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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. 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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 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.  

September 24, 2018 |
U.S. Court of Appeals Allows Specific Personal Jurisdiction Over German Web-Services Firm With No Physical U.S. Presence

Click for PDF On September 13, 2018, the U.S. Court of Appeals for the First Circuit handed down an important personal-jurisdiction ruling in the age of e-commerce.  In Plixer International, Inc. v. Scrutinizer GmbH, the First Circuit interpreted Federal Rule of Civil Procedure 4(k)(2) to affirm a district court’s exercise of personal jurisdiction over a German company whose only ties to the United States were the provision of web-based services to businesses all over the world, including in the United States.[1]  This is still a developing area of personal jurisdiction law without clear guidance from the U.S. Supreme Court, and non-U.S. companies should carefully consider whether and how their online commerce might subject them to U.S. litigation. The decision arose out of a trademark dispute between two companies—U.S.-based Plixer International, Inc. and the German firm Scrutinizer GMBH—over whether Scrutinizer’s use of its corporate name in the U.S. caused confusion with Plixer’s registered “Scrutinizer” mark.[2]  Scrutinizer offers web-based services to software companies, principally in helping customers build better software.  These offerings are all cloud-based, and Scrutinizer’s activities occur exclusively outside the United States.  In particular, Scrutinizer does not have any office, phone number, or agent for service of process in the United States; its employees do not travel to the United States for business; and it does not advertise in the United States.  Scrutinizer accepts payment only in euros, and its contracts provide that only German law governs disputes, which would be adjudicated only in German courts.  Notwithstanding these non-U.S. ties, Scrutinizer does have business dealings in the United States: its website is published in English, and although its business is “global,” 156 of its customers were based in the United States over a three year period, with revenues amounting to just under $200,000.00 (€165,212.07).  The only U.S.-based conduct highlighted in the opinion was an unexplained trademark application for the term “Scrutinizer ” in January 2017, three years after the case was filed.[3] Plixer sued Scrutinizer in the U.S. District Court for the District of Maine and Scrutinizer contested personal jurisdiction.[4]  (The dispute was not based on Scrutinizer’s contracts and thus did not trigger the forum selection clause.)  The district court rejected Plixer’s initial effort to base personal jurisdiction solely on Scrutinizer’s Maine-based contacts, which consisted only of two sales worth approximately €3,100.[5]  But, after allowing for jurisdictional discovery, the district court ultimately found jurisdiction based on Scrutinizer’s contacts with the United States as a whole, finding that Scrutinizer “operated a highly interactive website that sold its cloud-based services directly through the website, that it was open to business throughout the world, that it accepted recurrent business from the United States in a substantial amount, and that it did so knowingly.”[6]  According to the district court, this sufficed to exercise personal jurisdiction over Scrutinizer under Federal Rule of Civil Procedure 4(k)(2), which provides: (2) Federal Claim Outside State-Court Jurisdiction. For a claim that arises under federal law, serving a summons or filing a waiver of service establishes personal jurisdiction over a defendant if: (A) the defendant is not subject to jurisdiction in any state’s courts of general jurisdiction; and (B) exercising jurisdiction is consistent with the United States Constitution and laws. The district court denied Scrutinizer’s motion to dismiss on these grounds, but granted Scrutinizer’s motion to file an interlocutory appeal under 28 U.S.C. § 1292(b). On appeal, the First Circuit affirmed.  The court explained at the outset that the only contested aspect of the case was Rule 4(k)(2)(B), which invokes the requirement that personal jurisdiction comport with due process, a test requiring Plixer to show that (1) its claim directly arises out of or relates to the defendant’s forum activities; (2) the defendant’s forum contacts represent a purposeful availment of the privilege of conducting activities in that forum, thus invoking the benefits and protections of the forum’s laws and rendering the defendant’s involuntary presence in the forum’s courts foreseeable; and (3) the exercise of jurisdiction is reasonable.[7] As Plixer’s trademark claim necessarily related to Scrutinizer’s U.S. sales, the First Circuit analyzed only elements (2) and (3), and held that Plixer had satisfied both. The court first found that Scrutinizer had purposely availed itself of the United States—such that Scrutinizer had the necessary “minimum contacts” with the United States for personal jurisdiction—despite the fact that it had no physical contacts with the United States.  The court recognized that a prior personal-jurisdiction decision from the Supreme Court, Walden Fiore, expressly “le[ft] questions about virtual contacts for another day,” and the First Circuit therefore based its ruling solely on Scrutinizer’s “sizeable and continuing commerce with United States customers,” but was otherwise “extremely reluctant to fashion any general guidelines beyond those that exist in law [and] emphasize[d] that [its] ruling [was] specific to the facts of this case.”[8] The court also rejected each of Scrutinizer’s arguments against the finding of minimum contacts.  According to the court, Scrutinizer had not simply “enter[ed] its products into the stream of commerce” and thus had no control where those products ended; “Scrutinizer’s service [went] only to the customers that Scrutinizer has accepted.”[9]  Scrutinizer did not attempt to limit access to its website to block U.S. users, nor did it “take the low-tech step of posting a disclaimer that its service is not intended for U.S. users.”[10]  The court similarly rejected Scrutinizer’s argument that its U.S. contacts were solely “the product of its customers’ unilateral actions,” because Scrutinizer “knew that it was serving U.S. customers” through its “globally accessible website.”[11] But the key minimum-contacts analysis arose in the Court’s rejection of Scrutinizer’s final argument that it did not “specifically target” the United States.[12]  That test came from a four-justice plurality opinion in the 2011 Supreme court Decision, J. McIntyre Machinery, Ltd. v. Nicastro, where the plurality would have allowed jurisdiction only “where the defendant can be said to have targeted the forum.”[13]  The First Circuit instead relied on Justice Breyer’s more narrow concurrence in Nicastro, which relied on findings that the defendant in Nicastro had not made any regular course of sales in the jurisdiction to support a finding of purposeful availment or minimum contacts.[14]  According to the First Circuit, Nicastro thus did not concern itself with companies that, like Scrutinizer, “‘target[] the world’ by making its website globally available.”[15]  Ultimately, the Court held that “the German company could have ‘reasonably anticipated’ the exercise of specific personal jurisdiction based on its U.S. contacts,” including Scrutinizers regular sales to the U.S. and its use of a website “to obtain U.S. customer contracts.”[16]  The First Circuit defended this conclusion as consistent prior decisions from the Supreme Court and other courts emphasizing the importance of forum sales in minimum-contacts analysis.[17] Having found that Scrutinizer had sufficient minimum contacts, the First Circuit concluded that exercising personal jurisdiction was reasonable.[18]  The First Circuit recognized that litigating in the United States would burden Scrutinizer given its location in Germany, but discounted that burden in light of Scrutinizer’s U.S. business and the fact that “modern travel ‘creates no especially ponderous burden for business travelers.'”[19] But no other factor weighed against exercising jurisdiction.  The court concluded that “‘[w]hen minimum contacts have been established, often the interests of the plaintiff and the forum in the exercise of jurisdiction will justify even the serious burdens placed on the alien defendant.'”[20] The First Circuit’s decision is drafted in narrow terms, but non-U.S. companies should take note of Plixer’s potentially sweeping conclusion:  A company with no physical ties to the U.S. whatsoever could be hauled into a U.S. court based solely on rather modest web-based sales.  The Internet and e-commerce have revolutionized the ways in which companies can do business all over the world, opening up markets in ways that were unthinkable in the analog past.  But the flip-side of this openness is the risk of litigation in foreign fora.  In light of decisions such as Plixer, non-U.S. companies should carefully assess the costs and benefits of selling their products to identifiable U.S. individuals and companies. [1]   — F.3d —-, 2018 WL 4357137 (1st Cir. Sept. 13, 2018). [2]   Id. at *2. [3]   Id. at *1-2. [4]   Id. at *2. [5]   Id. at *2 n.4. [6]   Id. at *2. [7]   Id.at *3. [8]   Id. at *4 (citing Walden v. Fiore, 571 U.S. 227, 290 n.9 (2014)). [9]   Id.  at *5. [10]   Id. at *5. [11]   Id. at *5. [12]   See id. at *6-7. [13]   564 U.S. 873, 882 (2011) (plurality). [14]   Id. at 889 (Breyer, J., concurring). [15]   Plixer, 2018 WL 4357137, at *6 (quoting Nicastro, 564 U.S. at 890 (Breyer, J. concurring)). [16]   Id. at *6. [17]   Id. at *7 (citing Keeton v. Hustler Magazine, 465 U.S. 770 (1984); Oticon, Inc. v. Sebotek Hearing Sys., LLC, 865 F. Supp. 2d 501 (D.N.J. 2011); Willemsen v. Invacare Corp., 282 P.3d 867 (Or. 2012); Mavrix Photo, Inc. v. Brand Techs., Inc., 647 F.3d 1218 (9th Cir. 2011); Bird v. Parsons, 289 F.3d 865 (6th Cir. 2002); Advanced Tactical Ordnance Sys., LLC v. Real Action Paintball, Inc., 751 F.3d 796 (7th Cir. 2014); Carefirst of Md., Inc. v. Carefirst Pregnancy Ctrs., Inc., 334 F.3d 390 (4th Cir. 2003)). [18]   Id. at *8. [19]   Id. at *8. [20]   Id. at *9 (quoting Asahi Metal Indus. Co. v. Super. Ct. of Cal., Solano, Cnty., 480 U.S. 102, 114 (1987)). The following Gibson Dunn lawyers assisted in the preparation of this client update: Perlette Jura, Andrea Neuman, William Thomson and Christopher Leach. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work or any of the following members of the firm’s Transnational Litigation Group: United States: Randy M. Mastro – New York (+1 212-351-3825, rmastro@gibsondunn.com) Theodore J. Boutrous, Jr. – Los Angeles (+1 213-229-7000, tboutrous@gibsondunn.com) Scott A. Edelman – Los Angeles (+1 310-557-8061, sedelman@gibsondunn.com) Andrea E. Neuman – New York (+1 212-351-3883, aneuman@gibsondunn.com) William E. Thomson – Los Angeles (+1 213-229-7891, wthomson@gibsondunn.com) Perlette Michèle Jura – Los Angeles (+1 213-229-7121, pjura@gibsondunn.com) Kahn A. Scolnick – Los Angeles (+1 213-229-7656, kscolnick@gibsondunn.com) Anne M. Champion – New York (+1 212-351-5361, achampion@gibsondunn.com) Europe: Philip Rocher – London (+44 20 7071 4202, procher@gibsondunn.com) Charlie Falconer – London (+44 20 7071 4270, cfalconer@gibsondunn.com) Patrick Doris – London (+44 20 7071 4276, pdoris@gibsondunn.com) Michael Walther – Munich (+49 89 189 33 180, mwalther@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 11, 2018 |
SFO Successfully Defends Challenge over the Territorial Scope of Compulsory Document Requests

Click for PDF Last week the High Court in London handed down its decision following a challenge by KBR, Inc. against the issuing of compulsory document requests that required the production of documents held by the company outside of the UK. KBR, Inc. is a U.S. engineering and construction company and ultimate parent company of the KBR Group. It does not have a physical presence in the UK, but has a subsidiary, KBR Ltd, that does. KBR Ltd is under investigation by the SFO for suspected bribery. At the heart of the proceedings was a notice issued to KBR, Inc. by the Serious Fraud Office (“SFO“) under section 2(3) of the Criminal Justice Act 1987 (“CJA“) (the “July Section 2 Notice“) compelling the production of documents held outside the UK.  The SFO issued the July Section 2 Notice to a representative of KBR, Inc. who had attended a meeting with the SFO in the UK to discuss its investigation into KBR Ltd. The Challenge KBR, Inc. challenged the July Section 2 Notice on three grounds: Jurisdiction:  the July Section 2 Notice was ultra vires the CJA, as it requested material held outside of the UK from a company incorporated outside of the UK. Discretion:  the Director of the SFO made an error of law in issuing the July Section 2 Notice instead of using its power to seek Mutual Legal Assistance (“MLA“) from the US authorities under the UK’s 1994 bilateral MLA Treaty with the US. Service:  the July Section 2 Notice was not properly served on KBR, Inc. under the CJA. Jurisdiction The Court held that in relation to UK companies with documents outside of the UK, that section 2(3) of the CJA must have “an element of extraterritorial application” otherwise “a UK company could resist an otherwise lawful s.2(3) notice on the ground that the documents in question were held on a server out of the jurisdiction“. The extraterritorial reach would minimize the risk of the SFO’s investigations being frustrated by companies moving their documents out of the jurisdiction. As regards documents held by foreign companies outside of the UK, the court held that section 2(3) will extend to some foreign companies in respect of documents held abroad, when there is a “sufficient connection” between the foreign company and the jurisdiction (the UK). This test is fact specific in order to allow for “practical justice in the individual case“. In KBR, Inc.’s case, the Court found that certain following factors were not sufficient on their own to satisfy the “sufficient connection” test, including: the fact that KBR, Inc. was the parent company of KBR Ltd, as it would ensnare parent companies of multinational groups without justification. the fact that KBR, Inc. cooperated to a degree with the SFO’s request for documents and remained willing to do so voluntarily, on terms that it would apply SFO search terms across data held in the US.  Cooperation is to be encouraged but it should not give rise to a risk of being held to imply acceptance of jurisdiction. the fact that a KBR, Inc. representative agreed to, and did, attend a meeting with the SFO.  This is for similar reasons as those set out above. However, the Court went on to find that there was a sufficient connection between KBR, Inc. and the UK in this case, based on the fact that some suspected corrupt payments made by KBR to Unaoil required the express approval of KBR, Inc. and were processed by KBR, Inc.’s treasury function, and for a period approval was also required from KBR, Inc.’s compliance function before payment could be released.  The Court also observed that a corporate officer of KBR, Inc. was based in the Group’s UK office. Discretion KBR, Inc. argued that even if the CJA did confer jurisdiction on the SFO to compel the production of materials abroad, the Director of the SFO should not have exercised his power under section 2(3) of the CJA, which is discretionary, and should have first considered using the MLA route.  KBR, Inc.’s position was that in failing to do this amounted to an error of law. This argument was rejected. The High Court held that the MLA option was an additional power available to the SFO: “The availability of MLA gives the Director additional options; it does not curtail his discretion to use the separate power of issuing s.2(3) notices… It follows that KBR [Inc] has failed to demonstrate any error of law on the part of the Director in the exercise of his discretion to issue the July Notice.” The High Court noted additionally in the SFO’s favour that there are “good practical reasons” for the Director to use a section 2 notice instead of MLA. Such reasons included delays, the risk that a request is ignored, and the burden on the requested state of having to deal with a request when it would be simpler to obtain the materially directly. KBR, Inc. had neither shown nor suggested that compliance with the July Section 2 Notice would have raised any complexities or issues of local U.S. law, or conflict with duties owed by KBR, Inc. to third parties. Service KBR, Inc. argued that simply giving the July Notice to KBR, Inc.’s representative during an SFO meeting was not enough to “serve” KBR, Inc. with the July Section 2 Notice, and that the fact that KBR, Inc. ‘s representative was in the UK did not signify that KBR, Inc. was present in the UK. The court rejected this challenge, noting in particular that section 2(3) required no additional formality beyond the giving of the notice. The Court held that KBR, Inc. was “plainly present” in the jurisdiction when the SFO gave the July Section 2 Notice to its representative. The SFO made the meeting in question conditional on the attendance of “the clients” (i.e., KBR, Inc.). As such, it was clear that KRB Inc’s representatives were in the jurisdiction in their capacity as representatives and not “coincidentally or on some personal frolic“. The High Court, however, noted that the SFO’s plan to give the July Notice to KBR, Inc.’s representative during the course of the meeting had “unappealing features“. However, those features did not invalidate the July Notice; rather they serve as a warning to others who may attend similar meetings with the SFO in the future. Implications The decision has helped to clarify the scope of the SFO’s section 2 notice power, which to-date has not been considered comprehensively by the courts. The SFO will no doubt be satisfied with the result. Foreign companies that hold documents outside of the UK will not be immune from the SFO’s section 2 power, provided that the SFO can illustrate a “sufficient connection” between the company in question and the UK.  A parent / subsidiary relationship alone will not suffice, but where there are links between a UK subsidiary and its foreign parent, for example if they share accounting or compliance functions, this will likely suffice.  In this case, another connection was the presence of a KBR, Inc. employee in KBR Ltd’s office. This seems a rather tenuous connection. Whether that factor alone would have been enough is difficult to assess. The High Court, however, obviously thought it was sufficiently material to identify and take into account. This decision is likely to embolden the SFO in serving section 2 notices on foreign companies involved in their investigations. The Crime (Overseas Production Orders) Bill, which is currently before Parliament, may soon render the decision less relevant, at least as far as documents are stored electronically and in states where reciprocal arrangements are made for recognition of production orders.  The Bill has received little press attention to date but it may have significant implications.  If enacted, the SFO (amongst other authorities) will be able to make an application to the Crown Court for an order requiring an overseas person to produce electronic data in connection with an investigation, where there is an international cooperation agreement in place with the jurisdiction in question.  We note that the U.S. has passed the CLOUD Act (Clarifying Lawful Use of Overseas Data Act), which the UK Government has stated was passed “in anticipation and preparation” for a bilateral UK-US data access agreement.  If the Bill becomes law and agreements are put in place, it may become much easier for the SFO to obtain electronic data from overseas to aid its investigations. This client alert was prepared by Patrick Doris, Sacha Harber-Kelly, Steve Melrose and Rose Naing. Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these developments.  If you would like to discuss this alert in greater detail, please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following members of the firm’s disputes practice: Philip Rocher (+44 (0)20 7071 4202, procher@gibsondunn.com) Patrick Doris (+44 (0)20 7071 4276, pdoris@gibsondunn.com) Sacha Harber-Kelly (+44 20 7071 4205, sharber-kelly@gibsondunn.com) Charles Falconer (+44 (0)20 7071 4270, cfalconer@gibsondunn.com) Allan Neil (+44 (0)20 7071 4296, aneil@gibsondunn.com) Steve Melrose (+44 (0)20 7071 4219, smelrose@gibsondunn.com) Sunita Patel (+44 (0)20 7071 4289, spatel2@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.

August 17, 2018 |
Miguel Estrada and Robert Weigel Named Litigators of the Week

The Am Law Litigation Daily named Washington, D.C. partner Miguel Estrada and New York partner Robert Weigel as “Litigators of the Week” [PDF] for obtaining a significant victory for client Crystallex International Corporation that holds a $1.4 billion judgment against Venezuela.  The profile was published on August 17, 2018.

August 13, 2018 |
Wayne Barsky and James Zelenay Named Top Litigators in Los Angeles

Century City partner Wayne Barsky and Los Angeles partner James Zelenay were named to Los Angeles Business Journal’s list of Top Litigators in Los Angeles. The list highlights “50 of the very best litigators in the business” who “go to the proverbial mat to fight for their clients.”  The list was published on August 13, 2018.

August 2, 2018 |
EPA & NHTSA Issue SAFE Vehicles Rule, Proposing Changes to Vehicle GHG Limits and Revocation of California Waiver

Click for PDF On August 2, 2018, the U.S. Environmental Protection Agency (EPA) and the National Highway Traffic Safety Administration (NHTSA) issued a notice of proposed rulemaking (NPRM), the Safer Affordable Fuel-Efficient (SAFE) Vehicles Rule for Model Years 2021–2026 Passenger Cars and Light Trucks (SAFE Vehicles Rule), relating to the national automobile fuel economy and greenhouse gas (GHG) emissions standards set by EPA for cars and light-duty trucks.[1] The proposed SAFE Vehicles Rule is the expected next step in the Trump Administration’s efforts to reevaluate fuel economy and emissions standards set by the Obama Administration.  In 2012, the Obama Administration set GHG and fuel economy standards for passenger cars and light-duty trucks for model years 2017 to 2025, but EPA and NHTSA committed in that rulemaking to “a comprehensive midterm evaluation and agency decision-making process for the MYs 2022–2025 standards.”[2]  This “midterm evaluation” was to be completed by April 1, 2018.[3] On December 6, 2016, the Obama EPA published a “proposed determination,” finding that the standards set in the October 2012 rule should remain in place,[4] and on January 12, 2017, the agency issued a final determination to that effect.[5]  In March 2017, the Trump EPA announced its intention to reconsider that final determination.[6]  And in April 2018, the agency formally withdrew the Obama Administration’s January 2017 final determination and announced that it would initiate a notice and comment rulemaking to evaluate the appropriate standards for MYs 2022–2025.[7] The SAFE Vehicles Rule is the first step in the rulemaking process to evaluate the appropriate future GHG emissions and fuel economy standards for light-duty vehicles.  The proposed rulemaking includes several important developments of interest for the automotive industry: The proposed rulemaking includes several alternative regulatory proposals for fuel economy and tailpipe carbon dioxide (CO2) standards that would be applicable to vehicles sold in MYs 2021 to 2026. The alternative preferred by EPA and NHTSA would freeze fuel economy and CO2 standards at MY 2020 levels for MYs 2021 through 2026. The agencies are inviting comments on seven other options presented in the NPRM.  These options include maintaining the regulatory plan promulgated under the Obama Administration, or implementing increasingly stringent fuel economy and CO2 requirements at varying rates between MYs 2020 and 2026. EPA and NHTSA are also seeking comment on the compliance flexibilities associated with the fuel economy and CO2 programs, including whether to require some level of public disclosure for credit trading, or whether to eliminate credit trading in the CAFE program altogether. EPA is proposing to change CO2 targets after MY 2021 to remove the adjustments related to refrigerant and the offsets for nitrous oxide and methane emissions.  In practice, this would increase the applicable threshold for CO2 requirements for MYs 2020 and 2021. The NPRM also proposes to create a single 50-state standard for GHG emissions.  This would be accomplished by withdrawing California’s waiver of preemption under the Clean Air Act for the GHG and Zero Emissions Vehicle (ZEV) requirements of California’s Advanced Clean Cars program. California does not have authority to regulate fuel economy directly, as the Energy Policy and Conservation Act of 1975 (EPCA), as amended by the Energy Independence and Security Act of 2007 (EISA), preempts state standards relating to fuel economy.[8] The SAFE Vehicles Rule will be published in the Federal Register in the coming weeks, and will be open for public comment for a period of 60 days after publication.  In addition, EPA and NHTSA will hold three public hearings on the rule in Washington, DC, Detroit, MI, and Los Angeles, CA.  The dates for these hearings will be announced in a forthcoming notice in the Federal Register. If the agencies’ preferred proposals are adopted and the rule becomes final, it is virtually certain that the revised standards and the withdrawal of California’s waiver authority will be challenged in court by California and other states, and by the environmental community.    [1]   The official version of the SAFE Vehicles Rule will be published in the Federal Register in the coming weeks.  Until it is published, the proposed rule is available at https://www.epa.gov/sites/production/files/2018-08/documents/safe-my-2021-2026-cafe-ld-ghg-nhtsa-epa-nprm-2018-08-02.pdf.    [2]   2017 and Later Model Year Light-Duty Vehicle Greenhouse Gas Emissions and Corporate Average Fuel Economy Standards, 77 Fed. Reg. 62,624, 62,628 (Oct. 15, 2012).    [3]   Id. at 62,784.    [4]   Proposed Determination on the Appropriateness of the Model Year 2022–2025 Light-Duty Vehicle Greenhouse Gas Emissions Standards Under the Midterm Evaluation, 81 Fed. Reg. 87,927 (Dec. 6, 2016).    [5]   Final Determination on the Appropriateness of the Model Year 2022-2025 Light-Duty Vehicle Greenhouse Gas Emissions Standards Under the Midterm Evaluation (Jan. 12, 2017), available at https://nepis.epa.gov/Exe/ZyPDF.cgi?Dockey=P100QQ91.pdf.    [6]   Notice of Intention to Reconsider the Final Determination of the Mid-Term Evaluation of Greenhouse Gas Emissions Standards for Model Year 2022–2025 Light Duty Vehicles, 82 Fed. Reg. 14,671 (Mar. 22, 2017).    [7]   Mid-Term Evaluation of Greenhouse Gas Emissions Standards for Model Year 2022–2025 Light-Duty Vehicles, 83 Fed. Reg. 16,077 (Apr. 13, 2018).  Gibson Dunn is currently representing the Association of Global Automakers as movant-intervenors before the Court of Appeals for the District of Columbia Circuit in California v. EPA, No. 18-1114, California’s challenge to the withdrawal of the January 2017 final determination.    [8]   From 2006 to 2008, Gibson Dunn represented the Association of Global Automakers in litigation regarding the EPCA preemption of GHG motor vehicle emissions standards adopted by several states. The following Gibson Dunn lawyers assisted in the preparation of this client alert: Ray Ludwiszewski, Stacie Fletcher, Rachel Levick Corley and Veronica Till Goodson. Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues.  For additional information about this regulatory change and other regulations, or related litigation, please contact the Gibson Dunn lawyer with whom you usually work or the following leaders and members of the firm’s Environmental Litigation and Mass Tort practice group in Washington, D.C.: Avi S. Garbow – Co-Chair (+1 202-955-8558, agarbow@gibsondunn.com) Daniel W. Nelson – Co-Chair (+1 202-887-3687, dnelson@gibsondunn.com) Peter E. Seley – Co-Chair (+1 202-887-3689, pseley@gibsondunn.com) Raymond B. Ludwiszewski (+1 202-955-8665, rludwiszewski@gibsondunn.com) Stacie B. Fletcher (+1 202-887-3627, sfletcher@gibsondunn.com) © 2018 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.

July 31, 2018 |
EPA Amendments to the Coal Ash Rule

Click on PDF On July 30, 2018, the Environmental Protection Agency (“EPA”) published a final rule amending the national minimum criteria for existing and new landfills and surface impoundments that contain coal combustion residuals (“CCR”), also known as coal ash.[1]  This rule, which directly affects over four hundred coal-fired electricity generating plants nationwide, is the first in a series of anticipated amendments altering regulations promulgated under the Obama Administration to address the disposal of coal ash in landfills and surface impoundments.  This first phase of regulatory changes has three key elements: It adopts two alternative performance standards that either participating state directors or the EPA may apply to owners and operators of CCR units; It revises groundwater protection standards (“GWPS”) for four regulated constituents which do not have an established maximum contaminant level under the Safe Drinking Water Act; and It extends certain deadlines by which facilities must cease the placement of waste in CCR units that are closing. I.   Background and Context Coal ash is produced from the burning of coal in coal-fired power plants.  According to the American Coal Ash Association, approximately 110 million tons of coal ash are generated every year, making it one of the most-generated forms of industrial waste in the United States.  While over one-third of all coal ash produced in the United States is recycled into construction materials, such as concrete or wallboard, a significant amount must be disposed of each year.  Coal ash contains contaminants like mercury, cadmium, and arsenic, which can pose environmental and health risks if not properly managed or disposed of. On April 17, 2015, the Obama Administration promulgated regulations setting federal standards for the disposal of coal ash pursuant to its authority under the Resource Conservation and Recovery Act, notably regulating such waste as a solid waste pursuant to Subtitle D, rather than as a hazardous waste pursuant to Subtitle C.[2]  The regulations addressed the risks associated with disposal, including leaking of contaminants into ground water, blowing into the air as dust, and catastrophic failure of coal ash surface impoundments.  EPA set certain minimum criteria consisting of location restrictions, design and operating criteria, groundwater monitoring and corrective action requirements, closure and post-closure care requirements, and record keeping, notification, and internet posting requirements. It also required unlined CCR surface impoundments contaminating groundwater above certain protection standards to stop receiving wastes and either retrofit or close, except in certain circumstances. Congress subsequently passed the Water Infrastructure for Improvements to the Nation (“WIIN”) Act, signed into law on December 16, 2016, which authorized EPA-approved state permitting programs to regulate coal ash disposal.[3]  Under the WIIN Act’s Section 2301, states may develop and operate their own permitting programs that adhere to, or are at least as protective as, the EPA’s standards.  On June 18, 2018, Oklahoma became the first (and so far only) state to have its permit program approved for the management of coal ash.  The EPA regulates coal ash disposal in states that choose not to implement permitting programs or that have inadequate programs that fail to meet federal standards. II.   Amendments to the 2015 Regulations On September 13, 2017, the EPA granted petitions from certain industry groups requesting reconsideration of certain provisions of the 2015 regulations in light of the WIIN Act and other factors.  EPA announced that it anticipates completing reconsideration of all provisions in two phases:  a first phase, which includes these amendments, to be finalized no later than June 2019, and a second phase to be proposed by September 30, 2018 and finalized by December 2019. The recently signed Amendments constituting phase one, part one, make three major changes to the prior regulations governing coal ash management and disposal.  First, EPA adopted two alternative performance standards that either participating state directors in states with approved CCR permit programs, or EPA where it is the permitting authority, may apply to owners and operators of CCR units:  (1) the suspension of groundwater monitoring requirements if there is evidence that there is no potential for migration of hazardous constituents to the uppermost aquifer during the active life of the unit and post-closure care; and (2) the issuance of technical certifications in lieu of the current requirement to have professional engineers issue certifications. Second, the Amendments revise the GWPSs for the four constituents[4] which do not have established maximum contaminant levels under the Safe Drinking Water Act, in place of the background levels under 40 CFR § 257.95(h)(2).  This revision adopts national criteria as health-based standards available to facilities to use to compare against monitored groundwater concentrations and to develop cleanup goals. Finally, the Amendments extend the deadline for when CCR units closing for cause must initiate closure under two circumstances:  (1) where the facility has detected a statistically significant increase from an unlined surface impoundment above a GWPS; and (2) where the unit is unable to comply with the aquifer location restriction.  With respect to unlined surface impoundments, the Amendments extend the 90-day period in which the owner or operator is to perform the required analysis and demonstrations by 18 months, until October 31, 2020.  With respect to aquifer location restrictions, the revision extends the timeframes during which facilities may continue to use the units by the same period, until October 31, 2020.  The EPA states that this extension allows facilities time to adjust their operations and better coordinate engineering, financial, and permitting activities. Generally speaking, these changes reduce the compliance obligations for facilities managing coal ash surface impoundments and provide increased flexibility in the management of coal ash.  They also grant the industry more time for compliance with the 2015 regulations, addressing concerns about feasibility of compliance within the original deadlines. These regulations are subject to challenge, even as EPA considers additional rulemakings to address other aspects of the 2015 coal ash rule.  In addition, EPA is currently scheduled to propose revisions to the Clean Water Act’s Effluent Limitation Guidelines applicable to steam electric power generators in December 2018, potentially posing added challenges relating to overlapping compliance schedules relevant to the management and disposal of coal ash.  In light of the ongoing complexities of the regulatory landscape, owners or operators of coal ash disposal facilities should evaluate how these proposed changes will impact their operations, costs, and investments.    [1]   See Hazardous and Solid Waste Management System:  Disposal of Coal Combustion Residuals from Electric Utilities; Amendments to the National Minimum Criteria (Phase One, Part One); Final Rule (83 Fed. Reg. 36435, July 30, 2018) (hereinafter, the “Amendments”).    [2]   40 C.F.R. § 257 pt. D.    [3]   Water Infrastructure for Improvements to the Nation Act, Pub. L. No. 114-322, 130 Stat. 1628 (2016).    [4]   These four constituents are cobalt, lithium, molybdenum, and lead. The following Gibson Dunn lawyers assisted in the preparation of this client alert: Avi Garbow and Courtney Aasen. Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues.  For additional information about this regulatory change and other regulations affecting the management and disposal of coal ash, or related litigation, please contact the Gibson Dunn lawyer with whom you usually work or the following leaders of the firm’s Environmental Litigation and Mass Tort practice group: Avi S. Garbow (+1 202-955-8558, agarbow@gibsondunn.com) Daniel W. Nelson (+1 202-887-3687, dnelson@gibsondunn.com) Peter E. Seley (+1 202-887-3689, pseley@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

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

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

Click for PDF The continued explosion in the number of securities class action filings is once again the big headline in our half yearly update.  The now-sustained increase in both the number of filings and average and median settlement amounts—including a five-fold increase in average settlement amounts in the first half of 2018 to $124 million from $25 million in 2017—is causing significant alarm in the securities defense bar, prompting insurance carriers and others to seek regulatory reform and explore other alternatives to reverse these trends.  The trends and critical case law updates are explored in detail below. I.    Filing and Settlement Trends In the first half of 2018, new securities class actions filings are on pace to repeat the 2017 results of significantly exceeding annual filing rates in previous years.  According to a newly-released NERA Economic Consulting study (“NERA”),[1] 217 cases were filed in the first half of this year.  While this lags slightly behind the first half of 2017, which saw 246 new filings, the 2018 rate nonetheless substantially outpaces the average number of 235 cases filed annually over the five years from 2012-2016.  At the current pace, filings for 2018 are projected to reach 434 total cases—compared with 428 total cases filed in 2017.  So-called “merger objection” cases, which more than doubled each year from 2015 to 2017, remain a driving force although the rate of increase in the number of such cases filed has greatly slowed.  NERA projects that the number of merger objection cases filed in federal court in 2018 will be slightly greater than 2017, representing 218 projected filings of the 434 total projected federal filings for 2018 compared to 203 merger objection filings in 2017. While the total number of such federal filings is not projected to increase drastically over the number of filings in 2017, both average and median settlement amounts are up significantly in the first half of 2018. Notably, median settlement amounts as a percentage of alleged investor losses also increased significantly, and have broken a pattern that has persisted for decades.  In the last fifteen years, median settlement amounts have never exceeded 3% of total alleged investor losses.  In the first half of 2018, that percentage is 3.9%, up sharply from 2.6% in 2017. The industry sectors most frequently sued in 2018 continue to be healthcare (25% of all cases filed), tech (23%), and finance (16%).  Cases filed against healthcare companies in the first half of 2018 are showing the continuation of a downward trend from a spike in 2016.  Cases filed against tech and finance companies are both on pace for increases from 2017.  The tech sector’s share of filings is showing a near-doubling from 2017, with the first-half 2018 numbers indicating 23% of cases filed in this sector—up from 12% in 2017. A.    Filing Trends Figure 1 below reflects filing rates for the first half of 2018 (all charts courtesy of NERA).  Two hundred and seventeen cases have been filed so far this year, annualizing to 434 cases. This figure does not include the many class suits filed in state courts or the rising number of state court derivative suits, including many such suits filed in the Delaware Court of Chancery. B.    Mix of Cases Filed in First Half of 2018 1.    Filings by Industry Sector New filings for the first half of 2018 show a marked increase in cases targeting defendants in the tech industry, reversing a downward trend from 2016 and 2017.  Tech sector filings have spiked significantly, from 12% of the total in 2017 to 23% of the total for the first half of 2018.  Healthcare still owns the dubious honor as the top industry in the category of new filings, at 25% of total filings, but the industry is showing a continued downward trend from a high of 34% in 2016.  Among the top five industries by number of new cases filed so far in 2018, healthcare is the only sector on pace for fewer filings than in 2017.  Tech, finance, consumer and distribution services, and producer/manufacturing sectors each are on pace for increases from 2017.  Outside of the top-five industry sectors for new filings, all other measured industry sectors show a decline in their respective 2017 shares of new cases filed.  Of these sectors, the two reflecting the largest decline are consumer durables and non-durables (at 5%, down from 10% in 2017) and energy and non-energy minerals (at 2%, down from 7% in 2017). 2.    Merger Cases As shown in Figure 3, 109 “merger objection” cases have been filed in federal court in the first half of 2018 alone—continuing a high rate of such filings from 2017, which saw a drastic increase in the number of such cases over previous years.  If the 2018 pace continues, this year will see an increase both in the total number of these cases filed in federal court and in the percentage of federal filings that are merger objection filings. C.    Settlement Trends As Figure 4 shows below, after a significant decrease year-over-year from 2016 to 2017, average settlements jumped from $25 million in 2017 to an eye-popping $124 million in the first half of 2018.  As we have noted in previous updates, in any given year the statistics can mask a number of important factors that contribute to any particular settlement value.  Average and median settlement statistics also can be influenced by the timing of large settlements.  In 2017, there were no settlements at $1 billion or greater; while in the first half of 2018, $3.0 billion of a total $3.8 billion of aggregate settlement value is accounted for by settlements of $1 billion or more.    Removing settlements over $1 billion shows a much smaller increase in the average settlement—from $25 million in 2017 to $28 million in the first half of 2018.  However, as Figure 5 shows, the median settlement value, even when excluding settlements over $1 billion, still shows a significant increase from $6 million in 2017 to $16 million in the first half of 2018.  In the first half of 2018, the percentage of settlements above $100 million shows a continuation of a downward trend—from 15% in 2016 to 8% in 2017 to 6% in the first half of 2018.  The percentage of settlements below $10 million decreased substantially from 61% in 2017 to 39% in the first half of 2018, while over the same period settlements valued between $20 million and $49.9 million increased substantially from 14% to 32%. Mid-Year 2018 Securities Litigation Update: What to Watch for in the Supreme Court A.    Making Sense of “Gibberish”—Cyan and the Securities Litigation Uniform Standards Act As readers may recall, on November 28, 2017, the Supreme Court heard oral argument in Cyan, Inc. v. Beaver County Employees Retirement Fund, No. 15-1439.  The fundamental issue in Cyan was whether Congress intended to preclude state court jurisdiction over “covered class actions” under the Securities Act of 1933 (the “1933 Act”) when it enacted the Securities Litigation Uniform Standards Act (“SLUSA”) in 1998.  As amended by SLUSA, the 1933 Act provides for concurrent state and federal court jurisdiction “except as provided in section 77p of this title with respect to covered class actions.”  15 U.S.C. § 77v(a).  The Court also considered a secondary question raised by the U.S. government as amicus curiae:  whether SLUSA granted defendants the ability to remove a 1933 Act class action from state to federal court. As we reported in our 2017 Year-End Securities Litigation Update, at oral argument, several Justices referred to SLUSA’s jurisdictional limitation as “obtuse” at best and “gibberish” at worst and seemed frustrated by the statute’s confusing language.  See, e.g., Transcript of Oral Argument at 11, 47.  Those concerns were not reflected, however, in the Court’s decision:  In an opinion authored by Justice Kagan and joined by all other Justices, the Court concluded on March 20, 2018 that SLUSA did not preclude state court jurisdiction over 1933 Act suits.  Cyan, Inc. v. Beaver Cty. Employees Ret. Fund, 138 S. Ct. 1061, 1069 (2018). Parsing the statutory text, the Court explained that the “except clause” in § 77v(a) only precluded concurrent jurisdiction over class actions based on state law.  Id.  Consequently, “as a corollary of that prohibition,” SLUSA allowed state courts the ability to remove state law-based suits to federal courts for dismissal.  Id.  The Court also noted that the statute was silent with respect to class actions based on federal law, and interpreted this silence to suggest that Congress did not intend to deprive state courts of the ability to hear those cases.  Id. The Court declined to accept Cyan’s textual argument that the definition of “covered class actions,” located in § 77p(f)(2), which denotes individual lawsuits seeking damages on behalf of more than 50 people or in which at least one named party seeks “to recover damages on a representative basis,” as well as groups of lawsuits seeking damages on behalf of more than 50 people or which have been “joined, consolidated, or otherwise proceed as a single action,” exempted all sizable class actions from state court jurisdiction, explaining that a “definition does not provide an exception, but instead gives meaning to a term.”  Id. at 1070.  The Court elaborated that Cyan’s interpretation of the definition “fits poorly with the remainder of the statutory scheme” because it would prohibit state courts from hearing any 1933 Act class actions made up of more than 50 class members regardless of whether or not they were “covered class actions” under § 77p.  Id. at 1071. The Court similarly rejected Cyan’s legislative intent arguments, noting that SLUSA was initially created in order “[t]o prevent plaintiffs from circumventing” the requirements of the Private Securities Litigation Reform Act (“PSLRA”).  Id. at 1067.  The Court thus reasoned that “stripping state courts of jurisdiction over 1933 Act class suits” was simply not something Congress needed or intended to do in order to effect that goal.  Id. at 1072–73.  Cyan also argued that SLUSA’s legislative reports demonstrated Congress’s intent to keep securities class actions solely in federal court.  Id. at 1072.  In response, the Court explained that SLUSA already ensured that most securities class action cases would be brought in federal court by amending the Securities Act of 1934 to provide for exclusive jurisdiction in federal court.  Id. at 1073.  Ultimately, the Court summarized its decision by stating that “we have no sound basis for giving the except clause a broader reading than its language can bear.”  Id. at 1075. The Court similarly rejected the Solicitor General’s argument that § 77p(c) permits the removal of 1933 Act cases to federal court if they allege the types of misconduct listed in § 77p(b), including “false statements or deceptive devices in connection with a covered security’s purchase or sale.”  Id.  Instead, the Court held that in light of its determination that § 77p(b) only prohibited claims based on state law, the state law claims were removable, and therefore subject to dismissal in federal court.  Id.  However, federal law suits—like Cyan—which alleged 1933 Act violations are not “covered class actions,” and therefore, they “remain subject to the 1933 Act’s removal ban.”  Id. B.    China Agritech and the Limits of American Pipe Tolling As discussed in our 2017 Year-End Securities Litigation Update, on December 8, 2017, the Supreme Court granted certiorari in China Agritech, Inc. v. Resh, No. 17-432.  The principal issue raised by China Agritech was whether a statute of limitations is tolled for absent class members who bring successive class actions outside the applicable limitations period, rather than just individual claims. By way of background, as readers will know, the Supreme Court held in American Pipe and Construction Co. v. Utah, 414 U.S. 538 (1974), that the statute of limitations is tolled by “the commencement of the original class suit” “for all purported members of the class who make timely motions to intervene after the court has found the suit inappropriate for class action status.”  Id. at 553.  The Court then extended this holding in Crown, Cork & Seal Co. v. Parker, 462 U.S. 345 (1983), to include “class members . . . choos[ing] to file their own suits,” effectively allowing the statute of limitations to remain tolled for individual suits by any “members of the putative class until class certification is denied.”  Id. at 354.  Crown went on to hold that in the event class certification is denied, “class members may [then] choose to file their own suits or to intervene as plaintiffs in the pending action.”  Id.  In Smith v. Bayer, 564 U.S. 299, 314 n.10 (2011), the Court summarized the rule of American Pipe and Crown thusly:  “[A] putative member of an uncertified class may wait until after the court rules on the certification motion to file an individual claim or move to intervene in the suit.” At oral argument on March 26, 2018, China Agritech argued that American Pipe should not be expanded to toll the claims of “absent class members who have not shown diligence . . . by not filing their own claims when class certification was denied” and that the Court should “require that anyone who wants to file a class action come to court early and in no event later than the running of the statute of limitations.”  Transcript of Oral Argument at 3.  Several of the Justices questioned China Agritech’s push to force additional actions to file while other actions may still be pending.  Justice Sotomayor, for example, observed that “if my financial interest is moderately sized or small sized, there’s no inducement for me to do anything other than what American [Pipe] tells me to do, which is to wait until the class issues are resolved before stepping forward. . . . [Y]our regime is encouraging the very thing that American Pipe was trying to avoid, which is having a multiplicity of suits being filed and encouraging every class member to come forth and file their own suit.”  Id. at 8–9. On the other hand, Justice Gorsuch commented that extending American Pipe could lead plaintiffs to “stack [cases] forever, so that try, try again, [] the statute of limitations never really has any force in these cases[.]”  Id. at 39.  Chief Justice Roberts echoed this concern, noting that American Pipe’s holding applied only to plaintiffs who sought to bring individual claims past the statute of limitations period and that “if you allow [plaintiffs to bring class actions after the statute of limitations have run every time class certification is denied], you’ve got to allow the third and then the fourth and the fifth.  And there’s no end in sight.”  Id. at 46. Ultimately, these concerns about a never-ending succession of class actions prevailed, and on June 11, 2018, the Court issued an 8-1 opinion declining to extend American Pipe to successive class actions.  Specifically, the Court held that after the denial of class certification, a putative class member may not commence a new class action beyond the time allowed by the statute of limitations.  China Agritech, Inc. v. Resh, 138 S. Ct. 1800, 1804 (2018). The Court dismissed Resh’s concerns that such a holding would result in a “needless multiplicity” of protective class action filings, pointing to the Second and Fifth Circuits—both of which had long ago declined to extend American Pipe in this context—and neither of which has faced excessive filings as a result.  Id. at 1810.  The Court went on to explain that its decision would not harm prospective plaintiffs or require them to file a protective, duplicative class action simply to protect against possible statute of limitations issues because “[a]ny plaintiff whose individual claim is worth litigating on its own rests secure in the knowledge that she can avail herself of American Pipe tolling if certification is denied to a first putative class.”  Id. (emphasis added).  Furthermore, even if courts faced an influx of multiple pre-emptive class actions, district courts have sufficient tools, “including the ability to stay, consolidate, or transfer proceedings” to deal with such an increase in an efficient way.  Id. at 1811. Justice Sotomayor concurred in the decision, stating that although she agreed with the majority that plaintiffs in the instant case should not be permitted to bring successive class actions under the American Pipe tolling provision, she believes that this bar should apply only to class actions brought under the PSLRA.  Id. (Sotomayor, J., concurring). Gibson Dunn represented the U.S. Chamber of Commerce, Retail Litigation Center, and American Tort Reform Association as amici curie supporting China Agritech in this case. C.    Lorenzo: Can Misstatement Claims Be Repackaged as Fraudulent Scheme Claims Post-Janus? On June 18, 2018, the Supreme Court granted certiorari in Lorenzo v. Securities and Exchange Commission, No. 17-1077, which raises the question of whether a securities fraud claim premised on a misstatement that does not meet the elements set forth in the Court’s decision in Janus Capital Group, Inc. v. First Derivative Traders for a Rule 10b-5(b) claim can instead be pursued as a “fraudulent scheme” claim under Rule 10b-5(a) and 10b-5(c).  See Petition for Writ of Certiorari at i.  The decision could limit the scope of Rule 10b-5 and significantly affect how the SEC chooses to pursue fraud claims against defendants who are alleged to have made false statements to investors. We expect that, in Lorenzo, the Court will further explicate its holding in Janus that only the “maker” of a fraudulent statement could be held liable for that misstatement under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5(b).  564 U.S. 135, 142 (2011).  In Lorenzo, the SEC accused brokerage firm director Francis Lorenzo of violating Rule 10b-5 by providing false information about a debenture offering to two potential investors.  Lorenzo claimed that he did not intentionally convey any false information and that he had merely copied and pasted information from an email he received from his boss without checking to see if it was accurate.  In the Matter of Francis V. Lorenzo, File No. 3-15211, at 15–16 (Dec. 31, 2013). Nevertheless, an SEC Administrative Law Judge found that Lorenzo had violated all three parts of Rule 10b-5: (a) employing a “device, scheme or artifice to defraud;” (b) making a false statement or omitting information that misleads investors; and (c) engaging in conduct that “would operate as a fraud or deceit.”  Id. at 8–17.  This decision was affirmed by the Commission.  Id. at 17.  Lorenzo was barred from associating with other advisers, brokers, or dealers in the industry and from participating in penny stock offerings and ordered to pay a $15,000 penalty and to cease and desist from further violations.  Id. at 1. Lorenzo appealed to the D.C. Circuit, arguing that under Janus, he could not be liable for a violation of Rule 10b-5(b) because he had not intended to convey false information to the investors and had merely transmitted information he received from his firm.  The D.C. Circuit agreed, finding that Lorenzo was not “the ‘maker’ of the false statements” and therefore could not be liable for a 10b-5(b) violation.  Lorenzo v. Sec. & Exch. Comm’n, 872 F.3d 578, 580 (D.C. Cir. 2017).  Nevertheless, the D.C. Circuit upheld the SEC’s findings that Lorenzo violated Rule 10b-5(a) and (c) and remanded back to the SEC to redetermine the appropriate sanctions.  Id. at 595.  Judge Kavanaugh dissented, arguing that the majority’s decision “create[d] a circuit split by holding that mere misstatements, standing alone, may constitute the basis for so-called scheme liability under [Rules 10b-5(a) and (c)]—that is, willful participation in a scheme to defraud—even if the defendant did not make the misstatements.”  Id. at 600 (Kavanaugh, J., dissenting). Lorenzo filed a petition for a writ of certiorari to the Supreme Court on January 26, 2018.  The petition contended that the D.C. Circuit’s holding “allows the SEC and private plaintiffs to sidestep Janus’ carefully drawn out elements of a fraudulent statement claim merely by relabeling the claim—with nothing more—as a fraudulent scheme claim.”  Petition for Writ of Certiorari at 5.  Lorenzo identified a 3-2 circuit split on the issue, noting that Second, Eighth, and Ninth Circuits have all held that a fraudulent scheme claim cannot be premised on misstatements alone, id. at 17–20, while the Eleventh and D.C. Circuits opine that a person can be liable for violations of Rule 10b-5(a) and (c) even where they are not the “maker” of an untrue statement, id. at 20–21.  The Petition further argued that the D.C. Circuit’s opinion “erases the important distinction between primary and secondary violators of the securities laws and opens up large numbers of defendants who are secondary actors at best to claims for securities fraud—claims that would otherwise be barred in private litigation.”  Id.  The SEC filed its opposition brief on May 2, 2018, arguing that the Second, Eighth, Ninth, Eleventh, and D.C. Circuit’s “inconsistent” rulings on Rule 10b-5(a) and (c) violations are distinguishable because they “have involved different conduct by the defendants, and they arose out of suits brought by private plaintiffs, rather than (as in this case) an administrative enforcement action brought by the SEC.”  Respondent’s Opposition to Writ of Certiorari at 8.  Respondent further contended that “petitioner does not identify any conflict over the scope of liability under Section 17(a)(1),” which uses the same language as Rule 10b-5(a) and makes it unlawful “to employ any device, scheme, or artifice to defraud.”  Id. The Supreme Court granted certiorari on June 18, 2018.  We expect that the parties will submit their briefs to the Supreme Court in the Fall of 2018, with oral argument to follow in the coming months.  We will continue to monitor this matter and provide an update in our 2018 Year-End Securities Litigation Update. D.    Securities Enforcement Updates In our 2017 Year-End Securities Litigation Update, we noted that the Court granted certiorari in two major SEC enforcement actions:  Lucia v. SEC, No. 17-130 and Digital Realty Trust, Inc. v. Somers, No. 16-1276.  For further analysis of Lucia and Digital Realty, please see our 2018 Mid-Year Securities Enforcement Update. II.    Delaware Developments A.    Transactions Involving A Potentially Controlling Stockholder Four recent decisions involved transactions with a potentially controlling stockholder.  In one, the Court of Chancery extended the MFW standard of review-shifting framework to all transactions in which a controlling stockholder receives a “non-ratable” benefit.  In another, the court concluded a company’s visionary founder was a controlling stockholder in part due to longstanding public acknowledgement of his influence.  In a similar case, the Court of Chancery held demand was excused because a majority of a board was not independent of its visionary founder, but stopped short of deciding whether that founder was a controlling stockholder.  Last, the Court of Chancery declined to enjoin a controlling stockholder from interfering with a special committee’s plan to dilute its voting control from around 80% to 17%. 1.    Controlling stockholder transactions satisfying the requirements of MFW will be reviewed under the business judgment rule. In Kahn v. M & F Worldwide Corp., the Delaware Supreme Court held that the business judgment rule applies to a merger between a controlling stockholder and its subsidiary where the merger is conditioned on “both the approval of an independent, adequately-empowered Special Committee that fulfills its duty of care; and the uncoerced, informed vote of a majority of the minority stockholders.”  88 A.3d 635, 644 (Del. 2014).  Late last year, the Court of Chancery extended MFW to stock reclassifications.  IRA Tr. FBO Bobbie Ahmed v. Crane, 2017 WL 7053964, at *9 (Del. Ch. Dec. 11, 2017).  In Crane, NRG Yield, Inc. was dominated by a controlling stockholder, NRG Energy, Inc. (“NRG”), as part of a “yieldco” ownership structure.  When stock issuances threatened NRG’s control, the NRG-dominated board sought to eliminate or reduce the voting rights of the publicly-traded stock class through reclassification.  The independent Conflicts Committee negotiated an agreement with NRG whereby both NRG and minority stockholders were issued new classes of stock with 1/100 of a voting share each, substantially slowing down NRG’s vote dilution, and conditioned the deal on the approval of a majority of minority stockholders.  The measure passed, and a minority stockholder challenged the transaction.  As a matter of first impression, the Court of Chancery held that the reclassification’s compliance with MFW shifted the standard of review from entire fairness to the business judgment rule because “[t]he animating principle of the MFW framework is that . . . the controlled company replicates an arms-length bargaining process in negotiating and executing a transaction.”  Id. at *11.  Importantly, however, the Court of Chancery expressly extended its holding beyond reclassifications, reasoning that there is “no principled basis on which to conclude that the dual protections in the MFW framework should apply to squeeze-out mergers but not to other forms of controller transactions.”  Id. 2.    Elon Musk is Tesla’s controlling stockholder. In In re Tesla Motors Inc. Stockholder Litigation, the Court of Chancery denied defendants’ motion to dismiss and found, “in a close call,” that the complaint sufficiently alleged that Tesla’s CEO and Chairman Elon Musk is its controlling stockholder for purposes of its 2016 acquisition of SolarCity, a Musk-related entity.  2018 WL 1560293 (Del. Ch. Mar. 28, 2018).  According to the court, Musk’s ownership of 22% of Tesla’s outstanding stock and a combination of “other factors” made him a controlling stockholder for purposes of the SolarCity acquisition.  First, Musk pitched the proposed transaction to the board on three separate occasions, and the board did not consider any other solar power companies or form an independent committee to consider the proposal.  Second, a majority of the five directors who approved the acquisition “were interested in the Acquisition or not independent of Musk.”  Id. at *17.  Third, the court relied on Musk’s and the board’s public statements acknowledging Musk’s influence on Tesla, such as Musk’s role in shaping the company’s vision, hiring executives and engineers, and raising capital.  The court concluded that the combination of Musk’s control over the board, board level conflicts, and the public acknowledgment of Musk’s influence allowed a reasonable inference that Musk enjoyed “the equivalent of majority voting control” in the transaction.  Id. at *15. 3.    A majority of Oracle’s board of directors is not independent of Larry Ellison. In a similar vein, the Court of Chancery found that plaintiffs sufficiently alleged demand futility against the board of Oracle Corporation because the majority of the board was not independent of Larry Ellison, Oracle’s co-founder and Chairman, for purposes of the acquisition of NetSuite, Inc., another Ellison-founded company.  In re Oracle Corp. Derivative Litig., 2018 WL 1381331 (Del. Ch. Mar. 19, 2018).  Because a breach of loyalty claim belongs to the company, in the normal course a plaintiff must demand that the board take a particular action before bringing a lawsuit.  In lieu making a demand on the board, however, a plaintiff may plead that demand is excused because a majority of the directors were not independent or disinterested.  At the time of the challenged acquisition, Ellison owned roughly 28% of Oracle and about 45% of NetSuite.  After concluding that Ellison and the four manager directors were not independent due to Ellison’s outsized impact on the company’s day-to-day operations, the court went on to find that three other directors, including two of the three directors on the Special Committee that approved the NetSuite acquisition, had sufficient entanglements with Ellison to call into question their independence with respect to the acquisition of the Ellison-controlled NetSuite.  Specifically, those directors had substantial business ties with Ellison, and two of the three directly owed their director positions to Ellison because a majority of non-Ellison stockholders disapproved of their performance on the Compensation Committee.  Without deciding whether Ellison “qualif[ies] as a controller,” the court held that the “constellation of facts” were sufficient, “taken together, [to] create reasonable doubt” about the ability of the directors to “objectively consider a demand.”  Id. at *16, *18. 4.    Equity favors a controller’s right to protect its control preemptively. In CBS Corp. v. National Amusements, Inc., CBS and a special committee of five independent directors sought to enjoin CBS’s controlling stockholder from interfering with their plan to dilute its voting power from around 80% to 17%.  2018 WL 2263385, at *1 (Del. Ch. May 17, 2018).  Through her control of National Amusements, Inc. (“NAI”), Shari Redstone controls 79.6% of CBS’s voting power, even though NAI owns only 10.3% of CBS’s economic stake.  Id.  According to the plaintiffs, dilution was justified by Ms. Redstone’s efforts to combine CBS with Viacom, which she also controls, and various actions she took over two years that “present[ed] a significant threat of irreparable and irreversible harm to [CBS]” and “the interests of the stockholders who hold approximately 90% of [its] economic stake.”  Id. at *1, *4.  The Court of Chancery agreed that the plaintiffs allegations were “sufficient to state a colorable claim for breach of fiduciary duty against Ms. Redstone and NAI as CBS’s controlling stockholder,” id. at *4.  Nonetheless, the court declined to issue the unprecedented temporary restraining order because case law “expressly endorsed a controller’s right to make the first move preemptively to protect its control interest” and subjected exercise of that right to further judicial review.  Id. This dispute is ongoing, and an expedited trial is scheduled for the fall. B.    Bad Faith, Waste, And The Business Judgment Rule Delaware’s default standard of review, the business judgment rule presumes that a company’s directors make business decisions in good faith, on an informed basis, and in the honest belief that the decisions are in the best interest of the company.  In general, unless a plaintiff rebuts this presumption, its claims will not survive a motion to dismiss.  In the first half of 2018, plaintiffs survived a motion to dismiss in three notable cases. 1.    Directors who knowingly cause a corporation to violate the law act in bad faith. A plaintiff’s breach of loyalty claim survived a motion to dismiss where the complaint adequately alleged that “the directors knowingly permitted [the company] to continue with marketing campaigns containing false representations in violation of law.”  City of Hialeah Emps.’ Ret. Sys. v. Begley, 2018 WL 1912840, at *4 (Del. Ch. Apr. 20, 2018).  The defendants in Begley were directors of a company that operated DeVry University.  Id. at *1.  According to the complaint, the defendants authorized marketing campaigns that misrepresented DeVry graduates’ employment rates and income despite knowing the information was wrong and the campaigns violated federal law, resulting in the company paying over $100 million to settle various government lawsuits and investigations.  Id.  The Court of Chancery denied the defendants’ motion to dismiss, concluding that specific facts alleged in the complaint supported a reasonable inference that “the defendants chose to maintain DeVry’s marketing campaign and operate DeVry in violation of law because that was the route to maximizing DeVry’s profits.”  Id. at *3.  Operating a company in violation of law to maximize profits “expose[s] [directors] to liability for acting in bad faith, which is a breach of the duty of loyalty.”  Id. at *3. 2.    A board commits waste when it fails to consider terminating an incapacitated employee earning millions of dollars. In an “extreme factual scenario,” the Court of Chancery found that plaintiffs successfully pleaded demand futility and stated a claim for corporate waste with respect to payments made to CBS’s controlling stockholder, Sumner Redstone, during his twenty-month incapacitation beginning in 2014.  Feuer on behalf of CBS Corp. v. Redstone, 2018 WL 1870074 (Del. Ch. Apr. 19, 2018), judgment entered sub nom. Feuer v. Redstone, 2018 WL 2006677 (Del. Ch. 2018).  Despite having the inherent ability to terminate his employment agreement, CBS continued making payments to Redstone after he fell critically ill.  Id. at *12.  Because the board “made no effort to reckon with the financial consequences of Redstone’s severe incapacity,” id. at *14, however, and Redstone’s contributions during that time “were so negligible and inadequate in value that no person of ordinary, sound business judgment would deem them worth the millions of dollars in salary that the Company was paying him,” the court held that the board faced “a substantial threat of liability for non-exculpated claims for waste and/or bad faith,” id. at *13, and denied the defendants’ motion to dismiss. 3.    A transaction negotiated by an allegedly conflicted CEO is not protected by the business judgment rule. In In re Xerox Corp. Consolidated Shareholder Litigation, the New York Supreme Court recently enjoined a multi-billion dollar merger of Xerox Corp. and Fujifilm Holdings Corp. (“Fuji”), concluding the plaintiffs adequately rebutted the business judgment rule and showed a likelihood of success on the merits of their claims that the merger was not entirely fair.  2018 WL 2054280, at *8 (N.Y. Sup. Apr. 27, 2018).  The merger arose from a decades-long joint venture between Xerox and Fuji whose governing documents made it difficult for Xerox to do a deal with anyone else.  Id. at *2.  The transaction was structured so that Fuji would transfer its 75% stake in the joint venture without additional consideration to Xerox and be issued enough new Xerox shares to become its 50.1% stockholder; simultaneously, Xerox would borrow $2.5 billion to pay its non-Fuji stockholders a special dividend in the same amount.  Id. at *1.  The Supreme Court enjoined the deal, however, because Xerox’s CEO, who negotiated the deal, was “massively conflicted” and a majority of Xerox’s board lacked independence.  Id. at *7.  According to the court, the CEO was conflicted because after Carl Icahn, Xerox’s largest stockholder, stated his preference for an all-cash deal and convinced the board to fire the CEO, the CEO negotiated a non-cash deal in which he would remain as the CEO of the combined entity.  Id.  The court also concluded that Xerox’s board lacked independence from the CEO because he recommended by name a majority of Xerox’s directors to continue as directors after the merger.  Id. This decision is on appeal to the First Department. B.    Delaware Continues to Restrict Appraisal Awards In our 2017 Year-End Update, we reported on the significant shift in Delaware appraisal law in Dell, Inc. v. Magnetar Global Event Driven Master Fund Ltd., 177 A.3d 1 (Del. 2017).  In Dell, the Delaware Supreme Court held that “[t]here is no requirement that a company prove that the sale process is the most reliable evidence of its going concern value in order for the resulting deal price to be granted any weight,” id. at 35, and reversed “the trial court’s decision to give no weight to any market-based measure of fair value.”  Id. at 19. The Court of Chancery began interpreting the high court’s directives in the first half of 2018.  In Verition Partners Master Fund Ltd. v. Aruba Networks, Inc., for example, the Court of Chancery interpreted Dell as (i) endorsing a company’s unaffected market price and deal price as reliable indicators of value when, respectively, the market for the company’s stock is efficient or a third-party merger is negotiated at arm’s length; and (ii) cautioning against relying on discounted cash flow analyses when such reliable market indicators are available.  2018 WL 2315934, at *1 (Del. Ch. May 21, 2018) (awarding $17.13 per share—the unaffected market price and significantly below the $24.67 deal price—as the only reliable indicator of value).  And in In re AOL, Inc., the Court of Chancery found the deal was not “Dell-compliant” based both on provisions in the merger agreement and on the CEO’s public statements that the deal was “done.”  2018 WL 1037450, at *1 (Del. Ch. Feb. 23, 2018) (conducting its own discounted cash flow analysis where the deal price was unreliable, but awarding a price close to it).  These two cases suggest that while there may continue to be some uncertainty as to when and how the Delaware Court of Chancery will choose among market indicators of a company’s value, the Court will continue to enforce the Supreme Court’s directive to use market factors to determine the fair value of a company’s stock, which should continue to keep appraisal awards in check. III.    Loss Causation Developments The first half of 2018 saw several notable circuit court opinions addressing loss causation, including continued developments relating to Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014), discussed below in Section VI. Leading the way, on January 31, 2018, the Ninth Circuit issued a per curiam opinion resolving a perceived ambiguity in prior precedent regarding the correct test for loss causation under the Exchange Act.  See Mineworkers’ Pension Scheme v. First Solar Inc., 881 F.3d 750 (9th Cir. 2018).  The First Solar court held that “to prove loss causation, plaintiffs need only show a causal connection between the fraud and the loss . . . by tracing the loss back to the very facts about which the defendant lied.”  Id. at 753 (internal citations and quotation marks removed).  This test does not require loss causation to rest on a revelation of fraud to the marketplace.  Instead, “[a] plaintiff may also prove loss causation by showing that the stock price fell upon the revelation of an earnings miss, even if the market was unaware at the time that fraud had concealed the miss.”  Id. at 754.  In so holding, the Ninth Circuit rejected a more “restrictive view,” in which “[s]ecurities fraud plaintiffs can recover only if the market learns of the defendants’ fraudulent practices” before the claimed loss.  Id. at 752.  As long as the revelation that caused the decline in a company’s stock price is related to the facts allegedly concealed, a plaintiff has adequately plead loss causation for the purposes of stating a claim under the Exchange Act.  At least one district court has relied upon First Solar to deny a defendants’ motion for summary judgment on the issue of loss causation.  See Mauss v. NuVasive, Inc., No. 13CV2005 JM (JLB), 2018 WL 656036, at *5 (S.D. Cal. Feb. 1, 2018) (rejecting defendants’ argument that plaintiffs failed to show that the market learned of the actual fraud, because “the Ninth Circuit does not require that fraud be affirmatively revealed to the market to prove loss causation”). Over in the Fourth Circuit, a split panel issued a decision on February 22, 2018 holding that a plaintiff can plead loss causation based on “an amalgam” of two theories: corrective disclosure and the materialization of a concealed risk.  Singer v. Reali, 883 F.3d 425 (4th Cir. Feb. 22, 2018).  The complaint in Singer alleged that TranS1, Inc., a medical device company, and its officers made misrepresentations and omissions in public filings by failing to disclose that a large portion of TranS1’s revenues were generated by a purportedly fraudulent reimbursement scheme.  In vacating the lower court opinion dismissing the complaint, the majority concluded that two disclosures highlighted in the complaint—a Form 8-K reporting that TranS1 had received a subpoena from the Department of Health and Human Services and an analyst report revealing that the subpoena sought communications relating to certain reimbursements—sufficiently revealed information for investors to recognize that defendants had perpetrated a fraud on the market.  Id. at 447.  Moreover, the allegation that the disclosures resulted in a 40% stock price drop was sufficient to plead that the revelation of the purported fraud was at least “one substantial cause” of the drop.  Id.  The decision in Singer adds to the debate about the extent to which the disclosure of a government investigation, without a later disclosure of wrongdoing, is sufficient to establish loss causation.  See, e.g., Public Employees’ Retirement System of Mississippi v. Amedisys, Inc., 769 F.3d 313, 323-24 (5th Cir. 2014) (“commencement of government investigations . . . do not, standing alone, amount to a corrective disclosure,” but can support a finding of loss causation when coupled with other disclosures); Meyer v. Greene, 710 F.3d 1189, 1201 (11th Cir. 2013) (company disclosure of SEC investigations were not “corrective disclosures” for the purposes of loss causation); SEC investigation was insufficient to plead loss causation). 2018 Mid-Year Securities Litigation Update: Falsity of Opinions Under Omnicare As we have reported in our past several updates, courts continue to grapple with the reach of Omnicare, Inc. v. Laborers Dist. Council Const. Indus. Pension Fund, 135 S. Ct. 1318 (2015).  The Supreme Court’s Omnicare decision addressed the scope of liability for false opinion statements under Section 11 of the Securities Act.  The Court held that “a sincere statement of pure opinion is not an ‘untrue statement of material fact,’ regardless whether an investor can ultimately prove the belief wrong.”  Id. at 1327.  An opinion statement can give rise to liability only when the speaker does not “actually hold[] the stated belief,” or when the opinion statements contains “embedded statements of fact” that are untrue.  Id. at 1326–27.  In addition, the Court held that a factual omission from a statement of opinion gives rise to liability only when the omitted facts “conflict with what a reasonable investor would take from the statement itself.”  Id. at 1329. In the first half of 2018, two courts issued notable opinions about how Omnicare applies to disclosure of financial information.  The United States District Court for the Central District of California denied a motion to dismiss when plaintiffs alleged that defendants issued false opinions about the company’s financial health by recognizing revenue in violation of Generally Accepted Accounting Principles.  In re Capstone Turbine Corp. Sec. Litig., No. CV 15-8914, 2018 WL 836274, at *7–8 (C.D. Cal. 2018).  The parties disputed whether the amount of revenue recognized in a particular period is an opinion or a statement of fact, and the court held that “revenue is an opinion with an embedded fact,” clarifying that “[t]he fact is the actual quantity of the sales and the opinion is that collectability on these sales is reasonably assured.”  Id. at *6.  The court further concluded that the falsity of the opinion portions of the statements regarding revenue recognition were sufficiently pled under Omnicare because the complaint alleged facts showing that defendants knew collectability was not reasonably assured.  Id. at *7.  In the United States District Court for the District of Massachusetts, plaintiffs brought a suit under Massachusetts security law, which closely mirrors federal securities law, alleging that an auditor’s statement of compliance with PCAOB standards was false.  Miller Inv. Trust v. Morgan Stanley & Co., No. 11-12126, 2018 WL 1567599 (D. Mass. Mar. 30, 2018) appeal docketed No. 18-1460 (1st Cir. May 17, 2018).  Acknowledging that courts have reached contradictory conclusions as to whether an auditor’s statements of compliance are statements of fact or statements of opinion, the court ultimately reasoned that “statements by auditors of their own compliance with [standards] are statements of fact” even though “one auditor may apply the standards differently from another.”  Id. at *11–12. Omnicare continued to act as a pleading barrier to securities fraud claims in the first half of this year, with courts paying close attention to the role of context in determining whether an opinion could be allegedly false.  For example, in Martin v. Quartermain, investors alleged that a mining company’s opinion statements expressing continued optimism in its mining operations were false when the company failed to disclose that one of its experts had expressed doubt.  No. 17-2135, 2018 WL 2024719 (2d Cir. May 1, 2018).  Investors alleged that the opinion was false on two theories:  first, that company did not actually believe its statement of continued optimism given that one of its experts had expressed concern with the mine’s projected viability; and, second, that the company’s failure to disclose this concern was an omission that made the opinion statement misleading to a reasonable investor.  Id. at 2.  As to the first theory, the court held that the plaintiffs failed to show that the company believed the concerned expert instead of the optimistic projection, so plaintiffs failed to show that the company did not hold the stated belief.  As for the second theory, the Second Circuit concluded that omitting the concerned expert’s views did not render the opinion misleading when viewed in context, even if the company knew “but fail[ed] to disclose some fact cutting the other way.”  Id. at *3 (citing Omnicare, 135 S. Ct. at 1329).  The court reasoned that the risk that a mine will not be successful is part of the “broader frame” of the industry that a reasonable investor would understand as part of the “weighing of competing facts.”  Id. (citing Omnicare, 135 S. Ct. 1329). Similarly, the United States District Court for the Southern District of New York rejected allegations that a company’s guardedly optimistic assessments about the implementation of a new software program were false because they did not include disclosure of implementation challenges the company was facing.  Oklahoma v. Firefighters Pension and Ret. Sys. v. Xerox Corp., 300 F. Supp. 3d 551, 575 (S.D.N.Y. 2018), appeal docketed No. 18-1165 (2d Cir. April 20, 2018).  The court reasoned that these “quintessential statements of opinion” were not false even though the defendant only disclosed in general terms the challenges it was facing because a reasonable investor “does not expect that every fact known to an issuer supports its opinion statement.”  Id. at 577 (citing Omnicare, 135 S. Ct. 1329).  Another court in the Southern District of New York permitted an omission claim to proceed, but this case may simply highlight how difficult it is to overcome Omnicare.  Plaintiffs alleged that Blackberry’s optimistic sales projections were contradicted by omitted data Blackberry had about its sales numbers.  Pearlstein v. Blackberry Ltd., No. 13-CV-7060, 2018 WL 1444401 (S.D.N.Y. Mar. 19, 2018).  In their second amended complaint, plaintiffs supplemented these allegations with evidence that came to light in a related criminal trial that revealed that Blackberry had adverse sales data when it issued its optimistic projections.  The court concluded that Blackberry’s failure to disclose adverse sales data could plausibly be misleading to a reasonable investor.  Id. at *3–4.  Most plaintiffs, of course, do not have the benefit of evidence unearthed in a related criminal proceedings to demonstrate that an opinion is false. Further highlighting the barriers imposed by Omnicare, two courts in the first half of this year also rejected claims alleging that pharmaceutical companies made false statements about their clinical trials.  One court held that plaintiff’s allegations that defendants issued a false opinion when they opined on a drug’s efficacy but failed to disclose an allegedly flawed clinical methodology did not support a Section 10(b) claim because plaintiff’s claims amounted to nothing more than an attack on the trial’s methodology.  Hoey v.  Insmed Inc., No. 16-4323, 2018 WL 902266, at *9, 14 (D.N.J. Feb. 15, 2018).  The court noted that the failure to reveal that the results of a study were inaccurately reported or that a study was manipulated to conceal data may support allegations that an omission made a statement of opinion misleading, but that disagreements over the proper methodology will not support such an allegation.  Likewise, a company’s failure to disclose the recurrence of a known side effect did not render opinions that the clinical trial was “predictable and manageable” and that the company was seeing “favorable clinical data” false or misleading since a reasonable investor would expect the recurrence of a known side effect.  In re Stemline Therapeutics, Inc. Sec. Litig., No. 17 CV 832, 2018 WL 1353284, at *5 (S.D.N.Y. Mar. 15, 2018) appeal docketed No. 18-1044 (2d Cir. Apr. 12, 2018). Courts in the first half of 2018 also provided guidance for companies making opinion statements about legal and compliance risks.  The United States District Court for the Southern District of Texas rejected allegations that a company’s opinion that it was in “substantial compliance” with regulations was false on the ground that a regulatory agency had sent informal communications and had issued two infraction notices about recordkeeping practices on a different and small part of the company’s large-scale and pipeline operations.  In re Plains All Am. Pipeline, L.P. Sec. Litig., No. H:15-02404 2018 WL 1586349, at * 38–39 (S.D. Tex. Mar. 30, 2018) appeal docketed No. 18-20286 (5th Cir. May 7, 2018).  The court reasoned that the opinion that the company was in “substantial compliance,” when combined with other hedges and qualifications, would inform a reasonable investor that the company was operating in substantial, but not perfect, compliance with relevant laws.  Id. at *39.  On the other hand, the United States District Court for the Northern District of Georgia permitted a claim to proceed where the defendant opined that it had been in material compliance with the laws and that pending lawsuits had no merit because plaintiffs’ complaint sufficiently alleged that defendant had been informed by legal counsel that its model was not in compliance with applicable laws.  In re Flowers Foods, Inc. Sec. Litig., No. 7:16-CV-222, 2018 WL 1558558, at *7–8 (M.D. Ga. Mar. 23, 2018). IV.    Halliburton II Market Efficiency and “Price Impact” Cases Courts across the country continue to grapple with implementing the Supreme Court’s landmark ruling in Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014) (“Halliburton II“), and the first half of 2018 did not bring any new decisions from the federal circuit courts of appeal.  In Halliburton II, the Supreme Court preserved the “fraud-on-the-market” presumption—a presumption enabling plaintiffs to maintain the common proof of reliance that is essential to class certification in a Rule 10b-5 case—but made room for defendants to rebut that presumption at the class certification stage with evidence that the alleged misrepresentation had no impact on the price of the issuer’s stock.  Two key questions continue to recur: first, how should courts reconcile the Supreme Court’s explicit ruling in Halliburton II that direct and indirect evidence of price impact must be considered at the class certification stage, Halliburton II, 123 S. Ct. at 2417, with its previous decisions holding that plaintiffs need not prove loss causation or materiality until the merits stage, see Erica P. John Fund, Inc. v. Halliburton Co., 563 U.S. 804 (2011) (“Halliburton I“); Amgen Inc. v. Conn. Ret. Plans & Trust Funds, 568 U.S. 455 (2013).  And second, what standard of proof must defendants meet to rebut the presumption with evidence of no price impact of Basic Inc. v. Levinson, 485 U.S. 224, 237 (1988)? As we reported in our 2017 Year-End Securities Litigation Update, the Second Circuit recently addressed both of these key questions in Waggoner v. Barclays PLC, 875 F.3d 79 (2d Cir. 2017) (“Barclays“) and Ark. Teachers Ret. Sys. v. Goldman Sachs, 879 F.3d 474 (2d Cir. 2018) (“Goldman Sachs“).  Those decisions remain the most substantive interpretations of Halliburton II.  Barclays addressed the standard of proof necessary to rebut the presumption of reliance and held that after a plaintiff establishes the presumption of reliance applies, defendant bears the burden of persuasion to rebut the presumption by a preponderance of the evidence.  As we have previously noted, this puts the Second Circuit at odds with the Eighth Circuit, which cited Rule 301 of the Federal Rules of Evidence when reversing a trial court’s certification order on price impact grounds, see IBEW Local 98 Pension Fund v. Best Buy Co., 818 F.3d 775, 782 (8th Cir. 2016), because Rule 301 assigns only the burden of production—i.e., producing some evidence—to the party seeking to rebut a presumption, but “does not shift the burden of persuasion, which remains on the party who had it originally.”   In Goldman Sachs, the Second Circuit directed that price impact evidence must be analyzed prior to certifying a class, even if price impact “touches” on the issue of materiality.  Goldman Sachs, 879 F.3d at 486.  In April, the Supreme Court declined to take up the Barclays case, Waggoner v. Barclays PLC, 875 F.3d 79 (2d Cir. 2017), cert. denied, 138 S. Ct. 1702 (2018), and Goldman Sachs remains pending before the Southern District of New York on remand, where an evidentiary hearing and oral argument on class certification was held on July 25, 2018. The Third Circuit is poised to be the next to substantively address the issue, as the court recently agreed to review Li v. Aeterna Zentaris Inc., 324 F.R.D. 331 (D.N.J. 2018) (“Aeterna“).  See Order, Vizirgianakis v. Aeterna Zentaris, Inc., No. 18-8021 (3d Cir. Mar. 30, 2018).  That ruling is likely to address the nature of the evidence a defendant must put forward to defeat plaintiff’s presumption of reliance.  Before the district court, defendants sought to rebut plaintiffs’ presumption of reliance by challenging plaintiffs’ expert’s event study for failing to demonstrate price impact to the industry’s standard level of confidence.  Aeterna, 324 F.R.D. at 344-45.  The argument failed to convince the court, which noted that (1) plaintiffs’ report had been prepared to show an efficient market, not to demonstrate price impact, (2) the report’s failure to find a movement with 95% confidence did not prove the “lack of price impact with scientific certainty,” and (3) defendants did not present any competent evidence of their own to demonstrate price impact.  Id. at 345 (citation omitted).  Defendants’ 23(f) petitions requesting review of class certification on price impact grounds are pending in several other circuit courts of appeal. We will continue to monitor developments in these and other cases. The following Gibson Dunn lawyers assisted in the preparation of this client update: Monica Loseman, Matt Kahn, Brian Lutz, Laura O’Boyle, Mark Perry, Lissa Percopo, Lauren Assaf, Jefferson Bell, Michael Eggenberger, Kim Lindsay Friedman, Leesa Haspel, Mark Mixon, Emily Riff, and Zachary Wood. Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work, or any of the following members of the Securities Litigation Practice Group Steering Committee: Brian M. Lutz – Co-Chair, San Francisco/New York (+1 415-393-8379/+1 212-351-3881, blutz@gibsondunn.com) Robert F. Serio – Co-Chair, New York (+1 212-351-3917, rserio@gibsondunn.com) Meryl L. Young – Co-Chair, Orange County (+1 949-451-4229, myoung@gibsondunn.com) Thad A. Davis – San Francisco (+1 415-393-8251, tadavis@gibsondunn.com) Jennifer L. Conn – New York (+1 212-351-4086, jconn@gibsondunn.com) Ethan Dettmer – San Francisco (+1 415-393-8292, edettmer@gibsondunn.com) Barry R. Goldsmith – New York (+1 212-351-2440, bgoldsmith@gibsondunn.com) Mark A. Kirsch – New York (+1 212-351-2662, mkirsch@gibsondunn.com) Gabrielle Levin – New York (+1 212-351-3901, glevin@gibsondunn.com) Monica K. Loseman – Denver (+1 303-298-5784, mloseman@gibsondunn.com) Jason J. Mendro – Washington, D.C. (+1 202-887-3726, jmendro@gibsondunn.com) Alex Mircheff – Los Angeles (+1 213-229-7307, amircheff@gibsondunn.com) Robert C. Walters – Dallas (+1 214-698-3114, rwalters@gibsondunn.com) Aric H. Wu – New York (+1 212-351-3820, awu@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

July 25, 2018 |
Contractual Duties to Conduct a Business in Accordance With ‘Sound Business Practices’

New York partner Gabriel Herrmann and associate Lee R. Crain are the authors of “Contractual Duties to Conduct a Business in Accordance With ‘Sound Business Practices'” [PDF] published in the Delaware Business Court Insider on July 25, 2018.

July 18, 2018 |
Second Quarter 2018 Update on Class Actions

Click for PDF This update provides an overview and summary of significant class action developments during the second quarter of 2018 (April through June), as well as a brief look ahead to some of the key class action issues anticipated later this year. Part I discusses the U.S. Supreme Court’s decisions in two key cases, Epic Systems Corp. v. Lewis, and China Agritech, Inc. v. Resh. Part II looks forward to the Supreme Court’s October 2018 Term and previews a new class action case on the Court’s docket, Nutraceutical Corp. v. Lambert. Part III discusses two recent circuit-level cases involving class action settlements. I.     The U.S. Supreme Court Affirms Validity of Arbitration Clauses in Employment Agreements, and Limits American Pipe Tolling to Individual Suits The Supreme Court issued two important opinions in the past quarter of significant relevance to class action defendants. First, in the consolidated cases of Epic Systems Corp. v. Lewis, Ernst & Young LLP v. Morris, and National Labor Relations Board v. Murphy Oil USA, Inc., 138 S. Ct. 1612 (2018), the Supreme Court held that arbitration agreements in which an employee waives his right to bring a claim against an employer on a class or collective basis are enforceable under the Federal Arbitration Act (“FAA”) and do not violate the National Labor Relations Act (“NLRA”).  The Court’s ruling resolved a longstanding circuit split on this issue. In a 5-4 decision written by Justice Gorsuch, the Court held that “Congress has instructed in the Arbitration Act that arbitration agreements providing for individualized proceedings must be enforced, and neither the Arbitration Act’s saving clause nor the NLRA suggests otherwise.”  138 S. Ct. at 1616, 1624–27.  The Court rejected the employees’ argument that the FAA’s savings clause—which allows courts to refuse to enforce arbitration agreements “upon such grounds as exist at law or in equity for the revocation of any contract”—precludes enforcement of their arbitration agreements.  Because the employees’ argument was not applicable to “any” contract, and instead singled out “individualized arbitration proceedings” as invalid, the Court explained that the savings clause was not implicated, and there was no “generally applicable contract defense[]” to overcome the FAA’s presumption of enforceability.  Id. at 1622–23. The Court also rejected the argument that enforcing an arbitration agreement’s class action waiver would violate employees’ right to engage in collective action under the NLRA.  It disagreed with the suggestion that the later-passed NLRA had impliedly repealed portions of the FAA, emphasizing that “repeals by implication are ‘disfavored,’” and “Congress ‘does not alter the fundamental details of a regulatory scheme in vague terms or ancillary provisions.’”  Id. at 1624, 1626–27.  Section 7 of the NLRA, moreover, “focuses on the right to organize unions and bargain collectively,” “does not express approval or disapproval of arbitration,” and “does not even hint at a wish to displace the Arbitration Act—let alone accomplish that much clearly and manifestly.”  Id. at 1624. Finally, the Court declined to apply Chevron deference to the NLRB’s contrary conclusions, noting that Congress had not given the NLRB any authority to interpret the FAA, a statute that the agency does not administer.  The Court also observed that although Chevron deference is premised on the notion that “‘policy choices’ should be left to the Executive Branch,” “here the Executive seems to be of two minds, for [the Court] received competing briefs from the [NLRB] and the United States (through the Solicitor General),” the latter of which had supported the employers.  Id. at 1630. Justice Ginsburg, joined by Justices Breyer, Sotomayor, and Kagan, dissented.  They expressed concern that “underenforcement of federal and state” employment statutes will result from the majority’s decision, because employees will be deterred by the relative expense and “slim relief obtainable” in individual suits.  Id. at 1637, 1646–48 (Ginsburg, J., dissenting).  In response, the majority observed that “the dissent retreats to policy arguments,” and underscored that “[t]he respective merits of class actions and private arbitration as means of enforcing the law are questions constitutionally entrusted not to the courts to decide but to the policymakers in the political branches where those questions remain hotly contested.”  Id. at 1632. Epic Systems confirms that courts will continue to enforce agreements between employers and employees to arbitrate their disputes on an individual—rather than class or collective—basis, and continues the Supreme Court’s trend of enforcing the FAA’s strong policy favoring arbitration. In the second important class action case of the Term, China Agritech, Inc. v. Resh, 138 S. Ct. 1800, the Court declined to extend the rule of equitable tolling announced in American Pipe & Construction Co. v. Utah, 414 U.S. 538 (1974), to the filing of successive class actions. Under American Pipe, the timely filing of a class action tolls the applicable statute of limitations for “all persons encompassed by the class complaint” to intervene in the action or to file individual suits after the denial of class certification.  China Agritech, 138 S. Ct. at 1804–05.  The Ninth Circuit had extended that ruling to the successive filing of class actions, but the Supreme Court reversed, explaining that the concerns underlying American Pipe simply do not apply in the class action context.  The rule announced in American Pipe serves to promote “the efficiency and economy of litigation” embodied in Rule 23, on the theory that plaintiffs “reasonably rel[y] on the class representative . . . to protect their interests in their individual claims,” and without equitable tolling, potential class members “would be induced to file protective motions to intervene” (id. at 1806), or “a needless multiplicity of [separate] actions” to protect their interests in the event certification is denied (id. at 1810). Extending American Pipe tolling to successive class actions, however, “would allow the statute of limitations to be extended time and again” and allow plaintiffs “limitless bites at the apple.”  Id. at 1808–09.  The Court noted that in those circuits that had already declined to extend American Pipe to successive class actions, there had not been “a disproportionate number of duplicative, protective class action filings.”  Id. at 1810.  The Court also reasoned that “efficiency favors early assertion of competing class representative claims” (id. at 1807), and early filing “may aid a district court in determining, early on, whether class treatment is warranted” (id. at 1811). All of the justices joined the Court’s opinion in China Agritech except for Justice Sotomayor, who wrote an opinion concurring in the judgment but expressing the view that the Court’s holding should be limited to cases governed by the Private Securities Litigation Reform Act.  Id. at 1811–15 (Sotomayor, J., concurring in the judgment). China Agritech emphasizes the importance of timely filing putative class actions and reaffirms the class action defendant’s reasonable expectation that class claims will not continue to emerge after the statute of limitations period has expired. II.     The U.S. Supreme Court Is Poised to Weigh In on the Timing of Rule 23(f) Petitions, Arbitration Issues, and the Validity of Cy Pres-Only Settlements The Supreme Court’s October 2018 Term promises to be another active one in the class action space, particularly on a number of bread-and-butter issues relating to class action procedure, settlement, and arbitration. On June 25, 2018, the Supreme Court granted certiorari in Nutraceutical Corp. v. Lambert (No. 17‑1094) to resolve whether equitable exceptions apply to non-jurisdictional claims-processing rules, and specifically, to decide if and when an appellate court may equitably toll the time to file a petition for permission to appeal the grant or denial of class certification under Federal Rule of Civil Procedure 23(f).  Ordinarily, a Rule 23(f) petition must be filed within 14 days following the grant or denial of class certification or decertification, but the Ninth Circuit held that, under the particular circumstances of the case, the filing of a motion for reconsideration 20 days after the decertification order equitably tolled the 14-day deadline.  The Ninth Circuit acknowledged, however, that its ruling conflicted with the other circuit courts that have considered the issue.  (We covered the Ninth Circuit’s decision in Lambert in our third quarter 2017 update.) As noted in our first quarter 2018 update, the Supreme Court is also expected to resolve a series of other issues of interest to class action practitioners in the coming Term.  In New Prime Inc. v. Oliveira (No. 17‑340), the Court will decide whether (a) a dispute regarding the applicability of the FAA must be resolved by an arbitrator under a valid delegation clause, and (b) an exemption for contracts of employment for transportation workers in Section 1 of the FAA applies to independent contractors.  Briefing is currently underway.  (Gibson Dunn represents the petitioner, New Prime, Inc.)  In Lamps Plus, Inc. v. Varela (No. 17‑988), the Court 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.  And 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.  Opening briefs were filed in both cases on July 9, 2018. III.     The Seventh and Eighth Circuits Issue Notable Class Action Settlement Decisions The federal courts of appeals continue to closely scrutinize class action settlements, and this past quarter saw the issuance of two significant decisions (which both coincidentally involved Target Corp.). In Pearson v. Target Corp., No. 17‑2275,  — F.3d —, 2018 WL 3117848 (7th Cir. June 26, 2018), the Seventh Circuit examined a common tactic employed by professional objectors—filing baseless appeals from a settlement approval as a form of “blackmail,” hoping that the parties will pay them to dismiss the appeals so that the settlement can become effective. In 2014, the parties in Pearson had agreed to a classwide settlement in response to allegations that the defendants had “violated consumer protection laws by making false claims about the efficacy of [a dietary] supplement.”  Id. at *1.  Ted Frank, a frequent objector to class action settlements, objected to the awards to class counsel in the district court, and appealed the settlement approval order to the Seventh Circuit.  The Seventh Circuit agreed with Frank’s objections and reversed the district court, holding that “the settlement provided outsized benefits to class counsel.”  Id. On remand, the parties reached a new settlement, which the district court approved.  It then dismissed the case “‘without prejudice’ so as to allow the Court to supervise the implementation and administration of the Settlement.”  Id.  Three different class members then objected and filed appeals.  Id. at *2.  All three subsequently dismissed their appeals, and the district court entered a new order dismissing the case with prejudice.  Id.  Frank then moved to intervene and disgorge any side settlements made with the other three objectors.  His concern was “‘objector blackmail’” in which an “absent class member objects to a settlement with no intention of improving the settlement for the class,” “appeals, and pockets a side payment in exchange for voluntarily dismissing the appeal.”  Id. at *1.  The district court refused to hear the motion, reasoning that the dismissal with prejudice had divested the court of jurisdiction.  Frank then moved under Federal Rule of Civil Procedure 60(b) to vacate the dismissal with prejudice and restore the court’s jurisdiction over the settlement.  Id. at *2.  The district court denied that motion as well, which led to Frank’s second appeal and the subject of this decision.  Id. The Seventh Circuit again ruled in Frank’s favor.  Writing for a three-judge panel, Judge Wood explained that Frank could bring a Rule 60(b) motion because he had objected the settlement and thus qualified as a “party.”  Id.  On the merits, the court held that the district court should have granted the Rule 60(b) motion because (1) the objectors voluntarily dismissed their appeals before briefing raised concerns that they had done so at the expense of the class; (2) the class was comprised of ordinary consumers rather than sophisticated financial institutions (and thus needed greater protection from the court); (3) Frank sought only to effectuate the limited ancillary jurisdiction contemplated by the settlement itself, so the interest in finality was less compelling that it would be had Frank sought to unwind the settlement and re-litigate merits issues; and (4) Rule 60(b)(6) exists as an “‘equitable’” “safety valve” for precisely these types of situations.  Id. at *3-4. This decision continues the trend among the federal courts of appeals to carefully scrutinize class settlements, particularly when they involve “ordinary consumers.”  And, as the Seventh Circuit recognized, it also highlights the importance of “an amendment of Rule 23”—Rule 23(e)(5)(B)—which is “designed to prevent this problem from recurring.”  Id. at *5.  That proposed rule would require district court approval, after a hearing, of any “‘payment or other consideration’ provided for ‘forgoing or withdrawing an objection’ or ‘forgoing, dismissing, or abandoning an appeal.’”  Id.  If Congress allows this new rule to go into effect, observers will be keen to see whether it “solve[s] the problem” of “objector blackmail,” or whether objectors will find new, creative ways to “leverage[]” the process “for a purely personal gain.”  Id. at *1, *5. The second case, In re Target Corporation Customer Data Security Breach Litigation, 892 F.3d 968 (8th Cir. 2018), also involved the re-examination of a class action settlement, at the urging of an objector, after the Eighth Circuit had rejected an earlier settlement. With the earlier settlement, the Eighth Circuit concluded the district court had “failed to conduct the appropriate pre-certification analysis.”  Id. at 972.  On the second go-around, however, the Eighth Circuit affirmed the judgment of the district court, reasoning that the court had not “fundamentally misunderstood the structure of the settlement agreement” (id. at 973), nor was separate legal counsel required to protect the interests of the subclass of plaintiffs who had yet to suffer any material loss from the data breach that formed the basis for the suit (id. at 976).  On the latter point, the Eighth Circuit maintained that the interests of those class members with “documented losses” and those without losses were “more congruent than disparate” because it was “hypothetically possible that a member” of either subclass could “suffer some future injury.”  Id. at 975-76. The Eighth Circuit also affirmed the district court’s approval of the settlement.  Even though it noted the district court’s analysis of the $6.75 million fee award may have been “perfunctory,” it held the court’s reasoning was sufficient and that the lodestar multiplier applied was “well within amounts [the court had] deemed reasonable in the past.”  Id. at 977.  The court also held that the district court was within its discretion to approve the settlement despite the objectors’ concerns about what arguably constituted a “clear-sailing” provision requiring defendants not to oppose the attorney’s fees request, and a “kicker” provision that permitted unused settlement funds to be returned to defendants rather than distributed to the class.  Id. at 979. The following Gibson Dunn lawyers prepared this client update: Christopher Chorba, Theane Evangelis, Kahn A. Scolnick, Bradley J. Hamburger, Brandon J. Stoker, Jeremy S. Smith, Lauren M. Blas, Michael Eggenberger, and Gatsby Miller. 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, 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.

July 10, 2018 |
Benchmark Litigation Recognizes Gibson Dunn Partners

Benchmark Litigation named four Gibson Dunn partners to its list of the Top 250 Women in Litigation: Los Angeles partner Perlette Jura, New York partners Caitlin Halligan and Andrea Neuman and Orange County partner Meryl Young.  This list is dedicated to honoring the accomplishments of America’s leading female trial lawyers and features female litigators from all 50 states, plus the District of Columbia.  The list was published on July 10, 2018. ​Benchmark Litigation also named six partners to its annual Under 40 Hotlist: Los Angeles partner Heather Richardson, New York partner Gabrielle Levin, Orange County partner Blaine Evanson and Washington, D.C. partners Daniel Chung, Michael Diamant and Amir Tayrani. This list honors the achievements of the nation’s most accomplished legal partners aged 40 or younger and was published on July 5, 2018.

July 12, 2018 |
The Politics of Brexit for those Outside the UK

Click for PDF Following the widely reported Cabinet meeting at Chequers, the Prime Minister’s country residence, on Friday 6 June 2018, the UK Government has now published its “White Paper” setting out its negotiating position with the EU.  A copy of the White Paper can be found here. The long-delayed White Paper centres around a free trade area for goods, based on a common rulebook.  The ancillary customs arrangement plan, in which the UK would collects tariffs on behalf of the EU, would then “enable the UK to control its own tariffs for trade with the rest of the world”.  However, the Government’s previous “mutual recognition plan” for financial services has been abandoned; instead the White Paper proposes a looser partnership under the framework of the EU’s existing equivalence regime. The responses to the White Paper encapsulate the difficulties of this process.  Eurosceptics remain unhappy that the Government’s position is far too close to a “Soft Brexit” and have threatened to rebel against the proposed customs scheme; Remainers are upset that services (which represent 79% of the UK’s GDP) are excluded. The full detail of the 98-page White Paper is less important at this stage than the negotiating dynamics.  Assuming both the UK and the EU want a deal, which is likely to be the case, M&A practitioners will be familiar with the concept that the stronger party, here the EU, will want to push the weaker party, the UK, as close to the edge as possible without tipping them over.  In that sense the UK has, perhaps inadvertently, somewhat strengthened its negotiating position – albeit in a fragile way. The rules of the UK political game In the UK the principle of separation of powers is strong as far as the independence of the judiciary is concerned.  In January 2017 the UK Supreme Court decided that the Prime Minister could not trigger the Brexit process without the authority of an express Act of Parliament. However, unlike the United States and other presidential systems, there is virtually no separation of powers between legislature and executive.  Government ministers are always also members of Parliament (both upper and lower houses).  The government of the day is dependent on maintaining the confidence of the House of Commons – and will normally be drawn from the political party with the largest number of seats in the House of Commons.  The Prime Minister will be the person who is the leader of that party. The governing Conservative Party today holds the largest number of seats in the House of Commons, but does not have an overall majority.  The Conservative Government is reliant on a “confidence and supply” agreement with the Northern Ireland Democratic Unionist Party (“DUP”) to give it a working majority. Maintaining an open land border between Northern Ireland and the Republic of Ireland is crucial to maintaining the Good Friday Agreement – which underpins the Irish peace process.  Maintaining an open border between Northern Ireland and the rest of the UK is of fundamental importance to the unionist parties in Northern Ireland – not least the DUP.  Thus, the management of the flow of goods and people across the Irish land border, and between Northern Ireland and the UK, have become critical issues in the Brexit debate and negotiations.  The White Paper’s proposed free trade area for goods would avoid friction at the border. Parliament will have a vote on the final Brexit deal, but if the Government loses that vote then it will almost certainly fall and a General Election will follow – more on this below. In addition, if the Prime Minister does not continue to have the support of her party, she would cease to be leader and be replaced.  Providing the Conservative Party continued to maintain its effective majority in the House of Commons, there would not necessarily be a general election on a change in prime minister (as happened when Margaret Thatcher was replaced by John Major in 1990) The position of the UK Government The UK Cabinet had four prominent campaigners for Brexit: David Davis (Secretary for Exiting the EU), Boris Johnson (Foreign Secretary), Michael Gove (Environment and Agriculture Secretary) and Liam Fox (Secretary for International Trade).  David Davis and Boris Johnson have both resigned in protest after the Chequers meeting but, so far, Michael Gove and Liam Fox have stayed in the Cabinet.  To that extent, at least for the moment, the Brexit camp has been split and although the Leave activists are unhappy, they are now weaker and more divided for the reasons described below. The Prime Minister can face a personal vote of confidence if 48 Conservative MPs demand such a vote.  However, she can only be removed if at least 159 of the 316 Conservative MPs then vote against her.  It is currently unlikely that this will happen (although the balance may well change once Brexit has happened – and in the lead up to a general election).  Although more than 48 Conservative MPs would in principle be willing to call a vote of confidence, it is believed that they would not win the subsequent vote to remove her.  If by chance that did happen, then Conservative MPs would select two of their members, who would be put to a vote of Conservative activists.  It is likely that at least one of them would be a strong Leaver, and would win the activists’ vote. The position in Parliament The current view on the maths is as follows: The Conservatives and DUP have 326 MPs out of a total of 650.  It is thought that somewhere between 60 and 80 Conservative MPs might vote against a “Soft Brexit” as currently proposed – and one has to assume it will become softer as negotiations with the EU continue.  The opposition Labour party is equally split.  The Labour leadership of Jeremy Corbyn and John McDonnell are likely to vote against any Brexit deal in order to bring the Government down, irrespective of whether that would lead to the UK crashing out of the EU with no deal.  However it is thought that sufficient opposition MPs would side with the Government in order to vote a “Soft Brexit” through the House of Commons. Once the final position is resolved, whether a “Soft Brexit” or no deal, it is likely that there will be a leadership challenge against Mrs May from within the Conservative Party. The position of the EU So far the EU have been relatively restrained in their public comments, on the basis that they have been waiting to see the detail of the White Paper. The EU has stated on many occasions that the UK cannot “pick and choose” between those parts of the EU Single Market that it likes, and those it does not.  For this reason, the proposals in the White Paper (which do not embrace all of the requirements of the Single Market), are unlikely to be welcomed by the EU.  It is highly likely that the EU will push back on the UK position to some degree, but it is a dangerous game for all sides to risk a “no deal” outcome.  Absent agreement on an extension the UK will leave the EU at 11 pm on 29 March 2019, but any deal will need to be agreed by late autumn 2018 so national parliaments in the EU and UK have time to vote on it. Finally Whatever happens with the EU the further political risk is the possibility that the Conservatives will be punished in any future General Election – allowing the left wing Jeremy Corbyn into power. It is very hard to quantify this risk.  In a recent poll Jeremy Corbyn edged slightly ahead of Theresa May as a preferred Prime Minister, although “Don’t Knows” had a clear majority. 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, 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.