated Systems Group:

Artificial Intelligence and Automated Systems Group:
H. Mark Lyon – Chair, Palo Alto (+1 650-849-5307, [email protected])
Michael Walther – Munich (+49 89 189 33 180, [email protected])
Alejandro Guerrero – Brussels (+32 2 554 7218, [email protected])
Selina X. Grün – Munich (+49 89 189 33-180, [email protected])
Frances A. Waldmann – Los Angeles (+1 213-229-7914,[email protected])
J. Alan Bannister – New York (+1 212-351-2310, [email protected])
Ari Lanin – Los Angeles (+1 310-552-8581, [email protected])
Robson Lee – Singapore (+65 6507 3684, [email protected])
Carrie M. LeRoy – Palo Alto (+1 650-849-5337, [email protected])
Alexander H. Southwell – New York (+1 212-351-3981, [email protected])
Eric D. Vandevelde – Los Angeles (+1 213-229-7186, [email protected])

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