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

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

October 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 3, 2018 |
2018 Mid-Year Activism Update

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

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

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

August 21, 2018 |
The Trump Trade Tariffs: A Roadmap for Private Equity Executives

Click for PDF Navigating Uncertainty and Volatility for Your Portfolio Companies As the daily headlines attest, trade tariffs – both those recently implemented and those currently pending or contemplated – continue to create a dynamic and challenging business environment, including for portfolio companies of private equity sponsors. With that in mind, our International Trade and Private Equity Practice Groups have collaborated to prepare the following “roadmap” for private equity executives to help their portfolio companies identify their exposure to and mitigate the impact of tariffs on their imports and exports, and to otherwise successfully navigate these complicated conditions. We hope you find it useful. Our lawyers remain available to further assist you with respect to these matters and any related developments. The Trump Trade Tariffs: A Roadmap for Private Equity Executives (click on link) Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s International Trade or Private Equity practice groups, or any of the following: International Trade Group: Judith Alison Lee – Washington, D.C. (+1 202-887-3591, jalee@gibsondunn.com) R.L. Pratt – Washington, D.C. (+1 202-887-3785, rpratt@gibsondunn.com) Private Equity Group: George P. Stamas – Washington, D.C./New York (+1 202-955-8280/+1 212-351-5300, gstamas@gibsondunn.com) Mark D. Director – Washington, D.C./New York (+1 202-955-8508/+1 212-351-5308, mdirector@gibsondunn.com) Steven R. Shoemate – New York (+1 212-351-3879, sshoemate@gibsondunn.com) Ari Lanin – Los Angeles (+1 310-552-8581, alanin@gibsondunn.com) Alexander D. Fine – Washington, D.C./New York (+1 202-955-8209/+1 212-351-5333, afine@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 20, 2018 |
Dodd-Frank 2.0: Potential Reform to the Federal Reserve Board’s “Control Rules” — What Is at Stake and Who May Benefit

Click for PDF 2018 has seen significant but pragmatic developments in the implementation of bank regulation by the Board of Governors of the Federal Reserve System (Federal Reserve) under its new Vice Chairman for Bank Supervision, Randal Quarles.  Vice Chairman Quarles has frequently touted transparency in regulation as a significant virtue, and has himself frequently adopted such transparency in his public speeches, by signaling areas that he considers a priority. One area where the Federal Reserve has not yet published a reform is in the area of “control” under the Bank Holding Company Act of 1956, as amended (BHC Act).  In January, Vice Chairman Quarles suggested that it would be on his to-do list: Under the Board’s control framework – built up piecemeal over many decades – the practical determinants of when one company is deemed to control another are now quite a bit more ornate than the basic standards set forth in the statute and in some cases cannot be discovered except through supplication to someone who has spent a long apprenticeship in the art of Fed interpretation . . . . We are taking a serious look at rationalizing and recalibrating this framework.[1] This description would be an understatement.  The control rules have become challenging for corporate lawyers and clients alike – one may be greeted with “That can’t be right!” when explaining the likely Federal Reserve view of control.  As such, “rationalization and recalibration” in this area would be highly welcome. This Client Alert describes the most important aspects of the Federal Reserve’s control rules as of today’s date, and suggests certain areas of potential reform. Reform of the control rules would be important for quite a few constituencies.  It would certainly benefit private investors that wish to commit capital to banks but that do not wish to become regulated as BHCs.[2]  It would benefit nonbanking companies that might wish to partner with banks and acquire bank equity at the same time.  And it has the potential to affect certain rules applicable to bank holding companies (BHCs) themselves, particularly in the area of so-called 4(c)(6) investments and the Volcker Rule. The Statutory Language The BHC Act defines “control” as follows: Any company has control over a bank or over any company if— (A)   the company directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25 per centum or more of any class of voting securities of the bank or company; (B)   the company controls in any manner the election of a majority of the directors or trustees of the bank or company; or the [Federal Reserve] determines, after notice and opportunity for hearing, that the company directly or indirectly exercises a controlling influence over the management or policies of the bank or company.[3] The Principal Federal Reserve Control Positions For over forty years, the Federal Reserve has issued interpretations of the “controlling influence” prong of the statutory definition to erect a detailed common law of control, and one that is more focused on “influence” than the statutory “controlling influence.”  Although some of the Federal Reserve’s positions are in its Regulation Y and some in policy statements,[4] many are set forth in interpretations granted to individual banks, and some are unwritten lore.  The Federal Reserve’s current principal positions may be described as follows: Voting Securities.  This definition is critical for purposes of the 25 percent control test that is the first part of the statutory definition.  Regulation Y defines “voting securities” as “shares of common or preferred stock, general or limited partnership shares or interests, or similar interests if the shares or interests, . . . in any manner, entitle the holder: To vote for or to select directors, trustees, or partners (or persons exercising similar functions) . . . or To vote on or to direct the conduct of the operations or other significant policies of the issuing company.”[5] The Federal Reserve takes the position that if a holder of a limited partnership interest has the right to vote on replacing a general partner or who the replacement general partner will be, the interest is a “voting security.” Class of Voting Securities.  The 25 percent control test applies to any “class” of voting securities.  Under Federal Reserve regulation, a class of voting securities is determined by considering whether the shares are voted together as a single class on all matters for which the shares have voting rights, other than certain very limited fundamental matters described immediately below (Fundamental Matters).[6] This approach makes it virtually impossible to give particular investors special voting rights outside of Fundamental Matters, because such rights will almost certainly make the investors own more than 25 percent of a separate class of voting securities and thus be in control.  Moreover, approval of a new line of business or a merger or acquisition that does not affect the rights of an investor’s security is not considered a Fundamental Matter for these purposes, and therefore cannot be subject to a separate class vote. The Federal Reserve considers the general partner of a partnership or a managing member of a limited liability company to hold 100% of a class of voting securities, and for that reason, a general partner or managing member always is deemed to control an entity. Nonvoting Securities.  One way of permitting an investor additional economic rights in a deal is to issue nonvoting securities.  The Federal Reserve, however, has placed substantial limitations on such securities.  Under Regulation Y, preferred shares, limited partnership shares or interests, or similar interests are not voting securities if: Any voting rights associated with the shares or interest are limited solely to the type customarily provided by statute with regard to Fundamental Matters; The shares or interest represent an essentially passive investment or financing device and do not otherwise provide the holder with control over the issuing company; and The shares or interest do not entitle the holder, . . . in any manner, to select or to vote for the selection of directors, trustees, or partners (or persons exercising similar functions).[7] Under Federal Reserve regulation and practice, Fundamental Matters are matters that “significantly and adversely affect the rights or preferences of the security,” and are generally limited to: the issuance of additional amounts or classes of senior securities; the modification of the terms of the security or interest; the dissolution of the issuing company; or the payment of dividends by the issuing company when preferred dividends are in arrears.[8] If a security is subject to a restriction on its voting rights, that restriction will be effective only if it is contained in the constitutive documents of the issuing entity – it cannot be in a side agreement.  The rationale for this position is that if contained in an agreement alone, the parties to the agreement could breach it and waive any consequences; such a breach is not possible when the restriction is contained in, for example, a corporate charter. Amount of Nonvoting Securities That May Be Held.  The Federal Reserve generally permits an investor to own one-third of the total equity of a company before finding control, as long as no more than 14.9 percent of that equity is voting.[9] Restrictions on Nonvoting Securities Becoming Voting Securities.  The Federal Reserve’s traditional position is that a security remains a voting or nonvoting security throughout its life – it cannot switch back and forth.  There is a long-standing exception designed to permit a degree of liquidity for nonvoting securities.  Such securities may become voting in a limited set of transfers: A transfer back to the issuer A transfer in a public offering A transfer in a private offering in which no transferee acquires more than 2% of the issuer’s voting securities A transfer in a change-of-control, where more than 50 percent of the issuer’s securities are transferred to a new owner (not counting the investor’s nonvoting securities for purposes of the 50 percent test) In practice, the Federal Reserve has also limited the transfers of nonvoting securities themselves to these four circumstances.[10]  This is because the Federal Reserve generally views control over the disposition of a security as control of the security. There is long-standing precedent for this position in the context of voting securities, although one may question its application to nonvoting securities.  In a 1982 letter, the Federal Reserve disapproved of a proposal whereby an investor that had an option for 32.4 percent of the voting shares of a bank holding company stated that it intended only to acquire 24.9 percent and sell the other 7.5 percent, stating: The [Federal Reserve] is concerned that approval of your proposal, which would effectively allow control of up to 32.4 per cent of the voting shares of Florida National, could seriously impair the objectives and purposes of the Change in Bank Control Act and Bank Holding Company Act. General approval of such arrangements would establish a precedent permitting acquirors of bank holding company stock to accumulate up to 24.9 per cent of voting shares, proceed to dispose of these shares in a form subject to their control, acquire additional shares up to the 24.9 per cent level, and then possibly repeat this process.[11] Options and Warrants as Voting Securities/Fed Math.  The Federal Reserve has taken the position that an option or warrant for a voting security that is freely exercisable must be counted as a voting security, no matter how out-of-the-money the warrant or option is.  Compounding the effects of this position, the Federal Reserve has also taken the position that when calculating the percentage of voting securities owned by an investor, one must treat the investor’s options or warrants as exercised (as long as they are freely exercisable, no matter how out of the money), but no one else’s.  This is the position that elicited the “That can’t be right!” statement cited above. Tear Down Rule.  The Federal Reserve has taken the position that if a party has control of a company – for example, controlling 25 percent of more of a class of voting securities – it is more difficult to shed control.  It has therefore insisted on sell downs to a lower level of control than would otherwise be the case – selling down to 24.9 percent has generally been insufficient, with 10 percent, and sometimes less, frequently desired.  This is a position more suited to metaphysics than law, and can have perverse results particularly when a BHC is seeking to divest a business but retain some form of economic interest in it. Directors/Observers.  The statute defines “control” as the ability to control the election or appointment of a majority of directors.  The Federal Reserve’s articulated position on “controlling influence,” however, is that a 24.9 percent voting share investor or a 14.9 percent voting/one-third total equity investor may generally only appoint one director to the company’s board.  Moreover, as a general matter, an investor’s director representation should be proportional to the percentage of voting shares it owns.  The Federal Reserve now generally permits an additional observer as long as the observer is truly an observer.[12] In addition, the director representative cannot be the chairman of the board and generally cannot chair a board committee.  Such a director may participate on a committee as long as he or she does not make up more than 25 percent of the seats on the committee or have the authority or practical ability to make or block the making of policy decisions.[13] Veto Rights.  Although an investor may wish to have the ability to veto material business decisions, the Federal Reserve has limited such veto rights generally to Fundamental Matters, not without some potential inconsistency in its written statements.  The 2008 Policy Statement declares that the Federal Reserve has traditionally been concerned about restrictions on the ability to raise “additional debt or equity capital,” but in the next paragraph states that it is permissible to have a veto over “issuing senior securities or borrowing on senior basis,”[14] in addition to modifications to the terms of the investor’s security or dissolution of the company. Business Relationships.  The extent of business connections between an investor and the company invested in is an area to which the Federal Reserve staff applies considerable attention.  The general principle is that such business relationships must be “quantitatively limited and qualitatively immaterial,”[15] but the Federal Reserve looks at the facts of each transaction and make its determination on a case-by-case basis.  Critical factors are that the connections be on market terms, be non-exclusive, and be terminable without penalty by the company invested in.  The 2008 Policy Statement stated a preference for allowing more extensive business relationships when the investor’s voting securities percentage was closer to 10 than 25 percent.[16] Why the Control Definition Is Important The Federal Reserve definition of control affects bank holding companies and nonbanks alike.  In the first instance, it limits the ability of private investors – principally private equity funds and hedge funds – from making equity investments in banks and their holding companies, because it is an extremely rare private fund that will take on the burdens of Federal Reserve supervision and regulation, including activity restrictions and capital requirements.  The disincentives have increased immeasurably with the Volcker Rule, which generally limits BHCs to owning no more than 3% of the ownership interests of any private fund they sponsor.  In the Financial Crisis, the current control rules – and other restrictions imposed by the Federal Deposit Insurance Corporation – clearly limited the ability of private capital to support the banking sector. In addition to private investors, the control definitions are relevant to nonbanking companies that wish to partner with banking organizations and may wish to obtain equity in their partner as well – since a controlling investment would subject them to the restrictions on commercial activities contained in the BHC Act. Finally, revised control interpretations would also be relevant to BHCs themselves.  One legal authority available to BHCs to make equity investments is the so-called “Section 4(c)(6)” authority permitting an investment in up to 5 percent of the voting shares of any company.  Such investments – which may also include nonvoting securities – must also be noncontrolling.  And because the Volcker Rule applies to every company that a BHC or other insured depository institution holding company controls, reform of the control rules would have beneficial effects in this area as well. Areas of Potential Rationalization and Recalibration The areas below are only certain examples where current Federal Reserve precedent may be an unduly restrictive interpretation of the statutory language.  Any suggested recalibrations, too, are only possible ones. Combination of Voting and Nonvoting Securities.  The current limitations to 14.9% voting and one-third total equity do not derive from any particular aspect of the statute – which is focused only on control of voting securities.  In another context, so-called “portfolio investments” under the Federal Reserve’s Regulation K, an investor may own 19.9% voting securities and up to 40 percent total equity of a company without being deemed in control.[17]  But this is but one alternative to the current limitation. Fed Math/Tear Down Rule.  It is very difficult to justifying treating freely exercisable but out-of-the-money warrants and options as voting securities, particularly when that rule applies only to the investor in question, but no other holder of the same securities – and so this “new math” should be one of the first candidates for “rationalization.”  Similarly, the so-called “tear down” rule is unanchored to the statutory language and thus is a prime candidate for reconsideration. Directors.  The Federal Reserve has stated that generally the number of directors must be proportionate to voting shareholdings.  Again, although a greater number of directors suggests “influence,” it does not necessarily lead to a “controlling influence.”  If an investor has contributed 40 percent of a company’s total equity, it does not seem unreasonable to permit a right to appoint 40 percent of a company’s board.  Moreover, the restriction on committee chairing is arguably inconsistent with the statutory language, and keeps qualified candidates – for example, retired Federal Reserve Governors or Reserve Bank Presidents affiliated with private investors – on the sidelines. Limitations on Transfer of Nonvoting Securities. Although one can understand the Federal Reserve’s concern about the circumstances in which nonvoting securities can become voting, this is a separate issue from the issue of transfers of nonvoting securities.  If one focuses on the statutory term “controlling influence,” it would seem reasonable to permit transfers of nonvoting securities to a wider group of transferees than the four limited circumstances in which nonvoting securities can currently become voting.  This is a prime example of the side effects of the piecemeal construction of the current control framework – one might have concerns about “seriously impair[ing] the objectives and purposes” of the BHC Act when control over transfer of 25 percent or more voting securities is at issue.  It is not clear that these concerns apply in the nonvoting securities context where there are substantial limitations on the securities ever becoming voting at all. In addition, recalibrating the circumstances when nonvoting securities may become voting should also be given consideration, because certain aspects of the current rules – such as not counting the transfer of an investor’s nonvoting securities for purposes of the 50 percent transfer test – seem to be conservative simply for conservatism’s sake. Veto Rights/Class Votes. Current Federal Reserve regulation and policy limit an investor’s veto rights to matters that “significantly and adversely affect the rights and privileges” of the investor’s security.  Even if this formulation is correct as an original matter (and a recalibration subject to notice and comment would allow for discussion of this point), there may well be more corporate matters than those the Federal Reserve currently permits that may be viewed as having such an effect.  Holding an equity interest of course gives economic rights, but it can also be considered as taking a fundamental stake in a particular business – and therefore, to use but one example, it is not clear why a material change to the nature of that business should not be a Fundamental Matter subject to an investor veto.  To the extent the scope of permissible investor vetoes is broadened, similar broadening of matters that may be subject to a class vote without creating a separate class of voting securities should also be considered. Business Relationships. The area of permitted business relationships between an investor and a bank or other company is one in particular where “supplication to someone who has spent a long apprenticeship in the art of Fed[eral Reserve] interpretation” is frequently necessary.  Granting that it is impossible to predict in advance every possible contemplated business relationship, it does seem that a retreat from the current all-facts-and-circumstances test is both possible and desirable, such as through the use of regulatory presumptions of permissible arrangements, in a manner similar to the approach taken in aspects of the proposed recalibration of the Volcker Rule. Conclusion If the hinted-at rationalization and recalibration of the control rules occurs, it is hoped that the Federal Reserve will do so – as it has done this year in other areas of federal banking law – in the transparent manner of a proposal subject to notice and comment.  The peculiarities of the common law of control that have developed over more than four decades provide considerable material for interested parties to share their perspectives on improvements for the future.    [1]   Vice Chairman Randal K. Quarles, “Early Observations on Improving the Effectiveness of Post-Crisis Regulation,” January 19, 2018.    [2]   Although this Client Alert focuses on control under the BHC Act, with the abolition of the Office of Thrift Supervision, the Federal Reserve also interprets control under the Savings and Loan Holding Company Act, which has a similar, if not identical, definition, including a “controlling influence” prong.    [3]   12 U.S.C. § 1841(a)(2).    [4]   See, e.g., 12 C.F.R. §§ 225.31, 225.143; Policy Statement on Investments in Banks and Bank Holding Companies (2008).    [5]   12 C.F.R. § 225.2(q)(1).    [6]   Id. § 225.2(q)(3).    [7]   Id. § 225.2(q)(2).  The Federal Reserve has considered certain subordinated debt to be a nonvoting security.    [8]   Id. [9]   See Policy Statement on Investments in Banks and Bank Holding Companies (2008). [10]   See, e.g., Letter from Scott G. Alvarez, Esq. to Peter Heyward, Esq., June 29, 2011.  An investor may also generally transfer nonvoting securities to one of its affiliates. [11]   See Letter of William W. Wiles (March 18, 1982). [12]   See Policy Statement on Investments in Banks and Bank Holding Companies (2008). [13]   See id. [14]   Id.  The two statements are reconcilable if a veto over additional pari passu and subordinated instruments is impermissible, but one over senior debt and equity issuances is permissible. [15]   Id. [16]   Id. [17]   See 12 C.F.R. § 211.8(c)(3). Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions practice group, or the authors: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) James O. Springer – Washington, D.C. (+1 202-887-3516, jspringer@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 6, 2018 |
The U.S. Office of the Comptroller of the Currency Will Permit Special Purpose National Bank Charters for Fintech Firms

Click for PDF Last week, the Office of the Comptroller of the Currency (OCC) announced that it would begin accepting proposals from Fintech firms to charter special purpose national banks (SPNBs).  This decision comes over 18 months after the White Paper proposing such charters was issued under President Obama’s Comptroller, Thomas Curry, in his last month in that position.  The OCC accompanied this announcement with a policy statement (Policy Statement) and a supplement to its licensing manual for national banks (Licensing Manual Supplement). This announcement, while expected, is an extremely significant development in federal banking law, and one almost assuredly to be legally challenged, at a time when the Chevron doctrine of administrative agency deference is receiving a fresh look. The OCC’s decision, when considered with its historical approach to preemption under the National Bank Act, could expand the scope of federal banking regulation considerably and provide substantial opportunities.  These opportunities could benefit not merely Fintech firms but investors in many such firms, who would appear to be able to control certain SPNBs and still avoid regulation under the Bank Holding Company Act (BHC Act), including the Volcker Rule. Powers of a Fintech SPNB When former Comptroller Curry introduced his Fintech national bank proposal in December 2016, he noted that “the number of Fintech companies in the United States and United Kingdom has ballooned to more than 4,000, and in just five years investment in this sector has grown from $1.8 billion to $24 billion worldwide.”[1]  The Policy Statement – consistent with the OCC’s traditional approach to the “business of banking” under the National Bank Act – makes clear that the special purpose charter is a response to this development, noting: The OCC recognizes that the business of banking evolves over time, as do the institutions that provide banking services. As the banking industry changes, companies that engage in the business of banking in new and innovative ways should have the same opportunity to obtain a national bank charter as companies that provide banking services through more traditional means.[2] Consistent with its existing regulations, the Policy Statement takes an expansive view of the National Bank Act’s powers provision, 12 U.S.C. § 24(SEVENTH).  Under this provision, a national bank is permitted, when a charter is issued, to: [E]xercise by its board of directors or duly authorized officers or agents, subject to law, all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by receiving deposits; by buying and selling exchange, coin, and bullion; by loaning money on personal security; and by obtaining, issuing, and circulating notes . . .[3] Prior to issuing the Policy Statement, the OCC had interpreted this provision to permit it to grant a charter to an institution that engaged in “any of the three core banking functions of receiving deposits, paying checks, or lending money.”[4]  Consistent with this existing regulation, a Fintech firm seeking a SPNB charter must conduct “at least one of these three core banking functions.”[5]  The Licensing Manual Supplement, however, provides greater elasticity to this requirement, as it states that “[t]he OCC views the National Bank Act as sufficiently adaptable to permit national banks to engage in traditional activities like paying checks and lending money in new ways. For example, facilitating payments electronically may be considered the modern equivalent of paying checks.”[6] Depending on the OCC’s ultimate position on “modern equivalence,” a Fintech SPNB charter could be available not only to Fintech firms engaged in lending activities without taking deposits (such as peer-to-peer lending companies), but also to companies engaged in payments broadly understood – including traditional money transmitters, and, in addition, virtual currency exchanges, because such exchanges also engage in money transmission, and indeed many have been licensed by the states as such.  It is noteworthy that the Licensing Manual Supplement states that: Beyond those core activities [deposits, lending, paying checks], the activities of an SPNB are limited to those that are permissible for national banks under a statute, regulation, or federal judicial precedent, or that the OCC has determined to be permissible. See e.g. 12 USC 24(Seventh); 12 CFR 7.5002; NationsBank of North Carolina, N.A. v. Variable Annuity Life Ins. Co., 513 U.S. 251 (1995).[7] In the NationsBank case cited, the Supreme Court, per Justice Ginsburg, “expressly h[e]ld” that “the ‘business of banking’ is not limited to the enumerated powers in § 24 Seventh and that the Comptroller therefore has discretion to authorize activities beyond those specifically enumerated.”[8] OCC Expectations As it indicated in its 2016 White Paper, the OCC is not proposing a “bank-lite” approach to Fintech SPNBs. The OCC expects any charter proposal to have a comprehensive business plan covering at a minimum three years.  The plan should include comprehensive alternative business strategies to address various best-case and worst-case scenarios.  In keeping with its post-Financial Crisis approach to corporate governance, the OCC emphasized the role of an SPNB’s board of directors, who must have a prominent role in the overall governance framework, actively oversee management, provide “credible challenge,” and exercise independent judgment.[9] The OCC also emphasized the importance of capital, minimum and ongoing levels of which need to be commensurate with the risk and complexity of the proposed activities (including on- and off-balance sheet activities).[10]  Where a SPNB’s business activities are principally off-balance sheet, traditional minimum capital requirements may not adequately reflect all risks, and the OCC could therefore require applicants in such circumstances to propose a minimum level of capital that the proposed SPNB would meet or exceed at all times.  In this regard, the OCC noted that other types of limited charter banks often hold capital that “exceeds the capital requirements for other types of banks.”[11]  The OCC would expect a similarly granular presentation with respect to a SPNB’s liquidity, including consideration of planned and unplanned balance sheet changes, varying interest ratio scenarios, and market conditions. Charter applicants would also be expected to demonstrate appropriate systems and programs to identify, assess, manage and monitor risk, including policies and procedures, practices, training, internal control and audit.  Of particular importance is a compliance program for anti-money laundering and OFAC sanctions, as well as a consumer compliance program designed to ensure fair treatment of customers. Two very important criteria for receiving an SPNB charter are financial inclusion and contingency planning.  As to the first, the OCC states: Consistent with the agency’s mission to ensure fair treatment of customers and fair access to financial services, the OCC expects any entity seeking an SPNB charter to demonstrate a commitment to financial inclusion that includes providing or supporting fair access to financial services and fair treatment of customers.  The nature of that commitment will depend on the proposed bank’s business model, and the types of products, services, or activities it intends to provide. An SPNB applicant should describe the proposed bank’s commitment to financial inclusion in its application. The description should include the proposed goals, approaches, activities, milestones, commitment measures, and metrics for serving the anticipated market and community consistent with the bank’s activities, business model, and product and service offerings.[12] On the second, because many SPNBs are likely not to be FDIC-insured, the OCC will be such institutions’ receiver in insolvency.  As a result, the OCC will insist on a detailed contingency plan to be prepared: Before receiving final approval for a charter, an SPNB will be required to develop a contingency plan to address significant financial stress that could threaten the viability of the bank. The contingency plan should outline strategies for restoring the bank’s financial strength and options for selling, merging, or liquidating the bank in the event the recovery strategies are not effective. The format and content of the plan are flexible and should be tailored to the bank’s specific business and reviewed and updated as the bank’s business evolves. As a condition for preliminary approval of a charter, an SPNB will be required to develop the contingency plan during the bank’s organization phase. The OCC’s final approval will require the bank to implement and adhere to the plan. The bank will be expected to review the contingency plan annually and update it as needed. Any significant changes to the contingency plan will require the non-objection of the appropriate supervisory office.[13] As a national banking association, a Fintech SPNB would be subject to the federal statutes applicable to other national banks, such as lending limits, limits on real estate and securities investments, the Bank Secrecy Act and other anti-money laundering laws, OFAC sanctions requirements, and, where applicable, such as with respect to lending, federal consumer law.  A Fintech SPNB would be required to become a member bank in the Federal Reserve System and subscribe for stock in its applicable Federal Reserve Bank in an amount equal to six percent of the bank’s paid-up capital and surplus. Benefits of a Special Purpose Charter to Fintech Firms The principal benefits of the special purpose charter to Fintech firms are national licensing and federal preemption.  Currently, peer-to-peer lending firms, money transmission companies, and virtual currency exchanges are all licensed by the states.  For such firms to carry out a national business, licensing on a state-by-state basis, and ongoing state examination processes, can be burdensome.  The SPNB charter will provide a federal alternative – and one regulator – to the state-by-state approach for qualifying firms. Second, an SPNB will benefit from federal preemption under the National Bank Act.  Such federal preemption is still broad, notwithstanding the Dodd-Frank Act’s attempt to narrow it.  After the Dodd-Frank Act, the OCC may preempt “state financial consumer law” if its application would have a discriminatory effect on national banks in comparison with its effect on state-chartered banks; the state consumer financial law prevents or significantly interferes with the execution by a national bank of its powers (the Barnett standard); or the state law is preempted by a federal consumer financial law other than Dodd-Frank.[14] Significantly, Dodd-Frank left unchanged the ability of a national bank to export interest rates of its home state nationally without regard to state law usury limitations; such interest rate exportation will be a significant benefit to SPNBs engaged in lending activities. Benefits of a Special Purpose Charter to Fintech Investors The SPNB charter may also provide benefits to Fintech investors, who would appear to be able to make controlling investments in certain SPNBs without becoming subject to the BHC Act, including the Volcker Rule.  The BHC Act defines a “bank” as either an FDIC-insured bank or as an institution that both accepts demand deposits and is engaged in the business of making commercial loans.[15]  Under the Policy Statement, the OCC can charter a SPNB that does not accept deposit funding – that is, one that is engaged in making loans or paying checks, or both such activities, as its core banking functions; such a SPNB would not be a BHC Act “bank.”  As a result, such an SPNB may be “controlled” by an investor without that investor becoming a bank holding company. This means that there is now another alternative to the state industrial bank charter available for investors such as private equity firms that wish to obtain the benefits of controlling a banking entity without the burdens of regulation by the Board of Governors of the Federal Reserve System.  In addition, although the OCC can be expected to require some form of capital support from a controlling investor of a non-deposit-taking SPNB, the explicit “source of strength” requirement added by the Dodd-Frank Act for a controlling investor will not apply, because that requirement applies only to controlling shareholders of insured depository institutions.[16] As a result, a Fintech firm that seeks a non-depository SPNB charter may find itself attractive to a wide range of investors. ________________________ It seems highly likely that certain state regulators will challenge the OCC’s Fintech SPNB determination, given its potential to shift a wide variety of firms to federal supervision and examination and preempt areas of state regulation.  Earlier such suits filed after the OCC’s December 2016 White Paper were dismissed as unripe; however, once the chartering process begins, litigation by state regulators could well be expected.  If the OCC’s interpretation of the National Bank Act is upheld by a reviewing court, the Fintech SPNB charter could be the most revolutionary development of regulatory reform in the Trump era, for both Fintech firms and their investors.    [1]   OCC, Exploring Special Purpose National Bank Charters for Fintech Companies (December 2016), at 3-4.    [2]   OCC, Policy Statement on Financial Technology Companies’ Eligibility to Apply for National Bank Charters (July 31, 2018), at 1.    [3]   12 U.S.C. § 24(SEVENTH).    [4]   12 C.F.R. § 5.20.    [5]   OCC, Policy Statement, at 2.    [6]   OCC, Licensing Manual Supplement:  Considering Charter Applications from Financial Technology Companies, at 2 n.5.    [7]   Id. at n.4.    [8]   513 U.S. 251, 258 n.2 (1995).  Given the Valic holding, the OCC would appear to have substantial discretion regarding permissible activities for SPNBs, as long as one core banking function was present.  The degree to which the OCC will exercise such discretion is currently unknown.    [9]   OCC Licensing Manual Supplement, at 16. [10]   Id. at 8. [11]   Id. at 9, n.26. [12]   Id. at 10. [13]  Id. [14]   12 U.S.C. § 25b(b)(1). [15]   Id. § 1841(c)(1). [16]   Id. § 1831o-1. The following Gibson Dunn lawyers assisted in preparing this client update: Arthur Long, Jeffrey Steiner and James Springer. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions practice group, or any of the following: Financial Institutions Group: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Carl E. Kennedy – New York (+1 212-351-3951, ckennedy@gibsondunn.com) James O. Springer – Washington, D.C. (+1 202-887-3516, jspringer@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

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

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

June 28, 2018 |
India – Legal and Regulatory Update (June 2018)

Click for PDF The Indian Market The Indian economy continues to be an attractive investment destination and one of the fastest growing major economies. After a brief period of uncertainty, following the introduction of a uniform goods and services tax and the announcement that certain banknotes would cease to be legal tender, the growth rate of the economy has begun to rebound, increasing to 7.7 percent in the first quarter of 2018, up from 6.3 percent in the previous quarter. In the World Bank’s most recent Ease of Doing Business rankings, India climbed 30 spots to enter the top 100 countries. This update provides a brief overview of certain key legal and regulatory developments in India between May 1, 2017 and June 28, 2018. Key Legal and Regulatory Developments Foreign Investment Compulsory Reporting of Foreign Investment: The Reserve Bank of India (“RBI“) has notified a one-time reporting requirement[1] for Indian entities with foreign investment. Each such entity must report its total foreign investment in a specified format (asking for certain basic information such as the entity’s main business activity) no later than July 12, 2018. Indian entities can submit their reports through RBI’s website. Indian entities that do not comply with this requirement will be considered to be in violation of India’s foreign exchange laws and will not be permitted to receive any additional foreign investment. This one-time filing requirement is a precursor to the implementation of a single master form that aims to integrate current foreign investment reporting requirements by consolidating nine separate forms into one single form. Single Brand Retail: The Government of India (“Government“) has approved up to 100% foreign direct investment (“FDI“) in single brand product retail trading (“SBRT“) under the automatic route (i.e., without prior Government approval), subject to certain conditions.[2] Previously, FDI in SBRT entities exceeding 49% required the approval of the Government. The Government has also relaxed local sourcing conditions attached to such foreign investment. SBRT entities with more than 51% FDI continue to be subject to local sourcing requirements in India, unless the entity is engaged in retail trading of products that have ‘cutting-edge’ technology. All such SBRT entities are required to source 30% of the value of goods purchased from Indian sources. The Government has now relaxed this sourcing requirement by allowing such SBRT entities to count any purchases made for its global operations towards the 30% local sourcing requirement for a period of five years from the year of opening its first store. The Government has clarified that this relaxation is limited to any increment in sourcing from India from the preceding financial year to the current one, measured in Indian Rupees. After this five year period, the threshold must be met directly by the FDI-receiving SBRT entity through its India operations, on an annual basis. Real Estate Broking Service: The Government has clarified that real estate broking service does not qualify as real estate business and is therefore eligible to receive up to 100% FDI under the automatic route.[3] Introduction of the Standard Operating Procedure: In mid-2017 the Government abolished the Foreign Investment Promotion Board – the Government body responsible for rendering decisions on FDI investments requiring Government approval. Instead, in order to streamline regulatory approvals, it has introduced the Standard Operating Procedure for Processing FDI Proposals (“SOP“).[4] The Government has designated certain competent authorities who are to process an application for FDI in the sector assigned to them. For example, the Ministry of Civil Aviation is responsible for considering and approving FDI proposals in the civil aviation sector. Under the SOP, the competent authorities must adhere to time limits within which a decision must be given. Significantly, the SOP mandates a relevant competent authority to obtain the DIPP’s concurrence before it rejects an application or imposes conditions on a proposed investment. Mergers and Acquisitions Relaxation of Merger Notification Timelines: Previously, parties to a transaction, regarded as a combination within the meaning of the [Indian] Competition Act, 2002 were required to notify the Competition Commission of India (“CCI“) within 30 days of a triggering event, such as execution of transaction documents or approval of a merger or amalgamation by the board of directors of the combining parties. Now, the CCI has exempted parties to combinations from the 30 day notice requirement until June 2022.[5] This move will provide parties involved in a combination sufficient time to compile a comprehensive notification and will possibly lead to faster approvals by easing the burden on CCI’s case teams. Rules for Listed Companies Involved in a Scheme: The Securities and Exchange Board of India (“SEBI“)’s listing rules requires listed companies involved in schemes of arrangement under the [Indian] Companies Act, 2013 (“Companies Act“), to file a draft version of the scheme with a stock exchange. This is in order to obtain a no objection/observation letter before the scheme can be filed with the National Company Law Tribunal. In March 2017, SEBI issued a revised framework for schemes proposed by listed companies in India. In January 2018, SEBI issued a circular[6] amending the 2017 framework. As a part of the 2018 amendments, SEBI clarified that a no objection/observation letter is not required to be obtained from a recognized stock exchange for a demerger/hive off of a division of a listed company into a wholly owned subsidiary, or a merger of a wholly owned subsidiary into its parent company. However, draft scheme documents will still need to be filed with the stock exchange for the purpose of information. The stock exchange will then disseminate the information on their website. Companies Act Action Against Non-Compliant Companies: Registrars of companies (“RoC“) in various Indian states, acting on powers granted under the Companies Act, have initiated action against companies which have either not commenced operations or have not been carrying on business in the past two years. In September 2017, the Government announced that over 200,000 companies had been struck-off from the register of companies based on the powers described above.[7] Further, the director identification numbers for individuals serving as directors on the board of such companies were cancelled, resulting in their disqualification to serve on the board of any company for a period of five years. The striking-off was targeted at Indian companies that failed to fulfill regulatory and compliance requirements (such as filing annual returns) for three years.[8] Notification of Layering Rules: The Government has notified a proviso to subsection 87[9] of Section 2 of the Companies Act along with the Companies (Restriction on Number of Layers) Rules, 2017 (the “Layering Rules“).[10] The effect of these notifications is that an Indian company which is not a banking company, non-banking financial company, insurance company or a government company, is not allowed to have more than two layers of subsidiaries. For the purposes of computing the number of layers, Indian companies are not required to take into account one layer consisting of one or more wholly owned subsidiaries. Further, the Layering Rules do not prohibit Indian companies from acquiring companies incorporated outside India which have subsidiaries beyond two layers (as long as such a structure is permitted in accordance with the laws of the relevant country). Provisions of Companies Act Extended to all Foreign Companies: India has enacted the Companies (Amendment) Act, 2017 in order to amend various sections of the Companies Act. The provisions of the amendment act are being brought into effect in a phased manner. Recently, the Government has notified a provision in the Companies (Amendment) Act, 2017[11] which extends the applicability of sections 380 to 386 and sections 392 and 393 of the Companies Act to all foreign companies which have a place of business in India or conduct any business activity in the country. Prior to this amendment, these provisions were only applicable to foreign companies where a minimum of fifty percent of the shares were held by Indian individuals or companies. These provisions of the Companies Act include a requirement to (a) furnish information and documents to the RoC, such as certified copies of constitutional documents, the company’s balance sheet and profit and loss account; and (b) comply with the provisions governing issuance of debentures, preparation of annual returns and maintaining books of account. Notification of Cross Border Merger Rules: The Government had notified Section 234 of the Companies Act and Rule 25A of the Companies (Compromises, Arrangements and Amalgamations) Rules 2016. Please refer to our regulatory update dated May 1, 2017 for further details. In this update, we had referred to the requirement of the RBI’s prior permission in order to commence cross border merger procedures under the Companies Act. On March 20, 2018, the RBI issued the Foreign Exchange Management (Cross Border Merger) Regulations, 2018 (the “Cross Border Merger Rules“).[12] The Cross Border Merger Rules provide for the RBI’s deemed approval where the proposed cross-border merger is in accordance with the parameters specified by it. These parameters include, where the resultant company is an Indian company, a requirement that any borrowings or guarantees transferred to the resultant entity comply with RBI regulations on external commercial borrowings within a period of two years from the effectiveness of the merger. End-use restrictions under the existing RBI regulations do not have to be complied with. However, where the resultant company is an offshore company, the transfer of any borrowings in rupees to the resultant company requires the consent of the Indian lender and must be in compliance with Foreign Exchange Management Act, 1999 and regulations issued thereunder. In addition, repayment of onshore loans will need to be in accordance with the scheme approved by the National Company Law Tribunal. Currently, these provisions apply only to mergers and amalgamations, and not to demergers. Labour Laws States Begin Implementing Model Labour Law: In mid-2016, the Government introduced the Model Shops and Establishments (Regulation of Employment and Conditions of Service) Bill (“S&E Bill“). The S&E Bill, as is the case with other shops and establishments legislation in India, mandates working hours, public holidays and regulates the condition of workers employed in non-industrial establishments such as shops, restaurants and movie theatres. States in India can either adopt the S&E Bill in its entirety, superseding existing regulations, or choose to amend their existing enactments based on the S&E Bill. The S&E Bill seeks to update Indian laws, adapting them to current business requirement for non-industrial establishments. For example, the S&E Bill (a) enables establishments to remain open 365 days in a year, and (b) allows women to work night shifts, while containing provisions for employers to ensure safety of women workers. Registration provisions under the new legislation have also been eased. In late 2017, the State of Maharashtra notified a new shops and establishments statute based on the S&E Bill.  Other states in India are expected to follow suit. Start–ups Issue of Convertible Notes by Start-ups: The Government had eased funding for start-ups in India in January 2016. Please refer to our regulatory update dated May 18, 2016, for an overview of this initiative. In January 2017, the RBI had permitted start-ups to receive foreign investment through the issue of convertible notes.[13] The revised FDI Policy issued in 2017 now incorporates these provisions. The provisions allow for an investment of INR 2,500,000 (approx. USD 36,700) or more to be made in a single tranche. These notes are repayable at the option of the holder, and convertible within a five year period. The issuance of the notes is subject to entry route, sectoral caps, conditions, pricing guidelines and other requirements that are prescribed for the sector by the RBI.[14] Capital Gains Tax Charging of Long Term Capital Gains Tax: An important amendment to Indian tax laws introduced by the Finance Act, 2018[15] is the levy of tax at the rate of 10% on capital gains made on the sale of certain securities (including listed equity shares) held at least for a year. The tax is levied if the total amount of capital gains exceeds INR 100,000 (approx. USD 1,448). This amendment came into effect on April 1, 2018. However, all gains made on existing holdings until January 31, 2018 are exempt from the tax.  In all such ‘grandfathering’ cases, the cost of acquisition of a security is deemed to be the higher of the actual cost of acquisition and the fair market value of the security as on January 31, 2018. Where the consideration received on transfer of the security is lower than the fair market value as on January 31, 2018, the cost of acquisition is deemed to be the higher of the actual cost of acquisition and the consideration received for the transfer.[16] [1] RBI Notification on Reporting in Single Master Form dated June 7, 2018. Available at https://rbidocs.rbi.org.in/rdocs/Notification/PDFs/NT194481067EB1B554402821A8C2AB7A52009.PDF [2] Press Note No. 1 (2018 Series) dated January 23, 2018, Department of Industrial Policy & Promotion, Ministry of Commerce & Industry, Government of India. [3] Id.  [4] Standard Operating Procedure dated June 29, 2017. Available at http://www.fifp.gov.in/Forms/SOP.pdf  [5] MCA Notification dated June 29, 2017. Available at http://www.cci.gov.in/sites/default/files/notification/S.O.%202039%20%28E%29%20-%2029th%20June%202017.pdf  [6] SEBI Circular dated January 3, 2018. Available at https://www.sebi.gov.in/legal/circulars/jan-2018/circular-on-schemes-of-arrangement-by-listed-entities-and-ii-relaxation-under-sub-rule-7-of-rule-19-of-the-securities-contracts-regulation-rules-1957-_37265.html. [7] Press Information Bureau, Government of India, Ministry of Finance, “Department of Financial Services advises all Banks to take immediate steps to put restrictions on bank accounts of over two lakh ‘struck off’ companies”, http://pib.nic.in/newsite/PrintRelease.aspx?relid=170546 (September 5, 2017). [8] Live Mint, “Govt blocks bank accounts of 200,000 dormant firms”, http://www.livemint.com/Companies/oTcu9b66rZQnvFw6mgSCGK/Black-money-Bank-accounts-of-209-lakh-companies-frozen.html (September 6, 2017).  [9] MCA Notification vide S.O. No. 3086(E) dated September 20, 2017.  [10] Notification No. G.S.R. 1176(E) dated September 20, 2017. Available at http://www.mca.gov.in/Ministry/pdf/CompaniesRestrictionOnNumberofLayersRule_22092017.pdf[11] MCA Notification dated February 9, 2018. Available at http://www.mca.gov.in/Ministry/pdf/Commencementnotification_12022018.pdf [12] FEMA Notification dated March 20, 2018. Available at https://rbidocs.rbi.org.in/rdocs/notification/PDFs/CBM28031838E18A1D866A47F8A20201D6518E468E.pdf  [13] RBI Notification of changes to RBI regulations dated January 10, 2017. Available at https://rbi.org.in/scripts/NotificationUser.aspx?Id=10825&Mode=0 [14] Consolidated FDI Policy Circular of 2017. Available at http://dipp.nic.in/sites/default/files/CFPC_2017_FINAL_RELEASED_28.8.17.pdf [15] Section 33 of the Finance Act, 2018. Available at http://egazette.nic.in/writereaddata/2018/184302.pdf [16] CBDT Notification No. F. No. 370149/20/2018-TPL. Available at https://www.incometaxindia.gov.in/news/faq-on-ltcg.pdf Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. For further details, please contact the Gibson Dunn lawyer with whom you usually work or the following authors in the firm’s Singapore office: India Team: Jai S. Pathak (+65 6507 3683, jpathak@gibsondunn.com) Karthik Ashwin Thiagarajan (+65 6507 3636, kthiagarajan@gibsondunn.com) Prachi Jhunjhunwala (+65.6507.3645, pjhunjhunwala@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.

June 25, 2018 |
Gibson Dunn Transaction Named Private Equity Deal of the Year by The Deal

The Deal named “Kindred Healthcare Inc. – Humana Inc.; TPG Capital LP & Welsh, Carson, Anderson & Stowe” as its Private Equity Deal of the Year. Gibson Dunn was counsel to Guggenheim Securities, financial advisor to Kindred Healthcare in its sale to TPG Capital; Welsh, Carson, Anderson & Stowe; and Humana. The Gibson Dunn team included New York corporate partners Barbara Becker and Dennis Friedman.  The awards list was published on June 25, 2018.

May 17, 2018 |
Gibson Dunn Strengthens Private Equity and M&A Practices With Four Corporate Partners

Gibson, Dunn & Crutcher LLP is pleased to announce that George Stamas, Mark Director, Andrew Herman, and Alexander Fine have joined the firm as partners.  Stamas will work in the firm’s New York and Washington, D.C. offices, while Director, Herman and Fine will be based in the Washington, D.C. office and also will work regularly in the New York office.  They all join from Kirkland & Ellis, continuing their corporate, mergers and acquisitions and private equity practices. “We are delighted to add this distinguished team to the firm,” said Ken Doran, Chairman and Managing Partner of Gibson Dunn.  “George, Mark, Andrew and Alex are talented, highly regarded lawyers and energetic business developers.  They have strong contacts in the legal and business communities in D.C., New York and internationally.  Their addition will significantly strengthen our M&A, private equity and corporate practices not just on the East Coast but across the firm worldwide.” “Many of us here at Gibson Dunn have worked opposite of this group in a number of transactions, and we have the utmost respect for them,” said Stephen Glover, a partner in the Washington, D.C. office and Co-Chair of the M&A Practice Group.  “Our combined practice will create a D.C. corporate powerhouse that will firmly establish our position as a leader in high-end corporate and M&A.  In addition, their private equity and public company M&A experience will complement and expand our national and international practice.” “We are excited about the opportunity to join the firm,” said Stamas.  “We have long admired Gibson Dunn’s culture and collaborative approach to servicing clients.  We are committed to joining the team and further developing our practice together.  We wish the very best to our former colleagues, who we hold in high regard.” About George Stamas Stamas served as a senior partner in Kirkland & Ellis’ corporate practice group since 2002 and will continue to serve as a senior partner in Gibson Dunn’s New York and Washington, D.C. offices.  He focuses on public company and private equity M&A and corporate securities transactions.  He also counsels C-level executives and board of directors on corporate governance matters. Stamas has previously served as Vice Chair of the Board of Deutsche Banc Alex Brown, Inc.; as a founding board member of FTI Consulting (NYSE); as a venture partner of international venture capital firm New Enterprise Associates; and as a member of numerous public and private corporate boards. He is an executive board member of New York private equity firm MidOcean Partners.  He also is a board member of the Shakespeare Theatre Company and on the National Advisory Council of Youth Inc.  He is a co-founder of The Hellenic Initiative and a member of The Council on Foreign Relations. Stamas is also is a partner of Monumental Partners, which controls the Washington Capitals and Washington Wizards and is a partner of the Baltimore Orioles. He graduated in 1976 from the University of Maryland Law School, where he was a member of the International Law Review, and from 1977 to 1979, he served as special counsel to Stanley Sporkin in the Enforcement Division of the Securities and Exchange Commission. About Mark Director Director represents public companies and private equity sponsors and their portfolio companies in a broad range of transactions, including M&A, leveraged buyouts, spin-offs, minority investments and joint ventures.  He also advises boards of directors and corporate executives on corporate governance, public disclosure, securities reporting, and compliance and risk management matters. He is a member of the Society for Corporate Governance and the Board of Directors of Everybody Wins! DC, a children’s literacy organization.  He serves as Vice President and a member of the Board of Directors of Washington Hebrew Congregation. Director was a partner with Kirkland & Ellis since 2002.  Before that he served as Executive Vice President and General Counsel of publicly traded US Office Products Co. and of a private equity-owned telecommunications company.  He graduated cum laude in 1984 from Harvard Law School, where he was a member of the Journal on Legislation and worked with the Hon. Douglas H. Ginsburg (then a professor at Harvard) to co-author a casebook on the regulation of the electronic mass media. About Andrew Herman Herman’s practice focuses on advising private equity sponsors and their portfolio companies on leveraged buyouts, growth equity investments and other transactions.  He also advises public companies on M&A transactions, securities law compliance and corporate governance.  He is experienced in advising on the acquisition and sale of sports franchises. Herman joined Kirkland & Ellis in 2002 and became a partner in 2004.  He graduated in 1995 from Columbia University School of Law, where he was a Harlan Fiske Stone Scholar and the submissions editor of the Journal of Transactional Law.  He received a master’s degree with honors in accounting from the University of North Carolina, Chapel Hill in 1992.  Herman serves on the Board of Directors and chairs the Finance Committee at Adas Israel Congregation. About Alexander Fine Fine’s practice focuses on advising private equity sponsors and public companies on a wide range of transactional matters, including strategic M&A, leveraged buyouts, minority investments, and joint ventures.  He also advises clients on corporate governance and securities law matters. Fine was previously a partner with Kirkland & Ellis since 2010, and before that served as Executive Vice President and Corporate Counsel of Allied Capital Corporation. He graduated in 2000 from the University of Virginia School of Law where he was a member of the Order of the Coif and of the Editorial Board of the Virginia Law Review.

April 23, 2018 |
5 Factors Driving Private Equity In Asia

Hong Kong partner Scott Jalowayski and Hong Kong associate James Jackson are the authors of “5 Factors Driving Private Equity In Asia,” [PDF] published by Law360 on April 23, 2018.

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

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

March 20, 2018 |
Supreme Court Approves Deferential Review of Bankruptcy-Court Determinations on “Insider” Status

Click for PDF On March 5, 2018, the U.S. Supreme Court issued a decision in U.S. Bank N.A. Trustee, By and Through CWCapital Asset Management LLC v. Village at Lakeridge, LLC (No. 15-1509), approving the application of the clear error standard of review in a case determining whether someone was a “non-statutory” insider under the Bankruptcy Code. We note that the Court’s narrow holding only addressed the appropriate standard of review, leaving for another day the question of whether the specific test that the Ninth Circuit used to determine whether the individual was a “non-statutory” insider was correct. The ruling is significant, however, because without the prospect of de novo review, a bankruptcy court’s ruling on whether a person is a “non-statutory” insider will be very difficult to overturn on appeal—which may have significant impact on case outcomes. The Bankruptcy Code “Insider” The Bankruptcy Code’s definition of an insider includes any director, officer, or “person in control” of the entity.[1] This definition is non-exhaustive, so courts have devised tests for identifying other, so-called “non-statutory” insiders, focusing, in whole or in part, on whether a person’s transactions with the debtor were at arm’s length. Background In this case, the debtor (Lakeridge) owed money to two main entities, its sole owner MBP Equity Partners for $2.76 million, and U.S. Bank for $10 million. Lakeridge submitted a plan of reorganization, but it was rejected by U.S. Bank. Lakeridge then turned to the “cramdown” option for imposing a plan impairing the interests of non-consenting creditors. This option requires that at least one impaired class of creditors vote to accept the plan, excluding the votes of all insiders. As the debtor’s sole owner, MBP plainly was an insider of the debtor, within the statutory definition of Bankruptcy Code §101(31)(B)(i)–(iii), so its vote would not count. Therefore, to gain the consent of the MBP voting block to pass the cramdown plan, Kathleen Bartlett (an MPB board member and Lakeridge officer), sold MPB’s claim of $2.76 million to a retired surgeon named Robert Rabkin, for $5,000. Rabkin agreed to buy the debt owed to MBP for $5,000 and proceeded to vote in favor of the proposed plan as a non-insider creditor. U.S. Bank, the other large creditor, objected, arguing that the transaction was a sham and pointing to a pre-existing romantic relationship between Rabkin and Bartlett. If Rabkin were an officer or director of the debtor, Rabkin’s status as an insider would have been undisputed. But because Rabkin had no formal relationship with the debtor, the bankruptcy court had to consider whether the particular relationship was close enough to make him a “non-statutory” insider. The bankruptcy court held an evidentiary hearing and concluded that Rabkin was not an insider, based on its finding that Rabkin and Bartlett negotiated the transaction at arm’s length. Because of this decision, the Debtor was able to confirm a cramdown plan over the objection of the senior secured lender. The Ninth Circuit affirmed the bankruptcy court’s ruling, holding that that the finding was entitled to clear-error review, and therefore would not be reversed. The Supreme Court Holds That the Standard of Review Is Clear Error On certiorari, the Supreme Court, in a unanimous opinion, took pains to emphasize that the sole issue on appeal was the appropriate standard of review, and not any determination of the merits of the “non-statutory” insider test that the Ninth Circuit had applied to determine whether Rabkin was an insider. The Supreme Court held that the Ninth Circuit was correct to review the bankruptcy court’s determination for “clear error” (rather than de novo). The Court discussed the difference between findings of law—which are reviewed de novo—and findings of fact—which are reviewed for clear error. The question in this case—whether Rabkin met the legal test for a non-statutory insider—was a “mixed” question of law and fact. Courts often review mixed questions de novo when they “require courts to expound on the law, particularly by amplifying or elaborating on a broad legal standard.”[2] Conversely, courts use the clearly erroneous standard for mixed questions that “immerse courts in case-specific factual issues.”[3] In sum, the Court explained, “the standard of review for a mixed question all depends on whether answering it entails primarily legal or factual work.”[4] Choosing between those two characterizations, the Court chose the latter. The basic question in this case was whether “[g]iven all the basic facts found, Rabkin’s purchase of MBP’s claim [was] conducted as if the two were strangers to each other.”[5] Because “[t]hat is about as factual sounding as any mixed question gets,”[6] the Court held that the clear error standard applied. The Supreme Court Avoids Adjudicating a Potentially Significant Circuit Split on Tests Used to Determine Non-Statutory Insiders All nine of the justices joined Justice Kagan’s opinion. However, the concurring opinion from Justice Sonia Sotomayor (joined by Justices Anthony Kennedy, Clarence Thomas and Neil Gorsuch) suggests grave doubts about the coherence of the Ninth Circuit’s standard for assessing non-statutory-insider status. Nevertheless, Justice Sotomayor agreed that resolving the propriety of that standard is not a task that warranted the Supreme Court’s attention. Impact of US Bank While this case does not break new ground, it firmly establishes the bankruptcy courts’ authority to make these determinations and limits appellate review. This opinion may embolden appellants (and bankruptcy courts) to push the envelope in the future. Debtors may be emboldened to seek to use a variety of affiliate-transaction structures as they seek the keys to confirming cramdown plans over the objections of senior lenders.    [1]   11 U.S.C. § 101(31)(B)(i)–(iii).    [2]   Decision at p. 8.    [3]   Ibid.    [4]   Id. at p. 2.    [5]   Id. at p. 10.    [6]   Ibid. Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization practice group, or the following authors: Samuel A.  Newman – Los Angeles (+1 213-229-7644, snewman@gibsondunn.com) Daniel B. Denny – Los Angeles (+1 213-229-7646, ddenny@gibsondunn.com) Sara Ciccolari-Micaldi – Los Angeles (+1 213-229-7887, sciccolarimicaldi@gibsondunn.com) Please also feel free to contact the following practice group leaders: Business Restructuring and Reorganization Group: Michael A. Rosenthal – New York (+1 212-351-3969, mrosenthal@gibsondunn.com) David M. Feldman – New York (+1 212-351-2366, dfeldman@gibsondunn.com) Jeffrey C. Krause – Los Angeles (+1 213-229-7995, jkrause@gibsondunn.com) Robert A. Klyman – Los Angeles (+1 213-229-7562, rklyman@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.

March 5, 2018 |
Supreme Court Settles Circuit Split Concerning Bankruptcy Code “Safe Harbor”

Click for PDF On February 27, 2018, the U.S. Supreme Court issued a decision in Merit Management Group, LP v. FTI Consulting, Inc. (No. 16-784), settling a circuit split regarding the “safe harbor” provision in § 546(e) of the Bankruptcy Code.  That section bars the avoidance of certain types of securities and commodities transactions that are made by, to or for the benefit of covered entities including financial institutions, stockbrokers and securities clearing agencies. Circuits had split regarding whether the safe harbor protects a transfer that passes through a covered entity, where the entity only acts as a conduit and has no beneficial interest in the property transferred.  In Merit Management, the Court held that the safe harbor does not apply when a covered entity only acts as a conduit, and that the safe harbor only applies when the “relevant transfer” (i.e., the “overarching” transfer sought to be avoided) is by, to or for the benefit of a covered entity.  As a result, the Court held that the safe harbor did not protect a private securities transaction where neither the buyer nor the seller was a covered entity, even though the funds passed through covered entities. The Bankruptcy Code “Safe Harbor” The Bankruptcy Code permits a trustee to bring claims to “avoid” (or undo) for the benefit of the bankruptcy estate certain prepetition transfers or obligations, including claims to avoid a preference (11 U.S.C. § 547) or fraudulent transfer (11 U.S.C. § 548(a)).  Section 546(e) limits those avoidance powers by providing that, “[n]otwithstanding” the trustee’s avoidance powers, “the trustee may not avoid a transfer that is” (1) a “margin payment” or “settlement payment” “made by or to (or for the benefit of)” a covered entity, or (2) “a transfer made by or to (or for the benefit of)” a covered entity “in connection with a securities contract . . . or forward contract.”  11 U.S.C. § 546(e).  The sole exception to the safe harbor is a claim for “actual fraudulent transfer” under § 548(a)(1)(A).  Id. Background Merit Management involved the acquisition of a “racino” (a combined horse racing and casino business) by its competitor.  To consummate the transaction, the buyer’s bank wired $55 million to another bank that acted as a third-party escrow agent, which disbursed the funds to the seller’s shareholders in exchange for their stock in the seller.  The buyer subsequently filed for Chapter 11 bankruptcy protection and a litigation trust was established pursuant to the buyer’s confirmed reorganization plan.  The trustee sued one of the selling shareholders that received $16.5 million from the buyer, alleging that the transaction was a constructive fraudulent transfer under § 548(a)(1)(B) because the buyer was insolvent at the time of the purchase and “significantly overpaid” for the stock. The district court held that the safe harbor barred the fraudulent transfer claim because the transaction was a securities settlement payment involving intermediate transfers “by” and “to” covered entities (the banks).  The Seventh Circuit reversed, holding that the safe harbor did not apply because the banks only acted as conduits and neither the buyer nor the shareholder was a covered entity.  In so holding, the Seventh Circuit diverged from other circuits that had applied the safe harbor to transactions consummated through a covered entity acting as a conduit.[1]  Those circuits interpreted the disjunctive language in the safe harbor that protects transfers “by or to (or for the benefit of)” a covered entity to mean that a transfer “by” or “to” a covered entity is protected even if the transfer is not “for the benefit of” the covered entity.  The Supreme Court granted certiorari to settle the circuit split. The Supreme Court Holds That the Safe Harbor Does Not Protect a Transfer When a Covered Entity Only Acts as a Conduit   The Supreme Court affirmed the Seventh Circuit’s decision, holding that the safe harbor does not protect a transfer when a covered entity only acts as a conduit.  The crux of the decision is that a safe harbor analysis must focus on whether the “relevant transfer,” meaning the “overarching” or “end-to-end” transfer that the trustee seeks to avoid, was by, to or for the benefit of a covered entity.  Whether an intermediate or “component” transfer was made by or to a covered entity is “simply irrelevant to the analysis under § 546(e).”[2]  The Court reasoned that, as an express limitation on the trustee’s avoidance powers, § 546(e) must be applied in relation to the trustee’s exercise of those powers with respect to the transfer that the trustee seeks to avoid, not component transfers that the trustee does not seek to avoid.[3]  In the case before it, because the trustee sought to avoid the “end-to-end” transfer from the buyer to the shareholder, and neither was a covered entity, the safe harbor did not apply. The Court Avoids Adjudicating a Potentially Significant Defense The shareholder did not argue in the lower courts that the buyer or the shareholder was a covered entity.  In its briefing in the Supreme Court, the shareholder argued that the buyer and seller were both covered entities because they were customers of the banks that facilitated the transaction, and the definition of “financial institution” in 11 U.S.C. § 101(22)(A) includes a “customer” of a financial institution when the institution “is acting as agent or custodian for a customer.”  During oral argument, Justice Breyer indicated that he might have been receptive to that potentially dispositive argument.  However, the decision expressly avoids adjudicating the argument on the basis that the shareholder raised the point “only in footnotes and did not argue that it somehow dictates the outcome in this case.”  Id. at n. 2.  As a result, the “customer-as-financial-institution defense” will likely be litigated in the lower courts going forward. Impact of Merit Management As a result of Merit Management, parties to securities and commodities transactions should expect that, in the event of a bankruptcy filing, the safe harbor will not protect a transaction unless the transferor, transferee or beneficiary of the “overarching” transfer is a covered entity.  Routing a transfer through a covered entity will no longer protect the transaction.  Given the increased importance placed on whether a party to the overarching transfer is a covered entity, Merit Management may lead to a new wave of litigation regarding the scope of the covered entities, including the circumstances in which the customer of a financial institution constitutes a covered entity, and related planning strategies to fall within such scope.    [1]   See, e.g., In re Quebecor World (USA) Inc., 719 F. 3d 94, 99 (2d Cir. 2013); In re QSI Holdings, Inc., 571 F. 3d 545, 551 (6th Cir. 2009); Contemporary Indus. Corp. v. Frost, 564 F. 3d 981, 987 (8th Cir. 2009); In re Resorts Int’l, Inc., 181 F. 3d 505, 516 (3d Cir. 1999); In re Kaiser Steel Corp., 952 F. 2d 1230, 1240 (10th Cir. 1991).    [2]   Decision at p. 14.    [3]   See id. at pp. 11-14 (“If a trustee properly identifies an avoidable transfer . . . the court has no reason to examine the relevance of component parts when considering a limit to the avoiding power, where that limit is defined by reference to an otherwise avoidable transfer, as is the case with §546(e). . . .”). Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization practice group, or the following authors: Oscar Garza – Orange County, CA (+1 949-451-3849, ogarza@gibsondunn.com) Michael A. Rosenthal – New York (+1 212-351-3969, mrosenthal@gibsondunn.com) Douglas G Levin – Orange County, CA (+1 949-451-4196, dlevin@gibsondunn.com) Please also feel free to contact the following practice group leaders: Business Restructuring and Reorganization Group: Michael A. Rosenthal – New York (+1 212-351-3969, mrosenthal@gibsondunn.com) David M. Feldman – New York (+1 212-351-2366, dfeldman@gibsondunn.com) Jeffrey C. Krause – Los Angeles (+1 213-229-7995, jkrause@gibsondunn.com) Robert A. Klyman – Los Angeles (+1 213-229-7562, rklyman@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.

March 1, 2018 |
To Form an Entity or Not to Form an Entity, That Is the Question; Deciding Between an Entity Joint Venture and a Contractual Strategic Alliance

Click for PDF People often speak of forming a joint venture as if the meaning of the term “joint venture” is self-evident.  However, the term “joint venture” can be used to describe a wide array of arrangements between two or more parties.  The universe of these arrangements can be divided into two broad categories: joint ventures that are implemented solely through contractual arrangements, which we refer to as “Contractual JVs,” and those in which the parties jointly own one or more entities, which we refer to as “JV Companies.”  Therefore, one of the first questions that the parties and their counsel should consider when developing the joint venture structure is “Will the joint venture be solely contractual or will the parties each own a stake in one or more legal entities that conduct the joint venture business?” A JV Company Is a Substantial Undertaking Establishing a JV Company offers a number of advantages that may be difficult to achieve through a Contractual JV.  For example, a JV Company may make it easier for the parties to share assets to be used in the venture business, manage liability risks associated with the business and establish a management team that is focused solely on the venture.  But establishing a JV Company may also be significantly more complex than forming a Contractual JV; this complexity may make a JV Company more expensive and burdensome for the venture parties than a Contractual JV. Some of the reasons for the additional complexity include the following: Additional Negotiation and Documentation: In addition to agreeing on the economic terms of the joint venture, the parties have to negotiate and document the governance arrangements of the JV Company, their obligations to make contributions to, and rights to receive distributions from, the JV Company, and the terms and conditions under which a party may exit the joint venture, such as through a transfer of joint venture company equity or a sale of the JV Company. Operational Burdens: Operating a JV Company imposes burdens on the parties that they may not have in connection with a Contractual JV.  Among other requirements, the JV Company may have to obtain required licenses and permits, design and implement internal controls and procedures, produce its own financial statements, maintain its corporate existence and books and records separate from those of the parties and, as noted below, employ a workforce, appoint officers and retain a managing board.  These burdens will increase both the time and expense required to run the joint venture. Governance Issues: Depending on the governance structure of the JV Company, the management decision-making process can also be much more involved than in a Contractual JV.  The parties must develop and implement mutually agreeable governance arrangements, potentially at the board and senior management levels, and each party must devote time to overseeing the venture.  Procedural requirements, for example, requirements for calling and conducting board or member meetings and taking board or member action, must be complied with or waived.  As the number of members of the joint venture with governance rights increases, so does the potential complexity of the JV Company’s governance arrangements as well as the potential for disputes about decisions the board and/or the members must make. Issues Associated with Terminating and Unwinding the Venture:  Terminating a joint venture structured as a JV Company may be more complicated than terminating a Contractual JV.  Unless the JV Company will be sold to a third party, the venture parties must decide what to do with the JV Company itself, how to provide for its liabilities and how any remaining JV Company assets will be distributed among the parties.  For example, will tangible assets be returned to the party that contributed them to the JV Company? Who will receive and/or be entitled to use any JV Company intellectual property? If the venture business will not be continued by one of the parties, they must wind it down and take any related required actions, such as terminating the JV Company’s employees, notifying the JV Company’s creditors, etc. It is important to note that the factors outlined above are generalizations, and this discussion is not intended to suggest that Contractual JVs are inevitably simpler than JV Companies, or that formation and structuring issues arising in connection with Contractual JVs are more easily resolved than those involving JV Companies.  Contractual JVs may present issues and impose burdens on the venture parties similar to those described above.  For example, the various contractual arrangements necessary to manage a complex Contractual JV can look like, and be just as difficult as, governance of a JV Company, with each party appointing representatives to a managing board that oversees the venture business.  Similarly, terminating a Contractual JV can raise issues like those implicated by terminating a JV Company if the parties’ business operations are significantly intertwined. Deciding between a JV Company or a Contractual JV The following list of questions is intended to help potential venture parties evaluate whether a JV Company or a Contractual JV is the best way to achieve their joint venture goals.  It may also help the parties identify areas where they have differing views about the proposed joint venture.  It is neither an exhaustive list nor one that can always be ticked through in a linear fashion as many of these considerations are related and/or address overlapping issues. Scope of the joint venture: Will the joint venture operate a stand-alone, self-sustaining business with many moving parts, such as designing, manufacturing and selling products all over the world, or will it have a simpler purpose, such as supplying a particular product or service to one of the parties?  Will the venture business be large in scope, or relatively small? The more complicated and expansive the enterprise, the more likely it is that a JV Company structure will be appropriate.  The simpler the purpose of the joint venture, the more likely it is that it can be structured as a Contractual JV. Need for significant investment:  Will the joint venture require significant capital expenditures or investment to be funded by contributions from both parties, for example, to conduct research, build facilities or purchase equipment?  If yes, it may make sense for a JV Company to own the assets that are created with this investment. New line of business, products or markets:  Do the parties plan to pool their respective resources and/or combine complementary assets to develop a new business (i.e., one that no party currently engages in)?  As was discussed above in “Need for Significant Investment,” if joint efforts are required to create a new business, it may make sense to establish a JV Company through which the parties can jointly own the venture business. Role of the parties:  Do both parties expect to have significant input into management decisions regarding the joint venture business?  If yes, it may be easier for the parties to provide such input if the venture business is run by a JV Company, rather than by one of the parties in a Contractual JV. Need for dedicated management team:  Will the venture business be sufficiently complex that it should be managed by a separate team focused only on the venture business, rather than by managers who are juggling responsibilities to the joint venture and one of the parties?  Will the joint venture benefit from a separate compensation structure tied to performance of the venture business to incentivize the management team?  If the answer to either question is yes, then this would support a decision to establish a JV Company. Need for separate employee base:  Will the joint venture need employees who are focused solely on the venture business?  Or can the venture business be run just as, or more, efficiently by employees of one or more parties?  If the former, this fact would support establishing a JV Company.  If the parties are contemplating transferring employees to the JV Company, they should also consider the willingness of their employees to work for the JV Company.  Employees may be reluctant to leave an established company to work for an unproven one. Intellectual property considerations:  Will the joint venture develop intellectual property to be used primarily in its business, such as new product designs or trademarks, and/or will the parties contribute certain existing intellectual property to the joint venture?  If yes, the parties may wish to form a JV Company to control these intellectual property assets, maintain applicable intellectual property registrations and otherwise protect the joint venture’s intellectual property rights.  However, a JV Company may not be required if new intellectual property is not needed for the joint venture business, or if the intellectual property to be used in the joint venture will be owned and controlled solely by one party. Liability concerns:  Will the joint venture business generate significant liability risk?  If yes, the parties may want to own the business through a JV Company to help develop a liability shield. Foreign law concerns: Will the joint venture operate in a jurisdiction that curtails foreigners’ rights to conduct certain businesses or own property?  For example, Canada restricts the ability of non-Canadians to own and control Canadian telecommunications carriers.  China limits the percentages of businesses in the financial sector, such as banks, securities firms and insurers, that foreigners may own.  If such restrictions will prevent one of the parties from owning the venture business, a Contractual JV may be the more attractive option. Ability to transfer assets to the venture:   If the venture business requires the use of assets owned by the parties, can these be transferred easily?  If there are encumbrances preventing the transfer of these assets, such as pledges to creditors, a Contractual JV may be a better choice. Regulatory issues:  Is the venture business in a highly regulated industry?  Does it require licenses that cannot be transferred, specialized employees and/or substantial infrastructure designed to ensure compliance with applicable laws?  If yes, and one of the parties already has such licenses, employees and/or infrastructure, it may be desirable for that party to continue to run the business, rather than transfer it to a new company. Strategic objectives:  What are the parties’ respective strategic objectives?  Does the venture represent an opportunity for one party to learn about a new business?  Or for a party to gain access to new funding, technology or markets?  In some cases, it may be easier for a party to achieve a strategic goal if a JV Company is established.    For example, let’s assume that the venture will be the sole supplier of raw materials to one of the parties.  That party may want the venture business to be contributed to a JV Company so the party can exercise more control over the business and have the option to buy out the other party in the event of any dispute between them.  Another example is an arrangement under which one party will adapt technology developed by the second party for use in the first party’s business.  In this context, it may make sense for the first party and the second party to form a JV Company, because joint ownership of the enterprise may make it easier for the first party to learn about the technology and control its commercialization. Term of the joint venture:  Do the parties expect the joint venture to have an extended or indefinite life?  Or is the venture being formed to take advantage of a short-term opportunity?  If the joint venture is expected to have an extended life, a JV Company may be the better choice. Exit plans:  Do the parties have a specific plan for how they will exit or terminate the joint venture?  For example, do they envision growing the venture business for several years and then selling it to a third party or taking the business public?  Is one party hoping that it can eventually buy out the other party’s interest?  Is the other party hoping that it can exit the business after participating in the joint venture for a period of time?  In these circumstances, it may be easier to develop exit plans if the parties establish a JV Company. Tax Considerations Tax planning is a critical element of venture planning, and parties would be well-advised to involve tax counsel as early as possible in the venture planning process.  Parties that form a Contractual JV should be aware of the risk that a Contractual JV may be treated as a separate entity for federal income tax purposes.  Generally, an arrangement under which the participants jointly conduct a business and share profits and losses will be treated as a partnership under the Internal Revenue Code.  (If a Contractual JV is such an arrangement, the parties can elect to treat the arrangement, i.e., the Contractual JV, as a corporation instead of a partnership for federal income tax purposes.)  Factors that courts consider when evaluating whether a Contractual JV is a partnership for federal income tax purposes include, among others, each party’s contributions to the venture, who controls income and withdrawals, if the venture is conducted in the joint names of the parties and if the parties have mutual control over the venture.  Significantly, if a Contractual JV is treated as a separate entity for federal income tax purposes, there is also a risk that a party’s activities that the parties do not consider to be part of the venture are nonetheless treated as part of the Contractual JV for federal income tax purposes.  These risks may result in unintended tax consequences.  In contrast, forming a JV Company provides certainty about what activities will be treated as part of the venture, and such certainty will make tax planning easier. By bringing more certainty to the taxation of the venture, the creation of a JV Company may also offer more opportunities for tax planning than a Contractual JV.  This is particularly the case in the cross-border context; if the venture will involve operations in multiple countries, it may be advisable to form multiple local-country entities to manage their tax liability.  Moreover, recent changes to the tax law, particularly those changes impacting the taxation of non-US income earned by US taxpayers, require particular attention.  Conclusion The decision whether to establish a JV Company or a Contractual JV is not always easily made.  There is no formula that can be applied to produce the right result.  Although the answers to the questions posed above do not invariably dictate whether a JV Company or a Contractual JV will be the best structure, they may provide valuable insight.  In some instances, one approach will have clear advantages over the other.  However, in most situations, the parties will be able to be accomplish their objectives through either a JV Company or a Contractual JV.  In these cases, the parties must balance a number of potentially competing considerations, and then make a judgment call. Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues. For further information, please contact the Gibson Dunn lawyer with whom you usually work or the authors of this alert: Stephen I. Glover – Washington, D.C. (+1 202-955-8593, siglover@gibsondunn.com) Eric B. Sloan – New York (+1 212-351-2340, esloan@gibsondunn.com) Alisa Babitz – Washington, D.C. (+1 202-887-3720, ababitz@gibsondunn.com) Please also feel free to contact any of the following practice group leaders: Mergers and Acquisitions Group: Barbara L. Becker – New York (+1 212-351-4062, bbecker@gibsondunn.com) Jeffrey A. Chapman – Dallas (+1 214-698-3120, jchapman@gibsondunn.com) Stephen I. Glover – Washington, D.C. (+1 202-955-8593, siglover@gibsondunn.com) Private Equity Group: Sean P. Griffiths – New York (+1 212-351-3872, sgriffiths@gibsondunn.com) Steven R. Shoemate – New York (+1 212-351-3879, sshoemate@gibsondunn.com) Ari Lanin – Los Angeles (+1 310-552-8581, alanin@gibsondunn.com) Charlie Geffen – London (+44 (0)20 7071 4225, cgeffen@gibsondunn.com) Scott Jalowayski – Hong Kong (+852 2214 3727, sjalowayski@gibsondunn.com) Tax Group: Art Pasternak Washington, D.C. (+1 202-955-8582, apasternak@gibsondunn.com) Jeffrey M. Trinklein – London/New York (+44 (0)20 7071 4224/+1 212-351-2344), jtrinklein@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

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

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