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January 16, 2019 |
2018 Trade Secrets Litigation Roundup

Click for PDF 2018 marked an exciting year of trade secret developments and demonstrated the federal government’s increased involvement in protecting trade secrets, a trend expected to continue in 2019. Courts continued to construe the Defend Trade Secrets Act (DTSA)—including first impression rulings under the whistleblower and attorneys’ fees provisions—and juries doled out significant damages awards in trade secrets cases. Massachusetts passed a new trade secrets bill. The Trump administration imposed tariffs on China in response to the alleged theft of trade secrets, and also charged nine Iranian nationals for a series of coordinated cyber intrusions. Jason Schwartz, Greta Williams, Mia Donnelly and Aaron Smith highlight these and other notable trade secrets developments from 2018 in their article “2018 Trade Secrets Litigation Roundup” published by BBNA. Reproduced with permission, January 15, 2019, from Copyright 2019 The Bureau of National Affairs, Inc. (800-372-1033) www.bna.com.  Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update.  Please contact the Gibson Dunn lawyer with whom you usually work or the following authors in the firm’s Washington, D.C. office: Jason C. Schwartz (+1 202-955-8242, jschwartz@gibsondunn.com) Greta B. Williams (+1 202-887-3745, gbwilliams@gibsondunn.com) Mia C. Donnelly (+1 202-887-3617, mdonnelly@gibsondunn.com) Please also feel free to contact any of the following practice group leaders and members: Labor and Employment Group: Catherine A. Conway – Los Angeles (+1 213-229-7822, cconway@gibsondunn.com) Jason C. Schwartz – Washington, D.C. (+1 202-955-8242, jschwartz@gibsondunn.com) Intellectual Property Group: Wayne Barsky – Los Angeles (+1 310-557-8183, wbarsky@gibsondunn.com) Josh Krevitt – New York (+1 212-351-2490, jkrevitt@gibsondunn.com) Mark Reiter – Dallas (+1 214-698-3360, mreiter@gibsondunn.com) Howard S. Hogan – Washington, D.C. (+1 202-887-3640, hhogan@gibsondunn.com) Michael Sitzman – San Francisco (+1 415-393-8200, msitzman@gibsondunn.com) Privacy, Cybersecurity and Consumer Protection Group: Alexander H. Southwell – New York (+1 212-351-3981, asouthwell@gibsondunn.com) Benjamin B. Wagner – Palo Alto (+1 650-849-5395, bwagner@gibsondunn.com) © 2019 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 13, 2019 |
Gibson Dunn Named a 2018 Law Firm of the Year

Gibson, Dunn & Crutcher LLP is pleased to announce its selection by Law360 as a Law Firm of the Year for 2018, featuring the four firms that received the most Practice Group of the Year awards in its profile, “The Firms That Dominated in 2018.” [PDF] Of the four, Gibson Dunn “led the pack with 11 winning practice areas” for “successfully securing wins in bet-the-company matters and closing high-profile, big-ticket deals for clients throughout 2018.” The awards were published on January 13, 2019. Law360 previously noted that Gibson Dunn “dominated the competition this year” for its Practice Groups of the Year, which were selected “with an eye toward landmark matters and general excellence.” Gibson Dunn is proud to have been honored in the following categories: Appellate [PDF]: Gibson Dunn’s Appellate and Constitutional Law Practice Group is one of the leading U.S. appellate practices, with broad experience in complex litigation at all levels of the state and federal court systems and an exceptionally strong and high-profile presence and record of success before the U.S. Supreme Court. Class Action: Our Class Actions Practice Group has an unrivaled record of success in the defense of high-stakes class action lawsuits across the United States. We have successfully litigated many of the most significant class actions in recent years, amassing an impressive win record in trial and appellate courts, including before the U. S. Supreme Court, that have changed the class action landscape nationwide. Competition: Gibson Dunn’s Antitrust and Competition Practice Group serves clients in a broad array of industries globally in every significant area of antitrust and competition law, including private antitrust litigation between large companies and class action treble damages litigation; government review of mergers and acquisitions; and cartel investigations, internationally across borders and jurisdictions. Cybersecurity & Privacy: Our Privacy, Cybersecurity and Consumer Protection Practice Group represents clients across a wide range of industries in matters involving complex and rapidly evolving laws, regulations, and industry best practices relating to privacy, cybersecurity, and consumer protection. Our team includes the largest number of former federal cyber-crimes prosecutors of any law firm. Employment: No firm has a more prominent position at the leading edge of labor and employment law than Gibson Dunn. With a Labor and Employment Practice Group that covers a complete range of matters, we are known for our unsurpassed ability to help the world’s preeminent companies tackle their most challenging labor and employment matters. Energy: Across the firm’s Energy and Infrastructure, Oil and Gas, and Energy, Regulation and Litigation Practice Groups, our global energy practitioners counsel on a complex range of issues and proceedings in the transactional, regulatory, enforcement, investigatory and litigation arenas, serving clients in all energy industry segments. Environmental: Gibson Dunn has represented clients in the environmental and mass tort area for more than 30 years, providing sophisticated counsel on the complete range of litigation matters as well as in connection with transactional concerns such as ongoing regulatory compliance, legislative activities and environmental due diligence. Real Estate: The breadth of sophisticated matters handled by our real estate lawyers worldwide includes acquisitions and sales; joint ventures; financing; land use and development; and construction. Gibson Dunn additionally has one of the leading hotel and hospitality practices globally. Securities: Our securities practice offers comprehensive client services including in the defense and handling of securities class action litigation, derivative litigation, M&A litigation, internal investigations, and investigations and enforcement actions by the SEC, DOJ and state attorneys general. Sports: Gibson Dunn’s global Sports Law Practice represents a wide range of clients in matters relating to professional and amateur sports, including individual teams, sports facilities, athletic associations, athletes, financial institutions, television networks, sponsors and municipalities. Transportation: Gibson Dunn’s experience with transportation-related entities is extensive and includes the automotive sector as well as all aspects of the airline and rail industries, freight, shipping, and maritime. We advise in a broad range of areas that include regulatory and compliance, customs and trade regulation, antitrust, litigation, corporate transactions, tax, real estate, environmental and insurance.

January 15, 2019 |
2018 Year-End Securities Enforcement Update

Click for PDF I.   Introduction: Themes and Developments A.   2018 In Review The Securities and Exchange Commission, like most federal agencies, ended 2018 with a whimper, not a bang. Most staffers were furloughed as part of the federal government shutdown, a note on the SEC homepage cautioning that until further notice only a limited number of personnel would be on hand to respond to emergency situations. The shutdown curtailed the Division of Enforcement’s ability to close out the year with a raft of last-minute filings, not to mention causing most SEC investigations to grind to a halt.  That said, between the December 27 shutdown and the date of this publication, the SEC did manage to institute two enforcement actions – a settlement with a car rental company for accounting errors occurring between 2012 and 2014[1]; and a settlement with a small accounting firm for failing to comply with the Custody Rule in connection with audits of an investment adviser conducted between 2012 and 2015.[2]  Given the age of the conduct, it is unclear the nature of the “emergency” requiring unpaid SEC staffers to come to work in the midst of the shutdown to release these two particular cases, though perhaps an impending statute of limitations was to blame. While the shutdown may have cut the Enforcement Division’s year short, it was more than compensated for by the flurry of actions filed as the agency’s September 30 fiscal year-end loomed.  Indeed, the SEC issued nearly a dozen press releases announcing enforcement actions on the last three days of the fiscal year, including several significant cases involving prominent public companies and financial institutions. The (fiscal) year-end rush appeared intended to blunt some of the criticism of the Enforcement Division’s productivity in the new administration.  After filing 446 new stand-alone enforcement actions in fiscal 2017, an over 18% drop from the 548 actions filed in 2016, the docket recovered somewhat in 2018, with the SEC filing 490 new actions.[3]  (The SEC’s tally of “stand-alone” enforcement actions excludes “follow-on” proceedings sanctioning individuals separately charged for violating the securities laws, and routine administrative proceedings to deregister the stock of companies with delinquent SEC filings.)  While still falling short of the final years under the prior SEC and Enforcement Division leadership, the current Division Directors were quick to note in their Annual Report that the 2015 and 2016 results were somewhat skewed by the SEC’s Municipalities Continuing Disclosure (MCDC) Initiative, under which municipal securities issuers and underwriters who self-reported disclosure violations to the Division received leniency.  The initiative produced nearly 150 enforcement actions; stripped of those matters, the 2018 results actually exceeded those of recent years. The Division Directors further explained that these results were achieved notwithstanding a hiring freeze in place at the SEC since the onset of the Trump administration, and the Division’s Annual Report included a plea for additional resources.  As stated in the Report, “While this achievement is a testament to the hardworking women and men of the Division, with more resources the SEC could focus more on individual accountability, as individuals are more likely to litigate and the ensuing litigation is resource intensive.”  The Directors also noted the challenges posed by the Supreme Court’s decision in Kokesh v. SEC, which confirmed a strict five-year statute of limitations on SEC demands for disgorgement[4], as well as the Court’s more recent decision in Lucia v. SEC, which held that the SEC’s method of appointing its administrative law judges violated the Appointments Clause of the U.S. Constitution and has necessitated the potential re-litigation of myriad administrative proceedings.[5] Thematically, the Enforcement Division (as well as SEC Chairman Clayton) repeatedly reiterated their focus on protecting “retail” or “Main Street” investors.  Indeed, the Division’s Annual Report invoked the word “retail” no fewer than twenty-six times.  (A close second was “cyber,” another Division priority, which appeared twenty-four times in the Report.)  The “retail” focus has led the SEC to highlight cases in which average investors appear to be victimized, particularly offering frauds, pump-and-dump-schemes, and misconduct by investment advisers and broker dealers directed at individual clients.  For fiscal 2018, according to the Annual Report, securities offering cases (which range from Ponzi schemes to various disclosure and registration violations in connection with securities offerings) comprised 25% of the year’s enforcement actions, the largest single category.  Cases against investment advisers and investment companies were just behind at 22% of the caseload; and while the SEC continues to bring cases involving private funds and institutional investors, the lion’s share of investment adviser cases fit within the SEC’s “retail” focus. Despite efforts in recent years for the Enforcement Division to renew its scrutiny of public company financial reporting and disclosure – which in the past had often been the top category of SEC enforcement actions, representing a quarter or more of the docket – such cases comprised only 16% of the SEC’s enforcement actions in 2018.  Rounding out the docket were cases involving broker-dealers (13%), insider trading (10%), and market manipulation (7%); FCPA cases and public finance abuse checked in at 3% of the enforcement filings apiece. B.   Whistleblowers The whistleblower bounty program enacted as part of Dodd-Frank continues to grow apace with each new year.  In its November 2018 annual report to Congress, the SEC’s Office of the Whistleblower reported that the program had once again netted a record number of tips.[6]  A total of 5,282 whistleblower complaints were received in fiscal 2018, up nearly 18% from 2017.  (The report noted that the Whistleblower Office appears to have its share of vexatious whistleblowers who submit an “unusually high” number of tips, which are excluded from the tally.) As with enforcement cases ultimately filed by the Enforcement Division in 2018, the largest single category for tips for 2018 was offering frauds, representing 20% of all complaints; tips concerning corporate disclosures and financials were a close second, representing 19% of the complaints. The SEC has also continued to announce large award payments to whistleblowers whose tips led to successful enforcement actions.  In September, the SEC announced that it had awarded $39 million to a single whistleblower, the second highest award in the history of the program; the same investigation also resulted in a $15 million payment to a second whistleblower.[7]  However, due to the whistleblower regulations’ confidentiality requirements, the nature of the enforcement action resulting in these awards is not reported. The SEC announced two additional whistleblower awards later that same month. First, the SEC reported a $1.5 million payment, while noting that “the award was reduced because the whistleblower did not promptly report the misconduct and benefitted financially during the delay.”[8]  And in a second case, the SEC awarded $4 million to an overseas whistleblower, touting the important service that even those outside the U.S. can provide to the SEC.[9]  The SEC further heralded the tipster’s continuing assistance throughout the course of the investigation. According to its most recent release, the SEC has now awarded over $326 million to 59 individuals under its whistleblower program. C.   Cybersecurity and Cryptocurrency As noted above, the SEC’s Enforcement Division remains acutely focused on all things “cyber.”  While this has manifested itself primarily, in recent months, on enforcement actions involving cryptocurrency and digital assets, the Division also had several noteworthy firsts in matters of cybersecurity in the latter half of the year. First, in September, the SEC brought its first enforcement action alleging violations of the Identity Theft Red Flags Rule.[10]  The SEC alleged that a broker-dealer lacked adequate safeguards to prevent intruders from resetting contractor passwords in order to gain access to personal information about certain customers.  Without admitting the allegations, the firm agreed to pay a $1 million penalty and to retain a consultant to evaluate its compliance with the Safeguards Rule and the Identity Theft Red Flags Rule. Then, in October, the Enforcement Division issued a report on its investigations of nine public companies which had been victimized by cyber fraud.[11]  According to the SEC, attackers had used fraudulent emails to pose as executives or vendors in order to dupe company personnel into sending about $100 million (in the aggregate) into bank accounts controlled by the perpetrators.  The SEC declined to charge the companies with wrongdoing, but cautioned companies that the internal controls provisions of the federal securities laws require them to ensure they have adequate policies and procedures to mitigate such incidents and safeguard shareholder assets.[12] But most of the high-tech action happened on the cryptocurrency front, with the Enforcement Division similarly touting a number of firsts.  Most of these actions related to registration-related conduct engaged in after the Commission’s 2017 DAO Report, in which the Commission concluded that digital assets may be securities under the federal securities laws. In September, the SEC settled an action against a so-called “ICO superstore” and its owners for acting as unregistered broker-dealers by operating a website that permitted visitors to purchase tokens in ICOs and engage in secondary trading.[13] This was the first case in which the SEC charged unregistered broker-dealers for selling digital assets.  Collectively, the company and owners paid nearly $475,000 in disgorgement, while the owners also paid $45,000 each in penalties and consented to industry and penny stock bars and an investment company prohibition with a right to reapply after three years. The same day, the SEC found for the first time that a hedge fund manager’s investments in digital assets constituted an investment company registration violation.[14]  According to the SEC, the fund falsely claimed to be regulated by and to have filed a registration statement with the SEC, and raised more than $3.6 million in four months.  It also engaged in an unregistered public offering and invested more than 40% of its assets in digital asset securities. The fund and its sole principal consented to pay a combined $200,000 penalty to settle the case. In November, the SEC settled an action against the founder of a digital token-trading platform, finding for the first time that such a platform operated as an unregistered national securities exchange.[15]  The platform in question matched buyers and sellers of digital assets, executed smart contracts, and updated a distributed ledger via the Ethereum blockchain, among other things. The founder consented to disgorge $300,000 and pay a $75,000 penalty.  The SEC noted that its investigation remains ongoing. Also in November, the SEC settled actions against two technology companies for failing to register their ICOs pursuant to federal securities laws.[16]  Both companies raised over $10 million worth of digital assets to fund their respective business ventures.  These were the first cases in which the SEC imposed civil penalties solely for ICO-related registration violations. The companies consented to return funds to investors, register their tokens as securities, file periodic reports with the SEC for at least one year, and pay $500,000 in total penalties. That same month, the SEC also for the first time brought actions against individuals for improperly promoting ICOs.  The SEC settled actions against two celebrities for their respective failures to disclose that they were being compensated for promoting upcoming ICOs on their social media accounts.[17]  The celebrities received approximately $350,000 in total for their promotions, all of which they were required to disgorge, along with $400,000 in total penalties. The celebrities also consented to a combined five-year ban on promoting any security. The second half of this year also saw the SEC crack down on ICOs claiming to be registered with the SEC.  In October, the SEC suspended trading of a company’s securities after the company issued two press releases falsely claiming to have partnered with an SEC-qualified custodian for use with cryptocurrency transactions and to be conducting an “officially registered” ICO.[18]  Also in October, the SEC obtained an emergency court order halting a planned ICO that falsely claimed to be SEC-approved.[19]  On October 11, a federal judge froze the assets of the defendants—the company and its founder.  Notably, in one of the few setbacks to the SEC’s aggressive enforcement program in the cryptocurrency space, the same judge subsequently denied the SEC’s motion for a preliminary injunction, finding that the Commission had failed to show that the digital asset offered in the ICO was a security subject to federal securities laws.[20]  Litigation remains ongoing. Finally, September saw the SEC file a litigated action against an international securities dealer and its CEO for soliciting investors to buy and sell securities-based swaps.[21]  The SEC filed the case after an undercover FBI agent allegedly purchased securities-based swaps on the company’s platform despite not meeting the required discretionary investment thresholds.  The SEC alleged that the company failed to register as a security-based swaps dealer and transacted the securities-based swaps outside of a registered national exchange. II.   Issuer and Auditor Cases A.   Accounting Fraud and Internal Controls In July, the SEC charged a drainage pipe manufacturer and its former CFO with reporting and accounting violations.[22]  According to the SEC, the company allegedly overstated its income before taxes from 2013-2015 as a result of insufficient internal accounting controls, improper accounting, and “unsupported journal entries directed or approved” by the former CFO.  Without admitting or denying the allegations, the company agreed to pay a $1 million penalty while the CFO agreed to pay a $100,000 penalty, reimburse the company approximately $175,000 in stock sale profits, and be barred from practicing as an accountant before the SEC. In early September, the SEC announced a settlement with a telecommunications expense management company and three members of the company’s senior management related to allegedly fraudulent accounting practices.[23]  According to the complaint, the company prematurely reported revenue for work that had not been performed or for transactions that did not actually produce revenue.  The SEC also alleged that the company’s former senior vice president of expense management operations falsified business records that were provided to auditors.  The company and three executives agreed to pay a combined penalty of $1.67 million to settle the allegations.  The litigated action against the senior VP of expense management operations remains pending. Later that month, the SEC charged a U.S.-based CFO of a public company in China with using his personal bank account to transfer over $400,000 in corporate funds from China to the U.S. to pay the company’s U.S. expenses.[24]  The SEC’s complaint alleged that he had previously engaged in the same practice for at least two other China-based public companies.  The SEC contended that the commingling of corporate and personal funds put the company’s assets at risk of misuse and loss, and that the CFO had failed to implement an adequate set of internal accounting controls.  The CFO agreed to settle the charges without admitting wrongdoing, agreeing to pay a $20,000 fine and to be barred from serving as a public company officer or director for five years. Also in September, the SEC initiated enforcement actions against a business services company, its former CFO, and the company’s former controller related to allegations of accounting fraud.[25]  The complaint alleged that the CFO manipulated the company’s books to hide the increasing expense of its workers’ compensation relative to revenue from its independent auditor.  When the company announced that it needed to restate its financial results to reflect the actual workers’ compensation expenses, the stock price fell by 32%.  Without admitting or denying the allegations, the company agreed to pay $1.5 million to settle the charges, and the controller, who allegedly approved some of the CFO’s accounting entries, agreed to pay $20,000 and be suspended from appearing before the SEC as an accountant for one year.  The case against the CFO is being litigated, and he has also been charged criminally by the United States Attorney’s Office for the Western District of Washington.  The company’s CEO, who was not charged with wrongdoing, agreed to pay the company back his $20,800 in cash bonuses received during the period of the alleged accounting violations. The following day, a pipeline construction company agreed to settle charges that it failed to implement adequate internal accounting controls, and failed to adequately evaluate its control deficiencies when assessing the effectiveness of its Internal Control over Financial Reporting (“ICFR”), after problems with its revenue recognition surfaced.[26]  According to the SEC, the company used contingent cost estimates to cover potential risks inherent in a project that could add unanticipated expenses to its total costs.  The company failed to implement adequate controls around its contingent cost estimates, despite recognizing that such estimates were critical for properly recognizing revenue.  Without admitting liability, the company agreed to pay a $200,000 civil penalty. Later in September, the SEC announced a settled action against a pharmaceutical company and its former CFO for allegedly understating the amount of inventory held by its wholesaler customers, which occurred as a result of the company flooding its distribution channel with products.[27]  According to the complaint, this created more short-term revenue at the expense of future sales.  Without admitting or denying the allegations, the company agreed to be enjoined from future violations and the former CFO agreed to pay approximately $1 million in penalties and disgorgement, be subject to an officer and director bar for five years, and to be barred from appearing before the SEC as an accountant with a right to apply for reinstatement after five years. In a November case involving the Kenyan subsidiary of a U.S.-based tobacco company, the SEC charged that managers at the subsidiary overrode existing internal controls and failed to report accounting errors to the parent company.[28]  As a result, the parent company filed materially misstated financial statements for more than four years, including errors to its inventory, accounts receivable, and retained earnings numbers.  The parent company agreed to settle the internal controls violations on a no admit/no deny basis.  The SEC imposed a cease-and-desist order, noting the company’s remedial actions already undertaken, including sharing the results of its internal investigation with the SEC, hiring new accounting control positions within the African region, and implementing new internal accounting control procedures and policies. In December, the SEC filed a complaint against a multinational agricultural company and its executive chairman, alleging that they concealed substantial losses by improperly accounting for the divestiture of its China-based operating company.[29]  According to the SEC, the company overstated the value of stock received in the transaction and assigned a value of nearly $60 million to worthless land use rights.  The company agreed to pay a $3 million penalty and to cooperate with the SEC in future investigations, without admitting or denying the allegations.  Additionally, the CEO agreed to pay $400,000 and accept a five year officer and director bar. The next day, the SEC brought charges against a natural food company stemming from alleged weaknesses in the company’s internal controls regarding end-of-quarter sales practices that helped the company meet its internal sales targets.[30]  According to the SEC, the company’s sales personnel regularly offered incentives to customers to move inventory near quarter-end, including the right to return products that expired or spoiled prior to ultimate purchase, cash incentives, substantial discounts, and extended payment terms.  The company had failed to implement adequate controls to both detect and document these practices.  According to the SEC’s press release, no monetary penalties were imposed based on the company’s self-reporting to the SEC and significant remediation efforts, which included significant organizational changes and changes to its revenue recognition policies. Also in December, the SEC also instituted settled proceedings against a publicly-traded issuer of subprime automobile loan securities related to allegations that the company failed to accurately calculate its credit loss allowance from certain impaired loans and failed to segregate those loans from its general loan assets.[31]  The SEC also alleged that flaws in the company’s internal controls led to its errors in calculating credit loss allowance and caused the company to restate its financial statements twice in a one-year period.  Without admitting or denying the allegations, the company agreed to pay a $1.5 million penalty. Finally, the SEC brought a settled proceedings against five separate companies for filing quarterly financial forms without having their financial statements reviewed in advance, which is a violation of Regulation S-X.[32]  The SEC announced the charges against all five companies in a single press release, and each company agreed to remedial action, including payment of penalties ranging from $25,000 to $75,000. B.   Misleading Disclosures Beyond the accounting-related cases discussed above, the SEC pursued an unusual number of cases based on misleading disclosures by public companies in the latter half of the year. Misleading Metrics Many of the disclosure cases instituted by the SEC involved the use of allegedly misleading metrics of interest to investors. In July, the SEC filed settled proceedings against an engineering and construction company related to allegations that it inflated a key performance metric and had various accounting control deficiencies.[33]  According to the SEC’s order, the company’s “work in backlog” metric, which measured the revenue the company expected to earn from future firm orders under existing contracts, improperly included at least $450 million from orders that the company had not received.  Additionally, the SEC alleged that the company’s deficient accounting controls caused it to make inaccurate estimates of the costs to complete seven contracts, leading the company to restate its earnings.  Without admitting wrongdoing, the company agreed to pay a $2.5 million penalty. In August, the SEC separately instituted proceedings against a cloud communications company and two of its executives as well as executives at two online marketing companies related to allegations that they provided misleading numbers to investors.  In the first order, the SEC alleged that the company projected first quarter 2015 revenue of $74 million based on improperly reclassified sales forecasts when the CFO was aware of red flags that undermined confidence in that figure.[34]  Just a week before the end of the quarter, the company announced revenue projects that were approximately $25 million lower, causing the stock price to fall 33%.  Without admitting wrongdoing, the company agreed to pay $1.9 million and the two executives agreed to pay penalties ranging from $30,000 to $40,000.  In the second complaint, the SEC alleged that the former CEO and CFO of two online marketing companies, which formed a parent-subsidiary relationship in 2016, knowingly provided inflated subscriber figures.[35]  These charges arose out of a settled enforcement action the SEC brought against the companies themselves in June, in which the parent company agreed to pay a $8 million penalty.  Without admitting or denying the allegations, the two executives agreed to pay $1.38 million and $34,000, respectively. In September, the SEC announced a settled action with a payment processing company and its CEO.[36]  According to the SEC’s allegations, the company materially overstated a key operating metric that caused research analysts to overrate the company’s stock and promoted it in  its filings with the SEC, even though both the company and CEO had reason to know that the metric was inaccurate.  Without admitting or denying the allegations, the company agreed to pay a penalty of $2.1 million while the former CEO agreed to pay $120,000. Finally, in a relatively novel action, the SEC settled charges against a seller of home and business security services for failing to afford equal or greater prominence to comparable GAAP earnings measures in two of its financial statements containing non-GAAP measures.[37]  While the SEC has highlighted concerns about the prominence of non-GAAP metrics previously, this appears to be the first case in which that issue alone has resulted in an enforcement action.  Without admitting or denying the allegations, the company agreed to pay $100,000 to settle the matter. Executive Perks The SEC also brought several cases involving executive perks.  In July, the SEC announced a settlement with a chemical company related to charges that the company allegedly failed to adequately disclose approximately $3 million in perquisites given to its CEO in its 2013-2016 proxy statements.[38]  The SEC alleged that the company failed to disclose personal benefits not widely available and not integrally and directly related to an executive’s job duties.  The company agreed to pay a $1.75 million penalty and hire an independent consultant to help implement new perquisite disclosure policies. Also in July, the SEC alleged that the CEO of an oil company hid approximately $10.5 million in personal loans from a company vendor and a prospective member of the board.[39]  Additionally, the SEC alleged that the CEO received undisclosed compensation and perks, and that the company failed to report more than $1 million in excess compensation in its disclosures.  Without admitting or denying the SEC’s allegations, the CEO agreed to pay a $180,000 penalty and be subject to a five year bar from serving as an officer or director of a public company.  The board member also agreed to pay a penalty. Other Disclosures In July, the SEC instituted settled proceedings against a publicly-traded real estate investment trust and four executives, alleging that they failed to adequately disclose certain cashflow issues and the status of real property within its portfolio.[40]  The parties agreed to settle the charges without admitting or denying the allegations. In September, the SEC instituted proceedings against an industrial waste water treatment company and two senior executives, alleging that they failed to disclose to investors certain contractual contingencies that had not occurred in a material contract with Nassau, New York.[41]  To settle the allegations, without admitting or denying the SEC’s findings, the company agreed to pay $133,000 in penalties, disgorgement, and pre-judgment interest and the two executives agreed to pay civil penalties of $60,000 and $35,000 respectively. Also in September, the SEC announced a settlement with SeaWorld Entertainment Inc. and its former CEO.[42]  The SEC’s complaint alleged that the company and its CEO failed to adequately disclose the damaging impact a critical documentary had on the company’s business.  Without admitting or denying the allegations, the company and former CEO agreed to pay $5 million in penalties and disgorgement.  A former vice president of communications also agreed to pay $100,000 in disgorgement and prejudgment interest, without admitting or denying the allegations. That same day, the SEC filed a settled action against a biopharmaceutical company, its CEO, and former CFO, related to allegations that the company failed to timely disclose questions about the efficacy of its flagship lung cancer drug.[43]  Without admitting or denying the SEC’s allegations, the company and the executives agreed to the payment of disgorgement and penalties. Later that month, the SEC filed a settled action against a large drugstore chain, its former CEO, and former CFO for failing to communicate the increased risk of missing operating income projections in the wake of a corporate merger.[44]  The SEC alleged that in 2012, one of the predecessor entities had reaffirmed earlier projections despite internal projections showing an increased risk of falling short.  Without admitting or denying the allegations, the company paid a $34.5 million penalty and the two executives each agreed to pay $160,000. And at the end of September, the SEC announced a settlement with Tesla, Inc. and its CEO arising out of the CEO’s tweets about plans to take the company private.[45]  The SEC alleged that the potential transaction was subject to numerous contingencies, and that the company lacked sufficient controls to review the CEOs tweets.  Without admitting or denying the allegations, the company and its CEO agreed to pay civil penalties; additionally, the CEO agreed to step down from the board and be replaced by an independent chairman, and the company agreed to install two new independent directors, implement controls to oversee the CEO’s tweets, and establish a new committee of independent directors. C.   Auditor Cases In September, the SEC instituted proceedings against an accounting firm for improper professional conduct and violations of the securities law during the course of an audit of an information technology company.[46]   According to the SEC’s complaint, the firm ignored a series of red flags concerning cash held by a related entity and provided an unqualified opinion.  The firm and two of its principals agreed to be barred from appearing before the SEC as accountants for five years, and to pay monetary penalties. In October, the SEC suspended three former accountants from a larger audit firm related to allegations that they violated auditing standards and engaged in unprofessional conduct during an audit of an insurance company.[47]  According to the SEC’s order, the audit team fell behind schedule during the audit, but the senior manager directed team members to sign off on “predated” workpapers to make it appear that the audit had been completed before the company’s annual report was filed with the SEC.  The SEC also concluded that the engagement partner and quality review partner failed to exercise due professional care that would have prevented these deficiencies in the audit.  Without admitting or denying the SEC’s findings, the three accountants agreed to be suspended from practicing before the SEC as accountants for periods ranging from one to five years, pending applications for reinstatement. In December, the SEC instituted proceedings against an audit firm, two of its partners, and two partners from a now-defunct auditing firm, relating to “significant failures” in their audit of a company that went bankrupt after the discovery of more than $100 million in federal tax liability.[48]  According to the SEC’s order, the firm identified pervasive risks of fraud in the company but failed to undertake additional steps to address the risk.  The SEC also alleged that the audit firm was not actually independent of the company due to an ongoing business relationship.  To settle the allegations, the firm agreed to  pay a penalty of $1.5 million, and hire an independent compliance consultant.  All four partners agreed to be suspended from practicing before the SEC for between one and three years, and to pay penalties ranging from $15,000 to $25,000. Finally, outside the public company audit context, the SEC charged an audit firm with failing to maintain its independence when conducting “Custody Rule” and broker-dealer audits.  The SEC alleged that the firm violated independence standards by both preparing and auditing client financial statements, accompanying notes, and accounting entries for more than 60 audits over five years.  Without admitting nor denying the allegations, the firm settled with the SEC, agreeing to pay a $300,000 penalty and to cease any engagements that fall within the purview of the SEC for one year.  If the firm later chooses to accept such engagements, it must retain an independent complaint consultant for a three-year period and comply with all of the consultant’s recommendations for auditor independence. D.   Private Company Cases Finally, the SEC brought a number of financial reporting and disclosure cases against private (or pre-public) companies, including the following: In September, the SEC instituted settled proceedings against a seller of drones, toys, and other consumer products and its CEO related to allegations that they provided inaccurate sales information to the company’s auditor, which caused its Form S-1 registration statement to overstate the company’s revenue by approximately 15%.[49]  Without admitting or denying the SEC’s allegations, the CEO agreed to pay a $10,000 penalty and the company agreed to withdraw its registration statement, which had never been declared effective. Also in September, the SEC instituted proceedings against a California-based medical aesthetics company and its former CEO.[50]  The SEC alleged that just days before the company was going to close a stock offering, the CEO learned that its Brazilian manufacturer’s certificate to sell products in the European Union had been suspended, but concealed it from the company’s General Counsel and underwriters.  After the offering closed and the suspension subsequently became public, the stock price fell by 52% and the CEO continued to misrepresent his knowledge.  The SEC settled with the company, recognizing the company’s self-reporting to the SEC and extensive cooperation.  The SEC is litigating against the CEO. In November, the SEC instituted proceedings against an entertainment media company and five of its former officers and directors.[51]  According to the complaint, the company purchased downloads for its mobile app from outside marketing firms in order to boost its download ranking in the Apple App Store.  The company allegedly misrepresented to its shareholders why its app had risen in the download rankings, and continued to allegedly lie to shareholders about the growth of its downloads even after it stopped paying for downloads and its rankings plummeted.  The parties agreed to settle the charges without admitting or denying the allegations; the individuals agreed to pay penalties of varying amounts, three agreed to a permanent officer and director bar, and one agreed to a five-year bar. III.   Investment Advisers and Funds A.   Fees and Expenses In November, a California-based investment adviser settled allegations that it overcharged clients by failing to apply “breakpoint” discounts as provided in its fee schedule.[52]  According to the SEC, the adviser’s fee schedule entailed “breakpoints” which would decrease advisory fees as the amount of client assets under management increased.  For approximately eight years, however, the advisory fee discounts were applied haphazardly, resulting in overcharges to certain client accounts.  Without admitting the allegations, the adviser agreed to pay a penalty of $50,000.  The SEC recognized that, during the investigation, the adviser undertook remedial efforts, including reimbursements to clients of overcharged fees and modifications to its policies. In December, a formerly SEC-registered fund manager settled allegations that it misallocated expenses (such as rent, overhead, and compensation) to its business development company clients as well as failed to review valuation models that caused a client to overvalue its portfolio companies.[53]  The adviser agreed to pay approximately $2.3 million disgorgement and prejudgment interest, as well as a civil money penalty of approximately $1.6 million. Also in December, the SEC filed a settled administrative proceeding against a Milwaukee-based investment adviser and its owner/chairman in connection with alleged undisclosed fees.[54]  According to the SEC, the adviser added a sum to client transactions, which it called a “Service Charge.”  Part of this “Service Charge” would go towards paying a third-party broker, while the remainder went to the adviser.  The SEC alleges that the adviser did not disclose these payments to clients.  Without admitting or denying the allegations, the investment adviser and its owner agreed to pay approximately $470,000 in disgorgement and prejudgment interest, as well as a $130,000 civil penalty. Later that month, the SEC settled with a private equity fund adviser for allegedly improperly allocating compensation-related expenses to three private equity funds that it advised.[55]  According to the SEC, firm employees charged the funds for work unrelated to the three funds, violating the mandates of the governing documents of the funds.  The alleged wrongdoing spanned four years.  The firm cooperated extensively with the SEC, and the Commission accounted for those remedial efforts in settlement.  The firm agreed to more than $2 million in disgorgement and a civil monetary penalty of $375,000.   In a similar case also filed in December, the SEC settled with a fund manager for inadequate disclosures regarding certain expense allocations, as well as the alleged failure to disclose potential conflicts of interest arising from certain third-party service providers.[56]  Without admitting or denying the SEC’s allegations, the company agreed to pay $1.9 million in disgorgement and prejudgment interest and a $1 million civil penalty to settle the charges. At the end of December, the SEC settled with a private equity investment adviser in connection with allegations of improper expense allocations.[57]  According to the SEC, the investment adviser manages private equity funds and as well as co-investment funds on behalf of the company’s employees.  The two types of funds invest alongside each other.  When the adviser sought to acquire certain portfolio companies, co-investors were able to provide additional capital to invest.  According to the SEC, over the course of approximately fifteen years, the adviser failed to allocate certain expenses on a proportional basis between the private equity funds and the co-investor funds.  In connection with settlement, the SEC acknowledged that, following an examination by the Commission’s Office of Compliance Inspections and Examinations but prior to being contacted by the Division of Enforcement staff, the adviser proactively made full reimbursements, with interest, to affected funds.  The adviser agreed to pay a civil money penalty of $400,000. The SEC also brought a number of cases involving wrap fee programs. In August, an investment advisory firm settled allegations that it lacked policies and procedures to provide investors with sufficient information for investors to evaluate the appropriateness of their investments in the company’s wrap fee programs.[58]  Without admitting or denying the allegations, the firm agreed to pay a $200,000 civil penalty and to undertake efforts to enhance its procedures.  And in September, an affiliated investment adviser settled allegations that it failed to disclose conflicts of interest in connection with wrap fee programs.[59]  According to the SEC, over the course of three years, the investment adviser recommended that its clients invest in wrap fee programs, one of which was sponsored by the investment adviser.  Without admitting or denying the allegations, the company agreed to pay a $100,000 civil penalty. B.   Conflicts of Interest In July, the SEC filed a settled administrative proceeding against the managing partner and chief compliance officer of a private equity fund adviser, alleging that he arranged for one of his funds to make a loan to a portfolio company, the proceeds of which were used to purchase his personal interest in the company.[60]  The SEC alleged that the manager failed to disclose the conflicted transaction to the fund’s limited partnership advisory committee.  The manager agreed to pay a civil money penalty of $80,000 without admitting or denying the allegations.  The SEC’s order noted that the fund ultimately did not lose any money on the transaction. In late August, the SEC instituted settled proceedings against an investment adviser in connection with alleged failures to disclose a conflict of interest relating to third-party products.[61]  According to the SEC, the adviser’s retail advisory accounts were invested in third-party products that a U.S. subsidiary of a foreign bank managed.  In contravention of established practice, the adviser’s governance committee did not vote on a proposed recommendation to terminate the third-party products, and instead later permitted new adviser accounts to invest in these products.  In so doing, according to the SEC, the adviser did not disclose a conflict of interest.  Without admitting or denying the allegations, the adviser agreed to pay nearly $5 million in disgorgement and prejudgment interest, as well as a $4 million penalty. C.   Fraud and Other Misconduct In July, the SEC charged a Connecticut-based advisory firm and its CEO with placing around $19 million of investor funds into risky investments, including into companies in which they had an ownership stake, while charging large commissions on top of those investments.[62]  The complaint further alleged that the company overbilled some of its clients by calculating fees based on the earlier value of investments that had decreased in value.  The case is being litigated. In August, a Michigan-based investment management firm and its representative settled claims that they had engaged in a cherry-picking scheme.[63]  According to the SEC, the representative disproportionately allocated profitable trades to favored accounts, including personal and family accounts, at the expense of other clients.  The firm agreed to pay $75,000, and the individual respondent agreed to pay approximately $450,000 in disgorgement and penalties and to be barred from the industry.  The following month, the SEC pursued similar cherry-picking claims against a Louisiana-based adviser and its co-founder.[64]  That case is being litigated.  According to the SEC, it was the sixth case arising out of a recent initiative to combat cherry picking. September was a particularly busy month, as the SEC settled a number of fraud-based cases with investment advisers. The SEC settled charges with two New York City-based investment advisers and their 100% owner and president.[65]  The advisers allegedly engaged in a complex scheme to conceal the loss in the value of their clients’ assets by making false statements, improperly redeeming investments, and failing to disclose a variety of conflicts of interest.  To settle the charges, the advisers agreed to jointly and severally pay disgorgement of approximately $1.85 million and a civil penalty of $600,000. Also in September, the SEC charged a hedge fund adviser and its principal with running a “short and distort” scheme, taking a short position and then making a series of false statements to shake investor confidence and lower the stock price of a publicly-traded pharmaceutical company.[66]  According to the SEC, the fund used written reports, interviews and social media to spread untrue claims, driving the stock price down by more than a third.  The matter is being litigated. Later that month, the SEC settled with an asset manager, its former president, and its former CFO.[67]  The asset manager and former president were charged with fraudulently using investor funds to purchase interests in products offered by the firm’s parent corporation to benefit the parent, at which the former president also worked.  The individuals were also charged with improperly adjusting fund returns to show more favorable results to investors.  No charges were pursued against the parent corporation because of its prompt reporting of the misconduct, extraordinary cooperation with the SEC, and the reimbursement of around $1 million to adversely impacted investors.  The company settled for more than $4.2 million in penalties and disgorgement.  The former president and CFO agreed to pay penalties, and the president also agreed to a three-year bar from the securities industry. Early in December, an investment company settled charges of improperly recording and distributing taxable dividends, when those monies should have been recorded as return of capital.[68]  According to the SEC, while the error was not quantitatively large, it impacted a key metric used by investors and analysts to evaluate performance.  The only sanction imposed was a cease-and-desist order.  The firm admitted that its conduct violated federal securities laws and consented to the imposition of the order. D.   Share Class Selection The SEC has been particularly focused on advisers which recommend mutual funds to clients without adequately disclosing the availability of less expensive share classes.  In February 2018, the Division of Enforcement announced its Share Class Selection Disclosure Initiative, under which the Division agreed not to recommend financial penalties against advisers which self-report violations of the federal securities laws relating to mutual fund share class selection and promptly return money to victimized investors.  While the SEC has yet to announce any enforcement actions resulting from the self-reporting initiative, it has filed a number of actions against advisers which did not self-report such violations. In August, the SEC filed a settled administrative proceeding against a Utah-based investment adviser and broker-dealer relating to mutual fund distribution fees, known as 12b-1 fees.[69]  According to the SEC, for more than four years, the company, in its capacity as a broker-dealer, reaped compensation in the form of 12b-1 fees due to its clients’ mutual fund investments.  However, the company, in its capacity as an investment adviser, disclosed to advisory clients that it did not receive compensation from the sale of mutual funds.  In addition, the adviser recommended more expensive share classes of certain mutual funds when cheaper shares of the same funds were available.  The company agreed to pay over $150,000 to compensate advisory clients and a $50,000 civil money penalty. In mid-September, the SEC filed a settled administrative proceeding against a limited liability company in connection with 12b-1 fees.[70]  According to the SEC, for approximately three years, the adviser improperly collected 12b-1 fees from clients by recommending more expensive mutual fund share classes with 12b-1 fees when lower-cost share classes, without 12b-1 fees, were available.  Further, the SEC alleged that the adviser received, but did not disclose, compensation it received when the adviser invested its clients in certain no-transaction fee mutual funds.  The SEC acknowledged remedial acts undertaken and the company’s cooperation with the Commission.  The adviser agreed to pay over $1.3 million in disgorgement and penalties. On the same day in late December, the SEC settled two additional share class selection cases.  In the first, a Tennessee-based investment adviser settled charges in connection with the recommendation and sale of higher-fee mutual fund shares when less expensive share classes were available.[71]  The SEC alleged that for a period of approximately four years, the company’s president and investment adviser representative were the top two recipients of avoidable 12b-1 fees.  The investment adviser agreed to pay approximately $850,000 in disgorgement and prejudgment interest, as well as $260,000 as a civil penalty; collectively, the two individuals agreed to pay approximately $430,000 in disgorgement and prejudgment interest, in addition to $140,000 in civil penalties.  In the second case, the SEC settled charges with two investment advisers and a CEO of one of the firm on the ground that, despite the availability of less expensive share classes of the same funds, advisory clients’ funds were invested in mutual fund share classes that paid 12b-1 fees to the firms’ investment adviser representatives.[72]  In total, the investment advisers and CEO agreed to pay more than $1.8 million to settle the charges. E.   Misleading Disclosures The SEC brought a number of cases alleging misleading disclosures and omissions in the second half of 2018.  In July, the SEC announced a settlement with a California-based investment adviser and its majority owner.[73]  In the firm’s written disclosures to clients, the firm allegedly made material misstatements about the firm’s financial condition – most saliently, omitting to disclose the firm was insolvent during the relevant period and was operating on $700,000 in loans.  The SEC also alleged that the firm improperly withheld refunds of prepaid advisory fees from clients who requested via email to terminate their relationships.  The firm and its majority owner agreed to pay $100,000 and $50,000 respectively in civil monetary penalties to settle the charges. In August, the SEC settled two cases based on failures to disclose and misleading disclosures by investment advisers.  First, a Boston–based employee-owned hedge fund sponsor settled with the SEC over allegations of omissions, misrepresentations, and compliance failures relating to its practices which resulted in materially different redemption amounts when the fund lost value in a short period of time.[74]  The allegations included a failure to implement a compliance program consistent with the adviser’s obligations under the Advisers Act, a lack of disclosure to all investors of their option to redeem their investment in the fund, and inaccurate statements concerning assets in the Form ADV filed annually with the SEC.  The firm agreed to pay a civil penalty of $150,000. Four days later, the SEC settled with four related investment adviser entities for allegedly misleading investors through the use of faulty investment models.[75]  According to the SEC, the  quantitative investment models contained errors, and after discovering the issue the firms discontinued their use but did not disclose the errors.  The entities agreed to pay $97 million in disgorgement and penalties without admitting liability.  Two individual defendants, the former Chief Investment Officer and the former Director of New Initiatives of one of the entities, were also charged and settled with civil penalties of $65,000 and $25,000 respectively. Also in August, the SEC filed a litigated case against a Buffalo-based advisory firm and principal.[76]  According to the SEC, in anticipation of an SEC imposed bar, the owner of the firm sold the firm to his son.  Yet, after the imposition of the bar, his son failed to apprise clients of the bar and made misleading statements when clients inquired about the bar.  Moreover, the father allegedly impersonated his son when on phone calls with clients. A Massachusetts-based investment manager settled with the SEC on the final day of August.[77]  The company allegedly disseminated advertisements touting hypothetical returns based on blended research strategies while failing to disclose that some key quantitative ratings were determined using a retroactive, back-tested application of the financial model.  The company agreed to pay a civil penalty in the amount of $1.9 million to settle the allegations of violating the Advisers Act by publishing, circulating, and distributing advertisements containing misleading statements of material fact. In the first week of September, the SEC settled with a private investment firm and its managing partner for allegedly failing to provide limited partners in a fund with material information related to a change in the valuation of the fund.[78]  The respondents jointly agreed to pay a civil penalty in the amount of $200,000.  A week later, the SEC filed a lawsuit against an Indianapolis-based investment advisory firm and its sole owner for omitting to disclose that the firm and its owner would receive commissions of almost 20% on sales of securities which it encouraged its clients to buy.[79]  The latter case is being litigated. In December, the SEC settled with a California-based registered investment adviser for material misstatements and omissions in its advertising materials, allegedly inflating the results and success of the back-tested performance for one of its indexes over the course of eight years.[80]  The adviser agreed to pay a civil penalty of $175,000. And in late December, the SEC brought its first enforcement action against robo-advisers for misleading disclosures.[81]  Robo-advisers provide software-based, automated portfolio management services.  In the first robo-adviser case, the company disclosed to clients that it would monitor client accounts for “wash sales,” which could negate the tax-loss harvesting strategy it provided to clients.  According to the SEC, however, for approximately three years the adviser did not provide such monitoring, and wash sales took place in almost one-third of accounts enrolled in the tax-loss harvesting program.  This robo-adviser agreed to pay a $250,000 penalty.  In a separate case, a second robo-adviser agreed to settle charges that it provided misleading performance information on its website and social media.  According to the SEC, the company purported to show its investment performance as compared to robo-adviser competitors, but only included a small fraction of its client accounts in the comparison.  This adviser agreed to pay a $80,000 penalty to settle the matter. F.   Other Investment Adviser Issues Supervision and Oversight In August, the SEC announced a settled action against a Minnesota-based diversified financial services company that had allegedly failed to protect retail investor assets from theft by its agents.[82]  The SEC alleged that the respondents’ agents, many of whom pled guilty to criminal charges, committed fraudulent actions such as stealing client funds and forging client documents.  The company allegedly failed to adopt and implement policies and procedures reasonably designed to safeguard investor assets against misappropriation by its representatives.  The company agreed to pay a penalty of $4.5 million to settle the charges. In November, the SEC settled charges with a formerly registered investment adviser and its former CEO for negligently failing to perform adequate due diligence on certain investments.[83]  The SEC alleges that the firm failed to implement and reasonably design compliance policies and procedures which led to a failure to escalate and advise clients regarding concerns surrounding the investments, which turned out to be fraudulent.  Without admitting or denying the allegations, the firm agreed to pay a $400,000 civil penalty and the CEO agreed to a $45,000 civil penalty. Cross-Trades The SEC brought a handful of cases involving cross-trades between client accounts which favored one client at the expense of another.  In August, an investment adviser settled allegations that it had engaged in mispriced cross trades that resulted in the allocation of market savings to selected clients.[84]  According to the SEC, approximately 15,000 cross trades were executed at the bid price, resulting in the allocation of market savings to the adviser’s buying clients, while depriving selling clients of market savings.  The SEC further alleged that the adviser cajoled broker-dealers into increasing the price of certain municipal bonds and executed cross trades at these inflated prices, thereby causing buying advisory clients to overpay in these transactions.  To settle the matter, the adviser agreed to reimburse its clients over $600,000, plus interest, and pay a $900,000 penalty.  The following month, the SEC instituted a similar settled administrative proceeding against a Texas-based investment adviser for failing to disclose two cross trades, causing its clients to sustain $125,000 in brokerage fees.[85] Also in September, the SEC brought a settled action against a Boston firm and one of its portfolio managers, alleging that they facilitated a number of pre-arranged cross-trades between advisory client accounts that purposefully benefited certain clients at the expense of others.[86]  In addition to paying a $1 million penalty, the company agreed to reimburse approximately $1.1 million to its harmed clients.  The former portfolio manager agreed to pay a $50,000 penalty and to submit to a nine-month suspension. Testimonial Rule Violations In July, the SEC instituted five distinct settled proceedings against two registered investment advisers, three investment adviser representatives, and one marketing consultant in connection with violations of the Testimonial Rule, which bars investment advisers from publishing testimonial advertisements.[87]  The advertisements were published on social media and YouTube.  The civil penalties ranged from $10,000 to $35,000 for each of the individuals. In September, a Kansas-based investment adviser and its president/majority owner agreed to settle charges in connection with violations of the Testimonial Rule and ethics violations.[88]  The SEC alleges that the investment adviser broadcast advertisements through the radio, and one of the radio hosts later became a client and broadcast his experience.  According to the SEC, the investment adviser contravened its policies by not monitoring the radio coverage.  The firm agreed to pay a civil penalty of $200,000.  Separately, the company’s president/majority owner violated the company’s code of ethics by not reporting transactions in brokerage accounts held for the benefit of his family.  He agreed to pay a civil penalty of $50,000. Pay To Play Abuses There were two “pay to play” cases settled on the same day in July.  In the first matter, the SEC alleged that three associates of a California-based investment adviser made campaign contributions to candidates who had the ability to decide on the investment advisers for public pension plans.[89]  Within two years of the contributions, in contravention of the Advisers Act, the investment adviser received compensation in connection with advising the public pension plans.  The investment adviser agreed to pay a civil penalty of $100,000.  In the other case, the SEC alleged that the firm’s associates made contributions in a number of states, and the investment adviser similarly received payment to advise public pension plans in those states.[90]  The investment adviser agreed to pay a $500,000 civil penalty to settle the charges. Custody Rule Compliance The second half of the year entailed two Custody Rule cases against New York-based investment advisory firms.  Neither firm distributed annual audited financial statements in a timely fashion.  In the July matter, the SEC also alleged that the investment adviser lacked policies and procedures to preclude violations of the Advisers Act.  Without admitting or denying the allegations, the adviser agreed to pay a $75,000 civil penalty.[91]  In the September matter, the SEC also alleged that the firm violated the Compliance Rule by failing to review its policies and procedures on an annual basis.[92]  Without admitting or denying the allegations, the adviser agreed to pay $65,000 as a civil penalty. IV.   Brokers and Financial Institutions A.   Supervisory Controls and Internal Systems Deficiencies In the latter half of 2018, the SEC brought a number of cases relating to failures of supervisory controls and internal systems – an increase in this area over the first half of the year.  As part of its ongoing initiative into American Depositary Receipt (“ADR”) practices, the SEC brought numerous cases relating to the handling of ADRs—U.S. securities that represent foreign shares of a foreign company and require corresponding foreign shares to be held in custody at a depositary bank.  In July, the SEC announced settled charges against two U.S. based-subsidiaries, a broker-dealer and a depositary bank, of an international financial institution alleging improper ADR handling that led to facilitating inappropriate short selling and profits.[93]  Without admitting or denying the allegations, the subsidiaries agreed to pay $75 million in disgorgement and penalties.  In September, the SEC brought settled charges against a broker-dealer and subsidiary of a French financial institution; the broker-dealer agreed to pay approximately $800,000 in disgorgement and penalties without admitting or denying the findings.[94]  In December, the SEC settled charges against a depositary bank; the bank agreed to pay $38 million in disgorgement and penalties without admitting or denying the findings. [95] And finally, also in December, the SEC brought settled charges in two cases for providing ADRs to brokers when neither the broker nor its customer owned the corresponding foreign shares.  In the first December case, the SEC settled charges with a depositary bank headquartered in New York; the bank agreed to disgorgement, interest, and penalties of approximately $55 million without admitting or denying the charges.[96]  In the second case, the SEC settled charges with another depositary bank, a subsidiary of a large New York financial services firm.[97]  The SEC’s order alleged that the improper ADR handling led to inappropriate short selling and dividend arbitrage.  The firm agreed to pay over $135 million in disgorgement, and penalties without admitting or denying the charges. In addition to the ADR cases, the SEC also brought supervision cases for the failure to safeguard customer information and for the failure to supervise representatives who sold unsuitable products.  In July, the SEC brought settled charges against an international investment banking firm for failing to maintain and enforce policies and procedures designed to protect confidential customer information, including the failure to maintain effective information barriers.[98]  The SEC’s order alleged that traders at the bank regularly disclosed material nonpublic customer stock buyback information to other traders and hedge fund clients; the bank agreed to a $1.25 million penalty without admitting or denying the charges.  In September, the SEC announced settled charges against a New York-based broker-dealer and two of its executives for failure to supervise representatives in sales of a leveraged exchange-traded note (“ETN”) linked to oil.[99]  The SEC’s order alleged that the broker-dealer’s representatives did not reasonably research or understand the risks of the ETN or the index it tracked.  The broker-dealer agreed to pay over $500,000 in penalties, interest, and customer disgorgement without admitting or denying the charges, and the two executives agreed to penalties as well as a 12-month supervisory suspension.  The broker who recommended the largest number of ETN sales also agreed to a penalty of $250,000. Along with the supervisory cases described above, the SEC also brought a few cases relating to internal controls.  In August, the SEC announced settled charges in two cases against a large financial institution and two subsidiary broker-dealers involving books and records, internal accounting controls, and trader supervision.[100]  The charges in one action related to losses due to trader mismarking and unauthorized proprietary trading, which the SEC alleged were not discovered earlier due to a failure to supervise.  In the second action, the SEC alleged that the bank lacked controls necessary to prevent certain fraudulent loans. The financial institution and subsidiaries agreed to pay over $10 million without admitting or denying the allegations. Also in August, the SEC initiated settled proceedings against a credit ratings agency for alleged internal controls deficiencies relating to a purported failure to consistently apply credit ratings symbols which were used in models used to rate residential mortgage backed securities.[101]  The ratings agency agreed to pay over $16 million without admitting or denying the allegations. B.   Anti-Money Laundering As in the first half of the year, the SEC continued to bring a number of cases in the anti-money laundering (“AML”) area, all relating to the failure to file suspicious activity reports (“SARs”).  The Bank Secrecy Act requires broker-dealers to file SARs to report transactions suspected to involve fraud or with no apparent lawful purpose. In July, the SEC announced the settlement with a national broker-dealer relating to the failure to file SARs on the transactions of independent investment advisers that it had terminated.[102]  The broker-dealer agreed to pay a $2.8 million penalty to settle the action, without admitting or denying the charges.  Similarly, in September, the SEC instituted a settled administrative proceeding against a New York brokerage firm for failing to file SARs relating to a number of terminated investment advisers.[103]  Without admitting or denying the allegations, the firm agreed to pay a penalty of $500,000; the SEC’s Order noted that the settlement took into account remedial acts undertaken by the firm.  Also in September, the SEC settled charges against a clearing firm for failure to file SARs relating to suspicious penny stock trades.[104]  As part of the settlement, the clearing firm agreed to pay a penalty of $800,000 without admitting or denying the allegations, and also agreed that it would no longer sell penny stocks deposited at the firm. In December, the SEC brought settled charges against a broker-dealer alleging that during the period 2011-2013 it neglected to monitor certain movements of funds through customers’ accounts and to properly review suspicious transactions flagged by its internal monitoring systems.[105]  The firm agreed to pay a $5 million penalty to resolve the charges, as well as a $10 million penalty to the U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN) and the Financial Industry Regulatory Authority (FINRA) to resolve parallel charges.  The broker-dealer did not admit or deny the SEC’s allegations except to the extent they appeared in the settlement with FinCEN. Also In December, the SEC announced settled charges against a broker-dealer for the failure to file SARs concerning over $40 million in suspicious wire transfers made by one customer in connection with a payday lending scam.[106]  The firm agreed to certain undertakings, including the hiring of an independent compliance consultant, without admitting or denying the allegations.  The U.S. Attorney’s Office for the Southern District of New York also instituted a settled civil forfeiture action against the broker-dealer in which it paid $400,000; the U.S. Attorney’s Office additionally entered into a deferred prosecution agreement with the firm. C.   Market Abuse Cases In the second half of 2018, the SEC’s Market Abuse Unit was involved in bringing three cases relating to “dark pools” (i.e., private exchanges) and the use and execution of customer orders.  In September, the SEC announced settled charges against a large financial institution relating to alleged misrepresentations in connection with the operation of a dark pool by one of its affiliates.[107]  The SEC alleged that the firm misled customers relating to high-frequency trading taking place in the pool and also failed to disclose that over half of the orders routed to the dark pool were executed in other trading venues.  The firm and its affiliate agreed to pay over $12 million in disgorgement and penalties without admitting or denying the SEC’s allegations. Also in September, the SEC, together with the New York Attorney General (“NYAG”), brought settled charges against an investment bank relating to the execution of customer orders by one of its desks responsible for handling order flow for retail investors.[108]  The SEC alleged that while the firm promoted the desk’s access to dark pool liquidity, a minimal number of orders were executed in dark pools; additionally, the firm allegedly failed to disclose that retail customers did not receive price improvement on non-reportable orders.  The firm agreed to pay a total of $10 million ($5 million to the SEC and $5 million to the NYAG) without admitting or denying the allegations. And in November, the SEC brought charges against a financial technology company and its affiliate for misstatements and omissions relating to the operation of the firm’s dark pool.[109]  The SEC alleged that the firm failed to safeguard subscribers’ confidential trading information despite assuring firm clients that it would do so, and also did not disclose certain structural features of the dark pool to clients.  The firm and its affiliate agreed to pay a $12 million penalty to settle the charges without admitting or denying the allegations. D.   Books and Records In July, the SEC brought settled charges against a New York-based broker-dealer relating to its failure to preserve records.[110]  The SEC alleged that the broker-dealer deleted audio files after receiving a document request from the Division of Enforcement (because the department responsible for the files was unaware of the request), and also failed to maintain books and records that accurately recorded expenses.  Without admitting or denying the allegations, the firm agreed to pay a penalty of $1.25 million. In September, the SEC announced charges against a broker-dealer for providing the SEC with incomplete and deficient securities trading information known as “blue sheet data” used by the SEC in its investigations.[111]  The SEC’s order alleged that approximately 29% of the broker-dealer’s blue sheet submissions over a four-year time period contained deficiencies due to coding errors.  The broker-dealer admitted the findings in the SEC’s Order and agreed to pay a $2.75 million penalty to settled the charges.  In December, the SEC instituted settled administrative proceedings against three broker-dealers for recordkeeping violations in another matter relating to deficient blue sheet data submissions.[112]  The SEC’s Orders noted that as a result largely of undetected coding errors, the three firms submitted blue sheet data that continued various inaccuracies.  The three broker-dealers admitted the findings in the SEC’s Orders and agreed to pay penalties totaling approximately $6 million.  The SEC’s Orders noted the remedial efforts undertaken by the firms, including the retention of an outside consultant and the adoption of new policies and procedures for processing blue sheet requests. E.   Individual Brokers Finally, in addition to its cases involving large financial institutions, the SEC brought a number of cases against individual broker-dealer representatives.  In September, the SEC filed complaints against two brokers in New York and Florida for excessive trading in retail customer accounts which generated large commissions for the brokers but caused losses for their customers.[113]  The case is being litigated. Also in September, the SEC filed a complaint against a broker for a cherry-picking scheme in which the broker allegedly misused his access to an allocation account to cherry pick profitable trades for his own account while placing unprofitable trades in customer accounts.[114]  The SEC noted that it uncovered the alleged fraud using data analysis.  The case is being litigated, and the U.S. Attorney’s Office for the District of Massachusetts announced parallel criminal charges. Finally, in December, the SEC settled with a self-employed trader (and entities that he owned and controlled) for violations of Rule 105 of Regulation M, which prohibits a person from purchasing an equity security during the restricted period of an offering where that person has sold short the same security.[115]  The SEC’s Order alleged that the trader violated Rule 105 by effecting short sales during restricted periods and mismarking short sales as “long sales” in a total of 116 offerings.  The trader agreed to pay disgorgement, interest, and penalties total approximately $1.1 million without admitting or denying the charges V.   Insider Trading A.   Cases Against Corporate Insiders Corporate Executives July was a busy month for corporate executives accused of insider trading and tipping.  First, the SEC charged the former CEO of a New Jersey-based payment processing company and his romantic partner in an insider trading scheme that leveraged nonpublic information about the potential acquisition of his company by another payment processing company.[116]  On the CEO’s instructions and with his funds, the romantic partner opened a brokerage account and used almost $1 million of the funds to purchase stock in the target company.  According to the SEC, the pair generated $250,000 in profits after the merger was announced.  The case is being litigated. The SEC also settled with a former VP of Investor Relations at a company operating country clubs and sports clubs alleged to have traded in his company’s stock after learning that it was negotiating to be acquired.[117]  After receiving an inquiry from FINRA, the officer resigned from the company and retained counsel who reported the misconduct to the SEC and provided them substantiating documentation.  In return, the SEC agreed to a settlement that involved disgorgement of his profits of approximately $78,000 and a civil penalty equal to about one-half of the disgorgement amount. Later in July, the SEC sued a senior executive at a Silicon Valley tech company for allegedly short selling as well as selling stock in his company ahead of three different quarterly announcements that the company was likely going to miss its revenue guidance.[118]  According to the SEC, the executive made nearly $200,000 in profits from these trades.  Without admitting wrongdoing, the executive agreed to disgorge his profits and pay a corresponding civil penalty, and to bebarred from acting as an officer or director of a public company for five years.  The SEC noted that it had utilized data analysis from its Market Abuse Unit’s Analysis and Detection Center to detect suspicious trading patterns in advance of earnings announcements over time. And at the end of July, the SEC sued a VP of Finance who learned from a senior executive at his company that a Chinese investment group might acquire the company.[119]  While preparing financial projections and conducting diligence, the VP allegedly used his spouse’s brokerage account to purchase shares of his company.  When it became public that his company had rejected the Chinese investment group’s offer in the hopes of receiving a higher price, the company’s share increased 24%, resulting in the VP earning nearly $90,000.  Without admitting liability, the officer agreed to disgorgement of his gains and a corresponding civil penalty. In August, the SEC charged a former biotech executive and others with participating in a scheme that generated $1.5 million of profits by trading ahead of the announcement of a licensing agreement between his company and another large pharmaceutical company.[120]  According to the complaint, the executive informed a friend of the license agreement.  The friend then tipped a former day trader, who, in connection with an insider-trading ring, purchased stock and options and made $1.5 million in illegal profits when the agreement was announced and the company’s stock price jumped 38 percent.  In a parallel action, the U.S. Attorney’s Office for the District of New Jersey charged the day trader and four members of his group with illegal insider trading ahead of secondary public stock offerings. All five defendants have pled guilty to the parallel criminal charges; the four members of the insider-trading ring other than the trader have agreed to partial settlements with the SEC for conduct including their trading on the license agreement, with potential monetary sanctions to be determined at a later date.  The SEC is continuing a previous action against the trader for alleged insider trading ahead of the secondary stock offerings. In August, the SEC sued a former Sales VP at a cemetery and funeral home operator for allegedly benefiting from confidential information obtained through his employer.[121]  After learning about a substantial decline in sales that would necessitate a reduction in the company’s distribution payments, the executive sold all of his shares in the company.  As part of a settlement, the executive agreed to pay disgorgement and a civil penalty. Also in August, the SEC settled charges against a former executive of a cloud security and services company.[122]  According to the SEC, the executive informed his two brothers, to whom he had gifted stock in the past, that the company would miss its revenue guidance, and contacted his brothers’ brokerage firm to coordinate the sale of all of their stock.  When the negative news was announced, the stock price dropped significantly and the brothers collectively avoided losses of over $580,000.  Under the terms of his settlement, the former executive will be barred from serving as an officer or director of a public company for two years and will pay a $581,170 penalty. In September, the SEC brought a settled action against a former executive at a mortgage servicing company.[123]  The SEC alleged that the executive engaged in insider trading surrounding three separate events, including the resolution of litigation and a CFPB enforcement action against the company, as well as negotiations to sell the company. Without admitting or denying the allegations, the executive agreed to disgorge his ill-gotten gains of almost $65,000 and to pay a penalty equal to the disgorgement amount. In October, the SEC charged a company’s former Director of SEC Reporting with trading ahead of a corporate acquisition.[124]  The complaint alleged that the individual bought call options and stock in a company targeted for acquisition by a subsidiary of the company. The matter is being litigated. In November, the acquisition of two health care networks by a large health care company led to two separate misappropriation cases.  The SEC charged a man with insider trading based on information he misappropriated from his wife, a human resources executive at the acquiring company, about the planned acquisitions.[125]  According the SEC, the man overheard his wife’s phone calls while she was working at home.  The husband agreed to pay disgorgement of about $64,000 and a penalty of $72,144.  The SEC also settled an insider trading charge against a man alleged to have misappropriated information from his brother, an executive at one of the target companies.[126]  According to the SEC, the insider had shared the information in confidence at a family holiday party.  The trader agreed to pay disgorgement and penalties totaling about $40,000. Board Members In a high profile case involving drug trials, the SEC and DOJ filed parallel charges for insider trading against a U.S. Congressman, his son, and a host of other individuals.[127]  According to the SEC’s complaint, the Congressman learned of negative drug trial results through his seat on a biotech company’s board.  The Congressman allegedly provided his son the inside information, who then told a third individual.  Over the next few days, the Congressman’s son, the third individual, and a number of their friends and family members sold over a million shares of the biotech company’s stock, which plummeted more than 92 percent following the announcement of the negative results.  As a result of the trading, the Congressman’s son and the third individual avoided approximately $700,000 in losses.  Two of the individuals sued ultimately settled with the SEC without admitting or denying the charges, agreeing to disgorge their gains totaling approximately $35,000 and to pay a matching civil penalty.  The SEC’s cases against the Congressmen, his son, and a third individual are ongoing. In August, the SEC sued the son of a bank board member who learned of the bank’s potential acquisition by another bank from his father prior to the acquisition’s public announcement.[128]  The son realized approximately $40,000 in gains after the acquisition became public.  Without admitting or denying the charges, the son agreed to disgorge the gains and to pay a matching civil penalty. Employee Insiders In July, the SEC sued a former financial analyst at a medical waste disposal company and his mother for trading on inside information that the company would miss its revenue guidance.[129]  Following the company’s earnings announcement, its stock fell 22%, resulting in the analyst and his mother avoiding losses and earning profits of approximately $330,000.  Both the analyst and his mother agreed to settle the case without admitting liability.  They will be required to disgorge their profits and pay a civil penalty in amounts to be later determined by the court. Also in July, in the second SEC case arising out of the Equifax data breach, the SEC charged a software engineer tasked with constructing a website for consumers who were impacted by the data breach for trading the company’s stock before the data breach was publicly disclosed .[130]  The engineer was fired after refusing to cooperate with the company’s investigation, though he and the SEC ultimately settled the case.  As part of that settlement, the engineer was ordered to disgorge $75,000 in profits.  The U.S. Attorney’s Office also filed criminal charges against the engineer. The SEC also filed a number of cases involving corporate scientists.  In July, the SEC charged a scientist at a California biotech company for trading based on positive developments in a genetic sequencing platform.[131]  According to the SEC, the scientist traded during company trading blackouts, in a brokerage account not disclosed to his employer.  He settled the case, agreeing to disgorge approximately $40,000 in profits and paying a similar civil penalty.  In August, the SEC filed suit against a scientist who learned that his healthcare diagnostics company was about to acquire another company in a tender offer.[132]  On the date the acquisition was announced, his company’s stock increased 176%.  As part of the settlement, the scientist agreed to disgorge $14,000 in profits and pay a corresponding civil penalty.  And in a third case, the SEC settled with a scientist at a pharmaceutical company for allegedly trading in advance of positive results of a clinical trial.[133]  The scientist agreed to disgorgement of $134,000, but based on her voluntarily coming forward and reporting her improper trades, the SEC agreed to a reduced penalty of $67,000. The SEC brought charges in August against an in-house attorney for a shipping company who traded on inside information that his company had entered into a strategic partnership with a private equity fund.[134]  As part of a settlement, he was ordered to disgorge nearly $30,000 in profits with a matching civil penalty. And in September, the SEC charged a former professional motorcycle racer handling promotional activities for a beverage company, as well as his father, family friend, and investment adviser, with insider trading for tipping and trading ahead of an impending deal with a large beverage company.[135]  According to the SEC, after the racer had learned a significant deal was imminent, the four individuals collectively purchased over $770,000 in stock and options, in certain instances borrowing funds for the purchases.  Following the announcement, they made over $283,000 in trading profits. Without admitting or denying the findings, the individuals agreed to disgorge ill-gotten gains and to pay civil penalties. B.   Misappropriation by Investment Professionals and Other Advisors Several deal advisors, including bankers, corporate advisors, and accountants, were charged with insider trading by the SEC.  In August, the SEC charged a professional football player and a former investment banker with insider trading in advance of corporate acquisitions.[136]  The SEC alleges that after meeting at a party, the player began receiving illegal tips, facilitated through coded text messages and FaceTime conversations, from the banker about upcoming corporate mergers.  The player allegedly made $1.2 million in illegal profits by purchasing securities in companies that were soon to be acquired, in one instance generating a nearly 400 percent return.  In return, he is alleged to have rewarded the analyst by setting up an online brokerage account that both men could access, by providing cash kickbacks, free NFL tickets, and an evening on the set of a pop star’s music video in which the player made a cameo appearance.  The SEC action is being litigated; both men have pled guilty to related criminal charges.  In November, the SEC also charged a family friend of the banker in connection with the same scheme.[137]  The U.S. Attorney’s Office announced parallel criminal charges against this individual. In September, the SEC filed insider trading charges against a corporate deal advisor for trading in securities of two China-based companies based on confidential information about their impending acquisitions.[138]  According to the SEC, the individual, who had been providing advice to the acquiring companies, opened a brokerage account in his wife’s name and used that account to generate more than $79,500 in trading profits. That same executive later became a director at a Hong Kong-based investment banking firm.  In connection with advising a client on an acquisition of its rival, he was alleged to have again used his wife’s brokerage account to buy high risk call options, which he sold after news of the acquisition for profits of more than $94,400. The case is being litigated. And in December, the SEC charged an individual with misappropriating information from his fiancé, an investment banker working on a merger between two airline companies.[139]   According to the SEC, the trader overheard calls his now-wife made at home on nights and weekends, purchasing call options in the target company and netting approximately $250,000 in profits.  Without admitting or denying liability, the trader agreed to disgorge his profits and pay a matching penalty. Also in December, the SEC alleged that an IT contractor working at an investment bank had traded, and tipped his wife and father, based on information he’d learned from the bank.[140] According to the SEC, the three collectively reaped approximately $600,000 in profits by trading in advance of at least 40 corporate events.  The SEC obtained a court-ordered freeze of assets in multiple brokerage accounts connected to the alleged trading. The SEC brought several cases against accountants and their tippees.  In August, the SEC brought a settled action against a CPA who learned of an acquisition through his work as an accountant providing tax advice to a private company owned by a member of one of the companies.[141]  The individual agreed to disgorge his profits of approximately $8,000 and pay a matching civil penalty. Also that month, the SEC sued a former director of a major accounting and auditing firm for trading ahead of a merger between two of the firm’s clients.[142]  According to the SEC, after learning of the planned merger, the director used a relative’s account to purchase call options, which increased in value by about $150,000 following announcement of the merger.  Though the director later allowed the options to expire without selling or exercising them, he did not inform his employer that he controlled the account when the relative’s name appeared on a list of individuals in connection with a FINRA investigation into suspect trading.  Without admitting liability, the director agreed to pay a $150,500 penalty and to be barred from appearing and practicing before the SEC as an accountant for two years. The SEC brought several other cases involving misappropriation by industry professionals.  In July 2018, the SEC settled charges against a broker who traded ahead of a multi-billion dollar acquisition.[143]  According to the SEC, the broker misappropriated the information from a friend who was a certified public accountant providing personal tax advice to a senior executive at the company being acquired, and who had shared the information in confidence.  Without admitting liability, he agreed to disgorgement of his nearly $90,000 in profits, a comparable civil penalty, and debarment from being a broker.  And in September, the SEC settled a claim against a CPA and a doctor for allegedly trading while in possession of confidential information regarding an impending acquisition.[144]  According to the SEC, the CPA misappropriated the information from a friend who worked at one of the companies. The SEC alleges that after the CPA shared the information with the doctor, both purchased call options in the target company.  Both the CPA and doctor agreed to pay disgorgement and civil penalties. VI.   Municipal Securities and Public Finance Cases With the SEC’s Municipalities Continuing Disclosure (MCDC) Initiative (which as noted above generated  a significant number of cases) completed, the SEC’s Public Finance Abuse Unit returned to its traditionally slower pace, filing just a few cases in the latter half of the year. In August, the SEC charged two firms and 18 individuals with participating in a municipal bond “flipping” scheme (i.e. improperly obtaining new bond allocations from brokers and reselling to broker-dealers for a fee.[145]  According to the SEC, the firms and their principals used false identities to pose as retail investors in order to receive priority from the bond underwriters, and then resold the bonds to brokers for a pre-arranged commission.  The SEC also charged a municipal underwriter with taking kickbacks as part of the scheme.  Most of the parties settled (with sanctions including disgorgement, penalties, and industry bars and suspensions), but aspects of the case are being litigated as well.  The SEC filed another settled case for municipal bond flipping in December.[146] In September, the SEC instituted a settled action against a municipal adviser and its principal for failing to register as municipal advisor and failing to disclose its nonregistration to a school district to which it provided services.[147]  The firm and its principal agreed to pay about $50,000 in disgorgement and penalties, and the principal agreed to be barred from the securities industry. [1]      Admin. Proc. File No. 3-18965, In re Hertz Global Holdings, Inc. (Dec. 31, 2018), available at www.sec.gov/litigation/admin/2018/33-10601.pdf. [2]      Admin. Proc. File No. 3-18966, In re Katz, Sapper & Miller, LLP (Jan. 9, 2019), available at www.sec.gov/litigation/admin/2019/34-84980.pdf. [3]      See SEC Press Release, SEC Enforcement Division Issues Report on FY 2018 Results (Nov. 2, 2018), available at www.sec.gov/news/press-release/2018-250; and accompanying Annual Report at www.sec.gov/files/enforcement-annual-report-2018.pdf. [4]      For more on Kokesh, see Gibson Dunn Client Alert, United States 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/. [5]      For more on Lucia, see Gibson Dunn Client Alert, Supreme Court Rules That SEC ALJs Were Unconstitutionally Appointed (June 21, 2018), available at www.gibsondunn.com/supreme-court-rules-that-sec-aljs-were-unconstitutionally-appointed. [6]      Whistleblower Program, 2018 Annual Report to Congress, available at www.sec.gov/files/sec-2018-annual-report-whistleblower-program.pdf. [7]      SEC Press Release, SEC Awards more Than $54 Million to Two Whistleblowers (Sept. 6, 2018), available at www.sec.gov/news/press-release/2018-179. [8]      SEC Press Release, Whistleblower Receives Award of Approximately $1.5 Million (Sept. 14, 2018), available at www.sec.gov/news/press-release/2018-194. [9]      SEC Press Release, SEC Awards Almost $4 Million to Overseas Whistleblower (Sept. 24, 2018), available at www.sec.gov/news/press-release/2018-209. [10]     SEC Press Release, SEC Charges Firm with Deficient Cybersecurity Procedures (Sept. 26, 2018), available at www.sec.gov/news/press-release/2018-213. [11]     SEC Press Release, SEC Investigative Report: Public Companies Should Consider Cyber Threats When Implementing Internal Controls (Oct. 16, 2018), available at www.sec.gov/news/press-release/2018-236. [12]     For further discussion, see Gibson Dunn Client Alert, SEC Warns Public Companies on Cyber-Fraud Controls (Oct. 27, 2018), available at www.gibsondunn.com/sec-warns-public-companies-on-cyber-fraud-controls/. [13]     SEC Press Release, SEC Charges ICO Superstore and Owners with Operating as Unregistered Broker-Dealers (Sept. 11, 2018), available at www.sec.gov/news/press-release/2018-185. [14]     SEC Press Release, SEC Charges Digital Asset Hedge Fund Manager with Misrepresentations and Registration Failures (Sept. 11, 2018), available at www.sec.gov/news/press-release/2018-186. [15]     SEC Press Release, SEC Charges EtherDelta Founder with Operating an Unregistered Exchange (Nov. 8, 2018), available at www.sec.gov/news/press-release/2018-258. [16]     SEC Press Release, Two ICO Issuers Settle SEC Registration Charges, Agree to Register Tokens as Securities (Nov. 16, 2018), available at www.sec.gov/news/press-release/2018-264. [17]     Admin. Proc. File No. 3-18906, In re Floyd Mayweather Jr. (Nov. 29, 2018), available at www.sec.gov/litigation/admin/2018/33-10578.pdf; SEC Admin. Proc. File No. 3-18907, In re Khaled Khaled (Nov. 29, 2018), available at www.sec.gov/litigation/admin/2018/33-10579.pdf. [18]     SEC Press Release, SEC Suspends Trading in Company for Making False Cryptocurrency-Related Claims about SEC Regulation and Registration (Oct. 22, 2018), available at www.sec.gov/news/press-release/2018-242. [19]     SEC Press Release, SEC Stops Fraudulent ICO That Falsely Claimed SEC Approval (Oct. 11, 2018), available at www.sec.gov/news/press-release/2018-232. [20]     R. Todd, Judge to SEC: You Haven’t Shown This ICO Is a Security Offering, The Recorder (Nov. 27, 2018), available at www.law.com/therecorder/2018/11/27/judge-to-sec-this-ico-isnt-a-security-offering/. [21]     SEC Press Release, SEC Charges Bitcoin-Funded Securities Dealer and CEO (Sept. 27, 2018), available at www.sec.gov/news/press-release/2018-218. [22]     Admin. Proc. File No. 3-18582, SEC Charges Pipe Manufacturer and Former CFO with Reporting and Accounting Violations (July 10, 2018), available at www.sec.gov/enforce/33-10517-s. [23]     SEC Press Release, SEC Charges Telecommunications Expense Management Company with Accounting Fraud (Sept. 4, 2018), available at www.sec.gov/news/press-release/2018-175. [24]     SEC Litigation Release, SEC Charges Outsourced CFO with Accounting Controls Deficiencies (Sept. 12, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24265.htm.  [25]     SEC Press Release, Business Services Company and Former CFO Charged With Accounting Fraud (Sept. 20, 2018), available at www.sec.gov/news/press-release/2018-205. [26]     Admin. Proc. File No. 3-18816, Pipeline Construction Company Settles Charges Relating to Internal Control Failures (Sept. 21, 2018), available at www.sec.gov/enforce/34-84251-s. [27]     SEC Press Release, SEC Charges Salix Pharmaceuticals and Former CFO With Lying About Distribution Channel (Sept. 28, 2018), available at www.sec.gov/news/press-release/2018-221. [28]     Admin. Proc. File No. 3-18891, Tobacco Company Settles Accounting and Internal Control Charges (Nov. 9, 2016), available at www.sec.gov/enforce/34-84562-s.  For a description of the company’s remedial measures, see www.sec.gov/litigation/admin/2018/34-84562.pdf.  [29]     SEC Press Release, SEC Charges Agria Corporation and Executive Chairman With Fraud (Dec. 10, 2018), available at www.sec.gov/news/press-release/2018-276. [30]     SEC Press Release, SEC Charges The Hain Celestial Group with Internal Controls Failures (Dec. 11, 2018), available at www.sec.gov/news/press-release/2018-277. [31]     Admin. Proc. File No. 3-18932, SEC Charges Santander Consumer for Accounting and Internal Control Failures (Dec. 17, 2018), available at www.sec.gov/enforce/34-84829-s. [32]     SEC Press Release, Public Companies Charged with Failing to Comply with Quarterly Reporting Obligations (Sept. 21, 2018), available at www.sec.gov/news/press-release/2018-207. [33]     SEC Press Release, SEC Charges KBR for Inflating Key Performance Metric and Accounting Controls Deficiencies (July 2, 2018), available at www.sec.gov/news/press-release/2018-127. [34]     SEC Press Release, SEC Charges Cloud Communications Company and Two Senior Executives With Misleading Revenue Projections (Aug. 7, 2018), available at www.sec.gov/news/press-release/2018-150. [35]     SEC Press Release, SEC Charges Former Online Marketing Company Executives With Inflating Operating Metrics (Aug. 21, 2018), available at www.sec.gov/news/press-release/2018-161. [36]     Admin. Proc. File No. 3-18819, SEC Charges Payment Processing Company and Former CEO for Overstating Key Operating Metric (Sept. 21, 2018), available at www.sec.gov/enforce/33-10558-s. [37]     Admin. Proc. File No. 3-18955, In re ADT Inc. (Dec. 26, 2018), available at www.sec.gov/litigation/admin/2018/34-84956.pdf. [38]     Admin. Proc. File No. 3-18570, Dow Chemical Agrees to $1.75 Million Penalty and Independent Consultant for Failing to Disclose Perquisites (July 2, 2018), available at www.sec.gov/enforce/34-83581-s. [39]     SEC Press Release, SEC Charges Oil Company CEO, Board Member With Hiding Personal Loans (July 16, 2018), available at www.sec.gov/news/press-release/2018-133. [40]     SEC Litigation Release, SEC Charges Real Estate Investment Funds and Executives for Misleading Investors (July 3, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24185.htm. [41]     Admin. Proc. File No. 3-18770, SEC Charges Arizona Company And Two Senior Executives In Connection With Misleading Disclosures About Material Contract (Sept. 17, 2018), available at www.sec.gov/enforce/33-10550-s. [42]     SEC Press Release, SeaWorld and Former CEO to Pay More Than $5 Million to Settle Fraud Charges (Sept. 18, 2018), available at www.sec.gov/news/press-release/2018-198. [43]     SEC Press Release, Biopharmaceutical Company, Executives Charged With Misleading Investors About Cancer Drug (Sept. 18, 2018), available at www.sec.gov/news/press-release/2018-199. [44]     SEC Press Release, SEC Charges Walgreens and Two Former Executives With Misleading Investors About  Forecasted Earnings Goal (Sept. 28, 2018), available at www.sec.gov/news/press-release/2018-220. [45]     SEC Press Release, Elon Musk Settles SEC Fraud Charges; Tesla Charged With and Resolves Securities Law Charge (Sept. 29, 2018), available at www.sec.gov/news/press-release/2018-226. [46]     Admin. Proc. File No. 3-18838, In re Lichter, Yu and Associates, Inc. et al. (Sept. 25, 2018), available at www.sec.gov/litigation/admin/2018/34-84281.pdf. [47]     SEC Press Release, SEC Suspends Former BDO Accountants for Improperly “Predating” Audit Work Papers (Oct. 12, 2018), available at www.sec.gov/news/press-release/2018-235. [48]     SEC Press Release, SEC Charges Audit Firm and Suspends Accountants for Deficient Audits (Dec. 21, 2018), available at www.sec.gov/news/press-release/2018-302. [49]     Admin. Proc. File No. 3-18856, SEC Charges Drone Seller for Failing to Ensure Accuracy of Financial Statement in Advance of Planned IPO (Sept. 28, 2018), available at www.sec.gov/enforce/33-10564-s. [50]     SEC Litigation Release, SEC Charges Medical Aesthetics Company and Its Former CEO with Misleading Investors in a $60 Million Stock Offering (Sept. 19, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24275.htm. [51]     SEC Press Release, SEC Charges Giga Entertainment Media, Former Officers and Directors with Fraud in Pay-For-Download Campaign (Nov. 15, 2018), available at www.sec.gov/news/press-release/2018-263. [52]     Admin. Proc. File No. 3-18901, SEC Charges San Jose Investment Adviser for Overcharging Fees (Nov. 19, 2018), available at www.sec.gov/enforce/ia-5065-s. [53]     Admin. Proc. File No. 3-18909, Investment Adviser Settles Charges Related to Expense Misallocation and Valuation Review Failures (Dec. 3, 2018), available at www.sec.gov/enforce/33-10581-s. [54]     Admin. Proc. File No. 3-18926, SEC Charges Milwaukee-Based Advisory Firm for Receiving Undisclosed Compensation on Client Transactions (Dec. 12, 2018), available at www.sec.gov/enforce/34-84807-s. [55]     Admin. Proc. File No. 3-18935, SEC Charges Private Equity Fund Adviser for Overcharging Expenses (Dec. 17, 2018), available at www.sec.gov/enforce/ia-5079-s. [56]     Admin. Proc. File No. 3-18930, SEC Settles with Investment Adviser Who Failed to Disclose Conflicts of Interest and Misallocated Expenses (Dec. 13, 2018), available at www.sec.gov/enforce/ia-5074-s. [57]     Admin Proc. File No. 3-18958, In re Lightyear Capital LLC (Dec. 26, 2018), available at www.sec.gov/litigation/admin/2018/ia-5096.pdf. [58]     Admin. Proc. File No. 3-18638, SEC Charges Investment Adviser for Compliance Failures Relating to Wrap Fee Programs (Aug. 14, 2018), available at www.sec.gov/enforce/ia-4984-s. [59]     Admin. Proc. File No. 3-18730, SEC Charges Investment Adviser for Failing to Fully Disclose Affiliate Compensation Arrangement (Sept. 7, 2018), available at www.sec.gov/enforce/ia-5002-s. [60]     Admin. Proc. File No. 3-18604, In re Michael Devlin (July 19, 2018), available at www.sec.gov/litigation/admin/2018/ia-4973.pdf. [61]     SEC Press Release, Merrill Lynch Settles SEC Charges of Undisclosed Conflict in Advisory Decision (Aug. 20, 2018), available at www.sec.gov/news/press-release/2018-159. [62]     SEC Press Release, SEC Charges Investment Adviser and CEO with Misleading Retail Investors (July 18, 2018), available at www.sec.gov/news/press-release/2018-137. [63]     Admin. Proc. File No. 3-18649, In re Roger T. Denha (Aug. 17, 2018), available at www.sec.gov/litigation/admin/2018/34-83873.pdf; Admin. Proc. File No. 3-18648, In re BKS Advisors LLC (Aug. 17, 2018), available at www.sec.gov/litigation/admin/2018/ia-4987.pdf. [64]     SEC Litigation Release, SEC Charges Investment Adviser and Senior Officers with Defrauding Clients (Sept. 20, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24278.htm. [65]     Admin. Proc. File No. 3-18724, In re Mark R. Graham et al. (Sept. 6, 2018), available at www.sec.gov/litigation/admin/2018/ia-5000.pdf. [66]     SEC Litigation Release, SEC Charges Hedge Fund Adviser with Short-And-Distort Scheme (Sept. 13, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24267.htm. [67]     SEC Press Release, SEC Charges LendingClub Asset Management and Former Executives With Misleading Investors and Breaching Fiduciary Duty (Sept. 28, 2018), available at www.sec.gov/news/press-release/2018-223. [68]     Admin. Proc. File No. 3-18912, In re KCAP Financial, Inc. (Dec. 4, 2018), available at www.sec.gov/litigation/admin/2018/34-84718.pdf. [69]     Admin. Proc. File No. 3-18673, In re First Western Advisors (Aug. 24, 2018), available at www.sec.gov/litigation/admin/2018/34-83934.pdf. [70]     Admin. Proc. File 3-18765, In re Capital Analysts, LLC (Sept. 14, 2018), available at www.sec.gov/litigation/admin/2018/ia-5009.pdf. [71]     Admin. Proc. File No. 3-18952, SEC Charges Tennessee Investment Advisory Firm and Two Advisory Representatives with Steering Clients to Higher-Fee Mutual Fund Share Classes (Dec. 21, 2018), available at www.sec.gov/enforce/34-84918-s. [72]     SEC Press Release, Two Advisory Firms, CEO Charged With Mutual Fund Share Class Disclosure Violations (Dec. 21, 2018), available at www.sec.gov/news/press-release/2018-303. [73]     Admin. Proc. File No. 3-18607, SEC Charges Beverly Hills Investment Adviser for Improper Fees and False Filings (July 20, 2018), available at www.sec.gov/enforce/ia-4975-s. [74]     Admin. Proc. File No. 3-18657, In re Aria Partners GP, LLC (Aug. 22, 2018), available at www.sec.gov/litigation/admin/2018/ia-4991.pdf. [75]     SEC Press Release, Transamerica Entities to Pay $97 Million to Investors Relating to Errors in Quantitative Investment Models (Aug. 27, 2018), available at www.sec.gov/news/press-release/2018-167. [76]     SEC Press Release, SEC Charges Buffalo Advisory Firm and Principal With Fraud Relating to Association With Barred Adviser (Aug. 30, 2018), available at www.sec.gov/news/press-release/2018-172.  [77]     Admin. Proc. File No. 3-18704, In re Mass. Financial Services Co. (Aug. 31, 2018), available at www.sec.gov/litigation/admin/2018/ia-4999.pdf. [78]     Admin. Proc. File No 3-18729, In re VSS Fund Mmgt. LLC and Jeffrey T. Stevenson (Sept. 7, 2018), available at www.sec.gov/litigation/admin/2018/ia-5001.pdf. [79]     SEC Press Release, SEC Charges Investment Advisers With Defrauding Retail Advisory Clients (Sept. 14, 2018), available at www.sec.gov/news/press-release/2018-195. [80]     Admin. Proc. File No. 3-18948, In re Sterling Global Strategies LLC (Dec. 20, 2018), available at www.sec.gov/litigation/admin/2018/ia-5085.pdf. [81]     SEC Press Release, SEC Charges Two Robo-Advisers With False Disclosures (Dec. 21, 2018), available at www.sec.gov/news/press-release/2018-300. [82]     SEC Press Release, SEC Charges Ameriprise Financial Services for Failing to Safeguard Client Assets (Aug. 15, 2018), available at www.sec.gov/news/press-release/2018-154. [83]     Admin. Proc. File No. 3-18884, SEC Charges Advisory Firm With Due Diligence and Monitoring Failures (Nov. 6, 2018), available at www.sec.gov/enforce/ia-5061-s. [84]     Admin. Proc. File No. 3-18636, SEC Charges Investment Adviser With Mispricing Cross Trades Between Clients (Aug. 10, 2018), available at www.sec.gov/enforce/ia-4983-s. [85]     Admin. Proc. File No. 3-18767, In re Cushing Asset Management, LP (Sept. 14, 2018), available at www.sec.gov/litigation/admin/2018/ic-33226.pdf. [86]     Admin. Proc. File No. 3-18844, SEC Orders Putnam to Pay $1 Million Penalty, Suspends and Fines Former Portfolio Manager for Prearranged Cross-Trades (Sept. 27, 2018), available at www.sec.gov/enforce/ia-5050-s. [87]     Admin. Proc. File Nos. 3-18586, 3-18587, 3-18588, 3-18589, 3-18590, SEC Charges Investment Advisers and Representatives for Violating the Testimonial Rule Using Social Media and the Internet (July 10, 2018), available at www.sec.gov/enforce/3-18586-90-s. [88]     Admin. Proc. File No. 3-18779, Investment Adviser and Its President Settle Charges for Testimonial Rule and Code of Ethics Violations (Sept. 18, 2018), available at www.sec.gov/enforce/ia-5035-s. [89]     Admin. Proc. File No. 3-18585, In re Oaktree Capital Management, L.P. (July 10, 2018), available at www.sec.gov/litigation/admin/2018/ia-4960.pdf. [90]     Admin. Proc. File No. 3-18584, In re EnCap Investments L.P. (July 10, 2018), available at www.sec.gov/litigation/admin/2018/ia-4959.pdf.    [91]     Admin. Proc. File No. 3-18599, Investment Adviser Settles Charges for Custody Rule Violations (July 17, 2018), available at www.sec.gov/enforce/ia-4970-s. [92]     Admin. Proc. File No. 3-18837, Investment Adviser Settles Charges for Custody Rule and Compliance Rule Violations (Sept. 25, 2018), available at www.sec.gov/enforce/ia-5047-s. [93]     SEC Press Release, Deutsche Bank to Pay Nearly $75 Million for Improper Handling of ADRs (Jul. 20, 2018), available at www.sec.gov/news/press-release/2018-138. [94]     SEC Press Release, SG Americas Securities Charged for Improper Handling of ADRs (Sept. 25, 2018), available at www.sec.gov/news/press-release/2018-211. [95]     SEC Press Release, Citibank to Pay More Than $38 Million for Improper Handling of ADRs (Nov. 7, 2018), available at www.sec.gov/news/press-release/2018-255. [96]     Admin. Proc. File No. 3-18933, In re Bank of New York Mellon (Dec. 17, 2018), available at www.sec.gov/litigation/admin/2018/33-10586.pdf. [97]     SEC Press Release, JPMorgan to Pay More Than $135 Million for Improper Handling of ADRs (Dec. 26, 2018), available at www.sec.gov/news/press-release/2018-306. [98]     SEC Press Release, SEC Charges Mizuho Securities for Failure to Safeguard Customer Information (Jul. 23, 2018), available at www.sec.gov/news/press-release/2018-140. [99]     SEC Press Release, SEC Obtains Relief to Fully Reimburse Retail Investors Sold Unsuitable Product (Sept. 11, 2018), available at www.sec.gov/news/press-release/2018-184. [100]   SEC Press Release, Citigroup to Pay More Than $10 Million for Books and Records Violations and Inadequate Controls (Aug. 16, 2018), available at www.sec.gov/news/press-release/2018-155-0. [101]   SEC Press Release, SEC Charges Moody’s With Internal Controls Failures and Ratings Symbols Deficiencies (Aug. 28, 2018), available at www.sec.gov/news/press-release/2018-169. [102]   SEC Litigation Release, SEC Charges Charles Schwab with Failing to Report Suspicious Transactions (Jul. 9, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24189.htm. [103]   Admin. Proc. File No. 3-18829, In the Matter of TD Ameritrade, Inc. (Sept. 24, 2018), available at www.sec.gov/litigation/admin/2018/34-84269.pdf. [104]   SEC Press Release, Brokerage Firm to Exit Penny stock Deposit Business and Pay Penalty for Repeatedly Failing to Report Suspicious Trading (Sept. 28, 2018), available at www.sec.gov/news/press-release/2018-225. [105]   Admin. Proc. File No. 3-18931, SEC Charges UBS Financial Services Inc. with Anti-Money Laundering Violations (Dec. 17, 2018), available at www.sec.gov/enforce/34-84828-s. [106]   Admin. Proc. File No. 30-18940, Broker-Dealer Settles Anti-Money Laundering Charges (Dec. 19, 2018), available at www.sec.gov/enforce/34-84851-s. [107]   SEC Press Release, SEC Charges Citigroup for Dark Pool Misrepresentations (Sept. 14, 2018), available at www.sec.gov/news/press-release/2018-193. [108]   SEC Press Release, Credit Suisse Agrees to Pay $10 Million to Settle Charges Related to Handling of Retail Customer Orders (Sept. 28, 2018), available at www.sec.gov/news/press-release/2018-224. [109]   SEC Press Release, SEC Charges ITG With Misleading Dark Pool Subscribers (Nov. 7, 2018), available at www.sec.gov/news/press-release/2018-256. [110]   SEC Press Release, SEC Charges BCG Financial for Failure to Preserve Documents and Maintain Accurate Books and Records (Jul. 17, 2018), available at www.sec.gov/news/press-release/2018-134. [111]   SEC Press Release, Broker-Dealer to Pay $2.75 Million Penalty for Providing Deficient Blue Sheet Data (Sept. 13, 2018), available at www.sec.gov/news/press-release/2018-191. [112]   SEC Press Release, Three Broker-Dealers to Pay More Than $6 Million in Penalties for Providing Deficient Blue Sheet Data (Dec. 10, 2018), available at www.sec.gov/news/press-release/2018-275. [113]   SEC Press Release, SEC Charges Two Brokers With Defrauding Customers (Sept. 10, 2018), available at www.sec.gov/news/press-release/2018-183. [114]   SEC Press Release, SEC Uses Data Analysis to Detect Cherry-Picking By Broker (Sept. 12, 2018), available at www.sec.gov/news/press-release/2018-189. [115]   Admin. Proc. File No. 3-18941, In the Matter of Andrew Nicoletta et al. (Dec. 19, 2018), available at www.sec.gov/litigation/admin/2018/34-84876.pdf. [116]   SEC Litigation Release, SEC Charges Former Heartland CEO, Romantic Partner in Insider Trading Scheme (Jul. 10, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24191.htm. [117]   SEC Litigation Release, SEC Charges Former Executive for Insider Trading (Jul. 5, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24186.htm. [118]   SEC Press Release, SEC Detects Silicon Valley Executive’s Insider Trading (Jul. 24, 2018), available at www.sec.gov/news/press-release/2018-142. [119]   Admin. Proc. File No. 3-18618, SEC Charges VP of Finance with Insider Trading (Jul. 31, 2018), available at www.sec.gov/enforce/34-83742-s. [120]   SEC Litigation Release, SEC Charges Former Pharma Executive and Others with Insider Trading (Aug. 23, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24245.htm. [121]   Admin. Proc. File No. 3-18665, In re James T. Lentz (Aug. 22, 2018), available at www.sec.gov/litigation/admin/2018/33-10535.pdf. [122]   SEC Litigation Release, SEC Charges Former Senior Executive At Silicon Valley Company with Insider Trading (Aug. 30, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24251.htm. [123]   SEC Litigation Release, SEC Charges Former Vice President of Ocwen Financial Corporation with Insider Trading (Sept. 28, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24298.htm. [124]   SEC Litigation Release, SEC Charges Ebay’s Former Director of SEC Reporting with Insider Trading (Oct. 16, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24317.htm. [125]   SEC Litigation Release, SEC Charges Husband with Insider Trading Ahead of Announcements by Wife’s Employer (Nov. 8, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24340.htm. [126]   SEC Litigation Release, SEC Charges California Software Consultant with Insider Trading (Nov. 8, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24338.htm. [127]   SEC Press Release, SEC Charges U.S. Congressman and Others With Insider Trading (Aug. 8, 2018), available at www.sec.gov/news/press-release/2018-151; see also SEC Litigation Release, SEC Announces Settlement with Two Traders in Innate Insider Trading Case (Aug. 16, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24236.htm. [128]   Admin. Proc. File No. 34-83795, SEC Charges California Bank Board Member’s Son with Insider Trading (Aug. 7, 2018), available at www.sec.gov/enforce/34-83795-s. [129]   SEC Litigation Release, SEC Charges Former Stericycle Financial Analyst and His Mother with Insider Trading (Jul. 24, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24212.htm. [130]   SEC Litigation Release, Former Equifax Manager Charged With Insider Trading (Jul. 2, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24183.htm. [131]   SEC Litigation. Release, Former Biotech Company Employee Charged with Insider Trading (Jul. 10, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24194.htm. [132]   SEC Litigation Release, SEC Charges Scientist for Insider Trading (Aug. 1, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24221.htm. [133]   Admin. Proc. File No. 3-18645, In re Honglan Wang (Aug. 16, 2018), available at www.sec.gov/litigation/admin/2018/34-83857.pdf. [134]   Admin. Proc. File No. 3-18655, SEC Charges Former In-House Counsel with Insider Trading (Aug. 21, 2018), available at www.sec.gov/enforce/34-83896-s. [135]   SEC Press Release, SEC Charges Former Professional Motorcycle Racer, his Investment Adviser, and Others With Insider Trading (Sept. 27, 2018), available at www.sec.gov/enforce/34-84304-s. [136]   SEC Press Release, SEC Charges NFL Player and Former Investment Banker With Insider Trading (Aug. 29, 2018), available at www.sec.gov/news/press-release/2018-170. [137]   SEC Press Release, SEC Charges Family Friend of Former Investment Banker With Insider Trading (Nov. 2, 2018), available at www.sec.gov/news/press-release/2018-251. [138]   SEC Litigation Release, SEC Charges Acquisition Advisor with Insider Trading (Sept. 14, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24269.htm. [139]   SEC Litigation Release, SEC Charges Husband of Investment Banker with Insider Trading (Dec. 17, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24375.htm. [140]   SEC Press Release, SEC Halts Alleged Insider Trading Ring Spanning Three Countries (Dec. 6, 2018), available at www.sec.gov/news/press-release/2018-273. [141]   SEC Litigation Release, SEC Charges Certified Public Accountant with Insider Trading (Aug. 21, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24240.htm. [142]   Admin. Proc. File No. 3-18652, Former Director At Major Accounting Firm Settles Insider Trading Charges (Aug. 20, 2018), available at www.sec.gov/enforce/34-83889-s. [143]   Admin. Proc. File No. 3-18574, In re Michael Johnson (July 6, 2018), available at www.sec.gov/litigation/admin/2018/34-83602.pdf. [144]   Admin. Proc. File No. 3-18858, In re Unal Patel (Sept. 28, 2018), available at www.sec.gov/litigation/admin/2018/34-84315.pdf. [145]   SEC Press Release, SEC Files Charges in Municipal Bond “Flipping” and Kickback Schemes (Aug. 14, 2018), available at www.sec.gov/news/press-release/2018-153. [146]   Admin. Proc. File No. 3-18936, SEC Charges Former Municipal Bond Salesman with Fraudulent Trading Practices (Dec. 18, 2018), available at www.sec.gov/enforce/33-10587-s. [147]   Admin. Proc. File No. 3-18803, SEC Bars Head of Unregistered Municipal Advisory Firm for Failing to Disclose Material Facts to School District (Sept. 20, 2018), available at www.sec.gov/enforce/34-84224-s. The following Gibson Dunn lawyers assisted in the preparation of this client update:  Marc Fagel, Amy Mayer, Andrew Paulson, Tina Samanta, Elizabeth Snow, Craig Streit, Collin James Vierra, Timothy Zimmerman and Maya Ziv. 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. 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January 11, 2019 |
2018 Year-End German Law Update

Click for PDF Looking back at the past year’s cacophony of voices in a world trying to negotiate a new balance of powers, it appeared that Germany was disturbingly silent, on both the global and European stage. Instead of helping shape the new global agenda that is in the making, German politics focused on sorting out the vacuum created by a Federal election result which left no clear winner other than a newly formed right wing nationalist populist party mostly comprised of so called Wutbürger (the new prong for “citizens in anger”) that managed to attract 12.6 % of the vote to become the third strongest party in the German Federal Parliament. The relaunching of the Grand-Coalition in March after months of agonizing coalition talks was followed by a bumpy start leading into another session of federal state elections in Bavaria and Hesse that created more distraction. When normal business was finally resumed in November, a year had passed by with few meaningful initiatives formed or significant business accomplished. In short, while the world was spinning, Germany allowed itself a year’s time-out from international affairs. The result is reflected in this year’s update, where the most meaningful legal developments were either triggered by European initiatives, such as the General Data Protection Regulation (“GDPR”) (see below section 4.1) or the New Transparency Rules for Listed German Companies (see below section 1.2), or as a result of landmark rulings of German or international higher and supreme courts (see below Corporate M&A sections 1.1 and 1.4; Tax – sections 2.1 and 2.2 and Labor and Employment – section 4.2). In fairness, shortly before the winter break at least a few other legal statutes have been rushed through parliament that are also covered by this update. Of the changes that are likely to have the most profound impact on the corporate world, as well as on the individual lives of the currently more than 500 million inhabitants of the EU-28, the GDPR, in our view, walks away with the first prize. The GDPR has created a unified legal system with bold concepts and strong mechanisms to protect individual rights to one’s personal data, combined with hefty fines in case of the violation of its rules. As such, the GDPR stands out as a glowing example for the EU’s aspiration to protect the civic rights of its citizens, but also has the potential to create a major exposure for EU-based companies processing and handling data globally, as well as for non EU-based companies doing business in Europe. On a more strategic scale, the GDPR also creates a challenge for Europe in the global race for supremacy in a AI-driven world fueled by unrestricted access to data – the gold of the digital age. The German government could not resist infection with the virus called protectionism, this time around coming in the form of greater scrutiny imposed on foreign direct investments into German companies being considered as “strategic” or “sensitive” (see below section 1.3 – Germany Tightens Rules on Foreign Takeovers Even Further). Protecting sensitive industries from “unwanted” foreign investors, at first glance, sounds like a laudable cause. However, for a country like Germany that derives most of its wealth and success from exporting its ideas, products and services, a more liberal approach to foreign investments would seem to be more appropriate, and it remains to be seen how the new rules will be enforced in practice going forward. The remarkable success of the German economy over the last twenty five years had its foundation in the abandoning of protectionism, the creation of an almost global market place for German products, and an increasing global adoption of the rule of law. All these building blocks of the recent German economic success have been under severe attack in the last year. This is definitely not the time for Germany to let another year go by idly. We use this opportunity to thank you for your trust and confidence in our ability to support you in your most complicated and important business decisions and to help you form your views and strategies to deal with sophisticated German legal issues. Without our daily interaction with your real-world questions and tasks, our expertise would be missing the focus and color to draw an accurate picture of the multifaceted world we are living in. In this respect, we thank you for making us better lawyers – every day. ________________________ TABLE OF CONTENTS 1.      Corporate, M&A 2.      Tax 3.      Financing and Restructuring 4.      Labor and Employment 5.      Real Estate 6.      Compliance 7.      Antitrust and Merger Control 8.      Litigation 9.      IP & Technology 10.    International Trade, Sanctions and Export Controls ________________________ 1.       Corporate, M&A 1.1       Further Development regarding D&O Liability of the Supervisory Board in a German Stock Corporation In its famous “ARAG/Garmenbeck”-decision in 1997, the German Federal Supreme Court (Bundesgerichtshof – BGH) first established the obligation of the supervisory board of a German Stock Corporation (Aktiengesellschaft) to pursue the company’s D&O liability claims in the name of the company against its own management board after having examined the existence and enforceability of such claims. Given the very limited discretion the court has granted to the supervisory board not to bring such a claim and the supervisory board’s own liability arising from inactivity, the number of claims brought by companies against their (former) management board members has risen significantly since this decision. In its recent decision dated September 18, 2018, the BGH ruled on the related follow-up question about when the statute of limitations should start to run with respect to compensation claims brought by the company against a supervisory board member who has failed to pursue the company’s D&O liability claims against the board of management within the statutory limitation period. The BGH clarified that the statute of limitation applicable to the company’s compensation claims against the inactive supervisory board member (namely ten years in case of a publicly listed company, otherwise five years) should not begin to run until the company’s compensation claims against the management board member have become time-barred themselves. With that decision, the court adopts the view that in cases of inactivity, the period of limitations should not start to run until the last chance for the filing of an underlying claim has passed. In addition, the BGH in its decision confirmed the supervisory board’s obligation to also pursue the company’s claims against the board of management in cases where the management board member’s misconduct is linked to the supervisory board’s own misconduct (e.g. through a violation of supervisory duties). Even in cases where the pursuit of claims against the board of management would force the supervisory board to disclose its own misconduct, such “self-incrimination” does not release the supervisory board from its duty to pursue the claims given the preponderance of the company’s interests in an effective supervisory board, the court reasoned. In practice, the recent decision will result in a significant extension of the D&O liability of supervisory board members. Against that backdrop, supervisory board members are well advised to examine the existence of the company’s compensation claims against the board of management in a timely fashion and to pursue the filing of such claims, if any, as soon as possible. If the board of management’s misconduct is linked to parallel misconduct of the supervisory board itself, the relevant supervisory board member – if not exceptionally released from pursuing such claim and depending on the relevant facts and circumstances – often finds her- or himself in a conflict of interest arising from such self-incrimination in connection with the pursuit of the claims. In such a situation, the supervisory board member might consider resigning from office in order to avoid a conflict of interest arising from such self-incrimination in connection with the pursuit of the claims. Back to Top 1.2       Upcoming New Transparency Rules for Listed German Companies as well as Institutional Investors, Asset Managers and Proxy Advisors In mid-October 2018, the German Federal Ministry of Justice finally presented the long-awaited draft for an act implementing the revised European Shareholders’ Rights Directive (Directive (EU) 2017/828). The Directive aims to encourage long-term shareholder engagement by facilitating the communication between shareholders and companies, in particular across borders, and will need to be implemented into German law by June 10, 2019 at the latest. The new rules primarily target listed German companies and provide some major changes with respect to the “say on pay” provisions, as well as additional approval and disclosure requirements for related party transactions, the transmission of information between a stock corporation and its shareholders and additional transparency and reporting requirements for institutional investors, asset managers and proxy advisors. “Say on pay” on directors’ remuneration: remuneration policy and remuneration report Under the current law, the shareholders determine the remuneration of the supervisory board members at a shareholder meeting, whereas the remuneration of the management board members is decided by the supervisory board. The law only provides for the possibility of an additional shareholder vote on the management board members’ remuneration if such vote is put on the agenda by the management and supervisory boards in their sole discretion. Even then, such vote has no legal effects whatsoever (“voluntary say on pay”). In the future, shareholders of German listed companies will have two options. First, the supervisory board will have to prepare a detailed remuneration policy for the management board, which must be submitted to the shareholders if there are major changes to the remuneration, and in any event at least once every four years (“mandatory say on pay”). That said, the result of the vote on the policy will continue to remain only advisory. However, if the supervisory board adopts a remuneration policy that has been rejected by the shareholders, it will then be required to submit a reviewed (not necessarily revised) remuneration policy to the shareholders at the next shareholders’ meeting. With respect to the remuneration of supervisory board members, the new rules require a shareholders vote at least once every four years. Second, at the annual shareholders’ meeting the shareholders will vote ex post on the remuneration report (which is also reviewed by the statutory auditor) which contains the remuneration granted to the present and former members of the management board and the supervisory board in the past financial year. Again, the shareholders’ vote, however, will only be advisory. Both the remuneration report including the audit report, as well as the remuneration policy will have to be made public on the company’s website for at least ten years. Related party transactions German stock corporation law already provides for various safeguard mechanisms to protect minority shareholders in cases of transactions with major shareholders or other related parties (e.g. the capital maintenance rules and the laws relating to groups of companies). In the future, in the case of listed companies, these mechanisms will be supplemented by a detailed set of approval and transparency requirements for transactions between the company and related parties. Material transactions exceeding certain thresholds will require prior supervisory board approval. A rejection by the supervisory board can be overcome by shareholder vote. Furthermore, a listed company must publicly disclose any such material related party transaction, without undue delay over media providing for a Europe-wide distribution. Identification of shareholders and facilitation of the exercise of shareholders’ rights Listed companies will have the right to request information on the identity of their shareholders, including the name and both a postal and electronic address, from depositary banks, thus allowing for a direct communication line, also with respect to bearer shares (“know-your-shareholder”). Furthermore, depositary banks and other intermediaries will be required to pass on important information from the company to the shareholders and vice versa, e.g. with respect to voting in shareholders’ meetings and the exercise of subscription rights. Where there is more than one intermediary in a chain, the intermediaries are required to pass on the respective information within the chain. In addition, companies will be required to confirm the votes cast at the request of the shareholders thus enabling them to be certain that their votes have been effectively cast, including in particular across borders. Transparency requirements for institutional investors, asset managers and proxy advisors German domestic institutional investors and asset managers with Germany as their home member state (as defined in the applicable sector-specific EU law) will be required (i) to disclose their engagement policy, including how they monitor, influence and communicate with the investee companies, exercise shareholders’ rights and manage actual and potential conflicts of interests, and (ii) to report annually on the implementation of their engagement policy and disclose how they have cast their votes in the general meetings of material investee companies. Institutional investors will further have to disclose (iii) consistency between the key elements of their investment strategy with the profile and duration of their liabilities and how they contribute to the medium to long-term performance of their assets, and, (iv) if asset managers are involved, to disclose the main aspects of their arrangement with the asset manager. The new disclosure and reporting requirements, however, only apply on a “comply or explain” basis. Thus, investors and asset managers may choose not to make the above disclosures, provided they give an explanation as to why this is the case. Proxy advisors will have to publicly disclose on an annual basis (i) whether and how they have applied their code of conduct based again on the “comply or explain” principle, and (ii) information on the essential features, methodologies and models they apply, their main information sources, the qualification of their staff, their voting policies for the different markets they operate in, their interaction with the companies and the stakeholders as well as how they manage conflicts of interests. These rules, however, do not apply to proxy advisors operating from a non-EEA state with no establishment in Germany. The present legislative draft is still under discussion and it is to be expected that there will still be some changes with respect to details before the act becomes effective in mid-2019. Due to transitional provisions, the new rules on “say on pay” will have no effect for the majority of listed companies in this year’s meeting season. Whether the new rules will actually promote a long-term engagement of shareholders and have the desired effect on the directors’ remuneration of listed companies will have to be seen. In any event, both listed companies as well as the other addressees of the new transparency rules should make sure that they are prepared for the new reporting and disclosure requirements. Back to Top 1.3       Germany Tightens Rules on Foreign Takeovers Even Further After the German government had imposed stricter rules on foreign direct investment in 2017 (see 2017 Year-End German Law Update under 1.5), it has now even further tightened its rules with respect to takeovers of German companies by foreign investors. The latest amendment of the rules under the German Foreign Trade and Payments Ordinance (Außenwirtschaftsverordnung, “AWV“) enacted in 2018 was triggered, among other things, by the German government’s first-ever veto in August 2018 regarding the proposed acquisition of Leifeld Metal Spinning, a German manufacturer of metal forming machines used in the automotive, aerospace and nuclear industries, by Yantai Taihai Corporation, a privately-owned industry group from China, on the grounds of national security. Ultimately, Yantai withdrew its bid shortly after the German government had signaled that it would block the takeover. On December 29, 2018, the latest amendment of the Foreign Trade and Payments Ordinance came into force. The new rules provide for greater scrutiny of foreign direct investments by lowering the threshold for review of takeovers of German companies by foreign investors from the acquisition of 25% of the voting rights down to 10% in circumstances where the target operates a critical infrastructure or in sensitive security areas (defense and IT security industry). In addition, the amendment also expands the scope of the Foreign Trade and Payments Ordinance to also apply to certain media companies that contribute to shaping the public opinion by way of broadcasting, teleservices or printed materials and stand out due to their special relevance and broad impact. While the lowering of the review threshold as such will lead to an expansion of the existing reporting requirements, the broader scope is also aimed at preventing German mass media from being manipulated with disinformation by foreign investors or governments. There are no specific guidelines published by the German government as it wants the relevant parties to contact, and enter into a dialog with, the authorities about these matters. While the German government used to be rather liberal when it came to foreign investments in the past, the recent veto in the case of Leifeld as well as the new rules show that in certain circumstances, it will become more cumbersome for dealmakers to get a deal done. Finally, it is likely that the rules on foreign investment control will be tightened even further going forward in light of the contemplated EU legislative framework for screening foreign direct investment on a pan-European level. Back to Top 1.4       US Landmark Decision on MAE Clauses – Consequences for German M&A Deals Fresenius wrote legal history in the US with potential consequences also for German M&A deals in which “material adverse effect” (MAE) clauses are used. In December 2018, for the first time ever, the Supreme Court of Delaware allowed a purchaser to invoke the occurrence of an MAE and to terminate the affected merger agreement. The agreement included an MAE clause, which allocated certain business risks concerning the target (Akorn) for the time period between signing and closing to Akorn. Against the resistance of Akorn, Fresenius terminated the merger agreement based on the alleged MAE, arguing that the target’s EBITDA declined by 86%. The decision includes a very detailed analysis of an MAE clause by the Delaware courts and reaffirms that under Delaware law there is a very high bar to establishing an MAE. Such bar is based both on quantitative and qualitative parameters. The effects of any material adverse event need to be substantial as well as lasting. In most German deals, the parties agree to arbitrate. For this reason, there have been no German court rulings published on MAE clauses so far. Hence, all parties to an M&A deal face uncertainty about how German courts or arbitration tribunals would define “materiality” in the context of an MAE clause. In potential M&A litigation, sellers may use this ruling to support the argument that the bar for the exercise of the MAE right is in fact very high in line with the Delaware standard. It remains to be seen whether German judges will adopt the Delaware decision to interpret MAE clauses in German deals. Purchasers, who seek more certainty, may consider defining materiality in the MAE clause more concretely (e.g., by reference to the estimated impact of the event on the EBITDA of the company or any other financial parameter). Back to Top 1.5       Equivalence of Swiss Notarizations? The question whether the notarization of various German corporate matters may only be validly performed by German notaries or whether some or all of these measures may also be notarized validly by Swiss notaries has long since been the topic of legal debate. Since the last major reform of the German Limited Liability Companies Act (Gesetz betreffend Gesellschaften mit beschränkter Haftung – GmbHG) in 2008 the number of Swiss notarizations of German corporate measures has significantly decreased. A number of the newly introduced changes and provisions seemed to cast doubt on the equivalence and capacity of Swiss notaries to validly perform the duties of a German notary public who are not legally bound by the mandatory, non-negotiable German fee regime on notarial fees. As a consequence and a matter of prudence, German companies mostly stopped using Swiss notaries despite the potential for freely negotiated fee arrangements and the resulting significant costs savings in particular in high value matters. However, since 2008 there has been an increasing number of test cases that reach the higher German courts in which the permissibility of a Swiss notarization is the decisive issue. While the German Federal Supreme Court (Bundesgerichtshof – BGH) still has not had the opportunity to decide this question, in 2018 two such cases were decided by the Kammergericht (Higher District Court) in Berlin. In those cases, the court held that both the incorporation of a German limited liability company in the Swiss Canton of Berne (KG Berlin, 22 W 25/16 – January 24, 2018 = ZIP 2018, 323) and the notarization of a merger between two German GmbHs before a notary in the Swiss Canton of Basle (KG Berlin, 22 W 2/18 – July 26, 2018 = ZIP 2018, 1878) were valid notarizations under German law, because Swiss notaries were deemed to be generally equivalent to the qualifications and professional standards of German-based notaries. The reasons given in these decisions are reminiscent of the case law that existed prior to the 2008 corporate law reform and can be interpreted as indicative of a certain tendency by the courts to look favorably on Swiss notarizations as an alternative to German-based notarizations. Having said that and absent a determinative decision by the BGH, using German-based notaries remains the cautious default approach for German companies to take. This is definitely the case in any context where financing banks are involved (e.g. either where share pledges as loan security are concerned or in an acquisition financing context of GmbH share sales and transfers). On the other hand, in regions where such court precedents exist, the use of Swiss notaries for straightforward intercompany share transfers, mergers or conversions might be considered as an alternative on a case by case basis. Back to Top 1.6       Re-Enactment of the DCGK: Focus on Relevance, Function, Management Board’s Remuneration and Independence of Supervisory Board Members Sixteen years after it has first been enacted, the German Corporate Governance Code (Deutscher Corporate Governance Kodex, DCGK), which contains standards for good and responsible governance for German listed companies, is facing a major makeover. In November 2018, the competent German government commission published a first draft for a radically revised DCGK. While vast parts of the proposed changes are merely editorial and technical in nature, the draft contains a number of new recommendations, in particular with respect to the topics of management remuneration and independence of supervisory board members. With respect to the latter, the draft now provides a catalogue of criteria that shall act as guidance for the supervisory board as to when a shareholder representative shall no longer be regarded as independent. Furthermore, the draft also provides for more detailed specifications aiming for an increased transparency of the supervisory board’s work, including the recommendation to individually disclose the members’ attendance of meetings, and further tightens the recommendations regarding the maximum number of simultaneous mandates for supervisory board members. Moreover, in addition to the previous concept of “comply or explain”, the draft DCGK introduces a new “apply and explain” concept, recommending that listed companies also explain how they apply certain fundamental principles set forth in the DCGK as a new third category in addition to the previous two categories of recommendations and suggestions. The draft DCGK is currently under consultation and the interested public is invited to comment upon the proposed amendments until the end of January 2019. Since some of the proposed amendments provide for a rather fundamentally new approach to the current regime and would introduce additional administrative burdens, it remains to be seen whether all of the proposed amendments will actually come into force. According to the current plan, following a final consultancy of the Government Commission, the revised version of the DCGK shall be submitted for publication in April 2019 and would take effect shortly thereafter. Back to Top 2.         Tax On November 23, 2018, the German Federal Council (Bundesrat) approved the German Tax Reform Act 2018 (Jahressteuergesetz 2018, the “Act”), which had passed the German Federal Parliament (Bundestag) on November 8, 2018. Highlights of the Act are (i) the exemption of restructuring gains from German income tax, (ii) the partial abolition of and a restructuring exemption from the loss forfeiture rules in share transactions and (iii) the extension of the scope of taxation for non-German real estate investors investing in Germany. 2.1       Exemption of Restructuring Gains The Act puts an end to a long period of uncertainty – which has significantly impaired restructuring efforts – with respect to the tax implications resulting from debt waivers in restructuring scenarios (please see in this regard our 2017 Year-End German Law Update under 3.2). Under German tax law, the waiver of worthless creditor claims creates a balance sheet profit for the debtor in the amount of the nominal value of the payable. Such balance sheet profit is taxable and would – without any tax privileges for such profit – often outweigh the restructuring effect of the waiver. The Act now reinstates the tax exemption of debt waivers with retroactive effect for debt waivers after February 8, 2017; upon application debt waivers prior to February 8, 2017 can also be covered. Prior to this legislative change, a tax exemption of restructuring gains was based on a restructuring decree of the Federal Ministry of Finance, which has been applied by the tax authorities since 2003. In 2016, the German Federal Fiscal Court (Bundesfinanzgerichtshof) held that the restructuring decree by the Federal Ministry of Finance violates constitutional law since a tax exemption must be legislated by statute and cannot be based on an administrative decree. Legislation was then on hold pending confirmation from the EU Commission that a legislative tax exemption does not constitute illegal state aid under EU law. The EU Commission finally gave such confirmation by way of a comfort letter in August 2018. The Act is largely based on the conditions imposed by a restructuring decree issued by the Federal Ministry of Finance on the tax exemption of a restructuring gain. Under the Act, gains at the level of the debtor resulting from a full or partial debt relief are exempt from German income tax if the relief is granted to recapitalize and restructure an ailing business. The tax exemption only applies if at the time of the debt waiver (i) the business is in need of restructuring and (ii) capable of being restructured, (iii) the waiver results in a going-concern of the restructured business and (iv) the creditor waives the debt with the intention to restructure the business. The rules apply to German corporate income and trade tax and benefit individuals, partnerships and corporations alike. Any gains from the relief must first be reduced by all existing loss-offsetting potentials before the taxpayer can benefit from tax exemptions on restructuring measures. Back to Top 2.2       Partial Abolition of Loss Forfeiture Rules/Restructuring Exception Under the current Loss Forfeiture Rules, losses of a German corporation will be forfeited on a pro rata basis if within a period of five years more than 25% but not more than 50% of the shares in the German loss-making corporation are transferred (directly or indirectly) to a new shareholder or group of shareholders with aligned interests. If more than 50% are transferred, losses will be forfeited in total. There are exceptions to this rule for certain intragroup restructurings, built-in gains and business continuations, especially in the venture capital industry. On March 29, 2017, the German Federal Constitutional Court (Bundesverfassungsgericht – BVerfG) ruled that the pro rata forfeiture of losses (a share transfer of more than 25% but not more than 50%) is incompatible with the constitution. The court has asked the German legislator to amend the Loss Forfeiture Rules retroactively for the period from January 1, 2008 until December 31, 2015 to bring them in line with the constitution. Somewhat surprisingly, the legislator has now decided to fully cancel the pro rata forfeiture of losses with retroactive effect and with no reference to a specific tax period. Currently pending before the German Federal Constitutional Court is the question whether the full forfeiture of losses is constitutional. A decision by the Federal Constitutional Court is expected for early 2019, which may then result in another legislative amendment of the Loss Forfeiture Rules. The Act has also reinstated a restructuring exception from the forfeiture rules – if the share transfer occurs in order to restructure the business of an ailing corporation. Similar to the exemption of restructuring gains, this legislation was on hold until the ECJ’s decision (European Court of Justice) on June 28, 2018 that the restructuring exception does not violate EU law. Existing losses will not cease to exist following a share transfer if the restructuring measures are appropriate to avoid or eliminate the illiquidity or the over-indebtedness of the corporation and to maintain its basic operational structure. The restructuring exception applies to share transfers after December 31, 2007. Back to Top 2.3       Investments in German Real Estate by Non-German Investors So far, capital gains from the disposal of shares in a non-German corporation holding German real estate were not subject to German tax. In a typical structure, in which German real estate is held via a Luxembourg or Dutch entity, a value appreciation in the asset could be realized by a share deal of the holding company without triggering German income taxes. Under the Act, the sale of shares in a non-German corporation is now taxable if, at some point within a period of one year prior to the sale of shares, 50 percent of the book value of the assets of the company consisted of German real estate and the seller held at least 1 percent of the shares within the last five years prior to the sale. The Act is now in line with many double tax treaties concluded by Germany, which allow Germany to tax capital gains in these cases. The new law applies for share transfers after December 31, 2018. Capital gains are only subject to German tax to the extent the value has been increased after December 31, 2018. Until 2018, a change in the value of assets and liabilities, which are economically connected to German real estate, was not subject to German tax. Therefore, for example, profits from a waiver of debt that was used to finance German real estate was not taxable in Germany whereas the interest paid on the debt was deductible for German tax purposes. That law has now changed and allows Germany to tax such profit from a debt waiver if the loan was used to finance German real estate. However, only the change in value that occurred after December 31, 2018 is taxable. Back to Top 3.         Financing and Restructuring – Test for Liquidity Status Tightened On December 19, 2017, the German Federal Supreme Court (Bundesgerichtshof – BGH) handed down an important ruling which clarifies the debt and payable items that should be taken into account when determining the “liquidity” status of companies. According to the Court, the liquidity test now requires managing directors and (executive) board members to determine whether a liquidity gap exceeding 10% can be overcome by incoming liquidity within a period of three weeks taking into account all payables which will become due in those three weeks. Prior to the ruling, managing directors had often argued successfully that only those payables that were due at the time when the test is applied needed be taken into account while expected incoming payments within a three week term could be considered. This mismatch in favor of the managing directors has now been rectified by the Court to the disadvantage of the managing directors. If, for example, on June 1 the company liquidity status shows due payables amounting to EUR 100 and plausible incoming receivables in the three weeks thereafter amounting to EUR 101, no illiquidity existed under the old test. Under the new test confirmed by the Court, payables of EUR 50 becoming due in the three week period now also have to be taken into account and the company would be considered illiquid. For companies and their managing directors following a cautious approach, the implications of this ruling are minor. Going forward, however, even those willing to take higher risks will need to follow the court determined principles. Otherwise, delayed insolvency filings could ensue. This not only involves a managing directors and executive board members’ personal liability for payments made on behalf of the company while illiquid but also potential criminal liability for a delayed insolvency filing. Managing directors are thus well advised to properly undertake and also document the required test in order to avoid liability issues. Back to Top 4.         Labor and Employment 4.1       GDPR Has Tightened Workplace Privacy Rules The EU General Data Protection Regulation (“GDPR”) started to apply on May 25, 2018. It has introduced a number of stricter rules for EU countries with regard to data protection which also apply to employee personal data and employment relationships. In addition to higher sanctions, the regulation provides for extensive information, notification, deletion, and documentation obligations. While many of these data privacy rules had already been part of the previous German workplace privacy regime under the German Federal Data Protection Act (Bundesdatenschutzgesetz – BDSG), the latter has also been amended and provides for specific rules applicable to employee data protection in Germany (e.g. in the context of internal investigations or with respect to employee co-determination). However, the most salient novelty is the enormous increase in potential sanctions under the GDPR. Fines for GDPR violations can reach up to the higher of EUR 20 million or 4% of the group’s worldwide turnover. Against this backdrop, employers are well-advised to handle employee personnel data particularly careful. This is also particularly noteworthy as the employer is under an obligation to prove compliance with the GDPR – which may result in a reversal of the burden of proof e.g. in employment-related litigation matters involving alleged GDPR violations. Back to Top 4.2       Job Adverts with Third Gender Following a landmark decision by the German Federal Constitutional Court in 2017, employers are gradually inserting a third gender into their job advertisements. The Federal Constitutional Court (Bundesverfassungsgericht – BVerfG) decided on October 10, 2017 that citizens who do not identify as either male or female were to be registered as “diverse” in the birth register (1 BvR 2019/16). As a consequence of this court decision, many employers in Germany have broadened gender notations in job advertisements from previously “m/f” to “m/f/d”. While there is no compelling legal obligation to do so, employers tend to signal their open-mindedness by this step, but also mitigate the potential risk of liability for a discrimination claim. Currently, such liability risk does not appear alarming due to the relative rarity of persons identifying as neither male nor female and the lack of a statutory stipulation for such adverts. However, employers might be well-advised to follow this trend, particularly after Parliament confirmed the existence of a third gender option in birth registers in mid-December. Back to Top 4.3       Can Disclosure Obligation Reduce Gender Pay-Gap? In an attempt to weed out gender pay gaps, the German lawmaker has introduced the so-called Compensation Transparency Act in 2017. It obliges employers, inter alia, to disclose the median compensation of comparable colleagues of the opposite gender with comparable jobs within the company. The purpose is to give a potential claimant (usually a female employee) an impression of how much her comparable male colleagues earn in order for her to consider further steps, e.g. a claim for more money. However, the new law is widely perceived as pointless. First, the law itself and its processes are unduly complex. Second, even after making use of the law, the respective employee would still have to sue the company separately in order to achieve an increase in her compensation, bearing the burden of proof that the opposite-gender employee with higher compensation is comparable to her. Against this background, the law has hardly been used in practice and will likely have only minimal impact. Back to Top 4.4       Employers to Contribute 15% to Deferred Compensation Schemes In order to promote company pension schemes, employers are now obliged to financially support deferred compensation arrangements. So far, employer contributions to any company pension scheme had been voluntary. In the case of deferred compensation schemes, companies save money as a result of less social security charges. The flipside of this saving was a financial detriment to the employee’s statutory pension, as the latter depends on the salary actually paid to the employee (which is reduced as a result of the deferred compensation). To compensate the employee for this gap, the employer is now obliged to contribute up to 15% of the respective deferred compensation. The actual impact of this new rule should be limited, as many employers already actively support deferred compensation schemes. As such, the new obligatory contribution can be set off against existing employer contributions to the same pension scheme. Back to Top 5.         Real Estate – Notarization Requirement for Amendments to Real Estate Purchase Agreements Purchase agreements concerning German real estate require notarization in order to be effective. This notarization requirement relates not only to the purchase agreement as such but to all closely related (side) agreements. The transfer of title to the purchaser additionally requires an agreement in rem between the seller and the purchaser on the transfer (conveyance) and the subsequent registration of the transfer in the land register. To avoid additional notarial fees, parties usually include the conveyance in the notarial real estate purchase agreement. Amendment agreements to real estate purchase agreements are quite common (e.g., the parties subsequently agree on a purchase price adjustment or the purchaser has special requests in a real estate development scenario). Various Higher District Courts (Oberlandesgerichte), together with the prevailing opinion in literature, have held in the past that any amendments to real estate purchase agreements also require notarization unless such an amendment is designed to remove unforeseeable difficulties with the implementation of the agreement without significantly changing the parties’ mutual obligations. Any amendment agreement that does not meet the notarization requirement may render the entire purchase agreement (and not only the amendment agreement) null and void. With its decision on September 14, 2018, the German Federal Supreme Court (Bundesgerichtshof – BGH) added another exception to the notarization requirement and ruled that notarization of an amendment agreement is not required once the conveyance has become binding and the amendment does not change the existing real estate transfer obligations or create new ones. A conveyance becomes binding once it has been validly notarized. Before this new decision of the BGH, amendments to real estate purchase agreements were often notarized for the sake of precaution because it was difficult to determine whether the conditions for an exemption from the notarization requirement had been met. This new decision of the BGH gives the parties clear guidance as to when amendments to real estate purchase agreements require notarization. It should, however, be borne in mind that notarization is still required if the amendment provides for new transfer obligations concerning the real property or the conveyance has not become effective yet (e.g., because third party approval is still outstanding). Back to Top 6.         Compliance 6.1       Government Plans to Introduce Corporate Criminal Liability and Internal Investigations Act Plans of the Federal Government to introduce a new statute concerning corporate criminal liability and internal investigations are taking shape. Although a draft bill had already been announced for the end of 2018, pressure to respond to recent corporate scandals seems to be rising. With regard to the role and protection of work product generated during internal investigations, the highly disputed decisions of the Federal Constitutional Court (Bundesverfassungsgericht – BVerfG) in June 2018 (BVerfG, 2 BvR 1405/17, 2 BvR 1780/17 – June 27, 2018) (see 2017 Year-End German Law Update under 7.3) call for clearer statutory rules concerning the search of law firm premises and the seizure of documents collected in the course of an internal investigation. In its dismissal of complaints brought by Volkswagen and its lawyers from Jones Day, the Federal Constitutional Court made remarkable obiter dicta statements in which it emphasized the following: (1) the legal privilege enjoyed for the communication between the individual defendant (Beschuldigter) and its criminal defense counsel is limited to their communication only; (2) being considered a foreign corporate body, the court denied Jones Day standing in the proceedings, because the German constitution only grants rights to corporate bodies domiciled in Germany; and (3) a search of the offices of a law firm does not affect individual constitutional rights of the lawyers practicing in that office, because the office does not belong to the lawyers’ personal sphere, but only to their law firm. The decision and the additional exposure caused by it by making attorney work product created in the course of an internal investigation accessible was a major blow to German corporations’ efforts to foster internal investigations as a means to efficiently and effectively investigate serious compliance concerns. Because it does not appear likely that an entirely new statute concerning corporate criminal liability will materialize in the near future, the legal press expects the Federal Ministry of Justice to consider an approach in which the statutes dealing with questions around internal investigations and the protection of work product created in the course thereof will be clarified separately. In the meantime, the following measures are recommended to maximize the legal privilege for defense counsel (Verteidigerprivileg): (1) Establish clear instructions to an individual criminal defense lawyer setting forth the scope and purpose of the defense; (2) mark work product and communications that have been created in the course of the defense clearly as confidential correspondence with defense counsel (“Vertrauliche Verteidigerkorrespondenz”); and (3) clearly separate such correspondence from other correspondence with the same client in matters that are not clearly attributable to the criminal defense mandate. While none of these measures will guarantee that state prosecutors and courts will abstain from a search and seizure of such material, at least there are good and valid arguments to defend the legal privilege in any appeals process. However, with the guidance provided to courts by the recent constitutional decision, until new statutory provisions provide for clearer guidance, companies can expect this to become an up-hill battle. Back to Top 6.2       Update on the European Public Prosecutor’s Office and Proposed Cross-Border Electronic Evidence Rules Recently the European Union has started tightening its cooperation in the field of criminal procedure, which was previously viewed as a matter of national law under the sovereignty of the 28 EU member states. Two recent developments stand out that illustrate that remarkable new trend: (1) The introduction of the European Public Prosecutor’s Office (“EPPO”) that was given jurisdiction to conduct EU-wide investigations for certain matters independent of the prosecution of these matters under the national laws of the member states, and (2) the proposed EU-wide framework for cross-border access to electronically stored data (“e-evidence”) which has recently been introduced to the European Parliament. As reported previously (see 2017 Year-End German Law Update under 7.4), the European Prosecutor’s Office’s task is to independently investigate and prosecute severe crimes against the EU’s financial interests such as fraud against the EU budget or crimes related to EU subsidies. Corporations receiving funds from the EU may therefore be the first to be scrutinized by this new EU body. In 2018 two additional EU member states, the Netherlands and Malta, decided to join this initiative, extending the number of participating member states to 22. The EPPO will presumably begin its work by the end of 2020, because the start date may not be earlier than three years after the regulation’s entry into force. As a further measure to leverage multi-jurisdictional enforcement activities, in April 2018 the European Commission proposed a directive and a regulation that will significantly facilitate expedited cross-border access to e-evidence such as texts, emails or messaging apps by enforcement agencies and judicial authorities. The proposed framework would allow national enforcement authorities in accordance with their domestic procedure to request e-evidence directly from a service provider located in the jurisdiction of another EU member state. That other state’s authorities would not have the right to object to or to review the decision to search and seize the e-evidence sought by the national enforcement authority of the requesting EU member state. Companies refusing delivery risk a fine of up to 2% of their worldwide annual turnover. In addition, providers from a third country which operate in the EU are obliged to appoint a legal representative in the EU. The proposal has reached a majority vote in the Council of the EU and will now be negotiated in the European Parliament. Further controversial discussions between the European Parliament and the Commission took place on December 10, 2018. The Council of the EU aims at reaching an agreement between the three institutions by the end of term of the European Parliament in May 2019. Back to Top 7.         Antitrust and Merger Control 7.1       Antitrust and Merger Control Overview 2018 In 2018, Germany celebrated the 60th anniversary of both the German Act against Restraints of Competition (Gesetz gegen Wettbewerbsbeschränkungen -GWB) as well as the German federal cartel office (Bundeskartellamt) which were both established in 1958 and have since played a leading role in competition enforcement worldwide. The celebrations notwithstanding, the German antitrust watchdog has had a very active year in substantially all of its areas of competence. On the enforcement side, the Bundeskartellamt concluded a number of important cartel investigations. According to its annual review, the Bundeskartellamt carried out dawn raids at 51 companies and imposed fines totaling EUR 376 million against 22 companies or associations and 20 individuals from various industries including the steel, potato manufacturing, newspapers and rolled asphalt industries. Leniency applications remained an important source for the Bundeskartellamt‘s antitrust enforcement activities with a total of 21 leniency applications received in 2018 filling the pipeline for the next few months and years. On the merger control side, the Bundeskartellamt reviewed approximately 1,300 merger cases in 2018 – only 1% of which (i.e. 13 merger filings) required an in-depth phase 2 review. No mergers were prohibited but in one case only conditional clearance was granted and three filings were withdrawn in phase 2. In addition, the Bundeskartellamt had its first full year of additional responsibilities in the area of consumer protection, concluded a sector inquiry into internet comparison portals, and started a sector inquiry into the online marketing business as well as a joint project with the French competition authority CNIL regarding algorithms in the digital economy and their competitive effects. Back to Top 7.2       Cartel Damages Over the past few years, antitrust damages law has advanced in Germany and the European Union. One major legislative development was the EU Directive on actions for damages for infringements of competition law, which was implemented in Germany as part of the 9th amendment to the German Act against Restraints of Competition (Gesetz gegen Wettbewerbsbeschränkungen -GWB). In addition, there has also been some noteworthy case law concerning antitrust damages. To begin with, the German Federal Supreme Court (Bundesgerichtshof, BGH) strengthened the position of plaintiffs suing for antitrust damages in its decision Grauzementkartell II in 2018. The decision brought to an end an ongoing dispute between several Higher District Courts and District Courts, which had disagreed over whether a recently added provision of the GWB that suspends the statute of limitations in cases where antitrust authorities initiate investigations would also apply to claims that arose before the amendment entered into force (July 1, 2015). The Federal Supreme Court affirmed the suspension of the statute of limitations, basing its ruling on a well-established principle of German law regarding the intertemporal application of statutes of limitation. The decision concerns numerous antitrust damage suits, including several pending cases concerning trucks, rails tracks, and sugar cartels. Furthermore, recent case law shows that European domestic courts interpret arbitration agreements very broadly and also enforce them in cases involving antitrust damages. In 2017, the England and Wales High Court and the District Court Dortmund (Landgericht Dortmund) were presented with two antitrust disputes where the parties had agreed on an arbitration clause. Both courts denied jurisdiction because the antitrust damage claims were also covered by the arbitration agreements. They argued that the parties could have asserted claims for contractual damages instead, which would have been covered by the arbitration agreement. In the courts’ view, it would be unreasonable, however, if the choice between asserting a contractual or an antitrust claim would give the parties the opportunity to influence the jurisdiction of a court. As a consequence, the use of arbitration clauses (in particular if inconsistently used by suppliers or purchasers) may add significant complexity to antitrust damages litigation going forward. Thus, companies are well advised to examine their international supply agreements to determine whether included arbitration agreements will also apply to disputes about antitrust damages. Back to Top 7.3       Appeals against Fines Risky? In German antitrust proceedings, there is increasing pressure for enterprises to settle. Earlier this year, Radeberger, a producer of lager beer, withdrew its appeal against a significant fine of EUR 338 million, which the Bundeskartellamt had imposed on the company for its alleged participation in the so-called “beer cartel”. With this dramatic step, Radeberger paid heed to a worrisome development in German competition law. Repeatedly, enterprises have seen their cartel fines increased by staggering amounts on appeal (despite such appeals sometimes succeeding on some substantive legal issues). The reason for these “appeals for the worse” – as seen in the liquefied gas cartel (increase of fine from EUR 180 million to EUR 244 million), the sweets cartel (average increase of approx. 50%) and the wallpaper cartel (average increase of approx. 35%) – is the different approach taken by the Bundeskartellamt and the courts to calculating fines. As courts are not bound by the administrative practice of the Bundeskartellamt, many practitioners are calling for the legislator to step in and address the issue. Back to Top 7.4       Luxury Products on Amazon – The Coty Case In July 2018, the Frankfurt Higher District Court (Oberlandesgericht Frankfurt) delivered its judgement in the case Coty / Parfümerie Akzente, ruling that Coty, a luxury perfume producer, did not violate competition rules by imposing an obligation on its selected distributors to not sell on third-party platforms such as Amazon. The judgment followed an earlier decision of the Court of Justice of the European Union (ECJ) of December 2017, by which the ECJ had replied to the Frankfurt court’s referral. The ECJ had held that a vertical distribution agreement (such as the one in place between Coty and its distributor Parfümerie Akzente) did not as such violate Art. 101 of the Treaty on the Functioning of the European Union (TFEU) as long as the so-called Metro criteria were fulfilled. These criteria stipulate that distributors must be chosen on the basis of objective and qualitative criteria that are applied in a non-discriminatory fashion; that the characteristics of the product necessitate the use of a selective distribution network in order to preserve their quality; and, finally, that the criteria laid down do not go beyond what is necessary. Regarding the platform ban in question, the ECJ held that it was not disproportionate. Based on the ECJ’s interpretation of the law, the Frankfurt Higher District Court confirmed that the character of certain products may indeed necessitate a selective distribution system in order to preserve their prestigious reputation, which allowed consumers to distinguish them from similar goods, and that gaps in a selective distribution system (e.g. when products are sold by non-selected distributors) did not per se make the distribution system discriminatory. The Higher District Court also concluded that the platform ban in question was proportional. However, interestingly, it did not do so based on its own reasoning but based on the fact that the ECJ’s detailed analysis did not leave any scope for its own interpretation and, hence, precluded the Higher District Court from applying its own reasoning. Pointing to the European Commission’s E-Commerce Sector Inquiry, according to which sales platforms play a more important role in Germany than in other EU Member States, the Higher District Court, in fact, voiced doubts whether Coty’s sales ban could not have been imposed in a less interfering manner. Back to Top 8.         Litigation 8.1       The New German “Class Action” On November 1, 2018, a long anticipated amendment to the German Code of Civil Procedure (Zivilprozessordnung, ZPO) entered into force, introducing a new procedural remedy for consumers to enforce their rights in German courts: a collective action for declaratory relief. Although sometimes referred to as the new German “class action,” this new German action reveals distinct differences to the U.S.-American remedy. Foremost, the right to bring the collective action is limited to consumer protection organizations or other “qualified institutions” (qualifizierte Einrichtung) who can only represent “consumers” within the meaning of the German Code of Civil Procedure. In addition, affected consumers are not automatically included in the action as part of a class but must actively opt-in by registering their claims in a “claim index” (Klageregister). Furthermore, the collective action for declaratory relief does not grant any monetary relief to the plaintiffs which means that each consumer still has to enforce its claim in an individual suit to receive compensation from the defendant. Despite these differences, the essential and comparable element of the new legal remedy is its binding effect. Any other court which has to decide an individual dispute between the defendant and a registered consumer that is based on the same facts as the collective action is bound by the declaratory decision of the initial court. At the same time, any settlement reached by the parties has a binding effect on all registered consumers who did not decide to specifically opt-out. As a result, companies must be aware of the increased litigation risks arising from the introduction of the new collective action for declaratory relief. Even though its reach is not as extensive as the American class action, consumer protection organizations have already filed two proceedings against companies from the automotive and financial industry since the amendment has entered into force in November 2018, and will most likely continue to make comprehensive use of the new remedy in the future. Back to Top 8.2       The New 2018 DIS Arbitration Rules On March 1, 2018, the new 2018 DIS Arbitration Rules of the German Arbitration Institute (DIS) entered into force. The update aims to make Germany more attractive as a place for arbitration by adjusting the rules to international standards, promoting efficiency and thereby ensuring higher quality for arbitration proceedings. The majority of the updated provisions and rules are designed to accelerate the proceedings and thereby make arbitration more attractive and cost-effective for the parties. There are several new rules on time limitations and measures to enhance procedural efficiency, i.e. the possibility of expedited proceedings or the introduction of case management conferences. Furthermore, the rules now also allow for consolidation of several arbitrations and cover multi-party and multi-contract arbitration. Another major change is the introduction of the DIS Arbitration Council which, similar to the Arbitration Council of the ICC (International Chamber of Commerce), may decide upon challenges of an arbitrator and review arbitral awards for formal defects. This amendment shows that the influence of DIS on their arbitration proceedings has grown significantly. All in all, the modernized 2018 DIS Arbitration Rules resolve the deficiencies of their predecessor and strengthen the position of the German Institution of Arbitration among competing arbitration institutions. Back to Top 9.         IP & Technology – Draft Bill of German Trade Secret Act The EU Trade Secrets Directive (2016/943/EU) on the protection of undisclosed know-how and business information (trade secrets) against their unlawful acquisition, use and disclosure has already been in effect since July 5, 2016. Even though it was supposed to be implemented into national law by June 9, 2018 to harmonize the protection of trade secrets in the EU, the German legislator has so far only prepared and published a draft of the proposed German Trade Secret Act. Arguably, the most important change in the draft bill to the existing rules on trade secrets in Germany will be a new and EU-wide definition of trade secrets. This proposed definition requires the holder of a trade secret to take reasonable measures to keep a trade secret confidential in order to benefit from its protection – e.g. by implementing technical, contractual and organizational measures that ensure secrecy. This requirement goes beyond the current standard pursuant to which a manifest interest in keeping an information secret may be sufficient. Furthermore, the draft bill provides for additional protection of trade secrets in litigation matters. Last but not least, the draft bill also provides for increased protection of whistleblowers by reducing the barriers for the disclosure of trade secrets in the public interest and to the media. As a consequence, companies would be advised to review their internal procedures and policies regarding the protection of trade secrets at this stage, and may want to adapt their existing whistleblowing and compliance-management-systems as appropriate. Back to Top 10.       International Trade, Sanctions and Export Controls – The Conflict between Complying with the Re-Imposed U.S. Iran Sanctions and the EU Blocking Statute On May 8, 2018, President Donald Trump announced his decision to withdraw from the Joint Comprehensive Plan of Action (JCPOA) and re-impose U.S. nuclear-related sanctions. Under the JCPOA, General License H had permitted U.S.-owned or -controlled non-U.S. entities to engage in business with Iran. But with the end of the wind-down periods provided for in President Trump’s decision on November 5, 2018, such non-U.S. entities are now no longer broadly permitted to provide goods, services, or financing to Iranian counterparties, not even under agreements executed before the U.S. withdrawal from the JCPOA. In response to the May 8, 2018 decision, the EU amended the EU Blocking Statute on August 6, 2018. The effect of the amended EU Blocking Statute is to prohibit compliance by so-called EU operators with the re-imposed U.S. sanctions on Iran. Comparable and more generally drafted anti-blocking statutes had already existed in the EU and several of its member states which prohibited EU domiciled companies to commit to compliance with foreign boycott regulations. These competing obligations under EU and U.S. laws are a concern for U.S. companies that own or seek to acquire German companies that have a history of engagement with Iran – as well as for the German company itself and its management and the employees. But what does the EU prohibition against compliance with the re-imposed U.S. sanctions on Iran mean in practice? Most importantly, it must be noted that the EU Blocking Statute does not oblige EU operators to start or continue Iran related business. If, for example, an EU operator voluntarily decides, e.g. due to lack of profitability, to cease business operations in Iran and not to demonstrate compliance with the U.S. sanctions, the EU Blocking Statute does not apply. Obviously, such voluntary decision must be properly documented. Procedural aspects also remain challenging for companies: In the event a Germany subsidiary of a U.S. company were to decide to start or continue business with Iran, it would usually be required to reach out to the U.S. authorities to request a specific license for a particular transaction with Iran. Before doing so, however, EU operators must first contact the EU Commission directly (not the EU member state authorities) to request authorization to apply for such a U.S. special license. Likewise, if a Germany subsidiary were to decide not to start or to cease business with Iran for the sole reason of being compliant with the re-imposed U.S. Iran sanctions, it would have to apply for an exception from the EU Blocking Statute and would have to provide sufficient evidence that non-compliance would cause serious damage to at least one protected interest. The hurdles for an exception are high and difficult to predict. The EU Commission will e.g. consider, “(…) whether the applicant would face significant economic losses, which could for example threaten its viability or pose a serious risk of bankruptcy, or the security of supply of strategic goods or services within or to the Union or a Member State and the impact of any shortage or disruption therein.” As such, any company caught up in this conflict of interests between the re-imposed U.S. sanctions and the EU Blocking Statute should be aware of a heightened risk of litigation. Third parties, such as Iranian counterparties, might successfully sue for breach of contract with the support of the EU Blocking Regulation in cases of non-performance of contracts as a result of the re-imposed U.S. nuclear sanctions. Finally, EU operators are required to inform the EU Commission within 30 days from the date on which information is obtained that the economic and/or financial interests of the EU operator are affected, directly or indirectly, by the re-imposed U.S. Iran sanctions. If the EU operator is a legal person, this obligation is incumbent on its directors, managers and other persons with management responsibilities of such legal person. Back to Top The following Gibson Dunn lawyers assisted in preparing this client update:  Birgit Friedl, Marcus Geiss, Silke Beiter, Lutz Englisch, Daniel Gebauer, Kai Gesing, Maximilian Hoffmann, Philipp Mangini-Guidano, Jens-Olrik Murach, Markus Nauheim, Dirk Oberbracht, Richard Roeder, Martin Schmid, Annekatrin Schmoll, Jan Schubert, Benno Schwarz, Balthasar Strunz, Michael Walther, Finn Zeidler, Mark Zimmer, Stefanie Zirkel and Caroline Ziser Smith. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. The two German offices of Gibson Dunn in Munich and Frankfurt bring together lawyers with extensive knowledge of corporate, tax, labor, real estate, antitrust, intellectual property law and extensive compliance / white collar crime experience. The German offices are comprised of seasoned lawyers with a breadth of experience who have assisted clients in various industries and in jurisdictions around the world. Our German lawyers work closely with the firm’s practice groups in other jurisdictions to provide cutting-edge legal advice and guidance in the most complex transactions and legal matters. For further information, please contact the Gibson Dunn lawyer with whom you work or any of the following members of the German offices: General Corporate, Corporate Transactions and Capital Markets Lutz Englisch (+49 89 189 33 150), lenglisch@gibsondunn.com) Markus Nauheim (+49 89 189 33 122, mnauheim@gibsondunn.com) Ferdinand Fromholzer (+49 89 189 33 121, ffromholzer@gibsondunn.com) Dirk Oberbracht (+49 69 247 411 510, doberbracht@gibsondunn.com) Wilhelm Reinhardt (+49 69 247 411 520, wreinhardt@gibsondunn.com) Birgit Friedl (+49 89 189 33 180, bfriedl@gibsondunn.com) Silke Beiter (+49 89 189 33 121, sbeiter@gibsondunn.com) Marcus Geiss (+49 89 189 33 122, mgeiss@gibsondunn.com) Annekatrin Pelster (+49 69 247 411 521, apelster@gibsondunn.com Finance, Restructuring and Insolvency Sebastian Schoon (+49 89 189 33 160, sschoon@gibsondunn.com) Birgit Friedl (+49 89 189 33 180, bfriedl@gibsondunn.com) Alexander Klein (+49 69 247 411 518, aklein@gibsondunn.com) Marcus Geiss (+49 89 189 33 122, mgeiss@gibsondunn.com) Tax Hans Martin Schmid (+49 89 189 33 110, mschmid@gibsondunn.com) Labor Law Mark Zimmer (+49 89 189 33 130, mzimmer@gibsondunn.com) Real Estate Peter Decker (+49 89 189 33 115, pdecker@gibsondunn.com) Daniel Gebauer (+49 89 189 33 115, dgebauer@gibsondunn.com) Technology Transactions / Intellectual Property / Data Privacy Michael Walther (+49 89 189 33 180, mwalther@gibsondunn.com) Kai Gesing (+49 89 189 33 180, kgesing@gibsondunn.com) Corporate Compliance / White Collar Matters Benno Schwarz (+49 89 189 33 110, bschwarz@gibsondunn.com) Michael Walther (+49 89 189 33 180, mwalther@gibsondunn.com) Mark Zimmer (+49 89 189 33 130, mzimmer@gibsondunn.com) Finn Zeidler (+49 69 247 411 530, fzeidler@gibsondunn.com) Antitrust Michael Walther (+49 89 189 33 180, mwalther@gibsondunn.com) Jens-Olrik Murach (+32 2 554 7240, jmurach@gibsondunn.com) Kai Gesing (+49 89 189 33 180, kgesing@gibsondunn.com) Litigation Michael Walther (+49 89 189 33 180, mwalther@gibsondunn.com) Mark Zimmer (+49 89 189 33 130, mzimmer@gibsondunn.com) Finn Zeidler (+49 69 247 411 530, fzeidler@gibsondunn.com) Kai Gesing (+49 89 189 33 180, kgesing@gibsondunn.com) International Trade, Sanctions and Export Control Michael Walther (+49 89 189 33 180, mwalther@gibsondunn.com) Richard Roeder (+49 89 189 33 218, rroeder@gibsondunn.com) © 2019 Gibson, Dunn & Crutcher LLP, 333 South Grand Avenue, Los Angeles, CA 90071 Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

November 28, 2018 |
Law360 Names Eight Gibson Dunn Partners as MVPs

Law360 named eight Gibson Dunn partners among its 2018 MVPs and noted that the firm had the most MVPs of any law firms this year.  Law360 MVPs feature lawyers who have “distinguished themselves from their peers by securing hard-earned successes in high-stakes litigation, complex global matters and record-breaking deals.” Gibson Dunn’s MVPs are: Christopher Chorba, a Class Action MVP [PDF] – Co-Chair of the firm’s Class Actions Group and a partner in our Los Angeles office, he defends class actions and handles a broad range of complex commercial litigation with an emphasis on claims involving California’s Unfair Competition and False Advertising Laws, the Consumers Legal Remedies Act, the Lanham Act, and the Class Action Fairness Act of 2005. His litigation and counseling experience includes work for companies in the automotive, consumer products, entertainment, financial services, food and beverage, social media, technology, telecommunications, insurance, health care, retail, and utility industries. Michael P. Darden, an Energy MVP [PDF] – Partner in charge of the Houston office, Mike focuses his practice on international and U.S. oil & gas ventures and infrastructure projects (including LNG, deep-water and unconventional resource development projects), asset acquisitions and divestitures, and energy-based financings (including project financings, reserve-based loans and production payments). Thomas H. Dupree Jr., an MVP in Transportation [PDF] –  Co-partner in charge of the Washington, DC office, Tom has represented clients in a wide variety of trial and appellate matters, including cases involving punitive damages, class actions, product liability, arbitration, intellectual property, employment, and constitutional challenges to federal and state statutes.  He has argued more than 80 appeals in the federal courts, including in all 13 circuits as well as the United States Supreme Court. Joanne Franzel, a Real Estate MVP [PDF] – Joanne is a partner in the New York office, and her practice has included all forms of real estate transactions, including acquisitions and dispositions and financing, as well as office and retail leasing with anchor, as well as shopping center tenants. She also has represented a number of clients in New York City real estate development, representing developers as well as users in various mixed-use projects, often with a significant public/private component. Matthew McGill, an MVP in the Sports category [PDF] – A partner in the Washington, D.C. office, Matt practices appellate and constitutional law. He has participated in 21 cases before the Supreme Court of the United States, prevailing in 16. Spanning a wide range of substantive areas, those representations have included several high-profile triumphs over foreign and domestic sovereigns. Outside the Supreme Court, his practice focuses on cases involving novel and complex questions of federal law, often in high-profile litigation against governmental entities. Mark A. Perry, an MVP in the Securities category [PDF] – Mark is a partner in the Washington, D.C. office and is Co-chair of the firm’s Appellate and Constitutional Law Group.  His practice focuses on complex commercial litigation at both the trial and appellate levels. He is an accomplished appellate lawyer who has briefed and argued many cases in the Supreme Court of the United States. He has served as chief appellate counsel to Fortune 100 companies in significant securities, intellectual property, and employment cases.  He also appears frequently in federal district courts, serving both as lead counsel and as legal strategist in complex commercial cases. Eugene Scalia, an Appellate MVP [PDF] – A partner in the Washington, D.C. office and Co-Chair of the Administrative Law and Regulatory Practice Group, Gene has a national practice handling a broad range of labor, employment, appellate, and regulatory matters. His success bringing legal challenges to federal agency actions has been widely reported in the legal and business press. Michael Li-Ming Wong, an MVP in Cybersecurity and Privacy [PDF] – Michael is a partner in the San Francisco and Palo Alto offices. He focuses on white-collar criminal matters, complex civil litigation, data-privacy investigations and litigation, and internal investigations. Michael has tried more than 20 civil and criminal jury trials in federal and state courts, including five multi-week jury trials over the past five years.

November 26, 2018 |
FERC Issues Proposed Rule on Return of Excess ADITs by Electric Utilities

Click for PDF On November 15, 2018, the Federal Energy Regulatory Commission (“FERC”) issued a Notice of Proposed Rulemaking (“NOPR”) addressing how electric utilities are to modify their cost-based rates to account for the impact of the Tax Cuts and Jobs Act of 2017 on accumulated deferred income taxes (“ADITs”).  FERC’s prior orders related to tax reform had deferred action on how to treat ADITs. FERC-jurisdictional transmission providers have billions of dollars of ADITs recorded on their books and the return of excess ADITs resulting from the Tax Act could return billions of dollars to ratepayers in coming years.  FERC’s rulemaking proceeding should provide guidance on how utilities are to address these ADITs, but the details will likely only be decided in company-specific proceedings initiated in the next year or so. ADITs are values recorded on the books of utilities that arise from the differences between the accelerated rates of depreciation used to calculate federal corporate income taxes and straight-line depreciation used to calculate FERC jurisdictional cost-based rates.  ADITs are generally liabilities that reflect money that will need to be paid to the IRS in the future and are based on an assumption that current income tax rates will remain the same. If federal corporate income tax rates fall, however, the amount the utility will actually need to pay to the IRS in the future is less than what was assumed.  And, as a result, the utility will be viewed as having over-collected from customers in the past.  In accounting parlance, the utility will be considered to have recovered “excess ADITs” through rates that, in the view of many, will need to be returned to customers, lest the utility enjoy a windfall from the tax cut that is not shared with customers. Indeed, this is the view taken by FERC in its NOPR.  It proposes to require utilities with formula transmission rates to adjust their rates to reflect the impact of the Tax Act on ADITs, whether that means returning excess ADITs to ratepayers or collecting deficient ADITs from ratepayers (though the former is likely to eclipse the latter for most utilities). Specifically, FERC proposes requiring such utilities to include a mechanism in their formula transmission rates that deducts any excess ADITs from rate base (or adds any deficient ADITs to rate base).  Notably, FERC states in the NOPR that it does not intend to adopt a “one size fits all” approach.  Instead, it intends to “allow public utilities to propose any necessary changes to their formula rates on an individual basis.” FERC also proposes that these utilities include a mechanism to decrease (or increase) any income tax allowances—i.e., a mechanism that provides for the return to or collection of excess or deficient ADITs from ratepayers over time.  In keeping with its approach of allowing flexibility, FERC does not propose any specific period of time but, instead, states that a “case-by-case approach to amortizing excess or deficient unprotected ADIT remains appropriate.”  Following this case-by-case approach, shortly before the NOPR issued, FERC approved a proposal by Emera Maine to return unprotected excess ADITs to customers over a period of 10 years. For utilities with stated transmission rates, however, FERC does not propose to require rate base adjustments prior to their next rate case.  But it does propose to require that such utilities determine their excess and deficient ADITs and propose in compliance filings a manner to return or recover these amounts from ratepayers. FERC-regulated transmission providers appear to have billions of dollars of ADITs recorded on their books.  Assuming FERC’s final rule generally follows its proposal, these utilities will likely need to return billions of dollars in excess ADITs.  But the precise manner in which this is done—and importantly the period of time over which excess ADITs will be returned—will likely be resolved only in company specific proceedings in the future. These proceedings are likely to be contentious at times, as customers will generally push for a faster return, but at the same time will need to balance that speed against future rate shock once the amortization is complete.  FERC recently approved Emera Maine’s request to return unprotected excess ADITs over 10 years, finding that doing so “balances passing through the benefits of the Tax Cuts and Jobs Act to ratepayers in a timely manner with avoiding rate shock.”  Whether other utilities will propose similar or different periods, and how FERC will respond, remains to be seen. The deadline for comments on the NOPR (issued in Docket No. RM19-5-000) is December 24, 2018.  FERC proposes that compliance filings be due within 90 days of the date of any Final Rule. *   *   *   * Gibson Dunn was counsel to Emera Maine in the matter noted above. Gibson Dunn’s Energy, Regulation and Litigation lawyers are available to assist in addressing any questions you may have regarding the developments discussed above.  To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work, or the authors: William S. Scherman – Washington, D.C. (+1 202-887-3510, wscherman@gibsondunn.com) Jeffrey M. Jakubiak – New York (+1 212-351-2498, jjakubiak@gibsondunn.com) Jennifer C. Mansh – Washington, D.C. (+1 202-955-8590, jmansh@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.

November 21, 2018 |
Gibson Dunn Ranked in the 2019 UK Legal 500

The UK Legal 500 2019 ranked Gibson Dunn in 13 practice areas and named six partners as Leading Lawyers. The firm was recognized in the following categories: Corporate and Commercial: Equity Capital Markets Corporate and Commercial: M&A – Upper Mid-Market and Premium Deals, £250m+ Corporate and Commercial: Private Equity – High-value Deals Dispute Resolution: Commercial Litigation Dispute Resolution: International Arbitration Finance: Acquisition Finance Finance: Bank Lending: Investment Grade Debt and Syndicated Loans Human Resources: Employment – Employers Public Sector: Administrative and Public Law Real Estate: Commercial Property – Hotels and Leisure Real Estate: Commercial Property – Investment Real Estate: Property Finance Risk Advisory: Regulatory Investigations and Corporate Crime The partners named as Leading Lawyers are Sandy Bhogal – Corporate and Commercial: Corporate Tax; Steve Thierbach – Corporate and Commercial: Equity Capital Markets; Philip Rocher – Dispute Resolution: Commercial Litigation; Cyrus Benson – Dispute Resolution: International Arbitration; Jeffrey Sullivan – Dispute Resolution: International Arbitration; and Alan Samson – Real Estate: Commercial Property and Real Estate: Property Finance. Claibourne Harrison has also been named as a Next Generation Lawyer for Real Estate: Commercial Property.

November 1, 2018 |
U.S. News – Best Lawyers® Awards Gibson Dunn 132 Top-Tier Rankings

U.S. News – Best Lawyers® awarded Gibson Dunn Tier 1 rankings in 132 practice area categories in its 2019 “Best Law Firms” [PDF] survey. Overall, the firm earned 169 rankings in nine metropolitan areas and nationally. Additionally, Gibson Dunn was recognized as “Law Firm of the Year” for Litigation – Antitrust and Litigation – Securities. Firms are recognized for “professional excellence with persistently impressive ratings from clients and peers.” The recognition was announced on November 1, 2018.

October 31, 2018 |
Amendments to Section 205 of the Federal Power Act May Not Have Intended Result

Click for PDF Last week, President Trump signed into law the America’s Water Infrastructure Act of 2018 (the “Act”) that, among other things, amends Section 205 of the Federal Power Act to make it easier to challenge new electric transmission rates for utilities regulated by the Federal Energy Regulatory Commission (“FERC” or “the Commission”). In recent years problems have arisen when the FERC Commissioners are evenly split on an issue (i.e., two-to-two with one Commissioner seat vacant) and when the Commission lacks a quorum of Commissioners (i.e., three or four Commissioner seats are vacant).  In either case, the Commission is unable to issue an order on the merits and thus the Section 205 applications are deemed accepted as a matter of law after 60 days.  Also problematic in these instances is that, because there is no written order, there is nothing to appeal.  Congress passed the Act to, among other things, address this problem and allow for an appeals process. Under Section 205 of the Federal Power Act, absent waiver, FERC-jurisdictional electric utilities must give the Commission and the public 60-days’ notice of any proposed changes to the rates, terms and conditions for transmission service or wholesale sales of electricity.  16 U.S.C. § 824d.  In that 60-day period, the Commission may issue an order accepting, amending, or rejecting the proposed rates, terms and conditions.  It may also take other action such as ordering a trial-like hearing.  Entities displeased with the order may appeal it to the federal courts, but only after they have sought and the Commission has denied a request for rehearing. If the Commission takes no action in that 60-day period, then the rates become effective automatically but, without a written order from the Commission.  This has happened only rarely.  But if it does happen, and there is no written order, then there is no order upon which to request rehearing and thus no avenue for seeking judicial appeal. In recent years there have been multiple prolonged vacancies at the Commission, resulting in either a lack of quorum or two-to-two splits on a matter.  As a result, there may be instances in which the Commissioners are split two-to-two and thus are unable to act upon a Section 205 filing within the statutory 60-day period. This problem first gained lawmakers’ attention after a contentious ISO New England capacity auction in 2014 whose results were filed with FERC for approval under Section 205.  At that time, FERC had four Commissioners who were split two-to-two on whether to approve the auction results.  Consequently, the auction results went into effect by default when the 60-day notice period expired and there was no order for aggrieved parties to challenge before the Commission or in court.  See Notice of Filing Taking Effect by Operation of Law, ISO New England Inc., Docket No. ER14-1409-000 (Sept. 16, 2014). The Act amends Section 205 of the Federal Power Act to address similar results when the Commission is split “two against two . . . as a result of vacancy, incapacity, or recusal, or if the Commission lacks a quorum.”  In those circumstances, the new law provides that “the failure to issue an order accepting or denying” a changed rate “shall be considered to be an order issued by the Commission accepting the change,” and requires each Commissioner to issue a written statement with his or her views on the change.  In addition, the Act provides that if “the Commission fails to act on the merits of the rehearing request [within 30 days] because the Commissioners are divided two against two . . . or if the Commission lacks a quorum, such person may appeal [to federal court].”  This language appears in the new Section 205(g). Perhaps unintentionally, the amended law does not fully resolve the problem Congress seeks to correct as there are at least two ways in which the objective can still be undermined.  Importantly, while the Act permits a path forward towards filing an appeal, entities remain statutorily required to first file requests for rehearing.  In instances where the Commission is divided two-to-two, it could issue a tolling order on the request for rehearing (which is very often done), and this order would indefinitely toll the statutory deadline for issuing a decision on the rehearing request.  Notably, these circumstances are only present when the Commission is split two-to-two, and do not apply when the Commission lacks a quorum. If FERC instead wishes to “kick the can down the road” until five Commissioners are seated, it can issue an order tolling the 30-day deadline and explicitly stating that it needs more time to deliberate and that it is not issuing the tolling order due to a two-to-two split but instead is doing so for some other reason.  Because the new language in Section 205(g) applies only when the Commission fails to issue an order due to a two-to-two split, a tolling order that is specifically not issued for that reason would fall outside the new law’s purview.  The rehearing request could remain undecided and un-appealable indefinitely. A second, thornier problem could arise if a four-member Commission issues a tolling order for a rehearing request but does not explain why it is being issued.  This is a likely scenario, as most tolling orders are brief and boilerplate.  An aggrieved party could interpret FERC’s silence to mean that the Commission is divided two-to-two on the merits.  Accordingly, that party could understand that the new Section 205(g) applies and that the rehearing request is denied as a matter of law after 30 days pass without a FERC order on the merits, and seek judicial review.  The court would need to decide whether it has jurisdiction under the new law, and in turn decide novel questions like whether the challenging party or FERC has the burden to prove that the Commission did or did not issue the tolling order due to a two-to-two split. Because the Commission is currently short a member, and there may be prolonged periods in the future when the Commission lacks five members, the coming months may test the new law’s efficacy. Gibson Dunn’s Energy, Regulation and Litigation lawyers are available to assist in addressing any questions you may have regarding the developments discussed above.  To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work, or the authors: William S. Scherman – Washington, D.C. (+1 202-887-3510, wscherman@gibsondunn.com) Jeffrey M. Jakubiak – New York (+1 212-351-2498, jjakubiak@gibsondunn.com) Jennifer C. Mansh – Washington, D.C. (+1 202-955-8590, jmansh@gibsondunn.com) Amy E. Mersol-Barg – Washington, D.C. (+1 202-955-8529, amersolbarg@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 18, 2018 |
Gibson Dunn Named Among “Fearsome Foursome” and Litigation Powerhouses Lists by BTI Consulting Group

BTI Consulting Group named Gibson Dunn to “The BTI Fearsome Foursome – the most feared law firms in litigation.” [PDF] The list featured four firms that “stand out for their new, unexpected, and winning strategies,” “start off with a show of force,” “cut through complexity swiftly and decisively,” and are “unrelenting in meeting their client’s goal.” The report also recognized the firm as one of five Complex Commercial Powerhouses, one of five Complex Employment Powerhouses and a Securities and Finance Standout. The BTI Litigation Outlook 2019 report was released on October 18, 2018.

October 24, 2018 |
Third Quarter 2018 Update on Class Actions

Click for PDF This update provides an overview and summary of significant class action developments during the third quarter of 2018 (July through September), as well as a brief look ahead to some of the key class action issues anticipated for the end of 2018 and into 2019. Part I covers the class action cases on the U.S. Supreme Court’s docket this Term. Part II reviews several decisions from the federal courts of appeals relating to the interplay between class actions and arbitration agreements, including Gibson Dunn’s recent win before the Ninth Circuit in O’Connor v. Uber Technologies. Part III highlights two decisions that have created circuit splits on important issues of class action procedure. Part IV wraps up with a discussion of a new Ninth Circuit decision on the amount-in-controversy requirement in the Class Action Fairness Act (CAFA). I.   The U.S. Supreme Court Is Hearing Argument on Arbitration Issues and Will Consider Several Other Class Action Cases As previewed in our first and second quarter 2018 updates, an eight-member U.S. Supreme Court heard argument on October 3, 2018 in New Prime Inc. v. Oliveira (No. 17‑340).  (Gibson Dunn represents the petitioner, New Prime Inc.) The Court—now with all nine members—will also hear argument in three other cases involving arbitration or class action issues in late October, as previewed in our first and second quarter 2018 updates and 2018 Supreme Court Roundup.  On October 29, the Court will hear argument in Lamps Plus, Inc. v. Varela (No. 17‑988), to decide whether the Federal Arbitration Act forecloses a state-law interpretation of an arbitration agreement that authorizes class arbitration based on general language commonly used in such agreements.  The same day, argument will be held in Henry Schein, Inc. v. Archer & White Sales, Inc. (No. 17-1272), which concerns whether a court can decline to enforce an agreement delegating questions of arbitrability to an arbitrator if the court concludes that the claim of arbitrability is “wholly groundless.”  And on October 31, in Frank v. Gaos (No. 17-961), the Court will consider the validity of cy pres-only settlements that provide no direct compensation to class members. The Court also added another class action case to its docket in September, Home Depot U.S.A., Inc. v. Jackson (No. 17-1471), which presents two questions regarding the permissibility of removal to federal court under CAFA:  (a) whether CAFA’s statement that “any defendant” may remove an action permits removal by a party that was brought into the suit when an original named defendant filed a counterclaim, and (b) whether the Supreme Court’s holding in Shamrock Oil & Gas Co. v. Sheets, 313 U.S. 100 (1941)—that an original plaintiff may not remove a counterclaim against it—extends to third-party counterclaim defendants.  In Home Depot, Citibank filed a state-court collection action against Jackson, and Jackson filed a counterclaim against Citibank, Home Depot, and another company, alleging class-action consumer-protection claims.  The Fourth Circuit held that Home Depot could not remove the case to federal court under CAFA because Home Depot was a counterclaim defendant, not an original defendant.  The three other circuits to have addressed this issue have also held that CAFA does not permit removal in these circumstances.  Home Depot argues that this interpretation creates an “unfortunate loophole” in CAFA’s grant of federal jurisdiction over certain class actions, allowing plaintiffs’ attorneys to keep consumer class actions out of federal court simply by bringing them as counterclaims in minor debt-collection and other state court suits.  Home Depot presents the Court with the opportunity to determine whether its precedent and CAFA’s text requires this result. II.   Several Federal Courts of Appeals Issue Significant Rulings Regarding the Interplay Between Class Actions and Arbitration Arbitration—and class arbitration in particular—continues to be actively litigated in the circuit courts. In an important decision that will have significant implications for attempts to pursue class actions notwithstanding individual arbitration agreements, the Ninth Circuit in O’Connor v. Uber Technologies, Inc., 904 F.3d 1087, 2018 WL 4568553 (9th Cir. 2018), reversed an order certifying a class of hundreds of thousands of current and former drivers alleging they were misclassified as independent contractors.  Relying on its earlier decision in Mohamed v. Uber Technologies, Inc., 848 F.3d 1201 (9th Cir. 2016), which upheld the enforceability of Uber’s arbitration agreements with drivers, the Ninth Circuit reversed the district court’s class certification orders, orders denying Uber’s motions to compel arbitration, and orders regulating Uber’s communications with drivers under Rule 23(d).  (Gibson Dunn represented Uber in O’Connor and Mohamed.) In O’Connor, the plaintiffs argued that the arbitration agreements were unenforceable because the named plaintiffs had supposedly “opted out of arbitration on behalf of the entire class,” and the agreements contained class-action waivers that violated the National Labor Relations Act.  2018 WL 4568553, at *4.  The Ninth Circuit rejected both arguments, holding that the plaintiffs’ opt-out argument—which was premised on the Georgia Supreme Court’s decision in Bickerstaff v. Suntrust Bank, 788 S.E.2d 787 (Ga. 2016)—was not supported by federal law and, in fact, “would be preempted by the FAA.”  O’Connor, 2018 WL 4568553, at *4–5.  The court also held that the plaintiffs’ NLRA argument was “extinguished” by Epic Systems Corp. v. Lewis, 138 S. Ct. 1612 (2018).  O’Connor, 2018 WL 4568553, at *5. Because the district court’s class-certification orders were premised on its erroneous finding that the arbitration agreements were unenforceable, the Ninth Circuit reversed the district court’s decisions on those issues as well, emphasizing that a class cannot be certified where drivers “entered into agreements to arbitrate their claims and . . . waive[d] their right to participate in a class action with regard to those claims.”  O’Connor, 2018 WL 4568553, at *5.  The Ninth Circuit’s decision in O’Connor makes clear that a class cannot be certified where putative class members are subject to binding arbitration agreements that include class waivers. In several other decisions this past quarter, the Tenth and Eleventh Circuits sided with the Second and Fifth Circuits in a widening split with the Third, Fourth, Sixth, and Eighth Circuits over whether the availability of class arbitration is a “question of arbitrability” that presumptively must be decided by courts in the first instance, absent clear evidence of contrary intent in the parties’ arbitration agreement. In Spirit Airlines, Inc. v. Maizes, 899 F.3d 1230 (11th Cir. 2018), the Eleventh Circuit affirmed a district court’s ruling that the availability of class arbitration was presumptively one for the court to decide, but that the parties’ arbitration agreement evidenced a clear intent to overcome that default presumption.  Id. at 1233–34.  In particular, the parties’ agreement adopted American Arbitration Association (AAA) arbitration rules, including Rule 3 of the AAA’s Supplementary Rules for Class Arbitrations, which explicitly provides that an arbitrator shall decide whether an arbitration clause permits class arbitration.  Id.  Siding with the Fifth Circuit, the Eleventh Circuit rejected the “higher burden for showing ‘clear and unmistakable’ evidence for questions of class arbitrability [relative to] . . . ordinary questions of arbitrability” adopted by the Third, Fourth, Sixth, and Eighth Circuits following Stolt-Nielsen S.A. v. AnimalFeeds Int’l Corp., 559 U.S. 662 (2010).  See Catamaran Corp. v. Towncrest Pharmacy, 864 F.3d 966, 972-73 (8th Cir. 2017) (“The risks incurred by defendants in class arbitration . . . and the difficulties presented by class arbitration . . . all demand a more particular delegation of the issue than we may otherwise deem sufficient in bilateral disputes.”); accord Chesapeake Appalachia, LLC v. Scout Petroleum, LLC, 809 F.3d 746, 762–63 (3d Cir. 2016); Dell Webb Cmtys., Inc. v. Carlson, 817 F.3d 867, 876–77 (4th Cir. 2015); Reed Elsevier, Inc. ex rel. LexisNexis Div. v. Crockett, 734 F.3d 594, 599–600 (6th Cir. 2013).  But see Wells Fargo Advisors, L.L.C. v. Sappington, 884 F.3d 392, 395 (2d Cir. 2018); Robinson v. J & K Admin. Mgmt. Servs., Inc., 817 F.3d 193, 196 (5th Cir. 2016). The Eleventh Circuit reached the same conclusion one month later in JPay, Inc. v. Kobel, 904 F.3d 923 (11th Cir. 2018), affirming a district court’s summary judgment ruling that the availability of class arbitration was presumptively one for the court to decide, but that, like Spirit Airlines, the parties’ arbitration agreement evidenced a clear intent to overcome that default presumption by adopting the AAA’s arbitration rules.  Id. at 937–40.  The court acknowledged that a plurality of the U.S. Supreme Court in Green Tree Financial Corp. v. Bazzle, 539 U.S. 444 (2003), held that whether an agreement provides for class arbitration is not a question of arbitrability, but observed that the Supreme Court has since repeatedly emphasized—in Stolt-Nielsen and Oxford Health Plans LLC v. Sutter, 569 U.S. 564 (2013)—that Bazzle was a plurality opinion and that the question remains open.  JPay, 904 F.3d at 931. Similarly, in Dish Network, L.L.C. v. Ray, 900 F.3d 1240 (10th Cir. 2018), the Tenth Circuit held that the issue of classwide arbitrability presumptively is for a court to decide, but rejected the argument that the arbitrator exceeded his authority in considering that issue and ordering class arbitration because the parties’ agreement demonstrated a clear intent to delegate the issue to the arbitrator.  As in Spirit Airlines and JPay, the parties agreed that “any claim, controversy and/or dispute between them” would be resolved through arbitration under AAA rules, which give the arbitrator authority to decide his own jurisdiction.  Id. at 1245–46. These cases serve as an important reminder to pay close attention to the terms incorporated by reference into an arbitration agreement in order to avoid inadvertently delegating key issues like classwide arbitrability to an arbitrator, whose decision may be unreviewable by a court or reviewable only under a highly deferential standard.  Also, as noted above and in our second quarter 2018 update, the Supreme Court in Lamps Plus, Inc. v. Varela (No. 17‑988), will decide whether the FAA forecloses a state-law interpretation of an arbitration agreement that would authorize class arbitration based solely on general language commonly used in such agreements.  While not explicitly teed up for resolution in Lamps Plus, the Court could weigh in on the widening split over whether the availability of classwide arbitration presumptively should be decided by a court or an arbitrator. III.   Circuit Splits Regarding Appealability of Class Action Orders After Settlement and on the Propriety of “Issue” Certification Class action procedure was another active topic this past quarter, with a Tenth Circuit decision breaking with the Ninth Circuit on the question whether class certification rulings may be appealed following settlement and voluntary dismissal of individual claims, and a Sixth Circuit decision that deepens an existing circuit split as to whether predominance is a prerequisite to “issue” certification under Rule 23(c)(4).  Ultimately, one or both of these questions may end up before the Supreme Court. In Anderson Living Trust v. WPX Energy Production, LLC, 904 F.3d 1135 (10th Cir. 2018), the Tenth Circuit held—contrary to the Ninth Circuit’s decision in Brown v. Cinemark USA, Inc., 876 F.3d 1199 (9th Cir. 2017)—that voluntary dismissal of individual claims following settlement does not convert a previous denial of class certification into a final appealable order.  In Anderson, the parties settled the plaintiffs’ individual claims two years after the district court had denied class certification.  The district court then entered a stipulated judgment dismissing the individual claims with prejudice, but reserving the plaintiffs’ right, if any, to appeal the class-certification denial.  But the Tenth Circuit dismissed the appeal, relying on the U.S. Supreme Court’s decision in Microsoft v. Baker, 137 S. Ct. 1702 (2017), which held that the federal courts of appeals lack jurisdiction “to review an order denying class certification . . . after the named plaintiffs have voluntarily dismissed their claims with prejudice.”  Id. at 1712.  The Ninth Circuit in Brown had come to the opposite conclusion, and distinguished Baker on the ground that there was a difference between dismissing claims following a settlement for consideration and dismissing claims voluntarily as a mechanism to trigger appellate review.  The Tenth Circuit, by contrast, held that distinction was illusory, and that the policy concerns articulated in Baker—the danger of protracted litigation and piecemeal appeals, preventing parties from usurping Rule 23(f), and wanting to avoid giving plaintiffs an asymmetrical advantage in seeking interlocutory review of class certification decisions—applied in both scenarios. The Sixth Circuit in Martin v. Behr Dayton Thermal Products, 896 F.3d 405 (6th Cir. 2018), added to the division among the federal courts of appeals as to whether plaintiffs must satisfy Rule 23(b)(3)’s predominance requirement for a claim as a whole when seeking “issue” certification under Rule 23(c)(4).  In Martin, a group of Ohio residents alleged that four companies had contaminated the local drinking water.  Plaintiffs sought class certification under Rule 23(b)(3), which requires that “questions of law or fact common to class members predominate over any questions affecting only individual members, and that a class action is superior to other available methods for fairly and efficiently adjudicating the controversy,” as well as Rule 23(c)(4), which provides that “[w]hen appropriate, an action may be brought or maintained as a class action with respect to particular issues.”  The district court denied certification under Rule 23(b)(3), holding that the plaintiffs could not meet that rule’s predominance requirement as to “injury-in-fact and causation,” but granted certification under Rule 23(c)(4) on seven discrete issues, including the extent of “[e]ach [d]efendant’s role in creating the contamination” at issue and “[w]hether [the d]efendants negligently failed to investigate and remediate the contamination at and flowing from their respective [f]acilities.”  Martin, 896 F.3d at 409–10. The Sixth Circuit affirmed the class certification order.  It noted the existing circuit split between the “broad” view of Rule 23(c)(4) taken by the Second, Fourth, Seventh, and Ninth Circuits, and the “narrow” view held by the Fifth and Eleventh Circuits.  According to the Sixth Circuit, under the “broad” view of Rule 23(c)(4), a district court may certify a class on specific common issues “even where predominance has not been satisfied for the cause of action as a whole,” so long as predominance and superiority are satisfied for the issues identified for class treatment.  Martin, 896 F.3d at 411–12.  The “narrow” view of Rule 23(c)(4), by contrast, “prohibits certification if predominance has not been satisfied as to the cause of action as a whole.”  Id.  The Sixth Circuit adopted the broad view, reasoning that it “respects each provision’s contribution to class determinations by maintaining Rule 23(b)(3)’s rigor without rendering Rule 23(c)(4) superfluous.”  Id. at 413.  The court also explained that the superiority requirement of Rule 23 “functions as a backstop against inefficient use of Rule 23(c)(4).”  Id. IV.   Ninth Circuit Clarifies CAFA’s Amount-In-Controversy Requirement Finally, the Ninth Circuit’s opinion in Fritsch v. Swift Transportation Co. of Arizona, LLC, 899 F.3d 785 (9th Cir. 2018), slightly relaxed the amount-in-controversy requirement for defendants seeking to remove an action to federal court under CAFA.  This holding will likely be of particular import in cases brought under Title VII and other statutes that include a fee-shifting provision for prevailing plaintiffs. Fritsch was a putative wage-and-hour class action asserting various violations of the California Labor Code.  899 F.3d at 789.  The defendant removed the case to federal court, relying on a combination of claimed damages and attorneys’ fees to meet the $5 million removal threshold under CAFA.  Id.  The district court concluded that the defendant could not include any fees beyond those that had “been incurred prior to removal,” which caused the total amount in controversy to fall below the removal threshold.  Id.  The Ninth Circuit reversed, explaining that under existing circuit precedent, while the threshold is measured “at the time of removal,” it includes “all relief claimed at the time of removal to which the plaintiff would be entitled if she prevails.”  Id. at 793 (quotation omitted).  For attorneys’ fees, this meant that district courts “must include future attorneys’ fees recoverable by statute or contract when assessing whether the amount-in-controversy requirement is met,” rather than just fees actually incurred at the time of removal.  Id. at 794.  In so ruling, the Ninth Circuit parted ways with the Seventh Circuit’s decision in Gardynski-Leschuck v. Ford Motor Co., 142 F.3d 955, 958 (7th Cir. 1998), which had held that future attorneys’ fees are too speculative to count toward the amount-in-controversy requirement for federal jurisdiction under the Magnuson-Moss Warranty Act.  Fritsch, 899 F.3d at 795.  To address the concern that future fees may be too speculative, the Ninth Circuit held that a district court must count only those future fees that the removing defendant can substantiate under a preponderance-of-the-evidence standard.  Id. at 795–96. The following Gibson Dunn lawyers prepared this client update: Christopher Chorba, Theane Evangelis, Kahn A. Scolnick, Bradley J. Hamburger, Brandon J. Stoker, Lauren M. Blas, David Schnitzer, Jessica Culpepper, Gatsby Miller, and Timothy Kolesk. Gibson Dunn attorneys are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Class Actions or Appellate and Constitutional Law practice groups, or any of the following lawyers: Theodore J. Boutrous, Jr. – Co-Chair, Litigation Practice Group – Los Angeles (+1 213-229-7000, tboutrous@gibsondunn.com) Christopher Chorba – Co-Chair, Class Actions Practice Group – Los Angeles (+1 213-229-7396, cchorba@gibsondunn.com) Theane Evangelis – Co-Chair, Class Actions Practice Group – Los Angeles (+1 213-229-7726, tevangelis@gibsondunn.com) Kahn A. Scolnick – Los Angeles (+1 213-229-7656, kscolnick@gibsondunn.com) Bradley J. Hamburger – Los Angeles (+1 213-229-7658, bhamburger@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 22, 2018 |
IRS Provides Much Needed Guidance on Opportunity Zones through Issuance of Proposed Regulations

Click for PDF On October 19, 2018, the Internal Revenue Service (the “IRS“) and the Treasury Department issued proposed regulations (the “Proposed Regulations“) providing rules regarding the establishment and operation of “qualified opportunity funds” and their investment in “opportunity zones.”[1]  The Proposed Regulations address many open questions with respect to qualified opportunity funds, while expressly providing in the preamble that additional guidance will be forthcoming to address issues not resolved by the Proposed Regulations.  The Proposed Regulations should provide investors, sponsors and developers with the answers needed to move forward with projects in opportunity zones. Opportunity Zones Qualified opportunity funds were created as part of the tax law signed into law in December 2017 (commonly known as the Tax Cuts and Jobs Act (“TCJA“)) to incentivize private investment in economically underperforming areas by providing tax benefits for investments through qualified opportunity funds in opportunity zones.  Opportunity zones are low-income communities that were designated by each of the States as qualified opportunity zones – as of this writing, all opportunity zones have been designated, and each designation remains in effect from the date of designation until the end of the tenth year after such designation. Investments in qualified opportunity funds can qualify for three principal tax benefits: (i) a temporary deferral of capital gains that are reinvested in a qualified opportunity fund, (ii) a partial exclusion of those reinvested capital gains on a sliding scale and (iii) a permanent exclusion of all gains realized on an investment in a qualified opportunity fund that is held for a ten-year period. In general, all capital gains realized by a person that are reinvested within 180 days of the recognition of such gain in a qualified opportunity fund for which an election is made are deferred for U.S. federal income tax purposes until the earlier of (i) the date on which such investment is sold or exchanged and (ii) December 31, 2026. In addition, an investor’s tax basis in a qualified opportunity fund for purposes of determining gain or loss, is increased by 10 percent of the amount of gain deferred if the investment is held for five years prior to December 31, 2026 and is increased by an additional 5 percent (for a total increase of 15 percent) of the amount of gain deferred if the investment is held for seven years prior to December 31, 2026. Finally, for investments in a qualified opportunity fund that are attributable to reinvested capital gains and held for at least 10 years, the basis of such investment is increased to the fair market value of the investment on the date of the sale or exchange of such investment, effectively eliminating any gain (other than the deferred gain that was reinvested in the qualified opportunity fund and taxable or excluded as described above) in the investment for U.S. federal income tax purposes (such benefit, the “Ten Year Benefit“). A qualified opportunity fund, in general terms, is a corporation or partnership that invests at least 90 percent of its assets in “qualified opportunity zone property,” which is defined under the TCJA as “qualified opportunity zone business property,” “qualified opportunity zone stock” and “qualified opportunity zone partnership interests.”  Qualified opportunity zone business property is tangible property used in a trade or business within an opportunity zone if, among other requirements, (i) the property is acquired by the qualified opportunity fund by purchase, after December 31, 2017, from an unrelated person, (ii) either the original use of the property in the opportunity zone commences with the qualified opportunity fund or the qualified opportunity fund “substantially improves” the property by doubling the basis of the property over any 30 month period after the property is acquired and (iii) substantially all of the use of the property is within an opportunity zone.  Essentially, qualified opportunity zone stock and qualified opportunity zone partnership interests are stock or interests in a corporation or partnership acquired in a primary issuance for cash after December 31, 2017 and where “substantially all” of the tangible property, whether leased or owned, of the corporation or partnership is qualified opportunity zone business property. The Proposed Regulations – Summary and Observations The powerful tax incentives provided by opportunity zones attracted substantial interest from investors and the real estate community, but many unresolved questions have prevented some taxpayers from availing themselves of the benefits of the law.  A few highlights from the Proposed Regulations, as well as certain issues that were not resolved, are outlined below. Capital Gains The language of the TCJA left open the possibility that both capital gains and ordinary gains (e.g., dealer income) could qualify for deferral if invested in a qualified opportunity fund.  The Proposed Regulations provide that only capital gains, whether short-term or long-term, qualify for deferral if invested in a qualified opportunity fund and further provide that when recognized, any deferred gain will retain its original character as short-term or long-term. Taxpayer Entitled to Deferral The Proposed Regulations make clear that if a partnership recognizes capital gains, then the partnership, and if the partnership does not so elect, the partners, may elect to defer such capital gains.  In addition, the Proposed Regulations provide that in measuring the 180-day period by which capital gains need to be invested in a qualified opportunity fund, the 180-day period for a partner begins on the last day of the partnership’s taxable year in which the gain is recognized, or if a partner elects, the date the partnership recognized the gain.  The Proposed Regulations also state that rules analogous to the partnership rules apply to other pass-through entities, such as S corporations. Ten Year Benefit The Ten Year Benefit attributable to investments in qualified opportunity funds will be realized only if the investment is held for 10 years.  Because all designations of qualified opportunity zones under the TCJA automatically expire no later than December 31, 2028, there was some uncertainly as to whether the Ten Year Benefit applied to investments disposed of after that date.  The Proposed Regulations expressly provide that the Ten Year Benefit rule applies to investments disposed of prior to January 1, 2048. Qualified Opportunity Funds The Proposed Regulations generally provide that a qualified opportunity fund is required to be classified as a corporation or partnership for U.S. federal income tax purposes, must be created or organized in one of the 50 States, the District of Columbia, or, in certain cases a U.S. possession, and will be entitled to self-certify its qualification to be a qualified opportunity fund on an IRS Form 8996, a draft form of which was issued contemporaneously with the issuance of the Proposed Regulations. Substantial Improvements Existing buildings in qualified opportunity zones generally will qualify as qualified opportunity zone business property only if the building is substantially improved, which requires the tax basis of the building to be doubled in any 30-month period after the property is acquired.  In very helpful rule for the real estate community, the Proposed Regulations provide that, in determining whether a building has been substantially improved, any basis attributable to land will not be taken into account.  This rule will allow major renovation projects to qualify for qualified opportunity zone tax benefits, rather than just ground up development.  This rule will also place a premium on taxpayers’ ability to sustain a challenge to an allocation of purchase price to land versus improvements. Ownership of Qualified Opportunity Zone Business Property In order for a fund to qualify as a qualified opportunity fund, at least 90 percent of the fund’s assets must be invested in qualified opportunity zone property, which includes qualified opportunity zone business property.  For shares or interests in a corporation or partnership to qualify as qualified opportunity zone stock or a qualified opportunity zone partnership interest, “substantially all” of the corporation’s or partnership’s assets must be comprised of qualified opportunity zone business property. In a very helpful rule, the Proposed Regulations provide that cash and other working capital assets held for up to 31 months will count as qualified opportunity zone business property, so long as (i) the cash and other working capital assets are held for the acquisition, construction and/or or substantial improvement of tangible property in an opportunity zone, (ii) there is a written plan that identifies the cash and other working capital as held for such purposes, and (iii) the cash and other working capital assets are expended in a manner substantially consistent with that plan. In addition, the Proposed Regulations provide that for purposes of determining whether “substantially all” of a corporation’s or partnership’s tangible property is qualified opportunity zone business property, only 70 percent of the tangible property owned or leased by the corporation or partnership in its trade or business must be qualified opportunity zone business property. Qualified Opportunity Funds Organized as Tax Partnerships Under general partnership tax principles, when a partnership borrows money, the partners are treated as contributing money to the partnership for purposes of determining their tax basis in their partnership interest.  As a result of this rule, there was uncertainty regarding whether investments by a qualified opportunity fund that were funded with debt would result in a partner being treated, in respect of the deemed contribution of money attributable to such debt, as making a contribution to the partnership that was not in respect of reinvested capital gains and, thus, resulting in a portion of such partner’s investment in the qualified opportunity fund failing to qualify for the Ten Year Benefit.  The Proposed Regulations expressly provide that debt incurred by a qualified opportunity fund will not impact the portion of a partner’s investment in the qualified opportunity fund that qualifies for the Ten Year Benefit. The Proposed Regulations did not address many of the other open issues with respect to qualified opportunity funds organized as partnerships, including whether investors are treated as having sold a portion of their interest in a qualified opportunity fund and thus can enjoy the Ten Year Benefit if a qualified opportunity fund treated as a partnership and holding multiple investments disposes of one or more (but not all) of its investments.  Accordingly, until further guidance is issued, we expect to see most qualified opportunity funds organized as single asset corporations or partnerships. Effective Date In general, taxpayers are permitted to rely upon the Proposed Regulations so long as they apply the Proposed Regulations in their entirety and in a consistent manner.    [1]   Prop. Treas. Reg. §1.1400Z-2 (REG-115420-18). Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the Tax Practice Group, or the following authors: Brian W. Kniesly – New York (+1 212-351-2379, bkniesly@gibsondunn.com) Paul S. Issler – Los Angeles (+1 213-229-7763, pissler@gibsondunn.com) Daniel A. Zygielbaum – New York (+1 202-887-3768, dzygielbaum@gibsondunn.com) Please also feel free to contact any of the following leaders and members of the Tax practice group: Jeffrey M. Trinklein – Co-Chair, London/New York (+44 (0)20 7071 4224 / +1 212-351-2344), jtrinklein@gibsondunn.com) David Sinak – Co-Chair, Dallas (+1 214-698-3107, dsinak@gibsondunn.com) David B. Rosenauer – New York (+1 212-351-3853, drosenauer@gibsondunn.com) Eric B. Sloan – New York (+1 212-351-2340, esloan@gibsondunn.com) Romina Weiss – New York (+1 212-351-3929, rweiss@gibsondunn.com) Benjamin Rippeon – Washington, D.C. (+1 202-955-8265, brippeon@gibsondunn.com) Hatef Behnia – Los Angeles (+1 213-229-7534, hbehnia@gibsondunn.com) Dora Arash – Los Angeles (+1 213-229-7134, darash@gibsondunn.com) Scott Knutson – Orange County (+1 949-451-3961, sknutson@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 18, 2018 |
FERC Issues Long-Awaited Order on Return on Equity for New England Electric Utilities

Click for PDF On October 16, 2018, the Federal Energy Regulatory Commission (“FERC”) issued a long-awaited order on the return on equity (“ROE”) to be used by electric utilities in New England for setting their transmission rates.  The order has major implications for all electric utilities—not just those in New England—because the order establishes a new methodology for reviewing and setting ROEs that will be applied to all FERC-regulated electric utilities going forward.  There is no indication in the order that FERC intends this methodology to apply to natural gas pipeline rates. In Tuesday’s order, FERC charted a wholly new course for setting ROEs by using neither a one-step or two-step discounted cash flow (“DCF”) methodology as it has used historically.  Implicitly responding to long standing criticism of the DCF model, FERC instead adopted a new approach in which it: (i) will first look to whether an existing ROE falls within a particular range of ROEs within a “zone of reasonableness” established through three separate financial models (one of which is the DCF) and then, if the ROE falls outside the range, (ii) it will establish a new ROE through application of four separate methodologies for estimating ROEs. The order was issued in four separate but related proceedings initiated by complaints filed against the New England utilities.  One of these proceedings was on remand from the U.S. Court of Appeals for the D.C. Circuit’s 2017 decision in Emera Maine v. FERC.  Three were pending before FERC on “exceptions” (i.e., appeal) from FERC administrative law judge (“ALJ”) decisions issued in 2016 and 2018. These four related cases began with a complaint filed against New England’s utilities on September 30, 2011 by Martha Coakley, the Attorney General of Massachusetts, and other entities and state agencies.  FERC set that matter for hearing before an ALJ but, on appeal of the ALJ’s decision, issued its then-seminal 2014 order in Coakley v. Bangor Hydro in which it changed its historic methodology for setting electric utility ROEs. Prior to Coakley, FERC established electric utility ROEs based on a “one-step” DCF methodology that estimated actual ROEs of publicly traded electric utilities to determine the appropriate ROE for the subject utility.  More specifically, the methodology calculated what investors in comparable utilities expected for ROEs (as evidenced by dividend yields and analyst earnings forecasts) and then set the ROE for the subject utility at either the midpoint or median of the range of ROEs of these comparable utilities (the so-called “zone of reasonableness”). In Coakley, FERC instead used a “two-step” DCF methodology to set the ROEs for the New England utilities.  This methodology, which had been used by FERC for natural gas pipelines for some time, looked not only at ROEs of comparable utilities but also at long-term economic growth forecasts.  All things being equal, the two-step methodology thus resulted in a lower ROE than the one-step methodology because long-term forecast economic growth generally is lower than ROEs imputed from divided yields and earnings forecasts.  However, in a major departure from precedent, FERC set the ROE for the New England utilities not at the median or midpoint of the zone of reasonableness, but at the midpoint of the upper half of the zone.  FERC explained that anomalous capital market conditions justified this departure from precedent. From 2012 to 2014, three additional complaints were filed against the New England utilities by a variety of entities seeking lower ROEs.  FERC set all three for hearing before ALJs.  All three resulted in ALJ decisions that were appealed up to FERC, where they remain pending, and partially rendered moot by yesterday’s FERC order. The Coakley decision was widely criticized as an opportunistic means to lowering overall returns at a time when lower interest rates were actually encouraging new infrastructure investment.  The decision was appealed to the U.S. Court of Appeals for the D.C. Circuit by both the utilities and their customers. The Court in 2017—in an order titled Emera Maine v. FERC—found in part for the utilities and in part for the customers.  Finding for the customers, the Court held that an existing ROE that falls within the zone of reasonableness is not per se just and reasonable and, thus, may be changed by FERC.  Finding for the utilities, the Court held that FERC had not adequately shown that the New England utilities’ existing ROE was unjust and reasonable.  The Court thus vacated the underlying Coakley decision and remanded the matter to FERC.  But by vacating the underlying decision, the Court gave FERC wide berth in adopting a new and revised approach to establishing ROE policy. Yesterday’s FERC order addresses the Coakley decision’s shortcomings identified by the Court in Emera Maine v. FERC by establishing a clear two-step approach to ROE complaint matters.  But it goes much further by looking beyond DCF analyses and espousing a methodology that uses multiple financial models. First, FERC proposes using three different financial models—the DCF, the CAPM, and the Expected Earnings models—to establish a zone of reasonableness of estimated ROEs enjoyed by utilities with comparable risk to that at issue (with risk generally indicated by credit ratings).  The DCF model, as noted, has historically been the sole model used by FERC to establish the zone of reasonableness and, if necessary, the new ROE; parties, however, have often presented evidence of results from the CAPM or Expected Earnings models as additional evidence seeking to support or refute the DCF results. Importantly, FERC held that if a utility’s existing ROE falls within a particular range (i.e., effectively a sub-zone) within the zone of reasonableness it will be presumed to be just and reasonable.  As a result, FERC will dismiss a complaint if the ROE falls within the range unless other evidence sufficiently rebuts that presumption.  Given the D.C. Circuit’s ruling in Emera Maine v. FERC, this part of FERC’s order will likely be challenged in court again. Second, if the existing ROE is found to be unjust and unreasonable, FERC will establish a new ROE based on four financial models—the three used to set the zone of reasonableness as well as the Risk Premium Model.  More specifically, FERC will set the new ROE at the average of (i) the midpoints or medians of the zones of reasonableness established by the DCF, the CAPM, and the Expected Earnings models and (ii) the single numerical result of the Risk Premium Model (which, like the CAPM and Expected Earnings models, has been used in FERC proceedings as additional evidence).  More detail on the models is provided in an appendix to the FERC order. As FERC applied this new methodology to the pending New England utility cases, it found that the range for evaluating the current ROE is 9.60 percent to 10.99 percent and that the pre-Coakley 11.14 percent ROE for the utilities is unjust and unreasonable.  FERC then applied the new composite methodology to setting ROEs and reached a “preliminary” finding that a 10.41 percent ROE is just and reasonable.  FERC however established a “paper hearing” and invited parties to submit briefs regarding the proposed new approach to ROEs and its application to the four New England complaint proceedings.  Initial briefs are due within 60 days of the date of the order and reply briefs are due 30 days thereafter. The order was issued by Chairman McIntryre, and Commissioners LaFleur and Chatterjee. Commissioner Glick did not participate in the decision, but no reason was given.  It is suspected that Commissioner Glick recused himself because he previously worked for Iberdrola, the parent of two of the New England electric utilities directly impacted by the order. On balance, FERC’s new approach, while complicated, appears to be a sounder approach to establishing ROEs than simply using the DCF method.  However, the order fails to specify many implementation details that will need to be hashed out in the upcoming briefing process.  How these details are determined will have a large impact on the end result of the new approach.  And all of this will likely be done in the context of rising interest rates and the need to invest in new transmission infrastructure in a number of parts of the country. Gibson Dunn’s Energy, Regulation and Litigation lawyers are available to assist in addressing any questions you may have regarding the developments discussed above.  To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work, or the authors: William S. Scherman – Washington, D.C. (+1 202-887-3510, wscherman@gibsondunn.com) Jeffrey M. Jakubiak – New York (+1 212-351-2498, jjakubiak@gibsondunn.com) Jennifer C. Mansh – Washington, D.C. (+1 202-955-8590, jmansh@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 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 10, 2018 |
Artificial Intelligence and Autonomous Systems Legal Update (3Q18)

Click for PDF We are pleased to provide the following update on recent legal developments in the areas of artificial intelligence, machine learning, and autonomous systems (or “AI” for short), and their implications for companies developing or using products based on these technologies.  As the spread of AI rapidly increases, legal scrutiny in the U.S. of the potential uses and effects of these technologies (both beneficial and harmful) has also been increasing.  While we have chosen to highlight below several governmental and legislative actions from the past quarter, the area is rapidly evolving and we will continue to monitor further actions in these and related areas to provide future updates of potential interest on a regular basis. I.       Increasing Federal Government Interest in AI Technologies The Trump Administration and Congress have recently taken a number of steps aimed at pushing AI forward on the U.S. agenda, while also treating with caution foreign involvement in U.S.-based AI technologies.  Some of these actions may mean additional hurdles for cross-border transactions involving AI technology.  On the other hand, there may also be opportunities for companies engaged in the pursuit of AI technologies to influence the direction of future legislation at an early stage. A.       White House Studies AI In May, the Trump Administration kicked off what is becoming an active year in AI for the federal government by hosting an “Artificial Intelligence for American Industry” summit as part of its designation of AI as an “Administration R&D priority.”[1] During the summit, the White House also announced the establishment of a “Select Committee on Artificial Intelligence” to advise the President on research and development priorities and explore partnerships within the government and with industry.[2]  This Select Committee is housed within the National Science and Technology Council, and is chaired by Office of Science and Technology Policy leadership. Administration officials have said that a focus of the Select Committee will be to look at opportunities for increasing federal funds into AI research in the private sector, to ensure that the U.S. has (or maintains) a technological advantage in AI over other countries.  In addition, the Committee is to look at possible uses of the government’s vast store of taxpayer-funded data to promote the development of advanced AI technologies, without compromising security or individual privacy.  While it is believed that there will be opportunities for private stakeholders to have input into the Select Committee’s deliberations, the inaugural meeting of the Committee, which occurred in late June, was not open to the public for input. B.       AI in the NDAA for 2019 More recently, on August 13th, President Trump signed into law the John S. McCain National Defense Authorization Act (NDAA) for 2019,[3] which specifically authorizes the Department of Defense to appoint a senior official to coordinate activities relating to the development of AI technologies for the military, as well as to create a strategic plan for incorporating a number of AI technologies into its defense arsenal.  In addition, the NDAA includes the Foreign Investment Risk Review Modernization Act (FIRRMA)[4] and the Export Control Reform Act (ECRA),[5] both of which require the government to scrutinize cross-border transactions involving certain new technologies, likely including AI-related technologies. FIRRMA modifies the review process currently used by the Committee on Foreign Investment in the United States (CFIUS), an interagency committee that reviews the national security implications of investments by foreign entities in the United States.  With FIRRMA’s enactment, the scope of the transactions that CFIUS can review is expanded to include those involving “emerging and foundational technologies,” defined as those that are critical for maintaining the national security technological advantage of the United States.  While the changes to the CFIUS process are still fresh and untested, increased scrutiny under FIRRMA will likely have an impact on available foreign investment in the development and use of AI, at least where the AI technology involved is deemed such a critical technology and is sought to be purchased or licensed by foreign investors. Similarly, ECRA requires the President to establish an interagency review process with various agencies including the Departments of Defense, Energy, State and the head of other agencies “as appropriate,” to identify emerging and foundational technologies essential to national security in order to impose appropriate export controls.  Export licenses are to be denied if the proposed export would have a “significant negative impact” on the U.S. defense industrial base.  The terms “emerging and foundational technologies” are not expressly defined, but it is likely that AI technologies, which are of course “emerging,” would receive a close look under ECRA and that ECRA might also curtail whether certain AI technologies can be sold or licensed to foreign entities. The NDAA also established a National Security Commission on Artificial Intelligence “to review advances in artificial intelligence, related machine learning developments, and associated technologies.”  The Commission, made up of certain senior members of Congress as well as the Secretaries of Defense and Commerce, will function independently from other such panels established by the Trump Administration and will review developments in AI along with assessing risks related to AI and related technologies to consider how those methods relate to the national security and defense needs of the United States.  The Commission will focus on technologies that provide the U.S. with a competitive AI advantage, and will look at the need for AI research and investment as well as consider the legal and ethical risks associated with the use of AI.  Members are to be appointed within 90 days of the Commission being established and an initial report to the President and Congress is to be submitted by early February 2019. C.       Additional Congressional Interest in AI/Automation While a number of existing bills with potential impacts on the development of AI technologies remain stalled in Congress,[6] two more recently-introduced pieces of legislation are also worth monitoring as they progress through the legislative process. In late June, Senator Feinstein (D-CA) sponsored the “Bot Disclosure and Accountability Act of 2018,” which is intended to address  some of the concerns over the use of automated systems for distributing content through social media.[7] As introduced, the bill seeks to prohibit certain types of bot or other automated activity directed to political advertising, at least where such automated activity appears to impersonate human activity.  The bill would also require the Federal Trade Commission to establish and enforce regulations to require public disclosure of the use of bots, defined as any “automated software program or process intended to impersonate or replicate human activity online.”  The bill provides that any such regulations are to be aimed at the “social media provider,” and would place the burden of compliance on such providers of social media websites and other outlets.  Specifically, the FTC is to promulgate regulations requiring the provider to take steps to ensure that any users of a social media website owned or operated by the provider would receive “clear and conspicuous notice” of the use of bots and similar automated systems.  FTC regulations would also require social media providers to police their systems, removing non-compliant postings and/or taking other actions (including suspension or removal) against users that violate such regulations.  While there are significant differences, the Feinstein bill is nevertheless similar in many ways to California’s recently-enacted Bot disclosure law (S.B. 1001), discussed more fully in our previous client alert located here.[8] Also of note, on September 26th, a bipartisan group of Senators introduced the “Artificial Intelligence in Government Act,” which seeks to provide the federal government with additional resources to incorporate AI technologies in the government’s operations.[9] As written, this new bill would require the General Services Administration to bring on technical experts to advise other government agencies, conduct research into future federal AI policy, and promote inter-agency cooperation with regard to AI technologies.  The bill would also create yet another federal advisory board to advise government agencies on AI policy opportunities and concerns.  In addition, the newly-introduced legislation seeks to require the Office of Management and Budget to identify ways for the federal government to invest in and utilize AI technologies and tasks the Office of Personal Management with anticipating and providing training for the skills and competencies the government requires going-forward for incorporating AI into its overall data strategy. II.       Potential Impact on AI Technology of Recent California Privacy Legislation Interestingly, in the related area of data privacy regulation, the federal government has been slower to respond, and it is the state legislatures that are leading the charge.[10] Most machine learning algorithms depend on the availability of large data sets for purpose of training, testing, and refinement.  Typically, the larger and more complete the datasets available, the better.  However, these datasets often include highly personal information about consumers, patients, or others of interest—data that can sometimes be used to predict information specific to a particular person even if attempts are made to keep the source of such data anonymous. The European Union’s General Data Protection Regulation, or GDPR, which went into force on May 25, 2018, has deservedly garnered a great deal of press as one of the first, most comprehensive collections of data privacy protections. While we’re only months into its effective period, the full impact and enforcement of the GDPR’s provisions have yet to be felt.  Still, many U.S. companies, forced to take steps to comply with the provisions of GDPR at least with regard to EU citizens, have opted to take many of those same steps here in the U.S., despite the fact that no direct U.S. federal analogue to the GDPR yet exists.[11] Rather than wait for the federal government to act, several states have opted to follow the lead of the GDPR and enact their own versions of comprehensive data privacy laws.  Perhaps the most significant of these state-legislated omnibus privacy laws is the California Consumer Privacy Act (“CCPA”), signed into law on June 28, 2108, and slated to take effect on January 1, 2020.[12]  The CCPA is not identical to the GDPR, differing in a number of key respects.  However there are many similarities, in that the CCPA also has broadly defined definitions of personal information/data, and seeks to provide a right to notice of data collection, a right of access to and correction of collected data, a right to be forgotten, and a right to data portability.  But how do the CCPA’s requirements differ from the GDPR for companies engaged in the development and use of AI technologies?  While there are many issues to consider, below we examine several of the key differences of the CCPA and their impact on machine learning and other AI-based processing of collected data. A.       Inferences Drawn from Personal Information The GDPR defines personal data as “any information relating to an identified or identifiable natural person,” such as “a name, an identification number, location data, an online identifier or to one or more factors specific to the physical, physiological, genetic, mental, economic, cultural or social identify of that nature person.”[13]  Under the GDPR, personal data has implications in the AI space beyond just the data that is actually collected from an individual.  AI technology can be and often is used to generate additional information about a person from collected data, e.g., spending habits, facial features, risk of disease, or other inferences that can be made from the collected data.  Such inferences, or derivative data, may well constitute “personal data” under a broad view of the GDPR, although there is no specific mention of derivative data in the definition. By contrast, the CCPA goes farther and specifically includes “inferences drawn from any of the information identified in this subdivision to create a profile about a consumer reflecting the consumer’s preferences, characteristics, psychological trends, preferences, predispositions, behavior, attitudes, intelligence, abilities and aptitudes.”[14]  An “inference” is defined as “the derivation of information, data, assumptions, or conclusions from evidence, or another source of information or data.”[15] Arguably the primary purpose of many AI systems is to draw inferences from a user’s information, by mining data, looking for patterns, and generating analysis.  Although the CCPA does limit inferences to those drawn “to create a profile about a consumer,” the term “profile” is not defined in the CCPA.  However, the use of consumer information that is “deidentified” or “aggregated” is permitted by the CCPA.  Thus, one possible solution may be to take steps to “anonymize” any personal data used to derive any inferences.  As a result, when looking to CCPA compliance, companies may want to carefully consider the derivative/processed data that they are storing about a user, and consider additional steps that may be required for CCPA compliance. B.       Identifying Categories of Personal Information The CCPA also requires disclosures of the categories of personal information being collected, the categories of sources from which personal information is collected, the purpose for collecting and selling personal information, and the categories of third parties with whom the business shares personal information. [16]  Although these categories are likely known and definable for static data collection, it may be more difficult to specifically disclose the purpose and categories for certain information when dynamic machine learning algorithms are used.  This is particularly true when, as discussed above, inferences about a user are included as personal information.  In order to meet these disclosure requirements, companies may need to carefully consider how they will define all of the categories of personal information collected or the purposes of use of that information, particularly when machine learning algorithms are used to generate additional inferences from, or derivatives of, personal data. C.       Personal Data Includes Households The CCPA’s definition of “personal data” also includes information pertaining to non-individuals, such as “households” – a term that the CCPA does not further define.[17]  In the absence of an explicit definition, the term “household” would seem to target information collected about a home and its inhabits through smart home devices, such as thermostats, cameras, lights, TVs, and so on.  When looking to the types of personal data being collected, the CCPA may also encompass information about each of these smart home devices, such as name, location, usage, and special instructions (e.g., temperature controls, light timers, and motion sensing).  Furthermore, any inferences or derivative information generated by AI algorithms from the information collected from these smart home devices may also be covered as personal information.  Arguably, this could include information such as conversations with voice assistants or even information about when people are likely to be home determined via cameras or motion sensors.  Companies developing smart home, or other Internet of Things, devices thus should carefully consider whether the scope and use they make of any information collected from “households” falls under the CCPA requirements for disclosure or other restrictions. III.       Continuing Efforts to Regulate Autonomous Vehicles Much like the potential for a comprehensive U.S. data privacy law, and despite a flurry of legislative activity in Congress in 2017 and early 2018 towards such a national regulatory framework, autonomous vehicles continue to operate under a complex patchwork of state and local rules with limited federal oversight.  We previously provided an update (located here)[18] discussing the Safely Ensuring Lives Future Deployment and Research In Vehicle Evolution (SELF DRIVE) Act[19], which passed the U.S. House of Representatives by voice vote in September 2017 and its companion bill (the American Vision for Safer Transportation through Advancement of Revolutionary Technologies (AV START) Act).[20]  Both bills have since stalled in the Senate, and with them the anticipated implementation of a uniform regulatory framework for the development, testing and deployment of autonomous vehicles. As the two bills languish in Congress, ‘chaperoned’ autonomous vehicles have already begun coexisting on roads alongside human drivers.  The accelerating pace of policy proposals—and debate surrounding them—looks set to continue in late 2018 as virtually every major automaker is placing more autonomous vehicles on the road for testing and some manufacturers prepare to launch commercial services such as self-driving taxi ride-shares[21] into a national regulatory vacuum. A.       “Light-touch” Regulation The delineation of federal and state regulatory authority has emerged as a key issue because autonomous vehicles do not fit neatly into the existing regulatory structure.  One of the key aspects of the proposed federal legislation is that it empowers the National Highway Traffic Safety Administration (NHTSA) with the oversight of manufacturers of self-driving cars through enactment of future rules and regulations that will set the standards for safety and govern areas of privacy and cybersecurity relating to such vehicles.  The intention is to have a single body (the NHTSA) develop a consistent set of rules and regulations for manufacturers, rather than continuing to allow the states to adopt a web of potentially widely differing rules and regulations that may ultimately inhibit development and deployment of autonomous vehicles.  This approach was echoed by safety guidelines released by the Department of Transportation (DoT) for autonomous vehicles.  Through the guidelines (“a nonregulatory approach to automated vehicle technology safety”),[22] the DoT avoids any compliance requirement or enforcement mechanism, at least for the time being, as the scope of the guidance is expressly to support the industry as it develops best practices in the design, development, testing, and deployment of automated vehicle technologies. Under the proposed federal legislation, the states can still regulate autonomous vehicles, but the guidance encourages states not to pass laws that would “place unnecessary burdens on competition and innovation by limiting [autonomous vehicle] testing or deployment to motor vehicle manufacturers only.”[23]  The third iteration of the DoT’s federal guidance, published on October 4, 2018, builds upon—but does not replace—the existing guidance, and reiterates that the federal government is placing the onus for safety on companies developing the technologies rather than on government regulation. [24]  The guidelines, which now include buses, transit and trucks in addition to cars, remain voluntary. B.       Safety Much of the delay in enacting a regulatory framework is a result of policymakers’ struggle to balance the industry’s desire to speed both the development and deployment of autonomous vehicle technologies with the safety and security concerns of consumer advocates. The AV START bill requires that NHTSA must construct comprehensive safety regulations for AVs with a mandated, accelerated timeline for rulemaking, and the bill puts in place an interim regulatory framework that requires manufacturers to submit a Safety Evaluation Report addressing a range of key areas at least 90 days before testing, selling, or commercialization of an driverless cars.  But some lawmakers and consumer advocates remain skeptical in the wake of highly publicized setbacks in autonomous vehicle testing.[25]  Although the National Safety Transportation Board (NSTB) has authority to investigate auto accidents, there is still no federal regulatory framework governing liability for individuals and states.[26]  There are also ongoing concerns over cybersecurity risks[27], the use of forced arbitration clauses by autonomous vehicle manufacturers,[28] and miscellaneous engineering problems that revolve around the way in which autonomous vehicles interact with obstacles commonly faced by human drivers, such as emergency vehicles,[29] graffiti on road signs or even raindrops and tree shadows.[30] In August 2018, the Governors Highway Safety Association (GHSA) published a report outlining the key questions that manufacturers should urgently address.[31]  The report suggested that states seek to encourage “responsible” autonomous car testing and deployment while protecting public safety and that lawmakers “review all traffic laws.”  The report also notes that public debate often blurs the boundaries between the different levels of automation the NHTSA has defined (ranging from level 0 (no automation) to level 5 (fully self-driving without the need for human occupants)), remarking that “most AVs for the foreseeable future will be Levels 2 through 4.  Perhaps they should be called ‘occasionally self-driving.'”[32] C.       State Laws Currently, 21 states and the District of Columbia have passed laws regulating the deployment and testing of self-driving cars, and governors in 10 states have issued executive orders related to them.[33]  For example, California expanded its testing rules in April 2018 to allow for remote monitoring instead of a safety driver inside the vehicle.[34]  However, state laws differ on basic terminology, such as the definition of “vehicle operator.” Tennessee SB 151[35] points to the autonomous driving system (ADS) while Texas SB 2205[36] designates a “natural person” riding in the vehicle.  Meanwhile, Georgia SB 219[37] identifies the operator as the person who causes the ADS to engage, which might happen remotely in a vehicle fleet. These distinctions will affect how states license both human drivers and autonomous vehicles going forward.  Companies operating in this space accordingly need to stay abreast of legal developments in states in which they are developing or testing autonomous vehicles, while understanding that any new federal regulations may ultimately preempt those states’ authorities to determine, for example, crash protocols or how they handle their passengers’ data. D.       ‘Rest of the World’ While the U.S. was the first country to legislate for the testing of automated vehicles on public roads, the absence of a national regulatory framework risks impeding innovation and development.  In the meantime, other countries are vying for pole position among manufacturers looking to test vehicles on roads.[38]  KPMG’s 2018 Autonomous Vehicles Readiness Index ranks 20 countries’ preparedness for an autonomous vehicle future. The Netherlands took the top spot, outperforming the U.S. (3rd) and China (16th).[39]  Japan and Australia plan to have self-driving cars on public roads by 2020.[40]  The U.K. government has announced that it expects to see fully autonomous vehicles on U.K. roads by 2021, and is introducing legislation—the Automated and Electric Vehicles Act 2018—which installs an insurance framework addressing product liability issues arising out of accidents involving autonomous cars, including those wholly caused by an autonomous vehicle “when driving itself.”[41] E.       Looking Ahead While autonomous vehicles operating on public roads are likely to remain subject to both federal and state regulation, the federal government is facing increasing pressure to adopt a federal regulatory scheme for autonomous vehicles in 2018.[42]  Almost exactly one year after the House passed the SELF DRIVE Act, House Energy and Commerce Committee leaders called on the Senate to advance automated vehicle legislation, stating that “[a]fter a year of delays, forcing automakers and innovators to develop in a state-by-state patchwork of rules, the Senate must act to support this critical safety innovation and secure America’s place as a global leader in technology.”[43]  The continued absence of federal regulation renders the DoT’s informal guidance increasingly important.  The DoT has indicated that it will enact “flexible and technology-neutral” policies—rather than prescriptive performance-based standards—to encourage regulatory harmony and consistency as well as competition and innovation.[44]  Companies searching for more tangible guidance on safety standards at federal level may find it useful to review the recent guidance issued alongside the DoT’s announcement that it is developing (and seeking public input into) a pilot program for ‘highly or fully’ autonomous vehicles on U.S. roads.[45]  The safety standards being considered include technology disabling the vehicle if a sensor fails or barring vehicles from traveling above safe speeds, as well as a requirement that NHTSA be notified of any accident within 24 hours. [1] See https://www.whitehouse.gov/wp-content/uploads/2018/05/Summary-Report-of-White-House-AI-Summit.pdf; note also that the Trump Administration’s efforts in studying AI technologies follow, but appear largely separate from, several workshops on AI held by the Obama Administration in 2016, which resulted in two reports issued in late 2016 (see Preparing for the Future of Artificial Intelligence, and Artificial Intelligence, Automation, and the Economy). [2] Id. at Appendix A. [3] See https://www.mccain.senate.gov/public/index.cfm/2018/8/senate-passes-the-john-s-mccain-national-defense-authorization-act-for-fiscal-year-2019.  The full text of the NDAA is available at https://www.congress.gov/bill/115th-congress/house-bill/5515/text.  For additional information on CFIUS reform implemented by the NDAA, please see Gibson Dunn’s previous client update at https://www.gibsondunn.com/cfius-reform-our-analysis/. [4] See id.; see also https://www.treasury.gov/resource-center/international/Documents/FIRRMA-FAQs.pdf. [5] See https://foreignaffairs.house.gov/wp-content/uploads/2018/02/HR-5040-Section-by-Section.pdf.   [6] See, e.g. infra., Section III discussion of SELF DRIVE and AV START Acts, among others. [7] S.3127, 115th Congress (2018). [8] https://www.gibsondunn.com/new-california-security-of-connected-devices-law-and-ccpa-amendments/. [9] S.3502, 115th Congress (2018). [10] See also, infra., Section III for more discussion of specific regulatory efforts for autonomous vehicles. [11] However, as 2018 has already seen a fair number of hearings before Congress relating to digital data privacy issues, including appearances by key executives from many major tech companies, it seems likely that it may not be long before we see the introduction of a “GDPR-like” comprehensive data privacy bill.  Whether any resulting federal legislation would actually pre-empt state-enacted privacy laws to establish a unified federal framework is itself a hotly-contested issue, and remains to be seen. [12] AB 375 (2018); Cal. Civ. Code §1798.100, et seq. [13] Regulation (EU) 2016/679 (General Data Protection Regulation), Article 4 (1). [14] Cal. Civ. Code §1798.140(o)(1)(K). [15] Id.. at §1798.140(m). [16] Id. at §1798.110(c). [17] Id. at §1798.140(o)(1). [18] https://www.gibsondunn.com/accelerating-progress-toward-a-long-awaited-federal-regulatory-framework-for-autonomous-vehicles-in-the-united-states/. [19]   H.R. 3388, 115th Cong. (2017). [20]   U.S. Senate Committee on Commerce, Science and Transportation, Press Release, Oct. 24, 2017, available at https://www.commerce.senate.gov/public/index.cfm/pressreleases?ID=BA5E2D29-2BF3-4FC7-A79D-58B9E186412C. [21]   Sean O’Kane, Mercedes-Benz Self-Driving Taxi Pilot Coming to Silicon Valley in 2019, The Verge, Jul. 11, 2018, available at https://www.theverge.com/2018/7/11/17555274/mercedes-benz-self-driving-taxi-pilot-silicon-valley-2019. [22]   U.S. Dept. of Transp., Automated Driving Systems 2.0: A Vision for Safety 2.0, Sept. 2017, https://www.nhtsa.gov/sites/nhtsa.dot.gov/files/documents/13069a-ads2.0_090617_v9a_tag.pdf. [23]   Id., at para 2. [24]   U.S. DEPT. OF TRANSP., Preparing for the Future of Transportation: Automated Vehicles 3.0, Oct. 4, 2018, https://www.transportation.gov/sites/dot.gov/files/docs/policy-initiatives/automated-vehicles/320711/preparing-future-transportation-automated-vehicle-30.pdf. [25]   Sasha Lekach, Waymo’s Self-Driving Taxi Service Could Have Some Major Issues, Mashable, Aug. 28, 2018, available at https://mashable.com/2018/08/28/waymo-self-driving-taxi-problems/#dWzwp.UAEsqM. [26]   Robert L. Rabin, Uber Self-Driving Cars, Liability, and Regulation, Stanford Law School Blog, Mar. 20, 2018, available at https://law.stanford.edu/2018/03/20/uber-self-driving-cars-liability-regulation/. [27]   David Shephardson, U.S. Regulators Grappling with Self-Driving Vehicle Security, Reuters. Jul. 10, 2018, available at https://www.reuters.com/article/us-autos-selfdriving/us-regulators-grappling-with-self-driving-vehicle-security-idUSKBN1K02OD. [28]   Richard Blumenthal, Press Release, Ten Senators Seek Information from Autonomous Vehicle Manufacturers on Their Use of Forced Arbitration Clauses, Mar. 23, 2018, available at https://www.blumenthal.senate.gov/newsroom/press/release/ten-senators-seek-information-from-autonomous-vehicle-manufacturers-on-their-use-of-forced-arbitration-clauses. [29]   Kevin Krewell, How Will Autonomous Cars Respond to Emergency Vehicles, Forbes, Jul. 31, 2018, available at https://www.forbes.com/sites/tiriasresearch/2018/07/31/how-will-autonomous-cars-respond-to-emergency-vehicles/#3eed571627ef. [30]   Michael J. Coren, All The Things That Still Baffle Self-Driving Cars, Starting With Seagulls, Quartz, Sept. 23, 2018, available at https://qz.com/1397504/all-the-things-that-still-baffle-self-driving-cars-starting-with-seagulls/. [31]   ghsa, Preparing For Automated Vehicles: Traffic Safety Issues For States, Aug. 2018, available at https://www.ghsa.org/sites/default/files/2018-08/Final_AVs2018.pdf. [32]   Id., at 7. [33]   Brookings, The State of Self-Driving Car Laws Across the U.S., May 1, 2018, available at https://www.brookings.edu/blog/techtank/2018/05/01/the-state-of-self-driving-car-laws-across-the-u-s/. [34]   Aarian Marshall, Fully Self-Driving Cars Are Really Truly Coming to California, Wired, Feb. 26, 2018, available at, https://www.wired.com/story/california-self-driving-car-laws/; State of California, Department of Motor Vehicles, Autonomous Vehicles in California, available at https://www.dmv.ca.gov/portal/dmv/detail/vr/autonomous/bkgd. [35]   SB 151, available at http://www.capitol.tn.gov/Bills/110/Bill/SB0151.pdf. [36]   SB 2205, available at https://legiscan.com/TX/text/SB2205/2017. [37]   SB 219, available at http://www.legis.ga.gov/Legislation/en-US/display/20172018/SB/219. [38]   Tony Peng & Michael Sarazen, Global Survey of Autonomous Vehicle Regulations, Medium, Mar. 15, 2018, available at https://medium.com/syncedreview/global-survey-of-autonomous-vehicle-regulations-6b8608f205f9. [39]   KPMG, Autonomous Vehicles Readiness Index: Assessing Countries’ Openness and Preparedness for Autonomous Vehicles, 2018, (“The US has a highly innovative but largely disparate environment with little predictability regarding the uniform adoption of national standards for AVs. Therefore the prospect of  widespread driverless vehicles is unlikely in the near future. However, federal policy and regulatory guidance could certainly accelerate early adoption . . .”), p. 17, available at https://assets.kpmg.com/content/dam/kpmg/nl/pdf/2018/sector/automotive/autonomous-vehicles-readiness-index.pdf. [40]   Stanley White, Japan Looks to Launch Autonomous Car System in Tokyo by 2020, Automotive News, Jun. 4, 2018, available at http://www.autonews.com/article/20180604/MOBILITY/180609906/japan-self-driving-car; National Transport Commission Australia, Automated vehicles in Australia, available at https://www.ntc.gov.au/roads/technology/automated-vehicles-in-australia/. [41]   The Automated and Electric Vehicles Act 2018, available at http://www.legislation.gov.uk/ukpga/2018/18/contents/enacted; Lexology, Muddy Road Ahead Part II: Liability Legislation for Autonomous Vehicles in the United Kingdom, Sept. 21, 2018,  https://www.lexology.com/library/detail.aspx?g=89029292-ad7b-4c89-8ac9-eedec3d9113a; see further Anne Perkins, Government to Review Law Before Self-Driving Cars Arrive on UK Roads, The Guardian, Mar. 6, 2018, available at https://www.theguardian.com/technology/2018/mar/06/self-driving-cars-in-uk-riding-on-legal-review. [42]   Michaela Ross, Code & Conduit Podcast: Rep. Bob Latta Eyes Self-Driving Car Compromise This Year, Bloomberg Law, Jul. 26, 2018, available at https://www.bna.com/code-conduit-podcast-b73014481132/. [43]   Freight Waves, House Committee Urges Senate to Advance Self-Driving Vehicle Legislation, Sept. 10, 2018, available at https://www.freightwaves.com/news/house-committee-urges-senate-to-advance-self-driving-vehicle-legislation; House Energy and Commerce Committee, Press Release, Sept. 5, 2018, available at https://energycommerce.house.gov/news/press-release/media-advisory-walden-ec-leaders-to-call-on-senate-to-pass-self-driving-car-legislation/. [44]   See supra n. 24, U.S. DEPT. OF TRANSP., Preparing for the Future of Transportation: Automated Vehicles 3.0, Oct. 4, 2018, iv. [45]   David Shephardson, Self-driving cars may hit U.S. roads in pilot program, NHTSA says, Automotive News, Oct. 9, 2018, available at http://www.autonews.com/article/20181009/MOBILITY/181009630/self-driving-cars-may-hit-u.s.-roads-in-pilot-program-nhtsa-says. 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 the authors: H. Mark Lyon – Palo Alto (+1 650-849-5307, mlyon@gibsondunn.com) Claudia M. Barrett – Washington, D.C. (+1 202-887-3642, cbarrett@gibsondunn.com) Frances Annika Smithson – Los Angeles (+1 213-229-7914, fsmithson@gibsondunn.com) Ryan K. Iwahashi – Palo Alto (+1 650-849-5367, riwahashi@gibsondunn.com) Please also feel free to contact any of the following: Automotive/Transportation: Theodore J. Boutrous, Jr. – Los Angeles (+1 213-229-7000, tboutrous@gibsondunn.com) Christopher Chorba – Los Angeles (+1 213-229-7396, cchorba@gibsondunn.com) Theane Evangelis – Los Angeles (+1 213-229-7726, tevangelis@gibsondunn.com) Privacy, Cybersecurity and Consumer Protection: Alexander H. Southwell – New York (+1 212-351-3981, asouthwell@gibsondunn.com) Public Policy: Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Mylan L. Denerstein – New York (+1 212-351-3850, mdenerstein@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 10, 2018 |
Why We Think the UK Is Heading for a “Soft Brexit”

Click for PDF Our discussions with politicians, civil servants, journalists and other commentators lead us to believe that the most likely outcome of the Brexit negotiations is that a deal will be agreed at the “softer” end of the spectrum, that the Conservative Government will survive and that Theresa May will remain as Prime Minister at least until a Brexit deal is agreed (although perhaps not thereafter).  There is certainly a risk of a chaotic or “hard” Brexit.  On the EU side, September’s summit in Salzburg demonstrated the possibility of unexpected outcomes.  And in the UK, the splits in the ruling Conservative Party and the support it relies upon from the DUP (the Northern Irish party that supports the Government) could in theory result in the ousting of Prime Minister May, which would likely lead to an extension of the Brexit deadline of 29 March 2019.  However, for the reasons set out below we believe a hard or chaotic Brexit is now less likely than more likely. Some background to the negotiations can be found here.  It should be noted that any legally binding deal will be limited to the terms of the UK’s departure from the EU (“the Withdrawal Agreement”) and will not cover the future trading relationship.  But there will be a political statement of intent on the future trading relationship (“the Future Framework”) that will then be subject to further detailed negotiation. There is a European Council meeting on 17/18 October although it is not expected that a final agreement will be reached by then.  However, the current expectation is that a special meeting of the European Council will take place in November (probably over a weekend) to finalise both the Withdrawal Agreement and the Future Framework. Whatever deal Theresa May finally agrees with the EU needs to be approved by the UK Parliament.  A debate and vote will likely take place within two or three weeks of a deal being agreed – so late November or early December.  If Parliament rejects the deal the perceived wisdom is that the ensuing political crisis could only be resolved either by another referendum or a general election. However: the strongest Brexiteers do not want to risk a second referendum in case they lose; the ruling Conservative Party do not want to risk a general election which may result in it losing power and Jeremy Corbyn becoming Prime Minister; and Parliament is unlikely to allow the UK to leave without a deal. As a result we believe that Prime Minister May has more flexibility to compromise with the EU than the political noise would suggest and that, however much they dislike the eventual deal, ardent Brexiteers will likely support it in Parliament.  This is because it will mean the UK has formally left the EU and the Brexiteers live to fight another day. The UK’s current proposal (the so-called “Chequers Proposal”) is likely to be diluted further in favour of the EU, but as long as the final deal results in a formal departure of the UK from the EU in March 2019, we believe Parliament is more likely than not to support it, however unsatisfactory it is to the Brexiteers. The key battleground is whether the UK should remain in a Customs Union beyond a long stop date for a transitional period.  The UK Government proposes a free trade agreement in goods but not services, with restrictions on free movement and the ability for the UK to strike its own free trade deals.  This has been rejected by the EU on the grounds that it seeks to separate services from goods which is inconsistent with the single market and breaches one of the fundamental EU principles of free movement of people.  The Chequers Proposal is unlikely to survive in its current form but the EU has acknowledged that it creates the basis for the start of a negotiation. There has also been discussion of a “Canada style” free-trade agreement, which is supported by the ardent Brexiteers but rejected by the UK Government because it would require checks on goods travelling across borders.  This would create a “hard border” in Northern Ireland which breaches the Good Friday Agreement and would not be accepted by any of the major UK political parties or the EU.  The consequential friction at the borders is also unattractive to businesses that operate on a “just in time” basis – particularly the car manufacturers.  The EU has suggested there could instead be regulatory alignment between Northern Ireland and the EU, but this has been accepted as unworkable because it would create a split within the UK and is unacceptable to the DUP, the Northern Ireland party whose support of the Conservatives in Parliament is critical to their survival.  This is the area of greatest risk but it remains the case that a “no deal” scenario would guarantee a hard border in Ireland. If no deal is reached by 21 January 2019 the Prime Minister is required to make a statement to MPs.  The Government would then have 14 days to decide how to proceed, and the House of Commons would be given the opportunity to vote on these alternate plans.  Although any motion to reject the Government’s proposal would not be legally binding, it would very likely catalyse the opposition and lead to an early general election or a second referendum.  In any of those circumstances, the EU has already signalled that it would be prepared to grant an extension to the Article 50 period. This client alert was prepared by London partners Charlie Geffen and Nicholas Aleksander and of counsel Anne MacPherson. We have a working group in London (led by Nicholas Aleksander, Patrick Doris, Charlie Geffen, Ali Nikpay and Selina Sagayam) addressing Brexit related issues.  Please feel free to contact any member of the working group or any of the other lawyers mentioned below. Ali Nikpay – Antitrust ANikpay@gibsondunn.com Tel: 020 7071 4273 Charlie Geffen – Corporate CGeffen@gibsondunn.com Tel: 020 7071 4225 Nicholas Aleksander – Tax NAleksander@gibsondunn.com Tel: 020 7071 4232 Philip Rocher – Litigation PRocher@gibsondunn.com Tel: 020 7071 4202 Jeffrey M. Trinklein – Tax JTrinklein@gibsondunn.com Tel: 020 7071 4224 Patrick Doris – Litigation; Data Protection PDoris@gibsondunn.com Tel:  020 7071 4276 Alan Samson – Real Estate ASamson@gibsondunn.com Tel:  020 7071 4222 Penny Madden QC – Arbitration PMadden@gibsondunn.com Tel:  020 7071 4226 Selina Sagayam – Corporate SSagayam@gibsondunn.com Tel:  020 7071 4263 Thomas M. Budd – Finance TBudd@gibsondunn.com Tel:  020 7071 4234 James A. Cox – Employment; Data Protection JCox@gibsondunn.com Tel: 020 7071 4250 Gregory A. Campbell – Restructuring GCampbell@gibsondunn.com Tel:  020 7071 4236 © 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.

September 27, 2018 |
Three Gibson Dunn Partners Recognized Among Americas Rising Stars

Euromoney Legal Media Group recognized three Gibson Dunn partners among its inaugural list of Americas Rising Stars. Blaine Evanson was named Best in Litigation: Appellate; Stacie Fletcher was named Best in Environment; and John Partridge was named Best in Life Sciences. Stacie Fletcher was also recognized for her work on behalf of International Paper in an Alabama Environmental Suit, which was named as one of the Matters of the Year. The winners were announced on September 27, 2018.  

September 26, 2018 |
Chancery Reaffirms Safe Harbor for Directors’ Reasonable Reliance on Expert Advice

San Francisco partner Brian M. Lutz and New York associate Mark H. Mixon Jr. are the authors of “Chancery Reaffirms Safe Harbor for Directors’ Reasonable Reliance on Expert Advice” [PDF] published in the Delaware Business Court Insider on September 26, 2018.