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October 17, 2018 |
SEC Warns Public Companies on Cyber-Fraud Controls

Click for PDF On October 16, 2018, the Securities and Exchange Commission issued a report warning public companies about the importance of internal controls to prevent cyber fraud.  The report described the SEC Division of Enforcement’s investigation of multiple public companies which had collectively lost nearly $100 million in a range of cyber-scams typically involving phony emails requesting payments to vendors or corporate executives.[1] Although these types of cyber-crimes are common, the Enforcement Division notably investigated whether the failure of the companies’ internal accounting controls to prevent unauthorized payments violated the federal securities laws.  The SEC ultimately declined to pursue enforcement actions, but nonetheless issued a report cautioning public companies about the importance of devising and maintaining a system of internal accounting controls sufficient to protect company assets. While the SEC has previously addressed the need for public companies to promptly disclose cybersecurity incidents, the new report sees the agency wading into corporate controls designed to mitigate such risks.  The report encourages companies to calibrate existing internal controls, and related personnel training, to ensure they are responsive to emerging cyber threats.  The report (issued to coincide with National Cybersecurity Awareness Month) clearly intends to warn public companies that future investigations may result in enforcement action. The Report of Investigation Section 21(a) of the Securities Exchange Act of 1934 empowers the SEC to issue a public Report of Investigation where deemed appropriate.  While SEC investigations are confidential unless and until the SEC files an enforcement action alleging that an individual or entity has violated the federal securities laws, Section 21(a) reports provide a vehicle to publicize investigative findings even where no enforcement action is pursued.  Such reports are used sparingly, perhaps every few years, typically to address emerging issues where the interpretation of the federal securities laws may be uncertain.  (For instance, recent Section 21(a) reports have addressed the treatment of digital tokens as securities and the use of social media to disseminate material corporate information.) The October 16 report details the Enforcement Division’s investigations into the internal accounting controls of nine issuers, across multiple industries, that were victims of cyber-scams. The Division identified two specific types of cyber-fraud – typically referred to as business email compromises or “BECs” – that had been perpetrated.  The first involved emails from persons claiming to be unaffiliated corporate executives, typically sent to finance personnel directing them to wire large sums of money to a foreign bank account for time-sensitive deals. These were often unsophisticated operations, textbook fakes that included urgent, secret requests, unusual foreign transactions, and spelling and grammatical errors. The second type of business email compromises were harder to detect. Perpetrators hacked real vendors’ accounts and sent invoices and requests for payments that appeared to be for otherwise legitimate transactions. As a result, issuers made payments on outstanding invoices to foreign accounts controlled by impersonators rather than their real vendors, often learning of the scam only when the legitimate vendor inquired into delinquent bills. According to the SEC, both types of frauds often succeeded, at least in part, because responsible personnel failed to understand their company’s existing cybersecurity controls or to appropriately question the veracity of the emails.  The SEC explained that the frauds themselves were not sophisticated in design or in their use of technology; rather, they relied on “weaknesses in policies and procedures and human vulnerabilities that rendered the control environment ineffective.” SEC Cyber-Fraud Guidance Cybersecurity has been a high priority for the SEC dating back several years. The SEC has pursued a number of enforcement actions against registered securities firms arising out of data breaches or deficient controls.  For example, just last month the SEC brought a settled action against a broker-dealer/investment-adviser which suffered a cyber-intrusion that had allegedly compromised the personal information of thousands of customers.  The SEC alleged that the firm had failed to comply with securities regulations governing the safeguarding of customer information, including the Identity Theft Red Flags Rule.[2] The SEC has been less aggressive in pursuing cybersecurity-related actions against public companies.  However, earlier this year, the SEC brought its first enforcement action against a public company for alleged delays in its disclosure of a large-scale data breach.[3] But such enforcement actions put the SEC in the difficult position of weighing charges against companies which are themselves victims of a crime.  The SEC has thus tried to be measured in its approach to such actions, turning to speeches and public guidance rather than a large number of enforcement actions.  (Indeed, the SEC has had to make the embarrassing disclosure that its own EDGAR online filing system had been hacked and sensitive information compromised.[4]) Hence, in February 2018, the SEC issued interpretive guidance for public companies regarding the disclosure of cybersecurity risks and incidents.[5]  Among other things, the guidance counseled the timely public disclosure of material data breaches, recognizing that such disclosures need not compromise the company’s cybersecurity efforts.  The guidance further discussed the need to maintain effective disclosure controls and procedures.  However, the February guidance did not address specific controls to prevent cyber incidents in the first place. The new Report of Investigation takes the additional step of addressing not just corporate disclosures of cyber incidents, but the procedures companies are expected to maintain in order to prevent these breaches from occurring.  The SEC noted that the internal controls provisions of the federal securities laws are not new, and based its report largely on the controls set forth in Section 13(b)(2)(B) of the Exchange Act.  But the SEC emphasized that such controls must be “attuned to this kind of cyber-related fraud, as well as the critical role training plays in implementing controls that serve their purpose and protect assets in compliance with the federal securities laws.”  The report noted that the issuers under investigation had procedures in place to authorize and process payment requests, yet were still victimized, at least in part “because the responsible personnel did not sufficiently understand the company’s existing controls or did not recognize indications in the emailed instructions that those communications lacked reliability.” The SEC concluded that public companies’ “internal accounting controls may need to be reassessed in light of emerging risks, including risks arising from cyber-related frauds” and “must calibrate their internal accounting controls to the current risk environment.” Unfortunately, the vagueness of such guidance leaves the burden on companies to determine how best to address emerging risks.  Whether a company’s controls are adequate may be judged in hindsight by the Enforcement Division; not surprisingly, companies and individuals under investigation often find the staff asserting that, if the controls did not prevent the misconduct, they were by definition inadequate.  Here, the SEC took a cautious approach in issuing a Section 21(a) report highlighting the risk rather than publicly identifying and penalizing the companies which had already been victimized by these scams. However, companies and their advisors should assume that, with this warning shot across the bow, the next investigation of a similar incident may result in more serious action.  Persons responsible for designing and maintaining the company’s internal controls should consider whether improvements (such as enhanced trainings) are warranted; having now spoken on the issue, the Enforcement Division is likely to view corporate inaction as a factor in how it assesses the company’s liability for future data breaches and cyber-frauds.    [1]   SEC Press Release (Oct. 16, 2018), available at www.sec.gov/news/press-release/2018-236; the underlying report may be found at www.sec.gov/litigation/investreport/34-84429.pdf.    [2]   SEC Press Release (Sept. 16, 2018), available at www.sec.gov/news/press-release/2018-213.  This enforcement action was particularly notable as the first occasion the SEC relied upon the rules requiring financial advisory firms to maintain a robust program for preventing identify theft, thus emphasizing the significance of those rules.    [3]   SEC Press Release (Apr. 24, 2018), available at www.sec.gov/news/press-release/2018-71.    [4]   SEC Press Release (Oct. 2, 2017), available at www.sec.gov/news/press-release/2017-186.    [5]   SEC Press Release (Feb. 21, 2018), available at www.sec.gov/news/press-release/2018-22; the guidance itself can be found at www.sec.gov/rules/interp/2018/33-10459.pdf.  The SEC provided in-depth guidance in this release on disclosure processes and considerations related to cybersecurity risks and incidents, and complements some of the points highlighted in the Section 21A report. Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Securities Enforcement or Privacy, Cybersecurity and Consumer Protection practice groups, or the following authors: Marc J. Fagel – San Francisco (+1 415-393-8332, mfagel@gibsondunn.com) Alexander H. Southwell – New York (+1 212-351-3981, asouthwell@gibsondunn.com) Please also feel free to contact the following practice leaders and members: Securities Enforcement Group: New York Barry R. Goldsmith – Co-Chair (+1 212-351-2440, bgoldsmith@gibsondunn.com) Mark K. Schonfeld – Co-Chair (+1 212-351-2433, mschonfeld@gibsondunn.com) Reed Brodsky (+1 212-351-5334, rbrodsky@gibsondunn.com) Joel M. Cohen (+1 212-351-2664, jcohen@gibsondunn.com) Lee G. Dunst (+1 212-351-3824, ldunst@gibsondunn.com) Laura Kathryn O’Boyle (+1 212-351-2304, loboyle@gibsondunn.com) Alexander H. Southwell (+1 212-351-3981, asouthwell@gibsondunn.com) Avi Weitzman (+1 212-351-2465, aweitzman@gibsondunn.com) Lawrence J. Zweifach (+1 212-351-2625, lzweifach@gibsondunn.com) Washington, D.C. Richard W. Grime – Co-Chair (+1 202-955-8219, rgrime@gibsondunn.com) Stephanie L. Brooker  (+1 202-887-3502, sbrooker@gibsondunn.com) Daniel P. Chung (+1 202-887-3729, dchung@gibsondunn.com) Stuart F. Delery (+1 202-887-3650, sdelery@gibsondunn.com) Patrick F. Stokes (+1 202-955-8504, pstokes@gibsondunn.com) F. Joseph Warin (+1 202-887-3609, fwarin@gibsondunn.com) San Francisco Marc J. Fagel – Co-Chair (+1 415-393-8332, mfagel@gibsondunn.com) Winston Y. Chan (+1 415-393-8362, wchan@gibsondunn.com) Thad A. Davis (+1 415-393-8251, tdavis@gibsondunn.com) Charles J. Stevens (+1 415-393-8391, cstevens@gibsondunn.com) Michael Li-Ming Wong (+1 415-393-8234, mwong@gibsondunn.com) Palo Alto Paul J. Collins (+1 650-849-5309, pcollins@gibsondunn.com) Benjamin B. Wagner (+1 650-849-5395, bwagner@gibsondunn.com) Denver Robert C. Blume (+1 303-298-5758, rblume@gibsondunn.com) Monica K. Loseman (+1 303-298-5784, mloseman@gibsondunn.com) Los Angeles Michael M. Farhang (+1 213-229-7005, mfarhang@gibsondunn.com) Douglas M. Fuchs (+1 213-229-7605, dfuchs@gibsondunn.com) Privacy, Cybersecurity and Consumer Protection Group: Alexander H. Southwell – Co-Chair, New York (+1 212-351-3981, asouthwell@gibsondunn.com) M. Sean Royall – Dallas (+1 214-698-3256, sroyall@gibsondunn.com) Debra Wong Yang – Los Angeles (+1 213-229-7472, dwongyang@gibsondunn.com) Christopher Chorba – Los Angeles (+1 213-229-7396, cchorba@gibsondunn.com) Richard H. Cunningham – Denver (+1 303-298-5752, rhcunningham@gibsondunn.com) Howard S. Hogan – Washington, D.C. (+1 202-887-3640, hhogan@gibsondunn.com) Joshua A. Jessen – Orange County/Palo Alto (+1 949-451-4114/+1 650-849-5375, jjessen@gibsondunn.com) Kristin A. Linsley – San Francisco (+1 415-393-8395, klinsley@gibsondunn.com) H. Mark Lyon – Palo Alto (+1 650-849-5307, mlyon@gibsondunn.com) Shaalu Mehra – Palo Alto (+1 650-849-5282, smehra@gibsondunn.com) Karl G. Nelson – Dallas (+1 214-698-3203, knelson@gibsondunn.com) Eric D. Vandevelde – Los Angeles (+1 213-229-7186, evandevelde@gibsondunn.com) Benjamin B. Wagner – Palo Alto (+1 650-849-5395, bwagner@gibsondunn.com) Michael Li-Ming Wong – San Francisco/Palo Alto (+1 415-393-8333/+1 650-849-5393, mwong@gibsondunn.com) Ryan T. Bergsieker – Denver (+1 303-298-5774, rbergsieker@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 15, 2018 |
Flood v. Synutra Refines “Ab Initio” Requirement for Business Judgment Review of Controller Transactions

Click for PDF On October 9, 2018, in Flood v. Synutra Intth’l, Inc.,[1] the Delaware Supreme Court further refined when in a controller transaction the procedural safeguards of Kahn v. M & F Worldwide Corp.[2] (“MFW“) must be implemented to obtain business judgment rule review of the transaction.  Under MFW, a merger with a controlling stockholder will be reviewed under the deferential business judgment rule standard, rather than the stringent entire fairness standard, if the merger is conditioned “ab initio” upon approval by both an independent, adequately-empowered Special Committee that fulfills its duty of care, and the uncoerced, informed vote of a majority of the minority stockholders.[3]  Writing for the majority in Synutra, Chief Justice Strine emphasized that the objective of MFW and its progeny is to incentivize controlling stockholders to adopt the MFW procedural safeguards early in the transaction process, because those safeguards can provide minority stockholders with the greatest likelihood of receiving terms and conditions that most closely resemble those that would be available in an arms’ length transaction with a non-affiliated third party.  Accordingly, the Court held that “ab initio” (Latin for “from the beginning”) requires that the MFW protections be in place prior to any substantive economic negotiations taking place with the target (or its board or Special Committee).  The Court declined to adopt a “bright line” rule that the MFW procedures had to be a condition of the controller’s “first offer” or other initial communication with the target about a potential transaction. Factual Background Synutra affirmed the Chancery Court’s dismissal of claims against Liang Zhang and related entities, who controlled 63.5% of Synutra’s stock.  In January 2016, Zhang wrote a letter to the Synutra board proposing to take the company private, but failed to include the MFW procedural prerequisites of Special Committee and majority of the minority approvals in the initial bid.  One week after Zhang’s first letter, the board formed a Special Committee to evaluate the proposal and, one week after that, Zhang submitted a revised bid letter that included the MFW protections.  The Special Committee declined to engage in any price negotiations until it had retained and received projections from its own investment bank, and such negotiations did not begin until seven months after Zhang’s second offer. Ab Initio Requirement The plaintiff argued that because Zhang’s initial letter did not contain the dual procedural safeguards of MFW as pre-conditions of any transaction, the “ab initio” requirement of MFW was not satisfied and therefore business judgment standard of review had been irreparably forfeited.  The Court declined to adopt this rigid position, and considered that “ab initio” for MFW purposes can be assessed more flexibly.  To arrive at this view, the Court explored the meaning of “the beginning” as used in ordinary language to denote an early period rather than a fixed point in time.  The Court also parsed potential ambiguities in the language of the Chancery Court’s MFW opinion, which provided that MFW pre-conditions must be in place “from the time of the controller’s first overture”[4] and “from inception.”[5] Ultimately, the Court looked to the purpose of the MFW protections to find that “ab initio” need not be read as referring to the single moment of a controller’s first offer.  As Synutra emphasizes, the key is that the controller not be able to trade adherence to MFW protections for a concession on price.  Hence the “ab initio” analysis focuses on whether deal economics remain untainted by controller coercion, so that the transaction can approximate an arms’ length transaction process with an unaffiliated third party.  As such, the Court’s reasoning is consistent with the standard espoused by the Chancery Court in its prior decision in Swomley v. Schlecht,[6] which the Court summarily affirmed in 2015, that MFW requires procedural protections be in place prior to the commencement of negotiations.[7] In a lengthy dissent, Justice Valihura opined that the “ab initio” requirement should be deemed satisfied only when MFW safeguards are included in the controller’s initial formal written proposal, and that the “negotiations” test undesirably introduces the potential for a fact-intensive inquiry that would complicate a pleadings-stage decision on what standard of review should be applied.  Chief Justice Strine acknowledged the potential appeal of a bright line test but ultimately rejected it because of the Court’s desire to provide strong incentive and opportunity for controllers to adopt and adhere to the MFW procedural safeguards, for the benefit of minority stockholders.  In doing so, the Court acknowledged that its approach “may give rise to close cases.”  However, the Court went on to add, “our Chancery Court is expert in the adjudication of corporate law cases.”  The Court also concluded that the facts in Synutra did not make it a close case.[8] Duty of Care The Court also upheld the Chancery Court’s dismissal of plaintiff’s claim that the Special Committee had breached its duty of care by failing to obtain a sufficient price.  Following the Chancery Court’s reasoning in Swomley, Synutra held that where the procedural safeguards of MFW have been observed, there is no duty of care breach at issue where a plaintiff alleges that a Special Committee could have negotiated differently or perhaps obtained a better price – what the Chancery Court in Swomley described as “a matter of strategy and tactics that’s debatable.”[9]  Instead, the Court confirmed that a duty of care violation would require a finding that the Special Committee had acted in a grossly negligent fashion.  Observing that the Synutra Special Committee had retained qualified and independent financial and legal advisors and engaged in a lengthy negotiation and deal process, the Court found nothing to support an inference of gross negligence and thus deferred to the Special Committee regarding deal price.[10] Procedural Posture Synutra dismissed the plaintiff’s complaint at the pleadings stage.  In its procedural posture, the Court followed Swomley, which allowed courts to resolve the MFW analysis based on the pleadings.  The dissent noted that adoption of a bright-line test would be more appropriate for pleadings-stage dismissals.  However, the Court established that it would be willing to engage some degree of fact-finding at the pleadings stage in order to allow cases to be dismissed at the earliest opportunity, even using the Court’s admittedly more flexible view of the application of MFW. Takeaways Synutra reaffirms the Court’s commitment to promoting implementation of MFW safeguards in controller transactions.  In particular: The Court will favor a pragmatic, flexible approach to “ab initio” determination, with the intent of determining whether the application of the MFW procedural safeguards have been used to affect or influence a transaction’s economics; Once a transaction has business judgment rule review, the Court will not inquire further as to sufficiency of price or terms absent egregious or reckless conduct by a Special Committee; and Since the goal is to incentivize the controller to follow MFW at a transaction’s earliest stages, complaints can be dismissed on the pleadings, thus avoiding far more costly and time consuming summary judgment motions. Although under Synutra a transaction may receive business judgment rule review despite unintentional or premature controller communications that do not reference the MFW procedural safeguards as inherent deal pre-conditions, deal professionals would be well advised not to push this flexibility too far.  Of course, there can be situations where a controller concludes that deal execution risks or burdens attendant to observance of the MFW safeguards are too great (or simply not feasible), and thus is willing to confront the close scrutiny of an entire fairness review if a deal is later challenged.  However, if a controller wants to ensure it will receive the benefit of business judgment rule review, the prudent course is to indicate, in any expression of interest, no matter how early or informal, that adherence to MFW procedural safeguards is a pre-condition to any transaction.  Synutra makes clear that the availability of business judgment review under MFW will be a facts and circumstances assessment, but we do not yet know what the outer limits of the Court’s flexibility will be, should it have to consider a more contentious set of facts in the future. [1]       Flood v. Synutra Int’l, Inc., No. 101, 2018 WL 4869248 (Del. Oct. 9, 2018). [2]      Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014). [3]      Id. at 644. [4]      In re MFW Shareholders Litigation, 67 A.3d 496, 503 (Del. Ch. 2013). [5]      Id. at 528. [6]      Swomley v. Schlecht, 2014 WL 4470947 (Del. Ch. 2014), aff’d 128 A.3d 992 (Del. 2015) (TABLE). [7]      The Court did not consider that certain matters that transpired between Zhang’s first and second offer letters, namely Synutra’s granting of a conflict waiver to allow its long-time counsel to represent Zhang (the Special Committee subsequently hired separate counsel), constituted substantive “negotiations” for this purpose since the waiver was not exchanged for any economic consideration. [8]      Synutra, 2018 WL 4869248, at *8. [9]      Id. at *11, citing Swomley, 2014 WL 4470947, at 21. [10]     In a footnote, the Court expressly overruled dicta in its MFW decision that the plaintiff cited to argue that a duty of care claim could be premised on the Special Committee’s obtaining of an allegedly insufficient price.  Id. at *10, Footnote 81. The following Gibson Dunn lawyers assisted in preparing this client update: Barbara Becker, Jeffrey Chapman, Stephen Glover, Mark Director, Eduardo Gallardo, Marina Szteinbok and Justice Flores. Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Mergers and Acquisitions practice group: Mergers and Acquisitions Group / Corporate Transactions: Barbara L. Becker – Co-Chair, New York (+1 212-351-4062, bbecker@gibsondunn.com) Jeffrey A. Chapman – Co-Chair, Dallas (+1 214-698-3120, jchapman@gibsondunn.com) Stephen I. Glover – Co-Chair, Washington, D.C. (+1 202-955-8593, siglover@gibsondunn.com) Dennis J. Friedman – New York (+1 212-351-3900, dfriedman@gibsondunn.com) Jonathan K. Layne – Los Angeles (+1 310-552-8641, jlayne@gibsondunn.com) Mark D. Director – Washington, D.C./New York (+1 202-955-8508/+1 212-351-5308, mdirector@gibsondunn.com) Eduardo Gallardo – New York (+1 212-351-3847, egallardo@gibsondunn.com) Saee Muzumdar – New York (+1 212-351-3966, smuzumdar@gibsondunn.com) Mergers and Acquisitions Group / Litigation: Meryl L. Young – Orange County (+1 949-451-4229, myoung@gibsondunn.com) Brian M. Lutz – San Francisco (+1 415-393-8379, blutz@gibsondunn.com) Aric H. Wu – New York (+1 212-351-3820, awu@gibsondunn.com) Paul J. Collins – Palo Alto (+1 650-849-5309, pcollins@gibsondunn.com) Michael M. Farhang – Los Angeles (+1 213-229-7005, mfarhang@gibsondunn.com) Joshua S. Lipshutz – Washington, D.C. (+1 202-955-8217, jlipshutz@gibsondunn.com) Adam H. Offenhartz – New York (+1 212-351-3808, aoffenhartz@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 11, 2018 |
Financing Arrangements and Documentation: Considerations Ahead of Brexit

Click for PDF Since the result of the Brexit referendum was announced in June 2016, there has been significant commentary regarding the potential effects of the UK’s withdrawal from the EU on the financial services industry. As long as the UK is negotiating its exit terms, a number of conceptual questions facing the sector still remain, such as market regulation and bank passporting. Many commentators have speculated from a ‘big picture’ perspective what the consequences will be if / when exit terms are agreed.  From a contractual perspective, the situation is nuanced. This article will consider certain areas within English law financing documentation which may or may not need to be addressed. Bank passporting The EU “passporting” regime has been the subject of much commentary since the result of the Brexit referendum.  In short, in some EU member states, lenders are required under domestic legislation to have licences to lend.  Many UK lenders have relied on EU passporting (currently provided for in MiFID II), which allows them to lend into EU member states simply by virtue of being regulated in the UK (and vice versa). The importance for the economy of the passporting regime is clear. Unless appropriate transitional arrangements are put in place to ensure that the underlying principle survives, however, there is a risk that following Brexit passporting could be lost.  Recent materials produced by the UK Government suggest that the loss of passporting may be postponed from March 2019 until the end of 2020, although financial institutions must still consider what will happen after 2020 if no replacement regime is agreed.  The UK Government has committed to legislate (if required) to put in place a temporary recognition regime to allow EU member states to continue their financial services in the UK for a limited time (assuming there is a “no deal” scenario and no agreed transition period). However, there has not to date been a commitment from the EU to agree to a mirror regime. Depending on the outcome of negotiations on passporting, financial institutions will need to consider the regulatory position in relation to the performance of their underlying financial service, whether that is: lending, issuance of letters of credit / guarantees, provision of bank accounts or other financial products, or performing agency / security agency roles. Financial institutions may need to look to transfer their participations to an appropriately licensed affiliate (if possible) or third party, change the branch through which it acts, resign from agency or account bank functions, and/or exit the underlying transaction using the illegality protections (although, determining what is “unlawful” for these purposes in terms of a lender being able to fund or maintain a loan will be a complex legal and factual analysis).  More generally, we expect these provisions to be the subject of increasing scrutiny, although there seems to be limited scope for lenders to move illegality provisions in their favour and away from an actual, objective illegality requirement, owing to long-standing commercial convention. From a documentary perspective, it will be necessary to analyse loan agreements individually to determine whether any provisions are invoked and/or breached, and/or any amendments are required.  For on-going structuring, it may be appropriate for facilities to be tranched – such tranches (to the extent the drawing requirements of international obligor group can be accurately determined ahead of time) being “ring-fenced”, with proportions of a facility made available to different members of the borrower group and to be participated in by different lenders – or otherwise structured in an alternative, inventive manner – for example, by “fronting” the facility with a single, adequately regulated lender with back-to-back lending mechanics (e.g. sub-participation) standing behind.  In the same way, we also expect that lenders will exert greater control – for example by requiring all lender consent in all instances – on the accession of additional members of the borrowing group to existing lending arrangements in an attempt to diversify the lending jurisdictions.  Derivatives If passporting rights are lost and transitional relief is not in place, this could have a significant impact on the derivatives markets.  Indeed, without specific transitional or equivalence agreements in place between the EU and the UK, market participants may not be able to use UK clearing houses to clear derivatives subject to mandatory clearing under EMIR.  Additionally, derivatives executed on UK exchanges could be viewed as “OTC derivatives” under EMIR and would therefore be counted towards the clearing thresholds under EMIR.  Further, derivatives lifecycle events (such as novations, amendments and portfolio compressions) could be viewed as regulated activities thereby raising questions about enforceability and additional regulatory restrictions and requirements. In addition to issues arising between EU and UK counterparties, equivalence agreements in the derivatives space between the EU and other jurisdictions, such as the United States, would not carry over to the UK.  Accordingly, the UK must put in place similar equivalence agreements with such jurisdictions or market participants trading with UK firms could be at a disadvantage compared to those trading with EU firms. As a result of the uncertainty around Brexit and the risk that passporting rights are likely to be lost, certain counterparties are considering whether to novate their outstanding derivatives with UK derivatives entities to EU derivatives entities ahead of the exit date.  Novating derivatives portfolios from a UK to an EU counterparty is a significant undertaking involving re-documentation, obtaining consents, reviewing existing documentation, identifying appropriate counterparties, etc. EU legislation and case law Loan agreements often contain references to EU legislation or case law and, therefore, it is necessary to consider whether amendments are required. One particular area to be considered within financing documentation is the inclusion of Article 55 Bail-In language[1].  In the last few years, Bail-In clauses have become common place in financing documentation, although they are only required for documents which are governed by the laws of a non-EEA country and where there is potential liability under that document for an EEA-incorporated credit institution or investment firm and their relevant affiliates, respectively.  Following withdrawal from the EU, the United Kingdom will (subject to any transitional or other agreed arrangements) cease to be a member of the EEA and therefore English law governed contracts containing in-scope liabilities of EU financial institutions may become subject to the requirements of Article 55.  Depending on the status of withdrawal negotiations as we head closer to March 2019, it may be appropriate as a precautionary measure to include Bail-In clauses ahead of time – however, this analysis is very fact specific, and will need to be carefully considered on a case-by-case basis. Governing law and jurisdiction Although EU law is now pervasive throughout the English legal system, English commercial contract law is, for the most part, untouched by EU law and therefore withdrawal from the EU is expected to have little or no impact.  Further, given that EU member states are required to give effect to the parties’ choice of law (regardless of whether that law is the law of an EU member state or another state)[2], the courts of EU member states will continue to give effect to English law in the same way they do currently.  Many loan agreements customarily include ‘one-way’ jurisdiction clauses which limit borrowers/obligors to bringing proceedings in the English courts (rather than having the flexibility to bring proceedings in any court of competent jurisdiction). This allows lenders to benefit from the perceived competency and commerciality of the English courts as regards disputes in the financial sector. Regardless of the outcome of the Brexit negotiations, such clauses  are likely to remain unchanged due to the experience of English judges in handling such disputes and the certainty of the common law system. It is possible that the UK’s withdrawal will impact the extent to which a judgement of the English courts will be enforceable in other EU member states.  Currently, an English judgement is enforceable in all other EU member states pursuant to EU legislation[3].  However, depending on the withdrawal terms agreed with the EU, the heart of this regulation may or may not be preserved. In other words, English judgements could be in the same position to that of, for example, judgements of the New York courts, where enforceability is dependent upon the underlying law of the relevant EU member state; or, an agreement could be reached for automatic recognition of English judgements across EU member states.  In the same vein, the UK’s withdrawal could also impact the enforcement in the UK of judgements of the courts of the remaining EU member states. Conclusion Just six months ahead of the UK’s 29 March 2019 exit date, there remains no agreed legal position as regards the terms of the UK’s withdrawal from the EU. It is clear that, for so long as such impasse remains, the contractual ramifications will continue to be fluid and the subject of discussion.  However, what is apparent is that the financial services sector, and financing arrangements more generally, are heavily impacted and it will be incumbent upon contracting parties, and their lawyers, to consider the relevant terms, consequences and solutions at the appropriate time. [1]   Article 55 of the Bank Resolution and Recovery Directive [2]   Rome I Regulation [3]   Brussels I regulation. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Global Finance practice group, or the authors: Amy Kennedy – London (+44 (0)20 7071 4283, akennedy@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Alex Hillback – Dubai (+971 (0)4 318 4626, ahillback@gibsondunn.com) Please also feel free to contact the following leaders and members of the Global Finance and Financial Institutions practice groups: Global Finance Group: Thomas M. Budd – London (+44 (0)20 7071 4234, tbudd@gibsondunn.com) Gregory A. Campbell – London (+44 (0)20 7071 4236, gcampbell@gibsondunn.com) Richard Ernest – Dubai (+971 (0)4 318 4639, rernest@gibsondunn.com) Jamie Thomas – Singapore (+65 6507 3609, jthomas@gibsondunn.com) Michael Nicklin – Hong Kong (+852 2214 3809, mnicklin@gibsondunn.com) Linda L. Curtis – Los Angeles (+1 213 229 7582, lcurtis@gibsondunn.com) Aaron F. Adams – New York (+1 212 351 2494, afadams@gibsondunn.com) Financial Institutions Group: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Carl E. Kennedy – New York (+1 212-351-3951, ckennedy@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 3, 2018 |
2018 Mid-Year Activism Update

Click for PDF This Client Alert provides an update on shareholder activism activity involving NYSE- and NASDAQ-listed companies with equity market capitalizations above $1 billion during the first half of 2018.  After a modest decline in activist activity in the second half of 2017, activism resumed a torrid pace during the first half of 2018.  Compared to the same period in 2017, which had previously been the most active half-year period covered by any edition of this report, this mid-year edition of Gibson Dunn’s Activism Update reflects a further increase in public activist actions (62 vs. 59) and companies targeted by such actions (54 vs. 50). In this edition of the Activism Update, our survey covers 62 total public activist actions, involving 41 different activist investors targeting 54 different companies.  Eight of those companies faced activist campaigns from two different investors, and five of those situations involved at least some degree of coordination between the activists involved.  Nine activist investors were responsible for two or more campaigns between January 1, 2018 and June 30, 2018, representing 30, or nearly half, of the 62 campaigns covered by this report. By the Numbers – 2018 Full Year Public Activism Trends *All data is derived from the data compiled from the campaigns studied for the 2018 M Activism Update. Additional statistical analyses may be found in the complete Activism Update linked below.  While changes in business strategy were the top goal of activist campaigns covered by Gibson Dunn’s Activism Update for the second half of 2017, changes to board composition have returned to prominence in the first half of 2018 (75.8% of campaigns), coinciding with a dramatic uptick in publicly filed settlement agreements during the same period.  Activists pursued governance initiatives, sought to influence business strategy, and took positions on M&A-related issues (including pushing for spin-offs and advocating both for and against sales or acquisitions) at nearly equal rates, representing 35.5%, 33.9%, and 32.3% of campaigns, respectively.  Demands for management changes (21.0% of campaigns), attempts to take control of companies (9.5% of campaigns), and requests for capital returns (6.1% of campaigns) remained relatively less common goals of activist campaigns over the first half of 2018.  The frequency of activists filing proxy materials remained relatively consistent with periods covered by recent editions of this report, with investors filing proxy materials in just over one in five campaigns.  While market capitalizations of target companies ranged from this survey’s $1 billion minimum threshold to $100 billion, activists’ focus remained largely on small-cap companies with market capitalizations below $5 billion, which represented 64.8% of the 54 target companies captured by our survey. The most significant development noted in our previous report, covering the second half of 2017, was the decrease in publicly filed settlement agreements between activist investors and target companies, which we attributed partially to the concurrent decline in campaigns involving activists seeking board seats.  This trend has been reversed.  As campaigns seeking board representation have returned to prominence, the number of publicly filed settlement agreements in the first half of 2018 has seen a fivefold increase from the previous half-year period, from four such agreements in the second half of 2017 to 21 in the first half of 2018.  Trends in the key terms of settlement agreements remain relatively steady.  Voting agreements, standstills, and ownership thresholds remain nearly ubiquitous.  Non-disparagement provisions dropped off slightly in the first half of 2018, while committee appointments for new directors and other strategic initiatives (e.g., replacement of management, spin-offs, governance changes) remained near their historical averages in prior editions of this report.  The increased frequency of expense reimbursement noted in our last report has also continued into 2018, with 62% of publicly filed settlement agreements containing such a provision compared to a historical average of just 36% from 2014 through the first half of 2017.  Further details and data on publicly filed settlement agreements may be found in the latter half of this report. We hope you find Gibson Dunn’s 2018 Mid-Year Activism Update informative. If you have any questions, please do not hesitate to reach out to a member of your Gibson Dunn team. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this publication.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, or any of the following authors in the firm’s New York office: Barbara L. Becker (+1 212.351.4062, bbecker@gibsondunn.com) Richard J. Birns (+1 212.351.4032, rbirns@gibsondunn.com) Dennis J. Friedman (+1 212.351.3900, dfriedman@gibsondunn.com) Eduardo Gallardo (+1 212.351.3847, egallardo@gibsondunn.com) William Koch (+1 212.351.4089, wkoch@gibsondunn.com) Please also feel free to contact any of the following practice group leaders and members: Mergers and Acquisitions Group: Jeffrey A. Chapman – Dallas (+1 214.698.3120, jchapman@gibsondunn.com) Stephen I. Glover – Washington, D.C. (+1 202.955.8593, siglover@gibsondunn.com) Jonathan K. Layne – Los Angeles (+1 310.552.8641, jlayne@gibsondunn.com) Securities Regulation and Corporate Governance Group: Brian J. Lane – Washington, D.C. (+1 202.887.3646, blane@gibsondunn.com) Ronald O. Mueller – Washington, D.C. (+1 202.955.8671, rmueller@gibsondunn.com) James J. Moloney – Orange County, CA (+1 949.451.4343, jmoloney@gibsondunn.com) Elizabeth Ising – Washington, D.C. (+1 202.955.8287, eising@gibsondunn.com) Lori Zyskowski – New York (+1 212.351.2309, lzyskowski@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 2, 2018 |
M&A Report – Fresenius Marks a Watershed Development in the Analysis of “Material Adverse Effect” Clauses

Click for PDF On October 1, 2018, in Akorn, Inc. v. Fresenius Kabi AG,[1]  the Delaware Court of Chancery determined conclusively for the first time that a buyer had validly terminated a merger agreement due to the occurrence of a “material adverse effect” (MAE). Though the decision represents a seminal development in M&A litigation generally, Vice Chancellor Laster grounded his decision in a framework that comports largely with the ordinary practice of practitioners. In addition, the Court went to extraordinary lengths to explicate the history between the parties before concluding that the buyer had validly terminated the merger agreement, and so sets the goalposts for a similar determination in the future to require a correspondingly egregious set of facts. As such, the ripple effects of Fresenius in future M&A negotiations may not be as acute as suggested in the media.[2] Factual Overview On April 24, 2017, Fresenius Kabi AG, a pharmaceutical company headquartered in Germany, agreed to acquire Akorn, Inc., a specialty generic pharmaceutical manufacturer based in Illinois. In the merger agreement, Akorn provided typical representations and warranties about its business, including its compliance with applicable regulatory requirements. In addition, Fresenius’s obligation to close was conditioned on Akorn’s representations being true and correct both at signing and at closing, except where the failure to be true and correct would not reasonably be expected to have an MAE. In concluding that an MAE had occurred, the Court focused on several factual patterns: Long-Term Business Downturn. Shortly after Akorn’s stockholders approved the merger (three months after the execution of the merger agreement), Akorn announced year-over-year declines in quarterly revenues, operating income and earnings per share of 29%, 84% and 96%, respectively. Akorn attributed the declines to the unexpected entrance of new competitors, the loss of a key customer contract and the attrition of its market share in certain products. Akorn revised its forecast downward for the following quarter, but fell short of that goal as well and announced year-over-year declines in quarterly revenues, operating income and earnings per share of 29%, 89% and 105%, respectively. Akorn ascribed the results to unanticipated supply interruptions, added competition and unanticipated price erosion; it also adjusted downward its long-term forecast to reflect dampened expectations for the commercialization of its pipeline products. The following quarter, Akorn reported year-over-year declines in quarterly revenues, operating income and earnings per share of 34%, 292% and 300%, respectively. Ultimately, over the course of the year following the signing of the merger agreement, Akorn’s EBITDA declined by 86%. Whistleblower Letters. In late 2017 and early 2018, Fresenius received anonymous letters from whistleblowers alleging flaws in Akorn’s product development and quality control processes. In response, relying upon a covenant in the merger agreement affording the buyer reasonable access to the seller’s business between signing and closing, Fresenius conducted a meticulous investigation of the Akorn business using experienced outside legal and technical advisors. The investigation revealed grievous flaws in Akorn’s quality control function, including falsification of laboratory data submitted to the FDA, that cast doubt on the accuracy of Akorn’s compliance with laws representations. Akorn, on the other hand, determined not to conduct its own similarly wide-ranging investigation (in contravention of standard practice for an FDA-regulated company) for fear of uncovering facts that could jeopardize the deal. During a subsequent meeting with the FDA, Akorn omitted numerous deficiencies identified in the company’s quality control group and presented a “one-sided, overly sunny depiction.” Operational Changes. Akorn did not operate its business in the ordinary course after signing (despite a covenant requiring that it do so) and fundamentally changed its quality control and information technology (IT) functions without the consent of Fresenius. Akorn management replaced regular internal audits with “verification” audits that only addressed prior audit findings rather than identifying new problems. Management froze investments in IT projects, which reduced oversight over data integrity issues, and halted efforts to investigate and remediate quality control issues and data integrity violations out of concern that such investigations and remediation would upend the transaction. Following signing, NSF International, an independent, accredited standards development and certification group focused on health and safety issues, also identified numerous deficiencies in Akorn’s manufacturing facilities. Conclusions and Key Takeaways The Court determined, among others, that the sudden and sustained drop in Akorn’s business performance constituted a “general MAE” (that is, the company itself had suffered an MAE), Akorn’s representations with respect to regulatory compliance were not true and correct, and the deviation between the as-represented condition and its actual condition would reasonably be expected to result in an MAE. In addition, the Court found that the operational changes implemented by Akorn breached its covenant to operate in the ordinary course of business. Several aspects of the Court’s analysis have implications for deal professionals: Highly Egregious Facts. Although the conclusion that an MAE occurred is judicially unprecedented in Delaware, it is not surprising given the facts. The Court determined that Akorn had undergone sustained and substantial declines in financial performance, credited testimony suggesting widespread regulatory noncompliance and malfeasance in the Akorn organization and suggested that decisions made by Akorn regarding health and safety were re-prioritized in light of the transaction (and in breach of a highly negotiated interim operating covenant). In In re: IBP, Inc. Shareholders Litigation, then-Vice Chancellor Strine described himself as “confessedly torn” over a case that involved a 64% year-over-year drop-off in quarterly earnings amid allegations of improper accounting practices, but determined that no MAE had occurred because the decline in earnings was temporary. In Hexion Specialty Chemicals, Inc. v. Huntsman Corp., Vice Chancellor Lamb emphasized that it was “not a coincidence” that “Delaware courts have never found a material adverse effect to have occurred in the context of a merger agreement” and concluded the same, given that the anticipated decline in the target’s EBITDA would only be 7%. No such hesitation can be found in the Fresenius opinion.[3] MAE as Risk Allocation Tool. The Court framed MAE clauses as a form of risk allocation that places “industry risk” on the buyer and “company-specific” risk on the seller. Explained in a more nuanced manner, the Court categorized “business risk,” which arises from the “ordinary operations of the party’s business” and which includes those risks over which “the party itself usually has significant control”, as being retained by the seller. By contrast, the Court observed that the buyer ordinarily assumes three others types of risk—namely, (i) systematic risks, which are “beyond the control of all parties,” (ii) indicator risks, which are markers of a potential MAE, such as a drop in stock price or a credit rating downgrade, but are not underlying causes of any MAE themselves, and (iii) agreement risks, which include endogenous risks relating to the cost of closing a deal, such as employee flight. This framework comports with the foundation upon which MAE clauses are ordinarily negotiated and underscores the importance that sellers negotiate for industry-specific carve-outs from MAE clauses, such as addressing adverse decisions by governmental agencies in heavily regulated industries. High Bar to Establishing an MAE. The Court emphasized the heavy burden faced by a buyer in establishing an MAE. Relying upon the opinions that emerged from the economic downturns in 2001 and 2008,[4]  the Court reaffirmed that “short-term hiccups in earnings” do not suffice; rather, the adverse change must be “consequential to the company’s long-term earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months.” The Court underscored several relevant facts in this case, including (i) the magnitude and length of the downturn, (ii) the suddenness with which the EBITDA decline manifested (following five consecutive years of growth) and (iii) the presence of factors suggesting “durational significance,” including the entrance of new and unforeseen competitors and the permanent loss of key customers.[5] Evaluation of Targets on a Standalone Basis. Akorn advanced the novel argument that an MAE could not have occurred because the purchaser would have generated synergies through the combination and would have generated profits from the merger. The Court rejected this argument categorically, finding that the MAE clause was focused solely on the results of operations and financial condition of the target and its subsidiaries, taken as a whole (rather than the surviving corporation or the combined company), and carved out any effects arising from the “negotiation, execution, announcement or performance” of the merger agreement or the merger itself, including “the generation of synergies.” Given the Court’s general aversion to considering synergies as relevant to determining an MAE, buyers should consider negotiating to include express references to synergies in defining the concept of an MAE in their merger agreements. Disproportionate Effect. Fresenius offers a useful gloss on the importance to buyers of including “disproportionate effects” qualifications in MAE carve-outs regarding industry-wide events. Akorn argued that it faced “industry headwinds” that caused its decline in performance, such as heightened competition and pricing pressure as well as regulatory actions that increased costs. However, the Court rejected this view because many of the causes of Akorn’s poor performance were actually specific to Akorn, such as new market entrants in Akorn’s top three products and Akorn’s loss of a specific key contract. As such, these “industry effects” disproportionately affected and were allocated from a risk-shifting perspective to Akorn. To substantiate this conclusion, the Court relied upon evidence that Akorn’s EBITDA decline vastly exceeded its peers. The Bring-Down Standard. A buyer claiming that a representation given by the target at closing fails to satisfy the MAE standard must demonstrate such failure qualitatively and quantitatively. The Court focused on a number of qualitative harms wrought by the events giving rise to Akorn’s failure to bring down its compliance with laws representation at closing, including reputational harm, loss of trust with principal regulators and public questioning of the safety and efficacy of Akorn’s products. With respect to quantitative measures of harm, Fresenius and Akorn presented widely ranging estimates of the cost of remedying the underlying quality control challenges at Akorn. Using the midpoint of those estimates, the Court estimated the financial impact to be approximately 21% of Akorn’s market capitalization. However, despite citing several proxies for financial performance suggesting that this magnitude constituted an MAE, the Court clearly weighted its analysis towards qualitative factors, noting that “no one should fixate on a particular percentage as establishing a bright-line test” and that “no one should think that a General MAE is always evaluated using profitability metrics and an MAE tied to a representation is always tied to the entity’s valuation.” Indeed, the Court observed that these proxies “do not foreclose the possibility that a buyer could show that percentage changes of a lesser magnitude constituted an MAE. Nor does it exclude the possibility that a buyer might fail to prove that percentage changes of a greater magnitude constituted an MAE.” Fresenius offers a useful framework for understanding how courts analyze MAE clauses. While this understanding largely comports with the approach taken by deal professionals, the case nevertheless offers a reminder that an MAE, while still quite unlikely, can occur. Deal professionals would be well-advised to be thoughtful about how the concept should be defined and used in an agreement.    [1]   Akorn, Inc. v. Fresenius Kabi AG, C.A. No. 2018-0300-JTL (Del. Ch. Oct. 1, 2018).    [2]   See, e.g., Jef Feeley, Chris Dolmetsch & Joshua Fineman, Akorn Plunges After Judge Backs Fresenius Exit from Deal, Bloomberg (Oct 1, 2018) (“‘The ruling is a watershed moment in Delaware law, and will be a seminal case for those seeking to get out of M&A agreements,’ Holly Froum, an analyst with Bloomberg Intelligence, said in an emailed statement.”); Tom Hals, Delaware Judge Says Fresenius Can Walk Away from $4.8 Billion Akorn Deal, Reuters (Oct. 1, 2018) (“‘This is a landmark case,’ said Larry Hamermesh, a professor at Delaware Law School in Wilmington, Delaware.”).    [3]   The egregiousness of the facts in this case is further underscored by the fact that the Court determined that the buyer had breached its own covenant to use its reasonable best efforts to secure antitrust clearance, but that this breach was “temporary” and “not material.”    [4]   See, e.g., Hexion Specialty Chems. Inc. v. Huntsman Corp., 965 A.2d 715 (Del. Ch. 2008); In re: IBP, Inc. S’holders Litig., 789 A.2d 14 (Del. Ch. 2001).    [5]   This view appears to comport with the analysis highlighted by the Court from In re: IBP, Inc. Shareholders Litigation, in which the court determined that an MAE had not transpired in part because the target’s “problems were due in large measure to a severe winter, which adversely affected livestock supplies and vitality.” In re: IBP, 789 A.2d at 22. In this case, the decline of Akorn was not the product of systemic risks or cyclical declines, but rather a company-specific effect. The following Gibson Dunn lawyers assisted in preparing this client update:  Barbara Becker, Jeffrey Chapman, Stephen Glover, Mark Director, Andrew Herman, Saee Muzumdar, Adam Offenhartz, and Daniel Alterbaum. Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Mergers and Acquisitions practice group: Mergers and Acquisitions Group / Corporate Transactions: Barbara L. Becker – Co-Chair, New York (+1 212-351-4062, bbecker@gibsondunn.com) Jeffrey A. Chapman – Co-Chair, Dallas (+1 214-698-3120, jchapman@gibsondunn.com) Stephen I. Glover – Co-Chair, Washington, D.C. (+1 202-955-8593, siglover@gibsondunn.com) Dennis J. Friedman – New York (+1 212-351-3900, dfriedman@gibsondunn.com) Jonathan K. Layne – Los Angeles (+1 310-552-8641, jlayne@gibsondunn.com) Mark D. Director – Washington, D.C./New York (+1 202-955-8508/+1 212-351-5308, mdirector@gibsondunn.com) Andrew M. Herman – Washington, D.C./New York (+1 202-955-8227/+1 212-351-5389, aherman@gibsondunn.com) Eduardo Gallardo – New York (+1 212-351-3847, egallardo@gibsondunn.com) Saee Muzumdar – New York (+1 212-351-3966, smuzumdar@gibsondunn.com) Mergers and Acquisitions Group / Litigation: Meryl L. Young – Orange County (+1 949-451-4229, myoung@gibsondunn.com) Brian M. Lutz – San Francisco (+1 415-393-8379, blutz@gibsondunn.com) Aric H. Wu – New York (+1 212-351-3820, awu@gibsondunn.com) Paul J. Collins – Palo Alto (+1 650-849-5309, pcollins@gibsondunn.com) Michael M. Farhang – Los Angeles (+1 213-229-7005, mfarhang@gibsondunn.com) Joshua S. Lipshutz – Washington, D.C. (+1 202-955-8217, jlipshutz@gibsondunn.com) Adam H. Offenhartz – New York (+1 212-351-3808, aoffenhartz@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

July 30, 2018 |
2018 Mid-Year Securities Enforcement Update

Click for PDF I.  Significant Developments A.  Introduction For a brief moment in time, after several years with as many as 3 of the 5 commissioner seats vacant, the SEC was operating at full force, with the January 2018 swearing in of newest commissioners Hester Peirce and Robert Jackson.  This situation was short-lived, as Commissioner Piwowar, a Republican appointee with a deregulatory bent who had pulled back on certain enforcement powers, stepped down at the beginning of July.  While the president has named a potential replacement, the Senate has not yet held confirmation hearings; with Democratic Commissioner Kara Stein also set to leave the agency sometime later this year, the Senate may defer consideration until both the Republican and Democratic nominees have been named.  The vacancy could cause the Commission, which has already split on several key rulemakings, to defer some more controversial regulatory initiatives and even some enforcement actions which pose thornier policy questions. Meanwhile, the most noteworthy Enforcement-related event came with the Supreme Court’s Lucia decision, in which the Court held that the agency’s administrative law judges have been unconstitutionally appointed, resolving a technical but significant legal issue which has dogged the SEC’s administrative proceedings for several years.  As discussed further below, the decision throws a wrench in the works for the Enforcement Division, which until the past couple years had been litigating a growing number of enforcement actions in its administrative forum rather than in federal court. In terms of enforcement priorities, the SEC has continued to pursue a relatively small number of significant public company cases; despite a push in recent years to increase its focus on accounting fraud, few new actions were filed in the first half of 2018.  In contrast, the Division filed a surprisingly large number of cases against investment advisers and investment companies, including advisers to individual retail clients, private fund managers, and mutual fund managers. And the SEC’s concentration on all things “cyber” continued to make headlines in the initial months of 2018.  The SEC rolled out guidance on appropriate cybersecurity disclosures, and filed its first (and to date only) case against a public company for allegedly failing to report a data breach to investors on a timely basis.  Additionally, the SEC continues to institute enforcement actions in the cryptocurrency space, though is focus remains primarily on outright frauds, leaving ongoing uncertainty as to the regulatory status of certain digital assets. B.  Significant Legal Developments On June 21, 2018, the Supreme Court ruled in Lucia v. SEC that the SEC’s administrative law judges (ALJs) were inferior officers of the United States for purposes of the Constitution’s Appointments Clause, and that the SEC had failed to properly appoint its ALJs in a manner consistent with the Clause.[1]  (Mr. Lucia was represented by Gibson Dunn before the Supreme Court.)  After several years in which the SEC had increasingly filed contested proceedings administratively rather than in federal district court, the agency reversed course in the face of mounting court challenges to the constitutionality of its ALJs (who had been appointed by a government personnel office rather than by the commissioners themselves).  Even with the reduced number of pending, litigated administrative proceedings, the SEC still faces the prospect of retrying dozens of cases which had been tried before improperly-appointed ALJs.  As this report went to press, the SEC had yet to determine how it would handle these pending cases, or how or when it would go about appointing ALJs to hear litigated administrative proceedings going forward. Even with Lucia resolving the primary legal question which had been floating about in recent years, other questions about the legality of ALJs may continue to complicate administrative proceedings, and thus for the time being the SEC has determined to pursue most litigated cases in court.  (Though the SEC continues to bring settled administrative proceedings, as such settled orders are issued by the Commission itself rather than by an ALJ.) Another Supreme Court decision that curtailed SEC enforcement actions, SEC v. Kokesh, continues to impact the enforcement program.  As detailed previously, in June 2017 the Supreme Court overturned a lower court ruling that required the defendant to disgorge $34.9 million for conduct dating back to 1995.  The Supreme Court found that disgorgement was a form of penalty and was therefore subject to a five-year statute of limitations.[2]  In March 2018, on remand, the Tenth Circuit determined that the statute of limitations still did not bar the SEC’s action since the “clock” restarted with each act of misappropriation.[3]  Moreover, notwithstanding Kokesh, the issue of whether SEC actions seeking injunctive relief or other non-monetary sanctions (such as industry bars) are governed by the five-year statute remains hotly contested.  In a May 2018 speech, Co-Enforcement Director Steven Peiken noted that the SEC continues to maintain that injunctive relief is not subject to the five-year statute of limitations under Kokesh, and admonished parties that the staff would not forgo pursuing actions based on such arguments.[4]  However, the issue is far from settled, and just this month a district court came to a different conclusion.[5] In June, the Supreme Court granted a petition of certiorari filed by Francis V. Lorenzo, an investment banker who copied and pasted his boss’s allegedly fraudulent email into a message to his clients and who the D.C. Circuit found liable for fraud as a result[6].  Mr. Lorenzo has argued that, based on the Supreme Court’s 2011 decision in Janus Capital Group Inc. v. First Derivative Traders, he should not be considered the “maker” of the allegedly fraudulent statements.  Mr. Lorenzo’s petition asserts that the D.C. Circuit decision allows the SEC to avoid the requirements of Janus by characterizing fraud claim as “fraudulent scheme” claims.  A circuit split exists as to whether a misstatement alone can form the basis of a fraudulent scheme claim. C.  Whistleblower Developments The first half of 2018 saw the SEC’s largest whistleblower bounties to date, as well as some related rulemaking proposals which could potentially cap such awards.  As of April, the SEC reported that it had paid more than $266 million to 55 whistleblowers since 2012.[7] In March, the SEC announced its highest-ever whistleblower awards, paying a combined $50 million to two individuals and an additional $33 million to a third.[8]  While the SEC may not disclose the identities of whistleblowers, their counsel subsequently publicly disclosed that the awards were paid in connection with a $415 million SEC settlement with a major financial institution alleged to have misused customer cash.[9]  In its Order granting the awards, the Commission declined to grant awards to additional putative whistleblowers and, in doing so, clarified the standard for finding that a tip “led to” the success of a particular action.[10]  For a tip to “significantly contribute[] to the success of an . . . action” and entitle the whistleblower to an award, the “information must have been ‘meaningful,'” i.e., must “‘make a substantial and important contribution’ to the success of the . . . action.”  The Commission declined to adopt a more flexible standard. In a separate action the following month, the SEC awarded $2.2 million to a former company insider.[11]  The SEC noted that the $2.2 million award was paid under the 120-day “safe harbor” rule, which provides that, when a whistleblower reports to another federal agency and then submits the same information to the SEC within 120 days, the SEC will treat the information as having been submitted on the day it was submitted to the other agency.  A week later, the SEC announced a $2.1 million award to a former company insider whose tips had led to “multiple” successful enforcement actions.[12] In addition to developments relating to award payments, the first half of 2018 also included a Supreme Court decision affecting the rights of whistleblowers pursuant to anti-retaliation protections.  In Digital Realty Trust, the Court overturned the Ninth Circuit’s decision (described in our 2017 Year-End Update) and found that Dodd-Frank’s anti-retaliation measures protect only whistleblowers who report their concerns to the SEC and not those who only report internally.[13] Finally, in a late June open meeting, the Commission voted to propose various amendments to its whistleblower program.[14]  In response to the record-breaking award noted above, the proposed rules would give the SEC discretion to limit the size of awards in cases resulting in monetary sanctions greater than $100 million (which, given a permissible award size of 10-30% of money collected by the SEC, would effectively create a $30 million award cap).  Other proposed amendments include: allowing awards based on deferred prosecution agreements and non-prosecution agreements entered into in criminal cases; permitting awards made when the Commission reaches a settlement outside the context of a judicial or administrative proceeding; allowing the SEC to bar individuals from later seeking awards after they submit false or frivolous claims; and, in response to Digital Realty, requiring a whistleblower to submit information in writing to receive retaliation protection. D.  Cybersecurity and Cryptocurrency In 2017, the SEC touted cybersecurity as a major enforcement priority and created a dedicated “Cyber Unit” to investigate and prosecute cyber-related threats.  The SEC’s cyber-focus continued in the first half of 2018 with its February release of interpretive guidance on public companies’ disclosure obligations regarding cybersecurity risks and incidents.[15]  The Guidance, which reaffirms and expands upon the SEC Division of Corporation Finance’s existing guidance on the topic from 2011, encourages companies to adopt “comprehensive policies and procedures related to cybersecurity,” and to consider how their insider trading policies address trading related to cybersecurity incidents.  While not creating any bright-line rules, it discusses that the “materiality of cybersecurity risks and incidents depends upon their nature, extent, and potential magnitude,” as well as “the range of harm that such incidents could cause,” including “harm to a company’s reputation, financial performance, and customer and vendor relationships, as well as the possibility of litigation or regulatory investigations or actions.”  The SEC further noted that the existence of an ongoing internal or external investigation into an incident “would not on its own provide a basis for avoiding disclosures” of an otherwise material incident.  As discussed further below, the Guidance was followed two months later by the SEC’s announcement of its first enforcement action against a company arising out of a data breach. Regarding the continuing proliferation of digital (or “crypto”) currencies, the staff of the SEC’s Divisions of Enforcement and Trading and Markets issued a statement in March reinforcing that digital platforms that trade securities and operate as an “exchange,” as defined by the federal securities laws, must register as a national securities exchange or operate under an exemption from registration.[16]  The statement also outlines a list of questions that potential investors should consider before deciding to trade on such platforms.  The statement came on the heels of a litigated enforcement action charging a bitcoin-denominated platform, BitFunder, and its founder with operating an unregistered securities exchange, defrauding users by misappropriating their bitcoins and failing to disclose a cyberattack, and making false and misleading statements in connection with an unregistered offering of securities.[17]  In a parallel criminal case, the U.S. Attorney’s Office charged BitFunder’s founder with perjury and obstruction of the SEC’s investigation. The SEC also brought a handful of initial coin offering (ICO) enforcement actions in the first half of 2018.  In January, the SEC obtained a court order halting an ICO it characterized as “an outright scam,” which had raised $600 million in just two months by claiming to be the world’s first “decentralized bank” and falsely representing that it had purchased an FDIC-insured bank.[18]  In April, the SEC charged two co-founders of a financial services start-up with orchestrating a fraudulent ICO by falsely claiming to offer a debit card backed by major credit card companies that would allow users to convert cryptocurrencies into U.S. dollars.[19]  The U.S. Attorney’s Office for the Southern District of New York brought parallel criminal actions against the co-founders, and the SEC later charged a third co-founder with fraud after discovery of text-messages revealing fraudulent intent.[20]  Then, in May, the SEC obtained a court order halting an ICO by a self-proclaimed “blockchain evangelist” who had fabricated customer testimonials and misrepresented having business relationships with the Federal Reserve and dozens of companies.[21] Additionally, in April, the SEC obtained a court order freezing over $27 million in proceeds raised by Longfin Corp. after the company and its CEO allegedly violated Section 5 by issuing unregistered shares to three other individuals so they could sell them to the public right after the company’s stock had risen dramatically due to announcement of acquisition of a cryptocurrency platform.[22] II.  Issuer and Auditor Cases A.  Accounting Fraud and Other Misleading Disclosures In March, the SEC settled charges of accounting fraud against a California-based energy storage and power delivery product manufacturer and three of its former officers.[23]  The SEC alleged that the company prematurely recognized revenue to better meet analyst expectations, that a former sales executive inflated revenues by executing secret deals with customers and concealing them from finance and accounting personnel, and that the former CEO and former controller failed to adequately respond to red flags that should have alerted them to the misconduct.  Without admitting or denying the allegations, the company agreed to pay penalties of $2.8 million; the former CEO and controller agreed to pay a combined total of approximately $100,000 in disgorgement, interest and penalties; and the former sales executive agreed to be barred from serving as an officer or director of a public company for five years and pay a $50,000 penalty. In April, the SEC settled charges of accounting fraud against a Japanese electronics company.[24]  The SEC alleged that the company’s U.S. subsidiary prematurely recognized more than $82 million in revenue by backdating an agreement with an airline and providing misleading information to an auditor.  The matter involved FCPA allegations as well. Also in April, the SEC instituted settled proceedings against a California internet services and content provider.[25]  The SEC alleged that the company failed to timely disclose a major data breach in which hackers stole personal data relating to hundreds of millions of user accounts.  In addition, the SEC alleged that the company did not share its knowledge of the breach with its auditors or outside counsel, and failed to maintain adequate controls and procedures to assess its cyber-disclosure obligations.  Without admitting the allegations, the company agreed to pay a $35 million penalty to settle the charges. In May, the SEC filed a complaint against three former executives of a Houston-based health services company.[26]  The complaint alleged that the executives falsified financial information—including financial statements for three fictitious subsidiaries acquired by the company—to induce a private firm to acquire a majority of the company’s equity.  In a parallel action, DOJ brought criminal charges against the defendants. In June, the SEC filed a complaint against a California-based telecommunications equipment manufacturer and three of its executives.[27]  According to the SEC’s complaint, the executives inflated company revenues by prematurely recognizing revenue on sales and entering into undisclosed side agreements that relieved customers of payment obligations.  The SEC also alleged that the defendants inflated the prices of products to hit revenue targets with the agreement that the company would later repay the difference as marketing development fees.  Without admitting or denying the charges, the defendants agreed to pay penalties totaling $75,000.  In addition, two of the individual defendants consented to five-year officer and director bars; the other individual defendant consented to a bar from appearing or practicing before the SEC as an accountant for five years. B.  Auditor Cases In February, in a case the SEC said underscores its determination to pursue violations “regardless of the location of the violators,” a foreign auditor and his U.S.-based accounting firm, settled charges alleging they providing substantial assistance in a fraudulent shell company scheme by issuing misleading audit reports for numerous companies.[28]  The SEC suspended the auditor and his firm from appearing or practicing before the Commission. In March, the SEC announced settled charges against several foreign firms of the large international accounting networks based on allegations that the firms improperly relied on component auditors that were not registered with the PCAOB, even though the component auditors performed substantial work that should have triggered registration.[29] The SEC alleged violations of PCAOB standards that require sufficient analysis and inquiry when relying on another auditor.  Without admitting or denying the allegations, the four foreign firms agreed to pay roughly $400,000 combined in disgorgement and penalties. Additionally, an auditing firm, two of its partners and a registered financial advisory firm settled charges in May relating to violations of the Custody Rule.[30]  According to the SEC, the auditors failed to meet the independence requirements of the Custody Rule by both preparing and auditing financial statements of several funds and because they had a direct business relationship with the financial advisory firm through a fee-referral relationship.  The SEC also charged the respondents for failing to comply with the requirement of regular PCAOB inspections and cited multiple professional conduct violations, including for failing to design and implement appropriate oversight mechanisms, insufficient quality control and violation of professional due care, among others.  Without admitting or denying the allegations, the defendants were barred from appearing before the Commission and agreed to pay roughly $52,000 combined in disgorgement and penalties. The SEC is also ensuring that firms are not associating with barred auditors. In April, an accounting firm and its sole officer and founder settled charges with the SEC for allegedly violating the Sarbanes Oxley Act of 2012, which prohibits auditors barred by the PCAOB from association with a registered public accounting firm from associating with corporate issuers in an accountancy or financial management capacity.[31]  Without admitting or denying the findings, the company and its founding officer agreed to cease and desist from the association and agreed to pay a $22,500 civil penalty. C.  Private Company Cases While the number of cases against public companies remains low, the SEC has continued to step up its enforcement efforts against private companies. In March, the SEC instituted settled proceedings against a California-based financial technology company.[32]  The SEC alleged that the respondent offered unregistered stock options to its employees without providing the employees with timely financial statements and risk disclosures.  Without admitting the allegations, the company agreed to pay a $160,000 penalty to settle the charges. Also in March, the SEC filed a complaint against a California-based health care technology company, its former CEO, and a former president at the company.[33]  The complaint alleged that the defendants made numerous false statements in investor presentations, product demonstrations and media articles about their flagship product—including misrepresentations regarding expected revenue and the U.S. Department of Defense’s adoption of the product—which deceived investors into believing the product was revolutionary.  Without admitting the allegations, the company and former CEO agreed to settle the charges.  Under the settlement terms, the former CEO agreed to pay a $0.5 million penalty, be barred from serving as an officer or director of a public company for ten years, return 18.9 million shares of the company, and relinquish her voting control by converting her Class B Common shares to Class A Common shares.  The SEC will continue to litigate its claims against the former president in federal court. And in April, the SEC filed a fraud complaint against four parties:  a biotechnology startup formerly based in Massachusetts, its CEO, an employee, and the CEO’s close friend.[34]  According to the SEC, the CEO and the employee made false claims to investors about the company’s finances and the company’s progress in seeking FDA approval for one of its products.  The complaint also alleged that the defendants engaged in a fraudulent scheme to acquire and merge the company with a publicly traded company, manipulated the shares of the new entity, and diverted a portion of the sale proceeds.  The SEC is litigating the case in federal court and seeks to freeze the company’s and CEO’s assets, as well as prohibit the defendants from soliciting money from investors.  In addition, the SEC seeks a permanent injunction, the return of the ill-gotten gains with penalties, and industry and penny stock bars.  The DOJ brought parallel criminal charges against the individual defendants. III.  Investment Advisers and Funds A.  Fees and Expenses In June, a private equity firm settled allegations that it had charged accelerated monitoring fees on portfolio company exits without adequate disclosure.[35]  According to the SEC, the undisclosed receipt of accelerated fees from portfolio companies resulted in negligent violations of various provisions of the Advisers Act.  To settle the matter, the Respondents agreed to pay $4.8 million in disgorgement and prejudgment interest and $1.5 million in penalties. Shortly thereafter, the SEC filed a settled action against a New York-based venture capital fund adviser for allegedly failing to offset consulting fees against management fees in accordance with organizational documents for the funds it advised.[36]  The SEC alleged that the adviser received $1.2 million in consulting fees from portfolio companies in which the funds had invested, and that those fees were not properly offset against advisory or management fees paid by investors, resulting in an overpayment of over $750,000.  The adviser reimbursed its clients, plus interest, and agreed to pay a $200,000 penalty.  Significantly, the SEC’s press release cites to the adviser’s remediation and cooperation, indicating that this was taken into account in determining the appropriate resolution. B.  Conflicts of Interest In March, the SEC instituted settled proceedings against two investment adviser subsidiaries for undisclosed conflicts of interest with regard to the practice of recalling securities on loan.[37]  The SEC alleged that the advisers were affiliated with insurance companies, but also served as investment advisers to insurance-dedicated mutual funds.  The advisers would lend securities held by the mutual funds, and then recall those securities prior to their dividend record dates.  This meant that the insurance company affiliates, as record shareholders of such shares, would receive a tax benefit on the basis of the dividends received.  However, according to the SEC, this recall system resulted in the mutual funds (and their investors) losing income, while the insurance company affiliates reaped a tax benefit.  Without admitting or denying the allegations, the advisers agreed to pay approximately $3.6 million to settle the charges. In April, the SEC instituted proceedings against a New York-based investment adviser in connection with the receipt of revenue sharing compensation from a service provider without disclosing conflicts of interest to its private equity clients.[38]  According to the SEC, the investment adviser entered into an agreement with a company that provided services to portfolio companies.  Pursuant to that agreement, when portfolio companies made purchases, the service provider would receive revenue, and, in turn, the investment adviser would receive a portion of that revenue.  Without admitting or denying the allegations of Advisers Act violations, the investment adviser agreed to pay nearly $800,000 in disgorgement, prejudgment interest, and civil penalties. In early June, the SEC instituted settled proceedings against a New York-based investment adviser in connection with alleged failures to disclose conflicts of interest to clients and prospective clients relating to compensation paid to the firm’s individual advisers and an overseas affiliate.[39]  According to the SEC, this undisclosed compensation, which came from overseas third-party product and service providers recommended by the adviser, incentivized the adviser to recommend certain products and services and a pension transfer.  The SEC also found that the adviser made misleading statements regarding investment options and tax treatment of investments.  In settling the action without admitting or denying the allegations, the investment adviser agreed to pay an $8 million civil penalty and to engage an independent compliance consultant.  In a parallel action, the Commission filed a complaint in federal court in Manhattan against the adviser’s former CEO and a former manager. On the same day, the SEC filed another settled administrative proceeding relating to undisclosed conflicts of interest with a Delaware-based investment adviser.[40]  The settlement order alleges that the adviser negotiated side letters with outside asset managers resulting in arrangements under which the asset managers would make payments to the adviser based on the amount of client assets placed or maintained in funds advised by those asset managers.  This was not disclosed to clients, and contravened the adviser’s agreements with two specific advisory clients.  The SEC also alleged that the adviser failed to implement policies and procedures to prevent conflicts of interest and failed to maintain accurate records relating to the payments from the outside asset managers.  Without admitting or denying the Commission’s findings, the adviser agreed to pay a $500,000 penalty. C.  Fraud and Other Misconduct In January, the SEC filed settled charges against a California-based investment adviser and its CEO and President for failing to adequately disclose the risks associated with investing in their advisory business.[41]  According to the SEC, the firm decided to borrow cash from investors—including its own retail investor clients whose portfolio accounts were managed by the CEO—in the form of promissory notes, in order to fund its business expenses, which exceeded the amount of money received from advisory fees.  In their efforts to market the promissory notes, the CEO and President failed to disclose the true financial state of the firm or the significant risk of default.  In settling the action, the investment adviser agreed to various undertakings, including an in-depth review and enhancement of compliance policies and procedures, and the provision of detailed information regarding noteholders to the staff.  In addition, the firm paid a $50,000 penalty and each principal paid a $25,000 penalty. Also in January, the SEC filed charges in the District of Massachusetts against two Boston-based investment advisers, alleging they engaged in various schemes to defraud their clients, including stealing client funds, failing to disclose conflicts of interest, and secretly using client funds to secure financing for their own investments.[42]  The SEC also alleged that one of the individuals violated his fiduciary duties to clients by obtaining a loan from a client on unfavorable terms to that client and charging advisory fees over 50% higher than the promised rate.  According to the complaint, the pair in one instance misappropriated nearly $450,000 from an elderly client, using the funds to make investments in their own names and to pay personal expenses for one of the individual advisers.  The U.S. Attorney’s Office for the District of Massachusetts also filed criminal charges against the same advisers in a parallel action.  While the SEC action remains pending, the individuals have both pleaded guilty to criminal charges.[43] The SEC also initiated a number of enforcement actions for alleged cherry-picking by investment advisers.  In February, the SEC instituted a litigated action against a California-based investment adviser, its president and sole owner, and its former Chief Compliance Officer for allocating profitable trades to the investment adviser’s account at the expense of its clients.[44]  The SEC’s complaint also alleges that the adviser and president misrepresented trading and allocation practices in Forms ADV filed with the Commission.  The former CCO agreed to settle the charges against him—without admitting or denying allegations that he ignored red flags relating to the firm’s allocation practices—and pay a fine of $15,000; the litigation against the investment adviser and president remains ongoing.  And in March the SEC instituted settled proceedings against a Texas-based investment adviser and its sole principal for disproportionately allocating unprofitable trades to client accounts and profitable trades to their own accounts.[45]  The investment adviser agreed to pay a total of over $700,000 in disgorgement, prejudgment interest, and civil penalties, and the principal agreed to a permanent bar from the securities industry. In April, the SEC filed a settled administrative proceedings against an Illinois-based investment adviser and its president in connection with allegedly misleading advertisements about investment performance.[46]  According to the SEC, the adviser did not disclose that performance results included in advertisements—in the form of written communications and weekly radio broadcasts and video webcasts by its president—were often based on back-tested historical results generated by the adviser’s models, rather than actual results.  The adviser also allegedly failed to adopt written policies and procedures designed to prevent violations of the Advisers Act.  In reaching the agreed-upon resolution, the SEC took into account remediation efforts undertaken by the adviser during the course of the SEC’s investigation, including hiring a new CCO and engaging an outside compliance consultant who conducted an in-depth review of the compliance program and made recommendations which were then implemented by the adviser.  The investment adviser agreed to pay a $125,000 penalty, and the adviser’s president agreed to pay a $75,000 penalty. In May, the SEC charged a California-based individual investment adviser with lying to clients about investment performance and strategy, inflating asset values and unrealized profits in order to overpay himself in management fees and bonuses, and failing to have the private funds audited.[47]  The adviser settled the charges without admitting or denying the allegations, agreeing pay penalties and disgorgement in amounts to be determined by the court. Later that month, the SEC filed settled charges against a Delaware-based investment adviser and its managing member for allegedly making misrepresentations and omissions about the assets and performance of a hedge fund they managed.[48]  According to the SEC, the adviser misrepresented the performance and value of assets in the hedge fund after losing nearly all of its investments after the fund’s trading strategy led to substantial losses.  In addition to making false representations to the fund’s two investors, the adviser withdrew excessive advisory fees based on the inflated asset values.  Without admitting or denying the charges, the adviser and managing member agreed to a cease-and-desist order under which the individual also agreed to a broker-dealer and investment company bar, as well as a $160,000 penalty. In another pair of cases filed in May, the SEC charged a hedge fund and a private fund manager in separate cases involving inflated valuations.  In one case, the SEC alleged that the fund manager’s Chief Financial Officer failed to supervise portfolio managers who engaged in asset mismarking.[49]  The asset mismarking scheme resulted in the hedge fund reaping approximately $3.15 million in excess fees.  The SEC had previously charged the portfolio managers in connection with their misconduct in 2016.  The CFO agreed to pay a $100,000 penalty and to be suspended from the securities industry for twelve months, while the firm agreed to pay over $9 million in disgorgement and penalties.  In the other case, the SEC filed a litigated action in the U.S. District Court for the Southern District of New York against a New York-based investment adviser, the company’s CEO and chief investment officer, a former partner and portfolio manager at the company, and a former trader, in connection with allegations that the defendants inflated the value of private funds they advised.[50]  According to the complaint, the defendants fraudulently inflated the value of the company’s holdings in mortgage-backed securities in order to attract and retain investors, as well as to hide poor fund performance.  This litigation is ongoing. Finally, in late June the SEC announced a settlement with an investment adviser that allegedly failed to protect against advisory representatives misappropriating or misusing client funds.[51]  Without sufficient safeguards in place, one advisory representative was able to misappropriate or misuse $7 million from advisory clients’ accounts.  Without admitting or denying the SEC’s findings, the adviser agreed to pay a $3.6 million penalty, in addition to a cease-and-desist order and a censure.  The representative who allegedly misused the $7 million from client accounts faces criminal charges by the U.S. Attorney’s Office for the Southern District of New York. D.  Investment Company Share Price Selection The first half of 2018 saw the launch of the SEC’s Share Class Selection Disclosure Initiative (SCSD Initiative), as well as several cases involving share class selections.  Under the SCSD Initiative, announced in February, the SEC’s Division of Enforcement agreed not to recommend financial penalties against mutual fund managers which self-report violations of the federal securities laws relating to mutual fund share class selection and promptly return money to victimized investors.[52]  Where investment advisers fail to disclose conflicts of interest and do not self-report, the Division of Enforcement will recommend stronger sanctions in future actions. In late February, a Minnesota-based broker-dealer and investment adviser settled charges in connection with the recommendation and sale of higher-fee mutual fund shares when less expensive share classes were available.[53]  In turn, those recommendations resulted in greater revenue for the company and decreased customers’ returns.  The company, without admitting or denying the allegations, consented to a penalty of $230,000. In April, three investment advisers agreed to settle charges in connection with their failure to disclose conflicts of interest and violations of their fiduciary duties by recommending higher-fee mutual fund share classes despite the availability of less expensive share classes.[54]  Collectively, the companies agreed to pay nearly $15 million in disgorgement, prejudgment interest, and penalties.  The SEC used the announcement of the cases to reiterate its ongoing SCSDC Initiative. E.  Other Compliance Issues In January, the SEC announced settled charges against an Arizona-based investment adviser and its sole principal in connection with a number of Advisers Act violations, including misrepresentations in filed Forms ADV, misrepresentations and failure to produce documents to the Commission examination staff, and other compliance-related deficiencies.[55]  According to the SEC, the adviser’s Forms ADV for years misrepresented its principal’s interest in private funds in which its advisory clients invested.  While the clients were aware of the principal’s involvement with the funds, the adviser falsely stated in filings that the principal had no outside financial industry activities and no interests in client transactions.  Additionally, the SEC alleged that the adviser misstated its assets under management, failed to adopt written policies and procedures relating to advisory fees, and failed to conduct annual reviews of its policies and procedures.  Without admitting or denying the SEC’s allegations, the investment adviser agreed to pay a $100,000 penalty, and the principal agreed to a $50,000 penalty and to a prohibition from acting in a compliance capacity. In April, the SEC filed settled charges against a Connecticut-based investment adviser and its sole owner for improper registration with the Commission and violations of the Commission’s custody and recordkeeping rules.[56]  According to the settled order, the adviser misrepresented the amount of its assets under management in order to satisfy the minimum requirements for SEC registration.  The adviser also allegedly—while having custody over client assets—failed to provide quarterly statements to clients or to arrange for annual surprise verifications of assets by an independent accountant, as required by the Custody Rule, and also failed to make and keep certain books and records required by SEC rules.  Without admitting or denying the allegations, the adviser and its owner agreed to the entry of a cease-and-desist order, and the owner agreed to pay a $20,000 civil penalty and to a 12-month securities industry suspension. A few weeks later, a fund administrator settled cease-and-desist proceedings in connection with the company’s alleged noncompliance in maintaining an affiliated cash fund.[57]  According to the SEC, from mid-2008 to the end of 2012, the firm’s pricing methodology for its affiliated unregistered money market fund was flawed.  The SEC alleged that the deficiencies in the pricing methodology caused the affiliated cash fund to violate Investment Company Act.  To settle the charges, the trust agreed to pay a civil monetary penalty of $225,000. And in June, the SEC announced settlements with 13 private fund advisers in connection with their failures to file Form PF.[58]  Advisers who manage $150 million or more of assets are obligated to file annual reports on Form PF that indicate the amount of assets under management and other metrics about the private funds that they advise.  In turn, the SEC uses the data contained in Form PF in connection with quarterly reports, to monitor industry trends, and to evaluate systemic risks posed by private funds.  Each of the 13 advisers failed to timely file Form PF over a number of years.  Without admitting or denying the allegations, each of the 13 advisers agreed to pay a $75,000 civil penalty. IV.  Brokers and Financial Institutions A.  Supervisory Controls and Internal Systems Deficiencies The SEC brought several cases during the first half of 2018 relating to failures of supervisory controls and internal systems.  In March, the SEC filed a litigated administrative proceeding against a Los Angeles-based financial services firm for failing to supervise one of its employees who was involved in a long-running pump-and-dump scheme and who allegedly received undisclosed benefits for investing her customers in microcap stocks that were the subject of the scheme.[59]  The employee agreed to settle fraud charges stemming from the scheme.  The SEC alleged that the firm ignored multiple signs of the employee’s fraud, including a customer email outlining her involvement in the scheme and multiple FINRA arbitrations and inquiries regarding her penny stock trading activity.  The firm even conducted two investigations, deemed “flawed and insufficient” by the SEC, but failed to take action against the employee.  The SEC previously charged the orchestrator of the pump-and-dump scheme, as well as 15 other individuals and several entities. Also in March, the SEC announced settled charges against a New York-based broker-dealer for its failure to perform required gatekeeping functions in selling almost three million unregistered shares of stock on behalf of a China-based issuer and its affiliates.[60]  The SEC alleged that the firm ignored red flags indicating that the sales could be part of an unlawful unregistered distribution. At the end of June, the SEC charged a New York-based broker-dealer and two of its managers for failing to supervise three brokers, all three of whom were previously charged with fraud in September 2017.[61]  According to the SEC, the firm lacked reasonable supervisory policies and procedures, as well as systems to implement them, and if those systems had been in place, the firm likely would have prevented and detected the brokers’ wrongdoing.  In separate orders, the SEC found that two supervisors ignored red flags indicating excessive trading and failed to supervise brokers with a view toward preventing and detecting their securities-laws violations. B.  AML Cases During the first half of 2018, the SEC brought a number of cases in the anti-money laundering (“AML”) arena.  In March, the SEC brought settled charges against a New York-based brokerage firm for failure to file Suspicious Activity Reports (or “SARs”) reporting numerous suspicious transactions.[62]  The brokerage firm admitted to the charges, and agreed to retain a compliance expert and pay a $750,000 penalty.  The SEC also brought charges against the brokerage firm’s CEO for causing the violation, and its AML compliance officer for aiding and abetting the violation.  Without admitting or denying the charges, the CEO and AML compliance officer respectively agreed to pay penalties of $40,000 and $25,000. In May, the SEC instituted settled charges against two broker-dealers and an AML officer for failing to file SARs relating to the suspicious sales of billions of shares in penny stock.[63]  Without admitting or denying the SEC’s findings, the broker-dealers agreed to penalties; the AML officer agreed to a penalty and an industry and penny stock bar for a minimum of three years. C.  Regulatory Violations In January, the SEC instituted a settled administrative proceeding against an international financial institution for repeated violations of Rule 204 of Regulation SHO, which requires timely delivery of shares to cover short sales.[64]  The SEC’s order alleged that the firm improperly claimed credit on purchases and double counted purchases, resulting in numerous, prolonged fail to deliver positions for short sales.  Without admitting or denying the allegations, the firm agreed to pay a penalty of $1.25 million and entered into an undertaking to fully cooperate with the SEC in all proceedings relating to or arising from the matters in the order. In March, the SEC announced settled charges against a Los-Angeles broker dealer for violating the Customer Protection Rule, which requires that broker-dealers safeguard the cash and securities of customers, by illegally placing more than $25 million of customers’ securities at risk to fund its own operations.[65]  Specifically, the broker-dealer on multiple occasions moved customers’ securities to its own margin account without obtaining the customers’ consent.  The SEC’s Press Release noted that it had recently brought several cases charging violations of the Customer Protection Rule.  Without admitting or denying the allegations, the broker dealer agreed to pay a penalty of $80,000. Also in March, the SEC filed a settled action against a New York-based broker dealer and its CEO and founder for violating the net capital rule, which requires a broker-dealer to maintain sufficient liquid assets to meet all obligations to customers and counterparties and have adequate additional resources to wind down its business in an orderly manner if the firm fails financially.[66]  The SEC found that for ten months, the firm repeatedly failed to maintain sufficient net capital, failed to accrue certain liabilities on its books and records, and misclassified certain assets when performing its net capital calculations.  According to the SEC, the firm’s CEO was involved in discussions about the firm’s unaccrued legal liabilities and was aware of the misclassified assets, but he nevertheless prepared the firm’s erroneous net capital calculations.  As part of the settlement, he agreed to not serve as a financial and operations principal (FINOP) for three years and to pass the required licensing examination prior to resuming duties as a FINOP; the firm agreed to pay a $25,000 penalty. And in a novel enforcement action also arising in March, the SEC filed a settled action against the New York Stock Exchange and two affiliated exchanges in connection with multiple episodes, including several disruptive market events, such as erroneously implementing a market-wide regulatory halt, negligently misrepresenting stock prices as “automated” despite extensive system issues ahead of a total shutdown of two of the exchanges, and applying price collars during unusual market volatility on August 24, 2015, without a rule in effect to permit them.[67]  The SEC also, for the first time, alleged a violation of Regulation SCI, which was adopted by the Commission to strengthen the technology infrastructure and integrity of the U.S. securities markets.  The SEC charged two NYSE exchanges with violating Regulation SCI’s business continuity and disaster recovery requirement.  Without admitting or denying the allegations, the exchanges agreed to pay a $14 million penalty to settle the charges. D.  Other Broker-Dealer Enforcement Actions In June, the SEC settled with a Missouri-based broker-dealer, alleging that the firm generated large fees by improperly soliciting retail customers to actively trade financial products called market-linked investments, or MLIs, which are intended to be held to maturity.[68]  The SEC alleged that the trading strategy, whereby the MLIs were sold before maturity and the proceeds were invested in new MLIs, generated commissions for the firm, which reduced the customers’ investment returns.  The order also found that certain representatives of the firm did not reasonably investigate or understand the significant costs of the MLI exchanges.  The SEC also alleged that the firm’s supervisors routinely approved the MLI transactions despite internal policies prohibiting short-term trading or “flipping” of the products. Later in June, the SEC announced that it had settled with a New York-based broker-dealer for the firm’s violations of its record-keeping provisions by failing to remediate an improper commission-sharing scheme in which a former supervisor received off-book payments from traders he managed.[69]  The SEC also filed a litigated complaint in federal court against the former supervisor and former senior trader for their roles in the scheme.  As alleged by the SEC, the former supervisor and another trader used personal checks to pay a portion of their commissions to the firm’s former global co-head of equities and to another trader.  The practice violated the firm’s policies and procedures and resulted in conflicts of interest that were hidden from the firm’s compliance department, customers, and regulators. E.  Mortgage Backed Securities Cases The SEC appeared to be clearing out its docket of enforcement actions dating back to the mortgage crisis. In February, the SEC announced a settlement against a large financial institution and the former head of its commercial mortgage-backed securities (“CMBS”) trading desk, alleging that traders and salespeople at the firm made false and misleading statements while negotiating secondary market CMBS sales.[70]  According to the SEC’s order, customers of the financial institution overpaid for CMBS because they were misled about the prices at which the firm had originally purchased them, resulting in increased profits for the firm to the detriment of its customers.  The order also alleged that the firm did not have in place adequate compliance and surveillance procedures which were reasonably designed to prevent and detect the misconduct, and also found supervisory failures by the former head trader for failing to take appropriate corrective action.  The firm and trader, without admitting or denying the allegations, agreed to respective penalties of $750,000 and $165,000.  The firm also agreed to repay $3.7 million to customers, which included $1.48 million ordered as disgorgement, and the trader agreed to serve a one-year suspension from the securities industry. Similarly, in mid-June, a large New York-based wealth management firm paid $15 million to settle SEC charges that its traders and salespersons misled customers into overpaying for residential mortgage backed securities (RMBS) by deceiving them about the price that the firm paid to acquire the securities.[71]  The SEC also alleged that the firm’s RMBS traders and salespersons illegally profited from excessive, undisclosed commissions, which in some instances were more than twice the amount that customers should have paid.  According to the SEC, the firm failed to have compliance and surveillance procedures in place that were reasonably designed to prevent and detect the misconduct. V.  Insider Trading A.  Classical Insider Trading And Misappropriation Cases In January, a former corporate insider and a former professional in the brokerage industry agreed to settle allegations that they traded on the stock of a construction company prior to the public announcement of the company’s acquisition.[72]  The insider purportedly tipped his friend, who was then a registered broker-dealer, about the impending transaction in return for assistance in obtaining a new job with his friend’s employer following the merger.  According to the SEC, the broker-dealer traded on that information for a profit exceeding $48,000.  Without admitting or denying the SEC’s findings, both individuals consented to pay monetary penalties, and the trader agreed to disgorge his ill-gotten gains. The following month, the SEC sued a pharmaceutical company employee who allegedly traded in the stock of an acquisition target despite an explicit warning not to do so.[73]  According to the SEC, the defendant bought stock in the other company a mere 14 minutes after receiving an e-mail regarding the acquisition.  Without admitting or denying the SEC’s allegations, the employee agreed to disgorgement of $2,287 and a $6,681 penalty. In February, the SEC charged the former CEO and a former officer of a medical products company with trading on information regarding a merger involving one of their company’s largest customers.[74]  Without admitting or denying the allegations, the two executives agreed to disgorge a total of about $180,000 in trading proceeds and to pay matching penalties. In March, the SEC charged a former communications specialist at a supply chain services company with garnering more than $38,000 in illicit profits after purchasing shares in his company prior to the public announcement of its acquisition.[75]  Without admitting or denying the allegations, the defendant subsequently agreed to $38,242 in disgorgement and the payment of a penalty to be determined following a subsequent motion by the SEC.[76] That same month, the SEC filed suit against the former chief information officer of a company who sold shares of his employer prior to public revelations that that company had suffered a data breach.[77]  In addition, the U.S. Attorney’s Office for the Northern District of Georgia brought  parallel criminal charges.  Both cases are still pending.  Subsequently, at the end of June, the SEC charged another employee at that same company with trading on nonpublic information that he obtained while creating a website for customers affected by the data breach.[78]  The defendant agreed to a settlement requiring him to return ill-gotten gains of more than $75,000 plus interest, and a criminal case filed by the U.S. Attorney’s Office for the Northern District of Georgia remains ongoing. In April, the SEC charged a New York man with tipping his brother and father about the impending acquisition of a medical-supply company based on information that he learned from his friend, the CEO of the company being acquired.[79]  The SEC alleged that the father and brother garnered profits of about $145,000 based on their unlawful trading, and—without admitting or denying the SEC’s allegations—the tipper agreed to pay a $290,000 penalty.  The SEC’s investigation remains ongoing. Also in April, the SEC and the U.S. Attorney’s Office for the District of Massachusetts filed parallel civil and criminal charges against a man accused of trading on a company’s stock based on information gleaned from an unidentified insider.[80]  The man purportedly purchased shares using his retirement savings in advance of eight quarterly earnings announcements over a two-year period, reaping over $900,000 in illicit profits.  The SEC’s complaint also names the man’s wife as a relief defendant, and the matter remains ongoing. Finally, in May, the SEC charged two men with reaping small profits by trading on non-public information in advance of a merger of two snack food companies based on information gained from a close personal friend at one of the merging companies.[81]  Both defendants agreed to settle the lawsuit by disgorging ill-gotten gains and paying penalties. B.  Misappropriation by Investment Professionals and Other Advisors At the end of May, the SEC charged a vice president at an investment bank with repeatedly using confidential knowledge to trade in advance of deals on which his employer advised.[82]  The defendant allegedly used client information to trade in the securities of 12 different companies via a brokerage account held in the name of a friend living in South Korea, evading his employer’s rules that he pre-clear any trades and use an approved brokerage firm.  The trader purportedly garnered approximately $140,000 in illicit profits, and the U.S. Attorney’s Office for the Southern District of New York filed a parallel criminal case.  Both matters are still being litigated. In June, the SEC sued a Canadian accountant for trading on information misappropriated from his client, a member of an oil and gas company’s board of directors.[83]  Based on this relationship, the defendant gained knowledge of an impending merger involving the company.  Without admitting or denying the SEC’s allegations, he agreed to be barred from acting as an officer or director of a public company, and to pay disgorgement and civil penalties of $220,500 each.  The defendant also consented to an SEC order suspending him from appearing or practicing before the Commission as an accountant. Finally, that same month, the SEC charged a credit ratings agency employee and the two friends he tipped about a client’s nonpublic intention to acquire another company.[84]  According to the SEC, the tipper learned the confidential information when the client reached out to the agency to assess the impact of the merger on the company’s credit rating.  Based on the information they received, the friends allegedly netted profits of $192,000 and $107,000, respectively.  In addition, the U.S. Attorney’s Office for the Southern District of New York filed a parallel criminal case against all three individuals.. C.  Other Trading Cases And Developments In February, the Third Circuit Court of Appeals issued a decision in United States v. Metro reversing the district court’s sentencing calculation following the appellant’s conviction on insider trading charges.[85]  The appellant, Steven Metro, was a managing clerk at a New York City law firm, and over the course of five years, he disclosed material nonpublic information to a close friend, Frank Tamayo, concerning 13 different corporate transactions.  Tamayo then transmitted that information to a third-party broker, who placed trades on behalf of Tamayo, himself, and other clients, yielding illicit profits of approximately $5.5 million.  Metro pleaded guilty to one count of conspiracy and one count of securities fraud, and the district court attributed the entire $5.5 million sum to Metro in calculating the length of his sentence.  Metro objected, arguing that he was unaware of the broker’s existence until after he stopped tipping Tamayo. On appeal, the Third Circuit vacated Metro’s sentence after determining that the district court made insufficient factual findings to substantiate imputation of all illicit profits to Metro, holding: “When the scope of a defendant’s involvement in a conspiracy is contested, a district court cannot rely solely on a defendant’s guilty plea to the conspiracy charge, without additional fact-finding, to support attributing co-conspirators’ gains to a defendant.”  The court emphasized that “when attributing to an insider-trading defendant gains realized by other individuals . . . a sentencing court should first identify the scope of conduct for which the defendant can fairly be held accountable . . . .”  Such an inquiry “may lead the court to attribute to a defendant gains realized by downstream trading emanating from the defendant’s tips, but, depending on the facts established at sentencing, it may not,” and the court therefore found that the government erred in propounding a “strict liability” standard. Finally, the first half of this year also saw limited activity by the SEC to freeze assets used to effectuate alleged insider trades.  In January, the SEC obtained an emergency court order freezing the assets of unknown defendants in Swiss bank accounts.[86]  According to the SEC, those unknown defendants were in possession of material nonpublic information regarding the impending acquisition of a biopharmaceutical company, and some of the positions taken in those accounts represented almost 100 percent of the market for those particular options.  The illicit trades allegedly yielded about $5 million in profits.. VI.  Municipal Securities and Public Pensions Cases In the first half of 2018, the SEC’s Public Finance Abuse Unit continued the slower pace of enforcement that began in 2017, pursuing two separate cases against municipal advisors. In January, the SEC charged an Atlanta, Georgia-based municipal advisor and its principal with defrauding the city of Rolling Fork, Mississippi.[87]  The SEC alleged that the municipal advisor had fraudulently overcharged Rolling Fork for municipal advisory services in connection with an October 2015 municipal bond offering and had failed to disclose certain related-party payments.  The related-party payments consisted of an undisclosed $2500 payment made to the advisor by an employee of a municipal underwriter shortly before the advisor recommended that the city hire the underwriter’s firm.  The parties subsequently agreed to settle the case.[88]  Without admitting or denying the allegations against them, the advisor and principal consented to the entry of judgments permanently enjoining them from violating Sections 15B(a)(5) and 15B(c)(1) of the Securities Exchange Act of 1934 and MSRB Rule G-17.  The judgment also requires the defendants to pay a total of about $111,000 in disgorgement, interest, and penalties. In addition, the SEC settled its case against the municipal underwriter.  Without admitting the SEC’s findings, the underwriter agreed to a six-month suspension and to pay a $20,000 penalty. And in May, the SEC brought settled administrative proceedings against another municipal advisor and its owner.[89]  The SEC alleged that, by misrepresenting their municipal advisory experience and failing to disclose conflicts of interest, the advisor and owner had defrauded a South Texas school district and breached their fiduciary duties to that district.  Without admitting to the allegations, the advisor and owner agreed to pay a combined total of approximately $562,000 in disgorgement, interest, and penalties.. [1] Lucia v. SEC, 585 U.S. __ (2018).  For more on Lucia, see Gibson Dunn Client Alert, SEC Rules That SEC ALJs Were Unconstitutionally Appointed (June 21, 2018), available at www.gibsondunn.com/supreme-court-rules-that-sec-aljs-were-unconstitutionally-appointed. [2] See Gibson Dunn Client Alert, U.S. Supreme Court Limits SEC Power to Seek Disgorgement Based on Stale Conduct (June 5, 2017), available at www.gibsondunn.com/united-states-supreme-court-limits-sec-power-to-seek-disgorgement-based-on-stale-conduct. [3] SEC v Kokesh, No. 15-2087 (10th Cir. Mar. 5, 2018); see also Jonathan Stempel, SEC Can Recoup Ill-gotten Gains from New Mexico Businessman: U.S. Appeals Court, Reuters (Mar. 5, 2018), available at www.reuters.com/article/us-sec-kokesh/sec-can-recoup-ill-gotten-gains-from-new-mexico-businessman-u-s-appeals-court-idUSKBN1GH2YK. [4] Adam Dobrik, Unhelpful to Threaten SEC with Trial, Says Enforcement Director, Global Investigations Review (May 10, 2018), available at globalinvestigationsreview.com/article/jac/1169315/unhelpful-to-threaten-sec-with-trial-says-enforcement-director. [5] See SEC v. Cohen, No. 1:17-CV-00430 (E.D.N.Y. July 12, 2018) (holding claims for injunctive relief time-barred). [6] Dunstan Prial, High Court Agrees To Review Banker’s Copy-Paste Fraud, Law360 (Jun. 18, 2018), available at https://www.law360.com/securities/articles/1054568. [7] SEC Press Release, SEC Awards Whistleblower More Than $2.1 Million (Apr. 12, 2018), available at www.sec.gov/news/press-release/2018-64. [8] SEC Press Release, SEC Announces Its Largest-Ever Whistleblower Awards (Mar. 19, 2018), available at https://www.sec.gov/news/press-release/2018-44. [9] Ed Beeson, SEC Whistleblowers Net $83M In Largest Ever Bounties, Law360 (Mar. 19, 2018), available at www.law360.com/articles/1023646/sec-whistleblowers-net-83m-in-largest-ever-bounties. [10] In re Claims for Award in connection with [redacted], Admin. Proc. File No. 2018-6 (Mar. 19, 2018), available at https://www.sec.gov/rules/other/2018/34-82897.pdf. [11] SEC Press Release, SEC Awards More Than $2.2 Million to Whistleblower Who First Reported Information to Another Federal Agency Before SEC (Apr. 5, 2018), available at www.sec.gov/news/press-release/2018-58. [12] SEC Press Release, SEC Awards Whistleblower More Than $2.1 Million (Apr. 12, 2018), available at www.sec.gov/news/press-release/2018-64. [13] Digital Realty Trust, Inc. v. Somers, 583 U.S. __ (2018); see Dunstan Prial, Supreme Court Narrows Definition Of Whistleblower, Law360 (Feb. 21, 2018), available at www.law360.com/securities/articles/1003954. [14] Jennifer Williams Alvarez, SEC Proposes Changes to Whistle-Blower Program, Agenda: A Financial Times Services (Jun. 28, 2018), available at [insert]. [15] SEC Public Statement, Statement on Cybersecurity Interpretive Guidance (Feb. 21, 2018), available at www.sec.gov/news/public-statement/statement-clayton-2018-02-21. [16] SEC Public Statement, Statement on Potentially Unlawful Online Platforms for Trading Digital Assets (March 7, 2018), available at https://www.sec.gov/news/public-statement/enforcement-tm-statement-potentially-unlawful-online-platforms-trading. [17] SEC Press Release, SEC Charges Former Bitcoin-Denominated Exchange and Operator with Fraud (Feb. 21, 2018), available at https://www.sec.gov/news/press-release/2018-23. [18] SEC Press Release, SEC Halts Alleged Initial Coin Offering Scam (Jan. 30, 2018), available at www.sec.gov/news/press-release/2018-8. [19] SEC Press Release, SEC Halts Fraudulent Scheme Involving Unregistered ICO (April 2, 2018), available at www.sec.gov/news/press-release/2018-53. [20] SEC Press Release, SEC Charges Additional Defendant in Fraudulent ICO Scheme (April 20, 2018), available at www.sec.gov/news/press-release/2018-70. [21] SEC Press Release, SEC Obtains Emergency Order Halting Fraudulent Coin Offering Scheme (May 29, 2018), available at www.sec.gov/news/press-release/2018-94. [22] SEC Press Release, SEC Obtains Emergency Freeze of $27 Million in Stock Sales of Purported Cryptocurrency Company Longfin (April 6, 2018), available at www.sec.gov/news/press-release/2018-61. [23] SEC Press Release, SEC Charges Energy Storage Company, Former Executive in Fraudulent Scheme to Inflate Financial Results (Mar. 27, 2018), available at www.sec.gov/news/press-release/2018-48. [24] SEC Press Release, Panasonic Charged with FCPA and Accounting Fraud Violations (Apr. 30, 2018), available at www.sec.gov/news/press-release/2018-73. [25] SEC Press Release, Altaba, Formerly Known as Yahoo!, Charged With Failing to Disclose Massive Cybersecurity Breach; Agrees To Pay $35 Million (Apr. 24, 2018), available at www.sec.gov/news/press-release/2018-71. [26] SEC Press Release, SEC Charges Three Former Healthcare Executives With Fraud (May 16, 2018), available at www.sec.gov/news/press-release/2018-90. [27] SEC Litig. Rel. No. 24181, SEC Charges California Company and Three Executives with Accounting Fraud (July 2, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24181.htm. [28] SEC Press Release, SEC Obtains Bars and Suspensions Against Individuals and Accounting Firm in Shell Factory Scheme (Feb. 16, 2018), available at www.sec.gov/news/press-release/2018-21. [29] SEC Press Release, Foreign Affiliates of KPMG, Deloitte, BDO Charged in Improper Audits (Mar. 13, 2018), available at www.sec.gov/news/press-release/2018-39. [30] In the Matter of Winter, Kloman, Moter & Repp, S.C., Curtis W. Disrud, CPA, and Paul R. Sehmer, CPA, Admin. Proc. File No. 3-18466 (May 04, 2018), available at www.sec.gov/litigation/admin/2018/34-83168.pdf. [31] AP File No. 3-18442, SEC Charges New Jersey-Based Company and Founder for Impermissible Association with Barred Auditor (Apr. 19, 2018), available at www.sec.gov/enforce/34-83067-s. [32] SEC Admin. Proc. File No. 3-18398, Fintech Company Charged For Stock Option Offering Deficiencies, Failed To Provide Required Financial Information To Employee Shareholders (Mar. 12, 2018), available at www.sec.gov/litigation/admin/2017/34-82233-s.pdf. [33] SEC Press Release, Theranos, CEO Holmes, and Former President Balwani Charged With Massive Fraud (Mar. 14, 2018), available at www.sec.gov/news/press-release/2018-41. [34] SEC Litig. Rel. No. 24121, SEC Charges Biotech Start-up, CEO With Fraud (Apr. 24, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24121.htm. [35] In the Matter of THL Managers V, LLC, and THL Managers, VI, LLC, Admin. Proc. File No. 3-18565 (June 29, 2018), available at www.sec.gov/litigation/admin/2018/ia-4952.pdf. [36] SEC Admin. Proc. File No. 3-18564, SEC Charges New York-Based Venture Capital Fund Adviser for Failing to Offset Consulting Fees (June 29, 2018), available at www.sec.gov/enforce/ia-4951-s. [37] SEC Press Release, (Mar. 8, 2018), available at www.sec.gov/news/press-release/2018-35. [38] SEC Admin. Proc. File No. 3-18449, SEC Charges a New York-Based Investment Adviser for Breach of Fiduciary Duty (Apr. 24, 2018), available at www.sec.gov/enforce/ia-4896-s. [39] SEC Press Release, SEC Charges Investment Adviser and Two Former Managers for Misleading Retail Clients (June 4, 2018), available at www.sec.gov/news/press-release/2018-101. [40] In re Lyxor Asset Management, Inc., Admin Proc. File No. 3-18526 (June 4, 2018), available at www.sec.gov/litigation/admin/2018/ia-4932.pdf. [41] SEC Admin. Proc. File No. 3-18349, Investment Adviser and Its Principals Settle SEC Charges that They Failed to Disclose Risks of Investing in Their Advisory Business (Jan. 23, 2018), available at  www.sec.gov/enforce/33-10454-s. [42] SEC Litig. Rel. No. 24037, SEC Charges Two Boston-Based Investment Advisers with Fraud (Jan. 31, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24037.htm. [43] Nate Raymond, Ex-Morgan Stanley adviser sentenced to U.S. prison for fraud, Reuters (June 28, 2018), available at www.reuters.com/article/morgan-stanley-fraud/ex-morgan-stanley-adviser-sentenced-to-u-s-prison-for-fraud-idUSL1N1TU28Q. [44] SEC Litig. Rel. No. 24054, SEC Charges Orange County Investment Adviser and Senior Officers in Fraudulent “Cherry-Picking” Scheme (Feb. 21, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24054.htm. [45] SEC Press Release, Investment Adviser Settles Charges for Cheating Clients in Fraudulent Cherry-Picking Scheme (Mar. 8, 2018), available at www.sec.gov/news/press-release/2018-36. [46] In re Arlington Capital Management, Inc. and Joseph L. LoPresti, Admin. Proc. File No. 3-18437 (Apr. 16, 2018), available at www.sec.gov/litigation/admin/2018/ia-4885.pdf. [47] SEC Litig. Rel. No. 24142, SEC Charges California Investment Adviser in Multi-Million Dollar Fraud (May 15, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24142.htm. [48] In re Aberon Capital Management, LLC and Joseph Krigsfeld, Admin. Proc. File No. 3-18503 (May 24, 2018), available at www.sec.gov/litigation/admin/2018/ia-4914.pdf. [49] SEC Press Release, Hedge Fund Firm Charged for Asset Mismarking and Insider Trading (May 8, 2018), available at www.sec.gov/news/press-release/2018-81. [50] SEC Press Release, SEC Charges Hedge Fund Adviser With Deceiving Investors by Inflating Fund Performance (May 9, 2018), available at www.sec.gov/news/press-release/2018-83. [51] SEC Press Release, SEC Charges Morgan Stanley in Connection With Failure to Detect or Prevent Misappropriation of Client Funds (June 29, 2018), available at www.sec.gov/news/press-release/2018-124. [52] SEC Press Release, SEC Launches Share Class Selection Disclosure Initiative to Encourage Self-Reporting and the Prompt Return of Funds to Investors (Feb. 12, 2018), available at www.sec.gov/news/press-release/2018-15. [53] SEC Press Release, SEC Charges Ameriprise With Overcharging Retirement Account Customers for Mutual Fund Shares (Feb. 28, 2018), available at www.sec.gov/news/press-release/2018-26. [54] SEC Press Release, SEC Orders Three Investment Advisers to Pay $12 Million to Harmed Clients (Apr. 6, 2018), available at www.sec.gov/news/press-release/2018-62. [55] SEC Admin. Proc. File No. 3-18328, Formerly Registered Investment Adviser Settles SEC Charges Related to Filing False Forms ADV and Other Investment Advisers Act Violations (Jan. 3, 2018), available at www.sec.gov/litigation/admin/2018/ia-4836-s.pdf. [56] SEC Admin. Proc. File No. 3-18423, SEC Charges Investment Adviser for Improperly Registering with the Commission and Violating Several Rules (Apr. 5, 2018), available at www.sec.gov/enforce/ia-4875-s. [57] In re SEI Investments Global Funds Services, Admin. Proc. File No. 3-18457 (Apr. 26, 2018), available at www.sec.gov/litigation/admin/2018/ic-33087.pdf. [58] SEC Press Release, SEC Charges 13 Private Fund Advisers for Repeated Filing Failures (June 1, 2018), available at www.sec.gov/news/press-release/2018-100. [59] SEC Press Release, SEC Charges Recidivist Broker-Dealer in Employee’s Long-Running Pump-and-Dump Fraud (Mar. 27, 2018), available at www.sec.gov/news/press-release/2018-49. [60] SEC Press Release, Merrill Lynch Charged With Gatekeeping Failures in the Unregistered Sales of Securities (Mar. 8, 2018), available at www.sec.gov/news/press-release/2018-32. [61] SEC Press Release, SEC Charges New York-Based Firm and Supervisors for Failing to Supervise Brokers Who Defrauded Customers (June 29, 2018), available at www.sec.gov/news/press-release/2018-123. [62] SEC Press Release, Broker-Dealer Admits It Failed to File SARs (Mar. 28, 2018), available at www.sec.gov/news/press-release/2018-50. [63] SEC Charges Brokerage Firms and AML Officer with Anti-Money Laundering Violations (May 16, 2018), available at www.sec.gov/news/press-release/2018-87. [64] Administrative Proceeding File No. 3-18341, Industrial and Commercial Bank of China Financial Services LLC Agrees to Settle SEC Charges Relating to Numerous Regulation SHO Violations That Resulted in Prolonged Fails to Deliver (Jan. 18, 2018), available at www.sec.gov/litigation/admin/2018/34-82533-s.pdf. [65] SEC Press Release, Broker Charged with Repeatedly Putting Customer Assets at Risk (Mar. 19, 2018), available at www.sec.gov/news/press-release/2018-45. [66] Admin. Proc. File No. 3-18409, SEC Charges Broker-Dealer, CEO With Net Capital Rule Violations (Mar. 27, 2018), available at www.sec.gov/enforce/34-82951-s. [67] SEC Press Release, NYSE to Pay $14 Million Penalty for Multiple Violations (Mar. 6, 2018), available at www.sec.gov/news/press-release/2018-31. [68] SEC Press Release, Wells Fargo Advisors Settles SEC Chargers for Improper Sales of Complex Financial Products (June 25, 2018), available at www.sec.gov/news/press-release/2018-112. [69] Lit. Rel. No. 24179, SEC Charges Cantor Fitzgerald and Brokers in Commission-Splitting Scheme (June 29, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24179.htm. [70] SEC Press Release, Deutsche Bank to Repay Misled Customers (Feb. 12, 2018), available at www.sec.gov/news/press-release/2018-13. [71] SEC Press Release, SEC Charges Merrill Lynch for Failure to Supervise RMBS Traders (June 12, 2018), available at www.sec.gov/news/press-release/2018-105. [72] Admin. Proc. File No. 3-18335, Former Corporate Insider and Brokerage Industry Employee Settle Insider Trading Charges with SEC (Jan. 11, 2018), available at www.sec.gov/litigation/admin/2018/34-82485-s.pdf. [73] Lit. Rel. No. 24056,  SEC: Insider Bought Minutes After Warnings Not to Trade (Feb. 28., 2018), available at www.sec.gov/litigation/litreleases/2018/lr24056.htm. [74] Lit Rel. No. 24044, SEC Charges Former Medical Products Executives with Insider Trading (Feb. 12, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24044.htm. [75] Lit Rel. No. 24065, SEC Charges Corporate Communications Specialist with Insider Trading Ahead of Acquisition Announcement (Mar. 8, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24065.htm. [76] Lit Rel. No. 24163, Court Enters Consent Judgment against Robert M. Morano (June 11, 2018), available at https://www.sec.gov/litigation/litreleases/2018/lr24163.htm. [77] Press Release, Former Equifax Executive Charged With Insider Trading (Mar. 14, 2018), available at www.sec.gov/news/press-release/2018-40. [78] Press Release, Former Equifax Manager Charged With Insider Trading (June 28, 2018), available at www.sec.gov/news/press-release/2018-115. [79] Lit Rel. No. 24104, SEC Charges New York Man with Insider Trading (Apr. 5, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24104.htm. [80] Lit Rel. No. 24097, SEC Charges Massachusetts Man in Multi-Year Trading Scheme (Apr. 5, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24097.htm. [81] Lit Rel. No. 24134, SEC Charges Two Pennsylvania Residents with Insider Trading (May 4, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24134.htm. [82] Press Release, SEC Charges Investment Banker in Insider Trading Scheme (May 31, 2018), available at www.sec.gov/news/press-release/2018-97. [83] Lit Rel. No. 24165, SEC Charges Canadian Accountant with Insider Trading (June 12, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24164.htm. [84] Lit Rel. No. 24178, SEC Charges Credit Ratings Analyst and Two Friends with Insider Trading (June 29, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24178.htm. [85] 882 F.3d 431 (3d Cir. 2018); see also Tom Gorman, “SEC Disgorgement: A Path For Reform?,” SEC Actions Blog (Feb. 20, 2018), available at http://www.lexissecuritiesmosaic.com/net/Blogwatch/Blogwatch.aspx?ID=32139&identityprofileid=PJ576X25804. [86] Lit Rel. No. 24035, SEC Freezes Assets Behind Alleged Insider Trading (Jan. 26, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24035.htm. [87] SEC Press Release, SEC Charges Municipal Adviser and its Principal with Defrauding Mississippi City (January 5, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24025.htm. [88] SEC Press Release, SEC Obtains Judgments Against Municipal Adviser and Its Principal for Defrauding Mississippi City (July 2, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24182.htm. [89] SEC Press Release, SEC Levies Fraud Charges Against Texas-Based Municipal Advisor, Owner for Lying to School District (May 9, 2018), available at www.sec.gov/news/press-release/2018-82. The following Gibson Dunn lawyers assisted in the preparation of this client update:  Marc Fagel, Mary Kay Dunning, Amruta Godbole, Amy Mayer, Jaclyn Neely, Joshua Rosario, Alon Sachar, Tina Samanta, Lindsey Young and Alex Zbrozek. Gibson Dunn is one of the nation’s leading law firms in representing companies and individuals who face enforcement investigations by the Securities and Exchange Commission, the Department of Justice, the Commodities Futures Trading Commission, the New York and other state attorneys general and regulators, the Public Company Accounting Oversight Board (PCAOB), the Financial Industry Regulatory Authority (FINRA), the New York Stock Exchange, and federal and state banking regulators. Our Securities Enforcement Group offers broad and deep experience.  Our partners include the former Directors of the SEC’s New York and San Francisco Regional Offices, the former head of FINRA’s Department of Enforcement, the former United States Attorneys for the Central and Eastern Districts of California, and former Assistant United States Attorneys from federal prosecutors’ offices in New York, Los Angeles, San Francisco and Washington, D.C., including the Securities and Commodities Fraud Task Force. Securities enforcement investigations are often one aspect of a problem facing our clients. Our securities enforcement lawyers work closely with lawyers from our Securities Regulation and Corporate Governance Group to provide expertise regarding parallel corporate governance, securities regulation, and securities trading issues, ourSecurities Litigation Group, and our White Collar Defense Group. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work or any of the following: New York Reed Brodsky (+1 212-351-5334, rbrodsky@gibsondunn.com) Joel M. Cohen (+1 212-351-2664, jcohen@gibsondunn.com) Lee G. Dunst (+1 212-351-3824, ldunst@gibsondunn.com) Barry R. Goldsmith – Co-Chair (+1 212-351-2440, bgoldsmith@gibsondunn.com) Laura Kathryn O’Boyle (+1 212-351-2304, loboyle@gibsondunn.com) Mark K. Schonfeld – Co-Chair (+1 212-351-2433, mschonfeld@gibsondunn.com) Alexander H. Southwell (+1 212-351-3981, asouthwell@gibsondunn.com) Avi Weitzman (+1 212-351-2465, aweitzman@gibsondunn.com) Lawrence J. Zweifach (+1 212-351-2625, lzweifach@gibsondunn.com) Washington, D.C. Stephanie L. Brooker  (+1 202-887-3502, sbrooker@gibsondunn.com) David P. Burns (+1 202-887-3786, dburns@gibsondunn.com) Daniel P. Chung(+1 202-887-3729, dchung@gibsondunn.com) Stuart F. Delery (+1 202-887-3650, sdelery@gibsondunn.com) Richard W. Grime – Co-Chair (+1 202-955-8219, rgrime@gibsondunn.com) Patrick F. Stokes (+1 202-955-8504, pstokes@gibsondunn.com) F. Joseph Warin (+1 202-887-3609, fwarin@gibsondunn.com) San Francisco Winston Y. Chan (+1 415-393-8362, wchan@gibsondunn.com) Thad A. Davis (+1 415-393-8251, tadavis@gibsondunn.com) Marc J. Fagel – Co-Chair (+1 415-393-8332, mfagel@gibsondunn.com) Charles J. Stevens (+1 415-393-8391, cstevens@gibsondunn.com) Michael Li-Ming Wong (+1 415-393-8234, mwong@gibsondunn.com) Palo Alto Paul J. Collins (+1 650-849-5309, pcollins@gibsondunn.com) Benjamin B. Wagner (+1 650-849-5395, bwagner@gibsondunn.com) Denver Robert C. Blume (+1 303-298-5758, rblume@gibsondunn.com) Monica K. Loseman (+1 303-298-5784, mloseman@gibsondunn.com) Los Angeles Michael M. Farhang (+1 213-229-7005, mfarhang@gibsondunn.com) Douglas M. Fuchs (+1 213-229-7605, dfuchs@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

April 23, 2018 |
FinCEN Issues FAQs on Customer Due Diligence Regulation

Click for PDF On April 3, 2018, FinCEN issued its long-awaited Frequently Asked Questions Regarding Customer Due Diligence Requirements for Financial Institutions, FIN-2018-G001. https://www.fincen.gov/resources/statutes-regulations/guidance/frequently-asked-questions-regarding-customer-due-0.[1]  The timing of this guidance is very controversial, issued five weeks before the new Customer Due Diligence (“CDD”) regulation goes into effect on May 11, 2018.[2]  Most covered financial institutions (banks, broker-dealers, mutual funds, and futures commission merchants and introducing brokers in commodities) already have drafted policies, procedures, and internal controls and made IT systems changes to comply with the new regulation.  Covered financial institutions will need to review these FAQs carefully to ensure that their proposed CDD rule compliance measures are consistent with FinCEN’s guidance. The guidance is set forth in 37 questions.  As discussed below, some of the information is helpful, allaying financial institutions’ most significant concerns.  Other FAQs confirm what FinCEN has said in recent months informally to industry groups and at conferences.  A few FAQs raise additional questions, and others, particularly the FAQ on rollovers of certifications of deposit and loan renewals, are not responsive to industry concerns and may raise significant compliance burdens for covered financial institutions.  The guidance reflects FinCEN’s regulatory interpretations based on discussions within the government and with financial institutions and their trade associations.  The need for such extensive guidance on so many issues in the regulation illustrates the complexity of compliance and suggests that FinCEN should consider whether clarifications and technical corrections to the regulation should be made.  We provide below discussion of highlights from the FAQs, including areas of continued ambiguity and uncertainty in the regulation and FAQs. Highlights from the FAQs FAQ 1 and 2 discuss the threshold for obtaining and verifying beneficial ownership.  FinCEN states that financial institutions can “choose” to collect beneficial ownership information at a lower threshold than required under the regulation (25%), but does not acknowledge that financial institution regulators may expect a lower threshold for certain business lines or customer types or that there may be regulatory concerns if financial institutions adjust thresholds upward to meet the BSA regulatory threshold.  A covered financial institution may be in compliance with the regulatory threshold, but fall short of regulatory expectations. FAQ 7 states that a financial institution need not re-verify the identity of a beneficial owner of a legal entity customer if that beneficial owner is an existing customer of the financial institution on whom CIP has been conducted previously provided that the existing information is “up-to-date, accurate, and the legal entity’s customer’s representative certifies or confirms (verbally or in writing) the accuracy of the pre-existing CIP information.”  The example given suggests that no steps are expected to verify that the information is up-to-date and accurate beyond the representative’s confirmation or certification.  The beneficial ownership records must cross reference the individual’s CIP record. FAQs 9-12 address one of the most controversial aspects of the regulation, about which there has been much confusion: the requirement that, when an existing customer opens a new account, a financial institution must identify and verify beneficial ownership information.  FinCEN provides further clarity on what must be updated and how:Under FAQ 10, if a legal entity customer, for which the required beneficial ownership information has been obtained for an existing account, opens a new account, the financial institution can rely on the information obtained and verified previously “provided the customer certifies or confirms (verbally or in writing) that such information is up-to-date and accurate at the time each subsequent new account is opened,” and the financial institution has no knowledge that would “reasonably call into question” the reliability of the information.  The financial institution also would need to maintain a record of the certification or confirmation by the customer.There is no grace period.  If an account is opened on Tuesday, and a new account is opened on Thursday, the certification or confirmation is still required.  In advance planning for compliance, many financial institutions had included a grace period in their procedures. FAQ 11 provides that, when the financial institution opens a new account or subaccount for an existing legal entity customer whose beneficial ownership has been verified for the institution’s own recordkeeping and operational purposes and not at the customer’s request, there is no requirement to update the beneficial ownership information for the new account.  This is because the account would be considered opened by the financial institution and the requirement to update only applies to each new account opened by a customer.  This is consistent with what FinCEN representatives have said at recent conferences.The FAQ specifies that this would not apply to (1) accounts or subaccounts set up to accommodate a trading strategy of a different legal entity, e.g., a subsidiary of the customer, or (2) accounts of a customer of the existing legal entity customer, “i.e., accounts (or subaccounts) through which a customer of a financial institution’s existing legal entity carries out trading activity through the financial institution without intermediation from the existing legal entity customer.”  We believe the FAQ may fall far short of addressing all the concerns expressed to FinCEN on this issue by the securities industry. FAQ 12 addresses an issue which has been a major concern to the banking industry:  whether beneficial ownership information must be updated when a certificate of deposit (“CD”) is rolled over or a loan is renewed.  These actions are generally not considered opening of new accounts by banks.FinCEN continues to maintain that CD rollovers or loan renewals are openings of new accounts for purposes of the CDD regulation.  Therefore, the first time a CD or loan renewal for a legal entity customer occurs after May 11, 2018, the effective date of the CDD regulation, beneficial ownership information must be obtained and verified, and at each subsequent rollover or renewal, there must be confirmation that the information is current and accurate (consistent with FAQ 10) as for any other new account for an existing customer.  There is an exception or alternative approach authorized in FAQ 12 “because the risk of money laundering is very low”:  If, at the time of the rollover or renewal, the customer certifies its beneficial ownership information, and also agrees to notify the financial institution of any change in information in the future, no action will be required at subsequent renewals or rollovers.The response in FAQ 12 is not responsive to the concerns that have been expressed by the banking industry and will be burdensome for banks to administer.  Obtaining a certification in time, without disrupting the rollover or renewal, will be challenging, and it appears that if it the certification or promise to update is not obtained in time, the account may have to be closed. FAQs 13 through 17 address another aspect of the regulation that has generated extensive discussion: When (1) must beneficial ownership be obtained for an account opened before the effective date of the regulation, or (2) beneficial ownership information updated on existing accounts whose beneficial ownership has been obtained and verified.Following closely what was said in the preamble to the final rule, FAQ 13 states that the obligation is triggered when a financial institution “becomes aware of information about the customer during the course of normal monitoring relevant to assessing or reassessing the risk posed by the customer, and such information indicates a possible change in beneficial ownership.”FAQ 14 clarifies somewhat what is considered normal monitoring but is not perfectly clear what triggers obtaining and verifying beneficial ownership.  It is clear that there is no obligation to obtain or update beneficial ownership information in routine periodic CDD reviews (CDD refresh reviews) “absent specific risk-based concerns.” We would assume that means, following FAQ 13, concerns about the ownership of the customer.  Beyond that FAQ 14  is less clear.  It states that the obligation is triggered “when, in the course of normal monitoring a financial institution becomes aware of information about a customer or an account, including a possible change of beneficial ownership information, relevant to assessing or reassessing the customer’s overall risk profile.  Absent such a risk-related trigger or event, collecting or updating of beneficial ownership information is at the discretion of the covered financial institution.”The trigger or event may mean in the course of SAR monitoring or when conducting event-driven CDD reviews, e.g., when a subpoena is received or material negative news is identified – something that may change a risk profile.  Does the obligation then arise only if the risk profile change includes a concern about whether the financial institution has accurate ownership information?  That may be the intent, but is not clearly stated.  If the account is being considered for closure because of the change in risk profile, would the financial institution be released from the obligation to obtain beneficial ownership?   That would make sense, but is not stated.  This FAQ is in need of clarification and examples would be helpful.On another note, the language in FAQ 14 also is of interest because it may suggest, in FinCEN’s view, that periodic CDD reviews should be conducted on a risk basis, and CDD refresh reviews may not be expected for lower risk customers, as is the practice for some banks. FAQ 18 seems to address at least partially a technical issue with the regulation that arises because SEC-registered investment advisers are excluded from the definition of legal entity customer in the regulation, but U.S. pooled investment vehicles advised by them are not excluded.[3]  FAQ 18 states that, if the operator or adviser of a pooled investment vehicle is not excluded from the definition of legal entity customer, under the regulation, e.g., like a foreign bank, no beneficial ownership information is required to be obtained on the pooled investment vehicle under the ownership prong, but there must be compliance with beneficial ownership control party prong, i.e., verification of identity of a control party.  A control party could be a “portfolio manager” in these situations.FinCEN describes why no ownership information is required as follows:  “Because of the way the ownership of a pooled investment vehicle fluctuates, it would be impractical for covered financial institutions to collect and verify ownership identity for this type of entity.”  Thus, in the case where the operator or adviser of the pooled investment vehicle is excluded from the definition of legal entity, like an SEC-registered investment adviser, it would seem not to be an expectation to obtain beneficial ownership information under the ownership prong.  Nevertheless, the question of whether you need to obtain and verify the identity of a control party for a pooled investment vehicle advised by a SEC registered investment adviser is not squarely answered in the FAQ.  A technical correction to the regulation is still needed, but it is unlikely there would be regulatory or audit criticism for following the FAQ guidance at least with respect to the ownership prong. FAQ 19 clarifies that, when a beneficial owner is a trust (where the legal entity customer is owned more than 25% by a trust), the financial institution is only required to verify the identity of one trustee if there are multiple trustees. FAQ 20 deals with what to do if a trust holds more than a 25% beneficial interest in a legal entity customers and the trustee is not an individual, but a legal entity, like a bank or law firm.  Under the regulation, if a trust holds more than 25% beneficial ownership of a legal entity customer, the financial institution must verify the identity of the trustee to satisfy the ownership prong of the beneficial ownership requirement.  The ownership prong references identification of “individuals.”  Consequently, the language of the regulation does not seem to contemplate the situation where the trustee was a legal entity.FAQ 20 seems to suggest that, despite this issue with the regulation, CIP should be conducted on the legal entity trustee, but apparently, on a risk basis, not in every case:  “In circumstances where a natural person does not exist for purposes of the ownership/equity prong, a natural person would not be identified.  However, a covered financial institution should collect identification information on the legal entity trustee as part of its CIP, consistent with the covered institution’s risk assessment and customer risk profile.”  (Emphasis added.)More clarification is needed on this issue, and perhaps an amendment to the regulation to address this specific situation.  Pending additional guidance, the safest course appears to be to verify the identity of legal entity trustee consistent with CIP requirements, which may pose practical difficulties, e.g., will a law firm trustee easily provide its TIN?  Presumably, CIP would not be required on any legal entity trustee that is excepted from the definition of legal entity under 31 C.F.R. § 1010.230(e)(2). FAQ 21 addresses the question of how does a financial institution verify that a legal entity comes within one of the regulatory exceptions to the definition of legal entity customer in 31 C.F.R. § 1010.230(e)(2).  The answer is that the financial institution generally can rely on information provided by the customer if it has no knowledge of facts that would reasonably call into question the reliability of the information.  Nevertheless, that is not the end of the story.  The FAQ provides that the financial institution also must have risk-based policies and procedures that specify the type of information they will obtain and reasonably rely on to determine eligibility for exclusions. FAQ 24 may resolve another technical issue in the regulation.  The exceptions to the definition of legal entity in the regulation refer back to the BSA CIP exemption provisions, which in turn, cross reference the Currency Transaction Reporting (CTR) exemption for banks when granting so-called Tier One exemptions.  One category for the CTR exemption is “listed” entities, which includes NASDAQ listed entities, but excludes NASDAQ Capital Markets Companies, i.e., this category of NASDAQ listed entity is not subject to CIP or CTR Tier One exemptions.  31 C.F.R. § 1020.315(b)(4).  This carve out was not discussed in the preamble to the CDD final regulation or in FAQ 24.The FAQ simply states:  “[A]ny company (other than a bank) whose common stock or analogous equity interests are listed on the New York Stock Exchange, the American Stock Exchange (currently known as the NYSE American), or NASDAQ stock exchange” is excepted from the definition of legal entity.  In any event, as with the FAQ 18 issue, it would appear that a technical correction is needed on this point, but, given the FAQ, it is unlikely that a financial institution would be criticized if it treated NASDAQ Capital Markets Companies as excepted legal entities. FAQs 32 and 33 end the speculation that the CDD regulation impacts CTR compliance.  Consistent with FinCEN CTR guidance, under FAQ 32, the rule remains that, for purposes of CTR aggregation, the fact that two businesses share a common owner does not mean that a financial institution must aggregate the currency transactions of the two businesses for CTR reporting, except in the narrow situation where there is a reason to believe businesses are not being operated separately. Conclusion Financial institutions and their industry groups will likely continue to seek further guidance on the most problematic issues in the CDD regulation.  It is our understanding that FinCEN and the bank regulators also will address compliance with the CDD regulation in the upcoming update to the FFIEC Bank Secrecy Act/Anti-Money Laundering Examination Manual. Covered financial institutions already have spent, and will continue to spend, significant time and resources to meet the complex regulatory requirements and anticipated regulatory expectations.  In this flurry of activity to address regulatory risk, it is essential for financial institutions to continue to consider any money laundering risk of legal entity clients and that CDD not become simply mechanical.  It is not only a matter of documenting and updating all of the right information about beneficial ownership and control, but financial institutions should continue to assess whether the ownership structure makes sense for the business or whether it is overly complex for the business type and purposely opaque.  Also, it is important to consider whether it makes sense for a particular legal entity to be seeking a relationship with your financial institution and whether the legal entity is changing financial institutions voluntarily.  CDD measures to address regulatory risk and money laundering risk overlap but are not equivalent.    [1]   FinCEN also issued FAQs on the regulation on July 19, 2016. https://www.fincen.gov/sites/default/files/2016-09/FAQs_for_CDD_Final_Rule_%287_15_16%29.pdf.   FINRA issued guidance on the CDD regulation in FINRA Notice to Members 17-40 (Nov. 21, 2017). http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-17-40.pdf.    [2]   The Notice of Final Rulemaking was published on May 11, 2016 and provided a two-year implementation period.  81 Fed. Reg. 29,398 (May 11, 2016). https://www.gpo.gov/fdsys/pkg/FR-2016-05-11/pdf/2016-10567.pdf.  FinCEN made some slight amendments to the rule on September 29, 2017.  https://www.fincen.gov/sites/default/files/federal_register_notices/2017-09-29/CDD_Technical_Amendement_17-20777.pdf The new regulations are set forth in the BSA regulations at 31 C.F.R. § 1010.230 (beneficial ownership requirements); 31 C.F.R. § 1020.210(a)(5) (banks); 31 C.F.R. § 1023.210(b)(5) (broker-dealers); 31 C.F.R. § 1024.210(b)(4) (mutual funds); and 31 C.F.R. § 1026.210(b)(5) (future commission merchants and introducing brokers in commodities).    [3]   The regulation does not clearly address the beneficial ownership requirements for a U.S. pooled investment vehicle operated or controlled by a registered SEC investment adviser.  Pooled investment vehicles operated or advised by a “financial institution” regulated by a Federal functional regulator are not considered legal entities under the regulation.  31 C.F.R. § 1010.230(e)(2)(xi).  An SEC registered investment adviser, however, is not yet a financial institution under the BSA.  Under 31 C.F.R. § 1010.230(e)(3), a pooled investment vehicle that is operated or advised by a “financial institution” not excluded from the definition of legal entity is subject to the beneficial ownership control party prong. Gibson Dunn’s lawyers  are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions practice group, or the authors: Stephanie L. Brooker – Washington, D.C. (+1 202-887-3502, sbrooker@gibsondunn.com) Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Linda Noonan – Washington, D.C. (+1 202-887-3595, lnoonan@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

April 5, 2018 |
M&A Report – AOL and Aruba Networks Continue Trend of Delaware Courts Deferring to Deal Price in Appraisal Actions

Click for PDF Two recent decisions confirm that, in the wake of the Delaware Supreme Court’s landmark decisions in Dell and DFC, Delaware courts are taking an increasingly skeptical view of claims in appraisal actions that the “fair value” of a company’s shares exceeds the deal price.[1] However, as demonstrated by each of these recent Delaware Court of Chancery decisions—In re Appraisal of AOL Inc. and Verition Partners Master Fund Limited v. Aruba Networks, Inc.—several key issues are continuing to evolve in the Delaware courts.[2] In particular, Delaware courts are refining the criteria in appraisal actions for determining whether a transaction was “Dell-compliant.” If so, then the court will likely look to market-based indicators of fair value, though which such indicator (unaffected share price or deal price) is the best evidence of fair value remains unresolved. If not, the court will likely conduct a valuation based on discounted cash flow (DCF) analysis or an alternative method to determine fair value. The development of these issues will help determine whether M&A appraisal litigation will continue to decline in frequency and will be critical for deal practitioners.[3] DFC and “Dell-Compliant” Transactions In DFC, the Delaware Supreme Court endorsed deal price as the “best evidence of fair value” in an arm’s-length merger resulting from a robust sale process. The Court held that, in determining fair value in such transactions, the lower court must “explain” any departure from deal price based on “economic facts,” and must justify its selection of alternative valuation methodologies and its weighting of those methodologies, setting forth whether such methodologies are grounded in market-based indicators (such as unaffected share price or deal price) or in other forms of analysis (such as DCF, comparable companies analysis or comparable transactions analysis). In Dell, the Court again focused on the factual contexts in which market-based indicators of fair value should be accorded greater weight. In particular, the Court found that if the target has certain attributes—for example, “many stockholders; no controlling stockholder; highly active trading; and if information is widely available and easily disseminated to the market”—and if the target was sold in an arm’s-length transaction, then the “deal price has heavy, if not overriding, probative value.” Aruba Networks and AOL: Marking the Boundaries for “Dell-Compliant” Transactions In Aruba Networks, the Delaware Court of Chancery concluded that an efficient market existed for the target’s stock, in light of the presence of a large number of stockholders, the absence of a controlling stockholder, the deep trading volume for the target’s stock and the broad dissemination of information about the target to the market. In addition, the court found that the target’s sale process had been robust, noting that the transaction was an arm’s-length merger that did not involve a controller squeeze-out or management buyout, the target’s board was disinterested and independent, and the deal protection provisions in the merger agreement were not impermissibly restrictive. On this basis, the Court determined that the transaction was “Dell-compliant” and, as a result, market-based indicators would provide the best evidence of fair value. The Court found that both the deal price and the unaffected stock price provided probative evidence of fair value, but in light of the significant quantum of synergies that the parties expected the transaction to generate, the Court elected to rely upon the unaffected stock price, which reflected “the collective judgment of the many based on all the publicly available information . . . and the value of its shares.” The Court observed that using the deal price and subtracting synergies, which may not be counted towards fair value under the appraisal statute,[4] would necessarily involve judgment and introduce a likelihood of error in the Court’s computation. By contrast, AOL involved facts much closer to falling under the rubric of a “Dell-compliant” transaction, but the Court nonetheless determined that the transaction was not “Dell-compliant.” At the time of the transaction, the target was well-known to be “likely in play” and had communicated with many potential bidders, no major conflicts of interest were present and the merger agreement did not include a prohibitively large breakup fee. Nonetheless, the Court focused on several facts that pointed to structural defects in the sale process, including that the merger agreement contained a no-shop period with unlimited three-day matching rights for the buyer and that the target failed to conduct a robust auction once the winning bidder emerged. In addition, and importantly, the Court took issue with certain public comments of the target’s chief executive officer indicating a high degree of commitment to the deal after it had been announced, which the Court took to signal “to potential market participants that the deal was done, and that they need not bother making an offer.” On this basis, the Court declined to ascribe any weight to the deal price and instead conducted a DCF analysis, from which it arrived at a fair value below the deal price. It attributed this gap to the inclusion of synergies in the deal price that are properly excluded from fair value. Parenthetically, the Court did take note of the fact that its computation of fair value was close to the deal price, which offered a “check on fair value analysis,” even if it did not factor into the Court’s computation. Key Takeaways Aruba Networks and AOL provide useful guidelines to M&A practitioners seeking to manage appraisal risk, while also leaving several open questions with which the Delaware courts will continue to grapple: Whether market-based indicators of fair value will receive deference from the Delaware courts (and, correspondingly, diminish the incentives for would-be appraisal arbitrageurs) depends upon whether the sale process could be considered “Dell-compliant.” This includes an assessment of both the robustness of the sale process, on which M&A practitioners seeking to manage appraisal risk would be well-advised to focus early, and the efficiency of the trading market for the target’s stock, to which litigators in appraisal actions should pay close attention. For those transactions found to be “Dell-compliant,” the best evidence of fair value will be a market-based indicator of the target’s stock. Whether such evidence will be the deal price, the unaffected stock price or a different measure remains an open question dependent upon the facts of the particular case. However, for those transactions in which synergies are anticipated by the parties to be a material driver of value, Aruba Networks suggests that the unaffected share price may be viewed as a measure of fair value that is less susceptible to errors or biases in judgment. For those transactions found not to be “Dell-compliant,” DCF analyses or other similar calculated valuation methodologies are more likely to be employed by courts to determine fair value. As AOL and other recent opinions indicate, however, there is no guarantee for stockholders that the result will yield a fair value in excess of the deal price—particularly given the statutory mandate to exclude expected synergies from the computation. [1] Dell, Inc. v. Magnetar Global Event Driven Master Fund Ltd., 177 A.3d 1 (Del. 2017); DFC Global Corp. v. Muirfield Value Partners, L.P., 172 A.3d 346 (Del. 2017). See our earlier discussion of Dell and DFC here. [2] In re Appraisal of AOL Inc., C.A. No. 11204-VCG, 2018 WL 1037450 (Del. Ch. Feb. 23, 2018); Verition Partners Master Fund Ltd. v. Aruba Networks, Inc., C.A. No. 11448-VCL, 2018 WL 922139 (Del. Ch. Feb. 15, 2018). [3] It is worth noting that, after DFC and Dell, the Delaware Supreme Court summarily affirmed the decision of the Court of Chancery in Merlin Partners, LP v. SWS Grp., Inc., No. 295, 2017, 2018 WL 1037477 (Table) (Del. Feb. 23, 2018), aff’g, In re Appraisal of SWS Grp., Inc., C.A. No. 10554-VCG, 2017 WL 2334852 (Del. Ch. May 30, 2017). The Court of Chancery decided SWS Group prior to the Delaware Supreme Court’s decisions in DFC and Dell. Nonetheless, it is clear that the court would have found the transaction at issue in SWS Group not to be “Dell-compliant,” as the transaction involved the sale of the target to a buyer that was also a lender to the target and so could exercise veto rights over any transaction. Indeed, no party to the SWS Group litigation argued that the deal price provided probative evidence of fair value. See our earlier discussion of the SWS Group decision by the Delaware Court of Chancery here. [4] See 8 Del. C. § 262(h) (“[T]he Court shall determine the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation . . . .”); see also Global GT LP v. Golden Telecom, Inc., 993 A.2d 497, 507 (Del. Ch.) (“The entity must be valued as a going concern based on its business plan at the time of the merger, and any synergies or other value expected from the merger giving rise to the appraisal proceeding itself must be disregarded.” (internal citations omitted)), aff’d, 11 A.3d 214 (Del. 2010). The following Gibson Dunn lawyers assisted in preparing this client update:  Barbara Becker, Jeffrey Chapman, Stephen Glover, Eduardo Gallardo, Jonathan Layne, Joshua Lipshutz, Brian Lutz, Adam Offenhartz, Aric Wu, Meryl Young, Daniel Alterbaum, Colin Davis, and Mark Mixon. Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Mergers and Acquisitions practice group: Mergers and Acquisitions Group / Corporate Transactions: Barbara L. Becker – Co-Chair, New York (+1 212-351-4062, bbecker@gibsondunn.com) Jeffrey A. Chapman – Co-Chair, Dallas (+1 214-698-3120, jchapman@gibsondunn.com) Stephen I. Glover – Co-Chair, Washington, D.C. (+1 202-955-8593, siglover@gibsondunn.com) Dennis J. Friedman – New York (+1 212-351-3900, dfriedman@gibsondunn.com) Jonathan K. Layne – Los Angeles (+1 310-552-8641, jlayne@gibsondunn.com) Eduardo Gallardo – New York (+1 212-351-3847, egallardo@gibsondunn.com) Jonathan Corsico – Washington, D.C. (+1 202-887-3652), jcorsico@gibsondunn.com Mergers and Acquisitions Group / Litigation: Meryl L. Young – Orange County (+1 949-451-4229, myoung@gibsondunn.com) Brian M. Lutz – San Francisco (+1 415-393-8379, blutz@gibsondunn.com) Aric H. Wu – New York (+1 212-351-3820, awu@gibsondunn.com) Paul J. Collins – Palo Alto (+1 650-849-5309, pcollins@gibsondunn.com) Michael M. Farhang – Los Angeles (+1 213-229-7005, mfarhang@gibsondunn.com) Joshua S. Lipshutz – Washington, D.C. (+1 202-955-8217, jlipshutz@gibsondunn.com) Adam H. Offenhartz – New York (+1 212-351-3808, aoffenhartz@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

February 14, 2018 |
Compliance Reminders for Private Fund Advisers – 2018

Click for PDF Private fund advisers are subject to a number of regulatory reporting requirements and other compliance obligations, many of which need to be completed on an annual basis.  This Client Alert provides a brief overview. 1.         Regulatory Filing Obligations under the Advisers Act A private fund adviser that is either a registered investment adviser (“RIA“) or an exempt reporting adviser (“ERA“) under the U.S. Investment Advisers Act of 1940, as amended (the “Advisers Act“), must comply with a number of regulatory reporting obligations.  Chief among these is the obligation to update the adviser’s Form ADV and Form PF filings with the SEC on an annual basis.  The following is a brief summary of those filing obligations and the applicable deadlines (assuming a fiscal year end of December 31, 2017): Form ADV Annual Update (3/31/2018 deadline).  Each RIA and ERA has an ongoing obligation to update the information provided in its Form ADV no less frequently than annually.  This annual update must be filed within 90 days of the end of the adviser’s fiscal year.  An RIA must update the information provided in both the “check the box” portion of its Form ADV (Part 1A) and in its “disclosure brochure” (Part 2A).  An ERA is only required to update the information reported in its abbreviated Part 1A filing.  This year, most private fund advisers will be filing for the first time on the amended Part 1A that went into effect on October 1, 2017.[1]  We strongly recommend that each private fund adviser build extra time into its annual Form ADV updating process for this year in order to assess and address any changes to its reporting obligations.All such updates must be filed with the SEC electronically through IARD.  To avoid last minute delays, we recommend that each RIA and ERA check its IARD account early to ensure that its security access codes are up-to-date and that it has sufficient funds in its IARD account to cover all Federal and state filing fees. Each RIA is also required to update the information provided in its “supplemental brochures” (Part 2B) no less frequently than annually.[2]  Although an RIA is not required to publicly file its supplemental brochures with the SEC, up-to-date supplemental brochures must be kept on file at the RIA’s offices. Disclosure Brochure Delivery (4/30/2018 deadline).  An RIA is also required to deliver an updated version of its Part 2A disclosure brochure to all clients within 120 days of the end of its fiscal year.[3]  An RIA may comply with this requirement either by mailing a complete copy of its updated brochure to its clients or by sending a letter providing a summary of any material changes that have been made to the brochure since its last annual update and offering to provide a complete copy of the updated brochure upon request free of charge.[4] Forms PF and CPO-PQR (4/30/2018 deadline).  An RIA with regulatory assets under management attributable to private funds exceeding $150 million is required to provide a report on Form PF to the SEC regarding its private funds’ investment activities.  For most private fund advisers, the Form PF is required to be filed once a year within 120 days of the end of the RIA’s fiscal year.  However, a private fund adviser with assets under management exceeding certain thresholds may be required to file more frequently and/or on shorter deadlines.[5]  In addition, the information that such a large private fund adviser must provide to the SEC is significantly more extensive.An RIA that is also registered under the Commodity Exchange Act (“CEA“) as a Commodity Pool Operator (“CPO“) or Commodity Trading Adviser (“CTA“) should consider its reporting obligations under Form CPO-PQR, a Commodity Futures Trading Commission (“CFTC“) form that serves the same purpose as, and requires the reporting of similar types of information to, Form PF.  In theory, a dual registrant may comply with its reporting obligations under both the Advisers Act and the CEA by filing a single Form PF.  However, the CFTC still requires certain information to be provided in a Form CPO-PQR filing in order to take advantage of this feature. 2.         Annual Compliance Program Review Rule 206(4)-7 under the Advisers Act (the “Compliance Program Rule“) requires an RIA (but not an ERA) to review no less frequently than annually the adequacy of its compliance policies and procedures and the effectiveness of their implementation.  Although the Compliance Program Rule does not require that these reviews be in writing, the SEC’s examination staff has a clear expectation that an RIA will document its review.  SEC examiners routinely request copies of an RIA’s annual compliance program review reports as part of the examination process. Producing an annual compliance program review report need not be overly burdensome.  Although an RIA may consider engaging a third party to conduct a comprehensive audit of the firm’s compliance program from time to time, under normal circumstances an RIA can take a more risk-based approach to the process.  For example, an RIA might build a review around the following three themes where potential compliance risks may be most acute: Compliance policies and procedures that may be affected by changes in the RIA’s business or business practices since the last review was conducted; Any areas where SEC examiners have identified deficiencies or where the firm has experienced compliance challenges; and Any changes in applicable law, regulation, interpretive guidance or regulatory priorities. In addition, a CCO should document in the annual review report any incremental improvements that have been made to the firm’s compliance program throughout the year, not just as part of a formal annual review process. 3.         Notable Regulatory Developments  The following is a brief summary of the more notable regulatory developments for 2017 that a private fund adviser may want to consider when conducting its annual compliance program review: Fees and Expenses.  The SEC continues to focus on industry practices concerning the collection of non-investment advisory fees from portfolio companies and on the allocation of certain of the adviser’s expenses to funds.  This past year, in continuation of a line of enforcement actions against private fund advisers dating back to 2015, the SEC’s Enforcement Division settled several enforcement actions against private equity firms in which violations of fiduciary duties were found with respect to the collection of non-advisory fees and/or the allocation of expenses.[6]  Examples of the types of practices that could trigger SEC scrutiny (particularly if not the subject of clear prior disclosure and/or a contractual basis in the applicable fund governing documents) include: re-characterizing non-investment advisory fee revenue in a manner intended to avoid triggering management fee offsets; charging accelerated monitoring or similar fees to portfolio companies; allocating expenses related to the adviser’s overhead and/or back-office services to its funds; allocating broken deal expenses to funds without allocating a portion of those expenses to other potential co-investors (especially affiliated co-investors); and negotiating discounts on service provider fees for work performed on behalf of the adviser without also making the benefit of those discounts available to the adviser’s funds. We continue to encourage private fund advisers to review their financial controls with respect to fee collection, management fee offsets and expense allocation to ensure that their practices are consistent with their funds’ governing documents (including any disclosure documents) and in line with SEC expectations.  We also encourage private fund advisers to periodically review their policies regarding fee collection and expense allocation practices to make sure that they are up-to-date and comprehensive. Cybersecurity.  The SEC continues to make cybersecurity a high priority for the entire financial services industry.  In the past three years, OCIE has published five “Risk Alerts” relating to cybersecurity and identified cybersecurity as one of its examination priorities in 2015, 2016, 2017 and 2018.[7]  In addition, the SEC’s Division of Enforcement has formed a “CyberUnit” to focus on combatting cyber-related threats.  In light of this regulatory focus, we recommend that each private fund adviser review its information security policies and practices thoroughly and implement enhancements to address any identified gaps promptly. Custody Rule.  One two occasions in February 2017, the staff of the SEC’s Division of Investment Management issued interpretive guidance on Rule 206(4)-2 under the Advisers Act (the “Custody Rule“). In a no-action letter, the staff was asked to affirm that an adviser did not have custody under the Custody Rule in circumstances where an investment adviser was authorized to instruct a custodian to transfer client funds to a designated third party account pursuant a standing letter of instruction from the client to both the adviser and the custodian.  The staff refused, stating that “an investment adviser with power to dispose of client funds or securities for any purpose other than authorized trading” has access to the client’s assets and is therefore subject to the Custody Rule.  However, the staff did grant relief from the surprise audit requirements under the Custody Rule in circumstances where a standing letter of instruction meeting certain conditions is in place.[8] In a separate “IM Guidance Update,” the staff also cautioned investment advisers that, even in circumstances where the adviser’s investment management agreement with a client prohibits the adviser from gaining access to the client’s assets, the adviser may still “inadvertently” be subject to the requirements of the Custody Rule in circumstances where the client’s custodian agreement purports to grant the adviser broader access to the client’s assets.[9] Together, both interpretations demonstrate that the SEC continues to take a broad view of what constitutes “custody” under the Custody Rule.  Advisers may wish to review their custody arrangements in view of this interpretive guidance to ensure that they are in strict compliance with the Custody Rule. OCIE “Frequent Findings” Reports.  OCIE issued two Risk Alerts in 2017 in which it summarized the most frequent findings from its compliance examinations of investment advisers.  The first report focused on OCIE’s exam findings generally and identified the following topics as the five most frequently cited deficiencies:   failure to adopt or implement adequate compliance policies and procedures in accordance with Compliance Program Rule or to perform adequate annual reviews of such compliance policies and procedures; failure to submit accurate or timely regulatory filings; failure to comply with the Custody Rule; failure to comply with Rule 204-1 under the Advisers Act (the “Code of Ethics Rule“); and failure to maintain proper books and records in compliance with Rule 204-2 under the Advisers Act (the “Books and Records Rule“).[10] The second report focused more specifically on OCIE’s findings with respect to investment adviser advertising practices, and identified a number of topics as frequently cited deficiencies, including the use of misleading performance results, misleading one-on-one representations, misleading claims of compliance with voluntary performance standards, cherry-picked profitable stock selections, misleading selection of recommendations, and inadequate compliance policies and procedures.  The staff also identified several common deficiencies as a result of its “touting initiative” focusing on the use of “accolades” in advertising materials, including the misleading use of third-party rankings or awards, and the misleading use of professional designations and testimonials.[11] Other Conflicts.  Finally, private fund advisers should remain vigilant for any other practices or circumstances that could present actual or potential conflicts of interest.  Several recent enforcement actions serve to emphasize the SEC’s view that the failure to properly address and disclose potential conflicts of interest is a breach of an investment adviser’s fiduciary duties under the Advisers Act, even in the absence of clear harm to investors.[12]   4.         Compliance Program Maintenance Each private fund adviser should (and in some cases must) perform certain annual maintenance tasks with respect to its compliance program.  The following is a list of mandatory and recommended tasks that should be completed: Code of Ethics Acknowledgements.  Each RIA is required under the Code of Ethics Rule to obtain a written acknowledgement from each of its “access persons” that such person has received a copy of the firm’s Code of Ethics and any amendments thereto.  As a matter of best practice, many RIAs request such acknowledgements on an annual basis.  In addition, each access person must provide an annual “securities holdings report” at least once every 12 months and quarterly “securities transactions reports” within 30 days of the end of each calendar quarter.  We recommend that each RIA review its records to ensure that each of its access persons has complied with these acknowledgement and personal securities reporting requirements, as the failure to maintain such documentation is a frequent deficiency identified by the SEC’s examiners.[13] Custody Rule Audits.  Compliance with the Custody Rule generally requires a private fund adviser to prepare annual audited financial statements in accordance with US GAAP for each of its private funds and to deliver such financial statements to each fund’s investors within 120 days of the fund’s fiscal year end (180 days in the case of a fund-of-funds). Disclosure Documents/ Side Letter Certifications.  In addition to the updates to an RIA’s disclosure and supplemental brochures on Form ADV Parts 2A and 2B discussed above, private fund advisers whose funds are continuously raising new capital (e.g., hedge funds) should review the offering documents for their funds to ensure that the disclosure in these documents is up-to-date.  A private fund adviser should also check to see that it has complied with all reporting, certification or other obligations it may have under its side letters with investors. Privacy Notice.  An investment adviser whose business is subject to the requirements of Regulation S-P (e.g., because it maintains records containing “nonpublic personal information” with respect to “consumers”) is required to send privacy notices to its “customers” on an annual basis.  As a matter of best practice, most private fund advisers simply send privacy notices to all of their clients and investors, often at the same time they distribute the annual updates to their disclosure brochures on Form ADV (see above).  We recommend that each adviser review its privacy notice for any updates to reflect changes in its business practices and for compliance with the applicable safe harbor provided in Regulation S-P. Political Contributions.  For a firm whose current or potential investor base includes state or local government entities (e.g., state or municipal employee retirement plans or public universities), we recommend that the political contributions of any of the firm’s “covered associates” be reviewed for any potential compliance issues under Advisers Act Rule 206(4)-5 (the “Pay-to-Play” rule). 5.         Other Potential Compliance Obligations Depending on the scope and nature of a private fund adviser’s business, numerous other regulatory reporting requirements and other compliance obligations may apply.  For example: Rule 506(d) Bad Actor Questionnaires.  For a private fund adviser whose funds are either continuously raising capital (e.g., hedge funds), or where the firm anticipates raising capital in the next twelve months, we recommend that the firm ensure that it has up-to-date “Bad Actor Questionnaires” under Regulation D Rule 506(d) on file for each of its directors, executive officers and any other personnel that are or may be involved in such capital raising efforts.  Firms that are or are contemplating engaging in general solicitations under Rule 506(c) of Regulation D should also review their subscription procedures to ensure that they are in compliance with the enhanced accredited investor verification standards required under that Rule. ERISA.  Funds that are not intended to constitute ERISA “plan assets” (e.g., because the fund is a “venture capital operating company” or because “benefit plan investors” own less than 25% of each class of equity of the fund) are typically required to certify non-plan asset status to their ERISA investors annually.  Thus, a private fund adviser should confirm that its funds have continued to qualify for a plan asset exception and prepare the required certifications.  In addition, investment advisers to funds that are ERISA plan assets sometimes agree to prepare an annual Form 5500 for the fund as a “direct filing entity.”  This approach allows underlying ERISA plan investors to rely on this Form 5500 with respect to the investment and have more limited auditing procedures for their own Forms 5500.  If this approach is used, Form 5500 is due 9-1/2 months after year-end (i.e., October 15 for calendar year filers).  Alternatively, if the fund does not itself file a Form 5500, it will need to provide ERISA investors the information they need to complete their own Forms 5500. CFTC Considerations.  A private fund adviser that is registered as either a CPO or a CTA, or which relies on certain exemptions from registration as a CPO or CTA, is subject to certain annual updating and/or reaffirmation filing requirements under the CEA and the rules adopted by the CFTC thereunder. Exempt Advisers.  Many advisers and general partners of private funds that trade in a de minimis amount of commodity interests (i.e., futures, options on futures, options on commodities, retail forex transaction, swaps) are not required to register under the CEA as a CPO, but need to qualify for, and rely on, an exemption from CPO registration.  CFTC Regulation 4.13(a)(3) provides an exemption for advisers and general partners of private funds that engage in a de minimis amount of commodity interests (the “De Minimis Exemption“) pursuant to a test found in that regulation.  Other exemptions from registration as a CPO or a CTA may be available to advisers or general partners of private funds.  An adviser or general partner must claim an exemption from CPO registration with respect to each fund that invests in commodity interests by filing an initial exemption through the National Futures Association (“NFA“) website and must reaffirm its exemption filing within 60 days after the end of each calendar year or else the exemption will be deemed to be withdrawn. Registered CPOs and CTAs.  If a private fund does not qualify for the De Minimis Exemption or another exemption, the adviser or general partner of that private fund may be required to register with the CFTC as a CPO or a CTA, resulting in annual fees, disclosure, recordkeeping and reporting requirements.  Notably, a registered CPO must file an annual report with respect to each relevant commodity pool that it operates and update disclosures to investors (unless a limited exemption under CFTC Regulation 4.7 applies).  A registered CPO should also consider reporting obligations under Form CPO-PQR, which would need to be filed with the NFA within 60 days of the end of each calendar quarter (depending on AUM).  Similarly, registered CTAs must consider reporting obligations under Form CTA-PR, which must be filed with the NFA within 45 days after the end of each calendar quarter.  If a manager or general partner is dually-registered as both a CPO and a CTA, it must complete Form CTA-PR and Form CPO-PR with respect to the relevant private funds. Other Considerations – Clearing, Trading and Uncleared Margin.  Regardless of whether an adviser or general partner claims an exemption from CPO registration with respect to a private fund, the simple fact that the private fund invests in commodity interests makes the private fund a “commodity pool” and the adviser and general partner CPOs (even if they are exempt from registration).  The designation as a commodity pool has some practical implications for private funds as commodity pools are considered “financial entities” under Section 2(h)(7)(C)(i) of the CEA and are therefore subject to mandatory clearing, trade execution and margin requirements with respect to their swaps activities.  Notably, rules requiring commodity pools to exchange variation margin for uncleared swaps came into force on March 1, 2017. Exchange Act Reporting Obligations.  A private fund adviser that invests in “NMS securities” (i.e., exchange-listed securities and standardized options) is reminded that such holdings may trigger various reporting obligations under the Securities Exchange Act of 1934 (the “Exchange Act“). For example: Schedules 13D & 13G.  An investment adviser that exercises investment or voting power over more than 5% of any class of a public company’s outstanding equity securities must file a holdings report on Schedule 13G if it qualifies as a passive institutional investor.[14]  Schedule 13G filings must be made within 45 days of the end of the calendar year and within 10 days after the end of any calendar month in which the adviser’s holdings in the applicable equity security exceeds 10%.  A Schedule 13G filer is also required to file an amended report on Schedule 13G within 10 days after the end of any calendar month in which its holdings in an NMS security exceeded 10% and within 10 days after the end of any calendar month after that in which such holdings changes by more than 5%.  An investment adviser that does not qualify as a passive institutional investor must file a report on Schedule 13D within 10 days of acquiring more than 5% of any class of an issuer’s outstanding equity securities and “promptly” (typically within 24 hours) after any material change in the information provided in the Schedule 13D (including any change in such adviser’s holdings of more than 1% or a change in the adviser’s investment intent with respect to such holdings). Form 13F.  An institutional investment adviser who exercises investment discretion over accounts holding publicly-traded equity securities[15] having an aggregate fair market value in excess of $100 million on the last trading day of any month in a calendar year must report such holdings to the SEC on Form 13F within 45 days after the end of such calendar year and within 45 days after the end of each of the first three calendar quarters of the subsequent calendar year. Form 13H.  A private fund adviser whose trading activity in NMS securities exceeds certain “large trader” thresholds[16] is required to file a report on Form 13H “promptly” (within 10 days) after exceeding the threshold.  In addition, such filings must be amended within 45 days after the end of each calendar year and promptly after the end of each calendar quarter if any of the information in the Form 13H becomes inaccurate. Section 16.  A private fund adviser that holds a greater than 10% voting position in a public company or whose personnel sit on the board of directors of a public company may also have reporting obligations under Section 16 of the Exchange Act and be subject to that Section’s restrictions on “short swing profits.” Regulation D and Blue Sky Renewal Filings.  A private fund that engages in a private offering lasting more than one year may be subject to annual renewal filing requirements under Regulation D and/or State blue sky laws. State Pay-to-Play and Lobbyist Registration Laws.  A private fund adviser that is soliciting state or local government entities for business may be subject to registration and reporting obligations under applicable lobbyist registration or similar state or municipal statutes in the jurisdictions where the adviser is engaged in such activities. Cross-Border Transaction Reporting Requirements.   A private fund adviser that engages in cross-border transactions or which has non-US investors in its funds may be subject to various reporting requirements under the Department of Treasury’s International Capital System (“TIC“) or the Bureau of Economic Analysis’ (“BEA“) direct investment survey program.  In general, investments that take the form of investments in portfolio securities are subject to TIC reporting requirements, while investments that take the form of direct investments in operating companies are subject to the BEA’s reporting requirements. A direct investment is generally defined by the BEA as an investment that involves a greater than 10% voting interest in an operating company.  For purposes of applying this definition, general partners are the only entities considered to have a voting interest in a limited partnership.  Limited partner interests are not considered voting securities.  The BEA’s reporting requirements apply to any direct investment that exceeds $3 million in size (whether by a US investor overseas or by a non-US investor in the US), even if the BEA has not provided notice to the applicable investor that a reporting obligation applies.  Which BEA Form applies, and the extent of the reporting person’s reporting requirements, depends on the size and nature of the direct investment.  This year, the BEA will conduct a 5-year “benchmarking survey” of all foreign direct investment into the United States.  As of the date of this Client Alert, the BEA had not yet published the version of Form BE-12 that it will use to conduct the survey, but a private fund adviser that is either domiciled outside the U.S. or that makes direct investments into the U.S. through offshore funds should keep track of developments in this area. In general, any cross-border investment (whether by an investor in a fund or by a fund in a portfolio security) that does not meet the BEA’s definition of a direct investment is reportable under TIC.  Again, the form to be used and the frequency and scope of the reporting obligation depends on the size and nature of the investment.  In general, however, unless an investor receives written notice from the Federal Reserve Bank of New York to the contrary, an investor is only required to participate in the TIC’s “benchmark surveys”, which are conducted once every five years.[17]  In addition, the reporting requirement generally falls on the first (or last) US financial institution in the chain of ownership at the US border, which means that in many cases for private fund advisers, the actual reporting obligations applies to the fund’s custodian bank or prime broker, and not to the private fund adviser itself. European Regulatory Reporting Requirements.  Private fund advisers that are either registered as alternative investment fund managers (“AIFMs“) or authorized to manage or market alternative investment funds (“AIFs“) in the European Economic Area (“EEA“) are required to regularly report information (referred to as transparency information) to the relevant regulator in each EEA jurisdiction in which they are so registered or authorized (“Annex IV Reports“).  The process of registering to market an AIF is not consistent across jurisdictions.  Registration of some type (which can range from mere notice to a formal filing-review-approval process lasting many months) is generally necessary before any marketing of the AIF may take place. Once registered, the AIFM must begin making Annex IV Reports in each relevant jurisdiction.  The transparency information required by the Annex IV Reports concerns the AIFM and the AIFs it is managing or marketing in the EEA.  The AIFM must provide extensive details about the principal markets and instruments in which it trades on behalf of the AIFs it manages or markets in the EEA, as well as a thoughtful discussion of various risk profiles.  Preparing Annex IV Reports, therefore, can be a challenging exercise.  Further, while Annex IV Reports are conceptually analogous across jurisdictions, the precise reporting requirements imposed by each regulator differ. The reporting frequency will depend on the type and amount of assets under management of the AIFM, as well as the extent of leverage involved, but will be yearly, half-yearly, or quarterly. The reports must be filed within one month of the end of the annual (December 31st), half yearly (June 30th and December 31st) or quarterly (March 31st, June 30th, September 30th and December 31st) reporting periods, as applicable.  Furthermore, AIFMD requires the AIF to prepare annual reports for its European investors, covering a range of specified information. We generally recommend that firms assess reporting requirements on an on-going basis in accordance with any changes to assets under management, and in consultation with reliable local counsel. As well as requiring the submission of Annex IV reports, AIFMD also imposes other requirements on AIFMs for information to be given to investors and regulators on an on-going basis (including in relation to the acquisition of control of EU companies by the AIF).  Consequently, we have seen an increase in the number of firms choosing to adopt a “rent-an-AIFM” approach, effectively outsourcing the compliance function to a local service vendor.  This removes the need to continually monitor shifts in local regulations, but not the need to do the internal collection and analysis of investment data required to complete the filings. EU General Data Protection Regulation.  The European Union General Data Protection Regulation (“GDPR”) is a replacement for the current Data Protection Directive in the EU.  Notably, the scope of the GDPR has been broadened and now extends to data controllers and processors outside the EU whose processing activities relate to the offering of goods or services (even if for free) to, or monitoring the behavior of, data subjects within the EU.  Non-EU funds that are subject to the GDPR may be required to appoint an EU-based representative in connection with their GDPR obligations. The GDPR makes existing data protection obligations more onerous, and introduces a raft of new obligations. For example, the GDPR expands the information that must be provided to data subjects about how their data is processed, and introduces more stringent consent requirements.  In addition, the GDPR places onerous accountability obligations on data controllers and data processors to demonstrate compliance with the GDPR.  This includes requiring them to appoint data protection officers in certain instances and: (i) maintain and develop records of processing activities, (ii) conduct a data protection impact assessment (this applies only to data controllers), prior to data processing that is inherently “high risk” (e.g. a systematic monitoring of a publicly accessible area on a large scale), and (iii) implement data protection, including by not repurposing data (subject to limited exceptions, including consent) and through data minimization (which refers to the principle that personal data must be adequate, relevant and limited to what is necessary in relation to the purposes for which it is processed). Breaching the GDPR carries serious reputational and financial risk. A range of sanctions may be imposed for non-compliance, including fines of up to the greater of EUR 20,000,000 or 4% of total worldwide annual revenue for the preceding financial year, whichever is higher.[18] The Markets in Financial Instruments Directive II (“MiFID II”).  MiFID II came into force on January 3, 2018.  The impact of MiFID II on a firm will depend upon the relevant firm’s regulatory classification.  The MiFID II framework will continue to apply directly to EU discretionary portfolio managers conducting MiFID activities (“MiFID AIFMs“), but has now been extended to apply directly to management companies of undertakings for the collective investment in transferable securities (“UCITS“) and EU AIFMs which manage separate discretionary accounts.  MiFID II also harmonizes the EU’s regulatory approach to non-EU investment firms by introducing a passport regime for the provision of services to eligible counterparties and professional clients in the EU.  In order for a country to be eligible for a third country passport, the EU Commission will have to assess whether the relevant firm is subject to equivalent supervision in its home jurisdiction.  A MiFID third country passport may offer UK firms currently passporting their services to other EU countries under MiFID access to EU markets post-Brexit. MiFID AIFMs have needed to update their systems, controls, policies and procedures to address the following regulatory changes introduced by MiFID II: Best execution:  MiFID II has raised the best execution standard from an obligation to take “all reasonable steps” to an obligation to take “all sufficient steps consistently”, to achieve the best possible result for the customer. In addition, firms are now subject to more onerous disclosure obligations regarding best execution (including a requirement to publish annually information relating to the firm’s top five execution venues (including brokers, regulated markets, multi-lateral trading facilities and organized trading facilities) by volume, and on the execution quality provided by each (by reference to each different class of instrument). Client Categorization:  As a result of mis-selling concerns connected to the sale of complex products to local government authorities, under MiFID II firms are no longer permitted to treat such investors as eligible counterparties or as per se professional clients.  Under MiFID II, local authorities are now automatically deemed to be retail clients, with the ability to request an “opt-up” process in order to become elective professional clients.  If local authorities are unable to satisfy the opt-up criteria, firms will need to assess whether their existing permissions allow them to continue providing services to such entities or if additional retail permissions are necessary. Inducements and Investment Research:  MiFID II imposes additional restrictions affecting how discretionary investment managers may pay for research. Under MiFID II, firms carrying out MiFID business comprising portfolio management are restricted from how they may accept fees, commissions, or any monetary or non-monetary benefits paid or provided by a third party (e.g. research from an investment bank) in relation to the provision of services to clients.  Such firms may, nonetheless, continue to receive third party research without contravening the inducements rules, provided that they pay for research either directly from their own resources or from a separate research payment account controlled by the firm but charged to its clients (the latter will need to satisfy a number of requirements, including as to transparency). Product Governance:  A new regime has been introduced which imposes requirements on firms that manufacture and distribute financial instruments to act in the clients’ best interests during the lifecycle of the relevant products (for PE firms, the product is the fund itself).  The granular rules include requirements to ensure the clear identification of a target market, the review of existing products and their suitability for the target market, and review the risks for new products. Scope of Transaction Reporting Rules:  Prior to MiFID II, MiFID’s reporting rules applied to financial instruments admitted to trading on EU regulated markets and assets that derive their value from such investments (e.g. OTC derivatives). MiFID II extends the scope of the transaction reporting requirements to all financial instruments traded, or admitted to trading, on EU trading venues (this will expand the reporting regime to cover instruments traded on, inter alia, multi-lateral trading facilities and organized trading facilities). This is aimed at providing greater  transparency and ensuring that the MiFID II reporting requirements mirror the scope of the Market Abuse Directive. Telephone Recording:  Prior to MiFID II, the majority of private equity firms were exempt from the requirements to record calls and other electronic communications, under an exemption for discretionary managers. However, this exemption has now been removed and recording requirements under MiFID II apply to all communications that relate to activities such as arranging deals in investments, dealing in investments as agents, managing investments and in certain circumstances, managing AIFs.  The requirements cover communications that were intended to result in a transaction, even if the communication does not, in fact, result in a transaction.  Telephone recording is required to be carried out on a best endeavors basis and the recordings must be retained for 5 years.  UK Exemptions for Non-MiFID AIFMs.  In the UK the Financial Conduct Authority (“FCA”) has granted a number of exemptions from the above requirements to AIFMs that are not MiFID AIFMs.  For example: the scope of the Telephone Recording obligations is limited to activities which involve financial instruments being traded on a trading venue or for which a request for admission has been made; the Inducements and Investment Research obligations do not apply to an AIF or collective investment scheme, which generally invests in issuers or non-listed companies in order to acquire control over such companies; and the Best Execution obligations do not apply, but AIFMs that are not MiFID AIFMs will nonetheless still need to comply with the best execution rules under the AIFMD Level 2 Regulations. However, it is also worth noting that these exemptions will not be available if and when an AIFM is carrying on MiFID business. In practice, our experience has been that firms managing collective funds and segregated accounts have chosen to apply common standards across their MiFID and non-MiFID business activities. Tax.  Depending on the structure and nature of a private fund adviser’s investment activities and/or client base, certain tax filings or tax compliance procedures may need to be undertaken.  Examples include: Investments by U.S. persons in non-U.S. entities may need to be disclosed on IRS Form 5471 (ownership in non-U.S. corporation), IRS Form 8865 (ownership in non-U.S. partnership) and IRS Form 8858 (ownership in non-U.S. disregarded entity), which forms are required to be filed together with such U.S. persons’ annual U.S. federal income tax returns. Investments by non-U.S. persons in U.S. entities may need to be disclosed on IRS Form 5472 (25% ownership in a U.S. corporation).  For tax years beginning on or after January 1, 2017, a U.S. disregarded entity that is wholly owned by a non-U.S. person is treated as a U.S. corporation for purposes of determining any reporting obligations on IRS Form 5472. Transfer of property by a U.S. person to a foreign corporation may require the U.S. person to file an IRS Form 926. Ownership of interests in or signature authority over non-U.S. bank accounts and similar investments, may need to be disclosed under foreign bank and financial accounts reporting regime (FBAR) on Form FinCEN 114, the due date of which has been moved to April 15th for initial filings, with an automatic extension available to October 15th. Managers may need to report the existence of certain accounts to the U.S. IRS or their local jurisdiction under FATCA or the OECD Standard for Automatic Exchange of Financial Account Information – Common Reporting Standard. Managers should be aware that IRS Forms W-8 provided by non-U.S. investors generally expire after three years from the execution date of the form and they may need to collect updated IRS Forms W-8 from their non-U.S. investors. Clients are urged to speak to their Gibson Dunn contacts if they have any questions or concerns regarding these or any other regulatory requirements.   [1]   See Significant Amendments to Form ADV go into Effect on October 1, 2017, Gibson Dunn Client Alert (Sept. 25, 2017) https://www.gibsondunn.com/significant-amendments-to-form-adv-go-into-effect-on-october-1-2017/.  The most significant changes to Form ADV include the formalization of the SEC’s practice of permitting so-called umbrella registration of multiple private fund advisers operating as a single firm and the expansion of reporting requirements for advisers of separately managed accounts.   [2]   An RIA is required to prepare a supplemental brochure for each supervised person that (i) formulates investment advice for and has direct contact with a client, or (ii) has discretionary investment power over client assets (even if such person does not have direct client contact).  As a practical matter, most private fund advisers prepare supplemental brochures for each member of their investment committees and/or each of their portfolio managers.   [3]   As a technical matter, investors in a private fund are not considered “clients” of the fund’s investment adviser.  As a matter of best practice, however, most private fund advisers make updated copies of their disclosure brochures available to the investors in their funds.   [4]   Such letters must also provide a website address (if available), e-mail address (if available) and telephone number by which a client may obtain a copy of the RIA’s current disclosure brochure, as well as the website address through which a client may obtain information about the adviser through the SEC’s Investment Adviser Public Disclosure (IAPD) system.   [5]   In particular, a hedge fund adviser with more than $1.5 billion in regulatory assets under management attributable to its hedge funds is required to report on Form PF on a quarterly basis within 60 days of the end of each calendar quarter and to complete an additional section of the Form (Section 2).  A private liquidity fund adviser with more than $1.0 billion in combined regulatory assets under management attributable to both registered money market funds and private liquidity funds is required to report on Form PF on a quarterly basis within 15 days of the end of each calendar quarter and to complete an additional section of the Form (Section 3).  A private equity fund adviser with more than $2.0 billion in regulatory assets under management attributable to its private equity funds is only required to file on an annual basis within 120 days of the end of its fiscal year, but is required to complete an additional section of the Form (Section 4).   [6]   See TPG Capital Advisers, Advisers Act Release No. 4830 (Dec. 21, 2017); and Platinum Equity Advisers, Advisers Act Release No. 4772 (Sept. 17, 2017).  See also Apollo Management V, L.P., et. al.¸ Advisers Act Release No. 4493 (Aug. 23, 2016); Blackstreet Capital Management, LLC, et. al., Exchange Act Release No. 77957, Advisers Act Release No. 4411 (Jun. 1, 2016); Equinox Fund Management, LLC, Securities Act Release No. 10004, Exchange Act Release No. 76927, Advisers Act Release No. 4315 (Jan. 19, 2016); Cherokee Investment Partners, LLC, et. al., Advisers Act Release No. 4258 (Nov. 5, 2015); Fenway Partners, LLC, et. al., Advisers Act Release No. 4253 (Nov. 3, 2015); Blackstone Management Partners L.L.C., et. al., Advisers Act Release No. 4219 (Oct. 7, 2015); Kohlberg, Kravis Roberts & Co., Advisers Act Release No. 4131 (Jun. 29, 2015); and Alpha Titans, LLC, et al., Exchange Act Release No 74828, Advisers Act Release No. 4073, Investment Company Act Release No. 31586 (Apr. 29, 2015).   [7]   See OCIE Cybersecurity Initiative, National Exam Program Risk Alert, Vol. IV, Issue 2 (Apr. 15, 2014); Cybersecurity Examination Sweep Summary, National Exam Program Risk Alert, Vol. IV, Issue 4 (Feb. 3, 2015); OCIE’s 2015 Cybersecurity Examination Initiative, National Examination Program Risk Alert, Vol. IV, Issue 8 (Sept. 15, 2015); Cybersecurity: Ransomware Alert, National Exam Program Risk Alert, Vol. VI, Issue 4 (May 17, 2017); and Observations from Cybersecurity Examinations, National Exam Program Risk Alert, Vol. VI, Issue 5 (Aug. 7, 2017).  See also, Examination Priorities for 2015, National Exam Program, Office of Compliance Inspections and Examinations (Jan. 13, 2015); Examination Priorities for 2016, National Exam Program, Office of Compliance Inspections and Examinations (Jan. 11, 2016); Examination Priorities for 2017, National Exam Program, Office of Compliance Inspections and Examinations (Jan. 12, 2017); and 2018 National Exam Program Examination Priorities, National Exam Program, Office of Compliance Inspections and Examinations (Feb. 7, 2018).   [8]   Investment Adviser Association, SEC No-Action Letter (pub. avail. Feb. 21, 2017).   [9]   Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority, IM Guidance Update No. 2017-01 (February 2017). [10]   The Five Most Frequent Compliance Topics Identified in OCIE Examinations of Investment Advisers, National Exam Program Risk Alert, Vol. VI Issue 3 (Feb. 7, 2017). [11]   The Most Frequent Advertising Rule Compliance Issues Identified in OCIE Examinations of Investment Advisers, National Exam Program Risk Alert, Vol. VI Issue 6 (Sept. 14, 2017). [12]   See, e.g., Centre Partners Management, LLC, Advisers Act Release No. 4604 (Jan. 10, 2017) and New Silk Road Advisors, Advisers Act Release No. 4587 (Dec. 14, 2016). [13]   See Footnote 10 above and accompanying text. [14]   To qualify as a passive institutional investor, an investment adviser must be an RIA that purchased the securities in question “in the ordinary course of business and not with the purpose or effect of changing or influencing the control of the issuer nor in connection with or as a participant in any transaction having such purpose or effect.” [15]   The SEC maintains a definitive list of securities subject to Form 13F reporting at http://www.sec.gov/divisions/investment/13flists.htm. [16]   A “Large Trader” is defined as any person that exercised investment discretion over transactions in Regulation NMS securities that equal or exceed (i) two million shares or $20 million during any single trading day, or (ii) 20 million shares or $200 million during any calendar month. [17]   The next 5-year benchmark survey will cover foreign investment in U.S. securities and is scheduled to be conducted in 2019. [18]   For a further discussion of the requirements of the GDPR, see The General Data Protection Regulation: A Primer for U.S.-Based Organizations that Handle EU Personal Data, Gibson Dunn Client Alert (Dec. 4, 2017) https://www.gibsondunn.com/the-general-data-protection-regulation-a-primer-for-u-s-based-organizations-that-handle-eu-personal-data/. Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work, or any of the following leaders and members of the firm’s Investment Funds practice group: Chézard F. Ameer – Dubai (+971 (0)4 318 4614, cameer@gibsondunn.com) Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, jbellah@gibsondunn.com) Edward D. Sopher – New York (+1 212-351-3918, esopher@gibsondunn.com) Y. Shukie Grossman – New York (+1 212-351-2369, sgrossman@gibsondunn.com) Mark K. Schonfeld – New York (+1 212-351-2433, mschonfeld@gibsondunn.com) Edward D. Nelson – New York (+1 212-351-2666, enelson@gibsondunn.com) Marc J. Fagel – San Francisco (+1 415-393-8332, mfagel@gibsondunn.com) C. William Thomas, Jr. – Washington, D.C. (+1 202-887-3735, wthomas@gibsondunn.com) Gregory Merz – Washington, D.C. (+1 202-887-3637, gmerz@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

January 1, 2018 |
Public Company Virtual-Only Annual Meetings

Palo Alto partner Lisa Fontenot is the author of “Public Company Virtual-Only Annual Meetings,” [PDF] published in The American Bar Association’s The Business Lawyer Vol.73, Winter 2017-2018.

September 25, 2017 |
Significant Amendments to Form ADV Go into Effect on October 1, 2017

Investment advisers that file Form ADV with the Securities and Exchange Commission ("SEC") either as registered investment advisers ("RIAs") or as exempt reporting advisers ("ERAs")[1] are reminded that significant amendments to Part 1A of Form ADV ("Part 1A") go into effect on October 1, 2017.  For most investment advisers having a fiscal year end of December 31st, the amendments will first impact their annual updating filings that will be due on April 2, 2018. The following Client Alert provides a brief summary of the changes that have been made to Part 1A.  Investment advisers would be well-advised to begin considering how these changes will impact their Form ADV filing requirements for 2018 and how they will capture the additional data they will need to complete amended Part 1A.[2] 1.   Enhanced Reporting Regarding Separately Managed Accounts. One of the most significant changes to Part 1A is the addition of new reporting requirements for RIAs[3] with respect to their separately managed accounts ("SMAs").[4]  Specifically, new Item 5.K has been added to Part 1A that will require an RIA to identify (i) whether it has any regulatory assets under management ("RAUM") attributable to SMAs ("SMA Assets"), (ii) whether it engages in borrowing transactions on behalf of SMAs, (iii) whether it engages in derivatives transactions on behalf of SMAs, and (iv) whether any single custodian holds more than 10% of the RIA’s SMA Assets.  A "yes" answer to any of these questions will trigger a requirement to complete the applicable parts of new Section 5.K of Schedule D to Form ADV. New Section 5.K of Schedule D requires an RIA to report certain data on an aggregated basis with respect to its SMA Assets.[5]  In particular: Section 5.K(1) will require an RIA to report the percentage of SMA Assets it manages in each of twelve separate asset categories.[6]  An RIA with $10 billion or more in SMA Assets must report this data as of the end of its second fiscal quarter and as of the end of its fiscal year.  An RIA will less than $10 billion in SMA Assets is only required to report this data as of the end of its fiscal year. Section 5.K(2) will require an RIA with $10 billion or more in SMA Assets that engages in borrowing or derivatives transactions on behalf of its SMAs to report the amount of SMA Assets it manages in three ranges of "gross notional exposure:" (i) less than 10%, (ii) between 10% and 149%, and (iii) 150% or more.  For each range, the RIA is further required to report the aggregate dollar amount of all borrowings on behalf of the SMAs in such range, and the gross notional value of all derivatives held in such accounts, broken down into six categories of derivative instruments.[7]  This information must be presented on a semi-annual basis as of the end of the RIA’s second fiscal quarter and as of the end of its fiscal year.  For purposes of calculating this data, an RIA may (but is not required to) exclude SMAs with less than $10 million in RAUM.  An RIA with between $500 million and $10 billion in SMA Assets will be required to report the amount of SMA Assets it manages in each of the three ranges of gross notional exposure as of the end of its fiscal year only. Such RIAs will also be required to report the aggregate dollar amount of borrowings on behalf of its SMAs within each range of gross notional exposure, but will not be required to provide a breakdown of the derivative instruments held in such accounts.  An RIA with less than $500 million in SMA Assets will not be subject to this reporting requirement. Finally, Section 5.K(3) will require an RIA to identify each custodian that holds more than 10% of the RIA’s SMA Assets. 2.   Enhanced Reporting of Certain Information Regarding the Investment Adviser and its Business. A number of amendments have been made to Part 1A that will increase the level of detail an investment adviser is required to provide relating to itself and the nature of its business.  In particular: Item 1 of Part 1A has been amended to require an investment adviser to identify any publicly available social media sites whose content is controlled by the adviser.  In addition, the adviser will be required to report the total number of branch offices it has and identify each of its 25 largest branch offices by number of employees, including (i) the number of employees in such branch office engaged in performing investment advisory functions, (ii) any other business activities conducted by the investment adviser at the branch office, and (iii) a brief description of the investment-related activities conducted from the branch office.[8]  Further, an adviser who outsources its chief compliance officer ("CCO") function to a third party will be required to provide the name and IRS employer identification number of the CCO’s employer.  Finally, a large investment adviser with $1 billion or more in assets on its own balance sheet will be required to identify whether such assets fall within one of three ranges.[9] Item 5 of Part 1A has been amended to significantly change the manner in which RIAs report information relating to their client base.[10]  Specifically, an RIA will be required to complete a new table identifying the number of clients it has in each of thirteen enumerated classes of clients[11] and the amount of the RIA’s RAUM attributable to each class of clients.  RIA’s will also be required to identify approximately how many clients it has that do not have RAUM attributable to them (i.e., client accounts for which the RIA does not provide "continuous and regular supervisory or management services"),[12] the approximate percentage of its clients that are non-U.S. persons and the amount of its RAUM that is attributable to such non-U.S. person clients.  An RIA that manages registered investment companies or who participates in wrap fee programs will also be subject to additional reporting requirements with respect to those activities. Finally, Section 7.B(1) of Schedule D to Part 1A, under which an investment adviser is required to provide detailed information with respect to the private funds it manages, has been revised to require an investment adviser to provide the PCAOB number, if any, of the auditor of each of its private funds, and to report whether the investors in any 3(c)(1) funds it manages are required to be "qualified clients." 3.   Relying Advisers. The amendments to Part 1A also codify certain no-action relief granted by the SEC in 2012[13] permitting certain registered private fund advisers ("Filing Advisers") to register multiple entities ("Relying Advisers") under the Advisers Act using a single Form ADV filing ("Umbrella Registration").  For the most part, these amendments to Part 1A follow the already existing no-action letter precedent and do not impose significant additional reporting or other compliance burdens on a Filing Adviser that is already using Umbrella Registration.  However, as discussed below, in adopting the amendments the SEC has clarified certain interpretations of its requirements pertaining to Umbrella Registration that may result in some unexpected results for private fund advisers.  The conditions for qualifying to register Relying Advisers pursuant to an Umbrella Registration under amended Part 1A have not changed in substance.  A Filing Adviser and its Relying Advisers must operate as a single private fund investment advisory business where: (i) the firm’s only clients are private funds or SMAs for qualified clients that invest in parallel with such private funds, (ii) the principal place of business for the firm is located in the U.S., (iii) all personnel are subject to the Filing Adviser’s supervision and control, (iv) the investment activities of each Relying Adviser are subject to the Advisers Act and SEC examination, and (v) the Filing Adviser and all Relying Advisers are subject to a single compliance program and code of ethics administered by a single CCO. A Filing Adviser relying on Umbrella Registration will now be required to complete a new Schedule R to Form ADV for each Relying Adviser covered by the Umbrella Registration.  For the most part, the information that is required to be reported in Schedule R is as one would expect.  It should be noted, however, that new Schedule R will require a Filing Adviser to separately identify the basis upon which each Relying Adviser independently qualifies to register under the Advisers Act.[14]  In addition, a Filing Adviser will be required to separately report the complete ownership structure for each Relying Adviser in such Relying Adviser’s Schedule R to the same degree of detail as is required for the Filing Adviser in Schedules A and B of Form ADV.  Despite numerous requests in comment letters to do so, the SEC declined to expand the availability of Umbrella Registration beyond U.S. based RIAs whose business is limited exclusively to managing private funds.  In particular, Umbrella Registration is still not available to non-U.S. based advisers or to ERAs.  The SEC did state in the Adopting Release, however, that certain no-action relief permitting ERAs to rely on a somewhat different form of Umbrella Registration will still be available.[15] 4.   Other Changes. In addition to the changes summarized above, the SEC adopted two amendments to Rule 204-2 under the Advisers Act (the "Books and Records Rule") that expand an RIA’s record-keeping obligations with respect to written communications containing performance data.[16]  In particular: First, the SEC amended Rule 204-2(a)(16) such that RIAs will be required to maintain records to support performance claims in communications sent to any person.  Under the current rule, RIAs are only required to maintain such records for performance claims in communications sent to ten or more persons. In addition, the SEC added a new requirement to Rule 204-2(a)(7) that will require RIAs to maintain records of all written communications sent or received by the RIA relating to the performance or rate of return of any or all managed accounts or securities recommendations. Both of these amendments go into effect on October 1, 2017. Clients are urged to speak to their Gibson Dunn contacts if they have any questions or concerns regarding these or any other regulatory requirements.   [1]   RIAs and ERAs are referred to collectively herein as investment advisers.   [2]   Complete copies of the revised instructions to Form ADV and amended Part 1A can be found on the SEC’s website using the following links: General Instructions:  https://www.sec.gov/rules/final/2016/ia-4509-appendix-a.pdf Instructions for Part 1A:  https://www.sec.gov/rules/final/2016/ia-4509-appendix-b.pdf Glossary of Terms:  https://www.sec.gov/rules/final/2016/ia-4509-appendix-c.pdf Part 1A:  https://www.sec.gov/rules/final/2016/ia-4509-appendix-d.pdf In addition, a copy of amended Part 1A, marked to show changes against the current version, can also be found on the SEC’s website at https://www.sec.gov/rules/final/2016/ia-4509-form-adv-summary-of-changes.pdf.   [3]   ERAs will not be subject to these new reporting requirements.   [4]   An SMA is defined for this purpose as any client account other than a registered investment company, business development company or other pooled investment vehicle (including private funds).    [5]   The reporting requirements are somewhat akin to reporting obligations under Form PF that apply to an RIA with respect to any private funds it manages.  Unlike the data provided under Form PF, however, the data provided in response to Schedule D, Section 5.K, will be publicly available on the SEC’s website.   [6]   The asset categories are (i) exchange-traded equity securities, (ii) non exchange-traded equity securities, (iii) U.S. government/agency bonds, (iv) U.S. state and local government bonds, (v) sovereign bonds, (vi) investment grade corporate bonds, (vii) non-investment grade corporate bonds, (viii) derivatives, (ix) securities issued by registered investment companies or business development companies, (x) securities issued by other pooled investment vehicles, (xi) cash and cash equivalents, and (xii) other.   [7]   The six categories of derivative instruments are (i) interest rate derivatives, (ii) foreign derivatives, (iii) credit derivatives, (iv) equity derivatives, (v) commodities derivatives and (vi) other derivatives.   [8]   Unlike most of the information provided in Item 1 (which must be promptly updated on an other-than-annual basis if the information provided becomes inaccurate in any respect), the information with respect to an investment adviser’s branch offices will only need to be updated once a year as part of the investment adviser’s annual updating amendment to its Form ADV.   [9]   The ranges are (i) from $1 billion to $10 billion, (ii) from $10 billion to $50 billion, and (iii) more than $50 billion. [10]   ERAs, which are not required to complete Item 5 of Part 1A, will not be subject to these requirements. [11]   The enumerated classes of clients are (i) individuals (other than high net worth individuals), (ii) high net worth individuals, (iii) banking or thrift institutions, (iv) business development companies, (v) registered investment companies, (vi) other pooled investment vehicles, (vii) pension and profit sharing plans (other than government pension plans), (viii) state and municipal government entities (including government pension plans), (ix) other investment advisers, (x) insurance companies, (xi) sovereign wealth funds and foreign government institutions, (xii) corporations and other businesses, and (xiii) other clients.  [12]   In the Adopting Release, the SEC cites nondiscretionary accounts or one-time financial plans as examples of situations where, depending on the facts and circumstances, an adviser may provide investment advice but does not have RAUM.  See SEC Adopting Release, Form ADV and Investment Advisers Act Rule, Release No. IA-4509, File No. S7-09-15 (Aug. 25. 2016), https://www.sec.gov/rules/final/2016/ia-4509.pdf, at footnote 144.  [13]   See SEC No-Action Letter, Investment Advisers Act of 1940 – Sections 203(a) and 208(d) American Bar Association, Business Law Section (Pub. avail. Jan. 18, 2012), https://www.sec.gov/divisions/investment/noaction/2012/aba011812.htm. [14]   This will not be a problem for any Relying Adviser that has the same principal place of business with the Filing Adviser.  However, Relying Advisers whose principal place of business is not the same as the Filing Adviser will need to identify a separate grounds for claiming SEC jurisdiction under the Advisers Act, such as by having $100 million or more in RAUM or by having its principal place of business located outside of the U.S. [15]   See SEC Staff Interpretive Guidance, Frequently Asked Questions on Form ADV and IARD (June 12, 2017), https://www.sec.gov/divisions/investment/iard/iardfaq.shtml at "Reporting to the SEC as anExempt Reporting Adviser." [16]   ERAs are not subject to these record-keeping requirements. Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work, or any of the following leaders and members of the firm’s Investment Funds practice group: Chézard F. Ameer – Dubai (+971 (0)4 318 4614, cameer@gibsondunn.com)Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, jbellah@gibsondunn.com)Edward D. Sopher – New York (+1 212-351-3918, esopher@gibsondunn.com)Y. Shukie Grossman – New York (+1 212-351-2369, sgrossman@gibsondunn.com)Mark K. Schonfeld (+1 212-351-2433, mschonfeld@gibsondunn.com)Edward D. Nelson – New York (+1 212-351-2666, enelson@gibsondunn.com)Marc J. Fagel (+1 415-393-8332, mfagel@gibsondunn.com)C. William Thomas, Jr. – Washington, D.C. (+1 202-887-3735, wthomas@gibsondunn.com)Gregory Merz – Washington, D.C. (+1 202-887-3637, gmerz@gibsondunn.com) © 2017 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

May 8, 2017 |
UK Private Fund Limited Partnerships

On 6 April 2017, the Legislative Reform (Private Fund Limited partnerships) Order 2017 ("LRO") came into force. The LRO amends the Limited Partnerships Act 1907 ("LPA") and introduces a new form of limited partnership, the ‘private fund limited partnership’ ("PFLP") for use as a fund vehicle. UK limited partnerships are often used as investment vehicles across a range of asset classes, including private equity and real estate, due to their organisational flexibility, tax transparency and limited liability for investors. UK limited partnerships have not been as popular in recent years as certain, more flexible, forms of limited partnerships are available in other jurisdictions. The intention of the LRO is to enhance the competitiveness of UK limited partnerships compared to limited partnerships in other jurisdictions by reducing the administrative burdens and complexities of limited partnerships and codifying activities that may be taken by limited partners without jeopardising their limited liability status. Establishing a PFLP Designation as a PFLP is voluntary and open to existing and new limited partnerships. A limited partnership can elect to become a PFLP by making a filing with Companies House subject to the following conditions: (i) the PFLP is constituted by an agreement in writing; and (ii) the PFLP is a ‘collective investment scheme’ as defined in section 235 of the Financial Services and Markets Act 2000 (ignoring the exemptions from such classification for these purposes). While we would expect that most limited partnerships would be able to meet these two conditions, certain limited partnerships may fall outside of the definition of ‘collective investment scheme’ if the limited partners have significant involvement in the day-to-day operations. As was the case under the LPA prior to amendment, a PFLP must include ‘limited partnership’ or ‘LP’ after its name, but its status as a PFLP need not be disclosed in its name. It will not therefore be immediately obvious whether a partnership is a PFLP unless the Companies House filings are inspected. Once designated as a PFLP, the limited partnership will not be able to reverse the election. Both an existing limited partnership and a new limited partnership can be designated as a PFLP. It may be necessary for an existing limited partnership to amend its limited partnership agreements in order to become designated as a PFLP. To be designated as a PFLP, the general partner of a limited partnership must file either form LP7 with Companies House at the time of the initial registration of the limited partnership or form LP8 if designation as a PFLP is sought after the initial registration of the limited partnership. Key changes White list:  Limited partnerships have traditionally been a popular investment structure as they offer flexibility, tax transparency and, provided limited partners do not take part in management, limited liability to the limited partners. One problematic area under the previous law was uncertainty as to the scope of activities a limited partner could be involved in without being considered to have taken part in management of the limited partnership, with the consequent loss of limited liability status. While the fundamental position remains the same (if a limited partner engages in management it loses its limited liability), the LRO introduces a ‘white list’ of permitted activities that limited partners can undertake without the risk of being found to have taken part in management (the inclusion of this white list brings the LPA into line with equivalent limited partnership regimes in other jurisdictions, such as Jersey, Guernsey and Luxembourg). The full ‘white list’ can be found here and includes: taking part in a decision about the variation of the limited partnership agreement, the nature of the limited partnership or a disposal or dissolution of the limited partnership; consulting or advising the general partner or manager about the limited partnership’s affairs or accounts; providing surety or acting as guarantor for the limited partnership; taking part in decisions authorising the general partner to incur, extend, vary or discharge debt of the limited partnership; approving the accounts of the limited partnership or valuations of its assets; taking part in decisions regarding changes to persons in charge of the day-to-day management of the limited partnership; taking part in a decision regarding the disposal of the limited partnership, or the acquisition of another business by the limited partnership; acting, or authorising a person to act, as a director, member, employee, officer or agent of, or a shareholder or partner in, a general partner of, or a manager or adviser to, the limited partnership (provided that this does not extend to taking part in management of the partnership’s business); and appointing or nominating a representative to a committee, for example to an advisory committee. The ‘white list’ is a non-exhaustive list of activities and, therefore, it remains the case that if a limited partner undertakes an activity which is not on the list, a determination of whether a limited partner has taken part in the management of the company (and thus liable for all debts and obligations of the limited partnership as if it were a general partner) will continue to be subject to case law. Capital contributions:  Limited partners are generally required to make capital contributions to a limited partnership upon admission and, if such capital contributions are returned during the term of the limited partnership they are then liable for the debts and obligations of the limited partnership up to the amount returned. In the fund context, this restriction was typically addressed by allocating limited partners’ commitments into loan and capital contribution elements, allowing for earlier repayment of loan commitments without any adverse consequences to the limited partners. Limited partners in PFLPs are not required to contribute capital on admission to the limited partnership and may withdraw any capital contributions made to a PFLP without incurring liability for the amount withdrawn. However, the ability to withdraw capital contributions without liability does not apply (i) to capital contributions made before 6 April 2017, or (ii) where a capital contribution was made before the limited partnership became a PFLP. Winding up:  The LRO removes the requirement for the limited partners of a PFLP to obtain a court order to wind up the limited partnership in circumstances where the general partner has been removed. In such circumstances, the limited partners can instead appoint a third party to wind up the limited partnership. The LRO provides limited partners with further comfort in the ‘white list’ of activities that the appointment of a third party to wind up the limited partnership will not constitute ‘taking part in the management’ of the limited partnership. Gazette notices:  The LRO removes certain administrative burdens on PFLPs, including the requirement for a Gazette notice to be published upon the assignment by a limited partner of its interest in a PLFP to give the assignment legal effect, for the purposes of the LPA. Fewer Companies House filings:  A PFLP will not be required to notify Companies House of changes to (i) the nature of the limited partnership’s business, (ii) the character of the limited partnership or (iii) the amount of capital contributions made to the limited partnership. *          *          * These changes should make UK limited partnerships more attractive as investment vehicles by streamlining administration and bringing the law surrounding unlimited liability of limited partners into line with equivalent limited partnership regimes in, for example, Jersey, Guernsey, the Cayman Islands and Luxembourg, which have in recent years introduced reforms to make structuring and operating private funds more efficient. We expect that a significant number of fund sponsors that use UK limited partnerships will choose to register new limited partnerships as PFLPs and fund sponsors that have looked elsewhere for the formation of limited partnerships may now consider UK limited partnerships as a viable alternative. Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues. For further information, please contact the Gibson Dunn lawyer with whom you usually work or the authors: Wayne McArdle – Partner, London (+44 (0)20 7071 4237, WMcArdle@gibsondunn.com) Chézard F. Ameer – Partner, Dubai (+971 (0)4 318 4614, CAmeer@gibsondunn.com) Josh Tod – Of Counsel, London (+44 (0)20 7071 4157, JTod@gibsondunn.com) Edward A. Tran – Of Counsel, London (+44 (0)20 7071 4228, ETran@gibsondunn.com) © 2017 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

May 1, 2017 |
India – Legal and Regulatory Update (May 2017)

The Indian Market The Indian market continues to attract foreign investment as the Government of India (‘Government‘) accelerates the implementation of second generation market reforms. The Indian Parliament recently enacted the legislative framework to implement a uniform goods and services tax (‘GST‘) throughout the country. Once implemented, GST will substantially improve the trade of goods and services within India. This update provides a brief overview of certain key legal and regulatory developments in India between January 1, 2017 and April 28, 2017. Key Legal And Regulatory Developments Mergers & Acquisitions  Merger Control Exemptions Expanded: In 2011, the Government had introduced a de minimis target based exemption (i.e., based on the valuation of assets or turnover of the target company) (‘Exemption‘) which excluded certain transactions from the notification and approval requirements applicable to combinations under the [Indian] Competition Act, 2002 (‘Competition Act‘). Transactions that fell below the threshold did not have to be notified to the Competition Commission of India (‘CCI‘). The Exemption was applicable for a period of five years. According to the annual report published by CCI for 2015-2016, 113 notifications of combinations that were not eligible for the Exemption were filed with the CCI. The majority of such notifications were approved within a period of thirty days.[1] On March 4, 2016, the Government by a notification (‘2016 Notification‘) extended the period of Exemption for a further period of five years and increased the value of the assets/turnover thresholds (for details please refer to our client alert dated March 15, 2016). By a further notification dated March 27, 2017 (‘2017 Notification‘)[2], the Government introduced the following changes to the Exemption- (a) Extension of Exemption to All Combinations: Earlier, the CCI had interpreted the Exemption to include only acquisitions. The 2017 Notification extends the Exemption to mergers and amalgamations. (b) Acquisition of a Part of a Business: The 2017 Notification stipulates that when a part of a business is being acquired (for example an asset, slump, or business sale), only the value of the assets or turnover of that part of the business that is being acquired will be considered for the purposes of determining the de minimis thresholds. The value of assets or turnover in relation to the entire enterprise is no longer included for the purposes of determining the de minimis threshold exemption. The 2017 Notification will be applicable prospectively to transactions that are entered into from March 27, 2017. The 2016 Notification will continue to apply to transactions that were entered into prior to March 27, 2017.  Besides obviating the distinction between acquisitions and mergers/amalgamations for the purpose of the Exemption, the 2017 Notification significantly extends the scope of the Exemption. The Exemption, being a definitive test, provides transaction parties with greater certainty.   Cross-Border Mergers Permitted: Previously, under the [Indian] Companies Act, 1956, only inbound mergers were permitted and any capital gains arising from such transactions was exempt from tax. Now, the Government has notified Section 234 of the [Indian] Companies Act, 2013 (‘Companies Act‘) and Rule 25A of the Companies (Compromises, Arrangements and Amalgamations) Rules, 2016, (bringing them into effect from April 13, 2017), which enable inbound and outbound mergers between an Indian company and a foreign company. Cross-border mergers will require prior permission of the Reserve Bank of India (‘RBI‘) before an application can be made to the National Company Law Tribunal, in accordance with the procedure for court-approved mergers under the Companies Act. Additionally, transactions in certain sectors such as insurance or pension funds may require prior permission from the appropriate industry regulators. Outbound mergers will be permitted only with foreign companies incorporated in certain permitted jurisdictions, which includes most major jurisdictions.[3] However, amendments to certain other laws will be required to fully operationalise the outbound cross-border merger framework. These include amendments to current Indian exchange control and taxation laws.[4] The use of this structure, in the absence of alignment with laws of other major jurisdictions for transferring liabilities (including tax liabilities and external commercial borrowings subject to RBI regulations), is likely to be limited. Foreign Investment Promotion Board (‘FIPB‘) to be Abolished: The Government, in its annual budgetary statement to Parliament, announced its intention to abolish the FIPB. Under Indian exchange control regulations, there are two routes for foreign strategic investors to invest in an Indian company: (a) Government Route: Where prior approval of the Government is required for foreign investment in certain specific industry sectors or beyond certain prescribed investment thresholds; and (b) Automatic Route: Where foreign investment is freely permitted without the prior approval of the Government. In the case of Government Route sectors, the FIPB was the governmental authority that granted permission for investments up to INR 50 billion or approximately USD 775 million. However, in many Government Route sectors, additional permission from the industry regulator was also required. With this announcement, it appears that only one set of Government approvals (that of the relevant industry regulator) will be required for investment in Government Route sectors. While this change is aimed at further simplifying the approval process for foreign investment, much will depend on the language of the revised foreign direct investment policy, which will be announced later this year. Labour & Employment Laws Maternity Benefit Act Amendment: The Indian Parliament enacted the Maternity Benefit (Amendment) Act, 2017 (‘2017 Amendment‘) that incorporates the following significant changes in the [Indian] Maternity Benefits Act, 1961 (‘Maternity Benefits Act‘): (a) Increase in Maternity Leave: Maternity leave under the Maternity Benefits Act has been increased from twelve to twenty-six weeks. However, a woman with two or more surviving children will only be entitled to twelve weeks of maternity leave. (b) Adopting and Commissioning Mothers: The 2017 Amendment has introduced twelve weeks of maternity leave for a woman who adopts a child below the age of three months and for women who become mothers through surrogacy. This period of maternity leave is calculated from the date when the child is handed over to the mother. (c) Child Care Facilities:  Private employers with fifty or more employees are required to provide access to crèche facilities as prescribed by the Government, each female employee using the facilities has the right to visit it four times in a day. (d) Written Information of Benefits: Employers are mandated to inform their female employees, in writing and electronically, of all the benefits available to them under the Maternity Benefits Act. Consolidation of Statutory Registers: In an attempt to improve compliance with labour and employment laws, the Government has notified the [Indian] Ease of Compliance to Maintain Registers under various Labour Law Rules, 2016. Employers are obliged to maintain various statutory registers for employee matters under nine central (i.e., federal enactments).[5] With the implementation of these Rules the number of statutory registers have reduced from fifty-six to five, which are as follows: (a) Employee Register; (b) Wage Register; (c) Register of Loan and Recoveries; (d) Attendance Register, and (e) Register of Rest/Leave/Leave Wages.    [1]   Annual Report for 2015–-2016 published by the Competition Commission of India (available at http://www.cci.gov.in/sites/default/files/annual%20reports/annual%20report%202015-16.pdf); Notably, the Competition Act stipulates a statutory limit of two hundred and ten days for the disposal of notifications received for combinations.    [2]   Notification S.O. 988(E) dated March 27, 2017 (available at http://www.mca.gov.in/Ministry/pdf/Notification_30032017.pdf)    [3]      Permitted jurisdictions are those: (a) who are signatories to Appendix A of the Multilateral Memorandum of Understanding of the International Organization of Securities Commissions; (b) whose securities market regulator has executed a bilateral Memorandum of Understanding with the Securities and Exchange Board of India; or (c) whose central bank is a member of the Bank of International Settlement.       [4]   On April 26, 2017, the RBI released the draft  Foreign Exchange Management (Cross border Merger) Regulations, 2017 that will govern the exchange control aspects of cross-border mergers.(available at: https://rbidocs.rbi.org.in/rdocs/Content/PDFs/CBMD08484A86A9AE4780A2D825C5D85184B3.PDF)    [5]   Building and Other Construction Workers (Regulation of Employment and Conditions of Service) Act, 1996, Contract Labour (Regulation and Abolition) Act, 1970; Equal Remuneration Act, 1976; Inter-State Migrant Workmen (Regulation of Employment and Conditions of Service) Act, 1979; Mines Act, 1952;, Minimum Wages Act, 1948; Payment of Wages Act, 1936; Sales Promotion Employees (Conditions of Service) Act, 1976; Working Journalists and Other Newspaper Employees (Conditions of Service) and Miscellaneous Provisions Act, 1955. Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. For further details, please contact the Gibson Dunn lawyer with whom you usually work or the following authors in the firm’s Singapore office: India Team:Jai S. Pathak (+65 6507 3683, jpathak@gibsondunn.com)Karthik Ashwin Thiagarajan (+65 6507 3636, kthiagarajan@gibsondunn.com)Sidhant Kumar (+65 6507 3661, skumar@gibsondunn.com)  © 2017 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

February 17, 2017 |
Reporting Requirements for Private Fund Advisers Under the Department of Treasury’s Benchmark Survey on Form SHC Due March 3, 2017

A US resident private fund adviser that invests overseas or which sponsors offshore funds may be subject to reporting requirements under the Department of Treasury’s Form SHC.  The deadline for submitting Form SHC is March 3, 2017.  Form SHC is part of the Treasury International Capital (TIC) System, which collects data that the US Federal Government uses to determine the US balance of payment accounts and the US international investment position, and in the formulation of international economic and financial policies.  Information reported on TIC is confidential.  The Federal Reserve Bank of New York ("FRBNY") administers TIC on behalf of the Department of Treasury.  Form SHC is used to conduct a "benchmark survey" of holdings in foreign (i.e. non-US) portfolio securities by US investors once every five years.  Certain financial institutions may be required to report their holdings in foreign portfolio securities more frequently, but only if they receive notice to that effect from the FRBNY.  The following is a high-level summary of the applicable reporting requirements under Form SHC: Form SHC applies to all US resident "custodians" and "end investors" (together "Reporting Persons") that hold investments in foreign portfolio securities.  Based on the instructions in the Form, it appears that most private fund advisers would be considered "end investors" for this purpose. In general, whether a security is a "foreign security" is determined by reference to the jurisdiction in which the issuer has been organized.  Thus, any security issued by any non-US legal entity is considered a foreign security, even if the security is denominated in US dollars and trades in US markets.  A "portfolio" security is any security that is not a "direct investment."  A direct investment is generally defined as an equity investment in which the holder has a 10% or greater voting interest in the issuer.  Direct investments are subject to a separate reporting regime administered by the Bureau of Economic Analysis (BEA) and need not be reported on Form SHC.[1]  Investments taking the form of limited partnership interests are considered to be portfolio securities (regardless of the percentage ownership interest represented by the limited partnership interest), because limited partnership interests are not considered voting securities for this purpose.  Conversely, a general partner interest in an offshore limited partnership is considered a direct investment. Form SHC is comprised of three parts (or "Schedules"): Schedule I is required to be completed by all Reporting Persons who have either received notice from the FRBNY that they are subject to Form SHC reporting requirements or who are otherwise required to report data on either Schedule II or Schedule III (see below).  Schedule I requires a Reporting Person to provide basic information identifying itself and summaries of the information provided in the Schedule II and Schedule III reports submitted by the Reporting Person. Schedule II applies to any holdings in foreign portfolio securities that a Reporting Person (i) holds directly, (ii) holds through a US-resident or foreign central securities depository, or (iii) holds through a foreign-resident custodian, provided that the total aggregate amount of such holdings exceeds $200 million.  If a Reporting Person’s aggregate holdings in such securities is below the $200 million threshold, the Reporting Person is exempt from Schedule II reporting requirements.  If aggregate holdings in such securities exceeds the $200 million threshold, the Reporting Person must complete a separate Schedule II for each foreign security it holds that falls into one of the above three categories, including detailed information as to the type of security, amount held, and the fair market value of such holding. Schedule III applies to any holdings in foreign portfolio securities that a Reporting Person maintains though a US-resident custodian, provided that the total aggregate amount of such holdings exceeds $200 million.  If a Reporting Person’s aggregate holdings in such securities is below the $200 million threshold, the Reporting Person is exempt from Schedule III reporting requirements.  If aggregate holdings in such securities exceeds the $200 million threshold, the Reporting Person must complete a separate Schedule III for each US-resident custodian that it uses, reporting the identity of the custodian and the total value of the foreign portfolio securities held through that custodian.  Form SHC filings may be submitted electronically using the Federal Reserve Reporting Central System.  Use of the System is mandatory if the end investor is submitting more than one hundred Schedule II reports. Copies of the Schedules to Form SHC, and the instructions for completing them, can be found at http://ticdata.treasury.gov/Publish/shc2016in.pdf. Clients are urged to speak to their Gibson Dunn contacts if they have any questions or concerns regarding these or any other regulatory requirements.   [1]   The BEA’s reporting requirements apply to any direct investment that exceeds $3 million in size (whether by a US investor overseas or by a non-US investor in the US), even if the BEA has not provided notice to the applicable investor that a reporting obligation applies.  Which BEA Form applies, and the extent of the reporting person’s reporting requirements, depends on the size and nature of the direct investment. Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work, or any of the following leaders and members of the firm’s Investment Funds practice group: Chézard F. Ameer – Dubai (+971 (0)4 318 4614, cameer@gibsondunn.com)Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, jbellah@gibsondunn.com)Edward D. Sopher – New York (+1 212-351-3918, esopher@gibsondunn.com)Y. Shukie Grossman – New York (+1 212-351-2369, sgrossman@gibsondunn.com)Mark K. Schonfeld (+1 212-351-2433, mschonfeld@gibsondunn.com)Edward D. Nelson – New York (+1 212-351-2666, enelson@gibsondunn.com)Marc J. Fagel (+1 415-393-8332, mfagel@gibsondunn.com)C. William Thomas, Jr. – Washington, D.C. (+1 202-887-3735, wthomas@gibsondunn.com)Gregory Merz – Washington, D.C. (+1 202-887-3637, gmerz@gibsondunn.com)   © 2017 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

February 3, 2017 |
Compliance Reminders for Private Fund Investors

Private fund advisers are subject to a number of regulatory reporting requirements and other compliance obligations, many of which need to be completed on an annual basis.  This memorandum provides a brief overview. 1.      Regulatory Filing Obligations under the Advisers Act Private fund advisers that are either registered investment advisers ("RIAs") or exempt reporting advisers ("ERAs") under the U.S. Investment Advisers Act of 1940, as amended (the "Advisers Act"), must comply with a number of regulatory reporting obligations under the Advisers Act.  Chief among these are the obligations to update their Form ADV and Form PF filings with the SEC on an annual basis.  The following is a brief summary of those filing obligations and the applicable deadlines (assuming a fiscal year end of December 31, 2016): (a)        Form ADV Annual Update (3/31/2017 deadline).  Each RIA and ERA has an ongoing obligation to update the information provided in its Form ADV no less frequently than annually.  This annual update must be filed within 90 days of the end of the adviser’s fiscal year end.  An RIA must update the information provided in both the "check the box" portion of its Form ADV (Part 1A) and in its "disclosure brochure" (Part 2A).  An ERA is only required to update the information reported in its abbreviated Part 1A filing.  All such updates must be filed with the SEC electronically through IARD.  In order to avoid last minute delays, we strongly recommend that each private fund adviser check its IARD account early to ensure that its security access codes are up-to-date and working.  We also recommend that each firm check the balance in its IARD account and wire sufficient funds to cover all Federal and state filing fees well in advance of the filing deadline.  Each RIA is also required to update the information provided in its "supplemental brochures" (Part 2B) no less frequently than annually.[1]  Although an RIA is not required to publicly file its supplemental brochures with the SEC, updated supplemental brochures must be kept on file at the RIA’s offices.  (b)        Disclosure Brochure Delivery (5/01/2017 deadline).  An RIA is also required to deliver an updated version of its Part 2A disclosure brochure to all clients within 120 days of the end of its fiscal year.[2]  An RIA may comply with this requirement either by mailing a complete copy of its updated brochure to its clients or by sending a letter providing a summary of any material changes that have been made to the brochure since its last annual update and offering to provide a complete copy of the updated brochure upon request free of charge.[3] (c)        Forms PF and CPO-PQR (5/01/2017 deadline).  An RIA (but not an ERA) whose assets under management attributable to private funds exceeds $150 million is required to provide a report on Form PF to the SEC regarding its private funds’ investment activities.  For most registered private fund advisers, the Form PF is required to be filed once a year within 120 days of the end of the adviser’s fiscal year.  However, a private fund adviser whose assets under management exceed certain thresholds may be required to file more frequently and/or on shorter deadlines.[4]  In addition, the information that such a large private fund adviser must provide to the SEC is significantly more extensive.  An RIA that is also registered under the Commodity Exchange Act ("CEA") as a Commodity Pool Operator ("CPO") or Commodity Trading Adviser ("CTA") should also consider its reporting obligations under Form CPO-PQR, a Commodity Futures Trading Commission ("CFTC") form that serves the same purpose as, and requires the reporting of similar types of information to, Form PF.  In theory, a dual registrant may comply with its reporting obligations under both the Advisers Act and the CEA by filing a single Form PF.  However, the CFTC still requires certain information to be provided in a Form CPO-PQR filing in order to take advantage of this feature. 2.      Annual Compliance Program Review Rule 206(4)-7 under the Advisers Act (the "Compliance Program Rule") requires an RIA (but not an ERA) to review no less frequently than annually the adequacy of its compliance policies and procedures and the effectiveness of their implementation.  Although the Compliance Program Rule does not require that these reviews be in writing, the SEC’s Staff has a clear expectation that an RIA will document its review.  SEC examiners routinely request copies of an RIA’s annual compliance program review reports as part of the examination process. Producing an annual compliance program review report need not be overly burdensome.  Although an RIA may consider engaging a third party to conduct a comprehensive audit of the firm’s compliance program from time to time, under normal circumstances an RIA can take a more risk-based approach to the process.  For example, an RIA might build a review around the following three themes where potential compliance risks may be most acute: Compliance policies and procedures that may be affected by changes in the RIA’s business or business practices since the last review was conducted; Any areas where SEC examiners have identified deficiencies or where the firm has experienced compliance challenges; and Any changes in applicable law, regulation, interpretive guidance or regulatory priorities. In addition, a CCO should include in the report any incremental improvements that have been made to the firm’s compliance program throughout the year, not just as part of a formal annual review process. 3.      Notable Regulatory Developments The following is a brief summary of the more notable regulatory developments for 2016 that private fund advisers may want to take into consideration when conducting their annual compliance program reviews. (a)        Fees and Expenses.  The SEC continues to send clear signals that it places a high priority on industry practices concerning the collection of non-investment advisory fees from portfolio companies and on the allocation of the adviser’s expenses to funds.  This past year, the SEC’s Enforcement Division settled several well-publicized enforcement actions against private equity firms in which violations of fiduciary duties were found with respect to the collection of non-advisory fees and/or the allocation of expenses.[5]  Examples of the types of practices that could trigger SEC scrutiny, (particularly if not the subject of clear prior disclosure and/or a contractual basis in the applicable fund governing documents) include: re-characterizations of non-investment advisory fee revenue that appear to be intended to avoid triggering management fee offsets; charging accelerated monitoring or similar fees to portfolio companies; allocating expenses related to the adviser’s overhead and/or back-office services to its funds; allocating broken deal expenses to funds without allocating a portion of those expenses to other potential co-investors (especially affiliated co-investors); and negotiating discounts on service provider fees for work performed on behalf of the adviser without also making the benefit of those discounts available to the adviser’s funds.  We continue to encourage private fund advisers to review their financial controls with respect to fee collection, management fee offsets and expense allocations to ensure that their practices are consistent with their funds’ governing documents and in line with SEC expectations.  We also encourage firms to review their disclosure regarding fee collection and expense allocation practices to make sure that it is up-to-date and comprehensive. (b)        Unregistered Broker Activities.  This past year, the SEC settled a significant enforcement action against a private fund adviser for, among other things, engaging in unregistered securities broker activities in violation of the Securities Exchange Act of 1934 (the "Exchange Act").[6]  This enforcement action is notable in several respects.  First, although the SEC found that the private fund adviser had engaged in multiple serious violations of the Advisers Act, the SEC chose to emphasize only its finding that the adviser had acted as an unregistered broker in its press release announcing the enforcement action.[7]  More importantly, neither the press release nor the administrative order itself provide any meaningful detail as to precisely what activities the adviser had engaged in that required registration as a broker under the Exchange Act.  The administrative order acknowledges that the governing documents for the adviser’s funds expressly permitted the adviser to charge transaction or brokerage fees and that this practice had been fully disclosed to the investors in the funds.  Beyond that, however, the administrative order states only that the adviser received roughly $1.9 million in "transaction-based compensation" in connection with "soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, arranging financing and executing the transactions."  The SEC appears to have focused on the manner in which the adviser was being compensated and concluded that the receipt of "transaction based fees" for these services without being registered as a broker violated the Exchange Act.  In light of the uncertainty, we recommend that private fund advisers reexamine their practices with respect to the receipt of any compensation that might be characterized as transaction fees.  (c)        Supervisory Practices.  In September of 2016, the SEC’s Office of Compliance Investigations and Examinations ("OCIE") issued a Risk Alert announcing a new initiative focusing on the supervisory practices of RIAs.  In addition, the SEC also settled several enforcement actions against private fund advisers in 2016 in which a failure to properly supervise was among the violations found by the SEC.[8]  Although OCIE’s Risk Alert focuses primarily on the need to adopt enhanced supervisory and oversight procedures for employees with a history of disciplinary events, private fund advisers may want to consider whether any enhancements to their supervisory structure and practices are advisable in light of this initiative. (d)        Cybersecurity.  The SEC continues to make cybersecurity a high priority for the entire financial services industry.  In the past two years, OCIE has published three "Risk Alerts" relating to cybersecurity and identified cybersecurity as one of its examination priorities in 2015, 2016 and 2017.[9]  In light of this regulatory focus, we recommend that each private fund adviser review its information security policies and practices thoroughly and implement enhancements to address any identified gaps promptly. (e)        Other Conflicts.  Finally, private fund advisers should remain vigilant for any other practices or circumstances that could present actual or potential conflicts of interest.  In announcing its 2017 examination priorities, OCIE states that its examinations of private fund advisers would continue to focus on "conflicts of interest and disclosure of conflicts of interest as well as actions that appear to benefit the adviser at the expense of investors."[10]  Several recent enforcement actions also serve to emphasize the SEC’s view that the failure to properly address and disclose potential conflicts of interest is a breach of an investment adviser’s fiduciary duties under the Advisers Act, even in the absence of clear harm to investors.[11] The SEC adopted a new rule for RIAs in 2016 that amends Form ADV in a number of significant ways.  These include formalization of the SEC’s practice of permitting so-called umbrella registration of multiple private fund advisers operating as a single firm and enhancement of reporting requirements for advisers of separately managed accounts.  In addition, the SEC enhanced its record-keeping requirements with respect to performance advertising.  The compliance date for these new rules is not until October 1, 2017.  Nevertheless, each RIA should consider reviewing its record-keeping procedures now in order to make sure it will be able to capture the additional data that it will need to comply with these new reporting and recordkeeping requirements when they go into effect. The SEC also proposed a new rule in 2016 that would require RIAs to adopt written business continuity/disaster recovery plans ("BC/DR Plans") and written succession plans.  This rule has not yet been adopted, and its fate is uncertain in light of the many changes in personnel that are currently taking place at the SEC.  Nevertheless, OCIE already expects investment advisers to maintain written BC/DR Plans in accordance with its interpretation of an adviser’s fiduciary obligations under the Advisers Act, and it would not be surprising if SEC examiners were to begin asking advisers to produce copies of their written succession plans even if the proposed rule is not adopted. 4.      Compliance Program Maintenance Each private fund adviser should (and in many cases is required to) perform certain annual maintenance tasks with respect to its compliance program.  The following is a list of mandatory and recommended tasks that should be completed: (a)        Code of Ethics Acknowledgements.  Each RIA is required by Rule 204A-1 under the Advisers Act (the "Code of Ethics Rule") to obtain a written acknowledgement from each of its "access persons" that such person has received a copy of the firm’s Code of Ethics and any amendments thereto.  As a matter of best practice, many RIAs request such acknowledgements on an annual basis.  In addition, each access person must provide an annual "securities holdings report" at least once every 12 months and quarterly "securities transactions reports" within 30 days of the end of each calendar quarter.  We recommend that each RIA review its records to ensure that each of its access persons has complied with these acknowledgement and personal securities reporting requirements, as the failure to maintain such documentation is a frequent deficiency identified by the SEC’s examiners. In addition, the SEC’s Division of Investment Management issued a Guidance Update in June of 2015 in which the Staff cautioned RIAs against interpreting the exemption for managed accounts from the pre-clearance and reporting requirements of the Code of Ethics Rule too broadly.[12]  According to the Staff, the delegation of investment discretion to a third party trustee or investment adviser, by itself, may not be sufficient to demonstrate that an access person is not exercising "direct or indirect influence or control" over the investment account.  Among other things, the Staff suggested that RIAs adopt enhanced annual certification requirements for managed accounts designed to ensure that an access person is not in fact exercising direct or indirect influence or control over any investment portfolios for which an access person is claiming the managed account exemption.  RIAs may wish to review their practices with respect to managed account exemption in light of this interpretive guidance. (b)        Custody Rule Audits.  Compliance with Rule 206(4)-2 under the Advisers Act (the "Custody Rule") generally requires a private fund adviser to prepare annual audited financial statements in accordance with US GAAP for each of its private funds and to deliver such financial statements to the fund’s investors within 120 days of the fund’s fiscal year end (180 days in the case of a fund-of-funds).  The SEC’s Staff issued interpretive guidance in 2014 providing its views on the circumstances in which the annual audit requirement under the Custody Rule applies to special purpose vehicles and escrow arrangements.[13]  We encourage each private fund adviser to review its fund structures to ensure that every fund and special purpose vehicle that is subject to an annual audit requirement under the Custody Rule is being audited and that such audits are on schedule to be delivered to investors on a timely basis.  An RIA that is relying on the alternative "surprise audit" requirements to comply with the Custody Rule for any of its funds or separately managed accounts should engage its auditing firm early in the calendar year to conduct the required surprise audits. (c)        Disclosure Documents/ Side Letter Certifications.  In addition to the updates to an RIA’s disclosure and supplemental brochures on Form ADV Part 2A and 2B discussed above, private fund advisers whose funds are continuously raising new capital (e.g., hedge funds) should review the offering documents for their funds to ensure that the disclosure in these documents is up-to-date.  A private fund adviser should also check to see that it has complied with all reporting, certification or other obligations it may have under its side letters with investors.  (d)        Privacy Notice.  An investment adviser whose business is subject to the requirements of Regulation S-P, because it maintains records containing "nonpublic personal information" with respect to "consumers," is required to send privacy notices to its "customers" on an annual basis.  As a matter of best practice, most private fund advisers simply send privacy notices to all of their clients and investors, often at the same time they distribute the annual updates to their disclosure brochures on Form ADV (see above).  We recommend that each adviser review its privacy notice for any updates to reflect changes in its business practices and for compliance with the requirements of the safe harbor available under Regulation S-P.  (f)         Political Contributions.  For a firm whose current or potential investor base includes state or local government entities (e.g., state or municipal employee retirement plans or public university endowments), we recommend that the political contributions of any of the firm’s "covered associates" be reviewed for any potential compliance issues under Advisers Act Rule 206(4)-5 (the "pay-to-play" rule). 5.      Other Potential Compliance Obligations Depending on the nature and scope of a private fund adviser’s business, numerous other regulatory reporting requirements and other compliance obligations may apply.  For example: (a)        Rule 506(d) Bad Actor Questionnaires.  For a private fund adviser whose funds are either continuously raising capital (e.g., hedge funds), or where the firm anticipates raising capital in the next twelve months, we recommend that the firm ensure that it has up-to-date "Bad Actor Questionnaires" under Regulation D Rule 506(d) on file for each of its directors, executive officers and any other personnel that are or may be involved in such capital raising efforts.  Firms that are or are contemplating engaging in general solicitations under Rule 506(c) of Regulation D should also review their subscription procedures to ensure that they are in compliance with the enhanced accredited investor verification standards required under that Rule. (b)        ERISA.  Funds that are not intended to constitute ERISA "plan assets" (e.g., because the fund is a "venture capital operating company" or because "benefit plan investors" own less than 25% of each class of equity of the fund) are typically required to certify non-plan asset status to their ERISA investors annually.  Thus, a private fund adviser should confirm that its funds have continued to qualify for a plan asset exception and prepare the required certifications.  In addition, investment advisers to funds that are ERISA plan assets sometimes agree to prepare an annual Form 5500 for the fund as a "direct filing entity."  This approach allows an underlying ERISA plan investor to rely on this Form 5500 with respect to its investment in the fund and have more limited auditing procedures for its own Form 5500.  If this approach is used, Form 5500 is due 9-1/2 months after year-end (i.e., October 15 for calendar year filers).  Alternatively, if the fund does not itself file a Form 5500, it will need to provide ERISA investors the information they need to complete their own Form 5500s. (c)        CFTC Considerations.  A private fund adviser that is registered as either a CPO or a CTA, or which relies on certain exemptions from registration as a CPO or CTA, is subject to certain annual updating and/or reaffirmation filing requirements under the CEA and the rules adopted by the CFTC thereunder. Exempt Advisers.  Many advisers and general partners of private funds that trade in a de-minimis amount of commodity interests (i.e., futures, options on futures, options on commodities, retail forex transaction, swaps) are not required to register under the CEA as a CPO, but need to qualify for, and rely on, an exemption from CPO registration.  CFTC Regulation 4.13(a)(3) provides an exemption for advisers and general partners of private funds that engage in a "de minimis" amount of commodity interests (the "De Minimis Exemption") pursuant to a test found in that regulation.  Other exemptions from registration as a CPO or a CTA may be available to advisers or general partners of private funds.  An adviser or general partner must claim an exemption from CPO registration with respect to each fund that invests in commodity interests by filing an initial exemption through the National Futures Association ("NFA") website and must affirm its exemption filing within 60 days after the end of each calendar year or else the exemption will be deemed to be withdrawn.  Registered CPOs and CTAs.  If a private fund does not qualify for the De Minimis Exemption or another exemption, the adviser or general partner of that private fund may be required to register with the CFTC as a CPO or a CTA, resulting in annual fees, disclosure, recordkeeping and reporting requirements.  Notably, a registered CPO must file an annual report with respect to each relevant commodity pool that it operates and update disclosures to investors (unless a limited exemption under CFTC Regulation 4.7 applies).  A registered CPO should also consider reporting obligations under Form CPO-PQR, which would need to be filed with the NFA within 60 days of the end of each calendar quarter (depending on AUM).  Similarly, registered CTAs must consider reporting obligations under Form CTA-PR, which must be filed with the NFA within 45 days after the end of each calendar quarter.  If a manager or general partner is dually-registered as both a CPO and a CTA, it must complete Form CTA-PR and Form CPO-PR with respect to the relevant private funds. Other Considerations – Clearing, Trading and Uncleared Margin.  Regardless of whether an adviser or general partner claims an exemption from CPO registration with respect to a private fund, the simple fact that the private fund engages in commodity interests makes the private fund a "commodity pool" and the adviser and general partner CPOs (even if they are exempt from registration).  The designation as a commodity pool has some practical impacts on private funds as commodity pools are considered "financial entities" under Section 2(h)(7)(C)(i) of the CEA and are therefore subject to mandatory clearing, trade execution and margin requirements with respect to their swaps activities.  Notably, rules with respect to variation margin requirements for uncleared swaps come into force beginning on March 1, 2017, after which date all such uncleared swaps of commodity pools will be subject to variation margin requirements. (d)        Exchange Act Reporting Obligations.  Private fund advisers that invest in "NMS securities" (i.e., exchange-listed securities and standardized options) are reminded that such holdings may trigger various reporting obligations under the Exchange Act. For example: Schedules 13D & 13G.  Investment advisers that exercise investment or voting power over more than 5% of any class of a public company’s outstanding equity securities must file a holdings report on Schedule 13G if they qualify as passive institutional investors.[14]  Schedule 13G filings must be made within 45 days of the end of the calendar year and within 10 days after the end of any calendar month in which the adviser’s holdings in the applicable equity security exceeds 10%.  Schedule 13G filers are also required to file amended reports on Schedule 13G within 10 days after the end of any calendar month in which their holdings exceeded 10% and within 10 days after the end of any calendar month after that in which their holdings changes by more than 5%.  Investment advisers that do not qualify as passive institutional investors must file a report on Schedule 13D within 10 days of acquiring more than 5% of any class of an issuer’s outstanding equity securities and "promptly" (typically within 24 hours) after any material change in the information provided in the Schedule 13D (including any change in such adviser’s holdings of more than 1% or a change in the adviser’s investment intent with respect to such holdings). Form 13F.  Institutional investment advisers who exercise investment discretion over accounts holding publicly-traded equity securities[15] having an aggregate fair market value in excess of $100 million on the last trading day of any month in a calendar year must report such holdings to the SEC on Form 13F within 45 days after the end of such calendar year and within 45 days after the end of each of the first three calendar quarters of the subsequent calendar year. Form 13H.  Private fund advisers whose trading activity in NMS securities exceed certain "large trader" thresholds[16] are required to file a report on Form 13H "promptly" (within 10 days) after exceeding the threshold.  In addition, such filings must be amended within 45 days after the end of each calendar year and promptly after the end of each calendar quarter if any of the information in the Form 13H becomes inaccurate. Section 16.  Private fund advisers who hold a greater than 10% voting position in a public company or whose personnel sit on the board of directors of a public company may also have reporting obligations under Section 16 of the Exchange Act and be subject to that Section’s restrictions on "short swing profits." (e)        Regulation D and Blue Sky Renewal Filings.  A private fund that engages in a private offering lasting more than one year may be subject to annual renewal filing requirements under Regulation D and/or State blue sky laws. (f)         State Pay-to-Play and Lobbyist Registration Laws.  A private fund adviser that either has or is soliciting state or local government entities for business may be subject to registration and reporting obligations under applicable lobbyist registration or similar state or municipal statutes in the jurisdictions where the adviser is engaged in such activities. (g)        Cross-Border Transaction Reporting Requirements.  A private fund adviser that engages in cross-border transactions or which has non-US investors in its funds may be subject to various reporting requirements under the Department of Treasury’s International Capital ("TIC") System or the Bureau of Economic Analysis’ ("BEA") direct investment survey program.  In general, investments that take the form of investments in portfolio securities are subject to TIC reporting requirements, while investments that take the form of direct investments in operating companies are subject to the BEA’s reporting requirements.  BEA.  A direct investment is generally defined by the BEA as an investment that involves a greater than 10% voting interest in an operating company.  For purposes of applying this definition, general partners are the only entities considered by have a voting interest in a limited partnership.  Limited partner interests are not considered voting securities.  The BEA’s reporting requirements apply to any direct investment that exceeds $3 million in size (whether by a US investor overseas or by a non-US investor in the US), even if the BEA has not provided notice to the applicable investor that a reporting obligation applies.  Which BEA Form applies, and the extent of the reporting person’s reporting requirements, depends on the size and nature of the direct investment. TIC.  In general, any cross-border investment (whether by an investor in a fund or by a fund in a portfolio security) that does not meet the BEA’s definition of a direct investment is reportable under TIC.  Again, the form to be used and the frequency and scope of the reporting obligation depends on the size and nature of the investment.  In general, however, unless an investor receives written notice from the Federal Reserve Bank of New York to the contrary, an investor is only required to participate in the TIC’s "benchmark surveys", which are conducted once every five years.  In addition, the reporting requirement generally falls on the first (or last) US financial institution in the chain of ownership at the US border, which means that in many cases for private fund advisers, the actual reporting obligations applies to the fund’s custodian bank or prime broker, and not on the private fund adviser itself. (h)        European Regulatory Reporting Requirements.  Private fund advisers that are either registered as alternative investment fund managers ("AIFMs") or authorized to manage or market alternative investment funds ("AIFs") in the European Economic Area ("EEA") are required to regularly report information (referred to as transparency information) to the relevant regulator in each EEA jurisdiction in which they are so registered or authorized ("Annex IV Reports").  The process of registering to market an AIF is not consistent across jurisdictions.  Registration of some type (which can range from mere notice to a formal filing-review-approval process lasting many months) is generally necessary before any marketing of the AIF may take place. Once registered, the AIFM must begin making Annex IV Reports in each relevant jurisdiction.  The transparency information required by the Annex IV Reports concerns the AIFM and the AIFs it is managing or marketing in the EEA.  The AIFM must provide extensive details about the principal markets and instruments in which it trades on behalf of the AIFs it manages or markets in the EEA, as well as a thoughtful discussion of various risk profiles.  Preparing Annex IV Reports, therefore, can be a challenging exercise.  Further, while Annex IV Reports are conceptually analogous across jurisdictions, the precise reporting requirements imposed by each regulator differ. The reporting frequency will depend on the type and amount of assets under management of the AIFM, as well as the extent of leverage involved, but will be yearly, half-yearly, or quarterly. The reports must be filed within one month of the end of the annual (December 31st), half yearly (June 30th and December 31st) or quarterly (March 31st , June 30th, September 30th and December 31st) reporting periods, as applicable.  Furthermore, AIFMD requires the AIF to prepare annual reports for its European investors, covering a range of specified information. We generally recommend that firms assess reporting requirements on an on-going basis in accordance with any changes to assets under management, and in consultation with reliable local counsel.  As well as requiring the submission of Annex IV reports, AIFMD also imposes other requirements on AIFMs for information to be given to investors and regulators on an on-going basis (including in relation to the acquisition of control of EU companies by the AIF).  Consequently, we have seen an increase in the number of firms choosing to adopt a "rent-an-AIFM" approach, effectively outsourcing the compliance function.  This removes the need to continually monitor shifts in local regulations, but not the need to do the internal collection and analysis of investment data required to populate the filings. (i)         Tax.  Depending on the structure and nature of a private fund adviser’s investment activities and/or client base, certain tax filings or tax compliance procedures may need to be undertaken.  Examples include:  Investments by U.S. persons in non-U.S. entities may need to be disclosed on IRS Form 5471 (ownership in non-U.S. corporation), IRS Form 8865 (ownership in non-U.S. partnership) and IRS Form 8858 (ownership in non-U.S. disregarded entity), which forms are required to be filed together with such U.S. persons’ annual U.S. federal income tax returns. Investments by non-U.S. persons in U.S. entities may need to be disclosed on IRS Form 5472 (25% ownership in a U.S. corporation). Transfer of property by a U.S. person to a foreign corporation may require the U.S. person to file an IRS Form 926.  Ownership of interests in or signature authority over non-U.S. bank accounts and similar investments, may need to be disclosed under foreign bank and financial accounts reporting regime (FBAR) on Form FinCEN 114, the due date of which has been moved to April 15th for initial filings, with an automatic extension available to October 15th. Advisers may need to report the existence of certain accounts to the U.S. IRS or their local jurisdiction under FATCA or the OECD Standard for Automatic Exchange of Financial Account Information – Common Reporting Standard. Advisers should be aware that IRS Forms W-8 provided by non-U.S. investors generally expire after three years from the execution date of the form and they may need to collect updated IRS Forms W-8 from their non-U.S. investors. Clients are urged to speak to their Gibson Dunn contacts if they have any questions or concerns regarding these or any other regulatory requirements.                 [1]              An RIA is required to prepare a supplemental brochure for each supervised person that (i) formulates investment advice for and has direct contact with a client, or (ii) has discretionary investment power over client assets (even if such person does not have direct client contact).  As a practical matter, most private fund advisers prepare supplemental brochures for each member of their investment committees and/or each of their portfolio managers.                 [2]              As a technical matter, investors in a private fund are not considered "clients" of the fund’s investment adviser.  As a matter of best practice, however, most private fund advisers make updated copies of their disclosure brochures available to the investors in their funds.                 [3]              Such letters must also provide a website address (if available), e-mail address (if available) and telephone number by which a client may obtain a copy of the RIA’s current disclosure brochure, as well as the website address through which a client may obtain information about the adviser through the SEC’s Investment Adviser Public Disclosure (IAPD) system.                 [4]              In particular, a hedge fund adviser with more than $1.5 billion in regulatory assets under management attributable to its hedge funds is required to report on Form PF on a quarterly basis within 60 days of the end of each calendar quarter and to complete an additional section of the Form (Section 2).  A private liquidity fund adviser with more than $1.0 billion in combined regulatory assets under management attributable to both registered money market funds and private liquidity funds is required to report on Form PF on a quarterly basis within 15 days of the end of each calendar quarter and to complete an additional section of the Form (Section 3).  A private equity fund adviser with more than $2.0 billion in regulatory assets under management attributable to its private equity funds is only required to file on an annual basis within 120 days of the end of its fiscal year, but is required to complete an additional section of the Form (Section 4).                 [5]              See Apollo Management V, L.P., et. al.¸ Advisers Act Release No. 4493 (Aug. 23, 2016); Blackstreet Capital Management, LLC, et. al., Exchange Act Release No. 77957, Advisers Act Release No. 4411 (Jun. 1, 2016); and Equinox Fund Management, LLC, Securities Act Release No. 10004, Exchange Act Release No. 76927, Advisers Act Release No. 4315 (Jan. 19, 2016).  See also Cherokee Investment Partners, LLC, et. al., Advisers Act Release No. 4258 (Nov. 5, 2015); Fenway Partners, LLC, et. al., Advisers Act Release No. 4253 (Nov. 3, 2015); Blackstone Management Partners L.L.C., et. al., Advisers Act Release No. 4219 (Oct. 7, 2015); Kohlberg, Kravis Roberts & Co., Advisers Act Release No. 4131 (Jun. 29, 2015); and Alpha Titans, LLC, et al., Exchange Act Release No 74828, Advisers Act Release No. 4073, Investment Company Act Release No. 31586 (Apr. 29, 2015).                 [6]              Blackstreet Capital Management, LLC, et. al., Exchange Act Release No. 77957, Advisers Act Release No. 4411 (Jun 1, 2016).                 [7]              These violations included (i) diversion of fund assets to pay for political contributions, charitable donations, and business entertainment on behalf of the adviser, (ii) engaging in undisclosed affiliated transactions with the adviser’s funds, and (iii) multiple violations of the terms of the funds’ limited partnership agreements.                 [8]              See Artis Capital Management, L.P., et. al., Advisers Act Release No. 4550 (Oct. 13, 2016); Apollo Management V, L.P., et. al.¸ Advisers Act Release No. 4493 (Aug. 23, 2016),                 [9]              See OCIE Cybersecurity Initiative, National Exam Program Risk Alert, Vol. IV, Issuer 2 (Apr. 15, 2014); Cybersecurity Examination Sweep Summary, National Exam Program Risk Alert, Vol. IV, Issue 4 (Feb. 3, 2015), and OCIE’s 2015 Cybersecurity Examination Initiative, National Examination Program Risk Alert, Vol. IV, Issue 8 (Sept. 15, 2015).  See also, Examination Priorities for 2015, National Exam Program, Office of Compliance Inspections and Examinations (Jan. 13, 2015); Examination Priorities for 2016, National Exam Program, Office of Compliance Inspections and Examinations (Jan. 11, 2016); and Examination Priorities for 2017, National Exam Program, Office of Compliance Inspections and Examinations (Jan. 12, 2017).                 [10]           See Examination Priorities for 2017, National Exam Program, Office of Compliance Inspections and Examinations (Jan. 12, 2017) at page 5.                 [11]           See, e.g., Centre Partners Management, LLC, Advisers Act Release No. 4604 (Jan. 10, 2017) and New Silk Road Advisors, Advisers Act Release No. 4587 (Dec. 14, 2016).                 [12]           See Personal Securities Transactions Reports by Registered Investment Advisers: Securities Held In Accounts Over Which Reporting Persons Had No Influence or Control, IM Guidance Update No. 2015-03 (June 2015).                 [13]           See Private Funds and the Application of the Custody Rule to Special Purpose Vehicles and Escrows, IM Guidance Update No. 2014-07 (Jun. 2014).                 [14]           To qualify as a passive institutional investor, an investment adviser must be an RIA that purchased the securities in question "in the ordinary course of business and not with the purpose or effect of changing or influencing the control of the issuer nor in connection with or as a participant in any transaction having such purpose or effect."                 [15]           The SEC maintains a definitive list of securities subject to Form 13F reporting at http://www.sec.gov/divisions/investment/13flists.htm.                 [16]           A "Large Trader" is defined as any person that exercised investment discretion over transactions in Regulation NMS securities that equal or exceed (i) two million shares or $20 million during any single trading day, or (ii) 20 million shares or $200 million during any calendar month. Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work, or any of the following leaders and members of the firm’s Investment Funds practice group: Chézard F. Ameer – Dubai (+971 (0)4 318 4614, cameer@gibsondunn.com)Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, jbellah@gibsondunn.com)Edward D. Sopher – New York (+1 212-351-3918, esopher@gibsondunn.com)Y. Shukie Grossman – New York (+1 212-351-2369, sgrossman@gibsondunn.com)Mark K. Schonfeld (+1 212-351-2433, mschonfeld@gibsondunn.com)Edward D. Nelson – New York (+1 212-351-2666, enelson@gibsondunn.com)Marc J. Fagel (+1 415-393-8332, mfagel@gibsondunn.com)C. William Thomas, Jr. – Washington, D.C. (+1 202-887-3735, wthomas@gibsondunn.com)Gregory Merz – Washington, D.C. (+1 202-887-3637, gmerz@gibsondunn.com)   © 2017 Gibson, Dunn & Crutcher LLP, Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

January 19, 2017 |
India – Legal and Regulatory Update (January 2017)

The Indian Market The Indian economy continues to be an attractive investment destination due to its sustained stable growth and implementation of further liberalisation policies by the Government of India ("Government"). In November 2016, the Government announced that Indian Rupees 500 and 1000 would cease to be legal tender. These high-value currency notes comprised the majority of the currency in circulation in the market. While this move has created some uncertainty in the market, the Government expects that this will lead to an increase in tax collections and bank deposits, creating room for reductions in interest and tax rates in the first half of 2017. Following on from our previous update dated October 3, 2016 (which sets out an overview of key legal and regulatory developments in India from May 1, 2016 to August 31, 2016), this update will provide a brief overview of the key legal and regulatory developments in India between September 1, 2016 and December 31, 2016. Key Legal and Regulatory Developments Foreign Investment 100% Foreign Investment in Certain Financial Services: The Reserve Bank of India ("RBI") has permitted 100% foreign investment, without prior Government approval, in non-banking finance companies ("NBFCs") providing financial services regulated by financial services regulators such as the RBI, Securities and Exchange Board of India ("SEBI"), Insurance Regulation and Development Authority etc.[1] However, such investment will be subject to applicable conditions imposed by relevant financial services regulators or other applicable laws, including minimum capitalisation requirements. Further, 100% foreign investment in unregulated financial services has also been permitted under the Government approval route. Previously, foreign investment up to 100% was permitted under the automatic approval route only in NBFCs engaged in 18 specified financial services. India-Singapore Double Taxation Avoidance Agreement Amendment: India and Singapore have signed a protocol (the "Protocol") amending the agreement between India and Singapore for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income ("India-Singapore DTAA").[2] This radically changes the tax liability on capital gains earned by a Singapore tax resident from sale of shares of an Indian company. Under the erstwhile regime, such gains were taxable in the country of residence i.e. Singapore, where there is no tax on capital gains. Now, the Protocol imposes taxes on such gains at the source i.e. in India (where the company is registered) at the applicable domestic tax rate. This amendment effectively takes away the capital gains benefits that were available to investments by Singapore tax resident entities. The Protocol has been made effective on investments made on or after April 1, 2017. Therefore, investments made prior to March 31, 2017 and related exits/share transfers will remain unaffected by this change. This follows similar amendments to the convention for the avoidance of double taxation and the prevention of fiscal evasion between India and Mauritius ("India-Mauritius DTAA") (discussed in our previous update dated October 3, 2016). India-Cyprus Revised Double Taxation Avoidance Agreement: India and Cyprus have also revised their agreement for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital ("India-Cyprus DTAA"), to incorporate source-based taxation in place of the residence-based taxation under the existing agreement.[3] This change will be effective from April 1, 2017. This is in line with recent amendments to the India-Mauritius DTAA and the India-Singapore DTAA (as discussed above). Previously, the Government had, by a notification, declared Cyprus to be a jurisdictional area with lack of effective exchange of information, which made Cypriot entities ineligible for any tax benefits. This notification has now been withdrawn to make the revised India-Cyprus DTAA fully operational. Subsequent to the recent amendments to India’s tax agreements with various countries, Mauritius has emerged as an attractive jurisdiction for banking transactions. The withholding tax rate for interest payments by Indian residents to Mauritius-resident banks under the recently amended India-Mauritius DTAA is 7.5%, while the withholding rates on such interest payments under the India-Singapore DTAA and the India-Cyprus DTAA remain at 10%. Corporate Law and Financing Notification of Companies Act Provisions: The new [Indian] Companies Act, 2013 ("2013 Act") has been brought into force in a phased manner since the Act received presidential assent three years ago. In December 2016, the Government notified several provisions of the 2013 Act which effect significant changes to corporate laws in India. Two key provisions that were notified are discussed below. Procedure for Court Approved Mergers: Schemes for mergers, de-mergers and compromises will now fall under the jurisdiction of the National Company Law Tribunal ("NCLT"). While state High Courts previously had jurisdiction over these matters, the NCLT is now the dedicated quasi-judicial body responsible for company law matters. The 2013 Act introduces some major changes from the framework previously provided for such schemes under the [Indian] Companies Act, 1956 ("1956 Act"). These changes include (a) recognition of cross-border mergers; (b) shorter procedure for mergers of small companies[4] and those involving holding companies and their wholly owned subsidiaries; (c) prescription of monetary thresholds for maintaining objections to the approval of schemes; and (d) clear description of mandatory filings such as valuation reports for effective compliance. Purchase of Minority Shareholding: Under the 1956 Act there was no effective procedure for the purchase of minority shareholding other than in the circumstances of a purchase of shares of dissenting shareholders under a court-approved scheme or a contract approved by a majority of the shareholders. The 2013 Act provides for the acquisition of minority shareholding without court intervention. An "acquirer" or "a person acting in concert" ("Acquirer") holding 90% or more of the issued equity share capital of a company must notify the company of his intention to acquire the minority shareholding of such company. The minority shareholding may be acquired at a price determined by a registered valuer pursuant to an offer issued by the Acquirer or, alternatively, by an offer made by the minority shareholders. Notably, there is some ambiguity in relation to this provision as it does not make such purchase of minority shareholding a mandatory obligation nor does it provide for a specified time period to accept or reject such offer. Indian Banks Permitted to Issue Rupee Denominated Offshore Bonds: The RBI has permitted Indian banks to raise capital by issuing rupee denominated offshore bonds to meet their capital requirements and for financing infrastructure and affordable housing.[5] Insolvency and Restructuring Changes in the Corporate Insolvency Framework: A substantial part of the [Indian] Insolvency and Bankruptcy Code, 2016 ("Insolvency Code") came into effect on December 1, 2016. Please refer to our update dated June 8, 2016, for an overview of the Insolvency Code. Petitions for winding-up of companies under the 1956 Act that are currently pending will now be dealt with by the NCLT. This change applies to winding up petitions that have been filed on the grounds of a company’s inability to pay its debts that are yet to be served on all respondents.   Debt Restructuring Procedures Streamlined: Since 2014 the RBI has introduced several measures to better equip lenders to deal with distressed assets. The RBI continues to review and fine tune these schemes from time to time. In 2014, the RBI had provided banks with greater flexibility in structuring and refinancing long term project loans extended to key sectors such as infrastructure, energy and resources. In November 2016 the RBI extended such flexibility to project loans across all sectors. In June 2016, the RBI had announced the scheme for sustainable structuring of stressed assets ("S4A"), which permitted banks to separate funded liabilities of a stressed borrower into sustainable and unsustainable debt. While the sustainable debt portion is required to be serviced by the borrower in accordance with existing loan terms, the S4A scheme allows for the conversion of the unsustainable debt portion into equity or quasi-equity instruments. In November 2016, the RBI increased the time period for the formulation and implementation of such S4A resolution plans from 90 to 180 days.[6] Start-ups Rules Relaxed for Angel Funding for Start-ups: SEBI has amended the SEBI (Alternative Investment Funds) Regulation, 2012 to permit angel funds (registered with SEBI) to invest in entities incorporated up to five years ago. Further, the lock-in period has been reduced from three years to one year and the minimum investment threshold has been reduced to Indian Rupees 2.5 million (approximately USD 37,000) from Indian Rupees 5 million (approximately USD 74,000). Angel funds are now also permitted to invest up to 25% of their investible corpus overseas, in order to manage risks through diversification.    [1]   A.P. (DIR Series) Circular No. 8 dated October 20, 2016 issued by RBI available at https://rbidocs.rbi.org.in/rdocs/notification/PDFs/APDR087150F21E462D4D24AEDE64BDB65893C1.PDF    [2]   Third Protocol amending the Agreement Between the Government of the Republic of Singapore and the Government of the Republic of India for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, available at https://www.iras.gov.sg/irashome/uploadedFiles/IRASHome/ Quick_Links/Protocol%20amending%20Singapore-India%20DTA%20(Not%20in%20force)%20(31%20Dec% 202016).pdf    [3]   Press release issued by the Central Board of Direct Taxes, Government of India, dated December 16, 2016 available at http://www.incometaxindia.gov.in/Lists/Press%20Releases/Attachments/567/Notification-Completion-Internal-Procedures-Revised-Double-Taxation-Avoidance-Agreement-India-Cyprus-16-12-2016.pdf    [4]   Small Companies are companies with paid-up share capital less than Indian Rupees 5 million (approximately USD 74,000)    [5]   A.P. (DIR Series) Circular No. 14 dated November 3, 2016 issued by the RBI, available at: https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT10715D00F793D6D44E88CB1666FB1A4E791.PDF    [6]   Circular issued by RBI dated November 10, 2016 (DBR.No.BP.BC.34/21.04.132/2016-17) available at: https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NOTI12242DE6B307C1D4415934A9F672CC25571.PDF Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. For further details, please contact the Gibson Dunn lawyer with whom you usually work or the following authors in the firm’s Singapore office: India Team:Jai S. Pathak (+65 6507 3683, jpathak@gibsondunn.com)Karthik Ashwin Thiagarajan (+65 6507 3636, kthiagarajan@gibsondunn.com)Sidhant Kumar (+65 6507 3661, skumar@gibsondunn.com)  © 2017 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

December 7, 2016 |
Right Back Where We Started From? In Salman, the Supreme Court Clarifies the “Personal Benefit” Test but Otherwise Leaves Undisturbed Insider Trading Contours

On December 6, 2016, in Salman v. United States, the Supreme Court unanimously resolved a circuit split between the Courts of Appeals for the Second and Ninth Circuits over the meaning of the "personal benefit" element of insider trading law.  In doing so, the Court put to rest confusion on this aspect of insider trading jurisprudence.  But the murky nature of other aspects of insider trading was left untouched, leaving market participants, courts, and lawyers generally "right back where we started from" before Newman. Bassam Salman was convicted of trading on information he received from a corporate insider, after it was found that the insider had breached a fiduciary duty in giving the information.  In order to find that the insider breached a fiduciary duty, the jury had to find that he had received a personal benefit in exchange for the information.  It was from this finding, that the insider received a personal benefit, that Salman appealed to the Ninth Circuit, which affirmed his conviction and interpreted the "personal benefit" test broadly.  This resulted in a circuit split with the Second Circuit’s ruling in United States v. Newman, 773 F.3d 358 (2d Cir. 2014), cert. denied, 577 U.S. ___ (2015).  In Salman, the Supreme Court adopted the Ninth Circuit’s interpretation, finding that an insider-tipper receives a personal benefit where the tipper makes a gift of inside information to a trading relative or friend, and rejecting the additional requirements imposed by the Second Circuit in United States v. Newman.  This resolves the confusion over one often-contentious element of insider trading. Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 have been interpreted to prohibit individuals with material, nonpublic information who are bound by a duty of confidentiality from sharing that information with others for the purpose of trading.  In Dirks v. SEC, 463 U.S. 646 (1983), the Supreme Court explained that an individual who receives such information from an insider (the "tippee") may be liable for securities fraud where the insider who provided the information (the "tipper") breached a fiduciary duty in providing it.  The Dirks Court held that such a fiduciary breach occurs where the tipper receives a personal benefit in exchange for the information, a requirement known as the "personal benefit" test.  In 2014, the Second Circuit decided United States v. Newman.  In Newman, the Second Circuit held that no personal benefit accrues to a tipper from the gift of information to a trading relative or friend unless there is "proof of a meaningfully close personal relationship" between the tipper and tippee "that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature."  773 F.3d at 452.  The Newman standard established that providing inside information to a trading friend or relative is not by itself enough to satisfy the "personal benefit" test; there must be at least the potential of receiving some tangible benefit in return. Courts, prosecutors, and the white-collar bar viewed Newman as a milestone decision.  And its effect was immediate.  In a number of pending insider trading cases that were underway in the U.S. District Court for the Southern District of New York, prosecutors dropped charges against defendants where the evidence may not have been sufficient to meet the heightened "personal benefit" standard articulated in Newman.  Moreover, uncertainty regarding the scope of Newman quickly arose, with SEC civil enforcement actions moving forward against defendants whom federal prosecutors felt were now beyond their reach. One year after Newman, the Ninth Circuit addressed the same question in United States v. Salman, 792 F.3d 1087 (9th Cir. 2015).  The Ninth Circuit, however, reached the opposite conclusion.  In an opinion authored by Judge Jed Rakoff, a Southern District of New York judge sitting by designation on the Ninth Circuit, the Ninth Circuit interpreted Dirks more broadly, and held that the prosecution can show that a personal benefit to a tipper exists where an insider makes a gift of confidential information to a trading relative or friend.  To the extent that Newman required an additional benefit to the tipper, the Ninth Circuit declined to follow it. The Salman Decision Salman had been convicted of trading on material, nonpublic information about potential mergers and acquisitions activity, which he received from his brother-in-law, Mounir ("Michael") Kara, who, in turn, obtained the information from his younger brother, Maher Kara, an investment banker at Citigroup.  Using this information, Salman made more than $1.5 million in trading profits.  Salman promptly appealed his conviction to the Ninth Circuit, arguing that in light of Newman, his conviction should be reversed because there was no evidence that Maher received anything of "a pecuniary or similarly valuable nature" in exchange for the information he provided to Michael.  The Ninth Circuit declined to follow Newman and affirmed Salman’s conviction.  The Supreme Court granted Salman’s petition for writ of certiorari. The Supreme Court unanimously affirmed the Ninth Circuit’s decision, upholding Salman’s conviction for insider trading.  In relying squarely on the requirements of Dirks, the Court noted that a tipper’s "disclosure of confidential information without personal benefit is not enough" to constitute a breach of the tipper’s fiduciary duty, and thereby expose a tippee to liability for trading on such information.  Salman v. United States, 580 U.S. ___ (2016), slip op. at 8.  The Court described the Dirks test for whether a tipper derived a personal benefit as focusing "on objective criteria, i.e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings," but also allowing that a "personal benefit can ‘often’ be inferred ‘from objective facts and circumstances,’ . . . such as ‘a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient.’"  Id. at 9 (quoting Dirks, 463 U.S. at 663-64).  The Court emphasized that Dirks stands for the principle that the "elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend."  Id. (emphasis in original) (quoting Dirks, 463 U.S. at 664, 667). As such, the Court held that "Dirks makes clear that a tipper breaches a fiduciary duty by making a gift of confidential information to ‘a trading relative.’"  Id.  Giving a gift to a relative or friend–whether in the form of cash or a tip–benefits the insider.  Id. at 10.  If Maher had personally traded on the information and then gifted the proceeds to Michael, "[i]t is obvious that Maher would personally benefit in that situation."  Id. at 9.  By disclosing the information to his brother and letting him trade on it, "Maher effectively achieved the same result."  Id. The Court thus determined that Maher breached his fiduciary duty to Citigroup when he gifted inside information to his brother, Michael, knowing that Michael would trade on it.  Salman inherited this duty, and subsequently breached it himself when, with full knowledge that the information had been improperly disclosed, he traded on it anyway.  The Court rejected Newman‘s "pecuniary gain" requirement as inconsistent with Dirks.  Id. at 10. The Court agreed with Salman’s contention that, in some gift-giving cases, it may be difficult to assess whether an insider received a personal benefit for disclosing confidential information.  However, the Court noted that these hypothetical difficulties do not "render shapeless" or unconstitutionally vague the tipper-tippee liability rules, as Salman claimed, because "Dirks created a simple and clear ‘guiding principle’ for determining tippee liability."  Id. at 11.  The Court also rejected Salman’s appeal to the rule of lenity, saying that Salman failed to show "grievous ambiguity or uncertainty that would trigger the rule’s application."  Id. at 11.  The Court saw no need to address "difficult" factual questions regarding whether an insider personally benefits from a particular disclosure, because Salman’s conduct falls within the "heartland" of Dirks, involving "precisely the ‘gift of confidential information to a trading relative’ that Dirks envisioned."  Id. at 11-12. The Court’s Salman decision effectively overrules the Second Circuit’s decision in Newman insofar as Newman required prosecutors to show that a tipper received something of a "pecuniary or similarly valuable nature" in exchange for a gift of information to family or friends.  In a footnote, however, the Court stressed that its decision left untouched the secondary holding of Newman–that prosecutors must prove that downstream tippees had knowledge that the information was improperly disclosed.  Id. at 5, n.1. Moving Forward from Salman – Or Going Back to a Pre-Newman Landscape The Court’s holding in Salman already has been praised by prosecutors for its re-affirmance of the continued validity of Dirks, and for overruling the additional burdens imposed on insider trading prosecutions by Newman.  Going forward, Salman is likely to reenergize prosecutors to vigorously pursue tipping cases.  Preet Bharara, the U.S. Attorney for the Southern District of New York, lauded the "common sense" Salman opinion as a "victory for fair markets and those who believe that the system should not be rigged."  SEC Chair Mary Jo White said the decision "reaffirms our ability to continue to aggressively pursue illegal insider trading and bring wrongdoers to justice." Prior to the Court’s decision, prosecutors had been cautious about charging individuals criminally in certain tipping cases in the wake of the Newman ruling.  For example, the SEC recently filed a claim against Leon Cooperman and his firm Omega Advisors, Inc. in the Eastern District of Pennsylvania, while prosecutors from the U.S. Attorney’s Office for the District of New Jersey explicitly reserved their decision whether to bring a criminal case pending the Supreme Court’s decision in Salman.  Nevertheless, the Salman ruling is unlikely to mark a sea change for insider trading prosecutions.  First, cases most directly affected by Salman‘s holding–that is, cases in which a tip is passed to a family member or friend in exchange for a nonpecuniary personal benefit–fall outside of the core subset of insider trading prosecutions.  More typically, these prosecutions involve the provision of some consideration in exchange for inside information, or the misappropriation of inside information for trading purposes.  For example, in United States v. Riley, 90 F. Supp. 3d 176 (S.D.N.Y. 2015) (Caproni, J.), the defendant was convicted of insider trading in connection with his receipt of "three concrete personal benefits" that satisfied the requirements of Newman: assistance with the defendant’s side business, investment advice, and help in securing the defendant’s next job.  Id. at 186-89.  These types of traditional insider trading cases will not be affected by the Supreme Court’s decision in Salman to re-affirm the Dirks "personal benefit" test.  Importantly, because the Supreme Court granted certiorari in Salman, but not in Newman, the Supreme Court’s ruling does not touch the more resonant portion of the Second Circuit’s ruling in Newman: namely, the high burden it imposes to prove a downstream tippee’s scienter in insider trading cases.  As noted above, Justice Alito specifically stated that Newman‘s holding requiring evidence that defendants knew the information they traded on came from insiders or that the insiders received a personal benefit in exchange for the tips was not implicated in Salman.  580 U.S. ___, slip op. at 5 n.1.  Therefore, for cases such as Newman itself, in which there was no evidence that the downstream tippees who were multiple levels removed from the tipper knew they were trading on information obtained from insiders or that those insiders received any benefit in exchange for inside information, 773 F.3d at 453, the government will continue to have a harder time proving a defendant’s scienter, notwithstanding the Court’s decision in Salman. Conclusion With its Salman decision, the Court laid to rest part of the uncertainty that arose after Newman.  By reaffirming Dirks, the Court forcefully and resoundingly through its unanimous decision returned the legal landscape of tipper-tippee liability to its pre-Newman state.  Moving forward, in cases involving insiders who allegedly disclose confidential information to family members or friends, the prosecution need not prove that the insider-tipper received something of a pecuniary or similarly valuable nature in exchange for a tip.  Rather, in such cases, a personal benefit can be inferred merely by the close nature of the relationship. While Salman likely will affect cases involving alleged insider trading by family members or friends of tippees, Salman‘s impact in the overall landscape of insider trading enforcement may be limited, as the bulk of insider trading cases involve parties who reap clear personal benefits (most often pecuniary in nature) from disclosing confidential information.  Thus, Salman largely represents a return to the status quo that existed before Newman.  And importantly, Newman‘s other holding–that downstream tippees must have personal knowledge that the inside information was improperly disclosed–remains untouched, and may continue to constrain prosecutorial appetite to pursue some cases. The following Gibson Dunn lawyers assisted in the preparation of this client update:  Avi Weitzman, Joel Cohen, Mark Schonfeld, Marc Fagel, Jason Halperin, Jaclyn Neely, David Coon, Mark Cherry and Sara Ciccolari-Micaldi. Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding the issues discussed above.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Securities Enforcement practice group, or the following authors: Avi Weitzman – New York (+1 212-351-2465, aweitzman@gibsondunn.com)Joel M. Cohen – New York (+1 212-351-2664, jcohen@gibsondunn.com) Mark K. Schonfeld – New York (+1 212-351-2433, mschonfeld@gibsondunn.com)Marc J. Fagel – San Francisco (+1 415-393-8332, mfagel@gibsondunn.com) Please also feel free to contact the following practice group leaders and members: New YorkReed Brodsky (212-351-5334, rbrodsky@gibsondunn.com)Joel M. Cohen (212-351-2664, jcohen@gibsondunn.com) Lee G. Dunst (212-351-3824, ldunst@gibsondunn.com)Barry R. Goldsmith (212-351-2440, bgoldsmith@gibsondunn.com)Mark K. Schonfeld (212-351-2433, mschonfeld@gibsondunn.com)Alexander H. Southwell (212-351-3981, asouthwell@gibsondunn.com)Avi Weitzman (212-351-2465, aweitzman@gibsondunn.com)Lawrence J. Zweifach (212-351-2625, lzweifach@gibsondunn.com) Washington, D.C.Stephanie L. Brooker  (202-887-3502, sbrooker@gibsondunn.com)David P. Burns (202-887-3786, dburns@gibsondunn.com) Daniel P. Chung (202-887-3729, dchung@gibsondunn.com)Stuart F. Delery (202-887-3650, sdelery@gibsondunn.com)Richard W. Grime (202-955-8219, rgrime@gibsondunn.com)Patrick F. Stokes (202-955-8504, pstokes@gibsondunn.com)F. Joseph Warin (202-887-3609, fwarin@gibsondunn.com) San FranciscoWinston Y. Chan (415-393-8362, wchan@gibsondunn.com)Thad A. Davis (415-393-8251, tadavis@gibsondunn.com)Marc J. Fagel (415-393-8332, mfagel@gibsondunn.com)Charles J. Stevens (415-393-8391, cstevens@gibsondunn.com)Michael Li-Ming Wong (415-393-8234, mwong@gibsondunn.com) Palo AltoPaul J. Collins (650-849-5309, pcollins@gibsondunn.com)Benjamin B. Wagner (650-849-5395, bwagner@gibsondunn.com) DenverRobert C. Blume (303-298-5758, rblume@gibsondunn.com)Monica K. Loseman (303-298-5784, mloseman@gibsondunn.com) Los AngelesMichael M. Farhang (213-229-7005, mfarhang@gibsondunn.com) Douglas M. Fuchs (213-229-7605, dfuchs@gibsondunn.com) © 2016 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 27, 2016 |
Myanmar’s New Investment Law

Updated October 31, 2016 This revised alert supplements the version previously circulated on October 27, 2016.  Although the 2016 Law does not contain a commencement date, we have learnt from sources at the Directorate of Investment and Company Administration that it will come into force on April 1, 2017. I.   Introduction The Myanmar Investment Law ("2016 Law"), which replaces the Foreign Investment Law, 2012 ("2012 Law") and the Myanmar Citizen Investment Law, 2013 ("2013 Law"), has been enacted and, according to sources at the Directorate of Investment and Company Administration ("DICA"), will come into force on April 1, 2017.  This new legislation follows the landmark victory of the National League for Democracy ("NLD") in the November 2015 national elections and the largely smooth transition of power to an NLD-led government. The 2016 Law comes close on the heels of the lifting of nearly all sanctions against Myanmar by the United States of America on October 7, 2016. This action is expected to significantly increase inbound investment into Myanmar. At a landmark economic policy event in Naypyitaw on October 22, 2016 State Counsellor, Daw Aung San Suu Kyi, and Minister of Planning and Finance, U Kyaw Win, reiterated that Myanmar was open for business.  They had invited over 150 of Myanmar’s biggest tax payers to attend the event and they laid out high level plans to boost economic growth.  They emphasised that the government wanted to engage with the private sector in areas such as infrastructure development and reiterated the need to attract increased levels of responsible foreign investment.  This client alert summarises the salient features of the 2016 Law based on an unofficial translation made available by DICA. It focuses on the provisions of the 2016 Law that relate to foreign investments. II.   Background to the 2016 Law With a large and youthful population (an estimated 55% of Myanmar’s total population of over 50 million is under the age of 30) and a burgeoning middle class consumer base, Myanmar offers significant potential opportunities for foreign investors. It is no surprise that Myanmar’s gross domestic product has recorded an average growth rate of 7.9% between 2012 and 2015 and is forecast to grow by 7.8% during the fiscal year 2016-2017. The Union Government of the Republic of the Union of Myanmar ("Myanmar Government") has sought to facilitate the growth and economic transformation of Myanmar by revising several pieces of legislation.  Myanmar’s investment law and policies have been evolving over the last few years. While the 2012 Law stipulated the rules relating to foreign investment, separate legislation – the 2013 Law, regulated investments by citizens of Myanmar. However, these separate legal regimes created the perception of an uneven playing field for foreign investors on the one hand and domestic investors on the other. The 2016 Law is an attempt by the Myanmar Government to harmonise these investment laws and improve the ease of investing into Myanmar. While the Myanmar Government has sought to streamline and simplify investment procedures through the 2016 Law, the success of this endeavour will also depend on the quality of subsidiary legislation that is still in the works. The rules enacted under the 2012 Law, to the extent that they are not contrary to the 2016 Law, will continue to apply until the Myanmar Government formulates subsidiary legislation for the 2016 Law. Based on recent statements by senior Myanmar Government officials, subsidiary legislation to the 2016 Law is expected to be released by March 2017. III.   The Regulatory Structure The Myanmar Investment Commission ("MIC") continues to be the focal authority in relation to the regulation of foreign investment into Myanmar and is organised under the Ministry of Planning and Finance. The administrative activities of MIC are undertaken by DICA. MIC was reconstituted in June 2016, after the NLD-led Government came to power, and now consists of 11 members, including the Chairman. MIC’s key responsibilities include promoting investment into Myanmar and specifying investment conditions for various sectors. MIC also has primary responsibility for scrutinising investment proposals and applications for investment incentives. The 2016 Law mandates that MIC meet at least once every month to consider investment proposals and other applications, among its other duties. The 2016 Law provides MIC with a range of enforcement powers and enables it to monitor investment activities. It is empowered to impose administrative penalties against investors for violations of the 2016 Law, subsidiary legislation and investment conditions stipulated by MIC. Penalties that can be imposed by MIC include a censure, revocation of the investment permit and blacklisting of the investor. IV.   Classification of Investment Activities Unlike the 2012 Law, the 2016 Law regulates both foreign and domestic investments. It classifies investment activities into three categories: (i) promoted; (ii) restricted; and (iii) prohibited. Under Section 42 of the 2016 Law, an investment activity is considered to be restricted if such activity is: (i) reserved for the Myanmar Government; (ii) not open for foreign investment; (iii) permitted only if undertaken together with a Myanmar national or entity; or (iv) subject to the approval of a ministry of the Myanmar Government. MIC is required to issue notifications identifying promoted and restricted investment activities from time to time. Section 41 of the 2016 Law lists the types of investment activities that are prohibited. These include businesses or activities that may affect the environment, biodiversity, traditional culture and customs, and public health of Myanmar. Further, MIC is required to obtain the approval of the Pyidaungsu Hluttaw (Assembly of the Union of Myanmar) where an investment activity may significantly impact the security, economic condition and/or national interests of Myanmar. Based on recent media reports, the ‘promoted’ sectors in Myanmar are likely to include manufacturing, infrastructure, industrial zones, agriculture and food processing. V.   The Investment Approval Process The 2016 Law seeks to simplify procedures and enable more transparency in the investment approval process. In addition to allowing MIC to draw upon the expertise of external experts, MIC is also permitted under the 2016 Law to engage with investors during the course of its meetings. Further, the 2016 Law appears to decentralise the foreign investment approval process by allowing state governments to scrutinise and approve certain types of foreign investment.   A.   Investment Permits Under the 2016 Law, permits from MIC are required for business activities that: (i) are of strategic importance to Myanmar; (ii) are large-scale capital-intensive projects; (iii) could potentially impact the environment and any local community in Myanmar; (iv) utilise state-owned land or buildings; or (v) require the submission of a proposal to MIC. While some of the thresholds mentioned above appear to be ambiguously worded, MIC is expected to provide more clarity on these terms through subsidiary legislation. B.   Government Endorsements Even if the investment activity is one which does not require an investment permit, investors are required to obtain the endorsement of MIC in order to be eligible (i) to enter into long leases of land and buildings for conducting their businesses; or (ii) for fiscal exemptions and relief offered by the Myanmar Government. Upon the receipt of an endorsement from MIC, foreign investors are permitted to lease land and buildings in Myanmar for an initial period of 50 years. Investors can apply to MIC for an extension of their lease rights for an additional period of up to 20 years from the expiry of the initial lease period. Foreign investors who have obtained a permit and/or an endorsement are required to notify MIC in the event of any transfer of shares in or the business of the investee entity. Such a notice is also required where any encumbrance is created over the shares or assets of the investee company. VI.   Foreign Exchange Controls The 2016 Law facilitates cross-border fund flows in relation to permitted investment activities in Myanmar. Capital account and loan transactions are subject to greater regulation by the Central Bank of Myanmar ("CBM") than ‘ordinary’ (revenue account) transactions. The 2016 Law explicitly permits: (a)   repatriations of funds by foreign investors and transfer of capital gains and dividends earned on investments in Myanmar through normal banking channels; and (b)   current account transactions in relation to foreign investments, including payment by Myanmar nationals and entities of royalties, license fees, technical fees or management fees. The Myanmar Government retains the right to prevent or delay the transfer of funds in certain circumstances such as for the protection of rights of creditors or to ensure compliance with judicial or administrative orders. Cross-border fund transfers are subject to compliance with the Foreign Exchange Management Law, 2012 and Myanmar’s tax laws. The free flow of funds in relation to investment activities in Myanmar will also depend on the efficiency with which the CBM functions and the ready availability of the Myanmar kyat and ‘freely usable currencies’ such as the U.S. dollar in Myanmar. VII.   Employment Requirements The 2016 Law provides investors with greater flexibility than under the 2012 Law in relation to skilled jobs. A business commenced in Myanmar under the 2012 Law was required to employ a prescribed minimum number of Myanmar nationals in skilled jobs. The 2016 Law prescribes no such quotas in favour of Myanmar nationals. Businesses set up under the 2016 Law are permitted to employ foreigners in positions requiring managerial, technical and operational expertise. Foreign investors will have to comply with a myriad of labour laws and regulations in Myanmar, including the Employment and Skills Development Law, 2013 and the Social Security Law, 2012. Further, closure of a business in Myanmar is permitted only upon compliance with local laws, including the provision of notice and payment of severance to employees of the business. VIII.   Investment Incentives Foreign investors may apply to MIC for various economic incentives under the 2016 Law. These incentives generally take the form of exemptions and relief from income tax, customs duties and other internal taxes in Myanmar.      A.   Zonal Income Tax Exemptions The 2016 Law follows a more nuanced scheme when compared with the 2012 Law in relation to the grant of income tax exemptions to foreign investors. While the 2012 Law granted a blanket five-year income tax exemption to all foreign investors, the 2016 Law envisages the classification of geographical regions within Myanmar into three zones for the purpose of granting tax exemptions. The zonal classification listed below seeks to address regional disparities within Myanmar. (i)   Zone 1 (Least Developed): Investments in this zone may be granted a tax exemption for a period of seven consecutive years; (ii)   Zone 2 (Moderately Developed): Investments in this zone may be granted a tax exemption for a period of five consecutive years; and (iii)   Zone 3 (Adequately Developed): Investments in this zone may be granted a tax exemption for a period of three consecutive years. The zonal income tax exemption commences from the year of commencement of the business in Myanmar. MIC, in consultation with the Myanmar Government, is empowered to alter these zonal classifications from time to time. The Secretary of MIC recently indicated that these zonal classifications are likely to take into account disparities within each State of the Union of Myanmar. Further, such income tax exemptions will only be granted to businesses in sectors that are sought to be promoted by the Myanmar Government. B.   Customs and Internal Taxes MIC is empowered under the 2016 Law to grant, among other benefits, exemptions and reliefs from customs duties and other internal taxes on: (i)   capital goods and construction materials imported during the start-up phase of an investment activity that are not locally available; and (ii)   raw materials or inputs imported for the purpose of manufacturing goods to be exported. C.   Other Income Tax Exemptions In order to encourage Myanmar businesses to reinvest in and develop themselves, MIC may on receipt of an application: (i)   grant income tax exemptions for profits that are reinvested in the same business or a similar type of business within a period of one year; (ii)   permit depreciation at a rate that is faster than the actual life of the capital asset; and (iii)   permit the deduction of research and development expenses from assessable income. The Myanmar Government has the right to claw-back exemptions or relief utilised by a foreign investor if such investor discontinues its business activity before the expiry of the period for which it has obtained a permit/endorsement. IX.   Investment Protection and National Treatment The 2016 Law provides more clarity in relation to foreign investment guarantees than the 2012 Law. In addition to providing a guarantee against direct expropriation of investments made by foreign investors, the 2016 Law also addresses the issue of indirect expropriation. The 2016 Law provides that no measures will be taken that will result in indirect expropriation or termination of the business unless such action is (i) necessary for the public interest; (ii) non-discriminatory; (iii) in accordance with applicable laws; and (iv) done upon prompt payment of market-based compensation. The 2016 Law also affords investors an opportunity to challenge measures that they determine to be indirect expropriation of the investor’s business in Myanmar. The 2016 Law also enshrines the national treatment standard for foreign direct investment in Myanmar. Section 47 of the 2016 Law requires the Myanmar Government to offer treatment to foreign investors and their businesses in Myanmar that is no less favourable than that offered to Myanmar nationals. As is often the case with such guarantees, this national treatment standard is applicable post-establishment of the business in Myanmar. Notwithstanding the national treatment standard, the 2016 Law permits the Myanmar Government to offer more favourable lease conditions, exemptions and relief to local Myanmar investors. X.   Conclusion The 2016 Law is an effort to facilitate foreign investor participation in the on-going economic transformation of Myanmar. While the Myanmar Government has attempted to simplify foreign investment procedures through this new legislation, its success in facilitating more foreign investment into Myanmar will depend on the level of clarity that is provided by subsidiary legislation to the 2016 Law and the efficiency with which various governmental agencies in Myanmar implement the law and regulations in practice. For example, merely decentralising the investment approval process to agencies other than MIC might be counterproductive, especially where such other agencies (both at the Union and State levels) lack the capacity or the tools to efficiently process investment proposals. Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. For further details, please contact the Gibson Dunn lawyer with whom you usually work or the following authors. Co-author Robert Pé is a former senior adviser on legal affairs to Burmese/Myanmar leader and Nobel laureate, Daw Aung San Suu Kyi. Robert S. Pé – Hong Kong (+852 2214 3768, rpe@gibsondunn.com)Karthik Ashwin Thiagarajan – Singapore (+65 6507 3636, kthiagarajan@gibsondunn.com) © 2016 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 10, 2016 |
China Begins Major Overhaul of its Foreign Investment Regulatory Regime

It has been close to two years since China announced that it would make major changes in its foreign investment related laws and regulations.  The first step of such changes took effect on October 1, 2016, after the Standing Committee of the National People’s Congress (China’s parliament) passed resolutions (the "NPC Resolutions") to amend certain provisions of the FIE Laws (as defined below).  On October 8, 2016, in implementing the NPC Resolutions, the PRC National Development and Reform Commission ("NDRC") and the PRC Ministry of Commerce ("MOFCOM") issued Public Announcement No. 22 [2016] ("Announcement 22"), and MOFCOM issued the Interim Measures for the Record-filing Administration of the Incorporation and Change of Foreign Invested Enterprises (the "Interim Measures").  In essence, Announcement 22 and the Interim Measures have changed the regulation of certain matters relating to foreign investments in China from one that requires "prior approval" to one based on "subsequent filing".  This is consistent with the Chinese government’s stated goal to adopt a more market-based regulatory regime for foreign investments and to accord foreign investors a greater degree of national treatment in China. Background China currently has three major pieces of legislation governing foreign investments (the "FIE Laws") and related implementing rules (the "Implementing Rules"):  the Sino-Foreign Joint Venture Law passed in 1979 (the "Equity JV Law"), the Foreign Enterprise Law passed in 1986 (the "WFOE Law") and the Sino-Foreign Co-operative Joint Venture Law passed in 1988 (the "Co-operative JV Law").  A particular form of entity is allowed to be set up in China under each of these laws.  Under the WFOE Law, for example, a foreign investor can set up a wholly foreign owned enterprise (a "WFOE").  Similarly, under the Equity JV Law and the Co-operative JV Law, foreign investors can set up equity joint ventures or co-operative joint ventures with Chinese partners (the "Joint Ventures").  WFOEs and Joint Ventures are collectively called foreign invested enterprises ("FIEs"). There are three fundamental features of this regulatory regime.  First, foreign investors can only invest in sectors that are not prohibited to foreign investments.  China has and periodically updates a foreign investment catalogue (the "Investment Catalogue"), which divides foreign investments into three listed categories:  encouraged, restricted and prohibited.  Those that do not fall under any of these categories are treated as permitted.  A potential foreign investor has to find out first of all whether and under what restrictions (if any) it can make an investment in a particular sector. Second, prior to the adoption of Announcement 22 and the Interim Measures, regardless of the form of the FIE (a WFOE or a Joint Venture) and regardless of which category was involved (permitted, encouraged or restricted), the establishment of an FIE must go through a complicated three-step approval process.  To begin with, in respect of a greenfield project, the sponsors were required to obtain project-specific approvals/filings (the "Project Approval") from NDRC (including its local counterparts).[1]  After obtaining the Project Approval (or under circumstances where the Project Approval was not required, as in the case of a consulting WFOE), the sponsors must submit the incorporation documents (such as the articles of association and, if applicable, the joint venture contract) to MOFCOM (including its local counterparts) for review and approval (the "Establishment Approval").  Finally, based on the Establishment Approval, the sponsors had to register the FIE with the State Administration of Industry and Commerce (including its local counterparts, "SAIC") and obtain a business license (the "Company Registration").  An FIE only came into existence upon completion of the Company Registration. Third, prior to the adoption of Announcement 22 and the Interim Measures, there was a large number of matters relating to foreign investments that required prior approval or registration from various governmental authorities before they could become effective, such as any change in the business scope, amount of registered capital, pledge of registered capital, legal representative or shareholders of an FIE.  This caused many difficulties in how companies conducted their businesses.  In the first place, it often took a long time to obtain the required approvals.  While the FIE Laws and the Implementing Rules required that the relevant authorities issue or reject application for approvals within specified periods of time, such requirements were often ignored in practice, and the parties involved almost never complained for fear that they might not receive the approvals if they did. In addition, the approval authorities often engaged in substantive review of the commercial contracts entered into between the relevant parties.  For instance, MOFCOM sometimes required parties involved in a Joint Venture to change the commercial terms already agreed between them if such terms in its view were prejudicial to the Chinese party’s interests.  Another example was that MOFCOM officials often preferred simple templates for commercial contracts such as the joint venture contracts and equity interest transfer agreements.  To the extent the parties involved had agreed to terms that were not contained in such templates, MOFCOM officials often demanded that those terms be deleted or amended, even if they were among the most standard provisions in international transactions (such as adjustments in purchase price in an M&A transaction and the right by one party to a Joint Venture to put its shares to the other parties).  This forced parties in many cases to deal with these issues in parallel offshore agreements governed by non-PRC law even though the enforceability of such agreements in China was questionable. Moreover, the approval requirements added complications to commercial transactions and resulted in unnecessary transaction costs.  For example, because transfer of interest in an FIE required governmental approval and registration and such approval and registration themselves constituted transfer of title, parties in an M&A transaction often spent a long time negotiating when the purchase price should be paid.  A buyer would be reluctant to pay the price before obtaining the approval and registration because there was a risk that the approval and registration may not be granted.  Similarly, a seller often would not be willing to submit documents for approval and registration before it received the payment due to the concern that the buyer may not pay the purchase price after its interest in the FIE was already transferred.  In other words, it was basically impossible to have an M&A closing where transfer of title and payment of purchase price could happen simultaneously.  As a result, the parties often ended up negotiating escrow or security arrangements that were unnecessarily complicated and costly. New Changes The major changes adopted in Announcement 22 and the Interim Measures include: Negative List; Filing One primary change is the division of foreign investments into two categories: those that require special permits (commonly known as the "Negative List")[2] and those that do not.  Pursuant to Announcement 22, the Negative List consists of (i) sectors under the prohibited and restricted categories in the current Investment Catalogue and (ii) those sectors under the encouraged category that have special shareholding or management restrictions (such as requiring Chinese parties to have a controlling interest in a Joint Venture).  Foreign investments in any sectors on the Negative List are still prohibited or require prior approvals.  Procedures for applying for such approvals under the current FIE Laws and the Implementing Rules shall continue to apply without being affected by Announcement 22 or the Interim Measures. On the other hand, if a sponsor wishes to set up an FIE in a sector not on the Negative List, instead of applying to MOFCOM for the Establishment Approval, it can now submit the required documents and proceed with a filing procedure through an online FIE Information Comprehensive Administration System (the "Comprehensive Administration System").  The same filing process also applies to any amendments to the incorporation documents, including transfer of interests in an FIE. Filing Procedures To establish an FIE, the sponsors can make the filing through the Comprehensive Administration System either before the Company Registration or within 30 days thereafter.  This is a significant change, as the sponsors can now elect to set up an FIE without having to submit any documents to MOFCOM first. In case the documents filed with MOFCOM are subsequently amended (as in the case where there is a transfer of equity interest in an FIE), the FIE is required to file such amendments through the Comprehensive Administration System within 30 days thereafter.  Importantly, such amendments will become effective not upon filing with MOFCOM but upon the adoption of the relevant resolutions by the FIE.  Within three working days after receiving the filing materials, MOFCOM should complete the filing and publish the results through the Comprehensive Administration System or, if applicable, inform the filing parties that the relevant matters are not subject to filing.  The sponsors or the FIE can then obtain a filing receipt from MOFCOM.  Supervision As part of the filing process, the sponsors of an FIE or the FIE are required to warrant (among other things) that all information submitted through the Comprehensive Administration System is complete, true and accurate and that the FIE’s business activities do not involve any activity on the Negative List. If a party fails to make the required filing or if any false or misleading information is submitted, it will be ordered to take remedial actions.  It may also be subject to a fine not exceeding RMB30,000.  If other laws or regulations are also violated, other governmental authorities will enforce related remedies as well.   More Reforms Required There is little doubt that Announcement 22 and the Interim Measures represent a significant liberalization of China’s foreign investment regulatory regime.  Foreign investors now should find it much easier to set up an FIE and negotiate and execute M&A transactions.  On the other hand, it is important to point out that Announcement 22 and the Interim Measures are only a first step.  For instance, Announcement 22 specifically provides that the filing procedures under the Interim Measures do not apply to acquisitions by foreign investors of non-FIEs in China, which seriously restricts the scope of the Interim Measures and is a disappointment to market practitioners.  In addition, Foreign investments in China are subject to regulations by a number of agencies in addition to NDRC and MOFCOM, such as the State Administration of Foreign Exchange ("SAFE").  These agencies will need to adopt corresponding changes in order for Announcement 22 and the Interim Measures to achieve their intended results.  Furthermore, there are still many provisions in the FIE Laws and the Implementing Rules that are not "standard" compared with many other jurisdictions; nor do they apply to non-FIEs in China.  One example is that, under the Implementing Rules, certain matters relating to a Joint Venture are required to be decided by its board on a unanimous basis, including amendments to its articles of association, its termination or dissolution and the increase or decrease of its registered capital. More changes in these laws and regulations are obviously required to bring the Chinese system more in line with the international norm. In January 2015, China published a draft Foreign Investment Law (the "Draft Law") for public comments, which specifically provides that, except in cases where special entry permits are required, FIEs shall enjoy national treatment just as the non-FIE domestic companies.  The Draft Law is intended to replace the FIE Laws entirely such that FIEs will be governed by the PRC Company Law in the same way as all the non-FIE domestic companies.  However, currently there is no indication as to when the Draft Law will be adopted.   [1]  The Project Approval requirement has not changed as a result of Announcement 22 or the Interim Measures.   [2]  In recent years, China has experimented with a similar negative list-based system in a number of free trade zones where sponsors of an FIE can go through a simplified "filing" (as opposed to "approval") process to establish FIEs in sectors not on the negative list.  Announcement 22 and the Interim Measures essentially have made this system applicable to the whole country.              Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have about this development.  Please contact the Gibson Dunn lawyer with whom you usually work or the following: Yi Zhang – Hong Kong (+852 2214 3988, yzhang@gibsondunn.com)Fang Xue – Beijing (+86 10 6502 8687, fxue@gibsondunn.com)Joseph M. Barbeau – Beijing, Hong Kong, Palo Alto (jbarbeau@gibsondunn.com) © 2016 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 3, 2016 |
India – Quarterly Legal and Regulatory Update (October 2016)

The Indian Market The Indian economy continues to be an attractive investment destination due to its sustained stable growth and implementation of further liberalization policies by the Government of India ("Government"). Statistics indicate that India’s gross domestic product grew 7.6 per cent in 2015-16, up from 7.2 per cent a year ago. The full-year growth was fuelled by close to 8 per cent growth rate in the fourth quarter of 2015-16, the fastest in the world for the January-March quarter. As is evident from various amendments, the Government is focussed on making India a favoured destination for foreign investment. Following our previous update dated May 17, 2016 (which sets out an overview of key legal and regulatory developments in India from October 1, 2015 to April 30, 2016), this update provides a brief overview of the key legal and regulatory developments in India from May 1, 2016 to August 31, 2016. Key Legal and Regulatory Developments Foreign Investment Amendments to the Foreign Direct Investment Policy: The Foreign Direct Investment Policy of the Government ("FDI Policy") is the primary regulation governing foreign investment in India which is reviewed and amended by the Government annually. The Government introduced several amendments to the FDI Policy through the annual Consolidated Foreign Direct Investment Policy Circular, 2016 issued on June 7, 2016 ("2016 FDI Policy") and a subsequent press note issued on June 24, 2016 ("Press Note").[1] The amendments introduced by the 2016 FDI Policy and the Press Note, enable increased levels of foreign investment in a number of business sectors such as broadcasting, airports and pharmaceuticals, and further, simplify various sector-specific conditions. For a detailed analysis, please refer to our client alert dated July 1, 2016 at:  http://www.gibsondunn.com/publications/Pages/Indian-Government-Amends-Foreign-Direct-Investment-Policy-July-2016.aspx Deferred Consideration in Cross-border Share Purchase Transactions Allowed: The Reserve Bank of India ("RBI") has amended the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 to permit, under the automatic approval route, deferment of purchase consideration in share purchase transactions involving foreign investment[2]. Under the earlier regime, in a transaction where a non-resident purchased shares of an Indian company from a resident, there was a requirement that the entire agreed consideration be paid upfront at the time of the share transfer. Therefore, hold-backs, e.g., on account of post-closing adjustments or indemnity payments, were not permitted in such transactions unless the prior approval of the RBI was obtained. With this amendment, a non-resident is now permitted to hold-back a part of the agreed consideration (typically under an escrow mechanism) or require the resident to return the consideration received by it (on account of indemnity payments), subject to the following conditions:     (a)    at least 75% of the agreed consideration must be paid up-front, i.e. up to 25% of the agreed consideration can be held back. In this case, the balance consideration (after adjustments) must be paid within 18 months from the date of the share purchase agreement;     (b)    if the total consideration is paid up-front, up to 25% of the consideration can be returned to the non-resident by the resident on account of indemnity payments within 18 months from the date of payment of consideration. In both of the above circumstances, the total consideration received by the resident from the non-resident, upon the expiry of the 18 month-period mentioned above, must be equal to or more than the statutory floor price determined in accordance with the RBI’s pricing guidelines[3]. Prior approval of the RBI continues to be required for payment of deferred consideration, which does not conform to the above conditions. While the amendment will facilitate acquisitions in India by permitting better risk allocation between cross-border buyers and sellers, a few issues should be carefully considered during negotiations:     (a)    The 18 month-period in relation to a hold-back is to be reckoned from the "signing" or "execution" date of the share purchase agreement, not from the "closing" date (the actual date on which the seller transfers the shares to the buyer in return for the consideration). It is not uncommon for the time gap between execution and closing to exceed six months, depending on the complexity of the transaction and the need for regulatory approvals. Consequently, the longer the gap between execution and closing of the transaction, the shorter the actual period of hold-back will be. A non-resident will be able to avail the full 18-month hold-back period only in transactions that are executed and closed simultaneously;     (b)    As indicated above, the RBI has reiterated (in the amendment) that the total consideration paid by a non-resident to a resident must be equal to or more than the consideration determined in accordance with RBI’s pricing guidelines. Therefore, the price commercially agreed to between the parties is subject to the statutory floor price prescribed by the RBI, which needs to be paid by a non-resident to a resident. As a result, there may arise a situation where the hold-back amount will need to be paid by the non-resident to comply with the pricing guidelines of the RBI, even if such buyer is contractually permitted to retain the amount (for example, on account of indemnity payments). How this issue will be dealt with practically will need to be seen as transactions start to close subsequent to the new amendment. India-Mauritius Double Taxation Avoidance Agreement Amendment: India and Mauritius signed a protocol (the "Protocol") amending the India-Mauritius Double Taxation Avoidance Agreement ("India-Mauritius DTAA").[4] This radically changes the tax liability on capital gains arising from alienation of shares of an Indian resident company by a Mauritian tax resident. Under the erstwhile regime, such gains were taxable in the country of residence i.e. Mauritius, resulting in zero taxation. Now, the Protocol imposes taxes on such gains at the source i.e. at the level of the Indian resident company at the applicable domestic tax rate. This amendment effectively takes away the capital gains exemptions that were available investing through the Mauritius route. The Protocol has been made effective on investments made on or after April 1, 2017. Therefore, investments made prior to March 31, 2017 and related exits/share transfers will remain unaffected by this change. Corporate Law & Financing Clarification on Rupee Denominated Offshore Bonds: The Ministry of Corporate Affairs has clarified that issuance of rupee denominated offshore bonds will not be governed by the requirements of private placement or public offer under the [Indian] Companies Act, 2013.[5] Also, the securities regulator in India, Securities and Exchange Board of India ("SEBI") has issued a notification to clarify that the SEBI (Foreign Portfolio Investors) Regulations, 2013, will not apply to such offshore bonds.[6] Cumulatively, these clarifications have eliminated the confusion with regard to the regulations applicable to rupee denominated offshore bonds and clearly establish the jurisdiction of the RBI in this matter, under its Master Direction on External Commercial Borrowings issued in January 2016. Reforms in Debt Recovery and Enforcement of Security Interest Proceedings: The Indian Parliament has amended the [Indian] Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 and the [Indian] Recovery of Debts due to Banks and Financial Institutions Act, 1993. These amendments are aimed at reducing the time taken in debt recovery proceedings by reforming procedures followed by tribunals established for this purpose. These amendments include provisions on electronic filings and record keeping for all debt recovery tribunals. Additionally, these amendments provide greater powers to secured creditors to enforce their collateral interest and take over the management of defaulting corporate debtors. Insolvency and Bankruptcy Code, 2016:  The Insolvency and Bankruptcy Code, 2016 (the "Code") has been notified in the [Indian] official gazette on May 28, 2016. The Code overhauls laws governing insolvency in India and is a major initiative of the government towards improving the ease of doing business in the country. The Code applies to companies, partnerships, limited liability partnerships and individuals. The Code replaces the existing insolvency framework which was confusing and fraught with substantial delays. Insolvency proceedings against a corporate debtor commence with a resolution process that seeks to resolve the insolvency of a debtor as a going concern by formulating a resolution plan. If this process fails to achieve a resolution, the debtor is subjected to liquidation proceedings to settle pending claims against it within a specific time frame. The process of corporate insolvency is subject to the overarching supervision of the National Company Law Tribunal ("NCLT"). Further, the Code envisions the establishment of an Insolvency and Bankruptcy Board which is mandated with the task of training and regulating the functioning of insolvency professionals who will have an important role in administering the insolvency proceedings along with the NCLT. For a detailed analysis, please refer to our client alert dated June 08, 2016 available at: http://www.gibsondunn.com/publications/Pages/Indian-Parliament-Passes-Insolvency-and-Bankruptcy-Code-2016.aspx National Company Law Tribunal Notified: Corporate litigation in India has substantially been reformed with the constitution of the NCLT and the National Company Law Appellate Tribunal ("NCLAT") with benches across major cities.[7] The NCLT has jurisdiction over matters that were earlier dealt with by the Company Law Board and the High Courts, in addition to the functions assigned to it under the Code (as discussed above). This includes court approved mergers, winding-up, reduction of share capital, oppression of minority shareholders and mismanagement of companies, among others. The NCLAT will decide on appeals of the NCLT’s decisions.    [1]   Press Note 5 (2016 Series) dated June 24, 2016.    [2]   Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) (Seventh Amendment) Regulations, 2016, notified on May 20, 2016.    [3]   The fair value of the shares of the Indian company determined by a chartered accountant of a merchant banker registered with the Securities and Exchange Board of India, in accordance with any internationally accepted pricing methodology.    [4]   Press Release dated May 10, 2016 issued by the Central Board of Direct Taxes available at http://www.incometaxindia.gov.in/Lists/Press%20Releases/Attachments/468/Press-release-Indo-Mauritius-10-05-2016.pdf    [5]   General Circular No. 09/2016 issued by the Ministry of Corporate Affairs on August 3, 2016 available at http://www.mca.gov.in/Ministry/pdf/GeneralCircular09_03082016.pdf    [6]   Circular Issued by the Securities and Exchange Board of India dated August, 4, 2016 available at http://www.sebi.gov.in/cms/sebi_data/attachdocs/1470299109414.pdf    [7]   [Indian] Gazette Notification dated June 1, 2016 (S.O. 1932(E)). Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. For further details, please contact the Gibson Dunn lawyer with whom you usually work or the following authors in the firm’s Singapore office: India Team:Jai S. Pathak (+65 6507 3683, jpathak@gibsondunn.com)Priya Mehra (+65 6507 3671, pmehra@gibsondunn.com)Bharat Bahadur (+65 6507 3634, bbahadur@gibsondunn.com)Karthik Ashwin Thiagarajan (+65 6507 3636, kthiagarajan@gibsondunn.com)Sidhant Kumar (+65 6507 3661, skumar@gibsondunn.com)  © 2016 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.